F5 PM ALL in One Technical Articles

ALL F5 (PM) TECHNICAL ARTICLES
(2021)
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Performance Management (PM) was previously known as F5 Performance

Management. All technical articles listed as F5 can be used for studying PM.
Performance Management (PM)
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Performance Management (PM)

Pricing 1: Theoretical aspects
This article deals with the theoretical aspects of pricing and a second article deals with practical pricing.
Pricing 2: Practical aspects

This article deals with practical pricing approaches.
Balanced scorecard
For a profit-seeking company, sustained financial success and long-term shareholder value are the ultimate objectives and the
balanced scorecard suggests how this might be achieved.
Big data 1: What is big data?

Big data is part of the Performance Management syllabus. But what exactly is big data?
Big data 2: How companies use big data

This article will describe some real life examples of the use of big data for performance management and measurement purposes.
Relevant costs
This article looks at relevant costs, which can be defined as any cost relevant to a decision.
Information systems
o x
Information systems (IS) is a topic you need to be ready for in all sections of the Performance Management exam. The examiner
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reports state that students regularly overlook this area of the syllabus, so make sure you cover it during your studies.
Tackling performance evaluation questions

b a
l o
Performance evaluation is a regularly examined requirement in the Performance Management exam, and is a topic that students
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tend to misunderstand and struggle with. This article provides advice on successfully tackling this type of question, working
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through an approach for planning and answering this requirement, looking at common mistakes and tips on how to avoid them.
C
A C
Building blocks of performance management
Performance management – the processes that ensure organisations meet their objectives – is core to the Performance
Management syllabus, and understanding modern performance measurement systems is an important area within this topic. This
article reviews the importance of the modern approach to performance measurement, discusses the Building Block model, and
applies this model to an exam-based scenario.
Decentralisation and the need for performance measurement

This article focuses on a classic performance measurement question, which involves a combination of financial and non-financial
analysis.
Transfer pricing
The purpose of this article is to strip transfer pricing back to the basics and consider, first, why transfer pricing is important;
secondly, the general principles that should be applied when setting a transfer price; and thirdly, an approach to tackle exam
questions in this area, specifically the question from June 2014’s exam.
Activity-based costing
ABC undoubtedly requires an organisation to spend time and effort investigating more fully what causes it to incur costs, and then
to use that detailed information for costing purposes.
Target costing and lifecycle costing

An explanation of target costing and lifecycle costing, with examples as to how and when you would use these costing
techniques.
Throughput accounting and the theory of constraints – part 1

In the first of two articles, we look at the basic principles of the theory of constraints and throughput accounting.
Throughput accounting and the theory of constraints – part 2

A follow-up to the first part of this article featuring a discussion on the five focusing steps of the theory of constraints, with examples
of how these steps might be applied in practice or in the exam.
Environmental management accounting

Also available as a podcast on iTunes
Environmental management accounting is part of the Performance Management syllabus and requires students to describe the
issues businesses face in managing environmental costs, and the different methods they may use to account for these.
Cost-volume-profit analysis
Cost-volume-profit analysis allows a business to find its break-even point.
Linear programming
A simple example to illustrate the decision-making technique of linear programming.
The risks of uncertainty

Decisions, decisions – risk, probability and potential outcomes unravelled.
Decision trees
The addition of decision trees to the Performance Management syllabus is a relatively recent one. This article provides a step-by-
step approach to decision trees, using a simple example to guide you through.
All about budgeting - part 1, part 2, part 3, part 4, part 5 This series of articles covers the budgeting approaches flexible budgeting,
activity-based budgeting, rolling budgeting, zero-based budgeting, and beyond budgeting.
Comparing budgeting techniques (incremental v ZBB) in the public sector

Also available as a podcast on iTunes
This article critically evaluates the two main methods for preparing budgets - the incremental approach and the zero-based
approach.
The learning rate and learning effect

The purpose of this article is to summarise the history of the learning curve effect and help candidates understand why it is
important, as well as looking at what past learning curve questions have required of candidates and to clarify how future questions
may go beyond this.
Materials mix and yield variances

This article explains the theory behind mix and yield variances, and provides examples of how to use them in an exam.
Not-for-profit organisations – part 1

The first part of the article broadly describes the generic characteristics of not-for-profit organisations.
Not-for-profit organisations – part 2

The second part of the article takes a specific and deeper look at charities, which are one of the more important types of not-for-
profit organisations.
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ricin The retical as ects
Home / Students / Study resources / Performance Management (PM) / Technical articles / ricin Theoretical aspects
Section C (4) of the Performance Management syllabus deals with pricing decisions and this topic can be conveniently divided
into two parts:
• Theoretical approaches involving some relatively simple mathematics and microeconomics. These methods require accurate
economic information about how a product’s sales volume is affected by its selling price.
• Practical approaches which are likely to be more applicable to the many businesses that do not have the detailed economic
information referred to above.
This article deals with the theoretical aspects of pricing and a second article deals with practical pricing.
emand curves
Demand curves show the relationship between the price per unit of a product, P, and the quantity of units sold, Q. In your exam you
will be dealing with demand curves which are simplified and which can be represented by straight rather than curved lines.
They are always drawn with Q on the horizontal axis and P on the vertical axis. For example, here is a table showing price and
quantity and the corresponding demand curve:
The demand line slopes downwards showing that as the price decreases the quantity sold increases. You can see from both the
table and the graph that for every 20 decrease in price, the quantity sold increases by 1,000 units
At a price of 1 0 all demand is extinguished and at a price of 0 a maximum of 9,000 units could be sold’. You might be able to
see that at a price of 1 0 revenue will be zero as no items are sold. At a price of 0 revenue will also be zero as no charge is
made for the products.
The revenue can also be plotted by calculating Price x Quantity at each level:
So, revenue rises then falls, hitting a maximum at between 4,000 and 5,000 units sold.
On the left-hand part of the revenue curve, as the selling prices fall from 160 to 140, to 120 etc and quantity sold rises from 1,000 to
2,000 to 3,000, revenue increases: the increases in quantity outweigh the decreases in price. In this area, demand is said to be
elastic as a relatively small proportional decrease in price causes a relatively large proportional increase in volume and so
revenue increases
On the right-hand part of the revenue curve, as the selling prices fall from 0 to 60, to 40 etc and quantity sold rises from 5,000 to
6,000 to ,000, revenue decreases: the increases in quantity are outweighed the decreases in price being applied to all units. In
this area, demand is said to be inelastic as a decrease in price causes a relatively small increase in volume and so revenue
decreases.
The definition of the price elasticity of demand is:
It is usual to omit the minus signs so the two elasticities are 3.5 and 0.3.
If the price elasticity of demand is greater than 1 then demand is elastic. This is so on the left-hand part of the revenue curve. If the
price elasticity of demand is greater than one then a drop in price is more than compensated by the increase in volume and
revenue increases.
If the price elasticity of demand is less than 1 then demand is inelastic. This is so on the right-hand part of the revenue curve. If the
price elasticity of demand is less than one then a drop in price is not compensated by the increase in volume and revenue
decreases.
If the elasticity of demand is exactly 1 then any change in price is precisely compensated for by an increase in volume and the
revenue stays constant. This is what is happening at the small section at the very top the revenue curve. Where the line changes
from increasing to decreasing.
Marginal revenue
Associated with the elasticity of demand is the concept of marginal revenue, which is the change in revenue when one extra unit is
sold. If figures for one extra unit are unavailable the marginal revenue for (say) 10, 100 or 1,000 extra units can be used instead.
If you look again at the revenue curve, you can see that on its left side, revenue is increasing as more units are sold. The marginal
revenues will be positive here. At the earlier, steep part of the curve, revenue is increasing quickly as each extra 1,000 units are
sold: marginal revenue will be high. The steepness declines as you move along the curve until at the top the marginal revenue will
be zero (no change in revenue) then the revenue line starts to fall meaning that for each 1,000 units revenue decreases and
marginal revenue is negative.
High positive marginal revenue implies a high price elasticity of demand ( 1). A negative marginal revenue implies a low elasticity
of demand ( 1).
The marginal revenues can be worked out from the table as follows:
uantity Price per unit Revenue Marginal

P
0 1 0 0
1,000 160 160 160
2,000 140 2 0 120
3,000 120 360 0
4,000 100 400 40
5,000 0 400 0
6,000 60 360 -40
,000 40 2 0 - 0
,000 20 160 -120
9,000 0 0 -160
The marginal revenue is obtained by calculating the increase in revenue for each increment in volume. Thus at 4,000, the marginal
revenue, MR 400 – 360 40.
o
You will see that MR starts large and positive, decreases, then turns negative indicating that as more units are sold revenue x
actually decreases because the drop in price needed to sell more units outweighs the extra units sold.
l B
b a
Profit maximisation
G lo
To calculate profits, costs as well as revenues have to be taken into account. You will usually be dealing with a simple cost
function:
C A
Total costs Fixed costs
A C
( ariable cost per unit x Quantity sold)
Say that for this example, fixed costs are 50,000 and the variable cost per unit is 65, then
Costs 50,000 (65 x Quantity)
Costs can be added to the table as follows as can profit, being the difference between total revenue and total costs:
uantity Price per unit Revenue Costs Profit

Marginal revenue
P
0 1 0 0 50 -50
1,000 160 160 160 115 45
2,000 140 2 0 120 1 0 100
4,000 100 400 40 310 90
5,000 0 400 0 3 5 25
6,000 60 360 -40 440 - 0
,000 40 2 0 - 0 505 -225
,000 20 160 -120 5 0 -410
9,000 0 0 -160 635 -635
You can see that profit is maximised when the selling price is 120, generating sales of 3,000, revenue of 360,000 and costs of
245,000.
sing a table in this way and calculating the profit at each quantity sold is known at the Accountant’s approach. The Economist’s
approach is different. Economists argue that as each extra unit is sold if the extra revenue generated (the marginal revenue, MR)
exceeds the extra costs incurred (the marginal costs, MC), then it is worth making that item. However, if ever MC MR it means
that selling the extra unit will lose money as the additional costs are greater than the additional revenue.
So long as MR MC, make and sell the unit; if MC MR don’t make and sell that unit.
Profit is therefore maximised when:
The table below now also shows the marginal costs:
uantity Price per unit Revenue Costs Profit

Marginal revenue Marginal cost
P
0 1 0 0 50 -50 50
1,000 160 160 160 115 45 65
2,000 140 2 0 120 1 0 100 65
4,000 100 400 40 310 90 65
5,000 0 400 0 3 5 25 65
6,000 60 360 -40 440 - 0 65
,000 40 2 0 - 0 505 -225 65
,000 20 160 -120 5 0 -410 65
9,000 0 0 -160 635 -635 65
You can see that the marginal costs are constant at 65,000 per extra 1,000 units and this is simply the extra variable costs of 65
per unit.
Moving from 1,000 units to 2,000 units generates an extra 120,000 revenue for additional costs of 65,000. So, worthwhile.
Moving from 2,000 units to 3,000 units generates an extra 0,000 revenue for additional costs of 65,000. So, worthwhile.
Moving from 3,000 units to 4,000 units generates an extra 40,000 revenue for additional costs of 65,000. So, not worthwhile. Nor
is it worthwhile increasing quantity any further.
When MR MC, sell more. When MR MC sell less. Profits are maximised when MC MR.
Therefore, as before when we looked directly at profits, we have identified that sales of 3,000 units will be where profits are
maximised and these sales will be generated if the selling price is set at 120.
he alge raic approach
The problem with the tabular approach used above is that it only looked at the data in increments of 1,000 units. That allowed us to
conclude that profit was maximised when 3,000 units were sold. But could profits be better if, say, sales were 2,900, 3,010 or 3,100
units? We have no information in the table that allows the advice to be refined.
To obtain greater accuracy instead of relying on tables, the relationship between quantity and price has to be described by an
equation. The equation will be of the form:
P a - bQ
Where P price per unit and Q quantity sold. a and b are constants that have to be found using the demand curve data. This
formula is supplied in the PM exam.
We know from the table that at a price of (say) 140, 2,000 units are demanded. So:
140 a – b x 2,000
Moving to the previous quantity level, when Q 1,000, P 160. So:
160 a – b x 1,000
a and b are then found by simultaneous equations. Subtracting the two equations gives:
-20 -b x 1,000
So b 20/1,000 0.02
Put that information into either of the two original equations to find a. So the first equation becomes:
140 a – 0.02 x 2,000 a – 40
a 1 0.
The demand curve is therefore
P 1 0 – 0.02Q
Note that the formula sheet gives a simple way of finding a and b if the required information is supplied:
a price when Q 0. From the table this is 1 0
b change in price/change in quantity. For each increment of the table price changes by 20 and the quantity changes by 1,000, so
b 20/1,000 0.02
The formula sheet also shows how to convert the demand curve equation to an equation for the marginal revenue.
Demand curve: P a – bQ P 1 0 – 0.02Q
MR: MR a – 2bQ MR 1 0 – 0.04Q
We know that the marginal cost per unit is 65, the variable cost per unit. Profit is maximised when
MC MR
65 1 0 – 0.04Q
Solving for Q:
-115 -0.04Q
115 0.04Q
Q 115/0.04 2, 5
You will see that this is slightly less than our previous answer of 3,000. What’s happened is that as output increases from 2,000 to
3,000, the early additional units (2,001, 2,002 etc) are worthwhile but later ones are not (2,99 , 299 , 2,999, 3,000). However, all
of this detail is lost and in total moving from 2,000 to 3,000 is worthwhile. Moving from 2,000 to 2, 5 is even better.
Now used this quantity figure in the original demand curve equation to work out the selling price.
P 1 0 – (0.02 x 2, 5)
P 122.5
So, using the algebraic approach, profits will be maximised when 2, 50 units are sold and these sales will be generated if the
selling price is set at 122.50.
The second article on pricing will deal with more practical aspects of pricing decisions.
ritten en arrett a freelance lecturer and riter

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ricin ractical as ects
Home / Students / Study resources / Performance Management (PM) / Technical articles / ricin ractical aspects
This first article in this series dealt with the theoretical aspects of pricing. This one deals with practical pricing approaches.
he influences on product pricing
The influences on pricing decisions are often listed as:
• Cost – the selling price should cover the cost of production. Costs can be calculated in a number of different ways: marginal
cost, total absorption cost, lifecycle cost and relevant cost. A cost-plus approach is then used so that a mark-up is added to the
cost to produce a price. No company would ignore a cost-plus approach but as we will see it will not always give the best
answers to pricing decisions.
• Customers – what are they prepared to pay for the product? In effect this relates to the price elasticity of demand for the product
and its demand function as explained in the first article. If costs are too high, no-one will buy products – or not in a high enough
volumes.
• Competitors – Are there any? What is the strength of competition? What are they charging? If many competitors are selling
very similar products then companies have little flexibility in their pricing: all have to fall in line with the current market price. If a
company is a monopoly supplier, it has much more freedom to choose its selling price. Note that monopolists are not
guaranteed to make a profit: they might be trying to sell a product no-one wants.
There are a nu er of different approaches to pricin hich a co pan can adopt. n the rest of this article e ill look at
these different approaches.
Cost ased pricing
ar inal cost
If the marginal cost for a product was 120, and the company had a policy of adding a mark-up of 25 then the selling price would
be 150. That would generate a contribution of 30/unit. Whether the total contribution covers fixed costs so that the company
breaks into profit depends on the fixed costs and the volume sold.
There is no point in setting a selling price below variable cost unless the company were contractually obliged to (for example,
costs rose after the sales contract was signed) or the company was prepared to lose money initially to break into a new market eg
promotional discounts.
Total a sorption cost

If the marginal cost was 120, and the fixed overhead absorption rate were 40 per unit then the total absorption cost is 160.
Adding a mark-up of 20 would give a selling price of 192. That would generate a potential profit of 32/unit.
An advantage of this approach is that if the product was not selling well at 192 the company could consider lowering the price. If it
wanted to keep a mark-up of 20 , it would have to find ways of lowering the 160 cost of the product. The total absorption cost
contains both variable and fixed costs, therefore the company is unlikely overlook the importance of trying to reduce fixed
production costs as well as reducing variable production costs.
ifec cle costin

Lifecycle costing takes in to account all costs over a product’s life: pre-production costs, production costs and post-production
costs. In the long run, the total revenue generated by a product should be no less than the total costs needed to design, make and
close down the product’s production.
For example:
Initial design costs and production line machinery purchase 2m
ariable production costs and the fixed costs incurred over the product’s life 10m
Production close-down costs (eg clean-up costs potential redundancy costs - machinery scrap value) 1m
So, the lifetime cost of the product is 13m.
If the company estimated that it will make and sell 2 million units of the product, the lifetime cost per unit will be 6.50 and if a long-
term profit is to be made the selling price must be set above that.
Lifecycle costing emphasises the importance of taking all costs into account to try to ensure that these are covered by the decision
to embark on the production of a new product. In particular it can draw attention to the importance of the up-front costs as spending
more on product design might save much more during subsequent production. This would lower the overall life-time costs and
allow a profit to be made at a lower, more attractive selling price.
ele ant costin

Relevant costing uses relevant cash flows to assess the cost of the product or contract. These are future cash flows caused by
making the product or entering the contract.
For example, a contract required the use of:
1. Components currently in inventory which had cost 12,000. They are not currently used in the business, but they could be sold
for 10,500.
2. New components that must be bought for 15,000.
3. An additional member of staff for one year with a 20,000 salary.
4. Currently idle staff who would be set to work on the new contract - 16,000 salary.
o x
These items would be handled as follows:
l B
b a
1. 12,000 is a sunk/past cost and is irrelevant. However, the company does lose out on an inflow of 10,500 if the components
lo
are used instead of being sold. This is a relevant cost for the contract.
G
2. This is relevant. It is an additional cash outflow caused by the contract.
C A
3. This is relevant. It is an additional cash outflow caused by the contract.
4. This is irrelevant as it has no incremental cash flow effect. The staff are being paid and will continue being paid, but they will
C
simply be asked to spend time working on the new contract.
A
The total relevant cost is therefore: 10,500 15,000 20,000 45,500.
This represents the minimum price that should be demanded for the contract. Any amount less than this and the company would be
worse off.
The big flaw in all cost-plus based approaches to pricing is that simply because there is a mechanism for arriving at a selling price
does not mean that any units at all will sell at that price. The company could be very inefficient so that costs and resulting selling
prices are so outrageously high that no customers will buy the goods. Even if the resulting prices are not very high, competitors
might be offering the goods at a lower price.
All cost-based methods are entirely inward-looking and pay no attention to customers or competitors. The approach is simple to
apply and is often used in practice, but the company must look at the price it has arrived at and consider if it is realistic.
It is also worth noting that using costs to determine prices might n e esti ate a viable selling price. For example, a cotton t- shirt
might cost 3 to make but if a fashionable brand’s logo can be sewn on to it the potential selling price will be hugely boosted by the
brand association even though the logo costs next to nothing to apply. sing a cost-plus approach in this case would set a lower
selling price than customers would be willing to pay.
Price skimming and penetration pricing
Price skimming is when a new product is launched at a very high price. The seller assumes that there will be enough customers
who are willing to pay a lot to be one of the first to have the product. At the early stages of a new product launch output is often
limited so high prices with low volume makes sense. Eventually, the price is lowered to skim off another layer of customers. The
price is quickly forced down until it reaches a stable level. This approach is common in the mobile phone and technology markets.
In contrast, penetration pricing means going into the market with an aggressively low price. The aim is to win a large market share
and to sell large volumes. Large volumes can lead to low unit costs (for example, fixed costs are spread more thinly) and this can
allow the company to make profits even at low prices. Indeed, the market domination achieved can make it difficult for new
competitors to enter the market because they may find it difficult to match the market leader’s economies of scale needed to earn
profits at a low selling price.
Complementary product pricing
The initial product is sold at a low price to attract customers. Having enticed the customer to buy the initial product, subsequent
training, maintenance and consumables are sold at relatively high prices.
An example is seen in ink-jet printers: cost of the printer 0; cost of a set of replacement ink cartridges 30
Most profits are made on the follow-up sales rather than the initial product.
Product line pricing
A product-line is a group of products from a manufacturer that are similar in design, functionality and target customer. They present
a range of features and different prices. For example:
• Mobile phones: different screen sizes, resolutions, speed and camera resolutions.
• Cars: different engines, paint quality, interior fittings.
• Hotel rooms: different sizes of room, different types of bed, suites, rooms with or without a view.
The advantages of product-line pricing are:
• Buyers can adjust their purchases to suit their pocket and their requirements without having to go to a different supplier.
• People like reference points when choosing. The basic car at a relatively low price can attract interest. That sets the entry level
price for a new car (and provides some price justification), then buyers can decide whether to trade up to a better model
possibly concentrating on the price increments rather than the total price.
• People like choice. If only one level of trim and engine were offered you would certainly look elsewhere before choosing.
• The increase in price between a basic model and a better model is usually much greater than the increase in costs needed to
make the better model. This allows sales staff to profitably up-sell the better model.
olume discounting
Most people like bulk-buy deals as they see a way of saving money. For example, buy one and get 50 off the second.
olume discounts are often used in business-to business sales as larger purchases create economies of scale for the seller (one
large shipment to a customer is cheaper to organise than two small ones). This also has the effect of increasing the supplier’s
market share.
In turn, retailers benefit from the cheaper prices and they may decide to pass on this discount to their end customers. Retailers’
lower purchase costs mean that they maintain their profits even if they charge lower prices to their customers. You may have seen
large supermarkets (who are able to negotiate large volume discounts) offering goods more cheaply than their smaller competitors.
If the supermarket can offer very keen prices then more customers will enter their stores and probably make other purchases there
too.
Price discrimination
Price discrimination means offering the same goods in different markets at different prices.
Examples include:
• Pharmaceuticals priced radically differently in different countries depending on the wealth of each country’s patients or health
services.
• Advance purchase tickets for travel often cost much less than walk-on fares. Here, the two markets are people who can plan in
advance and those who must travel unexpectedly.
• In the SA electrical and photographic goods are often sold much more cheaply than, say, in the K. Often if an item cost
100 in the SA it will cost about 100 in the K.
What the sellers are trying to do is to maximise their profits in each country. As explained in the first pricing article, profits are
maximised when marginal revenue equals marginal cost so sellers adjust their prices in each market to achieve this.
For the scheme to work, it needs to be difficult for goods sold in the cheaper market to be bought there then transferred to the more
expensive market, either for the buyer’s personal use or to be sold on at a profit. So, for example, pharmaceuticals that have
identical chemical formulae will have different brand names, colour, shape and regulatory approval so that patients will feel
nervous about using irregular (grey) imports. Similarly, electrical goods bought in the SA may not work so well elsewhere
because they might require the SA voltage of 110, electricity frequency of 60Hz and will come with a different electrical plug.
Price discrimination works very well in service industries.
Conclusion
Pricing can be a fascinating area. Whereas, apart from commodities, many costs are within accountants’ control, pricing goods
means interacting with suppliers, customers, the economy and competitors. It is rarely completely clear that the correct price is
being charged for long-term profit maximisation. Even if the correct’ price were being charged today, it is unlikely to be stable: new
products, production technology, competitors and changes in customer taste will ensure that pricing decisions have to be
continuously revisited.
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alance sc recar
Home / Students / Study resources / Performance Management (PM) / Technical articles / alanced scorecard
You are part-way through your ACCA qualification and will certainly realise by now (if you hadn’t before) that accountancy is
primarily a numbers-based discipline. In particular, the numbers focus on financial data: published financial statements,
management accounts, financial management, tax calculations and auditing almost exclusively deal with financial information.
Of course, reliable financial information is vital for business management and survival, but reports of financial performance often
show little more than historical score-keeping. Yes, sales might have increased but nothing in classical accounting explains
sales increased or suggests o sales growth can be sustained in the future. For a profit-seeking company, sustained financial
success and long-term shareholder value are the ultimate objectives and the balanced scorecard of Kaplan and Norton (1992)
suggests how this might be achieved.
he four perspectives
The balanced scorecard says that four sets of measurements are needed. The sets are called perspectives’ and are:
• financial perspective
• customer perspective
• internal business process perspective
• innovation and learning perspective.
The financial perspective is the measurement of traditional financial performance: sales, costs, gross profit percentage, earnings
per share, share price, etc. You will be familiar with these measures, but as explained above, they contain no explanation as to
how the figures have been achieved.
To explain good financial performance, it is useful to look at the four perspectives as forming a hierarchy. Good financial
performance depends on happy satisfied customers who return, spread the word and are happy to pay for the products or services
offered.
Why do customers return? It is because the company is achieving excellence in areas that are important to customers. These
areas can be listed as time, quality, performance and service (including flexibility), and cost. Customers differ in the emphasis they
place on these. For example, some customers want fantastic quality and don’t worry so much about the cost. Others want very
short lead times with a flexible approach. But whatever customers value, the company must deliver.
How are these customer requirements to be delivered? Of course, that will depend on the internal business process perspective,
essentially the company’s capabilities to deliver what customers want. It might include long opening hours, an attractive and
efficient website, high use of computer aided design or quality control procedures which ensure negligible rejected production.
So, the company might be achieving great financial results because it has a loyal band of happy customers who are buying an
excellent product. But nothing in business stands still and you can be certain that customers’ tastes will change and that
competitors will be trying to muscle in. Therefore, it is essential that the company pays attention to innovation and learning. It must
never relax and must continually strive to keep up to date and improve its products and service. Otherwise, although current
financial results are good, these will not be s staine if competitors become more successful and better at pleasing customers by
delivering well on customers’ requirements.
oals and measures
All elements of the perspectives must be reinforced by formal oals and eas es. Goals define the general intentions and long-
term ambitions of the business. An o ecti e is a specific result that can be measured. For example, a company could have the
goal of increasing brand awareness and one objective to achieving this goal might be to increase website visits by 20 . Or, the
company’s goal under customer perspective could be to strengthen its customer base. This could be superficially measured by
simply counting the number of receivables accounts but would be more usefully measured by counting the number of actie sales
accounts and more active sales accounts would be an objective.
Similarly, under internal business process perspective, excellent quality might be the goal, but this would need to be measured by
metrics such as the number of reworked items, number of sales returns and number of warranty claims. Service industry measures
can be more challenging. For example, the company might have a goal of delivering good service, but defining and measuring the
various components necessary is difficult. Some sort of customer feedback is often used to assess employee performance. For
example, 'Was the employee able to answer your query?', 'Did the employee seem knowledgeable?'
Without numerous performance measures across all perspectives, the balanced scorecard is pointless: no one knows what’s
expected of them and no one knows if performance in each perspective is adequate. If the company thinks that an aspect of the
balanced scorecard is important for sustainable success then it makes no sense to then not attempt to set targets and measure
attainment – even if that is difficult to do directly. With the exception of the financial perspective, many of the measures of
performance are non-financial (such as rejected items, number of customers, days to fulfil orders, number of new products
launched). Many metrics also address qualities which are not easily quantifiable (such as customers’ opinions, service level,
product styling, brand strength, etc). Even something as difficult to measure as employee morale is important in a service industry –
no one wants to be dealt with by a grumpy employee Possible indicators of morale are: staff turnover rate, days of employee
sickness, customer feedback and complaints. These are imperfect, proxy measures of morale but are better than nothing – and if
morale is important to success then attempts must be made to measure it.
Examples success and failure
uccess Apple nc
• Financial perspective. Fantastically successful across every financial measure you could think of: profit, share price, cash
reserves, etc.
• Customer perspective. Held in awe by many customers as the designer and supplier of cool’, high quality products that work
well. Some would suggest that cost and price are not qualities that worry Apple’s customers too much as often their products
are perceived to be more expensive. You can be certain that Apple knows its customers and their requirements very well.
Sometime products are customised to suit particular international markets. When it seemed that iPhones were becoming too
expensive for many customers Apple did not hesitate to introduce cheaper models with less functionality but still with very high
quality. Customers needing high graphics functionality are particularly well-served.
• Internal business process perspective. Products are designed by Apple but mainly manufactured by sub-contractor
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companies. Designs go through a rigorous testing process and the management of inventory and manufacturing is very slick.
Quality is very high indeed. Apple will strike hard bargains with component manufacturers and will not tolerate poor quality.
Production and distributions deadlines will be very carefully monitored.
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•
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Innovation and learning. The iPod, iTunes, iPhone, iPad and Apple Watch provide ample evidence for continual innovation.
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The operating systems are frequently updated. The company spent around 1 bn on research and development for the year
ended 30 June 2020. There is a carefully mapped out route timetable for new product development and release.
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Advantages and criticisms of the alanced scorecard
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Claimed advantages are:
A C
• Helps to clarify how sustained, good financial performance can be achieved: what do our customers expect? How do we
deliver that well? How do we remain competitive?
• How do different aspects of the business result in good financial performance? For example, if a new website is developed
(innovation and learning), this could streamline the ordering and despatch process as these can be integrated and automated
(internal business process perspective) and customers should be delighted because they can browse products, order easily
and reliably receive the goods quickly.
• Conversely, it can highlight how poor performance in any area can damage long-term prosperity.
• All important aspects of a company’s existence are measured and monitored. Without the balanced scorecard, there is a
danger that only financial results are studied. Without measurement the company is working blind.
• Targets are set for current and future performance across a wide range of important activities and measures.
• It helps to balance long-term and short-term objectives. Short-term objectives often take precedence over long term objectives
such as when a company reduces research and development expenditure or reduces the number of customer-facing staff to
achieve this year’s budgeted profit. However, those cost cuts may have adverse longer-term effects, which are picked up on
customer perspective and innovation and learning measures.
Criticisms are:
• Potential information overload. There are four perspectives and even just five measures for each will result in 20 overall. Some
sort of prioritisation is certainly needed to stop managers concentrating on easy-to-achieve targets at the expense of vital
objectives.
• Picking or inventing measures can be difficult and perhaps arbitrary. As explained above, staff morale and customer
satisfaction are important but will they be measured accurately?
• Difficulty and cost in obtaining the information needed.
• Conflict. For example, flexibility in supplying a customer with a product might adversely affect the quality of the product if it is
made in a rush.
• Too little attention to external factors such as competitor activity. It is very much o innovation, o processes, o customers.
Applying the alanced scorecard in an exam question
ACCA arch ul a ple C uestions the full uestion and solution can e found on the ACCA e site
cenario e tract
Extracts from TripEvent, an influential online customer forum:
I love Hammocks Co; the service and attention to detail is exemplary and the resorts are always pristine. However, their competitor
Loungers has full body driers, ionised water taps and a range of professional haircare equipment in all their rooms.’
Our third time back to Hammocks Co this year and we continue to be amazed by the wonderful level of service. One thing though
is the menus don’t seem to have changed much from one visit to the next.’
We booked Hammocks Co on the spur of the moment but then found that we couldn’t get a flight. We called Hammocks Co
administration centre to change our booking to another resort where we could get a flight to and were told that it would not be a
problem. However, it took two more calls and three emails to get confirmation and then our credit card was charged twice in error.
Of course, it was eventually all resolved, the incorrect charge refunded, a complimentary limousine provided to and from the airport
and we received the most amazing customer service at the resort, but it was frustrating at the time.’
When I made my booking I was assured that my bed would be made with the special anti-allergenic bedding which I need for a
good night’s sleep and that my favourite blend of tea would be available. When I arrived, neither of these requirements were met.
To be fair to Hammocks Co though, everything was in order two hours later when I went to bed.’
i
Explain TWO advantages of Hammocks Co using the balanced scorecard approach to performance management. a s
Draft answer:
Tutorial note onl arks a aila le so not a lot needed. All the ad anta es listed a o e could e used ut the i portant
thin to note is that ou ust tailor this for a ocks Co.
Implementing a balanced scorecard will help Hammock Co by:
• Clarifying how the various classes of performance measure act together to produce good financial performance. For example,
the invoicing error, though essentially trivial and eventually resolved to the customer’s satisfaction was an error in internal
business processes which marred the customer’s experience. The error was made public.
• Balancing long-term and short-term objectives. The menu is apparently successful but hasn’t changed. Developing new
offerings will require experimentation and will incur immediate costs, but these should be recovered in the longer term.
ii
Suggest and justify ONE goal and TWO performance measures for each of the TWO perspectives of the balanced scorecard which
are not currently addressed by Hammock Co’s objectives. a s
Draft answer:
Tutorial note arks a aila le so rather ore needed. lse here in the uestion it is clear that the co pan has alread
addressed financial and custo er perspecti es so the ans er ust address internal usiness process and inno ation
and learnin perspecti es. The follo in ans er addresses onl the nu er of ele ents re uired others e ist.
nternal usiness process perspecti e
oal excellent administration so that specific arrangements made by customers (such as special bedding) are communicated and
acted on.
easures
• Reported errors, for example on feedback forms and web pages

• Delays in guests accessing rooms. This will indicate general housekeeping problems and investigation might uncover that
some delays are caused by administration errors.
ustification guest comments have indicated that the administration department has made a number of errors. Although not very
serious, these errors do detract from customers’ perception of the business and hence its potential number of bookings and
financial success.
nno ation and learnin perspecti e
oal to surpass competitors’ offerings on facilities and restaurant standards
easures
• Lists comparing competitors’ offerings to Hammock Co’s. This might require mystery shoppers’ visiting other vacation resorts
and listing facilities then comparing those to Hammock Co’s own.
• Frequency of menu changes.
ustification guest comments have indicated that Hammock Co’s facilities are not as good as some competitors’ and also that the
menus seem staid and repetitive. If Hammock Co wants to present itself to customers as a luxury resort it has to live up to its
promise and compete effectively by keeping up to date with trends and offering more variety on menus.

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i ata hat is i ata
Home / Students / Study resources / Performance Management (PM) / Technical articles / i data hat is i data
hat is ig data
There are many definitions of the term big data’ but most suggest something like the following:
'Extremely large collections of data (data sets) that may be analysed to reveal patterns, trends, and associations, especially
relating to human behaviour and interactions.'
In addition, many definitions also state that the data sets are so large that conventional methods of storing and processing the data
will not work.
Sources of ig data
Main sources of big data can be grouped under the headings of social (human), machine (sensor) and transactional.
Social (human) – this source is becoming more and more relevant to organisations. This source includes all social media posts,
videos posted etc.
Machine (sensor) – this data comes from what can be measured by the equipment used.
Transactional – this comes from the transactions which are undertaken by the organisation. This is perhaps the most traditional of
the sources.
Characteristics of ig data
The characteristics of big data, known as the 5 s, are:
• olume
• ariety
• elocity
• eracity
• alue
These characteristics have been generally adopted as the essential qualities of big data.
olume
The volume of big data held by large companies such as Walmart (supermarkets), Apple and EBay is measured in multiple
petabytes. A typical disc on a personal computer (PC) holds a gigabyte, so the big data depositories of these companies hold at
least the data that could typically be held on 1 million PCs, perhaps even 10 to 20 million PCs.
The scale of this is difficult to comprehend. It is probably more useful to consider the types of data that large companies will
typically store.
etailers
ia loyalty cards being swiped at checkouts: details of all purchases you make, when, where, how you pay, use of coupons.
ia websites: every product you have every looked at, every page you have visited, every product you have ever bought.
ocial edia such as ace ook and T itter

Friends and contacts, postings made, your location when postings are made, photographs (that can be scanned for identification),
any other data you might choose to reveal to the universe.
o ile phone co panies

Numbers you ring, texts you send (which can be automatically scanned for key words), every location your phone has ever been
whilst switched on (to an accuracy of a few metres), your browsing habits and voice mails.
nternet pro iders and ro ser pro iders

Every site and every page you visit. Information about all downloads and all emails (again these are routinely scanned to provide
insights into your interests). Search terms which you enter.
ankin s ste s
Every receipt, payment, credit card information (amount, date, retailer, location), location of ATM machines used.
ariety
Some of the variety of information can be seen from the examples listed above. In particular, the following types of information are
held:
• Browsing activities: sites, pages visited, membership of sites, downloads, searches

• Financial transactions
• Interests
• Buying habits
• Reaction to advertisements on the internet or to advertising emails
• Geographical information
• Information about social and business contacts
• Text
• Numerical information
• Graphical information (such as photographs)
• Oral information (such as voice mails)
• Technical information, such as jet engine vibration and temperature analysis
This data can be both structured and unstructured:
tructured data this data is stored within defined fields (numerical, text, date etc) often with defined lengths, within a defined
record, in a file of similar records. Structured data requires a model of the types and format of business data that will be recorded
and how the data will be stored, processed and accessed. This is called a data model. Designing the model defines and limits the
data which can be collected and stored, and the processing that can be performed on it.
An example of structured data is found in banking systems, which record the receipts and payments from your current account:
date, amount, receipt/payment, short explanations such as payee or source of the money.
Structured data is easily accessible by well-established database structured query languages.
nstructured data refers to information that does not have a pre-defined data-model. It comes in all shapes and sizes and it is
this variety and irregularity which makes it difficult to store in a way that will allow it to be analysed, searched or otherwise used. An
often quoted statistic is that 0 of business data is unstructured, residing it in word processor documents, spreadsheets,
PowerPoint files, audio, video, social media interactions and map data.
Here is an example of unstructured data and an example of its use in a retail environment:
You enter a large store and have your mobile phone with you. That allows your movement round the store to be tracked. The store
might or might not know who you are (depending on whether it knows your mobile phone number). The store can record what
departments you visit, and how long you spend in each. Security cameras in the ceiling match up your image with the phone, so
now they know what you look like and would be able to recognise you on future visits. You pass near a particular product and
previous records show that you had looked at that product before, so a text message can be sent perhaps reminding you about it,
or advertising a 10 price reduction. Perhaps the store has a marketing campaign that states that it will never be undersold, so
when you pass near products you might be making a price comparison and the store has to check prices on other stores websites
and message you with a new price. If you buy the product then the store might have further marketing opportunities for related
products and consumables and this data has to be recorded also. You pay with an affinity credit card (a card with associations with
another organisations such as a charity or an airline), so now the store has some insight into your interests. Perhaps you buy
several products and the store will want to discover if these items are generally bought together.
So just walking round a store can generate a vast quantity of data which will be very different in size and nature for every
individual.
elocity
Information must be provided quickly enough to be of use in decision-making and performance management. For example, in the
above store scenario, there would be little use in obtaining the price-comparison information and texting customers once they had
left the store. If facial recognition is going to be used by shops and hotels, it has to be more or less instant so that guests can be
welcomed by name.
You will understand that the volume and variety conspire against velocity and, so, methods have to be found to process huge
quantities of non-uniform, awkward data in real-time.
eracity
eracity means accuracy and truthfulness and relates to the quality of the data. In the context of big data, for any analysis to
provide useful findings for decision making, the data collected must be true. To assess how true the data collected is, companies
must consider not only how accurate or reliable a data set might be but also how trusted is the source of the data. Companies must
be able to trust the source of the data being collected and be confident that the data is reliable and accurate if they are to base
important, and often costly decisions on the findings of its analysis.
The difficulty that companies face here is that by its very nature, the data collected comes from many different sources. Some will
be more trustworthy that others. For example machine and transactional sourced data would be seen as more reliable than human
sourced data. Data from transactional and machine sources would be easier to verify and less easy to manipulate. Human data, for
example from social media, however can be more easily manipulated and care must be taken when using this type of data,
particularly given the recent increase in so called fake news’ and growing reports of deliberately manipulated customer reviews on
retail sites.
eracity also ties in to velocity. To be useful in decision making, data needs to be analysed as soon as possible. elocity shows
that the data being collected changes quickly. Analysing out of date data could lead to poor decision making.
alue
The last of big data (although some models have added more) is alue. There is little point in going to the effort and expense of
gathering and analysing the data if this does not ultimately result in adding value to the company. It is important for companies to
consider the potential of big data analytics and the value it could create if gathered, analysed and used wisely.
An example of how data analysis was used by British supermarket group Tesco to add value:
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Tesco has operations in several countries around the world. In Ireland, the company developed a system to analyse the
temperature of its in-store refrigerators. Sensors were placed in the fridges that measured the temperature every three seconds and
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sent the information over the internet to a central data warehouse. Analysis of this data allowed the company to identify units that
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were operating at incorrect temperatures. The company discovered that a number of fridges were operating at temperatures below
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the -21 C to -23 C recommended. This was clearly costing the company in terms of wasted energy. Having this information
allowed the company to correct the temperature of the fridges. Given that the company was spending 10 million per year on fridge
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cooling costs in Ireland, an expected 20 reduction in these costs was a significant saving.
The system also allowed the engineers to monitor the performance of the fridges remotely. When they identified that a particular
unit was malfunctioning, they could analyse the problem then visit the store with the right parts and replace them. Previously the
fridges would only be fixed when a problem had been discovered by the store manager, which would usually be when the problem
had developed into something more major. The engineers would have to visit the store, identify the problem, and then make a
second visit to the store with the required parts.
Processing and analysing ig data

The processing of big data is generally known as big data anal tics and includes:
• Data mining: analysing data to identify patterns and establish relationships such as associations (where several events are
connected), sequences (where one event leads to another) and correlations.
• Predictive analytics: a type of data mining which aims to predict future events. For example, the chance of someone being
persuaded to upgrade a flight.
• Text analytics: scanning text such as emails and word processing documents to extract useful information. It could simply be
looking for key-words that indicate an interest in a product or place.
• oice analytics: as above but with audio.
• Statistical analytics: used to identify trends, correlations and changes in behaviour.
Google provides website owners with Google Analytics that will track many features of website traffic. For example, the website
OpenTuition.com provides free ACCA study resources. Google analytics reports statistics such as the following:
A CA T T
The final table is instructive. OpenTuition.com does not ask for users’ ages, so this data has been pieced together from other
information available to Google. It has been able to do this for only about 5 of users.
These analytical findings can lead to:
• Better marketing
• Better customer service and relationship management
• Increased customer loyalty
• Increased competitive strength
• Increased operational efficiency
• The discovery of new sources of revenue.
The i ata p ra id
The DIKW pyramid, also known as the knowledge pyramid became well known in 19 9 from the work of Askoff. With the
emergence of big data, the pyramid has also become known as the big data pyramid. The work of Jennifer Rowley in 200
explained the relationships between data, information, knowledge and wisdom.
Rowley explained the pyramid: 'Typically information is defined in terms of data, knowledge in terms of information, and wisdom in
terms of knowledge.'
ata a range of data can be collected from various sources – this is raw data and not particularly useful in this form.
nfor ation The raw data can be analysed to look for trends or patterns, for example it may appear that there is a link between the
purchase of a particular product and a particular group of customers. This is information.
no led e The information can be analysed further to establish how the identified links are connected. Knowing the details of
exactly what types of customers buy a particular product or favour particular product features is knowledge.
isdo The knowledge gathered can be used to make informed business decisions.
a ple of ho the p ra id could e used

A soft drink manufacturer makes a range of fruity soft drinks in four different flavours (orange, apple, lime and pear). It has
traditionally used plastic bottles but has recently run a trial whereby two flavours were also made available in glass bottles. It is
making its plan for next year’s production and is considering if it should expand the use of glass bottles.
ata The company has collected a range of data from previous purchases, customer questionnaires, social media posts etc.
nfor ation The raw data was analysed to look for trends or patterns. The company finds that there appears to be a link between
the types of bottles purchased by different age groups.
no led e Further analysis has shown that younger customers prefer the glass bottles while customers from the older age range
prefer plastic bottles. Previous analysis also showed that lime flavour is almost exclusively only purchased by older customers and
pear is almost exclusively only purchased by younger customers.
isdo How can this knowledge be used? The company should only produce lime flavour in plastic bottles and only produce
pear flavour in glass bottles. Here, the company is using the insights gained in order to make a decision and therefore this is
classed as wisdom.
angers risks of ig data

Despite the examples of the use of big data in commerce, particularly for marketing and customer relationship management, there
are some potential dangers and drawbacks.
Cost It is expensive to establish the hardware and analytical software needed, though these costs are continually falling.
e ulation Some countries and cultures worry about the amount of information that is being collected and have passed laws
governing its collection, storage and use. Breaking a law can have serious reputational and punitive consequences.
oss and theft of data Apart from the consequences arising from regulatory breaches as mentioned above, companies might find
themselves open to civil legal action if data were stolen and individuals suffered as a consequence.
ncorrect data If the data held is incorrect or out of date incorrect conclusions are likely. Even if the data is correct, some
correlations might be spurious leading to false positive results.
pdated article e tracted fro articles en arrett a freelance lecturer and riter and ick an a lead tutor for
perfor ance ana e ent su ects
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i ata c anies se i ata
Home / Students / Study resources / Performance Management (PM) / Technical articles / i data o co panies use i data
Big data refers to the large collections of data that may be analysed to reveal patterns, trends and associations, especially relating
to human behaviour and interactions. Big data has already been explained in another article (Big data 1: What is big data?). This
article will describe some real life examples of the use of big data for performance management and measurement purposes.
Performance management involves managing the organisation in order to ensure that it meets its objectives. Broadly, big data is
relevant to performance management in the following ways:
• Gaining insights (eg about customers’ preferences) which can then be used to improve marketing and sales, thus increasing
profits and shareholders’ wealth.
• Forecasting better (eg customer’s future spending patterns, when machines will need replacing) so that more appropriate
decisions can be made.
• Automating of high level business processes (eg lawyers scanning documents) which can lead to organisations becoming
more efficient.
• Providing more detailed and up to date performance measurement.
Examples of companies using ig data
etflix
Netflix began as a D D mailing service and developed algorithms to help it to predict viewers’ preferences and habits. Now it
delivers films over the internet and can easily collect information about when movies are watched, how often films might be
stopped and restarted, where they might be abandoned, and how users rate films. This allows Netflix to predict which films will be
popular with which customers. It is also being used by Netflix to produce its own T series, with much greater assurance that these
will be hits.
Ama on
The world’s leading e-retailer collects huge amounts of information about customers’ preferences and habits which allow it to
market very accurately to each customer. For example, it routinely makes recommendations to customers based on products
previously purchased.
Airlines
Airlines know where you’ve flown, preferred seats, cabin class, when you fly, how often you search for a flight before booking, how
susceptible you are to price reductions, probably which airline you might book with instead, whether you are returning with them
but didn’t fly out with them, whether car hire was purchased last time, what class of hotel you might book through their site, which
routes are growing in popularity, seasonality of routes. They also know the profitability of each customer so that, for example, if a
flight is cancelled they can help the most valuable customers first.
This information allows airlines to design new routes and timings, match routes to planes and also to make individualised offers to
each potential passenger.
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arget
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Target is a large discount retailer in the SA. There is an often quoted story about their ability to predict when a customer is
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pregnant – frequently before the customer has informed her family. By looking at about 25 products it is claimed that they can
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create a pregnancy predictor. For example, early pregnancy often causes morning sickness so consumers would perhaps change
to blander food and less perfumed shower gel. Why would Target be interested in knowing whether a consumer is pregnant? Well
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that person will require different products during the pregnancy then in a few months the baby will have its own product needs:
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nappies, baby shampoo and clothes. Early identification of pregnancy can allow Target to establish the shopping habits of the
mother and perhaps even the preferences of the child.
almart s Polaris search engine
Walmart is an American retailer that operates in 2 countries around the world. It is the world’s largest company based on
revenues. Many of Walmart’s customers buy online through the company’s website. Walmart wanted to make sure that customers
can find what they are looking for on its website, so it developed its Polaris search engine. If customers are looking for a particular
product, they enter the description in a search box, and the website displays products which meet that description.
What is unusual about Polaris is the way it ranks the search results. It attempts to show the products that the customer is most
likely to buy towards the top of the list. The algorithm takes into account many factors, including the number of likes that the product
has on social media networks and how many favourable reviews it has.
The system also uses artificial intelligence to learn so that it can continually provide better search results. If a phrase has been
entered that the engine did not initially understand, for example, the engine can learn’ what that phrase meant based on what the
customer actually bought. Thus the system was soon able to figure out that when a user entered House’ into the search box, they
were probably looking for merchandise connected with the T series of that name, not furniture or other items for their house. If
someone searches for Flats’, the engine has learned that they probably want to buy shoes, not apartments or flat screen T s.
The metric that is used to measure the success of the website is customer conversion rate – the number of customers that actually
buy a product after a search. It is estimated that the Polaris search engine has increased the conversion rate by between 10 and
15 . That is worth billions of dollars in extra revenue.
eredynamic
Beredynamic is a manufacturer of high quality audio products such as microphones and headphones. The company is based in
Germany, but has a wide international sales and distribution network. The company wanted to improve its analysis of sales. Most
ad hoc reports required data to be extracted from its legacy systems into a spreadsheet where the reports would then be manually
compiled. This was time consuming, leading to delays in producing the reports. The reports themselves were not always accurate
either.
The company developed a data warehouse that automatically extracts transactions from its existing ERP and financial accounting
systems. The structure of this warehouse was carefully designed so that standard information is stored for each transaction such
as product codes, country code, customer and region. This is supplemented by a web based reporting solution that enables
managers to create their own reports, both standard and ad hoc, based on the data held in the warehouse.
The system allows the company to perform detailed analysis of sales, which helps it to identify trends in different products or
markets. This leads to two business advantages. The first is that the sales and distribution strategy can be changed when demand
changes in certain markets – for example, when sales of gaming headphones began to increase in Japan, the company introduced
promotions for all its gaming products in that country, including a large advertising campaign and introduction of product bundles
specially for the Japanese market. The second advantage is that production plans can quickly be changed as demand changes. If
demand is falling, production is slowed to ensure that the company is not left with excessive inventory. If demand is expanding,
production is increased to take advantage of higher sales.
The ability to provide more detailed analysis quickly can also be used for performance measurement and appraisal, for example,
comparing actual sales with targets by region, assessing whether a promotion achieved the expected increase in profits. Such
reports can be produced quickly based on real time data, meaning that management can respond quickly to any adverse
variances.
The success of the new system is measured in terms of the growth in revenues and profits. While this seems simple, it has to be
recognised that some growth would have been expected even if the system had not been implemented, so determining how much
revenue growth has resulted from the greater analysis can be difficult. Assumptions need to be made.
Morton s Steak ouse
A customer jokingly tweeted S chain Morton’s and requested that dinner be sent to the Newark airport where he was due to arrive
late. Morton’s saw the tweet, realised he was a regular customer, pulled up information on what he typically ordered, figured out
which flight he was on and then sent a waiter to meet him at the airport and serve him dinner.
Clearly this action was a publicity stunt which the restaurant hoped that their customer would publicise in future tweets. What it
demonstrates is how easy it was for Morton’s to identify the customer who sent the tweet, and to ascertain what his favourite meal
was. It also shows how companies like to influence social media users who have a large following as a means of increasing their
own publicity.
It is difficult to measure the impact of interventions into social media. No doubt the happy customer would have communicated this
story, and this may have improved the reputation of the restaurant, but it is very difficult to measure the impact of this on sales.
Conclusion
The cases above have shown how detailed analysis of data can be used in a number of different ways to improve the performance
of an organisation. Big data can be used to understand customers and trends better, to provide insights into costs, and to make it
easier for customers to find what they want on the website. Companies are likely to continue to identify innovative uses of the
increasing volumes of data available to them, and analysis of big data is likely to grow in importance as an important strategic tool
for many businesses.
pdated article e tracted fro articles en arrett a freelance lecturer and riter and ick an a lead tutor for
perfor ance ana e ent su ects
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ele ant c sts
Home / Students / Study resources / Performance Management (PM) / Technical articles / ele ant costs
Relevant costs’ can be defined as any cost relevant to a decision. A matter is relevant if there is a change in cash flow that is
ca se by the decision.
The change in cash flow can be:
• additional amounts that must be paid

• a decrease in amounts that must be paid
• additional revenue that will be earned
• a decrease in revenue that will be earned.
A change in the cash flow can be identified by asking if the amounts that would appear on the company’s bank statement are
affected by the decision, whether increased or decreased. Banks record cash so this test is reliable.
Sunk costs (past costs) or committed costs are not relevant
Sunk, or past, costs are monies already spent or money that is already contracted to be spent. A decision on whether or not a new
endeavour is started will have no effect on this cash flow, so sunk costs cannot be relevant.
For example, money that has been spent on market research for a new product or planning a new factory is already spent and isn’t
coming back to the company, irrespective of whether the product is approved for manufacture or the factory is built.
Committed costs are costs that would be incurred in the future but they cannot be avoided because the company has already
committed to them through another decision which has been made.
For example, if a company has two year lease for piece of machinery, that cost will not be relevant to a decision on whether to use
that machinery on a new project which will last for the next month.
Re apportionment of existing fixed costs are not relevant
Irrespective of what treatment is used in the company’s management accounts to split up costs, if the total costs remain the same,
there is no cash flow effect caused by the decision.
Note that additional fixed costs caused by a decision are relevant. So, if you were evaluating the viability of a new production
facility, then the rent of a building specially leased for the new facility is relevant.
epreciation and ook values (notional costs) are not relevant
Depreciation is not a cash flow and is dependent on past purchases and somewhat arbitrary depreciation rates. By the same
argument, book values are not relevant as these are simply the result of historical costs (or historical revaluation) and depreciation.
ncreases or decreases in cash flo s caused y a pro ect are relevant
So, if an old product is discontinued three years early to make room for a new product, the revenue and cost decreases relating to
the old product are relevant, as are the revenue and cost increases on the new. The cost effects relate to both changes in variable
costs and changes in total fixed costs.
Revenues forgone (given up) ecause of a decision are relevant
If a company decides to keep an asset for use in the manufacture of a new product rather than selling it, then its cash flow is
affected by the decision to keep the asset, as it will now not benefit from the sale of the asset. This effect is known as an
opportunity cost, which is the value of a benefit foregone when one course of action is chosen in preference to another. In this
case, the company has given up its opportunity to have a cash inflow from the asset sale.
T pes of decision
We will now look at some typical examples where you have to decide which costs are relevant to decision-making. We suggest
that you try each example yourself before you look at each solution. In all examples we ignore the time value of money.
Always think: what future cash flows are changed by the decision? Changes in future cash flows reliably indicate which amounts
are relevant to the decision.
a ple ele ant cost of aterials

A company is considering making a new product which requires several types of raw material:
nits in in entor nits re uired Additional infor ation
Material A Nil 40 Current purchase price is /unit.
Material B 100 purchased for 150 Current purchase price is 14/unit. The material has no use in the
10/unit company other than for the project under consideration. nits in
inventory can be sold for 12/unit.
Material C 50 purchased for 120 Current purchase price is 22/unit. The material is regularly used in
20/unit current manufacturing operations.
hat is the relevant cost of the materials required for manufacture of the ne product
olution
Taking each material in turn:
Material A – As there is no inventory, all 40 units required will have to be bought in at per unit. This is a clear cash outflow
caused by the decision to make the new product. Therefore, the relevant cost of Material A for the new product is (40 units x )
2 0.
Material B - The 100 units of the material already in inventory has no other use in the company, so if it is not used on the new
product, then the assumption is that it would be sold for 12/unit. If the new product is made, this sale won’t happen and the cash
flow is affected. The original purchase price of 10 is a sunk cost and so is not relevant. In addition, another 50 units are needed
for the new product and these will need to be bought in at a price of 14/unit.
The total relevant cost for Material B is:
100 units x 12 (lost sale proceeds) 1,200
50 units x 14 (current purchase price) 00
1,900
Material C – This material is regularly used in the company, so if the 50 units in inventory are diverted to the new product then this
will mean that inventory will need to be replenished. In order to do this, Material C purchases for existing products will be
accelerated by 50 units. The current purchase price of 22 will be used to determine the relevant cost of Material C as this will be
the value of each unit purchased. The original purchase price of 20 is a sunk cost and so is not relevant. Therefore the relevant
cost of Material C for the new product is (120 units x 22) 2,640.
a ple ele ant cost of la our

A company has a new project which requires the following three types of labour:
ours Additional infor ation

re uired
nskilled 12,000 Paid at per hour and existing staff are fully utilised. The company will hire new staff to meet this
additional demand.
Semi-skilled 2,000 Paid at 12 per hour. These employees are difficult to recruit and the company retains a number of
permanently employed staff, even if there is no work to do. There is currently 00 hours of idle time
available and any additional hours would be fulfilled by temporary staff that would be paid at
14/hour.
Skilled ,000 Paid at 15 per hour. There is a severe shortage of employees with these skills and the only way
that this labour can be provided for the new project would be for the company to move employees
away from making Product X. A unit of Product X takes 4 hours to make and makes a contribution of
24/unit.
hat is the relevant cost of the la our hours required for the ne pro ect
olution
Taking each type of labour in turn:
nskilled – 12,000 hours are required for the project and the company is prepared to hire more staff to meet this need. The
incremental cash outflow of this decision is (12,000 hours x ) 96,000.
Semi-skilled - Of the 2,000 hours needed, 00 are already available and already being paid. There is no incremental cost of using
these spare hours on the new project. However, the remaining 1,200 hours are still required and will need to be fulfilled by hiring
temporary workers. Therefore, there is an extra wage cost of (1,200 hours x 14) 16, 00.
Skilled: Determining the relevant cost of labour if it is diverted from existing activities is tricky and is often done incorrectly. If this is
the case, then the relevant cost is the variable cost of the labour plus the contribution foregone from not being able to use the
labour for its existing purpose.
The temptation is to see that the same number of skilled employees are paid before and after being moved to the new project and
therefore the opportunity cost of contribution foregone from diverting hours away from the existing production of Product X is the
onl relevant cost ( 24/4 hours 6 per hour). This is incorrect.
Say, for example, that 4 hours of labour were simply removed by sacking’ an employee for four hours, one less unit of Product X
could be made. sing the contribution foregone figure of 24 is the net effect of losing the revenue from that unit and also saving
the material, labour and the variable costs. In this situation however, the labour is simply being redeployed so 24 understates the
effect of this, as the labour costs are not saved.
Therefore, the relevant cost of skilled labour is:
,000 hours x 15 (current labour cost per hour) 120,000
,000 hours x 6 (lost contribution per hour diverted from making Product X) 4 ,000
16 ,000
a ple ele ant cost of achiner

Some years ago, a company bought a piece of machinery for 300,000. The net book value of the machine is currently 50,000.
The company could spend 100,000 on updating the machine and the products subsequently made on it could generate a
contribution of 150,000. The machine would be depreciated at 25,000 per annum. Alternatively, if the machine is not updated,
the company could sell it now for 5,000.
On a relevant cost asis should the company update and use the machine or sell it no
olution
Immediately we can say that the 300,000 purchase cost is a sunk cost and the 50,000 book value and 25,000 depreciation
charge are not cash flows and so are not relevant.
If the investment in the machinery is made, then the following cash flow changes are triggered:
• Machine update cost: 100,000

• Contribution from products: 150,000
• Opportunity cost: 5,000
Therefore, the relevant cost is:
pdate cost 100,000
Add contribution
o x 150,000
Less sales proceeds foregone

l B 5,000
b a
Net cash outflow
l o 25,000
G
C A
As the relevant cost is a net cash outflow, the machine should be sold rather than retained, updated and used.
a ple ele ant cost of achiner

A C
A business rents a factory for 60,000 per annum. Only half of the floor space is currently used and the company is considering
installing a new machine in the unused part. The machine would cost 2.1m, be depreciated over 10 years at 200,000 per annum
and then be sold for 100,000. The company would insure the new machine against damage for 5,000 per annum.
hat are the relevant costs of the ne machine purchase
olution
Rent – this is not a relevant cost. Irrespective of how the company might use the floor space in the factory to generate a return,
there is no change in cash flow relating to the rent as a result of the new machine.
Cost of machine - this is a relevant cost as 2.1m has to be paid out.
Depreciation – this is not a relevant cost as it is not a cash flow.
Sale proceeds – this is a relevant cost as it is a cash inflow which will occur in 10 years as a result of the decision to invest.
Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest.
These costs will have to be compared to the contribution that can be earned by the new machine to determine if the overall
investment in the asset is financially viable.
The effects sho n in a ples a o e are often found in uestions here ou are to deter ine hether or not a
co pan should o ahead ith a ne pro ect in est ent product or if ou are asked to calculate the ini u price a
co pan should char e a custo er for a piece of ork.
a ple urther processin decision

A company buys a chemical for 12,000, which it breaks down into two components:
Co ponent ales alue Allocated costs
A ,000 6,000
B 4,000 6,000
Component A can be converted into Product A if 6,000 is spent on further processing. Product A would sell for 12,000.
Component B can be converted into Product B if ,000 is spent on further processing. Product B would sell for 15,000.
hat processing decision should the company make in order to maximise

profits
olution
As the initial chemical is split into both components, it is not possible to make one component without the other, therefore if the
company were to make only the components, the costs and revenues of both components will need to be recognised:
Incremental revenue (sales of both components) 11,000
Incremental costs (cost of the chemical) 12,000
Net loss ( 1,000)
This is not worthwhile as incremental costs exceed incremental revenues.
Next we should consider whether the components should be further processed into the products.
Further processing Component A to Product A incurs incremental costs of 6,000 and incremental revenues of 5,000 ( 12,000 -
,000). It is not worthwhile to do this, as the extra costs are greater than the extra revenue.
Further processing Component B to Product B incurs incremental costs of ,000 and incremental revenues of 11,000 ( 15,000 –
4,000). It is worthwhile to do this, as the extra revenue is greater than the extra costs.
The production plan is therefore:
Component A revenue ,000
Component B revenue 15,000
Total re enue
Chemical cost 12,000
Further processing of Component B ,000
Total cost
Contri ution
a ple hut do n decision

A company has two production lines and its management accounts show the following:
roduction ine roduction ine

A
Revenue 2 30
Marginal costs 12 20
Fixed costs 10 14
Total cost
rofit loss
The total fixed costs of 24m have been apportioned to each production line on the basis of the floor space occupied by each line
in the factory.
The company is concerned about the loss that is reported by Production Line B and is considering closing down that line. Closing
down either production line would save 25 of the total fixed costs.
Should the company close do n Production Line
olution
The incremental cash flows of closing down Production Line B are:
Revenue lost 30m
Marginal costs saved 20m
Fixed costs saved ( 24m x 25 ) 6m
Therefore, the closure of Production Line B is not a good idea as the revenue lost is greater than the value of the costs saved.
What about closing down Production Line A?
The incremental cash flows of this decision would be:
Revenue lost 2 m
Marginal costs saved 12m
Fixed costs saved ( 24m x 25 ) 6m
The closure of Production Line A would also result in the revenue lost being greater than the value of the costs saved, so this isn’t
a good idea either.
Really, the heart of the matter is the misleading effect of the relatively arbitrary apportionment of the fixed costs. A more useful
presentation of the figures for decision-making would be:
roduction ine roduction ine Total

A
Revenue 2 30 5
Marginal costs 12 20 32
Contri ution
Fixed costs 24
rofit loss
Note that the 2m total profit is the same as the profit of 6m from Production Line A and the loss of 4m from Production Line B as
shown in the table at the start of this example.
If either production line were closed down, fixed costs saved are 25 x 24m 6m, however the contribution lost from the
products (and contribution looks at cash flows caused by production) would be either 16m or 10m, which exceed the cash saved
on the fixed costs.
a ple ake or u decision

A company makes a product which requires two sequential operations (Operation 1 and Operation 2) on the same machine. The
machine is fully utilised. Material costs 12 per unit.
Instead of carrying out Operation 1, the company could buy in components, for 15 per unit. This would allow production to be
increased because the machine has to deal with only Operation 2.
Operation 1 takes 0.25 hours of machine time and Operation 2 takes 0.5 hours of machine time. Labour and variable overheads
are incurred at a rate of 16/machine hour and the finished products sell for 30 per unit.
Should the company make the entire product internally or uy in the components and
complete them in Operation
olution
Some care is needed here to ensure all incremental cash flows caused by the decision are taken into account.
Machine running costs – the machine is already fully utilised on Operations 1 and 2 and will remain fully utilised, but only on
Operation 2. Therefore, the machine running costs will not change, so are not relevant to the decision.
Material - if the buy-in option is accepted, the material cost increases from 12 to 15 per unit.
Production volume – this can increase by 50 because currently each item takes 0.5 hours in Operation 2, but 0.25 hours per unit
will be released by Operation 1 which now will not be needed.
Assuming output is 1,000 units, the following would occur (ignoring labour and variable overheads which we know to be constant):
Increase in revenue (50 extra could be produced) 500 additional units x 30 15,000
Increase in costs (material/buy-in costs only) (1,500 x 15) – (1,000 x 12) 10,500
Therefore, it is worth buying in as incremental revenue exceeds incremental costs.
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Home / Students / Study resources / Performance Management (PM) / Technical articles / nfor ation s ste s
Information systems (IS) are critical for Performance Management (PM). Information systems greatly aid in defining, measuring and
monitoring performance metrics and comparing them against targets and benchmarks. It is a topic you need to be ready for in all
sections of your exam. The examiner reports state that students regularly overlook this area of the syllabus, so make sure you
cover it during your studies.
Role of S
Information systems are the backbone of a modern company. IS enables communication, sales and marketing, supply chain
management, decision-making, employee management, process improvement and much more. Once considered a tool to improve
efficiency, IS is now considered an important source of competitive advantage.
Think of a successful company you’ve recently read about or interacted with, and chances are you can also think of an example of
how that company uses IS to distinguish itself from the competition. You can probably think of ways IS has changed the way you
prepare for your ACCA exams - you might watch videos, take online courses, and participate in online forums. Moreover, you might
have learned of these solutions through targeted advertising in your social media.
First, make sure you are familiar with some of the basic terminology in this area for your PM exam:
nternet vs ntranet
The term internet’ describes the global network of computers and devices that are all connected with an Internet Protocol ( IP’)
address. I’m sure you are familiar with this and use it regularly to browse content on the web, for example, reading this article,
accessing social media, and using many of the apps on your smartphone.
Intranet’ refers to a subset of the internet that is blocked off from the public and only available to a certain organisation. For
example, a university might have a private’ web portal where students can log in with a username and password and then see
their schedules, access student message boards, or upload their assignments.
et orks
A network’ is a group of computer systems that communicate by physical and/or wireless connections. The wifi router you might
have in your home is connected to the internet with a physical cable, and it then allows computers in your home to connect through
the wireless network that it broadcasts.
ireless technology
Wireless technology is a fast-growing area of technology. As its name implies, it refers to communication without cables. Moreover,
you are probably interacting with wireless technology regularly. You might connect headphones, fitness trackers or other devices to
your smartphone with Bluetooth, the car you drive might use Radio Frequency ID (RFID) tags embedded on individual
components to monitor maintenance and repair history, and the shipping company that delivers parcels to your home is probably
using a variety of these technologies to track packages and monitor performance.
Categories of S
Ensure that you understand and can distinguish between different types of information systems. While the latest developments in
cloud computing, performance dashboards, and big data bring in new terminology and concepts, the following classic IS ideas
form a starting place and are required knowledge for your PM exam.
ransaction Processing Systems ( PS)
These are systems used by operational staff to capture data and make processes more efficient, improving the accuracy and
timeliness of information. Data will primarily be high frequency and short term.
At your local supermarket you end your shopping trips at the cashier, when your groceries are probably scanned, and your total bill
is then automatically calculated. This is a classic example of a TPS. The data collected helps the supermarket produce an
accurate sales receipt and is also used to track inventory and understand customer shopping patterns.
Large retailers are now using geo-analytic’ software which tracks your movements through a large store by monitoring your
smartphone’s wifi signal from various routers. This is another example of a TPS.
Starbucks is beginning to use high-tech coffee machines in their stores that communicate information via the cloud on the machine
usage, maintenance, and even customer preferences – these are examples of the use of transaction processing, big data, and
wireless technology.
Management nformation Systems (M S)
These are systems used for structured decision-making that help managers analyse performance and control the business. They
draw mainly on summarised, internal information from a company’s existing operations. This summarised information may have
been transferred from the organisation’s TPS. An MIS might help the manager of a supermarket to monitor inventory levels and
determine reordering requirements; understand product profitability to determine how to allocate floor space and what products to
stock and to set staffing schedules based on busy periods.
A modern MIS can access a variety of data types including using big data and presenting this information in real-time, with
visualisations. An e-commerce company might build an MIS for a sales manager that monitors key performance indicators (KPIs)
such as, site visit to purchase ratio,’ regional sales status,’ or sales by channel.’
Executive nformation System (E S)
These are systems that help senior managers analyse organisational performance, see trends, and make decisions with a highly
summarised picture of the business. An EIS not only uses internal information but also brings in external information, like
information related to the markets in which the company operates. A modern EIS is sometimes referred to as a dashboard,’ where
critical KPIs are presented with charts, tables, and other graphical tools, helping the manager to visualise performance.
Continuing with our supermarket example, a senior manager might use a performance management dashboard that compares the
sales or profitability of different regions using a chart showing performance over time. This information, for example, may support
strategic expansion plans which the company may be considering. The EIS might also show news headlines about the company
from external sources, the company share price, and a real-time summary of customer feedback.
Enterprise Resource Planning Systems (ERPS)
This term describes a system where many diverse business functions of an enterprise, such as human resources (HR), sales,
production and supply chain, are integrated under one database system. SAP is an example of such software.
o x
Consider an airline: 20 years ago, the airline might have had separate IT systems for passenger bookings, accounting, and HR.
Now, SAP offers a specific ERPS product for the airline industry that integrates business processes such as fuel management,
l B
route performance management, catering, airplane maintenance, real-time customer feedback, and direct flight booking all under
b a
one unified system. It allows information to flow between all business functions and facilitates connections with external
stakeholders, such as suppliers and customers. Such a tool greatly enhances control, data analytics and performance
lo
management, as KPIs from many business functions can be monitored on one dashboard.
G
and cost drivers.
C A
An ERPS will also enable modern accounting practices, such as activity-based costing, as it will be easier to identify cost pools
A C
Customer Relationship Management Soft are (CRMS)
CRM software (which can also be contained as a module in an ERPS) is software that helps companies by centralising customer
communications, purchasing history, sales leads and more into one database. This helps a company’s sales team become more
productive, improve communication, automation of processes, and measure sales performance.
A retail company might use a CRMS and customer loyalty card information to automatically email customers about specific offers
that they may be interested in, or drive a targeted social media advertising campaign.
If you’ve ever purchased anything using Amazon or other modern e-commerce companies, you have probably seen sections on
the website, which say recommended for you,’ or other people have also purchased ’ The content in these sections stem from
your purchasing history and these features are driven by CRM functionality.
e trends
The output of a MIS that can be viewed on a computer, tablet, or smartphone is often referred to as a dashboard.’ This idea is
similar to the purpose of dashboard in an airplane or a car which answers questions such as, How fast are we going?’, How much
fuel do we have?’, Is the engine running at the right temperature?’ An effective performance management dashboard answers
critical questions like that for a business manager.
New tools are readily available, such as Microsoft Business Intelligence, that allows for the creation of highly customised
dashboards for decision-makers at all levels of a company, drawing on many types of data (internal, external, financial, non-
financial), to create customised performance metrics for any organisation.
Sources of information
A company has many sources of information to draw upon, which can be traditionally be categorised as internal vs. external.
Internal information is easier to source, while external information can be more challenging to acquire. External information is
particularly useful for strategic planning, when a company needs to consider market share, industry trends, and customer
behaviours.
Internal sources can include, for example, the company’s accounting and production records, HR records, website traffic, and call
centre data. Information gained from these sources can enable a company to understand product profitability, production efficiency,
and employee utilisation. A retailer analysing customer shopping behaviour with information from their CRMS would be using
internal information.
External sources of information come from the environment in which a company operates and can include competitor’s websites,
social media, credit rating agencies, and internet news, for example. A company that analyses feedback from social media sites
and uses internet research to identify new customer segments would be using external information.
Cost vs enefit
Companies should ensure that the benefit received from management information exceeds the costs of gaining that information.
For example, the implementation of an ERPS can bring many benefits, such as improved business intelligence, streamlined
procedures, improved productivity, and lower cost per accounting transaction.
However, such a system also comes with costs. New software, hardware, testing, and other implementation costs will be incurred
by the company, as well as potential disruption to people’s work routines, and the need to overcome resistance to change.
Controls over S
You should ensure that you have a working knowledge of the following controls over information systems for your Performance
Management exam:
Physical controls
These are controls that prevent unauthorised people from gaining physical access to computer systems. Locked doors, picture IDs,
and security cameras are examples of physical controls.
Logical controls
Once someone has gained physical access to a computer system, the next level of security would be logical controls. Passwords
and access rights are examples of logical controls.
Administrative controls
Administrative controls are those that are designed to influence peoples’ behaviour toward IS systems and practices. IT training
and certifications, implementation of new procedures and discipline policies are examples of administrative controls.
Anti virus
Most computer users will be familiar with viruses: software intentionally created to harm your computer or data. Malware (malicious
software) is considered to be master group heading for viruses, trojans and worms etc. While this is a complex topic which evolves
quickly, the idea of anti-virus software is straight-forward: it is software designed to prevent, detect, and remove viruses. You will
most likely run both anti-virus and firewall (see below) software on your personal computer.
ire all
This term was first used to describe a physical wall in a building that keeps a fire contained. In IS, it describes a type of control that
prevents access to a computer or computer network. A firewall is used to control the flow of data between an external source, such
as the internet, and an internal network in order to protect it from malicious threats. It achieves this by use of access control rules
which define the source and destination IP addresses and the ports being used for the connection. Your company probably uses a
firewall to keep hackers out of their computer networks, and if you are using a Windows operating system there is firewall
functional included.
Additional protection can be achieved by use of Intrusion Detection System (IDS) and Intrusion Prevention System (IPS) which
inspects the data packet coming into the network and compares it to a list of approved and known data signatures in order to
ascertain if the data contained within the packet is known to be dangerous or malicious.
alidation
alidation is a broad type of control used to ensure the accuracy, rather than security, of data. When you enter your birthday on a
web form, you are usually asked to pick the date, month and year from pulldown menus or by clicking on a calendar tool. Moreover,
you are probably not allowed to proceed to the next step of what you are doing if you left the birthday field blank. These are two
examples of validation the first control forces you to enter a valid date, and the second ensures you don’t leave the field blank.
Encryption
This is a control whereby your data is encoded in a way that makes it extremely difficult for people to decode and then use your
data if they were to gain access to it. Flash drives often come with encryption software included; this doesn’t prevent loss of the
flash drive but, if it falls into the wrong hands, it prevents unauthorised access.
ial ack security
This is an older type of control that comes from the era of dial-up networking when computer users often used a physical phone
line to dial-in access the internet. This system works by calling the user back on a pre-determined phone line to ensure that access
is being granted from an authorised location.
Confidentiality agreements
This is an example of an administrative control that spells out the responsibilities, duties, and potential penalties of employees in
terms of ensuring that they keep data private, secure and safely stored away. Confidentiality agreements are commonly used in
many larger companies.
Conclusion
Information systems are becoming an ever-increasingly important aspect of performance management. Gaining knowledge in this
area will add to your employability if you are not yet working, and help you advance faster in your career if you already are. ACCA
recognises this importance which is why it’s an important part of your PM syllabus – make sure you study this often overlooked
area and be ready for it in your upcoming PM exam.
ritten te e illis finance and accountanc trainer
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Tac lin er r ance e al ati n esti ns
Home / Students / Study resources / Performance Management (PM) / Technical articles / Tacklin perfor ance e aluation uestions
Performance evaluation is a regularly examined requirement in the F5 Performance Management exam, and is a topic that
students tend to misunderstand and struggle with. Often examined as a full, 20 mark requirement, the task of crafting a free-form
answer that incorporates both supporting calculations and a developed, written discussion is a daunting task. It’s unfamiliar
territory moving up from F2, and requires a specific set of new skills.
This article is meant to help you successfully tackle this type of question. We will work through an approach for planning and
answering this requirement, look at common mistakes and how to avoid them, and finally take you through a completed answer
that demonstrates the points in this article.
Before you go further, please download Question 31, Jungle Co, from the September 2016 exam. It will serve as our model
throughout this article.
he requirement
isc ss t e inancial an non inancial e o ance o n le o o t e ea en in
ote t e e a e a s a aila le o calc lations an a s a aila le o isc ssion a s
As you see, this type of question can be examined as a single, 20-mark requirement – performance on this single answer can
mean the difference between a pass or a fail. In order to gain passing marks on this requirement, it’s suggested to use and practice
an approach that you can replicate under the stress of exam day.
A recommended approach is:
• nderstand time management and use your time appropriately

• Effectively read the requirement and plan your answer
• Decide on your calculations and complete your workings
• Plan your discussion
• Write up your discussion using a standard approach to paragraph creation
Let’s now work through this approach step-by-step, using Jungle Co as an example.
Understand time management

Time management is critical skill to develop for passing ACCA exams – if you don’t grasp the concepts we talk about here, you will
struggle not only with F5 but with all your future exams.
The idea is to set a time limit for everything you do in your exam. This keeps you on track, and helps you ensure that you cover all
questions in the exam. The golden rule here is to spend 1. minutes per mark if you are on the paper-based exam, and 1. minutes
per mark if you are on the CBE. This gives you a bit of buffer time in either case.
As question Jungle Co is 20 marks, you should spend either 34 or 36 minutes in your exam on this question. Do not exceed this
time limit: if you run out of time, move to the next question and come back later if you manage to find extra time.
You will have a lot to do in this short window so the next step is to allocate the total time allowed to the different tasks you’ll
complete in the question. With performance evaluation questions, you are usually given an important indication about this: the
spread of arks et een calculatin and discussin .
For example, in question Jungle Co, it’s clearly stated that the calculations are worth a maximum of marks and the discussion is
worth 13 marks. This eans that after readin and plannin ou should spend of the re ainin ti e on our
calculations and on ritin our discussion.
When time is up for the calculations you need to move to your discussion, even if you feel you haven’t done enough. Most of the
marks will come from your analysis, not your calculations. Students are often more comfortable performing calculations than writing
up an essay, so there is a real risk that you will spend too much time on the numbers and fail to give enough attention to the
discussion.
A oid the co on istake of o er calculatin and under ritin use ti e ana e ent to properl split our ti e
et een the t o tasks.
Effective reading and planning

For the scenario-based, section C questions, it’s critical that you carefully read the scenario as it will contain important information
that you need to relate to your answer. Finding this important information is your job here. Bring a highlighter marker with you (or
use the highlighter tool in the CBE) and highlight this information as you find it.
For example, in question Jungle Co, you will find important information about the company’s product lines, new services offered,
and a big change in their approach to logistics.
Time management: you will need roughly 15-20 of your total question time to properly read and plan your answer. Spend this
time and do a good plan here to save you time later in your answer.
A oid the co on istake of not linkin our ans er to the scenario. dentif in the ke issues in the scenario is the first
thin ou should do.
o for the easy marks first

This is an important concept relevant to all your ACCA exams and one that successful students follow carefully. 'Easy marks first'
means that you should always go for the easiest requirements in a question first, saving the difficult things for later, even if it means
taking things out of order. It also applies to sections A and B of the exam: do the easiest OTs first; flag the difficult ones and come
back to them later. If you are going to run out of time, do so while attempting the difficult parts of the question that you might not get
anyway, rather than missing out on easy marks.
This is relevant to performance analysis questions. The easiest marks in this type of question (and also the logical starting place
as you can’t evaluate performance without information) come from the calculations, so start here and get warmed up. But
remember, don’t over-do it with calculations, move to the discussion when time is up.
eciding hat to calculate

After you’ve completed your reading and planning, the next step is to do your calculations. But before you start, you need to decide
WHAT you are going to calculate. Your goal is to evaluate performance from a broad perspective. This means you should use as
wide a range of data as possible.
For example, the requirement in question Jungle Co clearly states, 'discuss the inancial and non inancial performance of the
company'. Linking these two perspectives is a core aspect of the Performance Management syllabus: it’s critical that you show,
and contrast, both perspectives in your answer.
Also, in question Jungle Co, you are practically overloaded with data as there are five separate sections, 19 rows, and two
columns of data. Don’t get bogged down here; find several relevant ratios from each section, rather than calculate everything
possible from one section.
For example, after you identify that there are multiple sections of data, you could calculate some of the following indicators,
touching on as many sections as you can:
ection s ndicator
Profit and loss statement Change in revenue

Change in gross margin
Change in net margin
Breakdown of revenue and cost of sales Change in revenue by product line

Change cost of sales by product line
Change in gross margin by product line
Administration expenses Change in customer service costs

Change in customer service costs as a of admin expenses
Non–financial data Change in on-time deliveries

Change in late deliveries
Change in customer complaints
Change in the of customers who complain
Change in late Gold member deliveries
These indicators are only some examples of what you could calculate – it also might be more than you can do in the allocated
time. But don’t worry; you don’t need to calculate this full list of indicators to reach passing marks. What’s more important is to (a)
not to over-do it calculating at the expense of your discussion (b) use data from all the sections (c) use the ratios effectively in your
discussion.
Time management: when 1/3 of the time remaining after reading and planning is up, stop your calculations and move to the
discussion. It’s normal to feel that there is more that you can do, but resist this urge; it’s time to move to the discussion part of your
answer.
A oid the co on istake of oin no further than the calculations the er is discuss not calculate. nl out of
arks in this uestion are a aila le for the nu ers.
Understand the o n figure rule and ho it orks in your favour

In a time-pressurised situation like your F5 exam, occasional slips of the calculator can happen. While your section A and B
answers need to be numerically correct to get marks, in section C constructed response questions, the 'own figure rule' applies.
This means that any numbers you calculate incorrectly will be assumed correct when used later in your answer.
For example, if sales are increasing, but you accidentally show this change as decreasing, you will miss the mark for the working.
However, in your narrative, if you correctly discuss the impact of sales decreasing, you will get full marks here e en t o o
calc lation as inco ect. But, make sure you show your workings.
In the computer based exam, your workings will be in spreadsheet cells and markers will look at your formulae if needed.
A oid the co on istake of tr in to et our nu

calculations and uickl
ers perfect in section C scenario ased uestions. o our
o x
o e to the discussion hen ti e is up don t aste alua le ti e dou le checkin e er thin .
f there happens to e a istake in our nu ers ut ou interpret this error correctl
l B
ou ill et full arks in our
discussion.
b a
l o
Moving on to the more challenging part the discussion
G
C A
Now that you’ve completed the calculations, it’s time to move to the part that many students dread: writing the discussion. This is
A C
the area where many students struggle. But, with the right approach to writing and enough practice, you can develop the skills to
successfully handle this component of the requirement.
Time management: as noted above, make sure you give this part of your answer the full 2/3 of your remaining time after reading
and planning – you will need it.
o to gain marks
It’s not enough to simply restate your calculation in words – for example, 'sales increased by 20 percent'. It’s also not enough to
only give short, generic statements – for example, 'this is a good sign'. You’ll get no marks for either – you must say more.
To gain a mark, your discussion needs to add value to your calculation and be linked to business performance. This means you
need to say WHY you think something has changed and LINK this to information in the scenario. You need to bring multiple pieces
of information together to actually discuss, or assess, performance.
A oid the co on istakes of a onl restatin our calculations as ords and onl pro idin short one phrase
eneric co ents. either of these approaches ill enerate an arks.
o much should you rite

There is no set rule for section C questions that says, one mark one point.’ Each question will have a different marking guide.
But, you need some reference to help you decide how much you should write. Work with the general rule when the requirement is
discuss’ or evaluate: 1 mark 1 idea. To generate an idea that is linked to the scenario, use roughly 3 short sentences or
independent clauses.
A good method for getting your ideas down quickly when discussing calculations is to use the writing and structuring tool,
Calculate Comment Discuss. This approach to structuring paragraphs ensures that you write enough, link to the scenario, and
efficiently generate marks.
Calculate-Comment-Discuss’ works like this.
ne ara raph
da a a n
A oid the co on istake of creatin a sea of ords this eans pa es of ritin ithout headin s and structure. se
short concise para raphs ith headin s and su headin s in our ans er.
Also, make sure you stick to the requirement, which is discuss'. Don’t drift by giving recommendations or definitions stay focused
on the requirement.
A oid the co on istake of re uire ent drift . ou on t et arks for ans erin in ented re uire ents.
hat to rite a out

se your calculations as a guide to structure your answer: focus on the areas of performance that have changed the most and that
seem to be linked to the important information in the scenario. It’s important to focus on the RELATI E change of an indicator as
this shows the significance of what you’re writing about.
A oid the co on istake of producin and ritin a out a solute chan es. nl relati e chan es ill e a arded
arks.
For example, in question Jungle Co, late Gold member deliveries increased from 2 to 14 . What’s important is that missed
deliveries increased 00 in relative terms this shows a major problem, coming from the move to in-house logistics, potentially
threatening continued growth of the business. This is hat ou are oin after in our discussion. To state the change simply
as in increase of 14 percentage points misses the point and won’t generate marks.
Make sure your ans er is linked to the scenario

In section C, it’s critical that you relate your answer to the scenario to gain marks.
For example, in question Jungle Co, you learned during reading and planning that the company took logistics in-house instead of
using international delivery companies. You then see in your calculations that both missed deliveries and complaints have
increased. It’s likely there is a cause-effect relationship here: moving to in-house logistics caused the quality to drop, which is
driving the increase in complaints. Bring this kind of relationship out in your answer.
A oid the co on istake of producin eneric co ents link our ideas directl to the issues in the scenario to ain
arks.
nclude a summary
If time permits, include an overall summary at the end of your answer, tying the financial and non-financial perspectives together.
Example of a good ans er

We’ve just looked a detailed approach to helping you construct an answer that can get you a comfortable pass on this type of
question. Here is a worked example, demonstrating the points in this article.
orkin s
a a n
increase in total re enue

This is a good sign. It shows that Jungle Co is selling more units because 'prices are stable', and/or the new cloud service is
expanding. But, we need a breakdown of revenue to understand this (see below).
. increase in net ar in
This is excellent sign. It’s linked to the lower cost of sales from Slabak imports and the launch of cloud computing, which is
probably a higher-margin product (for example, no distribution costs for IT services).
. increase in ad in e penses
This is a problem because admin costs are usually fixed. This is linked to the big increase in customer service costs, which, in turn,
is probably related to the lower quality of the new supplier which is causing more complaints (see below).
. drop in household oods re enue

This is a worrying sign – it could be linked to the possible drop in quality from the Slabak imports.
. chan e in electronic oods re enue

This is another positive signal. It shows that Jungle is outperforming the average market growth of 20 , which means they are
gaining market share.
increase in late deli eries

This is a major problem. It s linked to the move to in-house logistics. Clearly Jungle Co can’t match the quality of the external,
international suppliers. Jungle Co needs to address this as it threatens future growth of the business.
increase in of custo ers ho co plain

This is another major problem. It’s linked to both the outsourcing of production to Slabak, and the move to in-house logistics
(mentioned above). Clearly Jungle Co has serious internal process problems that will negatively affect their reputation.
erall
We see mostly good news from the financial indicators: sales, margins, and profits are generally increasing. However, the non-
financial information paints a different picture as we see serious problems emerging with Jungle Co’s quality and logistics. Jungle
Co needs to address these issues if they want their financial success to continue in the long term.
Summary
Co on istake o to a oid
'Over calculating' and 'under writing' Look for the time-management clue in the requirement – for example, if the requirement
says, '1/3 of the marks are available for calculations', spend 1/3 of your time calculating
and 2/3 writing
Not referencing the scenario in your discussion Highlight the key points from the scenario as you read and then link to them in your
discussion
Going no further than calculations Highlight the verb and do what the verb says. If it’s 'discuss', or 'evaluate', it’s likely at
least half of the marks will come from your writing, not your calculating
Double-checking all your calculations Calculate quickly once, and move to the discussion. 'Own figure rule' will be in effect.
Only restating your calculation as words se the paragraph writing tool, 'calculate-comment-discuss'
Providing only short, generic, one-phrase se the paragraph writing tool, 'calculate-comment-discuss'
comments
'Requirement drift' – answering an invented Highlight the verb and only do what is asked. Nothing more.
requirement, rather than the one given in the
question.
Discussing change in absolute, rather than Calculate changes in relative terms and discuss the impact of this. (For example, if missed
relative, terms. deliveries go from 3 to 6 , what’s important is that missed deliveries increased by 100 ,
or doubled, not that they increased three percentage points).
Producing a 'sea of words' – this is an se short paragraphs, with headings and sub-headings. se 1 paragraph per idea.
unstructured essay with no signposting or
breaks between ideas
Running out of time Follow the time management rule of 1. or 1. minutes per mark; remember you won’t
lose marks for spelling or grammar mistakes if you are understood by the marker
te e illis is head tutor for ana e ent Accountin e a s at C Acade

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il in l c s er r ance ana e ent
Home / Students / Study resources / Performance Management (PM) / Technical articles / uildin locks of perfor ance ana e ent
Performance management the processes that ensure organisations meet their objectives is core to the Performance
Management syllabus, and understanding modern performance measurement systems is an important area within this topic.
Performance Management students should already be familiar with Kaplan & Norton’s Balanced Scorecard which is a regularly
examined topic and one of the foundations of modern performance measurement. it erald and oon s uildin lock odel
is an evolution of the Balanced Scorecard, developed to meet the needs of service organisations. It is a tool that helps
management set a forward-looking performance management framework that links an organisation’s strategy and objectives to
employee targets and motivation.
This article will review the importance of the modern approach to performance measurement, discuss the Building Block model,
and apply this model to an exam-based scenario.
Measuring performance
An approach to measuring performance that we are familiar with is, looking at the numbers.’ Classic questions which are often
asked about a company are, 'How much profit has it made?' 'How much have sales grown?' 'What’s its market share compared to
the competition?' However, these traditional, financial performance metrics which are regularly calculated for accountancy exams
are no longer sufficient, according to leading thinkers on strategy and performance management.
Profit-based performance metrics measure past performance. They are also distorted by accounting policies. Just look at the
famous auto and engine maker Rolls Royce; its recently reported profits would be 900m lower under new IFRS revenue
recognition requirements. Financial metrics are also criticised as leading to managerial myopia,’ or short-termism, whereby
management make decisions which sacrifice future performance for profits today. Managers can be motivated to postpone
investments and other costs to maintain their quarterly or annual profits if their success is judged solely against financial
performance targets.
Performance management experts argue that in the increasingly competitive modern business environment, organisations now
need forward-looking performance measurement systems, linked to their critical success factors, to achieve long-term success.
The new question to ask is, 'what areas of performance are critical to achieving our strategic objectives and how do we measure
them?'
The following scenario will be used to discuss and illustrate the Building Block Model.
Scenario SmartCourier
SmartCourier is a package delivery company located in the developing country of Maxland. Since its formation in 19 0,
SmartCourier has evolved into one of the largest and most successful shipping companies in the country. Its mission is 'to exceed
customers’ expectations in the transfer of packages by offering the highest-quality services at competitive prices.'
SmartCourier offers a range of delivery services such as:
• Standard overnight delivery

• A premium add-on of guaranteed 10:30am delivery
• A cheaper, three-day service for less time-critical deliveries
SmartCourier has recently launched an app that lets customers set pickup times and locations on their smartphones which has
received positive reviews in the technology press.
SmartCourier has identified the following critical success factors:
• Deliver sustainable profits to shareholders

• Leave customers highly satisfied at every interaction with SmartCourier
• Provide a range of products which meet our clients’ evolving needs
• Lead the industry with constant innovation
Managers at SmartCourier have a dynamic compensation package which includes share options, goal-based incentives,
commissions, and non-monetary public recognition. SmartCourier also allows for flexible work schedules and is piloting an on-site
child care programme at one of its locations.
SmartCourier receives positive coverage in the press about its work environment and is considered to be an attractive employer,
with motivated employees and a good reputation among job seekers.
However, SmartCourier’s profits have dropped in recent years due to increasing competition from global transport companies who
have recently entered the market in Maxland.
he uilding lock Model

The Building Block model looks at three areas of performance: dimensions, standards, and rewards.
o x
l B
b a
G lo
C A
A C
imensions Explained
Companies compete across a range of dimensions besides financial performance. The Building Block model considers this and
describes two categories of dimensions: Results’ and Determinants.’
Results’ are the outcome of decisions and actions taken by management in the past. These are captured under the first two
dimensions of the model, financial perfor ance and co petiti eness.
Determinants’ refer to the forward-looking dimensions of the model: what areas of future performance are most important for a
company to achieve positive financial and competitive results? ualit inno ation fle i ilit and resource utili ation are the
determinants of future success.
imensions at SmartCourier
esults
As a listed company, the management of SmartCourier will be very interested in measuring financial success is it delivering the
right profits and returns for its shareholders? Co petiti eness is also critical to measure as new competitors are entering the
market in Maxland is SmartCourier maintaining or losing market share?
eter inants
SmartCourier’s managers and staff need to focus on the dimensions of performance that will determine positive financial and
competitive results. For example, on-time deliveries will lead to customer loyalty. This falls under ualit of service. The
company’s varied product range should meet the needs of different customer segments; this is an example of fle i ilit of service.
Flexibility and quality of service should in turn drive positive financial results, for example, higher sales revenue.
nno ation is also important to SmartCourier as it is investing in new technology and improving processes with its smartphone
app. esource utilisation is critical to its financial success as efficient use of delivery vehicles, staff and financial resources will
reduce costs and improve profitability. In other words, innovation and resource utilisation are driving financial success (higher
profits) and competitiveness (maintaining market share).
Standards Explained
After an organisation’s dimensions are understood, standards can be set. These will be the benchmarks, or targets, directly linked
to performance metrics under headings for each dimension. There are three aspects to consider in setting standards:
• Who is responsible for achieving the standard (o nership)?

• What level are the standards set at (achie a ilit )?
• Can we use the standards for a fair appraisal across the company (e uit )?
These three criteria are important. If it is unclear to whom targets are assigned, managers and staff will not have accountability and
performance management will fail. If personal targets are unachievable, people will not work harder to achieve their goals and
there will be little motivation. If appraisal is not fair and transparent, employee morale will suffer.
Standards at SmartCourier
Based on the dimensions above, we can suggest standards of performance for SmartCourier:
inancial perfor ance

o t in sales net o it a in and et n on in est ent are potential targets for regional managers. For example, fixed targets
could be set, such as ann al o t in sales or a ta et o Or, SmartCourier could use a league table approach by
ranking the regions according to these standards and then rewarding managers accordingly.
Co petiti eness
With new players on the market it is important for SmartCourier to measure this area of external performance. It can set a sol te
a et s a e as a standard for measuring competitiveness by dividing SmartCourier’s revenue by the total revenue of the industry
in Maxland. A target for regional managers could be to maintain market share as competitive rivalry is increasing in the industry.
ualit
As a service organisation, it is critical that SmartCourier delivers quality of service to retain its customer base. It can set targets for
courier agents such as 9 on ti e eli e , or for call centre representatives a e a e ti e to ta e an o e of 3 minutes. It will be
important to ensure that these targets are both fair and achievable to ensure employees are motivated (see below).
esource utilisation
SmartCourier can measure resource utilisation by using efficiency standards such as a e a e ti e e eli e or a e a e n e
o eli e ies e a However, equity should be considered here, as urban regions could potentially out-perform rural regions as
urban customers will be clustered closer together.
le i ilit of ser ice and inno ation

Flexibility of service can be measured with a targets such as 90 o o e s sc e le to c sto e s e est and Innovation can be
measured with o c sto e s sin t e s a t one a .
Re ards Explained
The last part of the model looks at the overall reward structure of the organisation and is the link to HR systems. Do compensation
packages in the company lead people to achieve the standards of performance which are set out above? This part of the model
has three aspects:
• Is the system understandable to all employees (clarit )?

• Will the system drive employees to achieve their objectives ( oti ation)?
• Do employees have control over their areas of responsibility (controlla ilit )?
The reward system should be clearly understood by all employees: this means unambiguous performance appraisal and bonus
triggers. Rewards should be sufficiently desirable so that employees are motived to work hard towards gaining them. Finally, if
employees are assessed against factors out of their control, they will lose interest in working towards their rewards.
Re ards at SmartCourier
It seems like SmartCourier has an effective reward system. The compensation package covers a range of financial and non-
financial rewards and benefits, which probably contributes to the motivation of employees by meeting their different needs. For
example, new parents will be motivated by the child care facilities, other staff may be motivated by the flexible work place
arrangements. It also appears that rewards are performance based (for example, 'goal based incentives') which will lead to
increased motivation.
It’s important for SmartCourier to ensure that rewards are controllable and clear, for example, by making sure that targets are well
defined and then agreed in appraisal meetings.
Conclusion
Like other modern performance measurement frameworks, the Building Block model connects an organisation’s strategic
objectives to a range of forward-looking, non-financial performance measures. Where the Building Block Model differs, however, is
that also considers reward systems and aims to create a framework of clearly understood and communicated individual metrics
that aligns individual performance targets with organizational objectives.
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ecentralisati n an the nee r

er r ance eas re ent

/ ecentralisation and the need for perfor ance easure ent
Decentralisation is essentially the delegation of decision-making responsibility. All organisations decentralise to some degree;
some do it more than others. Decentralisation is a necessary response to the increasing complexity of the environment that
organisations face and the increasing size of most organisations. Nowadays it would be impossible for one person to make all the
decisions involved in the operation of even a small company, hence senior managers delegate decision-making responsibility to
subordinates.
One danger of decentralisation is that managers may use their decision-making freedom to make decisions that are not in the best
interests of the overall company (so called dysfunctional decisions). To redress this problem, senior managers generally introduce
systems of performance measurement to ensure – among other things – that decisions made by junior managers are in the best
interests of the company as a whole. Table 1 below details different degrees of decentralisation and typical financial performance
measures employed.
TA
Profit centres and investment centres are often referred to as divisions. Divisionalisation refers to the delegation of profit-making
responsibility.
hat makes a good performance measure

A good performance measure should:
• provide incentive to the divisional manager to make decisions which are in the best interests of the overall company (goal
congruence)
• only include factors for which the manager (division) can be held accountable
• recognise the long-term objectives as well as short-term objectives of the organisation.
raditional performance indicators

Cost centres
Standard costing variance analysis is commonly used in the measurement of cost centre performance. It gives a detailed
explanation of why costs may have departed from the standard. Although commonly used, it is not without its problems. It focuses
almost entirely on short-term cost minimisation which may be at odds with other objectives, for example, quality or delivery time.
Also, it is important to be clear about who is responsible for which variance – is the production manager or the purchasing
manager (or both) responsible for raw material price variances? There is also the problem with setting standards in the first place –
variances can only be as good as the standards on which they are based.
rofit centres
Controllable profit statements are commonly used in profit centres. A pro-forma statement is given in Table 2.
TA
The major issue with such statements is the difficulty in deciding what is controllable or traceable. When assessing the
performance of a manager we should only consider costs and revenues under the control of that manager, and hence judge the
manager on controllable profit. In assessing the success of the division, our focus should be on costs and revenues that are
traceable to the division and hence judge the division on traceable profit. For example, depreciation on divisional machinery would
not be included as a controllable cost in a profit centre. This is because the manager has no control over investment in fixed
assets. It would, however, be included as a traceable fixed cost in assessing the performance of the division.
n est ent centres

In an investment centre, managers have the responsibilities of a profit centre plus responsibility for capital investment. Two
measures of divisional performance are commonly used:
1. Return on investment (ROI) controllable (traceable) profit/controllable (traceable) investment.
2. Residual income controllable (traceable) profit – an imputed interest charge on controllable (traceable) investment.
ote te inte est is calc late lti l in t e cont olla le t acea le in est ent t e cost o ca ital
Example 1 below demonstrates their calculation and some of the drawbacks of return on investment.
a ple
Division X is a division of XYZ plc. Its net assets are currently 10m and it earns a profit of 2.2m per annum. Division X's cost of
capital is 10 per annum. The division is considering two proposals.
• Proposal 1 involves investing a further 1m in fixed assets to earn an annual profit of 0.15m.
• Proposal 2 involves the disposal of assets at their net book value of 2.3m. This would lead to a reduction in profits of 0.3m.
Proceeds from the disposal of assets would be credited to head office not to Division X.
e uired
Calculate the current ROI and residual income for Division X and show how they would change under each of the two proposals.
Co entar
nder the current situation ROI exceeds the cost of capital and residual income is positive. The division is performing well.
In simple terms Proposal 1 is acceptable to the company. It offers a rate of return of 15 ( 0.15m/ 1m) which is greater than the
cost of capital. However, divisional ROI falls and this could lead to the divisional manager rejecting Proposal 1. This would be a
dysfunctional decision. Residual income increases if Proposal 1 is adopted and this performance measure should lead to goal
congruent decisions.
In simple terms Proposal 2 is not acceptable to the company. The existing assets have a rate of return on 13 ( 0.3m/ 2.3m)
which is greater than the cost of capital and hence should not be disposed of. However, divisional ROI rises and this could lead to
the divisional manager accepting Proposal 2. This would be a dysfunctional decision. Residual income decreases if Proposal 2 is
adopted and once again this performance measure should lead to goal congruent decisions.
Relative merits of RO and residual income
o x
Return on investment is a relative measure and hence suffers accordingly. For example, assume you could borrow unlimited
amounts of money from the bank at a cost of 10 per annum. Would you rather borrow 100 and invest it at a 25 rate of return or
borrow 1m and invest it at a rate of return of 15 ?
l B
b a
Although the smaller investment has the higher percentage rate of return, it would only give you an absolute net return (residual
G lo
income) of 15 per annum after borrowing costs. The bigger investment would give a net return of 50,000. Residual income,
being an absolute measure, would lead you to select the project that maximises your wealth.
C A
Residual income also ties in with net present value, theoretically the best way to make investment decisions. The present value of
a project's residual income equals the project's net present value. In the long run, companies that maximise residual income will
A C
also maximise net present value and in turn shareholder wealth. Residual income does, however, experience problems in
comparing managerial performance in divisions of different sizes. The manager of the larger division will generally show a higher
residual income because of the size of the division rather than superior managerial performance.
In addition because RI uses the cost of capital to calculate an imputed interest this cost of capital can be adjusted to recognise the
risk in different projects.
Pro lems common to oth RO and residual income

The following problems are common to both measures:
• Identifying controllable (traceable) profits and investment can be difficult.

• If used in a short-term way they can both overemphasise short-term performance at the expense of long-term performance.
Investment projects with positive net present value can show poor ROI and residual income figures in early years leading to
rejection of projects by managers (see Example 2).
• If assets are valued at net book value, ROI and residual income figures generally improve as assets get older. This can
encourage managers to retain outdated plant and machinery (see Example 2).
• Both techniques attempt to measure divisional performance in a single figure. Given the complex nature of modern
businesses, multi-faceted measures of performance are necessary.
• Both measures require an estimate of the cost of capital, a figure which can be difficult to calculate.
a ple
PQR plc is considering opening a new division to manage a new investment project. Forecast cash flows of the new project are as
follows:
PQR's cost of capital is 10 per annum. Straight line depreciation is used.
e uired
Calculate the project's net present value and its projected ROI and residual income over its five-year life.
esidual inco e
Co entar :
This example demonstrates two points. Firstly, it illustrates the potential conflict between NP and the two divisional performance
measures. This project has a positive NP and should increase shareholder wealth. However, the poor ROI and residual income
figures in the first year could lead managers to reject the project. Secondly, it shows the tendency for both ROI and residual income
to improve over time. Despite constant annual cash flows, both measures improve over time as the net book value of assets falls.
This could encourage managers to retain outdated assets.
on financial performance indicators ( P s)

In recent years, the trend in performance measurement has been towards a broader view of performance, covering both financial
and non-financial indicators. The most well-known of these approaches is the balanced scorecard proposed by Kaplan and
Norton. This approach attempts to overcome the following weaknesses of traditional performance measures:
Single factor measures such as ROI and residual income are unlikely to give a full picture of divisional performance.
• Single factor measures are capable of distortion by unscrupulous managers (eg by undertaking Proposal 2 in Example 1).
• They can often lead to confusion between measures and objectives. If ROI is used as a performance measure to promote the
maximisation of shareholder wealth some managers will see ROI (not shareholder wealth) as the objective and dysfunctional
consequences may follow.
• They are of little use as a guide to action. If ROI or residual income fall they simply tell you that performance has worsened,
they do not indicate why.
The balanced scorecard approach involves measuring performance under four different perspectives, as follows:
The term 'balanced' is used because managerial performance is assessed under all four headings. Each organisation has to
decide which performance measures to use under each heading. Areas to measure should relate to an organisation's critical
success factors.
Critical success factors (CSFs) are performance requirements which are fundamental to an organisation's success (for example
innovation in a consumer electronics company) and can usually be identified from an organisation's mission statement, objectives
and strategy.
Key performance indicators (KPIs) are measurements of achievement of the chosen critical success factors. Key performance
indicators should be:
• specific (ie measure profitability rather than 'financial performance', a term which could mean different things to different
people)
• measurable (ie be capable of having a measure placed upon it, for example, number of customer complaints rather than the
'level of customer satisfaction')
• relevant, in that they measure achievement of a critical success factor
Example 3 demonstrates a balanced scorecard approach to performance measurement in a fictitious private sector college training
ACCA students.
a ple
The balanced scorecard approach to performance measurement offers several advantages:
• it measures performance in a variety of ways, rather than relying on one figure

• managers are unlikely to be able to distort the performance measure as bad performance is difficult to hide if multiple
performance measures are used
• it takes a long-term perspective of business performance
• success in the four key areas should lead to the long-term success of the organisation
• it is flexible as what is measured can be changed over time to reflect changing priorities
• 'what gets measured gets done' – if managers know they are being appraised on various aspects of performance they will pay
attention to these areas, rather than simply paying 'lip service' to them.
The main difficulty with the balanced scorecard approach is setting standards for each of the KPIs. This can prove difficult where
the organisation has no previous experience of performance measurement. Benchmarking with other organisations is a possible
solution to this problem.
Allowing for trade-offs between KPIs can also be problematic. How should the organisation judge the manager who has improved
in every area apart from, say, financial performance? One solution to this problem is to require managers to improve in all areas,
and not allow trade-offs between the different measures.
ritten a e er of the erfor ance ana e ent e a inin tea
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Trans er ricin
Home / Students / Study resources / Performance Management (PM) / Technical articles / Transfer pricin
There is no doubt that transfer pricing is an area that candidates find difficult. It’s not surprising, then, that when it was examined in
June 2014’s Performance Management exam, answers were not always very good.
The purpose of this article is to strip transfer pricing back to the basics and consider, first, why transfer pricing is important;
secondly, the general principles that should be applied when setting a transfer price; and thirdly, an approach to tackle exam
questions in this area, specifically the question from June 2014’s exam. We will talk about transfer pricing here in terms of two
divisions trading with each other. However, don’t forget that these principles apply equally to two companies within the same group
trading with each other.
This article assumes that transfer prices will be negotiated between the two parties. It does not look at alternative methods such as
dual pricing, for example. This is because, in Performance Management, the primary focus is on working out a sensible transfer
price or range of transfer prices, rather than different techniques to setting transfer prices.
hy transfer pricing is important

It is essential to understand that transfer prices are only important in so far as they encourage divisions to trade in a way that
maximises profits for the company as a whole. The fact is that the effects of inter-divisional trading are wiped out on consolidation
anyway. Hence, all that really matters is the total value of external sales compared to the total costs of the company. So, while
getting transfer prices right is important, the actual transfer price itself doesn’t matter since the selling division’s sales (a credit in
the company accounts) will be cancelled out by the buying division’s purchases (a debit in the company accounts) and both
figures will disappear altogether. All that will be left will be the profit, which is merely the external selling price less any cost
incurred by oth divisions in producing the goods, irrespective of which division they were incurred in.
As well as transfer prices needing to be set at a level that maximises company profits, they also need to be set in a way that is
compliant with tax laws, allows for performance evaluation of both divisions and staff/managers, and is fair and therefore
motivational. A little more detail is given on each of these points below:
• If your company is based in more than one country and it has divisions in different countries that are trading with each other,
the price that one division charges the other will affect the profit that each of those divisions makes. In turn, given that tax is
based on profits, a division will pay more or less tax depending on the transfer prices that have been set. While you don’t need
to worry about the detail of this for the Performance Management exam, it’s such an important point that it’s simply impossible
not to mention it when discussing why transfer pricing is important.
• From bullet point 1, you can see that the transfer price set affects the profit that a division makes. In turn, the profit that a
division makes is often a key figure used when assessing the performance of a division. This will certainly be the case if return
on investment (ROI) or residual income (RI) is used to measure performance. Consequently, a division may, for example, be
told by head office that it has to buy components from another division, even though that division charges a higher price than
an external company. This will lead to lower profits and make the buying division’s performance look poorer than it would
otherwise be. The selling division, on the other hand, will appear to be performing better. This may lead to poor decisions
being made by the company.
• If this is the case, the manager and staff of that division are going to become unhappy. Often, their pay will be linked to the
performance of the division. If divisional performance is poor because of something that the manager and staff cannot control,
and they are consequently paid a smaller bonus for example, they are going to become frustrated and lack the motivation
required to do the job well. This will then have a knock-on effect to the real performance of the division. As well as being seen
not to do well because of the impact of high transfer prices on ROI and RI, the division really will perform less well.
The impact of transfer prices could be considered further but these points are sufficient for the level of understanding needed for
the Performance Management exam. Let us now go on to consider the general principles that you should understand about
transfer pricing. Again, more detail could be given here and these are, to some extent, oversimplified. However, this level of detail
is sufficient for the Performance Management exam.
eneral principles a out transfer pricing

. here there is an e ternal arket for the product ein transferred
ini u transfer price

When we consider the minimum transfer price, we look at transfer pricing from the point of view of the selling division. The question
we ask is: what is the minimum selling price that the selling division would be prepared to sell for? This will not necessarily be the
same as the price that the selling division would be happy to sell for, although, as you will see, if it does not have spare capacity, it
is the same.
The minimum transfer price that should ever be set if the selling division is to be happy is: marginal cost opportunity cost.
Opportunity cost is defined as the 'value of the best alternative that is foregone when a particular course of action is undertaken'.
Given that there will only be an opportunity cost if the seller does not have any spare capacity, the first question to ask is therefore:
does the seller have spare capacity?
a a a
If there is spare capacity, then, for any sales that are made by using that spare capacity, the opportunity cost is zero. This is
because workers and machines are not fully utilised. So, where a selling division has spare capacity the minimum transfer price is
effectively just marginal cost. However, this minimum transfer price is probably not going to be one that will make the managers
happy as they will want to earn additional profits. So, you would expect them to try and negotiate a higher price that incorporates
an element of profit.
a a a
If the seller doesn’t have any spare capacity, or it doesn’t have enough spare capacity to meet all external demand and internal
demand, then the next question to consider is: how can the opportunity cost be calculated? Given that opportunity cost represents
contribution foregone, it will be the amount required in order to put the selling division in the same position as they would have
been in had they sold outside of the group. Rather than specifically working an 'opportunity cost' figure out, it’s easier just to stand
back and take a logical approach rather than a rule-based one.
Logically, the buying division must be charged the same price as the external buyer would pay, less any reduction for cost savings
that result from supplying internally. These reductions might reflect, for example, packaging and delivery costs that are not incurred
if the product is supplied internally to another division. It is not really necessary to start breaking the transfer price down into
marginal cost and opportunity cost in this situation.
It’s sufficient merely to establish:
(i) what price the product could have been sold for outside the group
(ii) establish any cost savings, and
(iii) deduct (ii) from (i) to arrive at the minimum transfer price.
At this point, we could start distinguishing between perfect and imperfect markets, but this is not necessary in Performance
Management. There will be enough information given in a question for you to work out what the external price is without focusing
on the market structure.
We have assumed here that production constraints will result in fewer sales of the same product to external customers. This may
not be the case; perhaps, instead, production would have to be moved away from producing a different product. If this is the case
the opportunity cost, being the contribution foregone, is simply the shadow price of the scarce resource.
In situations where there is no spare capacity, the minimum transfer price is such that the selling division would make just as much
profit from selling internally as selling externally. Therefore, it reflects the price that they would actually be happy to sell at. They
shouldn’t expect to make higher profits on internal sales than on external sales.
a i u transfer price
When we consider the maximum transfer price, we are looking at transfer pricing from the point of view of the buying division. The
question we are asking is: what is the maximum price that the buying division would be prepared to pay for the product? The
answer to this question is very simple and the maximum price will be one that the buying division is also happy to pay.
The maximum price that the buying division will want to pay is the market price for the product – ie whatever they would have to
pay an external supplier for it. If this is the same as the selling division sells the product externally for, the buyer might reasonably
expect a reduction to reflect costs saved by trading internally. This would be negotiated by the divisions and is called an adjusted
market price.
. here there is no e ternal arket for the product ein transferred

Sometimes, there will be no external market at all for the product being supplied by the selling division; perhaps it is a particular
type of component being made for a specific company product. In this situation, it is not really appropriate to adopt the approach
above. In reality, in such a situation, the selling division may well just be a cost centre, with its performance being judged on the
basis of cost variances. This is because the division cannot really be judged on its commercial performance, so it doesn’t make
much sense to make it a profit centre. Options here are to use a cost based approach to transfer pricing but these also have their
advantages and disadvantages.
a da a
a a
o x
A transfer price set equal to the variable cost of the transferring division produces very good economic decisions. If the transfer
B
price is 1 , Division B’s marginal costs would be 2 (each unit costs 1 to buy in then incurs another 10 of variable cost). The
l
b a
group’s marginal costs are also 2 , so there will be goal congruence between Division B’s wish to maximise its profits and the
group maximising its profits. If marginal revenue exceeds marginal costs for Division B, it will also do so for the group.
G lo
Although good economic decisions are likely to result, a transfer price equal to marginal cost has certain drawbacks:
A
Division A will make a loss as its fixed costs cannot be covered. This is demotivating.
C
A C
Performance measurement is also distorted. Division A is condemned to making losses while Division B gets an easy ride as it is
not charged enough to cover all costs of manufacture. This effect can also distort investment decisions made in each division. For
example, Division B will enjoy inflated cash inflows.
There is little incentive for Division A to be efficient if all marginal costs are covered by the transfer price. Inefficiencies in Division A
will be passed up to Division B. Therefore, if marginal cost is going to be used as a transfer price, it at least should be standard
marginal cost, so that efficiencies and inefficiencies stay within the divisions responsible for them.
a a
A transfer price set at full cost or better, full standard cost is slightly more satisfactory for Division A as it means that it can aim to
break even. Its big drawback, however, is that it can lead to dysfunctional decisions because Division B can make decisions that
maximise its profits but which will not maximise group profits. For example, if the final market price fell to 35, Division B would not
trade because its marginal cost would be 40 (transfer-in price of 30 plus own marginal costs of 10). However, from a group
perspective, the marginal cost is only 2 ( 1 10) and a positive contribution would be made even at a selling price of only
35. Head office could, of course, instruct Division B to trade but then divisional autonomy is compromised and Division B
managers will resent being instructed to make negative contributions which will impact on their reported performance. Imagine you
are Division B’s manager, trying your best to hit profit targets, make wise decisions, and move your division forward by carefully
evaluated capital investment.
The full cost l s approach would increase the transfer price by adding a mark-up. This would now motivate Division A, as profits
can be made there and may also allow profits to be made by Division B. However, again this can lead to dysfunctional decisions
as the final selling price falls.
The difficulty with full cost, full cost plus and variable cost plus is that they all result in fixed costs and profits being perceived as
marginal costs as goods are transferred to Division B. Division B therefore has the wrong data to enable it to make good economic
decisions for the group – even if it wanted to. In fact, once you get away from a transfer price equal to the variable cost in the
transferring division, there is always the risk of dysfunctional decisions being made unless an upper limit – equal to the net
marginal revenue in the receiving division – is also imposed.
ackling a transfer pricing question

Thus far, we have only talked in terms of principles and, while it is important to understand these, it is equally as important to be
able to apply them. The following question came up in June 2014’s exam. It was actually a 20-mark question with the first 10 marks
in part (a) examining divisional performance measurement and the second 10 marks in part (b) examining transfer pricing. Parts of
the question that were only relevant to part (a) have been omitted here however the full question can be found on ACCA’s website.
The question read as follows:
eproduction of e a uestion
an a a a
The Rotech group comprises two companies, W Co and C Co.
W Co is a trading company with two divisions: the design division, which designs wind turbines and supplies the designs to
customers under licences and the Gearbox division, which manufactures gearboxes for the car industry.
C Co manufactures components for gearboxes. It sells the components globally and also supplies W Co with components for its
Gearbox manufacturing division.
The financial results for the two companies for the year ended 31 May 2014 are as follows:
(b) C Co is currently working to full capacity. The Rotech group’s policy is that group companies and divisions must always make
internal sales first before selling outside of the group. Similarly, purchases must be made from within the group wherever possible.
However, the group divisions and companies are allowed to negotiate their own transfer prices without interference from head
office.
C Co has always charged the same price to the Gearbox division as it does to its external customers. However, after being offered
a 5 lower price for the similar components from an external supplier, the manager of the Gearbox division feels strongly that the
transfer price is too high and should be reduced. C Co currently satisfies 60 of the external demand for its components. Its
variable costs represent 40 of the total revenue for the internal sales of the components.
e uired
Ad ise usin suita le calculations the total transfer price or prices at hich the co ponents should e supplied to the
ear o di ision fro C Co.
a
Approach
1. As always, you should begin by reading the requirement. In this case, it is very specific as it asks you to advise, using suitable
calculations ’ In a question like this, it would actually be impossible to advise’ without using calculations anyway and your
answer would score very few marks. However, this wording has been added in to provide assistance. In transfer pricing
questions, you will sometimes be asked to calculate a transfer price/range of transfer prices for one unit of a product. However,
in this case, you are being asked to calculate the total transfer price for the internal sales. You don’t have enough information to
work out a price per unit.
2. Allocate your time. Given that this is a 10-mark question then, since it is a three-hour exam, the total time that should be spent
on this question is 1 minutes.
3. Work through the scenario, highlighting or underlining key points as you go through. When tackling part (a) you would already
have noted that C Co makes .55m of sales to the Gearbox Division (and you should have noted who the buying division was
and who the selling division was). Then, in part (b), the first sentence tells you that C Co is currently working to full capacity.
Highlight this; it’s a key point, as you should be able to tell now. Next, you are told that the two divisions must trade with each
other before trading outside the group. Again, this is a key point as it tells you that, unless the company is considering changing
this policy, C Co is going to meet all of the Gearbox division’s needs.
Next, you are told that the divisions can negotiate their own transfer prices, so you know that the price(s) you should suggest will
be based purely on negotiation.
Finally, you are given information to help you to work out maximum and minimum transfer prices. You are told that the Gearbox
division can buy the components from an external supplier for 5 cheaper than C Co sells them for. Therefore, you can work out
the maximum price that the division will want to pay for the components. Then, you are given information about the marginal
cost of making gearboxes, the level of external demand for them and the price they can be sold for to external customers. You
have to work all of these figures out but the calculations are quite basic. These figures will enable you to calculate the minimum
prices that C Co will want to sell its gearboxes for; there are two separate prices as, when you work the figures through, it
becomes clear that, if C Co sold purely to the external market, it would still have some spare capacity to sell to the Gearbox
division. So, the opportunity cost for some of the sales is zero, but not for the other portion of them.
4. Having actively read through the scenario, you are now ready to begin writing your answer. You should work through in a logical
order. Consider the transfer from both C Co’s perspective (the minimum transfer price), then Gearbox division’s perspective (the
maximum transfer price), although it doesn’t matter which one you deal with first. Head up your paragraphs so that your answer
does not simply become a sea of words. Also, by heading up each one separately, it helps you to remain focused on fully
discussing that perspective first. Finally, consider the overall position, which in this case is to suggest a sensible range of
transfer prices for the sale. There is no single definitive answer but, as is often the case, a range of prices that would be
acceptable.
The suggested solution is shown below.
Always remember that you should only show calculations that actually have some relevance to the answer. In this exam, many
candidates actually worked out figures that were of no relevance to anything. Such calculations did not score marks.
Reproduction of ans er
C Co transfers components to the Gearbox division at the same price as it sells components to the external market. However, if C
Co were not making internal sales then, given that it already satisfies 60 of external demand, it would not be able to sell all of its
current production to the external market. External sales are ,010,000, therefore unsatisfied external demand is ( ,010,000/0.6
– ,010,000) 5,340,000.
From C Co’s perspective, of the current internal sales of ,550,000, 5,340,000 could be sold externally if they were not sold to
the Gearbox division. Therefore, in order for C Co not to be any worse off from selling internally, these sales should be made at the
current price of 5,340,000, less any reduction in costs that C Co saves from not having to sell outside the group (perhaps lower
administrative and distribution costs).
As regards the remaining internal sales of 2,210,000 ( ,550,000 – 5,340,000), C Co effectively has spare capacity to meet
these sales. Therefore, the minimum transfer price should be the marginal cost of producing these goods. Given that variable costs
represent 40 of revenue, this means that the marginal cost for these sales is 4,000. This is, therefore, the minimum price
which C Co should charge for these sales.
In total, therefore, C Co will want to charge at least 6,224,000 for its sales to the Gearbox division.
a d n
The Gearbox division will not want to pay more for the components than it could purchase them for externally. Given that it can
purchase them all for 95 of the current price, this means a maximum purchase price of ,1 2,500.
a
Taking into account all of the above, the transfer price for the sales should be somewhere between 6,224,000 and ,1 2,500.
Summary
The level of detail given in this article reflects the level of knowledge required for Performance Management as regards transfer
pricing questions of this nature. It’s important to understand why transfer pricing both does and doesn’t matter and it is important to
be able to work out a reasonable transfer price/range of transfer prices.
The thing to remember is that transfer pricing is actually mostly about common sense. You don’t really need to learn any of the
specific principles if you understand what it is trying to achieve: the trading of divisions with each other for the benefit of the
company as a whole. If the scenario in a question was different, you may have to consider how transfer prices should be set to
optimise the profits of the group overall. Here, it was not an issue as group policy was that the two divisions had to trade with each
other, so whether this was actually the best thing for the company was not called into question. In some questions, however it could
be, so bear in mind that this would be a slightly different requirement. Always read the requirement carefully to see exactly what
you are being asked to do.
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cti it ase c stin
Home / Students / Study resources / Performance Management (PM) / Technical articles / Acti it ased costin
en arrett de stifies acti it ased costin and pro ides so e tips leadin up to the all i portant e a s
Conventional costing distinguishes between variable and fixed costs. Typically, it is assumed that variable costs vary with the
number of units of output (and that these costs are proportional to the output level) whereas fixed costs do not vary with output. This
is often an over-simplification of how costs actually behave. For example, variable costs per unit often increase at high levels of
production where overtime premiums might have to be paid or when material becomes scarce. Fixed costs are usually fixed only
over certain ranges of activity, often stepping up as additional manufacturing resources are employed to allow high volumes to be
produced.
ariable costs per unit can at least be measured, and the sum of the variable costs per unit is the marginal cost per unit. The
marginal cost is the additional costs caused when one more unit is produced. However, there has always been a problem dealing
with fixed production costs such as factory rent, heating, supervision and so on. Making a unit does not cause more fixed costs, yet
production cannot take place without these costs being incurred. To say that the cost of producing a unit consists of marginal costs
only will understate the true cost of production and this can lead to problems. For example, if the selling price is based on a
mark up on cost, then the company needs to make sure that all production costs are covered by the selling price. Additionally,
focusing exclusively on marginal costs may cause companies to overlook important savings that might result from better controlled
fixed costs.
A sorption costing
The conventional approach to dealing with fixed overhead production costs is to assume that the various cost types can be lumped
together and a single overhead absorption rate derived. The absorption rate is usually presented in terms of overhead cost per
labour hour, or overhead cost per machine hour. This approach is likely to be an over-simplification, but it has the merit of being
relatively quick and easy.
a ple
In Table 1 in the spreadsheet above, we are given the budgeted marginal cost for two products. Labour is paid at 12 per hour and
total fixed overheads are 224,000. Fixed overheads are absorbed on a labour hour basis.
Based on Table 1 the budgeted labour hours must be 112,000 hours. This is derived from the budgeted outputs of 20,000 Ordinary
units which each take five hours (100,000 hours) to produce, and 2,000 Deluxe units which each take six hours (12,000 hours).
Therefore, the fixed overhead absorption rate per labour hour is 224,000/112,000 2/hour.
The costing of the two products can be continued by adding in fixed overhead costs to obtain the total absorption cost for each of
the products.
Table 1 has been amended to include the fixed overheads to be absorbed in both products.
Ordinary: (5 labour hours x 2 OAR) 10
Deluxe: (6 labour hours x 2 OAR) 12
This means we have arrived at the total production cost for both products under absorption costing. It also tell us that if production
goes according to budget then total costs will be (20,000 x 5) (2,000 x 102) 1,904,000.
The conventional approach outlined above is satisfactory if the following conditions apply:
1. Fixed costs are relatively immaterial compared to material and labour costs. This is the case in manufacturing environments
which do not rely on sophisticated and expensive facilities and machinery.
2. Most fixed costs accrue with time.
3. There are long production runs of identical products with little customisation.
However, much modern manufacturing relies on highly automated, expensive manufacturing plants – so much so that some
companies do not separately identify the cost of labour because there is so little used. Instead, factory labour is simply regarded as
a fixed overhead and added in to the fixed costs of running the factory, its machinery, and the sophisticated information technology
system which coordinates production.
Additionally, many companies rely on customisation of products to differentiate themselves and to enable higher margins to be
made. Dell, for example, a PC manufacturer, has a website which lets customers specify their own PC in terms of memory size,
capacity, processor speed etc. That information is then fed into their automated production system and the specified computer is
built, more or less automatically.
o x
Instead of offering customers the ability to specify products, many companies offer an extensive range of products, hoping that one
l B
member of the range will match the requirements of a particular market segment. In Example 1, the company offers two products:
b a
Ordinary and Deluxe. The company knows that demand for the Deluxe range will be low, but hopes that the price premium it can
charge will still allow it to make a good profit, even on a low volume item. However, the Deluxe product could consume resources
l o
which are not properly reflected by the time it takes to make those units.
G
C A
These developments in manufacturing and marketing mean that the conventional way of treating fixed overheads might not be
good enough. Companies need to know the causes of overheads, and need to realise that many of their fixed costs’ might not be
C
fixed at all. They need to try to assign costs to products or services on the basis of the resources they consume.
A
Activity ased costing
What we want to do is to get a more accurate estimate of what each unit costs to produce, and to do this we have to examine what
activities are necessary to produce each unit, because activities usually have a cost attached. This is the basis of activity-based
costing (ABC).
The old approach of simply pretending that fixed costs are incurred because of the passage of time, and that they can therefore be
accounted for on the basis of labour (or machine) time spent on each unit, is no longer good enough. Diverse, flexible
manufacturing demands a more accurate approach to costing.
The ABC process is as follows:
1. Split fixed overheads into activities. These are called cost pools.
2. For each cost pool identify what causes that cost. In ABC terminology, this is the cost driver’, but it might be better to think of it
as the cost causer’.
3. Calculate a cost per unit of cost driver (Cost pool/total number of cost driver).
4. Allocate costs to the product based on how much the product uses of the cost driver.
Let’s continue with our example from earlier; the total fixed overheads were 224,000. In the table below in Example 2 the total
overheads have been split into cost pools and cost driver data for the Ordinary and Deluxe products has been collated.
a ple
If we apply the ABC process we can see that Step 1 is complete as we know what the cost pools are.
For Step 2 we need to identify the cost driver for each cost pool.
Batch set-up costs will be driven by the number of set-ups required for production:
Ordinary: 20,000/2,000 10
Deluxe units: 2,000/100 20
Total set-ups: 30
Stores/material handling costs will be driven by the number of components required for production:
Ordinary: (20,000 units x 20) 400,000

Deluxe: (2,000 units x 30) 60,000
Total components 460,000
Other fixed overheads will have to be absorbed on a labour hour basis because there is no information provided which would
allow a better approach. We know from Example 1 that total labour hours required are 112,000.
In Step 3 we need to calculate a cost per unit of cost driver.
Batch set-ups:
90,000/30 3,000/set-up
Stores/material handling:
92,000/460,000 0.20/component
Other overheads:
42,000/112,000 0.3 5/labour hour
Step 4 then requires us to use the costs per unit of cost driver to absorb costs into each product based on how much the product
uses of the driver.
Batch set-ups:
Ordinary: ( 3,000/2,000 units) 1.50/unit
Deluxe: ( 3,000/100 units) 30/unit
Store/material handling:
Ordinary: ( 0.20 x 20 components) 4/unit
Deluxe: ( 0.20 x 30 components) 6/unit
Other overheads:
Ordinary: ( 0.3 5 x 5 hours) 1. 5/unit
Deluxe: ( 0.3 5 x 6 hours) 2.25/unit
The ABC approach to costing therefore results in the figures shown in the spreadsheet below.
Check:
If production goes according to budget total costs will be (20,000 x 2.3 5) (2,000 x 12 .25) 1,904,000
If you look at the comparison of the full cost per unit in the spreadsheet above, you will see that the ABC approach substantially
increases the cost of making a Deluxe unit. This is primarily because the Deluxe units are made in small batches. Each batch
causes an expensive set-up, but that cost is then spread over all the units produced in that batch – whether few (Deluxe) or many
(Ordinary). It can only be right that the effort and cost incurred in producing small batches is reflected in the cost per unit produced.
There would, for example, be little point in producing Deluxe units at all if their higher selling price did not justify the higher costs
incurred.
In addition to estimating more accurately the true cost of production, ABC will also give a better indication of where cost savings
can be made. Remember, the title of this exam is e o ance ana e ent, implying that accountants should be proactive in
improving performance rather than passively measuring costs. For example, it’s clear that a substantial part of the cost of
producing Deluxe units is set-up costs (almost 25 of the Deluxe units’ total costs).
Working on the principle that large cost savings are likely to be found in large cost elements, management’s attention will start to
focus on how this cost could be reduced.
For example, is there any reason why Deluxe units have to be produced in batches of only 100? A batch size of 200 units would
dramatically reduce those set-up costs.
The traditional approach to fixed overhead absorption has the merit of being simple to calculate and apply. However, simplicity
does not justify the production and use of information that might be wrong or misleading.
ABC undoubtedly requires an organisation to spend time and effort investigating more fully what causes it to incur costs, and then
to use that detailed information for costing purposes. But understanding the drivers of costs must be an essential part of good
performance management.
en arrett is a freelance riter and lecturer
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Tar et c stin an li ec cle c stin
Home / Students / Study resources / Performance Management (PM) / Technical articles / Tar et costin and lifec cle costin
en arrett e plains tar et costin and lifec cle costin and i es e a ples as to ho and hen ou ould use these
costin techni ues
Target costing and lifecycle costing can be regarded as relatively modern advances in management accounting, so it is worth first
looking at the approach taken by conventional costing.
Typically, conventional costing attempts to work out the cost of producing an item incorporating the costs of resources that are
currently used or consumed. Therefore, for each unit made the classical variable costs of material, direct labour and variable
overheads are included (the total of these is the marginal cost of production), together with a share of the fixed production costs.
The fixed production costs can be included using a conventional overhead absorption rate (absorption costing (AC)) or they can be
accounted for using activity-based costing (ABC). ABC is more complex but almost certainly more accurate. However, whether
conventional overhead treatment or ABC is used the overheads incorporated are usually based on the budgeted overheads for the
current period.
Once the total absorption cost of units has been calculated, a mark-up (or gross profit percentage) is used to determine the selling
price and the profit per unit. The mark-up is chosen so that if the budgeted sales are achieved, the organisation should make a
profit.
There are two flaws in this approach:
1. The product’s price is based on its cost, but no one might want to buy at that price. The product might incorporate features which
customers do not value and therefore do not want to pay for, and competitors’ products might be cheaper, or at least offer better
value for money. This flaw is addressed by target costing.
2. The costs incorporated are the current costs only. They are the marginal costs plus a share of the fixed costs for the current
accounting period. There may be other important costs which are not part of these categories, but without which the goods could
not have been made. Examples include the research and development costs and any close down costs incurred at the end of
the product’s life. Why have these costs been excluded, particularly when selling prices have to be high enough to ensure that
the product makes an overall profit for the company. To make a profit, total revenue must exceed total costs in the long-term.
This flaw is addressed by lifecycle costing.
arget costing
Target costing is very much a marketing approach to costing. The Chartered Institute of Marketing defines marketing as:
e ana e ent ocess es onsi le o i enti in antici atin an satis in c sto e e i e ents o ita l
In marketing, customers rule, and marketing departments attempt to find answers to the following questions:
• Are customers homogeneous or can we identify different segments within the market?
• What features does each market segment want in the product?
• What price are customers willing to pay?
• To what competitor products or services are customers comparing ours?
• How will we advertise and distribute our products? (There are costs associated with those activities too)
Marketing says that there is no point in management, engineers and accountants sitting in darkened rooms dreaming up products,
putting them into production, adding on, say 50 for mark-up then hoping those products sell. At best this is corporate arrogance;
at worst it is corporate suicide.
Note that marketing is not a passive approach, and management cannot simply rely on customers volunteering their ideas.
Management should anticipate customer requirements, perhaps by developing prototypes and using other market research
techniques.
Therefore really important information relating to a new product is:
Of course, there will probably be a range of products and prices, but the company cannot dictate to the market, customers or
competitors. There are powerful constraints on the product and its price and the company has to make the required product, sell it
at an acceptable and competitive price and, at the same time, make a profit. If the profit is going to be adequate, the costs have to
be sufficiently low. Therefore, instead of starting with the cost and working to the selling price by adding on the expected margin,
target costing will start with the selling price of a particular product and work back to the cost by removing the profit element. This
means that the company has to find ways of not exceeding that cost.
a ple
If a company normally expects a mark-up on cost of 50 and estimates that a new product will sell successfully at a price of 12,
then the maximum cost of production should be :
Cost Mark-up Selling price

100 50 150
4 12
This is a powerful discipline imposed on the company. The main results are:
• The establishment of multifunctional teams consisting of marketing people, cost accountants, production managers, quality
control professionals and others. These teams are vital to the design and manufacturing decisions required to determine the
price and feature combinations that are most likely to appeal to potential buyers of products.
• An emphasis on the planning and design stage. This becomes very important to the cost of the product because if something
is designed such that it is needlessly expensive to make, it does not matter how efficient the production process is, it will
always be a struggle to make satisfactory profits.
o x
l B
Here are some of the decisions, made at the design stage, which can affect the cost of a product:
• the features of the product

b a
•
•
how to avoid over design’
the number of components needed G lo

•
C A
whether the components are standard or specialised
•
• where the product can be made A C

the complexity of machining and construction
• what to make in-house and what to sub-contract

• the quality of the product
• the batch size in which the product can be made
You will see from this list that activity-based costing can also play an important part in target costing. By understanding the cost
drivers (cost causers) a company can better control its costs. For example, costs could be driven down by increasing batch size, or
reducing the number of components that have to be handled by stores. The concept of value engineering (or value analysis) can
be important here. alue engineering aims to reduce costs by identifying those parts of a product or service which do not add value
– where value’ is made up of both:
• use value (the ability of the product or service to do what it sets out to do – its function) and
• esteem value (the status that ownership or use confers)
The aim of value engineering is to maximise use and esteem values while reducing costs. For example, if you are selling perfume,
the design of its packaging is important. The perfume could be held in a plain glass (or plastic) bottle, and although that would not
damage the use value of the product, it would damage the esteem value. The company would be unwise to try to reduce costs by
economising too much on packaging. Similarly, if a company is trying to reduce the costs of manufacturing a car, there might be
many components that could be satisfactorily replaced by cheaper or simpler ones without damaging either use or esteem values.
However, there will be some components that are vital to use value (perhaps elements of the suspension system) and others which
endow the product with esteem value (the quality of the paint and the upholstery).
Lifecycle costing
As mentioned above, target costing places great emphasis on controlling costs by good product design and production planning,
but those up front activities also cause costs. There might be other costs incurred after a product is sold such as warranty costs and
plant decommissioning. When seeking to make a profit on a product it is essential that the total revenue arising from the product
exceeds total costs, whether these costs are incurred before, during or after the product is produced. This is the concept of life
cycle costing, and it is important to realise that target costs can be driven down by attacking any of the costs that relate to any part
of a product’s life. The cost phases of a product can be identified as:
There are four principal lessons to be learned from lifecycle costing:
• All costs should be taken into account when working out the cost of a unit and its profitability.
• Attention to all costs will help to reduce the cost per unit and will help an organisation achieve its target cost.
• Many costs will be linked. For example, more attention to design can reduce manufacturing and warranty costs. More attention
to training can machine maintenance costs. More attention to waste disposal during manufacturing can reduce end-of life
costs.
• Costs are committed and incurred at very different times. A committed cost is a cost that will be incurred in the future because
of decisions that have already been made. Costs are incurred only when a resource is used.
Typically, the following pattern of costs committed and costs incurred is observed:
The diagram shows that by the end of the design phase approximately 0 of costs are committed. For example, the design will
largely dictate material, labour and machine costs. The company can try to haggle with suppliers over the cost of components but
if, for example, the design specifies 10 units of a certain component, negotiating with suppliers is likely to have only a small overall
effect on costs. A bigger cost decrease would be obtained if the design had specified only eight units of the component. The design
phase locks the company in to most future costs and it this phase which gives the company its greatest opportunities to reduce
those costs.
Conventional costing records costs only as they are incurred, but recording those costs is different to controlling those costs and
performance management depends on cost control, not cost measurement.
A numerical example of target and lifecycle costing

A company is planning a new product. Market research information suggests that the product should sell 10,000 units at
21.00/unit. The company seeks to make a mark-up of 40 product cost. It is estimated that the lifetime costs of the product will be
as follows:
1. Design and development costs 50,000
2. Manufacturing costs 10/unit
3. End of life costs 20,000
The company estimates that if it were to spend an additional 15,000 on design, manufacturing costs/unit could be reduced.
e uired
(a) What is the target cost of the product?
(b) What is the original lifecycle cost per unit and is the product worth making on that basis?
(c) If the additional amount were spent on design, what is the maximum manufacturing cost per unit that could be tolerated if the
company is to earn its required mark-up?
olution
The target cost of the product can be calculated as follows:
(a)
Cost Mark-up Selling price

100 40 140
15 6 21
(b) The original life cycle cost per unit ( 50,000 (10,000 x 10) 20,000)/10,000 1
This cost/unit is above the target cost per unit, so the product is not worth making.
(c) Maximum total cost per unit 15. Some of this will be caused by the design and end of life costs:
( 50,000 15,000 20,000)/10,000 .50
Therefore, the maximum manufacturing cost per unit would have to fall from 10 to ( 15 – .50) 6.50.
en arrett is a freelance lecturer and author
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Thr h t acc ntin an the the r

c nstraints art

/ Throu hput accountin and the theor of constraints part
A e er of the erfor ance ana e ent e a inin tea shares her latest read and ho it chan ed her ie s on
throu hput accountin and the theor of constraints.
I’ve just finished reading a book. It was the type of book that you pick up and you cannot put down (other than to perform the
mandatory tasks that running a house and looking after a family entail). Even the much-awaited new series of one of my favourite
television programmes couldn’t tempt me away from my book.
Now obviously I’m telling you this for a reason. I love reading and it’s not unusual to find me glued to a book for several days, if it’s
a good one. But you’ve gathered by now that the book I’ve been reading was not the usual Man Booker or Orange prize fiction
novel that you might ordinarily find tucked away in my handbag. It was in fact e oal ocess o n oin o e ent by Eli
Goldratt and Jeff Cox. If by now you’ve settled quickly into the belief that I must conform to society’s expectations of your typical
number crunching’ accountant of which – by the way – I’ve met few in reality, you are wrong. So what then, you may ask, makes
this book so different from the image that the title conjures up? Let me tell you all about it.
e oal, originally published back in 19 4, presents the theory of constraints and throughput accounting within the context of a
novel. It tells the story of Alex Rogo, a plant manager at a fictional manufacturing company called niCo, which is facing imminent
closure unless Alex can turn the loss-making plant into a profitable one within three months. In his attempt to do so, Alex is forced
to question the whole belief in the S at the time that success in manufacturing is represented by a 100 efficient factory (ie
everyone and every machine is busy 100 of the time), which keeps cost per unit as low as possible.
To be honest, before I read the book, I wasn’t really convinced about throughput accounting – although the theory of constraints
has always made perfect sense to me. But, having read about both in the context of a very believable plant that was representative
of many at the time, my views have changed. It’s easy to stand in a classroom and lecture about throughput accounting and
criticise it for being nothing new’, but what we have to remember is, back in 19 4, this was new, and for those companies that
adopted it, it made a huge difference.
I’m aware that, if I want you to share my renewed interest in throughput accounting, I need to tell you more about the story that
gripped me. If I don’t do this, you’ll just go away having read yet another article about throughput accounting, and any doubts that
you have about its relevance today will remain the same. On the other hand, I’m also aware that, when sitting professional exams,
you need to have a working knowledge of throughput accounting that you can apply in the exam hall. Consequently, I’ve decided
that, in this first article, I’ll summarise the story contained in e oal, bringing out some of the basic principles of the theory of
constraints and throughput accounting. Then, in the second article, I’ll talk you through a practical approach to questions on
throughput accounting.
he importance of considering an organisation s goal

Alex Rogo’s journey begins with a chance meeting with his old physics teacher, Jonah, at an airport, after attending a conference
about robotics. This is just before Alex finds out about the threat of closure at the plant. The niCo factory has been using robotic
machines for some time now and Alex is proudly telling Jonah about the improvements in efficiency at the factory. Jonah is quick to
question whether these improvements in efficiency have actually led to an improvement in profits. Alex is confused by the way the
conversation is going. This confusion is reflective of the S thinking at the time. There is so much focus on efficiency and reducing
labour costs with increased automation, but without consideration of whether either of these things are having any impact on profit.
In the case of niCo – and indeed many other real factories at the time – the so-called improvements in efficiency are not leading
to increased profits. In fact, they seem to be leading to losses.
Jonah leads Alex to consider what the goal of niCo really is. ntil this point, he – like his superiors at Head Office – has just
assumed that if the factory is producing increasingly more parts at a lower unit cost, it is increasingly efficient and therefore must be
doing well. All the performance criteria that the business is using support this view; all Alex’s bosses are concerned about seems
to be cost efficiencies.
After some reflection, Alex realises that the overriding goal of an organisation is to make money. Just because a factory is making
more parts does not mean to say that it is making more money. In fact, niCo shows that just the opposite is happening. The plant
has become seemingly more efficient, thanks to the use of the robots, but the fact is that inventory levels are huge and the plant is
constantly failing to meet order deadlines. It is standard practice for orders to be five or six months late. An order at the plant only
ever seems to go out when one of the customers loses patience and complains loudly, resulting in the order being expedited – ie
all other work is put on hold in order to get the one order out. Customers are becoming increasingly dissatisfied, losses are
growing, and crisis point is reached.
Clearly, the goal’ that the objective of the plant is to make money needs to be more clearly defined, in order to generate
improvements, and Jonah helps Alex do this by explaining that it will be achieved by increasing throughput whilst simultaneously
reducing inventory and operational expense’. Some definitions are given at this point:
• throughput’ is the rate at which the system generates money through sales
• inventory’ is all the money that the system has invested in purchasing things that it intends to sell
• operational expense’ is all the money that the system spends in order to turn inventory into throughput
orking out ho to achieve the goal

Having worked out what the goal is, Alex is then left with the difficult task of working out how that goal can be achieved. The
o x
answer begins to present itself to Alex when he takes his son and some other boys on a 10-mile hike. Given that the average boy
walks at two miles an hour, Alex expects to reach the halfway point on the hike after about two and a half hours of walking. When
l B
this doesn’t happen, and Alex finds that the group is behind schedule and big gaps are appearing between them, he begins to
question what is going on. He soon realises that the problem is arising because one of the boys is much slower than the others.
b a
This boy is preventing the other boys from going faster and Alex realises that, if everyone is to stay in one group as they must, the
l o
group can only go as fast as their slowest walker. The slow walker is effectively a bottleneck: the factor that prevents the group from
going faster. It doesn’t matter how fast the quickest walker is; he cannot make up for the fact that the slowest walker is really slow.
G
While the average speed may be two miles per hour, the boys can all only really walk at the speed of the slowest boy.
C A
However, Alex also realises that they can increase the boy’s speed by sharing out the heavy load he is carrying in his bag,
A C
enabling him to walk faster. In this way, they can elevate the bottleneck’ – ie increase the capacity of the critical resource. Alex
cannot wait to get back and identify where the bottlenecks are happening in his factory and find out if they can be elevated in any
way, without laying out any capital expenditure.
Statistical fluctuations and dependent events

The other thing that Alex gains a better understanding of on the hike is the relationship between dependent events and statistical
fluctuations. Jonah has already explained to Alex that the belief that a balanced plant is an efficient plant is a flawed belief. In a
balanced plant, the capacity of each and every resource is balanced exactly with the demand from the market. In the 19 0s, it was
deemed to be ideal because, at the time, manufacturing managers in the Western world believed that, if they had spare capacity,
they were wasting money. Therefore, they tried to trim capacity wherever they could, so that no resource was idle and everybody
always had something to work on. However, as Jonah explains, when capacity is trimmed exactly to marketing demand,
throughput goes down and inventory goes up. Since inventory goes up, the cost of carrying it – ie operational expense also goes
up. These things happen because of the combination of two phenomena: dependent events and statistical fluctuations.
The fact that one boy walks at three miles an hour and one boy walks at one mile an hour on the hike is evidence of statistical
fluctuations. But the actual opportunity for the higher fluctuation of three miles an hour to occur is limited by the constraint of the
one mile per hour walker. The fast boy at the front of the group can only keep on walking ahead if the other boys are also with him
– ie he is dependent on them catching up if he is to reach his three mile per hour speed. Where there are dependent events, such
as this, the opportunity for higher fluctuations is limited. Alex takes this knowledge back to the factory with him and sets about
rescuing his plant.
dentifying ottlenecks
Back at the plant, Alex and his team set out to identify which machines at the plant are the bottleneck resources. After talking to
staff and walking around the factory, where there are big piles of inventory sitting in front of two main machines, the bottlenecks
become obvious. Eighty per cent of parts have to go through these machines, and the team make sure that all such parts are
processed on the non-bottleneck machines in priority to the other 20 of parts, by marking them up with a red label. The parts that
don’t go through the bottlenecks are marked with a green label. The result? Throughput increases. But the problem? nfortunately,
it doesn’t increase enough to save the factory.
Elevating ottlenecks
The next step is therefore to try and elevate the capacity of the bottlenecks. This is not easy without spending money, but
observation shows that, at times, the bottleneck machines are sometimes still idle, despite the labelling system giving priority to the
parts that have to be ready to go through the bottleneck machines. This is partly because workers are taking their breaks before
getting the machines running again, and partly because they have left the machines unmanned because they have been called
away to work on another (non-bottleneck) machine. Both of these absences result in the machines becoming idle. At this point,
Alex learns an important lesson: an hour lost on a bottleneck machine is an hour lost for the entire system. This hour can never be
recouped. It is pointless to leave a bottleneck machine unmanned in order to go and load up a non-bottleneck machine because
there is spare capacity on the non-bottleneck machine anyway. It doesn’t matter if it’s not running for a bit. But it does matter in the
case of the bottleneck. From this point onwards, the two bottlenecks are permanently manned and permanently running. Their
capacity is elevated this way, along with another few changes that are implemented.
he need to accept idle time

At this point, Alex and his team think they have saved the factory, and then suddenly they find that new bottlenecks seem to be
appearing. Parts with green labels on are not being completed in sufficient quantities, meaning that final assembly of the
company’s products is again not taking place, and orders are being delayed again (because final assembly of products requires
both bottleneck and non-bottleneck parts). Alex calls Jonah in a panic and asks for help. Jonah soon identifies the problem.
Factory workers are still trying to be as efficient as possible, all of the time. This means that they are getting their machines to
produce as many parts as possible, irrespective of the number of parts that can actually be processed by the bottleneck.
Jonah begins to explain, labelling a bottleneck machine as X and a non-bottleneck machine as Y. Some products may not need to
go through X, he says, but that doesn’t mean that workers should make as many parts as the machines can produce, just to keep
the machine’s efficiency rate looking good. Y parts should only be produced to the extent that they can be used in the assembly of
finished goods, and the production of these is constrained by their need for bottleneck parts too. Any excess Y parts will simply go
to the warehouse and be stored as finished goods, ultimately becoming obsolete and having to be written off at a substantial cost.
As for those products that do need to go through X, they may, for example, go from Y to Y to X to Y (as there are numerous steps
involved in the production process). But if the capacity of the first Y machine is far higher than the capacity of the next Y machine,
and it processes excessive X parts, another bottleneck may look like it has appeared on the second Y machine because so many
red labelled parts are being fed through that it never gets to process the green ones, which are also necessary for final assembly.
Suddenly Alex realises that all machines must work at the pace set by the bottleneck machines, just like the boys on the hike that
had to walk at the pace of the slowest walker.
Consequently, Alex realises that it is really important to let Y machines and workers sit idle when they have produced to the
capacity of the bottleneck machines. By definition, they have spare capacity. It’s not only wasteful to produce parts that are not
needed or cannot be processed; it also clogs up the whole system and makes it seem as if new bottlenecks are appearing. This
idea of idle time not only being acceptable but also being essential flies in the face of everything that is believed at the time and,
yet, when you understand the theory of constraints, it makes perfect sense. A balanced factory is not efficient at all; it is very
inefficient because different machines and processes have different capacities, and if machines that have spare capacity are
working 100 of the time, they are producing parts that are not needed. This is wasteful, not efficient. As evidenced in the novel,
inventory goes up and throughput goes down. Alex is quick to resolve the problem and get things running smoothly again.
hroughput and ust in time

Given that producing excess inventories both pushes costs up and prevents throughput, it becomes obvious that throughput
accounting and just in time operate very well together. This becomes clear towards the end of the novel when niCo secures even
more orders by reducing its delivery time dramatically. It is able to do this by adopting some of the principles of just-in-time.
First, Alex reduces batch sizes substantially. For those unfamiliar with throughput accounting and just-in-time, it can be hard to get
past the idea that if batch sizes are halved, financial results may still improve. The novice believes that if batch sizes are halved,
costs must go up, because more orders are needed, more set ups are needed, more deliveries are needed, and so on... and surely
these costs must be high? But the fact is – as proved in the novel – inventory costs are also halved and, even more importantly,
lead time is halved, which in this case gives niCo a competitive advantage. Throughput increases dramatically because of
increased sales volumes. These increased sales volumes also led to a significantly lower operating cost per unit, which, along
with the reduced inventory costs, more than makes up for increase in the other costs. Given that there is spare capacity for all of the
non-bottleneck machines anyway, if the number of set ups for these is increased, no real additional cost arises because there is
idle time. As Jonah says: An hour saved on a non-bottleneck resource is a mirage.’
Conclusion
It is not possible, within the space of a few pages, to convey everything that The Goal has to say. To think that I could do so would
be an insult to the authors of this 2 3-page novel. Nor is the theory contained within the novel beyond questioning and criticism;
but this article was not meant as a critique.
Hopefully, however, I have told you enough to convince you that this book is worth reading should you have a couple of days to
spare sometime. I haven’t, after all, told you the ending... Also, you should now have an understanding of the background to part 2
of this article (see 'Related links').
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Thr h t acc ntin an the the r

c nstraints art

/ Throu hput accountin and the theor of constraints part
n the pre ious article a e er of the erfor ance ana e ent e a inin tea re ealed all a out a the ook
in hich the theor of constraints and throu hput accountin ere introduced in the conte t of a no el. n this second
article she sets out the fi e focusin steps of the theor of constraints riefl e plainin each one and then ill o
throu h t o e a ples sho in ou ho these steps i ht e applied in practice or in e a uestions. t s orth notin
at this sta e that hile the theor of constraints and throu hput accountin ere introduced in a the ere
further de eloped oldratt later.
he five focusing steps

The theory of constraints is applied within an organisation by following what are called the five focusing steps.’ These are a tool
that Goldratt developed to help organisations deal with constraints, otherwise known as bottlenecks, within the system as a whole
(rather than any discrete unit within the organisation.) The steps are as follows:
tep dentif the s ste s ottlenecks

Often, in exam questions, you will be told what the bottleneck resource is. If not, it is usually quite simple to work out. For example,
let’s say that an organisation has market demand of 50,000 units for a product that goes through three processes: cutting, heating
and assembly. The total time required in each process for each product and the total hours available are:
The total time required to make 50,000 units of the product can be calculated and compared to the time available in order to
identify the bottleneck.
It is clear that the heating process is the bottleneck. The organisation will in fact only be able to produce 40,000 units (120,000/3)
as things stand.
tep ecide ho to e ploit the s ste s ottlenecks

This involves making sure that the bottleneck resource is actively being used as much as possible and is producing as many units
as possible. So, productivity’ and utilisation’ are the key words here. In e oal , Alex noticed that the NCX 10 was sometimes
dormant and immediately changed this by making sure that set ups took place before workers went on breaks, so that the
machines were always left running. Similarly, the furnaces were sometimes left idle for extended periods before the completed
parts were unloaded and new parts were put in. This was because workers were being called away to work on non-bottleneck
machines, rather than being left standing idle while waiting for the furnaces to heat the parts. This was addressed by making sure
that there were always workers at the furnaces, even if they had nothing to do for a while.
tep u ordinate e er thin else to the decisions ade in tep

The main point here is that the production capacity of the bottleneck resource should determine the production schedule for the
organisation as a whole. Remember how, in the previous article, I talked about how new bottlenecks seemed to be appearing at
the niCo plant, because non-bottleneck machines were producing more parts than the bottleneck resources could absorb? Idle
time is unavoidable and needs to be accepted if the theory of constraints is to be successfully applied. To push more work into the
system than the constraint can deal with results in excess work-in-progress, extended lead times, and the appearance of what
looks like new bottlenecks, as the whole system becomes clogged up. By definition, the system does not require the non-
bottleneck resources to be used to their full capacity and therefore they must sit idle for some of the time.
tep le ate the s ste s ottlenecks

In e oal, Alex was initially convinced that there was no way to elevate the capacities of the NCX 10 machine and the furnace
without investing in new machinery, which was not an option. Jonah made him and his team think about the fact that, while the
NCX 10 alone performed the job of three of the old machines, and was very efficient at doing that job, the old machines had still
been capable of producing parts. Admittedly, the old machines were slower but, if used alongside the NCX 10, they were still
capable of elevating production levels. Thus, one of Alex’s staff managed to source some of these old machines from one of
niCo’s sister plants; they were sitting idle there, taking up factory space, so the manager was happy not to charge Alex’s plant for
the machines. In this way, one of the system’s bottlenecks was elevated without requiring any capital investment.
This example of elevating a bottleneck without cost is probably unusual. Normally, elevation will require capital expenditure.
However, it is important that an organisation does not ignore Step 2 and jumps straight to Step 4, and this is what often happens.
There is often untapped production capacity that can be found if you look closely enough. Elevation should only be considered
once exploitation has taken place.
tep f a ne constraint is roken in tep o ack to tep ut do not let inertia eco e the s ste s ne
ottleneck
When a bottleneck has been elevated, a new bottleneck will eventually appear. This could be in the form of another machine that
can now process less units than the elevated bottleneck. Eventually, however, the ultimate constraint on the system is likely to be
market demand. Whatever the new bottleneck is, the message of the theory of constraints is: never get complacent. The system
should be one of ongoing improvement because nothing ever stands still for long.
I am now going to have a look at an example of how a business can go about exploiting the system’s bottlenecks – ie using them
in a way so as to maximise throughput. In practice, there may be lots of options open to the organisation such as the ones outlined
in e oal. In the context of an exam question, however, you are more likely to be asked to show how a bottleneck can be
exploited by maximising throughput via the production of an optimum production plan. This requires an application of the simple
principles of key factor analysis, otherwise known as limiting factor analysis or principal budget factor.
Limiting factor analysis and throughput accounting

Once an organisation has identified its bottleneck resource, as demonstrated in Step 1 above, it then has to decide how to get the
most out of that resource. Given that most businesses are producing more than one type of product (or supplying more than one
type of service), this means that part of the exploitation step involves working out what the optimum production plan is, based on
maximising throughput per unit of bottleneck resource.
In key factor analysis, the contribution per unit is first calculated for each product, then a contribution per unit of scarce resource is
calculated by working out how much of the scarce resource each unit requires in its production. In a throughput accounting context,
a very similar calculation is performed, but this time it is not contribution per unit of scarce resource which is calculated, but
throughput return per unit of bottleneck resource.
Throughput is calculated as selling price less direct material cost.’ This is different from the calculation of contribution’, in which
both labour costs and variable overheads are also deducted from selling price. It is an important distinction because the
fundamental belief in throughput accounting is that all costs except direct materials costs are largely fixed – therefore, to work on
the basis of maximising contribution is flawed because to do so is to take into account costs that cannot be controlled in the short
term anyway. One cannot help but agree with this belief really since, in most businesses, it is simply not possible, for example, to
hire workers on a daily basis and lay workers off if they are not busy. A workforce has to be employed within the business and
available for work if there is work to do. You cannot refuse to pay a worker if he is forced to sit idle by a machine for a while.
a ple
Beta Co produces 3 products, E, F and G all in the same factory, details of which are shown below:
There are 320,000 bottleneck hours available each month.
e uired
Calculate the optimum product mix each month.
olution
A few simple steps can be followed:
1. Calculate the throughput per unit for each product.
2. Calculate the throughput return per hour of bottleneck resource.
o x
3. Rank the products in order of the priority in which they should be produced, starting with the product that generates the highest
return per hour first.
l B
maximum demand for any of the products.
b a
4. Calculate the optimum production plan, allocating the bottleneck resource to each one in order, being sure not to exceed the
l o
G
It is worth noting here that you often see another step carried out between Steps 2 and 3 above. This is the calculation of the
C A
throughput accounting ratio for each product. Thus far, ratios have not been discussed, and while I am planning on mentioning
A C
them later, I have never seen the point of inserting this extra step in when working out the optimum production plan for products all
made in the same factory. The ranking of the products using the return per factory hour will always produce the same ranking as
that produced using the throughput accounting ratio, so it doesn’t really matter whether you use the return or the ratio. This is
because the cost per factory hour (the denominator of the throughput accounting ratio) will be the same for all the products.
It is worth noting that, before the time taken on the bottleneck resource was taken into account, product E appeared to be the most
profitable because it generated the highest throughput per unit. However, applying the theory of constraints, the system’s
bottleneck must be exploited by using it to produce the products that maximise throughput per hour first (Step 2 of the five focusing
steps). This means that product G should be produced in priority to E.
In practice, Step 3 will be followed by making sure that the optimum production plan is adhered to throughout the whole system,
with no machine making more units than can be absorbed by the bottleneck, and sticking to the priorities decided.
When answering a question like this in an exam it is useful to draw up a small table, like the one shown below. This means that the
marker can follow your logic and award all possible marks, even if you have made an error along the way.
Each time you allocate time on the bottleneck resource to a product, you have to ask yourself how many hours you still have
available. In this example, there were enough hours to produce the full quota for G and E. However, when you got to F, you could
see that out of the 320,000 hours available, 2 0,000 had been used up (120,000 150,000), leaving only 50,000 hours spare.
Therefore, the number of units of F that could be produced was a balancing figure – 50,000 hours divided by the four hours each
unit requires – ie 12,500 units.
The above example concentrates on Steps 2 and 3 of the five focusing steps. I now want to look at an example of the application of
Steps 4 and 5. I have kept it simple by assuming that the organisation only makes one product, as it is the principle that is
important here, rather than the numbers. The example also demonstrates once again how to identify the bottleneck resource (Step
1) and then shows how a bottleneck may be elevated, but will then be replaced by another. It also shows that it may not always be
financially viable to elevate a bottleneck.
a ple
Cat Co makes a product using three machines – X, Y and Z. The capacity of each machine is as follows:
The demand for the product is 1,000 units per week. For every additional unit sold per week, net present value increases by
50,000. Cat Co is considering the following possible purchases (they are not mutually exclusive):
urchase Replace machine X with a newer model. This will increase capacity to 1,100 units per week and costs 6m.
urchase Invest in a second machine Y, increasing capacity by 550 units per week. The cost of this machine would be 6. m.
urchase pgrade machine Z at a cost of .5m, thereby increasing capacity to 1,050 units.
e uired
Which is Cat Co’s best course of action?
olution
First, it is necessary to identify the system’s bottleneck resource. Clearly, this is machine Z, which only has the capacity to produce
500 units per week. Purchase 3 is therefore the starting point when considering the logical choices that face Cat Co. It would never
be logical to consider either Purchase 1 or 2 in isolation because of the fact that neither machines X nor machine Y is the starting
bottleneck. Let’s have a look at how the capacity of the business increases with the choices that are available to it.
From the table above, it can be seen that once a bottleneck is elevated, it is then replaced by another bottleneck until ultimately
market demand constrains production. At this point, it would be necessary to look beyond production and consider how to increase
market demand by, for example, increasing advertising of the product.
In order to make a decision as to which of the machines should be purchased, if any, the financial viability of the three options
should be calculated.
The company should therefore invest in all three machines if it has enough cash to do so.
The example of Cat Co demonstrates the fact that, as one bottleneck is elevated, another one appears. It also shows that elevating
a bottleneck is not always financially viable. If Cat Co was only able to afford machine Z, it would be better off making no
investment at all because if Z alone is invested in, another bottleneck appears too quickly for the initial investment cost to be
recouped.
Ratios
I want to finish off by briefly mentioning throughput ratios. There are three main ratios that are calculated: (1) return per factory hour,
(2) cost per factory hour and (3) the throughput accounting ratio.
. eturn per factor hour Throu hput per unit product ti e on ottleneck resource.
As we saw in Example 1, the return per factory hour needs to be calculated for each product.
. Cost per factor hour Total factor costs total ti e a aila le on ottleneck resource.
The total factory cost’ is simply the operational expense’ of the organisation referred to in the previous article. If the organisation
was a service organisation, we would simply call it total operational expense’ or something similar. The cost per factory hour is
across the whole factory and therefore only needs to be calculated once.
. Throu hput accountin ratio T A eturn per factor hour cost per factor hour.
In any organisation, you would expect the throughput accounting ratio to be greater than 1. This means that the rate at which the
organisation is generating cash from sales of this product is greater than the rate at which it is incurring costs. It follows on, then,
that if the ratio is less than 1, this is not the case, and changes need to be made quickly.
Conclusion
At this point, I’m hopeful that you are now looking forward to reading e oal as soon as possible and that you have a better
understanding of the theory of constraints and throughput accounting, which you can put into practice by tackling some questions.
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n ir n ental ana e ent acc ntin
Home / Students / Study resources / Performance Management (PM) / Technical articles / n iron ental ana e ent accountin
A e er of the erfor ance ana e ent e a inin tea pro ides students ith an introduction to en iron ental
ana e ent accountin
The two requirements of the Performance Management syllabus are as follows:
• discuss the issues businesses face in the management of environmental costs

• describe the different methods a business may use to account for its environmental costs.
You should note that the Performance Management syllabus examines 'environmental management accounting’ rather than
environmental accounting’. Environmental accounting is a broader term that encompasses the provision of environment-related
information both externally and internally. It focuses on reports required for shareholders and other stakeholders, as well of the
provision of management information. Environmental management accounting, on the other hand, is a subset of environmental
accounting. It focuses on information required for decision making within the organisation, although much of the information it
generates could also be used for external reporting.
The aim of this article is to give a general introduction on the area of environmental management accounting, followed by a
discussion of the first of the two requirements listed above.
Many of you reading this article still won’t be entirely clear on what environmental management accounting actually is. You will not
be alone There is no single textbook definition for it, although there are many long-winded, jargon ridden ones available. Before
we get into the unavoidable jargon, the easiest way to approach it in the first place is to step back and ask ourselves what
management accounting itself is. Management accounts give us an analysis of the performance of a business and are ideally
prepared on a timely basis so that we get up-to-date management information. They break down each of our different business
segments (in a larger business) in a high level of detail. This information is then used to assess how the business’ historic
performance has been and, moving forward, how it can be improved in the future.
Environmental management accounting is simply a specialised part of the management accounts that focuses on things such as
the cost of energy and water and the disposal of waste and effluent. It is important to note at this point that the focus of
environmental management accounting is not all on purely financial costs. It includes consideration of matters such as the costs vs
benefits of buying from suppliers who are more environmentally aware, or the effect on the public image of the company from
failure to comply with environmental regulations.
Environmental management accounting uses some standard accountancy techniques to identify, analyse, manage and hopefully
reduce environmental costs in a way that provides mutual benefit to the company and the environment, although sometimes it is
only possible to provide benefit to one of these parties.
a ple
Activity-based costing may be used to ascertain more accurately the costs of washing towels at a gym. The energy used to power
the washing machine is an environmental cost; the cost driver is washing’.
Once the costs have been identified and information accumulated on how many customers are using the gym, it may actually be
established that some customers are using more than one towel on a single visit to the gym. The gym could drive forward change
by informing customers that they need to pay for a second towel if they need one. Given that this approach will be seen as
environmentally-friendly’, most customers would not argue with its introduction. Nor would most of them want to pay for the cost of
a second towel. The costs to be saved by the company from this new policy would include both the energy savings from having to
run fewer washing machines all the time and the staff costs of those people collecting the towels and operating the machines.
Presumably, since the towels are being washed less frequently, they will need to be replaced by new ones less often as well.
In addition to these savings to the company, however, are the all-important savings to the environment since less power and cotton
(or whatever materials the towels are made from) is now being used, and the scarce resources of our planet are therefore being
conserved. Lastly, the gym is also seen as an environmentally friendly organisation and this, in turn, may attract more customers
and increase revenues. Just a little bit of management accounting (and common sense ) can achieve all these things. While I
always like to minimise the use of jargon, in order to be fully versed on what environmental management accounting is really seen
by the profession as encompassing today, it is necessary to consider a couple of the most widely accepted definitions of it.
In 199 , the International Federation of Accountants (IFAC) originally defined environmental management accounting as:
e ana e ent o en i on ental an econo ic e o ance t o t e e elo ent an i le entation o a o iate

en i on ent elate acco ntin s ste s an actices ile t is a incl e e o tin an a itin in so e co anies
en i on ental ana e ent acco ntin t icall in ol es li ec cle costin ll cost acco ntin ene its assess ent an st ate ic
lannin o en i on ental ana e ent
Then, in 2001, The nited Nations Division for Sustainable Development ( NDSD) emphasised their belief that environmental
management accounting systems generate information for internal decision making rather than external decision making. This is in
line with my statement at the beginning of this article that EMA is a subset of environmental accounting as a whole.
The NDSD make what became a widely accepted distinction between two types of information: physical information and
monetary information. Hence, they broadly defined EMA to be the identification, collection, analysis and use of two types of
information for internal decision making:
• physical information on the use, flows and destinies

of energy, water and materials (including wastes)
• monetary information on environment-related costs, earnings and savings.
This definition was then adopted by an international consensus group of over 30 nations and thus eventually adopted by IFAC in
its 2005 international guidance document on environmental management accounting’.
To summarise then, for the purposes of clarifying the coverage of the Performance Management syllabus, my belief is that EMA is
internally not externally focused and the Performance Management syllabus should, therefore, focus on information for internal
decision making only. It should not be concerned with how environmental information is reported to stakeholders, although it could
include consideration of how such information could be reported internally. For example, Hansen and Mendoza (1999) stated that
environmental costs are incurred because of poor quality controls. Therefore, they advocate the use of a periodical environmental
cost report that is produced in the format of a cost of quality report, with each category of cost being expressed as a percentage of
sales revenues or operating costs so that comparisons can be made between different periods and/or organisations. The
categories of costs would be as follows:
• Environmental prevention costs: the costs of activities undertaken to prevent the production of waste.
• Environmental detection costs: costs incurred to ensure that the organisation complies with regulations and voluntary
standards.
• Environmental internal failure costs: costs incurred from performing activities that have produced contaminants and waste that
have not been discharged into the environment.
• Environmental external failure costs: costs incurred on activities performed after discharging waste into the environment.
It is clear from the suggested format of this quality type report that Hansen and Mendoza’s definition of environmental cost’ is
relatively narrow.
Managing environmental costs

There are three main reasons why the management of environmental costs is becoming increasingly important in organisations.
First, society as a whole has become more environmentally aware, with people becoming increasingly aware about the carbon
footprint’ and recycling taking place now in many countries. A carbon footprint’ (as defined by the Carbon Trust) measures the total
greenhouse gas emissions caused directly and indirectly by a person, organisation, event or product. Companies are finding that
they can increase their appeal to customers by portraying themselves as environmentally responsible.
Second, environmental costs are becoming huge for some companies, particularly those operating in highly industrialised sectors
such as oil production. In some cases, these costs can amount to more than 20 of operating costs. Such significant costs need to
be managed.
Third, regulation is increasing worldwide at a rapid pace, with penalties for non-compliance also increasing accordingly. In the
largest ever seizure related to an environmental conviction in the K, a plant hire firm, John Craxford Plant Hire Ltd, had to not only
o x
pay 5,000 in costs and fines but also got 1.2m of its assets seized. This was because it had illegally buried waste and also
breached its waste and pollution permits. And it’s not just the companies that need to worry. Officers of the company and even
l B
junior employees could find themselves facing criminal prosecution for knowingly breaching environmental regulations.
b a
But the management of environmental costs can be a difficult process. This is because first, just as EMA is difficult to define, so too
G lo
are the actual costs involved. Second, having defined them, some of the costs are difficult to separate out and identify. Third, the
costs can need to be controlled but this can only be done if they have been correctly identified in the first place. Each of these
issues is dealt with in turn below.
C A
efining environmental costs
A C
Many organisations vary in their definition of environmental costs. It is neither possible nor desirable to consider all of the great
range of definitions adopted. A useful cost categorisation, however, is that provided by the S Environmental Protection Agency in
199 . They stated that the definition of environmental costs depended on how an organisation intended on using the information.
They made a distinction between four types of costs:
• conventional costs: raw material and energy costs having environmental relevance
• potentially hidden costs: costs captured by accounting systems but then losing their identity in general overheads’
• contingent costs: costs to be incurred at a future date – for example, clean up costs
• image and relationship costs: costs that, by their nature, are intangible, for example, the costs of preparing environmental
reports.
The NDSD, on the other hand, described environmental costs as comprising of:
• costs incurred to protect the environment – for example, measures taken to prevent pollution, and
• costs of wasted material, capital and labour, ie inefficiencies in the production process.
Neither of these definitions contradict each other; they just look at the costs from slightly different angles. As a Performance
Management student, you should be aware that definitions of environmental costs vary greatly, with some being very narrow and
some being far wider.
dentifying environmental costs

Much of the information that is needed to prepare environmental management accounts could actually be found in a business’
general ledger. A close review of it should reveal the costs of materials, utilities and waste disposal, at the least. The main problem
is, however, that most of the costs will have to be found within the category of general overheads’ if they are to be accurately
identified. Identifying them could be a lengthy process, particularly in a large organisation. The fact that environmental costs are
often hidden’ in this way makes it difficult for management to identify opportunities to cut environmental costs and yet it is crucial
that they do so in a world which is becoming increasingly regulated and where scarce resources are becoming scarcer.
It is equally important to allocate environmental costs to the processes or products which give rise to them. Only by doing this can
an organisation make well-informed business decisions. For example, a pharmaceutical company may be deciding whether to
continue with the production of one of its drugs. In order to incorporate environmental aspects into its decision, it needs to know
exactly how many products are input into the process compared to its outputs; how much waste is created during the process; how
much labour and fuel is used in making the drug; how much packaging the drug uses and what percentage of that is recyclable etc.
Only by identifying these costs and allocating them to the product can an informed decision be made about the environmental
effects of continued production.
In 2003, the NDSD identified four management accounting techniques for the identification and allocation of environmental costs:
input/outflow analysis, flow cost accounting, activity based costing and lifecycle costing. These are referred to later under different
methods of accounting for environmental costs’.
Controlling environmental costs

It is only after environmental costs have been defined, identified and allocated that a business can begin the task of trying to
control them.
As we have already discussed, environmental costs will vary greatly from business to business and, to be honest, a lot of the
environmental costs that a large, highly industrialised business will incur will be difficult for the average person to understand,
since that person won’t have a detailed knowledge of the industry concerned.
I will therefore use some basic examples of easy-to-understand environmental costs when considering how an organisation may
go about controlling such costs. Let us consider an organisation whose main environmental costs are as follows:
• waste and effluent disposal

• water consumption
• energy
• transport and travel
• consumables and raw materials.
Each of these costs is considered in turn below.
aste
There are lots of environmental costs associated with waste. For example, the costs of unused raw materials and disposal; taxes
for landfill; fines for compliance failures such as pollution. It is possible to identify how much material is wasted in production by
using the mass balance’ approach, whereby the weight of materials bought is compared to the product yield. From this process,
potential cost savings may be identified. In addition to these monetary costs to the organisation, waste has environmental costs in
terms of lost land resources (because waste has been buried) and the generation of greenhouse gases in the form of methane.
ater
You have probably never thought about it but businesses actually pay for water twice – first, to buy it and second, to dispose of it. If
savings are to be made in terms of reduced water bills, it is important for organisations to identify where water is used and how
consumption can be decreased.
ner
Often, energy costs can be reduced significantly at very little cost. Environmental management accounts may help to identify
inefficiencies and wasteful practices and, therefore, opportunities for cost savings.
Transport and tra el

Again, environmental management accounting can often help to identify savings in terms of business travel and transport of goods
and materials. At a simple level, a business can invest in more fuel-efficient vehicles, for example.
Consu a les and ra aterials

These costs are usually easy to identify and discussions with senior managers may help to identify where savings can be made.
For example, toner cartridges for printers could be refilled rather than replaced.
This should produce a saving both in terms of the financial cost for the organisation and a waste saving for the environment (toner
cartridges are difficult to dispose of and less waste is created this way).
Accounting for environmental costs

In the context of Performance Management, when the syllabus requires you to describe the different methods of accounting for
environmental costs, it aims to cover two areas:
• Internal reporting of environmental costs, which has already been discussed in the introduction.
• Management accounting techniques for the identification and allocation of environmental costs: the most appropriate ones for
the Performance Management syllabus are those identified by the NDSD, namely input/outflow analysis, flow cost
accounting, activity-based costing and lifecycle costing.
nput outflo analysis

This technique records material inflows and balances this with outflows on the basis that, what comes in, must go out. So, if 100kg
of materials have been bought and only 0kg of materials have been produced, for example, then the 20kg difference must be
accounted for in some way. It may be, for example, that 10 of it has been sold as scrap and 90 of it is waste. By accounting for
outputs in this way, both in terms of physical quantities and, at the end of the process, in monetary terms too, businesses are forced
to focus on environmental costs.
lo cost accounting
This technique uses not only material flows but also the organisational structure. It makes material flows transparent by looking at
the physical quantities involved, their costs and their value. It divides the material flows into three categories: material, system and
delivery and disposal. The values and costs of each of these three flows are then calculated. The aim of flow cost accounting is to
reduce the quantity of materials which, as well as having a positive effect on the environment, should have a positive effect on a
business’ total costs in the long run.
Activity ased costing

ABC allocates internal costs to cost centres and cost drivers on the basis of the activities that give rise to the costs. In an
environmental accounting context, it distinguishes between environment-related costs, which can be attributed to joint cost centres,
and environment driven costs, which tend to be hidden on general overheads.
Lifecycle costing
Within the context of environmental accounting, lifecycle costing is a technique which requires the full environmental
consequences, and, therefore, costs, arising from production of a product to be taken account across its whole lifecycle, literally
from cradle to grave’.
Summary
I hope you now have a clearer idea about exactly what environmental management accounting is and why it’s important. While I
have tried to give some simple, practical examples and explanations, a certain amount of jargon is unavoidable in this subject
area. Enjoy your further reading.
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st l e r it anal sis
Home / Students / Study resources / Performance Management (PM) / Technical articles / Cost olu e profit anal sis
Cost olu e profit anal sis looks pri aril at the effects of differin le els of acti it on the financial results of a usiness
In any business, or, indeed, in life in general, hindsight is a beautiful thing. If only we could look into a crystal ball and find out
exactly how many customers were going to buy our product, we would be able to make perfect business decisions and maximise
profits.
Take a restaurant, for example. If the owners knew exactly how many customers would come in each evening and the number and
type of meals that they would order, they could ensure that staffing levels were exactly accurate and no waste occurred in the
kitchen. The reality is, of course, that decisions such as staffing and food purchases have to be made on the basis of estimates,
with these estimates being based on past experience.
While management accounting information can’t really help much with the crystal ball, it can be of use in providing the answers to
questions about the consequences of different courses of action. One of the most important decisions that need to be made before
any business even starts is how much do we need to sell in order to break-even?’ By break-even’ we mean simply covering all
our costs without making a profit.
This type of analysis is known as cost-volume-profit analysis’ (C P analysis) and the purpose of this article is to cover some of the
straight forward calculations and graphs required for this part of the Performance Management syllabus, while also considering the
assumptions which underlie any such analysis.
he o ective of C P analysis
C P analysis looks primarily at the effects of differing levels of activity on the financial results of a business. The reason for the
particular focus on sales volume is because, in the short-run, sales price, and the cost of materials and labour, are usually known
with a degree of accuracy. Sales volume, however, is not usually so predictable and therefore, in the short-run, profitability often
hinges upon it. For example, Company A may know that the sales price for product X in a particular year is going to be in the region
of 50 and its variable costs are approximately 30.
It can, therefore, say with some degree of certainty that the contribution per unit (sales price less variable costs) is 20. Company A
may also have fixed costs of 200,000 per annum, which again, are fairly easy to predict. However, when we ask the question,
Will the company make a profit in that year?’ the answer is We don’t know’. We don’t know because we don’t know the sales
volume for the year. However, we can work out how many sales the business needs to achieve in order to make a profit and this is
where C P analysis begins.
ethods for calculatin the reak e en point

The break-even point is when total revenues and total costs are equal, that is, there is no profit but also no loss made. There are
three methods for ascertaining this break-even point:
The e uation ethod

A little bit of simple maths can help us answer numerous different cost volume-profit questions.
We know that total revenues are found by multiplying unit selling price ( SP) by quantity sold (Q). Also, total costs are made up
firstly of total fixed costs (FC) and secondly by variable costs ( C). Total variable costs are found by multiplying unit variable cost
( C) by total quantity (Q). Any excess of total revenue over total costs will give rise to profit (P). By putting this information into a
simple equation, we come up with a method of answering C P type questions. This is done below continuing with the example of
Company A above.
Total revenue – total variable costs – total fixed costs Profit

( SP x Q) – ( C x Q) – FC P
(50Q) – (30Q) – 200,000 P
Note: total fixed costs are used rather than unit fixed costs since unit fixed costs will vary depending on the level of output.
It would, therefore, be inappropriate to use a unit fixed cost since this would vary depending on output. Sales price and variable
costs, on the other hand, are assumed to remain constant for all levels of output in the short-run, and, therefore, unit costs are
appropriate.
Continuing with our equation, we now set P to zero in order to find out how many items we need to sell in order to make no profit,
i.e. to break even:
(50Q) – (30Q) – 200,000 0

20Q – 200,000 0
20Q 200,000
Q 10,000 units.
The equation has given us our answer. If Company A sells less than 10,000 units, it will make a loss. If it sells exactly 10,000 units
it will break-even, and if it sells more than 10,000 units, it will make a profit.
The contri ution ar in ethod

This second approach uses a little bit of algebra to rewrite our equation above, concentrating on the use of the contribution
margin’. The contribution margin is equal to total revenue less total variable costs. Alternatively, the unit contribution margin ( CM)
is the unit selling price ( SP) less the unit variable cost ( C). Hence, the formula from our mathematical method above is
manipulated in the following way:
( SP x Q) – ( C x Q) – FC P
( SP – C) x Q FC P
CM x Q FC P
Q FC P
CM
So, if P 0 (because we want to find the break-even point), then we would simply take our fixed costs and divide them by our unit
contribution margin. We often see the unit contribution margin referred to as the contribution per unit’.
Applying this approach to Company A again:
CM 20, FC 200,000 and P 0.

Q FC
CM
Q 200,000
20
Therefore, Q 10,000 units
The contribution margin method uses a little bit of algebra to rewrite our equation above, concentrating on the use of the
contribution margin’.
The raphical ethod

With the graphical method, the total costs and total revenue lines are plotted on a graph; is shown on the y axis and units are
shown on the x axis. The point where the total cost and revenue lines intersect is the break-even point. The amount of profit or loss
at different output levels is represented by the distance between the total cost and total revenue lines. i ure shows a typical
break-even chart for Company A. The gap between the fixed costs and the total costs line represents variable costs.
Alternatively, a contribution graph could be drawn. While this is not specifically covered by the Performance Management syllabus,
it is still useful to see it. This is very similar to a break-even chart; the only difference being that instead of showing a fixed cost line,
a variable cost line is shown instead.
Hence, it is the difference between the variable cost line and the total cost line that represents fixed costs. The advantage of this is
that it emphasises contribution as it is represented by the gap between the total revenue and the variable cost lines. This is shown
for Company A in i ure .
Finally, a profit–volume graph could be drawn, which emphasises the impact of volume changes on profit (Figure 3). This is key to
the Performance Management syllabus and is discussed in more detail later in this article.
Ascertaining the sales volume required to achieve a target profit

As well as ascertaining the break-even point, there are other routine calculations that it is just as important to understand. For
example, a business may want to know how many items it must sell in order to attain a target profit.
a ple
Company A wants to achieve a target profit of 300,000. The sales volume necessary in order to achieve this profit can be
ascertained using any of the three methods outlined above. If the equation method is used, the profit of 300,000 is put into the
equation rather than the profit of 0:
o x
l B
(50Q) – (30Q) – 200,000 300,000
20Q – 200,000 300,000
b a
20Q 500,000
Q 25,000 units.
G lo
Alternatively, the contribution method can be used:
C A
CM 20, FC 200,000 and P
Q FC P A C
300,000.
CM
Q 200,000 300,000
20
Therefore, Q 25,000 units.
Finally, the answer can be read from the graph, although this method becomes clumsier than the previous two. The profit will be
300,000 where the gap between the total revenue and total cost line is 300,000, since the gap represents profit (after the break-
even point) or loss (before the break-even point.)
A contribution graph shows the difference between the variable cost line and the total cost line that represents fixed costs. An
advantage of this is that it emphasises contribution as it is represented by the gap between the total revenue and variable cost
lines.
This is not a quick enough method to use in an exam so it is not recommended.
ar in of safet
The margin of safety indicates by how much sales can decrease before a loss occurs – ie it is the excess of budgeted revenues
over break-even revenues. sing Company A as an example, let’s assume that budgeted sales are 20,000 units. The margin of
safety can be found, in units, as follows:
Budgeted sales – break-even sales 20,000 – 10,000 10,000 units.
Alternatively, as is often the case, it may be calculated as a percentage:
(Budgeted sales – break-even sales)/budgeted sales
In Company A’s case, it will be (10,000/20,000) x 100 50 .
Finally, it could be calculated in terms of sales revenue as follows:
(Budgeted sales – break-even sales) x selling price 10,000 x 50 500,000.
Contri ution to sales ratio

It is often useful in single product situations, and essential in multi product situations, to ascertain how much each sold actually
contributes towards the fixed costs. This calculation is known as the contribution to sales or C/S ratio. It is found in single product
situations by either simply dividing the total contribution by the total sales revenue, or by dividing the unit contribution margin
(otherwise known as contribution per unit) by the selling price:
For Company A: ( 20/ 50) 0.4
In multi-product situations, a weighted average C/S ratio is calculated by using the formula:
Total contribution/total sales revenue
This weighted average C/S ratio can then be used to find C P information such as break-even point, margin of safety, etc.
a ple
As well as producing product X described above, Company A also begins producing product Y. The following information is
available for both products:
The weighted average C/S ratio of 0.343 5 or 34.3 5 has been calculated by calculating the total contribution earned across
both products and dividing that by the total revenue earned across both products.
The C/S ratio is useful in its own right as it tells us what percentage each of sales revenue contributes towards fixed costs; it is
also invaluable in helping us to quickly calculate the break-even point in sales revenue, or the sales revenue required to
generate a target profit. The break-even point in sales revenue can now be calculated this way for Company A:
Fixed costs/contribution to sales ratio 200,000/0.343 5 5 1, 19 of sales revenue.
To achieve a target profit of 300,000:
(Fixed costs required profit)/contribution to sales ratio ( 200,000 300,000)/0.343 5 1,454,546.
Of course, such calculations provide only estimated information because they assume that products X and Y are sold in a constant
mix of 2X to 1Y. In reality, this constant mix is unlikely to exist and, at times, more Y may be sold than X. Such changes in the mix
throughout a period, even if the overall mix for the period is 2:1, will lead to the actual break-even point being different than
anticipated. This point is touched upon again later in this article.
Contribution to sales ratio is often useful in single product situations, and essential in multi product situations, to ascertain how
much each sold actually contributes towards the fixed costs.
Multi product profit volume charts

When discussing graphical methods for establishing the break-even point, we considered break-even charts and contribution
graphs. These could also be drawn for a company selling multiple products, such as Company A in our example.
The one type of graph that hasn’t yet been discussed is a profit–volume graph. This is slightly different from the others in that it
focuses purely on showing a profit/loss line and doesn’t separately show the cost and revenue lines. In a multi product
environment, it is common to actually show two lines on the graph: one straight line, where a constant mix between the products is
assumed; and one bow-shaped line, where it is assumed that the company sells its most profitable product first and then its next
most profitable product, and so on.
In order to draw the graph, it is therefore necessary to work out the C/S ratio of each product being sold before ranking the products
in order of profitability. It is easy here for Company A, since only two products are being produced, and so it is useful to draw a
quick table as see on the spreadsheet below (prevents mistakes in the exam hall) in order to ascertain each of the points that need
to be plotted on the graph in order to show the profit/loss lines.
The table should show the cumulative revenue, the contribution earned from each product and the cumulative profit/(loss). It is the
cumulative figures which are needed to draw the graph.
The graph can then be drawn ( i ure ), showing cumulative sales on the x axis and cumulative profit/loss on the y axis. It can be
observed from the graph that, when the company sells its most profitable product first (X) it breaks even earlier than when it sells
products in a constant mix. The break-even point is the point where each line cuts the x axis.
Limitations of cost volume profit analysis

• Cost-volume-profit analysis is invaluable in demonstrating the effect on an organisation that changes in volume (in particular),
costs and selling prices, have on profit. However, its use is limited because it is based on the following assumptions: Either a
single product is being sold or, if there are multiple products, these are sold in a constant mix. We have considered this above
in Figure 3 and seen that if the constant mix assumption changes, so does the break-even point.
• All other variables, apart from volume, remain constant – ie volume is the only factor that causes revenues and costs to
change. In reality, this assumption may not hold true as, for example, economies of scale may be achieved as volumes
increase. Similarly, if there is a change in sales mix, revenues will change. Furthermore, it is often found that if sales volumes
are to increase, sales price must fall. These are only a few reasons why the assumption may not hold true; there are many
others.
• The total cost and total revenue functions are linear. This is only likely to hold a short-run, restricted level of activity.
• Costs can be divided into a component that is fixed and a component that is variable. In reality, some costs may be semi-fixed,
such as telephone charges, whereby there may be a fixed monthly rental charge and a variable charge for calls made.
• Fixed costs remain constant over the 'relevant range' - levels in activity in which the business has experience and can
therefore perform a degree of accurate analysis. It will either have operated at those activity levels before or studied them
carefully so that it can, for example, make accurate predictions of fixed costs in that range.
• Profits are calculated on a variable cost basis or, if absorption costing is used, it is assumed that production volumes are equal
to sales volumes.
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inear r ra in
Home / Students / Study resources / Performance Management (PM) / Technical articles / inear pro ra in
ecision akin is an i portant aspect of the erfor ance ana e ent s lla us and uestions on this topic ill e
co on. The ran e of possi le uestions is considera le ut this article ill focus on onl one linear pro ra in
The ideas presented in this article are based on a simple example. Suppose a profit-seeking firm has two constraints: labour,
limited to 16,000 hours, and materials, limited to 15,000kg. The firm manufactures and sells two products, X and Y. To make X, the
firm uses three kgs of material and four hours of labour, whereas to make Y, the firm uses five kgs of material and four hours of
labour. The contribution per unit made by each product are 30 for X and 40 for Y. The cost of materials is normally per kg, and
the labour rate is 10 per hour.
The first step in any linear programming problem is to define the variables and the objective function. Defining the variables simply
means stating what letter you are going to use to represent the products in the subsequent equations as follows;
Let X number of X to be produced

Let Y number of Y to be produced
The objective function is essentially the contribution formula as the objective is to maximise contribution and therefore profit.
Contribution ( 30 x units of X produced) ( 40 x units of Y produced), therefore:

C 30X 40Y
The next step is to define the constraints. In our example, the materials constraint will be 3X 5Y 15,000, and the labour
constraint will be 4X 4Y 16,000.
Note: You should not forget the non-negativity constraint, if needed, of X,Y 0.
In order to plot the graph you need to solve the constraints. This gives us the co-ordinates for the constraint lines on the graph.
Material:
If X 0, Y 3,000
If Y 0, X 5,000
Labour:
If X 0, Y 4,000
If Y 0, X 4,000
In order to be able to plot the objective function (contribution) line you need to insert a figure to represent contribution into the
formula and solve in the same way as the constraints.
Note: Select a figure for contribution which is easily divisible by your two contribution per unit figures – for example:
Let C 60,000
If X 0, Y 1,500
If Y 0, X 2,000
i ure pti al production plan
o x
l B
b a
l o
G
C A
A C
The area represented on the graph 0ABC is called the feasible region. Plotting the resulting graph will show that by pushing out
the objective function to the furthest vertex in the feasible region which is along the gradient of the objective function, the optimal
solution will be at point B – the intersection of materials and labour constraints. This is also the furthest vertex in the feasible region
along the gradient of the objective function.
The optimal point is X 2,500 and Y 1,500, which generates 135,000 in contribution. Check this for yourself (Working 1). The
ability to solve simultaneous equations is assumed in this article.
The point of this calculation is to provide management with a target production plan in order to maximise contribution and therefore
profit. However, things can change and, in particular, constraints can relax or tighten. Management needs to know the financial
implications of such changes. For example, if new materials are offered, how much should be paid for them? And how much
should be bought? These dynamics are important.
Suppose the shadow price of materials is 5 per kg (this is verifiable by Working 2). The important point is, what does this mean? If
management is offered more materials it should be prepared to pay no more than 5 per kg over the normal price. Paying less than
13 ( 5 ) per kg to obtain more materials will make the firm better off financially. Paying more than 13 per kg would render it
worse off in terms of contribution gained. Management needs to understand this.
There may, of course, be a good reason to buy expensive’ extra materials (those costing more than 13 per kg). It might enable the
business to satisfy the demands of an important customer who might, in turn, buy more products later. The firm might have to meet
a contractual obligation, and so paying too much’ for more materials might be justifiable if it will prevent a penalty on the contract.
The cost of this is rarely included in shadow price calculations. Equally, it might be that cheap’ material, priced at under 13 per
kg, is not attractive. Quality is a factor, as is reliability of supply. Accountants should recognise that price’ is not everything.
o many materials to uy
Students need to realise that as you buy more materials, then that constraint relaxes and so its line on the graph moves outwards
and away from the origin. Eventually, the materials line will be totally outside the labour line on the graph and the point at which
this happens is the point at which the business will cease to find buying more materials attractive (point D on the graph). Labour
would then become the only constraint.
We need to find out how many materials are needed at point D on the graph, the point at which 4,000 units of Y are produced. To
make 4,000 units of Y we need 20,000kg of materials. Consequently, the maximum amount of extra material required is 5,000kg
(20,000 – 15,000).
Note: Although interpretation is important at this level, there will still be marks available for the basic calculations.
orkings
orkin
The optimal point is at point B, which is at the intersection of:

3X 5Y 15,000, and
4X 4Y 16,000
Multiplying the first equation by four and the second by three we get:
12X 20Y 60,000
12X 12Y 4 ,000
The difference in the two equations is:

Y 12,000, or Y 1,500
Substituting Y 1,500 in any of the above equations will give us the X value:
3X 5 (1,500) 15,000
3X ,500
X 2,500
The contribution gained is (2,500 x 30) (1,500 x 40) 135,000
orkin hado price of aterials

To find this we relax the material constraint by 1kg and resolve as follows:
3X 5Y 15,001 and
4X 4Y 16,000
Again, multiplying by four for the first equation and by three for the second produces:
12X 20Y 60,004

12X 12Y 4 ,000
Y 12,004
Y 1,500.5
Substituting Y 1,500.5 in any of the above equations will give us X:
3X 5 (1,500.5) 15,001
3X ,49 .5
X 2,499.5
The new level of contribution is: (2,499.5 x 30) (1,500.5 x 40) 135,005
The increase in contribution from the original optimal is the shadow price:
135,005 – 135,000 5 per kg.
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The ris s ncertaint
Home / Students / Study resources / Performance Management (PM) / Technical articles / The risks of uncertaint
ele ant to an
This article introduces the concepts of risk and uncertaint to ether ith the use of pro a ilities in calculatin oth
e pected alues and easures of dispersion.
Clearly, risk permeates most aspects of corporate decision-making (and life in general), and few can predict with any precision
what the future holds in store.
Risk can take myriad forms – ranging from the specific risks faced by individual companies (such as financial risk, or the risk of a
strike among the workforce), through the current risks faced by particular industry sectors (such as banking, car manufacturing, or
construction), to more general economic risks resulting from interest rate or currency fluctuations, and, ultimately, the looming risk
of recession. Risk often has negative connotations, in terms of potential loss, but the potential for greater than expected returns
also often exists.
Clearly, risk is almost always a major variable in real-world corporate decision-making, and managers ignore its vagaries at their
peril. Similarly, trainee accountants require an ability to identify the presence of risk and incorporate appropriate adjustments into
the problem-solving and decision-making scenarios encountered in the exam hall. While it is unlikely that the precise probabilities
and perfect information, which feature in exam questions can be transferred to real-world scenarios, a knowledge of the relevance
and applicability of such concepts is necessary.
In this article, the concepts of risk and uncertainty will be introduced together with the use of probabilities in calculating both
expected values and measures of dispersion. In addition, the attitude to risk of the decision-maker will be examined by considering
various decision-making criteria, and the usefulness of decision trees will also be discussed.
The basic definition of risk is that the final outcome of a decision, such as an investment, may differ from that which was expected
when the decision was taken. We tend to distinguish between risk and uncertainty in terms of the availability of probabilities. Risk
is when the probabilities of the possible outcomes are known (such as when tossing a coin or throwing a dice); uncertainty is
where the randomness of outcomes cannot be expressed in terms of specific probabilities. However, it has been suggested that in
the real world, it is generally not possible to allocate probabilities to potential outcomes, and therefore the concept of risk is largely
redundant. In the artificial scenarios of exam questions, potential outcomes and probabilities will generally be provided, therefore a
knowledge of the basic concepts of probability and their use will be expected.
Pro a ility
The term probability’ refers to the likelihood or chance that a certain event will occur, with potential values ranging from 0 (the
event will not occur) to 1 (the event will definitely occur). For example, the probability of a tail occurring when tossing a coin is 0.5,
and the probability when rolling a dice that it will show a four is 1/6 (0.166). The total of all the probabilities from all the possible
outcomes must equal 1 – ie some outcome must occur.
A real world example could be that of a company forecasting potential future sales from the introduction of a new product in year
one (Ta le ).
From Ta le , it is clear that the most likely outcome is that the new product generates sales of 1,000,000, as that value has the
highest probability.
ndependent and conditional events

An independent event occurs when the outcome does not depend on the outcome of a previous event. For example, assuming that
a dice is unbiased, then the probability of throwing a five on the second throw does not depend on the outcome of the first throw.
In contrast, with a conditional event, the outcomes of two or more events are related – ie the outcome of the second event depends
on the outcome of the first event. For example, in Table 1, the company is forecasting sales for the first year of the new product. If,
subsequently, the company attempted to predict the sales revenue for the second year, then it is likely that the predictions made
will depend on the outcome for year one. If the outcome for year one was sales of 1,500,000, then the predictions for year two are
likely to be more optimistic than if the sales in year one were 500,000.
The availability of information regarding the probabilities of potential outcomes allows the calculation of both an expected value for
the outcome, and a measure of the variability (or dispersion) of the potential outcomes around the expected value (most typically
standard deviation). This provides us with a measure of risk which can be used to assess the likely outcome.
Expected values and dispersion

sing the information regarding the potential outcomes and their associated probabilities, the expected value of the outcome can
be calculated simply by multiplying the value associated with each potential outcome by its probability. Referring back to Table 1,
regarding the sales forecast, then the expected value of the sales for year one is given by:
Expected value
( 500,000 x 0.1) ( 00,000 x 0.2) ( 1,000,000 x 0.4) ( 1,250,000 x 0.2) ( 1,500,000)(0.1)
50,000 140,000 400,000 250,000 150,000
990,000
In this example, the expected value is very close to the most likely outcome, but this is not necessarily always the case. Moreover,
it is likely that the expected value does not correspond to any of the individual potential outcomes. For example, the average score
from throwing a dice is (1 2 3 4 5 6) / 6 or 3.5, and the average family (in the K) supposedly has 2.4 children. A further
point regarding the use of expected values is that the probabilities are based upon the event occurring repeatedly, whereas, in
reality, most events only occur once.
In addition to the expected value, it is also informative to have an idea of the risk or dispersion of the potential actual outcomes
around the expected value. The most common measure of dispersion is standard deviation (the square root of the variance), which
can be illustrated by the example given in Table 2, concerning the potential returns from two investments.
To estimate the standard deviation, we must first calculate the expected values of each investment:
Investment A
Expected value ( x 0.25) (10 x 0.5) (12 x 0.25) 10
Investment B
Expected value (5 x 0.25) (10 x 0.5) (15 x 0.25) 10
The calculation of standard deviation proceeds by subtracting the expected value from each of the potential outcomes, then
squaring the result and multiplying by the probability. The results are then totalled to yield the variance and, finally, the square root
is taken to give the standard deviation, as shown in Table 3.
o x
l B
b a
G lo
C A
A C
In Table 3, although investments A and B have the same expected return, investment B is shown to be more risky by exhibiting a
higher standard deviation. More commonly, the expected returns and standard deviations from investments and projects are both
different, but they can still be compared by using the coefficient of variation, which combines the expected return and standard
deviation into a single figure.
Coefficient of variation and standard error

The coefficient of variation is calculated simply by dividing the standard deviation by the expected return (or mean):
Coefficient of variation standard deviation / expected return
For example, assume that investment X has an expected return of 20 and a standard deviation of 15 , whereas investment Y
has an expected return of 25 and a standard deviation of 20 . The coefficients of variation for the two investments will be:
Investment X 15 / 20 0. 5
Investment Y 20 / 25 0. 0
The interpretation of these results would be that investment X is less risky, on the basis of its lower coefficient of variation. A final
statistic relating to dispersion is the standard error, which is a measure most often confused with standard deviation. Standard
deviation is a measure of variability of a sample, used as an estimate of the variability of the population from which the sample was
drawn. When we calculate the sample mean, we are usually interested not in the mean of this particular sample, but in the mean of
the population from which the sample comes. The sample mean will vary from sample to sample and the way this variation occurs
is described by the sampling distribution’ of the mean. We can estimate how much a sample mean will vary from the standard
deviation of the sampling distribution. This is called the standard error (SE) of the estimate of the mean.
The standard error of the sample mean depends on both the standard deviation and the sample size:
SE SD/ (sample size)
The standard error decreases as the sample size increases, because the extent of chance variation is reduced. However, a
fourfold increase in sample size is necessary to reduce the standard error by 50 , due to the square root of the sample size being
used. By contrast, standard deviation tends not to change as the sample size increases.
ecision making criteria

The decision outcome resulting from the same information may vary from manager to manager as a result of their individual
attitude to risk. We generally distinguish between individuals who are risk averse (dislike risk) and individuals who are risk seeking
(content with risk). Similarly, the appropriate decision-making criteria used to make decisions are often determined by the
individual’s attitude to risk.
To illustrate this, we shall discuss and illustrate the following criteria:
1. Maximin
2. Maximax
3. Minimax regret
An ice cream seller, when deciding how much ice cream to order (a small, medium, or large order), takes into consideration the
weather forecast (cold, warm, or hot). There are nine possible combinations of order size and weather, and the payoffs for each are
shown in Table 4.
The highest payoffs for each order size occur when the order size is most appropriate for the weather, i.e. small order/cold weather,
medium order/warm weather, large order/hot weather. Otherwise, profits are lost from either unsold ice cream or lost potential
sales. We shall consider the decisions the ice cream seller has to make using each of the decision criteria previously noted (note
the absence of probabilities regarding the weather outcomes).
. a i in
This criteria is based upon a risk-averse (cautious) approach and bases the order decision upon maximising the minimum payoff.
The ice cream seller will therefore decide upon a medium order, as the lowest payoff is 200, whereas the lowest payoffs for the
small and large orders are 150 and 100 respectively.
. a i a
This criteria is based upon a risk-seeking (optimistic) approach and bases the order decision upon maximising the maximum
payoff. The ice cream seller will therefore decide upon a large order, as the highest payoff is 50, whereas the highest payoffs for
the small and medium orders are 250 and 500 respectively.
. ini a re ret
This approach attempts to minimise the regret from making the wrong decision and is based upon first identifying the optimal
decision for each of the weather outcomes. If the weather is cold, then the small order yields the highest payoff, and the regret from
the medium and large orders is 50 and 150 respectively. The same calculations are then performed for warm and hot weather
and a table of regrets constructed (Table 5).
The decision is then made on the basis of the lowest regret, which in this case is the large order with the maximum regret of 200,
as opposed to 600 and 450 for the small and medium orders.
ecision trees
The final topic to be discussed in this first article is the use of decision trees to represent a decision problem. Decision trees
provide an effective method of decision-making because they:
• clearly lay out the problem so that all options can be challenged
• allow us to fully analyse the possible consequences of a decision
• provide a framework in which to quantify the values of outcomes and the probabilities of achieving them
• help us to make the best decisions on the basis of existing information and best guesses.
A comprehensive example of a decision tree is shown in Figures 1 to 4, where a company is trying to decide whether to introduce
a new product or consolidate existing products. If the company decides on a new product, then it can be developed thoroughly or
rapidly. Similarly, if the consolidation decision is made then the existing products can be strengthened or reaped. In a decision tree,
each decision (new product or consolidate) is represented by a square box, and each outcome (good, moderate, poor market
response) by circular boxes.
The first step is to simply represent the decision to be made and the potential outcomes, without any indication of probabilities or
potential payoffs, as shown in Figure 1.
The next stage is to estimate the payoffs associated with each market response and then to allocate probabilities. The payoffs and
probabilities can then be added to the decision tree, as shown in Figure 2. The expected values along each branch of the decision
tree are calculated by starting at the right hand side and working back towards the left recording the relevant value at each node of
the tree.
These expected values are calculated using the probabilities and payoffs. For example, at the first node, when a new product is
thoroughly developed, the expected payoff is:
Expected payoff (0.4 x 1,000,000) (0.4 x 50,000) (0.2 x 2,000) 420,400
The calculations are then completed at the other nodes, as shown in Figure 3. We have now completed the relevant calculations at
the uncertain outcome modes.
We now need to include the relevant costs at each of the decision nodes for the two new product development decisions and the
two consolidation decisions, as shown in Figure 4.
The payoff we previously calculated for new product, thorough development’ was 420,400, and we have now estimated the
future cost of this approach to be 150,000. This gives a net payoff of 2 0,400.
The net benefit of new product, rapid development’ is 31,400. On this branch, we therefore choose the most valuable option,
new product, thorough development’, and allocate this value to the decision node.
The outcomes from the consolidation decision are 99, 00 from strengthening the products, at a cost of 30,000, and 12, 00 from
reaping the products without any additional expenditure.
By applying this technique, we can see that the best option is to develop a new product. It is worth much more to us to take our time
and get the product right, than to rush the product to market. And it’s better just to improve our existing products than to botch a new
product, even though it costs us less.
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ecisi n trees
Home / Students / Study resources / Performance Management (PM) / Technical articles / ecision trees
This article pro ides a step step approach to decision trees usin a si ple e a ple to uide ou throu h.
There is no universal set of symbols used when drawing a decision tree but the most common ones that we tend to come across in
accountancy education are squares ( ), which are used to represent decisions’ and circles ( ), which are used to represent
outcomes.’ Therefore, I shall use these symbols in this article and in any suggested solutions for exam questions where decision
trees are examined.
ecision trees and multi stage decision pro lems

A decision tree is a diagrammatic representation of a problem and on it we show all possible courses of action that we can take in
a particular situation and all possible outcomes for each possible course of action. It is particularly useful where there are a series
of decisions to be made and/or several outcomes arising at each stage of the decision-making process. For example, we may be
deciding whether to expand our business or not. The decision may be dependent on more than one uncertain variable.
For example, sales may be uncertain but costs may be uncertain too. The value of some variables may also be dependent on the
value of other variables too: maybe if sales are 100,000 units, costs are 4 per unit, but if sales are 120,000 units costs fall to 3. 0
per unit. Many outcomes may therefore be possible and some outcomes may also be dependent on previous outcomes. Decision
trees provide a useful method of breaking down a complex problem into smaller, more manageable pieces.
There are two stages to making decisions using decision trees. The first stage is the construction stage, where the decision tree is
drawn and all of the probabilities and financial outcome values are put on the tree. The principles of relevant costing are applied
throughout – ie only relevant costs and revenues are considered. The second stage is the evaluation and recommendation stage.
Here, the decision is rolled back’ by calculating all the expected values at each of the outcome points and using these to make
decisions while working back across the decision tree. A course of action is then recommended for management.
Constructing the tree

A decision tree is always drawn starting on the left hand side of the page and moving across to the right. Above, I have mentioned
decisions and outcomes. Decision points represent the alternative courses of action that are available to you. These are within
your control – it is your choice. You either take one course of action or you take another. Outcomes, on the other hand, are not
within your control. They are dependent on the external environment – for example, customers, suppliers and the economy. Both
decision points and outcome points on a decision tree are always followed by branches. If there are two possible courses of action
– for example, there will be two branches coming off the decision point; and if there are two possible outcomes – for example, one
good and one bad, there will be two branches coming off the outcome point. It makes sense to say that, given that decision trees
facilitate the evaluation of different courses of actions, all decision trees must start with a decision, as represented by a .
A simple decision tree is shown below. It can be seen from the tree that there are two choices available to the decision maker since
there are two branches coming off the decision point. The outcome for one of these choices, shown by the top branch off the
decision point, is clearly known with certainty, since there is no outcome point further along this top branch. The lower branch,
however, has an outcome point on it, showing that there are two possible outcomes if this choice is made. Then, since each of the
subsidiary branches off this outcome point also has a further outcome point on with two branches coming off it, there are clearly
two more sets of outcomes for each of these initial outcomes. It could be, for example, that the first two outcomes were showing
different income levels if some kind of investment is undertaken and the second set of outcomes are different sets of possible
variable costs for each different income level.
Once the basic tree has been drawn, like above, the probabilities and expected values must be written on it. Remember, the
probabilities shown on the branches coming off the outcome points must always add up to 100 , otherwise there must be an
outcome missing or a mistake with the numbers being used. As well as showing the probabilities on the branches of the tree, the
relevant cash inflows/outflows must also be written on there too. This is shown in the example later on in the article.
Once the decision tree has been drawn, the decision must then be evaluated.
Evaluating the decision

When a decision tree is evaluated, the evaluation starts on the right-hand side of the page and moves across to the left – ie in the
opposite direction to when the tree was drawn. The steps to be followed are as follows:
1. Label all of the decision and outcome points – ie all the squares and circles. Start with the ones closest to the right-hand side of
the page, labelling the top and then the bottom ones, and then move left again to the next closest ones.
2. Then, moving from right to left across the page, at each outcome point, calculate the expected value of the cash flows by
applying the probabilities to the cash flows. If there is room, write these expected values on the tree next to the relevant outcome
point, although be sure to show all of your workings for them clearly beneath the tree too.
Finally, the recommendation is made to management, based on the option that gives the highest expected value.
It is worth remembering that using expected values as the basis for making decisions is not without its limitations. Expected values
give us a long run average of the outcome that would be expected if a decision was to be repeated many times. So, if we are in fact
making a one-off decision, the actual outcome may not be very close to the expected value calculated and the technique is
therefore not very accurate. Also, estimating accurate probabilities is difficult because the exact situation that is being considered
may not well have arisen before.
The expected value criterion for decision making is useful where the attitude of the investor is risk neutral. They are neither a risk
seeker nor a risk avoider. If the decision maker’s attitude to risk is not known, it difficult to say whether the expected value criterion
is a good one to use. It may in fact be more useful to see what the worst-case scenario and best-case scenario results would be
too, in order to assist decision making.
Let me now take you through a simple decision tree example. For the purposes of simplicity, you should assume that all of the
figures given are stated in net present value terms.
a ple
A company is deciding whether to develop and launch a new product. Research and development costs are expected to be
400,000 and there is a 0 chance that the product launch will be successful, and a 30 chance that it will fail. If it is successful,
the levels of expected profits and the probability of each occurring have been estimated as follows, depending on whether the
product’s popularity is high, medium or low:
If it is a failure, there is a 0.6 probability that the research and development work can be sold for 50,000 and a 0.4 probability that
it will be worth nothing at all.
The basic structure of the decision tree must be drawn, as shown below:
Next, the probabilities and the profit figures must be put on, not forgetting that the profits from a successful launch last for two years,
so they must be doubled.
Now, the decision points and outcome points must be labelled, starting from the right-hand side and moving across the page to the
left.
o x
l B
b a
G lo
C A
A C
Now, calculate the expected values at each of the outcome points, by applying the probabilities to the profit figures. An expected
value will be calculated for outcome point A and another one will be calculated for outcome point B. Once these have been
calculated, a third expected value will need to be calculated at outcome point C. This will be done by applying the probabilities for
the two branches off C to the two expected values that have already been calculated for A and B.
E at A (0.2 x 1,000,000) (0.5 x 00,000) (0.3 x 600,000) 0,000.

E at B (0.6 x 50,000) (0.4 x 0) 30,000.
E at C (0. x 0,000) (0.3 x 30,000) 555,000
These expected values can then be put on the tree if there is enough room.
Once this has been done, the decision maker can then move left again to decision point D. At D, the decision maker compares the
value of the top branch of the decision tree (which, given there were no outcome points, had a certain outcome and therefore
needs no probabilities to be applied to it) to the expected value of the bottom branch. Costs will then need to be deducted. So, at
decision point D compare the E of not developing the product, which is 0, with the E of developing the product once the costs
of 400,000 have been taken off – ie 155,000.
Finally, the recommendation can be made to management. Develop the product because the expected value of the profits is
155,000.
Often, there is more than one way that a decision tree could be drawn. In my example, there are actually five outcomes if the
product is developed:
1. It will succeed and generate high profits of 1,000,000.
2. It will succeed and generate medium profits of 00,000.
3. It will succeed and generate low profits of 600,000.
4. It will fail but the work will be sold generating a profit of 50,000.
5. It will fail and generate no profits at all.
Therefore, instead of decision point C having only two branches on it, and each of those branches in turn having a further outcome
point with two branches on, we could have drawn the tree as follows:
You can see that the probabilities on the branches of the tree coming off outcome point A are now new. This is because they
are oint o a ilities and they have been by combining the probabilities of success and failure (0. and 0.3) with the probabilities
of high, medium and low profits (0.2, 0.5, 0.3). The joint probabilities are found easily simply by multiplying the two variables
together each time:
Success and high profits: 0. x 0.2 0.14

Success and medium profits: 0. x 0.5 0.35
Success and low profits: 0. x 0.3 0.21
Fail and sell works: 0.3 x 0.6 0.1
Fail and don’t sell work: 0.3 x 0.4 0.12
All of the joint probabilities above must, of course, add up to 1, otherwise a mistake has been made.
Whether you use my initial method, which I always think is far easier to follow, or the second method, your outcome will always be
the same.
The decision tree example above is quite a simple one but the principles to be grasped from it apply equally to a more complex
decision resulting in a tree with far more decision points, outcomes and branches on.
Finally, I always cross off the branch or branches after a decision point that show the alternative I haven’t chosen, in this case
being the do not develop product’ branch. Not everyone does it this way but I think it makes the tree easy to follow. Remember,
outcomes are not within your control, so branches off outcome points are never crossed off. I have shown this crossing off of the
branches below on my original, preferred tree:
he value of perfect and imperfect information

Perfect information is said to be available when a 100 accurate prediction can be made about the future. Imperfect information,
on the other hand, is not 100 accurate but provides more knowledge than no information. Imperfect information is far more
difficult to calculate and you would only ever need to do this in the exam if the numbers were extremely straightforward to start with.
In this article, we are only going to deal with perfect information in any detail. This is because the calculations involved in
calculating the value of imperfect information from my example are more complex than Performance Management syllabus would
require you to calculate.
Perfect information
The value of perfect information is the difference between the expected value of profit with perfect information and the expected
value of profit without perfect information. So, in our example, let us say that an agency can provide information on whether the
launch is going to be successful and produce high, medium or low profits or whether it is simply going to fail. The expected value
with perfect information can be calculated using a small table. At this point, it is useful to have calculated the joint probabilities
mentioned in the second decision tree method above because the answer can then be shown like this.
However, it could also be done by using the probabilities from our original tree in the table below and then multiplying them by the
success and failure probabilities of 0. and 0.3:
E of success with perfect information 0. x 3 0,000 266,000
E of failure with perfect information 0.3 x 0 0.

Therefore, total expected value with perfect information 266,000.
Whichever method is used, the value of the information can then be calculated by deducting the expected value of the decision
without perfect information from the expected value of the decision with perfect information – ie 266,000 – 155,000 111,000.
This would represent the absolute maximum that should be paid to obtain such information.
mperfect information
In reality, information obtained is rarely perfect and is merely likely to give us more information about the likelihood of different
outcomes rather than perfect information about them. However, the numbers involved in calculating the values of imperfect
information are rather complex and at this level, any numerical question would need to be relatively simple. You should refer to the
recommended text for a worked example on the value of imperfect information. It is suffice here to say that the value of imperfect
information will always be less than the value of perfect information unless both are zero. This would occur when the additional
information would not change the decision. Note that the principles that are applied for calculating the value of imperfect
information are the same as those applied for calculating the value of perfect information.
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Home / Students / Study resources / Performance Management (PM) / Technical articles / All a out ud etin part
Budgeting is an essential part of planning, financial control, and performance management. It is a competency that must be
acquired for anyone who is working in finance and accounting and is also a topic which is guaranteed to come up on your
Performance Management (PM) exam. Expect to see it in Sections A or B, and there is a fair chance of it appearing in Section C,
so you need to be ready to handle 20-mark questions from both a numerical and a discussion-based perspective. This series of
articles will cover the budgeting approaches flexible budgeting, activity-based budgeting, rolling budgeting, zero-based budgeting,
and beyond budgeting.
lexi le udgeting
A flexible budget is a summary of revenues and costs across a range of different activity levels. So instead of looking at only one
activity level (which is called a fixed’ budget you should remember this from F2 FMA ), various activity levels are considered. A
critical aspect of this approach is to determine fixed and variable costs, which can then be expressed as a linear equation:
a d a a a n
With an understanding of revenue per unit and cost behaviours (ie fixed, variable, and stepped), financial results can then be
budgeted within a range of activity levels.
You should be ready for complications on your PM exam, such as:
• dealing with a stepped cost

• incorporating the impact of a learning curve
• using the high/low method to separate fixed and variable costs from a total cost
lexi le vs flexed udget

Ensure you know the difference between these terms. le i le budgeting happens at the beginning of a budgeting period
revenue, costs, and profit are forecast across a range of activity levels. With this information, a fle ed budget can then be created
at the end of the budget period based on the actual activity level. This flexed budget becomes a core part of financial control when
using standard costing the flexed budget answers the question, What should our financial results be at the actual activity level?
For more on this topic, see the Standard Costing section of your study materials.
Pros and cons

With flexible budgeting, managers will be able to plan and forecast more accurately. Performance management can be more
meaningful as actual results can be easily compared to flexed results – total variances can then be calculated for each revenue
and cost.
However, some businesses may have a high level of indirect costs, making it difficult to separate fixed and variable costs from total
indirect costs.
lexed udget example ( Corfe Septem er

o x exam)
l B
b a
Corfe Co is a business which manufactures computer laptop batteries and it has developed a new battery which has a longer
usage time than batteries currently available in laptops. The selling price of the battery is forecast to be 45. The maximum
l o
production capacity of Corfe Co is 262,500 units. The company’s management accountant is currently preparing an annual flexible
budget and has collected the following information so far:
G
C A
Production (units) A C
Material costs 40,000 00,000 900,000
Labour costs 1,01 ,500 1,100,000 1,23 ,500
Fixed costs 50,000 50,000 50,000
In addition to the above costs, the management accountant estimates that for each increment of 50,000 units produced, one
supervisor will need to be employed. A supervisor’s annual salary is 35,000.
Assu in the ud eted fi ures are correct hat ould the fle ed total production cost e if production is of
a i u capacit
Solution
An 0 activity level is 210,000 units.
Material and labour are both variable costs. Material is 4 per unit and labour is 5.50 per unit, so total variable cost per unit is
9.50
Total variable costs 9.50 x 210,000 units 1,995,000
Fixed costs 50,000
Supervision 1 5,000 as five supervisors are required for a production level of 210,000 units.
Total annual budgeted cost allowance 1,995,000 50,000 1 5,000 2,920,000
Part uestion
The management accountant has said that a machine maintenance cost was not included in the flexible budget but needs to be
taken into account.
The new battery will be manufactured on a machine currently owned by Corfe Co which was previously used for a product which
has now been discontinued. The management accountant estimates that every 1,000 units will take 14 hours to produce. The
annual machine hours and maintenance costs for the machine for the last four years have been as follows:
Machine time (hours) Maintenance costs
'000
ear
ear
ear
ear
hat is the esti ated aintenance cost if production of the atter is of the a i u capacit
Solution
ariable cost per hour ( 50,000 - 450,000)/(5,000 hours – 1, 00 hours) 125 per hour
Fixed cost ( 50,000 – (5,000 x 125)) 225,000
Number of machine hours required for production 210 x 14 hours 2,940 hours
Total cost ( 225,000 (2,940 x 125)) 592,500, or 593,000 to the nearest ’000.
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Rolling udget
Traditionally, budgets are prepared on an annual basis. After the annual budget is approved, it is usually set in stone’ and not
updated during this period. This approach can be useful for controlling a business in a stable, mature industry. However, as many
organisations face more volatility and uncertainty, this arbitrary, one-year budget cycle may be too long and unpredictable for
forecasts and targets to be meaningful. A lot can happen in one year – competitors can launch new products, consumer demand
can change, and costs can fluctuate. This can render the annual budget obsolete.
A solution to this problem is the rollin ud et approach. This means that the budget will be updated more frequently than
annually – either quarterly or even monthly – and a new budget period will be added to replace the expired period. sing this
approach, the budget will always extend one year into the future and will be continuously updated.
Pros and cons

The budget should be more accurate as it is updated more frequently, improving planning and control. This approach is also
particularly useful in more unpredictable and volatile industries where it is difficult to plan one year into the future. Managers will
revise their assumptions on a more regular basis, reducing the element of uncertainty.
However, rolling budgets require more work as managers will need training which is likely to be expensive and time-consuming.
Also, conflict may emerge regarding performance targets – managers may complain of, 'changing goal posts'. Managers may also
spend too much time preparing the budget, and not enough time controlling. The company may need to acquire new software
which allows for regular updating of the budget. If the rolling budget is done on a stand-alone spreadsheet not linked to the
company’s internal systems, data integrity problems can emerge.
Rolling udget example

Timana Co manufactures small-panel display screens for smartphones, car navigation and other consumer electronic products.
This is a competitive industry characterised by short product life cycles, pricing pressure from online retailers and the need to
continually innovate. The company has used annual, incremental budgeting, created on a standalone spreadsheet, as their
primary control tool and uses this budget as the basis for performance targets for both sales managers and other managers.
The finance director recently attended a conference on Budgeting in the Technology Industry’ and realised that the incremental
budgeting system they have been using is no longer fit for purpose in a volatile industry like technology. He is aware that the
budget has to be updated every quarter to take into account the changes in the market. He has therefore suggested that a rolling
budget approach is undertaken.
The finance staff have been unhappy about the proposal, claiming that the existing computer system will not support the rolling
budget approach and the sales managers were overheard saying: What is this rolling budget system and how will this affect our
bonuses?’
The following budget has been prepared for the current year ending 31 December 20X :
o x
l B
Revenue 4 0,000 494,400
b a 509,232 524,509
l o
Direct labour (24,000)
G (24, 20) (25,462) (26,225)
C A
Direct material
A C (4 ,000) (49,440) (50,923) (52,451)
Contribution
Fixed production overheads (120,000) (120,000) (130,000) (130,000)
Administration costs (210,000) (210,000) (216,300) (216,300)
Profit
The budget was based on the following assumptions:
1. Sales volume would grow at the same fixed compound rate every quarter
2. Direct material and direct labour are wholly variable costs
3. Fixed production overheads would now be 10,000 higher from Q3 onwards as it was decided the machinery would require
extra maintenance
4. Administration costs would increase by 3 in Q3 to account for an increase in the rent for the building
The actual results for Q1 were released.
Revenue 4 0,400
Direct labour (24,4 0)
Direct material (4 ,000)
Contri ution
Fixed production overheads (120,000)
Administration costs (210,000)
rofit
The sales manager and production manager both commented that the actual results were different because of the following
factors:
The sales manager said he had to reduce selling prices to boost demand as the market became more competitive. The decrease
in revenue is accounted for solely by changes in selling prices. Sales volume is expected to grow as forecast in the original budget
forecast.
The production manager confirmed that the direct labour cost was higher because of an increase in the minimum wage. It was also
agreed that in Q3 the direct labour cost will increase by a one-off amount of 5,000 to account for additional training required under
health and safety legislation.
The finance director decided to act on the comments he received from the finance team and the sales managers regarding training
and the computer system. The first step was to create a position for a change manager;’ this new manager will start at the
beginning of Q2 with an annual salary of 150,000 and the administration cost will need to be adjusted to reflect this.
e uired
(a) Prepare Timana Co’s rolling budget for the next four quarters (to the nearest ).
(Note: when preparing the budget the original assumptions are correct and should still be used).
(b) Discuss THREE issues related to the implementation of a rolling budget system in Timana Co.
u ested solution
• Question (a)
• Question (b)
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Activity ased udgeting

The rise of e-commerce, globalisation, and shorter product life-cycles are some of the factors increasing competitive rivalry across
many business sectors. Also, indirect costs are becoming a higher percentage of total costs for many companies as technology
and automation investments become more crucial to success. Because of this, managers need a deeper and more accurate
understanding of the true cost of delivering their goods or services. Activity-based budgeting (ABB) is a tool that helps with this and
is closely linked to activity-based costing (ABC), also in your syllabus.
nder an absorption costing system, indirect costs are pooled together and labelled overheads.’ An overhead absorption rate is
then calculated, based on a single driver – for example, direct labour hours (which can be easily found via payroll records).
Overheads are then assigned to products on the basis of the overhead absorption rate and direct labour hours per unit. This cost
per unit can then be used for the budgeting process.
ABB, in conjunction with ABC, focuses on understanding how overheads are consumed by the production process. Overheads are
analysed, and ABB then looks at costs from the perspective of the activities that are required to satisfy the customer. Production
and non-production activities are measured and quantified, and then a cost per activity (or cost per driver) is determined through
detailed analysis of operations and costs. Once the cost per driver is calculated, managers can then create a more accurate budget
based on departmental consumption of activities. ABB is essentially ABC in reverse.
Pros and cons

During an ABB/ABC exercise, non-value adding’ activities can be identified – these are activities which do not increase the
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customers’ perceived worth of the final product. These activities can then be eliminated. alue-adding activities and processes can
then be automated or improved. Also, the budgeted costs and profit per product should be more accurate as costs per driver are
B
determined after detailed analysis. ABB helps align value-added activities with objectives, reducing costs in the process.
l
b a
However, there can be some disadvantages to using ABB. As stated above, ABB will require detailed analysis of overheads and
l o
measuring of activities. This can be a complex, costly and time-consuming project. If direct costs are more significant than indirect
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costs, and if the product range is narrow, the costs might outweigh the benefits of switching to ABB.
A example C A
A C
Toy Co manufactures toys for toddlers and children. They are a small company and have a good reputation for producing high
quality, innovative products. Their profit margins have been consistently higher than competitors in the same industry.
However, profitability has been slowly dropping over the past two years due to increasing overhead costs and the loss of several
key customers because of shipping errors and missed delivery dates. The management accountant believes there are non-value
added activities which can be removed to improve efficiency and reduce costs, and is considering the introduction of activity-based
budgeting. He has decided to initially analyse two popular products, the Tod’ and the Kid’.
Much of the production process is automated and occurs in batches. Orders are placed by large retail chains and demand is
relatively constant during the year.
perational infor ation for each product is as follo s
Tod id
Quarterly demand (units) 30,000 36,000
Production batch size (units) 3000 1000
Order size (units) 150 120
nfor ation for the uarter
ours re uired Total ours a aila le
Quality inspection time 15 per batch 60
Packaging and shipping time 1 hour per order 460
e uire ent
(a) Calculate the hours required for the next quarter and whether there is any spare capacity or shortage in the hours for:
• Quality inspection
• Packaging and shipping
(b) Discuss the implications of your findings in (a) for Toy Co’s production process
u ested solution
• Question (a)
• Question (b)
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ero ased udgeting
Revie incremental udgeting
Incremental budgeting is a simple, straight-forward approach which uses either last year’s budget or actual results as the starting
base for the next year’s budget, only making adjustments for new assumptions, for example, the estimated change in sales, raw
material price inflation, or other incremental factors. Whilst this approach might be useful in a predictable, static environment, it
comes with drawbacks.
First, a cost centre manager might include slack’ in their budget proposal – this means adding a little extra,’ to cushion their
budget. Last year’s budget might also include outdated assumptions which would be carried forward into the new budgeting period
using incremental budgeting. Managers may also be motivated to spend everything in their budget towards the end of the year to
ensure they receive the same amount, or more, in the following year.
Zero-based budgeting was developed in response to the issues surrounding incremental budgeting.
Zero-based budgeting is an approach to budgeting where all expenses must be justified at the start of each new budgeting period.
This process starts at a zero-base,’ and every organisational function is analysed for their needs and costs before an item is
included in the budget.
First, decision units’ can be defined as business units, departments or programmes. Managers of each decision unit then evaluate
the activities and processes they need to achieve their objectives. This information is recorded in a decision package’ detailing
information on costs, resources required and different levels of output.
After the decision packages are generated, they are ranked, and a budget is created by allocating funds to the most attractive
decision packages. nder zero-based budgeting, there is now a business justification for each item in the budget.
Pros and cons
Zero-based budgeting focuses the budgeting process on the objectives of the organisation by linking decision packages to
organisational objectives. As it requires active involvement from managers and staff in preparing decision packages, their
understanding of cost behaviours will be improved. This approach can result in better resource allocation and overall lower costs.
Also, obsolete activities and processes will be cut out of the budget.
However, zero-based budgeting can be time-consuming. Data will need to be gathered for each decision package and some
unknown information may need to be estimated. Zero-based budgeting also requires extensive document creation and
management time when evaluating decision packages. Conflicts might arise in setting criteria for the ranking of decision packages,
and more budgeting skills are needed by managers. The budgeting cycle is annual, so short-term goals may be prioritised instead
of long-term goals.
Example
Plainfield County Public Authority (PCPA) is a local public agency which provides services to the community, including a public
library. PCPA is funded primarily from local tax revenues.
PCPA has recently moved from an incremental budgeting to a zero-based budgeting (ZBB) system. The central budget office now
provides decision unit managers with PCPA’s strategic plan, guidelines for budgeting and other support, and gives managers
autonomy in how to develop their decision packages.
In the past, the library manager adjusted the budget to account for inflation and operational assumptions. Some of the costs the
library currently incurs are as follows:
• Annual staff costs: 140,000 for five members of staff

• Annual Information Systems (IS) maintenance costs: 12,500
• Annual website hosting costs: 1, 50
The number of library visitors is expected to increase next year, increasing the workload for librarians. This will in turn increase
staff costs by 15 due to overtime payments.
o x
Despite the increase in the number of library visitors, the library has come under criticism for being old-fashioned’, and the library
B
manager wishes to respond to this. He is considering two projects for inclusion in his budget:
l
ecision packa e Co puter up rade
b a
l o
With this proposal, only the computers will be replaced. The total cost for this upgrade will be 45,000. Annual IS maintenance
costs will fall slightly to 9,000 as the new computing environment will require less support. Annual website costs will remain
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constant, and staff costs are expected to grow as projected above. This upgrade will not substantially change library operations.
ecision packa e
C A
Co puter up rade and inte rated li rar s ste
A C
nder this proposal, new computers plus additional hardware and software will be purchased which automates the core library
processes. The combined cost of the new system will be 9 ,500. This improvement will allow self-service’ borrowing of books.
Members of the public will scan books when borrowing and returning them, eliminating the need for interaction with a librarian. The
new system will allow the library to reduce staff members to 4, still earning the same average annual salary while avoiding
additional overtime payments. Annual IS maintenance costs will increase to 22,000, and annual website costs will increase to
3,000.
The new system will use a dynamic website that lets library members see, in real-time, what books are available at the library and
then reserve them online.
e uire ents
a eter ine the cost of each decision packa e for the first ear i nore ti e alue of one and choose et een the
t o options fro oth financial and non financial perspecti es.
iscuss the ad anta es and disad anta es of o in to for the li rar .
u ested solution
Computer upgrade 45,000
Annual IS maintenance costs 9,000
Website hosting 1, 50
Staff costs ( 140,000 x 1.15) 161,000
Computer upgrade including integrated library system 9 ,500
Annual IS maintenance costs 22,000
Website hosting 3,000
Staff costs ( 140,000 x 4/5 staff members) 112,000
nfor ation for the uarter
Evaluation
inancial perspecti e
Decision package 2 is the more expensive option by 1 , 50, or . . However, if the annual operating costs are considered,
assuming the initial IT investment costs will be amortised, decision package 2 will bring annual savings of 34, 50 (The difference
between decision package 1 1 1, 50 and decision package 2 13 , 000).
on financial perspecti e
Decision package 2 is the more innovative solution and addresses the criticism of the library being old-fashioned. This system will
save community members’ time as they will be able to search for and reserve books online without visiting the library. Also, the
community and staff will have access to accurate and real-time information about what books are available. Automation of library
tasks means librarians can be more focused on the needs of library visitors and allows for reducing the number of librarians in the
future once the system is up and running. Satisfied visitors may also boost the library’s reputation with positive comments and
feedback on social media.
Even though the initial cost for decision package 2 is higher than decision package 1, it seems like the best option as it will reduce
longer-term operational costs, improve efficiency, and improve the public’s ability to access and use library resources.
o e to
nder ZBB, the library manager is more focused on the objectives and needs of the community when preparing their budget.
Decision packages can be evaluated by the value for money provided for the community, not just by cost savings. The library
manager is now more involved in the budgeting process and has found operational efficiencies and quality improvements in the
process.
However, ZBB may be time-consuming for the library manager and can distract him from other important responsibilities. We also
don’t know if he has the appropriate skills to manage the budgeting process. As ZBB is an annual process and focused primarily
on next year’s budget, short-term objectives might take precedence over long-term benefits. For example, the new library system is
more expensive in the short-term but leads to long-term cost savings and benefits – the ZBB approach does not highlight these
long-term advantages.
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eyond udgeting
Beyond Budgeting is more than just a method of preparing an annual budget. Instead, Beyond Budgeting encompasses a modern,
alternative approach to performance management that looks past the traditional, annual budget as the primary control tool of a
company.
The Beyond Budgeting philosophy begins with the recognition that many successful modern companies are moving away from
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traditional, top-down, command-and-control cultures and structures. These organisations are becoming more decentralised and
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nimble to stay competitive and are using approaches such Balanced Scorecards, ERP systems, and business process re-
engineering to help them achieve this. Innovation and beating the competition to market with new products are new critical
a
success factors for these companies. However, the budgeting processes of such companies are often stuck in the past.
b
G lo
The creators of Beyond Budgeting argue that in the modern business environment, the traditional approach to budgeting is no
longer appropriate, and hinders performance. When a fixed, annual budget is used as the primary source of performance metrics
A
for managers, for example hitting static sales or cost targets, problems can emerge:
C
•
C
External factors, such as changing market conditions and competitors’ actions, can render fixed, annual financial targets out-
A
of-date and useless for fair performance evaluation.
• Modern organisations often depend upon teamwork, but traditional budgeting often rewards the manager to whom the team
reports to.
• Financial performance reports that compare actual results against budgets are lagging’ indicators. This means they only
measure past performance and they don’t help the user of the report identify the root cause of any issues flagged.
Beyond Budgeting emerged in the 1990s and its principles and main ideas are formally set out by the 'Beyond Budgeting Round
Table' (BBRT), an international network that helps organisations make a move to Beyond Budgeting. As a e o ance
ana e ent student it is a good idea to review this website and gain further insight into this modern performance management
topic.
Advantages of eyond udgeting

The BBRT spells out four advantages that organisations will gain from making a move to Beyond Budgeting:
aster response
Organisations using beyond budgeting, operate with speed and simplicity. This is achieved by giving managers more authority to
act immediately within clear strategic boundaries and allowing them to more quickly meet customer needs. Bureaucracy is highly
discouraged, and managers can react quickly to new threats and opportunities instead of being forced to follow to an outdated,
annual plan.
ore inno ati e strate ies

nder the Beyond Budgeting approach, rewards go to teams and are based on relative performance versus peers, rather than
individual incentives based on fixed targets. An open and self-managed environment is promoted, rather than a culture of sticking
to a set of rules. This helps enable empowered teams, continuous improvement and innovation.
o er costs
nder a fixed, annual budgeting approach, managers might be motivated to pad’ their budgets (ie include extra resources, just in
case) and have a use it or lose it’ attitude (spend everything in your budget or you won’t get it next year). The net result of this is
that the traditional budgeting process is protecting costs, rather than controlling or reducing costs.
nder Beyond Budgeting, this mentality is discouraged and instead managers are motivated to question fixed costs and look for
cost reductions. Managers no longer see the budget as an entitlement to spend, but rather as a scarce resource that should only be
used when it adds value to the customer.
ore lo al custo ers

Organisations using beyond budgeting, put customer value at the core of their strategy and then adapt their processes to satisfy
and delight them.
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ncre ental

/ Co parin ud etin techni ues ncre ental
The budgeting process is an essential component of management control systems, as it provides a system of planning,
coordination and control for management. It is often an arduous process, however, and often strikes dread in the hearts of those
involved in budget preparation.
In the public sector, the budgeting process can be even more difficult, since the objectives of the organisation are more difficult to
define in a quantifiable way than the objectives of a private company. For example, a private company's objectives may be to
maximise profit. The meeting of this objective can then be set out in the budget by aiming for a percentage increase in sales and
perhaps the cutting of various costs. If, on the other hand, you are budgeting for a public sector organisation such as a hospital,
then the objectives may be largely qualitative, such as ensuring that all outpatients are given an appointment within eight weeks of
being referred to the hospital. This is difficult to define in a quantifiable way, and how it is actually achieved is even more difficult to
define.
This leads onto the next reason why budgeting is particularly difficult in the public sector. Just as objectives are difficult to define
quantifiably, so too are the organisation's outputs. In a private company the output can be measured in terms of sales revenue, for
example. There is a direct relationship between the expenditure that needs to be input in order to achieve the desired level of
output. In a hospital, on the other hand, it is difficult to define a quantifiable relationship between inputs and outputs. What is easier
to compare is the relationship between how much cash is available for a particular area and how much cash is actually needed.
Therefore, budgeting naturally focuses on inputs alone, rather than the relationship between inputs and outputs.
The purpose of this article is to critically evaluate the two main methods for preparing budgets - the incremental approach and the
zero-based approach. Both of these have been used in both public sector and private sector organisations, with varying degrees of
success.
ncremental udgeting
Incremental budgeting is the traditional budgeting method whereby the budget is prepared by taking the current period's budget or
actual performance as a base, with incremental amounts then being added for the new budget period. These incremental amounts
will include adjustments for things such as inflation, or planned increases in sales prices and costs. It is a common
misapprehension of students that one of the biggest disadvantages of incremental budgeting is that it doesn't allow for inflation. Of
course it does; by definition, an 'increment' is an increase of some kind. The current year's budget or actual performance is a
starting point only.
a ple
A school will have a sizeable amount in its budget for staff salaries. Let's say that in one particular year, staff salaries were 1.5m.
When the budget is being prepared for the next year, the head teacher thinks that he will need to employ two new members of staff
to teach languages, who will be paid a salary of 30,000 each (before any pay rises) and also, that he will need to give all staff
members a pay increase of 5 . Therefore, assuming that the two new staff will receive the increased pay levels, his budget for
staff will be 1.63 m ( 1.5m 30k 30k) x 1.05
It immediately becomes apparent when using this method in an example like this that, while being quick and easy, no detailed
examination of the salaries already included in the existing 1.5m has been carried out. This 1.5m has been taken as a given
starting point without questioning it. This brings us onto the reasons why incremental budgeting is not always seen as a good thing
and why, in the 1960s, alternative methods of budgeting developed. Since I thoroughly believe that Performance Management
students should always go into the exam with their metaphorical Performance Management toolbox in their hand, pulling tools out
of the box as and when they need them in order to answer questions, I am going to list the benefits and drawbacks of both
budgeting methods in a easy-to-learn format that should take up less room in the 'box'. The problem I often find with Performance
Management students is that they think they can go into the exam without any need for such a toolbox, and while they may be able
to get through some of the numerical questions simply from remembering techniques that they have learnt in the past, when it
comes to written questions, they simply do not have the depth of knowledge required to answer them properly.
enefits of incre ental ud etin
• As indicated above, it is easy to prepare and is therefore quick. Since it is easy to prepare, it is also easily allocated to more
junior members of staff.
• As well as being easy to prepare, it is easy to understand.
• Less preparation time leads to lower preparation costs.
• Prevents conflict between departmental managers since a consistent approach is adopted throughout the organisation.
• The impact of change can be seen quickly. For example, the increase of 13 k in staff costs for the aforesaid school can
quickly be traced back to the employment of two new staff members and a 5 pay increase because everything else in the
staff salaries budget remained unchanged.
ra acks of incre ental ud etin
• It assumes that all current activities and costs are still needed, without examining them in detail. In our school example above,
we know that the head teacher has budgeted for two new language teachers. How carefully has he looked into whether both of
these new teachers are actually needed? It may be that, with some timetable changes, the school could manage with only one
new teacher, but there is no incentive for the head teacher to actually critically assess the current costs of 1.5m (provided, of
course, that the funding is available for the two new teachers).
• With incremental budgeting, the head teacher does not have to justify the existing costs at all. If he can simply prove that there
is an increase in the number of language lessons equivalent to two new staff's teaching hours, he can justify the cost of two
new teachers. By its very nature, incremental budgeting looks backwards rather than forwards. While this is not such a
problem is fairly stable businesses, it will cause problems in rapidly changing business environments.
• There is no incentive for departmental managers to try and reduce costs and in fact, they may end up spending money just for
the sake of it, knowing that if they don't spend it this year; they won't be allocated the cash next year, since they will be deemed
not to need it.
• Performance targets are often unchallenging, since they are largely based on past performance with some kind of token
increase. Therefore, managers are not encouraged to challenge themselves and inefficiencies from previous periods are
carried forward into future periods. In our school example above, the head teacher may have hired an extra cook for the school
kitchen when he thought that there was going to be greater demand for school dinners than there actually turned out to be.
One of the cooks may be sitting idle in the kitchen most of the time but, with no-one looking at the existing costs, it is unlikely to
change.
ime for change
x
After World War II, when money was tighter than ever, the problems with incremental budgeting began to give rise to a feeling that
o
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change was needed. By the 1960s, something called 'programme budgeting' began to develop in the S, introduced by the then
S Secretary of Defence. This budgeting system requires objectives, outputs, expected results and then detailed costs to be given
b a
for every activity or program. Only when all of the budgets are then put together for all of the activities is the 'programme budget'
then complete. This budgeting system requires a degree of transparency never before seen under incremental budgeting systems
l o
and, as you can imagine, it was not welcomed by the public sector at whom it was largely aimed. Therefore, it was closely followed
G
by the development of zero-based budgeting. Zero-based budgeting emerged first in the public sector in the 1960s, but it also
C A
gained popularity in the private sector and was adopted by Texas Instruments in 1969. It gained notoriety in the 19 0s when S
President Jimmy Carter introduced it in the state of Georgia. While I could talk at more length about the history of zero-based
C
budgeting, it's not particularly relevant for the Performance Management exam, so I won't.
A
ero ased udgeting
With zero-based budgeting, the budgeting process starts from a base of zero, with no reference being made to the prior period's
budget or actual performance. All of the budget headings, therefore, literally start with a balance of zero, rather than under
incremental budgeting, when they all start with a balance at least equal to last year's budget or spend. Every department function is
then reviewed comprehensively, with all expenditure requiring approval, rather than just the incremental expenditure requiring
approval.
Zero-based budgeting tries to achieve an optimal allocation of resources to the parts of the business where they are most needed.
It does this by forcing managers to justify every activity in their department as they know that, until they do this, the budget for their
department is zero. If they are unable to do this, they aren't allocated any resources and their work therefore stops (as does their
employment within the organisation, at this point, presumably). In this way, all unjustifiable expenditure theoretically ceases. A
questioning attitude is developed by management, who are constantly forced to ask themselves questions such as:
• Is the activity really necessary at all?

• What happens if the activity ceases?
• Is the current level of provision adequate?
• What other ways are there of carrying out the activity?
• How much should the activity cost?
• Do the benefits to be gained from the activity at least match the costs?
All of these questions are largely answered by breaking the budgeting process down into three distinct stages, as detailed below.
Stages in ero ased udgeting

Activities are identified by managers. Managers are then forced to consider different ways of performing the activities. These
activities are then described in what is called a 'decision package', which:
• analyses the cost of the activity

• states its purpose
• identifies alternative methods of achieving the same purpose
• establishes performance measures for the activity
• assesses the consequence of not performing the activity at all or of performing it at different levels.
As regards this last point, the decision package may be prepared at the base level, representing the minimum level of service or
support needed to achieve the organisation's objectives. Further incremental packages may then be prepared to reflect a higher
level of service or support.
For example, if ZBB was used by our head teacher in our example above, one of the activities that would have to be performed
would be the provision or facilitation of school lunches. The school catering manager may consider three options. Option 1:
providing an area where students can bring their own cold food to, with some sandwiches and other cold food and drinks being
prepared and sold by catering staff. Option 2: providing a self-service cafeteria with hot and cold food and drinks available. Option
3: providing a full, hot food, catered service for pupils. The base level of service would be option 1, with options 2 and 3 being
higher level service options. The school may, on the other hand, consider two mutually exclusive decision packages - providing a
service internally or outsourcing the whole catering activity to an external provider.
While some form of cost-benefit analysis may be useful at this stage, a degree of quantitative analysis must also be incorporated.
For example, cost-benefit analysis may show that the minimal level of provision for the school (option 1) is the most cost-effective.
However, this would present the school in a negative light to parents of potential pupils and would deter some parents from
sending their children to that school. Consequently, more able students may be discouraged from applying, thus leading to poorer
results which, in turn, could have a negative impact on the school's future funding. Simple cost-benefit analysis would find it
difficult to incorporate the financial effect of such considerations.
Management will then rank all the packages in the order of decreasing benefits to the organisation. This will help management
decide what to spend and where to spend it. This ranking of the decision packages happens at numerous levels of the
organisation. For example, in the case of the school, the catering manager will rank the numerous decision packages that he
prepares. Then, the headmaster will rank the catering packages amongst all the packages prepared for the rest of the school.
The resources are then allocated based on order of priority up to the spending level.
enefits of
The benefits of ZBB are substantial. They would have to be otherwise no organisation would ever go to the lengths detailed above
in order to implement it. These benefits are set out below:
• Since ZBB does not assume that last year's allocation of resources is necessarily appropriate for the current year, all of the
activities of the organisation are re-evaluated annually from a zero base. Most importantly therefore, inefficient and obsolete
activities are removed, and wasteful spending is curbed. This has got to be the biggest benefit of zero-based budgeting
compared to incremental budgeting and was the main reason why it was developed in the first place.
• By its nature, it encourages a bottom-up approach to budgeting in order for ZBB to be used in practice. This should encourage
motivation of employees.
• It challenges the status quo and encourages a questioning attitude among managers.
• It responds to changes in the business environment from one year to the next.
• Overall, it should result in a more efficient allocation of resources.
ra acks of
• Departmental managers may not have the necessary skills to construct decision packages. They will need training for this and
training takes time and money.
• In a large organisation, the number of activities will be so large that the amount of paperwork generated from ZBB will be
unmanageable.
• Ranking the packages can be difficult, since many activities cannot be compared on the basis of purely quantitative measures.
Qualitative factors need to be incorporated but this is difficult. Top level management may not have the time or knowledge to
rank what could be thousands of packages. This problem can be somewhat alleviated by having a hierarchical ranking
process, whereby each level of managers rank the packages of the managers who report to them.
• The process of identifying decision packages and determining their purpose, costs and benefits is massively time consuming
and costly. One solution to this problem is to use incremental budgeting every year and then use ZBB every three to five years,
or when major change occurs. This means that an organisation can benefit from some of the advantages of ZBB without an
annual time and cost implication. Another option is to use ZBB for some departments but not for others. Certain costs are
essential rather than discretionary and it could be argued that it is pointless to carry out ZBB in relation to these. For example,
heating and lighting costs in a school or hospital are expenses that will have to be paid, irrespective of the budget amount
allocated to them. Incremental budgeting would seem to be more suitable for costs like these, as with building repair costs.
• Since decisions are made at budget time, managers may feel unable to react to changes that occur during the year. This could
have a detrimental effect on the business if it fails to react to emerging opportunities and threats.
• The organisation's management information systems might be unable to provide the necessary information.
It could be argued that ZBB is far more suitable for public sector than for private sector organisations. This is because, firstly, it is
far easier to put activities into decision packages in organisations which undertake set definable activities. Local government, for
example, have set activities including the provision of housing, schools and local transport. Secondly, it is far more suited to costs
that are discretionary in nature or for support activities. Such costs can be found mostly in not for profit organisations or the public
sector, or in the service department of commercial operations.
Conclusion
Since ZBB requires all costs to be justified, it would seem inappropriate to use it for the entire budgeting process in a commercial
organisation. Why take so much time and resources justifying costs that must be incurred in order to meet basic production needs?
It makes no sense to use such a long-winded process for costs where no discretion can be exercised anyway. Incremental
budgeting is, by comparison, quick and easy to do and easily understood. However, the use of incremental budgeting indisputably
gives rise to inefficiency, inertia and budgetary slack.
In conclusion, neither budgeting method provides the perfect tool for planning coordination and control. However, each method
offers something positive to recommend it and one cannot help but think that the optimal solution lies somewhere between the two.
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The learnin rate an learnin e ect
Home / Students / Study resources / Performance Management (PM) / Technical articles / The learnin rate and learnin effect
The purpose of this article is twofold: first, it is to summarise the history of the learning curve effect and help candidates understand
why it is important. Second, it is to look at what past learning curve questions have required of candidates and to clarify how future
questions may go beyond this.
A rief history of the learning curve

In practice, it is often found that the resources required to make a product decrease as production volumes increase. It costs more
to produce the first unit of a product than it does to produce the one hundredth unit. In part, this is due to economies of scale since
costs usually fall when products are made on a larger scale. This may be due to bulk quantity discounts received from suppliers,
for example. The learning curve, effect, however, is not about this; it is not about cost reduction. It is a human phenomenon that
occurs because of the fact that people get quicker at performing repetitive tasks once they have been doing them for a while. The
first time a new process is performed, the workers are unfamiliar with it since the process is untried. As the process is repeated,
however, the workers become more familiar with it and better at performing it. This means that it takes them less time to complete it.
The first reported observation of the learning curve goes as far back as 1925 when aircraft manufacturers observed that the number
of man hours taken to assemble planes decreased as more planes were produced. TP Wright subsequently established from his
research of the aircraft industry in the 1920s and 1930s that the rate at which learning took place was not random at all and that it
was actually possible to accurately predict how much labour time would be required to build planes in the future. During World War
II, S government contractors then used the learning curve to predict cost and time for ship and plane construction. Gradually,
private sector companies also adopted it after the war.
The specific learning curve effect identified by Wright was that the cumulative average time per unit decreased by a fixed
percentage each time cumulative output doubled. While in the aircraft industry this rate of learning was generally seen to be
around 0 , in different industries other rates occur. Similarly, depending on the industry in question, it is often more appropriate
for the unit of measurement to be a batch rather than an individual unit.
The learning process starts as soon as the first unit or batch comes off the production line. Since a doubling of cumulative
production is required in order for the cumulative average time per unit to decrease, it is clearly the case that the effect of the
learning rate on labour time will become much less significant as production increases. Eventually, the learning effect will come to
an end altogether. You can see this in Figure 1 below. When output is low, the learning curve is really steep but the curve becomes
flatter as cumulative output increases, with the curve eventually becoming a straight line when the learning effect ends.
i ure
The learning curve effect will not always apply, of course. It flourishes where certain conditions are present. It is necessary for the
process to be a repetitive one, for example. Also, there needs to be a continuity of workers and they mustn’t be taking prolonged
breaks during the production process.
he importance of the learning curve effect

Learning curve models enable users to predict how long it will take to complete a future task. Management accountants must
therefore be sure to take into account any learning rate when they are carrying out planning, control and decision-making. If they
fail to do this, serious consequences will result. As regards its importance in decision-making, let us look at the example of a
company that is introducing a new product onto the market. The company wants to make its price as attractive as possible to
customers but still wants to make a profit, so it prices it based on the full absorption cost plus a small 5 mark-up for profit. The first
unit of that product may take one hour to make. If the labour cost is 15 per hour, then the price of the product will be based on the
inclusion of that cost of 15 per hour. Other costs may total 45. The product is therefore released onto the market at a price of 63.
Subsequently, it becomes apparent that the learning effect has been ignored and the correct labour time per unit should is actually
0.5 hours. Without crunching through the numbers again, it is obvious that the product will have been launched onto the market at
a price which is far too high. This may mean that initial sales are much lower than they otherwise would have been and the product
launch may fail. Worse still, the company may have decided not to launch it in the first place as it believed it could not offer a
competitive price.
Let us now consider its importance in planning and control. If standard costing is to be used, it is important that standard costs
provide an accurate basis for the calculation of variances. If standard costs have been calculated without taking into account the
learning effect, then all the labour usage variances will be favourable because the standard labour hours that they are based on
will be too high. This will make their use for control purposes pointless.
Finally, it is worth noting that the use of learning curve is not restricted to the assembly industries it is traditionally associated with.
It is also used in other less traditional sectors such as professional practice, financial services, publishing and travel. In fact,
research has shown that just under half of users are in the service sector.
o learning curves have een examined in the past

The learning curve effect has regularly been examined in Performance Management. For example, in December 2011, it was
examined in conjunction with life cycle costing. Candidates were asked to calculate a revised lifecycle cost per unit after taking
into account the learning effect. This involved working out the incremental labour time taken to produce the final 100th unit made
before the learning effect ended. This is a fairly common exam requirement which tests candidates’ understanding of the difference
between cumulative and incremental time taken to produce a product and the application of the learning curve formula. It is worth
mentioning at this point that you should never round learning curve calculations to less than three decimal places. In some
questions, where the learning effect is small, over-rounding will lead to a candidate wiping out the entire learning effect and then
the question becomes pointless.
The learning curve formula, as shown below, is always given on the formula sheet in the exam:
Y axb
Where Y cumulative average time per unit to produce x units
a the time taken for the first unit of output
x the cumulative number of units produced
b the index of learning (log LR/log2)
LR the learning rate as a decimal
should know how to use a scientific calculator and should be sure to take one into the exam hall.
o x
While a value for b’ has usually been given in past exams there is no reason why this should always be the case. All candidates
l B
b
case, the learning rate was given in the question, as was the value for b’. a
In June 2013, the learning effect was again examined in conjunction with lifecycle costing. Again, as has historically been the
G lo
Back in June 2009, the learning curve effect was examined in conjunction with target costing. Once again, the learning rate was
given, and a value for b’ was given, but this time, an average cost for the first 12 units made was required. It was after this point
C A
that the learning effect ended, so the question then went on to ask candidates to calculate the cost for the last unit made, since this
was going to be the cost of making one unit going forward in the business.
A C
It can be seen, just from the examples given above, that learning curve questions have tended to follow a fairly regular pattern in
the past. The problem with this is that candidates don’t always actually think about the calculations they are performing. They
simply practise past papers, learn how to answer questions, and never really think beyond this. In the workplace, when faced with
calculations involving the learning effect, candidates may not be able to tackle them. In the workplace, the learning rate will not be
known in advance for a new process and secondly, even if it has been estimated, differences may well arise between expected
learning rates and actual learning rate experienced. Therefore, it seemed only right that future questions should examine
candidates’ ability to calculate the learning rate itself. This leads us on to the next section of the article.
Calculating the learning rate

The learning effect can continue to be examined with candidates being asked to calculate the time taken to produce an individual
unit or a number of units of a product either when the learning curve is still in effect or when it has ended. In most questions b’ has
usually been given, however candidates can also be expected to calculate the learning rate itself. Here, the tabular method is the
simplest way to answer the question.
Example
P Co operates a standard costing system. The standard labour time per batch for its newest product was estimated to be 200
hours, and resource allocation and cost data were prepared on this basis.
The actual number of batches produced during the first six months and the actual time taken to produce them is shown below:
e uired
a Calculate the onthl learnin rate that arose durin the period.
dentif hen the learnin period ended and riefl discuss the i plications of this for Co.
olution
a onthl rates of learnin
Learning rate:
1 6/200
154. /1 6
136.29/154.
Therefore the monthly rate of learning was .
(b) End of learning rate and implications
The learning period ended at the end of September. This meant that from October onwards the time taken to produce each batch of
the product was constant. Therefore, in future, when P Co makes decisions about allocating its resources and costing the product,
it should base these decisions on the time taken to produce the eighth batch, which was the last batch produced before the
learning period came to an end. The resource allocations and cost data prepared for the last six months will have been inaccurate
since they were based on a standard time per batch of 200 hours.
P Co could try and improve its production process so that the learning period could be extended. It may be able to do this by
increasing the level of staff training provided. Alternatively, it could try to incentivise staff to work harder through payment of
bonuses, although the quality of production would need to be maintained.
Example
The first batch of a new product took six hours to make and the total time for the first 16 units was 42. hours, at which point the
learning effect came to an end.
e uired
(a) Calculate the rate of learning.
olution
Again, the easiest way to solve this problem and find the actual learning rate is to use a combination of the tabular approach plus,
in this case, a little bit of maths. There is an alternative method that can be used that would involve some more difficult maths and
use of the inverse log button on the calculator, but this can be quite tricky and candidates would not be expected to use this
method. Should they choose to do so, however, full marks would be awarded, of course.
sing algebra:
Step 1: Write out the equation:

42. 16 x (6 x r4)
Step 2: Divide each side by 16 in order to get rid of the ’16 x’ on the right hand side of the equation:
2.6 5 (6 x r4)
Step 3: Divide each side by 6 in order to get rid of the 6 x’ on the right hand side of the equation:
0.445 333 r4
Step 4: take the fourth root of each side in order to get rid of the r4 on the right hand side of the equation. You should have a button
on your calculator that says r4 or x1/y. Either of these can be used to find the fourth root (or any root, in fact) of a number. The key is
to make sure that you can use your calculator properly before you enter the exam hall rather than trying to work it out under exam
pressure. You then get the answer:
r 0. 1 1
This means that the learning rate 1. 1 .
Summary
The above two examples demonstrate the type of requirements that you may find in questions where you are asked to find the
learning rate. All that we are doing is encouraging you to think a little and, in some case, perhaps use a little bit of the maths that,
as a trainee accountant, you should be more than capable of applying.
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aterials i an iel ariances
Home / Students / Study resources / Performance Management (PM) / Technical articles / aterials i and ield ariances
o e tips to help alle iate students' fears of ariance anal sis
Since long ago, variance analysis has been an area that evokes fear in students worldwide. Students enter the exam hall,
desperately running through the formulae used to calculate all the different variances, fearful of forgetting them before they have
managed to put pen to paper. Then the inevitable happens: they turn over the exam paper and a variance question stares back at
them. Frantically, they scribble down all the formulae before they are lost forever. Alas, they can’t remember it quite accurately
enough. Is it actual quantity x standard price or standard quantity x actual price? Panic grips them. Logic flies out of the window.
They move desperately on to the next question.
Does this sound like a familiar story to you? If it does, carry on reading. This article might help you. Many articles have been written
about variance analysis over the years, but the purpose of this one is to cover the area of calculating materials mix and yield
variances.
aterial usa e ariance

Most students have relatively little difficulty in calculating a straightforward material usage variance. As a reminder, let’s recap on
what the material usage variance is and how it is calculated. The material usage variance analyses the difference between how
much actual material we used for our production relative to how much we expected to use, based on standard usage levels. So, for
example, if we made 5,000 items using 11,000kg of material A and our standard material usage is only 2kg per item, then we
clearly used 1,000kg of material more than we expected to (11,000kg – 2 kg x 5,000 items ). In terms of how we value this
difference, it must be at standard cost. Any difference between standard and actual cost would be dealt with by the material price
variance.
There can be many reasons for an adverse material usage variance. It may be that inferior quality material have been purchased,
perhaps at a lower price. This may be reflected in a favourable material price variance: the materials were cheaper but as a result
there was perhaps more waste.
On the other hand, it may be that changes to the production process have been made, or that increased quality controls have been
introduced, resulting in more items being rejected. Whatever the cause, it can only be investigated after separate material usage
variances have been calculated for each type of material used and then allocated to a responsibility centre.
urther ariance anal sis here se eral aterials are used

The fact that most products will be comprised of several, or sometimes hundreds of different materials, leads us back to the more
detailed materials mix and yield variances that can be calculated in these instances. In many industries, particularly where the
product being made undergoes a chemical process, it may be possible to combine different levels of the component materials to
make the same product. This, in turn, may result in differing yields, dependent on the mix of materials that has been used. Note,
when we talk about the materials mix’ we are referring to the quantity of each material that is used to make our product ie we are
referring to our inputs. When we talk about yield’, on the other hand, we are talking about how much of our product is produced, ie
our output.
aterials i ariance
In any process, much time and money will have been spent ascertaining the exact optimum mix of materials. The optimum mix of
materials will be the one that balances the cost of each of the materials with the yield that they generate. The yield must also reach
certain quality standards. Let us take the example of a chemical, C, that uses both chemicals A and B to make it. Chemical A has a
standard cost of 20 per litre and chemical B has a standard cost of 25 per litre. Research has shown that various combinations
of chemicals A and B can be used to make C, which has a standard selling price of 30 per litre. The best two of these
combinations have been established as:
Mix 1: 10 litres of A and 10 litres of B will yield 1 litres of C; and
Mix 2: litres of A and 12 litres of B will yield 19 litres of C.
Assuming that the quality of C produced is exactly the same in both instances, the optimum mix of materials A and B can be
decided by looking at the cost of materials A and B relative to the yield of C.
Mix 1: (1 x 30) – (10 x 20) – (10 x 25) 90 contribution
Mix 2: (19 x 30) – ( x 20) – (12 x 25) 110 contribution
Therefore, the optimum mix that minimises the cost of the inputs compared to the value of the outputs is mix 2: /20 material A and
12/20 material B. The standard cost per unit of C is ( x 20)/19 (12 x 25)/19 24.21. However, if the cost of materials A and B
changes or the selling price for C changes, production managers may deviate from the standard mix. This would, in these
circumstances, be a deliberate act and would result in a materials mix variance arising. It may be, on the other hand, that the
materials mix changes simply because managers fail to adhere to the standard mix, for whatever reason.
Let us assume now that the standard mix has been set (mix 2) and production of C commences. 1, 50kg of C is produced, using a
total of 900kg of material A and 1,100kg of material B (2,000kg in total). The actual costs of materials A and B were at the standard
costs of 20 and 25 per kg respectively. How do we calculate the materials mix variance?
The variance is worked out by first calculating what the standard cost of our 1, 50kg worth of C would have been if the standard
mix had been adhered to, and comparing that figure to the standard cost of our actual production, using our actual quantities. My
preferred approach has always been to present this information in a table as shown in Ta le below. The materials mix variance
will be 46,000 – 45,500 500 favourable.
Remember: it is essential that, for every variance you calculate, you state whether it is favourable or adverse. These can be
denoted by a clear A’ or F’ but avoid showing an adverse variance by simply using brackets. This leads to mistakes.
The formula for this is shown below, but if you were to use it, the variance for each type of material must be calculated separately.
(Actual quantity in standard mix proportions – actual quantity used) x standard cost
As a student, I was never a person to blindly learn formulae and rely on these to get me through. I truly believe that the key to
variance analysis is to understand what is actually happening. If you understand what the materials mix variance is trying to show,
you will work out how to calculate it. However, for those of you who do prefer to use formulae, the workings would be as follows:
aterial A: ( 00kg – 900kg) x 20 2,000 Adverse
aterial (1,200kg – 1,100kg) x 25 2,500 Favourable
et ariance 500 favourable
In this particular example, I have kept things simple by keeping all actual costs in line with the standards. The reality is that, in the
real world, actual costs will often vary from standards. Why haven’t I covered this above? Because any variance in materials price
is always dealt with by the materials price variance. If we try and bring this into our mix variance, we begin distorting the one thing
that we are trying to understand – how the difference in materials mix has affected our cost, rather than how the difference in price
has affected our cost.
o x
l B
Why haven’t I considered the fact that although our materials mix variance is 500 favourable, our changed materials mix may
have produced less of C than the standard mix? Because this, of course, is where the materials yield variance comes into play.
b a
lo
The materials mix variance focuses on inputs, irrespective of outputs. The materials yield variance, on the other hand, focuses on
outputs, taking into account inputs.
G
a le Calculating the standard cost of
C A kg orth of C (standard mix)
A C
Actual usage in standard Actual usage in actual
ar
proportions proportions
A 00kg
( /20 x 2,000kg) 16,000 A 900kg x 20 1 ,000 A
x 20
B 1,200kg
(12/20 x 2,000kg) 30,000 B 1,100kg x 25 2 ,500
x 25
Total Total
aterials ield ariance

Where there is a difference between the actual level of output for a given set of inputs and the standard output for a given set of
inputs, a materials yield variance arises. In our optimum mix, we calculated that 20kg of inputs of A and B should produce 19kg of
our output, C. We are effectively saying that there is a loss rate of 5 (20 – 1/20) in our process, ie our outputs, in kg, should be
95 of our inputs. Applying this to our example then, we can say that we would have expected our inputs of 2,000kg to yield an
output of 95 of 2,000kg, ie 1,900 kg. Our actual yield was only 1, 50kg, which is 50kg less than we would have expected. To
calculate the materials yield variance, all we have to do is value this difference between the actual yield (1, 50kg) and the
expected yield for our given set of inputs (1,900kg) at the standard cost of our output, C, ie at 24 per kg. It is easy to see how to
calculate this when we look at it logically and present it in a very simple table as shown in Ta le .
No formula really needs to be learnt if you understand the logic behind the materials yield variance and grasp the principle that any
price differences between actual and standard are always dealt with by the price variance alone. However, for those who do prefer
to use a formula, the materials yield variance formula is:
(Actual yield – standard yield from actual input of material) x standard cost per unit of output
(1, 50kg – 1,900kg) x 24 1,200 Adverse
akin o ser ations a out ariances

From our example, it can be seen that there is a direct relationship between our materials mix variance and our materials yield
variance. By using a mix of materials that was different from standard, we have resulted in a saving of 500, in standard cost terms.
However, the downside of this is that our cheaper mix of materials has resulted in a significantly lower yield of material C than we
would have got had our standard mix of materials been adhered to. This yield was 1,200 lower than it would have been, which is
over double the amount that we saved by using a cheaper mix of materials.
Overall, by netting the two variances off against each other, we have an adverse material usage variance of 00 ( 1,200 A less
500 F). As indicated earlier on in the article, this could have been calculated on its own, without breaking it down further into its
mix and yield elements, by comparing the quantity of materials we expected to use (based on standard usage) for our actual
production to the quantity of material we actually did use for our production.
sing my preferred method of a table, our calculations would look like Ta le .
Actual production of 1, 50kg requires an input of 1,94 kg (1, 50 x 100/95) in total of A and B
Ta le alue difference et een actual and e pected ield at standard cost of C
Standard yield for actual Standard

Actual yield ifference ar
quantities input cost per kg
1, 50kg 1,900kg 50kg 24 1,200A
Ta le Calculatin the ad erse aterial usa e ariance
Standard quantity for actual

Actual quantity ar
production
A 0kg A
15,600 1 ,000 A
(1,94 x /20) x 20 900kg x 20
B 1,16 kg B
29,200 2 ,500
(1,94 x 12/20) x 25 1,100kg x 25
Total Total A
Again, if you like to learn the formula, this is shown below, although it would have to be applied separately to each type of material.
(Standard quantity for actual production – actual quantity) x standard cost
nderstandin the i er picture

Now that you understand how to deal with the numerical side of materials mix and yield variances, and the fact that these are
simply a detailed breakdown of the material usage variance, it is also important to stress the fact that quality issues cannot really
be dealt with by this variance analysis. I have mentioned the fact that there is a direct relationship between the mix and the yield
variance and that neither of these can be considered in isolation. In addition to this, however, it is also essential to understand the
importance of producing products that are of a consistently good quality. It can be tempting for production managers to change the
product mix in order to make savings; these savings may lead to greater bonuses for them at the end of the day. However, if the
quality of the product is adversely affected, this is damaging to the reputation of the business and hence its long term survival
prospects. While substituting poor quality input materials may in some cases lead to yield volumes that are the same as those
achieved with higher quality materials, the yield may not be of the same quality.
nfortunately, this factor cannot be incorporated into the materials yield variance. In the long run, it may be deduced from an
adverse sales volume variance, as demand for the business’s product decreases, but it is likely to take time for sales volumes to
be affected. Any sales volume variance that does arise as a result of poor quality products is likely to arise in a different period from
the one in which the mix and yield variances arose, and the correlation will then be more difficult to prove.
Similarly, poorer quality materials may be more difficult to work with; this may lead to an adverse labour efficiency variance as the
workforce takes longer than expected to complete the work. This, in turn, could lead to higher overhead costs, and so on.
Fortunately, consequences such as these will occur in the same period as the mix variance and are therefore more likely to be
identified and the problem resolved. Never underestimate the extent to which a perceived improvement’ in one area (eg a
favourable materials mix variance) can lead to a real deterioration in another area (eg decreased yield, poorer quality, higher
labour costs, lower sales volumes, and ultimately lower profitability). Always make sure you mention such interdependencies when
discussing your variances in exam questions. The number crunching is relatively simple once you understand the principles; the
higher skills lie in the discussion that surrounds the numbers.
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ele ant to an
Several exams in the ACCA Qualification may feature questions on not-for profit organisations. Although many of the principles of
management and organisation apply to most business models, not-for-profit organisations have numerous features that distinguish
them from the profit maximising organisations often assumed in conventional economic theory.
This article explains some of these features. The first part of the article broadly describes the generic characteristics of not-for-profit
organisations.
The second part of the article takes a specific and deeper look at charities, which are one of the more important types of
not for profit organisations.
hat is a not for profit organisation

It would be simplistic to assume that any organisation that does not pursue profit as an objective is a not-for-profit organisation.
This is an incorrect assumption, as many such organisations do make a profit every year and overtly include this in their formal
plans. Quite often, they will describe their profit as a surplus’ rather than a profit, but as either term can be defined as an excess of
income over expenditure, the difference may be considered rather semantic.
Not-for-profit organisations are distinguished from profit maximising organisations by three characteristics. First, most not-for-profit
organisations do not have external shareholders providing risk capital for the business. Second, and building on the first point, they
do not distribute dividends, so any profit (or surplus) that is generated is retained by the business as a further source of capital.
Third, their objectives usually include some social, cultural, philanthropic, welfare or environmental dimension, which in their
absence, would not be readily provided efficiently through the workings of the market system.
ypes of not for profit organisation

Not-for-profit organisations exist in both the public sector and the private sector. Most, but not all, public sector organisations do not
have profit as their primary objective and were established in order to provide what economists refer to as public goods. These are
mainly services that would not be available at the right price to those who need to use them (such as medical care, museums, art
galleries and some forms of transportation), or could not be provided at all through the market (such as defence and regulation of
markets and businesses). Private sector examples include most forms of charity and self-help organisations, such as housing
x
associations that provide housing for low income and minority groups, sports associations (many football supporters’ trusts are set
o
B
up as industrial and provident societies), scientific research foundations and environmental groups.
l
Corporate form b a
l o
G
Not-for-profit organisations can be established as incorporated or unincorporated bodies. The common business forms include the
following:
C A
•
•
A C
in the public sector, they may be departments or agents of government
some public sector bodies are established as private companies limited by guarantee, including the Financial Services
Authority (the K financial services regulator)
• in the private sector they may be established as cooperatives, industrial or provident societies (a specific type of mutual
organisation, owned by its members), by trust, as limited companies or simply as clubs or associations.
A cooperative is a body owned by its members, and usually governed on the basis of one member, one vote’. A trust is an entity
specifically constituted to achieve certain objectives. The trustees are appointed by the founders to manage the funds and ensure
compliance with the objectives of the trust. Many private foundations (charities that do not solicit funds from the general public) are
set up as trusts.
ormation constitution and o ectives

Not-for-profit organisations are invariably set up with a purpose or set of purposes in mind, and the organisation will be expected to
pursue such objectives beyond the lifetime of the founders. On establishment, the founders will decide on the type of organisation
and put in place a constitution that will reflect their goals. The constitutional base of the organisation will be dictated by its legal
form.
If it is a company, it will have a Memorandum and Articles of Association, with the contents of the latter entrenched to ensure that
the objectives cannot be altered easily in the future. Not for-profit organisations that are not companies most commonly have a set
of Rules, which are broadly equivalent to Articles of Association.
As with any type of organisation, the objectives of not-for-profit organisations are laid down by the founders and their successors in
management.
nlike profit maximisers, however, the broad strategic objectives of not-for profit organisations will tend not to change over time.
The purposes of the latter are most often dictated by the underlying founding principles. Within these broad objectives, however,
the focus of activity may change quite markedly. For example, during the 1990s the British Know-How Fund, which was
established by the K government to provide development aid, switched its focus away from the emerging central European
nations in favour of African nations.
It is important to recognise that although not-for-profit organisations do not maximise profit as a primary objective, many are
expected to be self financing and, therefore, generate profit in order to survive and grow. Even if their activities rely to some extent
on external grants or subventions, the providers of this finance invariably expect the organisation to be as financially self-reliant as
possible.
As the performance of not for profit organisations cannot be properly assessed by conventional accounting ratios, such as ROCE,
ROI, etc, it often has to be assessed with reference to other measures. Most not for-profit organisations rely on measures that
estimate the performance of the organisation in relation to:
• effectiveness – the extent to which the organisation achieves its objectives

• economy – the ability of the organisation to optimise the use of its productive resources (often assessed in relation to cost
containment)
• efficiency – the output’ of the organisation per unit of resource consumed.
Many service-orientated organisations use value for money’ indicators that can be used to assess performance against objectives.
Where the organisation has public accountability, performance measures can also be published to demonstrate that funds have
been used in the most cost effective manner. It is important within an exam question to read the clues given by the examiner
regarding what is important to the organisation and what are its guiding principles, and to use these when assessing the
performance of the organisation.
Management
The management structure of not for-profit organisations resembles that of profit maximisers, though the terms used to describe
certain bodies and officers may differ somewhat.
While limited companies have a board of directors comprising executive and non-executive directors, many not-for-profit
organisations are managed by a Council or Board of Management whose role is to ensure adherence to the founding objectives. In
recent times there has been some convergence between how companies and not-for-profit organisations are managed, including
increasing reliance on non-executive officers (notably in respect of the scrutiny or oversight role) and the employment of career’
executives to run the business on a daily basis.
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The term charity’ refers to the practice of benevolent giving. Charities are established for general or specific philanthropic
purposes.
They are one type of not for profit organisation, but with several additional distinguishing features:
• they exist entirely to benefit defined groups in society

• as their purposes are philanthropic, they can usually avail themselves of favourable tax treatment, and for this reason have to
be registered with a regulator
• their activities are restricted or limited by a regulator
• they rely on the financial support of the public or businesses (or both) in order to achieve their objectives
• in order to be financially viable, they rely heavily on voluntary (unpaid) managers and workers.
Charita le activities
In the K, charities are regulated by the Charities Act 2006, which sets out in very broad terms what may be considered to be
charitable activities, many of which would be considered as such in other jurisdictions within most other countries. These include:
• the prevention or relief of poverty

• the advancement of education
• the advancement of religion
• the advancement of health or the saving of lives
• the advancement of citizenship or community development
• the advancement of the arts, culture, heritage or science
• the advancement of amateur sport
• the advancement of human
• rights, conflict resolution or reconciliation or the promotion of religious or racial harmony or equality and diversity
• the advancement of environmental protection or improvement
o x
•
B
the relief of those in need, by reason of youth, age, ill-health, disability, financial hardship or other disadvantage
l
• the advancement of animal welfare
b a
•
o
the promotion of the efficiency of the armed forces of the Crown or of the police, fire and rescue services or ambulance
services
l
•
G
other purposes currently recognised as charitable and any new charitable purposes which are similar to another charitable
purpose.
C A
A C
The activities of charities in England and Wales are regulated by the Charity Commission, itself a not-for-profit organisation,
located in Liverpool. The precise definition of what constitutes charitable activities differs, of course, from country to country.
However, most of the activities listed above would be considered as charitable, as they would seldom be associated with
commercial organisations.
Corporate form
Charities differ widely in respect of their size, objectives and activities. For example, Oxfam is a federal international organisation
comprising 13 different bodies across all continents, while many thousands of charities are local organisations managed and
staffed entirely by volunteers. nsurprisingly, most of the constituent organisations within Oxfam operate as limited companies,
while local charities would find this form inappropriate and prefer to be established as associations.
A charity is not forbidden from engaging in commercial activities provided that these activities fully serve the objectives of the
charity. For example, charities such as the British Heart Foundation, the British Red Cross, and Age Concern all raise funds by
operating chains of retail shops. These shops are profitable businesses, but if a company is formed to operate the shops, the
company would be expected to formally covenant its entire annual profits to the charity.
Charities with high value non-current assets, such as real estate, usually vest the ownership of such assets to independent
guardian trustees, whose role is to ensure that the assets are deployed in a manner that reflects the objectives of the charity.
The guardian trustees are empowered to lease land, subject to the provisions of the lease satisfying requirements laid down by the
Charity Commission.
ormation constitution and o ectives

Charities are always formed with specific philanthropic purposes in mind. These purposes may be expanded or varied over time,
provided the underlying purpose remains. For example, Oxfam was originally formed as the Oxford Committee for Famine Relief in
1942, and its original purpose was to relieve the famine in Greece brought about by the Allied blockade. Oxfam now provides
famine relief on a worldwide basis.
The governing constitution of a charity is normally set down in its rules, which expand on the purposes of the business. Quite often,
the constitution dictates what the organisation cannot do, as well as what it can do. Charities plan and control their activities with
reference to measures of effectiveness, economy and efficiency. They often publish their performance outcomes in order to
convince the giving public that the good causes that they support ultimately benefit from charitable activities.
Management
Most charities are managed by a Council, made up entirely of volunteers. These are broadly equivalent to non-executive directors
in limited companies. It is the responsibility of the Council to chart the medium to long-term strategy of the charity and to ensure that
objectives are met.
Objectives may change over time due to changes in the external environment in which the charity operates. Barnardos is
a childrens’ charity that was originally founded as Doctor Barnado’s Homes, to provide for orphans who could not rely on family
support. The development of welfare services after World War II and the increasing willingness of families to adopt and foster
children resulted in less reliance on the provision of residential homes for children but greater reliance on other support services.
As a result, the Barnardos charity had to change the way in which it looked at maximising the welfare of orphaned children.
Local charities are dependent on the support of a more limited population and therefore have to consider whether their supporters
will continue to provide the finance necessary to operate continuously. For example, a local charity supporting disabled sports
could be profoundly affected by the development of facilities funded by central or local government.
Every charity is confronted by distinctive strategic and operational risks, of which the Council must take account in developing and
implementing its plans. International aid charities are vulnerable to country risk and currency risk, so plans have to take account of
local conditions in countries whose populations they serve. Many such countries may, of course, be inherently unstable politically.
Operational risk for charities arises from the high dependence on volunteer workers, including the extent to which they can rely on
continued support, as well as problems of internal control.
For example, many charities staff their shops with the help of unpaid retired people, but there is some debate as to whether future
generations of retired people will be as willing to do this for nothing. As many charities have to contain operating expenses in order
to ensure that their objectives can be met, it is often difficult or impossible for them to employ full-time or part-time paid staff to
replace volunteer workers. Risks also arise from the social environment, particularly in times of recession, when members of the
public may be less disposed to give to benefit others as their discretionary household income is reduced. There is some evidence
of charity fatigue’ in the K. This arises when the public feel pressurised by so many different competing charities that they feel ill
disposed to give anything to anyone at all.
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Home / Students / Study resources / Performance Management (PM) / Technical articles

Performance Management (PM) was previously known as F5 Performance

Performance Management (PM)

Study support videos

Performance Management (PM)

Pricing 2: Practical aspects

Big data 1: What is big data?

Big data 2: How companies use big data

Tackling performance evaluation questions

Decentralisation and the need for performance measurement

Target costing and lifecycle costing

Throughput accounting and the theory of constraints – part 1

Throughput accounting and the theory of constraints – part 2

Environmental management accounting

The risks of uncertainty

Comparing budgeting techniques (incremental v ZBB) in the public sector

The learning rate and learning effect

Materials mix and yield variances

Not-for-profit organisations – part 1

Not-for-profit organisations – part 2

ricin The retical as ects

The definition of the price elasticity of demand is:

uantity Price per unit Revenue Marginal

1,000 160 160 160

2,000 140 2 0 120

3,000 120 360 0

4,000 100 400 40

6,000 60 360 -40

,000 20 160 -120

Costs 50,000 (65 x Quantity)

uantity Price per unit Revenue Costs Profit

1,000 160 160 160 115 45

2,000 140 2 0 120 1 0 100

4,000 100 400 40 310 90

6,000 60 360 -40 440 - 0

,000 40 2 0 - 0 505 -225

,000 20 160 -120 5 0 -410

9,000 0 0 -160 635 -635

Profit is therefore maximised when:

The table below now also shows the marginal costs:

uantity Price per unit Revenue Costs Profit

1,000 160 160 160 115 45 65

2,000 140 2 0 120 1 0 100 65

4,000 100 400 40 310 90 65

6,000 60 360 -40 440 - 0 65

,000 40 2 0 - 0 505 -225 65

,000 20 160 -120 5 0 -410 65

9,000 0 0 -160 635 -635 65

he alge raic approach

Moving to the previous quantity level, when Q 1,000, P 160. So:

140 a – 0.02 x 2,000 a – 40

The demand curve is therefore

a price when Q 0. From the table this is 1 0

Demand curve: P a – bQ P 1 0 – 0.02Q

MR: MR a – 2bQ MR 1 0 – 0.04Q

ritten en arrett a freelance lecturer and riter

ricin ractical as ects

he influences on product pricing

The influences on pricing decisions are often listed as: