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C H A P T E R

We will be covering two principal forecasting techniques Forecasting

in this chapter, regression analysis and time series
analysis. Regression analysis can be applied to costs and
revenues while time series analysis is generally applied to
revenue.

SYLLABUS
TOPIC LIST REFERENCE

1 Correlation C2(a)
2 The correlation coefficient and the coefficient of determination C2(c)
3 Lines of best fit C2(b),(c)
4 Least squares method of linear regression analysis C2(d)
5 The reliability of regression analysis forecasts C2(f)
6 The high-low method C2(a)
7 The components of time series C2(h), (l)
8 Finding the trend C2(i),(j)
9 Finding the seasonal variations C2(k)
10 Deseasonalisation C2(k)
11 Sales forecasting: time series analysis C2(e)
12 Forecasting problems C2(i)
13 Using index numbers C2(e),(m), (n)
14 Sales forecasting: the product life cycle C2(g)

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PART C: BUDGETING

Study Guide Intellectual level

C Budgeting

2 Statistical techniques

(a) Explain the advantages and disadvantages of using the high-

K
low method to estimate the fixed and variable element of
costing.
(b) Construct scatter diagrams and lines of best fit. S
(c) Analysis of cost data
(i) Explain the concept of correlation coefficient and
K
coefficient of determination.
(ii) Calculate and interpret correlation coefficient and
S
coefficient of determination.
(iii) Establish a linear function using regression analysis
S
and interpret the results.
(d) Use linear regression coefficients to make forecasts of costs
S
and revenues.
(e) Adjust historical and forecast data for price movements. S
(f) Explain the advantages and disadvantages of linear regression
K
analysis.
(g) Describe the product life cycle and explain its importance in
K
forecasting.
(h) Explain the principles of time series analysis (cyclical, trend,
K
seasonal variation and random elements).
(i) Calculate moving averages. S
(j) Calculation of trend, including the use of regression
S
coefficients.
(k) Use trend and seasonal variation (additive and multiplicative)
S
to make budget forecasts.
(l) Explain the advantages and disadvantages of time series
K
analysis.
(m) Explain the purpose of index numbers. K
(n) Calculate simple index numbers for one or more variables. S

1 Correlation

1.1 Introduction
Two variables are said to be correlated if a change in the value of one variable is accompanied by a
change in the value of another variable. This is what is meant by correlation.

Examples of variables which might be correlated are as follows.

 A person's height and weight
 The distance of a journey and the time it takes to make it
- hệ số tương quan càng tăng thì nó càng mạnh
- distance và time đồng biến
- có tương quan thì có thể có nhân quả
- có nhân quả thì chắc chắn có tương quan

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CHAPTER 14 // FORECASTING

1.2 Scattergraphs
One way of showing the correlation between two related variables is on a scattergraph or scatter
diagram, plotting a number of pairs of data on the graph. For example, a scattergraph showing monthly
selling costs against the volume of sales for a 12-month period might be as follows.

This scattergraph suggests that there is some correlation between selling costs and sales volume, so that
as sales volume rises, selling costs tend to rise as well.
A line of best fit, which is a line drawn by judgement to pass through the middle of the points, thereby
having as many points above the line as below it, can then be drawn.

1.3 Degrees of correlation

Two variables might be perfectly correlated, partly correlated or uncorrelated. Correlation can be
positive or negative.

The differing degrees of correlation can be illustrated by scatter diagrams.

1.3.1 Perfect correlation

All the pairs of values lie on a straight line. An exact linear relationship exists between the two variables.

1.3.2 Partial correlation

In (a), although there is no exact relationship, low values of X tend to be associated with low values of
Y, and high values of X with high values of Y.
In (b), again, there is no exact relationship, but low values of X tend to be associated with high values of
Y and vice versa.

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PART C: BUDGETING

1.3.3 No correlation

The values of these two variables are not correlated with each other.

1.3.4 Positive and negative correlation

Correlation, whether perfect or partial, can be positive or negative.

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

2 The correlation coefficient and the coefficient of determination

2.1 The correlation coefficient

The degree of linear correlation between two variables is measured by the Pearsonian (product moment)
correlation coefficient, r. The nearer r is to +1 or –1, the stronger the relationship.

When we have measured the degree of correlation between two variables we can decide, using actual
results in the form of pairs of data, whether two variables are perfectly or partially correlated and, if they
are partially correlated, whether there is a high or low degree of partial correlation.

FORMULA TO LEARN
n  XY   X  Y
Correlation coefficient, r =
[n  X   X 2 ][n  Y 2   Y 2 ]
2

where X and Y represent pairs of data for two variables X and Y

n = the number of pairs of data used in the analysis

EXAM FOCUS POINT

The formula for the correlation coefficient is given in the exam. Note that this correlation measure
measures the strength of linear relationships.

- hệ số tương quan càng tăng thì nó càng mạnh

The
- distance và timer,đồng
correlation coefficient, must always
biếnfall between –1 and +1. If you get a value outside this range
you have made a mistake.
- có tương quan thì có thể có nhân quả
-có rnhân
= +1
quảmeans that thechắn
thì chắc variables
cóaretương
perfectly positively
quan correlated
 r= –1 means that the variables are perfectly negatively correlated
 r= 0 means that the variables are uncorrelated

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CHAPTER 14 // FORECASTING

2.2 Example: The correlation coefficient formula

The cost of output at a factory is thought to depend on the number of units produced. Data have been
collected for the number of units produced each month in the last six months, and the associated costs,
as follows.
Month Output Cost
'000s of units $'000
X Y
1 2 9
2 3 11
3 1 7
4 4 13
5 3 11
6 5 15
Required
Assess whether there is any correlation between output and cost.
mode - 6 - 2 - nhập biến - AC - option - 3
Solution
n  XY   X  Y
r=
[n  X   X  ][n  Y2   Y  ]
2 2 2

We need to find the values for the following.

(a) XY Multiply each value of X by its corresponding Y value, so that there are six values for XY.
Add up the six values to get the total.
2
(b) X Add up the six values of X to get a total. (X) will be the square of this total.
2
(c) Y Add up the six values of Y to get a total. (Y) will be the square of this total.
2 2
(d) X Find the square of each value of X, so that there are six values for X . Add up these
values to get a total.
2 2
(e) Y Find the square of each value of Y, so that there are six values for Y . Add up these
values to get a total.
Workings
X Y XY X2 Y2
2 9 18 4 81
3 11 33 9 121
1 7 7 1 49
4 13 52 16 169
3 11 33 9 121
5 15 75 25 225
X = 18 Y = 66 XY = 218 X2 = 64 Y2 = 766
2 2 2 2
(X) = 18 = 324 (Y) = 66 = 4,356
n = 6
(6  218)  18  66 
r =
6  64  324  6  766  4,356 
1,308  1,188
=
384  324   4,596  4,356 
120 120 120
= = = =1
60  240 14,400 120

There is perfect positive correlation between the volume of output at the factory and costs which means
that there is a perfect linear relationship between output and costs.

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PART C: BUDGETING

2.3 Example: The correlation coefficient without the formula

If you are given a question with relatively simple numbers as variables, you may be able to estimate the
correlation coefficient without using the formula at all.
The following data is available for the number of materials purchased and the total cost.
Number of units purchased Total cost
x y
$
1 10
2 20
3 30
4 40
5 50
Required
Without using the formula, state the correlation coefficient between the two variables.

Solution
A correlation coefficient of +1 means that there is a perfect linear relationship between the two
variables. The equation relating the two variables would be of the form y = a + bx (see Section 4,
Chapter 4). If you plotted a graph, it would be a straight line.
You can see fairly easily that y is ten times the value of x. So the equation is y = 10x. This means that
there is perfect positive correlation and the correlation coefficient is +1.
Look at the following data.

x y
0.0 60
0.1 50
0.2 40
0.3 30
0.4 20
0.5 10

Required
Without using the formula, state the correlation coefficient between the two variables.

Solution
You could draw a quick sketch of the graph as follows.
70
60 *
50 *
y 40
*
30 *
20 *
10 *
0 0.1 0.2 0.3 0.4 0.5 0.6
x
This graph slopes downwards from right to left and therefore has a negative gradient. It is a straight line
so we are looking at perfect negative correlation with a correlation coefficient of –1.
Note that the gradient is –10/0.1 = –100 and the intercept is 60 (see Section 5, Chapter 4). The
equation of the line is therefore y = –100x + 60.

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CHAPTER 14 // FORECASTING

2.4 Correlation in a time series

Correlation exists in a time series if there is a relationship between the period of time and the recorded
value for that period of time. The correlation coefficient is calculated with time as the X variable
although it is convenient to use simplified values for X instead of year numbers.
For example, instead of having a series of years 20X1 to 20X5, we could have values for X from 0
(20X1) to 4 (20X5).
Note that whatever starting value you use for X (be it 0, 1, 2 ... 721, ... 953), the value of r will always
be the same.

QUESTION Correlation
Sales of product A between 20X7 and 20Y1 were as follows.
Year Units sold ('000s)
20X7 20
20X8 18
20X9 15
20Y0 14
20Y1 11
Required
Determine whether there is a trend in sales. In other words, decide whether there is any correlation
between the year and the number of units sold.

ANSWER
Workings
Let 20X7 to 20Y1 be years 0 to 4.
X Y XY X2 Y2
0 20 0 0 400
1 18 18 1 324
2 15 30 4 225
3 14 42 9 196
4 11 44 16 121
X = 10 Y = 78 XY = 134 X2 = 30 Y2 = 1,266
2 2
(X) = 100 (Y) = 6,084
n = 5
(5  134)  (10  78)
r =
5  30  100 5 1,266  6,084 
670  780 110
= =
150  100 6,330  6,084  50  246

110 110
= = = –0.992
12,300 110.90537

There is partial negative correlation between the year of sale and units sold. The value of r is close to
–1, therefore a high degree of correlation exists, although it is not quite perfect correlation. This means
that there is a clear downward trend in sales.

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PART C: BUDGETING
r: đo mức độ chắn chắn của htuong
r^2: đo đc sự tăng giảm của htuong
2.5 The coefficient of determination, r2
2 2
The coefficient of determination, r (alternatively R ) measures the proportion of the total variation in
the value of one variable that can be explained by variations in the value of the other variable. It denotes
the strength of the linear association between two variables.

Unless the correlation coefficient r is exactly or very nearly +1, –1 or 0, its meaning or significance is a
little unclear. For example, if the correlation coefficient for two variables is +0.8, this would tell us that
the variables are positively correlated, but the correlation is not perfect. It would not really tell us much
else. A more meaningful analysis is available from the square of the correlation coefficient, r, which is
called the coefficient of determination.
2
The question above entitled 'Correlation' shows that r = –0.992, therefore r = 0.984. This means that
over 98% of variations in sales can be explained by the passage of time, leaving 0.016 (less than 2%)
of variations to be explained by other factors.
Similarly, if the correlation coefficient between a company's output volume and maintenance costs was
2
0.9, r would be 0.81, meaning that 81% of variations in maintenance costs could be explained by
variations in output volume, leaving only 19% of variations to be explained by other factors (such as the
age of the equipment).
2
Note, however, that if r = 0.81, we would say that 81% of the variations in y can be explained by
variations in x. We do not necessarily conclude that 81% of variations in y are caused by the variations
in x. We must beware of reading too much significance into our statistical analysis.

2.6 Correlation and causation

If two variables are well correlated, either positively or negatively, this may be due to pure chance or
there may be a reason for it. The larger the number of pairs of data collected, the less likely it is that the
correlation is due to chance, though that possibility should never be ignored entirely.
If there is a reason, it may not be causal. For example, monthly net income is well correlated with
monthly credit to a person's bank account, for the logical (rather than causal) reason that for most
people the one equals the other.
Even if there is a causal explanation for a correlation, it does not follow that variations in the value of
one variable cause variations in the value of the other. For example, sales of ice cream and of sunglasses
are well correlated, not because of a direct causal link but because the weather influences both
variables.

3 Lines of best fit

3.1 Linear relationships

Correlation enables us to determine the strength of any relationship between two variables but it does
not offer us any method of forecasting values for one variable, Y, given values of another variable, X.
If we assume that there is a linear relationship between the two variables, however, and we determine
the equation of a straight line (Y = a + bX) which is a good fit for the available data plotted on a
scattergraph, we can use the equation for forecasting: we can substitute values for X into the equation
and derive values for Y.

3.1.1 Dependent and independent variables

If you are given two variables, the examiner might not tell you which is x and which is y. You need to be
able to work this out for yourself.
y is the dependent variable, depending for its value on the value of x.
x is the independent variable whose value helps to determine the corresponding value of y. Time is
usually an independent variable.

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r: đo mức độ chắn chắn của htuong
r^2: đo đc sự tăng giảm của htuong
For example, the total cost of materials purchases depends on the budgeted number of units of
production. The number of production units is the independent variable (x) and the total cost is the
dependent variable (y).

3.2 Estimating the equation of the line of best fit

There are a number of techniques for estimating the equation of a line of best fit. We will be looking at
simple linear regression analysis. This provides a technique for estimating values for a and b in the
equation
Y = a + bX
where X and Y are the related variables and
a and b are estimated using pairs of data for X and Y.

4 Least squares method of linear regression analysis

4.1 Introduction
Linear regression analysis (the least squares method) is one technique for estimating a line of best fit.
Once an equation for a line of best fit has been determined, forecasts can be made.

FORMULA TO LEARN
The least squares method of linear regression analysis involves using the following formulae for a and b
in Y = a + bX.
n  XY   X  Y
b=
n  X 2   X 2

Y X
a= b
n n
where n is the number of pairs of data

EXAM FOCUS POINT

The formulae will be given in the exam.

The line of best fit that is derived represents the regression of Y upon X.
A different line of best fit could be obtained by interchanging X and Y in the formulae. This would then
represent the regression of X upon Y (X = a + bY) and it would have a slightly different slope. For
examination purposes, always use the regression of Y upon X, where X is the independent variable, and
Y is the dependent variable whose value we wish to forecast for given values of X. In a time series, X will
represent time.

4.2 Example: The least squares method

(a) Using the data below for variables X (output) and Y (total cost), calculate an equation to
determine the expected level of costs, for any given volume of output, using the least squares
method.
Time period 1 2 3 4 5
Output ('000 units) 20 16 24 22 18
Total cost ($'000) 82 70 90 85 73
(b) Prepare a budget for total costs if output is 22,000 units.

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r: đo mức độ chắn chắn của htuong
r^2: đo đc sự tăng giảm của htuong
(c) Confirm that the degree of correlation between output and costs is high by calculating the
correlation coefficient.

Solution
(a) Workings
X Y XY X2 Y2
20 82 1,640 400 6,724
16 70 1,120 256 4,900
24 90 2,160 576 8,100
22 85 1,870 484 7,225
18 73 1,314 324 5,329
X = 100 Y = 400 XY = 8,104 X2 = 2,040 Y2 = 32,278

n = 5 (There are five pairs of data for x and y values)

n  XY   X  Y (5  8,104)  (100  400)
b = =
2
n  X  ( X)2
5  2,040  100 2
40,520  40,000 520
= = = 2.6
10,200  10,000 200

Y X 400  100 
a = b = – 2.6    = 28
n n 5  5 
Y = 28 + 2.6X
where Y = total cost, in thousands of dollars X = output, in thousands of units
Note that the fixed costs are $28,000 (when X = 0 costs are $28,000) and the variable cost per
unit is $2.60.
(b) If the output is 22,000 units, we would expect costs to be
28 + 2.6  22 = 85.2 = $85,200.
520 520 520
(c) r= = = = +0.99

200  5  32,278  400 2  200  1,390 527.3

4.3 Regression lines and time series

The same technique can be applied to calculate a regression line (a trend line) for a time series. This is
particularly useful for purposes of forecasting. As with correlation, years can be numbered from 0
upwards.

QUESTION Trend line

Using the data in the question entitled 'Correlation', calculate the trend line of sales and forecast sales in
20Y2 and 20Y3.

ANSWER
Using workings from the question entitled 'Correlation':
5 134   10  78  670  780
b= = = –2.2
5  30  102 150  100

Y X 78 2.2  10 
a= b =  = 20
n n 5 5
 Y = 20 – 2.2X where X = 0 in 20X7, X = 1 in 20X8 and so on.

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CHAPTER 14 // FORECASTING

Using the trend line, predicted sales in 20Y2 (year 5) would be:
20 – (2.2  5) = 9 ie 9,000 units
and predicted sales in 20Y3 (year 6) would be:
20 – (2.2  6) = 6.8 ie 6,800 units.

QUESTION Regression analysis

Regression analysis was used to find the equation Y = 300 – 4.7X, where X is time (in quarters) and Y
is sales level in thousands of units. Given that X = 0 represents 20X0 quarter 1, what are the forecast
sales levels for 20X5 quarter 4?

ANSWER
X = 0 corresponds to 20X0 quarter 1
Therefore X = 23 corresponds to 20X5 quarter 4
Forecast sales = 300 – (4.7 × 23)
= 191.9 = 191,900 units

QUESTION Forecasting
Over a 36-month period sales have been found to have an underlying regression line of Y = 14.224 +
7.898X where Y is the number of items sold and X represents the month.
What are the forecast number of items to be sold in month 37?

ANSWER
Y = 14.224 + 7.898X
= 14.224 + (7.898 × 37)
= 306.45 = 306 units

5 The reliability of regression analysis forecasts

As with all forecasting techniques, the results from regression analysis will not be wholly reliable. There
are a number of factors which affect the reliability of forecasts made using regression analysis.

(a) It assumes a linear relationship exists between the two variables (since linear regression
analysis produces an equation in the linear format) whereas a non-linear relationship might exist.
(b) It assumes that the value of one variable, Y, can be predicted or estimated from the value of one
other variable, X. In reality the value of Y might depend on several other variables, not just X.
(c) When it is used for forecasting, it assumes that what has happened in the past will provide a
reliable guide to the future.
(d) When calculating a line of best fit, there will be a range of values for X. In the example in
Paragraph 4.2, the line Y = 28 + 2.6X was predicted from data with output values ranging from
X = 16 to X = 24. Depending on the degree of correlation between X and Y, we might safely use
the estimated line of best fit to predict values for Y in the future, provided that the value of X
remains within the range 16 to 24. We would be on less safe ground if we used the formula to
predict a value for Y when X = 10, or 30, or any other value outside the range 16 to 24,

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PART C: BUDGETING

because we would have to assume that the trend line applies outside the range of X values used
to establish the line in the first place.
(i) Interpolation means using a line of best fit to predict a value within the two extreme
points of the observed range.
(ii) Extrapolation means using a line of best fit to predict a value outside the two extreme
points.
When linear regression analysis is used for forecasting a time series (when the X values represent
time) it assumes that the trend line can be extrapolated into the future. This might not
necessarily be a good assumption to make.
(e) As with any forecasting process, the amount of data available is very important. Even if
correlation is high, if we have fewer than about ten pairs of values, we must regard any forecast
as being somewhat unreliable. (It is likely to provide more reliable forecasts than the scattergraph
method, however, since it uses all the available data.)
(f) The reliability of a forecast will depend on the reliability of the data collected to determine the
regression analysis equation. If the data is not collected accurately or if data used is false,
forecasts are unlikely to be acceptable.
A check on the reliability of the estimated line Y = 28 + 2.6X can be made, however, by calculating the
coefficient of correlation. From the answer to the example in Paragraph 4.2, we know that r = 0.99.
2
This is a high positive correlation, and r = 0.9801, indicating that 98.01% of the variation in cost can
be explained by the variation in volume. This would suggest that a fairly large degree of reliance can
probably be placed on estimates.
If there is a perfect linear relationship between X and Y (r = 1) then we can predict Y from any given
value of X with great confidence.
If correlation is high (for example r = 0.9) the actual values will all lie quite close to the regression line
and so predictions should not be far out. If correlation is below about 0.7, predictions will only give a
very rough guide as to the likely value of Y.

5.1 Advantages of regression analysis

(a) It gives a definitive line of best fit, taking account of all the data.
(b) Linear regression makes efficient use of data and good results can be obtained with relatively
small data sets.
(c) The significance/reliability of the relationship between variables can be statistically tested (but
you don't need to know the details of this for FMA).
(d) Many processes are linear so are well described by regression analysis. Even many non-linear
relationships can be well approximated by a linear model over a short range.

6 The high-low method

The high-low method is a simple forecasting technique.

6.1 High-low method

(a) Records of costs in previous periods are reviewed and the costs of the following two periods are
selected.
(i) The period with the highest volume of activity
(ii) The period with the lowest volume of activity
(b) The difference between the total cost of these two periods will be the variable cost of the
difference in activity levels (since the same fixed cost is included in each total cost).

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(c) The variable cost per unit may be calculated from this (difference in total costs  difference in
activity levels), and the fixed cost may then be determined by substitution.
(d) This method may be applied to annual sales figures or any other activity as well as costs. So be
prepared to use this outside the context of costs.

hits rev 6.2 Example: The high-low method using revenues

80,000 115,000 The following information concerning sales revenues for a development, Cool Blue, for the last four
60,000 97,000 months have been as follows.
Month Sales revenues Website 'hits'
denta Y $18,000 $
b= = 1 110,000 70,000
denta X 20,000 hits
2 115,000 80,000
3 111,000 77,000
=$0,9/hits 4 97,000 60,000
a=Ymin-(b*Xmin) Required y
=$97,000-($0,9/hits x 60,000 hits)
x
Calculate the revenues that should be expected in month five when hits is expected to be 75,000 units.
=$43,000 Ignore inflation.

6.3 Solution
Hits Revenue
(a) $
High activity 80,000 115,000
Low activity 60,000 97,000
20,000 18,000
Variable revenue per hit $18,000/20,000 = $0.90

(b) Substituting in either the high or low volume activity:

High Low
$ $
Total revenue 115,000 97,000
Variable revenue (80,000 × $0.90) 72,000 (60,000 × $0.90) 54,000
Fixed revenue 43,000 43,000

(c) Estimated revenues when there are 75,000 hits:

$
Fixed revenues 43,000
Variable revenues (75,000 × $0.90) 67,500
Total revenues 110,500

6.4 Example: The high-low method with stepped fixed costs

The following data relate to the overhead expenditure of contract cleaners (for industrial cleaning) at two
activity levels.
Square metres cleaned 12,750 15,100
Overheads $73,950 $83,585
When more than 20,000 square metres are industrially cleaned, it is necessary to have another
supervisor and so the fixed costs rise to $43,350.
Required
Calculate the estimated overhead expenditure if 22,000 square metres are to be industrially cleaned.
tốc độ tăng 4.1
cost 9,635
b = denta Y = = 4.1
$83,585 denta X 2,350
a = Ymin - (b x Xmin) = 73,950 - (4.1 x 12,750) = 21,675
$73,950
y = FC + VC
297
m^2
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6.5 Solution
Units $
High output 15,100 Total cost 83,585
Low output 12,750 Total cost 73,950
2,350 9,635
$9,635
Variable cost =
2,350
= $4.10 per square metre
Estimated overhead expenditure if 22,000 square metres are to be industrially cleaned:
$
Fixed costs 43,350
Variable costs (22,000  $4.10) 90,200
133,550

QUESTION Cost model

The Valuation Department of a large firm of surveyors wishes to develop a method of predicting its total
costs in a period. The following past costs have been recorded at two activity levels.
Number of valuations Total cost
(V) (TC)
Period 1 420 82,200
Period 2 515 90,275
The total cost model for a period could be represented as follows.
A TC = $46,500 + 85V
B TC = $42,000 + 95V
C TC = $46,500 – 85V
D TC = $51,500 – 95V

ANSWER
Although we only have two activity levels in this question we can still apply the high-low method.
Valuations Total cost
V $
Period 2 515 90,275
Period 1 420 82,200
Change due to variable cost 95 8,075

 Variable cost per valuation = $8,075/95 = $85.

Period 2: fixed cost = $90,275 – (515  $85)
= $46,500
Using good multiple choice question technique, you should have managed to eliminate C and D as
incorrect options straightaway. The variable cost must be added to the fixed cost, rather than subtracted
from it. Once you had calculated the variable cost as $85 per valuation (as shown above), you should
have been able to select option A without going on to calculate the fixed cost (we have shown this
calculation above for completeness).

6.6 Example: The high-low method with inflation

You may be asked to use the high-low method when cost inflation is included. You need to deflate
(reduce) all the costs to a base year before the high-low method can be applied.
Year 1 Year 2 Year 3 Year 4
Sales/production (units) 85,000 93,400 95,800 94,300
Total costs $337,500 $365,670 $379,080 $382,395
Cost inflation index 100 102 104 106

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Required
Establish a linear equation for total costs per annum (at Year 1 prices) using the high-low method.

6.7 Solution
Cost data has to be reduced by dividing by the inflation index before the high-low method can be
applied.
Year 1 Year 2 Year 3 Year 4
Cost/inflation
$337,500 $365,670/1.02 $379,080/1.04 $382,395/1.06
index
= $337,500 =$358,500 =$364,500 =$360,750
After adjusting for inflation, the year of highest output (Year 3) is now also the year of the highest cost.
Using the high-low method for Year 1 and Year 3:
Units Cost
$
High 95,800 364,500
Low 85,000 337,500
10,800 27,000

 variable cost per unit = $27,000/10,800

= $2.50
Fixed cost = $337,500 – (85,000 × $2.50)
= $125,000
 Total cost (y) = $2.50x + $125,000 (where x is the number of units)

6.8 Advantages and disadvantages of the high-low method

Advantages
 It is easy to use and understand.
 It needs just two activity levels.
Disadvantages
 It uses two extreme data points which may not be representative of normal conditions.
 Using only two points to determine a formula may mean that the formula is not very accurate.

7 The components of time series

 A time series is a series of figures or values recorded over time.

 There are four components of a time series: trend, seasonal variations, cyclical variations and
random variations.

The time series analysis forecasting technique is usually used to forecast sales.
A time series is a series of figures or values recorded over time.

The following are examples of time series.

pt = tổng trend + seasonal
(a) Output at a factory each day for the last month
(b) Monthly sales over the last 2 years
(c) Total annual costs for the last 10 years
(d) Retail Prices Index each month for the last 10 years
(e) The number of people employed by a company each year for the last 20 years
A graph of a time series is called a historigram. (Note the 'ri'; this is not the same as a histogram.) For
example, consider the following time series.
cyclical variations: tác động dài hạn hơn 1 năm
random variations: tác động ngẫu nhiên ko ai mong đợi
seasonal variations: tính mùa vụ 299
trend: số thực tế tiêu thụ được
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Year Sales tính mùa vụ là tính thay đổi trong 1 năm

$'000
1 20
2 21
3 24
4 23
5 27
6 30
7 28
The historigram is as follows.

The horizontal axis is always chosen to represent time, and the vertical axis represents the values of the
data recorded.
There are several features of a time series which it may be necessary to analyse in order to prepare
forecasts.
(a) A trend
(b) Seasonal variations or fluctuations
(c) Cycles, or cyclical variations
(d) Non-recurring, random variations, which may be caused by unforeseen circumstances, such as a
change in the government of the country, a war, the collapse of a company, technological change
and a fire

7.1 The trend

The trend is the underlying long-term movement over time in the values of the data recorded.

In the following examples of time series, there are three types of trend.
A và B nghịch biến Output per Number of
Year labour hour Cost per unit employees
Units $
4 30 1.00 100
5 24 1.08 103
6 26 1.20 96
7 22 1.15 102
8 21 1.18 103
9 17pt = tổng trend
1.25 + seasonal
98
(A) (B) (C)
(a) In time series (A) there is a downward trend in the output per labour hour. Output per labour
hour did not fall every year, because it went up between years 5 and 6, but the long-term
movement is clearly a downward one.
(b) In time series (B) there is an upward trend in the cost per unit. Although unit costs went down in
year 7 from a higher level in year 6, the basic movement over time is one of rising costs.

cyclical variations: tác động dài hạn hơn 1 năm

random variations: tác động ngẫu nhiên ko ai mong đợi
300 seasonal variations: tính mùa vụ
trend: số thực tế tiêu thụ được
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(c) In time series (C) there is no clear movement up or down, and the number of employees
remained fairly constant, around 100. The trend is therefore a static, or level one.

7.2 Seasonal variations

Seasonal variations are short-term fluctuations in recorded values, due to different circumstances
which affect results at different times of the year, on different days of the week, at different times of day,
or whatever.

Here are two examples of seasonal variations.

(a) Sales of ice cream will be higher in summer than winter.
(b) The telephone network may be heavily used at certain times of the day (such as mid-morning
and mid-afternoon and much less used at other times (such as in the middle of the night).

QUESTION Seasonal variations

Can you think of some more examples of seasonal variations?

ANSWER
Here are some suggestions.
(a) Sales of overcoats will be higher in autumn than in spring.
(b) Shops might expect higher sales shortly before Christmas, or in their winter and summer sales.
(c) Sales might be higher on Friday and Saturday than on Monday.

'Seasonal' is a term which may appear to refer to the seasons of the year, but its meaning in time series
analysis is somewhat broader, as the examples given above show.

7.3 Example: A trend and seasonal variations

The number of customers served by a company of travel agents over the past four years is shown in the
following historigram.

'

In this example, there would appear to be large seasonal fluctuations in demand, but there is also a
basic upward trend. pt = tổng trend + seasonal
7.4 Cyclical variations
Cyclical variations are fluctuations which take place over a longer time period than seasonal variations.
It may take several years to complete the cycle. For example, the sales of fashion items, such as flared
trousers, could be said to be cyclical. The last cycle took approximately 30 years (mid 1960s to mid
1990s) to complete.

cyclical variations: tác động dài hạn hơn 1 năm

random variations: tác động ngẫu nhiên ko ai mong đợi
seasonal variations: tính mùa vụ 301
trend: số thực tế tiêu thụ được
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QUESTION Time series components

The following is an extract from a Financial Times article.
'It would be wrong to conclude too much from the encouraging 6% growth in BT's inland call volumes in
its final quarter. Even so, shareholders should be warmed by signs that its policy of boosting network
usage is at long last bearing fruit.
The general economic recovery, of course, goes some way to explain the strong growth in calls. So do
enforced price cuts. But the company's belated efforts to market its services also deserve some credit.
Over the past year, charge card customers rose two-thirds, residential subscribers to extra services such
as call diversion more than doubled, and freephone usage grew 30%. Sunday calls have responded to
lower weekend tariffs, though not enough to counterbalance the price cuts. Similarly, discounts targeted
at business customers have slowed BT's loss of market share and helped it win back customers from
Mercury.
BT realises it has so far exploited only a fraction of this growth opportunity. Britons use their phones
much less intensively than their American counterparts. The company therefore plans to step up its
marketing campaign in an attempt to create a 'high phone-usage culture'.
Investors, who have heard management promise similar things in the past, may be sceptical whether
growth will materialise, given that BT's market share is bound to fall further.'
Required
Explain what the extract tells us about the following.
(a) The underlying trend in telephone usage in the UK and any factors influencing that trend
(b) Short-term (or 'seasonal') variations as they have affected BT's business
(c) Cyclical variations affecting BT's performance

ANSWER
(a) BT believes that it can accelerate the long-term trend towards higher phone usage by increased
effort in marketing its services. The long-term potential for growth can be seen from the fact that
Britons use their phones much less than Americans. Only a fraction of this potential has been
tapped so far. Although there is some evidence of this growth in the 6% increase in inland calls
in BT's final quarter, it is too early to be sure about whether this increase reflects the underlying
trend.
(b) Types of 'seasonal' variation affecting BT are the fluctuations occurring over a weekly cycle and
those occurring over the 24-hour period. The extract refers to changes over the weekly cycle.
Calls made on Sundays have grown because of lower prices at the weekend, although this
additional volume of business was not enough to outweigh the cut in price. (In other words, there
was not a positive effect on revenue: there were more calls, but at lower prices.)
(c) One of the main factors explaining the strong rise in calls in the final quarter is the cyclical
variation arising from the general recovery in the economy. (Other factors are price cuts and
improved marketing efforts.)

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8 Finding the trend

One method of finding the trend is by the use of moving averages. Remember that when finding the
moving average of an even number of results, a second moving average has to be calculated so that
trend values can relate to specific actual figures.

Look at these monthly sales figures.

Year 6 Sales
$'000
August 0.02
September 0.04
October 0.04
November 3.20
December 14.60
It looks as though the business is expanding rapidly – and so it is, in a way. But when you know that
the business is a Christmas card manufacturer, then you see immediately that the January sales will no
doubt slump right back down again.
It is obvious that the business will do better in the Christmas season than at any other time – that is the
seasonal variation with which the statistician has to contend. Using the monthly figures, how can they tell
whether or not the business is doing well overall – whether there is a rising sales trend over time other than
the short-term rise over Christmas?
One possibility is to compare figures with the equivalent figures of a year ago. However, many things
can happen over a period of 12 months to make such a comparison misleading – for example, new
products might now be manufactured and prices will probably have changed.
In fact, there are a number of ways of overcoming this problem of distinguishing trend from seasonal
variations. One such method is called moving averages. This method attempts to remove seasonal (or
cyclical) variations from a time series by a process of averaging so as to leave a set of figures
representing the trend.

8.1 Finding the trend by moving averages

A moving average is an average of the results of a fixed number of periods. Since it is an average of
several time periods, it is related to the mid-point of the overall period.

8.2 Example: Moving averages

Year Sales
Units
20X0 390
20X1 380 410
20X2 460
20X3 450
20X4 470
20X5 440
20X6 500
Required
Take a moving average of the annual sales over a period of three years. 3 năm tính 1 lần
8.3 Solution l l l l l l l l l
(a) Average sales in the three-year period 20X0–20X2 were X0 X1 X2 X3 X4 X5 X6
 390+380+460  1,230
  = = 410
 3  3
This average relates to the middle year of the period, 20X1.

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(b) Similarly, average sales in the three-year period 20X1–20X3 were

 380+460+450  1,290
  = = 430
 3  3
This average relates to the middle year of the period, 20X2.
(c) The average sales can also be found for the periods 20X2–20X4, 20X3–20X5 and 20X4–20X6,
to give the following.
Moving total of Moving average of
Year Sales 3 years' sales 3 years' sales ( 3)
20X0 390
20X1 380 1,230 410
20X2 460 1,290 430
20X3 450 1,380 460
20X4 470 1,360 453
20X5 440 1,410 470
20X6 500
Note the following points.
(i) The moving average series has five figures relating to the years from 20X1 to 20X5. The
original series had seven figures for the years from 20X0 to 20X6.
(ii) There is an upward trend in sales, which is more noticeable from the series of moving
averages than from the original series of actual sales each year.

EXAM FOCUS POINT

Do not rush headlong into averaging over a certain number of time periods in an exam, but over what
period a moving average should be taken. The moving average that is most appropriate will depend on
the circumstances and the nature of the time series.
 A moving average which takes an average of the results in many time periods will represent
results over a longer term than a moving average of two or three periods.
 On the other hand, with a moving average of results in many time periods, the last figure in the
series will be out of date by several periods. In the example above, the most recent average
related to 20X5. With a moving average of five years' results, the final figure in the series would
relate to 20X4.
 When there is a known cycle over which seasonal variations occur, such as all the days in the
week or all the seasons in the year, the most suitable moving average would be one which covers
one full cycle.

8.3.1 Moving averages of an even number of results

In the previous example, moving averages were taken of the results in an odd number of time periods,
and the average then related to the mid-point of the overall period.
If a moving average were taken of results in an even number of time periods, the basic technique would
be the same, but the mid-point of the overall period would not relate to a single period. For example,
suppose an average were taken of the following four results.
Spring 120
Summer 90
Autumn 180 average 115
Winter 70
The average would relate to the mid-point of the period, between summer and autumn.
The trend line average figures need to relate to a particular time period; otherwise, seasonal variations
cannot be calculated. To overcome this difficulty, we take a moving average of the moving average. An
example will illustrate this technique.

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8.4 Example: Moving averages over an even number of periods

Calculate a moving average trend line of the following results of Linden Ltd.
Year Quarter Volume of sales
'000 units
20X5 1 600
2 840
645
3 420 => tb cộng 2 số = 650
655 4 720
20X6 1 640
2 860
3 420
4 740
20X7 1 670
2 900
3 430
4 760
chu kỳ 2-3-4-1
8.5 Solution tổng tính mùa vụ trong năm cộng lại = 0
A moving average of four will be used, since the volume of sales would appear to depend on the season
of the year, and each year has four quarterly results. The moving average of four does not relate to any
specific period of time; therefore a second moving average of two will be calculated on the first moving
average trend line.
Moving Moving Mid-point of
total of 4 average of 4 2 moving
Actual volume quarters' quarters' averages
Year Quarter of sales sales sales trend line
'000 units '000 units '000 units '000 units
(A) (B) (B  4) (C)
20X5 1 600
2 840
3 420 2,580 645.0 650.00
4 720 2,620 655.0 657.50
20X6 1 640 2,640 660.0 660.00
2 860 2,640 660.0 662.50
3 420 2,660 665.0 668.75
4 740 2,690 672.5 677.50
20X7 1 670 2,730 682.5 683.75
2 900 2,740 685.0 687.50
3 430 2,760 690.0
4 760
By taking a mid point (a moving average of two) of the original moving averages, we can relate the
results to specific quarters (from the third quarter of 20X5 to the second quarter of 20X7).

QUESTION Trend in sales

What can you say about the trend in sales of Linden Ltd in Paragraph 8.5 above?

ANSWER
The trend in sales is upward.

8.6 Moving averages on graphs

One way of displaying the trend clearly is to show it by plotting the moving average on a graph.

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8.7 Example: Moving averages on graphs

Actual sales of Slap-It-On suntan lotion for 20X5 and 20X6 were as follows.
Sales
20X5 20X6
$'000 $'000
January 100 110
February 645 120=> tb cộng130
2 số = 650
March 200 220
April 655 200 210
May 240 230
June 250 240
July 210 250
August 210 300
September 200 150
October 110 110
November 90 80
December 50 40
chu kỳ 2-3-4-1
1,980 2,070
tổng tính mùa vụ trong năm cộng lại = 0
Required
Calculate the trend in the suntan lotion sales and display it on a graph. (Hint. Calculate an annual
moving total.)

8.8 Solution
Moving
average
20X6 Sales Moving total (trend)
$'000 $'000 $'000
January 110 1,990 165.83
February 130 2,000 166.67
March 220 2,020 168.33
April 210 2,030 169.17
May 230 2,020 168.33
June 240 2,010 167.50
July 250 2,050 170.83
August 300 2,140 178.33
September 150 2,090 174.17
October 110 2,090 174.17
November 80 2,080 173.33
December 40 2,070 172.50
There is one very important point not immediately obvious from the above table, and that is to do with
the time periods covered by the moving total and moving average.
(a) The moving total, as we have seen, is the total for the previous 12 months. The figure of $1,990,
for instance, represents total sales from February 20X5 to January 20X6.
(b) The moving average is the average monthly sales over the previous 12 months. The figure of
$165.83, for instance, represents average monthly sales for each month during the period
February 20X5 to January 20X6.
When plotting a moving average on a graph, it is therefore important to remember that the points should
be located at the mid-point of the period to which they apply. For example, the figure of $165.83
(moving average at end of January 20X6) relates to the 12 months ending January 20X6 and so it must
be plotted in the middle of that period (31 July 20X5).

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The moving data on suntan lotion sales could be drawn on a graph as follows.
$

645
=> tb cộng 2 số = 650
655

chu kỳ 2-3-4-1
tổng tính mùa vụ trong năm cộng lại = 0

Points to note about this graph are as follows.

(a) The annual moving average can only be plotted from July 20X5 to May 20X6, as we have no
data prior to January 20X5 or after December 20X6.
(b) The moving average has the effect of smoothing out the seasonal fluctuations in the ordinary
sales graph (which is the reason why moving averages are used in the first place).

9 Finding the seasonal variations

Seasonal variations are the difference between actual and trend figures (additive model). An average of
the seasonal variations for each time period within the cycle must be determined and then adjusted so
that the total of the seasonal variations sums to zero.

Once a trend has been established, we can find the seasonal variations.
The actual and trend sales for Linden Ltd (as calculated in Paragraph 8.5) are set out overleaf. The
difference between the actual results for any one quarter and the trend figure for that quarter will be
the seasonal variation for that quarter.

9.1 Additive model

Year Quarter Actual Trend Seasonal variation
20X5 1 600
2 840
3 420 650.00 –230.00
4 720 657.50 62.50
20X6 1 640 660.00 –20.00
2 860 662.50 197.50
3 420 668.75 –248.75
4 740 677.50 62.50

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Year Quarter Actual Trend Seasonal variation

20X7 1 670 683.75 –13.75
2 900 687.50 212.50
3 430
4 760
The variation between the actual result for any one particular quarter and the trend line average is not
the same from year to year, but an average of these variations can be taken.
Q1 Q2 Q3 Q4
20X5 230.00 62.50
20X6 20.00 197.50 248.75 62.50
20X7 13.75 212.50
Total 33.75 410.00 478.75 125.00
tb seasonal qua các kì Average (÷ 2) 16.875 205.00 239.375 62.50
tổng là chênh lệch của Our estimate of the 'seasonal' or quarterly variation is almost complete, but there is one more important
seasonal trong 1 năm, step to take. Variations around the basic trend line should cancel each other out, and add up to zero. At
chia cho 4 kì the moment, they do not. We therefore spread the total of the variations (11.25) across the four
quarters (11.25 ÷ 4) so that the final total of the variations sum to zero.
Q1 Q2 Q3 Q4 Total
Estimated quarterly variations –16.8750 205.0000 –239.3750 62.5000 11.250
Adjustment to reduce variations to 0 –2.8125 –2.8125 –2.8125 –2.8125 –11.250
Final estimates of quarterly variations –19.6875 202.1875 –242.1875 59.6875 0
These might be rounded as follows Ql: –20 Ql: 202 Ql:-242 Ql: 60 Total: 0
tổng sản lượng = trend + seasonal
QUESTION Additive model
The results of an additive time series model analysing production are shown below.
Weekly production
'000 units
Week 1 –4
Week 2 +5
Week 3 +9
Week 4 –6
Which of the following statements is/are true in relation to the data shown in the table above?
I Production is on average 9,000 units above the trend in week 3.
II Production is on average 4% below the trend in week 1.
III Production is on average 5% above the trend in week 2.
IV Production in week 4 is typically 6% below the trend.
A I only
B I and II only
C I and III only
D II and IV only

ANSWER
A I With an additive model, the weekly component represents the average value of actual
production minus the trend for that week, so a component of +9 means production is
9,000 units above the trend.
This is the only correct statement.
If you selected option B, C or D, you have confused the additive variation of –4, +5 and
–6 (actually –4,000 units, +5,000 units and –6,000 units respectively) with the
multiplicative variation of –4%, +5% and –6% respectively. Multiplicative variations are
covered later in this chapter.

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EXAM FOCUS POINT

The ACCA examining team is unlikely to ask you to derive the seasonal variations in a time series, but
it is important that you have a good understanding of how to do it.

9.2 A weakness in moving average analysis

The moving average calculations described so far in this chapter are based on an additive model which
means that we add the values for a number of periods and take the average of those values.
An additive model has the important drawback that when there is a steeply rising or a steeply declining
trend, the moving average trend will either get ahead of or fall behind the real trend.

9.3 Examples
Suppose that we were to take a three year moving average of the following sales figures.
Actual Three-year Moving
sales moving total average
$'000 $'000 $'000
20X1 1,000
20X2 1,200 3,700 1,233
20X3 1,500 4,800 1,600
20X4 2,100 6,600 2,200
20X5 3,000 9,300 3,100
20X6 4,200 12,900 4,300
20X7 5,700 18,000 6,000
20X8 8,100
In this example, sales are on a steeply rising trend, which means that the moving average value for each
year consistently overstates sales because it is partly influenced by the value of sales in the next year.
The moving average value for 20X7, for example, is $6,000, which is $300 above actual sales for
20X7. This is because the moving average is partly based on the higher sales value in 20X8. The
consequences are as follows.
(a) The trend sales is not a good representation of actual sales.
(b) The trend will probably be unsuitable for forecasting.

9.4 Seasonal variations using the multiplicative model

The method of estimating the seasonal variations in the above example was to use the differences
between the trend and actual data. This model assumes that the components of the series are
independent of each other, so that an increasing trend does not affect the seasonal variations and make
them increase as well, for example.
The alternative is to use the multiplicative model whereby each actual figure is expressed as a
proportion of the trend.
It may be easier to understand this model if we state this as an equation. The example below uses the
equation to calculate the seasonal variation.

The proportional (multiplicative) model summarises a time series as Y = T  S  R (or Y = T*S*R).

The trend component will be the same whichever model is used but the values of the seasonal and
random components will vary according to the model being applied. In our examples, we assume that
the random component is small and so can be ignored for our purposes. So the multiplicative model will
be Y = T × S.
Refer back to our example, Linden Ltd taking the first two years of data only. We can use the equation
here to work out the seasonal variations. The trend is calculated in exactly the same way as before. So if
Y = T × S then S = Y/T and we can calculate S = Y/T for the multiplicative model.

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tỷ lệ cộng lại phải = 4 vì từng quý cộng lại = 1

Actual Trend Seasonal percentage
Year Quarter (Y) (T) (Y/T)
20X5 1 600
2 840
3 420 650.00 0.646
4 720 657.50 1.095
20X6 1 640 660.00 0.970
2 860 662.50 1.298
3 420
4 740
Suppose that seasonal variations for the next four quarters are 0.628, 1.092, 0.980 and 1.309
respectively. The summary of the seasonal variations expressed in proportional terms is therefore as
follows.
Year Q1 Q2 Q3 Q4
% % % %
20X5 0.646 1.095
20X6 0.970 1.298 0.628 1.092
20X7 0.980 1.309
Total 1.950 2.607 1.274 2.187
tổng = 4,009 Average 0.975 1.3035 0.637 1.0935

Instead of summing to zero, as with the additive approach, the averages should sum (in this case) to
4.0, 1.0 for each of the four quarters. They actually sum to 4.009 so 0.00225 has to be deducted
from each one.
Q1 Q2 Q3 Q4
Average 0.97500 1.30350 0.63700 1.09350
Adjustment –0.00225 –0.00225 –0.00225 –0.00225
Final estimate 0.97275 1.30125 0.63475 1.09125
Rounded 0.97 1.30 0.64 1.09

Note that the proportional model is better than the additive model when the trend is increasing or
decreasing over time. In such circumstances, seasonal variations are likely to be increasing or
decreasing too. The additive model simply adds absolute and unchanging seasonal variations to the
trend figures whereas the proportional model, by multiplying increasing or decreasing trend values by a
constant seasonal variation factor, takes account of changing seasonal variations.

10 Deseasonalisation

Deseasonalised data are often used by economic commentators.

Economic statistics, such as unemployment figures, are often 'seasonally adjusted' or 'deseasonalised' so
as to ensure that the overall trend (rising, falling or stationary) is clear. All this means is that seasonal
variations (derived from previous data) have been taken out, to leave a figure which might be taken as
indicating the trend.

10.1 Example: Deseasonalisation

Actual sales figures for four quarters, together with appropriate seasonal adjustment factors derived from
previous data, are as follows.
Actual Seasonal
Quarter sales adjustments
$'000 $'000
1 150 +3
2 160 +4
3 164 –2
4 170 –5

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Required
Deseasonalise these data.

10.2 Solution
We are reversing the normal process of applying seasonal variations to trend figures, so we subtract
positive seasonal variations (and add negative ones).
Actual Deseasonalised
Quarter sales sales
$'000 $'000
1 150 147
2 160 156
3 164 166
4 170 175

11 Sales forecasting: time series analysis

Forecasting using time series analysis involves calculating a trend line, extrapolating the trend line and
adjusting the forecasts by appropriate seasonal variations. The trend line can be extrapolated by eye or
by using a common sense 'rule of thumb' approach.

The main idea behind time series analysis is the identification of the trend in the data and its separation
from seasonal variations. Once that has been done, forecasts of future values can be made as follows.
Please note that you will not be asked to derive seasonal variations in a time series analysis. The
information and inclusion in the following example are for completeness only.
(a) The trend line should be calculated.
(b) The trend line should be used to forecast future trend line values.
(c) These values should be adjusted by the average seasonal variation applicable to the future
period, to determine the forecast for the period.
Extending a trend line outside the range of known data, in this case forecasting the future from a trend
line based on historical data, is known as extrapolation.
There are two principal methods of calculating the forecast trend line.

11.1 Inspection
The trend line can be drawn by 'eye' on a graph in such a way that it appears to lie evenly between the
recorded points. Forecasts can then be read off of an extrapolated trend line.

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($'000s)

In the diagram above, for example, the trend for sales in 20X3 quarter 4 can be forecast as $9,000 by
reading from the 'guessed' trend line. It could then be adjusted by the appropriate seasonal variation to
determine the actual forecast.

11.2 Common sense 'rule of thumb' approach

This method is simply to guess what future movements in the trend line might be, based on
movements in the past. It is not a mathematical technique, merely a common sense, rule of thumb
approach. See if you can produce your own solution to the following problem.

11.3 Example: Forecasting by rough approximation

The sales (in $'000) of swimwear by a large department store for each period of three months are as
follows.
Quarter 20X4 20X5 20X6 20X7
$'000 $'000 $'000 $'000
First 8 20 40
Second 30 50 62
Third 60 80 92
Fourth 24 20 40
Required
(a) Using an additive model, find the centred moving average trend.
(b) Find the average seasonal variation for each quarter.
(c) Predict sales for the last quarter of 20X7 and the first quarter of 20X8, stating any assumptions.

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11.4 Solution
4 quarter Centred Moving
Quarter moving total moving total average (÷4)
20X4 4

20X5 1 122
2 118 120 30
3 130 124 31
4 150 140 35
20X6 1 170 160 40
2 190 180 45
3 210 200 50
4 222 216 54
20X7 1 234 228 57
2
3
(a) The centred moving average trend is shown in the right-hand column of the table.
(b) Seasonal variations
Quarter
1 2 3 4 Total
Year 20X5 0.00 +29.00 –15.00
20X6 –20.00 +5.00 +30.00 –14.00
20X7 –17.00
Total –37.00 +5.00 +59.00 –29.00
Average –18.50 +2.50 +29.50 –14.50 –1
Adjust total variation to nil +0.25 +0.25 +0.25 +0.25 +1

Average seasonal variation –18.25 +2.75 +29.75 –14.25

(c) We might guess that the trend line is rising steadily, by (57 – 40)/4 = 4.25 per quarter in the
period 1st quarter 20X6 to 1st quarter 20X7 (57 being the prediction in 1st quarter 20X7 and
40 the prediction in 1st quarter 20X6).
Since the trend may be levelling off a little, a quarterly increase of +4 in the trend will be
assumed.
Seasonal
Trend variation Forecast
1st quarter 20X7 57
4th quarter 20X7 (+ (3 × 4)) 69 –14.25 54.75
1st quarter 20X8 (+ (4 × 4)) 73 –18.25 54.75
Rounding to the nearest thousand dollars, the forecast sales are $55,000 for each of the two
quarters.

QUESTION Forecast sales

Sales of product X each quarter for the last three years have been as follows (in thousands of units).
Trend values, found by a moving averages method, are shown in brackets.
Year 1st quarter 2nd quarter 3rd quarter 4th quarter
1 18 30 20 (18.75) 6 (19.375)
2 20 (20) 33 (20.5) 22 (21) 8 (21.5)
3 22 (22.125) 35 (22.75) 25 10
Average seasonal variations for quarters 1 to 4 are –0.1, +12.4, +1.1 and –13.4 respectively.
Required
Use the trend line and estimates of seasonal variations to forecast sales in each quarter of year 4.

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ANSWER
The trend line indicates an increase of about 0.6 per quarter. This can be confirmed by calculating the
average quarterly increase in trend line values between the third quarter of year 1 (18.75) and the
second quarter of year 3 (22.75). The average rise is

22.75 – 18.75 4
= = 0.57, say 0.6
7 7
Taking 0.6 as the quarterly increase in the trend, the forecast of sales for year 4, before seasonal
adjustments (the trend line forecast) would be as follows.
Year Quarter Trend line
3 *2nd (actual trend) 22.75, say 22.8
3rd 23.4
4th 24.0
4 1st 24.6
2nd 25.2
3rd 25.8
4th 26.4
* last known trend line value
(Note that you could actually plot the trend line figures on a graph, extrapolate the trend line into the
future and read off forecasts from the graph using the extrapolated trend line.)
Seasonal variations should now be incorporated to obtain the final forecast.
Average
Trend line seasonal Forecast of
Quarter forecast variation actual sales
'000 units '000 units '000 units
Year 4 1st 24.6 –0.1 24.5
2nd 25.2 +12.4 37.6
3rd 25.8 +1.1 26.9
4th 26.4 –13.4 13.0

12 Forecasting problems

All forecasts are subject to error, but the likely errors vary from case to case.
(a) The further into the future the forecast is for, the more unreliable it is likely to be.
(b) The less data available on which to base the forecast, the less reliable the forecast.
(c) The pattern of trend and seasonal variations cannot be guaranteed to continue in the future.
(d) There is always the danger of random variations upsetting the pattern of trend and seasonal
variation.

In summary, time series can be rather simplistic, as it assumes past trends will continue indefinitely.
There are a number of changes that also may make it difficult to forecast future events.

Type of change Examples

Political and Create uncertainty. For example, changes in interest rates, exchange rates and
economic changes inflation can mean that future sales and costs are difficult to forecast.

Environmental For example, the opening of the Channel Tunnel might have a considerable
changes impact on some companies' markets.

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Type of change Examples

Technological May mean that the past is not a reliable indication of likely future events. For
changes example, the availability of faster machinery may make it difficult to use
current output levels as the basis for forecasting future production output.

Technological Can also change the nature of production. The advent of advanced
advances manufacturing technology is changing the cost structure of many firms. Direct
labour costs are reducing in significance and fixed manufacturing costs are
increasing. This causes forecasting difficulties because of the resulting changes
in cost behaviour patterns, breakeven points and so on.

Social changes Alterations in taste and fashion and changes in the social acceptability of
different products can cause difficulties in forecasting future sales levels; for
example, tobacco.

13 Using index numbers

An index is a measure, over time, of the average changes in the value (price or quantity) of a group of
items relative to the situation at some period in the past.
 Composite indices cover more than one item.
 Weighting is used to reflect the importance of each item in the index.
 Weighted aggregate indices are found by applying weights and then calculating the index.
 There are two types of weighted aggregate index, the Laspeyre (which uses quantities/prices from
the base period as the weights) and the Paasche (which uses quantities/prices from the current
period as weights).
 Fisher's ideal index is the geometric mean of the Laspeyre and Paasche indices.
 Index numbers are a very useful way of summarising a large amount of data in a single series of
numbers. You should remember, however, that any summary hides some detail and that index
numbers should therefore be interpreted with caution.

Index numbers provide a standardised way of comparing the values, over time, of prices, wages, volume
of output and so on. They are used extensively in business, government and commerce. No doubt you
will be aware of some index numbers – for example, the Retail Prices Index (RPI) and the FTSE All
Share Index. This section will explain how to construct indices and will look at associated issues, such
as their limitations.
An index is a measure, over time, of the average changes in the values (prices or quantities) of a group
of items. An index comprises a series of index numbers. Although it is possible to prepare an index for a
single item, for example the price of an ounce of gold, such an index would probably be unnecessary. It
is only when there is a group of items that a simple list of changes in their values over time becomes
rather hard to interpret, and an index provides a useful single measure of comparison.

13.1 Price indices and quantity indices

An index may be a price index or a quantity index.
(a) A price index measures the change in the monetary value of a group of items over time.
Perhaps the best known price index in the UK is the RPI which measures changes in the costs of
items of expenditure of the average household.
(b) A quantity index (also called a volume index) measures the change in the non-monetary values
of a group of items over time. An example is a productivity index, which measures changes in
the productivity of various departments or groups of workers.

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When one commodity only is under consideration, we have the following formulae.
Pn
(a) Price index = × 100
Po

where Pn is the price for the period under consideration and P0 is the price for the base period.
Qn
(b) Quantity index = × 100
Qo
where Qn is the quantity for the period under consideration and Q0 is the quantity for the base
period.

13.2 Example: Single-item indices

If the price of a cup of coffee was 40c in 20X0, 50c in 20X1 and 76c in 20X2, then using 20X0 as a
base year the price index numbers for 20X1 and 20X2 would be as follows.
50
20X1 price index = × 100 = 125
40
76
20X2 price index = × 100 = 190
40
If the number of cups of coffee sold in 20X0 was 500,000, in 20X1 700,000 and in 20X2 600,000,
then using 20X0 as a base year the quantity index numbers for 20X1 and 20X2 would be as follows.
700,000
20X1 quantity index = × 100 = 140
500,000

600,000
20X2 quantity index = × 100 = 120
500,000
Given the values of some commodity over time (a time series), there are two ways in which index
relatives can be calculated.
In the fixed base method, a base year is selected (index 100), and all subsequent changes are
measured against this base. Such an approach should only be used if the basic nature of the commodity
is unchanged over time.
In the chain base method, changes are calculated with respect to the value of the commodity in the
period immediately before. This approach can be used for any set of commodity values but must be
used if the basic nature of the commodity is changing over time.

13.3 Example: Fixed base and chain base methods

The price of commodity was $2.70 in 20X0, $3.11 in 20X1, $3.42 in 20X2 and $3.83 in 20X3.
Construct both a chain base index and a fixed base index for the years 20X0 to 20X3 using 20X0 as the
base year.

13.4 Solution
Chain base index 20X0 100
20X1 115 (3.11/2.70 × 100)
20X2 110 (3.42/3.11 × 100)
20X3 112 (3.83/3.42 × 100)

Fixed base index 20X0 100

20X1 115
20X2 127 (3.42/2.70 × 100)
20X3 142 (3.83/2.70 × 100)

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The chain base relatives show the rate of change in prices from year to year, whereas the fixed base
relatives show changes relative to prices in the base year.

13.5 Composite index numbers

Most practical indices cover more than one item and are therefore termed composite index numbers.
The RPI, for example, considers such components as food, alcoholic drink, tobacco and housing. An
index of motor car costs might consider such components as finance payments, service costs, repairs
and insurance.
Suppose that the cost of living index is calculated from only three commodities: bread, tea and caviar,
and that the prices for 20X1 and 20X2 were as follows.
20X1 20X2
Bread 20c a loaf 40c a loaf
Tea 25c a packet 30c a packet
Caviar 450c a jar 405c a jar
A simple index could be calculated by adding the prices for single items in 20X2 and dividing by the
corresponding sum relating to 20X1 (if 20X1 is the base year). In general, if the sum of the prices in the
ΣPn
base year is P0 and the sum of the prices in the new year is Pn, the index is  100. The index,
ΣP0
known as a simple aggregate price index, would therefore be calculated as follows.
P0 Pn
20X1 20X2
$ $
Bread 0.20 0.40
Tea 0.25 0.30
Caviar 4.50 4.05
P0 = 4.95 Pn = 4.75

Year Pn /P0 Simple aggregate price index

20X1 4.95/4.95 = 1.00 100
20X2 4.75/4.95 = 0.96 96
This type of index has a number of disadvantages. It ignores the amounts of bread, tea and caviar
consumed (and therefore the importance of each item), and the units to which the prices refer. If, for
example, we had been given the price of a cup of tea rather than that of a packet of tea, the index would
have been different.
To overcome these problems we can use weighting. A weighting factor can be thought of as an indicator
of the importance of the component (such as alcohol in the RPI) with respect to the type of index being
calculated.

13.6 Weighted aggregate indices

This method of weighting involves multiplying each component value by its corresponding weight and
adding these products to form an aggregate. This is done for both the base period and the period in
question. The aggregate for the period under consideration is then divided by the base period aggregate.
The general form of a weighted aggregate index is
Σwvn
where w is the weighting factor
Σwvo
vo is the value of the commodity in the base period
vn is the value of the commodity in the period in question
Price indices are usually weighted by quantities and quantity indices are usually weighted by prices.

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QUESTION Weighted aggregate indexes

What are the formulae for calculating price and quantity weighted aggregate indices if base year weights
are used?

ANSWER
ΣQoPn
Price index:  100
ΣQoPo

where P0 represents the prices of items in the base year

Pn represents the prices of items in the new year
Q0 represents the quantities of the items consumed in the base year
ΣPoQn
Quantity index:  100
ΣPoQ o

where Q0 represents the quantities consumed in the base year

Qn represents the quantities consumed in the new year
P0 represents the prices in the base year

13.7 Example: A price index

In the previous example of the cost of living index (Paragraph 9.5), the 20X2 index value could have
been calculated as follows, assuming the quantities purchased by each household were as given below.
Item Quantity Price in 20X1 Price in 20X2
Q0 P0 P0Q0 Pn P n Q0
Bread 6 20 120 40 240
Tea 2 25 50 30 60
Caviar 0.067 450 30 405 27
200 327

327
Index in 20X2 =  100 = 163.5
200
We will now look at an example of a quantity index, which measures changes in quantities and uses
prices as weights.

13.8 Example: A quantity index

The Falldown Construction Company uses four items of materials and components in a standard
production job.
In 20X0 the quantities of each material or component used per job and their cost were as follows.
Quantity Price per unit
Units $
Material A 20 2
Material B 5 10
Component C 40 3
Component D 15 6
In 20X2 the quantities of materials and components used per job were as follows.
Quantity
Units
Material A 15
Material B 6
Component C 36
Component D 25

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Using 20X0 as a base year, calculate the quantity index value in 20X2 for the amount of materials used
in a standard job.

13.9 Solution
Quantity Quantity
used used
Price in 20X0 in 20X2
Po Qo PoQo ($) Qn PoQn ($)
Material A $2 20 40 15 30
Material B $10 5 50 6 60
Component C $3 40 120 36 108
Component D $6 15 90 25 150
300 348

348
Quantity index =  100 = 116
300
This would suggest that the company is using 16% more materials in 20X2 than in 20X0 on a standard
job.

13.10 Laspeyre, Paasche and Fisher indices

Laspeyre and Paasche indices are special cases of weighted aggregate indices.

13.11 Laspeyre indices

Laspeyre indices use weights from the base period and are therefore sometimes called base weighted
indices.

13.11.1 Laspeyre price index

A Laspeyre price index uses quantities consumed in the base period as weights. In the notation already
used it can be expressed as follows.

 PnQ o
Laspeyre price index =  100
 Po Q o

13.11.2 Laspeyre quantity index

A Laspeyre quantity index uses prices from the base period as weights and can be expressed as follows.
 P o Qn
Laspeyre quantity index =  100
 Po Q o

13.12 Paasche indices

Paasche indices use current time period weights. In other words, the weights are changed every time
period.

13.12.1 Paasche price index

A Paasche price index uses quantities consumed in the current period as weights and can be expressed
as follows.
 PnQn
Paasche price index =  100
 P o Qn

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13.12.2 Paasche quantity index

A Paasche quantity index uses prices from the current period as weights and can be expressed as
follows.
 PnQn
Paasche quantity index =  100
 PnQ o

13.13 Example: Laspeyre and Paasche price indices

The wholesale price index in Ruritania is made up from the prices of five items. The price of each item
and the average quantities purchased by manufacturing and other companies each week were as
follows, in 20X0 and 20X2.
Item Quantity Price per unit Quantity Price per unit
20X0 20X0 20X2 20X2
'000 units Roubles '000 units Roubles
P 60 3 80 4
Q 30 6 40 5
R 40 5 20 8
S 100 2 150 2
T 20 7 10 10
Required
Calculate the price index in 20X2, if 20X0 is taken as the base year, using the following.
(a) A Laspeyre index
(b) A Paasche index

13.14 Solution
Item Laspeyre Paasche
Qo Po Qn Pn PoQo PnQo PnQn PoQn
P 60 3 80 4 180 240 320 240
Q 30 6 40 5 180 150 200 240
R 40 5 20 8 200 320 160 100
S 100 2 150 2 200 200 300 300
T 20 7 10 10 140 200 100 70
900 1,110 1,080 950

20X2 index numbers are as follows.

1,110
(a) Laspeyre index = 100  = 123.3
900
1,080
(b) Paasche index = 100  = 113.7
950
The Paasche index for 20X2 reflects the decline in consumption of the relatively expensive items R and
T since 20X0. The Laspeyre index for 20X2 fails to reflect this change.

QUESTION Indexes
A baker has listed the ingredients they used and their prices, in 20X3 and 20X4, as follows.
Kgs used Price per kg Kgs used Price per kg
20X3 20X3 20X4 20X4
'000 $ '000 $
Milk 3 1.20 4 1.50
Eggs 6 0.95 5 0.98
Flour 1 1.40 2 1.30
Sugar 4 1.10 3 1.14

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Required
Calculate the following quantity indices for 20X4 (with 20X3 as the base year).
(a) A Laspeyre index
(b) A Paasche index

ANSWER
Workings
Laspeyre Paasche
Qo Po Qn Pn PoQo PoQn PnQn PnQo
Milk 3 1.20 4 1.50 3.60 4.80 6.00 4.50
Eggs 6 0.95 5 0.98 5.70 4.75 4.90 5.88
Flour 1 1.40 2 1.30 1.40 2.80 2.60 1.30
Sugar 4 1.10 3 1.14 4.40 3.30 3.42 4.56
15.10 15.65 16.92 16.24

Quantity index numbers for 20X4 are as follows.

15.65
(a) Laspeyre method = 100  = 103.64
15.10
16.92
(b) Paasche method = 100  = 104.19
16.24

13.15 Which to use – Paasche or Laspeyre?

Both patterns of consumption and prices change and a decision therefore has to be made as to whether
a Paasche or a Laspeyre index should be used.
The following points should be considered when deciding which type of index to use.
(a) A Paasche index requires quantities to be ascertained each year. A Laspeyre index only requires
them for the base year. Constructing a Paasche index may therefore be costly.
(b) For the Paasche index the denominator has to be recalculated each year because the
quantities/prices must be changed to current year consumption/price levels.
For the Laspeyre index, the denominator is fixed. The Laspeyre index can therefore be calculated
as soon as current prices/quantities are known. The Paasche index, on the other hand, cannot be
calculated until the end of a period, when information about current quantities/prices becomes
available.
(c) The denominator of a Laspeyre index is fixed and therefore the Laspeyre index numbers for
several different years can be directly compared. With the Paasche index, on the other hand,
comparisons can only be drawn directly between the current year and the base year (although
indirect comparisons can be made).
(d) The weights for a Laspeyre index become out of date, whereas those for the Paasche index are
updated each year.
(e) A Laspeyre price index implicitly assumes that, whatever the price changes, the quantities
purchased will remain the same. In terms of economic theory, no substitution of cheaper
alternative goods and services is allowed to take place. Even if goods become relatively more
expensive, it assumes that the same quantities are bought. As a result, the index tends to
overstate inflation.
(f) The effect of current year weighting when using the Paasche price index means that greater
importance is placed on goods that are relatively cheaper now than they were in the base year.
As a consequence, the Paasche price index tends to understate inflation.
In practice, it is common to use a Laspeyre index and revise the weights every few years. (Where
appropriate, a new base year may be created when the weights are changed.)

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13.16 Fisher's ideal index

Because Laspeyre's index uses base period weights, it tends to overstate any change in prices or
quantities. When prices increase there is usually a reduction in the quantities consumed. The index
numerator is therefore likely to be too large. Likewise, when prices decrease, quantities consumed
increase, resulting in an underweighting of those prices which have decreased and hence an
overstatement of change. The Paasche index, on the other hand, tends to understate change.
To overcome these difficulties some statisticians prefer to use Fisher's ideal index. This index is found by
taking the geometric mean of the Laspeyre index and the Paasche index.
Fisher's ideal index = (Laspeyre  Paasche)

QUESTION Fisher's index

The Laspeyre index of retail prices for 20X7 (with a base year of 20X1) is 137.2. The corresponding
Paasche index is 134.9.
Required
Calculate Fisher's ideal index.

ANSWER
(137.2  134.9) = 136.0

13.17 What items to include

The purpose to which the index is to be put must be carefully considered. Once this has been done, the
items selected must be as representative as possible, taking into account this purpose. Care must be
taken to ensure that the items are unambiguously defined and that their values are readily
ascertainable.
For some indices, the choice of items might be relatively straightforward. For example, the FTSE All
Share Index is made up of the share prices of approximately 800 companies quoted on The Inventory
Exchange. The weights are based on the market capitalisations of the companies (the number of shares
in issue multiplied by their market value).
For other indices, the choice of items will be more difficult. The RPI is an excellent example of the
problem. It would be impossible to include all items of domestic spending and a selective,
representative basket of goods and services must be found, ranging from spending on mortgages and
rents, to cars, public transport, food and drink, electricity, gas, telephone, clothing, leisure activities and
so on.

13.18 Collecting the data

Data are required to determine the following.
(a) The values for each item
(b) The weight that will be attached to each item
Consider as an example a cost of living index. The prices of a particular commodity will vary from place to
place, from shop to shop and from type to type. Also the price will vary during the period under
consideration. The actual prices used must obviously be some sort of average. The way in which the
average is to be obtained should be clearly defined at the outset.
When constructing a price index, it is common practice to use the quantities consumed as weights;
similarly, when constructing a quantity index, the prices may be used as weights. Care must be taken in
selecting the basis for the weighting. For example, in a cost of living index, it may be decided to use the
consumption of a typical family as the weights, but some difficulty may be encountered in defining a
typical family.

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13.19 The choice of a base year

The choice of a base date, or base year, is not significant, except that it should be representative. In the
construction of a price index, the base year must not be one in which there were abnormally high or low
prices for any items in the basket of goods making up the index. For example, a year in which there is a
potato famine would be unsuitable as a base period for the RPI.

13.20 The limitations and misinterpretation of index numbers

13.20.1 Limitations
Index numbers are usually only approximations of changes in price or quantity over time, and must be
interpreted with care.
(a) As we have seen, weightings become out of date over time. Unless a Paasche index is used, the
weightings will gradually cease to reflect current reality.
(b) New products or items may appear, and old ones may cease to be significant. For example,
spending has changed in recent years to include new items, such as personal computers and
video recorders, whereas the demand for twin tub washing machines has declined. These
changes would make the weightings of a price index for such goods out of date.
(c) The data used to calculate index numbers might be incomplete, out of date, or inaccurate. For
example, the quantity indices of imports and exports are based on records supplied by traders
which may be prone to error or even deliberate falsification.
(d) The base year of an index should be a normal year, but there is probably no such thing as a
perfectly normal year. Some error in the index will be caused by atypical values in the base
period.
(e) The 'basket of items' in an index is often selective. For example, the RPI is constructed from a
sample of households and from a basket of less than 400 items.
(f) A national index may not be very relevant to an individual town or region. For example, if the
national index of wages and salaries rises from 100 to 115, we cannot conclude that the wages
and salaries of people in, say, Glasgow have gone up by 15%.
(g) An index may exclude important items: for example, the RPI excludes payments of income tax
out of gross wages.

13.20.2 Misinterpretation
You must be careful not to misinterpret index numbers. Several possible mistakes will be explained
using the following example of an RPI.
20X0 20X1 20X2
January 340.0 January 360.6 January 436.3
February 362.5 February 437.1
March 366.2 March 439.5
April 370.0 April 442.1
(a) It would be wrong to say that prices rose by 2.6% between March and April 20X2. It is correct to
say that prices rose 2.6 points, or
2.6
= 0.6%
439.5
(b) It would be correct to say that the annual rate of price increases (the rate of inflation) fell
between March and April 20X2. It would be a mistake, however, to suppose that a fall in the rate
of inflation means that prices are falling, therefore the price index is falling.
The rate of price increases has slowed down, but the trend of prices is still upwards.

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(i) The annual rate of inflation from March 20X1 to March 20X2 is

 439.5 – 366.2 
 366.2  = 20%
 
(ii) The annual rate of inflation from April 20X1 to April 20X2 is

 442.1– 370.0 
 370.0  = 19.5%
 
Thus the annual rate of inflation has dropped from 20% to 19.5% between March and April
20X2, even though prices went up in the month between March and April 20X2 by 0.6%. (The
price increase between March and April 20X1 was over 1%. This is included in the calculation of
the rate of inflation between March 20X1 and March 20X2, but is excluded in the comparison
between April 20X1 and April 20X2 where it has been replaced by the lower price increase,
0.6%, between March and April 20X2.)

13.21 The Retail Prices Index (RPI) and Consumer Prices Index (CPI)
The RPI measures the change in the cost of living. It is published online monthly (on a Tuesday) near
the middle of the month by the Office for National Statistics. Since it measures the monthly change in
the cost of living, its principal use is as a measure of inflation.
The index measures the percentage changes, month by month, in the average level of prices of 'a
representative basket of goods' purchased by the great majority of households in the United Kingdom.
There are over 650 separate representative items that go to make up the RPI. It takes account of
practically all wage earners and most small- and medium-salary earners.
In recent years, the Government has chosen to use the Consumer Prices Index (CPI) as the main
measure of UK inflation for macroeconomic purposes. Thus the CPI is the basis for the Government's
inflation target: it is also used to make international comparisons.
The two main differences between the RPI and CPI are the exclusion of spending on many housing costs
from the CPI and the inclusion of financial services in the CPI. Also, the CPI is calculated using a wider
population and uses different mathematical formulae.
The Family Expenditure Survey is a continuing enquiry conducted by the Office for National Statistics
into the general characteristics of households, their income and their expenditures. From this
information the representative basket of goods is divided into main groups. Each group is divided into
sections and these sections may be further split into separate items. Each group, section and specific
item is weighted according to information from the Family Expenditure Survey to account for its relative
importance in the basket.

14 Sales forecasting: the product life cycle

The product life cycle model shows how sales of a product can be expected to vary with the passage of
time.

A product will probably go through the stages of introduction, growth, maturity, decline and senility.
Different levels of sales and profit can be expected at each stage. Note that the product life cycle is a
model of what might happen, not a law prescribing what will happen. In other words, not all products
go through these stages or even have a life cycle. However, the idea of a life cycle can be useful to
experienced marketing staff when forecasting sales and profits.

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14.1 Introduction
(a) A new product takes time to find acceptance by would-be purchasers and there is a slow growth
in sales. Unit costs are high because of low output and expensive sales promotion.
(b) The product for the time being is a loss-maker.

14.2 Growth
(a) If the new product gains market acceptance, sales will eventually rise more sharply and the
product will start to make profits.
(b) As sales and production rise, unit costs fall.

14.3 Maturity
The rate of sales growth slows down and the product reaches a period of maturity, which is probably the
longest period of a successful product's life. Most products on the market will be at the mature stage of
their life. Profits are good.

14.4 Decline
Eventually, sales will begin to decline so that there is overcapacity of production in the industry. Severe
competition occurs, profits fall and some producers leave the market. The remaining producers seek
means of prolonging the product life by modifying it and searching for new market segments. Many
producers are reluctant to leave the market, although some inevitably do because of falling profits.
Remember that it would be very foolish for a forecaster to assume that linear growth in sales will go on
forever. Eventually sales will begin to decline.

PER performance objective 13 requires you to 'Plan and control performance’. Activities could include
the use of sales forecasts based on the product life cycle.

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CHAPTER ROUNDUP
 Two variables are said to be correlated if a change in the value of one variable is accompanied by a
change in the value of another variable. This is what is meant by correlation.
 Two variables might be perfectly correlated, partly correlated or uncorrelated. Correlation can be
positive or negative.
 The degree of linear correlation between two variables is measured by the Pearsonian (product moment)
correlation coefficient, r. The nearer r is to +1 or –1, the stronger the relationship.
2 2
 The coefficient of determination, r (alternatively R ) measures the proportion of the total variation in
the value of one variable that can be explained by variations in the value of the other variable. It denotes
the strength of the linear association between two variables.
 Linear regression analysis (the least squares method) is one technique for estimating a line of best fit.
Once an equation for a line of best fit has been determined, forecasts can be made.
 As with all forecasting techniques, the results from regression analysis will not be wholly reliable. There
are a number of factors which affect the reliability of forecasts made using regression analysis.
 The high-low method is a simple forecasting technique.
 A time series is a series of figures or values recorded over time.
 There are four components of a time series: trend, seasonal variations, cyclical variations and random
variations.
 One method of finding the trend is by the use of moving averages. Remember that when finding the
moving average of an even number of results, a second moving average has to be calculated so that
trend values can relate to specific actual figures.
 Seasonal variations are the difference between actual and trend figures (additive model). An average of
the seasonal variations for each time period within the cycle must be determined and then adjusted so
that the total of the seasonal variations sums to zero.
 Deseasonalised data are often used by economic commentators.
 Forecasting using time series analysis involves calculating a trend line, extrapolating the trend line and
adjusting the forecasts by appropriate seasonal variations. The trend line can be extrapolated by eye or
by using a common sense 'rule of thumb' approach.
 All forecasts are subject to error, but the likely errors vary from case to case.
(a) The further into the future the forecast is for, the more unreliable it is likely to be.
(b) The less data available on which to base the forecast, the less reliable the forecast.
(c) The pattern of trend and seasonal variations cannot be guaranteed to continue in the future.
(d) There is always the danger of random variations upsetting the pattern of trend and seasonal
variation.
 An index is a measure, over time, of the average changes in the value (price or quantity) of a group of
items relative to the situation at some period in the past.
– Composite indices cover more than one item.
– Weighting is used to reflect the importance of each item in the index.
– Weighted aggregate indices are found by applying weights and then calculating the index.
– There are two types of weighted aggregate index, the Laspeyre (which uses quantities/prices from
the base period as the weights) and the Paasche (which uses quantities/prices from the current
period as weights).
– Fisher's ideal index is the geometric mean of the Laspeyre and Paasche indices.
– Index numbers are a very useful way of summarising a large amount of data in a single series of
numbers. You should remember, however, that any summary hides some detail and that index
numbers should therefore be interpreted with caution.
 The product life cycle model shows how sales of a product can be expected to vary with the passage of
time.

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CHAPTER 14 // FORECASTING

1 What is the disadvantage of the scattergraph method?

QUICK QUIZ

2 When plotting moving averages on a graph, where should the plotted points be located?
3 Why are average seasonal variations adjusted to sum to zero?
4 What is the weakness of the additive model?
5 What is deseasonalised data?
6 What is extrapolation?
7 What factors affect the accuracy of forecasts?
8 What is the standard calculation for removing the effects of price movements from data?
9 If the relationship between production costs and output is connected by the linear relationship y = 75x
+ 47,000, what is 47,000?
A The number of units produced
B Total production costs
C The production cost if 75 units are produced
D The fixed production costs
10 Based on the last seven periods, the underlying trend of sales is y = 690.24 – 2.75x. If the eighth
period has a seasonal factor of –25.25, assuming an additive forecasting model, then the forecast for
that period in whole units is:
A 643
B 646
C 668
D 671
11 Which of the following are necessary if forecasts obtained from a time series analysis are to be reliable?
I There must be no seasonal variation.
II The trend must be increasing.
III The model used must fit the past data.
IV There must be no unforeseen events.
A I and III only
B I and IV only
C II and III only
D III and IV only
12 What is the general form of a weighted aggregate index?
13 What type of weights do Laspeyre indices use?
14 Why might Fisher's ideal index be used?

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PART C: BUDGETING

1 The disadvantage of the scattergraph method for estimating costs is that the line of best fit is drawn by
ANSWERS TO QUICK QUIZ

visual judgement and so is only a subjective approximation of total cost.

2 Points should be plotted at the mid-point of the period to which they apply.
3 Average seasonal variations are adjusted to sum to zero because variations around the basic trend line
should cancel each other out and add up to zero.
4 An additive model has the important drawback that when there is a steeply rising or a steeply declining
trend, the moving average trend will either get ahead of or fall behind the real trend.
5 Deseasonalised data is data from which the seasonal variations have been removed, leaving a figure
which might be taken as indicating the trend.
6 Extrapolation is forecasting the future from a trend line based on historical data.
7 (a) The further into the future the forecast is for, the more unreliable it is likely to be.
(b) The less data available on which to base the forecast, the less reliable the forecast.
(c) The pattern of trend and seasonal variations cannot be guaranteed to continue in the future.
(d) There is always the danger of random variations upsetting the pattern of trend and seasonal
variation.
100
8 Actual data 
Index for time period in question

9 D
10 A If x = 8, y = 690.24 – (2.75  8) = 668.24
Forecast = trend + seasonal component = 668.24 – 25.25 = 642.99 = 643 (to the nearest
unit)
If you selected option B, you calculated the forecast for the seventh period and deducted the
seasonal component of the eighth period.
If you selected option C, you correctly forecast the trend for the eighth period but forgot to deduct
the seasonal component.
If you selected option D, you simply calculated the trend for the seventh period instead of the
eighth period.
11 D I Provided the seasonal variation remains the same in the future as in the past, it will not
make forecasts unreliable.
II Provided a multiplicative model is used, the fact that the trend is increasing need not have
any adverse effect on the reliability of forecasts.
III If the model being used is inappropriate, for example if an additive model is used when
the trend is changing sharply, forecasts will not be very reliable.
IV Forecasts are made on the assumption that everything continues as in the past.
III and IV are therefore necessary and hence the correct answer is D.

 wv n
12
 wv o

13 Weights from the base period

14 The Laspeyre index tends to overstate change, while the Paasche index tends to understate it.

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CHAPTER 14 // FORECASTING

Now try ...

Attempt the questions below from the Practice Question Bank

Q61 – Q66

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PART C: BUDGETING

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C H A P T E R

This chapter covers a new topic, budgeting.

The chapter begins by explaining the reasons for Budgeting
operating a budgetary planning and control system. It
explains some of the key terms associated with budgeting
and reminds you of the steps in the preparation of a
master budget.

pt biến phí: y = ax
pt định phí: y = b
pt hỗn hợp: y = ax + b

SYLLABUS
TOPIC LIST REFERENCE

1 The planning and control cycle C1(b)

2 Budgetary planning and control systems C1(a)
3 Responsibility centres C6(d)
4 Controllable costs C6(e)
5 Fixed and flexible budgets C4(a),(b),(c),(d)
6 Preparing flexible budgets C4(a),(b),(c),(d)
7 Flexible budgets and budgetary control C4(a),(b),(c),(d)
8 Features and functions of spreadsheets C2(o),(p)
9 Examples of spreadsheet formulae C2(o),(p)
10 Advantages and disadvantages of spreadsheet software C2(o),(p)
11 Uses of spreadsheet software C3(f)

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PART C: BUDGETING

Study Guide Intellectual level

C Budgeting

1 Nature and purpose of budgeting

(a) Explain why organisations use budgeting. K

(b) Describe the planning and control cycle in an organisation. K

2 Statistical techniques

(o) Explain the role and features of a computer spreadsheet

K
system.
(p) Identify applications for computer spreadsheets and their use
S
in cost and management accounting.
3 Budget preparation

(f) Explain and illustrate 'what if' analysis and scenario planning. S

4 Flexible budgets

(a) Explain the importance of flexible budgets in control. K

(b) Explain the disadvantages of fixed budgets in control. K
(c) Identify situations where fixed or flexible budgetary control
S
would be appropriate.
pt biến phí: y = ax
(d) Flex a budget to a given level of volume. S
pt định phí: y = b
6
pt hỗn hợp: yBudgetary
= ax + control
b and reporting

(d) Define the concept of responsibility accounting and its

K
significance in control.
(e) Explain the concept of controllable and uncontrollable costs. K
(f) Prepare control reports suitable for presentation to
S
management.

1 The planning and control cycle

There are seven steps in the planning and control cycle.

Step 1 Identify objectives
Step 2 Identity potential strategies
Step 3 Evaluate strategies
Step 4 Choose alternative courses of action
Step 5 Implement the long-term plan
Step 6 Measure actual results and compare with plan
Step 7 Respond to divergences from plan

The diagram below represents the planning and control cycle. Planning involves making choices
between alternatives and is primarily a decision-making activity. The control process involves measuring
and correcting actual performance to ensure that the strategies that are chosen and the plans for
implementing them are carried out.

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CHAPTER 15 // BUDGETING

pt biến phí: y = ax
pt định phí: y = b
Stepy1= ax +
pt hỗn hợp: Identify
b objectives
Objectives establish the direction in which the management of the organisation wish it
to be heading. Typical objectives include the following.
(a) To maximise profits
(b) To increase market share
(c) To produce a better quality product than anyone else
Objectives answer the question: 'where do we want to be?'.

Step 2 Identify potential strategies

Once an organisation has decided 'where it wants to be', the next step is to identify a
range of possible courses of action or strategies that might enable the organisation to
get there.
The organisation must therefore carry out an information-gathering exercise to ensure
that it has a full understanding of where it is now. This is known as a 'position audit' or
'strategic analysis' and involves looking both inwards and outwards.
(a) The organisation must gather information from all of its internal parts to find out
what resources it possesses: what its manufacturing capacity and capability is,
what is the state of its technical know-how, how well it is able to market itself,
how much cash it has in the bank, how much it could borrow and so on.
(b) It must also gather information externally so that it can assess its position in the
environment. Just as it has assessed its own strengths and weaknesses, it must
do likewise for its competitors (threats). Its market must be analysed (and any
other markets that it is intending to enter) to identify possible new opportunities.
The 'state of the world' must be considered. Is it in recession or is it booming?
What is likely to happen in the future? This process is known as SWOT analysis.
Having carried out a strategic analysis, alternative strategies can be identified.

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Step 3 Evaluate strategies

The strategies must then be evaluated in terms of suitability, feasibility and acceptability
in the context of the strategic analysis. Management should select those strategies that
have the greatest potential for achieving the organisation's objectives. One strategy may
be chosen, or several.

Step 4 Choose alternative courses of action

The next step in the process is to collect the chosen strategies together and co-ordinate
them into a long-term plan, commonly expressed in financial terms.
Typically a long-term financial plan would show the following.
(a) Projected cash flows
(b) Projected long-term profits
(c) Capital expenditure plans
(d) Forecasts of statement of financial position
(e) A description of the long-term objectives and strategies in words

Step 5 Implement the long-term plan

The long-term plan should then be broken down into smaller parts. It is unlikely that the
different parts will fall conveniently into successive time periods. Strategy A may take
two and a half years, while Strategy B may take five months, but not start until year
three of the plan. It is usual, however, to break down the plan as a whole into equal
time periods (usually one year). The resulting short-term plan is called a budget.

Steps 6 Measure actual results and compare with plan. Respond to divergences from plan
and 7
At the end of the year actual results should be compared with those expected under the
long-term plan. The long-term plan should be reviewed in the light of this comparison
and the progress that has been made towards achieving the organisation's objectives
should be assessed. Management can also consider the feasibility of achieving the
objectives in the light of unforeseen circumstances which have arisen during the year. If
the plans are now no longer attainable then alternative strategies must be considered for
achieving the organisation's objectives, as indicated by the feedback loop (the arrowed
line) linking step 7 to step 2. This aspect of control is carried out by senior
management, normally on an annual basis.
The control of day to day operations is exercised by lower-level managers. At frequent
intervals they must be provided with performance reports which consist of detailed
comparisons of actual results and budgeted results. Performance reports provide
feedback information by comparing planned and actual outcomes. Such reports should
highlight those activities that do not conform to plan, so that managers can devote their
scarce time to focusing on these items. Effective control requires that corrective action is
taken so that actual outcomes conform to planned outcomes, as indicated by the
feedback loop linking steps 5 and 7. Isolating past inefficiencies and the reasons for
them will enable managers to take action that will avoid the same inefficiencies being
repeated in the future. The system that provides reports that compare actual
performance with budget figures is known as responsibility accounting.

QUESTION Planning cycle

Is your organisation's planning and control cycle similar to the one described here? If it differs, how does
it differ? Why does it differ? Try to find out your organisation's objectives and the strategies it is adopting
to attain those objectives.

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CHAPTER 15 // BUDGETING

CP cơ hội tồn tại ở dạng tài chính và phi tài chính

2 Budgetary planning and control systems

A budget is a quantified plan of action for a forthcoming accounting period. A budget is a plan of what
the organisation is aiming to achieve and what it has set as a target whereas a forecast is an estimate of
what is likely to occur in the future.

The budget is 'a quantitative statement for a defined period of time, which may include planned
revenues, expenses, assets, liabilities and cash flows. A budget facilitates planning'.

There is, however, little point in an organisation simply preparing a budget for the sake of preparing a
budget. A beautifully laid out budgeted statement of profit or loss filed in the cost accountant's file and
never looked at again is worthless. The organisation should gain from both the actual preparation
process and from the budget once it has been prepared.

The objectives of a budgetary planning and control system are as follows.

 To ensure the achievement of the organisation's objectives
 To compel planning
 To communicate ideas and plans
 To co-ordinate activities
 To provide a framework for responsibility accounting
 To establish a system of control
 To motivate employees to improve their performance

Budgets are therefore not prepared in isolation and then filed away but are the fundamental components
of what is known as the budgetary planning and control system. A budgetary planning and control
system is essentially a system for ensuring communication, co-ordination and control within an
organisation. Communication, co-ordination and control are general objectives: more information is
provided by an inspection of the specific objectives of a budgetary planning and control system.

Objective Comment

Ensure the Objectives are set for the organisation as a whole, and for individual
achievement of the departments and operations within the organisation. Quantified expressions of
organisation's these objectives are then drawn up as targets to be achieved within the
objectives timescale of the budget plan.

Compel planning This is probably the most important feature of a budgetary planning and
control system. Planning forces management to look ahead, to set out detailed
plans for achieving the targets for each department, operation and (ideally)
each manager and to anticipate problems. It thus prevents management from
relying on ad hoc or unco-ordinated planning which may be detrimental to the
performance of the organisation. It also helps managers to foresee potential
threats or opportunities, so that they may take action now to avoid or
minimise the effect of the threats and to take full advantage of the
opportunities.

Communicate ideas A formal system is necessary to ensure that each person affected by the plans
and plans is aware of what they are supposed to be doing. Communication might be
one-way, with managers giving orders to subordinates, or there might be a
two-way dialogue and exchange of ideas.

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Objective Comment

Co-ordinate activities The activities of different departments or sub-units of the organisation need to
be co-ordinated to ensure maximum integration of effort towards common
goals. This concept of co-ordination implies, for example, that the purchasing
department should base its budget on production requirements and that the
production budget should in turn be based on sales expectations. Although
straightforward in concept, co-ordination is remarkably difficult to achieve,
and there is often 'sub-optimality' and conflict between departmental plans in
the budget so that the efforts of each department are not fully integrated into a
combined plan to achieve the company's best targets.

Provide a framework Budgetary planning and control systems require that managers of budget
for responsibility centres are made responsible for the achievement of budget targets for the
accounting operations under their personal control.

Establish a system of A budget is a yardstick against which actual performance is monitored and
control assessed. Control over actual performance is provided by the comparisons of
actual results against the budget plan. Departures from budget can then be
investigated and the reasons for the departures can be divided into
controllable and uncontrollable factors.

Motivate employees to The interest and commitment of employees can be retained via a system of
improve their feedback of actual results, which lets them know how well or badly they are
performance performing. The identification of controllable reasons for departures from
budget with managers responsible provides an incentive for improving future
performance.

Provide a framework Once the budget has been agreed by the directors and senior managers it acts
for authorisation as an authorisation for each budget holder to incur the costs included in the
budget centre's budget. As long as the expenditure is included in the
formalised budget the budget holder can carry out day to day operations
without needing to seek separate authorisation for each item of expenditure.

Provide a basis for As well as providing a yardstick for control by comparison, the monitoring of
performance actual results compared with the budget can provide a basis for evaluating
evaluation the performance of the budget holder. As a result of this evaluation the
manager might be rewarded, perhaps with a financial bonus or promotion.
Alternatively, the evaluation process might highlight the need for more
investment in staff development and training.

3 Responsibility centres

Responsibility centres can be divided into three types.

thấp nhất: qlys: chỉ có quyền thực hiện cv đc giao vs số tiền đc cấp chứ ko đc làm chuyện
– Cost centres khác
– Profit centres vừa dùng tiền cấp trên đưa xuống vừa tạo ra DT nhưng ko đc quyền tái đầu tư
– Investment centres

Responsibility accounting is a system of accounting that segregates revenue and costs into areas of
personal responsibility in order to monitor and assess the performance of each part of an organisation.
A responsibility centre is a function or department of an organisation that is headed by a manager who
has direct responsibility for its performance.

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If a manager is to bear responsibility for the performance of their area of the business they will need
information about its performance. In essence, a manager needs to know three things.

Requirements Examples of information

What are their resources? Finance, inventories of raw materials, spare machine capacity,
labour availability, the balance of expenditure remaining for a certain
budget, target date for completion of a job.

At what rate are their resources How fast is the labour force working, how quickly are the raw
being consumed? materials being used up, how quickly are other expenses being
incurred, how quickly is available finance being consumed?

How well are the resources How well are their objectives being met?
being used?

Decisions must also be made as to the level of detail that is provided and the frequency with which
information is provided. Moreover, the cost of providing information must be weighed against the benefit
derived from it.
In a traditional system managers are given monthly reports, but there is no logical reason for this except
that it ties in with financial reporting cycles and may be administratively convenient. With modern
systems, however, there is a danger of information overload, since information technology allows the
information required to be made available much more frequently.
The task of the management accountant, therefore, is to learn from the managers of responsibility
centres what information they need, in what form and at what intervals, and then to design a planning
and control system that enables this to be provided.
It is to this end that responsibility centres are usually divided into different categories. Here we shall
describe cost centres, profit centres and investment centres.

3.1 Cost centres

A cost centre acts as a collecting place for certain costs before they are analysed further.

Cost centres may include the following.

(a) A department
(b) A machine or group of machines
(c) A project (eg the installation of a new computer system)
(d) A new product (allowing development costs to be identified)
To charge actual costs to a cost centre, each cost centre will have a cost code. Items of expenditure
will be recorded with the appropriate cost code. When costs are eventually analysed, there may well be
some apportionment of the costs of one cost centre to other cost centres.
(a) The costs of those cost centres which receive an apportionment of shared costs should be divided
into directly attributable costs (for which the cost centre manager is responsible) and shared
costs (for which another cost centre is directly accountable).
(b) The control system should trace shared costs back to the cost centres from which the costs have
been apportioned, so that their managers can be made accountable for the costs incurred.
Information about cost centres might be collected in terms of total actual costs, total budgeted costs
and total cost variances (the differences between actual and budged costs) sub-analysed perhaps into
efficiency, usage and expenditure variances. In addition, the information might be analysed in terms of
ratios, such as the following.
actual cost: làm xong PS CP
(a) Cost per unit produced (budget and actual) cost variances = actual cost - budgeted cost
(b) Hours per unit produced (budget and actual) cost variances: chênh lệch CP, quá trọng yếu là
(c) Efficiency ratio phải đi điều tra
(d) Selling costs per $ of sales (budget and actual) budgeted cost: CP thực tế => đánh giá thành quả
(e) Transport costs per tonne/kilometre (budget and actual)

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3.2 Profit centres

A profit centre is any unit of an organisation (for example, division of a company) to which both
revenues and costs are assigned, so that the profitability of the unit may be measured.

Profit centres differ from cost centres in that they account for both costs and revenues and the key
performance measure of a profit centre is therefore profit.
For profit centres to have any validity in a planning and control system based on responsibility
accounting, the manager of the profit centre must have some influence over both revenues and costs;
that is, a say in both sales and production policies.
A profit centre manager is likely to be a fairly senior person within an organisation, and a profit centre is
likely to cover quite a large area of operations. A profit centre might be an entire division within the
organisation, or there might be a separate profit centre for each product, product range, brand or service
that the organisation sells. Information requirements will be similarly focused, as appropriate.
In the hierarchy of responsibility centres within an organisation, there are likely to be several cost
centres within a profit centre.

3.3 Revenue centres

A revenue centre is similar to a cost centre and a profit centre but is accountable for revenues only.
For revenue centres to have any validity in a planning and control system based on responsibility
accounting, revenue centre managers should normally have control over how revenues are raised.

3.4 Investment centres

An investment centre is a profit centre whose performance is measured by its return on capital
employed.

This implies that the investment centre manager has some say in investment policy in their area of
operations as well as being responsible for costs and revenues.
Several profit centres might share the same capital items, for example the same buildings, stores or
transport fleet, and so investment centres are likely to include several profit centres, and provide a basis
for control at a very senior management level, like that of a subsidiary company within a group.
Control can be exercised by reporting information, such as profit/sales ratios, asset turnover ratios,
cost/sales ratios, and cost variances. In addition, the performance of investment centres can be
measured by divisional comparisons.
đc cấp trên giao cho, tiết kiệm phải giải trình
3.5 Traceable and controllable costs
CP kiểm soát đc
The main problem with measuring controllable performance is in deciding which costs are controllable
and which costs are traceable. The performance of the manager of the division is indicated by the
controllable profit (and it is on this that they are judged) and the success of the division as a whole is
judged on the traceable profit.
Consider, for example, depreciation on divisional machinery. Would this be included as a controllable
fixed cost or a traceable fixed cost? Because profit centre managers are only responsible for the costs
and revenues under their control, this means that they do not have control over the investment in non-
current assets. The depreciation on divisional machinery would therefore be a traceable fixed cost
judging the performance of the division, and not of the individual manager.
accountability: trách nhiệm giải trình vdu tiền máy lạnh là non-traceable cost của trường
non-controllable = traceable: định phí
đánh giá TN qly dựa trên những j qly kiểm soát

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QUESTION Cost, profit and investment centres

Find out if your organisation has a system of cost, profit and investment centres. What is the scope of
planning and control within each centre?

4 Controllable costs

4.1 Controllable costs and uncontrollable costs

Managers of responsibility centres should only be held accountable for costs over which they have some
influence. From a motivation point of view this is important because it can be very demoralising for
managers who feel that their performance is being judged on the basis of something over which they
have no influence. It is also important from a control point of view in that control reports should ensure
that information on costs is reported to the manager who is able to take action to control them.
A controllable cost is 'a cost that can be controlled, typically by a cost, profit or investment centre
manager'. (CIMA Official Terminology)

Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the managers
most capable of controlling them. As a system of accounting, it therefore distinguishes between
controllable and uncontrollable costs. Most variable costs within a department are thought to be
controllable in the short term because managers can influence the efficiency with which resources are
used, even if they cannot do anything to raise or lower price levels.
A cost which is not controllable by a junior manager or supervisor might be controllable by a senior
manager. For example, there may be high direct labour costs in a department caused by excessive
overtime working. The supervisor may feel obliged to continue with the overtime in order to meet
production schedules, but their senior may be able to reduce costs by deciding to hire extra full-time
staff, thereby reducing the requirements for overtime.
A cost which is not controllable by a manager in one department may be controllable by a manager in
another department. For example, an increase in material costs may be caused by buying at higher
prices than expected (controllable by the purchasing department) or by excessive wastage and spoilage
(controllable by the production department) or by a faulty machine producing a high number of rejects
(controllable by the maintenance department).
Some costs are non-controllable, such as increases in expenditure items due to inflation. Other costs are
controllable, but in the long term rather than the short term. For example, production costs might be
reduced by the introduction of new machinery and technology but, in the short term, management must
đc cấp trên giao cho, tiết kiệm phải giải trình
attempt to do the best they can with the resources and machinery at their disposal.

CP kiểm soát đc
4.2 The controllability of fixed costs
It is often assumed that all fixed costs are non-controllable in the short run. This is not so.
(a)Committed fixed costs are those costs arising from the possession of plant, equipment, buildings
and an administration department to support the long-term needs of the business. These costs
định phí ko thể KS đc (depreciation, rent, administration, salaries) are largely non-controllable in the short term
vdu: khấu hao because they have been committed by longer-term decisions affecting longer-term needs. When a
company decides to cut production drastically, the long-term committed fixed costs will be
reduced, but arrangements for settling redundancy terms and the sale of assets cannot be made
quickly and in the short term.
ngược lại
(b)Discretionary fixed costs, such as advertising, sales promotion, research and development,
accountability: trách
training costs and nhiệm giải fees,
consultancy trìnhare costs whichvdu
are tiền máyaslạnh
incurred là non-traceable
a result cost của trường
of a top management
định phí tuỳ ý non-controllable = traceable: định
decision, but which could be raisedphí or lowered at fairly short notice (irrespective of the actual
đánh volume
giá TNofqly dựa trên
production những
and sales). j non-traceable
qly kiểm soát

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4.3 Controllability and apportioned costs

Managers should only be held accountable for costs over which they have some influence. This may
seem quite straightforward in theory, but it is not always so easy in practice to distinguish controllable
from uncontrollable costs. Apportioned overhead costs provide a good example.
Suppose that a manager of a production department in a manufacturing company is made responsible
for the costs of their department. These costs include directly attributable overhead items, such as the
costs of indirect labour employed in the department, the cost of metered power units consumed and
indirect materials consumed in the department. However, the department's overhead costs also include
an apportionment of costs from other cost centres, such as the following.
(a) Rent and rates for the building which the department shares with other departments
(b) Share of the costs of the maintenance department
(c) A share of the costs of the central data processing department
Should the production manager be held accountable for any of these apportioned costs?
(a) Managers should not be held accountable for costs over which they have no control. In this
example, apportioned rent and rates costs would not be controllable by the production
department manager.
(b) Managers should be held accountable for costs over which they have some influence. In this
example, it is the responsibility of the maintenance department manager to keep maintenance
costs within budget and of the production department manager to keep central production
department costs within budget. But their costs will be partly variable and partly fixed, and the
variable cost element will depend on the volume of demand for their services (the rate of usage of
the service). If the production department's staff treat their equipment badly we might expect
higher repair costs, and the production department manager should therefore be made
accountable for the repair costs that their department makes the maintenance department incur
on its behalf.

QUESTION Committed and discretionary costs

Try to discover some of your organisation's committed fixed costs and discretionary fixed costs.

5 Fixed and flexible budgets

5.1 Fixed budgets

Fixed budgets remain unchanged regardless of the level of activity;
đc cấpflexible
trênbudgets are designed
giao cho, to phải
tiết kiệm flex giải trình
with the level of activity.
Comparison of a fixed budget with the actual results for a different level of activity is of little
CP use forsoát đc
kiểm
control purposes. Flexible budgets should be used to show what cost and revenues should have been for
the actual level of activity.

A fixed budget is a budget which is designed to remain unchanged regardless of the volume of output
or sales achieved.

The master budget prepared before the beginning of the budget period is known as the fixed budget.
The term 'fixed' has the following meaning.
(a) The budget is prepared on the basis of an estimated volume of production and an estimated
accountability: trách nhiệm giải trình vdu tiền máyvolumes
lạnh làofnon-traceable cost của trường
volume of sales, but no plans are made for the event that actual production and sales
non-controllable = traceable: định phí
may differ from budgeted volumes.
đánh giá TN qly dựa trên những j qly kiểm soát
(b) When actual volumes of production and sales during a control period (month or four weeks or
quarter) are achieved, a fixed budget is not adjusted (in retrospect) to the new levels of activity.

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The major purpose of a fixed budget is at the planning stage, when it seeks to define the broad
objectives of the organisation.

5.2 Flexible budgets

A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to
change as volumes of output change.

Flexible budgets may be used in one of two ways.

(a) At the planning stage. For example, suppose that a company expects to sell 10,000 units of
output during the next year. A master budget (the fixed budget) would be prepared on the basis
of these expected volumes. However, if the company thinks that output and sales might be as
low as 8,000 units or as high as 12,000 units, it may prepare contingency flexible budgets at
volumes of, say, 8,000, 9,000, 11,000 and 12,000 units. There are a number of advantages of
planning with flexible budgets.
(i) It is possible to find out well in advance the costs of lay-off pay, idle time and so on if
output falls short of budget.
(ii) Management can decide whether it would be possible to find alternative uses for spare
capacity if output falls short of budget (could employees be asked to overhaul their own
machines, for example, instead of paying for an outside contractor?).
(iii) An estimate of the costs of overtime, subcontracting work or extra machine hire if sales
volume exceeds the fixed budget estimate can be made. From this, it can be established
whether there is a limiting factor which would prevent high volumes of output and sales
being achieved.
(b) Retrospectively. At the end of each month (control period) or year, flexible budgets can be used
to compare actual results achieved with what results should have been under the circumstances.
Flexible budgets are an essential factor in budgetary control and overcome the practical problems
involved in monitoring the budgetary control system.
(i) Management needs to be informed about how good or bad actual performance has been.
To provide a measure of performance, there must be a yardstick (budget or standard)
against which actual performance can be measured.
(ii) Every business is dynamic, and actual volumes of output cannot be expected to conform
exactly to the fixed budget. Comparing actual costs directly with the fixed budget costs is
meaningless (unless the actual level of activity turns out to be exactly as planned).
(iii) For useful control information, it is necessary to compare actual results at the actual
level of activity achieved against the results that should have been expected at this level
of activity, which are shown by the flexible budget.

QUESTION Flexible budgets

Why might flexible budgets be particularly useful to the car industry during a recession?

ANSWER
During a recession the car industry often has to put workers on a three- or four-day week due to lack of
demand for its products. Budgets therefore have to be reassessed to match the reduced production time
available.

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6 Preparing flexible budgets

Flexible budgeting uses the principles of marginal costing. In estimating future costs it is often
necessary to begin by looking at cost behaviour in the past. For costs which are wholly fixed or wholly
variable, no problem arises. But you may be presented with a cost which appears to have behaved in
the past as a mixed cost (partly fixed and partly variable). The high-low method may be used for
estimating the level of such a cost in a future period.

6.1 High-low method

(a) To estimate the fixed and variable elements of semi-variable costs, records of costs in previous
periods are reviewed and the costs of the following two periods are selected.
(i) The period with the highest volume of output
(ii) The period with the lowest volume of output
(Note. The periods with the highest/lowest output may not be the periods with the highest/lowest
cost.)
(b) The difference between the total cost of the high output and the total cost of the low output will
be the variable cost of the difference in output levels (since the same fixed cost is included in
each total cost).
(c) The variable cost per unit may be calculated from this (difference in total costs  difference in
output levels), and the fixed cost may then also be determined (total cost at either output level –
variable cost for output level chosen).

EXAM FOCUS POINT

You may need to use the high-low technique to answer questions on flexible budgets which include
semi-variable costs.

6.2 Example: The high-low method

The costs of operating the maintenance department of a television manufacturer for the last four months
have been as follows.
Month Cost Production volume
$ Units
1 110,000 7,000
2 115,000 8,000
3 111,000 7,700
4 97,000 6,000
Required
Calculate the costs that should be expected in month 5 when output is expected to be 7,500 units.
Ignore inflation.

6.3 Solution
(a) Units $
High output 8,000 total cost 115,000
Low output 6,000 total cost 97,000
Variable cost of 2,000 18,000
Variable cost per unit $18,000/2,000 = $9

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CHAPTER 15 // BUDGETING

(b) Substituting in either the high or low volume cost:

High Low
$ $
Total cost 115,000 97,000
Variable costs (8,000 × $9) 72,000 (6,000 × $9) 54,000
Fixed costs 43,000 43,000

(c) Estimated costs of 7,500 units of output:

$
Fixed costs 43,000
Variable costs (7,500 × $9) 67,500
Total costs 110,500

QUESTION High-low
Using the high-low method and the following information, determine the cost of electricity in July if
2,750 units of electricity are consumed.
Month Cost Electricity consumed
$ Units
January 204 2,600
February 212 2,800
March 200 2,500
April 220 3,000
May 184 2,100
June 188 2,200

ANSWER
Units $
High units 3,000 total cost = 220
Low units 2,100 total cost = 184
900 36

$36
Variable cost per unit = = $0.04
900
Substituting:
$
Total cost of 3,000 units 220
Variable costs (3,000 × $0.04) 120
Fixed cost 100

Total cost in July = $(100 + (2,750  0.04)) = $210

We can now look at a full example of preparing a flexible budget.

6.4 Example: Preparing a flexible budget

(a) Prepare a budget for 20X6 for the direct labour costs and overhead expenses of a production
biến phí (VC-variable cost) department at the activity levels of 80%, 90% and 100%, using the information listed below.
định phí
(i) The direct labour hourly rate is expected to be $3.75. VC
hỗn hợp
(ii) 100% activity represents 60,000 direct labour hours.
cấp bậc
(iii) Variable costs
Indirect labour $0.75 per direct labour hour
Consumable supplies $0.375 per direct labour hour
Canteen and other
welfare services 6% of direct and indirect labour costs
capacity 80% 90% 100% + Canteen (3.75+0.75) x 0.06 lần lượt nhân cho 36,000
48,000 54,000h 60,000h y = $1.375/h.x
Direct labour hour $180,000 $202,500 $225,000
y = 3.75/h.x
VC 343
+ Indirect labour $36,000 $40,500 $45,000
+ Consumable $18,000 $20,250 $22,500

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CP hỗn hợp
(iv) Semi-variable costs are expected to relate to the direct labour hours in the same manner
as for the last five years.
80% 90% 100% Direct Semi-
semi-VC 17600 18,800 20,000 labour variable
Year hours costs
$
20X1 a = 0,2 64,000 20,800
20X2 b = 8,000 59,000 19,800
20X3 53,000 18,600
20X4 49,000 17,800
20X5 (estimate) 40,000 16,000
(v) Fixed overhead per labour hour at 100% activity FC = tổng 75,000
80% 90% 100% $
fix cost: định phí Depreciation $18,000 $18,000 18,000 0.30
y = 53.345h/.x + $83,000 Maintenance 12,000 0.20
=> Q = 57,000 h Insurance 6,000 0.10
=> Convesion cost = 57,000 (CP chuyển đỏi)
Rates 15,000 0.25
Management salaries 24,000 0.40
y = $75,000 ko có chữ x
(vi) Inflation is to be ignored. vì ko có biến thiên theo x
(b) Calculate the budget cost allowance (ie expected expenditure) for 20X6 assuming that 57,000
direct labour hours are worked.

6.5 Solution
(a) 80% level 90% level 100% level
48,000 hrs 54,000 hrs 60,000 hrs
$'000 $'000 $'000
Direct labour 180.00 202.50 225.0
Other variable costs
Indirect labour 36.00 40.50 45.0
Consumable supplies 18.00 20.25 22.5
Canteen etc 12.96 14.58 16.2
Total variable costs ($5.145 per hour W1) 246.96 277.83 308.7
Semi-variable costs (W2) 17.60 18.80 20.0
Fixed costs
Depreciation (60  $0.3) 18.00 18.00 18.0
Maintenance (60  $0.2) 12.00 12.00 12.0
Insurance (60  $0.1) 6.00 6.00 6.0
Rates (60  $0.25) 15.00 15.00 15.0
Management salaries (60  $0.4) 24.00 24.00 24.0
Budgeted costs 339.56 371.63 403.7

Workings
1 Total variable cost = direct labour + indirect labour + canteen + consumables
= $4.50 + $0.27 + $0.375 = $5.145
2 Using the high-low method:
$
Total cost of 64,000 hours 20,800
Total cost of 40,000 hours 16,000
Variable cost of 24,000 hours 4,800
Variable cost per hour ($4,800/24,000) $0.20

$
Total cost of 64,000 hours 20,800
Variable cost of 64,000 hours ( $0.20) 12,800
Fixed costs 8,000

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Semi-variable costs are calculated as follows.

$
60,000 hours (60,000  $0.20) + $8,000 = 20,000
54,000 hours (54,000  $0.20) + $8,000 = 18,800
48,000 hours (48,000  $0.20) + $8,000 = 17,600
(b) The budget cost allowance for 57,000 direct labour hours of work would be as follows.
$
Variable costs (57,000  $5.145) 293,265
Semi-variable costs ($8,000 + (57,000  $0.20)) 19,400
Fixed costs 75,000
384,665

Note that in each case the fixed costs remain the same when the level of activity changes and are not
flexed.

6.6 The measure of activity in flexible budgets

The preparation of a flexible budget requires an estimate of the way in which costs (and revenues) vary
with the level of activity.
Sales revenue will clearly vary with sales volume, and direct material costs (and often direct labour
costs) will vary with production volume. In some instances, however, it may be appropriate to budget for
overhead costs as mixed costs (part-fixed, part-variable) which vary with an 'activity' which is neither
production nor sales volume. Taking production overheads in a processing department as an illustration,
the total overhead costs will be partly fixed and partly variable. The variable portion may vary with the
direct labour hours worked in the department, or with the number of machine hours of operation. The
better measure of activity, labour hours or machine hours may only be decided after a close analysis of
historical results.

EXAM FOCUS POINT

In an exam do not fall into the trap of flexing fixed costs. Do not forget that they remain unchanged
regardless of the level of activity. Even if fixed overheads are initially expressed on a 'per unit' basis in a
question, remember that once you have calculated the total fixed cost for a given activity level it will
remain unchanged when activity levels alter.

The measure of activity used to estimate variable costs should satisfy certain criteria.

Criteria Detail

Derived from the activity that

causes particular costs to vary

Independent of variable factors For example, if labour hours are the measure of activity, the level of
other than its own volume activity should be measured in labour hours, and not the labour cost
of those hours (the latter being prone to the effect of a price
change).

Stable In this respect, a standard unit of output provides a better measure

than actual units. For example, if total costs are assumed to vary
with direct labour hours, it would be more appropriate to choose
'standard hours produced' as a measure of activity than 'actual hours
worked' because the actual hours may have been worked efficiently
or inefficiently, and the variations in performance would probably
affect the actual costs incurred.

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7 Flexible budgets and budgetary control

A prerequisite of flexible budgeting is a knowledge of cost behaviour.

The differences between the components of the fixed budget and the actual results are known as budget
variances.

Budgetary control is the practice of establishing budgets which identify areas of responsibility for
individual managers (for example production managers and purchasing managers) and of regularly
comparing actual results against expected results. The differences between actual results and expected
results are called variances and these are used to provide a guideline for control action by individual
managers.

We will be looking at variances in some detail later in the Text.

Individual managers are held responsible for investigating differences between budgeted and actual
results, and are then expected to take corrective action or amend the plan in the light of actual events.
The wrong approach to budgetary control is to compare actual results against a fixed budget. Consider
the following example.
ko đc xét 2 cột tiền có
tổng sản lượng khác Tree manufactures a single product, the bough. Budgeted results and actual results for June are shown
nhau below.
F: favourable: chênh lệch Budget Actual results Variance
+ thuận lợi Production and sales of the bough (units) 2,000 3,000
A: adverse: chênh lệch $ $ $
bất lợi Sales revenue (a) 20,000 30,000 10,000 (F)
Direct materials : budget bnh tiền cho 1 vật phẩm 6,000 8,500 2,500 (A)
Direct labour 4,000 4,500 500 (A)
Maintenance 1,000 1,400 400 (A)
Depreciation 2,000 2,200 200 (A)
variance: CL giữ dự toán Rent and rates 1,500 1,600 100 (A)
và thực tế Other costs 3,600 5,000 1,400 (A)
Total costs (b) 18,100 23,200 5,100
budget - actual Profit (a)–(b) 1,900 6,800 4,900 (F)
=>dương: F
âm: A (a) In this example, the variances are meaningless for purposes of control. Costs were higher than
budget because the volume of output was also higher; variable costs would be expected to
chỉ đc đổi số lượng
increase above the budgeted costs. There is no information to show whether control action is
needed for any aspect of costs or revenue.
(b) For control purposes, it is necessary to know the following.
(i) Were actual costs higher than they should have been to produce and sell 3,000 boughs?
(ii) Was actual revenue satisfactory from the sale of 3,000 boughs?
(iii) Has the volume of units made and sold varied from the budget favourably or adversely?
Correct approach to budgetary control
(a) Identify fixed and variable costs.
(b) Produce a flexible budget using marginal costing techniques.
In the previous example of Tree, let us suppose that we have the following information regarding cost
behaviour.
(a) Direct materials and maintenance costs are variable.
(b) Although basic wages are a fixed cost, direct labour is regarded as variable in order to measure
efficiency/productivity.
(c) Rent and rates and depreciation are fixed costs.
(d) Other costs consist of fixed costs of $1,600 plus a variable cost of $1 per unit made and sold.

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CHAPTER 15 // BUDGETING

Now that the cost behaviour patterns are known, a budget cost allowance can be calculated for each
item of expenditure. This allowance is shown in a flexible budget as the expected expenditure on each
item for the relevant level of activity. The budget cost allowances are calculated as follows.
(a) Variable cost allowances = original budgets  (3,000 units/2,000 units)
eg material cost allowance = $6,000  3/2 = $9,000
(b) Fixed cost allowances = as original budget
(c) Semi-fixed cost allowances = original budgeted fixed costs
+ (3,000 units  variable cost per unit)
eg other cost allowances = $1,600 + (3,000  $1) = $4,600
The budgetary control analysis should be as follows. này cấn trừ này
fixed budget và flexible lập đầu năm Fixed Flexible Actual Budget
budget budget results variance
(a) (b) (c) (b)–(c)
Production and sales (units) 2,000 3,000 3,000
$ $ $ $
Sales revenue DT: thực tế > dự toán => F 20,000 30,000 30,000 0
Variable costs CP ngược lại
Direct materials 6,000 9,000 8,500 500 (F)
Direct labour 4,000 6,000 4,500 1,500 (F)
Maintenance 1,000 1,500 1,400 100 (F)
Semi-variable costs
Other costs 3,600 4,600 5,000 400 (A)
Fixed costs
Depreciation định phí 2,000 2,000 2,200 200 (A)
Rent and rates 1,500 1,500 1,600 100 (A)
Total costs 18,100 24,600 23,200 1,400 (F)
Profit 1,900 5,400 6,800 1,400 (F)

Note. (F) denotes a favourable variance and (A) an adverse or unfavourable variance. Adverse
variances are sometimes denoted as (U) for 'unfavourable'.
We can analyse the above as follows.
(a) In selling 3,000 units the expected profit should have been not the fixed budget profit of $1,900,
but the flexible budget profit of $5,400. Instead, actual profit was $6,800 ie $1,400 more than
we should have expected. One of the reasons for the improvement is that, given actual output
and sales of 3,000 units, costs were lower than expected (and sales revenue exactly as
expected).
$
Direct materials cost variance 500 (F)
Direct labour cost variance 1,500 (F)
Maintenance cost variance 100 (F)
Other costs variance 400 (A)
Fixed cost variances
Depreciation 200 (A)
Rent and rates 100 (A)
1,400 (F)

Profit was therefore increased by $1,400 because costs were lower than anticipated.

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PART C: BUDGETING

(b) Another reason for the improvement in profit above the fixed budget profit is the sales volume.
Tree sold 3,000 boughs instead of 2,000 boughs, with the following result.
$ $
Sales revenue increased by 10,000
Variable costs increased by:
direct materials 3,000
direct labour 2,000
maintenance 500
variable element of other costs 1,000
Fixed costs are unchanged 6,500
Profit increased by 3,500

Profit was therefore increased by $3,500 because sales volumes increased.

(c) A full variance analysis statement would be as follows.
$ $
Fixed budget profit 1,900
Variances
Sales volume 3,500 (F)
Direct materials cost 500 (F)
Direct labour cost 1,500 (F)
Maintenance cost 100 (F)
Other costs 400 (A)
Depreciation 200 (A)
Rent and rates 100 (A)
4,900 (F)
Actual profit 6,800

If management believes any variance is significant enough to warrant investigation, they will investigate
to see whether any corrective action is necessary or whether the plan needs amending in the light of
actual events.

QUESTION Budgetary control

The budgeted and actual results of Crunch for September were as follows. The company uses a marginal
costing system. There were no opening or closing inventories.
Fixed budget flex Actual variance
Sales and production 1,000 units 700 units
$ $ $ $
Sales 20,000 14,200
Variable cost of sales
Direct materials 8,000 5,600 5,200 400
Direct labour 4,000 3,100
Variable overhead 2,000 1,500
14,000 9,800
Contribution 6,000 4,400
Fixed costs 5,000 5,400
Profit/(loss) 1,000 (1,000)

Required
Prepare a budget that will be useful for management control purposes.

8 x 1,000 = 8,000
8 x 700 = 5,600
=> 2,400 (F) => 2,800 (F)
7,43 x 700 = 5,200
=> 400 (F)

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CHAPTER 15 // BUDGETING

ANSWER
We need to prepare a flexible budget for 700 units.
Flexed
Budget budget Actual
1,000 units Per unit 700 units 700 units Variances
$ $ $ $ $
Sales 20,000 (20) 14,000 14,200 200 (F)
Variable costs
Direct material 8,000 (8) 5,600 5,200 400 (F)
Direct labour 4,000 (4) 2,800 3,100 300 (A)
Variable production overhead 2,000 (2) 1,400 1,500 100 (A)
14,000 (14) 9,800 9,800
Contribution 6,000 4,200 4,400
Fixed costs 5,000 (N/A) 5,000 5,400 400 (A)
Profit/(loss) 1,000 (800) (1,000) 200 (A)

Note that the differences between actual results (what revenues and costs were for 700 units) and the
flexed budget (what revenues and costs should be for 700 units) have been noted in the right-hand
column as variances. (F) denotes a situation where actual results were better than the flexible budget
results whereas (A) denotes a situation where actual results were worse than flexible budget results.

By flexing the budget in the exercise above we removed the effect on sales revenue of the difference
between budgeted sales volume and actual sales volume. But there is still a variance of $200 (F). This
means that the actual selling price must have been different to the budgeted selling price, resulting in a
$200 (F) selling price variance.

7.1 Factors to consider when preparing flexible budgets

The mechanics of flexible budgeting are, in theory, fairly straightforward. In practice, however, there are
a number of points that must be considered before figures are flexed.
(a) The separation of costs into their fixed and variable elements is not always straightforward.
(b) Fixed costs may behave in a step-line fashion as activity levels increase/decrease.
(c) Account must be taken of the assumptions on which the original fixed budget was based. Such
assumptions might include the constraint posed by limiting factors, the rate of inflation,
judgements about future uncertainty and the demand for the organisation's products.

7.2 Fixed and flexible budgets: a summary

7.2.1 Fixed and flexible budgets differences
A fixed budget will not change to take into account variations in production, sales or expenses actually
experienced. A flexible budget can do this by adjusting expected total costs for the level of production
achieved. The original budget based on a given volume is 'flexed' to the actual volume by analysing
budgeted costs over budgeted volume and multiplying by actual units produced.

7.2.2 When fixed and flexible budgets are appropriate

Both sorts of budget are used essentially for cost control, although they also provide management with a
yardstick to measure achievement and may thus encourage the attainment of objectives.
Fixed budgets are useful at the planning stage, as they provide a common ground for the preparation of
all the many types of budget. At the end of the period, actual results may be compared with the fixed
budget and analysed for control. However, this analysis may be distorted by uncorrected errors
underlying the estimates on which the fixed budget was constructed.
A flexible budget may be needed at the planning stage to complement the master budget; output may
be budgeted at a number of different possible levels, for instance. During the period the flexible budget
may then be updated to the actual level of activity and the results compared.

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PART C: BUDGETING

As a result, flexible budgets assist management control by providing more dynamic and comparable
information. Relying only on a fixed budget would give rise to massive variances; since forecast volume
is very unlikely to be matched, the variances will contain large volume differences. Flexible budgets are
more likely to pinpoint actual problem areas over which control may be exercised.

EXAM FOCUS POINT

Flexible budgets are a key syllabus area. You should be able to explain why budget variances should be
based on flexed budget figures.

8 Features and functions of spreadsheets

Use of spreadsheets is an essential part of the day to day work of an accountant.

8.1 What is a spreadsheet?

A spreadsheet is an electronic piece of paper divided into rows and columns. The intersection of a row
and a column is known as a cell.

A spreadsheet is divided into rows (horizontal) and columns (vertical). The rows are numbered 1, 2, 3
etc and the columns lettered A, B, C etc. Each individual area representing the intersection of a row and
a column is called a 'cell'. A cell address consists of its row and column reference. For example, in the
spreadsheet below the word 'Jan' is in cell B2. The cell that the cursor is currently in or over is known as
the 'active cell'.
The most popular spreadsheet package is Microsoft Excel. Other spreadsheet packages include Google
Sheets and Open Office Calc. We will be referring to Microsoft Excel, as this is the most widely used
spreadsheet. A simple Microsoft Excel spreadsheet, containing budgeted sales figures for three
geographical areas for the first quarter of the year, is shown below.

8.2 Why use spreadsheets?

Spreadsheets provide a tool for calculating, analysing and manipulating numerical data. Spreadsheets
make the calculation and manipulation of data easier and quicker. For example, the spreadsheet above
has been set up to calculate the totals automatically. If you changed your estimate of sales in February
for the North region to $3,296, when you input this figure in cell C4 the totals (in E4 and C7) would
change accordingly.

8.2.1 Uses of spreadsheets

Spreadsheets can be used for a wide range of tasks. Some common applications of spreadsheets are:
 Management accounts  Revenue analysis and comparison
 Cash flow analysis and forecasting  Cost analysis and comparison
 Reconciliations  Budgets and forecasts

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CHAPTER 15 // BUDGETING

8.2.2 Cell contents

The contents of any cell can be one of the following.
(a) Text. A text cell usually contains words. Numbers that do not represent numeric values for
calculation purposes (eg a Part Number) may be entered in a way that tells Excel to treat the cell
contents as text. To do this, enter an apostrophe before the number eg '451.
(b) Values. A value is a number that can be used in a calculation.
(c) Formulae. A formula refers to other cells in the spreadsheet, and performs some sort of
computation with them. For example, if cell C1 contains the formula =A1-B1, cell C1 will
display the result of the calculation subtracting the contents of cell B1 from the contents of cell
A1. In Excel, a formula always begins with an equals sign: =. There are a wide range of formulae
and functions available.

8.2.3 Formula bar

The following illustration shows the formula bar. (If the formula bar is not visible, choose View, Formula
bar from Excel's main menu.)

Formula bar

The formula bar allows you to see and edit the contents of the active cell. The bar also shows the cell
address of the active cell (C4 in the example above).

EXAM FOCUS POINT

Questions on spreadsheets are likely to focus on the main features of spreadsheets and their issues.

9 Examples of spreadsheet formulae

Formulae in Microsoft Excel follow a specific syntax.

All Excel formulae start with the equals sign =, followed by the elements to be calculated (the operands)
and the calculation operators. Each operand can be a value that does not change (a constant value), a
cell or range reference, a label, a name, or a worksheet function.

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PART C: BUDGETING

Formulae can be used to perform a variety of calculations. Here are some examples.
(a) =C4*5. This formula multiplies the value in C4 by 5. The result will appear in the cell holding
the formula.
(b) =C4*B10. This multiplies the value in C4 by the value in B10.
(c) =C4/E5. This divides the value in C4 by the value in E5. (* means multiply and / means divide
by.)
(d) =C4*B10-D1. This multiplies the value in C4 by that in B10 and then subtracts the value in D1
from the result. Note that generally Excel will perform multiplication and division before addition
or subtraction. If in any doubt, use brackets (parentheses): =(C4*B10)–D1.
(e) =C4*117.5%. This adds 17.5% to the value in C4. It could be used to calculate a price
including 17.5% sales tax.
(f) =(C4+C5+C6)/3. Note that the brackets mean Excel would perform the addition first. Without
the brackets, Excel would first divide the value in C6 by 3 and then add the result to the total of
the values in C4 and C5.
2
(g) = 2^2. This gives you 2 to the power of 2; in other words, 2 . Likewise = 2^3 gives you 2
cubed and so on.
(h) = 4^ (1/2). This gives you the square root of 4. Likewise 27^(1/3) gives you the cube root of
27 and so on.
Without brackets, Excel calculates a formula from left to right. You can control how calculation is
performed by changing the syntax of the formula. For example, the formula =5+2*3 gives a result of
11 because Excel calculates multiplication before addition. Excel would multiply 2 by 3 (resulting in 6)
and would then add 5.
You may use parentheses to change the order of operations. For example =(5+2)*3 would result in
Excel firstly by adding the 5 and 2 together, then multiplying that result by 3 to give 21.

9.1 Displaying the formulae held in your spreadsheet

It is sometimes useful to see all formulae held in your spreadsheet to enable you to see how the
spreadsheet works. There are two ways of making Excel display the formulae held in a spreadsheet.

(a) You can 'toggle' between the two types of display by pressing Ctrl +` (the latter is the key above
the Tab key). Press Ctrl + ` again to get the previous display back.
(b) You can also click on Tools, then on Options, then on View and tick the box next to 'Formulas'.
In the following paragraphs we provide examples of how spreadsheets and formulae may be used in an
accounting context.

9.1.1 Example: Formulae

(a) In the spreadsheet shown above, which of the cells have had a number typed in, and which cells
display the result of calculations (ie which cells contain a formula)?

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CHAPTER 15 // BUDGETING

(b) What formula would you put in each of the following cells?
(i) Cell B7
(ii) Cell E6
(iii) Cell E7
(c) If the February sales figure for the South changed from $5,826 to $5,731, what other figures
would change as a result? Give cell references.

Solution
(a) Cells into which you would need to enter a value are: B4, B5, B6, C4, C5, C6, D4, D5 and D6.
Cells which would perform calculations are B7, C7, D7, E4, E5, E6 and E7.
(b) (i) =B4+B5+B6 or better =SUM(B4:B6)
(ii) =B6+C6+D6 or better =SUM(B6:D6)
(iii) =E4+E5+E6 or better =SUM(E4:E6). Alternatively, the three monthly totals could be
added across the spreadsheet: = SUM (B7: D7)
(c) The figures which would change, besides the amount in cell C5, would be those in cells C7, E5
and E7. (The contents of E7 would change if any of the sales figures changed.)

QUESTION SUM formulae

The following spreadsheet shows sales of two products, the Ego and the Id, for the period July to
September.

Devise a suitable formula for each of the following cells.

(a) Cell B7 (c) Cell E7
(b) Cell E6

ANSWER
(a) =SUM(B5:B6)
(b) =SUM(B6:D6)
(c) =SUM(E5:E6) or =SUM(B7:D7) or (best of all) =IF(SUM(E5:E6)
=SUM(B7:D7),SUM(B7:D7),"ERROR")

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PART C: BUDGETING

QUESTION Formulae
The following spreadsheet shows sales, exclusive of sales tax, in row 6.

Your manager has asked you to insert formulae to calculate sales tax at 17½% in row 7 and also to
produce totals.
(a) Devise a suitable formula for cell B7 and cell E8.
(b) How could the spreadsheet be better designed?

ANSWER
(a) For cell B7 =B6*0.175 For cell E8 =SUM(E6:E7)
(b) By using a separate 'variables' area that contains the sales tax rate and possibly the sales figures.
The formulae could then refer to these cells as shown below.

10 Advantages and disadvantages of spreadsheet software

10.1 Advantages of spreadsheets

 Excel is easy to learn and to use.
 Spreadsheets make the calculation and manipulation of data easier and quicker.
 They enable the analysis, reporting and sharing of financial information.
 They enable 'what if' analysis to be performed very quickly.

10.2 Disadvantages of spreadsheets

 A spreadsheet is only as good as its original design, garbage in = garbage out!
 Formulae are hidden from sight so the underlying logic of a set of calculations may not be
obvious.
 A spreadsheet presentation may make reports appear infallible.
 Research shows that a high proportion of large models contain critical errors.
 A database may be more suitable to use with large volumes of data.
 Spreadsheets are not good at word processing.
 Spreadsheets are not suitable for constructing entire accounting systems.

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QUESTION Spreadsheet advantages

An advantage of a spreadsheet program is that it:
A Can answer 'what if?' questions
B Checks for incorrect entries
C Automatically writes formulae
D Can answer 'when is?' questions

ANSWER
The correct answer is A.

11 Uses of spreadsheet software

Spreadsheets can be used in a variety of accounting contexts. You should practise using spreadsheets;
hands-on experience is the key to spreadsheet proficiency.

Management accountants will use spreadsheet software in activities such as budgeting, forecasting,
reporting performance and variance analysis.

11.1 Budgeting
Spreadsheet packages for budgeting have a number of advantages. what if: phân tích warst-best
(a) Spreadsheet packages have a facility to perform 'what if' calculations at great speed (see Section
11.2). For example, the consequences throughout the organisation of sales growth per month of
nil, 1/2%, 1%, 11/2% and so on can be calculated very quickly.
(b) Preparing budgets may be complex; budgets may need to go through several drafts. If one or two
figures are changed, the computer will automatically make all the computational changes to the
other figures.
(c) A spreadsheet model will ensure that the preparation of the individual budgets is co-ordinated.
Data and information from the production budget, for example, will be automatically fed through
to the material usage budget (as material usage will depend on production levels).
These advantages of spreadsheets make them ideal for taking over the manipulation of numbers,
leaving staff to get involved in the real planning process.

11.2 'What if?' analysis

Once a model has been constructed, the consequences of changes in any of the variables may be tested
by asking 'what if?' questions, a form of sensitivity analysis. For example, a spreadsheet may be used to
develop a cash budget, such as that shown overleaf.

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PART C: BUDGETING

A B C D
1 Month 1 Month 2 Month 3
2 Sales 1,000 1,200 1,440
3 Cost of sales (650) (780) (936)
4 Gross profit 350 420 504
5
6 Receipts:
7 Current month 600 720 864
8 Previous month – 400 480
9 – – –
10 600 1,120 1,344
11 Payments (650) (780) (936)
12 (50) 340 408
13 Balance b/f – (50) 290
14 Balance c/f (50) 290 698

Typical 'what if?' questions for sensitivity analysis

(a) What if the cost of sales is 68% of sales revenue, not 65%?
(b) What if payment from receivables is received 40% in the month of sale, 50% one month in
arrears and 10% two months in arrears, instead of 60% in the month of sale and 40% one
month in arrears?
(c) What if sales growth is only 15% per month, instead of 20% per month?
Using the spreadsheet model, the answers to such questions can be obtained simply and quickly, using
the editing facility in the program. The information obtained should provide management with a better
understanding of what the cash flow position in the future might be, and what factors are critical to
ensuring that the cash position remains reasonable. For example, it might be found that the cost of
sales must remain less than 67% of sales value to achieve a satisfactory cash position.

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CHAPTER 15 // BUDGETING

CHAPTER ROUNDUP

 There are seven steps in the planning and control cycle.

Step 1 Identify objectives
Step 2 Identify potential strategies
Step 3 Evaluate strategies
Step 4 Choose alternative courses of action
Step 5 Implement the long-term plan
Step 6 Measure actual results and compare with plan
Step 7 Respond to divergences from plan

 A budget is a quantified plan of action for a forthcoming accounting period. A budget is a plan of what
the organisation is aiming to achieve and what it has set as a target whereas a forecast is an estimate of
what is likely to occur in the future.
 The objectives of a budgetary planning and control system are as follows.
– To ensure the achievement of the organisation's objectives
– To compel planning
– To communicate ideas and plans
– To co-ordinate activities
– To provide a framework for responsibility accounting
– To establish a system of control
– To motivate employees to improve their performance
 Responsibility centres can be divided into three types.
– Cost centres
– Profit centres
– Investment centres
 Fixed budgets remain unchanged regardless of the level of activity; flexible budgets are designed to flex
with the level of activity.
 Comparison of a fixed budget with the actual results for a different level of activity is of little use for
control purposes. Flexible budgets should be used to show what cost and revenues should have been for
the actual level of activity.
 A prerequisite of flexible budgeting is a knowledge of cost behaviour.
 The differences between the components of the fixed budget and the actual results are known as budget
variances.
 Use of spreadsheets is an essential part of the day to day work of an accountant.

 A spreadsheet is an electronic piece of paper divided into rows and columns. The intersection of a row
and a column is known as a cell.
 Formulae in Microsoft Excel follow a specific syntax.

 Spreadsheets can be used in a variety of accounting contexts. You should practise using spreadsheets;
hands-on experience is the key to spreadsheet proficiency.

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PART C: BUDGETING

1 Which of the following is not an objective of a system of budgetary planning and control?
QUICK QUIZ

A To establish a system of control

B To co-ordinate activities
C To compel planning
D To motivate employees to maintain current performance levels
2 Choose the appropriate words from those highlighted.
A forecast/budget is an estimate/guarantee of what is likely to occur in the future/has happened in the
past.
A forecast/budget is a quantified plan/unquantified plan/guess of what the organisation is aiming to
achieve/spend.
3 Distinguish between a fixed budget and a flexible budget.
4 Flexible budgets are normally prepared on a marginal cost basis. True or false?
5 What are the two main reasons for differences between a fixed budget profit and actual profit?

1 D. The objective is to motivate employees to improve their performance.

ANSWERS TO QUICK QUIZ

2 A forecast is an estimate of what is likely to occur in the future.

A budget is a quantified plan of what the organisation is aiming to achieve.
3 A fixed budget is a budget which is designed to remain unchanged regardless of the volume of output or
sales achieved.
A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to
change if volumes of output change.
4 True
5 A fixed budget profit might differ from an actual profit because costs were higher or lower than expected
given the actual output and/or sales volumes were different to the level expected.

Now try ...

Attempt the questions below from the Practice Question Bank

Q67 – Q70

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sale budget

C H A P T E R
production sale & admin
budget cost budget

direct material direct labour overhead cost budget

cost budget cost budget

cash budget

budgeted financial statements

In this chapter we look at how the budget is put together.

You need to know the stages in budget preparation and The budgetary process
the importance of the principal budget factor. You also
need to know how to prepare functional and cash
budgets.
EX: sales budget
1. SG company is crafting budget for the second quarter of 2016
2. Expected sales units in the next months are as following
- April 20,000 units
- May 50,000 units
- June 30,000 units
- July 25,000 units
- August 15,000 units
3. Expected sales price is $10/unit
Sales Budget

SYLLABUS
TOPIC LIST REFERENCE

1 Administration of the budget C1(c)

2 The budget preparation timetable C1(d), C3(a), C3(b)
3 Functional budgets C3(c)
4 Cash budgets C3(d)
5 Budgeted statement of profit or loss and statement of financial position C3(e)
6 The master budget C3(e)

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PART C: BUDGETING

Study Guide Intellectual level

C Budgeting

1 Nature and purpose of budgeting

(c) Explain the administrative procedures used in the

K
budgeting process.
(d) Describe the stages in the budgeting process (including
K
sources of relevant data, planning and agreeing draft
budgets, and the purpose of forecasts and how they link to
budgeting).
3 Budget preparation

(a) Explain the importance of the principal budget factor in

K
constructing the budget.
(b) Prepare sales budgets. S
(c) Prepare functional budgets (production, raw materials
S
usage and purchases, labour, variable and fixed overheads).
(d) Prepare cash budgets. S
(e) Prepare master budgets (statement of profit or loss and
S
statement of financial position).

1 Administration of the budget

The budget manual is a collection of instructions governing the responsibilities of persons and the
procedures, forms and records relating to the preparation and use of budgetary data.
Managers responsible for preparing budgets should ideally be the managers responsible for carrying out
the budget.
The budget committee is the co-ordinating body in the preparation and administration of budgets.

Having seen why organisations prepare budgets, we will now turn our attention to the administrative
procedures that ensure that the budget process works effectively.

1.1 The budget period

The budget period is the time period to which the budget relates.

Except for capital expenditure budgets, the budget period is commonly the accounting year (subdivided
into 12 or 13 control periods).

1.2 Budget documentation: the budget manual

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

One of the functions of the budget is to improve communication. A budget manual should be produced
so that everyone can refer to it for information and guidance about the budgeting process. The budget
manual does not contain the actual budgets for the forthcoming period; it is more of an
instruction/information manual about the way budgeting operates in a particular organisation.
A budget manual will usually be prepared by the management accountant.

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Content Detail

Explanation of the objectives of  The purpose of budgetary planning and control

the budgeting process  The objectives of the various stages of the budgeting process
 The importance of budgets in the long-term planning and
administration of the enterprise

Organisational structures  An organisation chart

 A list of individuals holding budget responsibilities

Outline of the principal budgets  Relationship between them

Administrative details  Membership, and terms of reference, of the budget committee

 The sequence in which budgets are to be prepared
 A timetable

Procedural matters  Specimen forms and instructions for completing them

 Specimen reports
 Account codes (or a chart of accounts)
 The name of the budget officer to whom enquiries must be sent

1.3 Responsibility for the preparation of budgets

Managers responsible for preparing budgets should ideally be the managers who are responsible for
carrying out the budget. For example, the sales manager should draft the sales budget and selling
overhead cost centre budget and the purchasing manager should draft the material purchases budget.

1.4 Budget committee

The co-ordination and administration of budgets is usually the responsibility of a budget committee (with
the managing director as chairman). The budget committee is assisted by a budget officer who is usually
an accountant. Every part of the organisation should be represented on the committee, so there should be
a representative from sales, production, marketing and so on. Functions of the budget committee include
the following.
(a) Co-ordination of the preparation of budgets, which includes the issue of the budget manual
(b) Issuing of timetables for the preparation of functional budgets
(c) Allocation of responsibilities for the preparation of functional budgets
(d) Provision of information to assist in the preparation of budgets
(e) Communication of final budgets to the appropriate managers
(f) Continuous assessment of the budgeting and planning process, in order to improve the planning
and control function

QUESTION Budgets
(a) Try to obtain a copy of your organisation's budget manual. Is it user friendly? Could it provide
more useful information?
(b) Attempt to determine who is on your organisation's budget committee. What role do they play?

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2 The budget preparation timetable

The budget preparation process is as follows.

– Communicating details of the budget policy and budget guidelines
– Determining the factor that restricts output
– Preparation of the sales budget
– Initial preparation of budgets
– Negotiation of budgets with superiors
– Co-ordination and review of budgets
– Final acceptance of the budgets
– Budget review
The principal budget factor should be identified at the beginning of the budgetary process, and the
budget for this is prepared before all the others.

The procedures involved in preparing a budget will differ from organisation to organisation, but the step
by step approach described here is indicative of the steps followed by many organisations. The
preparation of a budget may take weeks or months and the budget committee may meet several times
before an organisation's budget is finally agreed.

Step 1 Communicating details of the budget policy and budget guidelines

The long-term plan is the starting point for the preparation of the annual budget.
Managers responsible for preparing the budget must be aware of the way it is affected
by the long-term plan so that it becomes part of the process of meeting the
organisation's objectives. For example, if the long-term plan calls for a more aggressive
pricing policy, the budget must take this into account. Managers should also be
provided with important guidelines for wage rate increases, changes in productivity and
so on, as well as information about industry demand and output.

Step 2 Determining the factor that restricts output

The principal budget factor (or key budget factor or limiting budget factor is the factor that limits an
organisation's performance for a given period and is often the starting point in budget preparation.

For example, a company's sales department might estimate that it could sell 1,000 units of product X,
which would require 5,000 hours of grade A labour to produce. If there are no units of product X already
in inventory, and only 4,000 hours of grade A labour available in the budget period, then the company
would be unable to sell 1,000 units of X because of the shortage of labour hours. Grade A labour would
be a limiting budget factor, and the company's management must choose one of the following options.
(a) Reduce budgeted sales by 20%
(b) Try to increase the availability of grade A labour by 1,000 hours (25%) by recruitment or
overtime working
(c) Try to subcontract the production of 1,000 units to another manufacturer, but still profit on the
transaction
In most organisations the principal budget factor is sales demand: a company is usually restricted from
making and selling more of its products because there would be no sales demand for the increased
output at a price which would be acceptable/profitable to the company. The principal budget factor may
also be machine capacity, distribution and selling resources, the availability of key raw materials or the
availability of cash. Once this factor is defined then the rest of the budget can be prepared. For example,
if sales are the principal budget factor then the production manager can only prepare their budget after
the sales budget is complete.

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However, in the public sector, the principal budget factor will not be profit related. You need to think
about the limiting factor for these organisations in terms of activity, for example insurance consultant
availability, cash budget or accommodation.

QUESTION Limiting factors

In the NHS and other public sector organisations, the principal budget factor may not be the same as
that faced by private sector organisations.
Required
List three or four limiting factors that would apply to public sector organisations.

ANSWER
Remember that State-run organisations providing services free at the point of consumption often face
almost unlimited demand for their services. Therefore resources available usually comprise the limiting
factors:
(a) Cash from government grants and ministries
(b) Trained staff such as nurses and doctors
(c) Equipment such as MRI scanners and hospital beds

Step 3 Preparation of the sales budget

For many organisations, the principal budget factor is sales volume. The sales budget is
therefore often the primary budget from which the majority of the other budgets are
derived.
Before the sales budget can be prepared a sales forecast has to be made.
Sales forecasting is complex and involves the consideration of a number of factors.
(a) Past sales patterns (g) New legislation chính sách thuế
(b) The economic environment (h) Distribution
(c) Results of market research (i) Pricing policies and discounts offered
chạy qcao (d) Anticipated advertising (j) Legislation
cạnh tranh (e) Competition (k) Environmental factors
thay đổi thị yếu(f) Changing consumer taste P (giá bán) x Q(sản lượng) = Revenue
ng tiu dùng
Management can use a number of forecasting methods.
(a) Sales personnel can be asked to provide estimates.
(b) Market research can be used (especially if an organisation is considering
introducing a new product or service).
(c) Various mathematical techniques can be used to estimate sales levels.
(d) Annual contracts, under which major customers set out in advance monthly ranges
of possible sales, can be reviewed.
On the basis of the sales forecast and the production capacity of the organisation, a sales
budget will be prepared. This may be subdivided, possible subdivisions being by product,
by sales area or by management responsibility.
For example, a sales budget might look like this.

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North region South region Total

Units Value Units Value Units Value
$ $ $
January Product A
Product B
Total
February
March
April
May
June
July
August
September
October
November
December
Total
Product A 6,000 2,400,000 5,000 2,000,000 11,000 4,400,000
Product B 1,000 560,000 1,200 672,000 2,200 1,232,000

Step 4 Initial preparation of budgets

Budget Detail
Finished goods Decides the planned increase or decrease in finished
inventory budget inventory levels.
Production Stated in units of each product and is calculated as
budget the sales budget in units plus the budgeted increase
in finished goods inventories or minus the budgeted
decrease in finished goods inventories.
Budgets of Materials usage budget is stated in quantities and
resources for perhaps cost for each type of material used. It should
production take into account budgeted losses in production.
Machine utilisation budget shows the operating hours
required on each machine or group of machines.
Labour budget or wages budget will be expressed in
hours for each grade of labour and in terms of cost. It
should take into account budgeted idle time.
Overhead cost Production overheads
budgets Administration overheads
Selling and distribution overheads
Research and development department overheads
Raw materials Decides the planned increase or decrease of the level
inventory budget of inventories.
Raw materials Can be prepared in quantities and value for each type
purchase budget of material purchased once the raw material usage
requirements and the raw materials inventory budget
are known.

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Budget Detail
Overhead Can be calculated once the production volumes are
absorption rate planned, and the overhead cost centre budgets
prepared.

Step 5 Negotiation of budgets with superiors

Once a manager has prepared their draft budget they should submit it to their superior for
approval. The superior should then incorporate this budget with the others for which they
are responsible and then submit this budget for approval to their superior. This process
continues until the final budget is presented to the budget committee for approval.
At each stage of the process, the budget would be negotiated between the manager who
had prepared the budget and their superior until agreed by both parties.

Step 6 Co-ordination of budgets

It is unlikely that the above steps will be problem-free. The budgets must be reviewed in
relation to one another. Such a review may indicate that some budgets are out of balance
with others and need modifying. The budget officer must identify such inconsistencies and
bring them to the attention of the manager concerned. The revision of one budget may
lead to the revision of all budgets. During this process the budgeted statement of profit or
loss and budgeted statement of financial position and cash budget should be prepared to
ensure that all the individual parts of the budget combine into an acceptable master
budget.

Step 7 Final acceptance of the budget

When all the budgets are in harmony with one another they are summarised into a master
budget consisting of a budgeted statement of profit or loss, budgeted statement of
financial position and cash budget.

Step 8 Budget review

The budgeting process does not stop once the budgets have been agreed. Actual results
should be compared on a regular basis with the budgeted results. The frequency with
which such comparisons are made depends very much on the organisation's
circumstances and the sophistication of its control systems but it should occur at least
monthly. Management should receive a report detailing the differences and should
investigate the reasons for the differences. If the differences are within the control of
management, corrective action should be taken to bring the reasons for the difference
under control and to ensure that such inefficiencies do not occur in the future.
The differences may have occurred, however, because the budget was unrealistic to begin
with or because the actual conditions did not reflect those anticipated (or could have
possibly been anticipated). This would therefore invalidate the remainder of the budget.
The budget committee, who should meet periodically to evaluate the organisation's actual
performance, may need to reappraise the organisation's future plans in the light of changes
to anticipated conditions and to adjust the budget to take account of such changes.
The important point to note is that the budgeting process does not end for the current year
once the budget period has begun: budgeting should be seen as a continuous and
dynamic process.

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QUESTION Budget preparation

A company that manufactures and sells a range of products, with sales potential limited by market
share, is considering introducing a system of budgeting.
Required
(a) List (in order of preparation) the budgets that need to be prepared.
(b) State which budgets the master budget will comprise.
(c) Consider how the work outlined in (a) and (b) can be co-ordinated in order for the budgeting
process to be successful.

ANSWER
(a) The sequence of budget preparation will be roughly as follows.
(i) Sales budget
(The market share limits demand and so sales is the principal budget factor. All other
activities will depend on this forecast.)
(ii) Finished goods inventory budget (in units)
(iii) Production budget (in units)
(iv) Production resources budgets (materials, machine hours, labour)
(v) Overhead budgets for production, administration, selling and distribution, research and
development and so on
(vi) Cash budget
(b) The master budget is the summary of all the budgets. It often includes a summary statement of
profit or loss, statement of financial position and cash budget.
(c) Procedures for preparing budgets can be contained in a budget manual which shows which
budgets must be prepared when and by whom, what each functional budget should contain and
detailed directions on how to prepare budgets including, for example, expected price increases,
rates of interest and rates of depreciation.
The formulation of budgets can be co-ordinated by a budget committee comprising the senior executives
of the departments responsible for carrying out the budgets: sales, production, purchasing, personnel
and so on.
The budgeting process may also be assisted by the use of a spreadsheet/computer budgeting package.

3 Functional budgets dự toán chức năng, qtrong nhất là 621, 2227

Functional (or departmental) budgets are the budgets for the various functions and departments of an
organisation. They therefore include production budgets, marketing budgets, sales budgets, personnel
budgets, purchasing budgets and research and development budgets.

We will look at the preparation of a number of types of functional budget in this chapter but the general
principles covered can be applied in most situations.
You must work through the examples here and make sure that you understand the principles well.

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CHAPTER 16 // THE BUDGETARY PROCESS

3.1 Production cost budget

If the principal budget factor was production capacity then the production cost budget would be the first
to be prepared.
To assess whether production is the principal budget factor, the production capacity available must be
determined. This should take into account the following factors.
(a) Available labour, including idle time, overtime and standard output rates per hour đủ giờ nhân công
(b) Availability of raw materials, including allowances for losses during production phải đủ NVL
(c) Maximum machine hours available, including expected idle time and expected output rates per
machine hour giới hạn năng suất lao động là mức độ ngắn hơn giữa máy móc và nhân công
However, it is normally sales volume that is the constraint and therefore the production budget is
prepared after the sales budget and the finished goods inventory budget.
The production cost budget will show the quantities and costs for each product and product group and
will tie in with the sales and inventory budgets. This co-ordinating process is likely to show any shortfalls
or excesses in capacity at various times over the budget period. If there is likely to be a shortfall then
consideration should be given to overtime, subcontracting, machine hire, new sources of raw materials
or some other way of increasing output. A significant shortfall means that production capacity is, in fact,
the limiting factor.
If capacity exceeds sales volume for a length of time then consideration should be given to product
diversification, a reduction in selling price (if demand is price elastic) and so on.
Once the production budget has been finalised, the labour, materials and machine budgets can be
drawn up. These budgets will be based on budgeted activity levels, existing inventory positions and
projected labour and material costs.

3.2 Example: The preparation of the production budget and direct labour
budget
Pearson manufactures two products, P and L, and is preparing its budget for 20X3. Both products are
made by the same grade of labour, grade G. The company currently holds 800 units of P and 1,200
units of L in inventory, but 250 of these units of L have just been discovered to have deteriorated in
hư quality, and must therefore be scrapped. Budgeted sales of P are 3,000 units and of L 4,000 units,
provided that the company maintains finished goods inventories at a level equal to three months' sales.
Grade G labour was originally expected to produce one unit of P in two hours and one unit of L in three
hours, at an hourly rate of $2.50 per hour. In discussions with trade union negotiators, however, it has
been agreed that the hourly wage rate should be raised by 50c per hour, provided that the times to
produce P and L are reduced by 20%.
Required
Prepare the production budget and direct labour budget for 20X3.

3.3 Solution
The expected time to produce a unit of P will now be 80% of 2 hours = 1.6 hours, and the time for a
unit of L will be 2.4 hours. The hourly wage rate will be $3, so that the direct labour cost will be $4.80
for P and $7.20 for L (thus achieving a saving for the company of 20c per unit of P produced and 30c
per unit of L).
(a) Production budget
Product P Product L
Units Units Units Units
Budgeted sales 3,000 4,000
Closing inventories (3/12 × 3,000) 750 (3/12 × 4,000) 1,000
Opening inventories (minus inventories scrapped) 800 950
(Decrease)/increase in inventories (50) 50
Production 2,950 4,050

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(b) Direct labour budget

Grade G Cost
Hours $
2,950 units of product P x 1.6h 4,720 14,160
4,050 units of product L x 2.4h 9,720 29,160
Total 14,440 43,320

It is assumed that there will be no idle time among grade G labour which, if it existed, would
have to be paid for at the rate of $3 per hour.

3.4 Labour budget

định mức giờ công đv sp, có tính giờ nghỉ ngơi
A useful concept in budgeting for labour requirements is the standard hour.
A standard hour is the quantity of work achievable at standard performance, expressed in terms of a
standard unit of work done in a standard period of time.

Budgeted output of different products or jobs in a period can be converted into standard hours of
production, and a labour budget constructed accordingly.
Standard hours are particularly useful when management wants to monitor the production levels of a
variety of dissimilar units. For example, product A may take five hours to produce and product B, seven
hours. If four units of each product are produced, instead of saying that total output is eight units, we
could state the production level as
(4  5) + (4  7) standard hours = 48 standard hours.

3.5 Example: Direct labour budget based on standard hours

Canaervon manufactures a single product, the close, with a single grade of labour. Its sales budget and
finished goods inventory budget for period 3 are as follows. Q product good = 700 + 70 - 50 = 720
số lượng sx = 720 x 90% = 800
Sales 700 units
Opening inventories, finished goods 50 units
Closing inventories, finished goods 70 units
đc ktra The goods are inspected only when production work is completed, and it is budgeted that 10% of
finished work will be scrapped. hư sau sx
800 x 3 = 2400
The standard direct labour hour content of the close is three hours. The budgeted productivity ratio for
direct labour is only 80% (which means that labour is only working at 80% efficiency). 2400 / 80% = 3000
The company employs 18 direct operatives, who are expected to average 144 working hours each in
period 3.
Required
(a) Prepare a production budget.
(b) Prepare a direct labour budget.
(c) Comment on the problem that your direct labour budget reveals, and suggest how this problem
might be overcome.

3.6 Solution
(a) Production budget
Units
Sales 700
Add closing inventory 70
770
Less opening inventory 50
Production required of 'good' output 720

Wastage rate 10%

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100 *
Total production required 720× = 800 units
90
(* Note that the required adjustment is 100/90, not 110/100, since the waste is assumed to be
10% of total production, not 10% of good production.)
(b) Now we can prepare the direct labour budget.
Standard hours per unit 3
Total standard hours required = 800 units  3 hours 2,400 hours
Productivity ratio 80%
100
Actual hours required 2,400× = 3,000 hours
80
(c) If we look at the direct labour budget against the information provided, we can identify the
problem.
Hours
Budgeted hours available (18 operatives  144 hours) 2,592
Actual hours required 3,000
Shortfall in labour hours 408

The (draft) budget indicates that there will not be enough direct labour hours to meet the
production requirements. This problem might be overcome in one, or a combination, of the
following ways.
(i) Reduce the closing inventory requirement below 70 units. This would reduce the number
of production units required.
(ii) Persuade the workforce to do some overtime working.
(iii) Perhaps recruit more direct labour if long-term prospects are for higher production
volumes.
(iv) Discuss with the workforce (or their union representatives) the following possibilities.
(1) Improve the productivity ratio, and so reduce the number of hours required to
produce the output.
(2) If possible, reduce the wastage rate below 10%.

3.7 Material purchases budget

QUESTION Material budget

Taylors manufactures two products, W and S, which use the same raw materials, R and T. One unit of
W uses 3 litres of R and 4 kilograms of T. One unit of S uses 5 litres of R and 2 kilograms of T. A litre of
R is expected to cost $3 and a kilogram of T $7.
Budgeted sales for 20X2 are 8,000 units of W and 6,000 units of S; finished goods in inventory at 1
January 20X2 are 1,500 units of W and 300 units of S; and the company plans to hold inventories of
600 units of each product at 31 December 20X2.
Inventories of raw material are 6,000 litres of R and 2,800 kilograms of T at 1 January, and the company
plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
The warehouse and stores managers have suggested that a provision should be made for damages and
deterioration of items held in store, as follows.
Product W: loss of 50 units
Product S: loss of 100 units
Material R: loss of 500 litres
Material T: loss of 200 kilograms
Required
Prepare a material purchases budget for the year 20X2.

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ANSWER
To calculate material purchase requirements, it is first of all necessary to calculate the budgeted
production volumes and material usage requirements.
Product W Product S
Units Units Units Units
Sales 8,000 6,000
Provision for losses 50 100
Closing inventory 600 600
Opening inventory 1,500 300
(Decrease)/increase in inventory (900) 300
Production budget 7,150 6,400

Material R Material T
Litres Litres Kg Kg
Usage requirements
To produce 7,150 units of W 21,450 28,600
To produce 6,400 units of S 32,000 12,800
Usage budget 53,450 41,400
Provision for losses 500 200
53,950 41,600
Closing inventory 5,000 3,500
Opening inventory 6,000 2,800
(Decrease)/increase in inventory (1,000) 700
Material purchases budget 52,950 42,300

Cost per unit $3 per litre $7 per kg

Cost of material purchases $158,850 $296,100
Total purchases cost $454,950

EXAM FOCUS POINT

The preparation of a material purchases budget will often require you to manipulate the expression:
opening inventory + purchases – closing inventory = material used in production
A material purchases figure is therefore given by:
closing inventory + material used in production – opening inventory
Likewise, a production budget may require manipulation of the expression:
opening inventory + units produced – closing inventory = sales
The ACCA examining team has commented that candidates have a poor understanding of purchases
budgets, particularly the effect of production levels on purchases.

Now try the following question which draws together budget preparation for functional budgets.
Remember the order in which budgets must be prepared using the steps in Section 3.

QUESTION Functional budget

XYZ company produces three products: X, Y and Z. For the coming accounting period, budgets are to be
prepared based on the following information.
Budgeted sales
Product X 2,000 at $100 each
Product Y 4,000 at $130 each
Product Z 3,000 at $150 each

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Budgeted usage of raw material

RM11 RM22 RM33
Product X 5 2 –
Product Y 3 2 2
Product Z 2 1 3
Cost per unit of material $5 $3 $4
Finished inventories budget
Product X Product Y Product Z
Opening 500 800 700
Closing 600 1,000 800
Raw materials inventory budget
RM11 RM22 RM33
Opening 21,000 10,000 16,000
Closing 18,000 9,000 12,000
Product X Product Y Product Z
Expected hours per unit 4 6 8
Expected hourly rate (labour) $9 $9 $9
Fill in the blanks.
(a) Sales budget
Product X Product Y Product Z Total

Sales quantity

Sales value $ $ $ $
(b) Production budget
Product X Product Y Product Z
Units Units Units

Budgeted production

(c) Material usage budget

RM11 RM22 RM33
Units Units Units

Budgeted material usage

(d) Material purchases budget

RM11 RM22 RM33

Budgeted material purchases $ $ $

(e) Labour budget

Budgeted total wages $

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ANSWER
(a) Sales budget
Product X Product Y Product Z Total

Sales quantity 2,000 4,000 3,000

Sales price $100 $130 $150

Sales value $ 200,000 $ 520,000 $ 450,000 $ 1,170,000

(b) Production budget

Product X Product Y Product Z
Units Units Units
Sales quantity 2,000 4,000 3,000
Closing inventories 600 1,000 800
2,600 5,000 3,800
Less opening inventories 500 800 700

Budgeted production 2,100 4,200 3,100

(c) Material usage budget

Production RM11 RM22 RM33
Units Units Units Units
Product X 2,100 10,500 4,200 –
Product Y 4,200 12,600 8,400 8,400
Product Z 3,100 6,200 3,100 9,300

Budgeted material usage 29,300 15,700 17,700

(d) Material purchases budget

RM11 RM22 RM33
Units Units Units
Budgeted material usage 29,300 15,700 17,700
Closing inventories 18,000 9,000 12,000
47,300 24,700 29,700
Less opening inventories 21,000 10,000 16,000
Budgeted material purchases 26,300 14,700 13,700

Standard cost per unit $5 $3 $4

Budgeted material purchases $ 131,500 $ 44,100 $ 54,800

(e) Labour budget

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

Budgeted total wages 525,600

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CHAPTER 16 // THE BUDGETARY PROCESS

QUESTION Treehorn
Treehorn produces a single product. The cost card for this product is as follows.
$ per unit
Direct materials 3 kg per unit at $6 per kg 18
Direct labour 2 hrs per unit at $10 per hour 20
Fixed overhead 2 hrs per unit at $2 per hour 4
Total cost 42

Notes
1 Treehorn prepares budgets on a quarterly basis. Each quarter consists of 13 weeks, with 5
working days per week.
2 Selling price is $56 per unit.
3 Treehorn incurs no costs other than those included in the cost card.
4 It is Treehorn's policy to maintain an inventory of finished goods at the end of each quarter equal
to 5 days' demand of the next quarter.
5 Because of its perishable nature it is not possible to hold raw material inventory.
6 Forecast sales units for the next 5 quarters are:
Quarter 1 1,950,000 units
Quarter 2 2,275,000 units
Quarter 3 3,250,000 units
Quarter 4 2,275,000 units
Quarter 5 1,950,000 units
Required
Produce the following budgets for each of the quarters 1, 2, 3 and 4.
(a) A sales budget showing sales volume in units and sales revenue in $ (1 mark)
(b) A production budget in units, showing opening and closing inventories, sales and production
(5 marks)
(c) A purchases budget showing purchases in kg and $ (4 marks)

ANSWER
Budgets
(a) Sales budget
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Sales (units '000) 1,950 2,275 3,250 2,275
Sales ($'000) (W1) 109,200 127,400 182,000 127,400
Working
Quarter 1 sales revenue = $56 × 1,950,000 units = $109,200,000
(b) Production budget
'000 units
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Desired closing inventory (W2) 175 250 175 150
Sales 1,950 2,275 3,250 2,275
Less opening inventory (W3) 150 175 250 175
Production 1,975 2,350 3,175 2,250

Working: Desired closing inventory

Quarter 1: 2,275,000 units × 5 days ÷13 weeks × 5 days = 175,000 units etc

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Working: Opening inventory

Quarter 1: 1,950,000 × 5 days ÷13 weeks × 5 days
(c) Purchases budget
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Production '000 units 1,975 2,350 3,175 2,250
Kg per unit 3 3 3 3
Purchases '000 kg 5,925 7,050 9,525 6,750
Price per kg $6 $6 $6 $6
Purchases $'000 35,550 42,300 57,150 40,500

3.8 Budgets for departments not involved in manufacturing

Budgets are also prepared for those departments and functions not involved in manufacturing. An
organisation may therefore also prepare an administration budget, a marketing budget, a research and
development budget and so on. Such budgets do not take the sales budget as their starting point (if
sales are the principal budget factor) because the level of administration costs, say, is unlikely to vary in
proportion to the level of sales. Instead, the administration cost budget will be drawn up following
meetings between the management accountant and various members of staff ranging from the managing
director down to office managers and supervisors.
The example below shows a typical marketing cost budget. Notice that only the selling and agency
commission varies directly with the level of sales.
ABC: MARKETING COST BUDGET
$'000
Description/detail of cost items
Salaries and wages of marketing staff X
Advertising expenses X
Travelling and distribution costs X
Market research activities X
Promotional activities and marketing relations X
Selling and agency commission (21/2% of sales) X
X

3.9 Co-ordination of functional budgets

It is vital that the functional budgets are prepared in the correct order (for example, the material usage
budget should be prepared after the production budget) and that the overall process is co-ordinated to
ensure that the budgets are all in balance with each other. There is little point in the material usage
budget being based on a budgeted production level of 10,000 units if the budgeted production level
specified in the production budget is 15,000 units.

Once prepared, the functional budgets must be reviewed to ensure they are consistent with one another.

QUESTION Rathbone
Rathbone is preparing its budgets for the coming year. It expects to be able to sell 5,000 units of its
only product, the Graham, in January 20X7. Sales are expected to rise to 5,500 units in February and
7,000 units in March and then remain stable for the rest of the year.
Rathbone aims to carry a finished goods inventory at the end of each month equal to 10% of the
following month's sales. Each Graham takes 4 hours' labour to make.
Rathbone's 138 production workers are employed on contracts that require them to work a minimum of
160 hours per month and are each paid $1,280 per month. Production workers are highly skilled and
require a minimum of one year's training. In the short term it is not possible to recruit any more

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production workers. Any labour hours required in excess of 160 hours per worker are made up by
overtime that is paid at basic rate plus an overtime premium of 50%.
Required
Prepare, on a monthly basis, for the first three months of 20X7:
(a) A production budget in units, showing opening and closing inventories of finished goods
(5 marks)
(b) A labour budget showing both hours and labour cost (5 marks)
(Assume that all production workers work at least 160 hours per month.)

ANSWER
(a) Production budget
January February March
Units Units Units Units Units Units
Budgeted sales 5,000 5,500 7,000
Closing inventories 550 700 700
Opening inventories (500) (550) (700)
Production 5,050 5,650 7,000

(b) Labour budget

January February March
Production units of Graham 5,050 5,650 7,000
Labour hours ( 4 hrs per unit) (A) 20,200 22,600 28,000
Standard hours available (138  160 hrs) (B) 22,080 22,080 22,080
Overtime required (A) – (B) 0 520 5,920
$ $ $
Basic rate payment ($1,280  138) 176,640 176,640 176,640
Overtime payment (at time and a half) 0
520/160  $1,280  1.50 (W) 6,240
5,920/160  $1,280  1.50 (W) 71,040
Total labour cost 176,640 182,880 247,680

Working
Overtime payments are calculated based on the overtime required. Taking February, for instance,
there are 520 hours of overtime needed for production. This is equivalent to 3.25 workers at 160
hours a month. These are paid at the basic rate plus 50%. Therefore 520/160 × $1,280 ×
1.50 = $6,240.

4 Cash budgets
A cash budget is a detailed budget of cash inflows and outflows incorporating both revenue and capital
items.

A cash budget is thus a statement in which estimated future cash receipts and payments are tabulated
in such a way as to show the forecast cash balance of a business at defined intervals.
Before we look at preparing cash budgets in detail, we need to consider cash and profit and the
differences between them.
A business which fails to make profits will go under in the long term. However, a business which runs
out of cash, even for a couple of months, will fail, despite the fact that it is basically profitable. Why?
If an organisation makes a loss, the value of the business falls and if there are long-term losses the
business may eventually collapse.

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Net profit measures how much the capital of an organisation has increased over a period of time. Profit
is calculated by applying the matching concept, that is to say by matching the costs incurred with the
sales revenue generated during a period.

4.1 The importance of cash

In addition to being profitable, an organisation needs to have enough cash in order to pay for the
following.
 Goods and services
 Capital investment (plant, machinery and so on)
 Labour costs
 Other expenses (rent, rates, taxation and so on)
 Dividends
Net cash flow measures the difference in the payments leaving an organisation's bank account and the
receipts that are paid into the bank account.

4.2 Net profit and net cash flow

Reasons why net profit and net cash flow differ are mainly due to timing differences.
(a) Purchase of non-current assets
Suppose an asset is purchased for $20,000 and depreciation is charged at 10% of the original
cost.
 Cash payment during the year = $20,000 (and this does not affect the statement of profit
or loss)
 Depreciation charge = 10% × $20,000 = $2,000. This is charged to the statement of
profit or loss and will reduce overall profits
(b) Sale of non-current assets
When an asset is sold there is usually a profit or loss on sale. Suppose an asset with a net book
value of $15,000 is sold for $11,000, giving rise to a loss on disposal of $4,000.
 Increase in cash flow during the year = $11,000 sale proceeds. There will be no effect on
the statement of profit or loss
 Loss on sale of non-current assets = $4,000. This will be recorded in the firm's statement
of profit or loss and will reduce overall profits
(c) Matching receipts from receivables and sales invoices raised
If goods are sold on credit, the cash receipts will be the same as the value of the sales(ignoring
early settlement discounts and bad debts). However, receipts may occur in a different period as a
result of the timing of payments.
(d) Matching payments to payables and cost of sales
If materials are bought on credit, the cash payments to suppliers will be the same as the value of
materials purchased. Again the payments may be in different periods due to timing. Materials
purchase are matched against sales in a particular period to calculate profit, demonstrating that
profit and cash flow will differ in a particular period.
(e) Loans, share issues and overdrafts
Cash may be obtained from a transaction which has nothing to do with profit or loss. For
example, an issue of shares or loan stock for cash has no effect on profit but is obviously a source
of cash. Similarly, an increase in bank overdraft or a loan provide a source of cash for payments,
but it are not reported in the statement of profit or loss.
You therefore need to watch out carefully for timing differences between sales being made and cash
being received, and purchases/expenditure and cash payments.

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Suppose that a company buys and resells products. Gross profit from trading and operational cash flows
from trading can be compared as follows.
Profit
Sales – Cost of sales = Profit

Operational cash flow

Cash in – Cash out = Operational cash flow

Notes
1 Cash in = Sales + Opening receivables – Closing receivables
2 Purchases = Cost of sales + Closing inventory – Opening inventory
3 Cash out = Purchases + Opening payables – Closing payables

4.3 Preparing cash budgets

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

Jan Feb Mar

$ $ $
Estimated cash receipts
From accounts payable 14,000 16,500 17,000
From cash sales 3,000 4,000 4,500
Proceeds on disposal of non-current assets 2,200
Total cash receipts 17,000 22,700 21,500

Estimated cash payments

To suppliers of goods 8,000 7,800 10,500
To employees (wages) 3,000 3,500 3,500
Purchase of non-current assets 16,000
Rent and rates 1,000
Other overheads 1,200 1,200 1,200
Repayment of loan 2,500
14,700 28,500 16,200

Net surplus/(deficit) for month 2,300 (5,800) 5,300

Opening cash balance 1,200 3,500 (2,300)
Closing cash balance 3,500 (2,300) 3,000

In this example (where the figures are purely for illustration) the accounts department has calculated
that the cash balance at the beginning of the budget period, 1 January, will be $1,200. Estimates have
been made of the cash which is likely to be received by the business (from cash and credit sales, and
from a planned disposal of non-current assets in February). Similar estimates have been made of cash
due to be paid out by the business (payments to suppliers and employees, payments for rent, rates and
other overheads, payment for a planned purchase of non-current assets in February and a loan
repayment due in January).
From these estimates it is a simple step to calculate the excess of cash receipts over cash payments in
each month. In some months cash payments may exceed cash receipts and there will be a deficit for
the month; this occurs during February in the above example because of the large investment in non-
current assets in that month.
The last part of the cash budget above shows how the business's estimated cash balance can then be
rolled along from month to month. Starting with the opening balance of $1,200 at 1 January a cash
surplus of $2,300 is generated in January. This leads to a closing January balance of $3,500 which
becomes the opening balance for February. The deficit of $5,800 in February throws the business's cash
position into overdraft and the overdrawn balance of $2,300 becomes the opening balance for March.
Finally, the healthy cash surplus of $5,300 in March leaves the business with a favourable cash
position of $3,000 at the end of the budget period.

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4.4 The usefulness of cash budgets

The usefulness of cash budgets is that they enable management to make any forward planning decisions
that may be needed, such as advising their bank of estimated overdraft requirements and strengthening
their credit control procedures to ensure that customers pay more quickly.
The cash budget is one of the most important planning tools that an organisation can use. It shows the
cash effect of all plans made within the budgetary process and therefore its preparation can lead to a
modification of budgets if it shows that there are insufficient cash resources to finance the planned
operations.
It can also give management an indication of potential problems that could arise and allows them the
opportunity to take action to avoid such problems. A cash budget can show four positions. Management
will need to take appropriate action depending on the potential position.

4.5 Potential cash positions

Cash position Appropriate management action

Short-term surplus  Pay suppliers early to obtain discount

 Attempt to increase sales by increasing receivables and inventories
 Make short-term investments

Short-term shortfall  Increase accounts payable

 Reduce receivables
 Arrange an overdraft

Long-term surplus  Make long-term investments

 Expand
 Diversify
 Replace/update non-current assets

Long-term shortfall  Raise long-term finance (such as via issue of share capital)
 Consider shutdown/disinvestment opportunities

QUESTION Cash budget

Tick the boxes to show which of the following should be included in a cash budget.

Include Do not
include
Funds from the receipt of a bank loan
Revaluation of a non-current asset
Receipt of dividends from outside the business
Depreciation of distribution vehicles
Bad debts written off
Share dividend paid

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ANSWER
Any item that is a cash flow will be included. Non-cash items are excluded from a cash budget.

Include Do not
include
Funds from the receipt of a bank loan 
Revaluation of a non-current asset 
Receipt of dividends from outside the business 
Depreciation of distribution vehicles 
Bad debts written off 
Share dividend paid 

4.6 Example: Cash budgets again

Peter Blair has worked for some years as a sales representative, but has recently been made redundant.
He intends to start up in business on his own account, using $15,000 which he currently has invested
with a building society. Peter maintains a bank account showing a small credit balance, and he plans to
approach his bank for the necessary additional finance. Peter asks you for advice and provides the
following additional information.
(a) Arrangements have been made to purchase non-current assets costing $8,000. These will be
paid for at the end of September and are expected to have a five-year life, at the end of which
they will possess a nil residual value.
(b) Inventories costing $5,000 will be acquired on 28 September and subsequent monthly
purchases will be at a level sufficient to replace forecast sales for the month.
(c) Forecast monthly sales are $3,000 for October, $6,000 for November and December, and
$10,500 from January 20X4 onwards.
(d) Selling price is fixed at the cost of inventory plus 50%.
(e) Two months' credit will be allowed to customers but only one month's credit will be received from
suppliers of inventory.
(f) Running expenses, including rent but excluding depreciation of non-current assets, are estimated
at $1,600 per month.
(g) Blair intends to make monthly cash drawings of $1,000.
Required
Prepare a cash budget for the six months to 31 March 20X4.

Solution
The opening cash balance at 1 October will consist of Peter's initial $15,000 less the $8,000 expended
on non-current assets purchased in September. In other words, the opening balance is $7,000. Cash
receipts from credit customers arise two months after the relevant sales.
Payments to suppliers are a little more tricky. We are told that cost of sales is 100/150  sales. Thus for
October cost of sales is 100/150  $3,000 = $2,000. These goods will be purchased in October but not
paid for until November. Similar calculations can be made for later months. The initial inventory of $5,000 is
purchased in September and consequently paid for in October.
Depreciation is not a cash flow and so is not included in a cash budget.
The cash budget can now be constructed.

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CASH BUDGET FOR THE SIX MONTHS ENDING 31 MARCH 20X4

Oct Nov Dec Jan Feb Mar
$ $ $ $ $ $
Payments
Suppliers 5,000 2,000 4,000 4,000 7,000 7,000
Running expenses 1,600 1,600 1,600 1,600 1,600 1,600
Drawings 1,000 1,000 1,000 1,000 1,000 1,000
7,600 4,600 6,600 6,600 9,600 9,600
Receipts
Receivables – – 3,000 6,000 6,000 10,500
Surplus/(shortfall) (7,600) (4,600) (3,600) (600) (3,600) 900
Opening balance 7,000 (600) (5,200) (8,800) (9,400) (13,000)
Closing balance (600) (5,200) (8,800) (9,400) (13,000) (12,100)

QUESTION ABC Co
The following information is available for ABC Co.
May Jun
$ $
Budgeted sales 30,000 40,000
Gross profit as a percentage of sales 30% 30%
Closing trade payables as a percentage of cost of sales 50 50%
Opening inventory Nil Nil
Closing inventory Nil Nil
How much money should be budgeted for supplier payments in June?
A $10,500
B $14,000
C $24,500
D $30,000

ANSWER
C
May Jun
$ $
Sales 30,000 40,000
Gross profit (@ 30%) 9,000 12,000
Cost of sales (sales – GP) 21,000 28,000
Closing trade payables (@ 50%) 10,500 14,000

$
June opening payables 10,500
Increase in amounts owing (COS) 28,000
June closing payables (14,000)
Amount paid in June 24,500

EXAM FOCUS POINT

Make sure that you read the article written by Beverley Jay on cash budgets, which appeared in the
July 2012 edition of Student Accountant. Go to:
www.accaglobal.com/gb/en/student/exam-support-resources/fundamentals-exams-study-
resources/f2/technical-articles/cash-budgets.html

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5 Budgeted statement of profit or loss and statement of financial

position
As well as wishing to forecast its cash position, a business might want to estimate its profitability and its
financial position for a coming period. This would involve the preparation of a budgeted statement of
profit or loss and statement of financial position, along with the cash budgets which form the master
budget.
Just like historical financial statements, budgeted accounts are based on the accruals concept. If you
keep this point in mind you will often be able to cut through the deliberately confusing detail of
examination questions to prepare an answer very quickly.

5.1 Example: Preparing a budgeted statement of profit or loss and

statement of financial position
Using the information below, you are required to prepare Peter Blair's budgeted statement of profit or
loss for the six months ending on 31 March 20X4 and a budgeted statement of financial position as at
that date.

5.1.1 Example
Peter Blair has worked for some years as a sales representative, but has recently been made redundant.
He intends to start up in business on his own account, using $15,000 which he currently has invested
with a building society. Peter maintains a bank account showing a small credit balance, and he plans to
approach his bank for the necessary additional finance. Peter asks you for advice and provides the
following additional information.
(a) Arrangements have been made to purchase non-current assets costing $8,000. These will be
paid for at the end of September 20X3 and are expected to have a five-year life, at the end of
which they will possess a nil residual value.
(b) Inventories costing $5,000 will be acquired on 28 September 20X3 and subsequent monthly
purchases will be at a level sufficient to replace forecast sales for the month.
(c) Forecast monthly sales are $3,000 for October, $6,000 for November and December, and
$10,500 from January 20X4 onwards.
(d) Selling price is fixed at the cost of stock plus 50%.
(e) Two months' credit will be allowed to customers but only one month's credit will be received from
suppliers of inventory.
(f) Running expenses, including rent but excluding depreciation of non-current assets, are estimated
at $1,600 per month.
(g) Blair intends to make monthly cash drawings of $1,000.
(h) Peter has prepared a cash budget for his bank manager. This shows a closing bank balance of
$12,100 outdrawn at 31 March 20X4.
Required
Prepare a budgeted statement of profit or loss and statement of financial position for the six months to
31 March 20X4.

5.2 Solution
5.2.1 Notes to help you
Payments to suppliers could be a little tricky. We are told that selling price = cost of sales  150% =
cost of sales  150/100, and so cost of sales is 100/150  sales. Thus for March cost of sales is
100/150  $10,500 = $7,000. These goods will be purchased in March but not paid for until April.

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The statement of profit or loss

The statement of profit or loss is straightforward. The first figure is sales, which can be computed very
easily from the information in the question. It is sufficient to add up the monthly sales figures given
there; for the statement of profit or loss there is no need to worry about any closing receivables.
Similarly, cost of sales is calculated directly from the information on gross margin contained in the
question.
Depreciation is over five years so the depreciation rate is 20%.
FORECAST TRADING AND STATEMENT OF PROFIT OR LOSS
FOR THE SIX MONTHS ENDING 31 MARCH 20X4
$ $
Sales (3,000 + (2  6,000) + (3  10,500)) 46,500
Cost of sales (2/3  $46,500) 31,000
Gross profit 15,500
Expenses
Running expenses (6  $1,600) 9,600
Depreciation ($8,000  20%  6/12) 800
10,400
Net profit 5,100

Items will be shown in the statement of financial position as follows.

(a) Inventory will comprise the initial purchases of $5,000 (as month-end inventory levels are
constant).
(b) Receivables will comprise sales made in February and March (not paid until April and May
respectively).
(c) Payables will comprise purchases made in March (not paid for until April).
(d) The bank overdraft is the closing cash figure computed in the cash budget.
FORECAST STATEMENT OF FINANCIAL POSITION AT 31 MARCH 20X4
Assets $ $
Non-current assets $(8,000 – 800 depreciation) 7,200
Current assets
Inventories 5,000
Receivables (2  $10,500) 21,000
26,000
33,200
Equity and liabilities
Proprietor's interest
Capital introduced 15,000
Profit for the period 5,100
Less drawings 6,000
Deficit retained (900)
14,100
Current liabilities
Bank overdraft 12,100
Trade payables (March purchases) 7,000
19,100
33,200

Budget questions are often accompanied by a large amount of sometimes confusing detail. This should
not blind you to the fact that many figures can be entered very simply from the logic of the trading
situation described. For example, in the case of Blair you might feel tempted to begin a T-account to
compute the closing receivables figure. This kind of working is rarely necessary, since you are told that
receivables take two months to pay. Closing receivables will equal total credit sales in the last two
months of the period.
Similarly, you may be given a simple statement that a business pays rates at $1,500 a year, followed by
a lot of detail to enable you to calculate a prepayment at the beginning and end of the year. If you are

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preparing a budgeted statement of profit or loss for the year, do not lose sight of the fact that the rates
expense can be entered as $1,500 without any calculation at all.

6 The master budget

When all the functional budgets have been prepared, they are summarised and consolidated into a
master budget which consists of the budgeted statement of profit or loss, budgeted statement of
financial position and cash budget and which provides the overall picture of the planned performance for
the budget period.

The master budget consists of a budgeted statement of profit or loss, a budgeted statement of financial
position and a cash budget.

6.1 Example: A master budget

Plagued Engineering produces two products, Niks and Args. The budget for the forthcoming year to 31
March 20X8 is to be prepared. Expectations for the forthcoming year include the following.
(a) PLAGUED ENGINEERING
STATEMENT OF FINANCIAL POSITION AS AT 1 APRIL 20X7
Assets $ $
Non-current assets
Land and buildings 45,000
Plant and equipment at cost 187,000
Less accumulated depreciation 75,000
112,000
Current assets
Raw materials 7,650
Finished goods 23,600
Receivables 19,500
Cash 4,300
55,050
212,050
Equity and liabilities
Capital and assets
Share capital 150,000
Accumulated profits 55,250
205,250
Current liabilities
Payables 6,800
212,050

(b) Finished products

The sales director has estimated the following.
Niks Args
(i) Demand for the company's products 4,500 units 4,000 units
(ii) Selling price per unit $32 $44
(iii) Closing inventory of finished products at 31 March 20X8 400 units 1,200 units
(iv) Opening inventory of finished products at 1 April 20X7 900 units 200 units
(v) Unit cost of this opening inventory $20 $28
(vi) Amount of plant capacity required for each unit of product
Machining 15 min 24 min
Assembling 12 min 18 min

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(vii) Raw material content per unit of each product

Material A 1.5 kilos 0.5 kilos
Material B 2.0 kilos 4.0 kilos
(viii) Direct labour hours required per unit of each product 6 hours 9 hours
Finished goods are valued on a first in, first out (FIFO) basis at full production cost.
(c) Raw materials
Material A Material B
(i) Closing inventory requirement in kilos at 31 March 20X8 600 1,000
(ii) Opening inventory at 1 April 20X7 in kilos 1,100 6,000
(iii) Budgeted cost of raw materials per kilo $1.50 $1.00
Actual costs per kilo of opening inventories are as budgeted cost for the coming year.
(d) Direct labour
The standard wage rate of direct labour is $1.60 per hour.
(e) Production overhead
Production overhead is absorbed on the basis of machining hours, with separate absorption rates
for each department. The following overheads are anticipated in the production cost centre
budgets.
Machining Assembling
department department
$ $
Supervisors' salaries 10,000 9,150
Power 4,400 2,000
Maintenance and running costs 2,100 2,000
Consumables 3,400 500
General expenses 19,600 5,000
39,500 18,650

Depreciation is taken at 5% straight line on plant and equipment. A machine costing the
company $20,000 is due to be installed on 1 October 20X7 in the machining department, which
already has machinery installed to the value of $100,000 (at cost). Land worth $180,000 is to
be acquired in December 20X7.
(f) Selling and administration expenses
$
Sales commissions and salaries 14,300
Travelling and distribution 3,500
Office salaries 10,100
General administration expenses 2,500
30,400

(g) There is no opening or closing work in progress and inflation should be ignored.
(h) Budgeted cash flows are as follows.
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Receipts from customers 70,000 100,000 100,000 40,000
Payments:
Materials 7,000 9,000 10,000 5,000
Wages 33,000 20,000 11,000 15,000
Other costs and expenses 10,000 100,000 205,000 5,000
Required
Prepare the following for the year ended 31 March 20X8 for Plagued Engineering Ltd.
(a) Sales budget
(b) Production budget (in quantities)
(c) Plant utilisation budget
(d) Direct materials usage budget

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(e) Direct labour budget

(f) Factory overhead budget
(g) Computation of the factory cost per unit for each product
(h) Direct materials purchases budget
(i) Cost of goods sold budget
(j) Cash budget
(k) A budgeted statement of profit or loss and statement of financial position

6.2 Solution
(a) Sales budget
Product Market demand Selling price Sales value
Units $ $
Niks 4,500 32.00 144,000
Args 4,000 44.00 176,000
320,000
(b) Production budget
Niks Args
Units Units
Sales requirement 4,500 4,000
(Decrease)/increase in finished goods inventory (500) 1,000
Production requirement 4,000 5,000
(c) Plant utilisation budget
Machining Assembling
Product Units Hours per unit Total hours Hours per unit Total hours
Niks 4,000 0.25 1,000 0.20 800
Args 5,000 0.40 2,000 0.30 1,500
3,000 2,300
(d) Direct materials usage budget
Material A Material B
kg kg
Required for production:
Niks: 4,000  1.5 kilos 6,000 –
4,000  2.0 kilos – 8,000
Args: 5,000  0.5 kilos 2,500 –
5,000  4.0 kilos – 20,000
Material usage 8,500 28,000

Unit cost $1.50 per kilo $1.00 per kilo

Cost of materials used $12,750 $28,000
(e) Direct labour budget
Hours
required
Product Production per unit Total hours Rate per hour Cost
Units $ $
Niks 4,000 6 24,000 1.60 38,400
Args 5,000 9 45,000 1.60 72,000
Total direct wages 110,400

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(f) Production overhead budget

Machining dept Assembling dept
$ $
Production overhead allocated and apportioned
(excluding depreciation) 39,500 18,650
Depreciation costs
(i) Existing plant
(5% of $100,000 in machining) 5,000
(5% of $87,000 in assembly) 4,350
Machining dept Assembling dept
$ $
(ii) Proposed plant
(5% of 6/12  $20,000) 500
Total production overhead 45,000 23,000
Total machine hours (see (c)) 3,000 hrs 2,300 hrs
Absorption rate per machine hour $15 $10

(g) Cost of finished goods

Niks Args
$ $
Direct material A 1.5 kg  $1.50 2.25 0.5 kg  $1.50 0.75
B 2.0 kg  $1.00 2.00 4.0 kg  $1.00 4.00
Direct labour 6 hrs  $1.60 9.60 9 hrs  $1.60 14.40
Production overhead
Machining department 15 mins at $15 per hr 3.75 24 min at $15 per hr 6.00
Assembling department 12 mins at $10 per hr 2.00 18 mins at $10 per hr 3.00
Production cost per unit 19.60 28.15
(h) Direct material purchases budget
A B
kg kg
Closing inventory required 600 1,000
Production requirements 8,500 28,000
9,100 29,000
Less opening inventory 1,100 6,000
Purchase requirements 8,000 23,000
Cost per unit $1.50 $1.00
Purchase costs $12,000 $23,000
(i) Cost of goods sold budget (using FIFO)
Niks Args
Units $ Units $
Opening inventories 900 ( 20.00) 18,000 200 ( 28.00) 5,600
Cost of production 4,000 ( 19.60) 78,400 5,000 ( 28.15) 140,750
4,900 96,400 5,200 146,350
Less closing inventories 400 ( 19.60) 7,840 1,200 ( 28.15) 33,780
Cost of sales 4,500 88,560 4,000 112,570

Notes
1 The cost of sales of Niks = 900 units at $20 each plus 3,600 units at $19.60 each.
2 The cost of sales of Args = 200 units at $28 each plus 3,800 units at $28.15 each.

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CHAPTER 16 // THE BUDGETARY PROCESS

(j) MASTER BUDGET

Cash budget for year to 31.3.X8
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
$ $ $ $ $
Receipts 70,000 100,000 100,000 40,000 310,000
Payments
Materials 7,000 9,000 10,000 5,000 31,000
Labour 33,000 20,000 11,000 15,000 79,000
Other costs and expenses 10,000 100,000 205,000 5,000 320,000
50,000 129,000 226,000 25,000 430,000
Receipts less payments 20,000 (29,000) (126,000) 15,000
(120,000)
Opening cash balance b/f 4,300 24,300 (4,700) (130,700) 4,300
Closing cash balance c/f 24,300 (4,700) (130,700) (115,700) (115,700)

Budgeted statement of profit or loss for year to 31.3.X8

Niks Args Total
$ $ $
Sales 144,000 176,000 320,000
Less cost of sales 88,560 112,570 201,130
Gross profit 55,440 63,430 118,870
Less selling and administration 30,400
Net profit 88,470

Note. There will be no under-/over-absorbed production overhead in the budgeted statement of

profit or loss.
BUDGETED STATEMENT OF FINANCIAL POSITION AT 31.3.X8
$ $ $
Assets
Non-current assets
Land and buildings (W1) 225,000
Plant and equipment at cost (W2) 207,000
Less accumulated depreciation (W3) 84,850
122,150
347,150
Current assets
Raw materials (W4) 1,900
Finished goods (W5) 41,620
Receivables (W6) 29,500
73,020
420,170
Equity and liabilities
Capital and reserves
Share capital 150,000
Retained profit (W9) 143,720
293,720
Current liabilities
Payables (W7) 10,750
Bank overdraft (W8) 115,700
126,450
420,170

Workings
1 $
Opening balance at 1.4.X7 45,000
Addition 180,000
Cost at 31.3.X8 225,000

2 $
Opening balance at 1.4.X7 187,000
Addition 20,000
Cost at 31.3.X8 207,000

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$
3
Opening balance at 1.4.X7 75,000
Addition in period 5,000
((f)(i) and (ii) of solution) 4,350
Accumulated depreciation at 31.3.X8 500
84,850

4 A B Total
Closing inventory (kg) 600 1,000
Cost per kg  $1.50  $1.00
Value of closing inventory $900 $1,000 $1,900

5 Niks Args Total

Closing inventory (units) 400 1,200
Cost per unit ((g) of solution)  $19.60  $28.15
$7,840 $33,780 $41,620

6 $
Opening balance 19,500
Sales ((a) of solution) 320,000
Receipts (from cash budget) (310,000)
Closing balance 29,500

7 $ $
Opening balance at 1.4.X7 6,800
Land 180,000
Machine 20,000
Labour 110,400
Production overhead 39,500
18,650
58,150
Materials 12,000
23,000
35,000
Expenses 30,400
433,950
440,750
Cash payments (from cash (430,000)
budget)
Closing balance at 31.3.X8 10,750

8 From cash budget $115,750 overdrawn

9 $
Retained profit b/f 55,250
Profit for year 88,470
Retained profit c/f 143,720

QUESTION Master budget

Of what does the master budget comprise?
A The budgeted statement of profit or loss
B The budgeted cash flow, budgeted statement of profit or loss and budgeted statement of financial
position
C The entire set of budgets prepared
D The budgeted cash flow

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CHAPTER 16 // THE BUDGETARY PROCESS

ANSWER
B This is basic knowledge.

PER performance objective 13 requires you to 'Coordinate, prepare and use budgets, selecting suitable
budgeting models'.
The knowledge covered in this chapter will help you demonstrate your competence in this area.

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PART C: BUDGETING

CHAPTER ROUNDUP

 The budget manual is a collection of instructions governing the responsibilities of persons and the
procedures, forms and records relating to the preparation and use of budgetary data.
 Managers responsible for preparing budgets should ideally be the managers responsible for carrying out
the budget.
 The budget committee is the co-ordinating body in the preparation and administration of budgets.
 The budget preparation process is as follows.
– Communicating details of the budget policy and budget guidelines
– Determining the factor that restricts output
– Preparation of the sales budget
– Initial preparation of budgets
– Negotiation of budgets with superiors
– Co-ordination and review of budgets
– Final acceptance of the budgets
– Budget review
 The principal budget factor should be identified at the beginning of the budgetary process, and the
budget for this is prepared before all the others.
 Once prepared, the functional budgets must be reviewed to ensure they are consistent with one another.

 The master budget consists of a budgeted statement of profit or loss, a budgeted statement of financial
position and a cash budget.

1 What is meant by the term principal budget factor?

QUICK QUIZ

2 What are the eight steps in the preparation of a budget?

3 How can a shortfall in capacity be overcome?
4 The master budget consists of the sales budget and the cash budget. True or false?
5 Which of the following are functional budgets?
I Purchasing budget
II Cash budget
III Sales budget
IV Marketing cost budget
A I and II
B None of the above
C All of the above
D I, III and IV
6 When preparing a material purchases budget, what is the quantity to be purchased?
A Materials required for production – opening inventory of materials – closing inventory of materials
B Materials required for production – opening inventory of materials + closing inventory of
materials
C Opening inventory of materials – materials required for production – closing inventory of materials
D Opening inventory of materials + closing inventory of materials – materials required for
production

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1 A principal budget factor is the factor that limits an organisation's performance for a given period.
ANSWERS TO QUICK QUIZ

2 (a) Communicating details of the budget policy and budget guidelines

(b) Determining the factor that restricts output
(c) Preparation of the sales budget
(d) Initial preparation of budgets
(e) Negotiation of budgets with superiors
(f) Co-ordination of budgets
(g) Final acceptance of the budgets
(h) Budget review
3 Consideration should be given to overtime, subcontracting, machine hire and/or new sources of
materials.
4 False. The master budget consists of the budgeted statement of profit or loss, the budgeted statement of
financial position and the cash budget.
5 D A functional budget is a budget of income and/or expenditure for a particular department or
process. A cash budget does not relate to a function.
6 B It may help you to think in terms of the inputs to a material purchases budget (opening inventory
and purchases) and the outputs (closing inventory and the quantity used in production). The
inputs should equal the outputs. Any one of the inputs or outputs can then be determined by
manipulating opening inventory + purchases = closing inventory + used in production.

Now try ...

Attempt the questions below from the Practice Question Bank

Q71 – Q75

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PART C: BUDGETING

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C H A P T E R

This chapter looks at how to put budgets into action.

Budgets can be motivational but they can also produce Making budgets work
undesirable negative reactions. Participative budgeting
can help to avoid a negative reaction but there are
disadvantages to this approach as well.

SYLLABUS
TOPIC LIST REFERENCE

1 Behavioural implications of budgeting C7(a), (b)

2 Participation and performance evaluation C7(b), (e), (f)
3 The use of budgets as targets C7(b), (c)
4 The management accountant and motivation C7(b), (d)

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PART C: BUDGETING

Study Guide Intellectual level

C Budgeting

7 Behavioural aspects of budgeting

(a) Explain the importance of motivation in performance

K
management.
(b) Identify factors in a budgetary planning and control system
S
that influence motivation.
(c) Explain the impact of targets upon motivation. K
(d) Discuss managerial incentive schemes. K
(e) Discuss the advantages and disadvantages of a
K
participative approach to budgeting.
(f) Explain top down, bottom up approaches to budgeting. K

1 Behavioural implications of budgeting

Used correctly, a budgetary control system can motivate but it can also produce undesirable negative
reactions.

The purpose of a budgetary control system is to assist management in planning and controlling the
resources of their organisation by providing appropriate control information. The information will only be
valuable, however, if it is interpreted correctly and used purposefully by managers and employees.
The correct use of control information therefore depends not only on the content of the information itself,
but also on the behaviour of its recipients. This is because control in business is exercised by people.
Their attitude to control information will colour their views on what they should do with it and a number
of behavioural problems can arise.
(a) The managers who set the budget or standards are often not the managers who are then made
responsible for achieving budget targets.
(b) The goals of the organisation as a whole, as expressed in a budget, may not coincide with the
personal aspirations of individual managers.
(c) Control is applied at different stages by different people. A supervisor might get weekly control
reports, and act on them; their superior might get monthly control reports, and decide to take
different control action. Different managers can get in each others' way, and resent the
interference from others.

1.1 Motivation
Motivation is what makes people behave in the way that they do. It comes from individual attitudes, or
group attitudes. Individuals will be motivated by personal desires and interests. These may be in line
with the objectives of the organisation, and some people 'live for their jobs'. Other individuals see their
job as a chore, and their motivations will be unrelated to the objectives of the organisation they work for.
It is therefore vital that the goals of management and the employees harmonise with the goals of the
organisation as a whole. This is known as goal congruence. Although obtaining goal congruence is
essentially a behavioural problem, it is possible to design and run a budgetary control system which
will go some way towards ensuring that goal congruence is achieved. Managers and employees must
therefore be favourably disposed towards the budgetary control system so that it can operate efficiently.
The management accountant should therefore try to ensure that employees have positive attitudes
towards setting budgets, implementing budgets (that is, putting the organisation's plans into practice)
and feedback of results (control information). If this desirable state of affairs does not exist, the
organisation is at risk of underperforming as a result of dysfunctional decision making.

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CHAPTER 17 // MAKING BUDGETS WORK

Goal congruence is the state which leads individuals or groups to take actions that are in their self-
interest and also in the best interest of the organisation. (CIMA Official Terminology)
Dysfunctional decision making occurs when goal congruence does not exist or is impaired. Managers
and others take decisions that promote their self-interest at the expense of the interest of the
organisation.

1.1.1 Poor attitudes when setting budgets

If managers are involved in preparing a budget, poor attitudes or hostile behaviour towards the budgetary
control system can begin at the planning stage.
(a) Managers may complain that they are too busy to spend much time on budgeting.
(b) They may build 'slack' into their expenditure estimates.
(c) They may argue that formalising a budget plan on paper is too restricting and that managers
should be allowed flexibility in the decisions they take.
(d) They may set budgets for their budget centre and not co-ordinate their own plans with those of
other budget centres.
(e) They may base future plans on past results, instead of using the opportunity for formalised
planning to look at alternative options and new ideas.
On the other hand, managers may not be involved in the budgeting process. Organisational goals may
not be communicated to them and they might have their budget decided for them by senior
management or an administrative decision. It is hard for people to be motivated to achieve targets set
by someone else.

1.1.2 Poor attitudes when putting plans into action

Poor attitudes also arise when a budget is implemented.
(a) Managers might put in only just enough effort to achieve budget targets, without trying to beat
targets.
(b) A formal budget might encourage rigidity and discourage flexibility.
(c) Short-term planning in a budget can draw attention away from the longer-term consequences of
decisions.
(d) There might be minimal co-operation and communication between managers.
(e) Managers will often try to make sure that they spend up to their full budget allowance, and do
not overspend, so that they will not be accused of having asked for too much spending allowance
in the first place.

1.1.3 Poor attitudes and the use of control information

The attitude of managers towards the accounting control information they receive might reduce the
information's effectiveness.
(a) Management accounting control reports could well be seen as having a relatively low priority in
the list of management tasks. Managers might take the view that they have more pressing jobs
on hand than looking at routine control reports.
(b) Managers might resent control information; they may see it as part of a system of trying to find
fault with their work. This resentment is likely to be particularly strong when budgets or
standards are imposed on managers without allowing them to participate in the budget-setting
process.
(c) If budgets are seen as pressure devices to push managers into doing better, control reports will
be resented.

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PART C: BUDGETING

(d) Managers may not understand the information in the control reports because they are unfamiliar
with accounting terminology or principles.
(e) Managers might have a false sense of what their objectives should be. A production manager
might consider it important to maintain quality standards regardless of cost. They would then
dismiss adverse expenditure variances as inevitable and unavoidable.
(f) If there are flaws in the system of recording actual costs, managers will dismiss control
information as unreliable.
(g) Control information might be received weeks after the end of the period to which it relates, in
which case managers might regard it as out of date and no longer useful.
(h) Managers might be held responsible for variances outside their control.
It is therefore obvious that accountants and senior management should try to implement systems that
are acceptable to budget holders and which produce positive effects.

1.1.4 Pay as a motivator

Many researchers agree that pay can be an important motivator, when there is a formal link between higher
pay (or other rewards, such as promotion) and achieving budget targets. Individuals are likely to work harder
to achieve budget targets if they know that they will be rewarded for their successful efforts. There are,
however, problems with using pay as an incentive.
(a) A serious problem that can arise is that formal reward and performance evaluation systems can
encourage dysfunctional behaviour. Many investigations have noted the tendency of managers to
pad their budgets either in anticipation of cuts by superiors or to make the subsequent variances
more favourable. And there are numerous examples of managers making decisions in response to
performance indices, even though the decisions are contrary to the wider purposes of the
organisation.
(b) The targets must be challenging, but fair, otherwise individuals will become dissatisfied. Pay can
be a demotivator as well as a motivator!

2 Participation and performance evaluation

There are basically two ways in which a budget can be set: from the top down (imposed budget) or from
the bottom up (participatory budget). Many writers refer to a third style (negotiated). There are three
ways of using budgetary information to evaluate managerial performance (budget constrained style,
profit conscious style, non-accounting style).

2.1 Participation
It has been argued that participation in the budgeting process will improve motivation and so will improve
the quality of budget decisions and the efforts of individuals to achieve their budget targets (although
obviously this will depend on the personality of the individual, the nature of the task (narrowly defined or
flexible) and the organisational culture).
There are basically two ways in which a budget can be set: from the top down (imposed budget) or from
the bottom up (participatory budget).

2.2 Imposed style of budgeting

An imposed/top-down budget is 'A budget allowance which is set without permitting the ultimate
budget holder to have the opportunity to participate in the budgeting process'.
(CIMA Official Terminology)

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In this approach to budgeting, top management prepare a budget with little or no input from operating
personnel which is then imposed on the employees who have to work to the budgeted figures.
The times when imposed budgets are effective
(a) In newly formed organisations
(b) In very small businesses
(c) During periods of economic hardship
(d) When operational managers lack budgeting skills
(e) When the organisation's different units require precise co-ordination
There are, of course, advantages and disadvantages to this style of setting budgets.
(a) Advantages
(i) Strategic plans are likely to be incorporated into planned activities.
(ii) They enhance the co-ordination between the plans and objectives of divisions.
(iii) They use senior management's awareness of total resource availability.
(iv) They decrease the input from inexperienced or uninformed lower-level employees.
(v) They decrease the period of time taken to draw up the budgets.
(b) Disadvantages
(i) Dissatisfaction, defensiveness and low morale among employees. It is hard for people to
be motivated to achieve targets set by somebody else.
(ii) The feeling of team spirit may disappear.
(iii) The acceptance of organisational goals and objectives could be limited.
(iv) The feeling of the budget as a punitive device could arise.
(v) Managers who are performing operations on a day to day basis are likely to have a better
understanding of what is achievable.
(vi) Unachievable budgets could result if consideration is not given to local operating and
political environments. This applies particularly to overseas divisions.
(vii) Lower-level management initiative may be stifled.

2.3 Participative style of budgeting

Participative/bottom-up budgeting is 'A budgeting system in which all budget holders are given the
opportunity to participate in setting their own budgets'. (CIMA Official Terminology)

In this approach to budgeting, budgets are developed by lower-level managers who then submit the
budgets to their superiors. The budgets are based on the lower-level managers' perceptions of what is
achievable and the associated necessary resources.

QUESTION Participative budgets

In what circumstances might participative budgets not be effective?
A In centralised organisations
B In well-established organisations
C In very large businesses
D During periods of economic affluence

ANSWER
The correct answer is A.
An imposed budget is likely to be most effective in a centralised organisation.
As well as in the circumstances in B, C and D, participative budgets are effective when operational
management have strong budgeting skills and when the organisation's different units act autonomously.

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Advantages of participative budgets

(a) They are based on information from employees most familiar with the department.
(b) Knowledge spread across several levels of management is pulled together.
(c) Morale and motivation is improved.
(d) They increase operational managers' commitment to organisational objectives.
(e) In general they are more realistic.
(f) Co-ordination between units is improved.
(g) Specific resource requirements are included.
(h) Senior managers' overview is mixed with operational level details.
(i) Individual managers' aspiration levels are more likely to be taken into account.
Disadvantages of participative budgets
(a) They consume more time.
(b) Changes implemented by senior management may cause dissatisfaction.
(c) Budgets may be unachievable if managers are not qualified to participate.
(d) They may cause managers to introduce budgetary slack and budget bias.
(e) They can support 'empire building' by subordinates.
(f) An earlier start to the budgeting process could be required.
(g) Managers may set 'easy' budgets to ensure that they are achievable.

2.4 Negotiated style of budgeting

A negotiated budget is 'A budget in which budget allowances are set largely on the basis of
negotiations between budget holders and those to whom they report'. (CIMA Official Terminology)

At the two extremes, budgets can be dictated from above or simply emerge from below but, in practice,
different levels of management often agree budgets by a process of negotiation. In the imposed budget
approach, operational managers will try to negotiate with senior managers the budget targets which they
consider to be unreasonable or unrealistic. Likewise, senior management usually review and revise
budgets presented to them under a participative approach through a process of negotiation with lower
level managers. Final budgets are therefore most likely to lie between what top management would
really like and what junior managers believe is feasible. The budgeting process is therefore a
bargaining process and it is this bargaining which is of vital importance, determining whether the
budget is an effective management tool or simply a clerical device.

2.5 Performance evaluation

A very important source of motivation to perform well (to achieve budget targets, perhaps, or to
eliminate variances) is, not surprisingly, being kept informed about how actual results are progressing,
and how actual results compare with targets. Individuals should not be kept in the dark about their
performance.
The information fed back about actual results should have the qualities of good information.

QUESTION Good information

Cast your mind back to your earlier studies. Which of the following is not a quality of good information?
A Relevant
B Complete
C Timely
D Cheap

ANSWER
The correct answer is D.
Good information is not necessarily cheap. However, the cost of providing it should be less than the
value of the benefits it provides.

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Here are the qualities of good information.

(a) Relevance (f) Completeness
(b) Accuracy (g) Clarity
(c) Inspires confidence (h) Appropriately communicated (channel and
recipient)
(d) Timely
(i) Manageable volume
(e) Cost of provision less than the value of benefits
provided

2.6 Features of feedback

(a) Reports should be clear and comprehensive.
(b) The 'exception principle' should be applied so that significant variances are highlighted for
investigation.
(c) Reports should identify the controllable costs and revenues, which are the items that can be
directly influenced by the manager who receives the report. It can be demotivating if managers
feel that they are being held responsible for items which are outside their control and which they
are unable to influence.
(d) Reports should be timely, which means they must be produced in good time to allow the
individual to take control action before any adverse results get much worse.
(e) Information should be accurate (although only accurate enough for its purpose, as there is no
need to go into unnecessary detail for pointless accuracy).
(f) Reports should be communicated to the manager who has responsibility and authority to act on
the matter.
Surprisingly, research evidence suggests that all too often accounting performance measures lead to a
lack of goal congruence. Managers seek to improve their performance on the basis of the indicator used,
even if this is not in the best interests of the organisation as a whole. For example, a production
manager may be encouraged to achieve and maintain high production levels and to reduce costs,
particularly if their bonus is linked to these factors. Such a manager is likely to be highly motivated. But
the need to maintain high production levels could lead to high levels of slow-moving inventory, resulting
in an adverse effect on the company's cash flow.
The impact of an accounting system on managerial performance depends ultimately on how the
information is used. Research by Hopwood has shown that there are three distinct ways of using
budgetary information to evaluate managerial performance.

Style of evaluation Comment

Budget 'The manager's performance is primarily evaluated upon the basis of his ability to
constrained continually meet the budget on a short-term basis. This criterion of performance
is stressed at the expense of other valued and important criteria and the manager
will receive unfavourable feedback from his superior if, for instance, his actual
costs exceed the budgeted costs, regardless of other considerations.'

Profit conscious 'The manager's performance is evaluated on the basis of his ability to increase
the general effectiveness of his unit's operations in relation to the long-term
purposes of the organisation. For instance, at the cost centre level one important
aspect of this ability concerns the attention which he devotes to reducing
long-run costs. For this purpose, however, the budgetary information has to be
used with great care in a rather flexible manner.'

Non-accounting 'The budgetary information plays a relatively unimportant part in the superior's
evaluation of the manager's performance.'

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A summary of the effects of the three styles of evaluation is as follows.

Style of evaluation
Budget Profit Non-
constrained conscious accounting
Involvement with costs HIGH HIGH LOW
Job-related tension HIGH MEDIUM MEDIUM
Manipulation of the accounting reports (bias) EXTENSIVE LITTLE LITTLE
Relations with the supervisor POOR GOOD GOOD
Relations with colleagues POOR GOOD GOOD
Research has shown no clear preference for one style over another.

2.7 Budgetary slack

Budgetary slack is the difference between the minimum necessary costs and the costs built into the
budget or actually incurred.

In the process of preparing budgets, managers might deliberately overestimate costs and underestimate
sales, so that they will not be blamed in the future for overspending and poor results.
In controlling actual operations, managers must then ensure that their spending rises to meet their
budget, otherwise they will be 'blamed' for careless budgeting.
A typical situation is for a manager to pad the budget and waste money on non-essential expenses so
that they use all their budget allowances. The reason behind their action is the fear that unless the
allowance is fully spent it will be reduced in future periods thus making their job more difficult, as the
future reduced budgets will not be so easy to attain. Because inefficiency and slack are allowed for in
budgets, achieving a budget target means only that costs have remained within the accepted levels of
inefficient spending.
Conversely, it has been noted that, after a run of mediocre results, some managers deliberately
overstate revenues and understate cost estimates, no doubt feeling the need to make an immediate
favourable impact by promising better performance in the future. They may merely delay problems,
however, as the managers may well be censured when they fail to hit these optimistic targets.

3 The use of budgets as targets

In certain situations it is useful to prepare an expectations budget and an aspirations budget.

Management and the management accountant require strategies and methods for dealing with the
tensions and conflict resulting from the conflicting purposes of a budget.

Once decided, budgets become targets. As targets, they can motivate managers to achieve a high level
of performance. But how difficult should targets be? And how might people react to targets of differing
degrees of difficulty in achievement?
(a) There is likely to be a demotivating effect where an ideal standard of performance is set, because
adverse efficiency variances will always be reported.
(b) A low standard of efficiency is also demotivating, because there is no sense of achievement in
attaining the required standards, and there will be no impetus for employees to try harder to do
better than this.
(c) A budgeted level of attainment could be 'normal': that is, the same as the level that has been
achieved in the past. Arguably, this level will be too low. It might encourage budgetary slack.
It has been argued that each individual has a personal 'aspiration level'. This is a level of performance
in a task with which the individual is familiar, which the individual undertakes for themselves to reach.
This aspiration level might be quite challenging and if individuals in a work group all have similar
aspiration levels it should be possible to incorporate these levels within the official operating standards.

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CHAPTER 17 // MAKING BUDGETS WORK

However, some care should be taken in applying this.

(a) If a manager's tendency to achieve success is stronger than the tendency to avoid failure,
budgets with targets of intermediate levels of difficulty are the most motivating, and stimulate a
manager to better performance levels. Budgets that are either too easy to achieve or too difficult
are demotivating, and managers given such targets achieve relatively low levels of performance.
(b) A manager's tendency to avoid failure might be stronger than the tendency to achieve success.
(This is likely in an organisation in which the budget is used as a pressure device on subordinates
by senior managers.) Managers might then be discouraged from trying to achieve budgets of
intermediate difficulty and tend to avoid taking on such tasks, resulting in poor levels of
performance, worse than if budget targets were either easy or very difficult to achieve.
It has therefore been suggested that in a situation where budget targets of an intermediate difficulty are
motivating, such targets ought to be set if the purpose of budgets is to motivate; however, although
budgets which are set for motivational purposes need to be stated in terms of aspirations rather than
expectations, budgets for planning and decision purposes need to be stated in terms of the best
available estimate of expected actual performance. The solution might therefore be to have two budgets.
(a) A budget for planning and decision making based on reasonable expectations
(b) A second budget for motivational purposes, with more difficult targets of performance (that is,
targets of an intermediate level of difficulty)
These two budgets might be called an 'expectations budget' and an 'aspirations budget' respectively.

4 The management accountant and motivation

We have seen that budgets serve many purposes, but in some instances their purposes can conflict and
have an effect on management behaviour. Management and the management accountant therefore
require strategies and methods for dealing with the resulting tensions and conflict. For example, should
targets be adjusted for uncontrollable and unforeseeable environmental influence? But then, what is the
effect on motivation if employees view performance standards as changeable?
Can performance measures and the related budgetary control system ever motivate managers towards
achieving the organisation's goals?
(a) Accounting measures of performance can't provide a comprehensive assessment of what a
person has achieved for the organisation.
(b) It is unfair, as it is usually impossible to segregate controllable and uncontrollable components
of performance.
(c) Accounting reports tend to concentrate on short-term achievements, to the exclusion of the
long-term effects.
(d) Many accounting reports try to serve several different purposes, and in trying to satisfy several
needs actually satisfy none properly.
The management accountant does not have the authority to do much on their own to improve hostile or
apathetic attitudes to control information. There has to be support, either from senior management or
from budget centre managers. However, the management accountant can do quite a lot to improve and
then maintain the standard of a budgetary control reporting system.
(a) How senior management can offer support
(i) Making sure that a system of responsibility accounting is adopted; we discussed this in
Chapter 15
(ii) Allowing managers to have a say in formulating their budgets
(iii) Offering incentives to managers who meet budget targets
(iv) Not regarding budgetary control information as a way of apportioning blame

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PART C: BUDGETING

(b) Budget centre managers should accept their responsibilities. In-house training courses could be
held to encourage a collective, co-operative and positive attitude among managers.
(c) How the management accountant can improve (or maintain) the quality of the budgetary
control system
(i) Develop a working relationship with operational managers, going out to meet them and
discussing the control reports
(ii) Explain the meaning of budgets and control reports
(iii) Keep accounting jargon in these reports to a minimum
(iv) Make reports clear and to the point, for example using the principle of reporting by
exception
(v) Provide control information with a minimum of delay
(vi) Make control information as useful as possible, by distinguishing between directly
attributable and controllable costs over which a manager should have influence and
apportioned or fixed costs which are unavoidable or uncontrollable.
(vii) Make sure that actual costs are recorded accurately.
(viii) Ensure that budgets are up to date, either by having a system of rolling budgets, or else
by updating budgets or standards as necessary, and ensuring that standards are 'fair' so
that control information is realistic

There are no ideal solutions to the conflicts caused by the operation of a budgetary control system.
Management and the management accountant have to develop their own ways of dealing with them,
taking into account their organisation, their business and the personalities involved.

QUESTION Participation in budgets

Discuss the behavioural aspects of participation in the budgeting process and any difficulties you might
envisage.

ANSWER
The level of participation in the budgeting process can vary from zero participation to a process of group
decision making. There are a number of behavioural aspects of participation to consider.
(a) Communication. Managers cannot be expected to achieve targets if they do not know what those
targets are. Communication of targets is made easier if managers have participated in the
budgetary process from the beginning.
(b) Motivation. Managers are likely to be better motivated to achieve a budget if they have been
involved in compiling it, rather than having a dictatorial budget imposed on them.
(c) Realistic targets. A target must be achievable and accepted as realistic if it is to be a motivating
factor. A manager who has been involved in setting targets is more likely to accept them as
realistic. In addition, managers who are close to the operation of their departments may be more
aware of the costs and potential savings in running it.
(d) Goal congruence. One of the best ways of achieving goal congruence is to involve managers in
the preparation of their own budgets, so that their personal goals can be taken into account in
setting targets.
Although participative budgeting has many advantages, difficulties might also arise.

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CHAPTER 17 // MAKING BUDGETS WORK

(a) Pseudo-participation. Participation may not be genuine, but merely a pretence of involving
managers in the preparation of their budgets. Managers may feel that their contribution is being
ignored, or that the participation consists of merely obtaining their agreement to a budget which
has already been decided. If this is the case then managers are likely to be more demotivated
than if there is no participation at all.
(b) Co-ordination. If participative budgeting is well managed it can improve the co-ordination of the
preparation of the various budgets. There is, however, a danger that too many managers will
become involved so that communication becomes difficult and the process become complex.
(c) Training. Some managers may not possess the necessary skill to make an effective contribution
to the preparation of their budgets. Additional training may be necessary, with the consequent
investment of money and time. It may also be necessary to train managers to understand the
purposes and advantages of participation.
(d) Slack. If budgets are used in a punitive fashion for control purposes then managers will be
tempted to build in extra expenditure to provide a 'cushion' against overspending. It is easier for
them to build in slack in a participative system.

4.1 Profit sharing schemes

A profit sharing scheme is a scheme in which employees receive a certain proportion of their
company's year-end profits (the size of their bonus being related to their position in the company and the
length of their employment to date).

The advantages of these schemes is that the company will only pay what it can afford out of actual
profits and the bonus can also be paid to non-production personnel.
The disadvantages of profit sharing are as follows.
(a) Employees must wait until the year end for a bonus. The company is therefore expecting a
long-term commitment to greater efforts and productivity from its workers without the incentive of
immediate reward.
(b) Factors affecting profit may be outside the control of employees, in spite of their greater efforts.
(c) Too many employees are involved in a single scheme for the scheme to have a great motivating
effect on individuals.

4.1.1 Incentive schemes involving shares

It is becoming increasingly common for companies to use their shares, or the right to acquire them, as a
form of incentive.
A share option scheme is a scheme which gives its members the right to buy shares in the company
for which they work at a set date in the future and at a price usually determined when the scheme is set
up.
An employee share ownership plan is a scheme which acquires shares on behalf of a number of
employees, and it must distribute these shares within a certain number of years of acquisition.

Some governments have encouraged companies to set up schemes of this nature in the hope that
workers will feel they have a stake in the company which employs them. The disadvantages of these
schemes are as follows.
(a) The benefits are not certain, as the market value of shares at a future date cannot realistically be
predicted in advance.
(b) The benefits are not immediate, as a scheme must be in existence for a number of years before
members can exercise their rights.

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PART C: BUDGETING

4.1.2 Value added incentive schemes

Value added is an alternative to profit as a business performance measure and it can be used as the
basis of an incentive scheme. It is calculated as follows.
Value added = sales – cost of bought-in materials and services

The advantage of value added over profit as the basis for an incentive scheme is that it excludes any
bought-in costs, and is affected only by costs incurred internally, such as labour.
A basic value added figure would be agreed as the target for a business, and some of any excess value
added earned would be paid out as a bonus. For example, it could be agreed that value added should
be, say, treble the payroll costs and a proportion of any excess earned, say one-third, would be paid as
bonus.
Payroll costs for month $40,000
Therefore, value added target ( 3) $120,000
Value added achieved $150,000
Therefore, excess value added $30,000
Employee share to be paid as bonus $10,000

4.1.3 Example: Incentive schemes

Swetton Tyres Co manufactures a single product. Its workforce consists of ten employees, who work a
36-hour week exclusive of lunch and tea breaks. The standard time required to make one unit of the
product is two hours, but the current efficiency (or productivity) ratio being achieved is 80%. No
overtime is worked, and the workforce is paid $4 per attendance hour.
Because of agreements with the workforce about work procedures, there is some unavoidable idle time
due to bottlenecks in production, and about four hours per week per person are lost in this way.
The company can sell all the output it manufactures, and makes a 'cash profit' of $20 per unit sold,
deducting currently achievable costs of production but before deducting labour costs.
An incentive scheme is proposed whereby the workforce would be paid $5 per hour in exchange for
agreeing to new work procedures that would reduce idle time per employee per week to two hours and
also raise the efficiency ratio to 90%.
Required
Evaluate the incentive scheme from the point of view of profitability.

Solution
The current situation
Hours in attendance 10  36 = 360 hours
Hours spent working 10  32 = 320 hours
320 80
Units produced, at 80% efficiency  = 128 units
2 100
$
Cash profits before deducting labour costs (128  $20) 2,560
Less labour costs ($4  360 hours) 1,440
Net profit 1,120

The incentive scheme

Hours spent working 10  34 = 340 hours
340 90
Units produced, at 90% efficiency  = 153 units
2 100

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CHAPTER 17 // MAKING BUDGETS WORK

$
Cash profits before deducting labour costs (153  $20) 3,060
Less labour costs ($5  360) 1,800
Net profit 1,260

In spite of a 25% increase in labour costs, profits would rise by $140 per week. The company and the
workforce would both benefit provided, of course, that management can hold the workforce to its
promise of work reorganisation and improved productivity.

QUESTION Labour cost

The following data relate to work at a certain factory.
Normal working day 8 hours
Basic rate of pay per hour $6
Standard time allowed to produce 1 unit 2 minutes
Premium bonus 75% of time saved at basic rate
What will be the labour cost in a day when 340 units are made?
A $48 B $51 C $63 D $68

ANSWER
Standard time for 340 units ( 2 minutes) 680 minutes
Actual time (8 hours per day) 480 minutes
Time saved 200 minutes
$
Bonus = 75%  200 minutes  $6 per hour 15
Basic pay = 8 hours  $6 48
Total labour cost 63

Therefore the correct answer is C.

Using basic multiple choice question technique you can eliminate option A because this is simply the
basic pay without consideration of any bonus. You can also eliminate option D, which is based on the
standard time allowance without considering the basic pay for the eight-hour day. Hopefully you were
not forced to guess, but had you been you would have had a 50% chance of selecting the correct
answer (B or C) instead of a 25% chance because you were able to eliminate two of the options
straightaway.

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PART C: BUDGETING

CHAPTER ROUNDUP

 Used correctly, a budgetary control system can motivate but it can also produce undesirable negative
reactions.
 There are basically two ways in which a budget can be set: from the top down (imposed budget) or from
the bottom up (participatory budget). Many writers refer to a third style (negotiated). There are three
ways of using budgetary information to evaluate managerial performance (budget constrained style,
profit conscious style, non-accounting style).
 In certain situations it is useful to prepare an expectations budget and an aspirations budget.
 Management and the management accountant require strategies and methods for dealing with the
tensions and conflict resulting from the conflicting purposes of a budget.

1 In what circumstances are imposed budgets effective?

QUICK QUIZ

2 Which one of the following correctly identifies the budgeting style used when the budget is set 'from the
bottom up'?
A Imposed
B Autocratic
C Realistic
D Participatory
3 Match the descriptions to the budgeting style.
Description
(a) Budget allowances are set without the involvement of the budget holder.
(b) All budget holders are involved in setting their own budgets.
(c) Budget allowances are set on the basis of discussions between budget holders and those to
whom they report.
Budgeting style
Negotiated budgeting
Participative budgeting
Imposed budgeting
4 Choose the appropriate words from those highlighted.
An expectations/aspirations budget would be most useful for the purposes of planning and decision
making based on reasonable expectations, whereas an aspirations/expectations budget is more
appropriate for improving motivation by setting targets of an intermediate level of difficulty.
5 Value added may be used to measure business performance. How is value added calculated?

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CHAPTER 17 // MAKING BUDGETS WORK

1 (a) In newly formed organisations

ANSWERS TO QUICK QUIZ

(b) In very small businesses

(c) During periods of economic hardship
(d) When operational managers lack budgeting skills
(e) When the organisation's different units require precise co-ordination
2 D Participatory budgets are set from the bottom-up.
3 (a) Imposed budgeting
(b) Participative budgeting
(c) Negotiated budgeting
4 Expectations
Aspirations
5 Value added = Sales – cost of bought-in materials and services

Now try ...

Attempt the questions below from the Practice Question Bank

Q76 – Q78

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PART C: BUDGETING

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C H A P T E R

This chapter looks at the importance of capital investment

planning. You need to understand the difference between Capital expenditure
capital and revenue expenditure and be able to identify
relevant and non-relevant costs.
budgeting

SYLLABUS
TOPIC LIST REFERENCE

1 Introduction C5(a)
2 What is capital expenditure? C5(a), (b)
3 Preparing capital expenditure budgets C5(c)

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PART C: BUDGETING

Study Guide Intellectual level

C Budgeting

5 Capital budgeting and discounted cash flows

(a) Discuss the importance of capital investment planning and

K
control.
(b) Define and distinguish between capital and revenue
K
expenditure.
(c) Outline the issues to consider and the steps involved in
K
the preparation of a capital expenditure budget.

1 Introduction

Capital expenditure often represents a significant investment by a company.

In this chapter we start with a reminder of what distinguishes capital from revenue expenditure. One of
the significant differences is that capital expenditure is often for very significant amounts. Therefore
expenditure for the wrong reasons or on the wrong assets can have a disastrous effect on an
organisation's position.
Therefore the need for capital expenditure should be assessed before any firm commitments are made.
Separate capital expenditure budgets need to be prepared, and expenditure and non-current assets
carefully monitored for problems or losses.

2 What is capital expenditure?

Capital expenditure results in the acquisition of non-current assets or an improvement in their earning
capacity. Revenue expenditure is expenditure which is incurred for the purpose of the trade of the
business or to maintain the existing earning capacity of non-current assets.

A non-current asset is an asset which is acquired and retained in the business with a view to earning
profits and not merely turning into cash. It is normally used over more than one accounting period.

Examples of non-current assets:

 Motor vehicles (except for a motor trader)
 Plant and machinery
 Fixtures and fittings
 Land and buildings
Non-current assets are to be distinguished from inventories which we buy or make in order to sell.
Inventories are current assets and, as we have already seen, a part of the working capital of a business,
along with cash and amounts owed to us by customers. For a motor trader, motor vehicles for resale are
inventories. For an estate agency business, say, company cars are a non-current asset.

2.1 Capital and revenue expenditure

Capital expenditure is expenditure which results in the acquisition of non-current assets, or an
improvement in their earning capacity.

So do you recall how capital expenditure is accounted for in the financial statements?

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CHAPTER 18 // CAPITAL EXPENDITURE BUDGETING

(a) Capital expenditure is not charged as an expense in the statement of profit or loss of a business
enterprise, although a depreciation charge will usually be made to write off the capital
expenditure gradually over time. Depreciation charges are expenses in the statement of profit or
loss.
(b) Capital expenditure on non-current assets results in the appearance of a non-current asset in the
statement of financial position of the business.
Special methods of accounting for capital expenditure apply in local authorities and in some other public
sector organisations. These are not explained further here.
Revenue expenditure is expenditure which is incurred for either of the following reasons.
(a) For the purpose of the trade of the business; this includes expenditure classified as selling and
distribution expenses, administration expenses and finance charges
(b) To maintain the existing earning capacity of non-current assets

Revenue expenditure is charged to the statement of profit or loss of a period, provided that it relates to
the trading activity and sales of that particular period.
Suppose that a business purchases a building for $30,000. It then adds an extension to the building at
a cost of $10,000. The building needs to have a few broken windows mended, its floors polished and
some missing roof tiles replaced. These cleaning and maintenance jobs cost $900. The original
purchase ($30,000) and the cost of the extension ($10,000) are capital expenditures, because they are
incurred to acquire and then improve a non-current asset. The other costs of $900 are revenue
expenditure, because these merely maintain the building and thus the 'earning capacity' of the building.

2.2 Capital income and revenue income

Capital income is the proceeds from the sale of non-trading assets (ie proceeds from the sale of non-
current assets, including non-current asset investments). The profits (or losses) from the sale of non-
current assets are included in the statement of profit or loss of a business, for the accounting period in
which the sale takes place.
Revenue income is derived from the following sources.
 The sale of trading assets
 Interest and dividends received from investments held by the business

2.3 Other capital transactions

The categorisation of capital and revenue items given above does not mention raising additional capital
from the owner(s) of the business, or raising and repaying loans. These are transactions which do either
of the following.
(a) Add to the cash assets of the business, thereby creating a corresponding liability (capital or loan)
(b) Reduce the liabilities (loan) and the assets (cash) of the business when a loan is repaid
None of these transactions would be reported through the statement of profit or loss.

QUESTION Capital expenditure

Which of the following are examples of capital expenditure?
A Purchase of inventories
B Improvements to the earning capacity of non-current assets
C Depreciation
D Settling trade credit balances

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PART C: BUDGETING

ANSWER
B Capital expenditure is expenditure used to purchase or improve non-current assets.

2.4 Why is the distinction important?

Revenue expenditure results from the purchase of goods and services that will do either of the following.
(a) Be used fully in the accounting period in which they are purchased, and so be a cost or expense
in the statement of profit or loss
(b) Result in a current asset at the end of the accounting period because the goods or services have
not yet been consumed or made use of (The current asset would be shown in the statement of
financial position and is not yet a cost or expense in the statement of profit or loss.)
Capital expenditure results in the purchase or improvement of non-current assets, which are assets
that will provide benefits for the business in more than one accounting period, and which are not
acquired with a view to being resold in the normal course of trade. The cost of purchased non-current
assets is not charged in full to the statement of profit or loss of the period in which the purchase occurs.
Instead, the non-current asset is gradually depreciated over a number of accounting periods.
Since revenue items and capital items are accounted for in different ways, the correct and consistent
calculation of profit for any accounting period depends on the correct and consistent classification of
items as revenue or capital.

QUESTION Capital and revenue expenditure

Explain briefly the effect on the final accounts if:
(a) Capital expenditure is treated as revenue expenditure.
(b) Revenue expenditure is treated as capital expenditure.

ANSWER
(a) If capital expenditure is treated as revenue expenditure, profits will be understated in the
statement of profit or loss and non-current assets will be understated in the statement of
financial position.
(b) If revenue expenditure is treated as capital expenditure, then the profits for the period will be
overstated in the statement of profit or loss and non-current assets will be overstated in the
statement of financial position.

2.5 Self-constructed assets

Where a business builds its own non-current asset (eg a builder might build their own office), then all
the costs involved in building the asset should be included in the recorded cost of the non-current asset.
These costs will include raw materials, but also labour costs and related overhead costs. This treatment
means that assets which are self-constructed are treated in a similar way to purchased non-current
assets.

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CHAPTER 18 // CAPITAL EXPENDITURE BUDGETING

3 Preparing capital expenditure budgets

Recurring and minor non-current asset purchases may be covered by an annual allowance provided for
in the capital expenditure budget. Major projects will need to be considered individually and will need
to be fully appraised.

The capital expenditure budget is essentially a non-current assets purchase budget, and it will form part
of the longer-term plan of a business enterprise.
Sales, production and related budgets cover, in general, a 12-month period. A detailed capital
expenditure budget should be prepared for the budget period but additional budgets should be drawn up
for both the medium and long term. This requires an in-depth consideration of the organisation's
requirements for land, buildings, plant, machinery, vehicles, fixtures and fittings and so on for the short,
medium and long term.
Suitable financing must be arranged as necessary. We looked at sources of finance in earlier chapters. If
available funds are limiting the organisation's activities then it will more than likely limit capital
expenditure. The capital expenditure budget should take account of this.
Some forms of capital expenditure may be budgeted for by means of a set annual 'allowance' for the
purchase and replacement of non-current assets. Examples here would be sets of new tools, or relatively
minor expenditure such as a few new desks and chairs.
As part of the overall budget co-ordination process, the capital expenditure budget must be reviewed in
relation to the other budgets. Proposed expansion of production may well require significant non-current
assets expenditure which should be reflected in the budget.
Before major capital expenditure is incurred, we need to be confident that the expenditure is worthwhile.
We therefore need to appraise the project on which the expenditure is to be made, to see if it is likely to
be of positive value to the business. In the next chapter, we turn to the methods of project appraisal
which are available in order to do this.

PER performance objective 13 requires you to ‘Coordinate, prepare and use budgets'. The knowledge
covered in this chapter will help you demonstrate your competence in this area.

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PART C: BUDGETING

CHAPTER ROUNDUP

 Capital expenditure often represents a significant investment by a company.

 Capital expenditure results in the acquisition of non-current assets or an improvement in their earning
capacity. Revenue expenditure is expenditure which is incurred for the purpose of the trade of the
business or to maintain the existing earning capacity of non-current assets.
 Recurring and minor non-current asset purchases may be covered by an annual allowance provided for
in the capital expenditure budget. Major projects will need to be considered individually and will need
to be fully appraised.
QUICK QUIZ

1 A …………… is an asset which is acquired and retained in the business with a view to earning profits
and not merely turning into cash.
2 How many periods should non-current asset expenditure benefit a business?
A One period
B More than one period, otherwise no minimum
C At least five periods
D At least ten periods
3 Revenue expenditure is expenditure incurred to maintain the existing earning capacity of non-current
assets.

True

False

4 What tasks would a capital expenditure budget officer carry out?

5 What types of capital expenditure might be covered by an annual budget allowance?

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CHAPTER 18 // CAPITAL EXPENDITURE BUDGETING

1 A non-current asset is an asset which is acquired and retained in the business with a view to earning
ANSWERS TO QUICK QUIZ

profits and not merely turning into cash.

2 B More than one period is all that is required
3 True
4 Communicating between interested parties; providing budget data; drawing up a timetable; etc
5 Minor expenditure; and routine replacement of existing items such as books

Now try ...

Attempt the questions below from the Practice Question Bank

Q79 – Q81

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PART C: BUDGETING

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C H A P T E R

In this chapter we continue our studies of capital

expenditure by looking at how to appraise projects to Methods of project
decide which are worthwhile. You need to understand the
time value of money, the payback period and the internal
rate of return.
appraisal

SYLLABUS
TOPIC LIST REFERENCE

1 Introduction n/a
2 Methods of project appraisal C5(j)
3 The payback period C5(j), (k)
4 The time value of money C5(d), (e)
5 Discounted cash flow C5(f), (h), (i), (j), (k)
6 Relevant and non-relevant costs C5(g)
7 Some rules for identifying relevant costs C5(g)

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PART C: BUDGETING

Study Guide Intellectual level

C Budgeting

5 Capital budgeting and discounted cash flows

(d) Explain and illustrate the difference between simple and

S
compound interest, and between nominal and effective
interest rates.
(e) Explain and illustrate compounding and discounting. S
(f) Explain the distinction between cash flow and profit and
K
the relevance of cash flow to capital investment appraisal.
(g) Identify and evaluate relevant cash flows for individual
S
investment decisions.
(h) Explain and illustrate the net present value (NPV) and
S
internal rate of return (IRR) methods of discounted cash
flow.
(i) Calculate present value using annuity and perpetuity
S
formulae.
(j) Calculate NPV, IRR and payback (discounted and non-
S
discounted).
(k) Interpret the results of NPV, IRR and payback calculations
S
of investment viability.

1 Introduction

A long-term view of benefits and costs must be taken when reviewing a capital expenditure project.

We stressed in the last chapter the importance of careful purchasing procedures for capital expenditure.
In this chapter we go on to consider how not just capital expenditure but also major investment projects
in general are assessed.
Another decision that organisations face is how to compare costs and benefits. Some simple approaches
(accounting rate of return and payback) take no account of when costs or revenues are incurred or
received. However, discounted cash flow approaches (net present value and payback) take a more
sophisticated approach, being based on the principle that a pound received in the future is not worth as
much as a pound received today. We shall explain how each of these approaches work, and have a look
at their advantages and limitations.

2 Methods of project appraisal

The key methods of project appraisal are:

 The payback period
 Net present value
 Discounted payback period
 Internal rate of return (IRR)

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CHAPTER 19 // METHODS OF PROJECT APPRAISAL

PER performance objective 9 requires you to evaluate investment and financing decisions, evaluating
and reviewing their financial viability. The knowledge you gain in this chapter will help you
demonstrate your competence in this area.

The following sections consider the different methods of project appraisal – the tools you can use when
deciding whether or not to make an investment.

EXAM FOCUS POINT

In NPV calculations, finance costs are irrelevant, as interest is taken into account in the discounting
process.

3 The payback period

The payback period is the time taken for the initial investment to be recovered in the cash inflows from
the project. The payback method is particularly relevant if there are liquidity problems, or if distant
forecasts are very uncertain.

The payback period method is one which gives greater weight to cash flows generated in earlier years.
The payback period is the length of time required before the total cash inflows received from the project
is equal to the original cash outlay. In other words, it is the length of time the investment takes to pay
itself back.
The payback method has obvious disadvantages. Consider the case of two machines for which the
following information is available.
Machine P Machine Q
$ $
Cost 10,000 10,000
Cash inflows year 1 1,000 5,000
2 2,000 5,000
3 6,000 1,000
4 7,000 500
5 8,000 500
24,000 12,000

Machine Q pays back at the end of year 2 and machine P not until early in year 4. Using the payback
method machine Q is to be preferred, but this ignores the fact that the total profitability of P ($24,000)
is double that of Q.

Advantages of payback method Disadvantages of payback method

It is easy to calculate and understand. Total profitability is ignored.

It is widely used in practice as a first screening The time value of money is ignored.
method.

Its use will tend to minimise the effects of risk and It ignores any cash flows that occur after the
help liquidity, because greater weight is given to project has paid for itself. A project that takes
earlier cash flows which can probably be time to get off the ground but earns substantial
predicted more accurately than distant cash flows. profits once established might be rejected if the
payback method is used, whereas a smaller
project, paying back more quickly, may be
accepted.

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Advantages of payback method Disadvantages of payback method

It identifies quick cash generators. The cut-off period for deciding what is acceptable
is arbitrary.

A more scientific method of investment appraisal is the use of discounted cash flow (DCF) techniques.
Before DCF can be understood it is necessary to know something about the time value of money.

QUESTION Payback period

Project X has the following cash flows.
Year Cash flow
$
0 (105,000)
1 25,000
2 35,000
3 35,000
4 40,000
5 50,000
What is project X's payback period?
A 3 years C 3.75 years
B 3.25 years D 4 years

ANSWER
B (25,000 + 35,000 + 35,000) = 95,000 will be paid back at the end of year 3 leaving 10,000
to be repaid in year 4.
10,000
= 0.25 therefore payback occurs after 3.25 years.
40,000

4 The time value of money

The time value of money is an important consideration in decision making.

Money is spent to earn a profit. For example, if an item of machinery costs $6,000 and would earn
profits (ignoring depreciation) of $2,000 per year for three years, it would not be worth buying because
its total profit ($6,000) would only just cover its cost.
In addition, the size of profits or return must be sufficiently large to justify the investment. In the
example given in the previous paragraph, if the machinery costing $6,000 made total profits of $6,300
over three years, the return on the investment would be $300, or an average of $100 per year. This
would be a very low return, because it would be much more profitable to invest the $6,000 somewhere
else (eg in a bank).
We must therefore recognise that if a capital investment is to be worthwhile, it must earn at least a
minimum profit or return so that the size of the return will compensate the investor (the business) for
the length of time which the investor must wait before the profits are made.
When capital expenditure projects are evaluated, it is therefore appropriate to decide whether the
investment will make enough profits to allow for the 'time value' of capital tied up. The time value of
money reflects people's time preference for $100 now over $100 at some time in the future. DCF is an
evaluation technique which takes into account the time value of money.

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4.1 Discounting and compound interest

If we were to invest $1,000 now in a bank account which pays interest of 10% per annum, with
interest calculated once each year at the end of the year, we would expect the following returns.
(a) After one year, the investment would rise in value to:
$1,000 plus 10% = $1,000 (1 + 10%) = $1,000  (1.10) = $1,100
Interest for the year would be $100. We can say that the rate of simple interest is 10%.
(b) If we keep all our money in the bank account, after two years the investment would now be
worth:
$1,100  1.10 = $1,210.
Interest in year two would be $(1,210  1,100) = $110.
Another way of writing this would be to show how the original investment has earned interest
over two years, as follows.
$1,000  (1.10)  (1.10) = $1,000  (1.10)2 = $1,210
(c) Similarly, if we keep the money invested for a further year, the investment would grow to $1,000
 (1.10)  (1.10)  (1.10) = $1,000  (1.10)3 = $1,331 at the end of the third year. Interest
in year three would be $(1,331  1,210) = $121.

4.2 Compound interest

This example shows, in a different way to that given earlier in this Text, how compound interest works.
The amount of interest earned each year gets larger because we earn interest on both the original capital
and also on the interest now earned in earlier years.
A formula which can be used to show the value of an investment after several years which earns
compound interest is:
S = P(1 + r)n
where S = future value of the investment after n years
P = the amount invested now
r = the rate of interest, as a proportion. For example, 10% = 0.10, 25% = 0.25, 8% = 0.08
n = the number of years of the investment
For example, suppose that we invest $2,000 now at 10%. What would the investment be worth after
the following number of years?
(a) Five years
(b) Six years
The future value of $1 after n years at 10% interest is given in the following table.
n (1 + r)n with r = 0.10
1 1.100
2 1.210
3 1.331
4 1.464
5 1.611
6 1.772
7 1.949
The solution is as follows.
(a) After 5 years: (b) After 6 years:
S = $2,000 (1.611) = $3,222 S = $2,000 (1.772) = $3,544
The principles of compound interest are used in DCF, except that discounting is compounding in reverse.

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4.3 Discounting
With discounting, we look at the size of an investment after a certain number of years, and calculate how
much we would need to invest now to build up the investment to that size, given a certain rate of interest.
This may seem complicated at first, and an example might help to make the point clear. With discounting,
we can calculate how much we would need to invest now at an interest rate of, say, 6% to build up the
investment to (say) $5,000 after four years.
The compound interest formula shows how we calculate a future sum S from a known current
investment P, so that if S = P (1 + r)n, then:
S 1
P= n
=S
(1r) (1r) n
-n
This is the basic formula for discounting, which is sometimes written as: P = S(1 + r)

-n 1
[ (1 + r) and mean exactly the same thing.]
(1  r) n

To build up an investment to $5,000 after four years at 6% interest, we would need to invest now:
1
P = $5,000  = $5,000  0.792 = $3,960
(10.06) 4

4.3.1 Further examples of discounting

If you have never done any discounting before, the basic principle and mathematical techniques might
take some time to get used to. The following examples might help to make them clearer.
(a) A businessperson wants to have $13,310 in three years' time, and has decided to put some
money aside now which will earn interest of 10% per annum. How much money must they put
aside in order to build up the investment to $13,310 as required?
1
Solution P = $13,310  = $10,000
(1.10) 3
Proof After one year the investment would be worth $10,000  1.10 = $11,000; after
two years it would be $11,000  1.10 = $12,100; and after three years it would
be $12,100  1.10 = $13,310.
(b) Another businessperson has two sons who are just 18 years and 17 years old. They wish to give
them $10,000 each on their 20th birthdays and they want to know how much they must invest
now at 8% interest to pay this amount.
The following table is relevant, giving values r = 8% or 0.08. Note that you can read the figures
in the 'present value' column from the Present Value Table in the Appendix to this Interactive
Text: look down the 8% column.
Year Future value of $1 Present value of $1
n (1 + r)n (1 + r)-n
1 1.080 0.926
2 1.166 0.857
3 1.260 0.794
4 1.360 0.735
The investment must provide $10,000 after two years for the elder son and $10,000 after three
years for the younger son.
After n years Discount factor Amount
n= 8% provided Present value
$ $
Elder son 2 0.857  10,000 8,570
Younger son 3 0.794  10,000 7,940
Total investment required 16,510

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Proof After 2 years the investment of $16,510 will be worth $16,510  1.166 =
$19,251. After paying $10,000 to the elder son, $9,251 will be left after 2 years.
This will earn interest of 8% in year 3, to be worth $9,251  1.08 = $9,991 at
the end of the year. This is almost enough to pay $10,000 to the younger son. The
difference ($9) is caused by rounding errors in the table of discount (present value)
factors and compound (future value) factors.
(c) A company is wondering whether to invest $15,000 in a project which will pay $20,000 after 2
years. It will not invest unless the return from the investment is at least 10% per annum. Is the
investment worthwhile? The present value of $1 in 2 years' time at 10% interest is 0.826.

Solution
The return of $20,000 after two years is equivalent to an investment now at 10% of $20,000 
0.826 = $16,520.
In other words, in order to obtain $20,000 after two years, the company would have to invest
$16,520 now at an interest rate of 10%. The project offers the same payment at a cost of only
$15,000, so that it must provide a return in excess of 10% and it is therefore worthwhile.
$
Present value of future profits at 10% 16,520
Cost of investment 15,000
The investment in the project offers the same return, but at a cost lower by 1,520

4.4 Equivalent rates of interest

An effective annual rate of interest is the corresponding annual rate when interest is compounded at
intervals shorter than a year.

4.4.1 Non-annual compounding

In the previous examples, interest has been calculated annually, but this isn't always the case. Interest
may be compounded daily, weekly, monthly or quarterly.
For example, $10,000 invested for 5 years at an interest rate of 2% per month will have a final value of
$10,000  (1 + 0.02)60 = $32,810. Notice that n relates to the number of periods (5 years  12
months) that r is compounded.

4.4.2 Effective annual rate of interest

The non-annual compounding interest rate can be converted into an effective annual rate of interest.
This is also known as the APR (annual percentage rate) which lenders such as banks and credit
companies are required to disclose.

FORMULA TO LEARN
Effective annual rate of interest: (1 + R) = (1 + r)n
Where R is the effective annual rate
r is the period rate
n is the number of periods in a year

4.4.3 Example: The effective annual rate of interest

Calculate the effective annual rate of interest (to two decimal places) of:
(a) 1.5% per month, compound
(b) 4.5% per quarter, compound
(c) 9% per half year, compound

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Solution
(a) 1 + R = (1 + r)n
1 + R = (1 + 0.015)12
R = 1.1956 – 1
= 0.1956
= 19.56%
(b) 1 + R = (1 + 0.045)4
R = 1.1925 – 1
= 0.1925
= 19.25%
(c) 1 + R = (1 + 0.09)2
R = 1.1881 – 1
= 0.1881
= 18.81%

4.5 Nominal rates of interest and the APR

A nominal rate of interest is an interest rate expressed as a per annum figure although the interest is
compounded over a period of less than one year. The corresponding effective rate of interest is the
annual percentage rate (APR) (sometimes called the compound annual rate, CAR).

Most interest rates are expressed as per annum figures even when the interest is compounded over
periods of less than one year. In such cases, the given interest rate is called a nominal rate. We can,
however, also work out the effective rate (APR or CAR).

EXAM FOCUS POINT

Students often become seriously confused about the various rates of interest.
 The nominal rate is the interest rate expressed as a per annum figure, eg 12% p.a. nominal,
even though interest may be compounded over periods of less than one year.
 Adjusted nominal rate = Equivalent annual rate
 Equivalent annual rate (the rate per day or per month adjusted to give an annual rate) =
Effective annual rate
 Effective annual rate = Annual percentage rate (APR) = Compound annual rate (CAR)

4.5.1 Example: Nominal and effective rates of interest

A building society may offer investors 10% per annum interest payable half-yearly. If the 10% is a
nominal rate of interest, the building society would in fact pay 5% every 6 months, compounded so that
the effective annual rate of interest would be:
[(1.05)2 – 1] = 0.1025 = 10.25% per annum.
Similarly, if a bank offers depositors a nominal 12% per annum, with interest payable quarterly, the
effective rate of interest would be 3% compound every 3 months, which is:
[(1.03)4 – 1] = 0.1255 = 12.55% per annum.

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QUESTION Effective rate of interest

A bank adds interest monthly to investors' accounts even though interest rates are expressed in annual
terms. The current rate of interest is 12%. Fred deposits $2,000 on 1 July. How much interest will have
been earned by 31 December (to the nearest $)?
A $123.00
B $60.00
C $240.00
D $120.00

ANSWER
The nominal rate is 12% p.a. payable monthly.
12%
 The effective rate = = 1% compound monthly.
12 months

 In the six months from July to December, the interest earned = ($2,000  (1.01)6) – $2,000 =
$123.04.
The correct answer is A.

5 Discounted cash flow

Discounted cash flow techniques take account of the time value of money – the fact that $1 received
now is worth more because it could be invested to become a greater sum at the end of a year, and even
more after the end of two years, and so on. As with payback, DCF techniques use cash figures before
depreciation in the calculations.

Discounted cash flow is a technique of evaluating capital investment projects, using discounting
arithmetic to determine whether or not they will provide a satisfactory return.

A typical investment project involves a payment of capital for non-current assets at the start of the
project and then there will be returns coming in from the investment over a number of years.
As we noted earlier, DCF can be used in either of two ways: the net present value method, or the
internal rate of return (sometimes called DCF yield, DCF rate of return) method. We will now look at
each method in turn.

5.1 The net present value (NPV) method of DCF

The net present value method calculates the present value of all cash flows, and sums them to give the
net present value. If this is positive, then the project is acceptable.

The net present value (NPV) method of evaluation is as follows.

(a) Determine the present value of costs
In other words, decide how much capital must be set aside to pay for the project. Let this be $C.
(b) Calculate the present value of future cash benefits from the project
To do this we take the cash benefit in each year and discount it to a present value. This shows
how much we would have to invest now to earn the future benefits, if our rate of return were
equal to the cost of capital. ('Cost of capital' is explained below.) By adding up the present value
of benefits for each future year, we obtain the total present value of benefits from the project. Let
this be $B.

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(c) Compare the present value of costs $C with the present value of benefits $B
The NPV is the difference between them: $(B  C).
(d) NPV is positive
The present value of benefits exceeds the present value of costs. This in turn means that the
project will earn a return in excess of the cost of capital. Therefore, the project should be
accepted.
(e) NPV is negative
This means that it would cost us more to invest in the project to obtain the future cash receipts
than it would cost us to invest somewhere else, at a rate of interest equal to the cost of capital, to
obtain an equal amount of future receipts. The project would earn a return lower than the cost of
capital and would not be worth investing in.

5.1.1 Example: The NPV method

Suppose that a company is wondering whether to invest $18,000 in a project which would make extra
profits (before depreciation is deducted) of $10,000 in the first year, $8,000 in the second year and
$6,000 in the third year. Its cost of capital is 10% (in other words, it would require a return of at least
10% on its investment). You are required to evaluate the project.

Solution
In DCF we make several assumptions. One such assumption is that DCFs (payments or receipts) occur
on the last day of each year. For example, although profits are $10,000 during the course of year 1, we
assume that the $10,000 is not received until the last day of year 1. Similarly, the profits of $8,000
and $6,000 in years 2 and 3 are assumed to occur on the last day of years 2 and 3 respectively. The
cash payment of $18,000 occurs 'now' at the start of year 1. To be consistent, we say that this payment
occurs on the last day of the current year which is often referred to as year 0.
The NPV is now calculated with discounting arithmetic. Note that the Present Value Table in the
Appendix to this Text gives us the following values.
Year Present value of $1
n (1 + r)-n where r = 0.10
1 0.909
2 0.826
3 0.751

Year Cash flow Present value factor Present value

$ $
0 (18,000) 1.000 (18,000)
1 10,000 0.909 9,090
2 8,000 0.826 6,608
3 6,000 0.751 4,506
NPV 2,204

The NPV is positive, which means that the project will earn more than 10%. ($20,204 would have to
be invested now at 10% to earn the future cash flows; since the project will earn these returns at a cost
of only $18,000 it must earn a return in excess of 10%.)

QUESTION Present value

A project would involve a capital outlay of $24,000. Profits (before depreciation) each year would be
$5,000 for six years. The cost of capital is 12%. Is the project worthwhile?
(Use the Present Value Table in the Appendix.)

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ANSWER
Years Cash flow Present value factor Present value
$ $
0 (24,000) 1.000 (24,000)
1 5,000 0.893 4,465
2 5,000 0.797 3,985
3 5,000 0.712 3,560
4 5,000 0.636 3,180
5 5,000 0.567 2,835
6 5,000 0.507 2,535
NPV (3,440)

The NPV is negative and so the project is not worthwhile.

5.1.2 Advantages and disadvantages of NPV

Advantages of NPV Disadvantages of NPV

Shareholder wealth is maximised. It can be difficult to identify an appropriate

discount rate.
It takes into account the time value of money. For simplicity, cash flows are sometimes all
assumed to occur at year ends: this assumption
may be unrealistic.

It is based on cash flows which are less subjective Some managers are unfamiliar with the concept
than profit. of NPV.

Shareholders will benefit if a project with a

positive NPV is accepted.

5.2 Discounted payback method

The discounted payback method applies discounting to arrive at a payback period after which the NPV
becomes positive.

We have seen how discounting cash flows is a way of reflecting the time value of money in investment
appraisal. The further into the future a cash flow is expected to be, the more uncertain it tends to be,
and the returns or interest paid to the suppliers of capital (ie to investors) in part reflects this
uncertainty. The discounted payback technique is an adaptation of the payback technique, which we
looked at earlier, taking some account of the time value of money. To calculate the discounted payback
period, we establish the time at which the NPV of an investment becomes positive.

5.2.1 Example: Discounted payback period

We can calculate the discounted payback period for the example above. Having produced an NPV
analysis as in the solution above, we calculate the discounted payback period as follows.
Year Present value Cumulative PV
$ $
0 (18,000) (18,000)
1 9,090 (8,910)
2 6,608 (2,302)
3 4,506 2,204
2,204

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Solution
If we assume now that cash flows in year 3 are even, instead of occurring on the last day of the year,
the discounted payback period can be estimated as follows.
Discounted payback period = 2 years + 2,302/4,506 years
= 2.51 years, say 2½ years

This compares with a non-discounted payback period of 2 years for the same project, since the initial
outlay of $18,000 is recouped in monetary terms by year 2. The discounted payback period of 2½
years suggests that if the project must be terminated within that period, it will not have added value to
the company.

5.3 Comparison with the basic payback method

Like the basic payback method, the discounted payback method fails to take account of positive cash
flows occurring after the end of the payback period.

5.4 The cost of capital

We have mentioned that the appropriate discount rate to use in investment appraisal is the company's
cost of capital. In practice, this is difficult to determine. It is often suggested that the discount rate
which a company should use as its cost of capital is one that reflects the return expected by its investors
in shares and loan notes, the opportunity cost of finance.
Shareholders expect dividends and capital gains; loan note investors expect interest payments. A
company must make enough profits from its own operations (including capital expenditure projects) to
pay dividends and interest. The average return is the weighted average of the return required by
shareholders and loan note investors. The cost of capital is therefore the weighted average cost of all
the sources of capital.

5.5 Annuities
Annuities are an annual cash payment or receipt which is the same amount every year for a number of
years.

In DCF the term 'annuities' refers to an annual cash payment which is the same amount every year for a
number of years, or else an annual receipt of cash which is the same amount every year for a number of
years.
In the question above, the profits are an annuity of $5,000 per annum for 6 years. The present value of
profits is the present value of an annuity of $5,000 per annum for 6 years at a discount rate of 12%.
When there is an annuity to be discounted, there is a shortcut method of calculation. You may already
have seen what it is. Instead of multiplying the cash flow each year by the present value factor for that
year, and then adding up all the present values (as shown in the solution above), we can multiply the
annuity by the sum of the present value factors.
Thus we could have multiplied $5,000 by the sum of (0.893 + 0.797 + 0.712 + 0.636 + 0.567 +
0.507) = 4.112. We then have $5,000  4.112 = $20,560.
This quick calculation is made even quicker by the use of 'annuity' tables. These show the sum of the
present value factors each year from year one to year n.

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The Annuity Table in the Appendix to this Text shows the following.
Present value of $1
Years received per year Notes
n [1  (1  r) n
]
r
1 0.893 PV factor for year 1 only
2 1.690 (0.893  0.797)
3 2.402 (add 0.712)
4 3.038 (add 0.636)
5 3.605 (add 0.567)
6 4.112 (add 0.507)

5.5.1 Example: Annuities

A project would involve a capital outlay of $50,000. Profits (before depreciation) would be $12,000 per
year. The cost of capital is 10%. Would the project be worthwhile if it lasts:
(a) Five years?
(b) Seven years?

Solution
We can find the discount factors from the Annuity Table in the Appendix.
(a) If the project lasts five years
Years Cash flow Discount factor 10% Present value
$ $
0 (50,000) 1.000 (50,000)
1–5 12,000 p.a. 3.791 45,492
NPV ( 4,508)

(b) If the project lasts seven years

Years Cash flow Discount factor 10% Present value
$ $
0 (50,000) 1.000 (50,000)
1–7 12,000 p.a. 4.868 58,416
NPV 8,416

The project is not worthwhile if it lasts only five years, but it would be worthwhile if it lasted for seven
years. The decision to accept or to reject the project must depend on management's view about its
duration.

QUESTION Two projects

(a) A project costs $39,500. It would earn $10,000 per year for the first three years and then
$8,000 per year for the next three. Cost of capital is 10%. Is the project worth undertaking?
(b) Another project would cost $75,820. If its life is expected to be five years and the cost of capital
is 10%, what are the minimum annual savings required to make the project worthwhile?
Use the Annuity Table in the Appendix to derive your answers.

ANSWER
(a)
Present value of $1 per annum, years 1-6 4.355
Less present value of $1 per annum, years 1-3 2.487
Gives present value of $1 per annum, years 4-6 1.868

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Year Cash flow Discount factor 10% Present value

$ $
0 (39,500) 1.000 (39,500)
1–3 10,000 p.a. 2.487 24,870
4–6 8,000 p.a. 1.868 14,944
NPV 314

The NPV is positive, but only just ($314). The project therefore promises a return a little above
10%. If we are confident that the estimates of cost and benefits for the next six years are
accurate, the project is worth undertaking. However, if there is some suspicion that earnings may
be a little less than the figures shown, it might be prudent to reject it.
(b) The project will just be worthwhile if the NPV is 0. For the NPV to be 0 the present value of
benefits must equal the present value of costs, $75,820.
PV of benefits = annual savings  present value of $1 per year for 5 years (at 10%)
$75,820 = annual savings  3.791

$75,820
=
3.791
Annual savings = $20,000

This example shows that annuity tables can be used to calculate an annual cash flow from a given
investment.

5.5.2 Example: More complex annuity

What is the present value of $2,000 costs incurred each year from years 3 to 6 when the cost of capital
is 5%?

Solution
We need to take the annuity factor for years 1 to 6 and deduct the annuity factor for years 1 to 2. This
will give us a factor for years 3 to 6 only.

PV of $1 per annum for years 1 – 6 at 5% = 5.076

$2,000  Less PV of $1 per annum for years 1 – 2 at 5% = 1.859
PV of $1 per annum for years 3 – 6 = 3.217

PV = $2,000  3.217 = $6,434

5.6 Annual cash flows in perpetuity

A perpetuity is an annuity that lasts forever. The present value of a perpetuity of 'a' per annum,
commencing in one year, is PV = a/r where r is the cost of capital as a proportion.

It can sometimes be useful to calculate the cumulative present value of $1 per annum for every year in
perpetuity (that is, forever).
When the cost of capital is r, the cumulative PV of $1 per annum in perpetuity is $1/r. For example, the
PV of $1 per annum in perpetuity at a discount rate of 10% would be $1/0.10 = $10.
Similarly, the PV of $1 per annum in perpetuity at a discount rate of 15% would be $1/0.15 = $6.67
and at a discount rate of 20% it would be $1/0.20 = $5.

5.6.1 Example: More complex perpetuity

An investment will produce an annual return of $1,500 in perpetuity with the first receipt starting in 3
years' time. What is the present value of this perpetuity discounted at 8%?

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Solution

Step 1 Calculate the future value of the income one year before the first receipt is due (year 2).
$1,500/0.08 = $18,750

Step 2 Discount it back to today using a discount factor of 8% over 2 years.

PV = $18,750 × 0.857
= $16,068.75

5.7 Calculating a 'breakeven' NPV

You might be asked to calculate how much income would need to be generated for the NPV of a project
to be zero. This must be referred to as 'breakeven' NPV.

5.7.1 Example: Breakeven NPV

For the project in Example 5.5.1 above, calculate how much the annual income from the project could
reduce before the NPV would reach a breakeven zero level.

Solution
For every $1 reduction in the annual income of $12,000, the NPV will fall by $1  4.868 = $4.868.
Breakeven fall in income = $8,416 ÷ 4.868 = $1,729
Annual income of $12,000  $1,729 = $10,271 will result in a breakeven NPV of zero.

5.8 Internal rate of return (IRR)

The internal rate of return technique uses a trial and error method to discover the discount rate which
produces the NPV of zero. This discount rate will be the return forecast for the project.

The internal rate of return (IRR) method of DCF involves two steps.
 Calculating the rate of return which is expected from a project
 Comparing the rate of return with the cost of capital
If a project earns a higher rate of return than the cost of capital, it will be worth undertaking (and its
NPV would be positive). If it earns a lower rate of return, it is not worthwhile (and its NPV would be
negative). If a project earns a return which is exactly equal to the cost of capital, its NPV will be 0 and it
will only just be worthwhile.

5.8.1 Calculating the IRR

You may find the method of calculating the rate of return to be rather unsatisfactory because it involves
some guesswork and approximation. An example will help to illustrate the technique.
Suppose that a project would cost $20,000 and the annual net cash inflows are expected to be as
follows. What is the IRR of the project?
Year Cash flow
$
1 8,000
2 10,000
3 6,000
4 4,000
The IRR is a rate of interest at which the NPV is 0 and the discounted (present) values of benefits add
up to $20,000. We need to find out what interest rate or cost of capital would give an NPV of 0.
We are after two rates of return.

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(a) One at which the NPV is a small positive value. The actual IRR will be higher than this rate of
return.
(b) One at which the NPV is a small negative value. The actual IRR will be lower than this rate of
return.
The actual IRR will then be found (approximately) by using the two rates in (a) and (b).
In our example, we might begin by trying discount rates of 10%, 15% and 20%.
Discount Present Discount Present Discount Present
factor value factor value factor value
Year Cash flow at 10% at 10% at 15% at 15% at 20% at 20%
$ $ $ $
0 (20,000) 1.000 (20,000) 1.000 (20,000) 1.000 (20,000)
1 8,000 0.909 7,272 0.870 6,960 0.833 6,664
2 10,000 0.826 8,260 0.756 7,560 0.694 6,940
3 6,000 0.751 4,506 0.658 3,948 0.579 3,474
4 4,000 0.683 2,732 0.572 2,288 0.482 1,928
NPV 2,770 756 (994)

The IRR is more than 15% but less than 20%. We could try to be more accurate by trying a discount
rate of 16%, 17%, 18% or 19%, but in this solution we will use the values for 15% and 20% to
estimate the IRR.
To estimate the IRR, we now assume that the NPV falls steadily and at a constant rate between $756
at 15% and $(994) at 20%. This represents a fall of $(756 + 994) = $1,750 in NPV between 15%
and 20%. This is an average fall of:

$1,750
= $350 in NPV for each 1% increase in the discount rate.
(20  15)%

$756
Since the IRR is where the NPV is 0, it must be  1% above 15%,
$350
ie about 2.2% above 15% = 17.2%.

5.8.2 A formula for the IRR

A formula for making this calculation (which is known as interpolation) is as follows.

 a 
IRR = A +  × (B – A) ss
a – b 
where A is the discount rate which provides the positive NPV
a is the amount of the positive NPV
B is the discount rate which provides the negative NPV
b is the amount of the negative NPV
In our example, using this formula, the IRR would be calculated as follows.

 756 
15% +  × (20 – 15) % = 15% + [0.432  5]%
 756 – 994 
= 15% + 2.16%
= 17.16%, say 17.2%

5.8.3 Advantages of the IRR method

The following are advantages of using IRR.
(a) It takes into account the time value of money, unlike other approaches such as payback.
(b) Results are expressed as a simple percentage, and are more easily understood than some other
methods.

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CHAPTER 19 // METHODS OF PROJECT APPRAISAL

(c) It indicates how sensitive calculations are to changes in interest rates.

5.8.4 Problems with the IRR method

The following are problems of using IRR.
(a) Projects with unconventional cash flows can produce negative or multiple IRRs.
(b) IRR may be confused with return on capital employed (ROCE), since both give answers in
percentage terms.
(c) It may give conflicting recommendations with mutually exclusive projects, because the result is
given in relative terms (percentages), and not in absolute terms ($s) as with NPV.
(d) Some managers are unfamiliar with the IRR method.
(e) It cannot accommodate changing interest rates.
(f) It assumes that funds can be reinvested at a rate equivalent to the IRR, which may be too high.

QUESTION Machine purchase

LCH Co manufactures product X which it sells for $5 per unit. Variable costs of production are currently
$3 per unit, and fixed costs 50c per unit. A new machine is available which would cost $90,000 but
which could be used to make product X for a variable cost of only $2.50 per unit. Fixed costs, however,
would increase by $7,500 per annum as a direct result of purchasing the machine. The machine would
have an expected life of 4 years and a resale value after that time of $10,000. Sales of product X are
estimated to be 75,000 units per annum. LCH Co expects to earn at least 12% per annum from its
investments. Ignore taxation.
You are required to decide whether LCH Co should purchase the machine.

ANSWER
Savings are 75,000  ($3 – $2.50) = $37,500 per annum.
Additional costs are $7,500 per annum.
Net cash savings are therefore $30,000 per annum. (Remember, depreciation is not a cash flow and
must be ignored as a 'cost'.)
The first step in calculating an NPV is to establish the relevant costs year by year. All future cash flows
arising as a direct consequence of the decision should be taken into account. It is assumed that the
machine will be sold for $10,000 at the end of year 4.
Year Cash flow PV factor 12% PV of cash flow
$ $
0 (90,000) 1.000 (90,000)
1 30,000 0.893 26,790
2 30,000 0.797 23,910
3 30,000 0.712 21,360
4 40,000 0.636 25,440
7,500

The NPV is positive and so the project is expected to earn more than 12% per annum and is therefore
acceptable.

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QUESTION IRR
Find the IRR of the project given below and state whether the project should be accepted if the
company requires a minimum return of 17%.
Time $
0 Investment (4,000)
1 Receipts 1,200
2 " 1,410
3 " 1,875
4 " 1,150

ANSWER
The total receipts are $5,635 giving a total profit of $1,635 and average profits of $409. Although the
average rate of return (ARR) is not on your syllabus, it gives us a useful starting point for calculating the
IRR.
ARR = average profit/average investment × 100%
The average investment is $2,000.
Initial investment – residual value
Average investment =
2
 4,000  0 
=  
 2 
= $2,000

The ARR is $409  $2,000 = 20%. We take two-thirds of the ARR (approximately 14%) to find an
initial estimate of the IRR. The initial estimate of the IRR that we shall try is therefore 14%.
Try 14% Try 16%
discount discount
Time Cash flow factor PV factor PV
$ $ $
0 (4,000) 1.000 (4,000) 1.000 (4,000)
1 1,200 0.877 1,052 0.862 1,034
2 1,410 0.769 1,084 0.743 1,048
3 1,875 0.675 1,266 0.641 1,202
4 1,150 0.592 681 0.552 635
NPV 83 NPV (81)

The IRR must be less than 16%, but higher than 14%. The NPVs at these two costs of capital will be
used to estimate the IRR.
Using the interpolation formula:

 83 
IRR =14% +  ×(16%  14%) =15.01%
 83  81 
The IRR is, in fact, almost exactly 15%. The project should be rejected, as the IRR is less than the
minimum return demanded.

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6 Relevant and non-relevant costs

Relevant costs are future incremental cash flows.

Avoidable costs, differential costs and opportunity costs are all relevant costs.
Non-relevant costs include sunk costs, committed costs and notional (imputed) costs.
Directly attributable fixed costs are relevant costs, general fixed overheads are not.

The costs which should be used for decision making are often referred to as relevant costs. Relevant
costing is also used in long-term decision making and investment decisions which we will look at in the
next chapter.
A relevant cost is a future cash flow arising as a direct consequence of a decision.

(a) Relevant costs are future costs.

(i) A decision is about the future – it cannot change the past. A cost that has been incurred is
irrelevant to any decision that is being made 'now'. It is a sunk cost.
(ii) Costs that have been incurred include not only costs that have already been paid but also
costs that are the subject of legally binding contracts, even if payments due under the
contract have not yet been made. These are committed costs.
(b) Relevant costs are cash flows.
Costs or charges which do not reflect additional cash inflows or spending should be ignored for
the purpose of decision making. These include the following.
(i) Depreciation, as a fixed overhead incurred
(ii) Notional rent or interest, as a fixed overhead incurred
(iii) All overheads absorbed; fixed overhead absorption is always irrelevant since it is
overheads to be incurred which affect decisions
(c) Relevant costs are incremental costs.
A relevant cost is one which arises as a direct consequence of a decision. Only costs which will
differ under some or all of the available opportunities should be considered. Relevant costs are
therefore sometimes referred to as incremental costs. For example, if an employee is expected to
have no other work to do during the next week, but will be paid their basic wage (of, say, $100
per week) for attending work, the manager might decide to give them a job which earns only
$40. The net gain is $40 and the $100 is irrelevant to the decision because, although it is a
future cash flow, it will be incurred anyway.
Relevant costs are therefore future, incremental cash flows.
Other terms can be used to describe relevant costs.
Avoidable costs are costs which would not be incurred if the activity to which they relate did not exist.

(a) One of the situations in which it is necessary to identify avoidable costs is in deciding whether or
not to discontinue a product. The only costs which would be saved are the avoidable costs.
These are usually the variable costs and sometimes some specific fixed costs. Costs which would
be incurred whether or not the product is discontinued are unavoidable costs.

Differential cost is the difference in relevant cost between alternatives.

(b) The term 'differential costs' is used to compare the differences in cost between two alternative
courses of action, while 'incremental costs' is used to state the relevant costs when two or more

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options are compared. If option A will cost an extra $300 and option B will cost an extra $360,
the differential cost is $60.

Opportunity cost is the benefit which has been given up, by choosing one option instead of another.

(c) Suppose for example that there are three mutually exclusive options, A, B and C. The net profit
from each would be $80, $100 and $70 respectively.
Since only one option can be selected, option B would be chosen because it offers the biggest
benefit.
$
Profit from option B 100
Less opportunity cost (ie the benefit from the most
profitable alternative, A) 80
Differential benefit of option B 20

The decision to choose option B would not be taken simply because it offers a profit of $100, but
because it offers a differential profit of $20 in excess of the opportunity cost.
Opportunity costs are not recorded in double entry accounts.

6.1 Non-relevant costs

A number of terms are used to describe costs that are irrelevant for decision making.
A sunk cost is a cost which has already been incurred and therefore should not be taken account of in
decision making.

(a) Management decisions can only affect the future. In decision making, managers therefore require
information about future costs and revenues which would be affected by the decision under
review. A sunk cost has either been charged already as a cost of sales in a previous accounting
period or will be charged in a future accounting period. An example of this type of cost is
depreciation. If the non-current asset has been purchased, depreciation may be charged for
several years but the cost is a sunk cost, about which nothing can now be done.

A committed cost is a future cash outflow that will be incurred anyway, whatever decision is taken now
about alternative opportunities.

(b) Committed costs may exist because of contracts already entered into by the organisation, which it
cannot get out of.
A notional cost is a hypothetical accounting cost to reflect the use of a benefit for which no actual cash
expense is incurred.

(c) Examples in cost accounting systems include the following.

(i) Notional rent, such as that charged to a subsidiary, cost centre or profit centre of an
organisation for the use of accommodation which the organisation owns
(ii) Notional interest charges on capital employed, sometimes made against a profit centre or
cost centre
(d) Although historical costs are irrelevant for decision making, historical cost data will often provide
the best available basis for predicting future costs.

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CHAPTER 19 // METHODS OF PROJECT APPRAISAL

6.2 Fixed and variable costs

Unless you are given an indication to the contrary, assume the following.
 Variable costs will be relevant costs.
 Fixed costs are irrelevant to a decision.
This need not be the case, however, and you should analyse variable and fixed cost data carefully. Do
not forget that 'fixed' costs may only be fixed in the short term.

6.2.1 Attributable fixed costs

There might be occasions when a fixed cost is a relevant cost, and you must be aware of the distinction
between 'specific' or 'directly attributable' fixed costs, and general fixed overheads.
(a) Directly attributable fixed costs are those costs which, although fixed within a relevant range of
activity level, are regarded as fixed because management has set a budgeted expenditure level:
(i) Increase if certain extra activities are undertaken
(ii) Decrease/are eliminated entirely if a decision is taken either to reduce the scale of
operations or shut down entirely
(b) General fixed overheads are those fixed overheads which will be unaffected by decisions to
increase or decrease the scale of operations; for example, an apportioned share of fixed costs
which would be completely unaffected by the decisions, such as share of head office charges.
Directly attributable fixed costs are relevant to decision making, general fixed overheads are not.

7 Some rules for identifying relevant costs

7.1 The relevant cost of using machines

Using machinery will involve some incremental costs, user costs. These include repair costs arising from
use, hire charges and any fall in resale value of owned assets which results from their use. Depreciation
is not a relevant cost.

7.2 Example: User costs

Sydney Co is considering whether to undertake some contract work for a customer. The machinery
required for the contract would be as follows.
(a) A special cutting machine will have to be hired for three months. Hire charges for this machine
are $75 per month, with a minimum hire charge of $300.
(b) All other machinery required in the production for the contract has already been purchased by the
organisation on hire purchase terms. The monthly hire purchase payments for this machinery are
$500. This consists of $450 for capital repayment and $50 as an interest charge. The last hire
purchase payment is to be made in two months' time. The cash price of this machinery was
$9,000 two years ago. It is being depreciated on a straight line basis at the rate of $200 per
month. However, it still has a useful life which will enable it to be operated for another 36
months.
The machinery is highly specialised and is unlikely to be required for other, more profitable jobs
over the period during which the contract work would be carried out. Although there is no
immediate market for selling this machine, it is expected that a customer might be found in the
future. It is further estimated that the machine would lose $200 in its eventual sale value if it is
used for the contract work.
Required
Calculate the relevant cost of machinery for the contract.

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7.3 Solution
(a) The cutting machine will incur an incremental cost of $300, the minimum hire charge.
(b) The historical cost of the other machinery is irrelevant as a past cost; depreciation is irrelevant as
a non-cash cost; and future hire purchase repayments are irrelevant because they are committed
costs. The only relevant cost is the loss of resale value of the machinery, estimated at $200
through use. This user cost will not arise until the machinery is eventually resold and the $200
should be discounted to allow for the time value of money. However, discounting is ignored here.
(c) Summary of relevant costs
$
Incremental hire costs 300
User cost of machinery 200
500

QUESTION User cost

A machine which originally cost $12,000 has an estimated life of ten years and is depreciated at the
rate of $1,200 a year. It has been unused for some time, as expected orders did not materialise.
A special order has now been received which would require the use of the machine for two months. The
current net realisable value of the machine is $8,000. If it is used for the job, its value is expected to fall
to $7,500. The net book value of the machine is $8,400.
Routine maintenance of the machine currently costs $40 a month. With use, the cost of maintenance
and repairs would increase to $60 a month.
Required
Determine the cost of using the machine for the order.

ANSWER
$
Loss in net realisable value of the machine through using it on the order $(8,000 – 500
7,500)
Costs in excess of existing routine maintenance costs $(120 – 80) 40
Total marginal user cost 540

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CHAPTER 19 // METHODS OF PROJECT APPRAISAL

CHAPTER ROUNDUP

 A long-term view of benefits and costs must be taken when reviewing a capital expenditure project.
 The key methods of project appraisal are:
 The payback period
 Net present value
 Discounted payback period
 Internal rate of return (IRR)
 The payback period is the time taken for the initial investment to be recovered in the cash inflows from
the project. The payback method is particularly relevant if there are liquidity problems, or if distant
forecasts are very uncertain.
 The time value of money is an important consideration in decision making.
 An effective annual rate of interest is the corresponding annual rate when interest is compounded at
intervals shorter than a year.
 A nominal rate of interest is an interest rate expressed as a per annum figure although the interest is
compounded over a period of less than one year. The corresponding effective rate of interest is the
annual percentage rate (APR) (sometimes called the compound annual rate, CAR).

 Discounted cash flow techniques take account of the time value of money – the fact that $1 received
now is worth more because it could be invested to become a greater sum at the end of a year, and even
more after the end of two years, and so on. As with payback, DCF techniques use cash figures before
depreciation in the calculations.
 The net present value method calculates the present value of all cash flows, and sums them to give the
net present value. If this is positive, then the project is acceptable.
 The discounted payback method applies discounting to arrive at a payback period after which the NPV
becomes positive.
 Annuities are an annual cash payment or receipt which is the same amount every year for a number of
years.
 The internal rate of return technique uses a trial and error method to discover the discount rate which
produces the NPV of zero. This discount rate will be the return forecast for the project.

 Relevant costs are future incremental cash flows.

 Avoidable costs, differential costs and opportunity costs are all relevant costs.
 Non-relevant costs include sunk costs, committed costs and notional (imputed) costs.

 Directly attributable fixed costs are relevant costs, general fixed overheads are not.

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PART C: BUDGETING

1 ……………….. is the length of time required before the total of the cash inflows received from a project
QUICK QUIZ

equals the original cash outlay.

2 Depreciation should be included in DCF calculation.

True False

3 What is the yardstick for acceptance of projects when using the net present value method?
A Accept if a profit is made
B Accept if the present value of future cash flows is positive
C Accept if payback occurs within an reasonable time frame
D Accept if the discount rate that achieves a breakeven return is greater than the company's cost of
capital
4 What is the discounted payback period?
5 The ……………….. is the weighted average cost of all sources of capital for an enterprise, used as the
discount rate in investment appraisal.
6 What are the two steps involved in assessing whether the internal rate of return of a project is sufficient?
Step 1 – Step 2 –
7 Which of the following statements is incorrect?
A Committed costs are relevant costs. C Incremental costs are relevant costs.
B Future costs are relevant costs. D Cash flows are relevant costs.
8 Define opportunity cost.
9 Which type of cost is described below?
'Costs which would not be incurred if the activity to which they relate did not exist'
A Differential costs C Opportunity costs
B Sunk costs D Avoidable costs

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CHAPTER 19 // METHODS OF PROJECT APPRAISAL

1 Payback is the length of time required before the total of the cash inflows received from a project is
ANSWERS TO QUICK QUIZ

equal to the original cash outlay.

2 False. Depreciation does not reflect additional cash spent, and so is not a relevant cost.
3 B Accept the project if the net present value is positive.
4 The time after which the net present value of an investment becomes positive.
5 The cost of capital is the weighted average cost of all sources of capital for an enterprise, used as the
discount rate in investment appraisal.
6 Step 1 – Calculate the rate of return expected.
Step 2 – Compare the rate of return with the cost of capital.
7 A Committed costs are not relevant costs.
8 Opportunity cost is the benefit which could have been earned, but which has been given up, by
choosing one option instead of another.
9 D Avoidable costs are not incurred if the related activity does not exist.

Now try ...

Attempt the questions below from the Practice Question Bank

Q82 – Q89

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part

Standard costing

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PART D: STANDARD COSTING

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C H A P T E R

Just as there are standards for most things in our daily

lives (cleanliness in hamburger restaurants, educational Standard costing
achievement of nine year olds, number of trains running
on time), there are standards for the costs of products
and services. Moreover, just as the standards in our daily
lives are not always met, the standards for the costs of
products and services are not always met. In this chapter
we will be looking at standards for costs, what they are
used for and how they are set.
In the next chapter we will see how standard costing
forms the basis of a process called variance analysis, a
vital management control tool.

SYLLABUS
TOPIC LIST REFERENCE

1 What is standard costing? D1(a), (b)

2 Setting standards D1(b), (c)

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PART D: STANDARD COSTING

Study Guide Intellectual level

D Standard costing

1 Standard costing systems

(a) Explain the purpose and principles of standard costing. K

(b) Explain and illustrate the difference between standard,
K
marginal and absorption costing.
(c) Establish the standard cost per unit under absorption and
S
marginal costing.

EXAM FOCUS POINT

Standard costing can be applied under both absorption and marginal costing and is important in
calculating variances, which we look at in the next chapter. You may be given the standard cost and
required to calculate the variance.

1 What is standard costing?

1.1 Introduction
A standard cost is a predetermined estimated unit cost, used for inventory valuation and control.

The building blocks of standard costing are standard costs and so before we look at standard costing in
any detail you really need to know what a standard cost is.

1.2 Standard cost card

A standard cost card shows full details of the standard cost of each product.

The standard cost card of product 1234 is set out below.

STANDARD COST CARD – PRODUCT 1234
$ $
Direct materials
Material X – 3 kg at $4 per kg 12
Material Y – 9 litres at $2 per litre 18
30
Direct labour
Grade A – 6 hours at $1.50 per hour 9
Grade B – 8 hours at $2 per hour 16
25
Standard direct cost 55
Variable production overhead – 14 hours at $0.50 per hour 7
Standard variable cost of production 62
Fixed production overhead – 14 hours at $4.50 per hour 63
Standard full production cost 125
Administration and marketing overhead 15
Standard cost of sale 140
Standard profit 20
Standard sales price 160

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CHAPTER 20 // STANDARD COSTING

Notice how the total standard cost is built up from standards for each cost element: standard quantities
of materials at standard prices, standard quantities of labour time at standard rates and so on. It is
therefore determined by management's estimates of the following.
 The expected prices of materials, labour and expenses
 Efficiency levels in the use of materials and labour
 Budgeted overhead costs and budgeted volumes of activity
We will see how management arrives at these estimates in Section 2.
But why should management want to prepare standard costs? Obviously to assist with standard costing,
but what is the point of standard costing?

1.3 The uses of standard costing

Standard costing has a variety of uses but its two principal ones are as follows.
(a) To value inventories and cost production for cost accounting purposes
(b) To act as a control device by establishing standards (planned costs), highlighting (via variance
analysis which we will cover in the next chapter) activities that are not conforming to plan and
thus alerting management to areas which may be out of control and in need of corrective action

QUESTION Standard cost card

Bloggs makes one product, the joe. Two types of labour are involved in the preparation of a joe, skilled
and semi-skilled. Skilled labour is paid $10 per hour and semi-skilled $5 per hour. Twice as many
skilled labour hours as semi-skilled labour hours are needed to produce a joe, four semi-skilled labour
hours being needed.
A joe is made up of three different direct materials. Seven kilograms of direct material A, four litres of
direct material B and three metres of direct material C are needed. Direct material A costs $1 per
kilogram, direct material B $2 per litre and direct material C $3 per metre.
Variable production overheads are incurred at Bloggs Co at the rate of $2.50 per direct labour (skilled)
hour.
A system of absorption costing is in operation at Bloggs Co. The basis of absorption is direct labour
(skilled) hours. For the forthcoming accounting period, budgeted fixed production overheads are
$250,000 and budgeted production of the joe is 5,000 units.
Administration, selling and distribution overheads are added to products at the rate of $10 per unit.
A mark-up of 25% is made on the joe.
Required
Using the above information, draw up a standard cost card for the joe.

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ANSWER
STANDARD COST CARD – PRODUCT JOE
Direct materials $ $
A – 7 kg  $1 7
B – 4 litres  $2 8
C – 3 m  $3 9
24
Direct labour
Skilled – 8  $10 80
Semi-skilled – 4  $5 20
100
Standard direct cost 124
Variable production overhead – 8  $2.50 20
Standard variable cost of production 144
Fixed production overhead – 8  $6.25 (W) 50
Standard full production cost 194
Administration, selling and distribution overhead 10
Standard cost of sale 204
Standard profit (25%  204) 51
Standard sales price 255

Working

$250,000
Overhead absorption rate = = $6.25 per skilled labour hour
5,000  8

QUESTION Marginal costing system

What would a standard cost card for product joe show under a marginal system?

ANSWER
STANDARD COST CARD – PRODUCT JOE
$
Direct materials 24
Direct labour 100
Standard direct cost 124
Variable production overhead 20
Standard variable production cost 144
Standard sales price 255
Standard contribution 111

Although the use of standard costs to simplify the keeping of cost accounting records should not be
overlooked, we will be concentrating on the control and variance analysis aspect of standard costing.
Standard costing is a control technique which compares standard costs and revenues with actual
results to obtain variances which are used to improve performance.

Notice that the above definition highlights the control aspects of standard costing.

1.4 Standard costing as a control technique

Differences between actual and standard costs are called variances.

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CHAPTER 20 // STANDARD COSTING

Standard costing therefore involves the following.

 The establishment of predetermined estimates of the costs of products or services
 The collection of actual costs
 The comparison of the actual costs with the predetermined estimates
The predetermined costs are known as standard costs and the difference between standard and actual
cost is known as a variance. The process by which the total difference between standard and actual
results is analysed is known as variance analysis.
Although standard costing can be used in a variety of costing situations (batch and mass production,
process manufacture, jobbing manufacture (where there is standardisation of parts) and service
industries (if a realistic cost unit can be established)), the greatest benefit from its use can be gained if
there is a degree of repetition in the production process. It is therefore most suited to mass production
and repetitive assembly work.

2 Setting standards

2.1 Introduction
Standard costs may be used in both absorption costing and in marginal costing systems. We shall,
however, confine our description to standard costs in absorption costing systems.
As we noted earlier, the standard cost of a product (or service) is made up of a number of different
standards, one for each cost element, each of which has to be set by management. We have divided
this section into two: the first part looks at setting the monetary part of each standard, whereas the
second part looks at setting the resources requirement part of each standard.

2.2 Types of performance standard

Performance standards are used to set efficiency targets. There are four types: ideal, attainable, current
and basic.

The setting of standards raises the problem of how demanding the standard should be. Should the
standard represent a perfect performance or an easily attainable performance? The type of performance
standard used can have behavioural implications. There are four types of standard.

Type of Description
standard
Ideal These are based on perfect operating conditions: no wastage, no spoilage, no
inefficiencies, no idle time, no breakdowns. Variances from ideal standards are useful for
pinpointing areas where a close examination may result in large savings in order to
maximise efficiency and minimise waste. However, ideal standards are likely to have an
unfavourable motivational impact because reported variances will always be adverse.
Employees will often feel that the goals are unattainable and not work so hard.
Attainable These are based on the hope that a standard amount of work will be carried out
efficiently, machines properly operated or materials properly used. Some allowance is
made for wastage and inefficiencies. If well set, they provide a useful psychological
incentive by giving employees a realistic but challenging target of efficiency. The consent
and co-operation of employees involved in improving the standard are required.
Current These are based on current working conditions (current wastage, current inefficiencies).
The disadvantage of current standards is that they do not attempt to improve on current
levels of efficiency.
Basic These are kept unaltered over a long period of time, and may be out of date. They are
used to show changes in efficiency or performance over a long period of time. Basic
standards are perhaps the least useful and least common type of standard in use.

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Ideal standards, attainable standards and current standards each have their supporters and it is by no
means clear which of them is preferable.

QUESTION Performance standards

Which of the following statements is not true?
A Variances from ideal standards are useful for pinpointing areas where a close examination might
result in large cost savings.
B Basic standards may provide an incentive to greater efficiency even though the standard cannot
be achieved.
C Ideal standards cannot be achieved and so there will always be adverse variances. If the
standards are used for budgeting, an allowance will have to be included for these 'inefficiencies'.
D Current standards or attainable standards are a better basis for budgeting, because they represent
the level of productivity which management will wish to plan for.

ANSWER
The correct answer is B.
Statement B is describing ideal standards, not basic standards.

2.3 Direct material prices

Direct material prices will be estimated by the purchasing department from their knowledge of the following.
 Purchase contracts already agreed
 Pricing discussions with regular suppliers
 The forecast movement of prices in the market
 The availability of bulk purchase discounts
Price inflation can cause difficulties in setting realistic standard prices. Suppose that a material costs
$10 per kilogram at the moment and during the course of the next 12 months it is expected to go up in
price by 20% to $12 per kilogram. What standard price should be selected?
 The current price of $10 per kilogram
 The average expected price for the year, say $11 per kilogram
Either would be possible, but neither would be entirely satisfactory.
(a) If the current price were used in the standard, the reported price variance will become adverse as
soon as prices go up, which might be very early in the year. If prices go up gradually rather than
in one big jump, it would be difficult to select an appropriate time for revising the standard.
(b) If an estimated mid-year price were used, price variances should be favourable in the first half of
the year and adverse in the second half of the year, again assuming that prices go up gradually
throughout the year. Management could only really check that in any month, the price variance
did not become excessively adverse (or favourable) and that the price variance switched from
being favourable to adverse around month six or seven and not sooner.

2.4 Direct labour rates

Direct labour rates per hour will be set by discussion with the personnel department and by reference to
the payroll and to any agreements on pay rises with trade union representatives of the employees.
(a) A separate hourly rate or weekly wage will be set for each different labour grade/type of
employee.
(b) An average hourly rate will be applied for each grade (even though individual rates of pay may
vary according to age and experience).

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Similar problems when dealing with inflation to those described for material prices can be met when
setting labour standards.

2.5 Overhead absorption rates

When standard costs are fully absorbed costs, the absorption rate of fixed production overheads will be
predetermined, usually each year when the budget is prepared, and based in the usual manner on
budgeted fixed production overhead expenditure and budgeted production.
For selling and distribution costs, standard costs might be absorbed as a percentage of the standard
selling price.
Standard costs under marginal costing will, of course, not include any element of absorbed overheads.

2.6 Standard resource requirements

To estimate the materials required to make each product (material usage) and also the labour hours
required (labour efficiency), technical specifications must be prepared for each product by production
experts (either in the production department or the work study department).
(a) The 'standard product specification' for materials must list the quantities required per unit of
each material in the product. These standard input quantities must be made known to the
operators in the production department so that control action by management to deal with excess
material wastage will be understood by them.
(b) The 'standard operation sheet' for labour will specify the expected hours required by each grade
of labour in each department to make one unit of product. These standard times must be
carefully set (for example by work study) and must be understood by the labour force. Where
necessary, standard procedures or operating methods should be stated.

EXAM FOCUS POINT

An exam question may give you actual costs and variances and require you to calculate the standard
cost.

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CHAPTER ROUNDUP

 A standard cost is a predetermined estimated unit cost, used for inventory valuation and control.
 A standard cost card shows full details of the standard cost of each product.

 Differences between actual and standard costs are called variances.

 Performance standards are used to set efficiency targets. There are four types: ideal, attainable, current
and basic.

1 A standard cost is ………………………………………………….. .

QUICK QUIZ

2 What are two main uses of standard costing?

3 A control technique which compares standard costs and revenues with actual results to obtain variances
which are used to stimulate improved performance is known as:
A Standard costing
B Variance analysis
C Budgetary control
D Budgeting
4 Standard costs may only be used in absorption costing.

True

False

5 Two types of performance standard are:

(a) …………………………..
(b) …………………………..

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CHAPTER 20 // STANDARD COSTING

1 A planned unit cost

ANSWERS TO QUICK QUIZ

2 (a) To value inventories and cost production for cost accounting purposes
(b) To act as a control device by establishing standards and highlighting activities that are not
conforming to plan and bringing these to the attention of management
3 A
4 False. They may be used in a marginal costing system as well.
5 (a) Attainable
(b) Ideal

Now try ...

Attempt the questions below from the Practice Question Bank

Q90 – Q92

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C H A P T E R

The actual results achieved by an organisation during a

reporting period (week, month, quarter, year) will more Cost variances
than likely be different from the expected results (the
expected results being the standard costs and revenues
which we looked at in the previous chapter). Such
differences may occur between individual items, such as
the cost of labour and the volume of sales, and between
the total expected profit/contribution and the total actual
profit/contribution.
Management will have spent considerable time and
trouble setting standards. Actual results have differed
from the standards. The wise manager will consider the
differences that have occurred and use the results of
these considerations to assist in attempts to attain the
standards. The wise manager will use variance analysis
as a method of control.
This chapter examines variance analysis and sets out the
method of calculating the variances stated below in the
Study Guide.
We will then go on to look at the reasons for and
significance of cost variances.
Chapter 22 of this Management Accounting Interactive
Text will build on the basics set down in this chapter by
introducing sales variances and operating statements.

SYLLABUS
TOPIC LIST REFERENCE

1 Variances D2
2 Direct material cost variances D2(b)
3 Direct labour cost variances D2(c)
4 Variable production overhead variances D2(d)
5 Fixed production overhead variances D2(e)
6 Flexed budgets and variances C6(a), D2
7 The reasons for cost variances D2(f), (g)
8 The significance of cost variances C6(b), C6(c), D2(g), (h)

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Study Guide Intellectual level

D Standard costing

2 Variance calculations and analysis

(b) Calculate materials total, price and usage variance. S

(c) Calculate labour total, rate and efficiency variance. S
(d) Calculate variable overhead total, expenditure and efficiency. S
(e) Calculate fixed overhead total, expenditure and, where
S
appropriate, volume, capacity and efficiency variance.
(f) Interpret the variances. S
(g) Explain factors to consider before investigating variances,
S
explain possible causes of the variances and recommend
control action.
(h) Explain the interrelationships between the variances. K

C Budgeting

6 Budgetary control and reporting

(a) Calculate simple variances between flexed budget, fixed

S
budget and actual sales, costs and profits.
(b) Discuss the relative significance of variances. K
(c) Explain potential action to eliminate variances. K

EXAM FOCUS POINT

Variance calculation is a very important part of your Management Accounting studies and it is vital that
you are able to calculate all of the different types of variance included in the syllabus.

1 Variances

A variance is the difference between a planned, budgeted or standard cost and the actual cost incurred.
The same comparisons may be made for revenues. The process by which the total difference between
standard and actual results is analysed is known as variance analysis.

When actual results are better than expected results, we have a favourable variance (F). If, on the other
hand, actual results are worse than expected results, we have an adverse variance (A).
Variances can be divided into three main groups.
 Variable cost variances
 Sales variances
 Fixed production overhead variances
In the remainder of this chapter we will consider, in detail, variable cost variances and fixed production
overhead variances.

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2 Direct material cost variances

2.1 Introduction
The direct material total variance can be subdivided into the direct material price variance and the
direct material usage variance.

The direct material total variance is the difference between what the output actually cost and what it
should have cost, in terms of material.
The direct material price variance is the difference between the standard cost and the actual cost for
the actual quantity of material used or purchased. In other words, it is the difference between what the
material did cost and what it should have cost.
The direct material usage variance is the difference between the standard quantity of materials that
should have been used for the number of units actually produced, and the actual quantity of materials
used, valued at the standard cost per unit of material. In other words, it is the difference between how
much material should have been used and how much material was used, valued at standard cost.

2.2 Example: Direct material variances

Product X has a standard direct material cost as follows.
10 kilograms of material Y at $10 per kilogram = $100 per unit of X.
During period 4, 1,000 units of X were manufactured, using 11,700 kilograms of material Y which cost
$98,600.
Required
Calculate the following variances.
(a) The direct material total variance
(b) The direct material price variance
(c) The direct material usage variance

Solution
(a) The direct material total variance
This is the difference between what 1,000 units should have cost and what they did cost.
$
1,000 units should have cost ( $100) 100,000
but did cost 98,600
Direct material total variance 1,400 (F)

The variance is favourable because the units cost less than they should have cost.
Now we can break down the direct material total variance into its two constituent parts: the
direct material price variance and the direct material usage variance.
(b) The direct material price variance
This is the difference between what 11,700 kg should have cost and what 11,700 kg did cost.
$
11,700 kg of Y should have cost ( $10) 117,000
but did cost 98,600
Material Y price variance 18,400 (F)

The variance is favourable because the material cost less than it should have.

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(c) The direct material usage variance

This is the difference between how many kilograms of Y should have been used to produce
1,000 units of X and how many kilograms were used, valued at the standard cost per kilogram.
1,000 units should have used ( 10 kg) 10,000 kg
but did use 11,700 kg
Usage variance in kg 1,700 kg (A)
 standard cost per kilogram × $10
Usage variance in $ $17,000 (A)

The variance is adverse because more material was used than should have been.
(d) Summary
$
Price variance 18,400 (F)
Usage variance 17,000 (A)
Total variance 1,400 (F)

2.3 Materials variances and opening and closing inventory

Direct material price variances are usually extracted at the time of the receipt of the materials rather
than at the time of usage.

Suppose that a company uses raw material P in production, and that this raw material has a standard
price of $3 per metre. During one month 6,000 metres are bought for $18,600, and 5,000 metres are
used in production. At the end of the month, inventory will have been increased by 1,000 metres. In
variance analysis, the problem is to decide the material price variance. Should it be calculated on the
basis of materials purchased (6,000 metres) or on the basis of materials used (5,000 metres)?
The answer to this problem depends on how closing inventories of the raw materials will be valued.
(a) If they are valued at standard cost (1,000 units at $3 per unit), the price variance is calculated
on material purchases in the period.
(b) If they are valued at actual cost (first in, first out) (1,000 units at $3.10 per unit) the price
variance is calculated on materials used in production in the period.
A full standard costing system is usually in operation and therefore the price variance is usually
calculated on purchases in the period. The variance on the full 6,000 metres will be written off to the
costing profit and loss account, even though only 5,000 metres are included in the cost of production.
There are two main advantages in extracting the material price variance at the time of receipt.
(a) If variances are extracted at the time of receipt they will be brought to the attention of managers
earlier than if they are extracted as the material is used. If it is necessary to correct any variances
then management action can be more timely.
(b) Since variances are extracted at the time of receipt, all inventories will be valued at standard
price. This is administratively easier and it means that all issues from inventory can be made at
standard price. If inventories are held at actual cost it is necessary to calculate a separate price
variance on each batch as it is issued. Since issues are usually made in a number of small
batches this can be a time-consuming task, especially with a manual system.
The price variance would be calculated as follows.
$
6,000 metres of material P purchased should cost ( $3) 18,000
but did cost 18,600
Price variance 600 (A)

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3 Direct labour cost variances

3.1 Introduction
The direct labour total variance can be subdivided into the direct labour rate variance and the direct
labour efficiency variance.

The direct labour total variance is the difference between what the output should have cost and what
it did cost, in terms of labour.
The direct labour rate variance is similar to the direct material price variance. It is the difference
between the standard cost and the actual cost for the actual number of hours paid for.
In other words, it is the difference between what the labour did cost and what it should have cost.
The direct labour efficiency variance is similar to the direct material usage variance. It is the
difference between the hours that should have been worked for the number of units actually
produced, and the actual number of hours worked, valued at the standard rate per hour.
In other words, it is the difference between how many hours should have been worked and how many
hours were worked, valued at the standard rate per hour.

The calculation of direct labour variances is very similar to the calculation of direct material variances.

3.2 Example: Direct labour variances

The standard direct labour cost of product X is as follows.
2 hours of grade Z labour at $5 per hour = $10 per unit of product X.
During period 4, 1,000 units of product X were made, and the direct labour cost of grade Z labour was
$8,900 for 2,300 hours of work.
Required
Calculate the following variances.
(a) The direct labour total variance
(b) The direct labour rate variance
(c) The direct labour efficiency (productivity) variance

Solution
(a) The direct labour total variance
This is the difference between what 1,000 units should have cost and what they did cost.
$
1,000 units should have cost ( $10) 10,000
but did cost 8,900
Direct labour total variance 1,100 (F)
The variance is favourable because the units cost less than they should have done. Again, we
can analyse this total variance into its two constituent parts.
(b) The direct labour rate variance
This is the difference between what 2,300 hours should have cost and what 2,300 hours did
cost.
$
2,300 hours of work should have cost ( $5 per hr) 11,500
but did cost 8,900
Direct labour rate variance 2,600 (F)

The variance is favourable because the labour cost less than it should have cost.

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(c) The direct labour efficiency variance

1,000 units of X should have taken ( 2 hrs) 2,000 hrs
but did take 2,300 hrs
Efficiency variance in hours 300 hrs (A)
 standard rate per hour × $5
Efficiency variance in $ $1,500 (A)

The variance is adverse because more hours were worked than should have been worked.
(d) Summary
$
Rate variance 2,600 (F)
Efficiency variance 1,500 (A)
Total variance 1,100 (F)

4 Variable production overhead variances

The variable production overhead total variance can be subdivided into the variable production overhead
expenditure variance and the variable production overhead efficiency variance (based on actual hours).

4.1 Example: Variable production overhead variances

Suppose that the variable production overhead cost of product X is as follows.
2 hours at $1.50 = $3 per unit
During period 6, 1,000 units of product X were made. The labour force worked 2,020 hours, of which
60 hours were recorded as idle time. The variable overhead cost was $3,075.
Calculate the following variances.
(a) The variable overhead total variance
(b) The variable production overhead expenditure variance
(c) The variable production overhead efficiency variance
Since this example relates to variable production costs, the total variance is based on actual units of
production. (If the overhead had been a variable selling cost, the variance would be based on sales
volumes.)
$
1,000 units of product X should cost ( $3) 3,000
but did cost 3,075
Variable production overhead total variance 75 (A)

In many variance reporting systems, the variance analysis goes no further, and expenditure and
efficiency variances are not calculated. However, the adverse variance of $75 may be explained as the
sum of two factors.
(a) The hourly rate of spending on variable production overheads was higher than it should have
been; that is, there is an expenditure variance.
(b) The labour force worked inefficiently, and took longer to make the output than it should have
done. This means that spending on variable production overhead was higher than it should have
bee;, in other words, there is an efficiency (productivity) variance. The variable production
overhead efficiency variance is exactly the same, in hours, as the direct labour efficiency
variance, and occurs for the same reasons.
It is usually assumed that variable overheads are incurred during active working hours, but are not
incurred during idle time (for example the machines are not running, therefore power is not being
consumed, and no indirect materials are being used). This means in our example that although the labour
force was paid for 2,020 hours, they were actively working for only 1,960 of those hours and so variable
production overhead spending occurred during 1,960 hours.

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The variable production overhead expenditure variance is the difference between the amount of
variable production overhead that should have been incurred in the actual hours actively worked, and
the actual amount of variable production overhead incurred.

(a) $
1,960 hours of variable production overhead should cost ( $1.50) 2,940
but did cost 3,075
Variable production overhead expenditure variance 135 (A)

The variable production overhead efficiency variance. If you already know the direct labour efficiency
variance, the variable production overhead efficiency variance is exactly the same in hours, but priced at
the variable production overhead rate per hour.

(b) In our example, the efficiency variance would be as follows.

1,000 units of product X should take ( 2 hrs) 2,000 hrs
but did take (active hours) 1,960 hrs
Variable production overhead efficiency variance in hours 40 hrs (F)
 standard rate per hour × $1.50
Variable production overhead efficiency variance in $ $60 (F)

(c) Summary
$
Variable production overhead expenditure variance 135 (A)
Variable production overhead efficiency variance 60 (F)
Variable production overhead total variance 75 (A)

5 Fixed production overhead variances

EXAM FOCUS POINT

The ACCA examining team has highlighted the calculation and explanation of fixed production
overhead expenditure, volume, capacity and efficiency variances as an area where students perform
poorly. Make sure you study this section carefully and attempt all the questions to ensure you will not
be one of these students!

5.1 Introduction
The fixed production overhead total variance can be subdivided into an expenditure variance and a
volume variance. The fixed production overhead volume variance can be further subdivided into an
efficiency and capacity variance.

You may have noticed that the method of calculating cost variances for variable cost items is essentially
the same for labour, materials and variable overheads. Fixed production overhead variances are very
different. In an absorption costing system, they are an attempt to explain the under- or over-absorption
of fixed production overheads in production costs. We looked at under-/over-absorption of fixed
overheads in Chapter 8.
The fixed production overhead total variance (ie the under- or over-absorbed fixed production overhead)
may be broken down into two parts as usual.

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 An expenditure variance
 A volume variance. This in turn may be split into two parts.
– A volume efficiency variance
– A volume capacity variance
You will find it easier to calculate and understand fixed overhead variances if you keep in mind the
whole time that you are trying to 'explain' (put a name and value to) any under- or over-absorbed
overhead.

EXAM FOCUS POINT

You will need to be able to distinguish between marginal and absorption costing. The variances
introduced above and discussed below relate to an absorption costing system. Marginal costing is dealt
with in Chapter 22. In the marginal costing system the only fixed overhead variance is an expenditure
variance.

5.2 Under/over absorption

Remember that the absorption rate is calculated as follows.
Budgeted fixed overhead
Overhead absorption rate =
Budgeted activity level

Remember that the budgeted fixed overhead is the planned or expected fixed overhead and the
budgeted activity level is the planned or expected activity level.
If either of the following are incorrect, then we will have an under- or over-absorption of overhead.
 The numerator (number on top) = Budgeted fixed overhead
 The denominator (number on bottom) = Budgeted activity level

5.3 The fixed overhead expenditure variance

The fixed overhead expenditure variance occurs if the numerator is incorrect. It measures the under- or
over-absorbed overhead caused by the actual total overhead being different from the budgeted total
overhead.
Therefore, fixed overhead expenditure variance = Budgeted (planned) expenditure – Actual
expenditure.

5.4 The fixed overhead volume variance

As we have already stated, the fixed overhead volume variance is made up of the following sub-
variances.
 Fixed overhead efficiency variance
 Fixed overhead capacity variance
These variances arise if the denominator (ie the budgeted activity level) is incorrect.
The fixed overhead efficiency and capacity variances measure the under- or over-absorbed overhead
caused by the actual activity level being different from the budgeted activity level used in calculating the
absorption rate.
There are two reasons why the actual activity level may be different from the budgeted activity level
used in calculating the absorption rate.
(a) The workforce may have worked more or less efficiently than the standard set. This deviation is
measured by the fixed overhead efficiency variance.

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CHAPTER 21 // COST VARIANCES

(b) The hours worked by the workforce could have been different to the budgeted hours (regardless
of the level of efficiency of the workforce) because of overtime and strikes etc. This deviation from
the standard is measured by the fixed overhead capacity variance.

5.5 How to calculate the variances

In order to clarify the overhead variances which we have encountered in this section, consider the
following definitions which are expressed in terms of how each overhead variance should be calculated.
Fixed overhead total variance is the difference between fixed overhead incurred and fixed overhead
absorbed. In other words, it is the under- or over-absorbed fixed overhead.
Fixed overhead expenditure variance is the difference between the budgeted fixed overhead
expenditure and actual fixed overhead expenditure.
Fixed overhead volume variance is the difference between actual and budgeted (planned) volume
multiplied by the standard absorption rate per unit.
Fixed overhead volume efficiency variance is the difference between the number of hours that actual
production should have taken, and the number of hours actually taken (that is, worked) multiplied by
the standard absorption rate per hour.
Fixed overhead volume capacity variance is the difference between budgeted (planned) hours of work
and the actual hours worked, multiplied by the standard absorption rate per hour.

You should now be ready to work through an example to demonstrate all of the fixed overhead
variances.

5.6 Example: Fixed overhead variances

Suppose that a company plans to produce 1,000 units of product E during August 20X3. The expected
time to produce a unit of E is five hours, and the budgeted fixed overhead is $20,000. The standard
fixed overhead cost per unit of product E will therefore be as follows.
5 hours at $4 per hour = $20 per unit
Actual fixed overhead expenditure in August 20X3 turns out to be $20,450. The labour force manages
to produce 1,100 units of product E in 5,400 hours of work.
Task
Calculate the following variances.
(a) The fixed overhead total variance
(b) The fixed overhead expenditure variance
(c) The fixed overhead volume variance
(d) The fixed overhead volume efficiency variance
(e) The fixed overhead volume capacity variance

Solution
All the variances help to assess the under- or over-absorption of fixed overheads, some in greater detail
than others.
(a) Fixed overhead total variance
$
Fixed overhead incurred 20,450
Fixed overhead absorbed (1,100 units  $20 per unit) 22,000
Fixed overhead total variance 1,550 (F)
(= under-/over-absorbed overhead)

The variance is favourable because more overheads were absorbed than budgeted.

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(b) Fixed overhead expenditure variance

$
Budgeted fixed overhead expenditure 20,000
Actual fixed overhead expenditure 20,450
Fixed overhead expenditure variance 450 (A)

The variance is adverse because actual expenditure was greater than budgeted expenditure.
(c) Fixed overhead volume variance
The production volume achieved was greater than expected. The fixed overhead volume variance
measures the difference at the standard rate.
$
Actual production at standard rate (1,100  $20 per unit) 22,000
Budgeted production at standard rate (1,000  $20 per unit) 20,000
Fixed overhead volume variance 2,000 (F)

The variance is favourable because output was greater than expected.

(i) The labour force may have worked efficiently, and produced output at a faster rate than
expected. Since overheads are absorbed at the rate of $20 per unit, more will be absorbed
if units are produced more quickly. This efficiency variance is exactly the same in hours
as the direct labour efficiency variance, but is valued in $ at the standard absorption rate
for fixed overhead.
(ii) The labour force may have worked longer hours than budgeted, and therefore produced
more output, so there may be a capacity variance.
(d) Fixed overhead volume efficiency variance
The volume efficiency variance is calculated in the same way as the labour efficiency variance.
1,100 units of product E should take ( 5 hrs) 5,500 hrs
but did take 5,400 hrs
Fixed overhead volume efficiency variance in hours 100 hrs (F)
 standard fixed overhead absorption rate per hour  $4
Fixed overhead volume efficiency variance in $ $400 (F)

The labour force has produced 5,500 standard hours of work in 5,400 actual hours and so
output is 100 standard hours (or 20 units of product E) higher than budgeted for this reason and
the variance is favourable.
(e) Fixed overhead volume capacity variance
The volume capacity variance is the difference between the budgeted hours of work and the
actual active hours of work (excluding any idle time).
Budgeted hours of work 5,000 hrs
Actual hours of work 5,400 hrs
Fixed overhead volume capacity variance 400 hrs (F)
 standard fixed overhead absorption rate per hour  $4
Fixed overhead volume capacity variance in $ $1,600 (F)

Since the labour force worked 400 hours longer than planned, we should expect output to be
400 standard hours (or 80 units of product E) higher than budgeted and therefore the variance is
favourable.
The variances may be summarised as follows.
$
Expenditure variance 450 (A)
Efficiency variance 400 (F)
Capacity variance 1,600 (F)
Over-absorbed overhead (total variance) 1,550 (F)

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CHAPTER 21 // COST VARIANCES

EXAM FOCUS POINT

In general, a favourable cost variance will arise if actual results are less than expected results. Be
aware, however, of the fixed overhead volume variance and the fixed overhead volume capacity
variance which give rise to favourable and adverse variances in the following situations.
 A favourable fixed overhead volume variance occurs when actual production is greater than
budgeted (planned) production.
 An adverse fixed overhead volume variance occurs when actual production is less than
budgeted (planned) production.
 A favourable fixed overhead volume capacity variance occurs when actual hours of work are
greater than budgeted (planned) hours of work.
 An adverse fixed overhead volume capacity variance occurs when actual hours of work are less
than budgeted (planned) hours of work.

You may remember a similar graph appearing in Chapter 8. This one shows over-absorption of
overheads.

$ Budgeted fixed overhead

Total fixed
overhead
variance
Actual fixed overhead

Absorbed
overhead

Budgeted Actual Activity

hours hours
Do not worry if you find fixed production overhead variances more difficult to grasp than the other
variances we have covered. Most students do. Read over this section again and then try the following
practice questions.

QUESTION Capacity variance

A manufacturing company operates a standard absorption costing system. Last month 25,000
production hours were budgeted and the budgeted fixed production overhead cost was $125,000. Last
month the actual hours worked were 24,000 and the standard hours for actual production were
27,000.
What was the fixed production overhead capacity variance for last month?
A $5,000 adverse
B $5,000 favourable
C $10,000 adverse
D $10,000 favourable

ANSWER
The correct answer is A.
Standard fixed overhead absorption rate per hour = $125,000/25,000 = $5 per hour

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Fixed overhead volume capacity variance

Budgeted hours of work 25,000 hrs
Actual hours of work 24,000 hrs
Fixed overhead volume capacity variance 1,000 hrs (A)
 standard fixed overhead absorption rate per hour  $5
Fixed overhead volume capacity variance in $ $5,000 (A)

Refer to the Exam focus point above for the rules on how to identify an adverse fixed overhead volume
capacity variance. Remember that the capacity variance represents part of the over-/under-absorption of
overheads. As the company worked less hours than budgeted (and the standard fixed overhead
absorption rate is calculated using budgeted hours) this will result in an under-absorption of overheads.

The following information relates to the questions shown below.

Barbados has prepared the following standard cost information for one unit of Product Zeta.
Direct materials 4 kg @ $10/kg $40.00
Direct labour 2 hours @ $4/hour $8.00
Fixed overheads 3 hours @ $2.50 $7.50
The fixed overheads are based on a budgeted expenditure of $75,000 and budgeted activity of 30,000
hours.
Actual results for the period were recorded as follows.
Production 9,000 units
Materials – 33,600 kg $336,000
Labour – 16,500 hours $68,500
Fixed overheads $70,000

QUESTION Material variances

The direct material price and usage variances are:
Material price Material usage
$ $
A – 24,000 (F)
B – 24,000 (A)
C 24,000 (F) –
D 24,000 (A) –

ANSWER
Material price variance
$
33,600 kg should have cost (× $10/kg) 336,000
and did cost 336,000
–
Material usage variance
9,000 units should have used ( 4 kg) 36,000 kg
but did use 33,600 kg
2,400 kg (F)
 standard cost per kg × $10
24,000 (F)
The correct answer is therefore A.

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CHAPTER 21 // COST VARIANCES

QUESTION Labour variances

The direct labour rate and efficiency variances are:
Labour rate Labour efficiency
$ $
A 6,000 (F) 2,500 (A)
B 6,000 (A) 2,500 (F)
C 2,500 (A) 6,000 (F)
D 2,500 (F) 6,000 (A)

ANSWER
Direct labour rate variance
$
16,500 hrs should have cost ( $4) 66,000
but did cost 68,500
2,500 (A)
Direct labour efficiency variance
9,000 units should have taken ( 2 hrs) 18,000 hrs
but did take 16,500 hrs
1,500 (F)
 standard rate per hour ( $4) × $4
6,000 (F)

The correct answer is therefore C.

QUESTION Overhead variances

The total fixed production overhead variance is:
A $5,000 (A)
B $5,000 (F)
C $2,500 (A)
D $2,500 (F)

ANSWER
$
Fixed production overhead absorbed ($7.50  9,000) 67,500
Fixed production overhead incurred 70,000
2,500 (A)

The correct answer is therefore C.

QUESTION XYZ Co
XYZ Co is planning to make 120,000 units per period of a new product. The following standards have
been set.
Per unit
Direct material A 1.2 kg at $11 per kg
Direct material B 4.7 kg at $6 per kg
Direct labour:
Operation 1 42 minutes
Operation 2 37 minutes
Operation 3 11 minutes

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Overheads are absorbed at the rate of $30 per labour hour. All direct operatives are paid at the rate of
$8 per hour. Attainable work hours are less than clock hours, so the 500 direct operatives have been
budgeted for 400 hours each in the period.
Actual results for the period were:
Production 126,000 units
Direct labour cost $1.7m for 215,000 clock hours
Material A cost $1.65m for 150,000 kg
Material B cost $3.6m for 590,000 kg
Required
(a) Calculate the standard cost for one unit. (2 marks)
(b) Calculate the labour rate variance and a realistic efficiency variance. (4 marks)
(c) Calculate the material price and usage variances. (4 marks)
(Total = 10 marks)

ANSWER
The information given should have led you to understand that the key standard figure was not clock
hours (500  400 = 200,000), but attainable work hours (120,000  1.5 = 180,000, 90% of clock
hours). Hence actual clock hours had to be scaled down by 10% in order to calculate the realistic
efficiency variance.

(a) Standard cost per unit $ $

Materials
A 1.2 kg  $11 = 13.20
B 4.7 kg  $6 = 28.20
41.40
Labour
1.5 hours  $8 12.00
Prime cost 53.40
Overheads
1.5 hours  $30 45.00
Standard cost per unit 98.40

(b) Labour rate variance

$
215,000 hrs should cost ( $8) 1,720,000
but did cost 1,700,000
20,000 (F)
Labour efficiency variance
126,000 units should take ( 1.5 hrs) 189,000 hrs
but did take (215,000 hrs  90%) 193,500 hrs
4,500 hrs (A)
Standard rate per hour  $8
$36,000 (A)

(c) Material A $
150,000 kg should cost ( $11) 1,650,000
but did cost 1,650,000
Price variance 0
126,000 units should use ( 1.2 kg) 151,200 kg
but did use 150,000 kg
1,200 kg (F)
 Standard cost per kg  $11
Usage variance $13,200 (F)

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Material B $
590,000 kg should cost ( $6) 3,540,000
but did cost 3,600,000
Price variance 60,000 (A)
126,000 units should use ( 4.7 kg) 592,200 kg
but did use 590,000 kg
2,200 kg (F)
 Standard cost per kg  $6
Usage variance $13,200 (F)

5.6.1 Example: Fixed overheads variances and the graph

Suppose a company plans to produce 3,000 units during the month. The standard fixed overhead cost
per unit is as follows.
2 hours  $2.50 per hour = $5 per unit
Actual fixed overhead expenditure during the month turns out to be $20,000 and the labour force
manages to produce 3,500 units.
We can plot these figures onto a graph.
Budgeted fixed overhead cost = 3,000 units  $5 = $15,000. This is shown as Line A on the graph.
Standard fixed overhead cost = $5 per unit. This is shown as Line B on the graph.
Actual cost = $20,000. This is shown as Line C on the graph.
Overhead absorbed = 3,500 units  $5 = $17,500. This is shown as Point D on the graph. You can
look up 3,500 units on the x axis and then read off the standard fixed overhead cost line ($17,500).
Graph of fixed overhead costs

22,500

Line C Actual fixed

20,000
overhead cost

17,500 Point D

Line A Budgeted fixed

15,000
overhead cost
st
co
h
o/

Fixed 12,500
de

overhead
fix

cost
rd
da

$ 10,000
an
St
B
e
Lin

7,500

5,000

2,500

600 1,200 1,800 2,400 3,000 3,600 4,200 4,800 5,400 x

3,500
Number of units produced

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We can now read the variances from the graph.

The fixed overhead expenditure variance is calculated as:
$
Budgeted fixed overhead expenditure (Line A cost) 15,000
Actual fixed overhead expenditure (Line C cost) 20,000
Fixed overhead expenditure variance 5,000 (A)

So if you only had a graph, you could read off the fixed overhead expenditure variance as A – C.
The fixed overhead volume variance is calculated as:
$
Actual production at standard rate (3,500  $5 per unit) (Point D cost) 17,500
Budgeted production at standard rate (Line A cost) 15,000
Fixed overhead volume variance 2,500 (F)

So if you only had a graph, you could read off the fixed overhead volume variance as D – A.
The total fixed overhead variance is calculated as:
$
Fixed overhead incurred (Line C cost) 20,000
Fixed overhead absorbed (Point D cost) 17,500
Fixed overhead total variance (= under absorbed) 2,500 (A)

(Note that under absorption means that we didn't charge enough to the statement of profit or loss. We
need to charge an extra $2,500. This is why the variance is adverse.) So if you only had a graph, you
could read off the total fixed overhead variance as C – D.
Here is the graph redrawn to show you the variances.
Graph of fixed overhead costs and variances

22,500

Line C Actual fixed

20,000
Total fixed overhead cost
Fixed overhead
overhead
expenditure
variance
17,500 variance Point D
Fixed o/h volume
variance Line A Budgeted fixed
15,000
overhead cost
st
co
h
o/

Fixed 12,500
ed

overhead
fix

cost
rd
da

$ 10,000
an
St
B
e
Lin

7,500

5,000

2,500

600 1,200 1,800 2,400 3,000 3,600 4,200 4,800 5,400 x

3,500 (= actual units)

Number of units produced

In the following month the actual fixed overhead expenditure during the month turns out to be $10,000
and the labour force manages to produce 2,400 units.
Budgeted fixed overhead cost = 3,000 units  $5 = $15,000. This is shown as Line A on the graph.

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Standard fixed overhead cost = $5 per unit. This is shown as Line B on the graph.
Actual cost = $10,000. This is shown as Line C on the graph.
Overhead absorbed = 2,400 units  $5 = $12,000. This is shown as Point D on the graph. You can
look up 2,400 units on the x axis and then read off the standard fixed overhead cost line ($12,000).
We can plot these figures onto a graph.
Graph of fixed overhead costs

22,500

20,000

17,500

Line A Budgeted fixed

15,000
overhead cost

Fixed 12,500
overhead 12,000 Point D
cost
$ Line C Actual fixed
10,000
overhead cost

7,500
B
e

5,000
Lin

2,500

600 1,200 1,800 2,400 3,000 3,600 4,200 4,800 5,400 x

Number of units produced

We can now read the variances from the graph.

The fixed overhead expenditure variance is calculated as:
$
Budgeted fixed overhead expenditure (Line A cost) 15,000
Actual fixed overhead expenditure (Line C cost) 10,000
Fixed overhead expenditure variance 5,000 (F)

So if you only had a graph, you could read off the fixed overhead expenditure variance as A – C.
The fixed overhead volume variance is calculated as:
$
Actual production at standard rate (2,400  $5 per unit) (Point D cost) 12,000
Budgeted production at standard rate (Line A cost) 15,000
Fixed overhead volume variance 3,000 (A)

So if you only had a graph, you could read off the fixed overhead volume variance as D – A.
The total fixed overhead variance is calculated as:
$
Fixed overhead incurred (Line C cost) 10,000
Fixed overhead absorbed (Point D cost) 12,000
Fixed overhead total variance 2,000 (F)
(= over-absorbed overhead)

(Note that we have over absorbed the overheads and so we have charged too much to the statement of
profit or loss. We need to add back $2,000 to profit and therefore the variance is favourable.)
So if you only had a graph, you could read off the total fixed overhead variance as C – D.

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Here is the graph redrawn to show you the variances.

Graph of fixed overhead costs

22,500

20,000

17,500

Line A Budgeted fixed

15,000
Fixed o/h overhead cost
volume Fixed overhead
Fixed variance expenditure
12,500 variance
overhead 12,000 Point D
cost Total fixed overhead
$ variance Line C Actual fixed
10,000
overhead cost

7,500
B
e

5,000
Lin

2,500

600 1,200 1,800 2,400 3,000 3,600 4,200 4,800 5,400 x

Number of units produced

You may have noticed that the first example involved under absorption and the second example involved
over absorption. Let's reproduce the graphs again next to each other so that you can see the difference.
Under-absorbed fixed overheads Over-absorbed fixed overheads

Actual fixed Budgeted fixed

TOTAL o/h VOLUME o/h
Fixed variance Fixed variance
EXPENDITURE EXPENDITURE
o/h cost o/h cost
VOLUME variance TOTAL variance
$ $
variance Budgeted fixed variance Actual fixed
o/h o/h

Actual no Actual no
of units of units
Number of units produced Number of units produced

If you get a question in the exam which requires you to estimate fixed overhead variances and under- or
over-absorption of overheads, it is crucial that you read the labels on the graph. As you can see above,
the left-hand graph shows that actual fixed overhead is greater than the budgeted fixed overhead. On the
right-hand graph, the actual fixed overhead is less than the budgeted fixed overhead. You will notice that
this makes a difference to the position on the graph of the total fixed overhead variance and the fixed
overhead volume variance.

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CHAPTER 21 // COST VARIANCES

You may also see graphs where the actual number of units produced falls outside of the actual fixed
overhead and budgeted fixed overhead lines, such as the following.
Under-absorbed fixed overhead Over-absorbed fixed overhead

D
VOLUME
var
Actual fixed Budgeted fixed
o/h o/h
TOTAL EXPENDITURE TOTAL
Fixed EXPENDITURE Fixed
variance variance variance
o/h cost variance o/h cost
$ $
Budgeted fixed Actual fixed
VOLUME o/h o/h
var

Actual no Actual no
of units of units
Number of units produced Number of units produced

Under-absorbed fixed overheads Over-absorbed fixed overheads

D
TOTAL
var
Budgeted fixed Actual fixed
o/hs o/hs
VOLUME EXPENDITURE VOLUME
Fixed EXPENDITURE Fixed
variance variance variance
o/h cost variance o/h cost
$ $
Actual fixed Budgeted fixed
TOTAL o/hs o/hs
variance

Actual no Actual no
of units of units
Number of units produced Number of units produced

You need to remember that:

Fixed overhead expenditure variance = Budgeted fixed overheads – actual fixed overheads. If this is a
positive number then the variance is favourable. This should be fairly obvious to you because if actual
expenditure is less than budgeted expenditure then this is good for the business. It is therefore a
favourable variance.
Fixed overhead volume variance = Point D cost – budgeted fixed overheads. If this is a positive
number then the variance is favourable. We treat a greater volume of production than the budgeted
volume of production as a good thing for the business. If Point D cost is greater than the budgeted fixed
overhead then it means that we have produced more and the variance is therefore favourable.
Total fixed overhead variance = Actual fixed overheads – Point D cost (standard fixed cost for actual
number of units). If this is a positive number then the variance is adverse. As we mentioned above, if
actual overheads are more than the absorbed amount then we have under absorbed and we need to
charge the statement of profit or loss with the difference. This is therefore an adverse variance.

Fixed overhead expenditure Budgeted fixed overheads – actual fixed +ve = favourable
variance overheads

Fixed overhead volume variance Point D cost – budgeted fixed overheads +ve = favourable

Total fixed overhead variance Actual fixed overhead – Point D* cost +ve = adverse

*where Point D cost is the standard fixed cost for the actual number of units produced

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6 Flexed budgets and variances

Total variances are the difference between flexed budget figures and actual figures.

You may remember from Chapter 15 that a flexed budget is a budget that is prepared at the actual
activity level that was achieved in the period. It shows what the costs should have been at that activity
level. We can compare these costs with the actual costs to obtain variances. These variances are the
total variances – for example, the total materials variance – rather than the material price variance or
usage variance.
XYZ Co prepared a cost budget for one of its products, product X, based on production of 3,000 units of
the product.
Number of units produced 3,000
$
Direct materials 300,000
Direct labour 30,000
Variable overheads 9,000
In reality, only 1,000 units were produced and the actual costs were $98,600 for materials, $8,900 for
labour and $3,075 for variable overheads.
We can flex the budget to see what the costs for 1,000 units should have been.
Number of units produced 3,000 1,000
Budget Flexed budget
$ $
Direct materials 300,000 100,000*
Direct labour 30,000 10,000**
Variable overheads 9,000 3,000***
* $300,000/3,000 = $100 per unit $100 × 1,000 units = $100,000
** $30,000/3,000 = $10 per unit $10 × 1,000 units = $10,000
*** $9,000/3,000 = $3 per unit $3 × 1,000 units = $3,000
We can now compare the flexed budget, which shows what the costs should have been, with the actual
costs.
Number of units produced 1,000 1,000 Difference
Flexed budget Actual Total variance
$ $ $
Direct materials 100,000 98,600 1,400 (F)
Direct labour 10,000 8,900 1,100 (F)
Variable overheads 3,000 3,075 75 (A)
If you look back at Sections 2, 3 and 4 you will see that the total variances that we calculated are the
same as the ones we have calculated here using the flexed budget.

7 The reasons for cost variances

One of the competences in your PER is about demonstrating that you are competent in using relevant
management accounting planning and control techniques to support management and evaluate
performance. One of the skills you might need in order to fulfil this objective is to be able to compare
actual performance against plans, and identify and explain any differences. This section can be used to
help you develop that skill in the workplace.

There are many possible reasons for cost variances arising, as you will see from the following list of
possible causes.

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7.1 General causes of variances

There are four general causes of variances.
(a) Inappropriate standard. Incorrect or out of date standards could have been used which will not
reflect current conditions. For example, a material price standard may have been wrong if an old
price was used or the wrong type of material was priced.
(b) Inaccurate recording of actual costs. For example, if timesheets are filled in incorrectly, this may
lead to variances.
(c) Random events. Examples include unusual adverse weather conditions and a flu epidemic. These
may cause additional unforeseen costs.
(d) Operating inefficiency. If the variance is not caused by inappropriate standards, inaccurate
recording or random events, then it must be due to operating efficiency. The operating efficiency
may be due to controllable or uncontrollable factors.

Variance Favourable Adverse

(a) Material price Unforeseen discounts received Price increase

More care taken in purchasing Careless purchasing
Change in material standard Change in material standard

(b) Material Material used of higher quality than Defective material

usage standard Excessive waste
More effective use made of material Theft
Errors in allocating material to jobs Stricter quality control
Errors in allocating material to jobs

(c) Labour rate Use of apprentices or other workers at a Wage rate increase
rate of pay lower than standard Use of higher grade labour

(d) Labour Output produced more quickly than Lost time in excess of standard
efficiency expected because of work motivation, allowed
better quality of equipment or materials, Output lower than standard set
or better methods because of deliberate restriction, lack
Errors in allocating time to jobs of training or substandard material
used
Errors in allocating time to jobs

(e) Overhead Savings in costs incurred Increase in cost of services used

expenditure More economical use of services Excessive use of services
Change in type of services used

(f) Overhead Labour force working more efficiently Labour force working less efficiently
volume (favourable labour efficiency variance) (adverse labour efficiency variance)
efficiency

(g) Overhead Labour force working overtime Machine breakdown, strikes, labour
volume shortages
capacity

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8 The significance of cost variances

8.1 Introduction
Materiality, controllability, the type of standard being used, the interdependence of variances and the
cost of an investigation should be taken into account when deciding whether to investigate reported
variances.

Once variances have been calculated, management have to decide whether or not to investigate their
causes. It would be extremely time consuming and expensive to investigate every variance, therefore
managers have to decide which variances are worthy of investigation.
There are a number of factors which can be taken into account when deciding whether or not a variance
should be investigated.
(a) Materiality. A standard cost is really only an average expected cost and is not a rigid
specification. Small variations either side of this average are therefore bound to occur. The
problem is to decide whether a variation from standard should be considered significant and
worthy of investigation. Tolerance limits can be set and only variances which exceed such limits
would require investigating.
(b) Controllability. Some types of variance may not be controllable even once their cause is
discovered. For example, if there is a general worldwide increase in the price of a raw material,
there is nothing that can be done internally to control the effect of this. If a central decision is
made to award all employees a 10% increase in salary, staff costs in division A will increase by
this amount and the variance is not controllable by division A's manager. Uncontrollable
variances call for a change in the plan, not an investigation into the past.
(c) The type of standard being used
(i) The efficiency variance reported in any control period, whether for materials or labour, will
depend on the efficiency level set. If, for example, an ideal standard is used, variances
will always be adverse.
(ii) A similar problem arises if average price levels are used as standards. If inflation exists,
favourable price variances are likely to be reported at the beginning of a period, to be
offset by adverse price variances later in the period as inflation pushes prices up.
(d) Interdependence between variances. Quite possibly, individual variances should not be looked at
in isolation. One variance might be interrelated with another, and much of it might have occurred
only because the other, interrelated variance occurred too. We will investigate this issue further in
a moment.
(e) Costs of investigation. The costs of an investigation should be weighed against the benefits of
correcting the cause of a variance.

8.2 Interdependence between variances

When two variances are interdependent (interrelated) one will usually be adverse and the other one
favourable.

8.3 Interdependence – materials price and usage variances

It may be decided to purchase cheaper materials for a job in order to obtain a favourable price variance.
This may lead to higher materials wastage than expected and therefore adverse usage variances occur.
If the cheaper materials are more difficult to handle, there might be some adverse labour efficiency
variance too.
If a decision is made to purchase more expensive materials, which perhaps have a longer service life,
the price variance will be adverse but the usage variance might be favourable.

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CHAPTER 21 // COST VARIANCES

8.4 Interdependence – labour rate and efficiency variances

If employees in a workforce are paid higher rates for experience and skill, using a highly skilled team
should incur an adverse rate variance at the same time as a favourable efficiency variance. In contrast,
a favourable rate variance might indicate a high proportion of inexperienced workers in the workforce,
which could result in an adverse labour efficiency variance and possibly an adverse materials usage
variance (due to high rates of rejects).

QUESTION Setting standards and variance interdependence

(a) List the factors which should be considered when setting material cost standards. (6 marks)
(b) Explain the meaning and relevance of interdependence of variances when reporting to managers.
(4 marks)
(Total = 10 marks)

ANSWER
(a) Factors to consider when setting material cost standards
 Expected availability of bulk discounts, if worthwhile taking up
 Economic factors likely to affect prices in the period, such as inflation, exchange and
interest rate movements
 Setting an expected, rather an ideal, standard but building in a target for reducing
wastage and shrinkage, where possible
 Efficiency of machinery; if deteriorating through age, wastage may increase
 Ancillary costs should be included (for example carriage, insurance, freight, duty)
(b) Interdependence of variances means that the cause of one variance may be wholly or partly
explained by the cause of another variance. For instance, an adverse material price variance may
have been caused by the purchase of a higher quality material than standard, which could result
in a favourable material usage variance and/or a favourable labour efficiency variance due to
lower wastage and/or easier working.
A favourable material price variance may be caused by purchasing substandard quality materials. This
could result in adverse material usage and labour efficiency variances. Thus, the purchasing manager's
actions can have a direct effect on the production manager's reported performance. Management
accountants should always be aware of this type of interaction if they are to interpret performance
reports correctly.

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PART D: STANDARD COSTING

CHAPTER ROUNDUP

 A variance is the difference between a planned, budgeted or standard cost and the actual cost incurred.
The same comparisons can be made for revenues. The process by which the total difference between
standard and actual results is analysed is known as variance analysis.
 The direct material total variance can be subdivided into the direct material price variance and the
direct material usage variance.
 Direct material price variances are usually extracted at the time of the receipt of the materials rather
than at the time of usage.

 The direct labour total variance can be subdivided into the direct labour rate variance and the direct
labour efficiency variance.
 The variable production overhead total variance can be subdivided into the variable production overhead
expenditure variance and the variable production overhead efficiency variance (based on actual hours).
 The fixed production overhead total variance can be subdivided into an expenditure variance and a
volume variance. The fixed production overhead volume variance can be further subdivided into an
efficiency and capacity variance.
 Total variances are the difference between flexed budget figures and actual figures.
 Materiality, controllability, the type of standard being used, the interdependence of variances and the
cost of an investigation should be taken into account when deciding whether to investigate reported
variances.

1 Subdivide the following variances.

QUICK QUIZ

(a) Direct materials cost variance

(b) Direct labour cost variance

(c) Variable production overhead variance

2 What are the two main advantages in calculating the material price variance at the time of receipt of
materials?
3 Adverse material usage variances might occur for the following reasons.
I Defective material
II Excessive waste
III Theft
IV Unforeseen discounts received
A I
B I and II
C I, II and III
D I, II, III and IV
4 List the factors which should be taken into account when deciding whether or not a variance should be
investigated.
5 The statement 'only significant variances should be investigated' reflects which one of the following
principles?
A Controllability
B Materiality
C Interdependence
D Absorption

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CHAPTER 21 // COST VARIANCES

Price
1 (a)
ANSWERS TO QUICK QUIZ

Usage
Rate
(b)
Efficiency
Expenditure
(c)
Efficiency

2 (a) The earlier variances are extracted, the sooner they will be brought to the attention of managers.
(b) All inventories will be valued at standard price which requires less administrative effort.
3 C
4  Materiality  Interdependence between variances
 Controllability  Costs of investigation
 Type of standard being used
5 B This statement reflects the principle of materiality. Investigation of all variances is not required
and would be a waste of resources.

Now try ...

Attempt the questions below from the Practice Question Bank

Q93 – Q96

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C H A P T E R

The objective of cost variance analysis, which we looked

at in the previous chapter, is to assist management in the Sales variances and
control of costs. Costs are, however, only one factor
which contribute to the achievement of planned profit.
Sales are another important factor and sales variances
operating statements
can be calculated to aid management's control of their
business. We will therefore begin this chapter by
examining sales variances.
Having discussed the variances you need to know about,
we will be looking in Section 2 at the ways in which
variances should be presented to management to aid
their control of the organisation.
We then consider in Section 3 how marginal cost
variances differ from absorption cost variances and how
marginal costing information should be presented.
Finally we will consider how actual data can be derived
from standard cost details and variances.

SYLLABUS
TOPIC LIST REFERENCE

1 Sales variances D2 (a)

2 Operating statements D3 (a), (b)
3 Variances in a standard marginal costing system D3 (b)
4 Deriving actual data from standard cost details and variances D2 (i)
5 Control action C6 (c)

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PART D: STANDARD COSTING

Study Guide Intellectual level

D Standard costing

2 Variance calculations and analysis

(a) Calculate sales price and volume variance. S

(i) Calculate actual or standard figures where the variances are
K
given.
D Standard costing

3 Reconciliation of budgeted and actual profit

(a) Reconcile budgeted profit with actual profit under standard S

absorption costing.
(b) Reconcile budgeted profit or contribution with actual profit or S
contribution under standard marginal costing.

EXAM FOCUS POINT

Variance analysis is traditionally a very popular exam topic. Make sure that you are able to prepare
operating statements and explain why calculated variances have occurred. You will not be expected to
prepare a whole operating statement in the exam, but you may be tested on your understanding of
these statements.

1 Sales variances

1.1 Selling price variance

The selling price variance is a measure of the effect on expected profit of a different selling price to
standard selling price. It is calculated as the difference between what the sales revenue should have
been for the actual quantity sold, and what it was.

1.2 Example: Selling price variance

Suppose that the standard selling price of product X is $15. Actual sales in 20X3 were 2,000 units at
$15.30 per unit. The selling price variance is calculated as follows.
$
Sales revenue from 2,000 units should have been ( $15) 30,000
but was ( $15.30) 30,600
Selling price variance 600 (F)

The variance calculated is favourable because the price was higher than expected.

1.3 Sales volume profit variance

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

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CHAPTER 22 // SALES VARIANCES AND OPERATING STATEMENTS

1.4 Example: Sales volume profit variance

Suppose that a company budgets to sell 8,000 units of product J for $12 per unit. The standard full
cost per unit is $7. Actual sales were 7,700 units, at $12.50 per unit.
The sales volume profit variance is calculated as follows.
Budgeted sales volume 8,000 units
Actual sales volume 7,700 units
Sales volume variance in units 300 units (A)
 standard profit per unit ($(12–7)) × $5
Sales volume variance $1,500 (A)

The variance calculated above is adverse because actual sales were less than budgeted (planned).

QUESTION Selling price variance

Jasper Co has the following budget and actual figures for 20X4.
Budget Actual
Sales units 600 620
Selling price per unit $30 $29
Standard full cost of production = $28 per unit.
Required
Calculate the selling price variance and the sales volume profit variance.

ANSWER
Sales revenue for 620 units should have been ( $30) 18,600
but was ( $29) 17,980
Selling price variance 620 (A)
Budgeted sales volume 600 units
Actual sales volume 620 units
Sales volume variance in units 20 units (F)
 standard profit per unit ($(30 – 28)) × $2
Sales volume profit variance $40 (F)

1.5 The significance of sales variances

The possible interdependence between sales price and sales volume variances should be obvious to
you. A reduction in the sales price might stimulate greater sales demand, so that an adverse sales price
variance might be counterbalanced by a favourable sales volume variance. Similarly, a price rise would
give a favourable price variance, but possibly at the cost of a fall in demand and an adverse sales
volume variance.
It is therefore important in analysing an unfavourable sales variance that the overall consequence should
be considered; that is, has there been a counterbalancing favourable variance as a direct result of the
unfavourable one?

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2 Operating statements

2.1 Introduction
Operating statements show how the combination of variances reconcile budgeted profit and actual
profit.

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

An operating statement is a regular report for management of actual costs and revenues, usually
showing variances from budget.

Here is a proforma for an operating statement under standard absorption costing.

$ $
Budgeted profit X
Sales volume profit variance X
Standard profit from actual sales X

(F) (A)
Variances $ $
Sales price
Material price
Material usage
Labour rate
Labour efficiency
Variable overhead expenditure
Variable overhead efficiency
Fixed overhead expenditure
Fixed overhead volume

X X X
Actual profit X

An extensive example will now be introduced, both to revise the variance calculations already described
and to show how to combine them into an operating statement.

2.2 Example 1: Variances and operating statements

Sydney manufactures one product, and the entire product is sold as soon as it is produced. There are no
opening or closing inventories and work in progress is negligible. The company operates a standard
costing system and analysis of variances is made every month. The standard cost card for the product, a
boomerang, is as follows.
STANDARD COST CARD – BOOMERANG
$
Direct materials 0.5 kilos at $4 per kilo 2.00
Direct wages 2 hours at $2.00 per hour 4.00
Variable overheads 2 hours at $0.30 per hour 0.60
Fixed overhead 2 hours at $3.70 per hour 7.40
Standard cost 14.00
Standard profit 6.00
Standing selling price 20.00

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CHAPTER 22 // SALES VARIANCES AND OPERATING STATEMENTS

Budgeted (planned) output for the month of June 20X7 was 5,100 units. Actual results for June 20X7
were as follows.
Production of 4,850 units was sold for $95,600.
Materials consumed in production amounted to 2,300 kg at a total cost of $9,800.
Labour hours paid for amounted to 8,500 hours at a cost of $16,800.
Actual operating hours amounted to 8,000 hours.
Variable overheads amounted to $2,600.
Fixed overheads amounted to $42,300.
Required
Calculate all variances and prepare an operating statement for the month ended 30 June 20X7.

Solution
(a) $
2,300 kg of material should cost ( $4) 9,200
but did cost 9,800
Material price variance 600 (A)

(b) 4,850 boomerangs should use ( 0.5 kg) 2,425 kg

but did use 2,300 kg
Material usage variance in kg 125 kg (F)
 standard cost per kg × $4
Material usage variance in $ $500 (F)

(c) $
8,500 hours of labour should cost ( $2) 17,000
but did cost 16,800
Labour rate variance 200 (F)

(d) 4,850 boomerangs should take ( 2 hrs) 9,700 hrs

but did take (active hours) 8,000 hrs
Labour efficiency variance in hours 1,700 hrs (F)
 standard cost per hour × $2
Labour efficiency variance in $ $3,400 (F)

(e) Idle time variance 500 hours (A)  $2 $1,000 (A)

(f) $
8,000 hours incurring variable o/hd expenditure should cost ( $0.30) 2,400
but did cost 2,600
Variable overhead expenditure variance 200 (A)

(g) Variable overhead efficiency variance in hours is the same as the

labour efficiency variance:
1,700 hours (F)  $0.30 per hour $510 (F)

(h) $
Budgeted fixed overhead (5,100 units  2 hrs  $3.70) 37,740
Actual fixed overhead 42,300
Fixed overhead expenditure variance 4,560 (A)

(i) $
4,850 boomerangs should take ( 2 hrs) 9,700 hrs
but did take (active hours) 8,000 hrs
Fixed overhead volume efficiency variance in hours 1,700 hrs (F)
 standard fixed overhead absorption rate per hour  $3.70
Fixed overhead volume efficiency variance in $ 6,290 (F)

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(j) $
Budgeted hours of work (5,100  2 hrs) 10,200 hrs
Actual hours of work 8,000 hrs
Fixed overhead volume capacity variance in hours 2,200 hrs (A)
 standard fixed overhead absorption rate per hour  $3.70
Fixed overhead volume capacity variance in $ 8,140 (A)

(k) $
Revenue from 4,850 boomerangs should be ( $20) 97,000
but was 95,600
Selling price variance 1,400 (A)

(l) Budgeted sales volume 5,100 units

Actual sales volume 4,850 units
Sales volume profit variance in units 250 units
 standard profit per unit × $6 (A)
Sales volume profit variance in $ $1,500 (A)

There are several ways in which an operating statement may be presented. Perhaps the most common
format is one which reconciles budgeted profit to actual profit.
SYDNEY – OPERATING STATEMENT JUNE 20X7
$ $
Budgeted profit 30,600
Sales volume profit variance 1,500 (A)
Standard profit from actual sales 29,100

(F) (A)
Variances $ $
Sales price 1,400
Material price 600
Material usage 500
Labour rate 200
Labour efficiency 3,400
Labour idle time 1,000
Variable overhead expenditure 200
Variable overhead efficiency 510
Fixed overhead expenditure 4,560
Fixed overhead volume efficiency 6,290
Fixed overhead volume capacity 8,140
10,900 15,900 5,000 (A)

Actual profit 24,100

Check $ $
Sales 95,600
Materials 9,800
Labour 16,800
Variable overhead 2,600
Fixed overhead 42,300
71,500
Actual profit 24,100

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CHAPTER 22 // SALES VARIANCES AND OPERATING STATEMENTS

2.3 Example 2: Variances and operating statements

A company uses a standard absorption costing system. The following figures are available for the last
accounting period in which actual profit was $270,000.
$
Sales volume profit variance 15,000 adverse
Sales price variance 12,500 favourable
Total variable cost variance 17,500 adverse
Fixed cost expenditure variance 7,500 favourable
Fixed cost volume variance 5,000 adverse
What was the standard profit for actual sales in the last accounting period?
A $252,500
B $267,500
C $272,500
D $287,500
The correct answer is C.
Notice that this question is asking for the standard profit for actual sales. It is not asking for the
budgeted profit. The correct answer can be obtained by working backwards by adding appropriate
adverse variances and subtracting appropriate favourable variances from actual profit. Standard profit on
actual sales equals actual units multiplied by standard profit per unit. As it is based on actual units, a
profit adjustment for the difference between budgeted and actual volumes is not required, and so the
sales volume variance should be ignored.
The calculation can be most easily understood by looking at the standard cost operating statement
below.
$
Budgeted profit not required
Sales volume variance not needed
Standard profit on actual sales 272,500
Sales price variance 12,500 favourable
Total variable cost variance 17,500 adverse
Fixed cost expenditure variance 7,500 favourable
Fixed cost volume variance 5,000 adverse
Actual profit 270,000
The correct answer can be quickly calculated as:
$270,000 + $5,000 – $7,500 + $17,500 – $12,500 = $272,500.

3 Variances in a standard marginal costing system

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

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PART D: STANDARD COSTING

EXAM FOCUS POINT

The ACCA examining team has commented that only 15% of students selected the correct answer in a
past question relating to the difference between variances in a standard absorption system and
variances in a standard marginal system. Read the above introduction again so that you know the
differences.

In all the examples we have worked through so far, a system of standard absorption costing has been in
operation. If an organisation uses standard marginal costing instead of standard absorption costing,
there will be two differences in the way the variances are calculated.
(a) In marginal costing, fixed costs are not absorbed into product costs and so there are no fixed cost
variances to explain any under- or over-absorption of overheads. There will, therefore, be no fixed
overhead volume variance. There will be a fixed overhead expenditure variance which is
calculated in exactly the same way as for absorption costing systems.
(b) The sales volume variance will be valued at standard contribution margin (sales price per unit
minus variable costs of sale per unit), not standard profit margin.

3.2 Preparing a marginal costing operating statement

Here is a proforma for an operating statement under standard marginal costing.
$ $
Budgeted contribution X
Sales volume contribution variance X
Standard contribution from actual sales X

(F) (A)
Variances $ $
Sales price
Material price
Material usage
Labour rate
Labour efficiency
Variable overhead expenditure
Variable overhead efficiency
X X X
Actual contribution X

Budgeted fixed costs X

Fixed costs expenditure variance X
Actual fixed overheads X
Actual profit X

Returning once again to the example of Sydney, the variances in a system of standard marginal costing
would be as follows.
(a) There is no fixed overhead volume variance (and therefore no fixed overhead volume efficiency
and volume capacity variances).
(b) The standard contribution per unit of boomerang is $(20 – 6.60) = $13.40, therefore the sales
volume contribution variance of 250 units (A) is valued at ( $13.40) = $3,350 (A).
The other variances are unchanged. However, this operating statement differs from an absorption
costing operating statement in the following ways.
(a) It begins with the budgeted contribution ($30,600 + budgeted fixed production costs $37,740
= $68,340).

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CHAPTER 22 // SALES VARIANCES AND OPERATING STATEMENTS

(b) The subtotal before the analysis of cost variances is actual sales ($95,600) less the standard
variable cost of sales ($4,850  $6.60) = $63,590.
(c) Actual contribution is highlighted in the statement.
(d) Budgeted (planned) fixed production overhead is adjusted by the fixed overhead expenditure
variance to show the actual fixed production overhead expenditure.
Therefore a marginal costing operating statement might look like this.
SYDNEY – OPERATING STATEMENT JUNE 20X7
$ $ $
Budgeted contribution 68,340
Sales volume contribution variance 3,350 (A)
Standard contribution from actual sales 64,990

(F) (A)
Sales price 1,400
Material price 600
Material usage 500
Labour rate 200
Labour efficiency 3,400
Labour idle time 1,000
Variable overhead expenditure 200
Variable overhead efficiency 510
4,610 3,200
1,410 (F)
Actual contribution 66,400
Budgeted fixed production overhead 37,740
Expenditure variance 4,560 (A)
Actual fixed production overhead 42,300
Actual profit 24,100

Notice that the actual profit is the same as the profit calculated by standard absorption costing because
there were no changes in inventory levels. Absorption costing and marginal costing do not always
produce an identical profit figure.

QUESTION Variances
Piglet, a manufacturing firm, operates a standard marginal costing system. It makes a single product,
PIG, using a single raw material, LET.
Standard costs relating to PIG have been calculated as follows.
Standard cost schedule – PIG Per unit
$
Direct material, LET, 100 kg at $5 per kg 500
Direct labour, 10 hours at $8 per hour 80
Variable production overhead, 10 hours at $2 per hour 20
600
The standard selling price of a PIG is $900 and Piglet Co produce 1,020 units a month.
During December 20X0, 1,000 units of PIG were produced. Relevant details of this production are as
follows.
Direct material LET
90,000 kg costing $720,000 were bought and used.
Direct labour
8,200 hours were worked during the month and total wages were $63,000.
Variable production overhead
The actual cost for the month was $25,000.
Inventories of the direct material LET are valued at the standard price of $5 per kg.

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Each PIG was sold for $975.

Required
Calculate the following for the month of December 20X0.
(a) Variable production cost variance
(b) Direct labour cost variance, analysed into rate and efficiency variances
(c) Direct material cost variance, analysed into price and usage variances
(d) Variable production overhead variance, analysed into expenditure and efficiency variances
(e) Selling price variance
(f) Sales volume contribution variance

ANSWER
(a) This is simply a 'total' variance.
$
1,000 units should have cost ( $600) 600,000
but did cost (see working) 808,000
Variable production cost variance 208,000 (A)

(b) Direct labour cost variances

$
8,200 hours should cost ( $8) 65,600
but did cost 63,000
Direct labour rate variance 2,600 (F)

1,000 units should take ( 10 hours) 10,000 hrs

but did take 8,200 hrs
Direct labour efficiency variance in hours 1,800 hrs (F)
 standard rate per hour × $8
Direct labour efficiency variance in $ $14,400 (F)

Summary $
Rate 2,600 (F)
Efficiency 14,400 (F)
Total 17,000 (F)

(c) Direct material cost variances

$
90,000 kg should cost ( $5) 450,000
but did cost 720,000
Direct material price variance 270,000 (A)

1,000 units should use ( 100 kg) 100,000 kg

but did use 90,000 kg
Direct material usage variance in kg 10,000 kg (F)
 standard cost per kg × $5
Direct material usage variance in $ $50,000 (F)

Summary $
Price 270,000 (A)
Usage 50,000 (F)
Total 220,000 (A)

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(d) Variable production overhead variances

$
8,200 hours incurring o/hd should cost ( $2) 16,400
but did cost 25,000
Variable production overhead expenditure variance 8,600 (A)

Efficiency variance in hrs (from (b)) 1,800 hrs (F)

 standard rate per hour × $2
Variable production overhead efficiency variance $3,600 (F)

Summary
$
Expenditure 8,600 (A)
Efficiency 3,600 (F)
Total 5,000 (A)
(e) Selling price variance
$
Revenue from 1,000 units should have been ( $900) 900,000
but was ( $975) 975,000
Selling price variance 75,000 (F)
(f) Sales volume contribution variance
Budgeted sales 1,020 units
Actual sales 1,000 units
Sales volume variance in units 20 units (A)
 standard contribution margin ($(900 – 600)) × $300
Sales volume contribution variance in $ $6,000 (A)
Workings
$
Direct material 720,000
Total wages 63,000
Variable production overhead 25,000
808,000

QUESTION Reconciling contributions

A company uses standard marginal costing. Last month the standard contribution on actual sales was
$10,000 and the following variances arose.
$
Total variable costs variance 2,000 (A)
Sales price variance 500 (F)
Sales volume contribution variance 1,000 (A)
What was the actual contribution for last month?
A $7,000
B $7,500
C $8,000
D $8,500

ANSWER
The correct answer is D.
$
Standard contribution on actual sales 10,000
Add favourable sales price variance 500
Less adverse total variable costs variance (2,000)
Actual contribution 8,500

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QUESTION Calculating actual contribution from variances

A company uses standard marginal costing. Last month, when all sales were at the standard selling
price, the standard contribution from actual sales was $50,000 and the following variances arose.
$
Total variable costs variance 3,500 (A)
Total fixed costs variance 1,000 (F)
Sales volume contribution variance 2,000 (F)
What was the actual contribution for last month?
A $46,500
B $47,500
C $48,500
D $49,500

ANSWER
The correct answer is A.
$
Standard contribution on actual sales 50,000
Less adverse total variable costs variance (3,500)
Actual contribution 46,500

4 Deriving actual data from standard cost details and variances

Variances can be used to derive actual data from standard cost details.

Rather than being given actual data and asked to calculate the variances, you may be given the
variances and required to calculate the actual data on which they were based. See if you can do these
two questions.

QUESTION Rate of pay

XYZ uses standard costing. The following data relates to labour grade ll.
Actual hours worked 10,400 hours
Standard allowance for actual production 8,320 hours
Standard rate per hour $5
Rate variance (adverse) $416
What was the actual rate of pay per hour?
A $4.95
B $4.96
C $5.04
D $5.05

ANSWER
The correct answer is C.
$416
Rate variance per hour worked = = $0.04 (A)
10,400
Actual rate per hour = $(5.00 + 0.04) = $5.04.
You should have been able to eliminate options A and B because they are both below the standard rate
per hour. If the rate variance is adverse then the actual rate must be above standard. Option D is
incorrect because it results from basing the calculations on standard hours rather than actual hours.

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CHAPTER 22 // SALES VARIANCES AND OPERATING STATEMENTS

QUESTION Quantity of material

The standard material content of one unit of product A is 10 kg of material X which should cost $10 per
kilogram. In June 20X4, 5,750 units of product A were produced and there was an adverse material
usage variance of $1,500.
Required
Calculate the quantity of material X used in June 20X4.

ANSWER
Let the quantity of material X used = Y
5,750 units should have used ( 10 kg) 57,500 kg
but did use Y kg
Usage variance in kg (Y – 57,500) kg
 standard price per kg × $10
Usage variance in $ $1,500 (A)

 10(Y – 57,500) = 1,500

Y – 57,500 = 150
 Y = 57,650 kg

5 Control action

A variance should only be investigated if the expected value of benefits from investigation and any
control action exceed the costs of investigation.
If the cause of a variance is controllable, action can be taken to bring the system back under control in
future. If the variance is uncontrollable, but not simply due to chance, it will be necessary to review
forecasts of expected results, and perhaps to revise the budget.

If a variance is assessed as significant, then control action may be necessary.

Since a variance compares historical actual costs with standard costs, it is a statement of what has gone
wrong (or right) in the past. By taking control action, managers can do nothing about the past, but they
can use their analysis of past results to identify where the 'system' is out of control. If the cause of the
variance is controllable, action can be taken to bring the system back under control in future. If the
variance is uncontrollable, on the other hand, but not simply due to chance, it will be necessary to
revise forecasts of expected results, and perhaps to revise the budget.
It may be possible for control action to restore actual results back on course to achieve the original
budget. For example, if there is an adverse labour efficiency variance in month 1 of 1,100 hours, control
action by the production department might succeed in increasing efficiency above standard by 100
hours per month for the next 11 months.
It is also possible that control action might succeed in restoring better order to a situation, but the
improvements might not be sufficient to enable the company to achieve its original budget. For example,
if for three months there has been an adverse labour efficiency in a production department, so that the
cost per unit of output was $8 instead of a standard cost of $5, control action might succeed in
improving efficiency so that unit costs are reduced to $7, $6 or even $5, but the earlier excess spending
means that the profit in the master budget will not be achieved.
Depending on the situation and the control action taken, the action may take immediate effect, or it may
take several weeks or months to implement. The effect of control action might be short-lived, lasting for
only one control period; but it is more likely to be implemented with the aim of long-term improvement.

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5.1 Possible control action

The control action which may be taken will depend on the reason why the variance occurred. Some
reasons for variances are outlined in the paragraphs below.

5.2 Measurement errors

In practice it may be extremely difficult to establish that 1,000 units of product A used 32,000 kg of
raw material X. Scales may be misread, the pilfering or wastage of materials may go unrecorded, items
may be wrongly classified (as material X3, say, when material X8 was used in reality), or employees
may make adjustments to records to make their own performance look better.
An investigation may show that control action is required to improve the accuracy of the recording
system so that measurement errors do not occur.

5.3 Out of date standards

Price standards are likely to become out of date when changes to the costs of material, power, labour
and so on occur, or in periods of high inflation. In such circumstances, an investigation of variances is
likely to highlight a general change in market prices rather than efficiencies or inefficiencies in
acquiring resources.
Standards may also be out of date where operations are subject to technological development or if
learning curve effects have not been taken into account. Investigation of this type of variance will
provide information about the inaccuracy of the standard and highlight the need to frequently review
and update standards.

5.4 Efficient or inefficient operations

Spoilage and better quality material/more highly skilled labour than standard are all likely to affect the
efficiency of operations and therefore cause variances. Investigation of variances in this category should
highlight the cause of the inefficiency or efficiency and will lead to control action to eliminate the
inefficiency being repeated or action to compound the benefits of the efficiency. For example, stricter
supervision may be required to reduce wastage levels.

5.5 Random or chance fluctuations

A standard is an average figure. It represents the mid-point of a range of possible values and therefore
actual results are likely to deviate unpredictably within the predictable range.
As long as the variance falls within this range, it will be classified as a random or chance fluctuation and
control action will not be necessary.

QUESTION Report on variances

As the management accountant of the ABC Production Co, you have prepared the following variance
report for the general manager.
VARIANCE REPORT: SEPTEMBER 20X5
Variance Variance Total
(adverse) (favourable) variance
$ $ $
Material (2,000)
Usage 5,500
Price 3,500
Labour (1,500)
Utilisation 3,000
Rate 1,500
Overhead (500)
Price 4,500
Efficiency 2,000
Capacity 3,000

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CHAPTER 22 // SALES VARIANCES AND OPERATING STATEMENTS

Actual costs for September 20X5 were as follows.

$
Materials $100,000
Labour $80,000
Overheads $75,000
Total $255,000

The general manager tells you that they are quite satisfied with this result because the total adverse
variance of $4,000 is only 1.57% of total costs.
Required
Write a brief report to the general manager giving your own interpretation of the month's results.

ANSWER
REPORT ON RESULTS FOR SEPTEMBER 20X5
1 TERMS OF REFERENCE
This report provides a management accounting interpretation of the company's results for
September 20X5. The report was prepared by A N Employee, Management Accountant and
submitted to A Boss, General Manager, on XX October 20X5.
2 METHOD
Using the management accounting department's variance report for September 20X5 and actual
cost data for the month, the company's results were analysed.
3 FINDINGS
Total variance
The total variance may only be 1.57% of total costs but this total disguises a number of
significant adverse and favourable variances which need investigating.
Materials variances
The fact that there is a favourable price variance and an adverse usage variance could indicate
interdependence. The purchasing department may have bought cheap materials but these
cheaper materials may have been more difficult to work with so that more material was required
per unit produced. The possibility of such an interdependence should be investigated. Whether or
not there is an interdependence, both variances do require investigation since they represent
5.5% (usage) and 3.5% (price) of the actual material cost for the month.
Labour variances
Again, there could be an interdependence between the adverse utilisation variance and the
favourable rate variance, less skilled (and lower paid) employees perhaps having worked less
efficiently than standard. Discussions with factory management should reveal whether this is so.
Both variances do need investigation since they again represent a high percentage (compared
with 1.57%) of the actual labour cost for the month (3.75% for the utilisation variance and
1.875% for the rate variance).
Overhead variances
An investigation into the fixed and variable components of the overhead would facilitate control
information. The cause of the favourable price variance, which represents 6% of the total
overhead costs for the month, should be encouraged.
The adverse overhead variances in total represent 6.67% of actual overhead cost during the
month and must therefore be investigated. The capacity variance signifies that actual hours of
work were less than budgeted hours of work. The company is obviously working below its
planned capacity level. Efforts should therefore be made to increase production so as to eradicate
this variance.

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4 CONCLUSION
It is not the total of the monthly variances which should be considered but the individual
variances, as a number of them represent significant deviations from planned results.
Investigations into their causes should be performed and control action taken to ensure that
either performance is back under control in future if the cause of the variance can be controlled or
the forecasts of expected results are revised if the variance is uncontrollable.

QUESTION Control problems

Jot down ideas for answering the following questions.
(a) Explain the problems concerning control of operations that a manufacturing company can be
expected to experience in using a standard costing system during periods of rapid inflation.
(b) Suggest a method by which the company could try to overcome the problems to which you have
referred in answer to (a) above, indicating the shortcoming of the method.

ANSWER
(a) (i) Inflation should be budgeted for in standard prices. But how can the rate of inflation and
the timing of inflationary increases be accurately estimated? Who decides how much
inflationary 'allowance' should be added to the standards?
(ii) How can actual expenditure be judged against a realistic 'standard' price level? Ideally,
there would be an external price index (for example, one published by the Government's
Office for National Statistics) but even external price indices are not reliable guides to the
prices an organisation ought to be paying.
(iii) The existence of inflation tends to eliminate the practical value of price variances as a
pointer to controlling spending.
(iv) Inflation affects operations more directly. Usually costs go up before an organisation can
put up the prices of its own products to customers. Inflation therefore tends to put
pressure on a company's cash flows.
(v) To provide useful and accurately valued variances the standard costs ought to be revised
frequently. This would be an administrative burden on the organisation.
(vi) If the organisation uses standard costs for pricing or inventory valuation, frequent revisions
of the standard would be necessary to keep prices ahead of costs or inventories sensibly
valued.
(b) To overcome the problems, we could suggest the following.
(i) Frequent revision of the standard costs. Problem – the administrative burden.
(ii) Incorporating estimates of the rate of inflation and the timing of inflation into standard
costs. Problem – accurate forecasting.

PER performance objective 13 requires you to ’Plan and control performance’ and PER objective 14
requires you to ’Monitor performance’.
The knowledge covered in this chapter will help you demonstrate your competence in these areas.

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CHAPTER 22 // SALES VARIANCES AND OPERATING STATEMENTS

CHAPTER ROUNDUP

 The selling price variance is a measure of the effect on expected profit of a different selling price to
standard selling price. It is calculated as the difference between what the sales revenue should have
been for the actual quantity sold, and what it was.
 The sales volume profit variance is the difference between the actual units sold and the budgeted
(planned) quantity, valued at the standard profit per unit. In other words, it measures the increase or
decrease in standard profit as a result of the sales volume being higher or lower than budgeted
(planned).
 Operating statements show how the combination of variances reconcile budgeted profit and actual
profit.
 There are two main differences between the variances calculated in an absorption costing system and
the variances calculated in a marginal costing system.
– In a marginal costing system the only fixed overhead variance is an expenditure variance.
– The sales volume variance is valued at standard contribution margin, not standard profit margin.
 Variances can be used to derive actual data from standard cost details.
 A variance should only be investigated if the expected value of benefits from investigation and any
control action exceed the costs of investigation.
 If the cause of a variance is controllable, action can be taken to bring the system back under control in
future. If the variance is uncontrollable, but not simply due to chance, it will be necessary to review
forecasts of expected results, and perhaps to revise the budget.

1 What is the sales volume profit variance?

QUICK QUIZ

2 A regular report for management of actual cost and revenue and that usually compares actual results
with budgeted (planned) results (and showing variances) is known as:
A Bank statement
B Variance statement
C Budget statement
D Operating statement
3 If an organisation uses standard marginal costing instead of standard absorption costing, which two
variances are calculated differently?
4 What are the first three lines in an operating statement under standard absorption costing?
5 What are the first three lines in an operating statement under standard marginal costing?

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1 It is a measure of the increase or decrease in standard profit as a result of the sales volume being higher
ANSWERS TO QUICK QUIZ

or lower than budgeted (planned).

2 D
3 (a) In marginal costing there is no fixed overhead volume variance (because fixed costs are not
absorbed into product costs).
(b) In marginal costing, the sales volume variance will be valued at standard contribution margin and
not standard profit margin.
4 Budgeted profit
Sales volume profit variance
Standard profit from actual sales
(Make sure that you learn this. After these three lines you need to include the variances.)
5 Budgeted contribution
Sales volume contribution variance
Standard contribution from actual sales
(Make sure that you learn this. After these three lines you need to include the variances.)

Now try ...

Attempt the questions below from the Practice Question Bank

Q97 – Q100

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part

Performance measurement

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PART E: PERFORMANCE MEASUREMENT

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C H A P T E R

We looked briefly at objectives and goals in Chapter 1.

Here we return to goals and objectives in the context of Performance
performance measurement. Performance measurement
helps to ensure that the business is being run as
efficiently as possible. So when we talk about
measurement
performance measurement, we are talking about control
of performance. We will look at how mission statements
are linked to objectives and to key performance indicators
and we will look at different types of performance
measure.

SYLLABUS
TOPIC LIST REFERENCE

1 Performance measurement and mission statements E1(a), (b)

2 Goals and objectives E1(b), E2(b)(iii),(iv), E4(b)
3 Performance measures E4(a)
4 Economy, efficiency and effectiveness E1(d), E2(c)(i),(ii),(iii), E4(d)
5 Measuring profitability and productivity E2(a), (f)
6 Performance measures based on the statement of financial position E2(a)
7 The balanced scorecard E2(b)(i), (ii)
8 External conditions E1(c), (d)

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PART E: PERFORMANCE MEASUREMENT

Study Guide Intellectual level

E Performance measurement

1 Performance measurement overview

(a) Discuss the purpose of mission statements and their

K
role in performance measurement.
(b) Discuss the purpose of strategic and operational and
K
tactical objectives and their role in performance
measurement.
(c) Discuss the impact of economic and market conditions
K
on performance measurement.
(d) Explain the impact of government regulation on
K
performance measurement.
2 Performance measurement – application

(a) Discuss and calculate measures of financial

S
performance (profitability, liquidity, activity and gearing)
and non-financial measures.
Perspectives of the balanced scorecard

(b)(i) Discuss the advantages and limitations of the balanced

K
scorecard.
(b)(ii) Describe performance indicators for financial success,
K
customer satisfaction, process efficiency and growth.
(b)(iii) Discuss critical success factors and key performance
K
indicators and their link to objectives and mission
statements.
(b)(iv) Establish critical success factors and key performance
S
indicators in a specific situation.
Economy, efficiency and effectiveness

(c)(i) Explain the concepts of economy, efficiency and

K
effectiveness.
(c)(ii) Describe performance indicators for economy, efficiency
K
and effectiveness.
(c)(iii) Establish performance indicators for economy,
S
efficiency and effectiveness in a specific situation.
Profitability

(f)(i) Calculate return on investment and residual income. S

(f)(ii) Explain the advantages and limitations of return on
K
investment and residual income.
4 Monitoring performance and reporting

(a) Discuss the importance of non-financial performance

K
measures.
(b) Discuss the relationship between short-term and long-
K
term performance.
(d) Discuss the measurement of performance in non profit
K
seeking and public sector organisations.

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CHAPTER 23 // PERFORMANCE MEASUREMENT

PER performance objectives 12, 13 and 14 all relate to business performance measurement in some
way, whether through effective systems and resource utilisation, planning processes or performance
measurement techniques. The knowledge you gain in this chapter will help you demonstrate your
competence in this area.

1 Performance measurement and mission statements

The higher direction of an organisation requires a clear vision, in general terms, of what the organisation
should be doing in the longer term and how it should go about doing it. This may be encapsulated in a
mission statement.

Performance measurement aims to establish how well something or somebody is doing in relation to a
planned activity. The 'thing' may be one of the following.
(a) A machine
(b) A factory
(c) An organisation as a whole
The 'body' may be one of the following.
(a) An individual employee
(b) A manager
(c) A group of people
Performance measurement is a vital part of the control process. The essence of control is that actual
performance is compared with a standard or target that was established earlier. For machines,
processes, departments and individuals, such targets are laid down by the budgetary process and
published in the budget itself. At a higher level, when we are trying to control the whole organisation, a
slightly more complex process is required.
The forecast statement of profit or loss and statement of financial position, which are the final products
of the budget process, obviously represent overall targets for the organisation. However, these targets
are not sufficient for the proper control of a large organisation. They only provide guidance for a very
short period and only in terms of decisions that have already been taken. Even if a new process is
scheduled to come into operation during the next year, that is the result of decisions long past. The
budgetary process offers little guidance for the longer-term progress of the organisation.
We must now take a brief look at the world of strategic management. It is in this arena that the wider
direction of the organisation is determined. Strategic managers must look several years into the future
and decide what they want the organisation to do and where they want it to go. An important part of
this process is the design and refinement of the organisational mission statement. This should
encapsulate the vision of top management, what it is they are trying to achieve and, in general terms,
how they wish to achieve it.

1.1 Elements of mission

(a) Purpose. Why does the company exist?
(i) To create wealth for shareholders?
(ii) To satisfy the needs of all stakeholders?
(iii) To reach some higher goal, such as the advancement of society?
(b) Strategy. Mission provides the commercial logic for the organisation, and so defines two things.
(i) The products or services it offers and therefore its competitive position
(ii) The competences by which it hopes to prosper, and its way of competing
(c) Policies and standards of behaviour. The mission needs to be converted into everyday
performance. For example, a firm whose mission covers excellent customer service must deal

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PART E: PERFORMANCE MEASUREMENT

with simple matters, such as politeness to customers and speed at which phone calls are
answered.
(d) Values and culture. Values are the basic, perhaps unstated, beliefs of the people who work in the
organisation.
For there to be a strong, motivating sense of mission, the four elements above must be mutually
reinforcing.

1.2 The importance of mission

Mission is taken seriously by many firms.
(a) Values and feelings are integral elements of consumers' buying decisions, as evidenced by
advertising, branding and market research. Customers ask not only 'What do you sell?' but also
'What do you stand for?'
(b) Studies into organisational behaviour suggest that employees are motivated by more than money.
A sense of mission and values can help to motivate employees.
(c) Some writers believe there is an empirical relationship between strong corporate values and
profitability.

1.3 Mission statements

Mission statements are formal statements of an organisation's mission which describe the organisation's
basic purpose and what it is trying to achieve. They might be reproduced in a number of places (eg at
the front of an organisation's annual report, on publicity material, in the chairman's office and in
communal work areas). There is no standard format, but they should possess certain characteristics.
(a) Brevity – easy to understand and remember
(b) Flexibility – to accommodate change
(c) Distinctiveness – to make the firm stand out

CASE STUDY
The following are the mission statements for some well-known companies.
Coca-Cola 'To refresh the world
To inspire moments of optimism and happiness
To create value and make a difference.'
Google 'To organise the world's information and make it universally accessible and useful.'
Starbucks 'Our mission: to inspire and nurture the human spirit – one person, one cup and
one neighbourhood at a time.'
eBay 'To provide a global trading platform where practically anyone can trade practically
anything.'

1.4 Mission and planning

Although the mission statement might be seen as a set of abstract principles, it can play an important
role in the planning process.
(a) Inspires and informs planning. Plans should further the organisation's goals and be consistent
with its core values.
(b) Evaluation and screening. Mission also acts as a yardstick by which plans are judged.
(i) The mission of an ethical investment trust would preclude investing in tobacco firms.
(ii) Mission helps to ensure consistency in decisions.
(c) Implementation. Mission also affects the implementation of a planned strategy in the culture and
business practices of the firm.

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CHAPTER 23 // PERFORMANCE MEASUREMENT

2 Goals and objectives

A hierarchy of SMART goals and objectives cascades downwards from the mission statement, eventually
providing the targets for the periodic budget process.

From the vision and mission, goals are derived.

(a) Operational goals. These can be expressed as objectives. Here is an example.
Operational goal: 'Cut costs'. The objective: 'Reduce budget by 5%'.
(b) Non-operational goals. A university's goal might be to 'seek truth'.
Not all goals can be measured.
In practice, most organisations set themselves quantified objectives in order to enact the corporate
mission. Many objectives are:
(a) Specific
(b) Measurable
(c) Attainable
(d) Results-orientated
(e) Time-bounded
There should be goal congruence. This means that the goals set for different parts of the organisation
should be consistent with each other.

2.1 Long-term objectives and short-term objectives

Objectives may be long term and short term. A company that is suffering from a recession in its core
industries and making losses in the short term might continue to have a long-term primary objective of
achieving a growth in profits, but in the short term its primary objective might be survival.

2.2 Strategic, tactical and operational objectives

Objectives can also be classified as strategic, tactical or operational. We looked at strategic, tactical and
operational information in Chapter 1.
Strategic objectives: Set the overall long-term objectives for the organisation as a whole
Tactical objectives: The 'middle tier' of objectives, designed to plan and control individual
functions within the organisation. Tactical objectives are then implemented
by setting operational objectives
Operational objectives: Day to day performance targets to ensure that the organisation's operations
are carried out efficiently or effectively
Strategic objectives would include such matters as required levels of company profitability. Tactical
objectives would concern the efficient and effective use of an organisation's resources; for example,
target productivity. Operational objectives would include guidelines for ensuring that specific tasks are
carried out. For example, the manager of a sales territory may specify weekly sales targets for each sales
representative.

2.3 Strategic (corporate) objectives

Objectives are normally quantified statements of what the organisation actually intends to achieve over a
period of time. Objectives can also be used as standards for measuring the performance of the
organisation and departments in it.

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Strategic objectives concern the firm as a whole, for example:

(a) Profitability (g) Customer satisfaction
(b) Market share (h) Quality
(c) Growth (i) Industrial relations
(d) Cash flow (j) Added value
(e) Return on capital employed (k) Earnings per share
(f) Risk

2.4 Critical success factors and key performance indicators

As long ago as 1955, Lewis made a study of GEC's management reporting system and found that it
produced reports on the following factors.
(a) Profitability (e) Personnel development
(b) Market share (f) Employee attitudes
(c) Productivity (g) Public responsibility
(d) Product leadership (h) Balance between short-range and long-range goals
These are examples of 'critical success factors'.

A critical success factor is a performance requirement that is fundamental to competitive success.

A critical success factor is 'An element of the organisational activity which is central to its future success.
Critical success factors (CSFs) may change over time, and may include items such as product, quality,
employee attitudes, manufacturing flexibility and brand awareness'.
(CIMA Official Terminology)
CSFs can be set and used by identifying objectives and goals, determining which factors are critical for
accomplishing each objective and then determining a small number of performance measures for each
factor. For example, if next-day delivery were an objective, an employee attitude survey that revealed
indifference (or overdefensiveness) towards customer complaints about late deliveries would be an
indication of failure.
Johnson, Scholes and Whittington define CSFs as: 'those components of strategy where the organisation
must excel to outperform competition. These are underpinned by competences which ensure this
success.'
The importance of this definition is that it links to the idea of performance. If an organisation has
identified the components of its strategy where it needs to outperform the competition, it also needs
some way of being able to measure its performance in those areas.
An organisation can measure how well it is achieving the CSFs through the use of key performance
indicators (KPIs). CSFs represent 'what' an organisation needs to do in order to be successful. KPIs are
the measures that are then used to assess whether or not the CSFs are being achieved.
These key performance measures are therefore a vital part of the control system for reviewing how
successfully a strategy has been implemented and how well an organisation is performing.
However, note that the definitions of CSFs highlight that, in order to be successful, organisations have to
perform well across a range of key processes. Therefore CSFs and KPIs should focus on key operational
processes and should avoid focusing on financial performance alone.
If a question asks you to recommend performance indicators, make sure you recommend KPIs rather
than CSFs. For example, 'ensuring high quality' is a CSF because it is what a company wants to achieve.
By contrast, 'the number of complaints' or 'the number of defects' would be KPIs, because they are
measurable.

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CHAPTER 23 // PERFORMANCE MEASUREMENT

2.5 The link between mission statements and KPIs

Mission statement  The business's rationale for existing, and a
statement of their aspirations

Strategic objectives  Quantified embodiments of mission
(timescales, profitability)

Critical success factors (CSFs)  Elements which are central to future
success

Key performance indicators  Measures used to assess whether CSFs are
being achieved

CASE STUDY
TDM is a private educational institution based in Western Europe. It offers a variety of courses, including
degrees both at Bachelor and Masters levels and courses aimed at professional qualifications. TDM has
always concentrated on the quality of its courses and learning materials. TDM has never seen the need
for market and customer research, as it has always achieved its sales targets. Its students consistently
achieve passes on a par with the national average. TDM has always had the largest market share in its
sector even though new entrants continually enter the market. TDM has a good reputation and has not
felt the need to invest significantly in marketing activities. In recent years, TDM has experienced an
increasing rate of employee turnover.
(a) Four critical success factors which may be appropriate for TDM are:
(1) Customer satisfaction with courses and learning materials
(2) Employee satisfaction
(3) The quality of its teaching and materials
(4) Reputation and brand image
(b) KPIs for each of the CSFs could be:
Customer satisfaction
Student satisfaction rating – At the end of a course, or at the end of a module within a course, students
could be asked to complete a questionnaire rating their satisfaction with various aspects of the course
(for example, the knowledge levels of the staff, the quality of the supporting materials and the
approachability/availability of staff to ask them questions).
Client retention – A number of the students attending the courses aimed at professional qualifications
are likely to have been funded by their employers. If employers continue to send their students to TDM
rather than one of its rivals in the market, this suggests they are happy with the level of tuition and
service their students are receiving. The pass rates that students achieve are likely to be a significant
influence on client satisfaction in this respect.
Employee satisfaction
Staff turnover – The quality of TDM's teaching staff is crucial in maintaining customer satisfaction, so it
is important for TDM to retain its best staff.
Staff absenteeism – High levels of absence are likely to also indicate dissatisfaction among the staff. If
absenteeism is rising in conjunction with employee turnover, then there is a danger that the quality of
service provided for students will suffer.
Quality of teaching and materials
Market share – It will be important to monitor TDM's market share, because the share of the market
TDM can capture will have a direct impact on its revenues.

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Accreditations – TDM's courses will be accredited by academic and professional bodies. TDM has
always concentrated on the quality of its courses and learning materials, so external accreditations will
provide an independent corroboration of this quality. The quality of course tuition and learning materials,
in turn, is likely to feed back into the level of customer satisfaction with TDM's courses.
Reputation and brand image
Brand reputation – TDM has never seen the need for market and customer research, and has always
had a good reputation. However, given the continuing entrance of new competitors into the market,
TDM needs to ensure that its brand reputation is maintained. This is important if TDM is to ensure that
potential customers will choose to come on its courses rather than going to one of its competitors.
Pass rates – If students, or their employers, think that selecting one tuition provider in preference to
another can affect their chances of passing their exam, they are likely to select the tuition provider with
the highest pass rate.

2.6 The problem of short-termism

Short-termism is when there is a bias towards short-term rather than long-term performance. It is often
due to the fact that managers' performance is measured on short-term results.

Short-termism is when there is a bias towards short-term rather than long-term performance.

Organisations often have to make a trade-off between short-term and long-term objectives. Decisions
that involve the sacrifice of longer-term objectives include the following.
(a) Postponing or abandoning capital expenditure projects, which would eventually contribute to
growth and profits, in order to protect short-term cash flow and profits
(b) Cutting research and development expenditure to save operating costs, and so reducing the
prospects for future product development
(c) Reducing quality control, to save operating costs (but also adversely affecting reputation and
goodwill)
(d) Reducing the level of customer service, to save operating costs (but sacrificing goodwill)
(e) Cutting training costs or recruitment (so the company might be faced with skills shortages)
Managers may also manipulate results, especially if rewards are linked to performance. This can be
achieved by changing the timing of capital purchases, building up inventories and speeding up or
delaying payments and receipts.

2.7 Methods to encourage a long-term view

Steps that could be taken to encourage managers to take a long-term view, so that the 'ideal' decisions
are taken, include the following.
(a) Make short-term targets realistic as, if budget targets are unrealistically tough, a manager will be
forced to make trade-offs between the short and long term.
(b) Provide sufficient management information to allow managers to see what trade-offs they are
making. Managers must be kept aware of long-term aims as well as shorter-term (budget)
targets.
(c) Evaluate managers' performance in terms of contribution to long-term as well as short-term
objectives.
(d) Link managers' rewards to share price; this may encourage goal congruence.
(e) Set quality based targets as well as financial targets. Multiple targets can be used.

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3 Performance measures

Performance measure can be divided into two groups.

– Financial performance measures
– Non-financial performance measures
Financial performance measures include profit, revenue, costs, share price and cash flow.
Non-financial performance measures include product quality, reliability and customer satisfaction.
Performance measures can be quantitative or qualitative.
Non-financial indicators (NFIs) are useful in a modern business environment.

3.1 Deciding what measures to use

When an organisation is content that it has set appropriate objectives, it then becomes possible to
consider how progress towards the achievement of these objectives is to be measured. This is what is
meant by performance measurement. Just as different objectives are appropriate to each business, so
different performance measures may be appropriate for any given objective. The choice of performance
measures will vary from organisation to organisation.

Factors to consider Detail

Measurement needs This means people, equipment and time to collect and analyse
resources information. The costs and benefits of providing resources to produce a
performance indicator must be carefully weighed up.

Performance must be If not, measurement is meaningless. Overall performance should be

measured in relation to measured against the objectives of the organisation. If the organisation has
something no clear objectives, the first step in performance measurement is to set
them. The second is to identify the factors that are critical to the success
of those objectives. These are the CSFs discussed earlier.

Measures must be This means finding out what the organisation does and how it does it so
relevant that measures reflect what actually occurs.

Measurement needs Managers will only respond to measures that they find useful. The
responses management accountant therefore needs to adopt a modern marketing
philosophy to the provision of performance measures: satisfy customer
wants, not pile 'em high and sell 'em cheap.

3.2 Monitoring performance measures

Once suitable performance measures have been selected they must be monitored on a regular basis to
ensure that they are providing useful information. There is little point in an organisation devoting
considerable resources to measuring market share if an increase in market share is not one of the
organisation's objectives.

3.3 A range of performance measures

Performance measures may be divided into two groups.
(a) Financial performance measures
(b) Non-financial performance measures

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3.4 Financial performance measures

Financial performance is fundamental to businesses.

Measure Example

Profit Profit is the most common measure of all. Return on investment is also frequently
used. 'ICI increased pre-tax profits to $233m'.

Revenue 'The US businesses contributed $113.9m of total group turnover of $409m'.

Costs 'The US dollar's fall benefited pre-tax profits by about $50m while savings from the
cost-cutting programme instituted in 2011 were running at around $100m a quarter'.

Share price 'The group's shares rose 31c to 1,278c despite the market's fall'.

Cash flow 'Cash flow was also continuing to improve, with cash and marketable securities
totalling $8.4bn on 31 March, up from $8bn at 31 December.'

Note that the monetary amounts stated are only given meaning in relation to something else. Financial
results should be compared against a yardstick, such as the following.
(a) Budgeted sales, costs and profits
(b) Standards in a standard costing system
(c) The trend over time (last year/this year, say)
(d) The results of other parts of the business
(e) The results of other businesses
(f) The economy in general
(g) Future potential (for example the performance of a new business may be judged in terms of
nearness to breaking even).

3.5 Non-financial objectives and performance measures

3.5.1 Non-financial objectives

Non-financial objectives include the welfare of employees and society in general and the fulfilment of
responsibilities towards customers and suppliers.

A company may have important non-financial objectives, which will limit the achievement of financial
objectives. Examples of non-financial objectives are as follows.
(a) The welfare of employees
A company might try to provide good wages and salaries, comfortable and safe working
conditions, good training and career development, and good pensions. If redundancies are
necessary, many companies will provide generous redundancy payments, or spend money trying
to find alternative employment for redundant staff.
(b) The welfare of management
Managers will often take decisions to improve their own circumstances, even though their
decisions will incur expenditure and so reduce profits. High salaries, company cars and other
perks are all examples of managers promoting their own interests.
(c) The provision of a service
The major objectives of some companies will include fulfilment of a responsibility to provide a
service for the public. Providing a service is of course a key responsibility of government
departments and local authorities.

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(d) The fulfilment of responsibilities towards customers

Responsibilities towards customers include providing in good time a product or service of a
quality that customers expect, and dealing honestly and fairly with customers. Reliable supply
arrangements, as well as after-sales service arrangements, are important.
(e) The fulfilment of responsibilities towards suppliers
Responsibilities towards suppliers are expressed mainly in terms of trading relationships. A
company's size could give it considerable power as a buyer. The company should not use its
power unscrupulously. Suppliers might rely on getting prompt payment, in accordance with the
agreed terms of trade.
(f) The welfare of society as a whole
Some companies are aware of the role that they have to play in exercising corporate social
responsibility. This includes compliance with applicable laws and regulations but is wider than
that. Companies may be aware of their responsibility to minimise pollution and other harmful
'externalities' (such as excessive traffic) which their activities generate. In delivering 'green'
environmental policies, a company may improve its corporate image as well as reducing harmful
externality effects. Companies also may consider their 'positive' responsibilities, for example to
make a contribution to the community by local sponsorship.
Other non-financial objectives are growth, diversification and leadership in research and development.
Non-financial objectives do not negate financial objectives, but they do suggest that the simple theory of
company finance, that the objective of a firm is to maximise the wealth of ordinary shareholders, is too
simplistic. Financial objectives may have to be compromised in order to satisfy non-financial objectives.

3.5.2 Non-financial performance measures

The use of non-financial performance measures has increased in recent years.
A key reason why non-financial performance measures are used is that they are considered to be leading
indicators of financial performance. For example, if customer satisfaction is low this could imply a future
fall in profits due to decreased sales demand. The non-financial measure of poor customer satisfaction
has given an indication that the financial measure of future sales may change.
You can appreciate the benefits of non-financial performance indicators when you contrast them with
financial performance measures and the effect both might have on management.
(a) Non-financial performance measures can provide managers with incentives to improve long-term
financial performance. Focusing on customer satisfaction encourages repeat business, which is
good for long-term profitability.
(b) Financial performance measures used alone may provide managers with shorter-term incentives,
which could be detrimental to the business in the long term. For example, price increases applied
in the short term to meet financial targets could damage customer relations in the long term if
quality has not improved.

3.5.3 Non-financial indicators

Changes in cost structures, the competitive environment and the manufacturing environment have led to
an increased use of NFIs.

Another reason for an increase in the use of non-financial performance measures is the significant
number of changes in organisations. Changes in the cost structures and manufacturing and increased
competition have meant that organisations need to look at new measures of performance.
These changes have led to a shift from treating financial figures as the foundation of performance
measurement to treating them as one of a range of measures.
(a) Changes in cost structures
Modern technology requires massive investment and product life cycles have got shorter. A
greater proportion of costs are sunk and a large proportion of costs are planned, engineered or

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designed into a product/service before production/delivery. At the time the product/service is

produced/delivered, it is therefore too late to control costs.
(b) Changes in competitive environment
Financial measures do not convey the full picture of a company's performance, especially in a
modern business environment where product quality, delivery, reliability and customer
satisfaction are so important.
(c) Changes in manufacturing environment
New manufacturing techniques and technologies focus on minimising throughput times, inventory
levels and set-up times. But managers can reduce the costs for which they are responsible by
increasing inventory levels through maximising output. If a performance measurement system
focuses principally on costs, managers may concentrate on cost reduction and ignore other
important strategic manufacturing goals.
Organisations are increasingly using quantitative and qualitative NFIs. (We covered quantitative and
qualitative data in Chapter 2.) Here are some examples.
(a) Quality rating (e) Rework
(b) Number of customer complaints (f) Delivery to time
(c) Number of warranty claims (g) Non-productive hours
(d) Lead times (h) System (machine) down time
Unlike traditional variance reports, measures such as these can be provided quickly for managers, per
shift or on a daily or even hourly basis as required. They are likely to be easy to calculate, and easier for
non-financial managers to understand and therefore to use effectively.
Anything can be compared if it is meaningful to do so. The measures should be tailored to the
circumstances. For example, the number of coffee breaks per 20 pages of text might indicate to you how
hard you are studying!
NFIs typically combine elements from the table below.

Errors/failure Time Quantity People

Defects Second Range of products Employees

Equipment failures Minute Parts/components Employee skills

Warranty claims Hour Units produced Customers

Complaints Shift Units sold Competitors

Returns Cycle Services performed Suppliers

Stockouts Day kg/litres/metres

Lateness/waiting Month m²/m³

Misinformation Year Documents

Miscalculation Deliveries

Absenteeism Enquiries

Traditional measures derived from these lists like 'kg (of material) per unit produced' or 'units produced
per hour' are very common. What may at first seem a fairly unlikely combination may also be very
revealing. For example, 'miscalculations per 1,000 invoices' would show how accurately the invoicing
clerk was working.

QUESTION Non-financial indicators

Using the above chart, devise five NFIs and explain how each might be useful.

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ANSWER
Here are five suggested indicators, showing you how to use the chart.
(a) Services performed late vs total services performed
(b) Total units sold vs total units sold by competitors (indicating market share)
(c) Warranty claims per month
(d) Documents processed per employee
(e) Equipment failures per 1,000 units produced
There are, of course, many other possibilities.

EXAM FOCUS POINT

If you are asked about suitable performance measures in an exam, think about NFIs. Remember that
anything can be compared if it is meaningful to do so.

3.5.4 Ratios and percentages

Ratios are a useful performance measurement technique. It is easier to look at changes over time by
comparing ratios in one time period with the corresponding ratios for periods in the past.
A percentage expresses one number as a proportion of another and gives meaning to absolute numbers.
Market share, capacity levels, wastage and staff turnover are often expressed using percentages.

4 Economy, efficiency and effectiveness

Comparing non profit seeking entities with the private sector raises several problems. The difficulties in
valuing outputs led to the creation of the 3E approach (economy, efficiency and effectiveness).
Economy, efficiency and effectiveness can be studied and measured with reference to inputs, process
and outputs.

4.1 Comparing State-regulated entities and non profit seeking entities with
the private sector
Non profit seeking entities include private sector organisations, such as charities and churches, and
much of the public sector. Commercial organisations generally have market competition and the profit
motive to guide the process of managing resources economically, efficiently and effectively. However,
non profit seeking entities cannot by definition be judged by profitability nor do they generally have to
be successful against competition, so other methods of assessing performance have to be used.
Private sector organisations are largely free from State control. This makes it more difficult to compare
the performance of a State-regulated entity with a private sector organisation.
The performance of State-controlled entities can be either constrained or enhanced by government
regulation. For example, State hospitals are obliged to provide universal care whereas private hospitals
are permitted to 'cherry pick' their patients. Public sector colleges may be subsidised by the State
whereas private sector colleges may not. This makes performance measurement comparisons between
the public and private sector much more difficult.
(a) Difference in objectives
A major problem with many non profit seeking entities, particularly government bodies, is that it
is difficult to define their objectives.
State-controlled bodies are all, ultimately, responsible to government for their activities, and their
purposes are defined in the laws that establish them. They have a range of aims and objectives

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but rarely will they set out to trade at a profit. Nevertheless, their managers will be expected to
exercise good stewardship and prevent waste of resources. Objectives will usually be defined in
terms of the provision of a service that is deemed to be beneficial to society.

QUESTION Objectives
One of the objectives of a local government body could be 'to provide adequate street lighting throughout
the area'.
(a) How could the 'adequacy' of street lighting be measured?
(b) Assume that other objectives are:
(i) To improve road safety in the area; and
(ii) To reduce crime.
How much does 'adequate' street lighting contribute to each of these aims?
(c) What is an excessive amount of money to pay for adequately lit streets, improved road safety and
reduced crime? How much is too little?

ANSWER
Mull over these questions and discuss them in class or with colleagues if possible. It is possible to
suggest answers, perhaps even in quantitative terms, but the point is that there are no easy answers,
and no right or wrong answers.

(b) Difference in income

An important feature of public sector bodies is that they have little control over their income. This
is because they depend on government for the funds they need to operate. The funds they receive
will be influenced by a large number of factors, including current public opinion, government
aspirations, the skill of their leaders in negotiation, the current state of the public finances overall
and the current economic climate.

4.2 Performance measurement in the public sector

Performance measurement in the public sector has traditionally been perceived as presenting special
difficulties.

4.2.1 Lack of profit measure

With public sector services, there has rarely been any market competition and no profit motive. In the
private sector, these two factors help to guide the process of fixing proper prices and managing
resources economically, efficiently and effectively. Since most public sector organisations cannot be
judged by their success against competition nor by profitability, other methods of assessing performance
have to be used. If an organisation is not expected to make a profit, or if it has no sales, indicators such
as return on investment and residual income are meaningless.

4.2.2 Multiple objectives and different expectations

Non profit seeking organisations tend to have multiple objectives, so that even if they can all be clearly
identified it is impossible to say which is the overriding objective. Different stakeholders hold different
expectations of public sector organisations. For example, parents, employers, the community at large
and central government might require different things from the education sector and even within groups
of stakeholders, such as parents, there might be a mix of requirements. Priorities of all the groups might
change over time. Schools have to reconcile the possibly conflicting demands made on them but to
make explicit statements of objectives might show that they are favouring one group of stakeholder at
the expense of another.

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4.2.3 Political, social and legal considerations

Given the role of government in public sector organisations, long-term organisational objectives are
sometimes sacrificed for short-term political gains.
(a) Unlike commercial organisations, public sector organisations are subject to strong political
influences. Local authorities, for example, have to carry out central government's policies as well
as their own (possibly conflicting) policies.
(b) The public may have higher expectations of public sector organisations than commercial
organisations. A decision to close a local hospital in an effort to save costs, for example, is likely
to be less acceptable to the public than the closure of a factory for the same reason.
(c) The performance indicators of public sector organisations are subject to far more onerous legal
requirements than those of private sector organisations.
(d) Whereas profit-seeking organisations are unlikely in the long term to continue services making a
negative contribution, not for profit organisations may be required to offer a range of services,
even if some are uneconomical.

4.2.4 Measuring outputs

Outputs can seldom be measured in a way that is generally agreed to be meaningful. (For example, are
good exam results alone an adequate measure of the quality of teaching?) Data collection can be
problematic. For example, unreported crimes are not included in data used to measure the performance
of a police force. It is difficult to assign a monetary value to many non profit seeking entity outputs. For
example, in a State hospital, what is the monetary value of a hip replacement? Is a hip replacement on
an old age pensioner worth more than a knee operation on a 35 year old?

4.2.5 Nature of service provided

Many not for profit organisations provide services for which it is difficult to define a cost unit. For
example, what is the cost unit for a local fire service? This problem does exist for commercial service
providers but problems of performance measurement are made simple because profit can be used.

4.2.6 Financial constraints

Although every organisation operates under financial constraints, these are more pronounced in not for
profit organisations. For instance, a commercial organisation's borrowing power is effectively limited by
managerial prudence and the willingness of lenders to lend, but a local authority's ability to raise finance
(whether by borrowing or via local taxes) is subject to strict control by central government.

4.3 Solutions – the 3E approach

The problem of valuing outputs in a non profit seeking entity led to the creation of the 3E approach.
Economy, efficiency and effectiveness are relevant considerations for all types of organisation but they
are particularly useful when judging the performance of non profit seeking organisations.
(a) Economy lies in operating at minimum cost. However, being very unwilling to spend money will
reduce effectiveness.
Economy is the 'acquisition of resources of appropriate quantity and quality at minimum cost'.
(CIMA Official Terminology)
(b) Efficiency consists of attaining desired results at minimum cost. It therefore combines
effectiveness with economy.
Efficiency is the 'achievement of either maximum useful output from the resources devoted to an
activity or the required output from the minimum resource input'. (CIMA Official Terminology)
(c) Effectiveness. There are usually several ways to achieve objectives, some more costly than
others.
Effectiveness is 'utilisation of resources such that the output of the activity achieves the desired
result'. (CIMA Official Terminology)

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The assessment of economy, efficiency and effectiveness should be a part of the normal management
process of any organisation, public or private.
(a) Management should carry out performance reviews as a regular feature of their control
responsibilities.
(b) Independent assessments of management performance can be carried out by 'outsiders', perhaps
an internal audit department, as value for money audits (VFM audits).

EXAM FOCUS POINT

In comments on the 2015 sittings, the ACCA examining team noted that candidates had an ‘imprecise’
knowledge of value for money concepts, particularly economy and efficiency.

4.4 Studying and measuring the three Es

Economy, efficiency and effectiveness can be studied and measured with reference to the following.

Inputs
Economy

Process
Efficiency

Outputs
Effectiveness

(CIMA Official Terminology)

(a) Inputs
(i) Money
(ii) Resources – the labour, materials, time and so on consumed, and their cost
For example, in a State-run hospital this would include the price paid for drugs (compared with a
budget or open market prices).
(b) Process. For example, in a State-run hospital this could be the cost per successful heart
operation. This is usually some ratio of economy and effectiveness measures.
(c) Outputs; in other words, the results of an activity, measurable as the services actually produced,
and the quality of the services.
In the case of a State-run hospital this may include, for example, the percentage of patients
recovering from heart surgery.
Value for money is the 'performance of an activity in such a way as to simultaneously achieve economy,
efficiency and effectiveness'. (CIMA Official Terminology)

4.4.1 Examples of indicators

(a) Financial indicators to measure efficiency
(i) Cost per unit of activity (eg cost per arrest/bed-night in a hospital/pupil)
(ii) Variance analysis
(iii) Comparisons with benchmark information

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(iv) Cost component as a proportion of total costs (eg administration costs as a proportion of
total costs)
(v) Costs recovered as a proportion of costs incurred (eg payment received from householders
requesting collection of bulky/unusual items of refuse)
(b) Non-financial (quantifiable) indicators to measure effectiveness
(i) Quality of service/output measures (eg exam results, crime rates)
(ii) Utilisation of resources (eg hospital bed occupancy ratios, average class sizes)
(iii) Flexibility/speed of response (eg hospital waiting lists)
(c) Qualitative indicators to measure effectiveness
(i) Workplace morale
(ii) Staff attitude to dealing with the public (eg can they provide the correct information in a
helpful and professional manner)
(iii) Public confidence in the service being provided (eg will a pupil be well educated, a patient
properly cared for)

4.5 Other solutions

4.5.1 Inputs
Performance can be judged in terms of inputs. This is very common in everyday life. If somebody tells
you that their suit cost $750, you would generally conclude that it was an extremely well-designed and
good quality suit, even if you did not think so when you first saw it. The drawback is that you might also
conclude that the person wearing the suit had been cheated or was a fool, or you may happen to be of
the opinion that no piece of clothing is worth $750. So it is with the inputs and outputs of a not for
profit organisation.

4.5.2 Judgement
A second possibility is to accept that performance measurement must to some extent be subjective.
Judgements can be made by experts in that particular not for profit activity or by the persons who fund
the activity.

4.5.3 Comparisons
We have said that most non profit seeking organisations do not face competition but this does not mean
that all are unique. Bodies like local governments and health services can judge their performance
against each other and against the historical results of their predecessors. In addition, since they are
not competing with each other, there is less of a problem with confidentiality and so benchmarking is
easier.
In practice, benchmarking usually encompasses:
 Regularly comparing aspects of performance (functions or processes) with best practitioners
 Identifying gaps in performance
 Seeking fresh approaches to bring about improvements in performance
 Following through with implementing improvements
 Following up by monitoring progress and reviewing the benefits

4.5.4 Quantitative measures

Unit cost measurements like 'cost per patient day' or 'cost of borrowing one library book' can fairly easily
be established to allow organisations to assess whether they are doing better or worse than their
counterparts.

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Efficiency measurement of inputs and outputs is illustrated in three different situations as follows.

(a) Where input is fixed

Actual output
25/30 miles per gallon = 83.3% efficiency
Maximum output obtainable for a given input
(b) Where output is fixed
Minimum input needed for a given output
55/60 hours to erect scaffolding = 91.7%
Actual input efficiency
(c) Where input and output are both variable
Actual output  actual input $9,030/7,000 meals = $1.29 per meal
compared with
standard output  standard input $9,600/7,500 meals = $1.28 per meal
Efficiency = 99.2%
As a further illustration, suppose that at a cost of $40,000 and 4,000 hours (inputs) in an average year
two policemen travel 8,000 miles and are instrumental in 200 arrests (outputs). A large number of
possibly meaningful measures can be derived from these few figures, as the table below shows.

$40,000 4,000 hours 8,000 miles 200 arrests

$40,000/200
$40,000/4,000 $40,000/8,000
Cost $40,000 = $200 per
= $10 per hour = $5 per mile
arrest
4,000/$40,000 = 4,000/8,000 = 4,000/200 =
Time 4,000 hours 6 minutes patrolling ½ hour to patrol 20 hours per
per $1 spent 1 mile arrest
8,000/4,000 = 8,000/200 =
8,000/$40,000 =
Miles 8,000 2 miles patrolled 40 miles per
0.2 of a mile per $1
per hour arrest
200/4,000 = 200/8,000 =
200/$40,000 =
Arrests 200 1 arrest every 20 1 arrest every
1 arrest per $200
hours 40 miles

These measures do not necessarily identify cause and effect (do teachers or equipment produce better
exam results?) or personal responsibility and accountability. Actual performance needs to be compared
as follows.
(a) With standards, if there are any (d) With targets
(b) With similar external activities (e) With indices
(c) With similar internal activities (f) Over time, as trends
Not for profit organisations are forced to use a wide range of indicators and can be considered early
users of a balanced scorecard approach (covered in Section 7).

4.6 Performance measurement in the public sector

In public sector organisations, an increasing volume of information on performance and 'value for money'
is produced for internal and external use. The ways in which performance can be measured depends
very much on which organisation is involved.
(a) The first question which would need to be asked is 'what are the aims and objectives of the
organisation?' For example, the objective of Companies House is to maintain and make available
records of company reports.
(b) The next question to ask is 'How can we tell if the organisation is meeting the objectives?'
Quantified information – ie information in the form of numbers – will be useful, and this will
consist mainly of output and performance measures and indicators. For these, targets can be set.
Any individual organisational unit should have no more than a handful of key targets.

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Individual targets are likely to fall under the headings:

(a) Financial performance targets
(b) Volume of output targets
(c) Quality of service targets
(d) Efficiency targets

4.7 Performance measurement in central government

Over recent years, much of the work of central government has been reorganised into semi-autonomous
executive agencies, which we mentioned earlier in the chapter.
The following are examples of targets related to financial performance in executive agencies.
(a) Full cost recovery (National School of Government, Central Office of Information and others), plus
unit cost targets
(b) Commercial revenue to offset costs (Met Office)
(c) Non-Exchequer income as a percentage of total income (National Engineering Laboratory)
Targets related to output can be difficult to set. In many cases, the output of executive agencies is not
tangible. For example, Historic Royal Palaces not only deals with visitors, whose numbers can be
counted, but is also responsible for maintaining the fabric of royal palaces – an output which is more
difficult to measure. In such cases, performance will be best measured by appraising the progress of the
project as a whole.
Example of quality targets set for executive agencies include the following.
(a) Timeliness
(i) Time to handle applications
(ii) Car driving tests to be reduced to six weeks nationally (Driving Standards Agency)
(b) Quality of product
(i) Number of print orders delivered without fault (Her Majesty's Stationery Office)
(ii) 95% business complaints handled within five days
(iii) 85% overall customer satisfaction rating
Efficiency improvements may come through reducing the cost of inputs without reducing the quality of
outputs. Alternatively, areas of activity affecting total costs may be reduced. Targets related to efficiency
include the following.
(a) Percentage reduction in price paid for purchases of stationery and paper
(b) Reduction in the ratio of cost of support services to total cost
(c) 8.7% efficiency increase in the use of accommodation

4.8 Performance measurement in local government

The performance measures chosen by local authorities usually consist of comparative statistics and unit
costs.
The following list illustrates the types of comparative statistics that could be used.

PERFORMANCE MEASURES IN LOCAL GOVERNMENT

For the authority's total expenditure Net cost per 1,000 population
and for each function Manpower per 1,000 population

Primary education, secondary education Pupil/teacher ratio

Cost per pupil

School meals Revenue/cost ratio

Pupils receiving free meals as a proportion of
school roll

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PERFORMANCE MEASURES IN LOCAL GOVERNMENT

Home helps Contract hours per 1,000 population over 65

Police Population per police officer

Serious offences per 1,000 population

Fire Proportion of area at high risk

Public transport Passenger journeys per week per 1,000

population

Highways Maintenance cost per kilometre

5 Measuring profitability and productivity

Profitability can be measured by return on investment (ROI) / return on capital employed (ROCE),
profit margin, gross profit margin or cost/sales ratios.

5.1 Typical performance measures

In order to ensure that junior managers in an organisation make decisions that are in the best interests
of the organisation as a whole, senior managers generally introduce the following systems of
performance measures.

Responsibility centre Manager responsible for? Financial performance measures

Cost centre Costs Variances

Revenue centre Revenues only Revenues

Profit centre Costs and revenues Controllable profit

Investment centre Costs, revenues and assets ROI, residual income and return on
equity (ROE)

We looked at variances in Part D of this Interactive Text, and we are now going to turn our attention to
the following performance measures.
(a) Return on investment (ROI)
(b) Residual income (RI)

5.2 Return on investment (ROI)

Return on investment (ROI) (also called return on capital employed (ROCE)) is calculated as
(profit/capital employed)  100% and shows how much profit has been made in relation to the amount
of resources invested.

Profits alone do not show whether the return is sufficient, in view of the value of assets committed. Thus
if company A and company B have the following results, company B would have the better performance.
A B
$ $
Profit 5,000 5,000
Sales 100,000 100,000
Capital employed 50,000 25,000
ROI 10% 20%
The profit of each company is the same but company B only invested $25,000 to achieve that profit
whereas company A invested $50,000.

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ROI may be calculated in a number of ways, but management accountants prefer to exclude from profits
all revenues and expenditures not related to the core operation of the business (such as interest payable
and income from trade investments). Profit before interest and tax is therefore often used.
Similarly all assets of a non-operational nature (for example, trade investments and intangible assets
such as goodwill) should be excluded from capital employed.

EXAM FOCUS POINT

When you use the ratios in this section, in many cases you will use a profit figure and/or a capital
employed figure. Unless you are told otherwise, use earning before interest and tax (EBIT) as profit,
and shareholder funds plus long-term liabilities for capital employed. Please note that EBIT is the same
as profit before interest and tax (PBIT).

Profits should be related to average capital employed. In practice, many companies calculate the ratio
using year-end assets. This can be misleading. If a new investment is undertaken near to year-end and
financed, for example, by an issue of shares, the capital employed will rise by the finance raised but
profits will only have a month or two of the new investment's contribution.
What does the ROI tell us? What should we be looking for? There are two principal comparisons that
can be made.
(a) The change in ROI from one year to the next
(b) The ROI being earned by other entities

EXAM FOCUS POINT

In an exam you may not be given the capital employed figure and you may be given several different
profit figures.
Capital employed = non-current assets + investments + current assets – current liabilities
Profit = operating profit before tax
ROCE can also be calculated as: Operating profit/(Ordinary shareholders' funds + non-current
liabilities)

QUESTION ROCE
$
Turnover 3,527,508
Gross profit 2,469,265
Operating profit 1,814,578
Non-current assets 2,291,000
Cash at bank 2,309,791
Short-term borrowings 474,670
Trade receivables 221,222
Trade payables 232,346
Calculate the return on capital employed.

ANSWER
Capital employed = non-current assets + investments + current assets – current liabilities
= $2,291,000 + $2,309,791 +$221,222 – $474,670 – $232,346
= $4,114,997
ROCE = 1,814,578/4,114,997 × 100%
= 44.10%

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5.2.1 ROI using controllable profit

If the performance of the investment centre manager is being assessed, it should seem reasonable to
base profit on the revenues and costs controllable by the manager and exclude service and head office
costs, except those costs specifically attributable to the investment centre.
ROI is therefore sometimes calculated as

Controllable (traceable) profit

ROI = ×100%
Controllable (traceable) investment
If it is the performance of the investment centre that is being assessed, however, the inclusion of general
service and head office costs would seem reasonable.

5.3 Residual income (RI)

(RI is calculated as follows.
RI = Controllable (traceable) profit – imputed interest charge on controllable (traceable) investment

5.4 Example: Calculation of ROI and RI

Division M is a division of MR plc. The following data relate to Division M.
Net assets $20m
Annual profit $5m
Cost of capital 15% per annum
MR plc is considering two proposals.
Proposal 1
Invest a further $2m in non-current assets to earn an annual profit of $0.40m.
Proposal 2
Dispose of non-current assets at their net book value of $5.5m. This would lead to profits falling by $1m
per annum. Proceeds from the disposal of these non-current assets would not be credited to Division M
(but to the Holding Company of MR plc instead).
Required
(a) Calculate the current ROI and RI for Division M.
(b) Consider each of the two proposals and show how the ROI and RI would change if these
proposals were adopted.

5.5 Solution
(a) Current ROI
Traceable profit
ROI =  100%
Traceable investment
$5m
=  100%
$20m
= 25%
RI = Traceable profit – imputed interest charge on traceable investment
= $5m – (15%  $20m)
= $5m – $3m
= $2m
The ROI (25%) exceeds the cost of capital (15%) and the residual income is positive (+$2m)
and therefore Division M is performing well.

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(b) Let us now look at the situations that would arise if proposals 1 and 2 were to be adopted.
Proposal 1
New traceable profit = $5m + $0.4m
= $5.4m
 New traceable investment = $20m + $2m
= $22m
$5.4m
 New ROI = × 100%
$22m
= 24.5%
 New RI = $5.4m – (15%  $22m)
= $5.4m – $3.3m
= $2.1m
Proposal 2
New traceable profit = $5m – $1m
= $4m
New traceable investment = $20m  $5.5m
= $14.5m
$4m
 New ROI =  100%
$14.5m
= 27.6%
 New RI = $4m – (15%  $14.5m)
= $4m – $2.18m
= $1.82m
Summary
Current Proposal 1 Proposal 2
ROI (%) 25 24.5 27.6
RI ($m) 2 2.1 1.82
Based on ROI alone, proposal 2 would appear the best, showing a relative increase in return
when proposal 1 shows a decrease.
However, the RI suggests the opposite is true and proposal 1 is best. This is because RI focuses
purely on the absolute result.
When considering proposal 2, divisional managers should also consider the asset rate of return.
Change in profit
Asset rate of return =
Change in investment

$1m
=  100%
$5.5m

= 18.2%
Since MR plc's current rate of return is 25%, any asset which has a rate of return less than this
should be disposed of. It is important to remember, therefore, that whichever proposal is
accepted, it should lead to goal congruence.

5.6 Advantages of ROI and RI

ROI is a relative measure, whereas RI is an absolute measure. Consequently, RI, as an absolute
measure of performance is used to select proposals based on the absolute increase in profits, rather than
the relative increases.
This can be demonstrated in the example above where the ROI increases to 29% with proposal 2, but
the reality is that RI only increases by an absolute value of $0.2m. RI therefore allows you to select a
proposal that will maximise your wealth (in absolute terms).

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RI can also be related to the net present value (NPV) of a project, and supports the NPV approach.
Therefore, organisations that maximise residual income will not necessarily, but are likely to, maximise
NPV in the long run (and therefore shareholder wealth).

5.7 Disadvantages of ROI and RI

These performance measures have a number of common disadvantages.
(a) It can be difficult to identify controllable (traceable) profits.
(b) When organisations value assets at net book value, ROI and RI generally increase as assets get
older. Consequently, management may hold on to out of date plant and machinery.
(c) Both ROI and RI involve a cost of capital figure which must be estimated. The cost of capital is
difficult to calculate and is not known with certainty.
(d) Both ROI and RI measure divisional performance based on a single value. Most organisations
these days are of such a complex nature that a single figure is unlikely to be adequate for an
investment decision.
(e) As a general rule, most investment projects with positive NPVs have correspondingly low ROI and
RI figures in early years. This can lead to the project being rejected in the first few years of a new
investment, because the payoffs are long term.

5.8 Return on Equity (ROE)

The return on equity ratio (ROE) measures the ability of a firm to generate profits from its
shareholders’ investment in the company. It shows how much profit each unit of shareholders’ equity
generates. ROE is also an indicator of how effectively management is using equity financing to fund
operations and grow the company. It is expressed as a percentage and calculated by dividing net income
by shareholder's equity.
ROE = Net income / Shareholder's equity

Net income is for the full year (before dividends paid to ordinary shareholders but after preference
dividends.) Shareholder's equity does not include preference shares.
Return on equity may also be calculated by dividing net income by the average shareholders' equity:
ROE = Net income / Average shareholder's equity
Average shareholders' equity is calculated by adding the shareholders' equity at the beginning of a period
to the shareholders' equity at the period's end, and dividing the result by two.
ROE is often said to be the ultimate ratio or ‘mother of all ratios’ that can be obtained from a company’s
financial statements. A company can only create shareholder value if its ROE is greater than its cost of
equity capital (the expected return that shareholders require for investing in the company, given the
particular risk of the company).

5.8.1 Example: ROE

XYZ is a retail store that sells tools to construction companies across the country. XYZ reported net
income of $100,000 during the year, before preference dividends of $10,000. XYZ had 100,000
$4.50 ordinary shares in issue during the year. XYZ would calculate ROE as follows:
$100,000-$10,000 / $450,000 = 20%

5.9 Profit margin

The profit margin (profit to sales ratio) is calculated as (profit  revenue)  100%.

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The profit margin provides a simple measure of performance for management. Investigation of
unsatisfactory profit margins enables control action to be taken, either by reducing excessive costs or by
raising selling prices.

5.10 Example: The profit to sales ratio

A company compares its year 2 results with year 1 results as follows.
Year 2 Year 1
$ $
Sales 160,000 120,000
Cost of sales
Direct materials 40,000 20,000
Direct labour 40,000 30,000
Production overhead 22,000 20,000
Marketing overhead 42,000 35,000
144,000 105,000
Profit 16,000 15,000
Profit to sales ratio 10% 12½%

Ratio analysis on the above information shows that there is a decline in profitability in spite of the
$1,000 increase in profit, because the profit margin is less in year 2 than year 1.

5.10.1 Gross profit margin

The profit to sales ratio above was based on a profit figure which included non-production overheads.
The pure trading activities of a business can be analysed using the gross profit margin, which is
calculated as (gross profit  turnover)  100%.
For the company in Paragraph 5.2 the gross profit margin would be:
((16,000 + 42,000)/160,000)  100% = 36.25% in year 2 and ((15,000 + 35,000)/120,000) 
100% = 41.67% in year 1.

5.10.2 Cost/sales ratios

There are three principal ratios for analysing statement of profit or loss information.
(a) Production cost of sales  sales
(b) Distribution and marketing costs  sales
(c) Administrative costs  sales
When particular areas of weakness are found, subsidiary ratios are used to examine them in greater
depth. For example, for production costs the following ratios might be used.
(a) Material costs  sales value of production
(b) Works labour costs  sales value of production
(c) Production overheads  sales value of production

5.11 Example: Cost/sales ratios

Look back to the example above. A more detailed analysis would show that higher direct materials are
the probable cause of the decline in profitability.
Year 2 Year 1
Material costs/sales 25% 16.7%
Other cost/sales ratios have remained the same or improved.

5.12 Productivity
This is the quantity of the product or service produced (output) in relation to the resources put in
(input); for example, so many units produced per hour, or per employee, or per tonne of material. It
measures how efficiently resources are being used.

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QUESTION Performance measures

An invoicing assistant works in a department with three colleagues. They are paid $8,000 per annum.
The department typically handles 10,000 invoices per week.
One morning they spend half an hour on the phone to their grandfather, who lives in Australia, at the
company's expense. The cost of the call proves to be $32.
Required
From this scenario identify as many different performance measures as possible, explaining what each is
intended to measure. Make any further assumptions that you wish.

ANSWER
Invoices per employee per week: 2,500 (activity)
Staff cost per invoice: $0.06 (cost/profitability)
Invoices per hour: 2,500/(7  5) = 71.4 (productivity)
Cost of idle time: $32 + $2.20 (half-hourly rate) = $34.20 (cost/profitability)
You may have thought of other measures and probably have slight rounding differences.

EXAM FOCUS POINT

Where a ratio includes capital employed, you should use shareholders' funds plus long-term liabilities
unless you are told otherwise.

6 Performance measures based on the statement of financial

position

Asset turnover is a measure of how well the assets of a business are being used to generate sales. It is
calculated as (sales  capital employed).
The current ratio is the 'standard' test of liquidity and is the ratio of current assets to current liabilities.
The quick ratio, or acid test ratio, is the ratio of current assets less inventories to current liabilities.

6.1 Asset turnover

Asset turnover is a measure of how well the assets of a business are being used to generate sales. It is
calculated as (sales  capital employed).

For example, suppose two companies each have capital employed of $100,000 and Company A makes
sales of $400,000 per annum whereas Company B makes sales of only $200,000 per annum.
Company A is making a higher turnover from the same amount of assets; in other words, twice as much
asset turnover as Company B, and this will help A to make a higher return on capital employed than B.
Asset turnover is expressed as 'x times' so that assets generate x times their value in annual turnover.
Here, Company A's asset turnover is four times and B's is two times.

6.1.1 Interrelationship between profit margin, asset turnover and ROI

Profit margin and asset turnover together explain the ROI. The relationship between the three ratios is as
follows.

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Profit margin  asset turnover = ROI

Profit Sales Profit
 =
Sales Capital employed Capital employed

6.2 Liquidity ratios: current ratio and quick ratio

The current ratio is the 'standard' test of liquidity and is the ratio of current assets to current liabilities.
current assets
Current ratio =
current liabilities

The idea behind the current ratio is that a company should have enough current assets that give a
promise of 'cash to come' to meet its future commitments to pay off its current liabilities. Obviously, a
ratio in excess of 1 should be expected. Otherwise, there would be the prospect that the company might
be unable to pay its debts on time. In practice, a ratio comfortably in excess of 1 should be expected,
but what is 'comfortable' varies between different types of businesses.
Companies are not able to convert all their current assets into cash very quickly. In particular, some
manufacturing companies might hold large quantities of raw material inventories, which must be used in
production to create finished goods inventories. Finished goods inventories might be warehoused for a
long time, or sold on lengthy credit. In such businesses, where inventory turnover is slow, most
inventories are not very 'liquid' assets, because the cash cycle is so long. For these reasons, we
calculate an additional liquidity ratio, known as the quick ratio or acid test ratio.
The quick ratio, or acid test ratio, is the ratio of current assets less inventories to current liabilities.
current assets less inventories
Quick ratio =
current liabilities

This ratio should ideally be at least 1 for companies with a slow inventory turnover. For companies with
a fast inventory turnover, a quick ratio can be comfortably less than 1 without suggesting that the
company is in cash flow trouble.
Both the current ratio and the quick ratio offer an indication of the company's liquidity position, but the
absolute figures should not be interpreted too literally. It is often said that an acceptable current ratio is
1.5 and an acceptable quick ratio is 0.8, but these should only be used as a guide. Different businesses
operate in very different ways. A supermarket, for example, might have a current ratio of 0.40 and a
quick ratio of 0.16 due to low receivables (people do not buy groceries on credit), low cash (good cash
management), medium inventories (high inventories but quick turnover, particularly in view of
perishability) and very high payables (many supermarkets buy their supplies of groceries on credit).
What is important is the trend of these ratios, which will show whether liquidity is improving or
deteriorating. If a supermarket has traded for the last 10 years (very successfully) with current ratios of
0.40 and quick ratios of 0.16 then it ought to be able to continue in business with those levels of
liquidity. If in the following year the current ratio were to fall to 0.38 and the quick ratio to 0.09, further
investigation would be needed. It is the relative position that is far more important than the absolute
figures.
However, a current ratio and a quick ratio can get bigger than they need to be. A company that has
large volumes of inventories and receivables might be overinvesting in working capital, and so tying up
more funds in the business than it needs to. This would suggest poor management of receivables or
inventories by the company.

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QUESTION Liquidity ratio

The following details have been extracted from the accounts of PQR plc. The company's year ends on 31
March.
Year 2 Year 3 Year 4
$m $m $m
Revenue 100 103 108
Gross profit 33.0 34.0 35.6
Net profit 15 15 15
Non-current assets 64 72 68
Inventory 4 4 4
Receivables 8 11 15
Payables 5 6 6
Cash at bank 5 – –
Bank overdraft – 6 5
Required
(a) Calculate the following for each of the three years.
(i) Gross profit percentage
(ii) Net profit percentage
(iii) Quick ratio (acid test)
(b) Comment briefly on the ratios you have calculated.

ANSWER
(a) Year 2 Year 3 Year 4
(i) Gross profit % (33/100)  100% = (34/103)  100% = (35.6/108)  100% =
33% 33% 33%
(ii) Net profit % (15/100)  100% = (15/103)  100% = (15/108)  100% =
15% 14.56% 13.9%
(iii) Quick ratio (8 + 5)/5 = 2.6 11/(6 + 6) = 0.9 15/(6 + 5) = 1.4
(b) Revenue has risen only slightly over the three years with the gross profit margin remaining high at
33%. This suggests that selling prices and costs have been increased only in line with inflation.
Net profit margin has fallen. While the fall is not great, it indicates that expenditure on overheads
has increased. The fall should be investigated and an attempt made to ensure that the trend does
not continue.
The quick ratio fell sharply in Year 3, although it has since recovered. The more worrying aspect
of the changes to working capital is that there is less cash (a bank overdraft) and more
receivables. It is worth enquiring whether this is due to poor credit control or extending credit in
an effort to boost or maintain sales.
It appears from the above that the company is showing a healthy profit, but needs to pay
attention to working capital. It should be emphasised, however, that it is difficult to draw
conclusions without knowing the sector in which PQR operates or any details about the
performance of its competitors.

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EXAM FOCUS POINT

A recent question on the current ratio and acid test ratio asked about the effect on the ratios if more
inventory was purchased. The ACCA examining team commented that only 23% of students selected
the correct answer, and said that the best way to answer these types of question is to substitute in
some simple numbers to test out the effects of the transaction.
Ratio analysis is the topic of an article in Student Accountant which you are advised to read. Go to:
www.accaglobal.com/gb/en/student/exam-support-resources/fundamentals-exams-study-
resources/f2/technical-articles/ratio-analysis.html

6.3 Example: Effect on current and quick ratio

At the beginning of the month, a company has current assets of $1.6m including inventory of $0.6m
and current liabilities of $1.1m. What would be the effect on the value of the current and quick ratios if
the company had sold some inventory on credit back to the supplier?

6.4 Solution
The question gives us some numbers that we can use and we can substitute in some simple numbers for
the ones that are missing.
Current ratio at the beginning of the month:
Current assets 1.6
= = 1.45
Current liabilities 1.1
Current ratio at the end of the month:
Let's say the inventory sold on credit was $0.5m. The current assets (inventory) would reduce by $0.5m
and the current assets (receivables) would increase by $0.5m.
Current assets 1.6  0.5  0.5
= = 1.45
Current liabilities 1.1
Therefore there would be no change in the current ratio.
Quick ratio at the beginning of the month:
Current assets less inventories 1.6  0.6
= = 0.91
Current liabilities 1.1
Quick ratio at the end of the month:
Again, we say that the inventory sold on credit was $0.5m. The reduction in inventory means that total
current assets become $1.6 – $0.5 = $1.1. The total inventory becomes $0.6 – $0.5 = $0.1. The
receivables would increase by $0.5m and so the current assets would increase by $0.5m.
Current assets less inventories 1.1  0.1  0.5
= = 1.36
Current liabilities 1 .1
Therefore the quick ratio has increased.

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6.5 Efficiency ratios: control of receivables, payables and inventory

A rough measure of the average length of time it takes for a company's receivables to pay what they owe
is the accounts receivable collection period. The accounts payable payment period is a rough measure
of the average length of time it takes a company to pay what it owes.
The inventory turnover period indicates the average number of days that items of inventory are held for.
Inventory turnover is a measure of how vigorously a business is trading.
The working capital period (or average age of working capital) identifies how long it takes to convert the
purchase of inventories into cash from sales.

6.5.1 Accounts receivable collection period

The estimated average accounts receivable collection period is a rough measure of the average length
of time it takes for a company's receivables to pay what they owe and is calculated as (trade
receivables/sales) × 365 days or (trade receivables/sales) × 12 months.

The estimate of receivables days is only approximate because the statement of financial position value
of receivables might be abnormally high or low compared with the organisation's 'normal' level.
A supermarket should have a very low accounts receivable collection period since sales should not be on
credit. Sales of most organisations, however, are usually made on 'normal credit terms' of payment
within 30 days. A period significantly in excess of this might be representative of poor management of
funds of a business. However, some companies must allow generous credit terms to win customers.
Exporting companies in particular may have to carry large amounts of receivables, and so their average
collection period might be well in excess of 30 days.
The trend of the collection period over time is probably the best guide. If the period is increasing year
on year, this is indicative of a poorly managed credit control function (and potentially therefore a poorly
managed company).

6.5.2 Inventory turnover period

Inventory turnover period is a calculation of the number of days that inventory is held for and is
calculated as (inventory ÷ cost of sales) × 365 days or (inventory ÷ cost of sales) × 12 months.

As with the average debt collection period, this is only an approximate estimated figure, but one which
should be reliable enough for comparing changes year on year.
Presumably if we add together the inventory days and the receivable days, this should give us an
indication of how soon inventory is convertible into cash. Both ratios therefore give us a further
indication of the company's liquidity.

6.5.3 Inventory turnover

'Cost of sales ÷ inventory' is termed inventory turnover, and is a measure of how vigorously a business
is trading.

A lengthening inventory turnover period from one year to the next indicates either a slowdown in
trading or a build-up in inventory levels, perhaps suggesting that the investment in inventories is
becoming excessive.
When you are interpreting inventory turnover data you should consider the type of organisation and the
systems it operates.
(a) Obviously there should be a marked difference between the inventory turnover of a retail
organisation, such as a supermarket, and a manufacturing group.

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(b) In an organisation which operates a just-in-time system you would expect to see very high
inventory turnover, but you may also notice other effects, such as low storage costs and higher
prices paid for supplies.

6.5.4 Accounts payable payment period

Accounts payable payment period or days provides a rough measure of the average length of time it
takes a company to pay what it owes. It is ideally calculated by the formula (payables/purchases) ×
365 days or (payables/purchases) × 12 months. Cost of sales can be used as an approximation for
purchases.

This ratio often helps to assess a company's liquidity. An increase is often a sign of a lack of long-term
finance or poor management of current assets, resulting in the use of extended credit from suppliers, an
increased bank overdraft and so on.

6.5.5 Working capital period

Working capital control is concerned with minimising funds tied up in net current assets while ensuring
that sufficient inventory, cash and credit facilities are in place to enable trading to take place. Calculation of
the ratio provides some insight into working capital control.
The working capital period (or average age of working capital) identifies how long it takes to convert
the purchase of inventories into cash from sales and is calculated as (working capital/cost of sales) 
365 days. The ratio can also be calculated as (working capital/ operating costs)  365 days.

Care needs to be taken when determining the ideal ratio. Reduce it too low and there may be insufficient
inventory and other current assets to sustain the volume of trade, but taking too much credit from suppliers
may jeopardise relationships and/or cause suppliers to increase prices.
A ratio in excess of a target indicates that working capital levels are probably too high and that
management action is needed to reduce them. This may involve stringent control of receivables, a
reduction in inventory levels and/or a more efficient use of available credit facilities. A receivables days
ratio, inventory turnover period and payables turnover period can be calculated to determine where the
problem lies.
The ratio has two principal limitations.
(a) It is based on the working capital level on one particular day, which may not be representative of
working capital levels throughout the entire period.
(b) Working capital includes a figure for inventory which may be a very subjective valuation.

QUESTION Liquidity and working capital

Calculate liquidity and working capital ratios from the accounts of the DOG Group, a manufacturer of
products for the construction industry. Discuss your results.
Year 8 Year 7
$m $m
Revenue 2,065.0 1,788.7
Cost of sales 1,478.6 1,304.0
Gross profit 586.4 484.7
EXTRACT FROM THE STATEMENT OF FINANCIAL POSITION
Current assets
Inventories 119.0 109.0
Receivables (note 1) 400.9 347.4
Short-term investments 4.2 18.8
Cash at bank and in hand 48.2 48.0
572.3 523.2

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Year 8 Year 7
$m $m
Payables: amounts falling due within one year
Loans and overdrafts 49.1 35.3
Corporation taxes 62.0 46.7
Dividend 19.2 14.3
Payables (note 2) 370.7 324.0
501.0 420.3

Notes $m $m
1 Trade receivables 329.8 285.4
2 Trade payables 236.2 210.8

ANSWER
Year 8 Year 7
Current ratio (572.3/501.0) = 1.14 (523.2/420.3) = 1.24
Quick ratio (453.3/501.0) = 0.90 (414.2/420.3) = 0.99
Accounts receivable payment period (329.8/2,065.0)  365 (285.4/1,788.7)  365
= 58 days = 58 days
Inventory turnover period (119.0/1,478.6)  365 (109.0/1,304.0)  365
= 29 days = 31 days
Accounts payable payment period (236.2/1,478.6)  365 (210.8/1,304.0)  365
= 58 days = 59 days
DOG is a manufacturing group serving the construction industry, and so would be expected to have a
comparatively lengthy accounts receivables' turnover period, because of the relatively poor cash flow in
the construction industry. It is clear that management compensates for this by ensuring that they do not
pay for raw materials and so on before they have sold their inventories of finished goods (hence the
similarity of receivables and payables turnover periods).
DOG's current ratio is a little lower than average but its quick ratio is better than average and very little
less than the current ratio. This suggests that inventory levels are strictly controlled, which is reinforced
by the low inventory turnover period. It would seem that working capital is tightly managed, to avoid the
poor liquidity which could be caused by a high accounts receivables payment period and comparatively
high payables period.

6.6 Debt and gearing/leverage ratios

Debt ratios are concerned with how much the company owes in relation to its size and whether it is
getting into heavier debt or improving its situation.
(a) When a company is heavily in debt, and seems to be getting even more heavily into debt, banks
and other would-be lenders are very soon likely to refuse further borrowing and the company
might well find itself in trouble.
(b) When a company is earning only a modest profit before interest and tax, and has a heavy debt
burden, there will be very little profit left over for shareholders after the interest charges have
been paid.
Leverage is an alternative term for gearing and the words have the same meaning.

6.6.1 Capital gearing or leverage

Capital gearing is concerned with the amount of debt in a company's long-term capital structure.
Gearing ratios provide a long-term measure of liquidity.
Prior charge capital (long­term debt)
Gearing ratio =
Prior charge capital  shareholders' equity

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CHAPTER 23 // PERFORMANCE MEASUREMENT

Prior charge capital is long-term loans and preference shares (if any). It does not include loans repayable
within one year and bank overdraft, unless overdraft finance is a permanent part of the business's
capital.

6.6.2 Interest cover

The interest cover ratio shows whether a company is earning enough profits before interest and tax to
pay its interest costs comfortably, or whether its interest costs are high in relation to the size of its
profits, so that a fall in profit before interest and tax (PBIT) would then have a significant effect on
profits available for ordinary shareholders.
PBIT
Interest cover =
Interest charges

An interest cover of two times or less would be low, and it should really exceed three times before the
company's interest costs can be considered to be within acceptable limits. Note that it is usual to
exclude preference dividends from 'interest' charges.

6.7 Limitations of statement of profit or loss and statement of financial

position measures
(a) On their own, they do not provide information to enable managers to gauge performance or
make control decisions. Yardsticks are needed for comparison purposes.
(b) The measures used must be carefully defined. For example, should 'return' equal profit before
interest and taxation, profit after taxation, or profit before interest, taxation and investment
income?
(c) Measures compared over a period of time at historical cost will not be properly comparable where
inflation in prices has occurred during the period, unless an adjustment is made to the measures
to make allowance for price level differences.
(d) The measures of different companies cannot be properly compared where each company uses a
different method to do the following.
(i) Value closing inventories (for example first in, first out, last in, first out, or
marginal/absorbed cost)
(ii) Apportion overheads in absorption costing
(iii) Value non-current assets (for example at net book value and replacement cost)
(iv) Estimate the life of assets in order to calculate depreciation
(v) Account for research and development costs
(vi) Account for goodwill
(e) Remember that measures calculated using historical costs may not be a guide to the future.

QUESTION Ratio calculations

You are given summarised results of an electrical engineering business as follows.
STATEMENT OF PROFIT OR LOSS FOR YEAR ENDED 31 DECEMBER YEAR 1

$'000
Revenue 60,000
Cost of sales 42,000
Gross profit 18,000
Operating expenses 15,500
Profit 2,500

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PART E: PERFORMANCE MEASUREMENT

STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER YEAR 1

$'000 $'000
Non-current assets 12,500
Current assets
Inventory 14,000
Receivables 16,000
Cash 500
43,000
Equity and liabilities
Capital and reserves 19,000
Current liabilities (payables only) 24,000
43,000
Required
Calculate the following ratios, clearly showing the figures used in the calculations.
(a) Current ratio
(b) Quick/acid test ratio
(c) Inventory turnover in days
(d) Accounts receivable collection period in days
(e) Accounts payable payment period in days
(f) Gross profit percentage
(g) Net profit percentage
(h) ROCE
(i) Asset turnover

ANSWER
(a) Current ratio = (Current assets/current liabilities) = (30,500/24,000) = 1.27
(b) Acid test ratio = (Current assets – inventory/current liabilities)
= (16,500/24,000) = 0.6875
(c) Inventory turnover = (Inventory/cost of sales)  365 days = (14,000/42,000)  365 = 122
days
(d) Accounts receivable collection period
= (Receivables/sales)  365 days = (16,000/60,000)  365 = 97
days
(e) Accounts payable = (Payables/cost of sales)  365 days = (24,000/42,000)  365 = 209
days
(f) Gross profit % = (Gross profit/sales)  100% = (18,000/60,000)  100% =
30%
(g) Net profit % = (Net profit/sales)  100% = (2,500/60,000)  100% = 4.2%
(h) ROCE = (Profit/capital employed)  100% = (2,500/19,000)  100% =
13.16%
(i) Asset turnover = (Sales/capital employed) = (60,000/19,000) = 3.2 times

QUESTION Limitations of ratios

Comment on any limitations of the ratios used in the last question and of comparisons made using such
ratios.

ANSWER
Limitations of the ratios and inter-company comparisons
There are a number of limitations of which management should be aware before drawing any firm
conclusions from a comparison of these ratios.

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CHAPTER 23 // PERFORMANCE MEASUREMENT

(a) The ratios are merely averages, based on year-end statement of financial position data, which
may not be representative.
(b) These ratios could be affected by any new investment towards the end of the financial year. Such
investment would increase the value of the assets or capital employed, but the profits from the
investment would not yet have accumulated in the statement of profit or loss. Generally, newer
assets tend to depress the asset turnover and hence the ROCE in the short term. It is possible
that this is the cause of our company's lower asset turnover and ROCE.
(c) Although the trade association probably makes some attempt to standardise the data, different
member companies may be using different accounting policies, for example in calculating
depreciation and valuing inventory.
(d) Our company's analyst may have used a different formula for calculating one or more of the
ratios. For example, as noted above, there are a variety of ways of calculating capital employed.
It is likely, however, that the trade association would provide information on the basis of
calculation of the ratios.
(e) The member companies will have some activities in common, hence their membership of the
trade association. However, some may have a diversified range of activities, which will distort the
ratios and make direct comparison difficult.

QUESTION Performance measures

Brainerd is a passenger airline. In 20X8 it spent $220m on new aeroplanes and $10m on staff training
in an attempt to improve its performance. Summarised financial statements are given below.
SUMMMARISED INCOME STATEMENT FOR THE YEAR ENDED 31 MAY
20X7 20X8
$m $m
Revenue 1,800 1,850
Operating profit 180 175
Financing costs (32) (47)
Tax expense (44) (35)
Profit for the period 104 93

SUMMARISED STATEMENT OF FINANCIAL POSITION AS AT 31 MAY

20X7 20X8
$m $m $m $m
Non-current assets (net) 1,200 1,400
Current assets
Inventory 53 90
Receivables 22 25
Cash 64 32
1,339 1,547
Equity and reserves 585 615
Long-term liabilities
8% Debenture 2009 650 650
Bank loan 20 160
670 810
Current liabilities 84 122
Total equity and liabilities 1,339 1,547

Required
(a) Calculate the following ratios for Brainerd for the years ending 31 May 20X7 and 20X8, clearly
defining the ratio you are calculating and showing the figures used in your calculations.
(i) Return on capital employed based on closing capital employed

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PART E: PERFORMANCE MEASUREMENT

(ii) Current ratio

(iii) Capital gearing ratio (6 marks)
(b) Give two reasons why it would be important for Brainerd to use non-financial measures in
assessing its performance. (4 marks)
(Total = 10 marks)

ANSWER
(a) Ratios
20X7 20X8
Operating profit $180m $175m
(i) Return on capital employed =
Capital employed $1,255m $1,425m

= 14.3% 12.3%
Current assets $139m $147m
(ii) Current ratio =
Current liabilities $84m $122m
= 1.65 1.20
Long-term liabilities $670m $810m
(iii) Capital gearing ratio =
Total equity $585m $615m

= 115% 132%

Note. Many of these ratios may be defined in different ways. Any sensible definition would be
accepted and given full credit.

(b) The importance of non-financial performance measures

The use of non-financial performance measures can be justified in several ways.
(i) Perhaps the most important reason for the use of non-financial performance measures is
that they give early warning signals of problems. For this reason, they are often referred to
as 'leading indicators'. Financial performance measures are often described as 'lagging
indicators'; that is, they tell the firm that something has gone wrong after it has gone
wrong. The use of non-financial performance measures gives a firm a chance of correcting
problems before they go too far. For example, a firm might be able to cure a quality
problem revealed by a high level of customer complaints before it has a damaging effect
on sales and profits.
(ii) Virtually all companies face increasingly competitive marketplaces. In the face of global
competition non-financial issues, such as product quality, customer service, delivery,
reliability and innovation, have become crucial elements of competitive strategy. None of
these variables are directly measurable in financial terms.
(iii) Non-financial performance measures may be more understandable and relevant for non-
financial staff.
(iv) Financial measures in isolation can potentially be manipulated by managers. Using a
range of financial and non-financial measures makes it more difficult for managers to
hide bad performance.
(v) Non-financial measures can be used as a method of implementing an organisation's
chosen strategy. For example, if a firm decides to compete by offering the quickest call-
out times for product repair, then the effectiveness of the delivery of this strategy can be
measured by a non-financial indicator, such as customer waiting time.
(only two reasons were required)

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CHAPTER 23 // PERFORMANCE MEASUREMENT

6.8 Internal and external analysis

External analysis of companies' performance using financial accounts is relatively straightforward since
the range of possible measures tends to be limited by the scarcity of the information available. We have
covered most of these measures in this section and the previous one.
The analysis of a company's internal management accounts uses more or less the same measures as a
starting point. The level of analysis and detail found in internal accounts tends to be much greater than
in published financial accounts, however, and so more extensive analysis is possible.
In the October 2000 edition of the ACCA Technician Bulletin, the author of the article 'Internal Financial
Analysis' illustrated how the performance of two sales regions could be analysed using conventional
ratios and other performance measures specific to the situation.
(a) Initially, using observations based on absolute figures (sales, level of receivables, bad debts
written off)
(b) Then using the conventional receivables days ratio
(c) Finally, using other relationships that might give further insights (bad debts per $1,000 of sales,
cost per employee, debts collected per employee)

7 The balanced scorecard

The balanced scorecard measures performance from four different perspectives: customer satisfaction,
financial success, process efficiency and growth.

So far in our discussion we have focused on performance measurement and control from a financial point
of view. Another approach, originally developed by Kaplan and Norton, is the use of what is called a
'balanced scorecard' consisting of a variety of indicators, both financial and non-financial. This approach
has developed over the years and is used by a wide range of companies. Consequently, different
terminology may be used by different companies.
The balanced scorecard approach is 'An approach to the provision of information to management to
assist strategic policy formulation and achievement. It emphasises the need to provide the user with a
set of information which addresses all relevant areas of performance in an objective and unbiased
fashion. The information provided may include both financial and non-financial elements, and cover
areas such as profitability, customer satisfaction, internal efficiency and innovation.'
(CIMA Official Terminology)

The balanced scorecard focuses on four different perspectives, as follows.

Perspective Question Explanation

Customer What do existing and new Gives rise to targets that matter to customers:
satisfaction customers value from us? cost, quality, delivery, inspection, handling and
so on
Process What processes must we excel at Aims to improve internal processes, decision
efficiency to achieve our financial and making and resource utilisation
customer objectives?
Growth Can we continue to improve and Considers the business's capacity to maintain its
create future value? competitive position through the acquisition of
new skills and the development of new products

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PART E: PERFORMANCE MEASUREMENT

Perspective Question Explanation

Financial How do we create value for our Covers traditional measures such as growth,
success shareholders? profitability and shareholder value but set
through talking to the shareholder or
shareholders direct

The scorecard is 'balanced' in the sense that managers are required to think in terms of all four
perspectives, to prevent improvements being made in one area at the expense of another.
The types of measure (KPIs) which may be monitored under each of the four perspectives include the
following in the example on the next page. The list is not exhaustive but it will give you an idea of the
possible scope of a balanced scorecard approach. The measures selected, particularly within the process
efficiency perspective, will vary considerably with the type of organisation and its objectives.
Two examples of how a balanced scorecard might appear are given below. One refers to a restaurant
which is a profit-making business. The other refers to a charity. Use these examples to think about how
a balanced scorecard may appear in your own workplace.
Balanced scorecard for a restaurant

Financial Success Customer Satisfaction

GOALS MEASURES (KPI) GOALS MEASURES (KPI)

To grow and New restaurants opened Great service Excellent results on

open new customer survey
restaurants
Repeat business Customers booking to come
Profitable Net profit margins again
Innovative food New menus on a regular
basis

Process Efficiency Growth

GOALS MEASURES (KPI) GOALS MEASURES (KPI)
Timely food Time from order to delivery Trained staff Employees with relevant
delivery training and qualifications
Efficient staff Processing of food order, New menu Number of new dishes
few mistakes choices introduced
Low food Amount of food discarded
wastage

Balanced scorecard for a charity

Financial Success Customer Satisfaction

GOALS MEASURES (KPI) GOALS MEASURES (KPI)

Income from Donations received Continued donor Pledges given and direct
charitable support debits set up
Lower costs and/or
donations
increased income from all Donor Fundraising and charity
Improved sources involvement in dinners
margins initiatives

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CHAPTER 23 // PERFORMANCE MEASUREMENT

Process Efficiency Growth

GOALS MEASURES (KPI) GOALS MEASURES (KPI)

Reduce Lower overheads measured More projects Number of projects given

overheads by monitoring and accounts supported support
Claim back tax Improved reclaim times for More fundraisers Number of fundraisers
on gift aid gift aided donation recruited
More money Amount of donations
pledged promised

EXAM FOCUS POINT

KPIs should be:

 Specific as to profitability
 Measurable and distinct
 Relevant, measuring achievement of a CSF
Each organisation has to decide which performance measure to use under each heading.

The following important features of this approach have been identified.

(a) It looks at both internal and external matters concerning the organisation.
(b) It is related to the key elements of a company's strategy.
(c) Financial and non-financial measures are linked together.
The balanced scorecard approach may be particularly useful for performance measurement in
organisations which are unable to use simple profit as a performance measure. For example, the public
sector has long been forced to use a wide range of performance indicators, which can be formalised
with a balanced scorecard approach.

QUESTION Balanced scorecard

For each of the following performance indicators, identify one balanced scorecard perspective being
measured.
(a) Labour cost per unit manufactured
(b) Asset turnover
(c) Training expenditure as a percentage of sales turnover
(d) Return on capital employed
(e) Percentage of on-time deliveries
(f) Percentage of turnover generated by new products
(g) Percentage of quality control rejects

ANSWER
(a) Process efficiency (the improvement of internal processes)
(b) Process efficiency (the intensity of asset usage)
(c) Growth or possibly process efficiency
(d) Financial success
(e) Customer satisfaction, or possibly process efficiency
(f) Growth
(g) Process efficiency, or possibly customer satisfaction

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PART E: PERFORMANCE MEASUREMENT

7.1 Advantages and disadvantages

As with all techniques, problems can arise when it is applied.

Advantages Explanation

All four perspectives Managers need to look at both internal and external matters affecting the
considered by managers organisation. They also need to link together financial and non-financial
measures.
Therefore they can see how factors in one area affect all other areas.

Consistency between It can be difficult to incorporate objectives into control systems such as
objectives, control budgets. So targets set by a budget, say, may conflict with objectives.
systems and staff Moreover, staff may put their own interpretation on objectives against the
actual intention of the original objective. The balanced scorecard should
improve communication between different levels of the organisation. The
balanced scorecard strives to keep all these factors in balance.

Disadvantages Explanation
Conflicting measures Some measures in the scorecard, such as research funding and cost
reduction, may naturally conflict. It is often difficult to determine the
balance that will achieve the best results.
Selecting measures Not only do appropriate measures have to be devised but the number of
measures used must also be agreed. Care must be taken that the impact of
the results is not lost in a sea of information.
Expertise Measurement is only useful if it initiates appropriate action. Non-financial
managers may have difficulty with the usual profit measures. With more
measures to consider this problem will be compounded.
Interpretation Even a financially trained manager may have difficulty in putting the figures
into an overall perspective.

8 External conditions

External conditions can affect performance.

So far we have looked in detail at some important aspects of performance measurement, but they have
all been concerned with information pertaining to the internal processes of the organisation. This
approach is necessary, but the analysis is not complete. The organisation is not sealed off from its
environment: it is subject to the conditions present in that environment and its performance is influenced
by them. We must always be aware when measuring performance of the influence of external conditions
and changes in them.
For a commercial business, success is subject to general economic and market conditions.
(a) Market conditions. A business operates in a competitive environment and suppliers, customers
and competitors all influence one another's operations. The entry of a new and dynamic
competitor, for example, is certain to have an effect on budgeted sales.
(b) General economic conditions. These influence businesses most obviously by raising or lowering
overall demand and supply. The role of government is very important here since government
economic policy affects demand in particular quite rapidly. Changes in interest rates are
determined largely by government policy and have a direct effect on credit sales.

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CHAPTER 23 // PERFORMANCE MEASUREMENT

For non-profit organisations that do not trade, economic conditions and government policy are still
important. Charities depending on donations will be subject to general feelings of prosperity or
otherwise, while public bodies may have their available funds controlled directly or indirectly by
government.
The general conclusion from these and similar considerations is that appropriate attention should be
paid to general and specific external conditions when measuring performance. We have already seen
some aspects of this when we considered the proper use of variances. Sales variances in particular are
often traceable to external conditions. However, it is important that external conditions are not
overemphasised and used as an excuse. Judgement is needed here, both on the part of those
responsible for interpreting the bald facts of numerical analysis, and on that of those to whom reports
are submitted.
Finally, note that the effect of external conditions is not always adverse! Managers may be as quick to
claim the credit for high performance caused by good conditions as they are to blame poor conditions for
their own failings.

8.1 Government influence

The Government does not have a direct interest in private sector organisations (except for those in which
it actually holds shares). However, the Government does often have a strong indirect interest in
businesses' affairs.
(a) Taxation
The Government raises taxes on sales and profits and on shareholders' dividends. It also expects
businesses to act as tax collectors for income tax and sales tax.
(b) Encouraging new investments
The government might provide funds towards the cost of some investment projects. It might also
encourage private investment by offering tax incentives.
(c) Encouraging a wider spread of share ownership
In the UK, the Government has made some attempts to encourage more private individuals to
become company shareholders, by means of attractive privatisation issues (such as in the
electricity, gas and telecommunications industries) and tax incentives, such as ISAs (Individual
Savings Accounts), to encourage individuals to invest in shares.
(d) Legislation
The Government also influences businesses through legislation, including the Companies Acts,
legislation on employment, health and safety regulations, legislation on consumer protection and
consumer rights and environmental legislation.
(e) Economic policy
A government's economic policy will affect business activity. For example, exchange rate policy
will have implications for the revenues of exporting firms and for the purchase costs of importing
firms. Policies on economic growth, inflation, employment, interest rates and so on are all
relevant to business activities.

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PART E: PERFORMANCE MEASUREMENT

CHAPTER ROUNDUP

 The higher direction of an organisation requires a clear vision, in general terms, of what the organisation
should be doing in the longer term and how it should go about doing it. This may be encapsulated in a
mission statement.
 A hierarchy of SMART goals and objectives cascades downwards from the mission statement, eventually
providing the targets for the periodic budget process.
 Short-termism is when there is a bias towards short-term rather than long-term performance. It is often
due to the fact that managers' performance is measured on short-term results.
 Performance measure can be divided into two groups.
– Financial performance measures
– Non-financial performance measures
 Financial performance measures include profit, revenue, costs, share price and cash flow.
 Non-financial performance measures include product quality, reliability and customer satisfaction.
 Performance measures can be quantitative or qualitative.
 Non-financial indicators (NFIs) are useful in a modern business environment.
 Non-financial objectives include the welfare of employees and society in general and the fulfilment of
responsibilities towards customers and suppliers.
 Changes in cost structures, the competitive environment and the manufacturing environment have led to
an increased use of NFIs.
 Comparing non profit seeking entities with the private sector raises several problems. The difficulties in
valuing outputs led to the creation of the 3E approach (economy, efficiency and effectiveness).
Economy, efficiency and effectiveness can be studied and measured with reference to inputs, process
and outputs.
 Profitability can be measured by return on investment (ROI) / return on capital employed (ROCE),
profit margin, gross profit margin or cost/sales ratios.
 Asset turnover is a measure of how well the assets of a business are being used to generate sales. It is
calculated as (sales  capital employed).
 The current ratio is the 'standard' test of liquidity and is the ratio of current assets to current liabilities.
The quick ratio, or acid test ratio, is the ratio of current assets less inventories to current liabilities.
 A rough measure of the average length of time it takes for a company's receivables to pay what they owe
is the accounts receivables collection period. The accounts payable payment period is a rough measure
of the average length of time it takes a company to pay what it owes.
 The inventory turnover period indicates the average number of days that items of inventory are held for.
 Inventory turnover is a measure of how vigorously a business is trading.
 The working capital period (or average age of working capital) identifies how long it takes to convert the
purchase of inventories into cash from sales.
 The balanced scorecard measures performance in four different perspectives: customer satisfaction,
financial success, process efficiency and growth.

 External conditions can affect performance.

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CHAPTER 23 // PERFORMANCE MEASUREMENT

1 List five possible financial performance measures.

QUICK QUIZ

2 Costs are down by 15% is an example of a qualitative performance measure. True or false?
3 How is ROI calculated?
4 When should a current ratio in excess of 1 be expected?
5 Should the quick ratio for a company with fast inventory turnover be greater than 1?
Profit before interest and tax
6 ROCE is ×100%
Capital employed
True
False
7 The debt ratio is a company's long-term debt divided by its net assets.
True
False
8 In the context of a balanced scorecard approach to performance measurement, to which of the four
perspectives does each measure relate?
Performance measure Perspective
(a) Time taken to develop new products …………………….
(b) Percentage of on-time deliveries …………………….
(c) Average set-up time …………………….
(d) Return on capital employed …………………….
9 To which perspective of the balanced scorecard could the measure 'training day per employee' be most
appropriately applied?
A Customer
B Internal
C Growth
D Financial

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PART E: PERFORMANCE MEASUREMENT

1 Profit, revenue, costs, share price and cash flow. Of course, there are others.
ANSWERS TO QUICK QUIZ

2 False. It is quantitative.
3 (Profit  capital employed)  100%
4 A current ratio in excess of 1 should always be expected.
5 No, it may be less than 1.
6 True. Profit before interest and tax or PBIT is the figure used in the question 'Ratio calculations' in the
chapter.
7 False. Refer to Section 6 if you are unclear what the ratio is made up of.

8 (a) Growth
(b) Customer
(c) Internal
(d) Financial
9 C

Now try ...

Attempt the questions below from the Practice Question Bank

Q101 – Q106

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C H A P T E R

This chapter continues with performance measurement

and includes measuring performance in service industries Applications of
and not for profit organisations.
performance
measurement

SYLLABUS
TOPIC LIST REFERENCE

1 Performance measures for manufacturing businesses E2(c)(iv),(v), (e)(ii)

2 Performance measures for contract and process costing environments E2(d), (e)(ii)
3 Performance measures for services E2(e)(i),(g), E4(c)
4 Management performance measures E4(e)
5 Benchmarking E4(f)
6 Cost control and cost reduction E3(a), (b)
7 Value analysis E3(c)

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PART E: PERFORMANCE MEASUREMENT

Study Guide Intellectual level

E Performance measurement

2 Performance measurement – application

Economy, efficiency and effectiveness

(c)(iv) Discuss the meaning of each of the efficiency, capacity

K
and activity ratios.
(c)(v) Calculate the efficiency, capacity and activity ratios in a
S
specific situation.
Unit costs

(d)(i) Describe performance measures which would be

K
suitable in contract and process costing environments.
Resource utilisation

(e)(i) Describe measures of performance utilisation in service

K
and manufacturing environments.
(e)(ii) Establish measures of resource utilisation in a specific
S
situation.
Quality of service

(g)(i) Distinguish performance measurement issues in service

K
and manufacturing industries.
(g)(ii) Describe performance measures appropriate for service
K
industries.
3 Cost reductions and value enhancement

(a) Compare cost control and cost reduction. K

(b) Describe and evaluate cost reduction methods. S
(c) Describe and evaluate value analysis. S

4 Monitoring performance and reporting

(c) Discuss the measurement of performance in service

K
industry situations.
(d) Discuss the measurement of performance in non profit
K
seeking and public sector organisations.
(e) Discuss measures that may be used to assess
K
managerial performance and the practical problems
involved.
(f) Discuss the role of benchmarking in performance
K
measurement.
(g) Produce reports highlighting key areas for management
S
attention and recommendations for improvement.

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1 Performance measures for manufacturing businesses

In a customer-focused organisation, basic performance measures for sales can be supplemented by a

host of other measures, including ratios such as customer rejects/returns: total sales.
Performance measures for materials and labour include variances.
Performance can be measured using the standard hour.
Efficiency, activity and capacity ratios provide useful information.

1.1 Performance measures for sales

Traditionally sales performance is measured in terms of price and volume variances, and a sales mix
variance. Other possible measures include revenue targets and target market share. They may be
analysed in detail: by country, by region, by individual products, by salesperson and so on.
In a customer-focused organisation the basic information 'Turnover is up by 14%' can be supplemented
by a host of other indicators.
(a) Customer rejects/returns: total sales. This ratio helps to monitor customer satisfaction, providing
a check on the efficiency of quality control procedures.
(b) Deliveries late: deliveries on schedule. This ratio can be applied both to sales made to customers
and to receipts from suppliers. When applied to customers it provides an indication of the
efficiency of production and production scheduling.
(c) Flexibility measures. These indicate how well a company is able to respond to customers'
requirements. Measures could be devised to indicate how quickly and efficiently new products
are launched, and how well procedures meet customer needs.
(d) Number of people served and speed of service, in a shop or a bank for example. If it takes too
long to reach the point of sale, future sales are liable to be lost.
(e) Customer satisfaction questionnaires. These can provide input to the organisation's management
information system.

1.2 Performance measures for materials

Traditional measures are standard costs, and price and usage variances. Many traditional systems also
analyse wastage.
Measures used in modern manufacturing environments include the number of rejects in materials
supplied, and the timing and reliability of deliveries of materials.

1.3 Performance measures for labour

Labour costs are traditionally measured in terms of standard performance (ideal, attainable and so on)
and rate and efficiency variances.
Qualitative measures of labour performance concentrate on matters such as ability to communicate,
interpersonal relationships with colleagues, customers' impressions and levels of skills attained.
Managers can expect to be judged to some extent by the performance of their staff. High profitability or
tight cost control are not the only indicators of managerial performance!

1.4 Performance measures for overheads

Standards for variable overheads and efficiency variances are traditional measures. Various time-based
measures are also available.
(a) Machine down time: total machine hours. This ratio provides a measure of machine usage and
efficiency.

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(b) Value added time: production cycle time. Value added time is the direct production time during
which the product is being made. The production cycle time includes non value added times
such as set-up time, downtime and idle time. The 'perfect' ratio is 100%, but in practice this
optimum will not be achieved. A high ratio means non value added activities are being kept to a
minimum.

1.5 Measures of performance using the standard hour

Nico manufactures plates, mugs and eggcups. Production during the first two quarters of 20X5 was as
follows.
Quarter 1 Quarter 2
Plates 1,000 800
Mugs 1,200 1,500
Eggcups 800 900
The fact that 3,000 products were produced in quarter 1 and 3,200 in quarter 2 does not tell us
anything about Nico's efficiency over the two periods because plates, mugs and eggcups are so different.
The fact that the production mix has changed is not revealed by considering the total number of units
produced. The problem of how to measure output when a number of dissimilar products are
manufactured can be overcome, however, by the use of the standard hour.
The standard hour (or standard minute) is the quantity of work achievable at standard performance,
expressed in terms of a standard unit of work done in a standard period of time.
The standard time allowed to produce one unit of each of Nico's products is as follows.
Standard time
Plate ½ hour
Mug ⅓ hour
Eggcup ¼ hour
By measuring the standard hours of output in each quarter, a more useful output measure is obtained.
We calculate the amount it should take to make each product. This time calculation is called standard
hours produced.
Quarter 1 Quarter 2
Standard Standard
Standard hours hours hours
Product per unit Production produced Production produced
Plate ½ 1,000 500 800 400
Mug ⅓ 1,200 400 1,500 500
Eggcup ¼ 800 200 900 225
1,100 1,125

The output level in the two quarters was therefore very similar.

1.6 Efficiency, activity and capacity ratios

Standard hours are useful in computing levels of efficiency, activity and capacity. Any management
accounting reports involving budgets and variance analysis should incorporate control ratios. The three
main control ratios are the efficiency, capacity and activity ratios.
(a) The capacity ratio compares actual hours worked and budgeted hours, and measures the extent
to which planned utilisation has been achieved. (Utilisation in this context refers to the
proportion of available time that was actually worked.)
(b) The activity or production volume ratio compares the number of standard hours to the actual
work produced and budgeted hours.
(c) The efficiency ratio measures the efficiency of the labour force by comparing equivalent
standard hours for work produced and actual hours worked.

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1.7 Example: Ratios and standard hours

Given the following information about Nico for quarter 1 of 20X5, calculate a capacity ratio, an activity
ratio and an efficiency ratio and explain their meaning.
Budgeted hours 1,100 standard hours
Standard hours produced 1,125 standard hours
Actual hours worked 1,200

1.8 Solution
Actual hours worked 1,200
Capacity ratio =  100% =  100% = 109%
Budgeted hours 1,100

Standard hours produced 1,125

Activity ratio =  100% =  100% = 102%
Budgeted hours 1,100

The overall activity or production volume for the quarter was 2% greater than forecast. This was
achieved by a 9% increase in capacity.

Standard hours produced 1,125

Efficiency ratio =  100% =  100% = 94%
Actual hours worked 1,200

The labour force worked 6% below standard levels of efficiency.

2 Performance measures for contract and process costing

environments

Performance measures need to be thought out carefully for contract environments. The high degree of
standardisation in process costing environments means that it is ideal for setting performance standards.
Non-financial performance measures for manufacturing include cost (behaviour), quality, time and
innovation.

In a contract environment each contract undertaken is unique. Products are made to the specific
requirements of individual customers. This has a number of implications for performance measurement.
(a) Detailed planning should be undertaken and performance targets set. As so many variables are
involved, this is a complicated process, and the likelihood of targets not being achieved is
significant.
(b) Suppliers may be different for each contract, making it harder to set standards for quality,
speed of delivery and so on.
(c) Customer satisfaction measures are particularly important in this environment (payment might
depend contractually on customer satisfaction). Feedback on performance should be obtained
from the customer during the contract.
(d) Because each contract will be different the organisation will have to be extremely flexible.
Measures of success in adapting to new requirements will provide a key indicator. Measures of
employee skills will be equally important.
(e) It is likely that the contract will need to be completed within a certain time and therefore an
ongoing check must be kept of performance in relation to the deadline.
(f) The size and consequences of overspending may be huge.
(g) The long timescale means that progress must be measured very carefully, since there is more
likelihood of slippage if deadlines seem a long way off.
In a batch production environment, products are more standardised, although some costs and activities
may be unique to a specific batch. Standardisation of products means that materials requirements and

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labour and machinery capabilities are also more standardised. Performance standards can be set for
materials quality and usage, labour efficiency, suppliers and so on.
The high degree of standardisation in a process costing environment means that it is ideal for setting
performance standards. However, costs, materials usage/wastage, labour inefficiencies, machine
breakdowns and so on cannot be traced to a specific item. These features can only be measured on an
average per unit basis. A measure like 'cost per unit' in a processing environment reflects average
performance over a period of time. It may therefore be more difficult to improve on existing performance
standards, as inefficiencies may not be easily identifiable.
A number of performance indicators can be used to assess operations.
 Quality
 Number of customer complaints and warranty claims
 Lead times
 Rework
 Delivery to time
 Non-productive hours
 System (machine) down time
These indicators can also be expressed in the form of ratios or percentages for comparative purposes.
Like physical measures, they can be produced quickly and trends can be identified and acted on rapidly.

2.1 Non-financial performance measurement for manufacturing

Performance measurement in manufacturing is increasingly using non-financial measures. Malcolm
Smith identifies four overarching measures for manufacturing environments.
 Cost: cost behaviour  Time: bottlenecks, inertia
 Quality: factors inhibiting performance  Innovation: new product flexibility

2.1.1 Cost
Possible non-financial or part-financial indicators are as follows.

Area Measure

Quantity of raw material inputs Actual vs target number

Equipment productivity Actual vs standard units

Maintenance efforts No. of production units lost through maintenance

No. of production units lost through failure
No. of failures prior to schedule

Overtime costs Overtime hours/total hours

Product complexity No. of component parts

Quantity of output Actual vs target completion

Product obsolescence % shrinkage

Employees % staff turnover

Employee productivity direct labour hours per unit

Customer focus % service calls; % claims

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2.1.2 Quality
Integrating quality into a performance measurement system suggests attention to the following items.

Area Measure

Quality of purchased components Zero defects

Equipment failure Downtime / total time

Maintenance effort Breakdown maintenance / total maintenance

Waste % defects; % scrap; % rework

Quality of output % yield

Safety Serious industrial injury rate

Reliability % warranty claims

Quality commitment % dependence on post-inspection

% conformance to quality standards

Employee morale % absenteeism

Leadership impact % cancelled meetings

Customer awareness % repeat orders; number of complaints

2.1.3 Time
A truly just-in-time system is an ideal to which many manufacturing firms are striving. Time-based
competition is also important for new product development, deliveries etc. The management accounting
focus might be on throughput, bottlenecks, customer feedback and distribution.

Area Measure

Equipment failure Time between failures

Maintenance effort Time spent on repeat work

Throughput Processing time / total time per unit

Production flexibility Set-up time

Availability % stockouts

Labour effectiveness Standard hours achieved / total hours worked

Customer impact No. of overdue deliveries

Mean delivery delay

2.1.4 Innovation
Performance indicators for innovation can support the 'innovation and learning' perspective on the
balanced scorecard. Some possible suggestions are outlined below.

Area Measure

The ability to introduce new % product obsolescence

products Number of new products launched
Number of patents secured
Time to launch new products

Flexibility to accommodate change Number of new processes implemented

Number of new process modifications

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Area Measure

Reputation for innovation Media recognition for leadership

Expert assessment of competence
Demonstrable competitive advantage

3 Performance measures for services

Performance measures covering the following six 'dimensions' have been suggested for service
organisations.
– Competitive performance
– Financial performance
– Quality of service
– Flexibility
– Resource utilisation
– Innovation

3.1 Service businesses

A service business does not produce a physical product. Instead it provides a service, for example a
haircut, or insurance.
(a) A service is intangible. The actual benefit being bought cannot be touched.
(b) The production and consumption of a service are simultaneous, and therefore it cannot be
inspected for quality in advance.
(c) Services are perishable; that is, they cannot be stored. For example, a hairdresser cannot do
haircuts in advance and keep them stocked away in case of heavy demand.
(d) A service is heterogeneous. The service received will vary each time. Services are more reliant on
people. People are not robots, so how the service is delivered will not be identical each time.

QUESTION Service measures

Consider how the factors intangibility, simultaneity, perishability and heterogeneity apply to the various
services that you use: public transport, your bank account, meals in restaurants, the postal service, your
annual holiday and so on.

3.2 'Dimensions' of performance measurement

Performance measurement in service businesses is made more difficult because of the four factors listed
above. However, performance measurement is possible, the key being to ensure what you are measuring
has been clearly enough defined. A range of performance measures covering six 'dimensions' are used.

Dimension Type Example of measure

Competitive performance Competitor focused Market share

Prices
Product features

Customer focused Customer retention

Customer numbers

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CHAPTER 24 // APPLICATIONS OF PERFORMANCE MEASUREMENT

Dimension Type Example of measure

Financial performance Profitability Profit

Working capital cycle
Liquidity Bad debts

Quality of service Reliability Punctuality

Dependability of service and staff
Responsiveness Response times
Number of phone lines
Delivery speed (for goods ordered online or by
phone)

Courtesy Politeness
Respect to customers

Competence Staff skill

Expertise
Knowledge
Diligence

Availability Product availability

Product range

Accessibility Ease of finding site

Flexibility Delivery speed Customer waiting time

Time from customer enquiry to job completion
Volume Spare capacity to deal with peak times
Specification Number of product lines
Range of staff

Resource utilisation Human resources Labour hours worked

(productivity) Skill levels of work performed by staff grade
Premises % of area used for value adding services, or
customer-facing services

Innovation Cost Development cost per new product line /

service

Speed Time taken from:

– concept to prototype launch
– concept to offered to customers

QUESTION Competitiveness and resource utilisation

A service business has collected some figures relating to its year just ended.
Budget Actual
Customer enquiries
New customers 6,000 9,000
Existing customers 4,000 3,000
Business won
New customers 2,000 4,000
Existing customers 1,500 1,500

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Types of services performed

Service A 875 780
Service B 1,575 1,850
Service C 1,050 2,870
Employees
Service A 5 4
Service B 10 10
Service C 5 8
Required
Calculate figures that illustrate competitiveness and resource utilisation.

ANSWER
Competitiveness can only be measured from these figures by looking at how successful the organisation
is at converting enquiries into firm orders.
Percentage of enquiries converted into firm orders
Budget Actual
New customers (W1) 33% 44%
Existing customers (W1) 37.5% 50%
Resource utilisation can be measured by looking at average services performed per employee.
Budget Actual Rise
Service A (W2) 175 195 +11.4%
Service B (W2) 157.5 185 +17.5%
Service C (W2) 175 358.75 +105.0%
Workings
1 For example 2,000/6,000 = 33%
2 For example 875/5 =175
What comments would you make about the results of these calculations? How well is the business
doing?

3.3 Setting a standard, budget or target

A standard, budget or target can be set for a service department in a number of ways.
(a) There might be a budgeted expenditure limit for the department.
(b) Standard performance measures might be established as targets for efficiency. Standard
performance measures are possible where the department carries out routine activities for much
of its work.
(c) Targets or standards might be set for the quality of the service.
(i) To provide training for employees up to a quantifiable standard
(ii) To respond to requests for help within a specified number of minutes, hours or days
(iii) To respond to materials requisitions within a specified period of time
(d) A target might be set to perform a certain quantity of work with a budgeted number of staff.
(e) A target might be set to meet schedules for completing certain work.
(i) Scheduled dates for completion of each stage in a product development project in the
R&D department
(ii) Scheduled dates for the information technology (IT) department to complete each stage of
a new computer project

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(f) To make a profit. A service department might be designated as a profit centre. It would charge
other departments for the services it provides at a 'commercial' transfer price rate, and it would
be expected to earn a 'profit' on the work it does.

3.3.1 Standards for cost or efficiency

Two methods of setting a standard measure of performance in a service department are:
 Standard cost per unit of activity
 Standard quantity of 'output' per unit of resource used up
With both methods, there has to be a measurable quantity or volume of activity in the department. Both
types of standard can be employed within a control system, and they are not mutually exclusive.
Examples of standard measures of performance in service departments might be as follows.
(a) In the accounts receivable section of an accounts department, for example, the volume of activity
could be measured by:
(i) Number or value of invoices issued
(ii) Number or value of payments received
(iii) The number or value of bad debts
A budget for the section could then establish a standard cost per invoice issued, or a standard
cost per $1 received or receivable, or a standard percentage of bad debts. In addition, there
could be standards for the number or value of invoices issued per person/day.
(b) In a sales department, activity could be measured by the number and value of orders taken, the
number of customer visits, or the number of miles travelled by sales representatives. There could
be a standard cost per customer visit, a standard cost per $1 of sales, and so on. Alternatively,
standards could be set for the amount of work done per unit of resource consumed and, in a
sales department, such standards include:
(i) Standard number of customer visits per salesperson per day
(ii) Standard number and value of sales per customer visit
(iii) Standard number of miles travelled per $1 of sales
(c) In a transport department, activity could be measured in tonne/miles (tonnes of goods delivered
and miles travelled) and standards could be established for:
(i) Cost per tonne/mile
(ii) Drivers' hours per tonne/mile
(iii) Miles per gallon consumed

4 Management performance measures

Possible management performance measures include the following.

– Subjective measures
– Judgement of outsiders
– Upward appraisal
– Accounting measures

We have not so far distinguished between measures of performance of individual managers and
measures of performance of what it is they manage.
The distinction is very important. A manager may improve performance of a poorly performing division,
but the division could still rank as one of the poorest performing divisions within the organisation. If the
manager is assessed purely on the division's results then they will not appear to be a good performer.
The problem is deciding which performance measures should be used to measure management
performance and which should be used to measure the performance of the business.

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It is difficult to devise performance measures that relate specifically to a manager to judge their
performance as a manager. It is possible to calculate statistics to assess the manager as an employee
(days absent, professional qualifications obtained, personality and so on), but this does not measure
managerial performance.
We looked at responsibility accounting in Chapters 3 and 15 and mentioned that it is necessary to
consider a manager in relation to their area of responsibility. If we want to know how good a manager is
at marketing, the marketing performance of their division is the starting point. Then we must consider to
what extent the manager is able to influence the performance, and the performance trend.
Remember that it is unreasonable to assess managers' performance in relation to matters that are
beyond their control. Management performance measures should therefore only include those items that
are directly controllable by the manager in question.

4.1 Possible management performance measures

Measures Detail

Subjective measures An example is ranking performance on a scale of 1 to 5. This approach is

imprecise but does measure managerial performance rather than divisional
performance. The process must be perceived by managers to be fair. The
judgement should be made by somebody impartial, but close enough to the
work of each manager to appreciate the efforts they have made and the
difficulties they face.

Judgement of An organisation might, for example, set up a bonus scheme for directors
outsiders under which they would receive a bonus if the share price outperforms the
FTSE 100 index for more than three years. This is fair in that the share price
reflects many aspects of performance, but it is questionable whether they can
all be influenced by the directors concerned.

Upward appraisal This involves staff giving their opinions on the performance of their managers.
To be effective this requires healthy working relationships.

Accounting measures These can be used, but must be tailored according to what or whom is being
judged.

The balanced scorecard (Chapter 23) can also be used to monitor performance, as it includes non-
financial performance measures to give a more balanced view of performance.

5 Benchmarking

Benchmarking is an attempt to identify best practices and, by comparison of operations, to achieve

improved performance.

Benchmarking is another type of comparison exercise through which an organisation attempts to

improve performance.
The idea is to seek the best available performance against which the organisation can monitor its own
performance.
CIMA's Official Terminology defines benchmarking as 'The establishment, through data gathering, of
targets and comparators, through whose use relative levels of performance (and particularly areas of
underperformance) can be identified. By the adoption of identified best practices it is hoped that
performance will improve.'

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CIMA lists four types of benchmarking.

Type Description
Internal benchmarking A method of comparing one operating unit or function with another
within the same industry
Functional benchmarking Internal functions are compared with those of the best external
practitioners of those functions, regardless of the industry they are in
(also known as operational or generic benchmarking)
Competitive benchmarking Information is gathered about direct competitors, through techniques
such as reverse engineering*
Strategic benchmarking A type of competitive benchmarking aimed at strategic action and
organisational change

* Reverse engineering: buying a competitor's product and dismantling it, in order to understand its
content and configuration
From this list you can see that a benchmarking exercise does not necessarily have to involve the
comparison of operations with those of a competitor. Indeed, it might be difficult to persuade a direct
competitor to part with any information which is useful for comparison purposes. Functional
benchmarking, for example, does not always involve direct competitors. For instance, a railway company
may be identified as the 'best' in terms of on-board catering, and an airline company that operates on
different routes could seek opportunities to improve by sharing information and comparing its own
catering operations with those of the railway company.
A 1994 survey of The Times top 1,000 companies (half of which were in manufacturing) revealed that
the business functions most subjected to benchmarking in the companies using the technique were
customer services, manufacturing, human resources and information services.

5.1 Obtaining information

Financial information about competitors is easier to acquire than non-financial information. Information
about products can be obtained from reverse engineering, product literature, media comment and
trade associations. Information about processes (how an organisation deals with customers or suppliers)
is more difficult to find.
Such information can be obtained from group companies or possibly non-competing organisations in
the same industry.

5.2 Why use benchmarking?

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

5.2.2 Other reasons

Anna Green, in her article The Borrowers in the October 1996 edition of Pass magazine, explains the
benefits of benchmarking.
(a) Its flexibility means that it can be used in both the public and private sector and by people at
different levels of responsibility.
(b) Cross comparisons (as opposed to comparisons with similar organisations) are more likely to
expose radically different ways of doing things.
(c) It is an effective method of implementing change, people being involved in identifying and
seeking out different ways of doing things in their own areas.
(d) It identifies the processes to improve.

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(e) It helps with cost reduction.

(f) It improves the effectiveness of operations.
(g) It delivers services to a defined standard.
(h) It provides a focus on planning.
'Most importantly benchmarking establishes a desire to achieve continuous improvement and helps
develop a culture in which it is easier to admit mistakes and make changes.'

Benchmarking works, it is claimed, for the following reasons.

(a) The comparisons are carried out by the managers who have to live with any changes
implemented as a result of the exercise.
(b) Benchmarking focuses on improvement in key areas and sets targets which are challenging but
'achievable'. What is really achievable can be discovered by examining what others have
achieved: managers are thus able to accept that they are not being asked to perform miracles.
Benchmarking has other advantages: it can provide early warning of competitive disadvantage and
should lead to a greater incidence of teamworking and cross-functional learning.

QUESTION Benchmarking
We've looked at the advantages of benchmarking. Can you think of any disadvantages?

ANSWER
 Difficulties in deciding which activities to benchmark
 Identifying the 'best in class' for each activity
 Persuading other organisations to share information
 Successful practices in one organisation may not transfer successfully to another
 The danger of drawing incorrect conclusions from inappropriate comparisons

6 Cost control and cost reduction

Cost reduction is a planned and positive approach to reducing expenditure.

Cost reduction should not be confused with cost control.

Cost control is concerned with regulating the costs of operating a business and keeping costs within
acceptable limits.

The limits will usually be the standard cost or target cost limits set out in the formal operational plan or
budget. If actual costs differ from planned costs by a significant amount, cost control action will be
necessary.
You might like to think of cost control as an exercise in good housekeeping; the wasteful use of valuable
resources is avoided and efficiency and cost consciousness are encouraged.
Cost reduction, in contrast, starts with an assumption that current cost levels, or planned cost levels, are
too high, even though cost control might be good and efficiency levels high.
Cost reduction is a planned and positive approach to reducing expenditure.

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Cost control action ought to lead to a reduction in excessive spending. A cost reduction programme,
on the other hand, aims to reduce expected cost levels to below current budgeted or standard levels by
changing methods of working.
Cost control aims to reduce costs to budget or standard level. Cost reduction aims to reduce costs to
below budget or standard level, as budgets and standards do not necessarily reflect the cost and
conditions which minimise costs.

6.1 Planning for cost reduction

Cost reduction measures ought to be planned programmes to reduce costs rather than crash
programmes to cut spending levels.

There are two basic approaches to cost reduction.

(a) Crash programmes to cut spending levels
If an organisation is having problems with its profitability or cash flow, the management might
decide on an immediate programme to reduce spending. Some current projects might be
abandoned, capital expenditures deferred, employees made redundant or new recruitment
stopped. The absence of careful planning might make such crash programmes look like panic
measures. Poorly planned crash programmes to reduce costs could result in reductions in
operational efficiency. For example, decisions by a company to reduce the size of its legal
department or its internal audit section might cut staff costs in the short term but increase costs
in the longer term.
(b) Planned programmes to reduce costs
Many companies tend to introduce crash programmes for cost reduction in times of crisis and
ignore the problem completely in times of prosperity. A far better approach is to have continual
assessments of the organisation's products, production methods, services, internal administration
systems and so on.
Cost reduction exercises should therefore be planned campaigns to cut expenditure. They should
preferably be continuous and long term, so that short-term cost reductions are not soon reversed and
'forgotten'.
Difficulties introducing cost reduction programmes
(a) There may be resistance from employees to the pressure to reduce costs. They may feel
threatened by the change. The purpose and scope of the campaign should be fully explained to
employees to reduce uncertainty and (hopefully) resistance.
(b) The programme may be limited to a small area of the business with the result that costs are
reduced in one cost centre, only to reappear as an extra cost in another cost centre.
(c) Cost reduction campaigns are often introduced as a rushed, desperate measure instead of a
carefully organised, well thought out exercise.
Cost reduction does not happen of its own accord. Managers must make positive decisions to reduce
costs.
(a) A planned programme of cost reduction must begin with the assumption that some costs can be
significantly reduced. The benefits of cost savings must be worthwhile, and should exceed the
costs of achieving them.
(b) Areas for potential cost reduction should be investigated, and unnecessary costs identified.
(c) Cost reduction measures should be proposed, agreed, implemented and then monitored.

QUESTION Cost reduction

Before looking for ways in which costs can be reduced it is useful to consider the reasons why
unnecessary costs occur. Can you think of any examples?

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PART E: PERFORMANCE MEASUREMENT

ANSWER
Here are some thoughts. You may well have come up with different ideas.
(a) Lack of information, for example about new materials, products or processes
(b) Lack of ideas
(c) Genuine but incorrect beliefs, for example the belief that quantities are too small to justify mass
production techniques
(d) Changed circumstances, for example a failure to take advantage of better processes that are now
available

6.2 The scope of cost reduction campaigns

The scope of a cost reduction campaign should embrace the activities of the entire company. In a
manufacturing company this would span purchasing and distribution levels within the organisation from
the shop floor upwards. Non-manufacturing industries and public sector organisations should equally
look at all areas of their activities.
A cost reduction campaign should have a long-term aim as well as short-term objectives.
(a) In the short term only variable costs, for the most part, are susceptible to cost reduction efforts.
Many fixed costs (for example rent) are not easily changed.
(b) Some fixed costs are avoidable in the short term (for example advertising and sales promotion
expenditure). These are called discretionary fixed costs.
(c) In the long term most costs can be either reduced or avoided. This includes fixed cost as well as
variable cost expenditure items.

6.3 Methods of cost reduction: improving efficiency

One way of reducing costs is to improve the efficiency of materials usage, the productivity of labour or
the efficiency of machinery or other equipment.

One way of reducing costs is to improve the efficiency of material usage, the productivity of labour, or
the efficiency of machinery or other equipment. There are several ways in which this might be done.
Improved materials usage might be achieved by reducing levels of wastage, where wastage is currently
high.

QUESTION Reducing wastage

How can wastage be reduced?

ANSWER
Here are some suggestions.
(a) Changing the specifications for cutting solid materials
(b) Introducing new equipment that reduces wastage in processing or handling materials
(c) Identifying poor quality output at an earlier stage in the operational processes
(d) Using better quality materials; even though more expensive, better quality materials might save
costs because they are less likely to tear or might last longer

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CHAPTER 24 // APPLICATIONS OF PERFORMANCE MEASUREMENT

Improving labour productivity

(a) Giving pay incentives for better productivity.
(b) Changing work methods to eliminate unnecessary procedures and make better use of labour time.
(c) Improving the methods for achieving co-operation between groups or departments.
(d) Setting more challenging standards of efficiency. Standards should be tight but achievable. If
efficiency standards are too lax, it is likely that the work force will put in the minimum effort
needed to achieve the required standard. Given the right motivation among the workforce, more
challenging standards will encourage greater effort.
(e) Introducing standards where they did not exist before.
Improving the efficiency of equipment usage
(a) Making better use of equipment resources. For example, if an office PC is only in use for 50% of
its available time, it might be possible to put another application onto it, and so improve office
productivity.
(b) Achieving a better balance between preventive maintenance and machine 'down time' for repairs.

QUESTION Improving efficiency

A machine may be maintained at one of three levels, 1, 2 and 3. The monthly costs of the maintenance
work, and the monthly hours of production lost, are as follows.
Hours lost
Level Maintenance cost (cost $350/hour)
$
1 4,000 14
2 5,200 10
3 6,700 6
Required
Determine which level of maintenance should be chosen.

ANSWER
Level Maintenance cost Cost of hours lost Total cost
$ $ $
1 4,000 4,900 8,900
2 5,200 3,500 8,700
3 6,700 2,100 8,800
Level 2 should be chosen, to give the lowest total monthly cost.

Once improved standards of efficiency have been set, as a means of reducing costs, it is important that
cost control should be applied by management.

6.4 Methods of cost reduction: material costs

Costs of materials can be reduced by lowering the costs of wastage. Other ways of reducing materials
costs are as follows.
(a) A company could obtain lower prices for purchases of materials and components. Bulk purchase
discounts might be obtainable. Alternatively, a more cost-conscious approach to buying, with a
system of putting all major purchase contracts out to tender, might help to reduce prices.
(b) A company could improve stores control and cut stores costs. The economic ordering quantity
(Chapter 6) will minimise the combined costs of ordering items for inventory and stockholding
costs. Stockholding costs might be reduced by dealing with problems of obsolescence,
deterioration of items in store or theft.
(c) It might be possible to use alternative materials. Cheaper substitute materials might be available.

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QUESTION Material cost reduction

Standardisation of parts and components might offer enormous cost reduction potential for some
manufacturing industries. Can you think why this might be the case?

ANSWER
(a) If a manufacturing business has fewer types of components to manufacture, it will be able to
increase the length of production runs, and so reduce production costs. Non-standard parts tend
to be produced in small runs, and unit costs will be higher as a consequence.
(b) Standardisation helps to cut purchasing costs for the following reasons.
(i) There are fewer items to buy and store. The company can purchase in bulk, and so
perhaps obtain bulk purchase discounts.
(ii) It may be possible to buy standard parts from more than one supplier, and so purchasing
will be more competitive.

6.5 Methods of cost reduction: labour costs

Work study is a means of raising the productivity of an operating unit by the reorganisation of work.
There are two main parts to work study: method study and work measurement.
Organisation and methods (O&M) is a term for techniques, including method study and work
measurement, that are used in examining clerical, administrative and management procedures in order
to make improvements.

Methods of reducing labour costs Detail

Improving efficiency or productivity

Changing the methods of work A work study or O&M programme (see below) might be set up
to look for cost savings from improved work methods.

Replacing people with machinery The substitution of labour by automatic equipment can reduce
costs substantially.

6.5.1 Work study

Work study is a means of raising the production efficiency (productivity) of an operating unit by the
reorganisation of work. There are two main parts to work study: method study and work measurement.
Method study is the systematic recording and critical examination of existing and proposed ways of
doing work in order to develop and apply easier and more effective methods, and reduce costs.
Work measurement involves establishing the time for a qualified worker to carry out a specified job at
a specified level of performance.

Main objectives of a work study

(a) The analysis, design and improvement of work systems, workplaces and work methods
(b) The establishment of standards enable an organisation to determine labour and equipment
requirements, assess performance, plan operations, cost operations and products and calculate
realistic wage levels
(c) The development and application of job evaluation schemes based on job descriptions
(d) The specification of plant facilities, layout and space utilisation
(e) The assessment of the most profitable alternative combinations of personnel, materials and
equipment

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CHAPTER 24 // APPLICATIONS OF PERFORMANCE MEASUREMENT

(f) The development of procedures for the planning and control of work and material usage
(g) The development of procedures for presenting information to management about work
performance
The use of work study has grown rapidly over the past decade. Why?
(a) Tangible results are produced quickly.
(b) No large capital outlay is required.
(c) It is, in its basic form, simple and readily grasped in outline, by all.
(d) The facts it produces can be used to increase efficiency throughout the organisation.
(e) There is no work to which it cannot be applied.

6.5.2 Organisation and methods (O&M)

Organisation and methods (O&M) is a term for techniques, including method study and work
measurement, that are used to examine clerical, administrative and management procedures in order to
make improvements.

O&M is primarily concerned with office work and looks in particular at such areas as the following.
(a) Organisation
(b) Duties
(c) Staffing
(d) Office layout
(e) Methods of procedure and documentation and the design of forms
(f) Office mechanisation
Work study and O&M are perhaps associated in your mind with establishing standard times for work,
but remember that the real aim is to decide the most efficient methods of getting work done, as well as
establishing standard times for work done by this method. More efficient methods and tighter standards
will improve efficiency and productivity, and so reduce costs.

QUESTION O&M
Do you think a work study or O&M programme would discover any ways in which the work methods you
use could be improved so as to reduce costs?

6.6 Other aspects of cost reduction

6.6.1 Finance costs
Finance costs might offer some scope for savings.
(a) There might be a finance cost in taking credit from suppliers, in the form of an opportunity cost
of failing to take advantage of discounts for early payment that suppliers might be offering.
(b) Similarly, a company should give some thought to the credit terms it offers to customers. Finance
tied up in working capital involves a cost. (This might be the interest charges on a bank overdraft,
the cost of borrowing long-term finance, or the opportunity cost of the capital tied up.) Costs
might be reduced by reassessing policies for offering early payment discounts to credit
customers.
(c) A company might wish to reassess its sources of finance. Is it borrowing at the lowest obtainable
rates?
(d) Savings might be achievable from improved foreign exchange dealings, for companies involved in
buying and selling abroad.

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6.6.2 Rationalisation
Where organisations grow, especially by means of mergers and takeovers, there is a tendency for work
to be duplicated in different parts of the organisation. Two or three factories, for example, might make
the same product, when it would be more economical to concentrate all production in one factory. The
elimination of unnecessary duplication and the concentration of resources is a form of rationalisation.
The end result of such rationalisation is therefore to reduce costs through greater efficiency.

6.6.3 Expense items

Expense items, other than materials and labour, may be a significant part of total costs, and these too
should be controlled. Examples are as follows.
(a) Capital expenditure proposals should be carefully evaluated.
(b) Management should continually question the need for any cost item.
(c) Consultancy organisations may be used to advise companies how to reduce specialised expense
items, such as IT.

6.6.4 Control over spending decisions

Cost reduction might be achieved if improved control over spending decisions is achieved. Often, costly
spending decisions are taken by managers without proper consideration of the long-term cost.
Authority for different types of spending is usually given to management at various levels in the
hierarchy, depending on the nature of the cost.

7 Value analysis

Value analysis is a planned, scientific approach to cost reduction, which reviews the material
composition of a product and the product's design so that modifications and improvements can be made
which do not reduce the value of the product to the customer or user.
Value engineering is the application of similar techniques to new products.
Value analysis considers four aspects of value: cost value, exchange value, use value and esteem
value.

An approach to cost reduction, which embraces many of the techniques already mentioned, is value
analysis (VA) and value engineering.
Value analysis is a planned, scientific approach to cost reduction, which reviews the material
composition of a product and the product's design so that modifications and improvements can be made
which do not reduce the value of the product to the customer or the user.

The value of the product must therefore be kept the same or else improved, at a reduced cost. The
administration of a VA exercise should perhaps be the responsibility of a cost reduction committee.

Value engineering is the application of VA techniques to new products, so that new products are
designed and developed to a given value at minimum cost.

7.1 What is different about VA?

Two features of VA distinguish it from other approaches to cost reduction.
(a) It encourages innovation and a more radical outlook for ways of reducing costs.

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CHAPTER 24 // APPLICATIONS OF PERFORMANCE MEASUREMENT

(b) It recognises the various types of value which a product or service provides, analyses this value,
and then seeks ways of improving or maintaining aspects of this value at a lower cost. Other
techniques often ignore this value aspect.
Not every exercise in VA results in suggestions for radically different ways of making a product or
service. But VA can result in radical ideas for change, because ideas for cost reduction are not
constrained by the existing product design.
Conventional cost reduction techniques try to achieve the lowest production costs for a specific
product design whereas VA recognises that the real goal should be the least-cost method of making a
product that achieves its desired function, not the least-cost method of accomplishing a product design
to a mandatory and detailed specification.

7.2 Value
Four aspects of 'value' should be considered.
Cost value is the cost of producing and selling an item.
Exchange value is the market value of the product or service.
Use value is what the article does; the purposes it fulfils.
Esteem value is the prestige the customer attaches to the product.

(a) VA seeks to reduce unit costs, and so cost value is the one aspect of value to be reduced.
(b) VA attempts to provide the same (or a better) use value at the lowest cost. Use value therefore
involves considerations of the performance and reliability of the product or service.
(c) VA attempts to maintain or enhance the esteem value of a product at the lowest cost.

QUESTION Value analysis

Classify the following features of a product, using the types of value set out above.
(a) The product can be sold for $27.50.
(b) The product is available in six colours to suit customers' tastes.
(c) The product will last for at least ten years.

ANSWER
(a) Exchange value
(b) Esteem value
(c) Use value

VA involves the systematic investigation of every source of cost and technique of production with the
aim of cutting all unnecessary costs. An unnecessary cost is an additional cost incurred without adding
use, exchange or esteem value to a product.
There might be a conflict between reducing costs and maintaining the aesthetic value (esteem value)
of a product. Whereas a VA exercise should not result in a sacrifice of the product's function in order to
cut costs, it might result in a product that is not as pleasing aesthetically. Where cost cutting and
aesthetics are incompatible, there should be a clear direction from senior management about which is
more important.

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7.3 The scope of VA

Value analysis concentrates on product design, components, material costs and production methods.

Three areas of special importance are as follows.

Area Method

Product design At the design stage VA is called value engineering. The designer should be cost
conscious and avoid unnecessary complications. Simple product design can avoid
production and quality control problems, thereby resulting in lower costs.

Components and The purchasing department should beware of lapsing into habit with routine
material costs buying decisions. Buyers ought to be fully aware of technology changes, and
significant changes in material prices that new technology creates. The
purchasing department has a crucial role to play in reducing costs and improving
value by obtaining the desired quality materials at the lowest possible price.

Production These ought to be reviewed continually, on a product by product basis, especially

methods with changing technology.

7.4 Carrying out a VA

The steps in a VA study are as follows.
– Select a product or service for investigation
– Obtain and record information about it
– Evaluate the product
– Consider alternatives
– Select the least-cost alternative
– Make a recommendation
– If accepted, implement the recommendation
– After a period, evaluate the outcome and measure the cost savings

7.4.1 The steps in VA

A VA study should be carried out by a team of experts, preferably with varying backgrounds, which
blends experience, skill and imagination. A team will typically consist of three to seven members who
collectively possess the necessary skills to examine the product, service or operation.
VA should be an interdisciplinary exercise, and ought to involve a management accountant but also
managers concerned with method study and work measurement, estimating, engineering, planning,
production, purchasing and marketing. Other experts might be called on to contribute to the team's
work.
Steps in value analysis

Step 1 Selecting a product or service for study. The product selected should be one which
accounts for a high proportion of the organisation's costs, since the greatest cost
savings should be obtainable from high cost areas. The choice should also take into
account the expected future life of the product and the stage of its 'life cycle' that it has
reached. A product reaching the end of its marketable life is unlikely to offer scope for
substantial savings, unless cost reduction measures would also extend the product's life.

Step 2 Obtaining and recording information. The questions to be asked include: What is the
product or service supposed to do? Does it succeed? What are the costs of the product
or service? Are there alternative ways of making or providing it? What do these
alternatives cost?

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CHAPTER 24 // APPLICATIONS OF PERFORMANCE MEASUREMENT

Step 3 Analysing the information and evaluating the product. Each aspect of the product or
service should be evaluated. Any cost reductions should be achieved without the loss of
use or esteem value. (Or at least, cost savings must exceed any loss in value suffered.)
The type of questions to be asked and answered in the analysis stage are as follows.
(a) Are all the parts necessary?
(b) Can the parts be obtained or made at a lower cost?
(c) Can standardised parts be used?
(d) Are all the features of the product or service necessary?
(e) Can any of the features be incorporated at a lower cost?
(f) Does the value provided by each feature justify its cost?
(g) Can the product be made or the service performed at a lower cost?

Step 4 Considering alternatives. From the analysis, a variety of options can be devised. This is
the 'new ideas' stage of the study, and alternative options would mix ideas for
eliminating unnecessary parts or features, combining several features into one,
standardising certain components or features, or introducing new methods of operation
or new sources of supply (for example external purchase of components instead of
in-house manufacture). New advances in technology might be considered, and a
creative approach should underlie this phase of the exercise.

Step 5 Selection of the least-cost alternative. The evaluation of each alternative should be
recorded, and costs (and other aspects of value) compared.

Step 6 Recommendation. The preferred alternative should then be recommended to the

decision makers for approval. The VA team itself will not have the authority to decide
whether or not a cost reduction proposal should be implemented.

Step 7 Implementation and follow-up. Once a VA proposal is approved and accepted, its
implementation must be properly planned and co-ordinated. The VA team should
review the implementation and, where appropriate, improve the new product or method
in the light of practical experience.

To be successful, VA programmes must have the full backing of senior management. Management
must therefore do the following.
(a) Give the VA programme their visible support, for example acting as a member of a VA steering
group and attending VA training sessions.
(b) Establish goals for the programme to achieve.
(c) Select the personnel for the VA team and establish a VA 'organisation' within the company.
(d) Give the VA programme a sufficient budget to carry out its work properly.
(e) Insist on a continuing audit of the achievements of the VA programme.
(f) Give rewards to individuals and groups for outstanding achievements.

PER performance objective 14 requires you to measure and assess departmental and business
performance.
The knowledge covered in this chapter will help you demonstrate your competence in this area.

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PART E: PERFORMANCE MEASUREMENT

CHAPTER ROUNDUP

 In a customer-focused organisation, basic performance measures for sales can be supplemented by a

host of other measures, including ratios such as customer rejects/returns: total sales.
 Performance measures for materials and labour include variances.

 Performance can be measured using the standard hour.

 Efficiency, activity and capacity ratios provide useful information.
 Performance measures need to be thought out carefully for contract environments. The high degree of
standardisation in process costing environments means that it is ideal for setting performance standards.
Non-financial performance measures for manufacturing include cost (behaviour), quality, time and
innovation.
 Performance measures covering the following six 'dimensions' have been suggested for service
organisations.
– Competitive performance
– Financial performance
– Quality of service
– Flexibility
– Resource utilisation
– Innovation

 Possible management performance measures include the following.

– Subjective measures
– Judgement of outsiders
– Upward appraisal
– Accounting measures
 Benchmarking is an attempt to identify best practices and, by comparison of operations, to achieve
improved performance.
 Cost reduction is a planned and positive approach to reducing expenditure.

 Cost reduction measures ought to be planned programmes to reduce costs rather than crash
programmes to cut spending levels.
 One way of reducing costs is to improve the efficiency of materials usage, the productivity of labour or
the efficiency of machinery or other equipment.

 Work study is a means of raising the productivity of an operating unit by the reorganisation of work.
There are two main parts to work study: method study and work measurement.
 Organisation and methods (O&M) is a term for techniques, including method study and work
measurement, that are used in examining clerical, administrative and management procedures in order
to make improvements.
 Value analysis is a planned, scientific approach to cost reduction, which reviews the material
composition of a product and the product's design so that modifications and improvements can be made
which do not reduce the value of the product to the customer or user.
 Value engineering is the application of similar techniques to new products.
 Value analysis considers four aspects of value: cost value, exchange value, use value and esteem
value.

 Value analysis concentrates on product design, components, material costs and production methods.

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CHAPTER 24 // APPLICATIONS OF PERFORMANCE MEASUREMENT

 The steps in a value analysis study are as follows.

– Select a product or service for investigation
– Obtain and record information about it
– Evaluate the product
– Consider alternatives
– Select the least-cost alternative
– Make a recommendation
– If accepted, implement the recommendation
– After a period, evaluate the outcome and measure the cost savings

1 What does the performance measure 'deliveries late: deliveries on schedule' indicate?
QUICK QUIZ

2 Suggest a measure for assessing machine usage and efficiency.

3 How is the efficiency ratio calculated?
4 What are the three aspects of flexibility?
5 What are the main difficulties of introducing cost reduction programmes?
6 Suggest five ways in which labour productivity might be improved.
7 What is method study?
8 In which areas of office work might an O&M study be applied?
9 Define the four aspects of value to be considered in a value analysis exercise.
10 Choose the correct words from those highlighted.
Value engineering/analysis is cost avoidance or cost prevention before production whereas value
engineering/analysis is cost reduction during production.

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PART E: PERFORMANCE MEASUREMENT

ANSWERS TO QUICK QUIZ

1 The efficiency of production and production scheduling
2 Machine down time: total machine hours
3 (Standard hours produced  actual hours worked)  100%
4 Speed of delivery, ability to respond to customers' specifications and coping with demand
5 The major difficulties with introducing cost reduction programmes are as follows.
(a) There may be resistance from employees to the pressure to reduce costs, usually because the
nature and purpose of the campaign has not been properly explained to them, and because they
feel threatened by the change.
(b) The programme may be limited to a small area of the business with the result that costs are
reduced in one cost centre, only to reappear as an extra cost in another cost centre.
(c) Cost reduction campaigns are often introduced as a rushed, desperate measure instead of a
carefully organised, well thought out exercise.
6 Labour productivity might be improved by the following methods.
(a) Giving pay incentives for better productivity
(b) Changing work methods to eliminate unnecessary procedures and make better use of labour time
(c) Improving the methods for achieving co-operation between groups or departments
(d) Setting more challenging standards of efficiency to aim for; given the right motivation among the
workforce, more challenging standards will encourage greater effort
(e) Introducing standards where they did not exist before
7 Method study is the systematic recording and critical examination of existing and proposed ways of
doing work in order to develop and apply easier and more effective methods, and reduce costs.
8 (a) Organisation
(b) Duties
(c) Staffing
(d) Office layout
(e) Methods of procedure and documentation and the design of forms
(f) Office mechanisation
9 (a) Cost value is the cost of producing and selling an item.
(b) Exchange value is the market value of the product or service.
(c) Use value is what the article does; the purposes it fulfils.
(d) Esteem value is the prestige the customer attaches to the product.
10 Value engineering, value analysis

Now try ...

Attempt the questions below from the Practice Question Bank

Q107 – Q115

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Practice question and answer bank

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PRACTICE QUESTION AND ANSWER BANK

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PRACTICE QUESTION BANK

1 Accounting for management

1 Which of the following statements is false?
A Management accounts detail the performance of an organisation over a defined period and
the state of affairs at the end of that period.
B There is no legal requirement to prepare management accounts.
C Limited liability companies must prepare financial accounts.
D The format of management accounts is entirely at management discretion. (2 marks)
2 Diane carries out routine processing of invoices in the purchasing department of L Co. Joanne is
Diane's supervisor. Lesley is trying to decide how many staff will be needed if some proposed
new technology is implemented. Tracey is considering the new work that L Co will be able to
offer and the new markets it could enter, once the new technology is well established.
Which member of L Co carries out tactical activities?
A Diane
B Joanne
C Lesley
D Tracey (2 marks)
3 Which of the following statements is false?
A Financial accounting information can be used for internal reporting purposes.
B Routine information can be used to make decisions regarding both the long term and the
short term.
C Management accounting provides information relevant to decision making, planning,
control and evaluation of performances.
D Cost accounting can only be used to provide inventory valuations for internal reporting.
(2 marks)
4 Which of the following is not part of the planning stage in the decision-making process?
A Deciding on the optimal way in which an objective might be achieved
B Identifying ways which might contribute to the achievement of specified objectives
C Obtaining data about actual results
D Identifying goals or objectives (2 marks)

2 Sources of data
5 A company which makes rechargeable batteries selects some of the batteries for examination.
The procedure used chooses two random numbers, say n and m. Starting at the nth battery,
every battery at an interval of m is then chosen for examination.
This type of sampling is known as:
A Stratified
B Systematic
C Random
D Multistage (2 marks)

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PRACTICE QUESTION BANK

6 Which of the following statements about stratification is/are true?

I The sample selected will be representative of the population.
II The structure of the sample will reflect that of the population if the same proportion of
individuals is chosen from each stratum.
III It requires prior knowledge of each item in the population.
A I and III only C II and III only
B I, II and III D III only (2 marks)
7 Which of the following is an example of discrete data from a primary source?
A A report in a newspaper giving retail sales for the month
B An eyewitness account of the number of customers
C A website showing the average height for children aged seven
D A colleague's measurement of the distance from the office to the head office (2 marks)
8 Which of the following is a disadvantage of quota sampling?
A It is expensive.
B It is administratively complicated.
C A sampling frame is necessary.
D It can result in certain biases. (2 marks)

9 A survey of heights of lampposts is carried out to find out if there is any variation across the
country.
What sort of data is being collected in such a survey?
A Quantitative Discrete
B Qualitative Discrete
C Quantitative Continuous
D Qualitative Continuous (2 marks)

3 Cost classification
10 Which of the following items might be a suitable cost unit within the accounts payable
department of a company?
(i) Postage cost (iii) Supplier account
(ii) Invoice processed
A Item (i) only C Item (iii) only
B Item (ii) only D Items (ii) and (iii) only (2 marks)
11 Which of the following are direct expenses?
(i) The cost of special designs, drawing or layouts
(ii) The hire of tools or equipment for a particular job
(iii) Salesperson's wages
(iv) Rent, rates and insurance of a factory
A (i) and (ii) C (i) and (iv)
B (i) and (iii) D (iii) and (iv) (2 marks)

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PRACTICE QUESTION BANK

12 Which of the following would be appropriate cost units for a passenger coach company?
Appropriate Not appropriate

(a) Passenger/kilometre

(b) Vehicle per kilometre

(c) Fixed cost per kilometre

(2 marks)
13 A cost which contains both fixed and variable elements, and so is partly affected by changes in
the level of activity, is called:
A A direct cost C An unavoidable cost
B A semi-variable cost D A prime cost
(2 marks)
14 A company employs three drivers to deliver goods to its customers. The salaries paid to these
drivers are:
A A part of prime cost
B A direct production expense
C A production overhead
D A selling and distribution overhead (2 marks)

4 Cost behaviour
15 Variable costs are conventionally deemed to:
A Be constant per unit of output
B Vary per unit of output as production volume changes
C Be constant in total when production volume changes
D Vary in total from period to period when production is constant (2 marks)
16 The following is a graph of total cost against level of activity.

To which one of the following costs does the graph correspond?

A Photocopier rental costs, where a fixed rental is payable up to a certain number of copies
each period; if the number of copies exceeds this amount, a constant charge per copy is
made for all subsequent copies during that period
B Vehicle hire costs, where a constant rate is charged per mile travelled, up to a maximum
monthly payment regardless of the miles travelled
C Supervisor salary costs, where one supervisor is needed for every five employees added to
the staff
D The cost of direct materials, where the unit rate per kg purchased reduces when the level
of purchases reaches a certain amount (2 marks)

575

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PRACTICE QUESTION BANK

17 Identify which type of cost is being described in (a)-(d) below.

VARIABLE COST FIXED COST STEPPED FIXED SEMI-VARIABLE

COST COST

(a) This type of cost stays the same, no matter how many units you
produce.

(b) This type of cost increases as you produce more units. The sum of
these costs are also known as the marginal cost of a unit.

(c) This type of cost is fixed but only within certain levels of activity.

(d) This type of cost contains both fixed and variable elements.

(2 marks)
18 At the beginning of the year, Bob Co enters into a rental agreement with a landlord who is
entitled, under the terms of the agreement, to change the rent (either upwards or downwards)
according to economic conditions. Bob Co cannot cancel the agreement during the first six
months.
For the first six months of the agreement, Bob Co could classify the rent as a:
A Fixed cost C Semi-variable cost
B Avoidable cost D Uncontrollable cost (2 marks)
19 Brady Co is a painting and decorating company. The following information is available for two
periods.
Period 1 Period 2
Square metres decorated 10,000 14,000
Total cost $44,000 $56,000
When more than 12,000 square metres are decorated, the fixed costs increase by $6,000.

The total cost for period 3 if 15,500 square metres are decorated is $ (2 marks)

5 Presenting information
20 The costs of materials for product B are made up as follows.
Material P: $1,000
Material Q: $600
Material R: $1,025
Material S: $375
If the material proportions were displayed on a pie chart, how many degrees would material Q
represent?
A 72 degrees C 144 degrees
B 120 degrees D 204 degrees (2 marks)

576

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PRACTICE QUESTION BANK

21 The following table shows the typical salary of part-qualified accountants in five different regions
of Flatland.
Area Salary
$
South-East 21,500
Midlands 20,800
North-East 18,200
North-West 17,500
South-West 16,700
The best diagram to draw to highlight the differences between areas is:
A A pie chart C A percentage component bar chart
B A line graph D A simple bar chart (2 marks)
22 You have just calculated for the last two six-monthly periods, the running costs of a factory,
broken down into five categories. You are using a computer package which can produce radar
charts, pie charts, time series graphs and scatter diagrams, among others. The graphics to best
illustrate the relative sizes of the cost categories in this situation will be:
A Line graphs C Radar charts
B Pie charts D Scatter diagrams (2 marks)

6 Accounting for materials

23 The following data relates to an item of raw material.
Unit cost of raw material $20
Usage per week 250 units
Cost of ordering material, per order $400
Annual cost of holding inventory, as a % of cost 10%
Number of weeks in a year 48
What is the economic order quantity, to the nearest unit?
A 316 units C 1,549 units
B 693 units D 2,191 units (2 marks)
24 The following data relates to the material control account of Duckboard Co, a manufacturing
company, for the month of October.
$
Opening inventory 18,500
Closing inventory 16,100
Deliveries from suppliers 142,000
Returns to suppliers 2,300
Cost of indirect materials issued 25,200
How would the issue of direct materials have been recorded in the cost accounts?
$ $
A Debit Material control account 119,200
Credit Work in progress control account 119,200
B Debit Work in progress control account 119,200
Credit Material control account 119,200
C Debit Material control account 116,900
Credit Work in progress control account 116,900
D Debit Work in progress control account 116,900
Credit Material control account 116,900
(2 marks)

577

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PRACTICE QUESTION BANK

25 Bovver Co manufactures one product (the Tate). The following information relates to the Tate.
EOQ 6,000 units
Average usage 150 units per day
Minimum usage 90 units per day
Maximum usage 195 units per day
Lead time 25 – 30 days

The maximum inventory level is units. (2 marks)

Questions 26 and 27 are based on the following data.

Date Units Unit price Value
$ $
1 Jan Balance b/f 100 5.00 500.00
3 Mar Issue 40
4 Jun Receipt 50 5.50 275.00
6 Jun Receipt 50 6.00 300.00
9 Sep Issue 70
26 If the first in, first out method of pricing had been used, the value of the issue on 9 September
would have been:
A $350 B $355 C $395 D $420
(2 marks)
27 If the last in, first out method of pricing had been used, the value of the issue on 9 September
would have been:
A $350 B $395 C $410 D $420
(2 marks)
28 Harry P Co uses 62,500 units of material HP at an even rate during the year. Each order placed
with the supplier of the units is for 5,000 units, which is the EOQ. The company holds buffer
inventory of 1,250 units. The annual cost of holding one unit in inventory is $5.
What is the total annual cost of holding inventory of the unit?
A $12,500 B $15,625 C $18,750 D $25,000
(2 marks)

7 Accounting for labour

29 Gross wages incurred in department 1 in June were $54,000. The wages analysis shows the
following summary breakdown of the gross pay. Overtime was worked to catch up on a backlog
after several employees were off sick.
Paid to Paid to
direct labour indirect labour
$ $
Ordinary time 25,185 11,900
Overtime: basic pay 5,440 3,500
premium 1,360 875
Shift allowance 2,700 1,360
Sick pay 1,380 300
36,065 17,935

What is the direct wages cost for department 1 in June?

A $25,185 C $34,685
B $30,625 D $36,065 (2 marks)

578

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PRACTICE QUESTION BANK

30 The wages control account for A Co for February is shown below.

WAGES CONTROL ACCOUNT
$ $
Bank 128,400 Work in progress control 79,400
Balance c/d 12,000 Production overhead control 61,000
140,400 140,400
Balance b/d 12,000

Which of the following statements about wages for February is not correct?
A Wages paid during February amounted to $128,400.
B Wages for February were prepaid by $12,000.
C Direct wages cost incurred during February amounted to $79,400.
D Indirect wages cost incurred during February amounted to $61,000. (2 marks)

The following information relates to questions 31 and 32.

Slocombe Co budgeted to produce 10,000 units of its product (the Brahms) in the budgeted time of
50,000 hours. During the period the company produced 12,500 units in a total time of 68,750 hours.

31 The capacity ratio for the period was % (work to one decimal place).
(2 marks)

32 The production volume ratio for the period was % (work to one decimal place).
(2 marks)
33 A company had 500 workers at the beginning of a period. During the period, 70 workers left the
company for various reasons and 46 new workers were employed.
What is the labour turnover rate for the period (to the nearest %)?

The labour turnover rate for the period is %

(2 marks)
34 An employee is paid on a piecework basis. The basis of the piecework scheme is as follows.
1 to 100 units – $0.25 per unit
101 to 200 units – $0.35 per unit
201 to 299 units – $0.45 per unit
Only the additional units qualify for the higher rates. Rejected units do not qualify for payment.
During a particular day the employee produced 250 units, of which 31 were rejected as faulty.
What did the employee earn for their day's work?
A $68.55
B $82.50
C $98.55
D $112.50 (2 marks)

579

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PRACTICE QUESTION BANK

8 Accounting for overheads

Questions 35 and 36 are based on the following data.
A company absorbs overheads based on labour hours. Data for the latest period are as follows.
Budgeted labour hours 8,500
Budgeted overheads $148,750
Actual labour hours 7,928
Actual overheads $146,200
35 Based on the data given above, what is the labour hour overhead absorption rate?
A $17.20 per hour C $18.44 per hour
B $17.50 per hour D $18.76 per hour (2 marks)
36 Based on the data given above, what is the amount of under-/over-absorbed overhead?
A $2,550 under-absorbed overhead C $7,460 over-absorbed overhead
B $2,550 over-absorbed overhead D $7,460 under-absorbed overhead (2 marks)
37 The budgeted production overheads and other budget data of Eiffel Co are as follows.
Production
Budget dept X
Overhead cost $36,000
Direct materials cost $32,000
Direct labour cost $40,000
Machine hours 10,000
Direct labour hours 18,000
What would be the absorption rate for Department X using the various bases of apportionment?

(a) % of direct material cost =

(b) % of direct labour cost =

(c) % of total direct cost =

(d) Rate per machine hour =

(e) Rate per direct labour hour = (2 marks)

38 Factory overheads can be absorbed by which of the following methods?

(i) Direct labour hours
(ii) Machine hours
(iii) As a % of prime cost
(iv) $x per unit
A (i), (ii), (iii) or (iv)
B (i) or (ii) only
C (i), (ii) or (iii) only
D (ii), (iii) or (iv) only (2 marks)
39 Which of the following would be the most appropriate basis for apportioning machinery insurance
costs to cost centres within a factory?
A The number of machines in each cost centre
B The floor area occupied by the machinery in each cost centre
C The value of the machinery in each cost centre
D The operating hours of the machinery in each cost centre (2 marks)

580

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PRACTICE QUESTION BANK

40 A factory consists of two production cost centres (A and B) and two service cost centres (C and
D). The total allocated and apportioned overhead for each is as follows.
A B C D
$95,000 $82,000 $46,000 $30,000
It has been estimated that each service cost centre does work for the other cost centres in the
following proportions.
A B C D
Percentage of service cost centre X to 40 40 – 20
Percentage of service cost centre Y to 30 60 10 –
After the reapportionment of service cost centre costs has been carried out using a method that
fully recognises the reciprocal service arrangements in the factory, what is the total overhead for
production cost centre A?
A $122,400
B $124,716
C $126,000
D $127,000 (2 marks)

9 Absorption and marginal costing

41 The overhead absorption rate for product Y is $2.50 per direct labour hour. Each unit of Y
requires 3 direct labour hours. Inventory of product Y at the beginning of the month was 200
units and at the end of the month was 250 units. What is the difference in the profits reported
for the month using absorption costing compared with marginal costing?
A The absorption costing profit would be $375 less.
B The absorption costing profit would be $125 greater.
C The absorption costing profit would be $375 greater.
D The absorption costing profit would be $1,875 greater. (2 marks)
42 B Co makes a product which has a variable production cost of $21 per unit and a sales price of
$39 per unit. At the beginning of 20X5, there was no opening inventory and sales during the year
were 50,000 units. Budgeted and actual fixed costs (production, administration, sales and
distribution) totalled $328,000. Budgeted and actual production was 70,000 units.
The value of closing inventory under absorption costing is $ . (2 marks)
43 Davy Crockett Co makes hats, mainly for fancy dress costumes. The company expected to
produce 25,000 hats during the year which would be expected to incur $125,000 in fixed costs.
The total cost of each hat is $30 (including fixed costs) and the company can sell them for $40
each. Sales during the year were 15,000 hats from a production volume of 20,000. Actual fixed
costs were $80,000 and there was no opening inventory.

What is the marginal costing net profit for the year? $ (2 marks)
44 HMF Co produces a single product. The budgeted fixed production overheads for the period are
$500,000. The budgeted output for the period is 2,500 units. Opening inventory at the start of
the period consisted of 900 units and closing inventory at the end of the period consisted of 300
units. Using marginal costing principles the profit was $800,000. If absorption costing principles
were applied, what would the profit for the period be?
A $925,000
B $675,000
C $920,000
D $680,000 (2 marks)

581

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PRACTICE QUESTION BANK

45 A company producing a single product reported the following profits.

Basis Profit
Marginal costing $100,000
Absorption costing $110,000
Fixed overheads per unit for the period were $5.
Which of the following statements are true?
(i) Closing inventory levels are 2,000 units higher than opening inventory.
(ii) Opening inventory levels are 2,000 units higher than closing inventory.
(iii) It is impossible to say whether inventory levels have changed.
(iv) More units were produced than sold during the period.
A (iv) only
B (ii) and (iv)
C (iii) only
D (i) and (iv) (2 marks)

10 Job, batch and service costing

46 In which of the following situation(s) will job costing normally be used?

Production is continuous.

Production of the product can be completed in a single accounting period.

Production relates to a single special order. (2 marks)

47 Consider the following features and identify whether they relate to job costing, contract costing,
service costing or none of these costing methods.
J= Job costing
C= Contract costing
S= Service costing
N= None of these costing methods

(i) Production is carried out in accordance with the wishes of the customer.

(ii) Work is usually of a relatively long duration.

(iii) Work is usually undertaken on the contractor's premises.

(iv) Costs are averaged over the units produced in the period.

(v) It establishes the costs of services rendered.

(2 marks)

582

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PRACTICE QUESTION BANK

48 Ali Pali Co is a small jobbing company. Budgeted direct labour hours for the current year were
45,000 hours and budgeted direct wages costs were $180,000.
Job number 34679, a rush job for which overtime had to be worked by skilled employees, had
the following production costs.
$ $
Direct materials 2,000
Direct wages
Normal rate (400 hrs) 2,000
Overtime premium 500
2,500
Production overhead 4,000
8,500
Production overhead is based on a direct labour hour rate.

If production overhead had been based on a percentage of direct wages costs instead, the
production cost of job number 34679 would have been:
A $5,500 C $10,250
B $9,000 D $10,750 (2 marks)
49 Which of the following is a feature of job costing?
A Production is carried out in accordance with the wishes of the customer.
B It is associated with continuous production of large volumes of low-cost items.
C It establishes the cost of services rendered.
D It uses equivalent units. (2 marks)

11 Process costing
50 A chemical is manufactured in two processes, X and Y. Data for process Y for last month are as
follows.
Material transferred from process X 2,000 litres @ $4 per litre
Conversion costs incurred $12,240
Output transferred to finished goods 1,600 litres
No losses occur in the process.
Closing work in progress is fully complete for material, but is only 50% processed.
What is the value of the closing work in progress (to the nearest $)?
A $1,360 C $2,960
B $2,160 D $4,320 (2 marks)
51 20,000 litres of liquid were put into a process at the beginning of the month at a cost of $4,400.
The output of finished product was 17,000 litres. The normal level of waste in this process is
20% and the waste which is identified at the end of the process can be sold at $0.50 per litre.
What is the abnormal gain or loss and what is the cost per unit?
A Abnormal gain $1,000, cost per unit $0.15
B Abnormal loss $1,000, cost per unit $0.15
C Abnormal loss $1,000, cost per unit $0.28
D Abnormal gain $1,000, cost per unit $0.28 (2 marks)

52 A food manufacturing process has a normal wastage of 10% of input. In a period, 3,000 kg of
material was input and there was an abnormal loss of 75 kg. No inventories are held at the
beginning or end of the process.
The quantity of good production achieved was kg. (2 marks)

583

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PRACTICE QUESTION BANK

53 A company makes a product, which passes through a single process.

Details of the process for the last period are as follows.
Materials 5,000 kg at 50c per kg
Labour $700
Production overheads 200% of labour
Normal losses are 10% of input in the process, and without further processing any losses can be
sold as scrap for 20c per kg.
The output for the period was 4,200 kg from the process.
There was no work in progress at the beginning or end of the period.
The value of the abnormal loss for the period is $ (2 marks)

54 In a process account, abnormal losses are valued:

A At good production cost less scrap value
B At their scrap value
C The same as good production
D Nil (2 marks)

12 Process costing, joint products and by-products

55 SH Co manufactures three joint products and one by-product from a single process.
Data for May are as follows.
Opening and closing inventories Nil
Raw materials input $90,000
Conversion costs $70,000
Output
Units Sales price
$ per unit
Joint product J 2,500 36
K 3,500 40
L 2,000 35
By-product M 4,000 1
By-product sales revenue is credited to the process account. Joint costs are apportioned on a
physical units basis.
What were the full production costs of product K in May?
A $45,500 C $68,250
B $46,667 D $70,000 (2 marks)
56 Samakand Preparations Co operates a continuous process producing three products and one by-
product. Output from the process for one month was as follows.
Selling price
per unit Output
Joint product $ Units
A 38 20,000
B 54 40,000
C 40 35,000
By-product
D 4 20,000
Total output costs were $4,040,000.
The saleable value of the by-product is deducted from process costs before apportioning costs to
each joint product. Using the sales revenue basis for allocating joint costs, the unit valuation for
joint product B was (to decimal places):
A $49.50 C $50.00
B $45.00 D $100.00 (2 marks)

584

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PRACTICE QUESTION BANK

57 Robbie Co manufactures three products in a common process. Details of production and sales for
a period are as follows.
Product Production Sales Selling price per unit
(units) (units) $
Gary 20,000 18,000 50
Howard 15,000 10,000 40
Jason 10,000 6,000 90
Common costs for the period are $1,500,000.
Using the sales value method, what is the cost allocated to product Howard during the period,
assuming that no other costs are incurred in production?

Cost for product Howard is $ (2 marks)

13 Alternative costing principles

58 Which one of the following ideas is not usually associated with a TQM environment?
A Continuous improvement
B Right first time
C Reduced customer service
D Zero defects (2 marks)

59 Which of the following statements about activity based costing is/are correct?
1 Short-term variable overhead costs should be traced to products using volume-related cost
drivers, such as machine hours and direct labour hours.
2 Long-term variable production overheads are driven partly by the complexity and diversity
of production work, as well as by the volume of output.
3 Transactions undertaken by support department personnel are the appropriate cost drivers
for long-term variable costs.
4 Overheads should be charged to products on the basis of their usage of an activity. A
product's usage of an activity is measured by the number of the activity's cost driver it
generates.
A All of the above
B 1 only
C 2 only
D 1, 3 and 4 only (2 marks)

60 Setting controls for the process of manufacture or service delivery is known as:
A Inspection
B Quality control
C Quality circles
D Internal failure costs (2 marks)

585

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PRACTICE QUESTION BANK

14 Forecasting
61 In a time series analysis, the multiplicative model is used to forecast sales and the following
seasonal variations apply. Remember, instead of summing to zero, as with the additive approach,
the averages should sum (in this case) to 4.0, 1.0 for each of the four quarters.
Quarter 1 2 3 4
Seasonal variation 0.45 1.22 1.31 ?
The seasonal variation for quarter 4 is:
A 0.02
B 1.02
C 1.98
D 2.98 (2 marks)
62 A company's weekly costs ($C) were plotted against production level (P) for the last 50 weeks
and a regression line calculated to be C = 1,000 + 250P. Which statement about the
breakdown of weekly costs is true?
A Fixed costs are $1,000. Variable costs per unit are $5.
B Fixed costs are $250. Variable costs per unit are $4.
C Fixed costs are $250. Variable costs per unit are $1,000.
D Fixed costs are $1,000. Variable costs per unit are $250. (2 marks)
63 The value of the correlation coefficient between x and y is 0.9. Which of the following is correct?
A There is a weak relationship between x and y.
B x is 90% of y.
C If the values of x and y were plotted on a graph, the line relating them would have a slope
of 0.9.
D There is a very strong relationship between x and y. (2 marks)

64 The correlation coefficient between A and B is 0.4 and the correlation coefficient between C and
D is –0.7.
Which of the following statements is correct?
A There is a stronger relationship between A and B than between C and D.
B There is a stronger relationship between C and D than between A and B.
C The relationship between A and B and between C and D is the same.
D There is insufficient information to determine which relationship is stronger. (2 marks)
65 Four years ago material X cost $5 per kg and the price index most appropriate to the cost of
material X stood at 150.
The same index now stands at 430.
What is the best estimate of the current cost of material X per kg?
A $1.74 ($5  150 ÷ 430)
B $9.33 ($5  (430 – 150) ÷ 150
C $14.33 ($5  430 ÷ 150)
D $21.50 ($5  430 ÷ 100) (2 marks)
66 If X = 100, Y = 400, X2 = 2,040, Y2 = 32,278, XY = 8,104 and n = 5, which of the
following values for a and b are correct in the formula Y = a + bX?
a b
A 28 –2.6
B 28 +2.6
C –28 –2.6
D –28 +2.6 (2 marks)

586

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PRACTICE QUESTION BANK

15 Budgeting
67 Which of the following may be considered to be objectives of budgeting?
(i) Co-ordination
(ii) Communication
(iii) Expansion
(iv) Resource allocation
A All of them C (ii) and (iii) only
B (i), (ii) and (iv) only D (i) and (iii) only (2 marks)
68 The following observations have been made of total overhead cost.
Output level (units) 5,000 10,000
Total overhead cost ($) 14,000 27,000
The variable element of total overhead cost is known to increase by $1 per unit at output levels
above 7,000 units.
What is the variable element of total overhead cost at an output level of 5,000 units?
A $2.00 per unit ($27,000 – $14,000 – 3,000 units  $1) ÷ (10,000 units – 5,000
units)
B $2.60 per unit ($27,000 – $14,000) ÷ (10,000 units – 5,000 units)
C $3.20 per unit ($27,000 – $14,000 + 3,000 units  $1) ÷ (10,000 units – 5,000
units)
D $3.60 per unit ($27,000 – $14,000) ÷ (10,000 units – 5,000 units) + $1 (2 marks)
69 A manufacturing company always carries finished goods inventory equal to 20% of the next
month's budgeted sales.
Sales for the current month are 2,000 units and are budgeted to be 20% higher next month.
How many units will be produced in the current month?
A 2,080
B 1,920 (400 + 2,000 – 480)
C 2,000 (no adjustment)
D 2,400 (2,000 + 400) (2 marks)
70 Adams Co manufactures one product whose output level varies from month to month. No
inventory is held. The flexed budget is given below, together with actual figures for November
20X9.
Cost Flexed Budgeted
classification budget maximum Actual
Output 35,000 units 40,000 units 35,000 units
$ $ $
Sales revenue 700,000 800,000 735,000
Less
Direct materials Variable cost 420,000 480,000 430,000
Direct labour Variable cost 87,500 100,000 80,000
Indirect labour Semi-variable cost 22,500 25,000 31,000
Indirect materials Fixed cost 6,000 6,000 6,500
Profit 164,000 189,000 187,500

Required
(a) Calculate revenue, cost and profit variances for November 20X9. (5 marks)
(b) Explain the meaning of the terms fixed budget and flexible budget and the importance of
basing variance calculations on flexible budgeting principles. (5 marks)
(Total = 10 marks)

587

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PRACTICE QUESTION BANK

16 The budgetary process

71 What does the statement 'sales is the principal budget factor' mean?
A The level of sales will determine the level of cash at the end of the period.
B The level of sales will determine the level of profit at the end of the period.
C The company's activities are limited by the level of sales it can achieve.
D Sales is the largest item in the budget. (2 marks)
72 Which of the following is unlikely to be contained with a budget manual?
A Organisational structures
B Objectives of the budgetary process
C Selling overhead budget
D Administrative details of budget preparation (2 marks)
73 Which of the following is not a functional budget?
A Production budget
B Distribution cost budget
C Selling cost budget
D Cash budget (2 marks)
74 PQ Co plans to sell 24,000 units of product R next year. Opening inventory of R is expected to be
2,000 units and PQ Co plans to increase inventory by 25% by the end of the year. How many
units of product R should be produced next year?
A 23,500 units
B 24,000 units
C 24,500 units
D 30,000 units (2 marks)
75 Which one of these costs would not be included in the cash budget of a travel company?

Depreciation of computer terminals

Commission paid to travel agents
Capital cost of a new computer
Advertising expenses (2 marks)

17 Making budgets work

76 Which of the following statements about participative budgeting is/are false?
(i) Morale and motivation are improved.
(ii) They may cause managers to introduce budgetary slack.
(iii) They are quicker to produce than non-participative budgets.
A (i) and (ii) only
B (ii) and (iii) only
C (iii) only
D (i), (ii) and (iii) (2 marks)
77 Choose the appropriate words from those highlighted.
The correct approach to budgetary control is to compare actual/budgeted results with a budget
that has been flexed to the actual/budgeted level of activity. (2 marks)

588

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PRACTICE QUESTION BANK

78 What is goal congruence (in terms of organisational control systems)?

A When the goals of management and employees harmonise with the goals of the
organisation as a whole
B When the goals of management harmonise with the goals of employees
C When the work-related goals of management harmonise with their personal goals
D When an organisation's goals harmonise with those of its customers (2 marks)

18 Capital expenditure budgeting

79 Which of the following are examples of revenue expenditure?
(i) Purchasing inventory
(ii) Maintenance of production equipment
(iii) Purchasing a factory building
(iv) Paying employee salaries
A (i), (ii) and (iii) only
B (i), (ii) and (iv) only
C (i), (iii) and (iv) only
D (ii), (iii) and (iv) only (2 marks)

80 Build Co is a company that constructs office buildings and has decided that it will build its new
head office. Which of the following costs should be included in the recorded cost of the new
building?
(i) Raw materials
(ii) Labour costs
(iii) Related overhead costs
(iv) Legal costs that will be incurred to purchase the land
A All of them
B (i), (ii) and (iii) only
C (i), (iii) and (iv) only
D (ii), (iii) and (iv) only (2 marks)

81 Raven Co is considering a new investment and is following the steps of the decision-making and
control cycle. Which step of the cycle follows immediately after detailed evaluation?
A Project monitoring
B Post-completion audit
C Implementation
D Authorisation (2 marks)

19 Methods of project appraisal

82 Which method of investment appraisal leads to the selection of projects that maximise
shareholder wealth?
A Discounted payback
B Wealth rate of return
C Net present value
D Internal rate of return (2 marks)

589

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PRACTICE QUESTION BANK

83 The following information relates to a two-year project.

Initial investment $1 million
Cash inflow Year 1 $750,000
Cash inflow Year 2 $500,000
Cost of capital Year 1 10%
Cost of capital Year 2 15%
What is the net present value of the project (to the nearest $500)?
A ($12,000)
B ($55,000)
C $77,000
D $116,500 (2 marks)
84 HMF Co is evaluating a project which requires investments of $5,000 now and $2,000 at the
end of Year 1. The cash inflow will be $7,000 at the end of Year 2 and $6,000 at the end of
Year 3. Calculate the NPV to the nearest $. The cost of capital is 16%.
NPV $.................... (2 marks)
85 Which of the following statements are true?
(i) An investment with a positive NPV is viable.
(ii) IRR is technically superior to NPV.
(iii) Both IRR and NPV give the same accept or reject decision, regardless of the pattern of the
cash flows.
A (i) and (ii) only
B (i) and (iii) only
C (i) only
D (i), (ii) and (iii) (2 marks)
86 A company is considering investing $320,000 in a project which will generate the following cash
inflows.
Year Cash flow
1 $73,400
2 $282,000
3 $37,900
The net present value of the project's cash flows at a cost of capital of 17% is (to the nearest $)
$............... (2 marks)
87 A Co has three options for machine B. One of these options involves modifying the machine now
at a cost of $7,200, which will mean that the company does not have to hire an alternative
machine at a cost of $19,800. This modification would mean that machine B would have to be
disposed of in one year's time at a cost of $4,000. Ignoring the time value of money, calculate
the relevant cost of this option.
$............... (2 marks)
88 How much will an investor have after five years if they invest $5,000 at 12% simple interest per
annum?
$............... (2 marks)
89 If the interest rate is 8%, what would you pay for a perpetuity of $1,500 starting in one year's
time? (to the nearest $)
$............... (2 marks)

590

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PRACTICE QUESTION BANK

20 Standard costing
90 JC Co operates a bottling plant. The liquid content of a filled bottle of product T is 2 litres. During
the filling process there is a 30% loss of liquid input due to spillage and evaporation. The
standard price of the liquid is $1.20 per litre. The standard cost of the liquid per bottle of product
T, to the nearest cent, is:
A $2.40 C $3.12
B $2.86 D $3.43 (2 marks)
91 Standard costing provides which of the following? Tick all that apply.

(a) Targets and measures of performance

(b) Information for budgeting

(c) Simplification of inventory control systems

(d) Actual future costs (2 marks)

92 What is an attainable standard?

A A standard which includes no allowance for losses, waste and inefficiencies. It represents
the level of performance which is attainable under perfect operating conditions.
B A standard which includes some allowance for losses, waste and inefficiencies. It
represents the level of performance which is attainable under efficient operating
conditions.
C A standard which is based on currently attainable operating conditions.
D A standard which is kept unchanged, to show the trend in costs. (2 marks)

21 Cost variances
93 Which of the following would help to explain a favourable direct material price variance?
Would help Would not help
to explain to explain
variance variance
(a) The standard price per unit of direct material was
unrealistically high.

(b) Output quantity was greater than budgeted and it

was possible to obtain bulk purchase discounts.
(c) The material purchased was of a higher quality
than standard.
(2 marks)
94 Extracts from H Co's records for June are as follows.
Budget Actual
Production 3,936 units 3,840 units
Direct labour cost $15,744 $17,280
What is the total direct labour cost variance?
A $1,536 (F)
B $1,536 (A)
C $1,920 (F)
D $1,920 (A) (2 marks)

591

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95 A standard cost card for product Lee is given below.

$ per unit
Direct labour 4 hours at $12 per hour 48

In the most recent period, 2,000 units were produced. Direct labour was paid for 10,000 hours
and cost $130,000. The labour rate variance was $10,000 adverse and the labour efficiency
variance was $24,000 adverse.
It was subsequently discovered that of the 10,000 labour hours paid, 2,200 hours were idle due
to the late delivery of material.
Required
Using this new information:
(a) Calculate revised direct labour efficiency and idle time variances. (5 marks)
(b) Explain the meaning of the idle time variance. (2 marks)
(c) Suggest two actions the company could take to eliminate idle time variances. (3 marks)
(Total = 10 marks)
96 A company uses absorption costing for both internal and external reporting purposes, as it has a
considerable level of fixed production costs.
The following information has been recorded for the past year.
Budgeted fixed production overheads $2,500,000
Budgeted (normal) activity levels:
Units 62,500 units
Labour hours 500,000 hours

Actual fixed production overheads 2,890,350

Actual levels of activity:
Units produced 70,000 units
Labour hours 525,000 hours
Required
(a) Calculate the fixed production overhead expenditure and volume variances and briefly
explain what each variance shows. (5 marks)
(b) Calculate the fixed production overhead efficiency and capacity variances and briefly
explain what each variance shows. (5 marks)
(Total = 10 marks)

592

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PRACTICE QUESTION BANK

22 Sales variances and operating statements

97 W Co uses a standard absorption costing system. The following data relate to one of its products.

$ per unit $ per unit

Selling price 27.00
Variable costs 12.00
Fixed costs 9.00
21.00
Profit 6.00

Budgeted sales for control period 7 were 2,400 units, but actual sales were 2,550 units. The
revenue earned from these sales was $67,320.
Profit reconciliation statements are drawn up using absorption costing principles. What sales
variances would be included in such a statement for period 7?
Price Volume
A $1,530 (F) $900 (F)
B $1,530 (A) $900 (F)
C $1,530 (F) $900 (A)
D $1,530 (A) $900 (A) (2 marks)
98 A standard marginal costing system:
(i) Calculates fixed overhead variances using the budgeted absorption rate per unit
(ii) Calculates sales volume variances using the standard contribution per unit
(iii) Values finished goods stock at the standard variable cost of production
Which of the above statements is/are correct?
A (i), (ii) and (iii) C (ii) and (iii) only
B (i) and (ii) only D (i) and (iii) only (2 marks)
99 Diddly Co earned a profit of $305,000 in the last month. Variances were as follows.
Labour: Rate 15,250 (F)
Efficiency 10,750 (A)
Material: Usage 8,675 (A)
Price 9,825 (F)
Variable overheads: Efficiency 6,275 (A)
Expenditure 2,850 (F)
Fixed overheads: Expenditure 7,000 (F)
Sales: Price 25,000 (A)
Volume 32,000 (F)
What was Diddly Co's budgeted profit for last month?
A $321,225 C $371,925
B $288,775 D $254,300 (2 marks)

593

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PRACTICE QUESTION BANK

100 The B Co uses a standard absorption costing system and produces one product, the Blob. The
following information is available for September.
Standard cost per Blob $31
Budgeted sales (units) 7,100
Actual sales (units) 6,600
Sales price variance $1,250 (A)
Sales volume variance $4,500 (A)
Calculate the sales revenue for September .
A $256,750
B $252,250
C $262,750
D $265,250 (2 marks)

23 Performance measurement
101 The following information relates to P Limited at 31 December 20X0.
$
Inventories 1,550
Short-term payables 2,100
Receivables 1,300
Cash at bank 1,250
Which of the following is the quick ratio for P Limited to two decimal places?
A 1.95
B 1.21
C 0.62
D 0.74 (2 marks)
102 Which of the following is a non-financial performance measure?
A Share price
B Delivery time
C Cash flow
D Revenue (2 marks)
103 The following information relates to P Limited at 31 December 20X4.
$
Revenue 3,000
Gross profit 990
Net profit 450
Non-current assets 1,920
Calculate the net profit percentage.
A 15%
B 33%
C 66%
D 85% (2 marks)

594

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PRACTICE QUESTION BANK

104 The following information relates to P Limited at 31 December 20X7.

$
Revenue 3,000
Gross profit 990
Net profit 450
Inventory 125
Trade receivables 260
Cash 1,920
Calculate the accounts receivable payment period. (All sales are on credit.)
A 32 days
B 49 days
C 95 days
D 211 days (2 marks)
105 The directors of Donny Co are reviewing the performance of two of its divisions. The following
information is available for the year ending 31 March 20X9.
South division North division
$'000 $'000
Sales 50,000 3,200
Operating profit 700 840
Capital employed 3,500 4,000
South division is a food retailer that sells low priced food from a number of stores that are rented
on short-term contracts. North division sells luxury motor vehicles, which it manufactures in a
fully automated production plant.
Required
(a) Calculate the following performance measures for the two divisions.
(i) Return on capital employed (2 marks)
(ii) Return on sales (2 marks)
(iii) Asset turnover (based on capital employed) (2 marks)
(b) Suggest one reason for the differences between the two divisions in each of the following
ratios.
(i) Return on sales
(ii) Asset turnover (4 marks)
(Total = 10 marks)
106 Lewisville is a town with a population of 100,000 people. The town council of Lewisville
operates a bus service which links all parts of the town with the town centre. The service is non
profit seeking and its mission statement is 'to provide efficient, reliable and affordable public
transport to all the citizens of Lewisville.'
One member of the council has recently criticised the performance of the Lewisville bus service
compared with those operated by private sector bus companies in other towns. They have
produced the following information.
LEWISVILLE BUS SERVICE
SUMMARISED INCOME AND EXPENDITURE ACCOUNT
YEAR ENDING 31 MARCH 20X6
$'000 $'000
Passenger fares 1,200
Staff wages 600
Fuel 300
Depreciation 280
1,180
Surplus 20

595

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PRACTICE QUESTION BANK

SUMMARISED STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X6

$'000 $'000
Assets
Non-current assets (net) 2,000
Current assets
Inventory 240
Cash 30
270

270
2,270
Equity and liabilities
Ordinary share capital ($1 shares) 2,000
Reserves 210
2,210
Current liabilities 60
2,270

OPERATING STATISTICS FOR THE YEAR ENDED 31 MARCH 20X6

Total passengers carried 2,400,000 passengers
Total passenger miles travelled 4,320,000 passenger miles
Private sector bus companies industry average ratios
Year ended 31 March 20X6
Return on capital employed 10%
Average cost per passenger mile 37.4c
Required
(a) Calculate the following ratios for the Lewisville bus service.
(i) Return on capital employed (based on opening investment)
(ii) Average cost per passenger mile (2 marks)
(b) Explain the meaning of each ratio you have calculated. (2 marks)
(c) Another council member suggests that the performance of the bus service should be
assessed on the basis of economy, effectiveness and efficiency.
Required
Explain the meaning of the following terms in the context of performance measurement
and suggest a measure of each one appropriate to a bus service.
(i) Economy
(ii) Effectiveness
(iii) Efficiency (6 marks)
(Total = 10 marks)

24 Application of performance measures

107 Match the definition to the term.
Terms Definition
(a) Economy (1) Ensuring outputs succeed in achieving objectives
(b) Efficiency (2) Getting out as much as possible for what goes in
(c) Effectiveness (3) Spending money frugally
A a =1, b =2, c = 3
B c =1, b = 2, a = 3
C b = 1, c = 2, a = 3
D a = 1, c = 2, b = 3 (2 marks)

596

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PRACTICE QUESTION BANK

108 Which of the following is a feature of the residual income performance measure?
A It is a relative measure.
B It measures divisional performance based on multiple values.
C It generally decreases as assets get older.
D It helps you to select a proposal that will maximise wealth in absolute terms. (2 marks)
109 Which of the following is not a perspective associated with the balanced scorecard?
A Customer satisfaction
B Financial success
C Reliability
D Growth (2 marks)
110 In the last year a division's controllable return on investment was 25% and its controllable profit
was $80,000. The cost of finance appropriate to the division was 18% per annum.
What was the division's controllable residual income in the last year?
A $5,600 $80,000  (0.25 – 0.18)
B $22,400 $80,000 – ($80,000 ÷ 0.25  0.18)
C $74,400 $80,000 – ($80,000  (0.25 – 0.18)
D $76,400 $80,000 – ($80,000  0.25  0.18) (2 marks)
111 The following information is available for the month of June.
Budgeted hours 2,850 standard hours
Standard hours produced 3,150 standard hours
Actual hours worked 3,000
The following information is available for the month of July.
Budgeted hours 2,750 standard hours
Standard hours produced 2,800 standard hours
Actual hours worked 3,000
Calculate the percentage change in the activity ratio from June to July. Work to the nearest whole
percentage.
A 92%
B 8%
C 9%
D 109% (2 marks)
112 Match the statements to either cost control or cost reduction.
Terms Statement
(a) Cost control (1) Often carried out on an ad hoc basis
(b) Cost reduction (2) Directed towards reducing expected costs below
current or standard levels
(3) The regulation of the costs of operating a business
(4) Concerned with keeping costs within acceptable
limits
(2 marks)
113 Match the definition to the term.
Terms Definition
(a) Cost value (1) The market value of the product or service
(b) Exchange value (2) The cost of producing and selling an item
(c) Use value (3) The prestige the customer attaches to the product
(d) Esteem value (4) What the article does; the purpose it fulfils
(2 marks)

597

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PRACTICE QUESTION BANK

114 (1) Work measurement is the systematic recording and critical examination of existing and
proposed ways of doing work in order to develop and apply easier and more effective
methods, and reduce costs.
(2) Work study is a means of raising the production efficiency (productivity) of an operating
units by the reorganisation of work.
Which statements are true?
A Both are true.
B Both are false.
C (1) is true and (2) is false.
D (1) is false and (2) is true. (2 marks)
115 ML was formed three years ago to develop e-commerce systems and design websites for clients.
The company has expanded rapidly since then and now has a multi-site operation with bases in
the UK and overseas.
Techniques that are used in order to improve an organisation's performance include cost
reduction and value analysis.
Required
Explain these techniques and how they may be used by ML as part of its planning activities.
(10 marks)

598

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PRACTICE ANSWER BANK

1 Accounting for management

1 A Financial accounts (not management accounts) detail the performance of an organisation
over a defined period and the state of affairs at the end of that period. Management
accounts are used to aid management record, plan and control the organisation's activities
and to help the decision-making process.
2 C Diane and Joanne work at operational level, as they are concerned with routine activities.
Lesley is at an intermediate level and is managing resources. She is therefore part of
tactical management. Tracey is concerned with direction setting for the business and is
therefore part of strategic management.
3 D Cost accounting can also be used to provide inventory valuations for external reporting.
4 C Obtaining data about actual results is part of the control process.

2 Sources of data
5 B Systematic sampling is a sampling method which works by selecting every nth item (or
mth in this case) after a random start.
6 B The sample selected will be representative since it guarantees that every important
category will have elements in the final sample. So I is true. The structure of the sample
will reflect that of the population if the same proportion of individuals is chosen from each
stratum. So II is true. The main disadvantage of stratification is that it requires prior
knowledge of each item in the population. So III is true.
7 B An eyewitness's account is primary data and the number of customers is discrete data. A
report in a newspaper is secondary data. A website is secondary data and height is
continuous data. Distance is continuous data.
8 D Quota sampling is cheap and administratively easy so A and B are false. No sampling
frame is necessary because the interviewer questions every person they meet up to the
quota, so C is false. The method can result in certain biases. For example, an interviewer
in a shopping centre may fill their quota by only meeting people who can go shopping
during the week.
9 C The heights of lampposts is an example of quantitative data, as they can be measured.
Since the lampposts can take on any height, the data is continuous. You should have been
able to eliminate options B and D immediately since qualitative data are data that cannot
be measured but which reflect some quality of what is being observed.

3 Cost classification
10 D It would be appropriate to use the cost per invoice processed and the cost per supplier
account for control purposes. Therefore items (ii) and (iii) are suitable cost units and the
correct answer is D.
Postage cost, item (i), is an expense of the department, therefore option A is not a suitable
cost unit.
If you selected option B or option C you were probably rushing ahead and not taking care
to read all the options. Items (ii) and (iii) are suitable cost units, but neither of them are
the only suitable suggestions.
11 A Special designs and the hire of tools etc for a particular job can be traced to a specific cost
unit. Therefore they are direct expenses and the correct answer is A.
Item (iii) is a selling and distribution overhead and item (iv) describes production
overheads.

599

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PRACTICE ANSWER BANK

Appropriate Not appropriate

12 (a) Vehicle cost per passenger-
kilometre 
(b) Fuel cost for each vehicle
per kilometre 
(c) Fixed cost per kilometre 
13 B A direct cost is one that can be directly related to a unit of output; an unavoidable cost is
one that would be incurred whether or not a certain activity took place.
14 D The deliveries occur after a sale is made, therefore drivers' wages are a selling and
distribution overhead. Options A, B and C are all a part of production cost, incurred before
an item is sold.

4 Cost behaviour
15 A Variable costs are conventionally deemed to increase or decrease in direct proportion to
changes in output. Therefore the correct answer is A. Descriptions B and D imply a
changing unit rate, which does not comply with this convention. Description C relates to a
fixed cost.
16 B The cost depicted begins as a linear variable cost, increasing at a constant rate in line with
activity. At a certain point the cost becomes fixed regardless of the level of activity. The
vehicle hire costs follow this pattern.
Graphs for the other options would look like this.
$ $
Total
Total
cost Cost

Level of activity
Option A Option C

$
Total
cost

Level of activity
Option D

17 (a) FIXED COST

(b) VARIABLE COST
(c) STEPPED FIXED COST
(d) SEMI-VARIABLE COST

600

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PRACTICE ANSWER BANK

18 D Bob cannot control the rent within the six-month period, as he is unable to get out of
the agreement during this time, therefore the rent is an uncontrollable cost.
Rent is not a fixed cost, as the landlord may change it during the period.
Bob has agreed to pay the rent therefore he cannot avoid it (that is, rent is not an
unavoidable cost).
A semi-variable cost comprises a fixed and a variable element, which is not the case with
Bob Co's rent.
19 The total cost for period 3 if 15,500 square metres are decorated is $ 58,250
The first step is to eliminate the extra fixed costs from period 2 total costs so that we are
comparing 'like with like'.
Total costs with no extra fixed costs = $56,000 - $6,000 = $50,000
We can now use the high-low method in the usual way to calculate variable cost per unit.
Square metres $
High output 14,000 Total cost 50,000
Low output 10,000 Total cost 44,000
4,000 6,000

Variable cost per square metre = $6,000/4,000 = $1.50

Using the high level to calculate fixed costs:
$
Total costs 56,000 (includes the step up in fixed costs)
Total variable costs 21,000 (14,000 square metres × $1.50 per sq m)
Total fixed costs 35,000

Total cost for 15,500 square metres:

$
Total variable costs 23,250 (15,500 square metres × $1.50)
Total fixed costs 35,000 (see above)
Total costs 58,250

5 Presenting information
20 A
Material Cost $ Percentage % Degrees

P 1,000 33.3 120

Q 600 20 72*
R 1,025 34.2 123
S 375 12.5 45
3,000 100 360
*600/3,000 × 360o = 72o

21 D The best diagram to draw to highlight the differences between areas is a simple bar
chart. A simple bar chart is a chart consisting of one or more bars, in which the
length of each bar indicates the magnitude of the corresponding data items. This is
the best diagram to draw to highlight the differences of typical salaries in different
areas.
22 B Pie charts illustrate the way in which one or more totals are broken down into their
components.

601

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PRACTICE ANSWER BANK

6 Accounting for materials

2  $400  (250  48)
23 D EOQ = = 2,191
$20  10%

Therefore the correct answer is D.

If you selected option A you used weekly usage in the calculations instead of the annual
usage.
If you selected option B you did not take 10% of the material cost as the annual inventory
holding cost.
If you selected option C you omitted the 2.
24 D The easiest way to solve this question is to draw up a stores ledger control account.
STORES LEDGER CONTROL ACCOUNT
$ $
Opening inventory b/f 18,500 Payables (returns) 2,300
Payables/cash (deliveries) 142,000 Overhead account (indirect
materials) 25,200
WIP (balancing figure) 116,900
Closing inventory c/f 16,100
160,500 160,500

If you selected option C you determined the correct value of the direct materials issued but
you reversed the entries.
If you selected options A or B you placed the figure for returns on the wrong side of your
account, and in option A you reversed the entries for the issue of direct materials from
stores.
25 The maximum inventory level is 9,600 units.
Reorder level = maximum usage × maximum lead time
= 195 × 30 = 5,850 units
Maximum inventory level = reorder level + reorder quantity – (minimum usage ×
minimum lead time)
= 5,850 + 6,000 – (90 × 25)
= 9,600 units
26 B Using FIFO, the issue on 9 September would consist of the remaining 60 units from the
opening balance (40 units were issued on 3 March) plus 10 units from the batch received
on 4 June.
$
60 units  $5 300
10 units  $5.50 55
355

If you selected option A you used the opening inventory rate of $5 for all the units issued:
you didn't notice that 40 of these units had already been issued on 3 March.
If you selected option C you ignored the opening inventory and based your calculations
only on the receipts during the year.
Option D is incorrect because it values all the issues at the latest price paid, $6 per unit.

602

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PRACTICE ANSWER BANK

27 C Using LIFO, the issue on 9 September would consist of the 50 units received on 6 June,
plus 20 of the units received on 4 June.
$
50 units  $6 300
20 units  $5.50 110
410

Option A is incorrect because it is based on the opening inventory rate of $5 per unit –
this is certainly not the latest batch received.
Option B is a FIFO calculation based on the receipts on 4 and 6 June.
Option D is incorrect because it values all the issues at the latest price paid, $6 per unit.
However, there were only 50 units in this batch. The price for the remaining 20 units
issued is the $5.50 per unit paid for the next latest batch received.
28 C [Buffer inventory + (EOQ/2)] × annual holding cost per component
= [1,250 + (5,000/2)] × $5
= $18,750

7 Accounting for labour

29 B The only direct costs are the wages paid to direct workers for ordinary time, plus the basic
pay for overtime.
$25,185 + $5,440 = $30,625.
If you selected option A you forgot to include the basic pay for overtime of direct workers,
which is always classified as a direct labour cost.
If you selected option C you have included overtime premium and shift allowances, which
are usually treated as indirect costs. However, if overtime and shift work are incurred
specifically for a particular cost unit, then they are classified as direct costs of that cost
unit. There is no mention of such a situation here.
Option D includes sick pay, which is classified as an indirect labour cost.
30 B The credit balance on the wages control account indicates that the amount of wages
incurred and analysed between direct wages and indirect wages was higher than the
wages paid through the bank. Therefore there was a $12,000 balance of wages owing at
the end of February and statement B is not correct. Therefore the correct option is B.
Statement A is correct. $128,400 of wages was paid from the bank account.
Statement C is correct. $79,400 of direct wages was transferred to the work in progress
control account.
Statement D is correct. $61,000 of indirect wages was transferred to the production
overhead control account.
31 The capacity ratio for the period was 137.5 %
Actual hours worked
Labour capacity ratio = × 100% = (68,750/50,000) × 100% =
Hours budgeted
137.5%

603

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PRACTICE ANSWER BANK

32 The production volume ratio for the period was 125 %

Output measured in expected

or standard hours
Production volume ratio =
Hours budgeted

 12,500×5 hours 
=    100%
 50,000 
= 125%
[Expected hours per unit = budgeted hours (50,000 units) / budgeted output (10,000)]
33 The labour turnover rate for the period is 9 %.
Replacements
Labour turnover rate =  100%
Average number of employees in period

Average number of employees = (500 +[500 – 70 + 46])/2 = 488

Labour turnover rate = (46/488)  100% = 9%
34 A Number of units qualifying for payment = 250 – 31
= 219
Piecework payment to be made:
$
First 100 units @ $0.25 25.00
Next 100 units @ $0.35 35.00
Last 19 units @ $0.45 8.55
68.55

Option B is not correct because it includes payment for the 31 rejected units. If you
selected option C you calculated the correct number of units qualifying for payment, but
you evaluated all of them at the higher rate of $0.45 per unit. Option D is incorrect
because it includes the 31 rejected units, and evaluates them all at the higher rate of
$0.45 per unit.

8 Accounting for overheads

budgeted overheads $148,750
35 B Overhead absorption rate = = = $17.50 per hour
budgeted labour hours 8,500

If you selected option A you divided the actual overheads by the budgeted labour hours.
Option C is based on the actual overheads and actual labour hours. If you selected option
D you divided the budgeted overheads by the actual hours.

36 D $
Overhead absorbed = $17.50  7,928 = 138,740
Overhead incurred = 146,200
Under-absorbed overhead = 7,460

If you selected options A or B you calculated the difference between the budgeted and
actual overheads and interpreted it as an under or over absorption. If you selected option
C you performed the calculations correctly but misinterpreted the result as an over
absorption.

604

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37 (a) % of direct material cost = 112.5%

(b) % of direct labour cost = 90%

(c) % of total direct cost = 50%

(d) Rate per machine hour = $3.60

(e) Rate per direct labour hour = $2

Workings

$36,000
(a) % of direct materials cost  100% = 112.5%
$32,000

$36,000
(b) % of direct labour cost  100% = 90%
$40,000

$36,000
(c) % of total direct cost  100% = 50%
$72,000

$36,000
(d) Rate per machine hour = $3.60 per machine hour
10,000 hrs

$36,000
(e) Rate per direct labour hour = $2 per direct labour hour
18,000 hrs

38 A All of the overhead absorption methods are suitable, depending on the circumstances.
Method (i), direct labour hours, is suitable in a labour-intensive environment. Method (ii),
machine hours, is suitable in a machine-intensive environment. Method (iii), a percentage
of prime cost, can be used if it is difficult to obtain the necessary information to use a
time-based method. Method (iv), a rate per unit, is suitable if all cost units are identical.
39 C The insurance cost is likely to be linked to the cost of replacing the machines, therefore
the most appropriate basis for apportionment is the value of machinery.
Options A, B and D would all be possible apportionment bases in the absence of better
information, but option C is preferable.

40 D $127,000
Production Production
centre A centre B C D
$ $ $ $
Overhead costs 95,000 82,000 46,000 30,000
First C apportionment 18,400 18,400 (46,000) 9,200
0 39,200
First D apportionment 11,760 23,520 3,920 (39,200)
3,920 0
Second C apportionment 1,568 1,568 (3,920) 784
0 784
Second D apportionment 235 471 78 (784)
78 0
Third C apportionment 31 31 (78) 16
0 16
Third D apportionment 6 10 0 (16)
(approx)
127,000 126,000 0 0

605

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9 Absorption and marginal costing

41 C Difference in profit = change in inventory level  fixed overhead per unit
= (200 – 250)  ($2.50  3)
= $375
The absorption costing profit will be greater because inventories have increased.
If you selected option A you calculated the correct profit difference but the absorption
costing profit would be greater because fixed overheads are carried forward in the
increasing inventory levels.
If you selected option B you multiplied the inventory difference by the direct labour-hour
rate instead of by the total overhead cost per unit, which takes three hours.
If you selected option D you based the profit difference on the closing inventory only (250
units  $2.50  3).
42 OAR = Budgeted fixed costs / budgeted prod'n volume = $328,000/70,000 = $4.69
Closing inventory volume = 70,000 units – 50,000 units
= 20,000 units
Value of closing inventory = 20,000 units × ($21 + $4.69)
= $513,800

43
$ $
Sales (at $40 per unit) 600,000
Opening inventory –
Variable production cost ($25  20,000) (W1) 500,000
Less closing inventory ($25  5,000) 125,000
Variable cost of sales 375,000

Contribution 225,000
Less fixed costs 80,000
Profit 145,000

W1 Variable production cost per unit = Total cost per unit – fixed cost per unit
= $30 – ($125,000/25,000 units) = $25 per unit
44 D Units
Opening inventory 900
Closing inventory 300
Decrease 600 × ($500,000/2,500) = $120,000 lower
Profit under absorption costing = $800,000 – $120,000 = $680,000
45 D 2,000 more units of product have been produced than sold, resulting in the same increase
in inventory levels.
Closing inventories will not include any fixed overheads where marginal costing is used, as
they are written off in the period incurred.
However, where absorption costing is used, $5 of additional fixed cost will be included per
unit of increase in inventory over the period, accounting for the profit being $10,000
higher under this method for the period.

606

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10 Job, batch and service costing

46  Production of the product can be completed in a single accounting period.

 Production relates to a single special order.

Job costing is appropriate where each cost unit is separately identifiable and is of
relatively short duration.

47 (i) Production is carried out in accordance with the wishes of the customer. J

(ii) Work is usually of a relatively long duration. C

(iii) Work is usually undertaken on the contractor's premises. N

(iv) Costs are averaged over the units produced in the period. S

(v) It establishes the costs of services rendered. S

48 D
Hours for job 34679 = 400 hours
Production overhead cost $4,000
 Overhead absorption rate ($4,000  400) $10 per direct labour hour
Budgeted direct labour hours 45,000
 Total budgeted production overheads $450,000
Budgeted direct wages cost $180,000
 Absorption rate as % of wages cost = $450,000/$180,000 × 100%
= 250%
Cost of job 34679
$
Direct materials 2,000
Direct labour, including overtime premium * 2,500
Overhead (250% × $2,500) 6,250
Total production cost 10,750

* The overtime premium is a direct labour cost because the overtime was worked
specifically for this job.
If you selected option A you got your calculation of the overhead absorption rate 'upside
down' and derived a percentage rate of 40% in error. If you selected option B you did not
include the overtime premium and the corresponding overhead. If you selected option C
you did not include the overtime premium in the direct labour costs.
49 A Job costing is a costing method applied where work is undertaken to customers' special
requirements. Option B describes process costing, C describes service costing and D
describes process costing.

11 Process costing
50 C Step 1. Determine output and closing WIP
Equivalent units of production
Input Output Total Process X Conversion costs
Units Units Units % Units %
2,000 Finished units 1,600 1,600 100 1,600 100
Closing inventory (bal) 400 400 100 200 50
2,000 2,000 2,000 1,800

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Step 2. Calculate cost per unit of output and WIP

Equivalent Cost per
Input Cost units equivalent unit
$ $
Process X material 8,000 2,000 4.00
Conversion costs 12,240 1,800 6.80
10.80

Step 3. Calculate total cost of closing WIP

Using the unit rates from answer (a) step 2:
Cost Number of Cost per
element equivalent units equivalent unit Total
$ $
Work in progress Process X material 400 4.00 1,600
Conversion costs 200 6.80 1,360
2,960

If you selected option A you only included the conversion costs in your calculation. If you
selected option B you did not account for the fact that closing WIP was fully complete for
materials and multiplied total cost per equivalent unit by 200. Option D does not allow for
the fact that the work in progress (WIP) is incomplete when calculating the total cost of
WIP.
51 A Abnormal gain 1,000 litres and cost per unit $0.15
PROCESS ACCOUNT
Litres $ Litres $
Materials 20,000 4,400 Normal waste
(4,000  $0.50) 4,000 2,000
Finished goods 17,000 2,550
Abnormal gain 1,000 150
21,000 4,550 21,000 4,550

Workings
Normal loss = 20%  20,000 litres = 4,000 litres
Expected output = 20,000 – 4,000 = 16,000 litres
Process costs – scrap proceeds of normal loss
Cost per unit =
Expected output
$4,400  (4,000  $0.50)
=
16,000 litres
$4,400  $2,000
=
16,000 litres
$2,400
=
16,000 litres
= $0.15
52 The quantity of good production achieved was 2,625 kg.
Good production = input – normal loss – abnormal loss
= 3,000 – (10% × 3,000) – 75
= 3,000 – 300 – 75
= 2,635 kg

608

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53 The value of the abnormal loss for the period is $ 300

kg
Input 5,000
Normal loss (10%  5,000 kg) (500)
Abnormal loss (300)
Output 4,200

Input costs  scrap value of normal loss

Cost per kg =
Expected output
$4,600*  $100
=
5,000  500
$4,500
= = $1.00
4,500

Value of abnormal loss = 300  $1.00 = $300

$
* Materials (5,000 kg  0.5) 2,500
Labour 700
Production overhead 1,400
4,600

54 C Abnormal losses have the same value as good production.

12 Process costing, joint products and by-products

55 C Net process costs
$
Raw materials 90,000
Conversion costs 70,000
Less by-product revenue (4,000)
Net process costs 156,000

Apportionment of net process costs

Units Apportioned costs
$ $
Product J 2,500 $156,000  (2,500/8,000) 48,750
K 3,500 $156,000  (3,500/8,000) 68,250
L 2,000 $156,000  (2,000/8,000) 39,000
8,000 156,000

If you selected option A or B you apportioned a share of the process costs to the by-
product, and with option B or D you did not deduct the by-product revenue from the
process costs.
56 A Workings

Joint product Sales revenue

$
A 760,000 ($38  20,000)
B 2,160,000 ($54  40,000)
C 1,400,000 ($40  35,000)
Total sales revenues 4,320,000

Joint costs to be allocated = Total output costs – sales revenue from by-product D
= $4,040,000 – $80,000 ($4 × 20,000)

609

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= $3,960,000
$2,160,000
Costs allocated to joint product B =  $3,960,000
$4,320,000
= $1,980,000

$1,980,000
Unit valuation (joint product B) =
40,000
= $49.50 (to 2 decimal places)
If you selected option B, you forgot to deduct the sales revenue (from by-product D) from
the joint costs to be allocated.
If you selected option C, you excluded by-product D from your calculations completely.
If you selected option D, you divided the total sales revenue (instead of the joint costs to
be allocated) by the number of units of joint product D.
57 The correct answer is $360,000.
Remember to allocate costs according to sales value of production rather than sales value
of units sold.
Sales value of production: $
Gary (20,000 units  $50) 1,000,000
Howard (15,000  $40) 600,000
Jason (10,000  $90) 900,000
2,500,000
Common costs allocated to Howard = ($600,000/$2,500,000)  $1,500,000
= $360,000

13 Alternative costing principles

58 C Reduced customer service. The TQM philosophy includes accepting that the only thing
that matters is the customer.
59 D 1: Short-term variable overhead costs vary with the volume of activity, and should be
allocated to products accordingly.
2: This statement is not completely correct. Many overhead costs, traditionally regarded
as fixed costs, vary in the long run with the volume of certain activities, although they do
not vary immediately. The activities they vary with are principally related to the complexity
and diversity of production, not to sheer volume of output. For example, set-up costs vary
in the long run with the number of production runs scheduled, not the number of units
produced.
3: For example, the number of credit investigations undertaken within the credit review
department of a bank would be the cost driver of the department's costs.
4: Following on from 3 above, a mortgage might require three credit investigations and
therefore the mortgage should bear the proportion of the departments' costs reflected by
three credit investigations.
60 B Quality control. Note that inspection is concerned with looking at products made or
supplies delivered to establish whether they are up to specification.

14 Forecasting
61 B As this is a multiplicative model, the seasonal variations should sum (in this case) to 4 (an
average of 1) as there are four quarters.
Let x = seasonal variation for quarter 4.

610

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0.45 + 1.22 + 1.31 + x = 4

2.98 + x = 4
x = 4 – 2.98
= 1.02
If you selected option A you subtracted the sum of the seasonal variations from 3 instead
of 4.
If you selected option D, you forgot to subtract the sum of the seasonal variations for
quarters 1-3 from 4.
62 D If C = 1,000 + 250P, then fixed costs are $1,000 and variable costs are $250 per unit.
63 D The correlation coefficient of 0.9 is very close to 1 and so there is a very strong
relationship between x and y.
64 B It does not matter what the sign of the correlation coefficient is – the size of the
correlation coefficient between C and D (0.7) is larger than that between A and B (0.4)
therefore the relationship between C and D is stronger than between A and B.
65 C The calculation in C applies the relative increase in the price index to the specific material
X.
66 B The least squares method of linear regression analysis involves using the following
formulae for a and b in Y = a + bX.
n  XY  X  Y
b =
n  X 2 (  X)2
(5  8,104)  (100  400)
=
(5  2,040)  100 2
40,520  40,000
=
10,200  10,000
520
=
200
= 2.6
At this stage, you can eliminate options A and C.
Y X
a = b
n n
400 100
= – 2.6  ( )
5 5
= 28

15 Budgeting
67 B Co-ordination (i) is an objective of budgeting. Budgets help to ensure that the activities of
all parts of the organisation are co-ordinated towards a single plan. Communication (ii) is
an objective of budgeting. The budgetary planning process communicates targets to the
managers responsible for achieving them, and it should also provide a mechanism for
junior managers to communicate to more senior staff their estimates of what may be
achievable in their part of the business. Expansion (iii) is not in itself an objective of
budgeting. Although a budget may be set within a framework of expansion plans, it is
perfectly possible for an organisation to plan for a reduction in activity. Resource allocation
(iv) is an objective of budgeting. Most organisations face a situation of limited resources
and an objective of the budgeting process is to ensure that these resources are allocated
among budget centres in the most efficient way.

611

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68 A The calculation in A uses the high-low method but adjusts for the additional variable
element over 7,000 units (by subtracting the affected 3,000 units of $1 each).
If you selected B then you did not take into account the increase in the variable element
for above 7,000 units.
If you selected C then you added instead of subtracted 3,000 units to adjust for the
increase in the variable element.
If you selected D you performed an unadjusted high-low calculation initially and added the
increase in variable element per unit at the end.
69 A The correct calculation is as follows.
Units Comment
Sales 2,000 Current month sales
Less opening inventory (400) 20% of sales (2,000) in the current month
Add closing inventory 480 20% of budgeted sales (2,400  20% =
480)
2,080

70 (a) Flexed budget variances November 20X9

Budget Actual Variance
Output units 35,000 35,000
$
Sales revenue 700,000 735,000 35,000 favourable
Less
Direct materials 420,000 430,000 10,000 adverse
Direct labour 87,500 80,000 7,500 favourable
Indirect labour 22,500 31,000 8,500 adverse
Indirect materials 6,000 6,500 500 adverse
Profit 164,000 187,500 23,500 favourable

(b) Meaning of terms

A fixed budget
A fixed budget is a financial expression of a plan of action based on a single activity level.
A flexible budget
A flexible budget is a financial expression of a plan of action which, by recognising cost
behaviour patterns, is designed to change as the volume of activity changes.
Importance of calculating variances from flexible budgets
Variances show the difference (adverse or favourable) between actual results and budgets
and are used in measuring and controlling performance. In calculating variances it is
important that like is compared with like. This is particularly true in the case of variable
costs. If output level is, for example, higher than originally forecast, we would expect
variable costs such as direct materials to be higher than we originally anticipated, simply
because we have produced more output. By flexing the budget we can allow for changes
in costs caused by changes in volume. A variance calculated against the flexed budget will
therefore exclude changes caused by changes in volume, leaving only variances due to
efficiency and price effects.

16 The budgetary process

71 C The principal budget factor is the factor which limits the activities of an organisation.
Although cash and profit are affected by the level of sales (options A and B), sales is not
the only factor which determines the level of cash and profit.

612

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72 C This is a detail budget.

73 D A functional budget is a budget prepared for a particular function or department. A cash
budget is the cash result of the planning decisions included in all the functional budgets. It
is not a functional budget itself. Therefore the correct answer is D.
The production budget (option A), the distribution cost budget (option B) and the selling
cost budget (option C) are all prepared for specific functions, therefore they are functional
budgets.
74 C Units
Required for sales 24,000
Required to increase inventory (2,000 × 0.25) 500
24,500
If you selected option A you subtracted the change in inventory from the budgeted sales.
However, if inventories are to be increased then extra units must be made for inventory.
Option B is the budgeted sales volume, which would only be equal to budgeted production
if there were no planned changes to inventory volume.
If you selected option D you increased the sales volume by 25%, instead of adjusting
inventory by this percentage.

75  Depreciation of computer terminals

Depreciation is not a cash flow, so it would not be included in a cash budget.

17 Making budgets work

76 C (i) and (ii) are true but (iii) is false because participative budgets consume more time than
non-participative budgets.
77 The correct approach to budgetary control is to compare actual results with a budget that has
been flexed to the actual level of activity.
78 A When the goals of management and employees harmonise with the goals of the
organisation as a whole

18 Capital expenditure budgeting

79 B Purchasing a building would be classed as capital expenditure. Expenditure on
maintaining the earning capacity of non-current assets is classed as revenue expenditure.
80 A All the costs can be included in the recorded cost of a self-constructed non-current asset.
81 D Authorisation follows detailed evaluation in the decision-making and control cycle.

19 Methods of project appraisal

82 C The main benefit of using net present value is that it maximises shareholder wealth.
83 C Discounting at 10% for one year = 1/1.10 and for two years = 1/1.10 × 1/1.10 but if
the interest changes in year 2 to 15% then the discount rate is 1/1.10 × 1/1.15.

Year Cash flow PV factor PV

0 ($1,000,000) 1 ($1,000,000)
1 $750,000 1/1.10 = 0.909 $681,750
2 $500,000 1/1.0 × 1/1.15 = 0.909 × 0.870 $395,415
NPV = $77,165

613

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Alternatively:
NPV = –$1,000,000 + $750,000/1.10 + $500,000/(1.10  1.15)
= $77,000 (to the nearest $500)
84 $2,323
Net present value
Year Cash flow Discount factor Present value
$ $
0 (5,000) 1.000 (5,000)
1 (2,000) 0.862 (1,724)
2 7,000 0.743 5,201
3 6,000 0.641 3,846
Net present value 2,323

85 C It is true that an investment with a positive NPV is financially viable. The IRR is not
superior to the NPV. NPV and IRR only give the same accept or reject decision when the
cash flows are conventional.
86 ($27,451)
Year Cash flow DCF PV
$ $
0 (320,000) 1 (320,000)
1 73,400 0.855 62,757
2 282,000 0.731 206,142
3 37,900 0.624 23,650
NPV (27,451)
87 Modification = $7,200, hire costs avoided = $(19,800) and disposal costs = $4,000
and so the relevant cost is a saving of $8,600.
88 $8,000. Interest = $5,000 × 12% × 5 years = $3,000.
Total value of investment = 5,000 + 3,000 = 8,000.
89 $18,750. $1,500/0.08 = $18,750

20 Standard costing
100
90 D Required liquid input = 2 litres × = 2.86 litres
70
Standard cost of liquid input = 2.86 × $1.20 = $3.43 (to the nearest cent)
If you selected option A you made no allowance for spillage and evaporation. Option B is
the figure for the quantity of material input, not its cost. If you selected option C you
simply added an extra 30% to the finished volume. However, the wastage is 30% of the
liquid input, not 30% of output.

91 (a) Targets and measures of performance 

(b) Information for budgeting 
(c) Simplification of inventory control systems 
(d) Actual future costs

Standard costing provides targets for achievement, and yardsticks against which actual
performance can be monitored (item (a)). It also provides the unit cost information for
evaluating the volume figures contained in a budget (item (b)). Inventory control systems
are simplified with standard costing. Once the variances have been eliminated, all
inventory units are evaluated at standard price (item (c)).

614

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Item (d) is incorrect because standard costs are an estimate of what will happen in the
future, and a unit cost target that the organisation is aiming to achieve.
92 B An attainable standard assumes efficient levels of operation, but includes allowances
for normal loss, waste and machine downtime.
Option A describes an ideal standard.
Option C describes a current standard.
Option D describes a basic standard.

21 Cost variances
93 Would help Would not help
to explain to explain
variance variance
(a) The standard price per unit of direct material was
unrealistically high. 
(b) Output quantity was greater than budgeted and it was
possible to obtain bulk purchase discounts.

(c) The material purchased was of a higher quality than 
standard.
Statement (a) is consistent with a favourable material price variance. If the standard is
high then actual prices are likely to be below the standard.
Statement (b) is consistent with a favourable material price variance. Bulk purchase
discounts would not have been allowed at the same level in the standard, because
purchases were greater than expected.
Statement (c) is not consistent with a favourable material price variance. Higher quality
material is likely to cost more than standard, resulting in an adverse material price
variance.
94 D Standard labour cost per unit = $15,744/3,936 units = $4 per unit
$
Standard direct labour cost for 3,840 units ( $4) 15,360
Actual direct labour cost 17,280
1,920 (A)

95 (a) Idle time and revised efficiency variances

Idle time variance
2,200 hours × $12 per hour $26,400 (A)
Revised efficiency variance
2,000 units should have taken × 4 hours per unit 8,000 hours
but did take 7,800 hours
Variance in hours 200 hours (F)
× standard rate per hour ×$12
Labour efficiency variance 2,400 (F)

(b) Meaning of variances

Idle time variances are caused by workers being paid while they are not working. In this
situation, hours paid exceed hours worked and the idle time variance is the difference
between these two figures evaluated at the standard wage rate per hour.

615

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(c) Eliminating idle time variances

Idle time variances are caused by paying workers while they are not working. This is
commonly due to late delivery of materials or machine breakdowns.
They can be eliminated in several ways.
If the company employed its workers on a piecework basis, then no wage cost would be
incurred while workers were idle. As idle time is usually outside the control of the
workforce and this could be considered ethically unacceptable.
Secondly, management could take steps to prevent idle time occurring. These could
include:
(i) Carrying high levels of raw material and work in progress inventory to protect
against late deliveries or machine breakdowns
(ii) Including clauses in supplier contracts whereby the supplier bears any costs which
may be caused to the company due to late deliveries
(iii) Taking steps to avoid machine breakdowns, such as regular maintenance
programmes
Thirdly, an allowance for idle time could be built into the standard labour cost.
(only two actions were required)

$2,500,000
96 (a) Fixed overhead absorption rate = = $40 per unit
62,500 units

This variance represents an under absorption of fixed production overheads.

Fixed production overhead total variance
$
Fixed production overhead incurred 2,890,350
Fixed production overhead absorbed (70,000 units  $40) 2,800,000
Fixed production overhead total variance 90,350 (A)

Fixed production overhead expenditure variance

$
Budgeted fixed production overhead expenditure 2,500,000
Actual fixed production overhead expenditure 2,890,350
Fixed production overhead expenditure variance 390,350 (A)

This variance shows that actual fixed production expenditure was greater than budgeted
fixed production expenditure.
Fixed production overhead volume variance
$
Actual production at standard rate (70,000 units  $40 per unit) 2,800,000
Budgeted production at standard rate (62,500 units  $40 per unit) 2,500,000
300,000 (F)

This variance shows that production levels (volumes) were greater than expected
(budgeted).
The fixed production overhead volume variance can be subdivided into an efficiency
variance and a capacity variance.

616

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(b) Fixed production overhead volume efficiency variance

$
70,000 units should take ( 8 hours (see W1)) 560,000 hrs
but did take 525,000 hrs
Actual fixed production overhead expenditure 35,000 hrs (F)
 standard fixed overhead absorption rate per hour (see (W2))  $5
175,000

This variance shows that the workforce worked more efficiently than expected; they took
less time than expected to produce 70,000 units.
Workings
500,000 hours
1 Budgeted hours per unit = = 8 hours per unit
62,500 units

£2,500,000
2 Fixed overhead absorption rate = = $5 per hour
500,000 units

Fixed production overhead volume capacity variance

$
Budgeted hours for work 500,000 hrs
Actual hours of work 525,000 hrs
25,000 hrs (F)
 fixed overhead absorption rate per hour (W2 above)  $5
125,000 (F)

This variance shows that the labour force worked more hours than originally planned.
$
PROOF Fixed production overhead volume efficiency variance 175,000 (F)
Fixed production overhead volume capacity variance 125,000 (F)
Fixed production overhead volume variance (part (a)) 300,000 (F)

22 Sales variances and operating statements

97 B
$
Revenue from 2,550 units should have been ( $27) 68,850
but was 67,320
Sales price variance 1,530 (A)

Actual sales 2,550 units

Budgeted sales 2,400 units
Variance in units 150 units (F)
 standard profit per unit ($(27 – 12))  $6
Sales volume variance in $ $900 (F)
If you selected option A, C or D, you calculated the monetary values of the variances
correctly, but misinterpreted their direction.
98 C Statement (i) is not correct. Fixed overhead is not absorbed into production costs in a
marginal costing system.
Statement (ii) is correct. Sales volume variances are calculated using the standard
contribution per unit (and not the standard profit per unit which is used in standard
absorption costing systems).
Statement (iii) is correct. As stated above, fixed overhead is not absorbed into production
costs in a marginal costing system.

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99 B Remember you are working in reverse (you have been given actual profit), so all adverse
variances have to be added back to actual profit and favourable variances deducted to
arrive at budgeted profit.
Fav. Adv.
$ $ $
Actual profit 305,000
Variances:
Labour: Rate (15,250)
Efficiency 10,750
Material: Price (9,825)
Usage 8,675
Variable overheads: Efficiency 6,275
Expenditure (2,850)
Fixed overheads: Expenditure (7,000)
Sales: Price 25,000
Volume (32,000)
(66,925) 50,700
Net favourable variance (16,225)
Budgeted profit 288,775

100 C Sales volume variance

Should have sold 7,100 units
but did sell 6,600 units
500 units (A)
× unit profit margin × $p
4,500 (A)
So unit profit margin = 4,500/500 = $9
Sales price variance
Selling price = cost + profit margin = $31+$9 = $40
$
Sales revenue from 6,600 units should have been (× $40) 264,000
but was ?
1,250(A)

Sales revenue = $264,000 – $1,250

= $262,750

23 Performance measurement
101 B ($1,300 + $1,250)  $2,100 = 1.21
If you selected A you calculated the current ratio and included inventory in your
calculation.
C is receivables divided by payables.
D is inventory divided by payables.
102 B A, C and D are all financial performance measures.
103 A 15%
Net profit percentage = 450/3,000  100% = 15%
104 A 32 days
Accounts receivable payment period = trade receivables/revenue  365 days
= 260/3,000  365 days
= 32 days

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105 (a) Performance measures

South division North division
(i) Return on capital employed
(Operating profit ÷ Capital employed × 100)
($700k ÷ $3,500k × 100) 20.0%
($840k ÷ $4,000k × 100) 21.0%

(ii) Return on sales

(Operating profit ÷ Sales × 100)
($700k ÷ $50,000k × 100) 1.4%
($840k ÷ $3,200k × 100) 26.3%

(iii) Asset turnover

(Sales ÷ Capital employed)
($50,000k ÷ $3,500k) 14.3
($3,200k ÷ $4,000k) 0.8
(b) Differences in performance
The differences in performance between the two divisions are probably due to the
difference in the nature of their businesses.
The South division sells low priced food from rented stores. Low sales prices result in a
low margin on sales. In turn, low prices are attractive to customers and result in a high
level of sales. Add to this the fact that the stores are rented (leading to a low investment in
non-current assets) and this results in a very high asset turnover.
The North division sells luxury motor vehicles which are likely to command a premium
price, leading to a higher return on sales. The high prices in turn are likely to lead to a low
level of sales. North operates an automated production plant, which is likely to require a
high level of investment in non-current assets, resulting in a low asset turnover.
106 (a) (i) Return on capital employed (ROCE) (also called return on investment (ROI)) is
calculated as (profit/capital employed)  100%. This shows how much profit has
been made in relation to the amount of resources invested. In the case of the bus
service, the measure is calculated by using the surplus figure as profit.
Profit = $20,000
Capital employed (or total assets less liabilities) = $2,210,000
Therefore ROCE = (20,000/2,210,000) × 100% = 0.9% = 1%
(ii) Average cost per passenger mile. When service organisations are being measured,
the cost unit needs to be relevant to the service and reflect what is being provided.
For the bus service, take the cost of providing the service as $1,180k and divide by
the number of passenger miles travelled:
Average cost per revenue mile = $1,180,000/4,320,000 = 27.3c
(b) (i) Return on capital employed (ROCE). This is a measure of how much profit has
been made in relation to the amount of resources invested. The bus service appears
to have a very low return compared with private bus companies. However, the bus
service does not have investors, nor does it have the same profit maximisation
objectives as private operators. As a public service, it also operates to provide a
public good and has public service requirements such as availability to all, unlike
private companies. It also has low fares and so could be unable to increase
profitability. The Lewisville bus service is only generating an annual profit of 0.9
cents for every $1 invested. Private bus companies are showing a return of 10
cents or 10%.

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(ii) Average cost per passenger mile. This is a measure of the costs of transporting
passengers per mile travelled. Based on this measure the public service is more
economical than its comparators.
The Lewisville bus service is cheaper on this measure than the private bus
companies. It has a cost of 27.3 cents per passenger mile compared with 37.4
cents per mile in these companies.
(c) Performance is often judged in terms of inputs and outputs. This ties in with the 'value for
money' criteria often used to assess non profit making organisations.
(i) Economy (spending money frugally). This is a measure of input, which is normally
based on expenditure.
(ii) Efficiency (getting out as much as possible for what goes in). This is a measure of
input in relation to output. This measure links economy to effectiveness.
(iii) Effectiveness (getting done, by means of economy and efficiency, what was
supposed to be done). This is an output measure and measures what the
organisation achieves in relation to its objectives.
So effectiveness is the relationship between an organisation's outputs and its objectives,
efficiency is the relationship between inputs and outputs, and economy means controlling
expenditure.
Interpreting these for a bus service:
Economy would mean spending as little money as possible to provide an adequate
service. This would be measured by, say, total expenditure compared to budget. Efficiency
would mean providing the best service for the money available, so for instance cost per
passenger mile travelled. Effectiveness would be providing the service that is supposed to
be provided for the best price, and so could be measured by the number of passengers or
miles travelled.

24 Application of performance measures

107 B (a) (3)
(b) (2)
(c) (1)
108 D Residual income is an absolute measure (compared to return on investment which is a
relative measure) which allows you to select a proposal that will maximise your wealth in
absolute terms.
It measures divisional performance based on a single value and as assets get older it
generally increases. This is because the number subtracted from traceable profits
decreases as the book value decreases.
109 C The fourth perspective not listed is process efficiency.
110 B Residual income (RI) = traceable profit – imputed interest charge on traceable investment
You are given the return on investment and know that:
ROI = traceable profit/traceable investment
Therefore to arrive at the traceable investment you can rearrange the formula above to:
Traceable investment = traceable profit/ROI = $80,000/25% = $80,000/0.25 =
$320,000.
Substituting $320,000 back into the first formula together with other information in the
question gives an RI of $22,400.
RI = $80,000 – ($320,000  0.18) = ($80,000 – $57,600) = $22,400

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111 B June
Activity ratio = (Output measured in std hrs/Budgeted hrs)  100%
= (3,150/2,850)  100%
= 111% (to the nearest whole percent)
July
Activity ratio = (Output measured in std hrs/Budgeted hrs)  100%
= (2,800/2,750)  100%
= 102% (to the nearest whole percent)
Difference between June and July activity ratio = 111 – 102
=9
9 as a percentage of June's activity ratio of 111 = 9/111 × 100%
= 8%
112 Cost reduction (1) and (2)
Cost control (3) and (4)
113 (b) Exchange value (1) The market value of the product or service
(a) Cost value (2) The cost of producing and selling an item
(d) Esteem value (3) The prestige the customer attaches to the product
(c) Use value (4) What the article does; the purpose it fulfils
114 D The first statement describes method study, not work measurement, so (1) is false. (2) is
true.
115 Cost reduction
Cost reduction is a planned and positive approach to reducing the unit cost of goods/services
below current budgeted or standard levels without impairing the suitability for the use intended
for the goods produced/services provided by the organisation. It should not be confused with cost
control, which is all about keeping costs within acceptable (standard or budgeted) limits.
Cost reduction in ML
A cost reduction programme in ML would therefore look at how to reduce, for example, the costs
of designing a website, or even a particular part of a website, without the customer perceiving
any fall in the value of the service the company is providing.
Value analysis
Conventional cost reduction techniques try to achieve the lowest unit cost for a specific product
design/way of providing a service. Value analysis tries to find the least-cost method of making a
product or providing a service that achieves the desired function/outcome.
Value analysis in ML
Value analysis within ML of, say, the design of websites for customers, would involve the systematic
investigation of both the costs connected with it and the way in which it is provided, with the aim of
getting rid of all unnecessary costs. An unnecessary cost is an additional cost incurred without adding
to the following aspects of value.
(i) Use value – the purpose fulfilled by the service
(ii) Exchange value – the market value of the service
(iii) Esteem value – the prestige the customer attaches to the service
Example
Given that ML has a multi-site operation with bases in the UK and overseas, cost reduction and
value analysis techniques could investigate possible duplication of activities that occur as a result.
However, it is important that duplicated activities are not eliminated in an effort to reduce costs if
value is adversely affected.
For example, given the nature of its services, specialist teams could be based anywhere in the
world. However, maintaining a physical presence in different parts of the world should improve
customers' perceptions of the value of ML's services; customers would feel they were dealing with
a local organisation.

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Appendix - Formula sheet and

mathematical tables

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F2/FMA MANAGEMENT ACCOUNTING

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// APPENDIX

FORMULA SHEET GIVEN IN THE EXAM

Regression analysis

y= a + bx
Y X
a= b
n n

n  XY   X  Y
b=
n  X 2   X 2

n  XY   X  Y
r=
[n  X 2   X 2 ][n  Y 2   Y 2 ]

Economic order quantity

2C 0D
Ch

Economic batch quantity

2C 0D
D
C h (1  )
R

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APPENDIX

PRESENT VALUE TABLE

Present value of £1 ie (1+r)-n
where r = interest rate
n = number of periods until payment
Periods Discount rates (r)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065

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// APPENDIX

ANNUITY TABLE
1  (1  r) n
Present value of an annuity of 1 ie .
r
where r = interest rate
n = number of periods
Periods Discount rates (r)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675

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Index

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F2/FMA MANAGEMENT ACCOUNTING

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INDEX

Note. Key Terms and their page references are given in bold.

ABC method of stores control, 119 Budget variance, 347

Budgetary control, 346
Abnormal gain, 224 Budgetary slack, 400
Abnormal loss, 224 Budgeted income statement, 383
Absorption base, 172 Budgeted statement of financial position, 381,
Absorption costing, 157 383
Absorption costing and marginal costing Bulk discounts, 115
compared, 190 By-products, 252, 259
Absorption of overheads, 171
Accounting measures, 556
Accounts payable payment period, 531 C apacity ratio, 136, 548
Accounts receivable collection period, 530 Capital expenditure, 410, 508
Acid test ratio, 527 Capital income, 411
Active cell, 350 Capital transactions, 411
Activity based costing (ABC), 266, 267 Cash, 376
Activity ratio, 136, 548 Cash budget, 375
Additive model, 309 Cell, 350, 351
Administration overhead, 41 Census, 26
Allocation, 159 Chain base method, 316
Apportioned costs, 340 Clock card, 143
Appraisal costs, 274 Cluster sampling, 30, 31
Aspiration level, 400 Coefficient of determination, 292
Aspirations budget, 401 Column, 350
Asset turnover, 526 Committed cost, 436
Attainable standards, 450 Committed fixed costs, 339
Attendance record, 143 Component bar chart, 84
Attributable fixed costs, 437 Composite codes, 47
AVCO, 125 Composite index numbers, 317
Average age of working capital, 531 Compound bar chart, 86
Average inventory, 111 Consumer Prices Index (CPI), 324
Avoidable costs, 435 Continuous data, 20
Continuous improvement, 275
Continuous stocktaking, 107
Balanced scorecard approach, 537 Contribution, 187
Banks, 23 Control, 9, 332
Bar chart, 83 Control process, 503
Basic standard, 449 Control ratios, 548
Batch, 209 Controllable cost, 339, 399
Batch costing, 209organi Controllable profit, 520
Behavioural implications of budgeting, 394 Corporate objectives, 506
Benchmarking, 556 Corporate planning, 8
Bill of materials, 201 Correlation, 286
Bin cards, 105 Correlation and causation, 292
Blanket absorption rates, 174 Correlation coefficient, 288
Blanket overhead absorption rate, 174 Correlation in a time series, 291
Bonus schemes, 139 Cost
Bottom-up budgeting, 397 relevant, 418
Breakeven NPV, 431 Cost accounting, 14
Browsers, 24 Cost accounting department, 147
Budget, 335, 365 Cost accounts, 14
capital expenditure, 413 Cost behaviour, 56
Budget committee, 361 Cost behaviour and budgeting, 56
Budget cost allowance, 344, 347 Cost behaviour and cost control, 56
Budget documentation, 360 Cost behaviour and decision making, 56
Budget manual, 360 Cost behaviour and levels of activity, 57
Budget period, 360 Cost behaviour assumptions, 63
Budget preparation, 361 Cost behaviour patterns, 58
Budget review, 365 Cost behaviour principles, 57

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INDEX

Cost centre, 49, 337 Discounting, 422

Cost codes, 46 Discrete data, 20
Cost control, 558 Discretionary fixed costs, 339
Cost drivers, 267, 271 Distribution overhead, 41
Cost gap, 279 Dysfunctional decision making, 395
Cost object, 50
Cost of appraisal, 273
Cost of capital, 428
E -commerce, 24
Cost of conformance, 273 Economic Batch Quantity (EBQ), 114, 115
Cost of external failure, 273 Economic Order Quantity (EOQ), 112
Cost of internal failure, 273 Economic policy, 541
Cost of non-conformance, 273 Effectiveness, 11
Cost of prevention, 273 Efficiency, 11
Cost of quality, 273 Efficiency ratio, 136, 530, 548
Cost per service unit, 212 Efficiency targets, 519
Cost plus pricing, 203 Employee share ownership plan, 403
Cost pools, 267 Equivalent units, 237
Cost reduction, 558 Esteem value, 565
Cost unit, 50 Exchange value, 565
Cost value, 565 Executive agencies, 519
Cost/sales ratios, 525 Expectations budget, 401
Critical success factor, 506, 508 Expenses, 39
Cumulative weighted average pricing, 125 External failure costs, 274
Current ratio, 527, 529
Current standards, 450 Feedback information, 334
Curve fitting, 90 Feedback loop, 334
Curvilinear variable costs, 60 FIFO (first in, first out), 122
Customer service, 508 FIFO (first in, first out) method, 240
Cyclical variations, 301 Financial accounts, 13
Financial information, 7
Daily timesheets, 144 Financial newspapers, 23
Data, 4 Financial performance measures, 510
Data sources, 21 Financial performance targets, 519
Data types, 20 Fisher's ideal index, 322
Day-rate system, 137 Fixed base method, 316
Debt ratios, 532 Fixed budget, 340
Decision making, 10 Fixed costs, 44, 58, 437
Decline, 325 Fixed overhead expenditure variance, 463
Delivery note, 102 Fixed overhead total variance, 463
Departmental absorption rates, 174 Fixed overhead variances, 463
Departmental budgets, 366 Fixed overhead volume capacity variance, 463
Deseasonalisation, 310 Fixed overhead volume efficiency variance,
Deteriorating inventory, 108 463
Differential cost, 435 Fixed overhead volume variance, 462, 463
Direct costs, 39 Fixed production overhead variances, 461
Direct expenses, 40 Flexible budget, 341
Direct labour, 39 Forecasting and price movements, 315
Direct labour cost variances, 459 Formal report, 79
Direct labour efficiency variance, 459 Formula bar, 351
Direct labour rate variance, 459 Formulae, 352
Direct labour total variance, 459 Free inventory, 106
Direct material, 39 Function costing, 210
Direct material price variance, 457 Functional budgets, 366
Direct material total variance, 457 Functional costs, 42
Direct material usage variance, 457
Direct wages, 39 Gearing ratio, 532
Directly attributable fixed costs, 437 Get it right, first time, 275
Directly attributable overhead, 340 Goal congruence, 394, 395, 399, 505
Discounted cash flow, 425 Goods received note (GRN), 103
Discounted cash flow (DCF) techniques, 420 Google, 24
Discounted payback method, 427

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INDEX

Governments, 22 Joint products and common costs, 253

Graphs, 68 Joint products in process accounts, 256
Gross profit margin, 525
Group bonus scheme, 141
Guaranteed minimum wage, 138
Key budget factor, 362

High day-rate system, 140 L abour, 39

High-low method, 63, 296, 342 Labour turnover, 147, 148
Historical costs, 436 Labour turnover rate, 148
Historigram, 299 Laspeyre indices, 319
Holding costs, 108 Last in, first out, 124
Hopwood, 399 Least squares method of linear regression
analysis, 293
Legislation, 541
Ideal standard, 449 Life cycle costing, 276, 277
Idle time, 146 Limiting budget factor, 362
Idle time ratio, 147 Linear equations, 68
Imposed budget, 396 Lines of best fit, 292
Incentive schemes, 139 Liquidity ratios, 527, 529
Incentive schemes involving shares, 403 Long-term objectives, 505
Incremental costs, 435 Long-term plan, 334
Index numbers, 315 Long-term strategic planning, 8, 152, 174
Indirect cost, 39
Indirect expenses, 41
Indirect materials, 41
Management accounting, 14
Indirect wages, 41 Management accounting information, 15
Individual bonus schemes, 141 Management accounts, 13
Informal report, 80 Management control, 11
Information, 4 Management control system, 11
Intercept, 69 Management performance measures, 555
Interest cover, 533 Managerial performance, 399
Internal failure costs, 274 Marginal cost, 186
Internal rate of return (IRR), 431 Marginal costing, 186, 189, 342
International Accounting Standard 2 (IAS 2), Marginal costing and absorption costing
158 compared, 190
Internet, 24 Marginal costing operating statement, 488
Inventory codes, 107 Marginal costing principles, 187
Inventory control, 100, 109 Master budget, 381, 383
Inventory control levels, 108, 109 Materials, 39
Inventory control systems, 104 Materials codes, 107
Inventory costs, 108 Materials requisition note, 103
Inventory count, 107 Materials returned note, 104
Inventory discrepancies, 107 Materials returns, 104
Inventory turnover, 530 Materials transfer note, 104
Inventory turnover period, 530 Materials transfers, 104
Inventory valuation, 120 Materials variances and opening and closing
Investment centres, 49, 51, 338 inventory, 458
Issue of materials, 103 Maturity, 325
Maximum level, 110
Memorandum report, 79, 81
Job, 200 Method study, 562, 570
Job cards, 144 Microsoft Internet Explorer, 24
Job cost cards, 201 Minimum level, 110
Job cost information, 201 Mission, 503, 559, 560, 561, 562, 563
Job cost sheets, 201 Mixed costs, 61
Job costing, 200 Motivation, 394
Job costing and computerisation, 205 Moving averages, 303
Job costing for internal services, 207 Multiple bar chart, 86
Job time, 144 Multiplicative model, 309
Joint costs, 253 Multistage sampling, 30
Joint product, 252

633

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INDEX

Performance measures for manufacturing

Negative correlation, 288 businesses, 547
Negotiated budget, 398 Performance measures for manufacturing
Net present value (NPV) method, 425 environments, 549
NFIs, 512 Performance standard, 449
Non profit making organisations, 555 Period costs, 45
Non-conformance, 273 Periodic stocktaking, 107
Non-controllable costs, 339 Perpetual inventory, 108
Non-current asset, 410 Perpetuity, 430
Non-financial indicators, 510, 511 Personnel department, 142
Non-financial information, 7 Pie chart, 86
Non-financial objectives, 510 Piecework schemes, 138
Non-financial performance measures, 510 Piecework ticket, 145
Non-linear variable costs, 60 Planning, 7, 332, 503
Non-operational goals, 505 Population, 26
Non-probability sampling method, 31 Population data, 21
Non-relevant costs, 436 Position audit, 333
Normal loss, 224 Positive correlation, 288
Notional cost, 436 Power (^), 352
NPMOs, 555 Predetermined overhead absorption rate, 171
Preventative costs, 149
O bjective classification, 47 Prevention costs, 274
Objectives, 8, 333, 505 Price indices, 315
Obsolete inventory, 108 Primary data, 20
One-off report, 77 Principal budget factor, 362
Operating statements, 484 Probability sampling methods, 27
Operation card, 145 Process costing, 222, 223
Operational control, 11 Process costing and closing work in progress,
Operational goals, 505 236
Opportunity cost, 436 Process costing and losses, 224
Order cycling method of stores control, 118 Process costing and opening work in progress,
Ordering costs, 109 240
Ordering materials, 101 weighted average cost method, 245
Organisation and methods (O&M), 563 Process costing framework, 223
Over absorption, 176 Procurement costs, 109
Overhead absorption, 171, 173 Product life cycle, 277
Overhead absorption rate, 174, 175, 462 Production, 41
Overhead apportionment, 160 Production planning department, 142
Overhead recovery, 171 Production volume (P/V) ratio, 136, 548
Overheads, 39, 156 Productivity, 134, 525
Overtime, 39, 150 Productivity ratio, 136
Overtime premium, 137 Profit, 510
Profit centres, 50, 338
Profit margin, 524
Paasche indices, 319 Profit sharing scheme, 403
Pareto (80/20) distribution, 119 Profit to sales ratio, 524, 525, 529
Partial correlation, 287 Proportional (multiplicative) model, 309
Participation, 396 Public sector, 518
Participative budgeting, 397 Purchase order, 102
Payback method, 419 Purchase requisition, 101
Percentage component bar chart, 85
Percentages, 513, 516
Perfect correlation, 287
Q uality, 273, 508
Performance evaluation, 398 Quality of service targets, 519
Performance measurement, 503, 550 Quality-related costs, 273
Performance measurement in central Quantity indices, 315
government, 519 Quick ratio, 527, 529
Performance measurement in local government, Quota sampling, 31
519
Performance measures, 509, 510 R&D, 508
Random sampling, 27

634

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INDEX

Ratios, 513 Simple indices, 316

Receiving materials, 101 Simple interest, 421
Rectification costs, 203 Simple random sample, 27
Regression, 292 Slope, 69
Regression lines and time series, 294 Slow-moving inventories, 108
Relevant cost, 435 Split off point, 253
Relevant cost of using machines, 437 Spreadsheet, 350
Remuneration methods, 137 Spreadsheet formulae, 351
Reorder level, 110 Standard cost, 446
Replacement costs, 148 Standard costing, 446, 448
Residual income (RI), 520, 524 Standard hour, 368, 548
Responsibility accounting, 334, 336 Standard hour of production, 135
Responsibility centre, 51, 336 Standard operation sheet, 451
Responsibility for the preparation of budgets, Standard product specification, 451
361 Standard resource requirements, 451
Retail Prices Index (RPI), 324 Statement of financial position, 381
Return on capital employed (ROCE), 520 Step costs, 58
Return on equity ratio (ROE), 524 Step down method of reapportionment, 164
Return on investment – advantages, 523 Stockout costs, 109
Return on investment (ROI), 520 Storage of raw materials, 105
Revenue centres, 49, 51, 338 Stores ledger accounts, 105
Revenue expenditure, 411 Stores requisition, 103
Revenue income, 411 Strategic analysis, 333
Reverse engineering, 557 Strategic information, 12
Routine reports, 77 Strategic planning, 11
Row, 350 Strategies, 333, 503
Strategy and organisational structure, 8
Stratified random sampling, 29
Salaried labour, 145 Subjective classification, 47
Sales budget, 363 Sunk cost, 436
Sales variances, 482 Systematic sampling, 29
Sales variances – significance, 483
Sales volume profit variance, 482
Sample data, 20 Table, 81
Sampling, 26 Tactical information, 12
Sampling frame, 28 Target cost, 278
Scattergraph, 287 Target costing, 278
Scrap, 230 Time preference, 420
Search engine, 24 Time series, 299
Seasonal variations, 301, 307 Time series analysis, 299, 311
Secondary data, 20, 22 Time value of money, 420
Selling overhead, 41 Time work, 137
Selling price variance, 482 Timekeeping department, 142
Semi-fixed costs, 61 Top-down budget, 396
Semi-variable costs, 61 Total quality management (TQM), 274, 275
Sensitivity analysis, 356 Trade journals, 23
Separate absorption rates, 174 Training, 508
Service cost analysis, 212 Transfers and returns of materials, 104
Service cost analysis in service industry Trend, 300
situations, 215 Trend line, 90
Service costing, 210 Two-bin system of stores control, 119
unit cost measures, 211
Share option scheme, 403
Share ownership, 541
U ncontrollable costs, 339
Shift premium, 137 Under absorption, 176
Short formal report, 79 Under-/over-absorbed overhead account, 179
Short informal report, 79, 80 Use value, 565
Short-term objectives, 505 User costs, 437
Short-term tactical planning, 8
Short-termism, 508 V alue, 565
Signing-in book, 143 Value added, 404
Simple bar charts, 83, 95

635

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INDEX

Value added incentive schemes, 404 Volume of output targets, 519

Value analysis, 564
Value engineering, 564
Variable costs, 44, 59, 437
W ages control account, 149
Variable overhead total variance, 460 Wages department, 146
Variable production overhead efficiency Website, 24
variance, 461 Weekly timesheets, 144
Variable production overhead expenditure Weighted aggregate indices, 317
variance, 461 Weighted average price, 125
Variable production overhead variances, 460 What if analysis, 355
Variance, 346, 347, 349, 456, 482 Work measurement, 562
Variances – interdependence, 476 Work study, 562
Variances – significance, 476 Working capital period, 531
Variances in a standard marginal costing World Wide Web (www), 24
system, 487

636

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