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F5 Performance Management 2016


Part A – Specialist Cost and Management Accounting Techniques.................................................................................. 3
1. Costing Techniques – Recap.................................................................................................................................. 3
2. Activity Based Costing ........................................................................................................................................... 5
3. Target Costing ....................................................................................................................................................... 8
4. Life Cycle Costing ................................................................................................................................................ 10
5. Throughput Accounting ...................................................................................................................................... 13
6. Environmental Accounting .................................................................................................................................. 20

Part B – Decision Making Techniques ............................................................................................................................. 22
7. Cost Volume Profit (CVP) Analysis ...................................................................................................................... 22
8. Limiting Factor Analysis ...................................................................................................................................... 31
9. Pricing Decisions ................................................................................................................................................. 38
10. Short Term Decisions ...................................................................................................................................... 48
11. Risk and Uncertainty ....................................................................................................................................... 53

Part C – Budgeting and Control....................................................................................................................................... 67
12. Budgetary Systems .......................................................................................................................................... 67
13. Quantitative Analysis ...................................................................................................................................... 72
14. Standard Costing ............................................................................................................................................. 78
15. Variance Analysis ............................................................................................................................................ 81
16. Planning and Operational Variances ............................................................................................................... 99
17. Performance Analysis.................................................................................................................................... 102

Part D – Performance Measurement and Control ........................................................................................................ 105
18. Performance Management Information Systems ........................................................................................ 105
19. Sources of Management Information ........................................................................................................... 108
20. Performance Measurement in Private Sector Organisations ....................................................................... 111
21. Performance Analysis – Additional ............................................................................................................... 143

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F5 Performance Management 2016

Part A – Specialist Cost and Management Accounting Techniques

1. Costing Techniques – Recap

Costing: It is the process of determining the costs of products, services or activities

Direct Cost: A cost that can be traced back in full to a product, service or department.

Indirect Production Cost: Also known as Overheads. It is a cost that cannot be directly linked in full to the
actual production of goods/ provision of services. Example: Rent of factory where five different products
are manufactured.

Indirect Non Production Cost: Also referred to as Overheads. It is a cost incurred in a support function that
is not directly involved in the manufacturing process or provision of the main service. Example: Marketing
expenses of a television sets manufacturer.

Traditional Costing Systems:

Absorption Costing: a form of costing in which the costs of products are calculated by adding an amount
for indirect production costs (overheads) to the direct costs of production.

Marginal Costing: a form of costing where only the direct costs are considered relevant for the cost of a
product. Fixed costs are treated as Period Costs.

Absorption Costing Marginal Costing
Per Unit Product Cost Calculation
$ $
Direct Material X Direct Material X
Direct Labour X Direct Labour X
Other Direct Expenses X Other Direct Expenses X
Absorbed Production Overheads (Step 5) X Variable Production Cost X
Full Production Cost X
$ $
Sales xx Sales xx
Less : Full production cost of sale (Full (x) Less : Variable production cost (Variable
production cost per unit x number of units) production cost per unit x units sold) (x)
Less/Add: Under/Over absorbed (Step 6) (x)/x Gross contribution xx
Production overheads Less : Variable non production cost (x)
Gross Profit xx Contribution xx
Less : Fixed non-production overhead (x) Less : Fixed non-production overhead (x)
Less : Variable non production cost (x) Less : Fixed production overhead (x)
Profit xx Profit xx

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Step 2: Apportion general overheads amongst the cost centres. Page 4 of 147 . Step 3: Re-apportion the costs of service cost centres’ amongst the production cost centres on a fair basis. on a fair basis. Step 4: Determine Absorption rate for each production cost centre using the formula: Estimated Fixed Production Overheads Budgeted Activity Level With one of the following bases for activity level:  % of direct material cost  % of direct labour cost  % of prime cost  Rate per machine hour  Rate per labour hour  Rate per unit Step 5: Absorbed Production Overheads: Actual activity level x Absorption rate Step 6: Under/ Over Absorption: Absorbed Production Overheads – Actual Overheads Expenditure Under-absorbed: Absorbed production overheads < Actual overheads expenditure Over-absorbed: Absorbed production overheads > Actual overheads expenditure Arguments for Absorption Costing System: Used for financial reporting purposes to comply with the Accounting standards and inventory valuations. F5 Performance Management 2016 Absorption Costing – Recap: Step 1: Allocate direct costs to a cost unit or cost centre. to determine profitability of each product. Arguments for Marginal Costing System: Provides more useful information for managers in decision making process as contribution calculated under this system is directly proportionate to the sales volume. which gives a more accurate picture of the impact of sales volume on cashflows and profits. Helpful in cases where companies attempt to set selling prices based on the full cost of production or sales of each product. Best practice in case of a company selling multiple products.

For each product.  To get a more accurate estimate of what each unit costs to produce. derived. This activity is the ‘Cost Driver’. using an over-simplified base is not good enough. The ABC Process: 1. Identify the activity that causes this cost. or cost per machine hour. 4. 2. Traditional absorption costing Production overheads Allocated/apportioned to Production cost centre Production cost centre Absorbed from cost centres into: Product costs Activity based costing Production overheads Allocated/apportioned to Activity (cost pool) Activity (cost pool) Absorbed from cost centres into: Product costs Page 5 of 147 . especially for organisations manufacturing multiple products.  With production processes becoming highly automated the conventional way of treating fixed overheads. This is the basis of Activity Based Costing (ABC). 3. For each cost pool. charge the overheads cost based on the use of the relevant cost driver by the product. Identify a distinct ‘fixed’ overhead cost. because activities usually have a cost attached. it is necessary to examine what activities are necessary to produce each unit. also termed as a Cost Pool. calculate an absorption rate per cost driver. F5 Performance Management 2016 2. Companies need to know the causes of overhead and they need to try to assign costs to products or services on the basis of the resources they consume. Activity Based Costing Introduction:  The simplest method of dealing with the fixed production costs is to assume that all of the production overheads can be treated together and a single overhead absorption rate per labour hour.

 Cost of implementing this system may be more than benefits derived.000 500 machine hours Production Scheduling Costs $14.  Promoting or discontinuing products.800 100 labour hours Under the ABC method.000 x 20 labour hours = $6.000 100 production runs Total Fixed Overheads $34. activities or parts of business as there will be better indication of where cost savings can be made.000 x 15 machine hours = $600 500 machine hours Production Scheduling $14.  It’s an adaptation of the Absorption costing method and decision making is more effective based on Marginal Costing information.  Developing new ways or products to do business. F5 Performance Management 2016 Example: An organisation manufactures 3 different products. Page 6 of 147 . its Fixed Production Overheads comprise of: Cost Pool Cost Driver Machine Handling Costs $20.160 Arguments for ABC:  Based on the information made available. Fixed Overheads cost for Product A will be: $34. In a year. the following types of decision making processes will be supported:  Pricing on mark-up basis for individual products will become fair as the cost of production is assessed more accurately.000 x 4 production runs = $560 100 production runs = $1. the working will change to: Machine Handling $20. Arguments against ABC:  Cost drivers may not be very easy to identify or quantify.000 100 labour hoours Assuming that the manufacturing of Product A requires:  20 labour hours  15 machine hours  4 production runs Under the traditional Absorption costing method.

F5 Performance Management 2016 Past Paper Analysis Activity based costing June 08 – Q 4 June 10 – Q 1 Dec 10 – Q 4 June 14 – Q 1 June 15 – Q 1 Page 7 of 147 .

These teams are vital to the design and manufacturing decisions required to determine the price and feature combinations that are most likely to appeal to potential buyers of products. Target Costing Introduction: Traditionally the selling price of a product is determined by adding a profit mark-up to the Product cost. determine the estimated Production Cost. This flaw is addressed by target costing. The product has to be developed using Value Engineering Techniques. cost accountants. F5 Performance Management 2016 3. production managers. Calculate Target Cost: Target Selling Price – Target Profit 5. before production commences Closing the Target Cost Gap:  Establishment of multifunctional teams consisting of marketing people. Target Costing Process: 1. Determine product specification and possible sales volume. quality control professionals and others. Decide on a Target Selling Price at which the product can be successfully sold. 4. Make efforts to reduce the Target Cost Gap. 2. But an organisation may not be able to find customers who might want to buy at that price as the product may not have the features customer’s value or the competitors’ products might be cheaper. which can affect the cost of a product:  Reducing components  Arranging cheaper labour/ training existing staff  Acquiring new and efficient technology etc. made at the design stage. From this the desired profit margin is deducted to arrive at a target cost. Here are some of the decisions. 3.  Value engineering aims to reduce costs by identifying those parts of a product or service which do not add value – where ‘value’ is made up of both:  Use value (the ability of the product or service to perform its function)  Esteem value (the status that ownership or use confers) Page 8 of 147 .  An emphasis is on the planning and design stage to ensure that the design is not needlessly expensive to make. Estimate Target Profit. 6. or at least offer better value for money.  The total target cost can be split into broad cost categories based on functions to ensure better control over costs. Calculate Target Cost Gap: Estimated Production Cost – Target Cost 7. Based on product specification and costs level. Target Costing: Target costing is very much a marketing approach to costing as it involves setting a selling price for the product by reference to the market.

Challenges:  Services do not have any material content (tangibility) making it difficult to reduce target cost gap through material cost reduction. Services do not result in the transfer of property but only access to or a right to use a facility. fast food. teaching. the banking sector.g. F5 Performance Management 2016 For example. and although there will be no damage to the use value.) No service exists until it is actually being experienced/ consumed by the person who has bought it. (Think of dental treatment. Variability/heterogeneity. No transfer of ownership. psychotherapy (c) Personal service e. Target Costing in Service Industries: Because of the characteristics and information requirements. the esteem value will be damaged. hotels and holidays. Perishability Services are time bound.  Services vary each time resulting in there being an estimated average cost for each service but not a specific standard cost that can be reduced. if you are selling perfume. the design of its packaging is important. Inseparability/simultaneity. air). The services of a dentist are purchased for a period of time. mass entertainment (b) Either / or e. It is hard to attain precise standardisation of the service offered. it is difficult to use Target Costing in service industries. Examples of service businesses include: (a) Mass service e. The perfume could be sold in a plain glass bottle. The company would be unwise to try to reduce costs by economising too much on packaging. transportation (rail.g. car maintenance There are five major characteristics of services that distinguish services from manufacturing. pensions and financial advice. Many services are created at the same time as they are consumed. Intangibility Unlike goods there is no substantial material or physical aspects to a service.g. Past Paper Analysis Target costing Dec 01 – Q 1 Dec 09 – Q 2 June 12 – Q 2 Dec 15 – Q 1 Page 9 of 147 .

 Many costs will be linked. Maybe learning effect and economies of scale. cost of the initial investment is progressively recovered. Stages of Life cycle (product life cycle) The development stage The product has a research and development stage where costs are incurred but no revenue is generated. the product becomes well-known in the market. Examples: R&D costs. during or after the product is produced. The organisation will spend on advertising to bring the product or service to the attention of the potential customers. such as Research & Development costs. Increased costs of working capital The maturity stage At this stage. F5 Performance Management 2016 4. are considered. Examples: Operating costs. Life Cycle Costing Introduction:  Under traditional costing methods. only the current costs.  When seeking to make a profit on a product it is essential that the total revenue arising from the product exceeds total costs. But other costs.  Costs are committed and incurred at very different times. comprising of marginal costs plus a share of fixed costs. whether these costs are incurred before. are ignored. Examples: Costs of increasing capacity. it captures a bigger market and starts to make a profit. Due to increase in demand. This is addressed by lifecycle costing. Capital Expenditure decisions The introduction stage The product is introduced to the market. Marketing and advertising. A committed cost is a cost that will be incurred in the future because of decisions that have already been made. At this stage. Costs are incurred only when a resource is used. Set up and expansion of distribution channels The growth stage At this stage. Lifecycle Costing: There are four principal lessons to be learned from lifecycle costing:  All costs should be taken into account when working out the cost of a unit and its profitability. For example.  Attention to all costs will help reduce the cost per unit and will help an organisation achieve its target cost. more attention to design can reduce manufacturing and warranty costs. demand for the product stabilises or the rate of growth slows Page 10 of 147 . without which the goods could not have been made.

The product may start making loss at this stage. therefore. Expenses for marketing and distribution can be minimised at this stage. Page 11 of 147 . Life cycle costing is therefore particularly suited to such organisations and products. Remaining warranties to be supported The Importance of early stage in Lifecycle: Organisations operating within an advanced manufacturing technology environment find that approximately 90% of a product's life cycle cost is determined by decisions made early within the cycle at the design stage. Cost reduction at the planning. Examples: Incur costs to maintain manufacturing capacity. Possible restructuring costs. rather than during the production process. Benefits of Life cycle costing:  The potential profitability of product can be assessed before major development of the product is carried out and costs incurred and non-profit-making products can be abandoned. At this stage the demand for the product starts to fall and marketing costs are cut down. is one of the most important ways of reducing product cost. In order to sustain the demand. reaches a saturation point. the product may be differentiated / modified. design and development stage of a product's life cycle. It continues to be profitable. Examples: Asset decommissioning costs. F5 Performance Management 2016 down. Marketing and product enhancement costs to extend maturity The decline / saturation A point comes where large / adequate quantities of the product have been stage sold in the market and the product. The organisation may decide to discontinue the production and to develop a new product.  Techniques can be used to reduce costs over the life of the product  Pricing strategy can be determined before the product enters production.

and discounted cash flow calculations are invariably used to cost them over their life cycle in advance. and an organisation will wish to maximise the return from a customer over their life cycle.  Decision-making: Helps with decision about making new investments in the product (new capital expenditure) or withdrawing a product from the market. The initial cost is high but once customers get used to a supplier they tend to use them more frequently.  Performance management: Understanding the changes in the financial performance of the product as it moves from one stage to another and being prepared for the changes.  By monitoring the actual performance of products against plans. Service Life Cycles: In Service lifecycles. The projected cash flows over the full lives of customers or customer segments can be analysed to highlight the worth of customers and the importance of customer retention. The aim is to extend the life cycle of a particular customer by encouraging customer loyalty. However consideration should be given in advance about how to carry out the services and arrange them so as to minimise cost. bringing in the benefit to the company. the R & D stages do not exist in the same way and will not have the same impact on subsequent costs. They are monitored very carefully over their life to make sure that they remain on schedule and that cost overruns are not being incurred. Support to Management: An understanding of the product life cycle can also assist management with decisions about:  Pricing: As a product moves from one stage in its lifecycle to the next. lessons can be learnt to improve the performance of future products. Customer Life Cycles: Customers also have life cycles. Past Paper Analysis Life-cycle costing Dec 08 – Q 4 Dec 11 – Q 4 June 13 – Q 3 Page 12 of 147 . a change in pricing strategy might be necessary to maintain the market share and recover the costs incurred over the lifecycle. F5 Performance Management 2016  Attention can be focused on reducing the research and development phase to get the product to market as quickly as possible. Project Life Cycles: Products that take years to produce are usually called projects.

000 200.000 units 100.000 Shortfall in hours 0 30.000/3) as things stand. So.000 Total hours available 100. F5 Performance Management 2016 5. extended lead times.000 units for a product that goes through three processes: cutting. If not. and the appearance of Page 13 of 147 . otherwise known as bottlenecks. The total time required in each process for each product and the total hours available are: Process Cutting Heating Assembly Hrs per unit 2 3 4 Total hours available 100. it is usually quite simple to work out. To push more work into the system than the constraint can deal with results in excess work-in-progress.000 150.000 220. Step 3: Subordinate everything else to the decisions made in Step 2 The main point here is that the production capacity of the bottleneck resource should determine the production schedule for the organisation as a whole? Idle time is unavoidable and needs to be accepted if the theory of constraints is to be successfully applied.000 0 It is clear that the heating process is the bottleneck.) The steps are as follows: Step 1: Identify the system’s bottlenecks Often.’ These are a tool developed to help organisations deal with constraints. Step 2: Decide how to exploit the system’s bottlenecks This involves making sure that the bottleneck resource is actively being used as much as possible and is producing as many units as possible.000 The total time required to make 50. For example. let’s say that an organisation has market demand of 50. Throughput Accounting The theory of constraints The theory of constraints is applied within an organisation by following what are called ‘the five focusing steps. The organisation will in fact only be able to produce 40. within the system as a whole (rather than any discrete unit within the organisation.000 120. heating and assembly. in exam questions.000 units (120. ‘productivity’ and ‘utilisation’ are the key words here. you will be told what the bottleneck resource is. Process Cutting Heating Assembly Hrs per unit 2 3 4 Total hours required for 50.000 220.000 120.000 units of the product can be calculated and compared to the time available in order to identify the bottleneck.

to work on the basis of maximising contribution is flawed because to do so is to take into account costs that cannot be controlled in the short term anyway. Eventually. Page 14 of 147 . it then has to decide how to get the most out of that resource. elevation will require capital expenditure. it is important that an organisation does not ignore Step 2 and jumps straight to Step 4. the contribution per unit is first calculated for each product. based on maximising throughput per unit of bottleneck resource. but this time it is not contribution per unit of scarce resource which is calculated.. However.’ This is different from the calculation of ‘contribution’. F5 Performance Management 2016 what looks like new bottlenecks. There is often untapped production capacity that can be found if you look closely enough. The system should be one of ongoing improvement because nothing ever stands still for long. By definition. this means that part of the exploitation step involves working out what the optimum production plan is. and this is what often happens. but do not let inertia become the system’s new bottleneck When a bottleneck has been elevated. Step 5: If a new constraint is broken in Step 4. then a contribution per unit of scarce resource is calculated by working out how much of the scarce resource each unit requires in its production. however. as the whole system becomes clogged up. the system does not require the non-bottleneck resources to be used to their full capacity and therefore they must sit idle for some of the time. This could be in the form of another machine that can now process less units than the elevated bottleneck. go back to Step 1. in which both labour costs and variable overheads are also deducted from selling price. In a throughput accounting context. Given that most businesses are producing more than one type of product (or supplying more than one type of service). a new bottleneck will eventually appear. Throughput is calculated as ‘selling price less direct material cost. It is an important distinction because the fundamental belief in throughput accounting is that all costs except direct materials costs are largely fixed – therefore. Whatever the new bottleneck is. you are more likely to be asked to show how a bottleneck can be exploited by maximising throughput via the production of an optimum production plan. In the context of an exam question. Elevation should only be considered once exploitation has taken place. a very similar calculation is performed. the ultimate constraint on the system is likely to be market demand. LIMITING FACTOR ANALYSIS AND THROUGHPUT ACCOUNTING Once an organisation has identified its bottleneck resource. the message of the theory of constraints is: never get complacent. as demonstrated in Step 1 above. but throughput return per unit of bottleneck resource. This requires an application of the simple principles of key factor analysis. Step 4: Elevate the system’s bottlenecks Normally. otherwise known as limiting factor analysis or principal budget factor. In key factor analysis.

I have never seen the point of inserting this extra step in when working out the optimum production plan. A workforce has to be employed within the business and available for work if there is work to do. E F G $ $ $ Selling price per unit 120 110 130 Direct material cost per unit 60 70 85 Throughput per unit 60 40 45 Time required on the bottleneck resource (hours per unit) 5 4 3 Return per factory hour $12 $10 $15 Ranking 2 3 1 Page 15 of 147 . and while I am planning on mentioning them later. details of which are shown below: E F G $ $ $ Selling price per unit 120 110 130 Direct material cost per unit 60 70 85 Maximum demand (units) 30. for example. in most businesses. being sure not to exceed the maximum demand for any of the products. 3. F5 Performance Management 2016 One cannot help but agree with this belief really since. F and G. Calculate the optimum production plan. Calculate the throughput return per hour of bottleneck resource. A few simple steps can be followed: 1. E. It is worth noting here that you often see another step carried out between Steps 2 and 3 above. Rank the products in order of the priority in which they should be produced. Thus far. it is simply not possible.000 Time required on the bottleneck resource (hours per unit) 5 4 3 There are 320.000 25. The ranking of the products using the return per factory hour will always produce the same ranking as that produced using the throughput accounting ratio. ratios have not been discussed. 2. This is the calculation of the throughput accounting ratio for each product. Calculate the optimum product mix each month. to hire workers on a daily basis and lay workers off if they are not busy. 4. starting with the product that generates the highest return per hour first. allocating the bottleneck resource to each one in order.000 bottleneck hours available each month.000 40. Calculate the throughput per unit for each product. so it doesn’t really matter whether you use the return or the ratio. Example 1 Beta Co produces 3 products. You cannot refuse to pay a worker if he is forced to sit idle by a machine for a while.

000 $15 $1.000 + 150. Example 2 Cat Co makes a product using three machines – X. The example also demonstrates once again how to identify the bottleneck resource (Step 1) and then shows how a bottleneck may be elevated. you could see that out of the 320.800. Step 3 will be followed by making sure that the optimum production plan is adhered to throughout the whole system. 270.000 had been used up (120. I now want to look at an example of the application of Steps 4 and 5. However. In practice. This means that product G should be produced in priority to E. However.00 Each time you allocate time on the bottleneck resource to a product. In this example.000 hours available. leaving only 50. I have kept it simple by assuming that the organisation only makes one product. Product No. F5 Performance Management 2016 It is worth noting that. the system’s bottleneck must be exploited by using it to produce the products that maximise throughput per hour first (Step 2 of the five focusing steps).000). The above example concentrates on Steps 2 and 3 of the five focusing steps.000 hours divided by the four hours each unit requires – ie 12.000 $12 $1. rather than the numbers. This means that the marker can follow your logic and award all possible marks.000 hours spare. Y and Z. there were enough hours to produce the full quota for G and E. when you got to F. before the time taken on the bottleneck resource was taken into account. It also shows that it may not always be financially viable to elevate a bottleneck. of units Hrs per unit Total hrs T/put per hr Total t/put G 40. and sticking to the priorities decided. even if you have made an error along the way.500 4 50.800. product E appeared to be the most profitable because it generated the highest throughput per unit. When answering a question like this in an exam it is useful to draw up a small table.000 E 30.000 $4. but will then be replaced by another.000 3 120.500 units.100. The capacity of each machine is as follows: Machine X Y Z Capacity per week 800 600 500 Page 16 of 147 . like the one shown below. applying the theory of constraints.000 5 150. the number of units of F that could be produced was a balancing figure – 50. with no machine making more units than can be absorbed by the bottleneck.000 F 12. as it is the principle that is important here.000 $10 $5000. Therefore. you have to ask yourself how many hours you still have available.

Purchase 2 Invest in a second machine Y. this is machine Z.500 = 100 units $'000 Benefit: 100 x $50.500) Page 17 of 147 .050 1.150 1.100 1.100 units per week and costs $6m. it is necessary to identify the system’s bottleneck resource. Clearly.050 1.000 Buy Z & Y 800* 1.8m. The cost of this machine would be $6. for example.000 Buy Z.5m. the financial viability of the three options should be calculated. X Y Z Demand Current capacity per week 800 600 500* 1. Y & X 1.000* * = bottleneck resource From the table above. thereby increasing capacity to 1. Buy Z Additional sales = 600 . net present value increases by $50. it would be necessary to look beyond production and consider how to increase market demand by. For every additional unit sold per week. Purchase 3 is therefore the starting point when considering the logical choices that face Cat Co.500) Net cost (2.000 Cost (7. if any.000 5. increasing capacity by 550 units per week. This will increase capacity to 1. it can be seen that once a bottleneck is elevated. At this point.000 Buy Z 800 600* 1.050 1. Cat Co is considering the following possible purchases (they are not mutually exclusive): Purchase 1 Replace machine X with a newer model. it is then replaced by another bottleneck until ultimately market demand constrains production. It would never be logical to consider either Purchase 1 or 2 in isolation because of the fact that neither machines X nor machine Y is the starting bottleneck.050 units.150 1. F5 Performance Management 2016 The demand for the product is 1.000 units per week. which only has the capacity to produce 500 units per week. Purchase 3 Upgrade machine Z at a cost of $7.000. increasing advertising of the product.In order to make a decision as to which of the machines should be purchased. Required: Which is Cat Co’s best course of action? Answer First. Let’s have a look at how the capacity of the business increases with the choices that are available to it.

500 = 300 units Benefit : 300 x $50. This means that the rate at which the organisation is generating cash from sales of this product is greater than the rate at which it is incurring costs.300) Net benefit 4. this is not the case. you would expect the throughput accounting ratio to be greater than 1. Page 18 of 147 . RATIOS There are three main ratios that are calculated: (1) return per factory hour.000 15.000 Cost ($7.000 Cost ($7.500 = 500 units Benefit: 500 x $50. It follows on. (3) Return per factory hour/cost per factory hour. If the organisation was a service organisation. F5 Performance Management 2016 Buy Z & Y Additional sales = 800 . (1) Return per factory hour Throughput per unit/product time on bottleneck resource. we would simply call it ‘total operational expense’ or something similar. another bottleneck appears too quickly for the initial investment cost to be recouped. another one appears.5m + $6. and changes need to be made quickly. The ‘total factory cost’ is simply the ‘operational expense’ of the organisation referred to in the previous article.8m + $6m) (20. the return per factory hour needs to be calculated for each product.000 .000 25. (2) Total factory costs/total time available on bottleneck resource. It also shows that elevating a bottleneck is not always financially viable. that if the ratio is less than 1. The cost per factory hour is across the whole factory and therefore only needs to be calculated once.700 The company should therefore invest in all three machines if it has enough cash to do so. The example of Cat Co demonstrates the fact that. If Cat Co was only able to afford machine Z.(throughput accounting Ratio) In any organisation. (2) cost per factory hour and (3) the throughput accounting ratio. As we saw in Example 1.5m = $6.300) Net benefit 700 Buy Z. then. it would be better off making no investment at all because if Z alone is invested in.8m) (14. Y & X Additional sales = 1. as one bottleneck is elevated.

all costs except materials are fixed. Inventory is valued at total production cost. Concepts of throughput accounting/Assumptions  In the short run. Value is added when an item is sold. Priority should be given to the products generating the highest TPARs. Past Paper Analysis Throughput accounting June 09 – Q 1 June 11 – Q 5 Dec 13 – Q 2 Dec 14 – Q 2 Page 19 of 147 . Value is added when an item is produced. as no value is added and no profit earned until a sale takes place  Closing stock is referred as unsynchronized production Difference between traditional costing and throughput accounting Traditional Costing Throughput accounting Labour costs and variable overheads are treated as All costs other than materials are seen as fixed in variable costs.  The ideal inventory level is zero and so unavoidable. Product profitability can be determined by deducting Profitability is determined by the rate at which a product cost from selling price. idle capacity in some operations must be accepted(JIT system is preferred)  WIP is valued at material cost only. F5 Performance Management 2016 How to improve a throughput accounting ratio (TPAR):  Reduce the bottleneck  Increase the selling price  Buy cheaper materials  Reduce the conversion costs etc Important:  Products and/or divisions can be ranked according to TPAR. Inventory is valued at material cost only.  Alternatively the products generating highest TP contribution per unit of constraint should be given priority. the short term. money is earned. The TPAR should be greater than one for a product to be viable.

Flow diagrams are often used to illustrate how the input is split across different output such as stored goods and waste. Input/output analysis This method operates on the principal that what comes in must go out. it is often difficult to pinpoint and allocate them to a particular service Methods of Environmental accounting in different organizations 1. Page 20 of 147 . Environmental Accounting Environmental accounting is becoming increasingly topical in the modern business environment due to increased regulation and media coverage Environmental management accounting (EMA) The generation and analysis of both financial and non-financial information in order to support environmental management processes Why environmental costs are important  Identifying environmental costs associated with individual products and services can assist with pricing decisions  Ensuring compliance with regulatory standards  Potential for cost savings  Government support  Reputation & goodwill Typical environmental costs  Consumables and raw materials  Transport and travel  Waste disposal  Energy consumption  Recycled material  Water usage  Pollution Important The majority product or of environmental costs are already captured within accounting systems. F5 Performance Management 2016 6. Output is split across sold and stored goods and waste. Measuring these categories in physical quantities and monetary terms forces businesses to focus on environmental costs.

This method focuses on reducing costs and having a positive effect on the environment 4. Examples of environmental cost drivers include volume of emissions and the cost of complying with environmental 3. Life-cycle costing Environmental costs are considered from the design stage right up to the last stage costs such as decommissioning and waste removal etc. This may influence the design of the product itself. saving on future costs. Past Paper Analysis Environmental accounting Dec 13 – Q 1c Page 21 of 147 . Environmental -driven costs such as increased depreciation or higher staff wages are allocated to general overheads. Flow cost accounting Material flows through an organization are divided into three categories  Material  System and delivery  Disposal The values and costs of each material flow are calculated. Environmental activity-based costing Two costs are relevant: Environment -related costs such as costs relating to a sewage plant or an incinerator are attributed to joint environmental cost centers. F5 Performance Management 2016 2.

of course. they could ensure that staffing levels were exactly accurate and no waste occurred in the kitchen. it can be of use in providing the answers to questions about the consequences of different courses of action. when we ask the question: ‘Will the company make a profit in that year?’. are fairly easy to predict. Take a restaurant. say with some degree of certainty that the contribution per unit (sales price less variable costs) is $20. profitability often hinges upon it. we can work out how many sales the business needs to make in order to make a profit and this is where CVP analysis begins. or. There are three methods for ascertaining this break-even point: Page 22 of 147 . We don’t know because we don’t know the sales volume for the year. hindsight is a beautiful thing. that decisions such as staffing and food purchases have to be made on the basis of estimates. the answer is ‘We don’t know’. F5 Performance Management 2016 Part B – Decision Making Techniques 7. with these estimates being based on past experience. For example. therefore. One of the most important decisions that needs to be made before any business even starts is ‘how much do we need to sell in order to break-even?’ By ‘break-even’ we mean simply covering all our costs without making a profit. While management accounting information can’t really help much with the crystal ball. The reality is. It can. Company A may also have fixed costs of $200. in the short-run. Methods for calculating the break-even point The break-even point is when total revenues and total costs are equal. However. which again. If only we could look into a crystal ball and find out exactly how many customers were going to buy our product. If the owners knew exactly how many customers would come in each evening and the number and type of meals that they would order. that is. The reason for the particular focus on sales volume is because. there is no profit but also no loss made. Cost Volume Profit (CVP) Analysis Cost-volume-profit analysis looks primarily at the effects of differing levels of activity on the financial results of a business In any business. indeed. Company A may know that the sales price for product x in a particular year is going to be in the region of $50 and its variable costs are approximately $30.000 per annum. however. and the cost of materials and labour. However. are usually known with a degree of accuracy. Sales volume. for example. while also considering the assumptions which underlie any such analysis. THE OBJECTIVE OF CVP ANALYSIS CVP analysis looks primarily at the effects of differing levels of activity on the financial results of a business. in the short-run. is not usually so predictable and therefore. we would be able to make perfect business decisions and maximise profits. in life in general. This type of analysis is known as ‘cost-volume-profit analysis’ (CVP analysis) and the purpose of this article is to cover some of the straight forward calculations and graphs required for this part of the Paper F5 syllabus. sales price.

it will break-even. it will make a profit. Also.000 units. are assumed to remain constant for all levels of output in the short-run. total costs are made up firstly of total fixed costs (FC) and secondly by variable costs (VC). Sales price and variable costs.000 units. if it sells exactly 10.000 units. We often see the unit contribution margin referred to as the Page 23 of 147 . We know that total revenues are found by multiplying unit selling price (USP) by quantity sold (Q). It would. By putting this information into a simple equation. This is done below continuing with the example of Company A above. and. The contribution margin is equal to total revenue less total variable costs. Total revenue – total variable costs – total fixed costs = Profit (USP x Q) – (UVC x Q) – FC = P (50Q) – (30Q) – 200. Any excess of total revenue over total costs will give rise to profit (P).000 = 0 20Q – 200. If Company A sells less than 10. be inappropriate to use a unit fixed cost since this would vary depending on output.000 = P Note: total fixed costs are used rather than unit fixed costs since unit fixed costs will vary depending on the level of output. it will make a loss. The equation has given us our answer. Alternatively.000 = 0 20Q = 200. ie to break even: (50Q) – (30Q) – 200. the unit contribution margin (UCM) is the unit selling price (USP) less the unit variable cost (UVC).000 units. unit costs are appropriate. then we would simply take our fixed costs and divide them by our unit contribution margin. and if it sells more than 10. Total variable costs are found by multiplying unit variable cost (UVC) by total quantity (Q). on the other hand. therefore. 2 The contribution margin method This second approach uses a little bit of algebra to rewrite our equation above. the formula from our mathematical method above is manipulated in the following way: (USP x Q) – (UVC x Q) – FC = P (USP – UVC) x Q = FC + P UCM x Q = FC + P Q = FC + P UCM So. Hence. F5 Performance Management 2016 1 The equation method A little bit of simple math can help us answer numerous different cost-volume-profit questions. if P=0 (because we want to find the break-even point). Continuing with our equation. we now set P to zero in order to find out how many items we need to sell in order to make no profit. concentrating on the use of the ‘contribution margin’.000 Q = 10. therefore. we come up with a method of answering CVP type questions.

This is very similar to a break-even chart.000 20 Therefore Q = 10. The advantage of this is that it emphasises contribution as it is represented by the gap between the total revenue and the variable cost lines. which emphasises the impact of volume changes on profit (Figure 3). Finally. a contribution graph could be drawn.000 units The contribution margin method uses a little bit of algebra to rewrite our equation above. Hence. F5 Performance Management 2016 ‘contribution per unit’. a variable cost line is shown instead. $ is shown on the y axis and units are shown on the x axis.000 and P = 0. Q = FC UCM Q = 200. Alternatively. Page 24 of 147 . While this is not specifically covered by the Paper F5 syllabus. This is key to the Paper F5 syllabus and is discussed in more detail later in this article. it is the difference between the variable cost line and the total cost line that represents fixed costs. This is shown for Company A in Figure 2. The point where the total cost and revenue lines intersect is the break-even point. FC = 200. a profit–volume graph could be drawn. Applying this approach to Company A again: UCM = 20. Figure 1 shows a typical break-even chart for Company A. the total costs and total revenue lines are plotted on a graph. 3 The graphical method With the graphical method. concentrating on the use of the ‘contribution margin’. The amount of profit or loss at different output levels is represented by the distance between the total cost and total revenue lines. The gap between the fixed costs and the total costs line represents variable costs. the only difference being that instead of showing a fixed cost line. it is still useful to see it.

F5 Performance Management 2016 Figure 1 Figure 2 Page 25 of 147 .

000. Example 1 Company A wants to achieve a target profit of $300. Alternatively.000 Q = 25. the profit of $300. Q = FC + P UCM Page 26 of 147 . FC = 200.000.000 is put into the equation rather than the profit of $0: (50Q) – (30Q) – 200. F5 Performance Management 2016 Figure 3 Ascertaining the sales volume required to achieve a target profit As well as ascertaining the break-even point. The sales volume necessary in order to achieve this profit can be ascertained using any of the three methods outlined above.000 and P = 300.000 = 300.000 units.000 20Q = 500. there are other routine calculations that it is just as important to understand. For example.000 = 300. the contribution method can be used: UCM = 20. If the equation method is used.000 20Q – 200. a business may want to know how many items it must sell in order to attain a target profit.

F5 Performance Management 2016

Q = 200,000 + 300,000

Therefore Q = 25,000 units.

Finally, the answer can be read from the graph, although this method becomes clumsier than the previous
two. The profit will be $300,000 where the gap between the total revenue and total cost line is $300,000,
since the gap represents profit (after the break-even point) or loss (before the break-even point.)

A contribution graph shows the difference between the variable cost line and the total cost line that
represents fixed costs. An advantage of this is that it emphasises contribution as it is represented by the
gap between the total revenue and variable cost lines.

This is not a quick enough method to use in an exam so it is not recommended.

Margin of safety
The margin of safety indicates by how much sales can decrease before a loss occurs, ie it is the excess of
budgeted revenues over break-even revenues. Using Company A as an example, let’s assume that
budgeted sales are 20,000 units. The margin of safety can be found, in units, as follows:

Budgeted sales – break-even sales = 20,000 – 10,000 = 10,000 units.

Alternatively, as is often the case, it may be calculated as a percentage:

Budgeted sales – break-even sales/budgeted sales.
In Company A’s case, it will be 10,000/20,000 x 100 = 50%.

Finally, it could be calculated in terms of $ sales revenue as follows:

Budgeted sales – break-even sales x selling price = 10,000 x $50 = $500,000.

Contribution to sales ratio
It is often useful in single product situations, and essential in multi-product situations, to ascertain how
much each $ sold actually contributes towards the fixed costs. This calculation is known as the contribution
to sales or C/S ratio. It is found in single product situations by either simply dividing the total contribution
by the total sales revenue, or by dividing the unit contribution margin (otherwise known as contribution
per unit) by the selling price:

For Company A: $20/$50 = 0.4

In multi-product situations, a weighted average C/S ratio is calculated by using the formula:

Total contribution/total sales revenue

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F5 Performance Management 2016

This weighted average C/S ratio can then be used to find CVP information such as break-even point, margin
of safety etc.

Example 2
As well as producing product x described above, Company A also begins producing product y. The following
information is available for both products:

Product x Product y
Sales price $50 $60
Variable cost $30 $45
Contribution per unit $20 $15
Budgeted sales (units) 20,000 10,000

The weighted average C/S ratio can be once again calculated by dividing the total expected contribution by
the total expected sales:

(20,000 x $20) + (10,000 x $15) /(20,000 x $50) + (10,000 x $60) = 34.375%

The C/S ratio is useful in its own right as it tells us what percentage each $ of sales revenue contributes
towards fixed costs; it is also invaluable in helping us to quickly calculate the break-even point in $ sales
revenue, or the sales revenue required to generate a target profit. The break-even point can now be
calculated this way for Company A:

Fixed costs / contribution to sales ratio = $200,000/0.34375 = $581,819 of sales revenue.

To achieve a target profit of $300,000:

Fixed costs + required profit /contribution to sales ratio = $200,000 + $300,000/0.34375 = $1,454,546.

Of course, such calculations provide only estimated information because they assume that products x and
y are sold in a constant mix of 2x to 1y. In reality, this constant mix is unlikely to exist and, at times, more y
may be sold than x. Such changes in the mix throughout a period, even if the overall mix for the period is
2:1, will lead to the actual break-even point being different than anticipated. This point is touched upon
again later in this article.

Contribution to sales ratio is often useful in single product situations, and essential in multi-product
situations, to ascertain how much each $ sold actually contributes towards the fixed costs.

Table 3: Figure 3 continued

Product x Product y
Sales price $50 $60
Variable cost $30 $45

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F5 Performance Management 2016

Product x Product y
Contribution per unit $20 $15
Budgeted sales (units) 20,000 10,000
C/S ratios 0.4 0.25
Weighted average C/S ratio 0.34375
Product ranking (most profitable first) 1 2

Cumulative Cumulative
Contribution profit/loss Revenue revenue
Product $'000 $'000 $'000 $'000
(Fixed costs) 0 (200) 0 0
X 400 200 1,000,000 1,000,000
Y 150 350 600,000 1,600,000

In order to draw a multi-product/volume graph it is necessary to work out the C/S ratio of each product
being sold.

Multi-product profit–volume charts

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

See Table 3.

The graph can then be drawn (Figure 3), showing cumulative sales on the x axis and cumulative profit/loss
on the y axis. It can be observed from the graph that, when the company sells its most profitable product
first (x) it breaks even earlier than when it sells products in a constant mix. The break-even point is the
point where each line cuts the x axis.

Page 29 of 147

it is often found that if sales volumes are to increase. such as telephone charges. In reality. This is only likely to hold a short-run. make accurate predictions of fixed costs in that range. However. if absorption costing is used. These are only a few reasons why the assumption may not hold true.  The total cost and total revenue functions are linear. economies of scale may be achieved as volumes increase. We have considered this above in Figure 3 and seen that if the constant mix assumption changes. so does the break-even point.  All other variables. costs and selling prices. revenues will change. whereby there may be a fixed monthly rental charge and a variable charge for calls made.  Costs can be divided into a component that is fixed and a component that is variable. for example. It will either have operated at those activity levels before or studied them carefully so that it can. if there are multiple products. there are many others. Furthermore. restricted level of activity. this assumption may not hold true as. if there is a change in sales mix. F5 Performance Management 2016 Limitations of cost-volume-profit analysis  Cost-volume-profit analysis is invaluable in demonstrating the effect on an organisation that changes in volume (in particular). In reality. for example. remain constant. its use is limited because it is based on the following assumptions: Either a single product is being sold or.levels in activity in which the business has experience and can therefore perform a degree of accurate analysis. sales price must fall. it is assumed that production volumes are equal to sales volumes. apart from volume. some costs may be semi-fixed.  Fixed costs remain constant over the 'relevant range' . these are sold in a constant mix. Past Paper Analysis CVP analysis Dec 12 – Q 1 Dec 15 – Q 4 Page 30 of 147 . Similarly.  Profits are calculated on a variable cost basis or. have on profit. ie volume is the only factor that causes revenues and costs to change.

which should not be difficult at this level. the firm uses 3kg of material and four hours of labour. limited to 15. You should not forget the non-negativity constraint. The cost of materials is normally $8 per kg. To make X. and materials. The contributions made by each product are $30 for X and $40 for Y.000. of X. The first step in any linear programming problem is to produce the equations for constraints and the contribution function.000kg. the firm uses 5kg of material and four hours of labour. X and Y. the optimal production plan) will show that by pushing out the contribution function. The firm manufactures and sells two products. F5 Performance Management 2016 8.000 hours. the optimal solution will be at point B – the intersection of materials and labour constraints. If there are multiple limiting factor-Linear programming approach is used. Page 31 of 147 . The contribution function is 30X + 40Y = C Figure 1: Optimal production plan Plotting the resulting graph (Figure 1. Limiting Factor Analysis 1. if needed. and the labour rate is $10 per hour.Y ≥ 0. and the labour constraint will be 4X + 4Y ≤ 16. If there is a single limiting factor-Optimal plan is made based on ranking (Contribution per limiting factor -7 steps) 2. It is a mathematical approach and is best understood through an exam question LINEAR PRGRAMMING To understand linear programming in detail the following scenario is relevant: Suppose a profit-seeking firm has two constraints: labour. In our example. whereas to make Y.000. limited to 16. the materials constraint will be 3X + 5Y ≤ 15.

Paying less than $13 ($5 + $8) per kg to obtain more materials will make the firm better off financially. Equally. The point of this calculation is to provide management with a target production plan in order to maximise contribution and therefore profit. Quality is a factor. How many materials to buy? Students need to realise that as you buy more materials.500. be a good reason to buy ‘expensive’ extra materials (those costing more than $13 per kg). It might enable the business to satisfy the demands of an important customer who might. There may. The important point is. buy more products later. which generates $135. WORKINGS Working 1: The optimal point is at point B. and so paying ‘too much’ for more materials might be justifiable if it will prevent a penalty on the contract. the point at which 4. as is reliability of supply. However. in turn. The firm might have to meet a contractual obligation. The ability to solve simultaneous equations is assumed in this article. constraints can relax or tighten. priced at under $13 per kg. Check this for yourself (see Working 1). Eventually. For example. the maximum amount of extra material required is 5. which is at the intersection of: 3X + 5Y = 15.000 Page 32 of 147 .000 units of Y are produced. Suppose the shadow price of materials is $5 per kg (this is verifiable by calculation – see Working 2). is not attractive. The cost of this is rarely included in shadow price calculations. what does this mean? If management is offered more materials it should be prepared to pay no more than $5 per kg over the normal price. Note: Although interpretation is important at this level. how much should be paid for them? And how much should be bought? These dynamics are important. Accountants should recognise that ‘price’ is not everything. Management needs to understand this.000). it might be that ‘cheap’ material. Consequently. the materials line will be totally outside the labour line on the graph and the point at which this happens is the point at which the business will cease to find buying more materials attractive (point D on the graph). To make 4. things can change and. Labour would then become the only constraint. Paying more than $13 per kg would render it worse off in terms of contribution gained. We need to find out how many materials are needed at point D on the graph.000 units of Y we need 20.000 – 15. in particular.000 in contribution.000kg (20. F5 Performance Management 2016 The optimal point is X = 2. if new materials are offered. there will still be marks available for the basic calculations.000 and 4X + 4Y = 16.000kg of materials. Management needs to know the financial implications of such changes.500 and Y = 1. then that constraint relaxes and so its line on the graph moves outwards and away from the origin. of course.

multiplying by four for the first equation and by three for the second produces: 12X + 20Y = 60.500. Page 33 of 147 .5 x 40) = $135.500 x 40) = $135.000 12X + 12Y = 48.500 x 30) + (1.000 Important Definitions: 1.500 X = 2. Surplus: when the resource use is more than the minimum required. if a resource is not binding at the optimal point it will have slack 3.000 = $5 per kg. it is said to have surplus Working 2: Shadow price of materials (from the above example) To find this we relax the material constraint by 1kg and resolve as follows: 3X + 5Y = 15.000 8Y = 12.5 in any of the above equations will give us X: 3X + 5 (1. Slack: the best utilization of resource is not the full utilization of resource.500) = 15.499.005 The increase in contribution from the original optimal is the shadow price:’s the maximum premium the company could pay by having one extra unit of the limited resource at optimal point 2. or Y = 1.000 Again.5 X = 2.500 Substituting Y = 1.5 x 30) + (1.000 The difference in the two equations is: 8Y = 12.5) = 15.000.004 12X + 12Y = 48.5 The new level of contribution is: (2.000 3X = 7.500.499.500.005 – 135.498.004 Y = 1.001 3X = 7.500.500 in any of the above equations will give us the X value: 3X + 5 (1.500 The contribution gained is (2.5 Substituting Y = 1.001 and 4X + 4Y = 16. Shadow price: the amount of contribution generated by having one extra unit of the binding constraint. F5 Performance Management 2016 Multiplying the first equation by four and the second by three we get: 12X + 20Y = 60.

F5 Performance Management 2016

Example 2:

Consider the following past exam paper question in detail to improve on your concepts:

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F5 Performance Management 2016

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F5 Performance Management 2016 Page 37 of 147 .

F5 Performance Management 2016 Past Paper Analysis Limiting Factor Analysis June 08 – Q 2 June 10 – Q 3 Dec 10 – Q 3 June 14 – Q 2 Page 38 of 147 .

may start a price war (e. E. Inflation Prices have to reflect the increase in material and labour cost. they will stock-up on the product. Suppliers If a company increases the price of its products.g. F5 Performance Management 2016 9. Quality Customers may consider high prices to be a reflection of the high quality of the product Competitors Some companies show unified increase in price (e. Pricing Decisions Influences on Price: Price of a product is decided after taking into account many factors apart from Cost.g. A customer will travel business class if his/ her company is bearing the expenses but will reconsider if he/ she has to spend own money. Newness Pricing will depend upon reference points and in the case of new products’ a company may have to look at other markets where the product/ similar product has been launched. power to influence price •Customer preference • Form cartels dictates who holds the power Page 39 of 147 . their focus is quality and accessibility of product but if income decreases. Ethics Does the company want to exploit the market by increasing prices when there is a short term shortage of the product in the market? Market: Price is determined by the type of market. sell ink pens cheaper but make up for profit in the price of ink. mobile network services). focus is on price. they will not be price sensitive. Product Range Price can be spread over a complete product range to maintain profitability.g. the suppliers may start providing the raw material at a higher price too.g.g. if the price of sugar is increased and the customer perceives that the price will further increase. E. Price Sensitivity If customers of the product can pass on the burden of the cost to someone else. Incomes If customers have more income. the company operates in: • Multiple buyers and • One seller with the sellers power to influence price • No power saturation Perfect Monopoly Competition Monopolistic Oligopoly Competition • Few companies offering •Multiple suppliers with same product have similar products. Price Perception E. petrol) but in others a change in price.

Price Elasticity of Demand: It is a measure of the change in sales demand that would occur for a given change in the selling price. the lower will be the quantity demanded. However there are two extremes to this theory: A company is able to sell a fixed quantity (Q) of the A company is able to sell limitless quantity (Q) of product. F5 Performance Management 2016 Competition: If competitors cut prices. This is termed as as completely inelastic demand as change in price completely elastic demand as change in price will does not affect the quantity demanded. Raise Price and use extra revenue for Reduce price non price counter attack Demand: Economic theory argues that the higher the price of a good. A more normal situation is the downward-sloping demand curve which shows that demand will increase as prices are lowered. This is termed the product at a set price (P). a company can react in the following possible ways: Non Price Counter Attack: maintain Maintain exitsing prices price but improve product/ promotion. Demand is therefore elastic. PED = The change in quantity demanded as a percentage of original demand The change in sales price as a percentage of the original price PED > 1 than demand is elastic: impact on quantity demanded is greater due to change in price PED< 1 than demand is inelastic: impact on quantity demanded due to change in price is nominal Page 40 of 147 . regardless of any price (P). substantially affect the quantity demanded.

 Quality: If the product is of good quality. service. Demand/ Price Influencers – Organisation Specific  Product Life Cycle: Demand varies over the life cycle of a product. Very Elastic Demand Try and control elasticity by creating customer preferences through quality. Complements: Increase in demand for one product will give rise to demand of complementary product. to maintain demand. service etc. increase the price so that revenue increases and costs reduce due to smaller quantity being produced. Inelastic Demand As price has nominal impact on demand. when there is little or no competition in the market.  Marketing: The 4 P’s of marketing are demand influencers:  Price Page 41 of 147 . company should focus on quality. F5 Performance Management 2016 Elasticity and Pricing: Very Inelastic Demand As price will have no impact on quantity demanded. Tastes or fashion A change in tastes or fashion will alter the demand for a good. Obsolescence Many products and services have to be replaced periodically because of obsolescence. the demand may be high regardless of price. Elastic Demand Find right balance to ensure that the revenue earned is greater than the costs incurred. because there is a limit to what consumers can or want to consume. Increase in Income Normal goods: more income more demand Inferior goods: more income less demand Necessities: demand rises up to a certain point and then remains unchanged. Expectations Stock up may occur if customers expect the prices to rise and this will lead to more demand.  Decline: Prices may fall due to lower demand or prices can be increased if the competition withdraws from the market and you are the only one offering the product.  Growth: Prices will have to be reduced as competition increases. Demand Influencers: Price of other goods Substitutes: Increase in price of one product will lead to customers moving towards the substitute available. product design etc to attract customers. or a particular variety of a good.  Introduction Phase: The price has no impact on demand at the initial stage.  Maturity: Prices can be stabilised unless the competitors reduce their prices.

For demand to be nil.05 x 100) 18 =a-5 Page 42 of 147 . customers will turn to substitutes. but only 75 items are sold at this price.$18 = 4 = 0. One month the company decides to raise the price to $22. Determine the demand equation. Solution Step 1: Find the price at which demand would be nil Assuming demand is linear. this can be shown as a = $18 + ((100/25) x $4) = $34 Step 2: Calculate b b = Change in price $22.  Promotion: developing a brand name and using a variety of promotional tools will lead to increased demand for the product. If goods are not easily accessible. Demand Equation: Example: The current price of a product is $18.05 Change in quantity 100 -75 75 Step 3: Substitute the known value for ‘b’ into the demand function to find ‘a’ P = a . At this price the company sells 100 items a month. F5 Performance Management 2016  Product  Place: of purchase. Using the formula above.(0.05Q) 18 = a . each increase of $4 in the price would result in a fall in demand of 25 units. the price needs to rise from its current level by as many times as there are 25 units in 100 units (100/25 = 4) ie to $18 + (4 x $4) = $34.(0.

05Q = 23 – 18 0. Page 43 of 147 . 18 = 23 – (0. Errors in using these models:  Assume that fixed costs remain constant when in reality there is a concept of Step Fixed Costs  Assume that Variable Cost per unit remains constant when in reality they change due to economies/ diseconomies of scale or Volume Based Discounts (discounts given for bulk transactions) The Profit-Maximizing Price/Output Level Profits are maximized when marginal cost (MC) = marginal revenue (MR).05Q) 0.05Q = 5 Q = 5 = 100 0.05 The Total Cost Function: Cost behaviour can be modelled using equations. Total Cost (TC) = Fixed Cost (FC) + [Variable Cost (VC) x Quantity sold (Q)] The following graph demonstrates the total cost function. F5 Performance Management 2016 a = 23 The demand equation is therefore P = 23 – 0.05Q Step 4: Check your equation We can check this by finding Q when P is $18.

Page 44 of 147 .  The Marginal revenue (MR) – Marginal cost (MC) method is based on the fact that total profit in a perfect market reaches its maximum point where marginal revenue equals marginal cost.  The Total revenue (TR) – Total cost (TC) method is based on the fact that profit equals revenue minus cost. we can see that at an output level of Qn. the sales price per unit would be Pn. If we add a demand curve to the graph. ie at a volume of Qn units. Determining the Profit-Maximising Selling Price: Using Equations The optimal selling price can be determined using equations (ie when MC = MR). There are two common approaches to this problem. This is the profit maximising output quantity. Profits are maximised at the point where MC = MR. F5 Performance Management 2016 Microeconomic theory and profit maximisation Profit Maximisation is the process by which a firm determines the price and output level that returns the greatest profit. it is evident that the difference between total costs and total revenue is greatest at point Q. From the graph.

The marginal cost of product G is $120. Calculate the profit-maximising selling price for product G.$120) x (10/1) = 8.800 is profit maximising demand Step 5: Substitute Q into the demand function and solve to find P (the optimum price) P = a – bQ = $1.800) = $560 Price Strategies Full cost plus pricing: Calculate full cost of product and add desired profit to determine selling price.05) Q = $1.000 /20) x $1] = $1.000 Step 2: Establish MC (the marginal cost). Demand will rise or fall by 20 units for every $1 fall/rise in the selling price. Profit is expressed as either:  a percentage of the full cost (a profit 'mark-up') or  a percentage of the sales price (a 'profit margin').000 – 0.000 . F5 Performance Management 2016 Example: It has been determined based on research that if a price of $400 is charged for product G.000 – (2 x 0. Example: Mark-Up Margin % $ % $ Variable production costs 600 600 Other variable costs 200 200 Production overheads absorbed 800 800 Page 45 of 147 .1Q Q = ($1. This will simply be the variable cost per unit MC = $120 (given) Step 3: State MR. demand will be 12. Solution: The following step-by-step approach can be applied to most questions involving algebra and pricing. assuming MR = a – 2bQ MR = $1.05 x 8.000 units.000 – (0.05 change in quantity 20 a = $400 + [(12.000 – 0. Step 1: Establish the demand function (find the values for ‘a’ and ‘b’) b = change in price = $1 = 0. equate MC and MR to find Q $120 = $1.1Q Step 4: To maximise profit.

Marginal Cost plus Pricing (Mark-Up Pricing): A mark-up or profit margin is added to the marginal cost in order to obtain a selling price.  Useful in industries where the Variable cost per unit is easily available.  Disadvantages:  Ignores profit maximisation combination of price and demand. which is a key factor in decision making. simple and cheap method to set product price.  When a company is aware of market segments that are willing to pay more.  Mark up % can be varied to reflect demand conditions.  Suitable basis for overhead absorption rate has to be selected. all the expenses are easily recovered.  Ignores fixed overheads in pricing decisions. This is an appropriate approach for:  When the product is new and different.  When a product has a short lifecycle and its costs are to be recovered as soon as possible. F5 Performance Management 2016 Non-production overheads absorbed 300 300 Full cost 100 1. other relevant market factors.  Relies on budgeted output volume to determine appropriate absorption rate for overheads. The method of calculating sales price is similar to full-cost pricing.  Advantages:  Simple and easy to calculate. with the hope of skimming the market for profits. The price of the product is adjusted at a later date. Market Skimming Prices: Charging a high price when the product is introduced in the market for the first time. Page 46 of 147 .  When its demand elasticity is unknown.375  Advantages:  Quick.  Disadvantages:  Apart from demand.900 Profit (added to full cost) 25 475 20 475 Selling price 125 2. like prices set by competitors etc. are ignored.  As profit % is added to full cost.900 80 1.  In reality the price has to be adjusted to market and demand conditions.  Focuses attention on the contribution of the product. except that marginal cost is used instead of full cost.375 100 2.  When a company is trying to resolve its liquidity issues.

 Product Version: Add-ons/ extras for mobile phones. Product Lines Pricing: Setting a consistent pricing policy for a group of products that are related to each other. Past Paper Analysis Pricing Decisions Dec 09 – Q 5 June 11 – Q 2 June 15 – Q 4 Page 47 of 147 . the company needs to sell the product/ order at a price higher than the minimum price. F5 Performance Management 2016 Market Penetration Prices: Introducing a product at low costs to establish its stronghold in the market.  When a company can enjoy great economies of scale at high sales volume. skin care products etc. Loss Leader: is when a company sells a low price for one product to attract customers and ends up selling complementary products with high profit margins. This is also termed as ‘Captive Product Pricing’. This is an appropriate approach for:  When a company is trying to discourage new entrants in the market.g. E.  Time: Off peak travel discounts. Price Discrimination (Differential Pricing): Charging different prices to different groups of buyers for the same product. nor worse off.  Place: Seating arrangements in cinema halls. with expensive tickets for more comfortable seats. at which the company will neither be better off. The minimum price calculated must take into account the following:  Incremental cost of producing and selling the product  Opportunity costs in the form of resources uses to produce and sell the product To earn a profit. same policy for shampoos. that are not reflected in the original price of the phone but offered as a separate package. Some bases for price discrimination is:  Market Segment: students get discounted tickets on public transport.  Product demand is highly elastic and so low prices will generate a lot of demand. Computer games console and computer games. Complementary Products Pricing: Setting a single pricing policy for goods that are complementary i. are normally bought together.g.  When a company wishes to push a product to its growth and maturity stage quickly. Relevant Cost Pricing (Minimum Pricing): Calculating a minimum price of the product/ order. of the same brand. the company will enjoy a profit. If sold at more than the minimum price.e. E.

 The rent of a machine hired for a job. Short Term Decisions Relevant Costs: Are incremental future cash flows. Relevant Costs for Material: Relevant Costs for Labour:  If labour is re-assigned tasks to take up new project or product. is relevant. the variable cost of labour. it may be transferred from the production of one product to that of another product. in order to avail the benefit from an alternative. if a material is in short supply. Opportunity Costs The value of a benefit given up. Relevant Costs for Machinery:  Purchase cost of machinery is irrelevant unless specifically bought for a product/ job. Committed costs and non-cash expenses like depreciation are irrelevant costs. Page 48 of 147 .  Sunk costs. due to use of the machinery in a specific job. variable overheads and the contribution foregone are relevant for decision making.  User Cost: is the fall in resale value of owned assets. The opportunity cost is the contribution lost from ceasing production of the original product. arising as a direct consequence of a decision. F5 Performance Management 2016 10. For example.

000 2.000 Unit marginal costs $ $ Direct materials 4 5 Direct Labour 8 9 Variable production overheads 2 3 Directly attributable fixed costs per annum and committed fixed costs: Incurred as a direct consequence of making F $1.000 2.000 A sub-contractor has offered to supply units of F & P for $12 and $21 respectively. or whether it should sub-contract the work to another company  Whether a service should be carried out by an internal department or whether an external organisation should be employed  Without limiting factors the relevant costs for the make or buy decision will be the differential costs between the two options.000 The company would save $3.000) (5.000 pa by subcontracting component Z (because of the saving in fixed costs of $8. Example A company makes two components F and P.000 $ $ Extra variable cost of buying (per annum) (2. F5 Performance Management 2016 Make or Buy Decisions:  Normally applied in the following circumstances:  Whether a company should manufacture its own components. F P Production (units) 1.000) Extra total cost of buying (3.000 Fixed costs saved by buying (1. Page 49 of 147 .000).000 Incurred as a direct consequence of making P $5. Should the company make or buy the components? Solution F P $ $ Unit variable cost of making 14 17 Unit variable cost of buying 12 21 2 4 Annual requirements (units) 1. or else buy the components from an outside supplier  Whether a construction company should do some work with its own employees.000 pa by sub-contracting component W (where the purchase cost would be less than the marginal cost per unit to make internally) and would save $2. for which costs in the forthcoming year are expected to be as follows.000) 8.000) 3.

25 per unit for S and $2. and these need to be allocated (apportioned) in some manner to each of the joint products. when 100. but which are indistinguishable from each other up to their point of separation.  Problems in accounting for joint products are basically of two different sorts. Should the company sell S or Splus? Solution Page 50 of 147 .  Costs incurred prior to this point of separation are common or joint costs. but at an extra fixed cost of $20. This is also known as contract manufacturing or sub-contracting. F5 Performance Management 2016 Outsourcing:  This is the use of external suppliers for finished products.00 per unit for T.000 units of a new chemical. or to process the product further and sell it at a later stage. The selling prices at split-off point are $1.000 units of T are produced.  Reasons for Outsourcing:  Hiring specialists ensures the quality of the end product and efficiency.000 units of S and 50.  Whether it is more profitable to sell a joint product at one stage of processing.  The point at which joint products become separately identifiable is known as the split-off point or separation point.  A joint product is regarded as an important saleable item.000 and variable cost of 30c per unit of input. Example A Company produces two joint products. Splus. components or services. The profitability of each joint product should be assessed in the cost accounts.25 per unit. Joint processing costs of $150. The units of S could be processed further to produce 60. and so it should be separately costed. The selling price of Splus would be $3.  Outsourcing leads to spare resources that can be effectively utilised in other core areas. Each product post separation has a substantial sales value. in order to put a value to closing inventory and to the cost of sale (and profit) for each product. Joint Products:  Joint products are two or more products which are output from the same processing operation.000 are incurred up to split-off point.  The performance of ‘outsourcers’ has to be monitored and measured to make sure quality and targets are not compromised upon. S and T from the same process.  Companies rely on outsourcing facilities for administrative and maintenance tasks.  How common costs should be apportioned between products.  Company’s offering outsourcing services have the capacity and flexibility to meet ad-hoc variations in the demand.  There isn’t enough work to justify the recruitment of resources for a specific function.

000 (further processing) costs It is $20. Every other cost is irrelevant: they will be incurred regardless of what the decision is.000 ___ Variable 30. The budget for next year is as follows: P Q R S Total $000 $000 $000 $000 $000 Direct materials 300 500 400 700 1.000 150 1.000 Sales minus post-separation 125. R and S.000 Post-separation processing costs ___ Fixed 20.250) Share of general fixed costs (200) (200) (300) (400) (1.200 Variable overheads 100 200 100 100 500 800 1. however. Shut Down Decisions  Discontinuance or shutdown problems involve the following decisions.000 195.550 7. department or other activity.25 $ $ $ Total sales 125.200 1.900 Direct labour 400 800 600 400 2.100 350 2.  Income from non-current asset sales would match redundancy costs and so these capital items would be self-cancelling. by making one of the following assumptions.100 1.  Whether or not to close down a loss making / expensive product line. Q.100) Profit/(loss) 400 (300) 500 (350) 250 Page 51 of 147 .  Permanent or temporary closure?  Employees affected by the closure must be made redundant or relocated.200 Contribution 1.  It is possible. P.800 1. perhaps after retraining.650 2.000 145.  In such circumstances the financial aspect of shutdown decisions would be based on short-run relevant costs.600 Sales 1.25 $3.000 50.200 4. or else offered early retirement.600 Directly attributable fixed costs (400) (250) (300) (300) (1. Example: Company V makes four products.000 more profitable to convert S into Splus. for shutdown problems to be simplified into short-run decisions.500 1.  Non-current asset sales and redundancy costs would be negligible. S Splus Selling price per unit $1. F5 Performance Management 2016 The only relevant costs/incomes are those which compare selling S against selling Splus.

000) (150) (1. a product should be withdrawn from the market if the savings from closure exceed the benefits of continuing to make and sell the product. If a product is withdrawn from the market. However. Product P and product R both make a profit even after charging a share of general fixed costs. These costs would be saved if operations to make and sell the product were shut down. Past Paper Analysis Short term decision making June 09 – Q 4 Dec 11 – Q 1 Dec 14 –Q 3 June 12 – Q 1 Dec 07 – Q 4 Dec 13 – Q 1a Page 52 of 147 . and we should therefore consider whether it might be appropriate to stop making and selling either or both of these products. Answer From a financial viewpoint. shutdown would reduce annual cash flows because the contribution lost would be greater than the savings in directly attributable fixed costs. F5 Performance Management 2016 'Directly attributable fixed costs' are cash expenditures that are directly attributable to each individual product.000. but -will save the directly attributable fixed costs. and withdrawal is therefore recommended on the basis of this financial analysis. On the other hand. Required: State with reasons whether any of the products should be withdrawn from the market. the company will lose the contribution. in order to eliminate the losses. Decision recommended: Stop making and selling product Q but carry on making and selling product S. product Q and product S both show a loss after charging general fixed costs. Effect of shutdown P Q R S $000 $000 $000 $000 Contribution forgone (1.100) (350) Directly attributable fixed costs saved 400 250 300 300 Increase/(reduction) in annual cash flows (600) 100 (800) (50) Although product S makes a loss. withdrawal of product Q from the market would improve annual cash flows by $100.

it has been suggested that in the real world. Risk often has negative connotations. the looming risk of recession. through the current risks faced by particular industry sectors (such as banking. may differ from that which was expected when the decision was taken. Page 53 of 147 . which feature in exam questions can be transferred to real-world scenarios. risk is almost always a major variable in real-world corporate decision-making. and therefore the concept of risk is largely redundant. The basic definition of risk is that the final outcome of a decision. However. We tend to distinguish between risk and uncertainty in terms of the availability of probabilities Risk is when the probabilities of the possible outcomes are known (such as when tossing a coin or throwing a dice). ultimately. Risk can take myriad forms – ranging from the specific risks faced by individual companies (such as financial risk. it is generally not possible to allocate probabilities to potential outcomes. While it is unlikely that the precise probabilities and perfect information. Risk and Uncertainty Risk permeates most aspects of corporate decision-making (and life in general). but the potential for greater than expected returns also often exists. car manufacturing. Attitudes to risk Risk seeker A decision maker interested in the best outcomes no matter how small the chance that they may occur. Risk Averse A decision maker who acts on the assumption that the worst outcome might occur. in terms of potential loss. potential outcomes and probabilities will generally be provided. trainee accountants require an ability to identify the presence of risk and incorporate appropriate adjustments into the problem-solving and decision-making scenarios encountered in the exam hall. a knowledge of the relevance and applicability of such concepts is necessary. or the risk of a strike among the workforce). and. such as an investment. and managers ignore its vagaries at their peril. Risk neutral A decision maker concerned with what will be the most likely outcome. In the artificial scenarios of exam questions. therefore a knowledge of the basic concepts of probability and their use will be expected. or construction). F5 Performance Management 2016 11. uncertainty is where the randomness of outcomes cannot be expressed in terms of specific probabilities. Clearly. Similarly. and few can predict with any precision what the future holds in store. to more general economic risks resulting from interest rate or currency fluctuations.

The total of all the probabilities from all the possible outcomes must equal 1. Referring back to Table 1. and the probability when rolling a dice that it will show a four is 1/6 (0.250. 0. ie the outcome of the second event depends on the outcome of the first event.2 0.5. in Table 1. For example.000 $700. with potential values ranging from 0 (the event will not occur) to 1 (the event will definitely occur).500. A real world example could be that of a company forecasting potential future sales from the introduction of a new product in year one (Table 1). with a conditional event. then the expected value of the sales for year one is given by: Page 54 of 147 .000.000.000. regarding the sales forecast. The availability of information regarding the probabilities of potential outcomes allows the calculation of both an expected value for the outcome. the probability of a tail occurring when tossing a coin is 0. the company is forecasting sales for the first year of the new product. EXPECTED VALUES AND DISPERSION Using the information regarding the potential outcomes and their associated probabilities.2 0. the expected value of the outcome can be calculated simply by multiplying the value associated with each potential outcome by its probability.000 $1.166). then it is likely that the predictions made will depend on the outcome for year one. then the predictions for year two are likely to be more optimistic than if the sales in year one were $500.000. F5 Performance Management 2016 PROBABILITY The term ‘probability’ refers to the likelihood or chance that a certain event will occur. as that value has the highest probability.000 $1. In contrast. and a measure of the variability (or dispersion) of the potential outcomes around the expected value (most typically standard deviation). the outcomes of two or more events are related. This provides us with a measure of risk which can be used to assess the likely outcome. subsequently.500.000 Probability 0. INDEPENDENT AND CONDITIONAL EVENTS An independent event occurs when the outcome does not depend on the outcome of a previous event.1 0. For example.000 $1. For example. the company attempted to predict the sales revenue for the second year. assuming that a dice is unbiased. it is clear that the most likely outcome is that the new product generates sales of £1. If the outcome for year one was sales of $1. then the probability of throwing a five on the second throw does not depend on the outcome of the first throw. ie some outcome must occur.000.1 From Table 1. Table 1: Probability of new product sales Sales $500. If.

1) + ($700.000 + $400. the square root is taken to give the standard deviation. In addition to the expected value. as shown in Table 3.000.25 5% 0. but this is not necessarily always the case. concerning the potential returns from two investments.4) + ($1.000 + $150.1) = $50.2) + ($1. The most common measure of dispersion is standard deviation (the square root of the variance). The results are then totalled to yield the variance and. the average score from throwing a dice is (1 + 2 + 3 + 4 + 5 + 6) / 6 or 3.000 = $990. we must first calculate the expected values of each investment: Investment A Expected value = (8%)(0. it is likely that the expected value does not correspond to any of the individual potential outcomes.250. A further point regarding the use of expected values is that the probabilities are based upon the event occurring repeatedly.25 10% 0.5) + (15%) (0.4 children.25) + (10%)(0.2) + ($1. For example. and the average family (in the UK) supposedly has 2. finally. Page 55 of 147 .000)(0.000)(0.500. then squaring the result and multiplying by the probability. the expected value is very close to the most likely outcome.000 + $140.000)(0. Moreover.000 In this example. it is also informative to have an idea of the risk or dispersion of the potential actual outcomes around the expected value. in reality. which can be illustrated by the example given in Table 2.000)(0.25) = 10% Investment B Expected value = (5%)(0.25) = 10% The calculation of standard deviation proceeds by subtracting the expected value from each of the potential outcomes. whereas.000)(0. Table 2: Potential returns from two investments Investment Investment A B Returns Probability of return Returns Probability of return 8% 0.000 + $250.25) + (10%)(0. most events only occur once.5 12% 0.5) + (12%) (0.5 10% 0.25 To estimate the standard deviation. F5 Performance Management 2016 Expected value = ($500.25 15% 0.5.

the appropriate decision-making criteria used to make decisions are often determined by the individual’s attitude to risk.536% deviation In Table 3.5% Standard 3. To illustrate this.25 1% 10% 10% 0% 0% 0. Similarly. which combines the expected return and standard deviation into a single figure. although investments A and B have the same expected return.25% Variance 12. the expected returns and standard deviations from investments and projects are both different.25% 10% 10% 0% 0% 0. F5 Performance Management 2016 Table 3: Application of standard deviation to potential returns Investment A Expected Returns minus expected Column 4 x Column Returns Squared Probability return returns 5 8% 10% -2% 4% 0.5 0% 15% 10% 5% 25% 0. we shall discuss and illustrate the following criteria: 1 Maximin 2 Maximax 3 Minimax regret Page 56 of 147 .414% deviation Investment B Expected Returns minus expected Column 4 x Column Returns Squared Probability return returns 5 5% 10% -5% 25% 0.25 6.5 0% 12% 10% 2% 4% 0. investment B is shown to be more risky by exhibiting a higher standard deviation. DECISION-MAKING CRITERIA The decision outcome resulting from the same information may vary from manager to manager as a result of their individual attitude to risk. but they can still be compared by using the coefficient of variation. More commonly.25 1% Variance 2% Standard 1. We generally distinguish between individuals who are risk averse (dislike risk) and individuals who are risk seeking (content with risk).25 6.

medium. whereas the highest payoffs for the small and medium orders are $250 and $500 respectively. then the small order yields the highest payoff. Table 4: Decision-making combinations Order/weather Cold Warm Hot Small $250 $200 $150 Medium $200 $500 $300 Large $100 $300 $750 The highest payoffs for each order size occur when the order size is most appropriate for the weather. or hot). The ice cream seller will therefore decide upon a large order. There are nine possible combinations of order size and weather. as the lowest payoff is £200. The same calculations are then performed for warm and hot weather and a table of regrets constructed (Table 5). The ice cream seller will therefore decide upon a medium order. Otherwise. large order/hot weather. 2 Maximax This criteria is based upon a risk-seeking (optimistic) approach and bases the order decision upon maximising the maximum payoff. warm. medium order/warm weather. 1 Maximin This criteria is based upon a risk-averse (cautious) approach and bases the order decision upon maximising the minimum payoff. We shall consider the decisions the ice cream seller has to make using each of the decision criteria previously noted (note the absence of probabilities regarding the weather outcomes). profits are lost from either unsold ice cream or lost potential sales. as the highest payoff is $750. when deciding how much ice cream to order (a small. Table 5: Table of regrets Order/weather Cold Warm Hot Small $0 $300 $600 Medium $50 $0 $450 Large $100 $200 $0 Page 57 of 147 . whereas the lowest payoffs for the small and large orders are £150 and $100 respectively. or large order). F5 Performance Management 2016 An ice cream seller. ie small order/cold weather. takes into consideration the weather forecast (cold. 3 Minimax regret This approach attempts to minimise the regret from making the wrong decision and is based upon first identifying the optimal decision for each of the weather outcomes. and the payoffs for each are shown in Table 4. and the regret from the medium and large orders is $50 and $150 respectively. If the weather is cold.

there will be two branches coming off the outcome point. Constructing the tree A decision tree is always drawn starting on the left hand side of the page and moving across to the right. They are dependent on the external environment – for example. suppliers and the economy. For example. has an outcome point on it. There are two stages to making decisions using decision trees. the decision is ‘rolled back’ by calculating all the expected values at each of the outcome points and using these to make decisions while working back across the decision tree. It can be seen from the tree that there are two choices available to the decision maker since there are two branches coming off the decision point. and if there are two possible outcomes – for example.80 per unit. customers. sales may be uncertain but costs may be uncertain too. A course of action is then recommended for management. The lower branch. as opposed to $600 and $450 for the small and medium orders. which in this case is the large order with the maximum regret of $200. Decision trees provide a useful method of breaking down a complex problem into smaller. more manageable pieces. but if sales are 120. The second stage is the evaluation and recommendation stage. These are within your control – it is your choice. A simple decision tree is shown below. The decision may be dependent on more than one uncertain variable. The value of some variables may also be dependent on the value of other variables too: maybe if sales are 100. Above. You either take one course of action or you take another. we may be deciding whether to expand our business or not. one good and one bad. The first stage is the construction stage. all decision trees must start with a decision. Decision points represent the alternative courses of action that are available to you. Page 58 of 147 . If there are two possible courses of action – for example. The principles of relevant costing are applied throughout – ie only relevant costs and revenues are considered. Here. It is particularly useful where there are a series of decisions to be made and/or several outcomes arising at each stage of the decision-making process. Both decision points and outcome points on a decision tree are always followed by branches. F5 Performance Management 2016 The decision is then made on the basis of the lowest regret. given that decision trees facilitate the evaluation of different courses of actions. I have mentioned decisions and outcomes. Many outcomes may therefore be possible and some outcomes may also be dependent on previous outcomes. since there is no outcome point further along this top branch. as represented by a □. Decision Trees Decision trees and multi-stage decision problems A decision tree is a diagrammatic representation of a problem and on it we show all possible courses of action that we can take in a particular situation and all possible outcomes for each possible course of action. there will be two branches coming off the decision point.000 units costs fall to $3. is clearly known with certainty. The outcome for one of these choices. costs are $4 per unit. where the decision tree is drawn and all of the probabilities and financial outcome values are put on the tree. are not within your control. For example. however.000 units. on the other hand. shown by the top branch off the decision point. It makes sense to say that. Outcomes.

It could be. The steps to be followed are as follows: 1. the probabilities and expected values must be written on it. write these expected values on the tree next to the relevant outcome point. although be sure to show all of your workings for them clearly beneath the tree too. Once the basic tree has been drawn. Start with the ones closest to the right-hand side of the page. the evaluation starts on the right-hand side of the page and moves across to the left – ie in the opposite direction to when the tree was drawn. F5 Performance Management 2016 showing that there are two possible outcomes if this choice is made. Label all of the decision and outcome points – ie all the squares and circles. for example. Once the decision tree has been drawn. the decision must then be evaluated. the probabilities shown on the branches coming off the outcome points must always add up to 100%. calculate the expected value of the cashflows by applying the probabilities to the cashflows. and then move left again to the next closest ones. As well as showing the probabilities on the branches of the tree. 2. Remember. that the first two outcomes were showing different income levels if some kind of investment is undertaken and the second set of outcomes are different sets of possible variable costs for each different income level. labelling the top and then the bottom ones. Finally. Evaluating the decision When a decision tree is evaluated. since each of the subsidiary branches off this outcome point also has a further outcome point on with two branches coming off it. there are clearly two more sets of outcomes for each of these initial outcomes. This is shown in the example later on in the article. If there is room. like above. the relevant cash inflows/outflows must also be written on there too. the recommendation is made to management. at each outcome point. otherwise there must be an outcome missing or a mistake with the numbers being used. Then. Then. based on the option that gives the highest expected value. Page 59 of 147 . moving from right to left across the page.

in order to assist decision making. and a 30% chance that it will fail. medium or low: Probability Profits High: 0. It may in fact be more useful to see what the worst-case scenario and best-case scenario results would be too. Also.6 probability that the research and development work can be sold for $50. depending on whether the product’s popularity is high. Expected values give us a long run average of the outcome that would be expected if a decision was to be repeated many times. there is a 0. The expected value criterion for decision making is useful where the attitude of the investor is risk neutral. the levels of expected profits and the probability of each occurring have been estimated as follows. They are neither a risk seeker nor a risk avoider.4 probability that it will be worth nothing at all. For the purposes of simplicity. If it is successful.000 per annum for two years If it is a failure. Example A company is deciding whether to develop and launch a new product. F5 Performance Management 2016 It is worth remembering that using expected values as the basis for making decisions is not without its limitations.000 and a 0.000 per annum for two years Low: 0. if we are in fact making a one-off decision. estimating accurate probabilities is difficult because the exact situation that is being considered may not well have arisen before.000 and there is a 70% chance that the product launch will be successful. as shown below: Page 60 of 147 . Research and development costs are expected to be $400. So.2 $500.3 $300. it difficult to say whether the expected value criterion is a good one to use. The basic structure of the decision tree must be drawn. you should assume that all of the figures given are stated in net present value terms. the actual outcome may not be very close to the expected value calculated and the technique is therefore not very accurate. If the decision maker’s attitude to risk is not known. Let me now take you through a simple decision tree example.000 per annum for two years Medium: 0.5 $400.

calculate the expected values at each of the outcome points. not forgetting that the profits from a successful launch last for two years. starting from the right-hand side and moving across the page to the left. Page 61 of 147 .000) + (0. Now. EV at B = (0. by applying the probabilities to the profit figures.000) = $780. the probabilities and the profit figures must be put on. so they must be doubled.2 x $1.000) = $555. EV at C = (0. An expected value will be calculated for outcome point A and another one will be calculated for outcome point B. a third expected value will need to be calculated at outcome point C.000.000 These expected values can then be put on the tree if there is enough room.3 x $600. Now. Once these have been calculated.7 x $780.3 x $30. F5 Performance Management 2016 Next. the decision points and outcome points must be labeled. EV at A = (0.000) + (0.5 x $800.000) + (0.000.000) + (0.000.4 x $0) = $30.6 x $50. This will be done by applying the probabilities for the two branches off C to the two expected values that have already been calculated for A and B.

It will fail but the work will be sold generating a profit of $50.000. had a certain outcome and therefore needs no probabilities to be applied to it) to the expected value of the bottom branch. the recommendation can be made to management. there is more than one way that a decision tree could be drawn. In my example. 3. At D. the decision maker compares the value of the top branch of the decision tree (which. Costs will then need to be deducted. It will succeed and generate low profits of $600.000. we could have drawn the tree as follows: Page 62 of 147 . It will succeed and generate medium profits of $800. which is $0. there are actually five outcomes if the product is developed: 1. with the EV of developing the product once the costs of $400. at decision point D compare the EV of not developing the product. 4. Finally.000. F5 Performance Management 2016 Once this has been done. It will fail and generate no profits at all. given there were no outcome points.000. So. It will succeed and generate high profits of $1. 2. Often. Therefore. Develop the product because the expected value of the profits is $155.000. and each of those branches in turn having a further outcome point with two branches on. 5. the decision maker can then move left again to decision point D.000 have been taken off – ie $155. instead of decision point C having only two branches on it.000.000.

5 = 0. medium and low profits (0. I always cross off the branch or branches after a decision point that show the alternative I haven’t chosen.18 Fail and don’t sell work: 0.3 x 0.35 Success and low profits: 0. outcomes and branches on. or the second method.3 = 0. I have shown this crossing off of the branches below on my original.6 = 0.3) with the probabilities of high. of course. your outcome will always be the same. Finally. in this case being the ‘do not develop product’ branch.4 = 0.3).5.14 Success and medium profits: 0.7 and 0.7 x 0. Not everyone does it this way but I think it makes the tree easy to follow. Remember. The decision tree example above is quite a simple one but the principles to be grasped from it apply equally to a more complex decision resulting in a tree with far more decision points.2 = 0.7 x 0. F5 Performance Management 2016 You can see that the probabilities on the branches of the tree coming off outcome point A are now new.7 x 0. preferred tree: Page 63 of 147 . 0. which I always think is far easier to follow. otherwise a mistake has been made.3 x 0.2. so branches off outcome points are never crossed off. Whether you use my initial method. The joint probabilities are found easily simply by multiplying the two variables together each time: Success and high profits: 0.21 Fail and sell works: 0. This is because they are joint probabilities and they have been by combining the probabilities of success and failure (0. 0. add up to 1. outcomes are not within your control.12 All of the joint probabilities above must.

it is useful to have calculated the joint probabilities mentioned in the second decision tree method above because the answer can then be shown like this.000 Yes $84.21 $200.000) No 0 $266.35 $400.000) No 0 Fail and don't sell 0. In this article. medium or low profits or whether it is simply going to fail.000 Success and medium 0. F5 Performance Management 2016 The value of perfect and imperfect information Perfect information is said to be available when a 100% accurate prediction can be made about the future.000 Fail and sell 0.12 $(400.000 However. let us say that an agency can provide information on whether the launch is going to be successful and produce high. is not 100% accurate but provides more knowledge than no information. Imperfect information is far more difficult to calculate and you would only ever need to do this in the exam if the numbers were extremely straightforward to start with. At this point. This is because the calculations involved in calculating the value of imperfect information from my example are more complex than the Paper F5 syllabus would require you to calculate.18 $(350.000 Yes $140.14 $600.3: Page 64 of 147 . Success of failure Joint Profit less EV of Proceed and demand level probability cost info Success and high 0.7 and 0. Perfect information The value of perfect information is the difference between the expected value of profit with perfect information and the expected value of profit without perfect information. in our example.000 Yes $42. So.000 Success and low 0. we are only going to deal with perfect information in any detail. on the other hand. The expected value with perfect information can be calculated using a small table. it could also be done by using the probabilities from our original tree in the table below and then multiplying them by the success and failure probabilities of 0. Imperfect information.

000 Low 0.000. It is suffice here to say that the value of imperfect information will always be less than the value of perfect information unless both are zero. Therefore. You should refer to the recommended text for a worked example on the value of imperfect information.000 Profit less EV of Demand level Probability development Proceed info cost Fail and sell 0. However.000 Yes $120.000) No 0 Expected value $0 EV of failure with perfect information = 0.000 Yes $200.000 Yes $60. Note that the principles that are applied for calculating the value of imperfect information are the same as those applied for calculating the value of perfect information.000 – $155.000 EV of success with perfect information = 0.000) No 0 Fail and don't sell 0. SENSITIVITY ANALYSIS  The essence of sensitivity analysis is to carry out calculations with one set of values for the variables and then substitute other possible values for the variables to see how this effects the overall outcome. the value of the information can then be calculated by deducting the expected value of the decision without perfect information from the expected value of the decision with perfect information – ie $266.3 $200.000 = $266.000 = $111. F5 Performance Management 2016 Profit less EV of Demand level Probability development Proceed info cost High 0. total expected value with perfect information = $266.6 $(350.000. any numerical question would need to be relatively simple.000 Medium 0. Imperfect information In reality.4 $(400. the numbers involved in calculating the values of imperfect information are rather complex and at Paper F5 level. information obtained is rarely perfect and is merely likely to give us more information about the likelihood of different outcomes rather than perfect information about them.000 $380.5 $400. Page 65 of 147 . This would represent the absolute maximum that should be paid to obtain such information.3 x $0 = $0.2 $600. Whichever method is used. This would occur when the additional information would not change the decision.7 x $380.

Past Paper Analysis Risk and uncertainty Dec 08 – Q 2 June 11 – Q 1 June 13 – Q 1 June 14 – Q 4 Page 66 of 147 . F5 Performance Management 2016  This technique can be used in any situation where relationships between key variables can be identified.  Sensitivity analysis is one form of ‘what-if? Analysis.

managers are required to draft a budget for their area of operations.  Ensure the achievement of the organisation's objectives  Compel planning  Communicate ideas and plans  Co-ordinate activities  Provide a framework for responsibility accounting  Establish a system of control  Motivate employees to improve their performance Page 67 of 147 .  In top-down budgeting. however it reflects views of managers actually dealing with operations and encourages motivation through participation. This is much more time consuming.  A budget can be set from the top down (imposed budget) or from the bottom up (participatory budget).  The objectives of a budgetary planning and control system. F5 Performance Management 2016 Part C – Budgeting and Control 12.  With bottom-up budgeting. senior management level sets the budgetary targets for the organisation. eventually becoming part of the budget for the whole organisation. This approach is a time saving technique. These are submitted to their superior. Budgetary Systems Budget: is a quantified plan of action for an upcoming accounting period.

E. Flexible Budget: is a budget which is changed as the volume of output and sales changes by using the cost behaviour patterns. Advantages:  Quick and easy method of budgeting  Suitable for organisations that operate in a stable environment Disadvantages:  Previous problems and inefficiencies are automatically included in the upcoming year’s budget.  These can be created at the planning stage.  Types of feedback: a) Negative feedback indicates that results or activities must be brought back on course. Fixed Budget: is a budget which remains unchanged throughout the budget period. Master Budget. Incremental Budgeting: method of budgeting in which adjustments are made to the current year actual data for inflation and other expected changes to arrive at the budget for the next year. within guidelines set by senior management  Provides a link between strategic plans at senior level and operational planning  Operational plans .g. as the organisation may prepare budgets for different levels of expected activities. b) Positive feedback results in control action continuing the current course. then a flexible budget for 10. as they are deviating from the plan.  Single Loop Feedback: Feedback is used to take corrective action to ensure original plan is met.Prepared by managers at a fairly junior level  Based on objectives about 'what' to achieve in operational terms  Detailed specifications of targets and standards Feedback: This is important aspect of control once the plan is being implemented. This Page 68 of 147 . c) Feedforward control is based on forecasts. For example. if actual activity was of 10.Prepared at lower management level ('management control' level)  Time horizon typically 12 months  Plans for individual departments or activities. Action can be taken well in advance if issues identified.  Double Loop Feedback: Feedback is used to revise the original plan. F5 Performance Management 2016 Planning and Control in the Performance Hierarchy  Corporate plans/strategic plans .Prepared at a strategic level  Focused on overall corporate performance  Set overall plans and targets for units and departments  Tactical plans .000 units produced.000 units is created. regardless of differences between the actual and the original planned volume of output or sales.  These can also be created retrospectively to reflect the actual level of activity achieved.  Managers may overspend in order to be able to claim the same or more budget for the next year.

Every item of expenditure has then to be justified in its entirety in order to be included in the next year's budget. These divide an aspect of operations into different levels of activity. Page 69 of 147 . (b) Incremental packages. and spending decisions should be planned: these are 'decision packages'.  Short-term benefits might be emphasised to the detriment of long-term benefits.  ZBB documentation provides an in-depth appraisal of an organisation's operations. Where resources such as money are in short supply.  It challenges the status quo. 3. Define items or activities for which costs should be budgeted. In summary.  It responds to changes in the business environment. Disadvantages:  Extra volume of paperwork created and the extra time required to prepare the budget. The 'base' package will contain the minimum amount of work that must be done to carry out the activity and the cost of this minimum level. in areas of operations where efficiency standards are not properly established.  Increases motivation of staff by promoting a culture of efficiency. such as administration work. Zero Based Budgeting: involves preparing a budget for each cost centre or activity from a zero base. Evaluate and rank the packages in order of priority: eliminate packages whose costs exceed their value. Allocate resources to the decision packages according to their ranking. Advantages:  Identification and removal of inefficient or obsolete operations. a) Mutually exclusive packages. 2. These are alternative methods of getting the same job done. 1. ZBB should result in a more efficient allocation of resources.  Avoidance of wasteful expenditure.  Managers may have to be trained in ZBB techniques.  It might give the impression that all decisions have to be made in the budget and discourage innovative ideas. F5 Performance Management 2016 supports the control element as management will be able to compare the actual performance with a budget of a corresponding level of activity. they are allocated to the most valuable activities.  The organisation's information systems may not be capable of providing suitable information. at what cost and for what benefits. Implementation: ZBB is particularly useful for budgeting for discretionary costs and for rationalisation purposes.  The ranking process can be difficult. The best option among the packages must be selected by comparing costs and benefits and the other packages are then discarded. The other incremental packages identify additional (incremental) work that could be done.

Principles:  Activities drive costs and the aim is to plan and control the causes (drivers) of costs rather than the costs themselves.)  Because concentration is focused on the whole of an activity.  Planning and control will be based on a realistic recent plan. effort and money involved in budget preparation.  Budgets provide poor value to users. Beyond Budgeting: is a budgeting model which proposes that traditional budgeting should be abandoned. not just its separate parts.  Budgets fail to focus on shareholder value.  Frequent budgeting might put off the managers. Rolling Budget: is a budget which is continuously updated by adding a further accounting period (a month or quarter) to the end of the budget when the corresponding period in the current budget has ended.  Budgets are reassessed regularly. there is more likelihood of getting it right first time. and up to date budgets produced.  Additional measures apart from traditional financial measures are needed to ensure continuous improvement. As a result. (A critical success factor is an activity in which a business must perform well if it is to succeed. a number of rolling budgets are prepared each year and each rolling budget covers the next 12- month period. Advantages:  Element of uncertainty in budgeting is reduced. Criticisms of Budgeting:  Budgets are time consuming and expensive. Page 70 of 147 . Disadvantages:  More time.  Non value adding activities should be removed. Adaptive management processes should be used rather than fixed annual budgets. Advantages:  Critical success factors will be identified and performance measures devised to monitor progress towards them.  Most departmental activities are driven by demands and decisions beyond the immediate control of the manager responsible for the department's budget.  There is always a budget which extends for several months ahead.  Realistic budgets are better motivational factors for employees. F5 Performance Management 2016 Activity Based Budgeting: This involves defining the activities that underlie the financial figures in each function and using the level of activity to decide how much resource should be allocated and how well it is being managed and to explain variances from budget.

What is needed instead is a system of monitoring the longer term progress against the organisation's strategy. rolling basis but with the focus on cash forecasting rather than purely on cost control.  Motivation..b June 09 – Q 5 June 13 –Q 5a Dec 10 –Q 5 June 13 – Q 5 c. mean building slack into the budget in order to create an easier target for achievement. Past Paper Analysis Budgetary Systems Dec 11 – Q 3 Dec 07 – Q 3 a.  The emphasis is on encouraging a culture of personal responsibility by delegating decision-making and performance accountability to line managers. Performance is monitored against world-class benchmarks.  Budgets focus on sales targets rather than customer satisfaction.  Budgets protect rather than reduce costs. In addition.  Faster response to threats and opportunities.  Resource constraints.  The process of planning and budgeting within a framework devolved from senior management perpetuates a culture of dependency. Once a manager has an authorised budget they can spend that amount of resource without further authorisation. Managers who consistently meet their annual budget targets may resist the adoption of beyond budgeting as it threatens their position and bonuses. Managers should plan on a more adaptive. Rewards are team based which fosters cooperation and helps achieve corporate goals. Challenges:  Resistance to change. F5 Performance Management 2016  Budgets are too rigid and prevent fast response.d June 15 – Q 5 June 11 – Q 3a Dec 12 – Q 4 June 13 – Q 5 b Page 71 of 147 . some public sector organisations may struggle to implement a beyond budgeting process due to the constraints on their resources. competitors and previous periods. The focus on achieving the budget discourages managers from taking risks.  Budgets are divorced from strategy. For example.  Budgets stifle product and strategy innovation.  Budgets lead to unethical behaviour. Fundamentals of Beyond Budgeting:  Use adaptive management processes for making decisions. Benefits:  The use of external benchmarks can lead to management focus on competitive success.

This means that it takes them less time to complete it. The learning process starts as soon as the first unit or batch comes off the production line. It is a human phenomenon that occurs because of the fact that people get quicker at performing repetitive tasks once they have been doing them for a while. this is due to economies of scale since costs usually fall when products are made on a larger scale. however. the learning curve is really steep but the curve becomes flatter as cumulative output increases. it is often more appropriate for the unit of measurement to be a batch rather than an individual unit. The learning curve. it is clearly the case that the effect of the learning rate on labour time will become much less significant as production increases. Similarly. The learning rate and learning effect In practice. You can see this in Figure 1 below. is not about this. While in the aircraft industry this rate of learning was generally seen to be around 80%. As the process is repeated. with the curve eventually becoming a straight line when the learning effect ends. It costs more to produce the first unit of a product than it does to produce the one hundredth unit. When output is low. depending on the industry in question. Figure 1 Page 72 of 147 . High Low Method-Previous Knowledge (F2) 2. effect. the learning effect will come to an end altogether. Eventually. however. Since a doubling of cumulative production is required in order for the cumulative average time per unit to decrease. In part. for example. This may be due to bulk quantity discounts received from suppliers. it is often found that the resources required to make a product decrease as production volumes increase. Quantitative Analysis 1. The specific learning curve effect identified by Wright was that the cumulative average time per unit decreased by a fixed percentage each time cumulative output doubled. in different industries other rates occur. it is not about cost reduction. The first time a new process is performed. the workers are unfamiliar with it since the process is untried. F5 Performance Management 2016 13. the workers become more familiar with it and better at performing it.

it becomes apparent that the learning effect has been ignored and the correct labour time per unit should is actually 0. It is also used in other less traditional sectors such as professional practice. In fact. serious consequences will result.  Product made largely by labour effort  New and relatively short lived product  Complex product made in small quantities for special orders The importance of the learning curve effect Learning curve models enable users to predict how long it will take to complete a future task. Let us now consider its importance in planning and control. let us look at the example of a company that is introducing a new product onto the market. it was examined in conjunction with life cycle costing. the company may have decided not to launch it in the first place as it believed it could not offer a competitive price. of course. Without crunching through the numbers again. This will make their use for control purposes pointless. financial services. Finally. F5 Performance Management 2016 The learning curve effect will not always apply. The company wants to make its price as attractive as possible to customers but still wants to make a profit. in December 2011. If the labour cost is $15 per hour. it is worth noting that the use of learning curve is not restricted to the assembly industries it is traditionally associated with. so it prices it based on the full absorption cost plus a small 5% mark-up for profit. It is necessary for the process to be a repetitive one. it is obvious that the product will have been launched onto the market at a price which is far too high. For example. The first unit of that product may take one hour to make. Management accountants must therefore be sure to take into account any learning rate when they are carrying out planning. If standard costing is to be used. then the price of the product will be based on the inclusion of that cost of $15 per hour. research has shown that just under half of users are in the service sector. control and decision-making. Other costs may total $45. This may mean that initial sales are much lower than they otherwise would have been and the product launch may fail. This involved working out the incremental labour Page 73 of 147 . If they fail to do this. As regards its importance in decision-making. Also. Worse still. Subsequently.5 hours. it is important that standard costs provide an accurate basis for the calculation of variances. How learning curves have been examined in the past The learning curve effect has regularly been examined in Paper F5. If standard costs have been calculated without taking into account the learning effect. for example. Where to Use Learning Curve This theory is best applied. publishing and travel. The product is therefore released onto the market at a price of $63. there needs to be a continuity of workers and they mustn’t be taking prolonged breaks during the production process. then all the labour usage variances will be favourable because the standard labour hours that they are based on will be too high. Candidates were asked to calculate a revised lifecycle cost per unit after taking into account the learning effect. It flourishes where certain conditions are present. where.

as shown below. In June 2013. questions have required the use of the algebraic method and a Page 74 of 147 . This is a fairly common exam requirement which tests candidates’ understanding of the difference between cumulative and incremental time taken to produce a product and the application of the learning curve formula. it seemed only right that future questions should examine candidates’ ability to calculate the learning rate itself. In the workplace. All candidates should know how to use a scientific calculator and should be sure to take one into the exam hall. over-rounding will lead to a candidate wiping out the entire learning effect and then the question becomes pointless. just from the examples given above. as has historically been the case. It can be seen. They simply practise past papers. F5 Performance Management 2016 time taken to produce the final 100th unit made before the learning effect ended. the learning effect could be examined exactly as it has been in past exams. Obviously. Once again. since this was going to be the cost of making one unit going forward in the business. the learning rate will not be known in advance for a new process and secondly. when faced with calculations involving the learning effect. with candidates being asked to calculate the time taken to produce an individual unit or a number of units of a product either when the learning curve is still in effect or when it has ended. the learning curve effect was examined in conjunction with target costing. differences may well arise between expected learning rates and actual learning rate experienced. the learning rate was given. As mentioned earlier. where the learning effect is small. It is worth mentioning at this point that you should never round learning curve calculations to less than three decimal places. as was the value for ‘b’. In the workplace. and never really think beyond this. Again. the learning rate was given in the question. It was after this point that the learning effect ended. an average cost for the first 128 units made was required. The problem with this is that candidates don’t always actually think about the calculations they are performing. Therefore. that learning curve questions have tended to follow a fairly regular pattern in the past. so the question then went on to ask candidates to calculate the cost for the last unit made. In some questions. is always given on the formula sheet in the exam. This objective of the syllabus has not changed. candidates may not be able to tackle them. but this time. The learning curve formula. b Y = ax Where Y = cumulative average time per unit to produce x units a = the time taken for the first unit of output x = the cumulative number of units produced b = the index of learning (log LR/log2) LR = the learning rate as a decimal While a value for ‘b’ has usually been given in past exams there is no reason why this should always be the case. historically. the learning effect was again examined in conjunction with lifetime costing. and a value for ‘b’ was given. learn how to answer questions. Back in June 2009. This leads us on to the next section of the article. even if it has been estimated.

8 October 8 1.64 32 4361. Solution (a) Monthly rates of learning Incremental Cumulative Cumulative Incremental total Cumulative total Month number of number of average hours hours hours batches batches per batch June 1 200 1 200 200 July 1 152 2 352 176 August 2 267.52 September 4 470. Moving forward. since calculations of the learning rate itself may be required in future exams.88 September 4 470. Example 1 P Co operates a standard costing system.32 November 16 2.180.29 November 16 2180.64 136. Here.64 Required (a) Calculate the monthly learning rate that arose during the period.52 4 619.090.29 Page 75 of 147 . The following question is an example of the kind of question that may appear in future exams.32 16 2180. it becomes even more important that candidates are familiar with both the tabular method and using their scientific calculators. (b) Identify when the learning period ended and briefly discuss the implications of this for P Co.8 8 1090. and resource allocation and cost data were prepared on this basis. The standard labour time per batch for its newest product was estimated to be 200 hours. F5 Performance Management 2016 value for ‘b’ has usually been given in the exam.29 October 8 1090.32 136. the tabular method is the simplest way to answer the question.28 136. The actual number of batches produced during the first six months and the actual time taken to produce them is shown below: Incremental number of batches Incremental labour hours taken to Month produced each month produce the batches June 1 200 July 1 152 August 2 267.52 154.

The resource allocations and cost data prepared for the last six months will have been inaccurate since they were based on a standard time per batch of 200 hours. Therefore. Alternatively.88/176 = 88% 136. It may be able to do this by increasing the level of staff training provided. at which point the learning effect came to an end. the easiest way to solve this problem and find the actual learning rate is to use a combination of the tabular approach plus. it could try to incentivise staff to work harder through payment of bonuses. Should they choose to do so. it should base these decisions on the time taken to produce th eighth batch. Solution Again. This meant that from October onwards the time taken to produce each batch of the product was constant. of course.29/154.88 = 88% Therefore the monthly rate of learning was 88%. full marks would be awarded. F5 Performance Management 2016 Learning rate: 176/200 = 88% 154. in future. Example 2 The first batch of a new product took six hours to make and the total time for the first 16 units was 42. Calculate the rate of learning.8 = 16 x (6 x r ) Page 76 of 147 . (b) End of learning rate and implications The learning period ended at the end of September. however. but this can be quite tricky and candidates would not be expected to use this method. when P Co makes decisions about allocating its resources and costing the product. which was the last batch produced before the learning period came to an end. P Co could try and improve its production process so that the learning period could be extended. although the quality of production would need to be maintained. a little bit of maths. There is an alternative method that can be used that would involve some more difficult maths and use of the inverse log button on the calculator. in this case. Using algebra: Step 1: Write out the equation: 4 42.8 hours.

F5 Performance Management 2016

Step 2: Divide each side by 16 in order to get rid of the ’16 x’ on the right hand side of the equation:
2.675 = (6 x r )

Step 3: Divide each side by 6 in order to get rid of the ‘6 x’ on the right hand side of the equation:
0.4458333 = r

Step 4: take the fourth root of each side in order to get rid of the r on the right hand side of the equation.
4 1/y
You should have a button on your calculator that says r or x . Either of these can be used to find the
fourth root (or any root, in fact) of a number. The key is to make sure that you can use your calculator
properly before you enter the exam hall rather than trying to work it out under exam pressure. You then
get the answer:
r = 0.8171

This means that the learning rate = 81.71%.

Example 3:

Learning curve 90% units produced till date 500 units.

Labor cost = $10/ hour

Time to make first unit 100 hours

Calculate the cumulative average time to produce 500 units.


= 100 (500)

= 38.88 / unit

Total cost = 500 × 38.8 × 10 = $194400

Past Paper Analysis
Quantitative Analysis Dec 08 – Q 3
Dec 09 – Q 2
Dec 13 – Q 3
Dec 14 – Q 1

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F5 Performance Management 2016

14. Standard Costing

Standard Cost: This is an estimated unit cost


The standard cost of a product XYZ might be:

Direct Materials:
aterial A: 2 litres at $4.50 per litre 9
Material B: 3 kilos at $4 per Kilo 12
Direct Labour:
Grade 1 labour: 0.5 hours at $20 per hour 10
Grade 2 labour: 0.75 hours at $16 per hour 12
Variable production overheads: 1.25 hours at $4 per hour 5
Fixed production overheads: 1.25 hours at $40 per hour 50
Standard ( production) cost per unit 95

 Standards are set by managers for their respective areas of expertise.
 Standard costing has four main uses.

Alternative system of cost accounting It is an alternative system of cost accounting. In a standard
costing system, all units produced are recorded at their
standard cost of production.

Used to prepare budgets When standard costs are established for products, they can
be used to prepare the budget.

System of performance measurement It is a system of performance measurement. The differences
between standard costs and actual costs can be measured
as variance. Variances can be reported regularly to
management, in order to identify areas of good
performance or poor performance.

Control reporting It is also a system of control reporting.

As a System for Control:

 Differences between actual and expected results are termed Variances.
 When the variances occur, this indicates that the operational performance is not as it should be, and so
the causes of the variance should be investigated, regardless of whether the variances are adverse of
favourable. Favourable variances could indicate errors in the standard or compromise on quality
aspects. This investigation is generally termed as Variance Analysis
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F5 Performance Management 2016

 Management can therefore use variance reports to identify whether control measures might be
needed, to improve poor performance or continue with good performances.

Types of Standards:

Ideal Standards The ideal standard cost is the cost that would be achievable if operating conditions
and operating performance were perfect. In practice, the ideal standard is not
achievable. Will demotivate employees if enforced.

Attainable standard These assume efficient but not perfect operating conditions. An allowance is made
for waste and inefficiency. However the attainable standard is set at a higher level
of efficiency than the current performance standard, and some improvements will
therefore be necessary in order to achieve the standard level of performance. This
can be a basis of motivating employees.

Current standards These are based on current working conditions and what the entity is capable of
achieving at the moment. Current standards do not provide any incentive to make
significant improvements in performance, which may cause employee performance
to slack.

Basic Standards These are standards which remain unchanged over a long period of time. Cause
employees to lose interest.

Using Standards in Performance Management

Flexible budgets are used to carry out effective performance management.

So if an organisation had originally budgeted for an activity level of 5,000 units but ended up producing/
selling 7,000 units, the following steps will have to be carried out to carry out an effective variance

Step 1: Use the standard cost card to determine flexible budget for 7,000 units. If the cost card is not
available, information from the fixed budget of 5,000 units can be picked up to create a budget for the
7,000 units. This will depend on following knowledge points:

 Total Budgeted Fixed Costs (unless Step Fixed) will not change regardless of level of activity
 Budgeted Variable Cost Per Unit will not change regardless of level of activity

Step 2: Compare the actual revenue and costs of 7,000 units with the flexed budget created in Step 1.

Step 3: Identify the differences between the actual and budget as positive (Favourable) or negative

Step 4: Carry out an investigation to determine causes of the variances (if material). Remember both
favourable and adverse variances may require investigation.

Page 79 of 147

the performance of various managers will be put to question but they should only be held accountable for controllable aspects.  Committed fixed costs are uncontrollable.  The principle of controllability is that managers should only be held accountable for costs over which they have some influence.  Controllable costs: Controllable costs are expenses which can be directly influenced by a given manager.  Variable costs are considered controllable in the short term.  Discretionary fixed costs can be controlled by the relevant authority. Page 80 of 147 .  Managers should not be held accountable for apportioned overhead costs. F5 Performance Management 2016 Controllability in Performance Management:  During Variance Analysis.

600 Total direct materials cost variance (3. Variance Analysis Material Cost Variance: Example: A unit of product P123 has a standard cost of five liters of material A at $3 per liter.000 2. which cost $33. Page 81 of 147 .000 units of product P123 did cost 33.000 units of product 123 were manufactured.600) (A) The total direct materials cost variance is adverse. The total direct material cost variance is calculated as follows: $ 2. In a particular month.000 units of product P123 should cost (x$15) 30. F5 Performance Management 2016 15. The standard direct material cost per unit of product 123 is therefore $15. 2.600. because actual costs were higher than the standard cost. These used 10.400 liters of material A.

400 (A) The price variance is adverse because the materials cost more to purchase than they should have. Example: Using the same example above that was used to illustrate the material price variance. The price variance is calculated as follows. F5 Performance Management 2016 Example: A unit of product p123 has a standard cost of five liters of material A at $3per liter. In a particular month. These used 10.600 Material price variance 2. The standard direct material cost per unit of product 123 is therefore $15.200 10.000 units of Product P123 should use (x 5 kilos) 10. The total direst material cost variance is $3.000 units of Product P123 did use 10.600.000 units of product 123 were manufactured.400 liters of materials did cost 33.400 liters of Material A. $ 10. in the previous example. 2. and this has added to costs.200 (A) The usage variance is adverse because more materials were used than expected.000 2. as calculated earlier.400 liters of materials should cost (x$3) 31.600 (A).400 Material usage variance in kilos 400 (A) Standard price per kilo of Material A $3 Material usage variance in $ $1. Causes of materials price and usage variances Materials usage variance Materials price variance  Efficient/ Inefficient use of material  Inflation/ Unexpected discounts  Experience of workforce  New supplier/ emergency purchase  Quality of material  Also: The standard materials price in the  Production process standard cost for materials might be a poor  Also: The standard usage rate in the estimate standard cost for materials might be a poor estimate Page 82 of 147 . which cost $33. the usage variance should be calculated as follows: kilos 2.

$ 2. Example: Using the same example that was used previously to calculate the total labour cost variance.000 2. Required: Calculate the total direct labour cost variance.5 hours x $12 per direct labour hour = $18 per unit.780 hours to make and the direct labour cost was $35. 2. because actual costs were less than the standard cost.000 units of product P123 should cost (x $18) 36. The direct labour total cost variance can be analysed into a rate variance and an efficiency variance.000 units of product P123 did cost 35. These took 2.700. Page 83 of 147 .700 Total direct labour cost variance 300 F The variance is favourable. During a particular month. F5 Performance Management 2016 Labour cost variance Example: Product P123 has a standard direct labour cost per unit of: 1. calculate the direct labour rate variance. The calculations are similar to the calculations for the materials price and usage variances.000 units of Product 123 were manufactured.

5 hours) 3. reducing efficiency Page 84 of 147 . which has reduced costs.700 Direct labour rate variance 2.340 (A) The rate variance is adverse because the labour hours worked cost more than they should have.640 F The efficiency variance is favourable because production took less time than expected. for example machine breakdowns.  Wage rates have been altered (usually.000 2.000 units of Product P123 should take (x 1.730 hours did cost 35.  New workforce due to high labour turnover. Example: Using the same example above that was used to illustrate the total direct labour cost variance and the direct labour rate variance. resulting in favourable or unfavourable raised).730 hours should cost (x $12) 33. different from the grade of labour in the  New workforce due to high labour standard cost turnover.000 units of Product P123 did take 2. Causes of labour rate and efficiency variances Labour efficiency variance Labour rate variance  Efficient or inefficient working by the work  The grade or level of labour actually used is force. the efficiency variance should be calculated as follows: hours 2. efficiency variance  The effect of a new incentive scheme.  Problems in the production process.780 Efficiency variance in hours 220 F Standard direct labour rate per hour $12 Direct labour efficiency variance in $ $2.  Quality of supervision good or bad.360 2. F5 Performance Management 2016 $ 2.

During a particular month.550 Total variable production overhead cost variance 550 (A) The variance is adverse.5hours x $2 per direct labour hour= $3 per unit.000 2.000 units of output did cost 6. (Note: this same example will be used to illustrate the variable overhead expenditure and efficiency variances. because actual costs were more than a standard cost. Required: Calculate for the month the total variable production overhead cost variance. These took 2. Page 85 of 147 .) Answer $ 2. F5 Performance Management 2016 Variable production overhead variance Example: Product P123 has a standard variable production overhead cost per unit of 1.550.000 units of output should cost (x$3) 6. 2.780 hours to make and the variable production overhead cost was 46.000 unit of a product 123 were manufactured.

780 hours should cost (x$2) 5.000 2. hours 2.560 2.000 units of Product P123 did take 2.000 units of Product P123 should take (x 1.789 hours did cost 6.550 Variable production overhead variance 990 (A) The expenditure variance is adverse because the expenditure on variable overhead is the hours worked was more than it should have been. which has reduced costs. Page 86 of 147 .780 Efficiency variance in hours 220 F Standard variable production overhead rate per hour $2 Variable production overhead efficiency variance in $ $440 F The efficiency variance is favourable because production took less time than expected. Variable production overhead variances cost variances: $ Summary Variable production overhead expenditure variance 990 (A) Variable production overhead efficiency variance 440 F Total variable production overhead cost variance 550 (A) Causes of variable overhead variances  The causes of variable overhead efficiency variances are the same as the causes of labour efficiency variances. calculate the variable production overhead expenditure variance.  The causes of variable overhead expenditure variances maybe:  Efficient or inefficient spending on overhead items of cost  Inaccurate estimates of the variable overhead expenditure rate per hour. when variable overhead expenditure is assumed to vary with the number of direct labour hours worked.5 hours) 3. $ 2. F5 Performance Management 2016 Example: Using the same example that was used previously to calculate the total variable production overhead cost variance.

F5 Performance Management 2016 Fix overhead variances Page 87 of 147 .

The fixed production overhead volume variance is $1. F5 Performance Management 2016 Example: A company budgeted to make 5. Summary $ Fixed overhead expenditure variance 500 (A) Fixed overhead volume variance 1. Budgeted direct labour hours are 10.000 hours.500 Fixed production overhead total cost variance 1.250 hours of work. Budgeted direct labour hours are 10. and fixed production overhead was $40.500.000. Budgeted fixed production overhead is $40. Fixed production overhead total cost variance $ 5.000 hours. Actual production in Year 1 was 5.200 units and fixed production overhead was $40. Standard fixed overhead cost per unit = $8 (2 hours per unit x $4 per hour). because fixed overhead costs have been over-absorbed.250 Fixed production overhead efficiency variance in hours 150 F x Standard fixed overhead rate per hour $4 Page 88 of 147 .000 Actual fixed production overhead expenditure 40. Budgeted fixed production overhead is $40.200 units in 10.500.100 F Example: A company budgeted to make 5.200 units: standard fixed cost (x $8) = fixed overhead absorbed 41.000 units of a single standard product in Year 1.000.200 units produced should take (x 2 hours per unit) 10.500 Fixed overhead expenditure variance 500 (A) This variance is adverse because actual expenditure exceeds the budgeted expenditure.600 F Fixed overhead total cost variance 1.100 F The variance is favourable.400 They did take 10. Actual production in Year 1 was 5. calculated earlier. Fixed overhead volume variance units of production Budgeted production volume in units 5.000 Actual production volume in units 5.600 Actual fixed overhead cost expenditure 40.600 F This variance is favourable because actual production volume exceeded the budgeted volume. Fixed production overhead efficiency variance hours 5. Fixed overhead expenditure variance $ Budgeted fixed production overhead expenditure 40.000 units of a single standard product in Year 1.600F.200 Fixed overhead volume variance in units 200 F Standard fixed production overhead cost per unit $8 Fixed overhead volume variance in $ $1.

600 F Sales Variances Page 89 of 147 . F5 Performance Management 2016 Fixed production overhead efficiency variance in $ $600 F Fixed production overhead capacity variance hours Budgeted hours of work 10.250 Capacity variance in hours 250 F x Standard fixed overhead rate per hour $4 Fixed overhead capacity variance in $ $1.000 F Fixed overhead volume variance 1. Summary $ Fixed overhead efficiency variance 600 F Fixed overhead capacity variance 1.000 F The capacity variance is favourable because actual hours worked exceeded the budgeted hours (therefore more units should have been produced).000 Actual hours of work 10.

 New competitor in the market.  Loss of major customer. Sales volume variance units Actual sales volume (units) 7.200 units.400. F5 Performance Management 2016 Example: A company budgets to sell 7.$42 = $8) $8 Sales volume variance (profit variance) $1.  Product design or after sales services Page 90 of 147 .  Inflation. Causes of sales price and sales volume variances Sales price variance  Sales volume variance  Demand for the product. Actual sales were 7.200 units did sell for 351.600 (A) The sales price variance is adverse because actual sales revenue from the units sold was less than expected.  Effective or ineffective advertising campaign.200 units should sell for (x $50) 360. which sold for $351.000 units of Product P456.000 Sales volume variance in units 200 F Standard profit per unit ($50 . The standard sales price of Product P456 is $50 per unit and the standard cost per unit is $42.600 F The sales volume variance is favourable because actual sales exceeded budgeted sales. The sales price variance and sales volume variance would be calculated as follows: Sales price variance $ 7.400 Sales price variance 8.   Price of product.  Major new customer in the market.200 Budgeted sales volume (units) 7.  Distribution methods.000 7.  Trade discounts.

not the standard full production cost variances are calculated and presented in the same way as for standard absorption costing. F5 Performance Management 2016 Operating Statements: Format of an operating statement under Standard Absorption Costing Fav Adv £000 £000 £000 Budgeted profit xxx Sales margin variances Price xxx (xxx) Volume xxx (xxx) xxx/(xxx) XXX Cost variances Materials Price xxx (xxx) Usage xxx (xxx) Labour Rate xxx (xxx) Idle time (xxx) Efficiency xxx (xxx) Variable Overhead Expenditure xxx (xxx) Efficiency xxx (xxx) Fixed Overhead Expenditure xxx (xxx) Capacity xxx (xxx) Efficiency xxx (xxx) xxx (xxx) xxx/(xxx) Actual profit XXX Standard Marginal Costing Standard marginal costing and standard absorption costing compared When a company uses standard marginal costing rather than standard absorption costing: finished goods inventory is valued at the standard variable production cost. the sales volume variance is calculated using standard contribution. but no fixed production overhead volume variance. Sales volume variances: In standard marginal costing. there is a fixed production overhead expenditure variance. but with two important differences: Fixed production overhead variances: In standard marginal costing. Page 91 of 147 .

Favourable or adverse variance. A variance should not be investigated unless the expected benefits exceed the costs of investigation and control. F5 Performance Management 2016 Format of an Operating Statement under Standard Marginal Costing: Fav Adv £000 £000 £000 Budgeted contribution xxx Sales margin variances Price xxx (xxx) Volume xxx (xxx) xxx (xxx) xxx/(xxx) XXX Cost variances Materials Price xxx (xxx) Usage xxx (xxx) Labour Rate xxx (xxx) Idle time (xxx) Efficiency xxx (xxx) Variable Overhead Rate xxx (xxx) Efficiency xxx (xxx) xxx (xxx) xxx(xxx) Actual contribution XXX Fixed overheads Budgeted overhead xxx Expenditure variance xxx (xxx) xxx(xxx) Actual profit XXX Factor Description Size of the variance. Costs and benefits of control Investigating a variance has a cost in terms of both management action. Page 92 of 147 . the larger the variance. the greater the potential benefit from investigation and control measures. time and expenditure. As a general rule. depend on the expectation of management that the cause of the variance will be controllable. Probability that the cause of the Whether or not to investigate the cause of a variance -will also variance will be controllable. Significant controllable favourable variances should be investigated as well as adverse variances.

If so. rather than by operational factors. A. variance in one month is due to random factors that will not recur next month. Example: Product N is produced front three direct materials. Reliability of budgets and Management might have a view about whether the variance is measurement systems. The following information relates to the budget and output for the month of January Budget Actual Material Quantity Standard price Standard Quantity per kilo cost used kg $ $ A 1 20 20 160 B 1 22 22 I80 C 8 6 48 1. If the variance is due to random factors. caused by poor planning and poor measurement systems. Mix and Yield Variances: Mix Variance: A mix variance occurs when the materials are not mixed or blended in standard proportions and it is a measure of whether the actual mix is cheaper or more expensive than the standard mix.  Materials mix and yield variances Direct materials usage variance When standard costing is used for products which contain two or more items of direct material. the total materials usage variance can be calculated by calculating the individual usage variances in the usual way and adding them up (netting them off). and management can probably ignore it without risk. it should not happen again next month. B and C that are mixed together in a process. investigating the variance would be a waste of time and would be unlikely to lead to any cost savings. F5 Performance Management 2016 Random variations in reported Management might take the view that a favourable or adverse variances. Yield Variance: A yield variance arises because there is a difference between what the input should have been for the output achieved and the actual input.760 10 90 2.100 Output 1 unit 200 units Direct materials usage variance Material Material Material A B C Page 93 of 147 .

100 2.760 Making 200 units should have used 200 200 1.600 Usage variance (kgs) 40 F 20 F (160) A Standard cost per kg $20 $22 $6 Volume variance (contribution) $800 $440 ($960) Total usage variance $280 F Direct materials mix variance The materials mix variance measures how much of the total usage variance is attributable to the fact that the actual combination or mixture of materials that was used was more expensive or less expensive than the standard mixture for the materials.180 (F) Direct materials yield variance The materials yield variance is the difference between the actual yield from a given input and the yield that the actual input should have given in standard terms.000 F B 180 1 210 30 F 22 660 F C 1. Page 94 of 147 . The mix component of the usage variance therefore indicates the effect on costs of changing the combination (or mix or proportions) of material inputs in the production process. It indicates the effect on costs of the total materials inputs yielding more or less output than expected. Step 2: The difference between the quantity of material used and the quantity hat should have been used according to the standard mix.760 8 1. F5 Performance Management 2016 Making 200 units used up 160 180 1. The materials mix variance is calculated as follows (making reference to the example above): Step 1: Take the total quantity of all the materials used and divide this into a standard mix for the materials used.100 0 1.680 (80) (A) 6 (480) (A) 2. cost per Mix variance mix mix (kgs) kg (Standard) kgs Units units $ $ A 160 1 210 50 F 20 1. The difference is then valued at the standard cost of output. Material Actual Standard Mix variance Std. Based on the above example note that: The standard cost of each unit (kg) of input = $90/10kg = $9 per kilo The standard cost of each unit of output = $90 per unit Method 1: This compares the actual yield to the expected yield from the material used. is the mix variance.

The cheapest mix may not be the most cost effective. Page 95 of 147 . therefore.000 did use 2. 200 units should use 2. Therefore. kg 200 units of product N should use (x 10 kilos) 2.100 Yield variance in quantities 100 (A) Standard cost of input $9/kg Yield variance in money value = $900 (A) Summary $ Mix variance 1.000 kg of input. F5 Performance Management 2016 In the above example 10 kg of material in should result in 1 unit of output. The difference between this figure and the actual output is the yield variance as a number of units.100 kgs of input should yield (@10 kg per unit) 210 did yield 200 Yield variance in units 10 (A) Standard cost of output $90 Materials yield variance $900 (A) Method 2: This compares the actual usage to achieve the yield to the expected usage to achieve the actual yield. Units 2. This is then multiplied by the expected cost of a unit of output. This is then multiplied by the expected cost of a unit of output. The difference between this figure and the actual output is the yield variance as a number of units.  Identification of the optimum mix involves consideration of several factors:  Cost. Management will seek to find the optimum mix for the product and ensure that the process operates as near to this optimum as possible. The difference is then valued at the standard cost of input.100 kg of material in should result in 210 units of output. In the above example 1 unit should use 10 kg of input.180 (F) Yield variance 900 (A) Usage variance (= mix + yield variances) 280 (F) Factors to consider when changing the mix  Analysis of the material usage variance into the mix and yield components is worthwhile if management have control of the proportion of each material used. 2. Often a favourable mix variance is offset by an adverse yield variance and the total cost per unit may increase.

Sales quantity variance: The sales quantity variance shows the difference in contribution/profit because of a change in sales volume from the budgeted volume of sales.000 2. Product X Y Z Total Budgeted sales (units) 2.000 Unit contribution $5 $7 $6 Total contribution $12. The unit’s method of calculation The sales mix variance is calculated as the difference between the actual quantity sold in the standard mix and the actual quantity sold in the actual mix.400 1. F5 Performance Management 2016  Quality. Using a cheaper mix may result in a lower quality product and the customer may not be prepared to pay the same price.000 $9.800 6. It is calculated as the difference between actual sales units and budgeted sales units. it is possible to analyse the overall sales volume variance into a sales mix variance and a sales quantity variance.000 Page 96 of 147 . The sales quantity variance is calculated as the difference between the actual sales volume in the budgeted proportions and the budgeted sales volumes.80 Actual sales (units) 2. valued at standard margin per unit.200 1. Sales mix variance: The sales mix variance occurs when the proportions of the various products sold are different from those in the budget. multiplied by the standard margin. Sales mix and quantity variances If a company sells more than one product. multiplied by the standard profit per unit.400 1.  Sales Mix and Quantity Variances Sales volume variance It measures the increase or decrease in the standard profit or contribution as a result of the sales volume being higher or lower than budgeted.000 Working Average contribution per unit $5. Example: The following information relates to the sales budget and actual sales volume results for X Inc for the month of March.800 $7.200 $29.200 5. A cheaper product may also result in higher sales returns and loss of repeat business.

Product Y: 1.200 The sales quantity variance The sales quantity variance indicates the effect on profits of the total quantity of sales being different front that budgeted.200 1.000 2.400 1. (For product X this is 2. Apply the percentages to the actual total sales to give the actual number of each that would have been sold if the actual sales were made in the standard mix. (For product X this figure is 48% of 6.200 Volume variance (units) (400) A 800 F 600 F Standard contribution per unit 5 7 6 Volume variance (contribution) ($2.000 (F) Weighted average standard contribution per unit $5. Thus the company has sold 480 units of X less than it would have if the actual sales were made in the standard mix) The variance for each product expressed as units is multiplied by the standard contribution per unit of that product to give the impact on contribution.000) $5.880 = 480 units.400/ = 48%.800 Budgeted sales (units) 2. If this was the case the average standard contribution per unit would be the same as budgeted at: $29.400 .000 = 24%).600 Total $7.80 Sales quantity variance in $ of standard contribution $5. F5 Performance Management 2016 Sales volume variance X Y Z Actual sales (units) 2.800 (F) The sales mix variance The sales mix variance is calculated as follows (making reference to the example above): Sum up the budgeted sales of each individual product and calculate the percentage that each bears to the total (Product X: 2.000 units = $5. Product Z: 1.80 per units The quantity variance is calculated as follows: Units of sale Budgeted sales in total 5. Page 97 of 147 .200/5.000 = 2.000 Actual sales in total 6. assuming that they are sold in the budgeted sales mix.880 units).2.000 Sales quantity variance in units 1.600 3.000/ 5.400 1.400/5.000 = 28%. The mix variance (in units) for each product is the difference between this number and the actual sales of that product.

Mix/yield variances June 09 – Q 2 Dec 11 – Q 5a Dec 14 – Q 5 Dec 15 – Q 3 Sales mix and quantity June 11 – Q 3 b. b.800 (F) Volume variance 7.800 24% 1. F5 Performance Management 2016 These figures are summed to give the total mix variance Product Actual Standard Mix Std.000 0 1.200 28% 1.200 (F) Past Paper Analysis Variance Analysis Dec 07 – Q 3 c.680 520 (F) 7 3.c June 13 Q 4.c June 14 – Q 5 Page 98 of 147 .400 (F) The total mix variance in units must come to zero. i.000 6. Summary $ Mix variance 1.880 880 (A) 5 4.440 360 (F) 6 2. iii.400 (F) Quantity variance 5.400 (A) Y 2.160 (F) 6.000 48% 2. contn Mix variance mix Mix Variance per unit (Std conf") (units) units units units $ $ X 2.e June 09 – Q 3 Dec 09 – Q 1a June 10 – Q 2 Dec 10 – Q 1a. In this illustration the total mix variance is favourable because the company has sold more high contribution items and less low contribution items.d.640 (F) Z 1.

Operational Variance: This is a result of the operational performance: favourable or adverse. Price Operational Variance ($) . availability of labour etc. Causes of Planning and Operational Variances:  Unexpected market changes related to sales demand. Revising Budgets:  Budgets should be revised when it is confirmed beyond reasonable doubt that the original budget is redundant or ineffective under the circumstances. Planning Variance: Variance arising as a result of error in planning.  The changes have to be approved by the senior management.  However care needs to be taken as there is a possibility of management manipulating the budget revision so that the end result is favourable variances. This is the difference between the original budget and the revised budget.  Unexpected changes in the product specification etc. Variance x Actual quantity of material used Material Price Operational Variance Revised standard cost for material actually used Less: Actual cost for material actually used . the budgets/ standard costs should be revised based on the new information available and the variances should be split into Planning or Operational variances. material cost. Strategic level management is responsible for these. Planning and Operational Variances Introduction: Sometimes based on circumstances the budget and the standard cost established by an organisation turns out to be inaccurate and this contributes towards the variances. Material Usage Planning Variance Quantity of material to be used as per original standard Less: Quantity of material to be used as per revised standard Usage Planning Variance . These are calculated by looking at the difference between the actual result and the revised budget/ standard. Operational level managers are responsible for these. F5 Performance Management 2016 16. Variance x Original Standard Price ($) Page 99 of 147 . Under the circumstances. Planning and Operational Variances: MATERIAL Material Price Planning Variance Original Standard Price Less: Revised Standard Price Price Planning Variance ($) .

F5 Performance Management 2016 Material Usage Operational Variance Quantity of material to be used as per revised standard Less: Quantity of material actually used for the actual production Usage Operational Variance . Sales Volume Planning Variance Original budgeted sales Less: Revised budgeted sales Volume Planning Variance . Variance x Actual number of units sold Sales Price Operational Variance Revised budgeted sales price for units actually sold Less: Actual sales price for units actually sold Price Operational Variance ($) . Variance x Original Standard Rate per hour ($) SALES Sales Price Planning Variance Original budgeted sales price Less: Revised budgeted sales price Price Planning Variance ($) . Rate Operational Variance ($) . Variance x Original Standard Price ($) LABOUR Labour Rate Planning Variance Original Standard Rate Less: Revised Standard Rate Rate Planning Variance ($) . Variance x Actual number of hours worked Labour Rate Operational Variance Revised standard rate for hours actually worked Less: Actual rate for hours actually worked . Labour Efficiency Planning Variance Hours to be worked as per original standard Less: Hours to be worked as per revised standard Efficiency Planning Variance . Variance x Original Standard Rate per hour ($) Labour Efficiency Operational Variance Hours to be worked as per revised standard Less: Hours actually worked for the actual production Efficiency Operational Variance . Variance x Standard contribution per unit ($) Page 100 of 147 .

 Planning variances can be used to update standard costs and revise budgets. b Dec 12 – Q 2 June 13 – Q 4 a. F5 Performance Management 2016 Sales Volume Operational Variance Revised sales volume Less: Actual sales volume Volume Operational Variance Variance x Standard contribution per unit ($) Advantages and disadvantages of using planning and operational variances Advantages  They identify variances due to poor planning and put a realistic value to variances resulting from operations.c Dec 10.  Managers might try to blame poor results on poor planning and not on their operational performance.Q 3 Page 101 of 147 . Disadvantages  It takes time and effort to revise budgets and prepare revised standard costs. ii.  The performance of managers is assessed on 'realistic' variance calculations.  Manipulation issues in revising budgets Past Paper Analysis Planning and operational variances Dec 09 Q 1 b.c Dec 13 – Q 5 June 15 -. Q 1 a.

 Reported variances must be realistic and reliable. Performance Analysis Uses of Variance Analysis:  Variance Analysis is a measure of control. Subordinates are unlikely to treat variances seriously unless their seniors do. and should demand explanations from their subordinates about significant variances and what has been done to investigate them.  Variances should be fairly current.the individuals concerned should be motivated by performance and variance reports. Variances and a TQM environment  The concept of Total Quality Management (TQM) is an approach to management based on the principle that all aspects of quality in an entity's operations should be managed so as to improve value for the customer. should only be held accountable for Operational Variances. If variance reports are not provided to management until several weeks after the control period.  The possible causes of a variance should be controllable by the person who is made responsible and accountable for the variance. and if it is discovered on investigation that the cause of variance can be controlled. Behavioural Aspects of Standard Costing  The effect of variance on staff motivation and action In principle. Page 102 of 147 . The analysis could highlight areas where efficiency needs to be improved etc. F5 Performance Management 2016 17. when variances are reported the staff responsible should investigate the causes of variances that appear to be significant. If the cause of a variance is unlikely to be controllable. Senior Management/ people involved in the planning aspect should be made accountable for the Planning Variances. suitable control actions should be taken.  If managers and other staff are given incentives for achieving favourable variances .for example if an annual cash bonus depends partly or entirely on achieving favourable variances . Staff will be reluctant to investigate variances if they do not trust the reported figures and consider the variances to be unrealistic. Managers responsible for the variances should be asked to account for them.  Variances not only identify the possible areas of concern but can be used to improve future performances. And managers/ people given responsibility for implementing the budget.  The monetary value of the variances also gives an indication of the profit or loss suffered in a period. the variances might be considered 'out of date' an 'no longer relevant'. it would be a waste of time to investigate its cause. This response by staff is only likely to happen under certain conditions:  Senior managers should indicate the importance they attach to variance reports.

Even where companies do not customise products for individual customers. with different product designs manufactured for each separate segment. in a JIT environment there will be no inventory of raw materials or finished goods. Standard Costing in a Dynamic Environment:  Standard costs may be incompatible with rapid change. Therefore it would be disappointing if actual results are ever worse than the standard. F5 Performance Management 2016  The concept of 'continuous improvement' is a view that in order to manage quality it is essential to keep looking for and identifying ways of improving quality in procedures.  In a system of absorption costing.  A consequence of JIT purchasing and production is that sometimes the purchase price for raw materials or the production cost for finished goods may be higher than they might otherwise be.  In principle. It is extremely difficult to establish a standard in such an environment. Page 103 of 147 . there will be favourable fixed production overhead variances if actual output exceeds budgeted output. and action to try to eliminate an adverse variance may in fact be inappropriate because operating conditions have now changed. This will be an adverse factor from Standard costing perspective. (in practice the aim is to keep these inventories as low as possible). there is extensive fragmentation of markets into segments or niches. products and services. Variances and a JIT Environment  Just in time (JIT) management involves purchasing raw materials and producing output 'just in time' for when they are needed.  This approach to management may possibly be inconsistent with some variance reporting. for similar reasons to those of TQM. This is because:  Variances are calculated by comparing actual results with a fixed standard: performance is considered 'good' if actual results are better than the standard  In a system of TQM. because in TQM any aspect of performance should be considered capable of improvement. But in JIT output is produced when and according to what is needed. Production costs per unit may also be higher when batch sizes are smaller. especially if a system of absorption standard costing is used.  Variance analysis and variance reporting becomes inconsistent with TQM. In other words. because a supplier may charge a higher unit price for a small quantity.  Many companies produce nonstandard products and try to customise their products according to needs of particular customers. it should be expected that the original standard or budget may get out of date. favourable variances are obtained and profit is improved by increasing finished goods inventory levels. In a rapidly-changing environment. the aim is to improve continually.  Variance reporting in a TQM environment may lead to dysfunctional behaviour if managers ignore aspects of performance where the variance is close to $0. systems.

But in most organisations the majority of costs. The modern manager needs much more prompt control information in order to function efficiently in a dynamic business environment Past Paper Analysis Reconciliation and TQM June 08 – Q 1 June 12 – Q 4 Page 104 of 147 . and does not give sufficient attention to issues such as quality and customer satisfaction. F5 Performance Management 2016 Other Problems with Using Standard Costing in Today's Environment  Variance analysis concentrates on only a narrow range of costs. Nowadays many organisations are forced continually to respond to customers’ changing requirements.  Most standard costing systems produce control statements weekly or monthly. including direct labour costs.  The use of standard costing relies on the existence of repetitive operations and relatively homogeneous output. Direct labour is only a small proportion of costs in the modern manufacturing environment and so this emphasis is not appropriate. with the result that output and operations are not so repetitive.  Many of the variances in a standard costing system focus on the control of short-term variable costs.  Standard costing places too much emphasis on direct labour costs. tend to be fixed in the short run.

 Input from many different areas of the organisation to ensure that the goals and targets link together smoothly. Also known as Tactical Planning. cashflows. non-financial and internally generated information. leading to ineffective decisions.e. control and decision making. Strategic Planning: Long term planning decisions that define the objectives of the organisation.  It provides information about: pricing of product.  Ensures business operations are focused on meeting shareholder’s needs. Strategic Management Accounting: focuses on external factors. Features of Management Accounting Information:  Management Accounting information is primarily used for strategic level planning i. It takes into account the following:  Competitive edge by understanding customer demands and competitors USP (unique selling point). Efficiency in the use of resources means that optimum output is achieved from the input resources used.  It is internally focused as it focuses on performance targets and ignores market competition and demand. efficiently and effectively with the aim of achieving the strategic objectives of the organisation. plans for long periods of the future and so relies on forecasts and estimates.  Brings together comparable information regarding different strategies. so the challenge lies in providing more relevant information for strategic planning. Performance Management Information Systems Information for Management Accountants: Management Accounting Information: Information that is used to support strategic planning.  The management accountant requires information for:  Project assessments: at the time of decision making and post implementation feedback. Management Control: The process of utilising resources.  Management accounting information also therefore incorporates some risk and uncertainty analysis. control and decision making. F5 Performance Management 2016 Part D – Performance Measurement and Control 18. customer analysis. market analysis etc.  Data is inflexible as it is often just based on historical performance.  Handling cash and operational matters  Management accounting information is primarily derived from internal sources but also takes into impact of external factors.  Management Accounting information has the following limitations:  It may provide misleading information. product profitability. Page 105 of 147 .

 The four important characteristics of a TPS are as follows. quantities of material.  Back-up and recovery procedures are in place as organisations rely heavily on TPS. and so on.  Scheduling of unexpected or 'ad hoc' work must be done at short notice. Page 106 of 147 . is expressed in terms of units.  Operational information.  Batch transaction processing (BTP) collects transaction data as a group and processes it after a time delay. hours. Information is entered in batches.  The processing is controlled as it supports the organisations operations. Management information systems (MIS) convert data from mainly internal sources into information. MIS have the following characteristics.  Real time transaction processing (RTTP) is the immediate processing of data. Transaction Processing Systems (TPS) collect.  Features of management control information  Primarily generated internally  Covers the entire organisation  Summarised at a relatively low level  Relevant to the short and medium terms  Collected in a standard manner  Commonly expressed in money terms Operational Control: Routine processing of transactions as per directions laid down in the Tactical plans.  Management control activities are short-term non-strategic activities. it is required for. modify and retrieve the transactions of an organisation.  Detail of information provided depends upon the purpose. which enables managers to make timely and effective decisions for planning and controlling the activities. These are termed as short- term non-strategic activities.  The time horizon involved in management control will be shorter than at the strategic decisions level.  All transactions are recorded in a pre-defined manner or format. although quantitative. store.  Information requirements:  Operational information includes transaction data which is needed for the conduct of day-to-day implementation of plans. F5 Performance Management 2016 Effectiveness in the use of resources means that the outputs obtained are according to set objectives or targets.  Provides rapid response to support customer satisfaction.

F5 Performance Management 2016  Support structured decisions at operational and management control levels and is internally focused. Open system is connected to and interacts with the environment and is influenced by it. as the company restructures its processes so that multiple departments can work together.  Adaptable. Executive information systems (EIS) provides a quick and efficient computing and communication environment for senior managers to support strategic decisions. Keeps pace with the dynamic environment. An open system accepts inputs from its surroundings. Executive information systems draw data from the MIS and allow communication with external sources of information. Information is not received from or provided to the environment. ERP systems work in real time.  A lot of inefficiencies in the way things are done can be removed. Executive resource planning systems (ERP systems) are modular software packages designed to integrate the key processes in an orgnanisation so that a single system can serve the information needs of all functional areas. Advantages:  Strong communication which leads to effective decision making.  Designed to report on existing operations rather than analyse data. ERP systems have the principal benefit that the same data can easily be shared between different departments. Closed system is isolated and shut off from the environment.  It helps managers focus on the external factors that affect the organisation. processes the inputs in some manner and then produces an output. Social systems cannot be part of closed system.  Standardising Information and work practices so that the terminology used is similar. Page 107 of 147 . Benefits of ERP  Easy access to shared real time information to support decision making.

Cost of Information: Direct search costs  Cost of a marketing research survey  Subscriptions to online information. Primary data: market research – is more tailored to the user's exact needs.  Control measures are dependent upon the feedback of the actual performance. surveys etc Indirect access costs  Time spent by employees on unsuccessful searches for information  Time spent on sifting through possibly inaccurate data to extract useful facts. pricing etc.)  Internet & online databases  Database information  Data warehouses Use of Information by Management Information is primarily used in an organisation. Page 108 of 147 . broadly. Internal Sources:  Formal communication channels  Informal communication between management and staff  Communication between managers  The financial accounting records External Sources:  Legal/ Tax expert  Research & Development and Marketing departments  Directories & other published sources  Associations and Government agencies  Information from customers  Information from suppliers (product details. for the following purposes:  Plans at all levels are made based on external information and current performance of the organisation. F5 Performance Management 2016 19. Awareness of the business environment is required to ensure that the full potential of the organisation is tapped. Sources of Management Information Types of Data: Secondary data: data not directly collected from the source by the user.

 The accuracy of the data is questionable. to facilitate flow of information. Using Internal Information: Generating Information:  Determine if the benefits of the information generated will be higher than the costs incurred to prepare it. Page 109 of 147 .  Ensure that the desired information will be of use to the decision makers before the information is gathered. Using External Information: Limitation: Quality of information may not be up to mark because of limitations in the parameters defined for collecting the information.  Some external information is expensive to access and may not be easily accessible. the method of collecting the data and age of the data etc.  The limitations of the information gathered should be communicated to the users as well as the details of the preparer/ originator. The formats should ideally focus on being user friendly for the ultimate users. Advantages: Cost savings can be substantial because secondary external data is cheaper than gathering primary data. internet etc. processing and dissemination of external information Infrastructure costs  Installation and maintenance of systems – communication. Time theft  Wasted time caused by abuse of internet and email access facilities  Information overload Benefits of Information:  Improvement in the quality of the decisions made based on the information available. F5 Performance Management 2016 Management costs  Recording.  Standardised formats for the information to be prepared should be set. Disadvantages:  The data may not be relevant to the research objectives as it has originally been collated by someone else.  Reduction in risk and uncertainties. especially if there are multiple prepares of the information. so that any queries can be directly forwarded.

Senior management should specify which user can have access to which assets and information.  Confidential information should be highlighted as such and users guided on how to deal with sensitive information.  Security and confidential information A number of procedures can be used to ensure the security of highly confidential information that is not for external consumption.  E-mail policy should be established specifying the do’s and donts’ for on-line communication. F5 Performance Management 2016 Distributing Information:  A procedures manual should be in place.  External security through firewalls should be established. as they can be used to protect data and databases from being accessed by unauthorised people.  Passwords  Logical access systems  Database controls  Firewalls  Personnel security planning  Anti-virus and anti-spyware software Page 110 of 147 . This would indicate what reports are to be prepared and issued to whom.  Physical computer security  Internal security should be established.

Targets. Performance Measurement Performance Measurement Performance measurement is a vital part of control and aims to establish how well something or somebody is doing in relation to a planned activity. and meeting budget targets. whether financial or non. Medium term performance: Medium-term performance measurement is perhaps most easily associated with the annual budget.  Indicate the risk that targets will not be met. the critical success factors must be achieved. so that corrective action can be taken. Long-term performance: Measures should be linked to the long-term objectives and the strategies of the organisation.  Reward the successful achievement of targets or standards. and actual results should be compared against the planning targets. so that action to correct the situation can be considered. in order to achieve its long-term and strategic objectives. Short-term performance: Short-term performance should be monitored by means of operational performance measures. Responsibility and controllability Two essential features of an effective performance reporting system are: Responsibility. Reasons for measuring performance The purpose of measuring performance is to:  Determine whether the planning targets or standards are being met. There is no sensible purpose in judging the performance of an individual by looking at factors that are outside the individual's control. Performance measurements for CSFs might be called key performance indicators (KPIs) or possibly key risk indicators (KRIs). can be set for a planning period such as the financial year. Performance reports should distinguish between aspects of performance that should be controllable by the individual who is made responsible and accountable. in order to check whether the CSF targets are being met. Page 111 of 147 .  Indicate poor performance. Performance reports should be provided to the individuals (and their managers) who are actually responsible for the performance. F5 Performance Management 2016 20. The most significant long-term objectives might be called critical success factors or CSFs. Performance reports are irrelevant if they are sent to individuals with no responsibility. there should be a way of measuring performance. Performance measures over Time Performance measurement should cover the long-term. For each critical success factor. medium-term and short.  Determine the performance of each of function/ department.

The management of an organisation is usually keen to measure its operating efficiency. F5 Performance Management 2016 Financial Performance Indicators (FPI)  Financial performance indicators are the tools used by financial analysts for making decisions regarding credit and investments. To assess performance by looking at profit margins. Sales growth is usually necessary for achieving a sustained growth in profits over time. The operating efficiency of a firm and its ability to ensure ample returns to its owners/ shareholders depends basically on the profits earned by it.  Analysts will compare the company’s ratios to its past performance. Percentage annual growth in sales = (Current Year Sales / Previous Year Sales) x 100% If a company wishes to increase its annual profits. without further analysis. it is necessary to look at the circumstances in which the profit margin has been achieved. as well as to industry statistics to determine risks. Again. This analytical tool facilitates inter- company as well as intra company comparisons. it will probably want to increase its annual sales revenue. although sales volume may be low. trends and to identify any peculiarities. Profit margin ratio Gross Profit Margin = (Gross Profit / Sales) x 100% Net Profit Margin = (Net Profit / Sales) x 100% It is wrong to conclude. that a high profit margin means 'good performance' and a low profit margin means 'bad performance'. the owners/ shareholders invest their funds in the expectation of reasonable returns. This method utilises the data found in financial statements to determine a company’s standing. Other companies may operate in a market where profit margins are low but sales volumes are Page 112 of 147 . Sales growth (or a decline in sales) can usually be attributed to two causes: Sales prices and sales volume. Profitability Indicators Profitability ratios are good indicators of the operating efficiency of an organisation. Some companies operate in an industry or market where profit margins are high.

Earnings per share (EPS) = Profits available to ordinary shareholder / Number of ordinary shares EPS is a convenient measure as it shows how well the shareholder is doing. and it is easily manipulated by changes in accounting policies and by mergers or acquisitions. especially in comparing results over a period of several years. Return on capital employed (ROCE) = (Capital Employed / Profit Before Interest & Tax) x 100% Capital employed = Shareholders' funds plus 'payables: amounts falling due after more than one year' plus any long-term provisions for liabilities = Total assets less current liabilities. the higher a company’s total net asset turnover. A company must be able to sustain its earnings in order to pay dividends and reinvest in the business so as to achieve future growth. the more efficiently its assets have been used. The use of the measure in calculating management bonuses makes it particularly liable to manipulation. Generally. Performance may be assessed by looking at changes in these ratios over time. There are Page 113 of 147 . F5 Performance Management 2016 much higher. such as: Ratio of cost of sales : sales Ratio of administration costs : sales Ratio of sales and distribution costs : sales Ratio of total labour costs : sales. Any change in profit margin front one year to the next will be caused by: changes in selling prices. if this information is available A comparison of the ROCE with current market borrowing rates We may analyse the ROCE. The change in ROCE from one year to the next The ROCE being earned by other companies. EPS is a figure based on past data. or changes in costs as a percentage of sales. EPS is widely used as a measure of a company's performance. Asset Turnover = (Total Sales / capital Employed) x 100% This ratio indicates the efficiency with which company is able to use all its (net) assets to gearing $1 sales. or better or worse than last year. Cost/sales ratios Profitability may also be measured by cost/sales ratios. Investors also look for growth in the EPS from one year to the next. to find out why it is high or low. A large increase or reduction in any of these ratios would have a significant effect on profit margin. or a combination of both.

Gearing ratio (leverage) = (Long term debt/ Share capital and reserves) x 100% Or (Long term debt/ Share capital and reserves plus long term debts) x 100% When there are preference shares. Profit margin and asset turnover together explain the ROCE. F5 Performance Management 2016 two factors that contribute towards a return on capital employed. Asset turnover. This means that a company is low-geared when the gearing ratio is less than either 50% or 100%. A company is said to be low-geared when the amount of its debt capital is less than its share capital and reserves. The relationship between the three ratios is as follows Profit Margin x Asset Turnover = ROCE Financial Risk Financial risk is the risk to a business entity that arises for reasons related to its financial structure or financial arrangements. Profit margin. it might fail to generate enough cash front its business operations to pay the interest or repay the debt principal. both related to turnover. This means that a company is high-geared when the gearing ratio is above either 50% or 100%. such as credit risk (= the risk of bad debts because customers who are given credit will fail to pay what they owe) and foreign exchange for companies that import or export goods or services (= the risk of an adverse movement in an important currency exchange rate). There are several major sources of financial risk. and if the ROCE is the primary profitability ratio. similar companies. A company is said to be high-geared or highly-leveraged when its debt capital exceeds its share capital and reserves. A company might make a high or a low profit margin on its sales. It can also be used to make comparisons with the gearing levels of other. these other two are the secondary ratios. or perhaps too little. not share capital. it is usual to include the preference shares within long-term debt. in its capital structure. Debt ratios Debt ratios can be used to assess whether the total debts of the entity are within control and are not excessive. Page 114 of 147 . The risk is that if an entity borrows very large amounts of money. depending on which method is used to calculate the ratio. Asset turnover is a measure of how well the assets of a business are being used to generate sales. depending on which method is used to calculate the ratio. to judge whether the company has too much debt. The gearing ratio can be used to monitor changes in the amount of debt of a company over time.

can be measured by financial gearing. much lower current ratios are normal. suggesting that the company could be at risk from too much debt in relation to the amount of profits it is earning. F5 Performance Management 2016 Interest cover ratio = Profit before interest and tax / Interest charges in the year Interest cover measures the ability of the company to meet its obligations to pay interest. so that the cash is 'idle'. but without having too much. and the entity will therefore be at risk from any legal action or other action that lenders might take. to meet liabilities when they fall due for payment. On the other hand a business entity may have too much liquidity. or having ready access to additional cash. due to the nature of the business that the company is involved in. although obtaining cash front these sources may need some time. Liquidity is important for a business entity because without it. Current Ratio = Current Assets / Current Liabilities It is sometimes suggested that there is an 'ideal' current ratio of 2. the entity. It is important to assess a current ratio by considering:  changes in the ratio over time  the liquidity ratios of other companies in the same industry. Page 115 of 147 . However. Operating gearing = Contribution / PBIT Financial risk. Managing liquidity is often a matter of ensuring that there is sufficient liquidity.0 times (2:1). this is not necessarily true and in some industries. earning little or no interest. when it is holding much more cash than it needs. there is a risk that a creditor will take legal action and this action could lead on to insolvency proceedings. such as the sale of a valuable non-current asset (such as land and buildings). or even losses. such as cash held on deposit or readily-marketable shares in other companies  a bank overdraft arrangement or a similar readily-available borrowing facility from a bank. The risk is that a significant fall in profitability could mean that profits are insufficient to cover interest charges. One way of measuring business risk is by calculating a company's operating gearing or 'operational gearing'. Liquidity Ratios Liquidity for a business entity means having enough cash. If the entity is unable to settle its liabilities when they fall due. Cash may also come front other sources. as we have seen.may become insolvent even though it is operating at a profit. The most important sources of liquidity for non-bank companies are:  operational cash flows (cash front sales)  liquid investments. An interest cover ratio of less than 3.0 times is considered very low. Business risk refers to the risk of making only low profits.

or  A build-up in inventory levels.0 times (1:1).department throughout the looking at changes in the ratio over time and comparisons with other companies and the industry norm. A lengthening inventory turnover period indicates:  A slowdown in trading. increased bank overdraft and so on. this is only an approximate figure. F5 Performance Management 2016 Quick Ratio = Current Assets excluding inventory / Current Liabilities The quick ratio or acid test ratio is the ratio of 'current assets excluding inventory' to current liabilities. It is sometimes suggested that there is an 'ideal' quick ratio of 1. much lower quick ratios are normal. Accounts Receivable Payment Period: (Trade Receivables/ Credit Sales Turnover) x 365 This is a rough measure of the average length of time it takes for a company's accounts receivable to pay what they owe. As with the average accounts receivable collection period. As indicated earlier. Some indicators are:  Product quality or quality of service  Speed of order processing or speed of any other processing cycle  Customer satisfaction  Brand awareness amongst target customers  Labour turnover rate  Number of man-days of training provided for employees  Amount of down-time with IT systems Page 116 of 147 . it is important to assess liquidity. However. an increase in accounts payable days is often a sign of lack of long-term finance or poor management of current assets. Inventory Turnover Period = (Inventory / Cost of Sales) x 365 This indicates the average number of days that items of inventory are held for. and performance targets can be set for every. Inventory is excluded from current assets on the assumption that it is not a very liquid item. perhaps suggesting that the investment in inventories is becoming excessive Accounts Payable Payment Period: (Trade Payables/ Credit Purchases) x 365 The accounts payable payment period often helps to assess a company's liquidity. Non Financial Performance Indicator Non-financial performance refers to every aspect of operations within a business except the financial aspect. resulting in the use of extended credit from suppliers. this is not necessarily true and in some industries. but one which should be reliable enough for finding changes over time.

F5 Performance Management 2016  Number of suppliers identified for key raw material supplies  Length of delays on completion of projects  Capacity utilised (as a percentage of 100% capacity). think of a suggestion for improving performance. Non Financial Performance indicators are adequately covered through different models – covered later.both financial and non-financial . Below are some examples of non-financial measures: AREA POSSIBLE CRITERIA Competitiveness sale growth by product or service relative market share and position Activity sales units labour/ machine hours number of material requisitions serviced Productivity efficiency measurements of resources planned against those consumed production per person Quality of Service number of customer complaints rejections as a percentage of production or sales Quality of Working Life labour turnover overtime Innovation proportion of new products and services to old ones new product or service sales level Page 117 of 147 . but the key measures that are best suited to service industries are often very different from the key NFPIs in manufacturing.are needed for service industries. and why? Look at the background information given in the exam question and try. What might be done by management to make performance better? NFPIs in service industries Performance measures .to identify a possible cause or reason for the good or bad performance.What does it mean? Does it indicate good or bad performance. Possibly. Analysing NFPIs It is not sufficient simply to calculate a performance ratio or other performance measurement. You need to explain the significance of the ratio .

 Measuring customer satisfaction. and so reducing the prospects for future product development. and the reaction of external customers. In many cases the measures used will be non-financial ones. Organisations often have to make a trade-off between short-term and long-term objectives. This may be monitored in the form of letters of complaint. Decisions which involve the sacrifice of longer-term objectives include the following. and measures such as the amount of scrap and reworking in relation to good production. the efforts of external suppliers. F5 Performance Management 2016 Customer Satisfaction informal listening by calling a certain number of customers each week number of customer visit to the factory or workplace Performance measurement in a TQM environment Total Quality Management embraces every activity of a business so performance measures cannot be confined to the production process but must also cover the work of sales and distribution departments and administration departments.  Monitoring work done as it proceeds.  Measuring the quality of incoming supplies. Page 118 of 147 . Short-termism and manipulation Short-termism is when there is a bias towards short-term rather than long-term performance. They may be divided into three types. which would eventually contribute to growth and profits. Quality control should include procedures for acceptance and inspection of goods inwards and measurement of rejects. claims under guarantee. 'In-process' controls include statistical process controls and random sampling.  Postponing or abandoning capital expenditure projects.  Cutting R&D expenditure to save operating costs. or requests for visits by service engineers. penalty discounts. returned goods. in order to protect short term cash flow and profits.

 New markets. their degree of satisfaction and the processes used to deliver products and services to customers. Particular areas of focus would include:  Quality performance. F5 Performance Management 2016 Balanced Scorecard A useful approach for a complete strategic performance evaluation is to include both financial and non- financial factors for an organisation. The balanced scorecard measures an organisation’s performance in four key areas: Customer satisfaction Financial performance Internal business process Learning and growth The justifications of balanced scorecard over the traditional measures are that:  Accounting figures are easily manipulated and as such unreliable changes in the business and market environment do not show in the financial results of a company until much later. using the balanced scorecard. Customer perspective How do customers perceive the firm? This focuses on the analysis of different types of customers.  Quality.  Customer retention. Internal business perspective How well the business is performing.  Motivated workforce.  New products.  Factors other than financial performance must therefore be targeted. Particular areas of focus would include:  Customer service. Innovation and learning perspective Can we continue to improve and create value? Particular areas of focus would include: Page 119 of 147 .  Customer satisfaction.

Shareholders are concerned with many aspects of financial performance.  Profit ratio. Financial perspective This is concerned with the shareholders view of performance.  Amount of training.  Cash flow.  Return on investment.  Return on capital employed. F5 Performance Management 2016  Product diversification.  % sales from new products.  Extent of employee empowerment. Diagram: A format of Balanced Scorecard Page 120 of 147 .  Economic value added.  Share price. Particular areas of focus would include:  Market share.  Number of employee suggestions.

Building Block Model Fitzgerald and Moon (1996) suggested that a performance management system in a service organisation can be analysed as a combination of three building blocks:  dimensions  standards. Building blocks for performance measurement systems (Fitzgerald and Moon 1996) Dimensions of Performance Dimensions of performance are the aspects of performance that are measured. which is known as the 'building block model'. however. a decision has to be made about the dimensions of performance that should be used for measuring performance. These are:  profit (financial performance)  competitiveness  quality Page 121 of 147 . F5 Performance Management 2016 Criticism The targets for each of the four perspectives might often conflict with each other. there might be disagreement about what the priorities should be. When this happens. The term 'balanced' scorecard indicates that some compromises have to be made between the different perspectives. if it is remembered that the financial is the most important of the four perspectives for a commercial business entity. These are shown in the following diagram. To establish a performance measurement system for a service industry. Research by Fitzgerald and others (1993) and by Fitzgerald and Moon (1996) concluded that there are six aspects to performance measurement that link performance to corporate strategy. This problem should not be serious. and  rewards.

such as material wastage rates. F5 Performance Management 2016  resource utilisation  flexibility  innovation. rates of loss in production. once the dimensions of performance have been selected. to assess flexibility of response to customers' needs Resource utilisation Efficiency/productivity measures. Some performance measures that might be used for each dimension are set out in the following table. Dimension of performance Possible measure of performance Financial performance Profitability Growth in profits Competitiveness Growth in sales Retention rate for customers (or percentage of customers who buy regularly: 'repeat sales') Service quality Number of complaints Customer satisfaction. or do they feel that the standard shave been imposed on them by senior management? Page 122 of 147 . to assess the flexibility of the work force Possibly the speed in responding to customer requests. labour efficiency Utilisation rates: percentage of available time utilised in 'productive' activities. This considers behavioral aspects of performance targets. machine utilsation Innovation Number of new services offered Percentage of total sales income that comes from services introduced in the last one or two years Standards of performance The second part of the framework for performance measurement suggested by Fitzgerald and Moon relates to setting expected standards of performance. Performance measures should be established for each of these six dimensions. There are three aspects to setting standards of performance:  To what extent do individuals feel that they own the standards that will be used to assess their performance? Do they accept the standards as their own. as revealed by customer opinion surveys Number of errors discovered Flexibility Possibly the mix of different types of work done by employees.

is that some costs are incurred for the benefit of several divisions or departments of the organisation. motivation to achieve the targets will be greater when the targets are clear (and when the managers have participated in the target-setting process). According to Fitzgerald. there are three aspects to consider in the reward system. Rewards for performance The third aspect of the performance measurement framework of Fitzgerald and Moon is rewards.  The system of setting performance targets and rewarding individuals for achieving those targets must be clear to everyone involved. Finding a balance between standards that the company thinks are achievable and standards that the individual thinks are achievable can be a source of conflict between senior management and their subordinates. and how individuals will be rewarded for the successful achievement of performance targets.  Individuals should only be held responsible for aspects of financial performance that they can control. arguments between divisional managers often arise because of disagreements as to how the shared costs should be shared. and managers are more likely to own the standards when they have been involved in the process of setting the standards. It has also been argued that if an individual accepts or 'owns' the standards of performance. This is a basic principle of responsibility accounting. better performance will be achieved when the standard is more demanding and difficult to achieve than when the standard is easy to achieve. in practice. or not?  Are the standards fair ('equitable') for all managers in all business units of the entity? It is recognised that individuals should 'own' the standards that will be used to assess their performance. F5 Performance Management 2016  Do the individuals held responsible for achieving the standards of performance consider that these standards are achievable. by linking operational performance with strategic objectives. A common problem. but not impossible to achieve. Budget targets should therefore be challenging. This aspect of performance also has behavioral implications. Provided that managers accept their performance targets.  Employees may be motivated to work harder to achieve performance targets when they are rewarded for successful achievements. One of the main roles of a performance measurement system should be to ensure that strategic objectives are achieved successfully. The costs of these shared services have to be allocated between the divisions or departments that use them. This refers to the structure of the re-wards system. Page 123 of 147 . This means that the standards of performance that are likely to motivate individuals the most are standards that will not be achieved successfully all the time. for example with the payment of an annual bonus. however. The principle that costs should be controllable therefore means that the allocation of shared costs between divisions must be fair.

 Top management may lose control over the organisation if they allow decentralisation without at head office and one in each of the investment centres. choose suppliers.  It is difficult to find a satisfactory measure of historical performance for an investment centre that will motivate divisional managers to take the best decisions. there can be tax advantages in creating a divisional structure.  Within a large multinational group. It may be necessary to monitor divisional performance closely. For example. Taking decisions that benefit a division might have adverse consequences for the organisation as a whole. there is a lack of 'goal congruence'. Divisions are commonly set up to be responsible for specific geographical areas or product lines within a large organisation. because the divisional managers make the tactical and operational decisions. The cost of such a monitoring system might be high.  Decision-making at a tactical and operational level should improve. Benefits of decentralisation  Decision-making should improve. This problem is explained in more detail later. Page 124 of 147 . make output decisions.  Economies of scale might be lost. because the divisional managers have better 'local' knowledge. there might be a need for four finance directors . such as accounting system and other IT systems. The term 'decentralised divisionalised structure' means an organisation structure in which authority has been delegated to the managers of each division to decide selling prices. a company might operate with cute finance director. When this happens.  Managers may be more motivated to perform well if they are empowered to make decisions and rewarded for performing well against fair targets  Divisions provide useful experience for managers who will one day become top managers in the organisation. and top management is free to concentrate on strategy and strategic planning. and so on. Disadvantages of decentralisation  The divisional managers might put the interests of their division before the interests of the organisation as a whole. For example. revenue centres. Within a large organisation. measuring divisional performance by Return 011 Investment (ROI) might encourage managers to make inappropriate long-term investment decisions. A divisionalised structure refers to the organisation of an entity in which each operating unit has its own management team which reports to a head office. profit centres and investment centres. because decisions will be made faster. Similarly there might be a duplication of other systems.  Decision-making should improve. F5 Performance Management 2016 Divisional Performance Evaluation Decentralisation of authority Decentralisation involves the delegation of authority within an organisation. Divisional managers can make decisions 'on the spot' without referring them to senior management. If it divides itself into three investment centres. by locating some divisions in countries where tax advantages or subsidies can be obtained. authority is delegated to the managers of cost centres.

with the performance of the decentralised units measured in terms of accounting results. buying and selling goods and services. Responsibility centre Manager has control over … Cost centre Controllable costs Revenue centre Revenues only Profit centre Controllable costs Contribution centre As for profit centre Investment centre Controllable costs Sales prices (including transfer prices) Output volumes Investment in non-current assets and working capital Page 125 of 147 . revenue centre. There may also be an allocation of general overheads. profit centre. Responsibility Accounting Responsibility accounting is the term used to describe decentralisation of authority. it is desirable to identify:  costs that are controllable by the manager of the division. in measuring performance. However. These are controllable costs plus other costs directly attributable to the division over which the manager does not have control. such as a share of head office costs. These are internal sales. Reporting systems should identify external sales of the division and internal sales as two elements of the total revenue of the division. With a system of responsibility accounting there are five types of responsibility centre: cost centre. F5 Performance Management 2016 Controllable profit and traceable profit Controllable profit is used to assess the manager and is therefore sometimes called the managerial evaluation. Traceable profit is used to assess the performance of the division and is sometimes called the economic evaluation. contribution centre. Profit is a key measure of the financial performance of a division. profit centres and investment centres often trade with each other. In a divisionalised system. and also  costs that are traceable to the division. investment centre. priced at an internal selling price (a 'transfer price').

000 Costs of production Variable costs 70. A transfer at cost maybe at either:  marginal cost (variable cost). A transfer price maybe:  the cost of the item (to the selling division).000 Page 126 of 147 . F5 Performance Management 2016 Transfer Pricing Purpose of transfer pricing When a company has a divisionalised structure. some of the divisions might supply goods or services to other divisions in the same company. or  a price that is higher than the cost to the selling division. or  full cost.000 Fixed costs 80. and total profit of the company as a whole is unaffected. This will be referred to as the 'buying division'.  One division sells the goods or services. It is an internal transaction within the company. which may be cost plus a profit margin or related to the external market price of the item transferred. A decision has to be made about what the transfer price should be. when the selling division is a profit centre or investment centre. Definition of a transfer price A transfer price is the price at which goods or services are sold by one division within a company to another division in the same company. 350. these internal transfers of goods or services are given a value. Example An entity has to divisions. This -will be referred to as the 'selling division'. Division A makes a component X which is transferred to Division B. Transfers at cost The transfer price may be the cost of making the item (goods) or cost of provision (services) to the selling division. For accounting purposes. Division B uses component X to make end-product Y. However.  Another division buys the goods or services.000 10. Details of budgeted annual sales and costs in each division are as follows: Division A Division B Units produced/sold 10. Internal sales are referred to as transfers. it will expect to make some profit on the sale. When goods are sold or transferred by one division to another. Transfers could be recorded at cost. and a company cannot make a profit from internal transfers. so the internal selling and buying price is the transfer price. Division A and Division B.000 $ $ Sales of final product . the sale for one division is matched by a purchase by the other division.000 30.000 90.

000 $ $ $ External sales of final product .000 350.000 Required What would be the budgeted annual profit for each division if the units of component X are transferred from Division A to Division B: a) at marginal cost b) at full cost? How would the reported profit differ if actual sales prices.000 Internal transfers (11.000 Fixed costs 80.000 190.000 Internal transfers (10.000 10.000 80. the buying division (Division B) reports a profit.000 350.000 x $7) 77. Division A Division B Company as a whole Units produced/sold 11.000 90.000 Total costs 150. 70. but Division A still makes a loss equal to its fixed costs.000 11.000 120.000 10.000 .000 $ $ $ External sales of final product .000 11. 0 Page 127 of 147 . 385. Because te fixed costs of Division A are not included in the transfer price. actual variables costs per unit and total fixed costs were as budgeted.000 By transferring goods at variable cost. the profits of Division B will increase. but units sold are 10% more than budget? Answer Transfers at marginal cost: budgeted performance: Division A Division B Company as a whole Units produced/sold 10. F5 Performance Management 2016 Total costs 150. Transfers at marginal cost: actual sales higher than budget The same situation occurs if actual output and sales differ from budget.000 170.000 x $7) .000 Costs of production Internal transfers (10. If production and sales are 11.000 Profit/(net cost or loss) (80.000 385. and its records a loss (or a net cost) equal to its fixed costs.000 30. The total company profits increase by the same amount as the increase in the profits of Division B.000 270. the profit of Division B exceeds the total profit of the company as a whole.000) 160. On the other hand.000 0 Other variable costs 70. It therefore bears the full cost of its fixed costs.000 x $7) 70. the transferring division earns revenue equal to its variable cost of production. 350.000 350. 0 Total sales 70.000 100.000 units.000 .

000 170. but this is simply the amount by which its fixed overhead costs are over-absorbed.000 350.000 Costs of production Internal transfers (11.000 10.000 385.000 units.000 Internal transfers (11. It still reports a profit. the full cost per unit produced in Division A is $15.000 350.000 Costs of production Internal transfers (10. If production and sales are 11.000 Transfers at full cost: budgeted performance: In this example. Division A is able to cover all its costs. with an absorption rate for fixed overheads of $S per unit produced and transferred Division A Division B Company as a whole Units produced/sold 10. However.000 x $15) 165.000 Fixed costs 80.000 Fixed costs 80.000 $ $ $ External sales of final product . the profits of Division B will increase.000 80.000 0 Other variable costs 77.000 200.000 270.000 x $15) 150.000 .000 Profit/(net cost or loss) (80.000 350.000 x $7) .000 105. F5 Performance Management 2016 Total sales 77.000 Total costs 150.000 110.000 Since the transfer price includes the fixed costs of the selling division. 0 Total sales 150.000) 185.000 385.000 Internal transfers (10.000 .000 33.000 0 Other variable costs 70. 150.000 11.000 x $15) .000 Profit 0 80.000 280. 77.000 100. Transfers at full cost: actual sales higher than budget A similar situation occurs if actual output and sales differ from budget. The buying division (Division B) has to pay for the fixed costs of division A in the transfer price. 385.000 90. 350.000 385. but this profit is now equal to the profit earned by the company as a whole. Division A Division B Company as a whole Units produced/sold 11. but it reports neither a profit nor a loss. It covers its costs exactly.000 30. Division A will make some 'profit'.000 Page 128 of 147 .000 385.000 90.000 10.000 Total costs 157.000 $ $ $ External sales of final product .000 11. 0 Total sales 165.000 385.000 170.000 270.

The objectives of transfer pricing should be to make it possible for divisionalisation to operate successfully within a company.000 97. Divisional autonomy Autonomy is freedom of action and freedom to make decisions. Transfer pricing at cost plus For the purpose of performance measurement and performance evaluation in a company with profit centres or investment centres.000 33.000 Total costs 157. The objectives of transfer pricing Transfer prices are decided by management. it is appropriate that:  the selling division should earn some profit or return on its transfer sales to other divisions and  the buying division should pay a fair transfer price for the goods or services that it buys from other divisions.000 90. to provide the selling division with a profit margin. One way of arranging for each division to make a profit on transfers is to set the transfer price at an amount above cost.000 These examples should illustrate that if transfers are at cost.000 0 Other variable costs 77. However the transfer price should not be so high that the buying division makes a loss on the items it obtains from the selling division.000 x $15) . For example. if an external market exists for the output Page 129 of 147 .000 110. the selling division is a cost centre rather than a profit centre or investment centre. and:  give autonomy (freedom to make decisions) to the managers of the profit centres or investment centres  enable the company to measure the performance of each division in a fair way. but this is only possible if an external market exists for the item. the managers of all divisions within the entity should be free to decide:  whether to sell their output to other divisions (internal transfers) or -whether to sell them to external customers. Autonomy should improve motivation of divisional managers.000 170.000 280. F5 Performance Management 2016 Costs of production Internal transfers (11. the selling division has no real incentive.000 288. 165.000 Fixed costs (incurred) 80.000 Profit 8. when transfer prices have been decided. because it will earn little or no profit from the transactions. Divisional managers should be free to make their own decisions. When authority is delegated to divisional managers. the managers of the selling and buying divisions should be given the authority to negotiate and agree the transfer prices for any goods or services 'sold' by one division to the other. Transfer pricing at market price It would be more realistic to set the transfer price at or close to a market price for the item transferred. in effect.000 105.

divisional managers will decide between internal transfers and using the external market in a way that maximises the profits of their division. When an external market exists for goods or services that are also transferred internally. F5 Performance Management 2016  whether to buy their goods from another division (internal transfers) or whether to buy them from external suppliers. the market might be called an external intermediate market. As a result.  In certain circumstances. and transfer prices based on opportunity cost As a general rule:  when an external intermediate market does not exist for transferred goods. divisional managers should be expected to make decisions that are in the best interest s of the company as a whole. the transfer price will be based on cost  when an external intermediate market does exist for transferred goods.  The selling division can sell its goods into this market. the transfer price will be based on the external market price. the situation is more complicated when:  there is a limit to production capacity in the selling division. the system should not encourage divisional managers to take decisions that do harm to the company. without having to be told by head office what they must do. but reduces the profits of another division. However. The main problems arise when there is an external market for the goods (or services) that one division transfers to another. A division may take action that maximises its own profit.  Unfortunately. instead of transferring them internally. or  there is a limit to sales demand in the external intermediate market. divisional managers often put the interests of their own division before the interests of the company as a whole. When there is an external intermediate market. the profits of the entity as a whole may also be reduced. Acting in the best interests of the company  In addition. if an external market exists. Problems with Transfer Pricing External intermediate markets A system of transfer pricing should allow the divisional managers the freedom to make their own decisions. Page 130 of 147 . the personal objectives of divisional managers may be in conflict with the interests of the company as a whole. Divisional managers will put the interests of their division before the interests of the company. instead of buying them internally from another division.  Similarly the buying division can buy its goods from other suppliers in this market. particularly if they are rewarded (for example with an annual cash bonus) on the basis of the profits or ROI achieved by the division. At the same time. Market-based and cost-based transfer prices.

what solution is best for the company?  Step 2. therefore transfer prices at cost are inappropriate for a divisional structure where the selling division is a profit centre or an investment centre. we need to consider the opportunity costs for the selling division of transferring goods internally instead of selling them externally. that will make the manager of the buying division want to work towards this plan. The ideal transfer price is a price at which both the selling division and the buying division -will want to do what is in the best interests of the company as a whole. F5 Performance Management 2016 In these circumstances. identify the transfer price.  For the buying division. Transfers at cost do not provide any profit for the selling division. that will make the manager of the selling division want to work towards the same plan. Page 131 of 147 . the opportunity cost of transferring goods internally to another division might include a loss of contribution and profit from not being able to sell goods externally in the intermediate market. Begin by identifying the arrangement for transferring goods internally that would maximise the profits of the company as a whole.  Step 3. given this transfer price. with responsibility for making profits. because it is also in the best interests of their divisions. Identifying the ideal transfer price The following rides should help you to identify the ideal transfer price in any situation:  Step 1. Finding the ideal transfer price: No external intermediate market When there is no external intermediate market. the transfer price must ensure that. The opportunity cost of transfers The selling division and the buying division have opportunity costs of transferring goods internally when there is an intermediate external market. Transfers at cost are appropriate only if the selling division is treated as a cost centre. Again. the opportunity cost of buying internally from another division is the price that it would have to pay for purchasing the items from external suppliers in the intermediate market. identify the transfer price. or range of transfer prices. the ideal transfer price is either:  cost or  cost plus a contribution margin or profit margin for the selling division. Ideal transfer prices must therefore take opportunity costs into consideration. the profits of the division will be maximised by doing what is in the best interests of the company as a whole. in other words. the profits of the division will be maximised by doing what is in the best interests of the company as a whole. The transfer price must ensure that. with responsibility for controlling its costs but not for making profit. In the same way. having identified the plan that is in the best interests of the company as a whole. given the transfer price. Having identified the plan that is in the best interests of the company as a whole.  For the selling division. or range of transfer prices.

transfers should therefore be at a negotiated 'cost plus' price. Example A company has two divisions. and there is 110 external intermediate market for the transferred item. per unit 40 Variable further processing costs in Division B 4 36 Page 132 of 147 . The sales price of product Y is $40. or what is a range of prices that would be ideal for the transfer price? Step 1: What is in the best interests of the company as a whole? The total variable cost of one unit of the end product. to provide some profit to the selling division. Division B $ Selling price of Product Y. is $14 ($10 + $4). Details of costs and selling price are as follows: Division A $ Cost of component X Variable cost 10 Fixed cost 8 Total cost 18 Division B Further processing costs Variable cost 4 Fixed cost 7 11 Selling price per unit of product Y 40 The further processing costs of Division B do not include the cost of buying component X from Division A. Required: What is the ideal transfer price. It is therefore in the best interests of the company to maximise production and sales of product Y. Division A and Division B. Fixed costs in both divisions will be the same. The entity therefore makes additional contribution of $26 for every unit of product Y that it sells. product Y. regardless of the volume of production and sales. One unit of component X goes into the production of one unit of Product Y. Division A makes a component X which is transferred to Division B. Both divisions are profit centres within the company. F5 Performance Management 2016 If the selling division is a profit centre or an investment centre. Division B uses component X to make end-product Y. Step 2: What will motivate the buying division to buy as many units of component X as possible? Division B will want to buy more units of component X provided that the division earns additional contribution from every unit of the component that it buys.

which it sells for $200 after incurring variable further processing costs of $25 per unit. ignoring the transfer price. The costs of making one unit of component X are: Component X $ Variable cost 60 Fixed cost 30 Total cost 90 Division Q uses one unit of component X to make one unit of product Y. Page 133 of 147 . Example A company has two divisions P and Q. If there are no production limitations in the selling division. Division A should therefore be willing to transfer as many units of component X as it can make (or Division B has the capacity to buy) if the transfer price is at least $10. A price somewhere within this range maybe negotiated. F5 Performance Management 2016 The opportunity cost of not buying units of component X. for each additional unit of product Y that is made and sold. The marginal cost of making and transferring a unit of component X is $10. which will provide profit to both divisions and the company as a whole. Any transfer price below $36 but above $4 per unit -will increase its contribution and profit Step 3: What will motivate the selling division to make and transfer as many units of component X as possible? Division A will want to make and sell more units of component X provided that the division earns additional contribution from every unit of the component that it sells. Division P makes a component X which it either transfers to Division Q or sells in an external market. Required What is the ideal transfer price or range of transfer prices. Finding the ideal transfer price: An external intermediate market and no production limitations When there is an external intermediate market for the transferred item. Division B should therefore be willing to pay up to $36 per unit for component X. Ideal transfer price The ideal transfer price is anywhere in the range $10 to $36. the ideal transfer price is usually the external market price. a different situation applies. if the price of component X in the external intermediate market is:  $140  $58? Step 1: What is in the best interests of the company as a whole? The company will benefit by maximising the total contribution from the total external sales of component X and product Y. is $36 per unit.

It the transfer price is higher than the external market price.$60) by selling the component externally.$140 . Division Q will be willing to buy internally if the transfer price is: a) not more than $140 when the external market price is $140 b) not more than $58 when the external market price is $58. Step 2: What will motivate the buying division (Division Q) to buy as many units of component X as possible from Division P? Division Q will be prepared to buy component X from Division P as long as it is not more expensive than buying in the external market from another supplier. therefore there is an opportunity cost of transfer that Division P will wish to include in the transfer price. Division Q will make an incremental contribution of $117 ($200 . Division Q will choose to buy component X in the external market.  The additional contribution for the company from making and selling one unit of product Y is $115 ($200 . Every unit of component X transferred internally therefore reduces the need to purchase a unit externally.$58 . F5 Performance Management 2016 If component X is not transferred by Division P to Division Q. If the external market price and transfer price are both $58. Division Q will make an incremental contribution of $35 ($200 . If the external market price and transfer price are both $140.$25) from each unit of component X that it buys and uses to make and sell a unit of product Y.$25) from each unit of component X that it buys and uses to make and sell a unit of product Y. and transfer component X from Division P to Division Q rather than sell component X externally. A profit-maximising plan is therefore to maximise the sales of Division Q.  When the external market rice is $58 for component X. Step 3: What will motivate the selling division to make and transfer to Division Q as many units of component X as possible? Division P should be prepared to transfer as many units of component X as possible to Division Q provided that its profit is no less than it would be if it sold component X externally. Division P would make an incremental loss of $2 per unit ($58 . Division Q will have to buy units of component X in the external market. This is the optimum plan if the external price for component X is either $140 or $58.$25).  The additional contribution from making one unit of component X and selling it externally is $80 ($140 - $60) when the external price is $140. Component X: market price $140 $ Variable cost 60 Opportunity cost of lost external sale (140-60) 80 Total cost = minimum transfer price 140 Component X: market price $58 $ Page 134 of 147 . Units transferred to division Q are lost sales to the external market.$60 . which would not be in the best interests of the company as a whole.

Division B buys Product Y. Both of these products have an external market. Division P should consider ending its operations to produce component X. and the selling division has a limitation on the number of units it can produce. Division A and Division B. F5 Performance Management 2016 Variable cost 60 Opportunity cost of lost external sale (58 -60) (2) Total cost = minimum transfer price 58 Ideal transfer price The ideal transfer price is the maximum that the buying division is prepared to pay and the minimum that the selling division will want to receive. the ideal transfer price is therefore the market price in the external intermediate market. Example A company consists of two divisions. Finding the ideal transfer price: An external intermediate market and production limitations When there is an external intermediate market for the transferred item. up to its capacity limitation. This selling cost is not incurred for internal sales/transfers from Division A to Division B. which it uses to make an end product. and can make either Product Y or Product Z. Every unit transferred means one less external sale. the ideal transfer price should allow for the opportunity cost of the selling division. Required: What is the ideal transfer price or range of transfer prices? Step 1: What is in the best interests of the company as a whole? Page 135 of 147 . It would also be cheaper for the entity as a whole to buy the component externally for $58 rather than make internally for a marginal cost of $60. The profit of the company as a whole will be maximised by making and selling as many units as possible of Division B’s end product. When the external market price is $58. Division A is working at full capacity on its machines. in both situations. The costs and selling prices of Product Y and Product Z are: Product Y Product Z $ $ Selling price 15 17 Variable cost of production 10 7 Variable cost of sale 1 2 Contribution per unit 4 8 The variable cost of sale is incurred on external sales of the division's products. Division P is losing contribution by selling component X externally. To make one unit of Product Y takes exactly the same machine time as one unit of Product Z.

otherwise it will prefer to make and sell Product Z. Transfer Pricing in Practice Transfer prices might be decided by head office and imposed on each division. not Product Y.2 ) 8 Total cost = minimum transfer price 18 Ideal transfer price/ideal production and selling plan Division B will not want to pay more than $15 for transfers of Product Y. Step 3: What would motivate the selling division to make and transfer as many units of Product Y as possible? The selling division will only be willing to make Product Y instead of Product Z if it earns at least as much contribution as it would front making Z and selling it externally. it can make and sell Product Z instead. otherwise it will buy Product Y externally. This price is only possible when an external market exists. whether it is better for Division B to buy Product Y externally or to buy internally from Division A. The company wants to make and sell as many units of the end product of Division B as possible. and Product Z earns a higher contribution). transfer prices may be agreed and expressed in one of the following ways. Alternatively. In practice. If Division A does not make Product Y. however. The ideal solution is for Division B to buy Product Y externally at $15 and for Division A to make and sell Product Z. Product Y $ Variable cost of making Product Y (the variable cost of sale is not relevant for internal transfers) 10 Opportunity cost of lost external sale of Product Z (17 . Page 136 of 147 . Division B will be willing to buy Product Y internally if the transfer price is $15 or less. Division A will want to receive at least $13 for transfers of Product Y. Step 2: What would motivate the buying division to buy as many units of Product Y as possible from Division A? Division B will be prepared to buy Product Y from Division A as long as it is not more expensive than buying in the external market from another supplier. Product Z earns a higher contribution per unit of machine time. the limiting factor in Division A. It is not clear. the division can make as many units of Z as it can make of Y. the managers of each division might have the autonomy to negotiate transfer prices with each other. Transfer price at market price A transfer price may be the external selling/buying price for the item in an external intermediate market. (in this situation.7 . F5 Performance Management 2016 This is stated in the example.

there are disadvantages in using full cost rather than variable cost to decide a transfer price. Transferring at market price also encourages efficiency in the supplying division. or  the selling price in the external market would fall if the selling division sold more of its output into the market. A transfer price below this amount will make the manager of the selling division want to sell externally. F5 Performance Management 2016 If the selling division would incur some extra costs if it sold its output externally rather than transferred it internally to another division. Advantages of market price as the transfer price Market price is the ideal transfer price when there is an external market. Page 137 of 147 . Distribution costs may also be cheaper and there will be no need for advertising. and caused by short-term conditions in the market. and a price above this amount will make the manager of the buying division want to buy externally. Full cost plus might be suitable when there is no external intermediate market. which must compete with the external competition. availability may not be so certain and there may be different levels of service back-up. Transfer price at full cost plus A transfer price may be the full cost of production plus a margin for profit for the selling division. Standard full costs should be used. Disadvantages of market price as the transfer price The current market price is not appropriate as a transfer price when:  the current market price is only temporary. not actual full costs. However. This will prevent the selling division from increasing its profit by incurring higher costs per unit. The opportunity cost of transferring output internally would not be the current market price. the transfer price may be reduced below market price. It may also be difficult to identify exactly what the external market price is. Products from rival companies may be different in quality. to allow for the variable costs that would be saved by the selling division.  The size of the profit margin or mark-up is likely to be arbitrary. This is very common as the selling division may save costs of packaging and warranties or guarantees. This might lead to decisions by the buying division manager that are against the best interests of the company as a whole.  The fixed costs of the selling division become variable costs in the transfer price of the buying division. Transfer price at variable cost plus or incremental cost plus A transfer price might be expressed as the variable cost of production plus a margin for profit for the selling division. because the selling price would have to be reduced in order to sell the extra units. This is because a higher variable cost may lead to the buying division choosing to set price at a higher level which would lose sales volume.

There are two different transfer prices. which the selling/transferring division has helped to earn. and  the buying division buys at a lower transfer price. In the accounts of the company. However. the selling division charges the buying division for units transferred in two ways:  a standard variable cost per unit transferred. the profits of the entity as a whole would be increased if transfers did occur. These situations are rare. F5 Performance Management 2016 Standard variable costs should be used. plus  a fixed charge in each period. However. the transfer price for the buying division should be low enough to motivate the divisional manager to buy more units from the selling division. This will prevent the selling division from increasing its profit by incurring higher variable costs per unit. two divisions may not be able to agree a transfer price. Dual pricing In some situations. the transferring division should be a cost centre. the transferred goods are:  sold by the selling division to head office and  bought by the buying division from head office. head office might find a solution to the problem by agreeing to dual transfer prices. The fixed charge could be set at an amount that provides a 'fair' profit for each division. because variable cost is a better measure of opportunity cost.  the selling division sells at one transfer price. and not a profit centre. However. Variable cost plus might be suitable when there is no external intermediate market. when they occur. Page 138 of 147 . Other methods that maybe used to agree transfer prices include:  Two-part transfer prices  Dual pricing Two-part transfer prices With two-part transfer prices. as stated earlier. because there is no transfer price at which the selling division will want to transfer internally or the buying division will want to buy internally. Similarly. The transfer price for the selling division should be high enough to motivate the divisional manager to transfer more units to the buying division. not actual variable costs. the charge could be seen as a charge to the buying division for a share of the fixed costs of the selling division in the period. The fixed charge is a lump stun charge at the end of each period. Alternatively. It is probably more suitable in these circumstances than full cost plus. when transfers are at cot. The fixed charge would represent a share of the contribution front selling the end product. although it is an arbitrary amount.

When this happens. dual pricing can be complicated and confusing. The divisional managers are given the autonomy to agree on transfer prices. However.  The transfer prices that are negotiated might not be fair. An advantage of negotiation is that if the negotiations are honest and fair. These profit measures can be used with variance analysis. return on investment. It also requires the intervention of head office and therefore detracts from divisional autonomy. residual income and non-financial performance measurements to evaluate performance. F5 Performance Management 2016 The loss from the dual pricing is a cost for head office. management from head office will have to act as judge or arbitrator in the case. ratio analysis. and treated as a head office overhead expense. Page 139 of 147 . but a reflection of the bargaining strength or bargaining skills of each divisional manager. the divisions should be willing to trade with each other on the basis of the transfer price they have agreed. Disadvantages of negotiation are as follows:  The divisional managers might be unable to reach agreement. Negotiated transfer prices A negotiated transfer price is a price that is negotiated between the managers of the profit centres. Negotiation might be a method of identifying the ideal transfer price in situations where an external intermediate market does not exist.

ROI and investment decisions  The performance of the manager of an investment centre may be judged on the basis of ROI. which for a division will normally consist of inventory plus trade receivables minus trade payables. It is also called the accounting rate of return (ARR). Page 140 of 147 . and reject investments that would reduce ROI in the current year.  It is often used as a measure of divisional performance for investment centres because:  the manager of an investment centre is responsible for the profits of the centre and also the assets invested in the centre. Profit ROI = Capital employed (size of investment) Profit. Working capital = current assets minus current liabilities. without any charge for interest on capital employed. ROI is the profit of the division as a percentage of capital employed.  An investment centre manager may therefore reject an investment because of its short-term effect on ROI. the manager will probably be motivated to make investment decisions that increase the division's ROI in the current year. Capital employed/investment. F5 Performance Management 2016 Return on Investment (ROI) The reason for using ROI as a financial performance indicator  Return on investment (ROI) is a measure of the return on capital employed for an investment centre.  The problem is that investment decisions are made for the longer term. This should be the stun of the non-current assets used by the division plus the working capital that it uses. and a new investment that reduces ROI in the first year may increase ROI in subsequent year. This should be the annual accounting profit of the division.  When an investment centre manager's performance is evaluated by ROI. without giving proper consideration.  A divisional manager may receive a bonus on the basis of the ROI achieved by the division. Measuring ROI Performance measurement systems could use ROI to evaluate the performance of both the manager and the division. This means that the profit is after deduction of any depreciation charges on non-current assets. Profit is not a suitable measure of performance for an investment centre. to the longer term. It does not make the manager accountable for his or her use of the net assets employed (the investment in the investment centre). and  ROI is a performance measure that relates profit to the size of the investment.

Imputed interest (notional interest) is the division's capital employed. Residual Income (RI) Measuring residual income Residual income = Divisional profit minus Imputed interest charge. whereas ROI is a percentage value. ROI will increase each year provided that annual profits are constant. The division's manager might not want to get rid of ageing assets. Imputed interest (notional interest) and the cost of capital: The interest charge is calculated by applying a cost of capital to the division's net investment (net assets). because ROI will fall if new (replacement) assets are purchased. Residual income and investment decisions One reason for using residual income instead of ROI to measure a division's financial performance is that residual income has a monetary value. Page 141 of 147 . Comparison of performance between different organisations is therefore difficult. and suffers from the same problem as ROI in defining capital employed and profit. after depreciation charges are subtracted.  Its main weakness is that it is difficult to compare the performance of different divisions using residual income.  Residual income is a flexible measure of performance. or  the weighted average cost of capital of the organisation. F5 Performance Management 2016 Disadvantages of using ROI  As explained above. Advantages of residual income  It relates the profit of the division to the capital employed.  When assets are depreciated.  There are different ways of measuring capital employed. A higher interest rate would be applied to divisions with higher business risk. and the division manager is responsible for both profit and capital employed. Disadvantages of residual income  Residual income is an accounting-based measure. or  a special risk-weighted cost of capital to allow for the special business risk characteristics of the division. It is the same figure for profit that would be used to measure ROI. Divisional profit is an accounting measurement of profit. investment decisions might be affected by the divisions ROI short term effect and this is inappropriate for making investment decisions. because a different cost of capital can be applied to investments with different risk characteristics. by charging an amount of notional interest on capital employed. multiplied by:  the organisation's cost of borrowing.

especially managers with little accounting knowledge. Past Paper Analysis Performance measures in private sector organizations Dec 07 – Q 2 June 09 – Q 2 Dec 09 – Q 4 June 10 – Q 5 Dec 10 – Q 2 Dec 12 – Q 3 Further Aspects of performance measurement Dec 15 – Q 2 Divisional performance June 08 – Q 3 Dec 13 – Q 4 June 15 – Q 2 Dec 15 – Q 5 Balance scorecard June 11 – Q 4 a June 13 – Q 2 Dec 14 – Q 4 ROI/ROCE Dec 08 – Q 1 June 11 – Q 4b June 12 – Q 5 June 14 Q 3a Transfer pricing June 10 – Q 4 Dec 11 – Q 2 Dec 12 – Q 5 Dec 13 -.1 b June 14 – Q 3 b Page 142 of 147 . F5 Performance Management 2016  Residual income is not easily understood by management.

 Not-for-profit organisations are entities that are not government-owned or in the public sector. and their performance should be measured and monitored as the directors or senior managers of public sector bodies are accountable to the public. mainly non-financial in nature Page 143 of 147 . which in turn should be accountable to the public.  A not-for-profit organisation will nevertheless have some financial objectives:  State-owned organisations must operate within their spending budget. Identifying performance targets in not-for-profit and public sector organisations The selection of appropriate targets will vary according to the nature and purpose of the organisation. but which are not in existence to make a profit. F5 Performance Management 2016 21. and of raising as much funding as possible for their charity work. The need for performance measurement Although the main objective of not-for-profit and public sector organisations is not financial. The leaders of not-for-profit organisations outside the public sector should also be accountable to the people who provide the finance to keep them in existence. More general objectives for not-for-profit organisations include:  Surplus maximisation (equivalent to profit maximisation)  Revenue maximisation (as for a commercial business)  Usage maximisation (as in leisure centre swimming pool usage)  Usage targeting (matching the capacity available. In practice. They include charitable organisations and professional bodies.  A common feature of public sector organisations and not-for-profit organisations is that their main objective is not financial. as in the NHS)  Full/partial cost recovery (minimising subsidy)  Budget maximisation (maximising what is offered)  Producer satisfaction maximisation (satisfying the wants of staff and volunteers)  Client satisfaction maximisation (the police generating the support of the public) Performance measurement should be related to achieving targets that will help the organisation to achieve its objectives.  Charitable organisations may have an objective of keeping running costs within a certain limit. this usually means accountability to the government. is that any not-for-profit organisation should have:  strategic targets. Performance Analysis – Additional Not-For-Profit Organisations and the Public Sector  The public sector refers to the sector of the economy that is owned or controlled by the government in the interests of the general public. whatever these may be. they need good management. The broad principle. however.

 Lack of profit measure: If an organisation is not expected to make a profit. The public may have higher expectations of public sector organisations than commercial organisations. and they are required to achieve all these objectives within the constraint of limited available finance. For example. The performance indicators of public sector organisations are subject to far more onerous legal requirements than those of private sector organisations. these are more pronounced in not-for-profit organisations.  Multiple objectives: An organisation in the public sector (and also not-for-profit organisations) may have a number of different 'main objectives'. Page 144 of 147 . which may be either financial (often related to costs and keeping costs under control) or non-financial (related to the nature of operations). unreported crimes are not included in data used to measure the performance of a police force. To identify suitable performance targets for Not for Profit organisations and Public sector organisations. However. This will also lead to conflict and it becomes difficult to prioritise. there are several reasons why the problems with performance measurement in the public sector are greater than those in commercial business organisations. indicators such as ROI and RI are meaningless. Problems with measuring performance in this sector A good performance measurement system seeks to monitor the success of an organisation in achieving its objectives. or if it has no sales.  To do this it must have clear objectives  set targets which are linked to objectives  measure performance against these targets.  Political.  Nature of service provided: Many not-for-profit organisations provide services for which it is difficult to define a cost unit. focus on:  Decide what the objectives of the organisation are  Identify what the managers of the organisation (or area of management responsibility within the organisation) must do to achieve those objectives  Identify a suitable way of measuring performance to judge whether those objectives are being achieved.  Measuring outputs: Outputs can seldom be measured in a way that is generally agreed to be meaningful. \Data collection can be problematic. F5 Performance Management 2016  operational targets.  Financial constraints: Although every organisation operates under financial constraints. public sector organisations are subject to strong political influences. social and legal considerations: Unlike commercial organisations.

Quantitative measures of efficiency Efficiency relates the quantity of resources to the quantity of output. F5 Performance Management 2016 Value for Money How can performance be measured? The performance of not-for-profit organisations or departments of government may be assessed on the basis of value for money 'VFM'. Audits by the government's auditors into departmental spending may be used to identify:  any significant failures to control prices. This can be measured in a variety of ways  Actual output/Maximum output for a given resource x 100%  Minimum input to achieve required level of output/actual input x 100%  Actual output/actual input x 100% compared to a standard or target Page 145 of 147 . and to keep spending within limits. It also means achieving the same purpose at a lower expense. Applied to employees. effectiveness is concerned with achieving outputs that meet the required aims and objectives. Management accounting systems and reporting systems may provide information to management about value for money. and  unnecessary expense. It also helps to ensure that the limited finance available is spent sensibly. Targets could be set for the prices paid for various items from external suppliers. Value for money is often referred to as the '3Es':  Economy means spending within limits. VFM as a public sector objective  Value for money is an objective that can be applied to any organisation whose main objective is non- financial but which has restrictions on the amount of finance available for spending.  Effectiveness refers to success in achieving end results or success in achieving objectives. It could therefore be appropriate for all organisations within the public sector. Value for money audits may be carried out to establish how much value is being achieved within a particular department and whether there have been improvements to value for money. and avoiding wasteful spending. efficiency is often called 'productivity'. Whereas efficiency is concerned with getting more outputs from available resources.  Efficiency means getting more output from available resources.  The objective of economy focuses on the need to avoid wasteful expenditure on items.

and are a cause of much pollution in the environment. and this change could affect its performance  Economic conditions and economic developments  Changes in public attitudes and behaviour  Technological changes  Competition in the market.  The government and the general public. or its actual performance. suppliers. customers. Their main expectation is likely to be that the company should provide good returns on investment. Broad categories of external factors include:  Political and legal developments: new laws may affect what a company is allowed to do or is not permitted to do. They also have an interest in working conditions. and each group has different expectations about what the organisation should do. Lenders will want the company to have a secure business. If they think they are receiving poor value. lenders. and they produce the goods or services that many people buy and rely on. They also judge its performance in different ways. and in some cases a company may come under severe criticism from protest groups. individuals or groups with an interest in what the company does and how it performs. Some large companies can have a major influence on the national economy.  Public sector entities and not-for-profit organisations also have different stakeholder groups. Public expectations of what particular companies should or should not be doing may become quite strong.  Lenders to a company expect to make a profit or return in the form of interest. in the form of dividends or share price growth. It is often convenient to group stakeholders into categories. and within its external environment. They provide work for large numbers of people.  Customers of a company expect to receive value for the money they pay to buy the goods or services that the company provides.  Employees are stakeholders in a company because the company provides them with a job and possibly also career opportunities.  The interests of each stakeholder group differ. They will expect honest and fair dealing from the company. companies are major users of natural resources. the government and the general public. Page 146 of 147 . such as shareholders. or to finding an alternative product. they are likely to switch to buying the products of competitors.  Shareholders in a company have invested money by buying shares. employees. The external factors that affect an organisation vary according to the type of organisation and the environment in which it operates. F5 Performance Management 2016 External Considerations in Performance Measurement External considerations are factors that arise or exist outside an organisation. Stakeholders:  Stakeholders of a company are any organisations.  Major suppliers to a company may depend on the company for a large proportion of their profits. and will not want the company to take risks that could threaten its ability to make the interest payments and repay the lending at maturity. In addition. and they will expect to be paid on time. that could have an impact on the objectives that the organisation should try to achieve and the targets that it sets for those objectives.

and economic conditions may be either favourable or adverse. such as changes in rates of taxation. F5 Performance Management 2016  For each company. when there are several influential stakeholder groups the company may need to take their conflicting interests into consideration. Market conditions Market conditions are any factors that influence the state of the market or markets in which a company operates. However. When the size of a market is fixed. a company may feel obliged to respond by cutting its own prices. Other financial conditions may affect a company's performance. and the performance that it achieves. are also affected the by nature of competition in the market. The performance of a company may also be affected by the actions taken by competitors. interest rates or foreign exchange rates. These include:  the state of the economy  innovation and technological change. Companies will usually hope to achieve growth in sales and profits. The performance of a company in a competitive market may be measured by the size of market share that it obtains. Page 147 of 147 . some stakeholders are likely to be more influential than others. For example if a major competitor has reduced its sales prices. Allowance for competitors The targets that a company sets. the rival firms will compete for market share. and set their objectives and performance targets accordingly. and competition is strong.