3.2 ADVANCED MAMANGEMENT ACCOUNTING..

7
Purpose: 7 LEARNING CONTENTS. 7 UNIT 1.011 CAPITAL INVESTMENT APPRAISAL.. 11 Element 1.1 Investment Appraisal Methods.. 11 Element 1.1.1 Net Present value. 12 Element 1.1.1.1 Discount Facts/Interest Rate. 12 Element 1.1.1.2 NPV and the Agency Theory.. 12 Element 1.1.1.3 Assumption In Net Present Value. 12 Element 1.1.1.4 Net Present Value, Risk and Uncertainly 14 Element 1.1.2 Internal Rate of Return.... 16 Element 1.1.2.1 Decision Criteria In Internal Rate Return. 17 Element 1.1.2.2 The Reinvestment Assumptions... 17 Element 1.1.2.3 Multiple IRR (Multiple Yields).... 22 Element 1.1.2.4 Internal Rate Of Return For Projects With Unequal Lines... 24 Element 1.1.3 Payback Period Method... 25 Element 1.1.3.1 Limitation Payback Period Method.. 26 Element 1.1.3.2 Discounted Payback Period.. 26 Element 1.1.4 The Accounting Rate Of Return (ARR).. 27 Element 1.2 Capital Replacement.. 33 Element 1.3 Capital Rationing 35 Element 1.4 Effect Of Taxation On Investment Appraisal.. 38 Element 1.4.1 Discounting Methods 38 Element 1.4.2 Annuities... 39 Element 1.4.3 The Basic Perpetuity. 41 Element 1.4.4 Perpetuity With Constant Growth.41 Element 1.4.5 The Net Present Value Format..43 Element 1.4.6 The relevant Cash Flows...44 Element 1.5 Effects of Inflate On Investment Appraisal..45 Element 1.5.1 Adjusting the discount Rate.. 47 Element 1.6 Treatment Of Leasing And Hire Purchase Transactions... 55 Element 1.6.1.1 Advantages of leasing 55 Element 1.6.1.2 Tax Benefits to The leaser. 56 Element 1.6.1.3 Tax Benefit To The Lessee 56 Element 1.6.2 Types Of Leases57 Element 1.6.2.1 Finance Lease 57 Element 1.6.2.2 Operating Leaser 58 Element 1.6.3 features Of Leases 58 Element 1.7 Cost-Benefit Analysis..64 Element 1.7.1.1 Structured And Unstructured Decisions 64 Element 1.7.1.2 Goal Congruence And Decision Making... 64 Element1.7.1.3 Nature Of cost-Benefit Analysis. 64 Element 1.7.1.4 Cost-Benefit Analysis Techniques.65 1

Element 1.7.1.5 Profitability/Net Cash-Flow... 65 Element1.7.1.6 Scoring And Ranking..65 Element 1.7.1.7 Mechanics Of Scoring And Ranking. 65 Element 1.72 Post Project Completion Audit.. 68 Element 1.7.2.1 Benefits Of Post-Completion Auditing..68 Element 1.7.2.2 Mechanics Of Post-Completion Audit 69 UNIT 2.0... 70 PRICING THEORY 70 Element 2.1Cost Plus Pricing.. ... 71 Element 2.2 Marginal Pricing. 72 Element 2.2.1 Full Cost Versus Marginal Cost Pricing.. 75 Element 2.2.2 Activity Based Pricing (ABP)..77 Element 2.3 Target Pricing. 80 Element 2.3.1 Managerial Thinking To Support Target Costing And Pricing81 Element 2.4 Life Cycle Pricing... 82 Element 2.5 Other Pricing Methods... 84 Element 2.5.1 Order Pricing84 Element 2.5.2 Minimum Pricing. 84 Element 2.5.3 Market Penetration Pricing.. 85 Element 2.5.4 Market Skimming Pricing 85 Element 2.5.5 Differential Pricing.. 86 Element 2.5.6 Adjusted Market Price. 88 Element 2.5.7 Cost-Based Approaches To Transfer Pricing.. 88 Element 2.6 Changes In Price Levels Element 2.7 Transfer Pricing Theory 90 Element 2.7.1Transfer Pricing Based On Opportunity Cost... 92 Element 2.7.2 Transfer Pricing When Unit Variable costs And Sales Prices are not constant 92 Element 2.7.3 Problems In Transfer Pricing... 93 Element 2.7.4 Negotiated Transfer Prices...93 Element 2.7.5 International Transfer Prices 94 Element 2.7.6 Using Transfer Prices...94 Element 2.7.7 Centrally Determined Transfer Prices And Strategy... 95 Element 2.7.8 The Eccles matrix 95 UNIT 3.0... 97 COST ANALYSIS... 97 Element 3.1 Cost Reductions. 105 Element 3.1.1 Traditional Cost-Reduction Programs. 106 Element 3.1.2 Examination Of Current Activities.. 106 Element 3.1.2.1 Over-Resourced Activity.. 107 Element 3.1.2.2 Inefficiently Managed Activities.. ... 107 Element 3.1.2.3 Value Added And Non-Value Added Activities.. 107 Element 3.1.3 Zero-Based Budgeting. 109

Element 3.1.4 Timing And Focus Of Cost Reduction Programmes.. 112 Element 3.2 Cost Control Element 3.3 Value Analysis. ... 112 Element 3.3.1 Functional Analysis. 116 Element 3.4 Value Engineering.. Element 3.5 Activity Based Costing... 117 Element 3.6 Total Quality Management UNIT 4.0126 MEASURES OF PERFORMANCE.. 126 Element 4.1Balanced Score Card... 126 Element 4.1.1 Growth In Non-Functional Measures.. 126 Element 4.1.2 Balanced Score Card In Detail.127 Element 4.1.3 The Four Perspectives.. ... 128 Element 4.2 Value For Money (Performance Measures For Net-For-Profit
organisations)... 132

Element 4.2.1 Nature Of A Net-For-Profit Organizations.. 132 Element 4.2.2 Nature of Performance Measurements in Not-For-Profit Organisations.. 132 Element 4.2.3 The Three Es (Effectiveness, Efficiency, Economic).. 133 Element 4.3 Financial Performance Measures. Element 4.4 Non Financial Performance Measures. Element 4.5 Divisional Performance Measures.134 Element 4.6 Benchmarking. 139 Element 4.6.1 Steps in Benchmarking 140 Element 4.6.2 Information Gathering. 140 Element 4.6.3 Financial Statement And Reverse Engineering... 140 Element 4.6.4 Other Sources Of Information. 140 Element 4.6.5 Types Of Benchmarking.. 141 Element 4.6.6 Benefits of Benchmarking... 142 Element 4.6.7 Pitfalls Of Benchmarking 142 Element 4.7 Behavioural Effects Of Performance Measurement. UNIT 5.0... 143 DECISION MAKING TECHNIQUES. 143 Element 5.1 Sensitivity Analysis 143 Element 5.1.1 Problems With Sensitivity Analysis 146 Element 5.1.2 Application Of Sensitivity Analysis In Project Appraisal... 149 Element 5.2 Learning Curve Theory. Element 5.3 Linear Programming.. 149 Element 5.4 Decision Trees. 164 Element 5.4.1 Notation Of A Tree Diagram... 166 Element 5.4.2 Qualitative Factors In Decision Making.. 169 Element 5.4.3 Identifying And calculating Relevant Costs 170 Element 5.5 Uncertainty And Risk Analysis.

Element 5.6 Multi-product Cost Volume Profit Analysis UNIT 6.0... 183 BUDGETING AND BUDGETING CONTROL... 183 Element 6.1 The Budget Process.184 Element 6.1.1 The Budget Committee 184 Element 6.1.2 The Budget Officer.. 184 Element 6.1.3 Role Of Budget Officer184 Element 6.1.4 The Budgeting Manual 184 Element 6.1.5 The Principle Budget Factor 185 Element 6.2 Types Of Budget. 185 Element 6.2.1 Functional Budget 185 Element 6.2.1.1 The Sales Budget.. 186 Element 6.2.1.2 The Production Budget. 187 Element 6.2.1.3 Labour Budget.. 191 Element 6.2.2 Cash Budget..... 193 Element 6.2.2.1 Advantages of cash Budget.. 206 Element 6.3 Flexible Budgets.. Element 6.4 Behavioural Aspects Of Budgeting... 206 Element 6.4.1 General Behavioural Budgeting...206 Element 6.4.2 Motivation 207 Element 6.4.3 Poor Attitude When Setting Budgets... 207 Element 6.4.4 Poor Attitude When Implementing budgets 207 Element 6.4.5 Poor Attitude When Utilizing Budgeting Control information 208 Element 6.4.6 Styles of Budgeting.. 208 Element 6.4.6.1 Imposed Style of Budgeting. 208 Element 6.4.6.2 Participation Style of Budgeting... 210 Element 6.4.6.3 Negotiated Style of Budgeting.. 210 Element 6.4.7 The Management Accountant and motivator...211 Element 6.5 Applications Of Information In budgeting Preparation. 214 Element 6.5.1 Merits of Using Computer Spreadsheets. 214 Element 6.5.2 Limitations of Spreadsheets. 214 Element 6.5.3 Budgeting Software. 215 UNIT 7.0... 216 MORDEN BUSINESS ENVIROMENT.... 216 Element 7.1 The Changing Business Environment...216 Element 7.1.1 Changing Customers Needs For Changing goods... 216 Element 7.1.2 Changing customer demands For High Quality Goods... 217 Element 7.1.3 Increase In Operational Overheads.. 217 Element 7.1.4 De-Regulation of Industries. 217 Element 7.1.5 Intensity In Competition And Globalisation 217 Element 7.1.6 Shortened Product Life Cycle.. 218 Element 7.2 Production Management Strategies.. 218 Element 7.2.1 Just-In-Time Production Systems 218

Element 7.2.2 Dedicated Cell Layout. 218 Element 7.2.3 Computer-Aided design (CAD)... 219 Element 7.2.4 Computer-Added Manufacturing (CAM) 219 Element 7.3 World Class Manufacturing Techniques. 220 Element 7.3.1 Automated Manufacturing Techniques (AMT)... 220 Element 7.3.2 Synchronized Manufacturing Systems 220 Element 7.3.3 Flexible Manufacturing Systems. 220 Element 7.3.4 Computer Controlled Machinery. 220 Element 7.3.5 Automated Storage And Retrieval Systems.221 Element 7.3.6 Material Requirement Plan (MRP).. 221 Element 7.3.7 Enterprise Resource Planning (ERP)... 221 Element 7.4 Product Life Cycle.. 222 Element 7.4.1 Concept Of Product Life Cycle... 222 Element 7.4.2 Introduction stage 222 Element 7.4.3 Growth Stage... 222 Element 7.4.4 Maturity stage.. 222 Element 7.4.5 Decline stage 222 Element 7.4.6 Cost Implication For The Product Life Cycle. 223 Element 7.4.7 Implications Of The Product Life cycle On The Advanced Manufacturing Technology Environment 223 UNIT 8.0... 232 ADVANCED VARIANCE ANALYSIS. 232 Element 8.1 Mix Variance.. Element 8.2 Yield Variance. 234 Element 8.3 Fixed Overhead Cost Variance.. Element 8.4 Sales Variance. 244 Element 8.5 Planning variance... 246 Element 8.5.1 Definite Of Planning Variances... 246 UNIT 9.0... 249 MORDERN MANAGEMENT ACCOUNTING TECHNIQUES... 249 Element 9.1 Throughput Accounting. 249 Element 9.2 Target Costing. 260 Element 9.2.1 Calculating Target Costs.. 262 Element 9.2.2 Establishing An Expected sales Price.. 262 Element 9.2.3 Establishing A Target Project.. 263 Element 9.2.4 The Residual: Target Cost... 263 Element 9.2.5 Cost Tables.. 264 Element 9.3 Service Costing 265 Element 9.3.1 Use Of Unit Cost In The Public Sector268 Element 9.3.2 Limitation Of the Cost Units... 269 Element 9.4 Life cycle costing. 269 Element 9.4.1 Life Cycle Budgeting And Resource Allocation. 271 Element 9.5 Back flush Accounting278

Element 9.6 Accounting Based Costing.. Element 9.7 Manufacturing Resource Planning Element 9.8 Enterprise Resource Planning UNIT 10.0. 286 Information Technology And Management Accounting. 286 Element 10.1 Decision Support Systems 286 Element 10.1.1 Management Information Design.. 288 Element 10.1.2 Management Levels And Information Requirement. 288 Element 10.2 Transaction Processing systems.. Element 10.3 Management Information Systems. 291 Element 10.3.1 Characteristics Of MIS.. 291 Element 10.4 Communication Technologies..292 Element 10.4.1 Information Dissemination-Effective Presentation of Information 293 Element 10.4.2 Use and Limitations of PCs... 294 Element 10.4.3 Use And Limitations of PCs In Management Accounting 295 Element 10.5 Computerized Manufacturing Environment.. Element 10.6 Computer Aided Design... 296 Element 10.7 Computer Aided manufacturing. 297 Element 10.7.1 Computer-Integrated Manufacturing. 298 Element 10.8 Flexible Manufacturing Techniques Element 10.9 Business Process Re-Engineering 301 Element 10.9.1 Principles Of Business Process Re-Engineering (BPR) 302 Element 10.9.2 Implications Of BPR-Management Accounting Systems. 303

PAPER 3.2: ADVANCED MANAGEMENT ACCOUNTING Purpose:

To develop knowledge of planning, control, co-ordinating resource mobilisation and decision making functions of management in a wide range of sectors, including manufacturing, retail and services provision. General Learning Objectives: On completion of the paper, the student should be able to: Discuss the use of accounting based management information. Produce and present budgets Prepare and present Flexible Budgets and their accompanying variance reports. Make computational and non computational analysis of data for management control reasons and decision making purposes 5. Make recommendations for Cost Reduction and Value Enhancement. 6. Make recommendations for adopting World Class Manufacturing techniques with a view to enhancing operation efficiency. 7. Prepare forecasts of Income and Expenditure of organisations. 1. 2. 3. 4.

LEARNING CONTENTS 1. Capital Investment Appraisal - (15%) 2. Pricing Theory - (10%) 3. Cost Analysis - (15%) 4. Measures of Performance - (10%) 5. Decision Making Techniques - (15%) 6. Budgeting and Budgetary Control - (10%) 7. Modern Business Environment - (5%) 8. Advanced Variance Analysis - (10%) 9. Modern Management Accounting Techniques (5%) 10. Information Technology and Management Accounting - (5%)

UNIT 1.0 CAPITAL INVESTMENT APPRAISAL (15%)

Element 1.1 Element 1.2 Element 1.3 Element 1.4 Element 1.5 Element 1.6 Element 1.7 Appraisal Methods Capital Replacement Capital Rationing Effects of Taxation on Investment Appraisal Effects of Inflation on Investment Appraisal Treatment of Leasing and Hire Purchase Transactions Cost-Benefit Analysis

UNIT 2.0 PRICING THEORY (10%)

Element 2.1 Element 2.2 Element 2.3 Element 2.4 Element 2.5 Element 2.6 Element 2.7 Cost Plus Pricing Marginal Pricing Target Pricing Life Cycle Pricing Other Pricing methods Changes in Price Levels Transfer Pricing theory

UNIT 3.0 COST ANALYSIS (15%)

Element 3.1 Element 3.2 Element 3.3 Element 3.4 Element 3.5 Element 3.6 Cost Reduction Cost Control Value Analysis Value Engineering Activity Based Costing Total Quality Management

UNIT 4.0 MEASURES OF PERFORMANCE (10%)

Element 4.1 Element 4.2 Organizations) Element 4.3 Element 4.4 Element 4.5 Element 4.6 Element 4.7 Balanced Scorecard Value For Money (Performance measures for Not For Profit Financial Performance Measures Non Financial Performance Measures Divisional Performance Measures Benchmarking Behavioural Effects of Performance Measurement

UNIT 5.0 DECISION MAKING TECHNIQUES (15%)

Element 5.1 Element 5.2 Element 5.3 Element 5.4 Element 5.5 Element 5.6

Sensitivity Analysis Learning Curve theory Linear Programming Decision Trees Uncertainty and Risk Analysis Multi-product Cost Volume Profit Analysis

UNIT 6.0 BUDGETING CONTROL (10%)

Element 6.1 Element 6.2 Element 6.3 Element 6.4 Element 6.5

AND

BUDGETARY

The Budgeting Process Types of Budgets Flexible Budgets Behavioural Aspects of Budgeting Applications of Information Technology in Budget preparation

UNIT 7.0 MODERN BUSINESS ENVIRONMENT (5%)

Element 7.1 Element 7.2 Element 7.3 Element 7.4 The changing Business Environment Production Management Strategies World Class Manufacturing Techniques Product Life Cycle

UNIT 8.0 ADVANCED VARIANCE ANALYSIS (10%)

Element 8.1 Element 8.2 Element 8.3 Element 8.4 Element 8.5 Element 8.6 Mix Variance Yield Variance Fixed Overhead Cost Variances Sales Variances Planning Variances Operational Variances

UNIT 9.0 MODERN MANAGEMENT ACCOUNTING TECHNIQUES (5%)

Element 9.1 Element 9.2 Element 9.3 Element 9.4 Element 9.5 Throughput Accounting Target Costing Service Costing Life Cycle Costing Backflush Accounting 9

Element 9.6 Element 9.7 Element 9.8

Activity Based Costing Manufacturing Resource Planning Enterprise Resource Planning

UNIT 10.0 INFORMATION TECHNOLOGY AND MANAGEMENT ACCOUNTING (5%)

Element 10.1 Element 10.2 Element 10.3 Element 10.4 Element 10.5 Element 10.6 Element 10.7 Element 10.8 Element 10.9 Decision Support Systems Transaction Processing Systems Management Information Systems Communication Technologies Computerised Manufacturing Environment Computer Aided Design Computer Aided Manufacturing Flexible Manufacturing Techniques Business Process Re-engineering

RELEVANT TEXTS ZICA Text Book Management and Cost Accounting, C Drury (Latest Edition) Issues in Management Accounting, Ashton, T Hopper and R W Scapens Accounting for Management Control, Emmanuel and Otley

STRUCTURE OF THE EXAMINATION PAPER The examination paper will be a THREE (3) hours paper divided into THREE (3) sections. Section A, Section B and Section C. Section A: This section will carry ONE COMPULSORY question worth THIRTY (30) marks. Section B: There will be THREE (3) questions in this section each carrying TWENTY FIVE (25) marks, out of which candidates will be required to attempt any TWO (2) questions. Section C: This section will have TWO (2) questions of TWENTY (20) marks each and candidates are required to attempt only ONE question.

10

UNIT 1.0 CAPITAL INVESTMENT APPRAISAL

Learning outcomes: After studying this chapter candidates must be able to: Demonstrate knowledge of key investment, regarding appraisal methods and the following. The concept of the time value of money Net present value (NPV) Real and normal interest rates Payback Internal rate of return Multiple IRRs Unequal Project appraisal & Audit

Capital Budgeting involves the assessment of how much should be spent on assets or project and which assets should be acquired. Before deciding which project/assets to invest in, corporations must compare the benefits to be derived from the acquisition/investment against the costs involved in the investment. The investment will not purely depend upon financial aspects but to a large extent, the strategic direction of the business. Remember the financial decisions fall with the long-term corporate strategy formulation process. Element 1.1 Appraisal Methods The main methods of investment appraisal, which are normally in use, are: (a) (b) (c) (d) Payback Internal rate of return Net present value Accounting rate of return.

The investment appraisal methods can be divided into traditional and scientific methods. The traditional methods ignore the fine value of money whilst the scientific methods recognise the fine value of money in the evaluation.

11

Element 1.1.1 Net Present Value (NPV) The Net Present Value of a project is the difference between the sum of the project discounted cash inflows and outflows attributable to a capital investment or other long-term project. The Net Present Value approach holds that cash received in the future is less valuable than cash received today. In the Net Present value computations, all cash flows are expressed in present day values by the cash flows, which are realised in the future. A comparison is then made, in present day terms of the total costs of the investment (cash outflows) and the total receipts from the investment (cash inflows). When the present value of the inflows exceeds that of outflows (which includes any relevant taxation liabilities, as well as the more obvious initial investment outlay), the net present value is positive and purely on financial grounds, the investment should be accepted. In contrast, if the present value of the outflows exceeds the present value of inflows, the net present value is negative and the investment should be rejected. Element 1.1.1.1 Discount Factors/ Interest Rate The interest rate, at which investors can borrow or lend money, is key to the Net Present Value model (NPV). The model is based on the assumption that an investor may invest money in the financial market at an interest rate prevailing or invest money in real assets, undertake a combination of the two options, or borrow in order to invest in real asset. Real assets will only be attractive to a rational investor if they offer a rate of return in excess of the cost of money (the rate at which the money has been borrowed). By discounting the financial costs and benefits associated with real assets at this rate, the investor can determine whether a return in excess of discount rate r is available from the real asset in question. Element 1.1.1.2 NPV and The Agency Theory Senior managers of an organisation normally save the interests of shareholders and they are thereby employed to maximise the wealth of shareholders.

12

Since Net present Value models decision rule advocates that a project whose financial benefits outweigh its financial cost, henceforth having a positive net present value should be accepted and be pursued and vice versa. The net present value upholds the thenetical sole objective of business of maximisation of shareholders wealth through maximisation of returns from the project. Element 1.1.1.3 Assumption in Net Present Value The Net Present Value technique is based on the following assumption. The Discount rate must be a measure of the opportunity cost of funds for wealth maximisation to result. Perfect capital market and perfect information exists The model assumes that a single rate which reflects the opportunity cost for all individuals and companies. All Shareholders have an objective of wealth maximisation

Element 1.1.1.4 Net Present Value, Risk and Uncertainty Risk management does not leave out project appraisal and evaluation process. Past experiences can be new, is a guide in assigning specific possible outcomes for the action currently proposed. This can also be used as the basis for assigning probabilities to these outcomes what we can use to calculate the expected cashflows of a project for our NPV computations. In the absence of past experience, we would have no basis upon which we can base our probability on. Advanced risk analysis and management are outside the scope of the text. EXAMPLE 1 Chaswe engineering consultants have been engaged in developing four (4) projects on behalf of their client, Ninsh Corporation. However, the project sponsors, Ninsh Corporation have asked their management Accountant to evaluate the 4 projects for their viability before it commits its finances to the projects. The cost of funds for NINSH Corporation is 5%.

13

REQUIRED: In your capacity as Management Accountant of NINSH Corporation, evaluate the viability of the four (4) projects given that the cash inflows and cash outflows of the projects are as shown below on the Net Present Value basis. Project: Capital (Outlay) year 0 Cash Inflows 1 2 3 4 Solution: Since the companys cost of capital is 5%, thus will serve as the discount rate at which the project cashflow will be discounted. Project A Discount factor @5% A B C D

(40,000) 20,000 20,000 100 100

K000 (40,000) (20,000) 400 400 32,000 32,000 12,800 12,800 400 400

(20,000) 0 0 0 36,000

Year

0 1.0000 1 0.9524 2 0.9070 3 0.8638 4 0.8227 Net Present Value

Cash flows K000 (40,000) 20,000 20,000 100 100

Present Value K000 (40,000.00) 19,048.00 18,140.00 86.38 82.27 (2,643.35)

14

Project B Discount factor @5%

Year

0 1.0000 1 0.9524 2 0.9070 3 0.8638 4 0.8227 Net Present Value

Cash flows K000 (40,000) 400 400 32,000 32,000

Present Values K000 (40,000.00) 380.96 362.50 27,641.60 26,326.40 14,711.76

Project C Discount factor @ 5 % 1.0000 0.9524 0.9070 0.8638 0.8227

Year 0 1 2 3 4

Cash flow K000 (20,000) 12,800 12,800 400 400

Present Values K000 (20,000.00) 12,190.72 11,609.60 245.52 329.08 4,474.92

Net Present Value

Project D Year 0 1 2 3 4 Discount factor @ 5% 1.0000 0.9524 0.9070 0.8638 0.8227 Cash flows K000 (20,000) 0 0 0 36,000 Present Values K000 (20,000.00) 0 0 0 29,617.20 9,617.20

Net Present Value

15

ANALYSIS AND CONCLUSION

Project B, C, & D are giving positive present values indicating that purely on financial information, they are viable and hence management of Ninsh Corporation should undertake the projects in order to maximize shareholder wealth. Project A is yielding a negative net present value and hence, purely on financial grounds, the project should not be undertaken as it is posed to destroy value of Ninsh Corporation.

Element 1.1.2 Internal Rate of Return (IRR) Internal rate of return is achieved by a project at which the sum of the discounted cash inflows over the life of the projects is equal to the sum of the discounted cash flow. In other terms, the IRR of an investment is that rate which when used to discount the cash flows of the investment will result in a rate present value of zero. The IRR of a project with conventional cashflows can be calculated using a process of trial and error. The following steps represent a systematic, methodical trial and error approach to the calculation of project IRR. 1. The net present value of the project at zero interest rate needs to be established. This must be a positive figure if an investment with conventional cashflows is to have a positive IRR. 2. A positive discount rate should be selected and the Net Present value of the project at this rate is calculated. 3. The procedure under (2) should be repeated for one or more additional discount rates. The Net Present Value profiles should be sketched and an approximate IRR estimated. EXAMPLE 2 Suppose a company has project Y with the following cashflows to evaluate. Estimate the IRR of project Y using the data given at a cost of capital of 14%.

16

Project Y Year 0 1 2 3 4 Solution: Years Cashflows Discount Factors (14%) 1.000 0.877 0.769 0.675 0.592

Cash flows K000 (20,000) 200 200 160,000 160,000

Present Values K000 (20,000.00) 178.40 153.80 108,000.00 94,920.00 183,252.20

K000 0 (20,000) 1 200 2 200 3 160,000 4 160,000 Net Present Value

Element 1.1.2.1 Decision Criteria In Internal Rate of Return In case the IRR, the decision rule is to compare opportunity cost of funds and accept the project if the IRR is greater than the companys cost of money and reject it if it is not i.e. purely on financial grounds. This decision rule would always lead to the selection of an identical set of projects as the application of NPV rule given the assumptions that have been made so far namely; certainty, conventional cashflows and perfect capital markets and the additional assumption of independent projects.

Element 1.1.2.2 The Reinvestment Assumptions The Net Present Value technique assumes that all cash flows from a project will be re-invested at the discount rate used in the calculation of the projects net present value, which in a real/free world is the prevailing base interest rate.

17

This assumption is realistic as application of the NPV rule means that all projects offering a return in excess of the discount rate will be accepted and the marginal funds are invested at the prevailing interest rate. In contrast IRR assumes that all cash flows will be reinvested at the projects own IRR. There are not practical supporting reasons for this assumption though. This assumption will lead to favour projects with concentrated cash flows in the early years of the project running than those with low cash flows in the early years of running. This can be illustrated by using an example of 2 projects M & K and calculations of their terminal values. In the early years of the project running than those with low cash flows in the early years of running. The terminal value of an investment is the total value of the cashflows generated by an investment at the end of its life. In calculating the terminal values, interim cash flows must be projected forward to the end of the investments life by the application of a particular reinvestment rate. The Net terminal value is calculated by subtracting the terminal value of the initial investment from the terminal value of the cashflows. Its assumed below that the interim cashflows will be reinvested at 5%. Projects Years 0 1 2 3 4 M cash flows K000 (18,000) 14,000 12,000 8,000 1,000 K cash flows K000 (16,000) 1,250 12,000 12,000 12,000

Projects

M Terminal values

18

Years 0 1 2 3 4

Cashflows K000 (18,000) 14,000 12,000 8,000 1,000

Reinvestment rate 5% (1.05)4 (1.05)3 (1.05)2 (1.05)1 1.00

terminal values K000 65,340 38,122 22,404 7,616 1,000

Conclusion And Analysis By definition, the IRR is the discount rate of zero and you should not be surprised to see that it is also the discount rate which gives a net terminal value of zero. This is clearly seen in the case of project K; the small positive NTV of M arises because 49% is a slight under estimate of the IRR as perusal of the above analysis. EXAMPLE 3 Seakwe Ltd is considering which of two mutually inclusive projects it should undertake. The finance director thinks that the project with the higher net present value should be chosen where the managing director thinks that one with the higher IRR should be undertaken especially as both projects have the same initial outlay and length of life. The company anticipates a cost of capital of 10% and the cashflows of the projects are as follows: Years Project X K000 0 1 2 3 4 5 (400) 70 160 180 150 40 Project Y K000 (400) 436 20 20 8 6

REQUIRED: 1. Calculate the Net Present Value and internal rate of return of each project. 2. Recommend with reasons, which project you would undertake. 3. Explain the inconsistency in ranking of the two projects in the light of the remarks of the two directors.

19

4. Identify the cost of capital at which your recommendation in (2) would be reversed.

Solution (1). Y 0 1 2 3 4 5 Factor 10% 1.000 0.909 0.826 0.751 0. 683 0.621 Factor 20% 1.000 0.833 0.694 0.579 0.482 0.402 Project X (400) 70 160 180 150 40 Present value 10% (400) 63.63 132.16 135.18 102.45 24.84 58.28 Present value 20% (400) 58.31 111.04 104.22 72.30 16.08 (38.05) Project Present Y value 10% (400) (400) 436 396.32 20 16.52 20 15.02 8 5.46 6 3.72 37.04 Present value 20% (400) 363.19 13.88 11.58 3.85 2.41 (5.08)

Therefore as it has been noticed in the calculations. At 10% the NPV of Project X = K58,280,000 At 10% the NPV of project Y = K37,040,000 At 10% the NPV of Project X = (K38,050,000) At 10% the NPV of project Y = (K5,080,000) The IRR of the two projects are as follows: Project X 1NPV1 IRR = Ra + [1NPV11+1NPV21 x (Rb Ra)] K58,280,000 IRR = 10% + [ K58,280,000 + K38,050,000 x (20%- 10%)] = 10% + 6.050036333% = 16.05% Project Y

20

1NPV1 IRR = Ra + [1NPV11+1NPV21 x (Rb Ra)] K37,040,000 IRR = 10% + [ K37,040,000 + 5,080,000 x (20%- 10%)] IRR= 10% + 8.793922127 IRR= 18.7939% IRR=18.79% (2) The recommendation should be to undertake Project X for the following Reasons. Project X has a positive Net Present Value, showing that it exceeds the companys cost of capital. In addition, assuming that the companys object is to maximise the Present Value of future cashflows Project X offers the higher Net Present Value. Project X indicates a higher NPV, whereas project Y offers a higher internal rate of return where such conflicting indications appear, it is generally appropriate to accept the Net Present Value result, net present value being regarded as technically more sound than internal rate of return. The two projects have radically different time profiles. Projects Xs cashflows are grouped in the three middle years of the project, while nearly 90% of Ys inflows come in the first year of the project, leading to a situation where project Y shows a higher internal rate of return. Risk, uncertainty and timing if cashflows may be considered by the Directors in making the final investment decisions.

21

+ + + + +

100 80 60 40 20 10 20 30 40 60 Discount rate; %

0
-

20 40

Although in the above illustration we have show the graphical representation using straight lines, the true relationship between the Net Present Value and discount rate is a cumulative one.

Element 1.1.2.3 Multiple IRR (Multiple Yields) At this point in time, we would want to appreciate that in cases where a project does not have conventional cashflows, there is a possibility of having multiple IRR in the project whose cashflows are unconventional. By a project having conventional cashflows, we mean that there will be a cash outflow followed by a stream of inflows. A project with non- conventional cashflows may have a cash outflow followed by an inflow or inflows then followed by a further outflow or by further outflows. As a result of these cashflows coming in and out of the project at different times, the IRR computation might give rise to two or more internal rate of return rates. EXAMPLE 4 Lunga Plc is proposing making a machine it will use in its manufacturing process, the cost of which will be paid in two stages. Revenue can be expected from its demonstration, although it will be expensive to break up and dispose of at the end of its useful life. The cashflows associated with the project are as follows. Years Cash flows K000

22

0 1 2 3 The appropriate discount rate is 15%.

(7,820) (20,000) 80,000 (53,020)

Solution: This project has two internal rates of return as shown below. Years Cash flows K000 0 (7,820) 1 (20,000) 2 80,000 3 (53,020) Net Present Value Discount Factor (6%) 1.0000 0.9434 0.8300 0.8396 PV K000 (7,820) (18,868) 71,200 (46,906) 16,000

Cash flows K000 0 (7,820) 1 (20,000) 2 80,000 3 (53,020) Net Present Value Graphical Representation NPV Investment NPV 200 100 0 (100) (200) (300) (400) Conclusion, Interpretation And Analysis 5 10 15

Years

Discount Factors (30%) 1.0000 0.9434 0.8300 0.8396

PV K000 (7,820) 15,384 47,336 24,034 78,934

20

25 30 Discount rate, %

23

As both IRRs are equally valid, the decision whether or not to accept this investment cannot be made by reference to these rates alone. Therefore, NPV method can be used to get a clearer result. If NPV shows that the NPV of the same project lower consideration is positive, then the project should be accepted as it shows that the net financial benefits far outweigh the financial costs of the project and hence demonstrating financial viability of the project.

Element 1.1.2.4 Internal Rate of Return for Projects With Unequal lines When two projects or more mutually exclusive investments with unequal lives are being evaluated and compared, consideration must be given to the time period over which a comparison of the investments is to be made.

EXAMPLE 5 Consider two projects Years Project P Q 0 K000 (60,000) (60,000) 1 K000 40,000 75,100 2 K000 40,000 -

Compute the IRRs of the two projects assuming a cost of capital of 10%. A comparison can be made over an equal time span for both investments; the lives of P and Q can be equalised by assuming that the company can invest in another project like Q at the end of year 1. The cashflows of two consecutive investments in Q would be as follows: Year Project Q Project Q repeated Total Cashflow 0 K000 (60,000) (60,000) 1 K000 75,100 (60,000) 15,100 2 K000 75,100 75,100

(1) Using unadjusted Cash flows

K000 NPVP = 4,711

IRR 22%

24

(I.e. P over 2 yrs And Q over 1 yr) (2) Cashflow adjusted to Equalise project lives (I.e. P over 2 yrs and Q over 2years) Conclusion and analysis

NPVQ = 4,090 K000 NPVP = 4,711 NPVQ = 7,810

25%

IRR 22% 25%

Ranking project P and Q on an IRR basis makes project Q the superior choice, irrespective of the period over which the comparison is made. In conclusion, regardless of the project lives, the project with a higher IRR should be chosen as the IRR does not seem to be affected by the length of the project life or repeated reinvestment of the cash flows. 1.6.1 TRADITIONAL APPROACHES TO PROJECTS/ CAPITAL INVESTMENT APPRAISAL

As you can remember, from the outset of the chapter, the payback period and accounting rate of return are the commonly used traditional methods of appraising capital investments. Element 1.1.3 Payback Period Method Computation of payback period of a project is the time required for the cash inflows from a capital investment project to equal the cash outflows. If we assume that cashflows are received at the end of each year, the payback period for the four projects below will be: Projects: Initial capital outlay Cash inflows Years A K000 0 (20,000) 1 10,000 2 20,000 3 20,500 4 21,000 B K000 (20,000) 400 400 16,400 32,400 C K000 (10,000) 6,400 12,800 13,000 13,200 D K000 (10,000) 0 0 0 18,000

25

The pay back period for the projects is as follows: Project A B C D Payback period 2 years 4years 2years 4years

In practice corporations will have a benchmark of the payback period, which is going to be adopted in their company policy as the threshold or cut off point for appraising and assessing the payback periods of projects. For instance if the company above has a corporate policy of only accepting project with payback period of 3 years only project A and C promise to payback a three year period. Hence only project A and C would be accepted and be undertaken in this instance. Decision rule: Only projects with short payback periods are preferred.

Element 1.1.3.1

Limitations of Payback Period Method

The payback period method has a limitation not taking the time value of money into consideration and it ignores the future cashflows beyond the payback threshold as per company policy no matter how healthy the cashflows might be.

Element 1.1.3.2 Discounted Payback Period In order to go round the problem of the lack of recognition of the time value of money some evaluators opt to use discounted pay back where the payback of the project is deferred using discounted cash flows as opposed to simple cashflows. Exercise 1 Please compute the present values of the cashflows from the above 4 projects A, B, C and D at a cost of capital of 5% and you will discover that the discounted payback (year) will be as follows:

26

Project A B C D

discounted payback (years) No Payback 4 years 2 years 4 years

This is a slightly more comprehensive evaluation that the crude simple method of using simple cash flows. Element 1.1.4 The Accounting Rate Of Return (ARR) Computing Accounting Rate of Return A mathematical expression of; Average annual profit from an investment x 100 Average Investment Defines the accounting rate of return as; The model that employs accounting profits rather than cash flows from the project as the input data to the model. To find the ARR of an investment, the average profit over the life of the investment is calculated. This is then expressed as a return on either the initial or the average investment in the project. An acceptable ARR must be specified by the decision maker in advance and projects exceeding this return will be accepted and those falling short of the return will be rejected. To illustrate the mechanics of the method, the following illustration can be used. Consider four projects A, B, C, & D with the following data. EXAMPLE 6: Project Name: Project life: A 4 B 4 C 4 D 4

Cash Inflows: K21, 000,000 K32, 400,000 K13, 200, 000 K18, 000,000 Deprecation: K20, 000,000 K20, 000,000 K10, 000,000 K10, 000,000 Profit: K1, 000,000 K12, 400,000 K3, 200,000 K8, 000,000

27

In the above figures, we are assuming that the deprecation and profit figures shown are for total (aggregate) figures over the lives of the projects. Average profits for the projects Total Profit over 4 years = Profit per year Project life years Projects: A B K1, 000,000 K12, 400,000 4yrs 4yrs K3, 100,000 C K3, 200,000 4yrs K800, 000 D K8, 000,000 4yrs K2, 000,000

= K250, 000

Computation of average capital investment: Assuming that all the resources invested in the project will be consumed and hence the investment at the end of the project life will reduce to zero (0), the Average investments are calculated as a simple mathematical mean. Project A K21, 000,000 + K0 2 years K10, 500,000 Project B K32, 400,000 + 0 2 years K16, 200,000

Project C K13,200,000 + K0 2 years K6, 600,000 The Accounting Rate of return: Projects A: K250, 000 = K10, 500,000 2.38%

Project D K18,000,000 + 0 2 years K9, 000,000

28

Projects B: Projects C:

K3, 100,000 = K16, 200,000 K800, 000 K6, 600,000 K2, 000,000 K9, 000,000 =

19.14% 12.12%

Projects D:

22.22%

For the technique to find use, the decision maker needs to specify a required rate of return when ARR is used as the project evaluation method. As mentioned under the payback period method, corporations need to establish and choose as a policy, an accounting rate of return percentage. ANNUALISED EQUIVALENT COSTS

EXAMPLE 7 Mpose Plc is considering the purchase of a new track, which will be required to travel 50,000 kilometers per year. Two suitable models are available details of which are as follows: The Kenworth having a life of four (4) years and a price of K200, 000,000 the running cost is initially K20,00 per kilometer but this will rise by K3,00 per kilometer for each year the truck is in service. Scania will incur the following cost over 6 years Years 0 1 2 3 4 5 6 K000 350,000 75,000 90,000 105,000 120,000 135,000 150,000

The cost of capital for Mpose Plc is 12% Required:

29

Explain which truck (between the Kenworth and the Scania) should be purchased. Solution: As we can see the comparison of the two projects is complicated by their unequal lines. We are going to use annualized costs to compare the two projects. Therefore the annualized cost of the Kenworth is:

Year 0 1 2 3 4

Costs K000 2,000,000 100,000 1,250,000 200,000 1,750,000

The annualized cost of the Kenworth Truck Year Costs K000 0 1 2 3 4 Totals: 2,000,000 100,000 1,250,000 200,000 1,750,000 1.000 0.8930 0.7970 0.7120 0.6360 3.038 12% DCF Present value K000 2,000,000 89,300 996,250 142,400 1,113,000 4,340,950

The annualized equivalent of K4, 340,950,000 K4, 340,950,000 3.038 = K1, 428,884,134 30

This is determined by calculating the Net Present Value of acquiring and operating a Kenwork truck over four years and converting it an equal annual equivalent cost by dividing the Net Present Value by 3.037. The annualized cost of the Scania truck is; Year 0 1 2 3 4 5 6 Totals: Costs K000 350,000 75,000 90,000 105,000 120,000 135,000 150,000 1.0000 0.8930 0.7970 0.7120 0.6360 0.5670 0.5070 4.112 12% DCF Present value K000 350,000 66,980 71,230 74,760 76,320 76,550 76,050 791,890

The annualized equivalent of K791, 890,000 is K 791,890,000 4.112 = K192, 580,252.90 Therefore in conclusion, the Scaina is the best option with a lower annualized cost.
PREFERENCE FOR APPRAISAL METHOD

Investment Appraisal method Advantages and disadvantages of Investment Appraisal Methods PAYBACK PERIOD METHOD Advantages

31

(a) It is easily understood and interpreted, especially to non-financial managers, and its implications for liquidity are clear. (b) It can be used as preliminary project appraisal screening method, before scientific methods (discounted cash flows are applied for the appraisal process). Disadvantages (a) It ignores cash flows beyond the payback period and it does not take into account of the time value of money. NET PRESENT VALUES Advantages (a) It takes account the timing of cash flows. (b) It takes proper account of the size and duration of projects. (c) It takes into account the greater uncertainty of later years cash flow by using a higher discount rate for these years. Disadvantages (a) It produces a number which is less familiar to management than a rate of return. (b) It's complex in its mechanics. (c) Not easily understood by non-financial managers. INTERNAL RATE OF RETURN Advantages (a) It takes into account of the timing of the cash flow. (b) It is easily compared to a given return, which project owners are looking for, in assessing a projects viability. Disadvantages (a) It does not take account of the size of the project, so a small project with a high return looks better than a large project with a lower return, even through the latter will contribute more to earnings. (b) The Internal Rate of Rate (IRR) cannot evaluate properly the duration of projects. This is because IRR takes no account of what happens to the returns after they are achieved.

32

(c) Another potential difficulty, which may sometimes arise, is the possibility of two or more solutions to the IRR calculation. This usually happens when a project has unconventional cash flows, meaning that cash flows with negative and positive signs may come through during the life of the project.

Element 1.2 Capital Replacement Corporations will most times want a specific type of capital asset for a period of time which exceeds the physical life of any one individual asset, or part of an asset or part of that type. For instance, demand for the output of a particular production process may extend into the indefinite future, whereas the life of the machine required carrying out the process will be limited to a finite period. Asset replacement may be undertaken in response to the poor physical condition of an asset or more reasonably replacement may be planned. The timetable for a planned replacement will be determined by a consideration of the costs of replacing over one time horizon rather than other. Consider the example of a company which provides its entire sales people with a company car. The cost to the company of providing the car is made up of the initial capital cost and the annual running costs, less the resale value at the time of disposal. Data on the type of car, which our hypothetical company provides for its sales people, is given below. Initial purchases price: Annual running cost (average per year) Re-sale value if sold after: 2yrs 3yrs 4yrs 5yrs K000 50,000 20,000 30,000 25,000 15,000 5,000

Since the company requires the cars to extend into future, a replacement policy must be decided upon. If the company would like to minimise the overall cost of operating its fleet of cars, cars should be replaced at the point in time at which this cost is minimised. For ease of exposition we would assume that the annual operating cost is independent of the age of the car and that the data given above will remain valid indefinitely. As the annual operating cost is constant, irrespective of the replacement cycle it can be ignored for the purposes of

33

setting the replacement policy. Therefore what needs to be considered are the purchase price of the car and the resale value. Although, the purchase price itself is not variable the total expenditure of the company is variable as it depends on the sale of the cars, which in turns depends on the replacement cycle. The net cost of the investment in each car is given by the initial outlay less the present value of the sale proceeds.

Assuming a cost of capital of 5%, the computation would be as below. Schedule 1

Year Resale Values K 000 Discount factor (5%) Present values K 000 Purchase price K 000 Net Present cost K 000

2 3 4 5

30,000 25,000 15,000 5,000

0.9070 0.8638 0.8227 0.7835

27,210 21,595 12,341 3,918

(50,000) (50,000) (50,000) (50,000)

(22,790) (28,405) (37,659) (46,082)

The final column of the table shows the net present cost of owning the car over differing time periods, two years in the case of the first row, and three years for the second row etc. This cost does not of itself provide a basis for comparing the relative attractiveness of the alternative replacement cycles. In order to make such a comparison, the cost must be expressed as a net present cost per annum, which is obtained by dividing the net present cost over the relevant time period. This procedure allows the expression as an annual figure of a cost or income occurring on a regular but not annual basis. For example taking the figures in the first row of the schedule, the K22,790,000 spent today is equivalent to an expenditure of K12,256,642 (22,790,000/1.8594) for each of the next two years at the discount rate is 5%, we would be indifferent as to which spending pattern we incurred.

34

Schedule 2 Replacement Cycle (years) Net Present Cost (a) K000 2 3 4 5 (22,790) (28,405) (37,659) (46,082) 1.8594 2.7232 3.5459 4.3295 Annuity factor (5%) (b) Annual Equivalent Cost (a/b) K000 (12,567) (10,431) (10,620) (10,644)

Conclusion and analysis It can be seen that the minimum annual equivalent cost is K10, 431,000 the cost of replacing the cars on a three-year cycle. Other things being equal the company should adopt a three-year replacement policy. The concept of annual equivalent costs can be used to facilitate the comparison of assets with unequal lives, providing the assumption can be made that assets will be required for a period which is a complete multiple of each projects own life. Refer to section 1.5.4.2 for such a computation.

Element 1.3 Capital Rationing In some instances, the amounts of capital which an organization can invest in its long-term projects are limited and so a choice must be made between a number of different projects. In financial wisdom, managers of the business will want to select and choose projects that will give the greatest return on the total investment, assuming that projects are in line with the long-term corporate strategic objectives. The illustration below shows the mechanics of capital rationing

35

Projects: Year: 0 1 2 3

W K, 000 (200,000) 40,000 100,000 140,000

X K, 000 (120,000) (80,000) 80,000 140,000

Y K, 000 (240,000) 120,000 90,000 90,000

Z K, 000 (160,000) (200,000) 200,000 220,000

If we suppose that the company with these four (4) projects above; W, X, Y, and Z has a cost capital of 5% and that the funds available in year 0 (i.e. in the current year), at the time of decision-making are K400, 000,000.00, it is clear that even if the net present values are positive the organization cannot invest in all four projects. Using the profitability index technique of ranking project will be employed to rank projects. The first step is to calculate the net present values of the projects and then express them as a percentage of the project outflow so that comparable returns are obtained. The computation below shows the return from each project and their rankings. Discount Rate @ 5% Year 0 1 2 3 1.000 0.952 0.907 0.864 W K, 000 (200,000) 40,000 100,000 140,000 X K, 000 (120,000) (80,000) 80,000 160,000 Y K, 000 (240,000) 120,000 90,000 90,000 Z K, 000 (160,000) (120,000) 200,000 220,000

36

Discounted cash flows Year Yr 0 1 2 3 1.000 0.952 0.907 0.864 W K, 000 (200,000) 38,080 90,700 120,960 X K, 000 (120,000) (76,160) 72,560 138,240 Y K, 000 (240,000) 85,680 81,630 77,760 Z K, 000 (160,000) (190,000) 181,400 190,000

NPV

49,740

14,640

5,070

21,000

The returns on the projects are as follow; W K49, 740,000 K200, 000,000 24.87% Ranking 1st X K14, 640,000 K120, 000,000 12.20% 4th Y K5, 070,000 K240, 000, 000 14.02% 2nd Z K21, 000,000 K160, 000,000 13.18% 3rd

Analysis and comment As it can be seen above, all projects have positive net present values and so they would be accepted if funds allowed. With only K400, 000,000 to invest, project W would be chosen and 5/6 of project Y, assuming that the investments are divisible. In many circumstances, divisibility of projects might not be possible, so decisions will have to be made based on net present value technique. Capital rationing is not really a practical approach for the majority of organizations. It usually works very well if the company in question is not an Investment Company such as Warren Buffets Bechshire Hathaway Inc, but for

37

most of organization providing a service or manufacturing products, this solution will not be very helpful. Element 1.4 Effects of Taxation on Investment Appraisal Although in many instances we are assuming that there are no taxes in perfect financial markets, in reality taxes are usually levied on income earned from investment. The section aims to show the effects of taxation on investment appraisal. However, the section starts by looking at basics of discounting future cashflows, which is going to be used widely in capital investment appraisal.

Element 1.4.1 Discounting Methods Time value of money Cash flows arising at different points in time cannot be compared directly and must be converted to a common point in time i.e. usually discounted to their present values.

Years 0 1 2 3 4

PV Present value

Discounting

FV Future value

Present value (PV) is the cash equivalent now of money received/payable at some future date.

38

Exercise

1 Year 0 (now) K 10,000,000,000 Year 5 K 15,000,000,000

Choose between

The discount rate is 10% Please make your decision by first discounting and then compounding. Discounting Year 0 (now) Year 5 K 10,000,000,000 K 9,315,000,000 = PV = FV x 1/ (1+r) n Compounding PV (1 + r) n = FV Year 0 (now) 10,000,000,000* (1.1)5 = Year 5 K 16,105,100,000 0.621 x K1, 500,000,000

Therefore we would choose the k 1, 000 now with both methods, please note that discounting is the preferred method of comparison in SFM. The Discount Factor

Formula 1 (1.10)5

or

Tables (given in exam) You can simply find discount factor from the present value table, by locating the discount factor at the 10% column and the 5-year row i.e. 0.621

=0.621

Element 1.4.2 Annuities An annuity is a constant annual cash flow for a number of years. To find present value of an annuity we would apply the factors from the annuity tables. Exercise 2: Immediate Annuity What is the present value of K100 earned each year from years 1-10, if the discount rate is 11%? 1 2 3 4 5 6 7 8 9 10

39

The annuity factor at year ten adds together all the present value factors for the first ten years. In fact the annuity is quite often called the cumulative present value factors. The annuity factors assume that the first cashflow occurs at the end of year one i.e. the first present value factor added in an annuity factor is for year one. Therefore when the first cash flow arises in year one you simply have to apply the annuity factor to find the present value of the annuity. An annuity which commences in year one is called 'an immediate annuity. Answer: PV = K100 X 5.889 = K588.9

Exercise 3:

Deferred Annuity

What is the present value of K200 incurred each year from years 3-6 the discount rate is 5%? Answer: (1 0 1 2 200 PV 3 200 4 200 5 200 4) 6

The annuity factor brings all the cash flows to one year before the first cashflow arises. As the first cash flow is in year 3, all the cash flows have been brought to year 2. To find the present value (year 0) of the annuity, which is currently valued in year two we must multiple it by the present value factor for year two. Answer = Apply the structured approached to deferred annuities: 1. Annual cash flow K200 X

40

2. Annuity factor for two years 1 to 4 3. Present value factor for year 2 Present value of deferred annuity

3.546 X 0.907 K643

Perpetuities Perpetuity is an annual cash flow forever. It is the simplest cash flow model known to man. The perpetuity with growth keeps appearing in the exam so you need to be very familiar with it. Goddard often implies perpetuity by simply stating, The cash flows will occur for the foreseeable future.

Element 1.4.3 The Basic Perpetuity PV of a perpetuity = Po = annual cash flow r

Discount rate

annual cash flow Po

Exercise 4 What is the maximum amount you would pay for perpetuity of K 25,000 per annum, if the discount rate is 10%? Answers Po = K25, 000 10 = K250, 000 r = 25,000 250,000 = 0.10

Element 1.4.4 Perpetuity with Constant Growth Perpetuity formulae also assumes that the first payment will be at the end of year one, thus they also bring the cash flows back one year. g = growth expressed as a decimal. PV of perpetuity Po = Cash Flow Year 0* (1+ g) rg

41

Discount rate in a perpetuity r = Cash Flow Year 0* (1 + g) Po Exercise 5

+g

What is the PV of perpetuity of K 25,000,000,000 per annum increasing at an annual rate of 5%, if the discount rate is 10% and the first payment is in year 1? Answer: PV of Perpetuity = 25,000,000,000 * (1 + 0.05) 0.1 - 0.05 = K525, 000,000,000

Exercise 6: An NPV calculates with both deferred annuity and a deferred perpetuity. The Financial Director of A plc has prepared the following schedule (excluding inflation) to enable her appraise a new project. The projects real WACC is 10%. She wants to calculate the NPV using two different assumptions regarding the project duration. The assumptions are as follows: a) That the real annual cash flow will be K 250,000,000,000 from year to the foreseeable future (deferred perpetuity). b) That the real annual cash flow will be K250, 000,000,000 from year to year eighteen (deferred annuity). Answer: Year 0 K000 2,000, 000 1 K000 440,000 0.909 400,000 2 K000 3 K000 4 18 K000 250,000

Net Cash Flow

363,000 250,000 0.826 300,000 0.751 300,000

Present value factors 1.000 Present value NPV perpetuity NPV annuity 2,000,000

42

Element 1.4.5 the Net Present Value Format Year Receipts (or cost savings) Payments: Wages Materials Variable / Fixed overheads Administration / Distribution expense Capital Allowances/Tax allow dep Taxable Profits = EBIT Tax: Add back: Capital Allowances Initial outlay Net Realisable Value Working capital (X) X (X) X X X X X X X(X) X X X X X X X

0 K000

1 K000 X (X) (X) (X) (X) (X) X (X) X

2 K000 X (X) (X) (X) (X) (X) X (X) X

3 4 K000 K000 X X (X) (X) (X) (X) (X) X (X) X (X) (X) (X) (X) (X) X (X) X

Net Cash Flows/Free Cash Flows (X) Discount rate (X%) Present value Net Present Value X (X)

A positive NPV is when the expected return on a project more than compensates the investor for the perceived level of (systematic) risk i.e. that the expected is greater than the required return. Decision Rules:

43

Single Project: Positive or zero NPV: Based on the estimates it appears that the project is financially viable. Negative NPV: Based on the estimates it appears that the project is not financially viable. Mutually exclusive project (A or B): (an absolute decision not a relative decision) Simply pick the project with the highest positive NPV. Element 1.4.6 The Relevant Cash Flows A key concept => include relevant / incremental cash flows in the NPV calculations.
FUTURE CASH FLOWS THAT ARISE AS A CONSEQUENCE OF THE DECICSION

1.

Ignore all sunk costs incurred prior to the decision. Ignore all sunk revenues generated prior to the decision. Sunk costs are costs which have already been incurred prior to the decision. They are therefore irrelevant to the decision making process. Exercise 7: R+D of K100, 000 was incurred last year. Ignore all non-cash flows. E.g. depreciation. Exercise 8: A company is considering investing in a project, which requires an immediate investment of K6m. This project will last for five years and at the end of the project the plant will have a scrap value of K1m. The company depreciates plant on a straight-line basis over a five-year period. What are the relevant cash flows? Answer: Simply when you buy and a fixed asset. Ignore all overheads in existence prior to the decision i.e. nonincremental cash flows. The allocation / apportionment of fixed costs already present prior to the decision are ignored. Exercise 9: A manufacturing company is considering the production of a new type of widget. Each widget will take two hours to make. Fixed overheads are allocated on the basis of K1 per labour hour. If the new widgets are produced the company will have to employ an additional superior at a salary of K15, 000 per annum. The company will produce 10,000 widgets per annum. What are the relevant cash flows?

2.

3.

44

Answer: The K15, 000 salary only. Exam Focus: If you are calculating an NPV in relation to the purchase or sale of a company you should include all existing fixed costs because to the purchaser / seller they represent future cash flows will commence / cease sale. 4. Ignore interest payments and their tax effects as implicit in the discount rate. This is because if it were subtracted this would amount to double counting because the opportunity cost of capital already incorporates the cost of these funds. This simple example ignores tax relief on interest.

Market values Equity Debt 1,000 1,000 2,000

Annual cash Flows required 200 100 300

Cost of Capital 20% Ke 10% Kd 15% Wacc

Element 1.5 Effects of Inflation on Investment Appraisal

NPV CALCULATION: Years 1% Sales Specific 4% Wages 3% Materials 6% Overheads Net cash flow General inflation 0 1 X (X) (X) (X) X 2 X (X) (X) (X) X 3 X (X) (X) (X) X 4 X (X) (X) (X) X 5 (X) (X) (X) (X) X

2% Discount rate factors Present value N.P.V Two types of inflation

45

Specific inflation rates Applies to all the individual cash flows items rate

General inflation Applies to the discount This is because the investors in a Project are interested in their ability to buy a basket of general goods. Not only one particular good. Project are interested in their

The two methods

Includes the two types inflation

Excludes the inflation

Money or normal Terms Discount money cash flows At money discount rate

Real terms Discount real cash flows at real discount rate Real term cash flows are Cashflows at current prices or year zero

EXAM FOCUS:

When to use the money or Real method Is there one rate of inflation in the question?

No

*Yes

46

Money / Nominal Method are in: E.g. Wages 3%, Materials 4% and General inflation 5% Real Terms

If the cash flows

Money Terms

Real Methods

Money Methods

* If there is one rate of inflation in the question both the real and money method will give the same answer. However it is easier to adjust one discount rate, rather than all the cash floes over a number of years. Thus the form of the cash flows defines the method to be used.

Element 1.5.1 Adjusting The Discount rate Invariably Goddard will give you the cash flows in one form and the discount rate in the other form. So you will have to adjust the discount rate. Cash flows in real terms Discount rate in money terms Deflate to find the real discount rate cash flows in money terms discount rate in real terms inflate up to find money discount rate

Real discount rate to money discount rate The fisher Equation (1 + money rate) = (1 + real rate) x (1 + general inflation rate) Exercise If the real rate of return is 10% and general inflation is 5%, what is the money rate of return? Answer: [(1.10) (1.05)] - 1 = 1.155 therefore 15.5% Exercise

47

If the real rate of return is 8% and general inflation is 4%, what is the money rate of return? Answer: Money discount rate to Real discount rate The money discount rate also sometimes called the market rate of return includes general inflation. Therefore to find the real rate of return you must deflate as follows: Deflate: 1 + money rate = 1+ real rate 1+ general inflation Exercise 12 If the money rate return is 14.4% and general inflation is 4%, what is the real rate of return? Answer: (1.144/1.04) - 1 = 0.1 say 10%

Exercise 13 If the money rate of return is 13.42% and general inflation is 3%, what is the real rate of return? Answer: (1.1342/1.03) 1 = 0.10 say 10%

CASH FLOWS DEFINE THE METHOD ESPECIALLY WHEN THERE IS AN ANNUITY: Exercise 14 ABC plc provides the following projected data for the next ten years excluding inflation. Net cash flows 0 (1,700) 1 100 2 200 3 10 300

The rate of inflation is 3% and the market return is 11.24%

48

Calculate the present value of the cash flows over the 10-year period. Real Method: - cash flows are in real terms; simply deflate the money discount rate to get the real rate. Real discount rate: (1.1124/1.03) - 1 = 0.08 say 8%

Real cash flows: Net cash flows Annuity factor Discount factor Present value NPV 0 (1,700) 1.000 (1,700) 1 100 0.926 93 42 2 200 0.857 171 3 10 300 5.747 0.857 1,478

Money Method: - calculate the money cash flows for each year and discount by the money discount rate.
Years 0 1 2 3 4 5 6 7 8 9 10

Net cash (1,700) 103 212

328

338

348

358

369

380

391
0.383 150

403
0.345 139

Disc F: 1 @ 11.24% PV

0.899 0.808 0 .726 0.653 0.587 0.528 0.474 0.426 171 238 221 204 189 175 162

(1,700) 93

NPV

42

ANSWER COMMENT: The understanding assumption that the general inflation rate is equal to the specific inflation rates for all the cash flows items is somewhat simplistic. In reality each cash flow item would probably have a different specific rate of inflation, thus requiring the money method approach. Examples: Twincle Plc has provided and marketed camping kits for several years. The camping bags are much heavier than some of the modern camping kits being brought into the market. The company is concerned about the effect this will

49

have on its sales. Twinkle Plc is considering investing in new technology that would enable them to provide a much lighter and more compact camping kits. The new machine will cost K500,000,000 and is expected to have a life of four (4) years with a scrap value of K20,000,000 in addition an investment of K70,000,000 in working capital will be required initially. The following forecast annual trading account has been prepared for the project: Sales Materials Labour Variable overheads Depreciation Annual profit K000 400,000 (80,000) (60,000) (20,000) (40,000) 200,000

The companys cost of capital is 10%. Corporation tax is charged at 30% and is payable quarterly, in the 7th and 10th months of the year in which the profit is earned and the 1st and 4th month of the following year. A writing down allowance of 25% on a reducing balance is available on capital expenditure. Required Advise the management of Twinkle Plc on whether they should invest in the new technology Your recommendation should be supported with relevant calculations. Solution- Writing down allowances
Year Asset Value K000 500,000 (125,000) 375,000 (93,750) 281,250 (70,313) 210,937 (20,000) 30% Tax K000 37,500 28,125 21,094 Year 1 K000 18,750 Year 2 K000 18,750 14,063 14,063 10,547 10,547 Year 3 K000 Year 4 K000 Year 5 K000

Yr1 25% WDA Yr2 25% WDA Yr3 25% WDA Yr4 Scrap value Yr 4

50

Bal adjusted

190,937

57,281 18,750 32,813 24,610 39,188 28,641

NET PRESENT VALUE CALCULATIONS

Year Machine W/Capital K000 (500,000) (70,000) 18,750 32,813 24,610 39,188 28,641 240,000 240,000 240,000 240,000 240,000 (36,000) (72,000) (72,000) (72,000) (36,000) Tax relief on WDA K000 Contribution Tax on contribution K000 Net cash flow K000 DCF 10% Present value K000

0
1 2 3 4 5

20,000 70,000

(570,000) 222,750 200,812 192,608 297,186 (7,360)

1.000 0.909 0.826 0.751 0.683

(570,000) 202,480 165,870 144.648 202,978 (4,570) 141,406

Net Present Value of new technology investment. Contribution = Annual Profit + Depreciation = K200,000,000 + K40,000,000 = K240,000,000

Therefore purely on financial grounds, management of Twincle Plc should invest in the new technology, as the Net Present Value of the new technology is positive.

DIFFERENT NPV FORMATS Exercise 15 DEF plc provides the following project financial data for the next 4 years, including inflation. Year 1 K000s 1,000 (600) Year 2 K000s 950 (555) Year 3 K000s 900 (530) Year 4 K000s 900 (500) 51

Sales Less Costs

The rate of inflation is 3% and the real discount rate is 6.80%. Machinery cost K800, 000 life 4 years, tax allowance depreciation is at straight line and the tax rate is 30%. Calculation of the present value of the cash flows. Note: Only one inflation rate and cash flows are in money terms therefore use the money method. Therefore need to calculate money discount rate i.e. (1.03) x (1.068) = 1.10. i.e. 10%. TAXABLE PROFITS APPROACH METHOD 1 Year 0 Sales Less Costs Less tax allowance depreciation Taxable profits Tax Add back tax allowance depreciation Initial outlay (800) Net cash flow Discount rate (10%) Present values NPV (800) 1 (800) 1 1,000 (600) (200) 200 2 3 4 950 900 900 (555) (530) (500) (200) (200) (200) 195 170 200 (60) 200 335 .826 277 (59) 200 (51) 200 5

(60)

200 400 .909 364

311 349 .751 .683 234 238 276

(60) .621 (37)

TAXABLE CASH FLOW APPROACH METHOD 2 Year 5 Sales Less Costs Taxable cash flows 0 1 1,000 (600) 400 2 950 (555) 395 (120) 60 3 900 (530) 370 (119) 60 4 900 (500) 400 (111) 60

Tax (120) Tax relief on depreciation 60 Initial outlay (800) Net cash flow (60) (800) 400

335

311

349

52

Discount rate (10%)

.621

.909

.826

.751

.683

Present values (37) NPV

(800)

364

277 276

234

238

CAPITAL ALLOWANCE

Exercise 16 Cost K200,000, Scrap value K30,000, Life 5 years, Method 25% reducing balance method and the tax rate is 30%. Answer: Cost K000s 200 25% W.D.A.S K000S 50 50 x 0.75 = 38 38 x 0.75 28 21 Balancing Allowance (170 -137) = Total Claimable 33 170 200 30 = 170 Year

1 2 3 4 5

THE INTERNAL RATE OF RETURN-IRR IRR is the discount rate, which gives a zero NPV i.e. the actual rate of return on investment. ESTIMATING THE IRR VIA LINEAR INTERPOLATION Calculate the NPV at two different discount rates and then use the following formula:

53

IRR = Rate + 1

NPV 1 * (Rate - Rate) NPV - NPV 2 1 1 2

If the first NPV is positive, choose a higher rate for the next calculate to get negative NPV. Exercise 17 Calculate the IRR (the expected return) of the following project: Year 0 1 2 3 4 Answer: Year Cash flow PV 0 1 2 3 4 NPV (40, 000) 16, 000 16, 000 16,000 12,000 10% 1 .909 .826 .751 .683 (40, 000) 14,544 13,216 12, 016 8, 196 7,972 20% 1 (40,000) .833 13,328 .694 11,104 . 579 9,264 .482 5,784 (520) investment cash inflow Dis Factor @ PV K (40, 000) 16,000 16,000 16,000 12,000 Dis Factor @

IRR = 10% +

7,972 * (20% - 10%) = 19.39% 7,972 + 520

Exercise 18: Breckhall plc Assume that you have been appointed finance director of Breakall plc. The company is considering investing in the production of an electronic security device, with an expected market life of five years. The pervious finance director has undertaken an analysis of the proposed project; the main features of analysis are shown below.

54

Proposed electronic security device project Year 0 Year 1 Year 2 Year 3 Year 4 K000 K000 K000 K000 K000 Investment in depreciable Fixed assets 4,500 Cumulative investment in Working capital 300 400 Sales 3,500 Materials Labour Overhead Interest Depreciation Taxable profit Taxation Profit after tax

Year 5 K000

500 4,900

600 5,320

700 5,740

700 5,320 900 1,800 100 576 900 4,276 1,044 365 679

535 750 900 1,050 1,070 1,500 1,800 2,100 50 100 100 100 576 576 576 576 900 900 900 900 3,286 4,276 4,276 3,131 396 1,074 1,044 1,014 129 376 365 355 267 689 679 659

Element 1.6 Treatment of Leasing and Hire Purchase Transactions Introduction Leasing is a technique used to finance the use of an asset. It is an alternative to outright purchase, financing by using existing cash reserves or by borrowing. The motivation for choosing leasing rather than purchasing is often tax efficiency. A lease contract is an agreement between the owner of an asset (the lessor) and the user (the lessee) under which. The lessee may have use of the asset for a specified period. The lessee in consideration for use of the asset promises to make a series of payments/ rentals to the lessor. The lessor remains the legal owner of the asset during the terms of the lease.

55

Typically lessors would be banks or subsidiaries of subsidiaries of banks. The lessee chooses the asset and the lessor / bank purchases the asset, thus fulfilling the ownership requirements for tax purchases. Element 1.6.1.1 Advantages of Leasing There are two significant reasons for a company to lease assets rather than buying outright. 1. Tax benefits 2. Flexibility / cash flow 3. Access to additional sources of liquidity as a result of increased debt capacity. Element 1.6.1.2 Tax Benefits to the Lessor Tax saving was the original drive or motivation behind the development of the leasing market. In many countries legal ownership of a qualifying asset entitles the owner (e.g. a bank) to amortize the capital cost over the life or the lease period of the asset for tax purposes. This gave valuable cash flows benefits to those with the taxable capacity to sketcher their tax allowances. Large commercial banks usually had such tax shelter, which they could use as lessors passing on to the lessee some of the economic benefits of tax relief cash flows. Element 1.6.1.3 Tax Benefits to the Lessee While the tax charges reduce the benefits of leasing, the ability of lessors to pass on capital allowance tax benefits to lessees still makes leasing attractive for entities which have no tax capacity themselves. The circumstances in which some entities might not have tax capacity and hence can benefit from leasing would include the following; 1. 2. In a situation where a loss making business is still creditworthy Where we have start-up projects or businesses, which may not move into profits for several years such as most Biotechnology companies and start-up information technology (IT) companies. For institutions which do not pay corporation tax e.g. local authorities universities and colleges.

3.

56

4.

In a situation where a profitable corporation, with large continuing capital expenditure and consequent large capital allowances but with low profits available as tax shelter.

FLEXIBILITY AND ENHANCE CASH FLOWS Whilst the availability of tax allowances continues to be important the users of the leasing market rely increasingly on the advantages of cash flows and flexibility. Lease structures can be flexible and innovative and the payment schedules can be tailored to fit the projected cash flows arising from the underlying business. For some types of assets such as aircrafts computers, containers and rail wagons, complex structures have been developed which facilitate the marketing of asset reconciling the news of the buyer and setter on their deliveries. Element 1.6.2 Types of Leases There are two main types of lease: 1 Finance leases 2 Operating leases Element 1.6.2.1. Finance Lease A finance lease transfers substantially all the risks and rewards of ownership of an asset to be leased. The rewards and risks which are to a very large extent transferred are as fellows: . The full use of assets owner its economic . Idle capacity . Breakdowns . Obsolescence The conductance below usually acts as criteria for testing a finance lease. In many laitance of a lease is going to be classified as a finance lease. 1. The present value of retails for the leased asset usually exceeds the value of the asset.

57

2. In a situation where the primary contact parole is somewhat equal or approximately equal to the useful economic life of the asset in question. 3. Where the retorm is margin over the lessors cost of funds reflecting the credit rate the contract. The main motivation of finance lease to the lessor is to make a profit by financing the asset. As we allowed to earlier, usually such lessor we financial institutions such as bank.

Element 1.6.2.2 Operating Lease By definition, an operating lease is one other than a finance lease. The motivation underlying an operating lease is the leased product (asset). The following criteria will be distinguished with operating lease. Usually in operating lease the present value of the rentals is way below the asset value. Usually the lease life (tenure) is less than the assets useful economic life. Operating leases may be a sales aid for the product manufacture/ distributor. However, if the manufacturer does not have the finance or tax capacity to act as lessor it may engage the services of a finance institution to act on its behalf. Element 1.6.3 Features of Leases - Lease rentals. Usually equal, but can be translated to sort the lessees cash flow if value contract is large enough to justify the effort. - Usually underlying interest rate Usually fixed interest rates are used smaller items for simplicity and a floating rate for large items if the lessee requires it. - Insurance and maintenance In finance leases the lessee will be responsible for payment of such costs where as in an operating lease since the lessor is clearly the legal owner and according to the substance over form standard, the lessor will be responsible for maintenance and insurance costs payments. Relocation

58

With finance leases the lessee is usually responsible for relocating the asset to the lessors instructions at the end of the lease contract so it can be sold. - Sale proceeds In most situations the major part of the sales proceeds are typically passed to the original lessee as a refund of the lease rentals.
LEASE RENTAL COMPUTATIONS. EXAMPLE TREATMENT OF LEASING AND HIRE PURCHASE TRANSACTIONS

Singa Ltd owns 20 print and computer shops in Kitwe. At present it hires its 35 photocopying machines from Rent-a-copier Ltd at an annual Rental fee of K11, 200,000 each, payable monthly (assume that cashflows occur at the year end). The rental agreement covers a 24 hour repair service which assists Singa Ltd to maintain high reputation for a quick and reliable service. Singa estimates that each machine generates K15, 200,000 of contribution each year. Xero company sells photocopier machines and is trying to break into the Kitwe market and offers to sell to Singa Ltd new machines for K36,000,000 each payable on installation. Singa Ltd is considering this and has found some research that suggests that each machine stands a 0.7 chance of being unreliable. The reliability of the machines will be discovered by the end of the first year. All machines that are reliable at the end of year 1 will still be reliable at the end of year 4. If a machine proves reliable, Singa Ltd will keep it for four (4) years in total and it will generate a contribution of K16, 000,000 each year after which time it will be scraped and sold for K1, 200,000. If the machine proves unreliable, it will be scrapped after year one (1) and sold for K800, 000. An unreliable machine is expected to generate a contribution of K10, 000,000 each year. The companys annual cost of capital is 8%. The management of Singa Ltd. Consider that a time horizon of no longer than 6 years should be used when evaluating decisions on photocopiers, as beyond the date photocopier machines are likely to be outdated technology. Required: a) Prepare computations to show whether a rented or purchased machine is the financially better option. b) Xero Company has now made an alternative introductory, once only, offer. It will buy back. 30% of the machines at the end of either the first or second year if, required. 59

The buy back price will be 60% of the original purchase price at the end of year 1 and 50% at the end of year 2. Singn Ltd must nominate in advance which replacement option it prefers. If Singa Ltd agrees to either of Xero companys proposals, it would remain with the company during the life of the purchased and replaced photocopiers. Because most shops have two photocopiers available, the management of Singa Ltd has now agreed that further replaced photocopiers available, the management of Singa Ltd has now agreed that further replacements after either year 1 or year 2 would be unnecessary. Required Advice Singa Ltd wether or not it should accept the revised offer. Having prepared the calculations in (a) and (b) you now realize that the effect of taxation should have been considered. The corporation tax rate is 30%. It is payable in four quarterly installments in the seventh and tenth months of the year in which the profit is earned and in the first and fourth months of the following year. The equipment will qualify for a 25% annual reducing balance writing down allowance. Assume that the 8% cost of capital is the after tax rate for part (c).

Required: Explain and illustrate with calculations the impact of taxation on the financial appraisal of: a rented machine a purchased reliatie machine (that is one that is kept for 4 years).

Solution: (a) Buying a single machine: K000 Year 0 cost 36,000 Reliable: Year 1-4 (K16, 000,000 x 3.312) Year 4 (K1, 200,000 x 0.735) 52,992 882 33,874 x 0.7 37,712 1,712 K000 (36,000)

60

Unreliable Year 1 (K10, 000,000 x 0.926) K800, 000 x 0.926 9,260 741 10,001 x 0.3 3,000 4,712

Renting machine over corporate time period: 0.7 Probability of machine kept for 4 years. = (K15, 200,000 - K11, 200,000) = K4, 000,000 K 4,000,000 x 0.7 x 3.312 = K9, 273,600 0.3 Probability of a machine kept for 1 year: 4,000,000 x 0.3 x 0.926 = Corporate figure for renting K1, 111, 2000 10,384,800

Therefore the rented machine is definitely the better option: K10, 384,800 K4, 712,000 = K5, 672,800 (i) Assume a faulty photocopier. Year 1 replacement over year 2: Year 1 Cashflow (K000) 21,600 (36,000) Discount rate 0.926 0.857 Present value (K000) (13,334) (cash received a new purchase price) 3,600 (net benefit of new over 2 yrs option) (18,000) 36,000 replacing in 5 1,080 * 2 0.857 15,426(saving year 2) 0.681 735 (sale of machine) by net

4,200 *1 machine

61

6 income)

(1,080) (14,200) 2,000 included for 0.630

(sale income forgone) (Loss of additional years (7,106) (income companion) from renting

*1 0.7 x K16,000,000 = K11,200,000 0.3 x K10,000,000 = K 3,000,000 K14, 200,000 K10, 000,000 = K4, 200,000 *2 0.7 x K1,200,000 = K840,000 0.3 x K800,000 = K240,000 K1, 080,000 Therefore replacement at the end of year 2 is better. Renting over a 6 (six) year cycle: Yr 1-6 : 35 machines x K4,000,000 x 4.623 = K647,220,000 Replacing in year 2 assuming a full 6 year cycle for comparison (in years 5 & 6, some machines will have to be rented, that is 35 machines x 0.7 = 24.5)

Year

Initial investment K000 (1,260,000)

Annual inflow Reliable machines K000 K000 392,000 392,000 392,000 392,000 117,600 117,600 117,600 117,600

Annual inflow Unreliable machines K000 105,000 105,000 31,500 31,500 31,500 31,500

Sale Price K000

Total

DCF Rate K000 1.0000 0.926 0.857 0.794 0.735 0.681 0.630

NPV

0 1 2 3 4 5

K000 (1,260,000) 497,000 308,000 541,100 570,500 149,100 16,440

K000 (1,260,000) 460,220 263,960 429,640 419,320 101,540 101,080

189,000 29,400 11,340

62

1.311

128,478 644,240

Rental: 5 & 6 24.5 machines x K4,000,000 Therefore, renting still remains the better option by a small margin. 4. The amount of taxation paid will be affected by the profit earned, business expenses and the purchase of assets. 5. Machine rented Taxation will be levied on the profit earned but the expense of renting a machine can be set against this, so the taxation calculation for renting a machine becomes (K15,200,000 K11,200,000) x 30% = K1,200,000 per year. Half of the tax will be paid in the year in which the profit is earned and half the following year. (This will reduce the net present value over 4 years by K1,200,000 x 3.312 = K3,974,400 approximately, ignoring the time factor (lag). 6. Machine purchased If the machine is purchased tax will still be paid on the profit earned but there will be no rented expense to set against this (increase in tax K11,200,000 x 0.3 = K3,360,000 each year for a reliable machine). However, instead of depreciation being charged each year a capital allowance may be set against profit. The government sets the capital allowance rates. The capital allowance rate in the scenario is 25% on a reducing balance basis and the table below shows how this would be applied to a reliable machine and the final net present value of the capital allowances.

Years 1 2 3

Year 1 K000 Purchase price 36,000 (9,000) 27,000 6,750 20,250 5062 15,188

2 K000 4,500 3,376 7,876

3 K000 4,500 3,376 2,532 5,908

4 K000

5 K000

2,532

63

4 (sale price) Residual value Tax @30%

1,200 13,988 1,350 2,362 6,994 9,526 1,772 6,994

Total NPV (K000): K1, 250 + K2, 024 + K1, 406 + K2, 100 + K1, 428) : K8, 208,000 Lease rental calculations are very similar to a discounted cash flow exercise as you could have seen it early in this chapter. Rental calculation assumptions for an example, which we will work, though are summarized below. In the illustration below the tax effect the extreme case of 100% in the first year allowance and 50% tax rate is used. Element 1.7 Cost-Benefit Analysis In many situations where senior managers of a business make decisions, the decisions made can either be structured or unstructured. Element 1.7.1.1 Structured and Unstructured Decisions In structured decisions managers use standard procedures in an outlined manner to deal with situations in a prescribed way. In unstructured decision-making, managers use the least pool of experience and intellect to make sound judgments, which are in the best interest of the company or organizations. Element 1.7.1.2 Goal Congruence And Decision Making All decisions which are made should be consistent with the corporate objectives. We should realize at this point that business managers are leading corporations which have been established with a view to making profits. Therefore, all decisions which the business managers make should be seen to be adding more value to the business ultimately in excess of the costs involved, than the costs involved in carrying them out.

64

Therefore, in whatever context we look at business decision making, business managers are going to consider the benefits against the cost of pursuing a given strategy before they embark on implementing that particular decision.

Element 1.7.1.3 Nature of Cost- Benefit Analysis As we have mentioned above, before a corporate strategy is implemented in a business, the managers will have need to carry out a rigorous cost benefit analysis. Therefore, a cost-benefit analysis will involve a comprehensive comparison of the net benefits expected to accrue to an organization by pursuing a chosen strategy against the costs which are to be incurred in pursuit of the strategy. Please note that the benefits and costs can be either quantitative and / or qualitative at the same time. However, as we mentioned earlier where, the qualitative costs and benefits might be more difficult to establish due to the grey nature of the qualitative consequences of our actions.

Element 1.7.1.4 Cost- Benefit Analysis Techniques There are a lot of techniques used to undertake cost benefit analyses. Some of the methods include the following: Element 1.7.1.5 Profitability/ Net Cash-Flow Typically and usually when carrying out a cost benefit analysis, most business list the financial and quantitative revenues which the business is likely to earn against the total costs likely to be incurred in the pursuing the strategy. Element 1.7.1.6 Scoring And Ranking Another commonly used technique for carrying out a cost-benefits analysis is by the use of scoring and ranking of several capital investments available to the business. Ranking and scoring is used both in situations where we are evaluating a single strategy or where we are evaluating multiple strategies so that we can eventually choose the best option out of them all.

65

Element 1.7.1.7 Mechanics of Scoring and Ranking In scoring, a corporation / decision maker will establish a scale which will act as a rating scale. This scale will give a worst and best rating on the scale.

Example: 0 1 2 3 4 5 6 7

You can choose 7 (seven) as the best score and choose 0 as the worst scenarios possible. Most importantly, the decision maker should list possible benefits and the likely costs to be incurred as a result pursuing a given strategy. Eventually the decision maker will total or aggregate the total scores for the benefits and for the costs separately and compare which one outweighs the other. Lets illustrate with a simple situation to show how ranking and scoring can be done. Assume that Chinsa Ltd has been experiencing low sales of its product, the Manex. As a result the entire management is concerned deeply and they have the following views; The marketing Director has suggested that the company should invest heavily in the marketing activities. However, the finance director is a bit sceptical concerning the likely benefits of this hefty expenditure on the marketing campaign. As a result, the CEO has requested you in your capacity as management accountant to carry out a comprehensive cost-benefit analysis. Suggested illustration STEP 1. Set and establish a rating scale or the purpose of this illustration assuming that 1 represents the worst situation and 5 represents the best scenario.

66

RATING SCALE

1 Worst

4 Best

STEP 2. List the likely benefits and costs of staging (mounting) up a massive marketing campaign. The likely benefits and costs would be the following: These are not exhaustive

Benefits - Good corporate image - Bigger client base - Increase profits

Costs - Huge financial outlay - Expected continued advertising

STEP 3. Assign weightings or ratings from the scale to each benefit and each cost

Benefits 1. Good corporate image 2. Bigger client base

Rating 3 4 2 9

3. Increase profits Total scores for benefits costs:

(i)

Huge financial outlay

67

(ii)

Expected continued advertising

4 8

Total scores for the costs:

STEP 4. Compare the total scores for benefits and the one for costs. Benefits Costs Difference 9 8 1

As can be seen above, the analysis and comparison show that the benefits of staging a massive campaign will gives Chinsa Ltd more of benefits than costs. So purely following the scoring and ranking we expect Chinsa Ltd to benefit greatly from the marketing campaign, and so the decision to invest in it should be upheld. This is only a simplistic approach. However, in practice so many factors are likely to be taken into consideration and the management accountant will need to be carryout the analysis with a great amount of help from marketing professionals and other business personal who may make work as researchers and general R&D employees with Chinsa Ltd. It should be noted that in the above exercise, the scores represent both the qualitative and quantitative benefits, which are associated to the various benefits and costs identified by the management accountant and his team.

Element 1.7.2 Post Project Completion Audit From the onset of the chapter we have only been looking at evaluation of projects, which is only a part of the investment process. To conclude the chapter, lets look at an equally important aspect of project evaluation and management. This is the aspect of Post-completion Audit.

68

The post completion audit of projects provide the mechanism whereby experience of past projects can be fed into the firms decision-making process as an aid to the improvement of further projects. Element 1.7.2.1 Benefits of Post Completion Auditing There are a number of benefits that stand out so clearly from a project post completion audit. The benefits can be classified in two main categories. Type 1 Those benefits that relate to the performance to the current project i.e. the project under review. Element 1.7.2.2 Mechanics of Post Completion Audit A post audit small team, typically professionals such as an engineer who had some involvement in the project, usually carries out completion audit. The post completion audit reviews all aspects of a completed project, to assess whether it lived up to initial expectations in term of revenues and costs and analyse the causes of deviations from planned results. Its main purpose is to enable the experiences, good or bad gained during the life of one project to be made available for the benefit of future projects. The audit is thus essentially a forward-looking one as it seeks to establish lessons from the past for the future benefit of the corporation. Type 2 The second and final category of benefits relates to the additional information concerning the choice and performance of future projects and the main benefits are given below.

It improves the quality of decision making by providing a mechanism whereby past experience can be made readily available to decision makers. It encourages greater realism in project appraisal by providing a mechanism where past inaccuracies in forecasts are made public. It highlights reasons for successful projects, which may be important in achieving greater benefits from future projects.

69

UNIT 2.0 PRICING THEORY

Learning Outcomes: At the end of this chapter candidate Should identify and discuss market situations which influence the pricing policy adopted by an organization Should explain and discuss the variations that influence demand of a product or service Should be able to calculate prices using full cost and marginal cost as the pricing base Should be able to compare the use of full costing pricing and marginal cost pricing as planning and decision making aids Should be able to appreciate the concept of transfer pricing and its mechanics.

Definition of price Organizations operating as businesses always produce or provide tangible products or intangible services for sales to customers in order for them to pursue their primary corporate objective of enhancing shareholders wealth. The products and services are sold at a price. Therefore price refers to the monetary amount which corporations sale their chosen units of products/services. Influences on Price There are so many variations that dictate the price at which given commodities or services can be sold at.

70

The following are the main factors that influence price of services or products.

(a)

Quality

This is an aspect of price perception. In the absence of other information, customers tend to judge quality by price. Thus a price rise may indicate improvements in quality, a price reduction may signal reduced quality. (b) Existence of intermediaries

If an organization distributes products or services to the market through independent intermediaries, such intermediaries are likely to deal with a range of suppliers and their aims concern their own profits rather than those of suppliers. (c) Competitor Activities

In the same industries, pricing moves in unison. In others, price changes by one supplier may initiate a price war. Competition is discussed in more detail below. (d) Inflation

In periods of inflation the organization may need to change prices to reflect increases in the prices of supplies, labour, rent and so on. Traditional Pricing Bases The two main traditional methods of pricing one (i) (ii) full-cost pricing marginal cost pricing

Element 2.1 Cost plus Pricing With full cost pricing, the sales price is determined by calculating the full cost of the product and then adding a percentage mark-up for profit, so this ensures that all costs are covered. The full cost pricing is useful if prices have to be justified to customers.

71

On the other side, the full cost pricing method takes no account of the market or demand conditions. It may also require arbitrary decisions about absorption of costs. The cost accountants may also have problems in determining the accurate profit mark-ups.

Element 2.2 Marginal Pricing With marginal cost pricing, a profit margin is added on to either the marginal cost of production or the marginal cost of sales. This is sometimes called mark-up pricing. It draws management attention to contribution, and the effects of higher or lower sales volumes on profit. In this way, it helps to create a better awareness of the concepts and implications of marginal costing and cost-volume profit analysis. The marginal cost pricing is convenient if there is a readily identifiable variable cost e.g. in retail businesses. However, again it takes no account of market or demand conditions. In practice as you already know, pricing decisions cannot ignore fixed costs in the long term. Example 1 Muti Ltd has begun to produce a new product, product X, for which the following cost estimates have been. K Direct materials 27,000 Direct labour: 4 hours at K5,000 per hour Variable production overheads Machining, 2 hour at K6,000 per hour 20,000 3,000 50,000

72

Production fixed overheads are budgeted at K300, 000 per month and because of the shortage of available machining capacity, the company will be restricted to 10,000 hours of machine time per month. The absorption rate will be a direct labour rate, however, and budgeted direct labour hours are 25,000 per month. It is estimated that the company could obtain a minimum contribution of K10,000 per machine hour on producing items other than product X. The Direct Cost estimates are not certain as to material usage rates and direct labour productivity, and it is recognized that the estimates of direct materials and direct labour costs may be subject to an error of + 15%. Machine time estimates are similarly subject to an error of + 10%. The company wishes to make a profit of 20% of full production cost from product X. What should the full cost based price be? The following solutions have been developed based on four (4) assumptions. (a) Exclude machine time opportunity costs: Ignore possible costing errors Direct materials Direct labour (4 hours) Variable production overheads Fixed production Overhead (K300,000,000 = K12,000 per 25,000 48,000 direct labour hour Full production cost 98,000 Profit mark-up (20%) 19,600 Selling price per unit of product X 117,600 K 27,000 20,000 3,000

73

(b)

Include machine time opportunity costs: Ignore possible costing errors. Full production cost is in (a) Opportunity cost of machine time (Contribution forgone (hr x K10,000) Adjusted full cost Profit mark-up (20%) K 98,000 5,000 103,000 20,600 123,600

(c)

Exclude machine time opportunity costs but make full allowance for possible under-estimates of costs. Direct materials Direct labour Possible error (15%) Variable production Overheads Fixed production Overheads (4 hrs x K12,000) Possible error (labour time) (15%) Potential full production cost Profit mark-up (20%) K 27,000 20,000 47,000 7,050 54,050 3,000 3,000 48,000 72,000 55,200 112,550 22,510 135,060 K

74

(d)

Include machine time opportunity costs and make a full allowance for possible under-estimates of cost. K Potential full production cost as in (c) Opportunity cost of machine time (Potential contribution forgone) (hr x K10,000 x 110%) 112,550

5,500 23,610

Profit mark-up (20%) Selling price per unit of product X

141,660

Element 2.2.1 Full Cost Versus Marginal Cost Pricing The most important and common criticism of full cost pricing is that it fails to recognize that since sale demand may be determined by sales price, there will be a profit maximization combination of price and demand. A full cost based approach to pricing will be most unlikely, except by coincidence or luck to arrive at the profit-maximising price. In contrast a marginal costing approach to looking at costs and prices would be more likely to help with identifying a profitmaximising price. Example 2 Luangwa Ltd has budgeted to make 50,000 units of its product, the Luan. The variable cost of a Luan is K5,000 and annual fixed costs are expected to be K150,000,000. The Finance Director of Luangwa Ltd suggested that a profit margin of 25% on full cost should be charged for every product sold. The Marketing Director has challenged the wisdom of this suggestion, and has produced the following estimates of sales demand for the Luan. Price per unit K 9,000 Demand Units 42,000

75

10,000 11,000 12,000 13,000 Required (a) (b)

38,000 35,000 32,000 27,000

Calculate the profit for the year if a full cost price is charged. Calculate the profit-maximising price. Assume in both (a) and (b) that 50,000 units of the Luan are produced regardless of sales volume.

Solution (a) (i) The full cost per unit is K5,000 variable cost plus K150,000,000 = K3,000\unit 50,000 units hence i.e. K8,000 (K5,000 + K3,000) in total. A 25% mark-up on this cost gives a selling price of K10,000 per unit so that sales demand would be 38,000 units. (production is given as 50,000 units). (i) Profit (absorption costing) K 000 Sales Costs of production (50,000 units) Variable (50,000 x K5,000) 250,000 Fixed (50,000 x K3,000) 150,000 400,000 Less increase in stocks (12,000 units x 8) (96,000) K000 380,000

76

Cost of sales Profit (ii)

304,000 76,000

Profit using marginal costing instead of absorption costing so that fixed overhead costs are written off in the period they occur, it would be as follows (the 38,000 unit demand level is chosen for comparison purposes). K Contribution (38,000 x K(10,000 5,000)190,000 Fixed costs Profit 150,000 40,000

Since the company go on indefinitely producing an output volume in excess of sales volume, this profit figure is more indicate of the profitability of the Luan in the longer term. (b) A profit-maximising price is one which gives the greatest net (relevant) cash flow, which in this case is the contribution-maximising price.

Price K 9,000 10,000 11,000 12,000 13,000

Unit Contribution K 4,000 5,000 6,000 7,000 8,000

Demand units 42,000 38,000 35,000 32,000 27,000

Amount K 168,000 190,000 210,000 224,000 216,000

The profit maximizing price is K12,000 with annual sales demand of 32,000 units. This example shows that a cost based price is unlikely to be the profit maximizing price, and that a marginal costing approach, calculating the total contribution at a variety of different selling prices, will be more helpful for establishing what the profit maximizing price ought to be.

77

Element 2.2.2 Activity Based Pricing (ABP) Activity based costing provides an opportunity for organizations that use costbased pricing to gain a greater understanding of their costs and so correct pricing anomalies that derive from the distorted view given by conventional volume-related costing. As you already know, under the ABC approach, overheads are allocated to products on the basis of the activities that caused them to be incurred, rather than according to some arbitrary base like labour hours. The implication for pricing is that the full cost on which prices are based may be radically different if ABC is used. Example 3 ABP Ltd makes two products, X and Y with the following cost patterns. Product X K 27,000 20,000 Product Y K 24,000 25,000

Direct materials Direct labour at K5,000/hr Variable production Overheads at K6,000 Per hour

3,000 50,000

6,000 55,000

Production fixed overheads total K300,000,000 per month and these are absorbed on the basis of direct labour hours. Budgeted direct labour hours are 25,000 hours per month. However, the company has carried out an analysis of its production support activities and found that its fixed costs actually vary in accordance with non volume-related factors. Product Cost Activity 000 Set-ups 40,000 Material 150,000 Production runs 30 20 Production runs 30 20 Cost driver X Y K Product Total

78

Inspection 110,000 300,000

Inspections

880

3,520

Budgeted production is 1,250 units of product X and 4000 units of product Y. Required: Given that the company wished to make a profit of 20% on full production cost, calculate the prices that should be charged for products X and Y using the following. (a) (b) Full cost pricing Activity based cost pricing

Solution (a) The full cost and mark-up will be calculated as follows: Product X K Variable costs 50,000 Product Y K 55,000

Fixed production Overheads *K300,000,000\25,000 = 12,000\hr) 48,000 98,000 Profit mark-up (20%) Selling price (b) 19,600 117,600

60,000 115,000 23,000 138,000

Using activity based costing, overheads will be allocated on the basis of cost drivers. Product X K 000 Product Y K 000 Total K000

79

Set ups (30:20) Material Handling (30:20) Inspections (880:3,520)

24,000 90,000 22,000 136,000

16,000 60,000 88,000 164,000 4,000 K41,000

40,000 150,000 110,000 300,000

Budgeted units Overhead cost per unit

1,250 K108,800

Therefore the price then calculated as before Product X K Variable costs 50,000 Production overhead 108,800 158,800 Profit mark-up (20%) 31,760 190,560 (c) Commentary Product X K 55,000 41,000 96,000 19,200 115,200

The results in (b) are radically different from those in (a). On this basis it appears that the company has previously been making a huge loss on every unit of product X sold for K117,600. If the market will not accept a price increase, it may be worth considering leasing production of product X entirely. It also appears that there is scope for a reduction in the price of product Y and this would certainly be worthwhile if demand for the product is elastic.

Element 2.3 Target Pricing Target costing is a pro-active cost control system. The target cost is calculated by deducting the target profit from a predetermined selling price based on customers views. Techniques such as value analysis are used to change production methods and or reduce expected costs so that the target is met. Target cost is an estimate of a product cost which is derived by subtracting a desired profit margin from a competitive market price.

80

Target cost management has been defined as a system that is effective in managing costs in new product design and development stages. It has also been viewed as allowing the production cost of a proposed product to be identified so that when sold it generates the desired profit level. Target cost management has also been viewed as playing a useful role in enabling an enterprise to set and support the attainment of cost levels to effectively reflect its planned financial performance. What appears to be evident is that there are almost as many misconceptions of target costing as there are companies deploying the approach and there are probably many companies engaging in various aspects of target cost management without referring to the term. Element 2.3.1 Managerial Thinking to Support Target Costing and Pricing Target costing requires managers to change the way they think about the relationship between cost, price and profit. (a) The traditional approach is to develop a product, determine the expected standard production cost of that product and then set a selling price\probably based on cost) with a resulting profit or loss. Costs are controlled through variance analysis at monthly intervals. The target costing approach is to develop a product concept and the primary specifications for performance and design and then to determine the price customers would be willing to pay for that concept.

(b)

The desired profit margin is deducted from the price leaving a figure that represents total cost. This is the target cost and the product cost and the product must be capable of being produced for this amount otherwise the product will not be manufactured. During the products life the target cost will constantly be reduced so that the price can fall. Continuous cost reduction techniques must therefore be employed. The Target Costing Process Step 1

81

Analyse the internal environment to ascertain what customers require and what competitors are producing. Determine the product concept, the price customers will be willing to pay and thus the target cost. Step 2 Split the total target cost into broad cost categories such as development, marketing, manufacturing and so on. Split up the manufacturing target cost per unit across the different functional areas of the product. Design the product so that each functional product area can be made within the target cost. If a functional product area cannot be made within the target costs, then a cost gap exists between the currently achievable cost and the target for the other areas must be reduced, or the product redesigned or scrapped. The product should be developed in an atmosphere of continuous improvement using value engineering techniques and close collaboration with suppliers, to enhance the product (in terms of service, quality, durability and so on) and reduce costs. Step 3 Once it is decided that it is feasible to meet the total target costs, detailed cost sheets will be prepared and processes formalized. Final Commentary on Target Pricing Target pricing therefore will involve pegging a pricing for a product or service which will well cover the targeted cost of manufacturing a product or providing a service. Element 2.4 Life Cycle Pricing Life cycle costing assists in the planning and control of a products life cycle by monitoring spending and commitments to spend during a products life cycle. Life cycle costs are incurred for products and services from their design stage through development to market launch production and sales, and their eventual withdrawal from the market. Traditional management accounting systems in general only report costs at the physical production stage of the life cycle and do not accumulate costs over the entire life cycle. They assess a products or projects profitability on a periodic basis. Life cycle costing, on the other hand, considers a products\projects entire life.

82

Life cycle costing tracks and accumulates actual costs and removes attributable costs to each product or project over the entire product\project life cycle. The total profitability of any given products\project can therefore be determined. Traditional management accounting systems usually total all non-production costs and record them as a period expense. Using life cycle costing, such costs are traced to individual products over complete life cycles. (a) The total of these costs for each individual product can therefore be reported and compared with revenues generated in the future. (b) The visibility of such costs is increased. (c) Individual product profitability can be more fully understood by attributing all costs to products. (d) As a consequence, more accurate feedback information is available on the organisations success or failure in developing products. In todays competitive environment were the ability to produce new and updated versions of products is paramount to the survival of an organization, this information is vital. The strong force which supports life cycle costing is that generally for organizations operating within the manufacturing technology environment, its found that approximately 90% of a products life cycle cost is determined by decisions made early within the cycle at the design stage. Life cycle costing is therefore particularly suited to such organizations and products, monitoring spending and commitments to spend during the early stages of a products life cycle. Life cycle pricing therefore involves pricing a product at a rate which covers the costs which are anticipated over the entire life cycle of the product in question. Remember the product life cycle you learnt in management. Illustration of product life cycle

Sales revenue

83

introduction

growth

maturity

decline

sales

Time Element 2.5 Other Pricing Methods Element 2.5.1 Order Pricing A special order is a one-off revenue earning opportunity. These may arise in the following situations. (i) When a business has a regular source of income but also has some spare capacity allowing it to take on extra work if demanded. For example Nkwazi Breweries might have a capacity of 500,000 barrels per month but only producing and selling 300,000 barrels per month. It could therefore consider special orders to use up some of its spare capacity. (ii) When a business has no regular source of income and relies exclusively on its ability to respond to demand.

A building firm is a typical example as are many types of subcontractors. In the case of (i) pricing for special orders need therefore take account of unavoidable fixed cost because any firm like in the case of (i) is not attempting to cover its longer-term running costs in its prices for its regular product or services. However, in the case of (ii) where the special order is the only source of income, all costs incidental to the special order and the fixed unavoidable cost should be incorporated in the special order pricing.

84

Element 2.5.2 Minimum Pricing A minimum price is that which would have to be charged so as to cover the following two groups of cost. (i) (ii) The incremental costs of producing and selling the product/service. The opportunity costs of the resources consumed in making and selling the product/service.

A minimum price would leave the business no better or worse off than if it did not sell the item. Two important points to understand here about a minimum price are as below: (a) It is based on relevant costs Relevant costs are incremental costs plus the opportunity costs of making and selling the product or providing a service. (b) It is unlikely that a minimum price would actually be charged because if it were it would not provide the business with any incremental profit.

If there are no scarce resources, and a company has spare capacity, the minimum price of a product would be an amount which equals the incremental cost of making it. If there are scarce resources and a company makes more than one product, minimum peeves would include an allowance for the opportunity cost of using the scarce resources to make and sell the product.

Element 2.5.3 Market Penetration Pricing Penetration pricing is a policy of low prices when a product is first launched in order to obtain sufficient penetration in to the market. A penetration policy may be ideal in the following cases: (a) When the firm wishes to discourage new entrants into the market.

85

(b)

When the firm wishes to shorten the initial period of the products life cycle in order to enter the growth and maturity stages as quickly as possible. When demand is highly elastic and so would respond well to low prices. When there are significant economies of scale to be achieved from a high volume of output.

(c) (d)

Element 2.5.4 Market Skimming Pricing Price skimming involves charging high prices when a product is first launched in order to maximize short term profitability. Initially there is heavy spending on advertising and sales promotion to obtain sales. As the product moves into the later stages of its life cycle, progressively lower prices are charged. The profitable cream is thus skimmed off in the early stages until sales can only be sustained at lower prices. The aim of market skimming prices is to gain high unit profits early in the products life. High unit prices makes it more likely that competitors will enter the market, that is if lower prices were to be charged. So market skimming pricing would be appropriate in the following cases. (a) (b) (c) When the product is new and different, so that customers are prepared to pay high prices so as to be one up on other people who do not own it. When high prices in the early stages of a products life might generate high initial cash flows. A firm with liquidity problems may prefer market-skimming for this reason. Where products may have a short-life cycle, and so need to recover their development costs and make a profit relatively quickly. Examples of products to which market skimming pricing policy could be applied would include latest versions of products such as (i) (ii) (iii) Calculator Video recorders Desktop computers and other technology based products.

Element 2.5.5 Differential Pricing The use of differential pricing means that the same product can be sold at different prices to different customers.

86

This can be very difficult to implement in practice because it relies for success, on the continued existence of certain market conditions. We can exercise differential pricing on the following cases: (i) (ii) (iii) By market segment e.g. services such as cinemas and hair dressing are often available at lower prices to juveniles and old age pensioners. By product version e.g. many car models have Add on extras which enable one brand to appeal to a wider cross-section of customers. By place e.g. theatre seats are usually sold according to their location so that patrons pay different prices for the same performance according to the seat type they occupy. By time e.g. this is perhaps the most popular type of differentiating pricing.

(iv)

E.g. Celtel charges less for its air time or credit in off peak period and vice versa. Price differentiation can only successfully be implemented if the market can be well segmented and there is little chance of arbitrage or chance of a black market developing (which would allow those in the lower priced segment or bracket resale to those in the higher priced segment or bracket). Example: Transferring Goods at market price A company has two profit centres; A and B. Centre A sells half of its output on the open market and transfers the other half to B. Costs and external revenues in a period are as follows. A K000 8,000 12,000 B K000 24,000 10,000 Total K000 32,000 22,000 10,000

External sales Costs of production Company profit Required;

What are the consequences of setting a transfer price at market price? If the transfer price is at market price, A would be happy to sell the output to B for K8, 000, 000, which is what A would get by selling it externally.

87

A K000 K000 Market sells Transfer sales Transfer costs Own costs _____ Profit The consequences, therefore, are as follows; (a) 12,000

K000 8,000 8,000 16,000 8,000 10,000 12,000 4,000

B K000 24,000

Total K000

32,000 24,000 22,000 18,000 6,000 10,000

A earns the same profit on transfers as on external sales. B must pay a commercial price for transferred goods.

(b) A will be indifferent about selling externally or transferring goods to B because the profit is the same on both types of transaction. B can therefore ask for and obtain as many units as it wants from A. Element 2.5.6 Adjusted Market Price Internal transfers in practice are often cheaper than external sales, with savings in selling and administration costs, bad debt risks and possibly transported/delivery costs. It would seem reasonable for the buying division to expect a discount on the external market price. If profit centres are established, however, and unit variable costs and sales price are constant, there are two possibilities. (a) Where the supplying division has spare capacity the ideal transfer price will simply be the standard variable cost of production. (b) When there is a scarce production resource, the ideal transfer price will be the variable cost of production plus the contribution forgone by using the scarce resource instead of putting it to its most profitable alternative use.

Element 2.5.7 Cost-based approaches to transfer pricing Cost-based approaches to transfer pricing are often used in practice, because there is often no external market for the product that is being transferred or because, although there is an external market, it is an imperfect one because there is only limited external demand.

88

Transfer prices based on full cost Under this approach the full standard cost (including fixed overheads absorbed) that is incurred by the supplying division in making the product is charged to the receiving division. If a full cost plus approach is used, a profit margin is also included in this transfer price. A company has 2 profit centers, A and B. Centre A can only sell half of its maximum output externally because of limited demand. It transfers the other half of its output to B which also faces limited demand. Costs and revenues in a period are as follows.

External sales Costs of production in the division (Loss)/Profit

A K000 8,000 12,000 (4,000)

B K000 24,000 10,000 14,000

Total K000 32,000 22,000 10,000

If the transfer price is at full cost, A in our example would have sales to B of K6,000,000 (ie half of its total costs of production). This would be a cost to B, as follows. A K000 Open market sales Transfer sales Total sales, inc Transfers Transfer costs Own costs Total costs, inc Transfers _____ Profit 10,000 K000 K000 8,000 6,000 14,000 12,000 12,000 2,000 6,000 10,000 16,000 8,000 B K000 24,000 24,000

The transfer sales of A are self-cancelling with the transfer costs of B so that total profits are unaffected. The transfer price simply spreads the total profit of K10,000,000 between A and B. Division A makes no profit on its work and using this method, would prefer to sell its output on the open market if it could.

89

Transfer prices based on full cost plus If the transfers are at cost plus a margin of, say, 25%, As sales to B would be K7,500,000. A K000 Open market sales Transfer sales Transfer costs Own costs _____ Profit 3,500 6,500 Compared to a transfer price at cost, A gains some profit at the expense of B. However, A makes a bigger profit on external sales in this case because the profit mark-up of 25% is less than the profit mark-up on open market sales, which is (K8,000,000 K6,000,000)/ K6,000,000 = 33%. The transfer price does not give A fair revenue or charge B a reasonable cost, and so their profit performance is distorted. It would seem to give A an incentive to sell more goods externally and transfer less to B. This may or may not be in the best interests of the company as a whole. Division As total costs of K12,000,000 will include an element of fixed costs. Half of division As total costs are transferred to division B. However from the point of view of division B the cost is entirely variable. Suppose that the cost per unit to A is K15,000 and that this includes a fixed element of K6,000, while division Bs own costs are K25,000 per unit, including a fixed element of K10,000. The total variable cost is really K9,000 + K15,000 = K24,000 but from division Bs point of view the variable cost is K15,000 + K15,000 = K30,000. This means that division B will be unwilling to sell the final product for less than K30,000 whereas any price above K24,000 would make a contribution. Element 2.6 Changes in price levels Element 2.6.1 : Changes in price levels are a common scenario in the operations of a company. The change in the price levels may be due to external or internal factors. A price change may be necessitated by a general increase in the cost of production or high levels of demand for the companys products or services. 12,000 12,000 K000 8,000 7,500 15,500 B K000 K000 24,000 24,000 22,000 17,500

7,500 10,000

90

It is important to relate the price changes to both production costs and selling price of the product or service. Element 2.6.2 A price change can also arise when a company is introducing a new product as it is common for a number of prices to be considered. Since price level changes represent decisionmaking under conditions of risk and uncertainty, it is important to analyse the expected outcome for each price level. Any price change is bound to affect the demand and therefore the variable costs giving varying possible outcomes.

Element 2.6.3

Example Mwine manufacturing company has come up with a new soap product, Buta detergent. From the preliminary studies the following analysis has been made; Selling price K 8,500 Demand Probability 0.6 0.1 0.3 Selling price K 10,000 Demand 50,000 20,000 30,000

Outcomes Probability Probable 40,000 0.1 Less Probable 30,000 0.5 Most Probable 60,000 0.4

Element 2.6.4

Outcomes At Selling Price K 8,500

Demand 40,000 80,000,000 90,000,000 30,000 60,000,000 50,000,000 10,000,000 700,000 50,000,000 30,000,000 50,000,000 40,000,000 12,600,000 1,200,000 Contribution Fixed Cost 120,000,000 50,000,000 Net Price Expected Value 70,000,000 12,600,000

91

180,000,000 50,000,000 130,000,000 60,000 120,000,000 50,000,000 70,000,000

11,700,000 14,700,000 53,500,000

At Selling Price K 10,000

Demand 50,000 175,000,000 90,000,000 20,000 70,000,000 135,000,000 30,000 105,000,000 50,000,000 55,000,000 15,400,000 52,600,000 50,000,000 50,000,000 20,000,000 7,000,000 85,000,000 10,200,000 50,000,000 50,000,000 125,000,000 40,000,000 8,750,000 6,000,000 Contribution 225,000,000 Fixed Cost 50,000,000 Net Price Expected Value 175,000,000 5,250,000

Element 2.6.5

From the outcome it is evident that chosing the selling price of K 8500 gives a higher expected value, even though the difference is not so significant. In practice however other factors may be considered. Furthermore it will not be an easy task to come up with an accurate estimate of future demand and the probable outcomes.

Element 2.7 Transfer Pricing Theory This is the price at which goods and services are transferred between different units of the same company. If those business units are located within different countries, the term international transfer pricing is used.

92

Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the measurement of divisional performance or discouraging overall corporate maximization. The management accountant therefore has to devise a transfer pricing method that meets the following criteria: Equity (provides a fair measure of divisional performance) Neutrality (avoids the distortion of business decision making) Administrative simplicity

The transfer price should provide an artificial selling price that enables the transferring division to earn a return for its efforts and the receiving division to incur a cost for benefits received, and should be set at a level that enables profit centers to be measured commercially. This means that the transfer price should be a fair commercial price. Transfer pricing with a constant unit variable costs and sales price: An ideal transfer price should reflect the opportunity cost. Where a perfect external market exists and unit variable costs and sales are constant, the opportunity cost f transfer will be one or other of the following External market price External market price less savings in selling costs.

Example A company has two profit centers, A and B. Center A sells half of its output on the open market and transfers half to B. Costs and external revenues in a period are as follows. A K External sales Costs of production Company profits Required 8,000,000 12,000,000 B K 24,000,000 10,000,000 Total K 32,000,000 (22,000,000) 10,000,000

93

What are the consequences of setting a transfer price at the market price? Transfer prices based on variable cost A variable cost approach entails charging the variable cost that has been incurred by the supplying division to the receiving division. As above, we shall suppose that As cost per unit is K15,000, of which K6,000 is fixed and K9,000 variable.

A K000 Market sales Transfer sales at variable cost (9,000 /15,000 x 6,000) Transfer costs Own variable costs Own fixed costs Total costs and transfers (Loss)/Profit K000 8,000 3,600 11,600 7,200 4,800 12,000 (400) 3,600 6,000 4,000 K000

B K000 24,000 24,000

13,600 10,400

The problem is that with a transfer price at variable cost the supplying division does not cover its fixed costs. Element 2.7.1 Transfer prices based on opportunity costs It has been suggested that transfer prices can be set using the following rule. Transfer price per unit = standard variable cost in the producing division plus the opportunity cost to the organization of supplying the unit internally. The opportunity cost will be one of the following. (a) (b) (a) The maximum contribution foregone by the supplying division in transferring internally rather than selling externally The contribution foregone by not using the same facilities in the producing division for their next best alternative use If there is no external market for the item being transferred, and no alternative uses for the divisions facilities, the transfer price = standard variable cost of production

94

(b)

If there is an external market for the item being transferred and no alternative use for the facilities, the transfer price = the market price.

Element 2.7.2 Transfer pricing when unit variable costs and sales prices are not constant When unit variable costs and/or unit selling prices are not constant there will be a profit-maximising level of output and the ideal transfer price will only be found by careful analysis and sensible negotiation. (a) The starting point should be to establish the output and sales quantities that will optimise the profits of the company or group as a whole. The next step is to establish the transfer price at which both profit centers, the supply division and the buying division, would maximize their profits at this company-optimising output level. There may be a range of prices within which both profit centers can agree on the output level that would maximize their individual profits and the profits of the company as a whole. Any price within the range would then be ideal.

(b)

(c)

Element 2.7.3 Problems in transfer pricing (a) If transfer prices are set at full cost, the transferring division makes no profit. (b) If full cost plus is used the problem is how to set the margin at a level that all parties perceive as being fair. (c) If variable cost is used the transferring division does not cover its fixed costs but two-part prices (the variable cost transfer price plus a fixed annual fee) might be used to overcome this. (d) Transfer prices based on standard cost are fairer than transfer prices based on actual costs because if actual costs are used the transferring division has no incentive to control its costs: it can pass on its inefficiencies to the receiving division. (e) On the other hand, standards may become out of date so it is advisable to have an agreement to revise them periodically.

95

Element 2.7.4 Negotiated transfer prices When authority is decentralized to the extent that divisional managers negotiate to transfer prices with each other, the agreed price may be finalized from a mixture of accounting arithmetic, politics and compromise. Inter-departmental disputes about transfer prices are likely to arise and these may need the intervention of head office to settle the problem. (a) Head office imposition. Head office management may impose a price that maximizes the profit of the company as a whole. (b) On the other hand, head office management might restrict its intervention to the task of keeping negotiations in progress until a transfer price is eventually settled. Where negotiation is necessary there should be an understanding of the risk/return profile. Tomkins suggests the following methodology, which head office can apply when mediating in disputes. (a) Identifying the outer bounds of the transfer price. In other words, at what transfer price does the buying division end up earning the entire group profit, and at what transfer price does the selling division earn the entire group profit? (b) Variability. At each transfer price, compare each divisions expected profits and the variability of the profits. (c) Incorporate risk attitudes in a fair transfer price, so that the profit-share between divisions takes the riskiness of the project into consideration.

Element 2.7.5 International transfer prices When firms transfer goods and services not only internally, but also internationally, the transfer price mechanism allows them to move value from one country to another without actually engaging in trade. Bearing in mind the difficulty discussed above of establishing the level at which a transfer price should be set, we may say that a low price effectively moves value into the receiving country, while a high one moves it into the transferring country.

Element 2.7.6 Using transfer prices

96

This ability to decide in which country value (and particularly profit) is created is extremely useful. (a) It can be used to manage taxation; (i) (ii) (iii) (b) (c) Profit can be minimized in states with high profit taxes Selling prices can be minimized in states with high levels of irrecoverable VAT (and similar taxes) The value imported into countries with high tariff levels can be minimized

It can be used to move profits to the home country from states with restrictions on repatriation of profits or on currency exchange. It can be used strategically (i) (ii) It can disguise the attractiveness of an operation to competitors by reducing profits. It can enable a low-price strategy aimed at driving out competition without arousing the suspicions of the local tax authorities by declaring a very low level of profit. However, this course of action is likely to lead to accusations of dumping.

Element 2.7.7 Centrally determined transfer prices and strategy These considerations produce pressure for multinational companies to set their transfer prices centrally. There are, however, other important strategic considerations relating to this approach. (a) Autonomy. Centrally determined transfer prices can seriously affect the ability of national managers to influence the performance of their divisions. This can affect their overall motivation, encourage them to seek ways around the restrictions imposed and make it more difficult to assess their overall performance. Transaction cost economics. Transaction cost theory is dealt with in Paper 5 but it is also relevant to Paper 6. In terms of transaction cost economics, a centrally determined, non-market based transfer price makes an implicit assumption that the hierarchy solution is the best one. However, there may not have been any actual consideration of the market alternative. A resource or competence based approach to strategy would immediately challenge this and call for detailed consideration of the benefit of a market based

(b)

97

approach. The crucial question is whether the business should actually be operating any given national subsidiary at all, whether its services should be bought in. Element 2.7.8 The Eccles matrix R J Eccles suggests that the method of setting transfer prices should reflect the organisations degree of diversification and its degree of vertical integration. Where both diversification and integration are low, as, for example, in the relationship between two shops in a retail chain, a transfer price may not even be required, but if it is, it can be set collaboratively. (b) Where diversification is low, but vertical integration is high, as in the relationship between two different stages of product assembly, cooperation is important, so the transfer price should be negotiated: it should probably be set at full cost so that resource allocation is appropriate and the supplying divisions costs are covered. (c) Where diversification is high and integration is low, as in the now unfashionable diversified conglomerate, transfers are likely to be uncommon and should be at market price, as is the rest of each subsidiarys trade. Nevertheless, where diversification and integration are both high, as may be the case when there is extensive trade along a supply chain combined with similarly extensive market-based exchanges, once again, the transfer price should be set collaboratively. (a)

98

STUDY UNIT 3.0 COST ANALYSIS

AIMS AND OBJECTIVES This chapter is concerned with the behaviour and reduction of costs in both traditional and advanced manufacturing environments. It brings together the following syllabus and syllabus related elements: the learning curve in theory and practice; the experience curve; traditional cost-reduction methods; focused cost-reduction programmes; value-added and non-value-added activities; zero-base budgeting systems (PPBS); value analysis (VA); value engineering (VE); functional analysis; target costs and costing; cost tables; life cycle costing; life cycle budgeting.

INTRODUCTION The well-known economists short-and long-run cost curves are illustrated in Figure 3.1.

99

Figure 3.1: Short-run and long-run cost curves As can be seen from the graphs, these curves show a general tendency for costs to decline as the volume of output increases. The long-run average cost curve reflects changes in plant capacity and processes; the short-run average cost curve reflects the change in unit production cost that arises through the operation of a given set of production factors over a limited range of outputs. Thus the short-run curves show that costs may increase in the short term, as excessive demands are placed on a particular plant, illustrating the economists law of diminishing marginal returns in respect of short-run costs. These increases can be avoided by moving onto the long-run curves by increasing capacity through a further investment in fixed assets, which enables a firm to continue to benefit from reducing unit cost as total output increases. Assuming the time scale allows investment, it is a firmly-established tenet of economics that unit cost will decline as output increases. The reasons for this decline, generally referred to, as economics of scale, will be familiar from stage 1 Economical Environment. The economists diagram is a static representation of costs, given a particular set of materials, technologies etc. It is accepted in economics that not all firms will enjoy the same level of success in actually attaining the minimum cost levels possible for a particular negotiate bulk discounts with suppliers, but firms can experience differing levels of success in such negotiations. A skilful negotiator is in a position to obtain a cost advantage for his company if competitors employ less adept buyers. Similarly, the economists cost curves are premised on the use of the most cost effective production processes and materials. A company which identifies the availability of and successfully implements or uses, a new cost effective production process or material will thus gain a cost advantage over its competitors. This advantage will only be temporary if the competitors quickly follow suit, but may be permanent if it allows the innovator to cut prices and gain market share at the expense of slower moving competitors, who may be driven out of business as a result. It will always be beneficial for a firm to be able to produce goods at a lower cost than the competition and firms will therefore strive constantly to achieve cost reduction. The CIMA Terminology defines cost reduction as: the reduction in unit cost of goods or services without impairing suitability for the use intended. As the above cost curves indicate, a reduction in unit cost can be achieved simply by increasing the volume of production. In the present context, it is more appropriate to think of cost reduction as the reduction in unit cost at all levels of output, i.e. to view it as an attempt to move the long-run average cost curve down and back towards the origin. In reality, many firms have a less than

100

precise understanding of the detailed cost curves relating to their industry. Nevertheless, they will usually have an understanding and a bench-mark against which to measure their success in cost reduction. If companies are able to reduce total cost, whilst maintaining current output, cost reduction will certainly have been achieved. If output is increased, but there is also an increase in cost, the position is less clear. If the increase is proportionally greater than the increase in cost and assuming that functionality of the product has been maintained, cost reduction in terms of the terminology definition will have taken place. However, this may not reflect a great achievement on the party of the company: the cost reduction may simply have arisen as an inevitable consequence of the economies of scale, which the increased production has facilitated. If an expanding company is to make genuine achievements in the area of cost reduction, in the sense outlined above, it may be able to distinguish between those saving which occur merely as a consequence of increased volume, and those which arise through management action. Management needs to be aware of both types of savings in view of the importance for budgeting and decision making of a clear understanding of how costs will vary with changing output level. One of the economies of scale enjoyed by firms as output increases may be attributable to the learning curve. This phenomenon, known as the cost reduction curve, is discussed in the following THE LEARNING CURVE
THE NATURE OF THE LEARNING CURVE

According to learning curve: The mathematical expression of the phenomenon that, when complex and labour-intensive procedures are repeated, unit labour times tend to decrease at a constant rate. The learning curve models mathematically this reduction in unit production time. The recognition of the so-called learning curve phenomenon stems from the experience of aircraft manufacturers, such as Boeing, during World War II. They observed that the time taken to assemble an individual aircraft declined as the number of aircrafts assembled: as workers gained experience of the process, their proficiency, and hence speed of working increased. The learning gained on the assembly of one plane was translated into the faster assembly of the next. (This is phenomenon to which any reader who has never put together a number of flat-pack items of furniture will readily relate). The actual time taken by the assembly workers was monitored, as it was discovered that the rate at which the learning took place was not random, but was rather predictable. It was found

101

that cumulative average time per unit decreased by a fixed percentage each time the cumulative production doubled. In the aircraft industry, the percentage by which the cumulative average time per unit declined was typicality 80percent. For other industries, other rates may be appropriate. Further, the unit of measurement may sensibly be taken as a batch of product, rather than as an individual unit. This does not, of course, affect the underlying principle. Let us take as an example a learning rate of 90percent. In this case, if the first batch of a product is produced in 100 hours, the cumulative average time taken to produce two batches (a doubling of the cumulative production) would be 90 hours giving a total production time of 20 x 90 = 180 hours. The actual time taken to produce the second batch (the batch being the unit of measure in this case) will thus be 80 hours the cumulative total time taken to produce two batches 80 hours less the time taken to produce the first batch-100 hours. As a doubling of cumulative production is required, in order to observe the benefit of learning in the form of reduced average labour hours per unit of cumulative production, it will be appreciated that the effect of the learning rates on labour time will become much less significant as production increases. The figure below shows this. FIGURE 3.2: CUMULATIVE DATA GRAPHS Cumulative data graph Log of cum. average time per batch, hours

Log of no. of batches (or units) In constructing table 1, it was assumed that we already knew the learning rate, which applied to this particular situation. However, it must be appreciated that, in the real world, this rate can only be established by observation. Records must be kept of the number of units/batches produced and the associated time taken, in order to construct the equivalent of Table 1 (although it is likely that fewer observations would actually be taken). It is then the job of the engineer or accountant to deduce the learning rate from these observations, which will

102

require the specification of an equation to fit the data. For example, the observation in Table 1 is plotted in Figure 3.2, and can be described by the equation: Yx = aXb Eqn 1 Where: (i) Yx is the cumulative average time per unit/ batch taken to produce a Cumulative numbers of units/ batches X; (ii) a is the time required to produce the first unit/batch; (i) (ii) X is the cumulative number of units/batches consideration The exponent b is the index of learning. under

This is known as the cumulative average-time learning model. Consideration of the formula in equation 1 shows that it is the value of b which determines the shape of the learning curve. If no learning effect were present, the time taken to produce any unit would be equal to the time required to produce the first unit, i.e. Yx = a And the learning curve would be a straight line, as all units would take the same timer to produce. Consideration of equation 1 shows that this can only be true if Xb=1.And, as x, by definition, is greater than 1 for all except the first unit, b must equal 0 if Xb is to equal 1(X0=1), i.e. no learning is present. Any value of b greater than 0 would result in Yx increasing as x increased, meaning that the average time taken to produce units was increasing rather than decreasing, i.e negative learning was taking place. Thus, if a positive learning effect is present, b must be less than zero, i.e. b must be a negative number. If we assume that a positive learning effect is present, at one unit/batch of output; Y1=a Consider now the effect of doubling the output, i.e. X = 2, then Y2=Y1x learning rate And; Y2 = a x learning rate

103

But from Equation1, Y2=a2b, therefore; A x learning rate = a2b Learning rate =2b Log (learning rate)=b (log2) Therefore b=log (learning rate) Log2 S0, for a 90% learning rate, b= log 0.9 log 2 All numbers less than zero have a negative logarithm, while all numbers greater than zero have a positive logarithm. Therefore, when learning is taking place, b must be negative. The Terminology gives the mathematical description of the learning curve as: Y= a X Where: (i) Y is the average time taken per unit/batch to produce a cumulative Number of units/batches (ii) a is the time required to produce the first unit; (iii) x is the cumulative number of units to be produced; (iv) B is the coefficient of learning, which can be calculated as: Please note the negative sign in front of this calculation of B. The B in the Terminology is thus equal to-b in Equation 1, and the two formulae are mathematically equivalent (students should note that, in examinations, yet another variant of Equation 1 is often given, i.e. the learning curve is expressed as). a Y = xn In this case, n is equal to both B as defined in the Terminology and b as in Equation 1. Let us apply the formula in Equation 1 to the operations of the manufacturer whose data is recorded in Table 1 and whose learning rate is 90 per cent, by checking the cumulative average time which we would expect will be necessary to produce 64 batches: Yx = aXb Eqn (1)

104

b = log 0.9 = -0.1520 log 2 Yx = aX-0.1520 Yx =100 x 64 -0.1520 Yx = 53.14 Which agrees with Table 1 above. In the example above, b equals 0.1520, giving learning rate of 0.90. The learning rate can take any value, but only values of less than one imply that learning is taking place. Learning rates greater than 1 imply that the time taken per unit/batch is increasing as production increases, a value of exactly 1 would indicate that the time taken per unit/batch was not changing at all, and values less than one mean that the time taken per unit/batch is declining as production increases. Equation 1 is not normally used to check earlier calculations in the way that we have just done, but is rather used to assess the time which will be required for an output level which does not represent a doubling of the cumulative production total, and thus cannot be determined by simply creating a table such as the one used earlier. For example, let us assume that the manufacturer above has the opportunity to bid for a contract to produce 10 batches of his product, and wishes to estimate the time it will take to complete the contract, in order to help set the tender price. If the cumulative total production of his product to date is 32 batches equation 1 can be employed to calculate the cumulative average time per batch to produce 42 batches the 32 already produced plus the 10 under consideration: Yx Yx Yx Yx
b = aX

x 42 -0.1520 =100 x 0.5666 = 56.66

= 100

i.e. the average time per batch to produce 42 batches is 56.66 hours, giving a total production time of 56.66 x 42 = 2,380 hours. Inspection of Table 1 above reveals that the average time per batch to produce 32 batches is 59.05 hours, with a total production time of 1,890 hours. The total time taken to produce the 10 batches under consideration will thus be 2,380 1,890 = 490 hours, i.e. an average time of 49 hours for each of the batches 33 to

105

42. This may be compared with the average of (3,401 1,890)/32 = 47.20 hours indicated by Table 1 for the next doubling of a full 32 batches from 33 to 64. obviously, if the current level of production does not lie on a table such as Table 1, that particular average time, and the corresponding cumulative hours to date, will need to be calculated from the same formula.
USES OF THE LEARNING CURVE

(i) (ii)

(iii)

In circumstances where the learning curve is likely to operate i.e. in complex assembly operations, knowledge of the rate of learning can help in price setting. When setting budgets, the effects of the learning curve should be taken into account. Standard costs should reflect the point which has been reached on the learning has become insignificant) will be lower than those set during the learning period are to be meaningful. The learning curve has been found to be particularly useful in determining the likely costs to be incurred in fulfilling government contracts. This provides a rational basis for price negotiation and cost control.

A number of points about learning curves must be stressed: (ii) Learning curves chart the reduction in time per unit as experience is gained; they do not measure a reduction in cost per se. However, if hourly wages are constant, the labour cost per unit will decline as a result of the learning curve phenomenon. In addition to direct labour costs, only those costs which are directly related to direct labour time, i.e. any overheads which vary directly with those hours, can be expected to decline as a result of the learning curve. Learning is likely to be greatest in complex assembly environments, of which aircraft assembly is a prime example. If labour is working in a machine-paced environment, there is no significant opportunity to alter the rate of working and thus the learning phenomenon in terms of direct labour time cannot exist. However, the experience which plant managers gain in scheduling work in such an environment may result in a reduction in the direct labour hours required for a given level of production. The learning rate, which is a function of workers learning, is not something which can be positively fostered as a cost reduction technique.

(iii)

(iv)

(v)

THE EXPERIENCE CURVE

106

It has been stressed that the learning curve was derived from observations of the reduction in direct labour time taken to complete successive repetitive but complex assembly tasks that have frequently been determined by fitting curves to total tasks. However, learning rates have frequently been determined by fitting curves to total cost per unit data. For example, Depuy (1993) used this method to ascertain for the US government the learning rate achieved by defence contractors. The purpose in gathering this data was to help in price negotiations with the contractors. The total cost data employed was expressed in constant dollar terms, and thus was not distorted by changing price levels. The slope of the learning curves derived ranged from 0.718 to 1.021, with a mean of 0.858. This data suggest that defence contractors typically enjoy a reduction of 14 per cent of average unit cost on each doubling of output. The strict application of the learning curve phenomenon is seen in the area of direct labour, and it is arguable that, in using unit cost data, the result outlined above actually reflects the so-called experience curve, rather than the learning curve as strictly defined. The experience curve extends the learning curve approach to areas other than direct labour. Rather than relating indirectly to cost via time, an experience curve relates directly to cost, and is a function which shows how total cost per unit declines as output increases. Total cost in experience curves includes all overhead types production, marketing and distribution and thus cost reductions arising from factors such as factory size, production, technology, substitution of materials and design modifications are reflected in an experience curve. Experience curve, like learning curves, can be regarded as statements of what will happen in practice. This could be considered to be a western approach. An alternative approach, adopted by the Japanese, is that these curves should be taken as an expression of what is desirable, and hence what should be striven for. The improvement oriented Japanese typically aim actively to foster a 67 per cent learning curve, as against the 80 per cent curve more usually found in the West. Moses (1991) has pointed out that the accounting policies adopted by companies can have a significant impact ob learning rates derived from experience curves, and so the results must be treated with caution. Element 3.1 Cost Reduction
INTRODUCTION

An appreciation of the relationship between cost and volume is important in many business decisions, of which pricing is a prime example. When average total unit cost is measured against volume, a measurement is being made which allows a long-run average cost curve of the type shown in Figure 3.1 to be graphed. Where learning or experience curves are used to predict future costs,

107

there is an implicit assumption that the experience of the past is helpful in predicting the future. This may well be the case, but it provides no operational guidance to management as to how cost reductions are to be achieved in the future. Indeed, knowing that the learning curve has led to cost reductions in the past could give rise to a dangerous complacency on managements part, if it is assumed that, as long as volume increases, savings will continue to be made in the future even if no positive action is undertaken to secure them. Organisations which set targets for cost reduction, and have systems in place to help the accomplishment of those targets, are more likely to achieve cost reductions, then organisations which do not adopt such a systematic approach. Obviously, the scope for cost reduction will be dependent on the type of cost under consideration, and the time scale involved. Element 3.1.1 Traditional Cost-Reduction Programmes Traditional cost reduction programmes have been characterized as a collection of crash programs that focus on cutting costs by reducing payrolls and eliminating jobs (shields and Young (1992). It is suggested that such programmes are typically triggered in reaction to an immediate threat, such as poor performance, loss of contracts, or price reductions in other words, traditional programmes are often reactions to events rather than anticipations of them. There is some evidence to suggest that these programmes do not meet their objective. Fisher (1991) cites two surveys on this point: half the managers in the first survey (representing corporations accounting for 26 per cent of US GNP) said that the cost cutting or restructuring programmes had failed to meet their objectives; the second survey of managers from 1,005 corporations found that more than half the corporations had failed to meet their cost reduction targets. Market pressure to reduce costs could lead companies to attempt a blanket approach to cost cutting, particularly for overheads. For example, in an attempt to reduce costs by, say 5 per cent, a company may take a decision to cut all departmental budgets by the same 5 per cent. This might achieve some short term savings but it is likely to be at the expense of the long-term health of the organisation. A blanket cut will affect all activities equally, which means that some areas which were of value to customers will inevitably suffer. In a commercial organisation, this will lead to some loss of business, which may lead to an increase in unit cost, as fixed overheads (albeit reduced by 5 per cent in our example) are spread over a smaller number of units sold. A successful cost reduction programme will seek to reduce the unit cost of the good or service at all volumes of output. This can be achieved by reducing either direct costs or overhead costs, and ideally reducing both, but without destroying value to the customer. The blanket cut strategy to achieving this is

108

ineffective in the long term. Firms must adopt approaches which enable them to pinpoint and realize specific opportunities for cost savings.

Element 3.1.2 Examination of Current Activities The starting point for cost reduction programmes often is the examination of existing activities. Any organisation can be seen as a collection of activities designed to lead to a desired result. In carrying out these activities to meet the short-term operating plan, a company may currently be incurring higher costs than are strictly necessary, i.e. the companys consumption of resources is excessive. Examination of current operations may reveal that this over consumption of resources arises from one or a combination of the following three reasons: 1. Over resourced activities 2. Inefficiently managed activities 3. Unnecessary (non-value added/diversionary) activities Each of these reasons will be looked at in turn and the effectiveness of a blanket cut in resources to achieve cost reduction in these circumstances will be considered.

Element 3.1.2.1 Over-Resourced Activities An activity is over resourced when the same objective could be achieved with less resource consumption. For example, in a production department, shop floor manning levels may have remained processes. The current position may be one in which a separate operative is assigned to each machine. However, if the process requires very little human intervention, it may be perfectly possible for machines to be physically grouped in such a way as to allow a reduction in staffing levels, so that one person may be able to oversee two, three, four or even more machines, without any loss of machine efficiency. A blanket cut in resources may provide the spur to such reorganizations, although the industrial relations implications of reduced staffing levels may make attainment of the most cost- effective arrangement difficult to achieve.

Element 3.1.2.2 Inefficiently Managed Activities Activities are inefficiently managed when current standards of achievement are not being attained. Loss of material through pilferage, excessive overtime working necessitated by poor production scheduling and excessive time spent

109

on rework through failure to identify problems at the earliest opportunity would all provide example which highlight variances from standards. Regular monitoring will identify these deficiencies and should lead to their elimination. However, a blanket cut in resources may provide an additional impetus to improvement. Element 3.1.2.3 Value Added and Non-Value Added Activities The concept of a value- added activity revolves around the customer, as we saw in our consideration of the value chain in the previous chapter. Value will be added when an activity results in an addition to a product or service which they ultimate consider to be valuable, and which is therefore some thing for which they are willing to pay. A non- value added activity is thus any activity which does not provide value to an end user. Non- value added activities often arise as a direct consequence of, and are sustained, by, a companys existing policies and organisational structure. It is only possible to eliminate such non- value added activities if changes are made to the current policies and structure. For example, a company may have a department devoted to dealing with customer complaints, and the rectification of problems which arise during a products warranty period. This departments activities will increase the costs of the business, but are non- value added as far as the consumer is concerned. The existence of a warranty is useful to the end user, and adds value as a result, as it provides a level of insurance, and hence peace of mind. However, not only is a claim under a warranty and value added for the customer, in as much as it provides law enhancement to product it self, but the customer is also invaluably put to some trouble in actually making such a claim. Problems with products are thus both a cost to company and an inconvenience to the costumer. Self evidently, as the reliability of a product increase, warranty claims will decline. The inherent reliability of a product will be the function of the product design, the quality of the materials used and the manufacturing process; non of these activities are under the control of warranty department management. A blanket cut in resources, applied to the warranty department along with all other departments, would be unlikely in its self, to result in the action which would improve the overall product reliability. If the warranty department is not currently over-resourced, and is efficiently managed, a cut in its resources is highly likely to reduce the level of service that it can provide to customerscustomers who, by definition, are already unhappy with the service which the company has provided in selling them a faulty product. Delays in rectifying faults are likely to lead to a further loss of consumer goodwill, and hence damage the competitive position of the company even more. To control the resources consumed by overhead department effectively, it is essential to understand: (a) why such departments exist;

110

(b) the services they provide; (c) there relationship to other areas of the business. In other words, it is necessary to adopt a cross-functional attitude to the examination of the business processes. Activity-based cost management adopts this approach, as we shall see in the next chapter. Other approaches to overhead cost reduction, which eliminates the disadvantages of blanket approach to cost, cutting, is zero-base (priority-base) budgeting, to which we now turn.

Element 3.1.3 Zero-Base Budgeting Like all budgeting techniques, zero-base budgeting (ZBB) is designed to be used in setting levels of future expenditure. As all cost reduction techniques must, by definition, relate to the reduction of future costs (past costs being sunk) it follows that cost-reduction programs and budgeting procedures are in inextricably entwined. The Terminology defines zero-base/priority-base budgeting as: A method of budgeting which requires each cost element to be specifically justified, as though the activities to which the budget relates were being undertaken for the first time. Without approval, the budget allowance is zero. The reference to funds available is particularly pertinent in public sector organisations, where funds are determined by tax revenues and government grants and allocations, i.e. the income of the organisation, is exogenously set. The aim of the fundholder is to achieve the best service levels possible within the given budget. In traditional budgeting, existing expenditure levels form the base line for discussions about future expenditure. Implicit in the traditional approach is an assumption and acceptance that current expenditure is adding value to the customer, and the focus of its attention is simply the justification of any proposed increases in the expenditure it therefore adopts an incremental philosophy to budgeting. The rejection of this base line as a starting point is what gives zero-base budgeting its name. An incremental approach is most likely to be applied to discretionary costs, as it is these costs, which is thus likely to lead to the most radical changes in discretionary areas. Nevertheless, the approach requires all activities to be justified and prioritised before the decision to devote resources to particular ones is taken.

111

All activities are subjected to the most basic scrutiny and answers sought to such fundamental questions as: (a) Should the activity be undertaken at all? (b) If the company undertakes, how much should be done and how well should it be done (for example, should an economy or a de-luxe service level be provided)? (c) How should the activity be performed- in house or sub contracted? (d) How much would the various alternative levels of service and provision cost? In order to answer these questions, all existing and potential organisational activities must be described and evaluated in a series of decision packages, giving the following four-step process to a ZBB exercise: 1. Determine the activities, which are to be used as the object of decision packages the provision of home support for the elderly or provision of catering facilities for the work force, for example and identify the manger responsible for each activity. 2. Request the managers identified in (1) above to prepare a number of alternative decision packages normally requested: one which sets out what could be delivered 80 per cent of the current level and one for an enhanced level of funding, (e.g. 120 per cent of the current level). 3. Rank the decision packages in order of their contribution towards the organisations objectives. 4. Analyse alternatives, and go for these those with the greatest cost benefit in term of the objectives; 5. Systematically implement the selected alternatives.

Some explanation of these steps is necessary. Effectiveness can be judged only against predetermined benchmarks set by the organisation. Yet the activities performed by public sector and not-for-profit organisations are often difficult to measure in a tangible way, and can take several years to be measurable, while required to overcome these difficulties. Many programmes will also have multiple results, and a choice must usually be made regarding the relative weights attached to them. Further, there will often be questions regarding the legitimacy of casual relationships when measuring these results: particular outcomes could be brought about by the actions of more than one programme,

112

given the nature of public sector and not for profit organisations and their objectives. On a more positive note, one feature of PPBS that should be particularly beneficial is that managers making budget requests are expected to be able to state clearly what would happen if their requests were cut by, say 10 per cent. Thus the director of leisure services in a local authority should be in a position to say that such a cut would reduce the hours that a swimming pool could open, for example, or require that the grass in public parks be cut every ten days instead of once a week. This feature of PPBS is, in its result, somewhat similar to ZBB, since different levels of service are associated with each level of requested funding. The interest in PPBS probably owes much to an increasing public demand for accountability by public and other not-for-profit organisations: taxpayers appear to have become dissatisfied with the performance of central and local government agencies; and donors to charitable causes have expressed concern about the proportion of contributed funds devoted to administrative expenses. PPBS specifies goals clearly, and allows people to see where their, money is going and, eventually, to see whether or not it was spent effectively. Exercise: the Alpha Group The Alpha Sufferers Group is a national charity offering support to sufferers and funding medical research. You have been invited to attend a trustees meeting at which the following report on this years performance and next years annual budget will be discussed. No further supporting information is provided for the trustees. The trustees have used an incremental approach to determine the budget. The treasurer has heard of programme planning budgeting system and wonders if it would be useful in their not-for profit-organisation. Criticise the current method of budgeting and explain the application (give specific examples) and possible advantages of PPBS to such an organisation. 19X3 Actual 18,000 200,000 440,000 658,000 19X4 Actual

Budget Income Subscription Donations received Fund raising 20,000 160,000 500,000 680,000

Budget

20,000 220,000 484,000 724,000

113

Expenditure Employees Premises Office expenses Administration Research Printing Room Rental Donations made

60,000 8,000 28,000 30,000 300,000 25,000 15,000 200,000 666,000

60,000 8,000 33,000 42,000 320,000 12,000 230,000 230,000 735,000

60,000 8,000 30,000 40,000 350,000 25,000 15,000 260,000 788,000

Excess of income over expenditure 14,000 77,000 (64,000) Element 3.1.4 Timing and Focus of Cost Reduction Programmes It is axiomatic that, in searching for cost savings, the greatest effort should be expended in investigating those costs which provide the greatest opportunities for savings. However, these opportunities are related to time. As Berliner and Brimson (1988) have pointed out, and as Figure 3.3 illustrates, up to 90 per cent of a products costs will be fairly limited for an existing range of products. Nevertheless, cost reduction programmes have tended to focus on current production costs, despite the evidence that the ability to influence cost is greatest at the planning, research and development stages. Programmes which focus on reducing cost at these early stages after the greatest opportunities for success in the medium to long term, although their impact in the short term may be small. The most successful cost-reduction programmes at the conceptual and design stage are those which have a strong market focus. Rather than aiming to meet the manufacturers own internal specification at least cost, they involve a thorough examination of customer requirements, in order that these can be satisfied at least cost. One technique of cost reduction, which recognises the importance of concentrating effort on the design and conceptual stage, is value analysis (also known as value engineering), which is discussed below. Element 3.2 Element 3.2.1 COST CONTROL Cost control involves management action undertaken to effectively mange the costs of running an under-taking. A good cost control system should be able to bring about control over the costs of the entity.

114

Element 3.2.2

In order to come up with an effective cost control system, a methodical approach is required. To this effect, the following approach can be used: Stage 1 Target Setting Any cost control system requires targets to be fixed for costs. The target so set must, however, be revised continuously in order to keep them in line with the current cost efficiencies. Stage 2 Measure the Actual Results There must be an effective and up-to-date system to measure actual results. The actual results should be measured as frequently as possible. Stage 3 Comparison between Targets and Actuals This stage involves comparing the targets with the actuals. It is important that any differences between the targets and the actuals are analysed into sufficient details. Reasons for the differences must be identified. Stage 4 Identifying the causes for the differences Stage 5 Action to prevent variances Having identified the reasons for the variances, it is important that necessary action is taken to void the recurrence of the variances. From the above, it is notable that in order to have an effective cost control system, the appropriate targets must be set, an effective comparison system must be in place and the results must be analysed sufficiently.

Element 3.2.3

The common types of cost control systems are the budgeting control systems and the standard costing systems.

Element 3.3 Value Analysis The disruption of normal supply lines to American manufacturers in World War II necessitated a search for substitute materials and alternative designs. Value analysis (VA) evolved as a result of these experiences. The approach was championed by General Electric of America, and is associated with two employees in particular: Harry Erlicher and Lawrence Miles. Erlicher, who was vice-president of purchasing, observed that many of the enforced changes which the war had brought about had actually improved performance and/or reduced

115

cost. At the ceassation of hostilities, therefore, he decided to maintain and institutionalise the search for substitute materials and methods. In 1947, the task of putting this into practice was assigned to Miles, who was then a staff engineer. The result was value analysis, which combines a number of preexisting techniques with its own particular procedural approach. General Electric adopted the approach as a company standard, and it was subsequently taken up by other companies and organisations, including the American military. In 1954, the Navy Bureau of Ships, aided by Miles set up a VA programme, in which the term (VE) rather than value engineering programme was established in 1956 by the Army Ordnance corps, and the Air Force began investigating the technique in 1961, having been stimulated by the success of suppliers, such as General Electric, in its operation. Indeed, the US Defence Department became so convinced of the benefits to be gained from VE that Secretary of Defence McNamara referred to it in 1962 as a key element in the drive to reduce defence costs. The Armed Service Procurement Regulations made the use of VE mandatory, and defined it as: A systematic effort directed at analysing the functional requirement of the Department of Defence systems, equipment, facilities and supplies for the purpose of achieving essential functions at the lowest total cost, consistent with the needed performance, reliability and maintainability. This definition can be seen to be consistent with the CIMA Terminology definition of value analysis, which is taken from BS 3138: Although the term value engineering is used by purists to refer to the applicant of the ideas of value analysis, Miles used the two terms synonymously, and they will be treated as such throughout the remainder of this chapter. The technique is regarded primarily as a means of achieving cost reduction, and can be applied to existing or new products at any stage of the life cycle. However, as we noted earlier, the scope for achieving cost savings is greater during the pre-production phases, and it is therefore at these early stages that the application of VA offers the greatest cost reduction opportunities.

116

Figure 3.4 ______________ A Cost content attributable to the product A-C Minimum amount that must be spent to make the product B Work added by Unnecessary design and specification features Work added by inefficient methods of manufacture

Value analysis zone Method study zone

C Total cost Associated with the product (under absorption system) A-D D

Overhead carried because man or machine or both are

Production control zone

117

In the search for cost reduction, the concept of minimum cost is a dynamic, not a static one. It alters with changes in design, volume, materials and technology etc. Figure 3.4, adapted from Gage (1967), provides a useful description of the focus of a number of cost-reduction techniques. There is a strong inter-relationship between the zones in Figure 3.4, particularly when new products are being considered. The minimum amount which must be spent to produce a new product cannot be determined until the design and specification of the product has been determined the value analysis zone and until the method of manufacture. A simultaneous consideration of the two (simultaneous engineering) is likely to lead to lower cost solutions rather than a sequential consideration (over-the-wall engineering). Value analysis seeks to facilitate this simultaneous approach. It aims to ensure that the product brief is tightly specified, in terms of the functionality required, and that design and production engineers not only understand the brief, but contribute simultaneously to it. A team approach is thus crucial to the VA philosophy. The VA team must ponder the following six basic questions when applying VA to any product or service: 1. 2. 3. 4. 5. 6. What is it? What does it do? What is it worth? What does it cost? What else would work? What does that cost?

Alternatives that reduce the design complexity of a product, and lower its bulk or weight and/or the number and variety of parts required in its manufacture, are frequently associated with reduced cost. The accountant clearly has a role to play in determining the cost of these alternatives. Miles (1972) has suggested that ; ... Meaningful costs may be obtained from a variety of sources or from a combination of sources: But since, in many instances of good value work, materials, products and processes will be utilised in different ways, really meaningful costs often must be worked up for the job(emphasis added). Miles suggests that cost estimates do not need to be of a high degree of accuracy, particularly in the initial stages of VA, when the aim is to identify fruitful avenues for investigation, rather than to make final decisions. Nevertheless, when final decisions are being made, accuracy will obviously be important. The ability to make accurate estimates in respect of products and

118

processes of which the firm may have no direct experience is therefore a valuable one. The Japanese find cost tables (see section 3.7.6) particularly useful in this context. The first two of the six questions above relate to the functions of the product or service. Functional requirements were mentioned in the definition of VE above, and we have talked of functionality in the context of the requirements of the product brief. The concept of product or service function is thus a key element in the VA approach, and its to this concept that we now turn.

Element 3.3.1 Functional Analysis Functional analysis (FA) is a systematic approach to the examination of the specified purpose of a product or service. In functional analysis, the cost object is the function of the product or service itself. Functional analysis views all products as bundles of services potential for customers, so that the cost object is represented by this intangible service potential. The focus is thus very different from traditional accounting, which often has a physical product as its cost object. As an example of functional analysis, let us consider a domestic telephone. This has as its major function the facilitation of communication between individuals who are physically separated. When expressed in this way, it is clear that the competition for sales of domestic telephones is represented not only by other handset manufacturers, but also by suppliers of any means of long distance communication telex, fax, the postal system etc. Functional analysis can be applied in a number of ways. It may be used as an aid to cost reduction, and as a means of improving products, by adding new features in a cost effective manner. In value analysis, for example, a clear understanding of the function of a product or service is essential, in order to determine how that functions can be supplied to the customer in the most cost effective way. Functional analysis can also be used to assist in the determination of expected selling prices, as consumers may be expected to pay particular prices for particular functions. In this context, functional analysis can be seen to underpin target costing, which we will discuss in the next section of this chapter. Yoshikawa et al (1993) suggest that the six basic questions listed in section 3.3 can be answered by following the nine basic steps set out below: 1. choose the object of analysis, such as product, service or overhead area;

119

2. 3. 4. 5. 6. 7.

select the members of the team; gather information; define the functions of the object; draw a functional family tree; evaluate the functions; suggest alternatives, and compare these with the target cost (see element 9.2); 8. choose the alternatives (for manufacturing etc); 9. review the actual results. The range of options for consideration under step 7 may relate to a whole range of functions, or may relate to alternative ways of satisfying a particular set of functions that will not yet have been fixed. Value analysis allows the team to consider a range of functional combinations, together with their associated costs and to compare these with the prices customers are likely to be willing to pay for the alternative combinations, in order that the optimal set can be selected. On the other hand, when a company is analysing a defence contract, the required functions are likely to be very closely specified, so that the analysis will probably be confined to financial evaluation of the differing means of satisfying the given functional ends. VE undertaken at the research and development phase is something referred to as zero look VE, that undertaken in the trial production phase as first look VE, and that in the trial production phase as second look VE. Second look VE can be used when design changes are being made to existing products. These descriptions illustrate the iterative nature of cost-reduction techniques. Element 3.4 VALUE ENGINEERING As discussed above is also called value analysis. Definition: This is a systematic interdisciplinary examination of factors affecting the cost of a product or service in order to devise means of achieving the specified purpose at the required standard of quality and reliability at target cost. Aim of Value Engineering The aim of value engineering is to achieve the assigned target cost by i. Identifying improved product designs that reduce the products cost without sacrificing functionality and ii. Eliminating unnecessary functions that increase the products costs and for which customers are not prepared to pay extra for.

120

Value engineering requires the use of functional analysis. This process involves decomposing the product into its many elements or attributes. Example In the case of automobiles, functions might consist of STYLE, COMFORT, SPEED, RELIABILITY, QUALITY, COLOUR etc (KATO 1993). A price or value for each element is determined which reflects the amount the customer is prepared to pay. To obtain this information companies normally conduct surveys and interviews with customers. The total of the values for each function gives the estimated selling price from which the target profit is deducted to derive the target cost. The cost of each function of product is compared with the benefits perceived by customers. If the cost of the function exceeds the benefit to the customer, then the function should be either eliminated, modified to reduce its cost or enhanced in terms of its perceived value so that its value exceed its cost. Also by focusing on the products functions, the design team will often consider components that perform the same function in other products thus increasing the possibility of using standard components and reducing costs,e.g. Nokia has the same charger for each type or mode phone manufactured.

Element 3.5 Activity based costing

INTRODUCTION

A core accounting activity is the analysis of costs. Costing systems accumulate costs by broad classifications material, labour, power etc. - and these costs are then further analysed by assigning them to cost objects. A cost object is defined as anything for which a separate measure of costs is desired, and thus the range of possible cost object is vast from individual product to department, customer, service, brand or project. The costing system will routinely collect information about some but by no means all, possible cost objects. Costing information is needed for a variety of reasons: (i) (ii) (iii) Stock valuation for financial accounting purposes; Cost control and performance evaluation; Decision-making, e.g. product pricing, drop a product, make or buy etc.

121

The selection of cost objects for the routine collection of information has implications for each of the above three purposes. It is common to find departments, cost centres and products as cost objects in costing systems. Considerable dissatisfaction has been expressed at the information provided by traditional costing systems for purposes (ii) and (iii), and particular attention has been directed to finding the true cost of producing a product to supply information for (iii). However, it is important to emphasise that the concept of a product as a cost object needs amplification. Cost management is as important for the automobile industry in the 1990s as what quality control was in the 1970 and 1980s. (extract from & corporate annual report)

Required (i) Explain the meaning of the cost management, which is sometimes known as cost management information). Discuss why it might be considered important in todays world. (ii) Discuss how a management accountant might use investment appraisal techniques to analyse customers in order to aid cost management.

Solution (a) At anytime there is usually a particular factor, which is key to remaining competitive and to developing the business strategically. These factors are often called critical success factors. For this automobile company this key factor is now cost management: in the recent past it was quality control: before the 1970s factors change over time, but while they are critical, management must focus on them. Different businesses in different industries are likely to have different factors, but often at one particular moment in time, organisations are focusing on similar factors because of general economic circumstances prevailing at any stage in the life cycle etc. (b) Cost management or cost management information are rather vague and general phrases used by different people to mean lightly different things. A general definition of cost management information is;

122

The application of management accounting concepts, methods of data collection, analysis and presentation, in order to provide the information required to enable costs to be planned, monitored and controlled. It is certainly important today for all organisations to satisfy their customers by meeting their needs precisely. This involves providing the right product at the right place at the right time and at the right cost. During the 1980s, Japanese car companies such as Toyota paid a great deal of attention to quality consider, for example, the development of the Lexus model targeted at the USA market. The management accountant has a role to play in this area, and target costing and life cycle costing are particularly helpful in driving costs down. (c) A management accountant can use discounted cashflow or payback to evaluate the work of customers, and the importance of customer segments can be discounted over their lives in a similar way to projects. For organisations with high customer set-up cost such as financial institutions such as mortgage leaders, its important that they retain all customers they have. By studying the increased revenue and decreased costs generated by an old customer, management can find strategies to meet their needs better and to retain them. Alternatively, if the company enters into long-term contract with customers, accounts could be discounted and ranked in order of preference just as jobs/contracts might be ranked. Cost Reduction Example It has been suggested that much of the training of management accountants is concerned with cost control where as the major emphasis should be on cost reduction. Required: i. Distinguish between cost control and cost reduction.

123

ii. iii.

Give three examples of the techniques and principles used for (i) cost control and (i) cost reduction. Discuss the proposition contained in the statement.

Solution: (i) Cost control is the process of containing costs to some predetermined amount. This is usually carried on by the formal comparison of actual results with those planned. The routine of budgets, standard costs, operating statements and the investigation of variances. Cost reduction is the wider ranging attempt to reduce costs below the previously accepted amount, standards and estimated selling price for new products preferable without reducing quality and/or effectiveness. This is a dynamic rather than routine process, often only carried out at infrequent intervals. A wide range of examples can be given here: 1. Budgetary control 2. Standard costing 3. Setting of expenditure limits by levels of management in an organisation 4. Procedure for formal authorization of recruitment. 5. Cost reduction 6. Target costing 7. Value analysis and value engineering 8. Work studies 9. Operational research 10. Investment appraisal 11. Zero base budgeting 12. Product life cycle costing

124

13. Value for money analysis and audits etc. The cost control techniques of standard costing and budgetary control would tend to support the proposition. However, a study of operation research techniques and of recent developments would lead to the conclusion that current practice is not purely control, but active cost reduction. There has been considerable interest in a range of topics relating to new manufacturing techniques and to Japanese methods. Quality management, quality costs, JIT stock and production control, flexible manufacturing systems and computer integrated manufacturing, target costing and life cycle costing. There has also been interest in a range of innovations in IT making management accounting faster and more effective especially with developments in data capture and transmission. There have been innovations in strategic management accounting and the links between management accounting in areas where it has been relatively under developed in service industries and the public sector often with the development of new techniques. ABC Limited. ABC Ltd produces a large number of products including A and B. A is a complex product of which 1,000 are made and sold in each period. B is a simple product of which 25,000 are made and sold in each period. A requires are direct labour hour to produce and B requires 0.6 direct labour hours to produce. ABC Ltd employees produce salaried support. Staff are engaged in three activities. Six employees engaged in receiving 25,000 consignments of components per period, three employees engaged in receiving 10,000 consignments of raw materials for per period and three employees engaged and materials for 5,000 production runs per period. Product A requires, 200 component consignments 50 raw materials consignments and ten production runs per period. Product B requires 100 component consignments, eight raw material consignments and five product runs per period. Required: Identify appropriate cost drivers and calculate an activity based costing system.

Solution: The three appropriate cost drives are:

125

(i) (ii) (iii)

Receiving components Receiving raw materials Disbursing kits of components and raw materials

Relating overhead costs to these drivers using the number of indirect staff engaged in each activity as the indirect staff engaged in each activity as the basis gives the following results: Number of staff (iv) (v) (vi) Receiving components 6 Number of staff receiving material 3 Number of staff disbursing kits 3

Total number of staff 12 Therefore the total amount of overhead expenditure relating to each of the activities is as follows: (d) Receiving components: 6/12 x K500,000,000 = K250,000,000 (e) Receiving material: 3/12 x K500,000,000 = K125,000,000 Disbursing kits: 3/12 x K500,000,000 = K125,000,000 Cost driver rates Receiving components:

Total component receiving costs divided by

126

Number of consignments received = K 250,000,000/ 25,000 = K10,000 per component Receiving materials

Total component receiving costs divided by Number of consignments received = K125,000,000/ 10,000 = K12,500 Disbursing kits

Total disbursing costs divided by Number of issues K125,000,000/ 5,000 Total costs attracted by product A 200 component consignments x K10,000 = K2,000,000 50 material consignments x 10 production runs x K12,500 = K625,000 K25,000 = K250,000 K2,875,000 Total costs attracted by product B 100 component consignments x K10,000 = K1,000,000 8 raw material consignments x K12,500 = K 100,000 5 production runs x K25,000 = K 100,000 K1,200,000 Summary of unit cost

127

Product Total cost = Example 2

A 2,875,000 1,000 units of A K2, 875/units

B 1,200,000 25,000units of B K48/ unit

Bean Products Ltd manufactures two types of bean bags the standard and the Deluxe. Both bean bags are produced on the same equipment and use similar process. The following budgeted data has been obtained for the year ended 31 December 20x2. Product: Standard Deluxe Production quality Number purchase orders Number of sets ups Resources required per unit Direct labour Direct labour (hours) Machine time (hours) 25,000 10 5 62,500 10 5 25,000 400 150 2,500 200 100

Budgeted Production overheads for the year has been analysed as follows: Volume related overheads Purchases related overheads Set up related overheads 275,000,000 300,000,000 525,000,000

The budgeted wage rate is K20,000 per hour. The company currently uses an absorption costing method of recovering overheads. However, its considering implementing a system of activity based costing. An activity based investigation revealed that the cost drivers for the overhead costs are as follows: Volume related overheads machine hours

128

Purchase related overheads orders Set up related overheads

number of purchase number of set-ups

Required: (2) Calculate the unit costs for each type of bean bag using the proposed activity based costing approach. Standard Production quantity 25,000 Direct labour hours required 250,000 Total production overhead 1,100,000,000 Machine hours required Purchase orders Total set-ups Cost per cost driver Volume related overheads Machine hours required - Volume related 125,000 400 150 K275,000,000 137,500hrs 12,500 200 100 K137, 500 600 250 deluxe 2,500 25,000 total 275,000 K000

Element 3.6 Element 3.6.1 the

TOTAL QUALITY MANAGEMENT (TQM) Todays business environment is remarkably different from Environment of many years or so go. Companies are becoming customer driven and making customer satisfaction

129

an overriding priority. Customers are demanding everimproving level of service regarding costs, quality, reliability, delivery and the choice of innovative new products. Quality has become one of the key competitive variables and this has created the need for management accountants o become more involved in the provision of information relating to the quality of products and services and activities that produce them. QUESTION- What is quality? Element 3.6.2 Total quality management defined Quality- the degree of excellence of a thing how well made it is, or how well performed if it is a service, how well it serves its purpose, and how it measures up against its rivals. These criteria imply two things: a) That quality is something that requires care on the part of the provider b) That quality is largely subjective. It is in the eye of the beholder, the customer. Element 3.6.3 The management of quality is the process of: a) Establishing standards of quality for a product or service. b) Establishing procedures or production methods which ought to ensure that these required standards of quality are met in a suitably high proportion of cases. c) Monitoring actual quality d) Taking control action when actual quality falls below standard. Quality management becomes total (Total quality management (TQM)) when it is applied to everything a business does. One aspect of Japanese management is the approach of get it right first time. In this spirit, total quality management (TQM) has the customer as its focal point. TQM is therefore a management function which could be seen as the key to improving profitability because there is a cost associated with failing to meet quality standards in products and services. Such costs could arise through loss of customers, claims for refunds in respect of defective supplies and the work of putting right mistakes. If costs can be controlled through TQM, then profits will increase.

Element 3.6.4

130

Through TQM it is possible to obtain defect-free work first time on consistent basis. Though this looks like an idealistic target but to have such a target encourages a culture where prevention of error is a key feature of operations. Element 3.6.5 COST OF QUALITY This activity of improving quality to improve profits will itself cause cost to be incurred. The term cost of quality is a collective name for all costs incurred in achieving a quality product or service. A cost of quality report should prepared to indicate the total cost to the organization of producing products or services that do not conform with quality requirements. Four categories of costs should be reported. Cost of conformance is the cost of achieving specified quality standards and include: i. Cost of prevention are costs incurred in preventing the production of products that do not conform to specification. They include cost of preventative maintenance, quality planning and training and the extra costs of acquiring higher quality raw materials. ii. Appraisal cost are costs incurred in order to ensure that outputs produced meet required standards. They include costs of inspecting purchased parts, work in process and finished goods, quality audits and field tests. Cost of non-conformance- is the cost of failure to deliver the required Standard of quality and include: i. Cost of internal failure are costs associated with materials and products that fail to meet quality standards. They include costs incurred before the product is dispatched to the customer, such as the costs of scrap, repair, downtime and work stoppages caused by defects. ii. Cost of external failure are cost incurred when inferior products are delivered to customers. They include the costs of handling customer complaints, warranty replacement, repairs of returned products and the costs arising from a damaged company reputation.

131

Element 3.6.6

Typical Cost of Quality Note that some of the items in the report will have to be estimated e.g. forgone due to sales lost because of poor quality is difficult to calculate and its preferable to include an estimate rather than omit it from the report. The report has the following uses: a) By expressing each cost category as a percentage of sales revenue, comparisons can be made with previous periods, divisions within the group or other organizations, thereby highlighting problem areas. A comparison of the proportion of external failure costs to sales revenue with the figures of other organizations, for example, can provide some idea of the level of customer satisfaction. b) It can be used to make senior management aware of how much is being spent on quality-related costs. c) It can provide an indication of how total quality costs could be reduced by a more sensible division of costs between four categories. For example, an increase in spending on prevention costs should reduce the costs of internal and external failure and hence reduce total spending.

Element 3.6.7

COST OF QUALITY REPORT YEAR ENDED DECEMBER 2006

K000 PREVENTION COSTS Quality training Quality engineering Preventive maintenance APPRAISAL COSTS Inspection of materials Received Inspection of WIP Testing equipment Quality audits INTERNAL FAILURE COSTS Srap Re-work Downtime 500 200 400 1,100 5.5 K000 COST AS % OF ANNUAL TURNOVER K20 MILLION

600 600 200 400 1,800 9.0

500 1000 300

132

Retesting EXTERNAL FAILURE COSTS Returns Handling customer Complaints Contribution figure from lost sales

400 2,200 11.0

1000 1500 2000 3,500 8,600 17.5 43

TQM ideas are widely practiced and there are many nonfinancial performance measures being used in business organisations such as: Number of customer complaints Number of warranty claims Number of defective units delivered to customers as a percentage of total units delivered. These measures are also appropriate especially for lower levels of management in an effort and progress to provide and monitor cost of quality.

UNIT 4.0 MEASURES OF PERFORMANCE

Learning Outcomes After studying this chapter, candidates will be expected to have full knowledge and they should be able to explain the different reasons of performance as shown below: The balanced scorecard Value for money measures The growth in non-financial performance measures Bench marking Investment centres Return on investment Residual income The measurement of assets and related problems 133

Behavioural aspects of performance measurement

Element 4.1 The Balanced Scorecard Element 4.11 Growth in non-financial measures In a traditional sense, profit has been the far greatest measure of business performance. This to a large extent can be attributed to the fact that theory has it that businesss sole objective is maximisation of shareholders wealth through payment of high streams of dividends and growing the invested capital in the business through raising the share price of a corporation from good economic performance. However, in the modern world, due to expanded corporate managements focus, it is essential to include non-financial measures in performance evaluations. Actually, it can be argued that financial-based measures merely measure the success of other activities and policies, and do not in themselves, provide information that can be used as a direct guide to management action. So in order to effectively manage a business, we need information to a large extent which is not financial in nature to aid our actions which will result in running an organization smoothly and ultimately result (lead) to good financial performance. The main non-financial measures of performance which are commonly applied and used are: Innovation Flexibility Short-lead times Quality Cost The importance of these measures or attributes ties in their contribution to the delivery of customer satisfaction, which determines the ability to survive that will be determined by its capacity to provide sufficient satisfaction at a profit. Element 4.1.2 Balanced Scorecard in Detail The incorporation of non-financial information along side financial information has become known as the balanced scorecard approach. This was exemplified by Kaplan and Norton. The balanced scorecard is an approach to the provision of information to management to assist strategic policy formulation and achievement. It

134

emphasises the need to provide the user with a set of information which addresses all relevant areas of performance in an objective and liberalised fashion. The typical contents of a balanced scorecard would be the following measures: (i) (ii) (iii) (iv) The financial perspective The customer perspective The internal business perspective Innovation and learning perspective.

Kaplan and Norton gave examples of the types of measures used to assess performance under the four perspectives. By providing all this information in a single report, management is able to assess the impact of particular actions on all perspectives of the companys activities. Usually, determining the specific items to be included in a balanced scorecard requires a business to examine its operations carefully, in order to address the following considerations. (i) (ii) (iii) Identity of the companys critical success factors Selection of performance measures which can be used to monitor attainment against the identified critical success factors. The identification of the changes that must be made to organizational processes in order to facilitate the improvement of performance against the critical success factors.

It should be noted that critical success factors of a business may change, following changes which are taking place in their market place.

Element 4.1.3 The Four Perspectives (a) The Financial Perspective

The financial perspective usually looks at the profit rock bottom. The financial prospects consider how we look at shareholders, especially, in relation to their goals, interests and returns from the business on their behalf.

135

Therefore, the main aims and objectives which the financial perspective will have attached to one. (i) Survival of the business

The survival of the corporation will be to a large extent be measured by level of cashflow or how healthy cashflows are. (ii) Success of the Business

The success of the business will usually be gauged by the sales growths being experienced and the operating income trickling down to the business. (iii) Prosperity

The prosperity of the business is going to be measured by the breakthrough of increases in market share and the return on equity which the business is giving on investors capital. (b) The Customer Perspective

The customer perspective looks at customer satisfaction. The customer perspective looks at how customers see the providers of a service (businesses). In order for a business to have a comprehensive customer perspective, it needs to set the following aims and goals established by the accompanied measures. (i) New products

This goal would encourage seeing development of new products/services and improvements in already existing products/services. The key measures in this regard would be the percentage of sales coming from the sale of the new products. (ii) Responsiveness to Supply

How does the corporation handle its supply chain system? The main measure would be on-time delivery as defined by customers. (iii) Customer Partnership

136

How cemented and integrated are the relationships between the business and its customers. This partnership can be measured by the number of cooperative engineering efforts. (c) The Internal Business Perspective The internal business perspective looks at what the business excels at if it has to deliver shareholder value. In order to achieve good performance in relation to the internal business perspective, a business should set out the following goals alongside the key performance indicators (KPIs). (i) Technology capability

The company should have cut-edge technology. This can be measured in terms of the corporate manufacturing geometry versus competition being faced.

(ii)

The manufacturing excellence

The manufacturing excellence must be explained though the perceived value of the organisations activities different consumers. The key measures to measure this would include measures such as cycle times, exact cost of manufacturing and yield. (iii) Design

The design of the product will concern itself with the features embedded in the products. This can be measured by efficiency, durability and ability to stand pressure, and versatility in the components used in the manufacturing process. (d) Innovation and learning perspective This perspective looks at whether we can continue to improve and create value for clients or not.

137

In order to be able to continue providing unrivalled products/services, a business should set the following goals and set out measures to track performance and achievement of the goals. (i) Technology leadership

The company must be able to employ state of the art technologies in its operations. The measure to use would be time to develop the next generation of the product. (ii) Time to Market

This measure and goal considers the time it takes a corporation to design, make and launch (deliver) the product to the market place. The main measure of performance in this area would be the number of new products and how the newly launched products are competing with similar rival products. Below is a typical diagrammatic representation of the balanced scorecard for an imaginary communication utility company to illustrate the application of the balanced scorecard.
Figure 4.1 The Balanced Scorecard and its application in performance evaluation

Overview of operations of Communications Utility

Identification of key Activities and the Value Creation Process

Categorising activities Into the four (4) Perspectives

Financial Perspective

Client (consumer) Perspective

Innovation and new services perspective 138

Internal process perspective

Develop Key Performance Indicators (KPIs)

Establish a performance evaluation system

With permission from Mpangwe Kasonso@2006 Element 4.2 Value For Money (Performance Measures For Not-For Profit Organisation)

Element 4.2.1 Nature of a Not-For Profit Organisation At this point in your studies you should appreciate that organizations can exist as business or non-business. Not for profit organizations are organizations, which have not been set up with the view to generating profits. Example of these organizations would include churches or religions organization, Non-Governmental Organisations (NGOs), and local government e.t.c. Even if these organizations are not businesses they have a wide number of stakeholders who have an interest in them. These stakeholders would want to know how efficiently and effectively the organizations they subscribe to are operating. The key stakeholders to an NGO for example would be the donors, employees and the local or domestic governments in which the NGOs are operating. In case of local government the can have the following as the key stakeholders 1. Political leaders 2. Citizens 3. Tax payers e.t.c

139

NATURE OF PERFORMANCE MEASUREMENT

Whether in case of a business or a not for profit organization, performance measurement looks at an exercise of comparing the actual performance level attained by an organization against the set objectives and set performance parameters (standards) Therefore we can have several and different performance measures depending on the nature of business or activities of an organization. Element 4.2.2 Nature of Performance Measurement in Not-For Profit Organisations In not for profit organization (NFPOs), the performance will be measured by comparing performance standards set out against the actual performance attained by the organization. However, since these organizations do not exist to make profits, it will not be a priority to ensure that the profit measure does not come up as a very important or paramount matter. However, most NFPOs aim to have a surplus (an excess of income over their expenditure) as they are not expected to continue pestering and exerting pressure on donor funds or tight government fiscal and monetary policies. Element 4.2.3 The Three Es (Effectiveness, Efficiency and Economic) The three Es are used as the main primary measures of performance in not for profit Organizations. 1. EFFECTIVENESS Effectiveness refers to the organizations ability to attain its set out objectives. So, is a measure that aims to asses whether organizations are achieving their corporate objectives or not. Care must be taken to realize that in effectiveness we do not give a lot of consideration to the resources we are putting into use when pursing the organizational goals. 2. EFFICIENCY Efficiency is a measure of how well organizations utilize their available resources. Therefore, efficiency looks at a comparison between the qualities of resources used in a particular activity to the level of output produced using the resources.

140

In some cases efficiency can be measured by using some efficiency ratios. Please refer to the ratios as illustrated in chapter 8 under variance accounting. 3. ECONOMY The economy aspect aims to measure the value for money for the service the organization is serving to its clients. Economy or value for money will differ from circumstance to circumstance. For instance when assessing the economic or value for money in a government ministry or local government, the tax payers will want to hold government official accountable and they will make independent assessments as to whether the taxes paid are being used according to public expectation or not. In other circumstances such as in a local government clinic, patients would like to see to it that they are given good healthcare. They will want to ensure that the waiting times before consulting the doctors are abbreviate and reduced. In addition they would like to see that the hospital is stocked with drugs required to cure various diseases.
KEY PERFORMANCE INDICATORS (KPIS)

The mostly used key performance indicates in assessing performance in not for profit organization will include the following and depending on the nature of business an organization is involved in: 1. 2. 3. 4. 5. Length of waiting time. Courtesy of employees toward, clients. Number of clients complaints Innovation levels. Financial discipline through financial surplus posted.

If a not for profit organization is not performing according to stakeholders expectations we would want to utilize benchmarking as a way of trying to enhance the performance of a given not for profit organization (you should remember that you will look at the subject of benchmarking in section 4.6 of this chapter).

141

Element 4.3

FINANCIAL PERFORMANCE MEASURE

Element 4.3.1 There is substantial evidence from a large number of studies that the existence of a defined quantitative goal or target is likely to motivate higher levels of performance than when no such target is stated. People perform better when they have a clearly defined goal to aim for and are aware of the standards that will be used to interpret their performance. There are three approaches that can be used to set financial target against which performance can be measured. They are: a) Targets derived from engineering studies of input output relationship b) Targets derived from historical data and c) Targets derived from negotiations between superiors and subordinates Element 4.3.2 Engineered Targets These can be used when there are clearly defined and stable inputs output relationships such that the input required can be estimated directly from product specifications. For example, in a fast-food restaurant for a given output of hamburgers it is possible to estimate the inputs required because there is a physical relationship between the ingredients such as meats, buns, condiments and packaging and the number of hamburgers made. Where clearly defined input-output relationships do not exist, other approaches must be used to set financial targets. One approach is to use historical targets derived directly from the results of previous periods. Previous results plus an increase for expected price changes may form the basis for setting the targets or an improvement factor maybe incorporated into the estimate, such s previous period costs less a reduction of 10%. The advantage of using historical targets is that they may include past inefficiencies or may encourage employees to under-perform if the outcome of efficient performance in a previous period is used as a basis for setting a more demanding target in the next period. Element 4.3.3 Negotiated Targets Are set based on negotiations between superiors and subordinates. The major advantage of negotiated targets is that they address the information asymmetry gap that can exist between superior and subordinate. This gap arises because subordinates have more information than their superiors on the

142

relationship between outputs and inputs and the constraints that exist at the operational level, whereas superiors have a broader view of the organization as a whole and the resource constraints that apply. Negotiated targets enable the information asymmetry gap to be reduced so that the targets set incorporate the constraints applying at both the operational level and the firm as a whole. Element 4.3.4 Performance Measurement Targets vary in their level of difficulty and the chosen level has a significant effect on motivation and performance. Targets are considered to be moderately difficult ( or highly achievable) when they are set at the average level of performance for a given task. According to Merchant (1990) most companies set their annual profit budgets targets at levels that are highly achievable. Their budget are set to be challenging but achievable say 80 90 % time by an effective management team working at a consistently high level of effort. Target set levels above average are labelled as difficult, tight or high, and those set below average are classed as easy loose or low. Research evidence suggests that setting specific difficult budget targets leads to higher task performance than setting specific moderate or easy targets (Stedry and Kay 1966). However Hirst (1987) has advocated that the benefits arising from setting specific difficult budget goals are dependent on the level of task uncertainty. He suggests that where uncertainty is low , setting specific difficult budget goals will promote performance, and the subsequent use of difficult budget goals to measure performance will minimize the incidence of dysfunctional behaviour such as falsifying accounting information. A flexible budget therefore is an important tool in performance measurement as it ensures that the cost targets used as a basis for comparison are flexible as levels of output change.

Element 4.4

NON-FINANCIAL PERFORMANCE

Element 4.4.1 Within an organisation people are employed to carry out specific activities. The only aspect of their work over which they have direct control may well be the volume and the quality of tasks they undertake, applying revenues and costs to these activities may be important to the organisation as a whole, but will have little meaning to the individual employee

143

who does not sell the goods or services directly and does not purchase the input material. To ensure that the motivation of employees is consistent with the profit objectives of the organization, it may be necessary to use non-financial performance measures to indicate what is required to achieve the overall financial targets. Using nonfinancial performance measures does not mean that the financial performance measures may be disregarded. They are ways of translating financial targets and measures into something that s more readily identifiable by a particular employee or group of employees. Element 4.4.2 Quality Measures As stated under financial performance measures, a flexible budget is important in ensuring that the cost targets used as a basis for comparison are flexible as levels of output change. This is essential in order to avoid a sense of injustice in the application of management accounting techniques. However, it may not be sufficient to motivate employees directly in understanding and meeting the targets expected of them. The accounting numbers have to be converted to some measure of quantity which relates more closely to the individual. If the employees are involved in the entire production process, then the financial target may be converted to units of product per period. This approach may be more difficult when a service activity is involved or a group of employees are involved in only part of a production process. Element 4.4.3 Illustration of the problems of performance measurement in a service business Take a school as an example, where activities are subdivided by subject area. The primary measure of activity will be the number of pupils taught, but the individual department will have no control over that number. If teaching staff are appointed on permanent contracts, so that salary costs are largely fixed costs, then the cost per student will vary depending on the number of students taught in any period. A performance measure of cost per student may be attractive to the management accountant but will have little impact on the staff of the history department whose main aim is to ensure that their pupils achieve high grades in the end-of-year examinations. For them, examination success rates are the prime performance measure and they will be concerned to ensure that fluctuations in pupils number do not affect that success rate. A performance report on the history department

144

would therefore, emphasise first of all the non-financial performance in terms of examination success but would then additionally report the cost implications so that the consequences of achieving high or low success rat could be linked to the cost of that activity. Element 4.4.4 Quality Measures The ultimate measure of quality is customer satisfaction. The important aspect of quality is the process undertaken by the organisation to achieve quality. This is so important that an external agency ( often the auditors) may be employed to provide independent certification of the quality of the process. Secondly, quality is measured also in terms of the inputs to the process, where inputs may be materials, labour and capital equipment. Quality f inputs may be controlled directly by imposing standards on suppliers, or may be monitored by reviewing the rate of return on unsatisfactory goods. The nonproductive time incurred because of faulty equipment or the reliability of delivery dates and quantities. Element 4.4.5 Some specific examples of on-financial measures are: 1. in respect of demand for products: a) the number of enquires per advertisement placed and b) percentage of customers who remember the advertisement; 2. in respect of delivering the product: a) error free deliveries as a percentage of total deliveries b) number of complaints as a percentage of units sold; and c) time between receiving customer order and supplying the goods or services Example : Zesco an electricity company provided the following information about non- financial performance over a one year period.
RESTORE SUPPLY IN THREE HOURS TARGET 90% PERFORMANCE 92.8% RESTORE SUPPLY IN 24 HOURS TARGET 99% PERFORMANCE 99.9%

145

MOVING A METER INSIDE 15 WORKING DAYS REPLY TO TELEPHONE CALLS WITHIN 10 SECONDS

TARGET 95% PERFORMANCE 96.7% TARGET PERFORMANCE 90% 86%

Element 4.4.6 ACTIVITY Write out any non-functional performance measures which could be reported by an organization which delivers parcels to the general public and businesses.

Element 4.5 Divisional Performance Measures In an organization; the degree of authority delegated by top management to lower level operating management can be viewed as an issue. In some organizations, control can be centralized, where senior management at head office exercise control over complete activities of the organization. In some cases senior management at head office can delegate to divisional managers to branches and divisions of the company. In this case the company will be running a decentralized control system. In the later case it will become necessary to provide program measures which will serve as guides and targets for performance expected of the various divisions operating under head office. Therefore at this point, we want to examine the different performance measures we can use to assess performance of divisions.
BACKGROUND INFORMATION (KNOWLEDGE)

At this point we would like to remind all candidates about the concept of Cost-centres Profit-centres Investment centres.

(a) A Cost Centre A cost centre according to the CIMA official terminology can be an ability location machine or business unit in relation to which cost are included

146

(b) Profit centre A profit centre can be an ability location machine or business unit for both cost containment and revenue generation, so that ultimately an actual motional profit can be determined (c) Investment centre An investment centre can be an activity location machine or business unit where managers are responsible for cost containment, revenue generation and the acquitting and disposal of the objects used to support the centres activities In different cases the division can be treated as any or in light of the abovementioned centres. The two commonly used financial measures of divisional performance in such cases are return on investment and residual income. However divisional and corporate performance nowadays can be assessed by use of other modern performance measures such as economic value added (EVA) a trademark from stern and Co- an American consulting company However we are not going to consider the modern performance measures of economic value added (EVA), and market shareholder value added in this text.

RETURN ON INVESTMENT (ROI)

This is the divisional equipment of the generally known as the on capital employment measure used in financial statement analysis and simply expresses percentage of the funds invested in the particular sub-unit. The return on investment can be calculated using the formula: Return on = Investment Divisional profit x 100% divisional Investment

As it can be understood profit only related to a period of time and investment can only be measured at a point in time, therefore it would be usual for the investment to be averaged over the time period in question. As it will be seen by concentrating on a percentage return rather than the absolute if the divisional profit, Return on investment adopt an efficiency criterion which recognizes the critical relationship / connection between a divisional income and the assets employed in generating the income.

147

For instance a profit of K400, 000, 000 on an investment of K2, 000, 000, 000 gives a return on investment of 20% This represent a more efficient use of assets than a profit of K800, 000, 000 of an investment of K10, 000, 000, 000, al other things being equal. We appreciate that capital will always have alternative uses and a firm must satisfy itself that it is not an opportunity cost associated with an investment in a particular division i.e. it must be determined whether the return exceeds that which could be obtained from an alternative use of the invested finances.

BREAK DOWN OF RESIDUAL INCOME.

In order to have fair insight into a divisions performance the basic formula as broken down by means of the so called Du Point method of probability analysis into the product of the investment tomour and profitability ratio: As you could have read further the Du Point Company of U.S.A did quite a lot of work around the subject of divisional performance assessment and assessment measures. Divisional Sales x Division investment Investment = Return on investment. As it can be seen from above simplifying the divisional sale cancels out leaving the same end formula. The breakdown has considerable significance for analysis and decision-making purposes, as the following example will show. Example: Sounds investments Ltd sells music records through its own, in-town street stores and through its agents out-of-town. Both businesses through agents and through own stores yield the same return on investment of 15% but this is earned in quite difficult ways. Division profit Divisional sale = Divisional profit Divisional

148

Through Agents Division profit Division Investment Divisional sales Through Agents the ROI is; ROI = Divisional profit = Divisional investment K600,000 K4,000,000 K8,000,000

Through own stores K960,000 K6, 400,000 K19,200,000

K300,000 X 100% K2,000,000

= 15%

Break Down

= Divisional sales X Divisional Investment

Divisional profit Divisional sales

= K8,000,000 X K4,000,000

K600,000 = 2 x 7.5% = 15% K8,000,000

Through own-stores ROI = Divisional Profit = Divisional Investment K 960,000 x 100 K6,400,000 Divisional Profit Divisional sales

=15% BREAK DOWN = Divisional sale X Divisional investment = K19,200,000 K6,400,000 = 3 x 5% = 15% x K960,000 K19,200,000

Even if the Business through agents earn a higher profit on the sales of 7.5% the investment in the business through the agents is only tomorrow over twice, whereas the lower profit margin accepted on sales in the own-stores business if 50%, which generator a higher sales volume leading to an investment tomour of three (3)

149

Example Last year, Pep stores of Chipata produced a profit of K600,000.00 on sales of K2, 000, 000. The investment in the division was K4, 000, 000 ROI = Divisional Profit x 100% Divisional Investment = K 600, 000 x 100% K4, 000, 000 = 15%

BREAK DOWN:

Divisional Sales x Divisional Investment K2, 000, 000 K4, 000, 000 x

Divisional Profit Divisional sale

K600, 000 K2, 000, 000

= 0.5 x 30% = 15%

In the current year the divisional manager has reported an increase in his ROI to 18%. How is this to be interpreted? First sight it is an unqualified improvement but review of the figure reveal that the 18% comes from a profit of K1, 080, 000 on sales of K2, 400, 000 generated by an investment of K6, 000, 000 ROI = K1, 080, 000 K6, 000, 000 Break Down = K2, 400, 000 K6, 000, 000 = 18% From the analysis it can be seen that a dramatic increase in the profit margin (form 30% to 45%) which has fortunately more than affected a marked determination in the investment tumors (from 0.5 to 0.4) lending to the overall increased ROI. If however the determination in the investment tumors was causes by an undesirable and expensive hand-up of stocks of finished goods due to excessive production during the current period and the dramatic rise in profit x K1,080, 000 K2,4 00, 000 = 0.4 x 45% X 100% = 18%

150

margin was a function of the operation of an absorption costing system which had improved profitability on those goods actually sold in the current period, by differing much of the periods fixed manufacturing costs to a later period then the improvement in ROI is no case for congratulation. The breakdown of ROI into investment tumors and profitability ratio provides top management with two additional criteria with which to measure a divisions performance. Further at the divisional level by highlighting the different factors, which contribute to ROI, it can provide a local manager with limits as to the type of action that would be necessary to improve the sub-limit return. For example if all other factors were held constant, ROI would be improved by any of the following individual actions i. ii. iii. iv. An increase in selling price (for any given volume of sales) An increase in sales volume (at a given selling price) A reduction in either fixed or variable costs. A reduction in the level of divisional investment.

Actions (i) to (iii) will increase the profitability ratio and hence the ROI; action (iv) will do likewise by increasing the investment tumors. It is obvious that any combination of (i) to (iv) will also improve the ROI as well as a combination containing opposite movements that happen to be more than affect by positive factors. This will be highlighted when we consider the example looked at under behavioural implication of using divisional measures of performance. Element 4.6 Benchmarking The term benchmarking refers to the establishment through data gathering of target and comparators through whose use relation levels of performance can be identified. By the adoption of best practice it is hoped that performance will improve. Therefore benchmarking aims to encourage corporations to improve their performance by comparing their own performance to that of other companies.

151

Element 4.6.1 Steps In Benchmarking The bench marking process starts by first relating appropriate comparators against which a company can compare its performance. This entails that the target against which benchmarking is going to be carried out should be a company with similar operations as ours. The comparators competitor should be of similar size and therefore showing as good comparator. Element 4.6.2 Information Gathering Benchmarking starts with obtaining the information required in order to benchmark against competitors Element 4.6.3 Financial Statement and Reverse Engineering The data obtained can be either financial information or non-financial information and we should acknowledge here that non-financial is not easy to obtain. Financial information is much more readily available especially for listed companies as we can easily access their published accounts through the register of companys files/archives. Non-financial information about competitors and their products can be obtained by reverse engineering. Reverse engineering insists buying a competitors products and dismantling it in order to understand its content and configuration Element 4.6.4 Other Sources of Information In order to obtain information about their competitors we would use the following sources; (i) (ii) Product literature Trade associations and press comments

However we should realize that a product is only the end result of the process, which a business follows, and thus effective benchmarking requires an understanding of the actual basic process of their businesses.

152

As noted above obtaining information about competitors processes is much more difficult than getting information about their products. For example, how do competitors process their customer orders, deal with customer enquiries, conduct their relationships with suppliers and other keep stakeholders? Element 4.6.5 Types of Benchmarking The exercise of benchmarking can be classified in different types. However in our studies here we want to classify benchmarking in two parts. Internal benchmarking External benchmarking Inter-industry benchmarking (a) Internal benchmarking With internal benchmarking, we compare the performance of the different departments or business units against the least department in class. Note that in internal benchmarking we are comparing different departments in the same organisation regardless of the business activities or discipline they are handling. (b) External benchmarking With external benchmarking, we compare the performance of the company against the performance of others in the same line of business, for example we can compare the performance of Shoprite Checkers against the performance of Game stores in a given control period. External benchmarking does not only apply to corporate performance but external benchmarking mighty also include the comparisons of departments in organization against the performance in the group of these departments from companies operating in the same industry. For instance we would want to compare the finance department of Shoprite, Game stores and Melissa against the performance of a top performing finance department in the chain store industry. (c) Inter- industry benchmarking

153

In inter- industry benchmarking we compare the performance of our corporation against the top in the class (or top) performing corporations regardless of the industry in which the top performing company originates from. Therefore to successfully carry out this, we need to identify a non- competing business, however, with similar processes and risk to participate in the benchmarking exercise. For instance, computer connection, a distributor of personal computers may approach a distributor of HI- FI equipment as HI- FI City, to establish a benchmarking relationship.

Element 4.6.6 Benefits of Benchmarking The benefits of benchmarking are quite obvious, however we can dwell on these few: Benchmarking enables the corporation to benefit from the experience of the others and thereby establishing best practice in their common business processes. By collaborating with other companies in a benchmarking exercise, the corporation can improve its performance by learning from the experience of others.

Element 4.6.7 Pitfalls of Benchmarking We should be mindful of that benchmarking might give planned results sometimes The planned results can be obtained in the following situations: In a situation where a comparative competitor is not right or comparable size and background, the comparisons might be flawed. In a situation where the company or business unit that has been identified as the best in class is not a highly performing business unit or company, it might be a situation of a one eyed person operating as king among the blind and this is not going to help the lagging companies or departments to make quantum leaps in terms of their performance improvement. Element 4.7 BEHAVIOURAL ASPECTS OF PERFORMANCE MANAGEMENT

Element 4.7.1 The human aspects of controls in relation to performance measurement is a key factor in evaluating the control system.

154

A control systems objective is primarily to enable the organization achieve its objectives. This means that employees must be motivated to achieve those targets. However, controls can sometimes result in employees behaviour which works against the objectives of the organization. Consequently such behaviour will lead to the non-achievement goal congruence. It is common for individual employees to pursue their personal performance in order to meet the control system measures even if in doing so the overall organisational objectives are impacted negatively. In general, performance measurement should result in desirable behaviour which will enable the organization to meet its corporate objectives. Element 4.7.2 PERFORMANCE INDICATORS Performance measures must be in such a way as to help the organization achieve its objectives. However, it is the case that performance measures will not necessarily reflect the ideal measure of overall performance. This results in some measures not achieving goal congruence or desirable organizational behaviour. Element 4.7.3 It is also important that employees do not concentrate only on what is measured even if it does not ultimately lead to achieving goal congruence. This should therefore encourage the organization to incorporate other control measures which are not necessarily specified in quantitative terms. Element 4.7.4 In evaluating performance, a fair appraisal system must be used which should create a positive attitude in employees. It is a basic principle that performance evaluations are considered fair only when employees are not held accountable for results which they have little control. Further more the outcomes should not be used as means of punishing employees but as a way of improving the efficiency and effectiveness of the organisations activities. Element 4.7.5 Performance indicators should always provide for controllable and uncontrollable factors. It is common practice for uncontrollable factors to be excluded from employee performance measurements. However, this does not mean that uncontrollable items should not be reported. It is also important not to make Departmental Heads accountable for areas where they do not seem to have significant influence. Element 4.7.6 BUDGETS AND PERFORMANCE MEASUREMENT

155

Budgets are supposed to provide a way of motivating employees (especially managers) to meet the desired financial targets. This however, can only be the case if people responsible with implementing the budget are agreeable to the set financial targets. It is however, practically difficult to reach a consensus as the ideal financial targets without some managers being dissatisfied. It is assumed that with each level of budget difficulty encountered by managers in meeting the targets, there is a corresponding increase in the performance and motivation levels. However, after a certain level of budget difficulty, performance and motivation levels will start declining. From this analysis, it is therefore important to identify some level of budget difficulty which should at least maximise employee performance and motivational levels. Element 4.7.7 In a study carried out by Hofstede concerning the budget difficulties, the following conclusions are made: a) Budgets have no motivational effect unless they are accepted by the managers involved as their own personal budgets. b) Up to the point where the budget target is no longer accepted, the more demanding the budget target the better the results achieved. c) Demanding budgets are also seen as more relevant than less difficult targets, but negative attitudes result if they are seen as too difficult. d) Acceptance of budgets is facilitated when good communication exists. The use of departmental meetings was found helpful in encouraging managers to accept budget targets. e) Managers reactions to budget targets were affected both by their own personality and general cultural and organizational norms.

156

STUDY UNIT 5.0 DECISION MAKING TECHNIQUES

Learning outcomes: After studying this chapter students should be able to Understand risk Demonstrate various ways of assessing risk and uncertainty Demonstrate full knowledge of sensitivity analysis Draw and prepare decision tree diagrams.

Element 5.1 Sensitivity Analysis Sensitivity analyses can be used in any situation so long as the relationship between the key variables can be established. Typically this involves changing the value of a variable and seeing how the results are affected. Definition Sensitivity analysis is a term used to describe any technique whereby decision options are tested for their vulnerability to changes in any variable such as expected sales volume, sales price per unit, material costs or labour costs. The main common approaches to sensitivity analysis are as follows: (a) To estimate by how much costs and revenues would need to differ from their estimated values before the decision would change. (b) To estimate whether a decision would change if estimated costs were X% higher than estimated, or estimated revenues Y% lower than estimated. (c) To estimate by how much costs and or revenues would need to differ from their estimated values before the decision maker would be indifferent between two options. The essence of the approach therefore, is to carry out the calculations with one set of values for the variables and then substitute other possible values for the variables to see how this affects the whole outcome. From close examination of other chapters in this book, you will actually discover that sensitivity analyses are included through the following exercises.

157

(i) (ii) (iii) (iv)

What if analysis under information systems (chapter 10) using spreadsheets). Linear programming in chapter 5 under linear programming. Flexible budgeting can also be a form of sensitivity analysis see chapter 6 under flexible budgets. Sensitivity analysis is one method of analyzing the risk surrounding a capital expenditure project and enables an assessment to be made of how responsive the projects NPV (net present value) is to changes in the variables that are used to calculate the net present values (NPV).

Example: SENSA (Z) Ltd has estimated the following sales and profits for a new product which it may launch on to the market. K000 Sales (2,000 units) Variable Costs: material labour Contribution Less: incremental fixed Profit Required: Analyse the sensitivity of the project. Solution: (a) If incremental fixed costs are more than 25% above estimate, the project would make a loss. (b) If unit costs of materials are more than 10% above estimate the project would make a loss. 4,000 2,000 (6,000) 2,000 (1,600) 400 K000 8,000

158

(c) Similarly, the project would be sensitive to an increase in unit labour cost of more than 20% above estimate. Management would then be able to judge more clearly whether the project is likely to be profitable. The items to which profitability is most sensitive to in this example are the selling price and material costs. Sensitivity analysis can help to concentrate management attention on the most important forecasts. Example: YUKAA PLC is considering a project with the following most likely cash flows Years Purchase costs K000 (7,000) 2,000 2,500 6,000 7,000 Running costs K000 Savings K000

0 1 2

The cost of capital for the project is 8%. Required: Measure the sensitivity (in percentages) of the project to changes in the levels of expected costs and savings. Solution: The present values of the cash flows are as follows Year discount Factor 8% 0 1 2 1.000 0.926 0.857 present value of plant cost K000 (7,000)

159

_______ (7,000) Present values of Running costs K000 Present Values of Savings K000 Present Values of Net Cash Flow K000 (7,000) (1,852) (2,143) (3,995) 5,556 5,999 11,555 3,704 3,856 560

The project has a positive NPV and would appear _____________. The changes in cash flows which would need to occur for the project to break even (NPV = 0) are as follows. (a) Plant costs would need to increase by present value of K560,000 that is by: K560,000 x 100% = 8% K7,000,000 (b) Running costs would need to increase by present value of 560,000 that is by: K560,000 x 100% = 14% K3,995,000 (c) Savings would need to fall by a present value of K560,000 that is by: K560,000 x 100% K11,555,000 = 4.8 Element 5.1.1 Problems with sensitivity analysis (a) The method requires that changes in each key variable are isolated but management is more interested in the combination of the effects of changes in two (2) or more key variables. Looking at factors in isolation is unrealistic since they are often interdependent.

160

(b) Sensitivity analysis does not examine the probability that any particular variation in costs or revenues might occur. Example DEF (Z) Ltd is considering the launch of a new product, the Delta. If 10,000 units per annum are sold, the net present value over five years will be K1,560,000,000, but if 20,000 units are sold per annum the net present value over the same period will be K2,875,000,000. Required Calculate the minimum annual sales volume that will justify the launch of the delta. Solution The minimum sales volume is the volume that produces a net present value of zero. This occurs at a volume of 10,000units + K1,560,000,000 x 10,000 units K1,560,000,000 + K2,875,000,000 = 13,517 units Sensitivity Analysis is a modelling and risk assessment procedure in which changes are made to significant variables in order to determine the effect of theses changes on the planned outcome. Of paramount importance, it is vital to identify variables that are of special significance. As the definition indicates sensitivity analysis can be applied to a variety of planning activities and not just to instruct decisions. For instance it can be used in conjunction with break-even analysis to ascertain by how much a give factor can change before the project ceases to make a profit. In sensitivity analysis a single input factor is changed at a time, while all other factors remain at their original estimated. We can approach sensitivity analysis from two perspectives.

161

1. An analysis can be made of all the key input factors to ascertain by how much each factor must change before the net present value reaches zero i.e. the indifference point. 2. Alternatively specific charges can be calculated, such as the sales decreasing by 5%, in order to determine the effect on the net present value. Example The example below shows how sensitivity analysis works in practice. Muponga Ltd is contemplating investing in a project which will need initial capital investment of K 100, 000, 000. It is estimated that this will generate sales of 10,000 units per annum for four years. The contribution per unit is expected to be K6, 000 and the fixed costs are expected to be K 26, 000, 000 per annum. The cost of capital is 5%. Required: i. ii. Calculate the net present value By how much can each factor change before the company becomes indifferent to the project?

Suggestion Solution: i. K000

Total Contribution = K 6, 000 x 10, 000 Units = 60,000 Less: fixed costs Net cash inflow per year NPV Years 0 14 Outlay annual cash Inflow Cash flow K000 (100, 000) 34, 000 = (26, 000) 34, 000 DCF @ 5% 1, 000 3.546 PV K000 (100, 000) 120, 564 20, 564 ii. Net present value can fall by K 20, 564, 000 before the indifference point is reached. This implies that the annual cash flows can change by

162

X x 3.546 = K 20, 564, 000 X = K 5, 800, 000 Therefore, the costs can fall by K 5, 800, 000 to K20, 200, 000

Element 5.1.2 Application of Sensitivity Analysis in Project Appraisal We dealt with capital investment appraisal chapter; we assumed that all the quantitative factors in the investment decision i.e. cash flows and the discount factors or costs of money were known with certainly. However, most practical investment decisions are married with a great deal of uncertainty. In order to give decision makes a clearer understanding of the problem without providing definitive guidance though, we have many approaches to deal with this. Sensitivity analysis is one of the methods of reducing uncertainly and assessing certainty in investment decisions. As it can be seen that most work in sensitivity analysis involves altering key variables and an assessment spreadsheet can be easily employed to carry out sensitivity analysis. Sensitivity analysis can be used as an attention directing technique as it directs attention to those factors that have the most significant impact on the outcome of a given Project. However in most projects the various variables will have interdependences amongst themselves. Therefore, we cannot just take a simplistic approach to assume that each variable has to be considered in isolation. Example: A company is contemplating investing in a new product; the net present value of the investment is K 2, 000, 000, 000. However, this is not a certain net present value; it has not been calculated with data on the most likely value of each of the four variables affecting the decision. These variables are listed below. Each of the factors has a significant influence on the profitability of the proposed project.

Element 5.3 Linear Programming

BASIC MECHANICS OF LINEAR PROGRAMMING

At this stage you are expects for know how to use basic linear programming technique to handle situation where you have two constraints limiting the undertaking of an entity.

163

STEPS IN LINEAR PROGRAMMING

STEP 1: Establish the objectives function In business, corporations are there to make profits as they wish maximum the wealth of shareholders. The profits will be maximized by either increasing turnover of the company or by minimizing costs of operations, since profit is a function of Revenue against expenditure. Profit = Revenue Expenses. Therefore, at any given point in time a business will want to either minimize cost or maximize profits and therefore shareholders wealth. Therefore, the first step in linear programming will initiate the establishing of an objective function, which usually will aim at minimizing costs of operations or maximizing revenues from operations. If the aim is to maximum profits from two products X and Y, we would construct an equation showing the total profit we would earn from the sale of one unit of X and one Unit of Y. Supposing that one unit of X gives us a unit profit of K 15, 000 and a unit of Y gives us a profit of K 20, 000, we would construct the total profit equation as follows: Total profit = Profit from + Profit from one One unity of X Unit of Y. Therefore, total profit = K15, 000 X + K 20, 000 Y This will serve as the objective function in a situation where a business aims to maximize profits. In a case where an organization would like to minimize costs, we would construct a similar objectives function which would however aim to minimize the costs of operating. Assuming that we have the same two products X and Y in our product catalogue at which each unit of the products income to that cost of production is K20, 000 and K 28,000 respectively, how would we construct the objectives function? Total cost = cost of manufacturing + cost of manufacturing One unit of X one unit of Y Total cost = K 20, 000 X + K 28, 000 Y. Therefore in this case the above equation will be the objective function in a case where the company aims to minimize the costs of operating.

164

STEP 2: Inequalities. The next step in linear programming is the establishment and determination of inequalities which show the different constraints. In most manufacturing situations raw materials, skilled labor, factory capacity and many more factors might act as constraints limiting factors. Therefore the inequalities are constructed according to the constructs shown in the scenario. Having established the inequalities you will need to convert them into equations, where we will replace the inequality signs (e.t.c) by the equal sign (=) STEP 3: Establish Non- Negativity equations. At this stage we want to realize that all the analysis we will conduct under linear programming will have to yield positive figures, if they have to make arithmetic sense. Therefore all the analysis and graphic representation will have to be made in the quadrant which has both positive X and Y variables on the graph as represented below. +Y

-X

+X

The shaded area shows the region where we will expect ourselves to have the linear programming results as this is the area where both the X and Y variables will be positive on the graph. The non-negativity equation therefore aims to form a block or boundary within which the graph has to be drawn. We cannot have negative figures coming from the graph as optional solutions. The non-negativity equation will be:

165

X And

Y O These will further need to be convert into equation, and the resulting equations will be X = O and Y = O respectively

STEP 4: Plot the equation lines on the graph.

STEP 5: Determine the Optimum position mix or combination. Since this is brought forward knowledge. Try the example below and see if you can remember your basic linear programming technique. Question: Manzi Co makes two components, K, and K2 and has the following constraints on a monthly production. Operative time Raw material A Raw material B 240 man-hours. 500 Kg 400 Litres

K1 uses man-hour, 5Kg of A and 5 litres of B to make each unit. K2 uses s man-hours, 5 Kg of A and 4 litres of B to make each unit. The contribution to profit from each unit of K1 and K2 are K 150,000 and K 100, 000 respectively. It is known that all production can be sold. Required: Represent the above situation as a linear programming model, if the objective is to maximize total monthly profit.

166

THE SIMPLEX METHOD

A linear programming problem with more than two constraints or decision varieties cannot be plotted on the two axes of the graph i.e. the X and Y axes. Therefore were need different method of solving the problem: i.e. the simplex method. The simplex method begins in the same way as the ordinary linear programming operation, by setting up equation for the objectives function and the constraints. In illustration below will explain the simplex method properly. Example Mulobezi timber table require time for the cutting of the component parts for assembly and for finishing. The data in the table below has been collected for the year now being planned.

HOUR REQUIRED FOR TABLE

CONTRIBUTION OF EACH TABLE

TABLE Small Medium Large Extra large Available Charge In Hours

CUTTING 2 2 1 6 3,000

ASSEMBLY 5 4 3 2 9,000

FINISHING 1 4 5 3 4,950

K000 60 123 135 90

Due to other commitments no more than a total of 1,800 coffee tables can be made in any given year. In addition market analysis reveals that the annual demand for the companys small coffee table is at least 800. The company wishes to determine how many of each type of coffee table it should produce in the coming year to maximize contribution. The detailed linear programmes procedure described above can be applied to the molobezi scenario as a linear programme. The objective variables are stated as: Let Z = total contribution earned in the coming year in kwacha from the production of the coffee tables. The quantities of the four types of coffee tables to be produced are the activities of the problem. There are four decision variables in the model defined as, Let X1, X2, X3, X4 = the number of small, medium large and extra, large coffee tables to be producing in the coming year.

167

The company wishes to maximum contribution so the objective function is; Maximize Z = K 60, 000X1 + K 123, 000X2 + K 135, 000X3 + K 90, 000X4 The quantities of the four types of coffee tables made will be restricted by the limited availability of cuttings, assembly and finishing time. This there will be three constraints specifying, respectively, that the amount of cutting, assembly and finishing time used in production cannot exceed that which is available. These are written as: 2X1 + 2X2 + 1X3 + 6X4 3, 000 5X1 + 4X2 + 3X3 + 2X4 9, 000 1X1 + 4X2 + 3X3 + 3X4 4, 950 The total of the 4 decision varieties cannot exceed 1,800 there is a ceiling (maximum) on the total number of coffee tables to be manufactured. Thus the following constraint must be included in the model; X1 +X2 + X3 + X4 1, 800. The requirement that at least 800 small coffee tables must be produced can be expressed in a mathematical equation as X1 800 Finally, non-negatively conditions (equations) must be states for the other three decision varieties i.e. X2, X3, X4 0 The complete model for Mulobezi, timbers linear program is therefore Maximize Z = K 60, 000X1 + K 123, 000X2 + K 135, 000X3 + K 90, 000X4 Subject to: 2X1 + 2X2 + 1X3 + 6X4 3, 000 5X1 + 4X2 + 3X3 + 2X4 9, 000 1X1 + 4X2 + 5X3 + 3X4 4,950 X1 + X2 + X3 + X4 + 1,800 X1 800

168

X2, X3, X4 0. As it can be seen, this model cannot be solved graphically as there are more than 2 variables. A general algebraic method of solving linear programming problems, based on the fundamental concept that the optical solution occurs at a corner point of the seeable region could be used this is called the simplex method. However, a computer package that incorporators this method has been used and this will typically yield the information as shown below: Objectives function Variable (Z) =K168, 750, 000 Variable X1 X2 X3 X4 Value 950, 000 250, 000 600, 000 0, 0000 Relative Loss. 0, 0000 0, 0000 0, 0000 48, 000

Constraint 1 2 3 4 5

Slack / surplus 0, 0000 1, 450, 000 0, 0000 0, 0000 150, 0000

Worth. 9, 000 0, 0000 21, 000 21, 000 0, 000

1.

The Variable and value columns mean that X1 = 950; X2 = 250; X3 = 600; X4 =0. Therefore to maximize contribution in the coming year, Mulobezi, should manufacture 950 small coffee tables, 250 medium one and 600 large one and none (nil) of the extra large coffee table

169

2. 3.

Z = K 168, 750, 000, shows the total contribution that will be earned from the above production of the tables in the coming year. The constraints and slack/surplus columns provide information concerning the slack values for the less than or equal to constraints and the surplus values for any greater than or equal to constraints. From your studies of linear programming we know that a slack variable is the amount of resource which will be unused in a specific linear programming solution and a surplus is the extra that is produced above the minimum requirement in a greater than or equal to constraint. a) Constraint 4 is and refers to cutting time. It slack to Zero showing that all availability cutting time will be used. b) Constraint Z is and refers to assembly time the slack here equals 1, 450 and this there will be 1, 450 unused hours of assembly time. This assembly time is not a binding constraint. c) Constraint 3 is and refers to finishing time. Its slack is zero indicating that all of this resource will be used. d) Constraint 4 is and refers to the ceiling on the total number of coffee tables produced of 1, 800. The slack is zero. Showing that this ceiling has been net exactly. e) Constraint 5 is and specifies that at least 800 small coffee tables will be made. It has a surplus equal to 150, indicates that production is 150 above the minimum requirement, so 950 of these tables are made. (This can be seen by the fact tat X1 = 950).

WORTH AND RELATIVE LOSS INTERPRETATION

In the above table, it can be seen that we have worth and relative loss columns. The worth shows the shadow price i.e. the amount which contribution would alter if the availability of the resource was changed by one unit. This is extra hour of cutting time would increase contribution by K 9, 000 and extra hour of finishing time would increase contribution by K21, 000.

NATURE OF RISK

It would be rare for the outcome of a business decision to be known with certainty in advance. A measure of risk or uncertainty is present in almost all circumstances in business. Decision theory attempts to distinguish the two concepts i.e. the concept of risk and the concept of uncertainty.

170

Risks exist where several alternative outcomes are possible, but previous expense enables the decision maker to give (assign) a probability to the likely outcome of each alternative. Uncertainty on the other hand refers to a situation where a decision maker has no previous experience and therefore no statistical evidence on which to base his predictions. However, for the consideration of our studies here, the two words i.e. risk and uncertainty will be used synonymously. Decision makers themselves may have differing attitudes to risk. They may be risk neutral, risk-seekers or risk averse. The difference between these three types is a function of attitude towards variability of returns around an expected value (EV). A risk neutral decision maker ignores variability and is concerned only with the expected values of outcomes. Risk seekers prefer of two outcomes with the same expects value time one until greater variation (usually the variation or risk can be measured by the standard deviation). Those who are risk-averse prefer in the same situation, the alternative with less variation associated with it. Decision taken under conditions of risk and uncertainly can be encapsulated in a formal model, which contains the following time outlined elements. An objective function. i.e. the qualification of the companys objectives in a particular situation. Typically, this would be the maximization of profits as it is the belief that the sole objective of a business is maximization of profits. A set of alternative causes of action These can be adopted in order to achieve the desired objectives. This set must be collectively exhaustive i.e. all alternative must be considered and mutually exclusive i.e. one course of action precludes any other. A set of the alternative states of nature that exist in respect of the situation together with the probability of each ones occurring. Again this set must be collectively exhausted and mutually exclusive (and the probabilities must sum up to 1.0) A set of outcomes

171

Each outcome associated with a particular course of action and state of nature. A set of pay-offs, each one associated with a particular outcome. Pay-offs are expressed in terms of the objectives of the function.

A risk neutral decision-maker would accept the alternative course of action that maximizes the pay-off in any particular situation. An illustration at this point in time might be used to show the use of such a model. Illustrative Example: NKETA Ltd buys in sub-assemblies for the manufacture of its own product. The decision it faces is whether to put each sub-Assembly through a details inspection process as it comes into stock. There are two alternative courses of action here:
INSPECT OR NOT INSPECT.

No alternatives are possible (i.e. they are collectively exhaustive), and the adoption of one precludes the other. (i.e. they are mutually exclusive) only two alternative states of nature exists, with the same characteristics either the subassembly comes up to the required quality standard (which it is likely to do 90% of the time) or it fonts to do so (which occurs 10% of the time) Four outcomes are possible: 1) Inspect and find no problems. 2) Inspect and find problems. 3) Do not inspect and no problem exists 4) Do not inspect and problems do exist. Each outcome can be assessed in terms of its pay-off. In the case of: (1) Unnecessary inspection reduces contribution by K 10, 000 per unit, under (2) Inspection and necessary modification reduces contribution by K20, 000; under (3) There is no loss of contribution and under

172

(4), extensive rework at the finished goods stage reduces contribution by K40, 000 As we already introduced the concept of expected value (EV); the expected value of each course of action in this particular example is as follows;
EXPECTED REDUCTOIN IN CONTRIBUTION

INSPECT [0.9x K10, 000] + [0.1x K20, 000] = (K11, 000) DO NOT INSPECT [0.9x K0] + [0.1 x (K40, 000)] = (K4, 000) Taken over a long period of time, a policy of not carrying out an inspection would lead to contribution being on average K7,000 higher for each subassembly purchased. On a purely quantitative analysis, therefore it is the correct policy to adopt. However in the real world, we could have seen a high level of failures incompatible with a requirement for a quality product and the concept of continuous improvement. It would be more useful to ask the supplier some basic questions regarding his quality management in order to bring about a fundamental shift towards outcome (3) rather than simply adopt a policy on the basis of such an uncritical situation. The extra example below introduces a further consideration. Example 2. An efficient middle-aged Zambian businesswoman is considering backing the production of a new musical in the west midlands. It would cost K100, 000, 000 to stage for the first month if it is well received by the critics and will be kept for a further 6 months in which case a profit of K250, 000, 000 over and above the initial investment of K100, 000, 000 would be made. If the critics dislike it, it will close at the end of the K100, 000 initially invested. There is a 50/50 chance of a favourable review using expects value leading to a decision to back the project as its shown in the computation below; Decision to back the musical [0.5x K250, 000, 000] + [0.5x (K100, 000, 000)] = K75, 000, 000 Decision not to back the musical [0.5xK0] + [0.5x K0] = K0

173

However expected value computations rely on repeated performance of an operation process or investment to give economic validity to their average figures. The analysis breaks down in a once-off situation. Such as this; obviously, the expected profit of K75, 000, 000 is not a feasible outcome of this particular decision, the only feasible outcomes of this would be a profit of K250,000,000 or a loss of K100,000,000. Whilst almost everybody welcomes a profit of K250, 000, 000, few individuals would afford to sustain a personal loss of K100, 000, 000. Many investors would be risk averse in such a situation they would not consider that a 50% chance of making K250, 000, 000 was worth an equal 50% percent risk (chance of losing K100, 000, 000, if the loss would bankrupt them). An economic argument will always be tempered by consideration of risk perception and preference, particularly where there is no chance of repetition and the investment is not part of a portfolio. The two examples below as earlier include only single-point outcomes. Conformity with present quality standard or non-conformity in example 1 and a successful show or a flop in example 2. While it is obvious that the two outcomes of the former represent the only possible alternative and qualification of the related pay-offs along the lines of our example appear reasonable, it is equally obvious that the profit of K250, 000, 000 predicts for a successful show in the latter is far too precise than a figure. It would be more realistic to assume a range of possible successful outcomes-after all, a theatre will not necessary sell the same number of tickets. Every performance, and seats in different parts of the theatre audition usually carry different prices and the theatre may offer group or other discounted deals to a potential audience. Pay-off will vary according to the actual mix achieved. If probabilities are attached to each estimate, the expected value of a successful outcome will take account of the range of possible outcomes, by weighting each of them by its assessed probability as follows: Examples 3 This example is a build up on Example 2. Outcome probability K 150,000,000 250,000,000 0.10 0.25 expenditure value K 15,000,000 50,000,000

174

250,000,000 300,000,000 350,000,000

0.40 0.15 0.10 1.00

100,000,000 45,000,000 35,000,000 245,000,000

Although the expected value is again seen to be infeasible, in as much as it does not correspond to any of the range of point estimates for a possible such outcome, it makes sense in economic terms, given the circumstances (unlike the overall expected value of a decision to back the project: (0.5 x K245, 000, 000) + [0.5 x (K100, 000, 000)] = K 72, 500, 000. Still on economically non-superficial outcome for this unique project. The statement of ranging possible outcomes and their assigned probabilities is known as a probability distribution. Its presentation to management in this form allows two further useful inferences to be drawn from the data: 1) The most likely outcome (being the outcome with highest probability a profit of K250, 000, 000 in our example 2) The probability of an outcome being above or below a particular figure (e.g. by summary the probabilities for pay-offs of K150, 000, 000, K200, 000, 000 and K250, 000, 000 we can conclude that there is a 75% probably that profit will be K250, 000, 000 or less if the musical is successful and summarising those for K300, 000, 000 and K350, 000, 000 allows us to say that the probability of a profit of K300, 000, 000 or more in the event of success is only 25%). In practice a grater number of alternative course of action may exist; uncertainly may be associated with more than one variable and value of variables may be interdependent giving rise to many different outcomes. In the following example we want to understand the application of the probability two or more states of nature occurring together. It is going to be taken that the probability of two or more states of nature occurring together is the product of their individual probabilities. i.e. if there is a 50% probability of the musical in examples 2 and 3 being well recurred and a 40% probability of its making a profit of K250, 000, 000 (as opposed to any other profit figure) if it is well recurred then the probability of

175

promoting a successful musical which makes a profit of K250, 000, 000 is 0.5 x 0.4 = 0.2 or 20%. This concept and application of multiple probabilities is gong of be amplified and shown further in the last example of this section. Example 4. NCWALA CEREMONY ORGANISING COMMITTEE is assessing the desirability of producing a souvenir to celebrate life of the souvenir will be one year only. Uncertainly surrounds the likely sales volume and contribution as well as the fixed costs of the venture. The organizing committee members who specialize in marketing and finance came up with the following data: Sales probability (units) attaches to sales units 200, 000 160, 000 120, 000 0.3 0.6 0.1 1.0 contribution probability attaches to contribution fixed cost probability attaches to fixed costs K000 0.5 0.5 1.0 800 900 500 0.2 0.5 0.3 1.0

14 5

As the number of individual variables subject to uncertainty increase, the decision becomes more complex. In this instance where we have three alternative sales volume two alternative contributions and three alternative levels of fixed costs the number of possible outcomes will be 3 x 2 x 3 = 18. The expected value table below shows that the companys that contribution on the project has an expected value of K and (summering up the joint probability in each lose) it has a 56-56% chance of making a net contribution as 33 percent chance of making a loss and a 10.5% chance of no net contribution /10 loss. Example 2 Musa ltd manufactures a product called the chumbu. One batch of the chumbu is produced and sold each quarter. It is not possible to hold stocks of the chumbu for any significantly long period of time. At a batch size of 24,000 units, the variable cost of a unit of the chumbu is K30,000. The variables costs are all labour-related and the production of chumbu involves an 80% learning curve. Market research has it that demand for the quarter of the chumbu relates as shown below to the selling price per unit.

176

Selling price per unit (K) Sales of the Chumbu 50,000, 23,000 60,000 23,000 70,000 17,500 80,000 15,000 90,000 12,000 There is a complete discontinuation between the batches as regards learning effects. You may assume that the variable cost per Chumbu (h) on an 80% learning curve may be obtained from the following formula; where B is the batch size and is a constant. h = ____a____ B 0.322
Requirements:

Calculate the optimum batch size for the Chumbu production. Suggested solution: - For as long as the candidate knows the mechanics of the learning curve effect, then it is quite straight forward to calculate the total variable costs at different batch sizes. It does not make a difference that is expressed in kwacha (monetary) terms rather than hours. - Once you have calculated the variable cost at different batch sizes, it is a simple matter to identify the batch size which maximizes contribution using revenue analysis. - From the formula given and using information supplied in regard to the batch size of K24, 000 units it may be deduced that a = K773, 437.67 as it can be seen from the calculation below; When B is 24, 000, h is K30, 000, therefore; K30, 000 = _____a______ 24,000 0.322 log 24, 000 = 4.380211242 4.380211242 X 0.322 = 1.41042802 Antilog of 1.41042802 = 25.72930291 a = K30,000 X 24,000 unit K773, 437.67

177

Revenue Analysis:

Sales revenue Batch size (units) K 000 23, 500 1, 175, 000 1, 380, 000 23, 000 1, 225, 000 17, 500 1, 200, 000 15, 000 12, 000 1, 080, 000

Variable costs K 000 711, 228 700, 933 582, 378 524, 584 450, 931

Contribution for the batches K 000 463, 772 679, 067 642, 622 657, 416 629, 069

Computation of the variable cost per batch h = K 773, 437.67 K 12, 000
0.322

h = K 773, 437.67

20.58241045 h = K 37, 577.60 As it can be seen, the batch, where contribution is being maximized is at the K 23, 000 batch units of the Chumbu.

Element 5.4 Decision Trees The decision tree is one way or method of analyzing risk and uncertainty. The decision tree model is only as good as the information it contains. The main difficult is of course, as always, accurately providing the probabilities that determine the uncertainties involved in the investments. The decision tree is a pictorial representation of the probabilistic information to manage and aid decision making. The technique is usually used to evaluate alternative investment plans. The illustration below gives a simple example to illustrate a diagrammatic representation of the decision tree. Illustration; Return in Investment C Probabilities Investment D Yr 1 40, 000 0.5 (20, 000) Yr 2 120, 000 0.5 180, 000
Expected 80, 000 160, 000 net profits

Probabilities 0.4 0.7

178

When the expected profit is calculated, it appears that plan D would be the best option; But the plan has a 0.4 chance of a loss K 20, 000, 000 whereas plan C will always generate a profit of some point.

Element 5.4.1 Notation of A Tree Diagram The tree diagram has squares and circles as symbols that take on extraordinary meaning; The square represents a point at which a decision is made; in this case there is only one decision to be made the choice between plan C and D at the onset. The circle represents a point at which a chance event takes place. The lines, the branches of the tree represent the logical sequence between possible outcomes. The values under the profit heading in the diagram below represent the possible outcomes. The payoff figures are then calculated by multiplying the possible outcomes by their probabilities of taking place. The diagram below shows the pictorial representation of the data in the table below.

This illustration is only a simplification, in practice, there could be many 179

features and factors that can be dictating or impacting strongly on the decision to be made in any given situation. These factors which might merit out attention could be the following; - The time value of money. - This is dealt with under Unit 1 where you studied capital investment appraisal methods in great detail. - The assumption of risk neutrality. - Again we might need to consider the level of risk involved in any given project as in practice all projects have some level of risk attached to them. This is dealt with under sensitivity analysis and management is outside the scope of this text. - In practice, other grey areas might be inherent in the analysis to be made. Therefore, these cannot be overlooked, they need to be considered in the investment evaluation process as well. Example; Munda corporation is considering launching a new product. There are 0.3 chances that the demand for the product will be strong and 0.2 chance that the demand will be weak. Two strategies for the launch are under consideration. Strategy A involves high promotion expenditure and it is likely to generate a net cash inflow of K 240,000,000 if demand proves to be strong. On the other hand, if demand proves to be weak, then a net Cashflow of (60,000,000) will result. Strategy B involves low promotion expenditure. If the demand proves to be strong, then this will generate a net cash inflow of only K160,000,000 but if the demand proves to be weak, then the net cash inflow of K40,000,000 is still expected to be generated. Required; (a) Draw a decision tree and advise which course of action generates the greatest expected profit. (b) What is the maximum amount that should be paid for market research to determine with certainty whether demand will be strong or weak?

Figure 5.1 Conclusion and analysis; As it can be seen from the tree diagram above,

180

strategy, A should be adopted purely on financial grounds as its insights that it will generate a higher expected value of K60,000 as opposed to strategy B which will only promise to generate K56,000,000 as the net expected value. - If the research predicts that the demand would be strong then strategy A would be adopted giving a cash inflow of K240,000,000. - If the research predicts that the demand would be weak, then strategy B would be adopted, giving a cash inflow of K40,000,000. - Therefore, the expected cash inflow outcome with research, will be K80,000,000, that is [(K240,000,000 X 0.3) + (K40,000,000 X 0.2)] - The expected cash inflow outcome without research is K120,000,000. -Therefore, the value of the research with certainty would be K20,000,000 i.e. (K80,000,000 K60,000,000). - The maximum amount that the decision making expenditure should pay for the research is therefore K20,000,000.
RELEVANT COSTING

A relevant cost is a future cash flow arising as a direct consequence of a decision. Thus, only costs, which differ under some or all of the available opportunities, should be considered, relevant costs are therefore sometimes referred to as incremental costs or differential costs.
RELEVANT COSTING TERMINOLOGY

Available Costs These are costs which are usually associated with shutdown or disinvestments decisions and are defined as those costs which can be identified with an activity or sector of a business and which could be avoided if that activity or sector did not exist. Opportunity Costs An opportunity cost is the benefit forgone by choosing an opportunity instead of the next best alternative. Non-Relevant Costs These are costs which are irrelevant for decision-making because they are either not future cash flows or they are costs which will be incurred anyway regardless of the decision that is taken. Sunk Cost

181

A sunk cost is used to describe the cost of an asset which has already been incurred and which can continue to since 2/3 present purpose, but which has as significant realizable value and no income value from any other alternative purpose. Committed Costs A Committed Cost is a future cash outflow that will be incurred anyway, whatever decision is taken now about alternative opportunities. They may exist because of contracts already entered into by the organization, which it cannot get out of. Notional Cost/Imputed costs These are costs, which are hypothetical in nature to reflect the benefit from the use of something for which no actual cash expense is incurred. Examples include notional rent and notional interest charged on management accounts for use of a freehold factory or interest charged on a loan obtained from within a group of companies. Assumptions in Relevant Costing (i) (ii) Cost behaviour patterns are known. It follows that, if a department closes, say, the attributable fixed cost savings would be known. The amount of fixed costs, unit variable costs, sales price and sales demand are known with certainty. It is assumed that it is possible to apply risk and uncertainty analysis to decisions and so recognize that what will happen in the future is not certain. (iii) The objective of decision-making in the short-run is to maximize satisfaction. Satisfaction is often regarded as short-term profit. However, there are many other qualitative factors or financial considerations which may influence a final decision. (iv) The information on which a decision is based is complete and reliable. Decisions usually have to be based on imperfect information.

Element 5.4.2 Qualitative Factors In Decision Making

182

Qualitative factors in decision-making will inevitably vary with the circumstances and nature of the opportunity being considered. Here are some examples: Factor Availability of cost Comment An opportunity may be profitable, but there must be Sufficient cost to finance any purchase of Equipment and build up working capital Any decision involving the shutdown of plant, Charges in work procedures and so on will require acceptance by employees, and out to have regard to employee welfare. Some decisions may stimulate a response from rival companies. The decision to reduce selling prices in order to raise demand may not be successful if all competitors take similar contraction. Suppliers long-term goodwill may be damaged by a decision. Decisions to change the specifications for bought-out components, or to charge stockholding policies so as to stockholding policies so as to create patchy, uneven demand, might put a strain on suppliers. If a company is the suppliers main customer, a decision might dime the supplier out of business Feasibility out in practice. Legal Restraints proposed action. A decision might occasionally be deferred or reflected because of doubts about the legality of the A proposal may look good or paper, but managers may have some reservations about their ability to carry it

Employee

Competitors

Suppliers

Element 5.4.3 Identifying and Calculating Relevant Costs As defined earlier, an opportunity cost is the benefit forgone by choosing one opportunity instead of the next best alternative.

183

A scarce resource may be defined as a resource (machine, labour, materials, cash and so on) that is in short supply, so that the total opportunities that exist for making profitable use of the resource exceed the amount of the resource available. So when a decision-maker is faced with an opportunity which would call for use of a scarce resource, the total incremental cost of using the resource will be higher than the direct cash cost of purchasing it. This is because the resource could be used for other purposes, and so by using it in one way, the benefits obtainable from using it another way must be forgone. Example: Suppose that a customer has asked whether your company would be willing to undertake a contract for him. The work would involve the use of certain equipment for 5 (five) hours and its running costs would be K20,000 per hour. However, your company faces heavy demand for usage of the equipment which earns a contribution of K70, 000 per hour from this other work. If the contract is undertaken, some of this work would have to be foregone. The contribution obtainable from putting the scarce resources to its alternative use is its opportunity costs (sometimes referred to as its internal opportunity cost). Since the equipment can earn K70, 000 per hour in an alternative use, the contract under consideration should also be expected to earn at least the same amount. This can be accounted for by charging K70, 000 per hour as an opportunity cost to the contract and the total relevant cost of 5 hours of equipment time would be? Solution: Running Costs (5 hrs x K20, 000) Internal Opportunity Cost (5 hrs x K70, 000) Relevant Cost K 100,000 350,000 450,000

It is important to note that the variable running costs of the equipment are included in the total relevant costs. Rule for identifying the relevant costs of a scarce resource.

184

The total relevant cost of a scarce resource is the sum of the contribution/incremental profit foregone from the next best opportunity for using the scarce resource and the variable cost of the scarce resource (that is, the cast expenditure to purchase the resource). Identifying Relevant Costs In this section, we provide an introduction to the sort of thought processes that you will have to go through when you encounter a decision-making question. First some general points about machinery, labour and materials that often catch people out will be considered. Machinery User costs Once a machine has been bought its costs is a sunk cost. Depreciation is not a relevant cost, because it is not a cash flow. However, using machinery may involve some incremental costs. These costs might be referred to as user costs and they include hire charges and any fall in resale value of owned assets through use. Example: PQZ Ltd is considering whether to undertake some contract work for a customer. The machine required for the contract would be as follows: (a) A special cutting machine will have to be hired for three months for the work (the length of the contract). Hire charges for this machine are K75,000 per month, with a minimum hire charge of K300,000. All other machinery required in the production for the contract have already been purchased by the organization on hire purchase terms. The monthly hire purchase payments for this machine are K500,000. This consists of K450,000 for capital repayment and K50,000 as an interest charge. The last hire purchase payment is to be made in two months time. The cost price of this machinery was K9,000,000 two years ago. It is being depreciated on a straight-line basis at the rate of K200,000 per month. However, it still has a useful life that will enable it to be operated for another 36 months. Solution: (a) The cutting machine will incur an incremental cost of K300, 000. The minimum hire charge.

(b)

185

(b)

The historical cost of the other machinery is irrelevant as a past cost; depreciation is irrelevant as a non-cash cost; future hire purchase repayments are irrelevant because they are committed costs. The only relevant cost is the loss of resale value of the machinery, estimated at K200, 000 through use. This user-cost will not arise until the machinery is eventually resold and the K200, 000 should be discounted to allow for the time value of money. However, discounting is ignored here, as they have already discussed in Chapter 1. Summary of relevant costs Incremental hire costs User cost of other machinery K 300,000 200,000 500,000

Labour Often the labour force will be paid irrespective of the decision made and the costs are therefore not incremental. Take care, however, if the labour force could be put to an alternative use, in which case the relevant costs are the variable costs of the labour and associated variable overheads plus the contribution forgone from not being able to put it to its alternative use. The machinery is highly specialized and is unlikely to be required for other more profitable jobs over the period during which the contract work would be carried out. Although there is no immediate market for selling this machine, it is expected that a customer might be found in the future. It is estimated that the machine would lose K200, 000 in its eventual sale value if it is used for the contract work. Required What is the relevant cost of machinery for the contract? Materials The relevant cost of raw materials is generally their current replacement cost, unless the materials have already been purchased and would not be replaced once used. If materials have already been purchased but will not be replaced, then the relevant cost of using them is either (a) their resale value or (b) the value they

186

would obtain if they were put to an alternative use, if this is greater than their current resale value. The higher of (a) or (b) is then the opportunity cost of the materials. If the materials have no resale value and no other possible use, then the relevant cost of using them for the opportunity under consideration would be nil. The flow chart below shows how the relevant costs of the materials can be identified, provided that the materials are not in short supply, and so have no internal opportunity cost. Are the materials already in stock, or contracted to buy in a Purchase Agreement? YES NO Are the materials regularly used and replaced with fresh supplies when stocks run out? YES NO Relevant cost = future/current purchase cost of materials Do the materials have an alternative use, or would they be scrapped if not used? Scrapped If not Used Other use available Relevant Cost = higher of value in other use or scrap value/disposal value

Relevant cost = future/current purchase cost of materials

Relevant Costs = Scrap value/ Disposal value

187

Decision Making Techniques Example: A customer who would like a special job to be done for him has approached Muma Ltd, and is willing to pay K22,000,000 for it. The job requires the following materials:
Materials A B C D Total units required 1,000 1,000 1,000 200 Units already in stock 0 600 700 200 Book value of units in stock K/unit 2,000 3,000 4,000 Realisable value K/unit 2,500 2,500 2,500 6,000 Replacement cost K/unit 6,000 5,000 4,000 9,000

(a)

Material B is used regularly by Muma Ltd, and if units of B are required for this job, they would need to be replaced to meet other production demand. Materials C and D are in stock as the result of previous over-buying, and they have a restricted use. No other use could be found for material C, but the units of material D could be used in another job as substitute for 300 units of material E, which currently costs K5, 000 per unit (of which the company has no units in stock at the moment). Required: What are the relevant costs of material, in deciding whether or not to accept the contract? Solution:

(b)

(a) (b)

Material A is not owned and would have to be bought in full at the replacement cost of K6, 000 per unit. Material B is used regularly by the company. There are existing stocks (600 units) but if these are used on the contract under review a further 600 units would be bought to replace them. Relevant cost therefore, 1,000 units at the replacement cost of K5, 000 per unit.

188

Material C: 1,000 units are needed and 700 are already in stock. If used for the contract, a further 300 units must be bought at K4, 000 each. The existing stocks of 700 will not be replaced. If they are used for the contract, they could not be sold at K2, 500 each. The realizable value of these 700 units is an opportunity cost of sales revenue forgone. Material D: These are already in stocks and will not be replaced. There is an opportunity cost of using D in the contract because there are alternative opportunities either to sell the existing stocks for K6, 000 per unit (K1, 200,000) or avoid other purchases (of material E), would cost 300 x K5, 000 =K1, 500, 000 Since substitution for E is more beneficial, K1, 500,000 is the opportunity cost.

Summary of Relevant Costs Material A (1,000 x K6, 000) Material B (1,000 x K5, 000) Material C (300 x 4,000) + (700 x 2,500) Material D Total K 6,000,000 5,000,000 2,950,000 1,500,000 15,450,000

BREAK EVEN ANALYSIS

This is the term given to the study of the interrelationships between costs, volume and profit at various levels of activity. Frequently these relationships are depicted by graphs, but this is not essential. The term break-even analysis is the one commonly used, but it is somewhat misleading as it implies that the only concern is with that level of activity that produces neither profit nor loss the break-even point although the behaviour of costs and profits at other levels is usually of much greater significance. Because of this on alternative term, cost-volume-profit analysis or C-V-P analysis, is frequently used and is more descriptive.
USES OF C.V.P. ANALYSIS

189

C.V.P. analysis uses many of the principles of marginal costing and is an important tool in short term planning. It explores the relationships that exists between costs, revenue, output levels and resulting profit and is more relevant where the proposed changes in the levels of activity are relatively small. In these cases the established cost patterns are likely to continue, so C.V.P. analysis may be useful for decision-making. Over greater changes of activity and in the longer-term existing cost structures e.g. the amount of fixed costs and the marginal cost per unit, are likely to change, so C.V.P. analysis becomes less appropriate. Typical short-run decisions where C.V.P. analysis can be useful include; choices of sale mix, pricing policies, multi-shift working and special order acceptance.

ASSUMPTION BEHIND C.V.P. ANALYSIS

Before any formulae are given or graphs drawn, the major assumptions behind C.V.P. analysis must be stated. These are: (a) (b) (c) (d) (e) (f) (g) All costs can be resolved into fixed and variable elements. Fixed costs will remain constant and variable costs vary proportionately with activity. Over the activity range being considered costs and revenues behave in a linear fashion That the only factor affecting costs and revenues is volume That technology, production methods and efficiency remain unchanged Particularly for graphical methods that the analysis relates to one product only or to a constant product mix. There are no stock level changes or that stocks are valued at marginal cost only it will be apparent that these are over simplifying assumptions for many practical problems.

190

It is because of this that C.V.P. analysis can only be an approximate guide for decision making. Nevertheless, by highlighting the interaction of costs, volume, revenue and profit, useful guidance can be provided for managers making short run, tactical decision.
BROUGHT FORWARD KNOWLEDGE

C.V.P. Analysis by formula C.V.P. analysis can be undertaken by graphical means that are dealt with later in this chapter, or by simple formulae that are listed below and illustrated by examples. (a) (b) Break-even point = (In units) fixed costs contribution/unit Fixed costs x sale price/unit Contribution/unit = Fixed x Cost (c) Contribution/sale = contribution/unit x 100% ratio (d) sales price per unit contribution/sales ratio 1

Break-even point (K sales) =

Level of sales to result in target profit (units) = Fixed costs + Target profit Contribution/unit

(e)

Level of sales to result in target profit = Fixed costs + Target profit Contribution/unit

(f)

Level of sales to result in target profit (K sales)

191

(Fixed cost + Target profit) x Sales price/unit Contribution/unit

NOTE: The above formulae relates to a single product firm or one with an unvarying mix of sales. With a multi-product firm it is possible to calculate the break-even point as follows: Break -even-point = Fixed costs x sales value (K sales) Contribution

MULTI-PRODUCT CHART

Graphs and computations of a mix of products can be derived from appropriate data. Example: A company which has fixed costs of K50, 000,000 per annum and has three products, the sales and contribution of which are shown below. Product X Y Z Sales K000 150,000 40,000 60,000 Contribution K000 20,000 20,000 25,000 C/S ratio 20% 50% 42%

Required: (a) Plot the products on a profit chart and show the break-even sales

192

Solution: The axes on the profit chart are drawn in the usual way and the contribution from the products, in the sequence of their C/S ratio i.e. Y, Z, X drawn on the chart.

+50,000

+25,000

50,000

100,000

150,000

200,000

250,000

Z
-25,000

Y
-50,000

NOTES (a) (b) (c) The solid lines represent the contributions of the various products. The dotted line represents the resulting profit of this particular sales mix and C/S ratios. Reading from the graph the break-even point is approximately. 193

K170,000,000. The exact figure can be calculated as follows: Product X Y Z Sales K000 150,000 40,000 60,000 250,000 Overall Contribution/Sales Ratio = Contribution K000 30,000 20,000 25,000 75,000

75,000 X 100% 250,000,000 30% Fixed costs C/S ratio K50,000 30/100 K50,000,000 0.3 K166,666,667

= Break-even point = = = =

LIMITATIONS OF BREAK-EVEN CHARTS AND ANALYSIS

(a)

The C.V.P. charts assume that fixed costs are always unaffected by activity, but in actual fact, they can exhibit features of stepped fixed cost, a more accurate representation. The charts and the analysis depicts relationships which are essentially short-term. This makes them inappropriate for planning purposes where the time scale stretches over several years.

(b)

194

(c)

The charts and C.V.P. analysis make the assumption that all variable costs vary according to the same activity indicator, usually sales or production. This is gross over simplification and reduces the accuracy of the charts and C.V.P. analysis.

Element 5.5 RISK AND UNCERTAINTY Element 5.5.1 Risk arises in situations where several possible outcomes are expected and where past experience provides statistical evidence which can be used to predict the possible outcomes. Element 5.5.2 Uncertainty on the other-hand arises where there are several possible outcomes, but there is little past statistical evidence to enable the predicting of the possible outcomes. Quite often, most business decisions fall in the uncertainty category. Element 5.5.3 PREDICTING POSSIBLE OUTCOMES Predicting possible outcomes makes use of probabilities. Probability is the likelihood that an event will occur. Where several possible outcomes are expected, a probability distribution can be tabulated. A possibility distribution is a list of all possible outcomes for an event and the probability that each will occur. Element 5.5.4 Probability can either be objective probabilities or subjective probabilities. Objective probabilities are probabilities which are established mathematically or compiled from past data e.g. Tossing a coin. Subjective probabilities are probabilities which are established by judgement rather than past data. Most business decisions involve subjective probabilities since many past observations or repeated experiments for particular decisions are not possible. Subjective probabilities are based on an individuals expert knowledge, past experience and observations of current variables which are likely to have an impact on future events. However, subjective probabilities have the advantage of providing more meaningful information, unlike stating the most likely outcome. Element 5.5.5 PROBABILITY AND EXPECTED VALUE Expected value is a simple way of showing the effects of uncertainty into decision-making. Expected value is the average value of an event which ha several possible outcomes. The expected value of a decision represents the long-run

195

average outcome that is expected to occur if a particular course of action is under-taken several times. Element 5.5.6 For example: A company is to make a decision to manufacture two products X and Y and the decision is repeated several times, the expected values can be calculated thus: PRODUCT X : Outcome Profits K000 4,800 5,600 6,400 7,200 8,000 PRODUCT Y : Outcome Profits K000 3,200 4,800 6,400 8,000 9,600 Probability 0.07 0.08 0.38 0.27 0.20 Weighted Amount K000 224 384 2,432 2,160 1,920 7,120 Probability 0.09 0.21 0.45 0.15 0.10 Weighted Amount K000 432 1,176 2,880 1,080 800 6,368

Element 5.5.7 From the above, we can conclude that if a decision was made to produce X and Y several times repeatedly, X will produce profits of K 6,368,000 and Y will produce profits of K 7,120,000. It is important to note that the expected values are the averages of the possible outcomes based on management estimates. It is therefore very possible for the actual results to be different from the expected values. Element 5.5.8 MEASURING DEGREE OF UNCERTAINTY The degree of uncertainty can be measured by calculating the standard deviation. This is the conventional measure of the dispersion of a probability distribution.

196

Element 5.5.9 Using the data in 5.5.6 the standard deviation of Product X and Product Y can be calculated: PRODUCT X Profit Amount (K000) 4,800 5,600 6,400 7,200 8,000 Deviation from (K000) - 1,568 -768 32 832 1,632 Standard deviation (K000) 2,458,624 589,824 1,024 692,224 2,663,424 Probability Weighted amount (K000) 0.09 221,276 0.21 1 23,863 0.45 461 0.15 103,834 0.10 2,663 342 3,112,776

Standard Deviation = 3 112 776 000 = K 1,095,445 PRODUCT Y Profit Amount (K000) 3,200 4,800 6,400 8,000 9,600 Deviation from (K000) - 3,920 - 2,320 - 720 880 2,480 Standard Probability deviation (K000) 15,366,400 5,382,400 518,400 774,400 6,150,400 0.07 0.08 0.38 0.27 0.20 Weighted amount (K000) 1,075,648 430,592 196,992 209,088 1,230,080 3,142,400

Standard Deviation = 3 142 000 = K 1,772,681 Element 5.5.10 So far we have defined risk in terms of the spread of possible outcomes, so that risk may be large even if all the possible outcomes involve earning high profits. This is the case with Product Y which has a higher expected value, but at the same time has risk (standard deviation) higher than Product X.

Element 5.5.11 DECISION TREE ANALYSIS

197

A decision tree is a diagram showing several possible courses of action and possible events and the potential outcomes for each course of action. The purpose of decision trees is to show the full range of alternatives and events that occur, under all possible conditions. The advantage of a decision tree is that it methodically and logically analyses a situation so that all possible outcomes are considered before a business can commit itself. Element 5.5.12 To illustrate how decision tree can be considered the following example will be used: Example: Koko Plc is a manufacturing company. The company is considering launching a product. The following estimates have been made: Profit estimate K000 43,200 8,000 32,000 Probability 0.50 0.30 0.20

In addition the company has estimated an amount of K 14,400,000 as the investment needed. The probability that the project will succeed is 0.6 and 0.4 for failure. Element 5.5.13 SOLUTION There are two decisions which must be considered by the company: to develop the product or not to develop the product. From these two decisions we can develop a decision-tree.

Estimated
P(0.5) LAUCH SUCEEDS

Probability

Expected Profit (K000) 43,200 8,000 32,000

0.3 0.18 0.12

Value (K000) 12,969 1,440 3,840

198

14,400
FAILS

0.4 1

5,760 0 4,800

0
NOT DEVELOP

Element 5.5.14 For two events to occur together, there must be joint probability. For example, the probability of the development succeeding and the company making a profit of K 8,000,000 is made up of the probability that the launch will succeed (P = 0.6) and the probability that a profit of K 8,000,000 will be achieved (P = 0.3), hence giving a joint probability of 0.3 * 0.6 = 0.18 Element 5.5.15 It is also worth noting that if the decision was repeated several times, an average expected profit of K 4,800,000 will be achieved. In theory this means that the decision to develop the product should be favoured as it results in n average profit of K 4,800,000 as compared to the decision not to develop the product as it gives zero profit.

Element 5.6 CVP ANALYSIS IN A MULTIPLE PRODUCT ENVIRONMENT Element 5.6.1 Organisations typically produce and sell a variety of products and services. To perform CVP analysis in a multi-product organisation, however, a constant product sales mix must be assumed. In other words, we assume that whatever x units of product A are sold, y units of products B and z units of product C are also sold. Element 5.6.2 Such an assumption allows us to calculate a weighted average contribution per mix, the weighting being on the basis of the quantities of each product in the constant mix. This means that the unit contribution of the product that makes up the largest proportion of the mix has the greatest impact on the average contribution per mix. Element 5.6.3 The only situation when the mix of products does not affect the analysis is when all of the products have the same ratio of contributions to sales (C/S ratio).

199

Breakeven point is The level of activity at which there is neither profit nor loss (CIMA Official Terminology) Element 5.6.4 BREAKEVEN POINT FOR MULTIPLE PRODUCTS Element 5.6.4 This calculation is exactly the same as that for single products but the single product is the standard mix. Lets look at an example. Element 5.6.5 EXAMPLE:BREAKEVEN POINT FOR MULTIPLE PRODUCTS Suppose that P Ltd produces and sells two products. The M sells for K7 per unit and has a total variable cost of K 2.94 per unit, while the N sells for K 15 per unit and has a total variable cost of K 4.50 per unit. The marketing department has estimated that for every five units of M sold, one unit of N will be sold. The organisations fixed costs total K 36,000. Element 5.6.6 SOLUTION We calculate the breakeven point as follows: Step 1. Calculate contribution per unit Selling price Variable cost Contribution Step 2. Calculate contribution per mix = (K 4.06 * 5) + (K 10.50 * 1) = K 30.80 Step 3. Calculate the breakeven point in terms of the number of mixes = fixed costs/contribution per mix = K 36,000/K 30.80 = 1,169 mixes (rounded) Step 4. Calculate the breakeven point in terms of the number of units of the products = (1,169 * 5) 5,845 units of M and (1,169 * 1) 1,169 units of N (rounded) M K per unit 7.00 2.94 4.94 N K per unit 15.00 4.50 10.50

200

Step 5. Calculate the breakeven point in terms of revenue = ( 5,845 * K 7) + (1,169 * K 15) = K 40,915 of M and K 17,535 of N = K 58,450 in total Element 5.6.7 It is important to note that the breakeven point is not K 58,450 of revenue, whatever the mix of products. The breakeven point is K 58,450 provided that the sales mix remains 5:1.Likewise the breakeven point is not at a production/sales level of (5,845 + 1,169) 7,014 units. Rather, it is when 5,845 units of M and 1,169 units of N are sold, assuming a sales mix of 5:1. Element 5.6.8 CONTRIBUTION TO SALES (C/S) RATIO FOR MULTIPLE PRODUCTS Element 5.6.8.1An alternative way of calculating the breakeven point is to Use the average contribution to sales (C/S) ratio for the standard mix. Element 5.6.8.2 As you should already know, the C/S ratio is sometimes called the profit/volume ratio or P/V ratio. Element 5.6.8.3 We can calculate the breakeven point of P LTD as follows: Step 1. Calculate revenue per mix = (5 * K 7) + (1 * K 15) = K 50 Step 2. Calculate contribution per mix = K 30.80 Step 3. Calculate average C/S ratio = (K 30.80/K 50.00) * 100% = 61.6% Step 4. Calculate breakeven point (total) Fixed costs C/S ratio =K 36,000/0.616 =K 58,442 (rounded) Step 5. Calculate revenue ratio mix =35:15, or 7:3 Step 6. Calculate breakeven sales

201

Breakeven sales of M = K 58,442 * 7/10 = K 40,909 (rounded) Breakeven sales of N = K 58,442 * 3/10 = K 17,533 (rounded) Element 5.6.8.4 Alternatively you might be provided with the individual C/S ratios of a number of products. For example if an organisation sells two products (A and B) in trhe ratio 2:5 and if the C/S ratio of A is 10% whereas that of B is 50%, the average C/S ratio is calculated as follows. Average C/S ratio = (2 * 10%) + (5 + 50%) 2+5

QUESTION: average C/S ratio TIM Ltd produces and sells two products, the MK and KL. The company expects to sell 1 MK for every 2 KLs and have monthly revenue of K 150,000.The Mk has a C/S ratio of 20% whereas the KL has a C/S ratio of 40%. Budgeted monthly fixed costs are K 30,000. What is the budgeted breakeven sales revenue? A B C D K 150,000 K 300,000 K 90,000 K 50,000

Answer The correct answer is C. Average C/S ratio = (20% * 1) + (40% * 2)= 33 1/3% 3 Sales revenue at the breakeven point = fixed cost = K 30,000 = K90,000 C/S ratio 0.333 Element 5.6.8.5 The C/S ratio is a measure of how much contribution is earned from each K1 of sales of the standard mix. The C/S ratio of 33 1/3% in the question above means that for every K1 of sales of the standard mix of products, a

202

contribution of 33.33 ngwee is earned. To earn a total contribution of, say, K 20,000 sales revenue from the standard mix must therefore be K1 * K 20,000 = K 60,000 33.33n Points to bear in mind Element 5.6.8.6 Any change in the proportions of products in the mix will change the contribution per mix and the average C/S and hence the breakeven point. a) If the mix shifts towards products with lower contribution margins, the breakeven point ( in units ) will increase and profits will fall unless there is a corresponding increase in total revenue. b) A shift towards products with higher contribution margins without a corresponding decrease in the revenues will cause an increase in profits and a lower breakeven point c) If sales are at the specified level but not in the specified mix, there will be either a profit or a loss depending on whether the mix shifts towards products with higher or lower contribution margins.

Element 5.6.9 SALES/PRODUCT MIX DECISIONS Element 5.6.9.1 One use of the methodology we have been looking at is to determine the most profitable sales mix option of number open to management. Element 5.6.9.2 EXAMPLE: SALES MIX DECISIONS JM Ltd makes and sells two products, the J and M. The budgeted selling price of the J is K 60 and that of the M, K 72.Variable costs associated with producing and selling the J are K 30 and, with the m, K 60.Annual fixed production and selling costs of JM Ltd are K 3,369,600. JM Ltd has two production/sales options. The J and the m can be sold either in the ratio two Js to three Ms or in the ratio one J to two Ms. Element 5.6.9.3 We can decide on the optional mix by looking at breakeven points. We need to begin by determining contribution per unit. J M K per unit K per unit Selling price 60 72

203

Variable cost Contribution

30 30

60 12

Mix 1 Contributions per 5 units sold = (K 30 * 2) + (K 12 * 3) = K 96 Breakeven point = K 3,369,600 = 35,100 sets of five units K96 J M Breakeven point: In units (35,100 * 2) 70,200 (35,100 * 3) 105,300 In K (70,200 * K 60) K 4,212,000 (105,300 * K 72) K7,581,600 Total breakeven point = K 11,793,600 Mix 2 Contribution per 3 units sold = (K 30 * 1) + (K 12 * 2) = K 54 Breakeven point = K 3,369,600 = 62,400 sets of three units. K 54 J M Breakeven point: In units (62,400 * 1) 62,400 (62,400 * 2) 124,800 In K (62,400 * K60) K 3,744,00 (124,800 * K 72) K 8,985,600 Total breakeven point = K 12,729,600 Element 5.6.9.4 Ignoring commercial considerations, mix 1 is preferable to mix 2.This is because it results in a lower level of sales to break even (because of the higher average contribution per unit sold).The average contribution for mix 1 is K 19.20 (K 96 5).In mix 2 it is K 18 (K 54 3). Mix 1 contains a higher proportion (40% as opposed to 33 1/3%) of the more profitable product. Element 5.6.9.5 The following question looks at the effect on the overall C/S ratio of a product/sales mix. Element 5.6.9.6 QUESTION : CHANGING THE PRODUCT MIX A Ltd sells three products Exe, Why and Zed in equal quantities and at the same selling price per unit. The C/S ratio is 55%. Suppose the product mix is changed to Exe 20%, Why 505 and Zed 30%.

204

Required Calculate the revised total contribution/total sales ratio. Element 5.6.9.7 SOLUTION Original proportions C/S ratio Market share Exe 0.5 *1/3 0.167 Why Zed Total 0.6 0.549 (W2) *1/3 *1/3 0.200 0.183 (W1) 0.55

Workings 1 The total C/S ratio is the sum of the weighted C/S ratios and so this figure is calculated as 0.55 0.167 0.2 = 0.183 2 This figure is then calculated as 0.183 1/3 = 0.549

Revised proportions C/S ratio (as above) Market share Exe 0.5 *0.2 0.1 Why 0.6 *0.5 0.3 Zed Total 0.549 *0.3 0.1647 0.5647

The total C/S ratio will increase because of the inclusion In the mix of proportionately more of Why, which has the Highest C/S ratio.

Element 5.6.10 Element 5.6.10.1

TARGET PROFITS FOR MULTIPLE PRODUCTS At breakeven point, sales revenue (S) is equal to variable Costs plus fixed costs (V + F), and there is no profit: S=V=F Suppose an organisation wishes to achieve a certain level of profit (P) during this period. To achieve this profit, sales must cover all costs and leave the required profit: S=V+F+P

205

therefore S V = F + P So total contribution required = F + P Element 5.6.10.2 Once we know the total contribution required we can calculate the sales revenue of each product needed to achieve a target profit. The method is similar to the method used to calculate the breakeven point. EXAMPLE: TARGET PROFITS FOR MULTIPLE PRODUCTS A company makes and sells three products, F, G and H. The products are sold in the proportion F:G:H = 2:1:3.The companys fixed costs are K 80,000 per month and details of the products are as follows. Product F G H Selling price K per unit 22 15 19 Variable cost K per unit 16 12 13

Element 5.6.10.3

The company wishes to earn a profit of K 52,000 next month. Calculate the required sales value of each product in order to achieve this target profit. Element 5.6.10.4 SOLUTION Step 1. Calculate contribution per unit F G K per unit K per unit Selling price 22 15 Variable cost 16 12 Contribution 6 3 Step 2. Calculate contribution per mix = (K 6 * 2) + (K 3 * 1) + (K 6 * 3) = K 33 Step 3. Calculate the required number of mixes = (Fixed costs + required profit)/contribution per mix = (K 80,000 + K 52,000)/K 33

H K per unit 19 13 6

206

= 4,000 mixes Step 4. Calculate the required sales in terms of the number of units of the products and sales revenue of each product Sales Selling revenue Product price required Units K per unit K F G H Total 4,000 * 2 8,000 4,000 * 1 4,000 4,000 * 3 12,000 22 15 19 176,000 60,000 228,000 464,000

The sales revenue of K 464,000 will generate a profit of K 52,000 if the products are sold in the mix 2:1:3 Element 5.6.10.5 Alternatively the C/S ratio could be used to determine the required sales revenue for a profit of K 52,000. The method is again similar to that demonstrated ealier when calculating the breakeven point. Element 5.6.10.6 EXAMPLE:USING THE C/S RATIO TO DETERMINE THEREQUIRED SALES Well the data from paragraph 5.6.10.3 Step 1. Calculate revenue per mix = (2 * K 22) + (1 * K 15) + (3 * K 19) = K 116 Step 2. Calculate contribution per mix = K 33 (from Paragraph 5.6.10.4) Step 3. Calculate average C/S ratio = (K 33/K 116) * 100% = 28.45% Step 4. Calculate required total revenue = required contribution C/S ratio = (K 80,000 + K 52,000) 0.2845 = K 463,972 Step 5. Calculate revenue ratio of mix

207

= (2 * K 22) : (1 * K 15) : (3 * K 19) = 44:15:57 Step 6. Calculate required sales Required sales of F = 44/116 * K 463,972 = K 175,989 Required sales of G = 15/116 * K 463,972 = K 59,996 Required sales of H = 57/116 * K 463,972 = K 227,9789 Which, allowing for roundings, is the same answer as calculated in Paragraph 5.6.10.4 Element 5.6.11 MARGIN OF SAFETY FOR MULTIPLE PRODUCTS

Element 5.6.11.1 It should not surprise you to learn that the calculation of The margin of safety for multiple products is exactly the same as for single products, but the single product is the standard mix. The easiest way to see how its done is to look at an example. Element 5.6.11.2 MARGIN OF SAFETY FOR MULTIPLE PRODUCTS J Ltd produces and sells two products. The W sells for K 8 per unit and has a total variable cost of K 3.80 per unit, while the R sells for K 14 per unit and has a total variable cost of K 4.20. For every five units of W sold, six units of R are sold. J Ltds fixed costs are K 43,890 per period. Budgeted sales revenue for next period is K 74,400, in the standard mix.

Element 5.6.11.3 SOLUTION To calculate the margin of safety we must first determine the breakeven point. Step 1. Calculate contribution per unit W K per unit Selling price 8.00 R K per unit 14.00

208

Variable cost Contribution

3.80 4.20

4.20 9.80

Step 2. Calculate contribution per mix = (K 4.20 * 5) + (K 9.80 * 6) = K 79.80 Step 3. Calculate the breakeven point in terms of the number of mixes = fixed costs/contribution per mix = K 43,890/K 79.80 = 550 mixes

Step 4. Calculate the breakeven point in terms of the number of units of the products = (550 8 5) 2,750 units of W and (550 * 6) 3,300 units of R Step 5. Calculate the breakeven point in terms of revenue = (2,750 * K 8) + (3,300 * K 14) = K 22,000 of W and K 46,200 of R = K 68,200 in total Step 6. Calculate the margin of safety = budgeted sales breakeven sales = K 74,400 K 68,200 = K 6,200 sales in total, in the standard mix Or, as a percentage = (K 74,400 K 68,200)/K 74,400 * 100% = 8.3% of budgeted sales

Element 5.6.12 Element 5.6.12.1

MULTI PRODUCT CVP CHARTS Breakeven charts KEY TERM: A breakeven chart is A chart which indicates approximate profit or loss at different levels of sales volume within a limited range. (CIMA official Terminology) A very serious limitation of breakeven charts is that they can show the costs, revenues, profits and margins of

Element 5.6.12.2

209

safety for a single product only, or at best for a single sales mix of products. Element 5.6.12.3 For example suppose that Farmyard Ltd sells three products, X, Y and Z which have variable unit costs of K 3, K 4 and K 5 respectively. The sales price of X is K 8, the price of Y is K 6 and the price of Z is K 6. Fixed costs per annum are K 10,000. A breakeven chart cannot be drawn, because we do not know the proportions of X, Y and Z in the sales mix. There are a number of ways in which we can overcome this problem, however. Output in K sales and a constant product mix Assume that budgeted sales are 2,000 units of X, 4,000 units of Y and 3,000 units of Z. A breakeven chart would make the assumption that output and sales of X, Y and Z are in the proportions 2,000 : 4,000 : 3,000 at all levels of activity, in order words that the sales mix is fixed in these proportions. We begin carrying out some caculations.
Budgeted costs Varible costs of X (2,000 * K 3) Varible costs of Y (4,000 * K 4) Varible costs of Z (3,000 * K 5) Total variable costs Fixed costs Total budgeted Costs Revenue K K 6,000 X (2,000 * K 8) 16,000 16,000 X (2,000 * K 6) 24,000 15,000 X (2,000 * K 6) 18,000 37,000 10,000 47,000 Budgeted revenue 58,000

Element 5.6.12.4

Element 5.6.12.5

Element 5.6.12.6 Element 5.6.12.7

Element 5.6.12.8

Element 5.6.12.9

The breakeven chart can now be drawn.

210

Element 5.6.12.10

The breakeven point is approximately K 27,500 of sales revenue. This may either be read from the chart or computed mathematically. a) The budgeted C/S ratio for all three products together is contribution/sales = K (58,00037,000)/K 58,000 = 36.21% b) The required contribution to break even is K 10,000, the fixed costs. The breakeven point is K 10,000/36.21% = K 27,500 (approx) in sales revenue. The margin of safety is approximately K (58,000 27,500) = K 30,500

211

STUDY UNIT 6.0 BUDGETING AND BUDGETARY CONTROL

Learning Outcomes: After reading this chapter candidates should: Understand the purpose of preparing budgets and the main processes and techniques involved in the budgeting process. Understand the use of flexible budgets and be able to prepare them from details of fixed and variable costs. Appreciate behavioural respect of budgeting Understand the use and application of information technology in the Budgeting process.

INTRODUCTION TO BUDGETING

A Budget is a plan that is quantified in monetary terms, showing incurred and the capital to be needed in generating the Revenues for a specified future period.
BROUGHT FORWARD KNOWLEDGE

Candidates should remember what they learned at their lower levels of Natech. Among the concepts learned earlier were: Objective of Budgeting Communicating Compel planning Control Motivation

212

THE CONCEPTUAL FRAMEWORK OF THE BUDGETING PROCESS

Budgeting and long term planning: The Budgeting process forms part of the long-term corporate planning process. Therefore the Budgeting process should not be looked at as a stand-alone process. Element 6.1 The Budget Process The Budgeting process starts with the board of Directors in a Business setting and mapping out the organisations horizon of two to ten years depending on the stability or dynamism of its business environment.

Element 6.1.1The Budget Committee The Board appoints a budget committee, which will comprise departmental heads from each department that exist in an organisation. Element 6.1.2 The Budget Officer The Budget committee is headed by a Budget officer who usually is a qualified Accountant or any finance profession with vast budgeting experience. Element 6.1.3 Role of Budget Officer Drawing budgeting meeting time tables Conducting Budgeting meetings Drawing Agendas for meetings Producing Budgeting meeting minutes giving technical expertise to non finance managers who sit on the Budget committee.

Element 6.1.4 The Budgeting Manual The Budgeting committee should produce a Budgeting manual which will act as a key guide to the whole budgeting process. The main theme of the manual will include the following:

213

The company (organisations) Mission statements and corporate objectives An organisation chart Pretensions of managers responsibilities A timetable for preparation of the budgets Statements of assumptions to be made in the budget as regards risk factors; inflation levels, interest rates and growth rates in other lay economic variables.

The committee will be charged with the whole process of preparing Budgets and presenting them to the Board of Directors for approval.

Element 6.1.5 The Principal Budget Factor Its of Paramount importance to identify the organisations limiting factor (resources) first. The principal budget factor is an alternative name for a limiting factor. It is an item, which limits an entitys undertakings. Classic examples of principal budget factors could be the following. Sales demand Scarcity of raw material Skilled labour Factory/ machine capacity.

Element 6.2 Types of Budgets There is a wide array of Budgets, which a company can prepare: Functional Budget Cash Budget Flexible Budgets Master budgets

Element 6.2.1 Functional Budget Functional Budget are budgets which are prepared to show the expenditure to be incurred and revenues to be generated by each department in their nature allow the departments to be both revenue generating and expenditure incurring.

214

Its the duty of the departmental Head to prepare the budget for the departments over which they preside. The main functional Budget which are typically drawn are (a) (b) (c) (d) (e) (f) Sales budget Production budgets Production cost budget Labour budget Material requirement budget Material purchase budgets

Element 6.2.1.1 The Sales Budget The Sales budget shows Quantities of products or events of a service which the firm intends to sale in a given future period. The Quantities of the sales should ultimately be expressed in monetary terms, by multiplying the units budgeted to be sold by the relevant unit selling price. Example 1. Kazhika Ltd intends to sell 40,000 units, 43,000 units, 46,000 and 41,000 units in quarters 1, 2, 3, and 4 of 20X7 respectively of its only product the LYN at K5,000 per unit in the first 3 quarters of the year and at K6,000 in the last quarter of 20X7. Requied: Produce a sales budget both in units and money terms for KAZHIKA Ltd for its control period 20X7. Solution: KAZHIKA Ltd Sales budget for 20X7 Quarter by quarter basis In UNITS Q1 Units 40,000 Q2 Units 43,000 Q3 Units 46,000 Q4 Units 41,000 TOTAL Units 170,000

215

IN MONEY TERMS Q1 K000 200,000 Q2 K000 215,000 Q3 K000 230,000 Q4 K000 246,000 TOTAL K000 891,000

Working 1 Q1 K5,000 X40,000units = K200,000,000 Q4 K6,000 X 41,000units = K246,000,000 Q2 K5,000X43,000units = K215,000,000 Q3 K5,000X46,000units = K230,000,000

Element 6.2.1.2 The Production Budget The Production Budget aims to maintain how many units of the product should be produced in a given budget period for an organisation to meet the sales demand for its product in the environment. The usual schedule for drawing up the production budget is drawn below. A quarter by quarter format has been adopted here but note that the format of the budget will be dictated by the length of time under consideration. XXX Plc PRODUCTION BUDGET FOR THE FOUR QUARTERS Q1 Budgeted units to be sold Add: closing stock for each quarter X X Q2 X X (X) X Q3 X X (X) X Q4 X X (X) X

LESS: Opening stock for each quarter (X) Production X

216

Example 2. Assuming that KAZHIKA Ltd has stocks of 10,000 units of the LYN on 1 January 20X7, and the company has a policy of hold 10% of the following quarters projected sales as closing stock. The company hopes to sell 50,000 units in quarter 1 of 20X8. Required: Prepare the production budget for KAZHIKA Ltd for the year 20X7 KACHIKA LTD PRODUCTION BUDGET Q1 Units 40,000 4,300 44,300 Q2 Units 43,000 4,600 47,600 (4,300) 43,300 Q3 Units 46,000 4,100 50,100 (4,600) 45,500 Q4 Units 41,000 5,000 16,000 (4,100) 41,900

Budgeted sales units Add: closing stock

Less: Opening stock (10,000) Production 34,300 Workings:

1. Closing stock figure Fine policy is to hold 10% of the subsequent quarters sales the closing stocks for the quarters will be calculated as follows: Q1 10% x 43,000units 4,300 units Q2 10% x 46,000units 4,600 units Q3 10% x 41,000units 4,100 units

217

Q4 10% x 50,000units 5,000 units

FURTHER CONSIDERATION

Assume that the KAZHIKA Ltds production system is experiencing problems and as a result 2% of all units produced will be defective and they will have to be scrapped of since they will not find use anywhere, Required: Redraft the production budget for KACHIKA Ltd for the year 20X7 Solution: Since the production budget earlier drawn represents good units to be sold in the market place, we need to build in extra units which have to be produced but however scrapped at the ends. KACHIKA LTD REUSED PRODUCTION BUDGET Q1 Production Per Example 2 Less (Scrap) factor Production 98 = 0.98 100% Since 2% will be scrapped Scrap factor 34,300 0.98 35,000 Q2 43,300 0.98 44,184 Q3 45,500 0.98 46,429 Q4 41,900 0.98 42,755

ANALYSIS:

Since 2% of the production will have to be scrapped, then the extra units to be scrapped would be.

218

Revised production LESS: Good units Scrapped units

Q1 35,000 (34,300) 700

Q2 44,184 (43,300) 884

Q3 46,429 (45,500) 929

Q4 42,755 (41,900) 855

Example 3. Z Non-Alcoholic Brewers manufacturers Maheu drinks. The company is currently in the process of preparing budgets for the next few months and the following Draft figures are available.

Sales forecast January February March April May 9,000 Cases 11,250 Cases 12,750 Cases 10,500 Cases 9,750 Cases

A CASE OF Maheu has a standard cost of K20,000 and a selling price of K25,000. Each case uses 2.5kgs of Maize Meal and it is policy to have stocks of Maize meal at the end of each month to cover 50% of next months production. There are 8,700kgs of maize meal in stock on 1 January. There are 1,125 cases of finished Maheu in stock on 1 January and it is policy to have stocks at the end of each month to cover 10% of the next months sales. Required: (a) Prepare the production Budget (in cases) for the months January, February, March and April (b) The maize meal purchase budget (in kg) for the months of January, July and August. (c) The Budgeted gross profit for the quarter from January to March.

219

Solution: (a) Z Ltd Production Budget January Sales quarters 9,000 Closing stock 1,125 10,125

February 11,250 1,275 12,525 (1,125) 11,400

March 12,750 1,050 13,800 (1,275) 12,525

April 10,500 975 11,475 (1,050) 10,425

Less opening stock ( 1,125) 9,000

(b) INGREDIENTS PURCHASE BUDGET January Kg Budgeted material usage (W1) 22,500 Closing stocks 14,250 Less opening stock (8,700) 18,700 Working (W1) January February March 9,000 x 2.5 = 22,500 11,250 x 2.5 = 28,500 12,750 x 2.5 = 31,312.50 February March

Kg Kg 28,500 31,312.50 15,656.25 13,032 (14,250) (15,656.25) 19,938 19,125

Element 6.2.1.3 Labour Budget The labour budget aims to show the expenditure to be expended on labour at the calculated production budget. Example 4. SOLINE Ltd makes two products, X and Y. The following Data relates to the two products.

220

Direct labour is paid at K5,000 per hour. Direct labour X 7hrs Y 10hrs

The sales manager forecasts that sales of X and Y will be 5,000 and 1,000 units respectively during year 2. The selling prices are: X - K130,000 per unit Y - K115,000 per unit It is estimated that at 1 January year 2 there will be 100 of X and Y units. At the end of year 2 the sales manager will need to close year 2 with stock levels of 150 units of each production in order to prepare the labour budget, we need to know what the product budget is first. PRODUCTION BUDGET
SOLINE LTD

X Units Required sales Closing stock Opening stock Production 5,000 150 5,150 (100) 5,050

Y Units 1,000 150 1,150 (200) 950

SOLINE LTD

DIRECT LABOUR BUDGET FOR YEAR 2 Labour Hour X 5,050 units Y- 950 units 35,350 9,500 Rate per hour K5,000 K5,000 labour cost K176,750,000 K47,500,000 K224,250,000

Workings number of labour hours 221

X 5050 x 7 hrs/unit = 35,350 hours Y 950 x 10hrs/unit = 9,500 hrs Element 6.2.2 Cash Budget From time to time and generally in the process of budgeting, corporations have to prepare cash budgets. Cash budgets are an integral part of the feed forward control system which enables management to anticipate future cash requirements and provide remedies for the future now. A cash budget compares cash receipts and cash expenses in respective periods. All the items of expenditure and income are cash transactions. They will include both capital and revenue expenses as long as they are cash based. It follows that all non-cash based items will not be incorporated in the cash budgets. The non-cash expenses to be excluded from the cash budget would be the following - Depreciation - Bad debts & provisions - Profit/ loss on disposal of Assets - Profit and loss accounts - Balance sheet Responsibility Accounting and Flexible Budgeting Responsibility accounting is a system of accounting that is based upon the identification of individual rates of a business, which fall under the responsibility of a single manager. This requires the classification of the individual parts of the business as responsibility centres. A responsibility centre is an individual part of a business headed by a manager who has responsibility over its performance. In general, there are four types of responsibility centres 1. Cost centre This can be defined as a production or service location, function, activity or item equipment whose cost may be attributed to units of output.

222

The performance of a manager who is responsible for a cost centre is judged on the extent to which cost targets are achieved. 2. Revenue centre This is a centre that is devoted to raising revenue with no responsibility for the cost of doing so. The performance of the manager who is responsible for revenue is judged on the basis of the revenue raised. 3. Profit centre This is a part of the business organisation that is accountable for both costs and revenues. A managers performance for a profit centre is measured on the basis of profits. In order for profit centres to be operated, data must be collected about costs and revenues. Problems Communication of the final budget Comparison of actual with budget figures and investigations of variances.

Budget preparation The procedure will differ from organisation to organisation. The following are the steps: identification of limiting budget factors preparation of the sales budget (assumption sales to be limiting) preparation of a finished stock preparation of production budget preparation of budget for production resources o materials usage budgets o machine usage budgets o labour budget preparation of raw material purchase budget both quantity and cost preparation of overhead administration overheads

223

selling and distribution budgets calculation of overheads absorption rates preparation of cash budget others would be capital expenditure budget working capital budgets the master budget

A flexible budget is a budget, which takes into account the difference in cost behaviour patterns and is designed to change as volume of output changes. Flexible budgets are often prepared on a marginal cost basis, which means that contribution is highlighted. Variable cost must be separately identified from the fixed costs so that it is possible to determine which costs will change as the activity level changes and which will remain Fixed. Feedback is used to describe both the process of reporting control information to management and the control information itself. Most control system makes use of a comparison between results of the current period and the planned results. Past events are therefore used as a means of controlling or adjusting future activities. This is called feed forward.

Alternative approaches to budgeting Incremental budgeting

The traditional approach to budgeting is to base years on the current years plus an extra amount for estimated growth or inflation next year. It is called incremental since it is concerned more with the increments in costs and revenue, which will occur in the coming period. Zero base budgeting A method of budgeting, which requires each cost element to be specifically justified as though the activities to which the budget relates were being undertaken for the first time. The steps in ZBBB are: 1. Define decision package, description of specific organisation activities which management can use to evaluate the activities and rank them in order of priority against other activities. 2. Evaluate and rank each activity on the basis of its benefits to the organisation. 224

3. Allocate resources in the budget according to the funds available and the evaluation and ranking of the competing packages. The advantages and limitation of ZBB Advantages it is possible to identify and remove inefficient or obsolete operation it forces employees to avoid wasteful expenditure it can increase motivation

This is a form of a profit centre whose performance is measured on the basis of the return on capital employed. A manager for an investment centre will normally be responsible for investment decisions as well.

Requirements for responsibility accounting A system of responsibility accounting requires each responsibility centre to have its own budget. There should be a distinction made between controllable and non-controllable costs, especially when dealing with cost centres. Even when costs are identified as controllable and non-controllable it would be unrealistic to judge the performance by comparing actual costs with budgeted costs. This is because no matter how carefully budgets would be set, actual performance will not be the same as budgeted performance. The original budget should be adjusted to the actual level of performance in order to judge the performance of a manager. Adjustment of the original budget to the actual level of performance is what is known as flexing a budget flexible budget is designed to change in output. A Flexible budget is one, which, by recognising the distinction between fixed and variable costs, is designed to change in response to changes in output. Flexible budgets are used for control purposes. Most of the costs, which will be under a managers control, are variable costs and as a result, they will change if the level of activity from the budgeted level of activity. A variance report will be prepared and a manager will be asked to provide explanations for significant adverse variances. As such, flexible budgets are an essential feature in the budgetary control and variance analysis process. Flexible budgets have also been used for planning purposes. However, in the modern industry most of the cost items are fixed in nature and this fact makes 225

flexible budgets not to be so useful anymore in budgetary planning. In those businesses where most of the costs are variable, flexible budgets will still be a useful technique for budgetary planning. Fixed and flexible budgets By the term fixed, we do not mean that the budget is kept unchanged. Revisions to a fixed budget will be made. The term fixed means that the budget is prepared based on an estimated volume of production and an estimated volume of sales. However, no plans are made for the event that actual volume may differ in terms. Format of cash budgets Periods Receipts Other Income Expenses Materials cost Labour Overheads Corporation Tax Capital Expenditure Surplus/ Deficit JUNE K000 X X X X X X X X JULY K000 X X X X X X X X X X X AUG. K000 X X X X X X X X X X SEPT. OCT. K000 K000 X X X X X X X X X X X X X X X X X X X X X

Add: Opening Balance X X

Examples 5 The following data and estimates are available for KASEMPA LTD for the month of June, July and August. June K000 90,000 24,000 17,000 July K000 100,000 26,000 19,000 August K000 120,000 29,000 18,000

Sales Wages Overheads

The following information is available concerning the direct materials.

226

June K000 Opening stock 10,000 Material usage 16,000

July K000 7,000 18,000

August K000 12,000 20,000

September K000 8,000 -

Notes (i) (ii) (iii) (iv) (v) (vi) 10% of sales are for cash, the balance is received the following month. The amount to be received in June for Mays sales s K59,000,000. Wages are paid in the month they are incurred. Overheads include K3,000,000 per month for depreciation. Overheads are settled the month following K13,000,000 is to be paid in June for Mays overheads. Purchases of direct materials are paid for in the month purchased. The opening cash balance in June is K23,000,000 Corporation tax of K50,000,000 is to be paid in July.

Required: (a) Prepare a cash budget for KASEMPA LTD in your capacitys Management Accountant of KASEMPA LTD. Cash budgets Examples Example 1. Kafue Ltd operates a small business purchases are sold at cost plus 33%. (a) Months

Budgeted sales in months K000

labour cost in month K000 1,500 1,500 2,500 2,000

expenses incurred in month K000 2,000 3,000 3,500 3,500

January February March April

20,000 30,000 80,000 60,000

It is management policy to have sufficient inventory in hand at the end of each month to meet half of next months sales demand. 227

Suppliers for materials and expenses are paid in the month after the purchases are made/ expenses incurred. Labour is paid in full by the end of each month. Labour costs and expenses are treated as period costs in the income statement. Expenses include a monthly depreciation charge of K1,000,000. (i) 75% of sales are for cash (ii) 25% of sales are on months credit. The company will buy equipment costing K9,000,000 for cash in February and will pay a divided of K10,000,000 in March. The opening cash balance at 1 February is K500,000. Required : 1) Prepare a cash budget for February and March 2) Prepare an income statement for February and March.

Solution: (1) Cash Budget February K000 Receipts Receipts from sales 27,500 (W1) 67,500(W2) March K000

Payments Trade payables Expenses payables Labour Equipment purchase Dividend Total payment 18,750 (W3) 1,000(W4) 1,500 9,000 30,250 41,250 (W3) 2,000 (W4) 2,500 10,000 9,500

228

Receipts less payments Opening cash balance b/f Closing cash balance b/f Workings

(2,750) 500 (2,250)

11,750 2,250 (9,500)

(2) Receipts of February 75% of February Sales (75% x 30,000,000) 25% of January sales (25% x 20,000,000) (3) Receipts in March 75% of March Sales (75% x K80,000,000) 25% of February Sales (25% x K30,000,000) K000 60000 7,500 67,500 K000 22,500 5,000 27,500

(4) Purchases K000 January For January Sales (50% x K15,000,000) For February Sales (50% x K22,500,000) February For February Sales (50% x K22,500,000) For March Sales (50% x K60,000) These purchases are paid for in February and March. (5) Expenses Cash expenses in January (K2,000,000 K1,000,000) and February (K3,000,000- K1,000,000) are paid in February and March respectively. Depreciation is not a cash item. K000 11,250 30,000 41,250 7,500 11,250 18,750

229

(ii) Income Statement February K000 K000 Sales Less: Cost of purchases Gross profit Less: Labour Expenses 1,500 3,000 (4,500) Net Profit 3,000 30,000 (22,500) 7,500 2,500 3,500 (6,000) 14,000 March K000 K000 80,000 (60,000) 20,000

A COMPARISON OF PROFIT AND CASHFLOWS

The cash flows and profit during the above example need not be the same amount and infact, are actually more likely to be different. The differences are explained by the following causes and reason; Sales and cost of sales are recognized in an income statement as soon as they are made/incurred. The cash budget does not show figures for sales of sales but is concerned with cash actually received from customers and paid to suppliers. An income statement may include accrued amounts for rates, insurance and other expenses. In the cash budget such amounts will appear in full in the period in which they are paid. There is no attempt to apportion payments to which they related. An income statement may show a charge for depreciation. This is not a cash expenses and will never appear in cash budget. The cash budget will show purchases of a non current asset as a payment in the period when the asset is paid for, and may also show the proceeds on disposal of a non current asset as a receipt of cash. No attempt is made to allocate the purchase cost over the life of the asset.

230

Flexible Budget Example: Chintu Ltd budgeted to sell 200 units and produced the following budget. K000 Sales Variable costs Labour Material Contribution Fixed costs Profit 63,200 25,200 (88,400) 54,400 (37,800) 16,600 K000 142,800

Actual sales turned out to be 230 units, which were sales for K138,000,000. Actual expenditure on labour was K54,000,000 and on material K48,000,000. Fixed cash totaled K20,000,000.

Required: Prepare a flexible budget that will be useful for management control purpose. Solution: Budget Variance 200 units K000 Sales. 142, 800 Variance Costs Labour Material 63, 200 25, 000 316 126 72, 680 28, 980 54, 000 48, 000 18,680(F) 19,020(A) per unit K000 714 230 units K000 164, 220 230 units K000 138, 000 K000 26,220(A) Budget Flexed budget Actual

231

88, 400 Contribution 54, 400 Fixed costs (37, 800) Profits _16, 600 _

442 272

101, 660 62, 560

102, 000 36, 000 26,560(A) 17,800(F) 8,760(A).

(37, 800) (20, 000) __24, 760__ 16, 000 __

Example: Kuku Ltd manufactures a single product, the sisy. Budget results and actual returns for May are as follows: Budget Production and Sales of the Sales (units) Actual Variance

15, 000 K000

16, 400 K 000 162,000 47,000 31,000 45,600 K 000 12,000 (F) 2,000 (A) 1,000 (A) 600 (A)

Sales revenue

150,000

Direct Materials 45,000 Direct labour Production overheads Admin overhead Profit 30,000 45,000

20,000 140,000 10,000

22,000 145,000 16,400

2,000 (A) 5,600 (A) 6,400(F)

Make the following assumption in dealing with the above scenario. (b) Direct material and direct labour are variable costs. (c) Production overhead is a semi variable costs the budgeted cost for an activity level of 20,000 units being K50,000,000. (d) Administration overhead is a fixed cost.

232

(e) Selling prices are constant at all levels of sales. Required: Prepare a budgeting control analysis. Solution: Fixed budget Production and sales (units) 15, 000 K 000 Sales revenue Direct Materials Direct labour Production overhead Administration over head Profit Flexible Budget 16,400 K 000 164,000 49,200 32,800 46,400 20,000 _______ 145,600 16,400 Actual results 16,400 K 000 162,000 47,000 31,000 45,600 22,000 ________ 145,600 16,400 K 000 2,000 (A) 2,200 (F) 1,800 (F) 800 (F) 2,000 (A) ________ 2,800 800 (F) 150, 000 45, 000 30, 000 45, 000 20, 000 140, 000 __10, 000__ Variance

233

Workings: Selling price per unit K 150,000,000 15,000 = K10,000 per unit Flexible Budget sales revenue = K10,000 x 16, 400 units = K164,000,000 Direct material cost per unit = K 45,000,000 15,000 units = K3,000 Budget cost allowance = K 3,000 x 16,400 units = K 49,200,000 Direct labour cost per unit = K 30,000,000 15,000 units = K2,000. Budget cost allowance = K2,000 x 16,400 units = K32,800,000 Variable production overhead cost per unit. Using the high low method. = _(K50,000,000 K45,000,000)_ 20, 000 15, 000 units = K 1, 000 per unit . . . fixed production overhead cost = K30,000,000 . . . Budget cost allowance = 30,000,000 + (16,400 x K1,000) = K 46,400,000 Administration overhead is a fixed cost and hence budget cost allowance

234

= K 20,000,000 Element 6.2.2.1 Advantages of Cash Budgets The cash budget reveals to senior managers whether there will be sufficient cash to enable the organisation to meet its cash obligations as they fall due. It gives forewarning of the cash effect of the decisions that could be taken in the budgetary planning process e.g. whether to decide to increase stocks and offer more credit to customers or not. If the cash budget indicated a forecast cash shortfall then managers can take action in advance to cover the shortfall, by for example starting to negotiate for a bank loan. If the cash budget forecasts a cash surplus then advance plans can be made to invest the cash investment portfolios as allowed by the corporate risk and investment policy of the company.

Element 6.3

FLEXIBLE BUDGETS

Element 6.3.1 One of the most commonly occurring problems in variance analysis is deciding which benchmark to use as a basis for comparison. When the standard costs are set at the beginning of the reporting period, they will be presented in the form of a budget based on activity levels expected at that point. Suppose activity level subsequently fall because of a downturn? It is preferable to base the variance analysis on the standard set for the original level of output, or to introduce some flexibility and compare actual outcome with the standard expected for the new level of activity? Element 6.3.2 DEFINITION Budgets which do allow for changing levels are called flexible budgets. Flexible budgets therefore are prepared based on the original level of activity and taking into account the changes in the new level of activity. Flexibility however, is often over looked when the need t analyse variances arise. Element 6.3.3 FLEXIBLE BUDGET PREPARATIONS AND VARIANCE ANALYSIS

235

Kuchinja Company sets the standards for the month coming to manufacture 10,000 units. By the time July was reached, output had fallen to 8,000 units per month because of a fall in market share of sales. The information below is for the original budget and the actual outcome for the month of July. The original budget is based on a standard direct cost of K 4000 per Kg of raw material, a standard cost rate of K 3000 per direct labour hour. Each unit of output requires 0.5 Kg of raw materials and 12 minutes of labour time. The actual cost of direct labour was found to be k 5000 per hour and raw materials K 4400 per Kg. The actual variable overhead cost rate was K 2800 per direct labour hour. 3800 kg of materials were used and the actual labour hours worked was 2000. Data relevant to the month of July is set out below: ORIGINAL BUDGET AND ACTUAL COSTS FOR JULY Units Manufactured Direct material Direct labour Variable overhead Fixed overhead Total costs Original Budget 10,000 K000 20,000 10,000 6,000 7,000 43,000 Actual for July 8,000 K000 16,720 11,000 5,600 7,500 40,820

Element 6.3.4 SOLUTION It is quite tempting to compare these two columns of figures directly and call the difference the cost variance. But that would be totally misleading because the budget is based on 10,000 units of output and the actual output was down to 8,000 units. So a flexible budget is therefore prepared as follows. Units manufactured Variable costs Direct materials Direct labour Variable overhead Total variable costs Fixed costs Total costs Original Budget 10,000 K000 20,000 10000 6,000 36,000 7,000 43,000 Actual Budget 8,000 K000 16,000 8,000 4,800 28,800 7,000 35,800

236

Variance analysis Units manufactured Variable Costs Direct materials Direct labour Variable overhead Fixed overhead Total costs Flexible Budget 8,000 16,000 8,000 4,800 7,000 35,000 Actual for July 8,000 16,720 11,000 5,600 7,500 40,820 Variance

720 (A) 3,000 (A) 800 (A) 500 (A) 5,020

Calculations : i) The fixed overhead are not flexible and therefore remain the same ii) Analysis of standard costs Item Standard cost Standard of item amount of item/unit of output Std Quality Std cost for for output for output level of of 8,000 8,000 units K000 0.5 Kg 4,000 Kg 16,000 12 min 1,600 hours 8,000 12 min per direct 1,600 direct 4,800 labour hour labour hour

K000 Direct material 4 per Kg Direct labour 5 per hour Variable o/head 3 per direct labour hour

Element 6.4 Behavioral Aspects of Budgeting When used correctly a budgeting control system can motivate but it can also produce undesirable negative relations from employees. Element 6.4.1 General Behavioral of Budgeting 1. The manger that set the budget or standards are often not the mangers that are then made responsible. 2. The goals of the organisation as a whole as expressed in a budget, may not coincide with the personal operations of individual managers.

237

3. Control is applied at different stage by different people. A supervisor might get weekly control reports, and act on them, his supervisor might get monthly reports, and decide to take different control action. Different mangers can get in each others way and resist the interference from others.

Element 6.4.2 Motivation Motivation is what makes people behave in the way that they do. It comes mainly from individual attitude or group attitudes. Individuals will usually be motivated by personal interests and desires. It is important that goals of management and employees harmonize with the goals of the whole organisation. This is known as goals congruence. Therefore management accountants should endeavor to design budgeting control systems, which will help an organisation to work towards goal congruence. Management accountants should therefore try to ensure that employees have positive attitude towards setting budgets, implementing budgets and giving feedback on organisational performance.

Element 6.4.3 Poor Attitude When Setting Budgets If managers are involved in preparing a budget, poor attitude or hostile behaviour towards the budgetary control system can begin at the planning stage. 1. Managers can complain that they want to spend their total time on their daily schedule activities and not on budgeting. 2. When budgeting, Managers might build budget slacks into the cost center budget of expenditure estimates. 3. Mangers may set budgets for their budgets center and not co-ordinate their own plans with those of other budget centers. 4. Mangers might all together not want to be involved in the budget process. Element 6.4.4 Poor Attitude When Implementing Budgets

238

Poor attitude also arise when a budget is implemented. (a) Mangers might put in only enough effort to achieve budget targets without aiming to beat target, as set is the budget. (b) Poor communication among different budget holders may creep and it may teal to poor co-operation. (a) A formal budget might encourage rigidity and discourage flexibility. (b) Some budgets implementing may fall on short-term goals at the expense of the long term goals of the organisation.

Element 6.4.5 Poor Attitude When Utilizing Budgeting Control Information The attitude of managers towards the accounting control information they receive might reduce its effectiveness. (a) Management accounting control responses could well be seen as having a relating low priority in the list of budget tasks. Managers might take the view that they have more pressing jobs on hand than looking at routine control reports. Budgets might be seen, as pressure devices that are just meant into doing better, control reports will be resented. If there are flows in the system of recording actual costs, mangers will dismiss control information as unreliable. Managers (Budget holders) might be held responsible for variances outside their control.

(b) (c) (d)

Element 6.4.6 Styles of budgeting It has been argued that motivation levels in the entire budgeting process will depend to a large extent on the level of participation from the members of the organisation. Therefore lets at this point in time examine the main budgeting style which incorporates participation at different levels.

239

Element 6.4.6.1 Imposed Style of Budgeting An imposed or top down budgeting is a budget allowance which is set without permitting the ultimate budget holder to have the opportunity to participate in the budgeting process. In the imposed style of budgeting, the management prepares a budget with little or no input from the operating core personnel which is then imposed upon the employees who have to work according to the budget figures.

IDEAL SITUATION FOR IMPOSED BUDGETS

Imposed budget will ideally be effective in the following circumstances. 1) During the period of economic down forms. 2) When operation managers lack budgeting skills 3) In very small businesses. 4) In newly formed organisations.

Disadvantages of imposed budgeting 1) The filling of team spirit may disappear. 2) Lower level management initiative may be stifled. 3) Operational staff may be dissatisfied, defensive and low morale amongst employees; this is because the targets are set by strategic managers who are detached form the implementers. 4) The acceptance of organisation goals and electives could be limited.

Advantages of imposed style budgeting 1) They tend to decrease the period of time taken to draw up the budgets. 2) Strategic plans are likely to be incorporated into planned activities.

240

3) They use senior managements awareness o total resource availability. 4) They decrease the input from independencies or uninformed lower level employees.

Element 6.4.6.2 Participative Style of Budgeting Participative/bottom up budgeting is a budgeting system in which all holders are given the opportunity to participate in setting their own budgets. In this style of budgeting, budgets are developed by lower level managers who then submit the budgets to their superiors for review and approval.

Advantages of participative budget 1) The budgets are usually very realistic as they are prepaid by people who know the actual needs of the organisation on the ground. 2) Morale and motivation among operation staff is improved. 3) Co-ordination between units is improved. 4) Specific resource requirements are included and budget slacks are avoided.

Disadvantage of participative budgets 1) They consume more time, as a lot of people will need to have an input into the budgeting process. 2) They may cause managers to introduce budgeting slack and budget bias. 3) They can support empire buildings by operational staff. 4) An earlier start to the budgeting process could be required. 5) Managers may set easy budgets to ensure that they are achievable.

Element 6.4.6.3 Negotiated Style of Budgeting A negotiated budget is a budget in which the budget allowance is set largely on the basis of negotiations between budget holders and those to whom they report.

241

The budgeting process is hence a bargaining process and it is this bargaining which is of virtual importance, determining whether the budget is an effective management tool. In practice, different levels of management often agree to budget by a process of negotiation. Operational Manager will try to negotiate with senior managers, the budget targets which they consider to be unreasonable and unrealistic. Like wise senior management usually review and revise budgets presented to them under a participative approach through a process of negotiation with lower managers. Therefore the final budgets are therefore most likely to lie between what top management would realty like and what junior managers believe is feasible.

Element 6.4.7 The Management Accountant and Motivation As it has been highlighted, targeting can bring conflict and bring an effect on management behavior. Hence the management accountant therefore will need to devise strategies and methods of dealing with the resulting tensions and conflict. But what then is the effect on motivation, if employees view performance standards as chargeable. The management accountant should devise performance measures and budgeting control systems that will motivate managers towards achieving organisational goals.

This can be done by adopting the following; Accounting measure of performance cant provide a comprehensive assessment of what a person has achieved for the organisation. A management accountant should supply accounting reports, which try to provide information requirements to several users and to satisfy several needs.

242

Management accountants should prepare Accounting reports, which will focus on both shortterm and long-term achievements of an organisation.

HOW MANAGEMENT ACCOUNTANTS SHOULD DELIVER HIGH QUALITY BUDGETARY CONTROL SYSTEM DATA

i. ii. iii. iv. v. vi.

Develop a working relationship with operational; managers, going out to meet them and discussing the control reports. Explain the meaning of budgets and control reports Keep accounting jargon in these reports to a minimum in their Accounting reports. Provide control information with a minimum delay. Make sure that actual costs are recorded accurately. Ensure that budgets are up to date, either by having a system of rolling budgets or by updating budgets or standards as necessary and ensuring that standards are fair so that control information is realistic.

BEYOND BUDGETING

The beyond budgeting round table have proposed that traditional budgeting should be abandoned and they attack the current budgeting process by giving the following criticisms. 1) Budgets are time consuming and expensive 2) Budgets provide poor value to the organisation generally the value added by the budgeting process has been found to be negotiable. 3) Budgets fail to focus on shareholder value. They may lead to short tenure especially where managers are remunerated on the basis of financial results.

243

4) Budgets are too rigid and prevent fast response to changes in the environment. 5) Budgets may stifle product and strategy innovation. 6) Budgets lead to unethical behaviour. For example in this chapter on budgeting we have discussed dysfunctional behaviour such as building slack into the budget in order to create an easier target for achievement.

CONCEPTS OF BEYOND BUDGETING

The following are the two pillar concepts on which beyond budgeting approach in based. (a) Use of adaptive management processes rather than more rigid annual budgets. Traditional annual plans tie managers to predetermined actions, which might not move in tandem with the current happenings. Therefore beyond budgeting suggests that manages should use forecasts on the cash expenses rather than focusing on purely cost control. Their performance is monitored against world class benchmarks, competitions and previous periods. (b) Move towards networks rather than centralized hierarchies. The emphasis is on encouraging a culture of personal responsibility by delegating decisions to personal, and performance accountabilities to managers.
FURTHER EXPLANATION ON THE CONCEPTS

Adaptive management process An adaptive management process does not tie a manger to the achievement of a fixed target but it expects managers to work on a continuous performance improvement in response to changing business environment conditions. Planning is a continuous, participative basis. Evaluation of managers performances therefore is based on a relative improvement and this evaluation is carried out using a range of relative

244

performance indicators with highlights i.e. taking account of the actual conditions in which the manager was working. Similar to Coldratts proposition in adaptive management process, managers are given the resources they need to deliver their duties and corporations are cross functionally coordinated to respond to customer demands.

Element 6.5 Application Of Information Technology in Budget Preparation Computers are finding increasing employment in the management accountants daily duties. Today computer spreadsheet such as Microsoft Excel and Quato pro can be used to assist in the preparation of budgets.

Illustration of a spreadsheet 1 2 3 4 5 A Cell B C D E

Spreadsheets come in handy in budgeting because the process involves a lot of alteration to be made as the key assumptions upon which they are based could need to be changed. In addition, if the Board of Directors do not approve the budget, alterations will have to be made to the budget.

Element 6.5.1 Merits of Using Computer Spreadsheets a) b) c) d) The spreadsheets are fast They are more accurate Can handle huge volumes of data Quick replanning and recalculations can be made with ease. 245

Element 6.5.2 Limitations of Spreadsheets a) They cannot judge. Spreadsheets just process all data fed to them. b) They may be costly to acquire c) Some spreadsheet are difficult to use.

Element 6.5.3 Budgeting Software Just like in financial accounting where we can use dedicated financial amounting packages such as PASTEL, ACCPAC, SUNSYSTEM and NAVISION, several dedicated Budgeting packages (Modules) have been developed to handle all the complexity in budgeting and to give detailed and robust analyses in budgeting. Examples of such packages include a) COMSHARE b) HYPERNION etc.

246

STUDY UNIT 7.0 MODERN BUSINESS ENVIRONMENT

Learning objectives: At the end of the chapter, a candidate should be able to Understand factors driving changes in business Explain the factors Identify need for new management accounting techniques Explain modern production strategies Explain what world class manufacturing techniques are Appreciate the concept of product life cycle Appreciate life cycle costing

Element 7.1 The Changing Business Environment From the 1970s, the world has seen a number of changes that are greatly impacting on business and revolutionalising the way businesses acquire their inputs, process them into finished goods and dispense them to the clients/customers. These developments have therefore demanded that management accountants develop new management accounting techniques that will accurately record and report costs in a more meaningful manner to aid management decision-making in a business or indeed in any other organization.

Element 7.1.1 Changing Customer Demands For Cheaper Goods Modern customers have become very complex in terms of product quality and the price at which they buy commodities. Now, more than ever before, all customers of both services and tangibles products want to buy these products at a very low or reasonably low prices. In order to meet these demands, corporations are being forced to find new and cheaper methods and techniques that will see the production or delivery of cheap products or services respectively.

247

Element 7.1.2 Changing Customer Demands For High Quality Goods Customers also want high quality products and services in the modern world. As a result corporations are being forced to better their production systems or their service delivery systems so that they deliver very high quality goods and services.

Element 7.1.3 Increase In Operational Overheads The cost structures of most businesses now exhibit a situation where most businesses have a big proportion of their costs being fixed in nature. This scenario will result in an increased operational risk of a firm. This being the case, companies want to devise new approaches to production and service delivery that will go round the increased operational risks.

Element 7.1.4 De-Regulation of Industries There has been a wave of privatisation of formerly state owned companies to private owners, and henceforth less government control in the management of these corporations. This has resulted in formation of self-regulatory bodies. Therefore this has put unprecedented pressure on corporations to suit their new environments.

Element 7.1.5 Intensity In Competition and Globalisation World over, most countries have loosened their former protective measures that they had. Yet other countries still, have formed economic blocks (unions) through which given economic objectives are being pursued, for instance the European union (EU) and COMESA. All these developments are turning the world into a global village where corporations can conduct business across boarders and continents with very little restraint. These turns in events have really increased competition among modern businesses and they have also unlevelled the competitive grounds. Therefore in order to survive this cutthroat competition, businesses now need to find ways and means of differentiating themselves from the rest in order to ward off the competition.

248

Element 7.1.6 Shortened Product Life Cycles There has been a growing trend among many corporations to shorten their products lifecycles. In order to achieve this goal, many businesses are indeed investing in non-traditional production methods that will help them achieve just that goal. This has heightened the quest to innovate the new and required techniques therefore.

Element 7.2 Production management Strategies

Element 7.2.1 Just-In-Time Production Systems The concept of just-in-time production was conceived by the Japanese in their relentless pursuit of excellence in the manufacturing factories. The concept promotes demand-pull production, meaning that corporations should only manufacture their products when there is demand for the products. If there is no ready demand then there is no need to manufacture any products at all because they may end up going to waste. Following the suggestions of the concept, there will be no need to hold huge stocks of raw materials as these will also only be needed when there is a production run that has been initiated by client demands. To make just-in-time production a success, companies that use the technique should endeavour to have only a few reliable suppliers to provide inputs to avoid delays and poor quality inputs. The suppliers will provide high quality inputs because there will be a strong and good relationship between the supplier and the company using just-in-time.

Element 7.2.2 Dedicated Cell Layout The dedicated cell layout concept stipulates that for a business to increase productivity among its workforce, it needs to arrange its production factory and factory equipment in a certain manner. The dedicated cell layout suggests that an employees work bench or work station should be surrounded by all the equipment and utensils which the employee needs in order to carry out his work without any need to walk long

249

distances across the factory floor, a practice that can waste time and reduce employee productivity. Further, it follows then that raw materials to be fed to the production system should also be located near the production site or factory for easy of retrieval when needed for production.

Element 7.2.3 Computer Aided Design (CAD) Computer aided design is a modern approach to designing of components and products where complex computer software is used in their design stage. Therefore engineers will be employing computers in their design work, that is, using a computer monitor and mouse to make designs on a computer screen. Computer aided design enables designers to easily alter or change the designs they are making of given components because the computer software has tools that can be used to make these alterations easily. Designing using a computer also offers high levels of accuracy in the design work being done, as a computer has high precisions measurements embedded in it. A further merit of using computers in designing is that it brings the design in three dimension on the computer screen, revealing the component being designed from all aspects or angles showing all intricacies which would have otherwise been hidden.

Element 7.2.4 Computer Aided Manufacturing (CAM) Computer aided manufacturing entails using computers and computer related technologies in the manufacturing process. Of late, we have, seen a big growth in the use of computers in manufacturing through the extensive use of robotics and computer controlled equipment in manufacturing by many automobile manufacturers like General motors and Toyota Corporation. Use of computers in manufacturing brings in a pool of benefits to the companies that employ these techniques. Accuracy is achieved at all levels of the manufacturing process.

250

Reduces operational costs in the long-term Can easily be integrated with other key information systems within the enterprise.

Element 7.3 World Class Manufacturing Techniques Element 7.3.1 Automated Manufacturing Technology (AMT) As the term suggests, in its basic terms, involves the automation of the manufacturing processes and all peripherals involved in service delivery systems.

Element 7.3.2 Synchronised Manufacturing Systems Corporations with worldwide operations will need to bring uniformity in their manufacturing systems. Therefore they will establish systems, which streamline and unify all their systems.

Element 7.3.3 Flexible Manufacturing Systems Flexible manufacturing systems are manufacturing systems that will enable a corporation to run different kinds of production runs to be made in different settings using the same machinery and factory equipment. This means that the same equipment can be varied in order to accommodate different production settings in production runs.

Element 7.3.4 Computer Controlled Machinery Most companies have their machinery controlled by computers. These computer controlled machinery systems have been put in place for the benefits that we discussed in element 7.2.4. For instance, Zambia bottlers uses computer controlled machinery to fill Fanta and Coca-Cola drinks of a predetermined quantity or volume in each bottle. So, the machine has been programmed to fill an exact quantity of the soft drink in each bottle. This really illustrates the application of computer-controlled machinery in practice.

251

Element 7.3.5 Automated Storage And Retrieval Systems In order to ease the process of storing and retrieving raw materials, most companies have invested heavily in automated systems that help them in the storage and retrieval of their raw material stocks. These automated systems provide a means by which by a computer button, storage spaces can be opened, stocks packed and retrieved when necessary. The inbuilt shelves and pigeonholes are all computer-controlled; hence they can easily be manipulated by use of a central computer to which the shelves and pigeonholes are connected.

Element 7.3.6 Material Requirement Plan (MRP) Material requirement planning system is a system that enables a manufacturing company to create a bill of materials that are required to meet a given production level. This is a vital part of a production material budget. It helps a company to know before actual production the quantities of materials required for any given production level.

Element 7.3.7 Enterprise Resource Planning (ERP) The enterprise resource planning system is a higher version of resource planning. The enterprise resource planning system involves planning for all resources required to successfully meet a given production level. This is a very comprehensive resource plan because it looks at all resources unlike the MRP that has been considered in section 7.3.6, which only looks at one resource, raw materials. The enterprise resources planning system considers all resources required to meet a certain production level. So, the enterprises resources planning will highlight all resources including raw materials, man-hours required, peripheral resources and overheads needed to meet given production levels.

252

Element 7.4 Product Life Cycle Element 7.4.1 Concept of Product Life cycle The concept of product life cycle proposes that products go through a cycle or phases from the time of their introduction right up to the time of their decline. Traditionally, the product life cycle has been split into four main stages or phases, namely, introduction, growth, maturity and decline stages.

Element 7.4.2 Introduction Stage At the introduction stage of a products life, the product is successfully introduced to the market and it is supported usually by an expensive advertising campaign. At this stage the products sales volume and hence revenues are relatively low.

Element 7.4.3 Growth Stage In the growth stage a product gains more support and acceptance of the clients/customers, so the products gains stability and clients build confidence in the product or service. Therefore, at this stage, sales volumes and sales revenues of the product or service increase. In many instances, new entrants from competitor companies may surface.

Element 7.4.4 Maturity Stage The product will be said to have reached its maturity stage when sales demand levels off. In a static market, price competition will reduce the profitability of each firm. Firms seek to differentiate their services and products at this stage.

Element 7.4.5 Decline Stage Eventually, the product will become obsolete and falling sales will ensue. The product/ services falls out of favour with the clients and therefore sales from the product fall. Before this stage is reached, the business should have developed a replacement product, thereby incurring further large research and development costs, design and production facilities establishment.

253

Element 7.4.6 Cost Implications For The Product Life Cycle The costs that are going to be incurred by a corporation throughout the life of the product will vary according to stages at which the product will have reached. At the introduction stage, the firm will have incurred huge research and development costs; further advertising costs will be incurred in order to help the product to find acceptability in the market place. At the Growth stage, the product finds acceptance and less advertising or marketing is needed than what was needed to sustain the introduction stage. Therefore, by and large, fewer costs are going to be incurred at this stage. The unit fixed costs will decrease. At maturity, the fixed unit costs even reduce further as the product will have stabilized. At decline stage, the situations vary; sometimes corporations might spend more money if they want to resuscitate the ailing product. On the other hand if the company does not want to continue offering the product, it will let the product to die a natural death by not investing any further support expenditure, but it will harvest all the revenues coming from the dying product.

Element 7.4.7 Implications of The Product Life Cycle On The Advanced Manufacturing Technology Environment In the advanced manufacturing technology (AMT) environment, a very large amount of fixed costs will already have been incurred in research and development, designing the product and building or re-equipping the production line Before the decline stage is reached, the business should have developed a replacement product, thereby incurring further large research and development costs, design and production facilities establishment. In the AMT environments, the time period for the product life cycle is decreasing. For example, the longest life cycle for a mass-produced motor car has reduced from over 4 decades for both the VW Beetle and the Morris minor to less than 25 years for the Renault, which ceased production in 1996. However, most models must be renewed in much shorter timeframes. Vauxhall is setting up new production facilities for manufacturing a revamped Corsa in the United Kingdom.

254

The Corsa was launched only a few years ago. The product life cycle concept enables corporations to carry out clear strategic plans regarding the development of new products, cash flows and marketing activities.
LIFE CYCLE COSTING

Life cycle costing involves collecting cost data for each product from inception, through its useful life and including any end-costs. These data are compared with the life cycle budgeted costs for the product. This comparison will show if the expected savings from using new technology or production methods would be worthwhile. The recognition of the total support required over the life of the product, whereas traditional costing methods follow costs by function e.g. research and development, production, marketing and so on. Thus for manufacturers, life cycle costing makes explicit the relationship between design choice and production and marketing costs. The insights gained from comparing budgeted and actual life cycle costs may be used to refine future decisions. Consumer as well as producers may use life cycle costing. A recent analysis has shown that the life cycle cost of purchasing a personal computer (PC) is around six times the purchase cost, computer skills training and extra software will cost three times the cost of the PC and maintenance will cost twice the purchase cost over the life of a personal computer. It has been recognized in the AMT environments that up to 90% of the costs incurred throughout a product life cycle will be determined before the product reached the market. Thus the early decisions regarding product design and production methods are paramount and life cycle costing attempts to recognize this situation. The high fixed costs of introducing a new product, coupled with reduced life cycle periods are a major challenge to profitability in advanced manufacturing environments. Life cycle is a technique that may be used to improve management decision-making in such conditions.

255

Question 1 Most companies that are operating in an advanced manufacturing environment are finding that about 90% of a products life cycle cost is determined by decisions made early in the cycle. Management accounting systems should therefore be developed that aid the planning and control of product life cycle costs and monitor spending at the early stages of the life cycle. Required (a) Explain the nature of the product life cycle concept and its impact on businesses operating in an advanced manufacturing environment. (10 marks) (b) Explain life cycle costing and state what distinguishes it from more traditional management accounting practices (8 marks) (c) Compare and Contrast life cycle budgeting with activity based management. Identify and comment on any theme that the two practices have in common. (7 marks)

256

Suggested Solution to Question 1 (a) The product life cycle (PLC) is shown in the diagram below.

Illustration of product life cycle

Sales revenue

introduction

growth

maturity

decline

Time When a product is first introduced successfully to the market, supported by an expensive advertising campaign, it will only achieve a relatively low sales volume. In an advanced manufacturing technology environment, a large amount of fixed costs will already have been incurred in research and development, designing the product and building or re-equipping the production facilities. In the growth stage, sales increase and unit costs fall as the high fixed cost per unit decrease although new entrants may start to compete at this stage. This is the most profitable stage of the product life cycle traditionally. The product is said to be mature when sales demand levels off. In a static market, price competition will reduce the profitability of each firm. Firms seek to differentiate their product at this stage.

257

Eventually, the product will become obsolete and falling sales will ensue. This is the decline phase of the product life cycle. At this stage, firms will begin to pull out of the market or focus on promotional marketing strategies and reducing selling prices. Before the stage is reached, the firm must have developed a replacement product, thereby incurring further large fixed costs for Research and development, design and new production facilities. It has been observed over the years that in the advanced manufacturing environment, the time period for the product life cycle is decreasing for most products such as automobiles (motor vehicles). (b) Life cycle Costing (LCC) involves collecting cost data for each product from inception, through its useful life and including any end costs. These data are compared with the life cycle budgeted cost for the product. This comparison will show if the expected savings from using new technology or production methods are worthwhile or not. The recognition of the total support required over the life of the product, whereas traditional costing methods follow costs by function e.g. Research and development costs, production, marketing and so on. Thus for manufacturers, life cycle costing makes explicit the relationship between design, choice and production and marketing costs. The insights gained from comparing budgeted and actual life cycle costs may be used to refine future decisions. Both consumers and manufacturers of commodities may use life cycle costing. A recent analysis has shown that the life cycle cost of purchasing a personal computer is around six times the purchase cost. Staff training and extra software will cost three times the cost of the personal computer and maintenance will cost twice the purchase cost over the life of the personal computer. It has been recognised in the AMT environments that up to 90% of the costs incurred throughout a product life cycle will be determined before the product reaches the market. Thus the early decisions regarding product design and production methods are paramount and life cycle costing attempts to recognise this situation. The high fixed cost of introducing a new product coupled with reduced life cycle periods is a major challenge to profitability in AMT

258

environments. Life cycle costing is a technique that may be used to improve management decision-making in such conditions. (c) Activity based management (ABM) uses the understanding of cost drivers formed from activity based costing (ABC) to make more informed decisions. In particular, this approach yields a better understanding of overhead costs in AMT environments compared to traditional absorption methods. Activity based management (ABM) aims to improve performance by: Eliminating waste Minimising cost driver Emulating best practise Considering how the use of resources supports both operational and strategic decisions

Thus, activity based management seeks to consider all activities performed by the organisation in order to serve a customer or produce a product. Results of activity of activity based management in an AMT environment include: Increased production efficiency Reduced production costs Increased throughput Increased quality assurance

These gains may be realised by: Simplified product design More use of common sub-assembles

259

Reduced set up times Reduced material handling Better use of the workforce e.g. Multi-Skilling

Therefore activity-based management is very similar to life cycle costing in the following aspects: Both attempt to increase management understanding of overhead costs Both consider how the use of resources supports strategic decisions, that is, both look at how resources inputs are used to obtain the organisational output.

In an AMT environment both methods focus management attention on the need to produce simplified product using common components and common sub-assemblies and to maximise the output from expensive capital investments. Life cycle costing leads to major review at the major stages in a product life cycle, whereas activity based management is a continuous system that strives to drive down both short term and long-term costs.

Question 2 Mode ltd is a company that manufactures mobile phones. This market is extremely volatile and competitive. Achieving adequate product profitability is extremely important. Mode is a mature company that has been producing electronic equipment for many years and has all the costing systems in place that one would expect in such a company. These include a comprehensive overhead absorption system, annual budgets and monthly variance reports and the balanced scorecard for performance measurement. The company is considering introducing: (1) Target Costing: and (2) Life Cycle Costing systems

260

Required: Discuss the advantages that this specific company is likely to gain from these two systems. (20 marks)

Suggested Solution to Question 2 The modern business environment tends to be an unstable one and is rapidly changing in terms of customer requirements, economic factors, technology and so on. Mode is in a particular unstable business because technology is changing rapidly as digital telephones takeover and text messaging develops. Both target costing and life cycle costing are systems that should help the company cope with this. These systems will help Mode ltd to compete in terms of cost and product development in the competitive telecommunications market. The specific advantages of the two systems are as follows. 1 Target Costing Target costing may replace and is often compared to traditional standard costing/ variance analysis, which has long been in place in the manufacturing world. Mode ltd may wish to replace standard costing/ variance analysis with target costing for control and reduction for the following reasons: It puts pressure on costs. It can be used as a cost reduction technique unlike standard costing and can incorporate a learning effect. This is likely to be important in the manufacture of phones. Traditional standards may be too rigid for cost control and reduction purposes for a company such as Mode ltd as they usually need to be set for a year at a time. Target costing is more flexible and targets can change/reduce from month to month

261

It considers the market and price customers are prepared to pay, so it forces an organisation to be outward rather than inward looking. Mode ltd needs to consider the final customer as well as the system supplier. It should motivate staff if used correctly and help break down any artificial functional barriers as it involves staff at all levels and in most functions and forces them to communicate. It leads towards the use of other techniques, such as value analysis and value engineering, which should simplify production methods and reduce costs. This is particularly important in an industry with short product life cycles.

(2) Life Cycle Costing The life cycle of Mode ltds products is likely to be short because of changing technology; therefore, it is imperative that the products begin to generate profits quickly. Estimating life cycle costs and revenues will highlight the following: Research and development costs are likely to be quite high and must be recovered in a short period. Many of Mode ltds costs are likely to be locked in during the design stage, say 84% to 94%. So it is important to control costs initially in order to maximise the profit over the products life It focuses on time as well as money. Time to market is often a key factor in generating profit. It is more important to measure time than money/ cost. It may be vital for Mode ltd to bring new products to market quickly and on time in order to achieve a profit. Monitoring of costs and benefits over the life cycle helps to stop a project early if events have changed or not turned out as planned. It presents a different perspective that could be advantageous to Mode ltd, as it is not tied to period reporting.

Because of the above, it would be advantageous for the company to adopt both of these techniques.

262

STUDY UNIT 8.0 Advanced Variance Analysis

Learning Outcomes After reading this chapter candidates should be able to Reconcile budgeted and actual profits through use of variance analysis Calculate and interpret variances and yield variance Calculate and interpret fixed production overhead variances Calculate and interpret planning and operational variances Appreciate principal sources of variances Appreciate and use rule of thumb investigation model Use statistical models in investigation Establish relationship of variances

Brought Forward Knowledge At this point in your studies, you should know and appreciate how to calculate basic variances. The main categories of these basic variances are: Price (a) Material variances Usage (b) Labour variances Idle time Efficiency Rate Variable overhead efficiency variances Variable overhead expenditure variance Fixed production overhead expenditure Fixed production volume

(c)

Overhead variances

Candidates must be able to make reconciliations of budgeted and actual profits in any given control period using the variances mentioned above. Working backwards is another area that candidates must demonstrate strong knowledge of:

263

Example 1: A company has the following standards for a mix to produce 500kg of product K: Input A B Kg 200 400 600 Cost/Kg K 1,000 1,600 Total cost of mix K 200,000 640,000 840,000

. . . 600kg of input should produce 500kgs of K at a standard cost of

K1,689/kg. K1,680/kg = K840,000 500kg In a particular period, the actual results of the process were as follows: Actual input A B kg 300 300 Actual cost/kg K 1,000 1,600 Total actual cost K 300,000 480,000

Actual output of K was 400 kg. Please note that in the above shown data, there is no direct material price variance, as the actual cost per kilogramme of inputs A and B was the standard cost in each case. The whole of the direct material variance is thus due to changes in the usage thereof. The total variance is the difference between the standard cost of the output of 400kg of K (400 x K1,680 = K672,000) and the output cost of K780,000. This gives an adverse direct material usage variance of K108,000. The direct material mix variance is defined as: Where substitutes within the mix of materials input to a process are possible, the mix variance measures the cost of any variation from the standard mix. The variance for each input, is based on : (a) The change in its weighting within the overall mix,

264

(b) Whether its unit standard cost is greater or less than the standard weighted average cost of all natural inputs, which is a subdivision of the direct material usage variance. Therefore, the mix variance is calculated using the formula Direct material mix variance: Total material X Input in a standard mix prices standard Actual material X prices

The standard price per kilogramme of the standard input mix is K840,000 ________ 600 kg = K1,400

Applying the formula above, the mix variance is then: (600 x K1,400) [(300 x K1,000) + (300 x K1,600)] K840,000 K780,000 = K60,000 (F) The mix yield is favourable as we have used less mixture of material than the standard proportion/mix

Element 8.1 MIX VARIANCE Element 8.1.1 When a product requires two or more raw materials in its make up it I often possible to sub-analyse the materials usage variance into materials mix and materials yield variances. Element 8.1.2 Adding a greater proportion of one material (therefore a smaller proportion of a different material) might make the materials mix cheaper or more expensive. For example, the standard mix materials for a product might consist of the following: Mix (2/3) 2 Kg of material A @ K 1,000 per Kg (1/3) 1 Kg of material B @ K 500 per Kg K 2000 500 2500

265

It may be possible to change the mix so that one kilogram of material A is used and two kilograms of material B. The mix would be cheaper. Mix (1/3) 1 Kg of material A @ K 1,000 per Kg (2/3) 2 Kg of material B @ K 500 per Kg K 1000 1000 2000

Element 8.1.3 By changing the proportions in the mix, the efficiency of the combined material usage may change. In our example, in making the proportions of A and B cheaper, at 1:2, the product may now require more than three kilograms of input for its manufacture, and the new materials requirement per unit of product might be 3.6 kilograms. Mix (1/3) 1.2 Kg of material A @ K 1,000 per Kg (2/3) 2.4 Kg of material B @ K 500 per Kg K 1200 1200 2400

In establishing a materials usage standard, management may therefore have to balance the cost of a particular mix of materials with the efficiency of the yield of the mix. Once the standard has been established it may be possible to exercise control over the mix. Element 8.1.4 Calculating the variances A) The mix variance for each material input is based on the following: a) The change in the materials weighing within the overall mix b) Whether the materials unit standard cost is greater or less than the standard weighted average cost of all the materials input. B) When to calculate the mix and yield variances. Mix and yield variances have no meaning and should never be calculated unless they are a guide to control action. They are only appropriate in the following situations: a) Where proportions of materials in the mix are changeable and controllable. If the mix is different in units, say, kilograms and litres, they are obviously completely different and can not be substituted for each other.

266

b) Where the usage variance of individual materials is of limited value because of the variability of the mix. It would be totally inappropriate to calculate a mix variance where the materials in the mix are discrete items. For example, a chair might consist of wood, covering material, stuffing and glue. These materials are separate components and it would not be possible to think in terms of controlling the proportions of each material in the final product. The usage of each material must be controlled separately. Element 8.1.5 Formula for the materials mix variance: (Actual quantity in standard mix proportions Actual quantity used) * Standard price

Element 8.1.6 Example A company manufactures a chemical used for eradicating rats called Mbeba Killer, using two compounds Miseshi and Bondwe. The standard materials used and cost of one unit of Mbeba Killer are as follows: K Miseshi 5 Kg @ K 2000 per Kg 10,000 Bondwe 10 Kg @ K 3000 per Kg 30,000 40,000 15 Kg In a particular period, 80 units of Mbeba Killer were produced from 500 Kg of Miseshi and 730 Kg of Bondwe. Required Calculate the materials usage, mix and the yield variances. Element 8.1.7 SOLUTION a) Usage variance Miseshi Bondwe 80 units of Mbeba Killer should have used 400 Kg 800Kg but did use 500 Kg 730 Kg Usage variance (Kg) 100 Kg (A) 70 Kg (F) * Standard cost per Kg * K 2000 * K 3000 Usage variance in K K 200,000 (A) K 210,000 (F) Total usage variance K 10,000 (F)

267

The total usage variance can be analysed into mix and yield variances. b) Mix variance Actual input = (500 + 730) Kg = 1,230 Kg Actual usage in standard proportions; Miseshi 1/3 * 1,230 Kg = 410 Kg Bondwe 2,/3 * 1,230 Kg = 820 Kg 1230 Kg Actual proportions Miseshi Bondwe Total Input should have been 410 Kg 820 Kg 1230 Kg But was 500 Kg 730 Kg 1230 Kg Variance in Kg 90 Kg (A) 90 Kg (F) * Standard price * K 2000 *K 3000 Variance in K K 180,000 (A) K 270,000 (F) K90,000 (F) The total difference or mix variance in Kgs must always be zero as the mix variance measures the change in the relative proportions of the atual total input. The favourable total variance is due to the greater use in the mix of the cheaper material, Miseshi. c) YIELD VARIANCE Each unit of output Mbeba Killer requires 5 Kg of Miseshi = K 10,000 and 10 Kg of Bondwe = K 30,000 1,230 kg Should have yielded (15 Kg) But did yield Yield variance in units * Standard cost per unit of output Yield variance in K 82 units of MK 80 units of MK 2 units (A) * K 40,000 K 80,000 (A)

The address yield variance is due to the output from the input being less than standard.

Element 8.2 Yield Variance

268

Direct material yield variance is defined as the measures of the effect on cost of any difference between the actual material usage and that justified by the output produced, it is a subdivision of the direct material usage variance.

Calculation of Material Yield Variance

(Standard quantity of materials specified for actual production X standard prices) (Actual total material input in standard proportions X standard prices)

Using the formula above, the yield variance is: [(400 x 6/5) x K1,400] [(600) x K1,400] = 120 x K1,400 = K168,000 Adverse Again, a tabular representation could also be used as an alternative presentation.
Actual quantity of Input Cost of Actual Actual quantity Cost of Column Standard Input Cost at Input at Standard Input at standard at standard quantity for actual output Mix actual output standard Column 3 200 400 Column 4 K200,000 K640,000 Column 5 160 320 Column 6 K160,000 K512,000

Column 1 Column 2 300 300 K300,000 K480,000

Remember that: Figures in columns 3 and 4 can only be calculated only after the other columns have been completed. Direct material mix variance. Total Column 4 Total Column 2 = K840,000 K780,000 = K60,000 (F) Direct material Yield variance Total Column 4 = K672,000 K840,000 = K168,000 (A)

269

In both cases, the sum of the direct material mix variance and the direct material yield variance can be seen to be K108,000 adverse, which in the absence of a direct material price variance, is equal to the total direct material variance. The direct material mix and yield variances must be interpreted into core, as there is a very strong interrelationship between them. If we consider the concept of a standard mix, it is clear that such a mix will represent the combination of inputs which provides an acceptable quality of output at the least possible. If some other combinations of inputs could produce a lower cost output without detriment to quality, then this alternative would have been selected as the standard. Any change in the input mix must therefore be expected to have an impact on the yield from the process, as well as on the price of the input mix. It is highly unlikely that any meaningful control can be exercised over the output from a process independent of the input to it, and thus the two variances should be considered simultaneously. Mix Labour Variances The same logic applied to the calculation of material mix and yield variances can be used or applied to labour cost mix & yield variances as well. When different classes of labour are engaged then the labour efficiency variance can be split into mix and yield components. We can demonstrate this by use of a simplistic example below: Example: KANSO Plc produces product 5. The standard labour input associated with the production of one unit is as follows: 4 hours of skilled labour paid at K15,000 per hour. 6 hours of unskilled labour at K10,000 per hour. The standard labour cost of one unit is [(K15,000 x 4 hours) + (K10,000/hour x 6 hours)] = K120,000. The total labour input associated with production of one unit is 10 (ten) hours at an average hourly rate of K12,000 i.e.

270

K120,000 10 hours

= K12,000

It can also be established that the standard labour mix is 40 per cent skilled and 60 percent unskilled. *40% = 4 hours x 100% 10 hours (total) = 40% *60% = 6 hours 10 hours = 60% Labour Yield Variances During period 4 the following performance level was achieved: 25 units were produced 95 hours of skilled labour was used 175 hours of unskilled labour are used. K3,267,500 in wages was paid. Required: Compute the labour cost variance and analyse this into labour rate and labour efficiency component variances. In addition, analyse the labour efficiency variance into labour mix and labour yield components. Stage 1: - Compute labour cost variance This is the difference between the standard labour cost of producing 25 units and the actual labour costs incurred. K Actual labour cost incurred 3,267,500 Standard labour cost of 25 units (25 x K120,000) 3,000,000 x 100%

271

Labour cost variance

________ 267,000 (A)

Stage 2: - Calculation of labour rate and labour efficiency variances The labour rate variance is the difference between the actual hours worked x standard rate and the actual wages paid. The labour efficiency variance is the standard hours required for output achieved actual hours Stage 3: Labour mix variance For 270 hours actually worked: Grade Actual Hours
Skilled 95 (40%) Unskilled 175 (60%) 270

Standard Mix variance Standard Mix Mix of hours Hours rate per hour Variance
108 162 270 13 (F) 13 (A) K15,000 K10,000 K195,000 (F) K130,000 (A) K 65,000 (F)

Labour Yield Variance

270 hours of work should yield: (270 hours 10 hours/unit) But did yield In money terms: 2 units x standard cost per unit (K120,000) = K240,000 (A) Yield variance = K240,000 (Adverse). = = 27 units 25 units 2 units (A)

Analysis and Interpretation: 272

The analysis carried out above, in stage 3 indicates that a cost advantage has been attained by substituting unskilled labour for skilled labour in the production process. However, the advantage has been more than offset by a cost disadvantage coming from the diminished efficiency of the entire workforce. Nkungu Ltd uses two (2) grades of labour that work together to produce product E. The standard composition of each team is five grade A employees paid at K6, 000 per hour and three (3) grade B employees are paid at K4, 000 per hour. Output is measured in standard hours and expected output is 95 standard hours for 100 hours worked in total. During the last period, 2,280 standard hours of output were produced using 1,500 hours of grade A labour costing K9, 750,000 and 852 hours of grade B labour costing K2, 982,000.

Required: Calculate the labour efficiency variance, the mix and yield labour variances. Suggested solutions: Preliminary work (calculation) Calculation of standard rate per hour of output. Labour Grade A B # of employees in each team 5 3 Hourly labour rate K6, 000 K4, 000 = = Total cost per group per hour K30, 000 K12, 000 K42, 000

Less 5% at 8 hours: 8hours 0.4hours = 7.60 hours 100 hours 95 standard hours = 5 hours . . . 5hours

x 100%

273

100 hours = 5% . . . the standard rate per hour of output is = K42, 000 = K5, 526.30 per standard hour 7.6 hours

i)

Direct labour efficiency variance: Grade A Grade B Hours (2280 0.95 x ) K1,500 _________ 900 552 (48 hrs F)

2280 standard Hours Hours of output should K1,500 Take an input of (2280 0.95 x ) But did take ________ Efficiency variance in hours. X standard Rate per hour ___________

x K6,000/hr ___________

x K 4,000/hr -K192,000 (F)

Now we can further analyze the labour efficiency variances to its two subsidiary i.e. the Labour mix variance (team composition variance) and the labour yield (team productively varies). (i) Labour Mix Variance Total actual hours = 1, 500 hrs + 852 = 2, 352 hours. Standard mix of actual input Hours

274

Grade A: Grade B:

x 2, 352 hrs x 2, 352 hrs

= =

1, 470 882 ______ 2, 352

Grade A Mix should have been but was X standard rate per hour 1,470 hrs 1,500 hrs 30 hrs (A) x K 6, 000/hrs __________ K180,000 (A)

Grade B 882 hrs 852 hrs 30 hrs (F) K 4, 000 ________ K120, 000 (F)

(ii) Labour yield variance (team productivity) 2352 hours of work should have produced x (0.95) standard hours But did produce standard hors team productivity variance in hours hours (F) x standard rate standard hour labour yield variance Try the following exercise RPP consultancy has established the following standard composition of a team of its staff performing the year and audit as follows. 2, 2, 234.40 280.0

________ 456 standard K 5, 52630 _____________ K 252, 000 (F)__

Standard hours hour to perform audit

Rate per K

Standard cost of audit

275

Audit manager Junior Auditor Auditor clerk

30 120 50 ___ 200

450,000 170,000 50,000

13,500,000 20,400,000 2,500,000 __________ 36, 400, 000

A year-end audit has not been completed for KWAZI breweries and the hours recorded in respect of each grade of staff are as follows:

Actual hours to perform the audit Audit Manager Junior Auditor Audit clerks 27 125 58 210

Required: Calculate the following labour variance for the KWAZI year end audit. 1) The labour efficiency. 2) The labour yield variance. 3) The labour mix variance.

Capacity Ratios At this point in time we would want to remind candidates that at this level, they should demonstrate full knowledge on how to work out capacity ratios. We are only going to highlight the three main ratios to be appreciated here.

276

1. Full capacity The output (expressed in standard hours) that could be achieved if sales orders, supplies and workforce were available for all installed work places. A standard hour or minute is the amount of work achievable at standard efficiency levels, in an hour or minute. A standard hour is a useful way of measuring output when a number of dissimilar products are manufactured. 2. Practical capacity Full capacity less an allowance for known unavailable volume losses.

3. Budgeted capacity The standard hours planned for a period, taking into account budgeted sales, supplies, workforce availability and efficiency expected. Example: A corporation has the following information: Full capacity standard hours Practical capacity standard hours Budgeted capacity standard hours (Budgeted input hours 90, at 90% efficiency) Actual input hours Standard hours produced From the information above, it can be seen that the (i) Idle capacity = Practical - budget capacity capacity ________________ x 100% Practical capacity 100 95 81 85 68

277

= 95 81 _______ x 100% 95 = 15% This means that the budgeted activity level would not utilize 15% of the practical capacity.

(ii) Production volume ratio = Standard hours produced ___________________ X 100% Budgeted capacity 68_ x 100% = 84% 81 This means that actual output achieved amounted to only 84% of the budgeted output: Efficiency ratio = = Standard hours produced x100% Actual hours 68 x 100% = 80% 85

This means that an 80% efficiency level was achieved, compared to a budget of 90% efficiency. This ratio may be measured in either direct labour or machine hours as appropriate.

278

Element 8.3

FIXED OVERHEAD VARIANCES Fixed overhead variance and variable overhead variance are defined in the same manner as over head variance as they represent the difference between the standard specified and the actual incurred. Fixed overhead variances are a product of the overhead absorption process. Fixed overhead variance depends on two i.e. the fixed express incurred and the volume of production obtained. The volume of product is in turn dependant upon the capacity the factory works. It is also important to note that overhead rates are calculated from estimates of expenditure and activity levels. Further more, its common for overhead absorption to be based on labour hours and therefore any variation in labour efficiency will directly affect the overhead variance. Types of fixed overhead variances:

Element 8.3.1

Element 8.3.2 Fixed overhead total variance This is the difference between the standard cost of fixed overhead absorbed in the production achieved, and the fixed overhead attributed and charged for that period. The fixed overhead total variance is made up of fixed overhead expenditure variance and the fixed overhead volume variance.

Element 8.3.3 Fixed overhead expenditure variance This is the difference between the budget cost allowance for production for a specified period and the actual expenditure charged for that period. It is therefore the difference between actual fixed overheads and allowed or budgeted fixed overheads.

Element 8.3.4 Fixed overhead volume variance This is the part of the fixed production overhead variance which I the difference between the standard cost absorbed in the production achieved and the budget cost allowance for the period. It is worth noting that the volume variance is due to the actual volume of production differing from the planned volume. This

279

difference in the planned volume of production can be due to the hour worked being less or more than planned (capacity) or labour efficiency being less or more than planned (efficiency).

Element 8.3.5 Fixed overheads efficiency variance This is the difference between the budget cost allowance and the actual labour hours worked valued at the standard hourly absorption rate. Element 8.3.6 Fixed overhead efficiency variance This is the difference between the standard cost absorbed in the production achieved and the actual direct labour hours worked valued at the standard hourly absorption rate.

Fixed overhead total variance SC AC

Expenditure Variance BFO AFO

Volume Variance (AP BP) * SR

Capacity Variance (AH BH) * SR

Efficiency Variance (SH AH) * SR

Element 8.3.7 Example The following data relates to PJ Ltd: October budgeted activities: Direct labour hours Standard hours of production Fixed overheads

16 400 hours 16 400 hours K 5,740,000

280

The actual results were as follows: Actual direct labour hours Standard hours produced Fixed overheads

15,750 hours 16,150 hours K 6,050,000

Element 8.3.8 SOLUTION Fixed overhead absorption rate = K 5 740 000 16 400 = K 350/hour

Fixed overhead total variance Standard cost Actual cost = ( 16 150 * K 350 ) K 6 050 000 = 5 652 500 6 050 000 = K 399, 500 (A) Fixed overhead expenditure Budgeted fixed overheads Actual fixed overheads = K 5,740,000 K 6,050,000 = K 310,000 (A) Fixed overhead volume variance (Actual Standard hours Budgeted Standard fours) * Standard rate = (16 150 hrs 16 400 hrs) * K350 = K 87,500 (A) Fixed overhead capacity variance (Actual hours Budgeted hours) * Standard rate = (15,750 hrs 16,400 hrs) * K 350 = 650 hrs * K 350 = K 227,500 (A) Fixed overhead efficiency variance (Standard hours Actual hours) * Standard rate = (16,150 hrs 15,750 hrs) * K 350 = 400hrs * K 350 = K 140,000 (F)

281

Element 8.3.9

Note: Further analysis can be done on the volume, efficiency and capacity variances using control ratios. These control ratios provide more relevant information than the variance measures as they are able to highlight important aspects of the organisations operations. The ratios which can be calculated are: Volume ratio = Standard labour produced *100 Budgeted labour hours Capacity ratio = Actual labour hours * 100 Budgeted labour hours Efficiency ratio = Standard hours produced *100 Actual labour hours

Element 8.3.10 Example: Calculate the volume, capacity and efficiency ratios from the data below: Budgeted: Actual Results: Labour hours 18,000 hrs Labour hours 16,000hrs Standard hours 18,000 hrs Standard hours 17,000hrs Volume ratio = 17 000 * 100 18 000 = 94% Capacity ratio = 16 000 * 100 18 000 = 89% Efficiency ratio = 17 000 * 100 16 000 = 106%

282

Element 8.4 Sales Variances At this point of our studies, we will be looking at sale variances, of which the main two variances are the selling price variances and the sales volume variance. An illustration below can well explain the application of the sales variances. Example: LUNA Co. manufactures a single product. Budget and actual data for the latest pencil is as follows: Budget Sales and production volume Standard selling price Standard variation cost Standard fixed cost The actual results were as follows: Sales & production volume Actual selling price Actual variable costs Actual fixed cost Using the above data Calculate the (i) Selling price variance (ii) Sales volume (profit) variance (i) Selling price variance = Budgeted x Standard profit -Actual sales x std sales units profit per unit units profit per unit 82,400 units K57,000/unit K23,000/unit K6,000/unit 81,600 units K59,000/units K24,000/unit K4,000/unit

283

Selling price per unit should have been But was Actually Units sold (82,400) Selling price variance

K59,000 K57,000 K 2,000 (Adverse)

K164,800,000 (Adverse)

The adverse variance shows that the actual selling price was lower than the standard price.

Sales Volume Variance This variance calculates the profit differences which is caused by selling a different quantity from that budgeted. Units Budgeted sales volume Actual sales volume *Standard profit per Unit (K59,000 K24,000 K4,000) = K31,000 Sales volume variance K24,800,000 (F) 81,600 82,400 800 (favourable)

The favourable variance shows that the increased sales volume could have increased profit by K24,800,000 i.e. if the selling price and the cost per unit had been equal to the standards. It is important to note that the sales volume variance is expressed in terms of the standard profit lost or gained as a result of change in the sales volume.

Element 8.5 Planning Variances

284

Some variances can arise from changes in factors internal to the business and may therefore be referred to as planning variances.

Element 8.5.1 Definition of Planning Variances A classification of variances caused by ----- budget allowances being changed to a post basis. A planning variance can also be referred to as a revision variance. Analysis and Comments Management will wish to draw a distinction between those two variances in order to gain a realistic measure of operational efficiency. As planning variances are self-evident not under the control of operational management, it cannot be held responsible for them, and there is no other benefit to be gained in spending time investigating such variances at an operational level. Planning variances may arise from faulty standard setting, but the responsibility for this lies with senior rather than operational management.CHISWE Ltd estimates that the standard direct labour cost for NSELE, its only product should be K40,000 (8 hours x K5,000/hr) actual production of 1,000 unit of the NSELE took 12,400 hours at a cost of K47,600, 000, in retrospect, it is realized that the standard cost should have been 12 hours x K4,000 per hour, i.e K48,000 per unit.

Required: Calculate the: i. ii. Planning variance Operational variance

Solution: (c) Operational variance Hours 1,000 units should take at 12 hrs/unit but did take 12, 000 12, 400 400 hours (A)

285

x revised standard cost per hour

K4,000/hour 1,600,000.00 (A)

ii)

12, 400 hours should cost @ K4, 000/hr But did cost

49, 600, 000

= 47, 600, 000 2, 000, 000 (F) K 47, 600, 000

iii)

Check Actual costs

Received standard cost (100 x K48, 000) = 48, 000, 000 Total operation variance (K1, 600, 000 (A) + K2, 000, 000 (F)) = 400, 000 (F)

(b)Planning Variance K Revised standard cost 1, 000 units x 12hrs x K4, 000/hr Original standard cost of 1, 000 units x 8 hours x K5, 000/hr 48, 000, 000 40, 000, 000 8, 000, 000_(A)

IMPORTANCE OF PLANNING AND OPERATIONAL VARIANCES

Advantages of a system of planning and operational 1. The analysis highlights those variances, which are controllable and those, which are non-controllable. 2. Managers acceptance of the variances for performance measurement, and their motivation, is likely to increase if they know they will not be held responsible for poor planning and faulty standard setting. 3. The planning and standard setting process should improve; standards should be more accurate, relevant and appropriate.

286

4. Operational variances will provide a fairer reflection of actual performance.

LIMITATIONS OF PLANNING AND OPERATIONAL VARIANCE

1. It is many times difficult to decide in hindsight what the realistic standard should have been. 2. Establishing realistic revised standards and analyzing the total variance into planning and operational variances can be a time consuming task even if a spreadsheet package is devised. 3. Even though the intention is to provide more meaningful information managers may be resistant to the very idea of variances and refuse to see the virtues of the approach. Careful presentation and explanation will be required until managers are used to the concepts.

287

STUDT UNIT 9.0 MODERN MANAGEMENT ACCOUNTING TECHNIQUES

Learning Outcomes After studying this chapter candidates should be able to Appreciate the various developments in the modern manufacturing scenario Demonstrate strong knowledge of throughput accounting Discuss target costing To show understanding of life cycle costing

Element 9.1 Throughput Accounting Introduction The CIMA Official Terminology defines throughput as: The rate of production of a defined process over a stated period of time. Rates may be expressed in terms of units of products, batches produced, turnover, or other meaningful measurements (CAM-I). The term throughput is defined by Goldratt and Cox (1989) by means of the following equation: Throughput = sales revenue less direct material cost. The aim of throughput accounting is to maximise this measure of throughput. The direct material cost referred to in the above definition relates to all material purchased during a particular period, and not simply to material used. The principle behind throughput accounting is that all costs other than material are effectively fixed; even those costs which are seen as variable in the traditional sense, or costs which would normally be split into fixed and variable elements, are treated as entirely fixed. The focus of throughput: As the equation shows, throughput is dependent on four elements:

288

1) 2) 3) 4)

unit selling price ; sales volume; purchase of usage of direct material. Usage of direct materials

A focus on throughput necessarily focuses management attention on these four areas. There are strong interrelationship between the above four items, particularly between 1, 2and 4. If a company were to reduce its selling price, if faced with a downward sloping demand curve, it would expect to see an increase in its sales volume, and might also see an increase in the speed of use of raw materials, particularly when the new sales are satisfied from stock. The throughput approach is therefore in sympathy with the JIT approach. Material held in raw material, work-in-progress or finished goods increases direct material cost, but does not increase throughput. Throughput is only increased when finished goods are sold, and the value of the sales feeds through into sales revenue in the throughput equation. However, the throughput approach does not go as far as the JIT philosophy in its attitude to stock. In throughput accounting, it is recognized that it may sometimes be necessary to maintain stock, in order to alleviate a resource constraint and therefore increase the speed of throughput. Constraints on throughput The idea of constraint is central to the throughput approach. It asks: what are the factors market, organisational and production which are preventing the company from expanding at the present time? These factors might include: (i) (ii) (iii) (iv) (v) (vi) Inadequately trained sales force; Poor reputation for meeting delivery dates; Poor physical distribution system; Unreliability of material suppliers, delivery and/or quality; inadequate production resources; inappropriate management accounting system.

Once the constraints have been identified, management attention and action can be focused on alleviating them. Some of the constraints may be interrelated: a poor reputation for meeting delivery dates could be associated with inadequate production resources, which in turn may be related to the signals generated by the management accounting system. For example, if a company operates a traditional standard costing system, interrupting the production schedule of a particular work station, so that goods can be completed to satisfy a customers rush order, will result in an adverse direct labour efficiency variance being reported, if the interruption in work requires the machine to be stopped and reset

289

to meet this rush demand. A stoppage of this kind is not necessarily undesirable, despite the signal sent out from the accounting system, but it needs to be noted that such a stoppage would always be discouraged if efficiency variances were based on keeping 100 per cent utilization of particular resources, a philosophy which traditional accounting systems have tended to encourage. Bottleneck resources Throughput accounting is most associated with the management of production resources. The ultimate aim of many modern manufacturing approaches CIM, JIT etc. is to enable production to take place in a complete balanced manner, so that productive resources are an exact match for the demand placed upon them. This means that there are no constraints known as bottleneck resources within a factory. However, the throughput approach recognizes that this will rarely be the case when there is a healthy demand for the changes in demand by the consumer. The throughput approach is dedicated to the identification and subsequent elimination of bottleneck resources. Where elimination is not possible, it seeks to ensure that bottleneck resources are utilized for 100 per cent of their availability. A reassessment of the measures traditionally employed to record the efficiency of surrounding resources may sometimes be required. For example, if the output of machine A becomes the input to machine B, and machine B is a bottleneck resource, it would make more sense in terms of the overall efficiency of the facility if machine A were to limit its production to the capacity of machine B, in order to avoid the output of machine A simply becoming work-in-progress, which would increase neither the throughput of the organisation nor its profit. As noted above, once a bottleneck has been identified, it is the aim of the throughput approach to eliminate it. This can sometimes be done with existing resources: it may be possible, for example, to modify other machinery in such a way that it can perform the operations of the bottleneck resource, and thereby eliminate the problem. However, the almost invariable result of this is simply to move the bottlenecks to some other part of the plant, and managements attention would then have to focus on the elimination of this second constraint. If reorganization of existing resources cannot get rid of a bottleneck, and alternatives such as buying in particular components are not available or are rejected, a company must consider investing in new equipment in order to alleviate it. The throughput may thus lead to a better allocation of capital investment funds than would be possible under traditional system.

290

The throughput approach should therefore be viewed as a search for continuous improvement, rather than another technique which simply reports on the status quo. Throughput measures The role of the accountant in a throughput environment is to devise measures which will; help production staff to achieve greater throughput volume. Attention should be drawn to the financial effects of bottlenecks. For example, if a particular machine which is a bottleneck resource fails to operate for one single hour as a whole, it will readily be appreciated that dividing this figure by total production time available results in a rate per throughput hour dramatically in excess of the cost of operating the bottleneck machine as measured by traditional accounting methods, thus highlighting the problem. Consistency between throughput as so far defined and traditional financial reporting The reader will have noted that direct material cost in the definition of throughput given earlier related to the cost of material purchased in a period, rather than the cost of the material actually used. The behavioural impact of this definition is to encourage managers to minimize stockholdings, an aim frequently found in modern manufacturing environments and one referred to throughout this chapter. However, if an attempt is being made to integrate throughput measure with traditional accounting systems, the measure of throughput would obviously need to be modified to reflect the more traditional approach. However, the authors wish to point out that a debate as to which is the right measure of throughput is sterile. As noted earlier, throughput is an approach to managing a business and management should select the measure which is most appropriate to the particular circumstances. A throughput report that deals with direct material in a manner which is consistent with traditional accounting measures is shown below: Throughput report Sales Direct material cost of sales Throughput Direct labour Production overhead Administration costs Selling expenses Operating profit x (x) x (x) (x) (x) (x) (x) x

291

(the reader will note that the throughput in this report is an absolute measure in financial terms. This may be surprising as the English word throughput contains connotations of movement or flow. However, throughput emphasises flow in the management of the production process, and as reiterated above, it is process management rather than accounting which reflects the true focus of the throughput approach). In this second version of throughput accounting, direct materials are treated in precisely the same way as in traditional accounting systems, i.e. direct material costs are associated with raw materials, work-in-progress, finished goods and cost of sales. However, both versions of throughput accounting differ from conventional accounting in their treatment of direct labour costs and production overheads. In throughput accounting, these are regarded as period costs, to be expensed in the period in which they are incurred and are thus treated in exactly the same way as selling, distribution and administrative costs (which, of course, will receive the same treatment under both throughput accounting and traditional systems). Clearly, these results in all stocks in a throughput accounting system being held at raw materials cost only. Horngren et al(1997) refer to throughput accounting as an example of super- variable costing. Throughput and contribution When making short term judgments as to the relative profitability of particular product lines, it has been conventional to look at the contribution selling price less direct costs and variables production overheads and to give priority to producing those items which show the highest contribution per unit. Certainly, this measure is often used as the basis for encouraging salesmen to push particular products. In a throughput environment, the attractiveness of particular products is related to their consumption of bottleneck resources. The production scheduling process would result in priority being given to those products which were best able to generate throughput. For example, product A, with a unit contribution of 20 but a requirement of two minutes of a bottleneck resource, would be preferred to product B, with a unit contribution of 40, but a requirement for five minutes of the bottleneck resource. In this respect, we should note, the throughput approach is simply employing the common short term decision making technique of maximizing contribution per limiting factor. It must be stressed that such product ranking are relevant for short-term production scheduling only, and their use should not be extrapolated to determine longer term sales effort. When adopting a throughput approach, it would be expected that bottlenecks will be alleviated, so that the ranking can be expected to change possibly very quickly over period of time. Indeed, as indicated above, any change in the mix of products demanded by customers can

292

have the effect of immediately switching the bottleneck resource within a production capacity, and hence altering the relative attractiveness of particular products. The relationship between the traditional accounting technique of maximising contribution per unit of scare resource and throughput accounting The relationship between the traditional accounting technique of maximising contribution per unit of scare resource and the throughput approach is illustrated by the simple example given below. Example A company produces two products, A and B, the production costs of which are shown below: A K 10 5 5 5 25 B K 10 9 9 9 37

Direct material cost Direct labour material cost Variable overhead Fixed overhead Total production cost

Fixed overhead is absorbed on the basis of direct labour cost. The products pass through two processes. Y and Z, with associated labour costs of 10 per direct labour hour in each. The direct labour associated with the two products during these processes is shown below: Process Y Z Time Taken Product A Product B 10 min. 20 min. 39min. 15min.

Selling prices are set by the market, the current market price for A being K65 and that for B K25. At these prices, the market will absorb as many units of A and B as the company can produce. The ability of the company to produce A and B is limited by the capacity to process the products in Y and Z. The company operates a two-shift system, giving 16 working hours per day. Process Z is a singleprocess line, and for technical reasons this line can only be operated for a maximum of 12 hours per day. Process Y is a dual process line, and thus two units can be processed simultaneously, although this doubles the

293

requirement for labour. Process Y operates for the full 16 working hours each day. Question: Based on the above information, what production plan should the company follow in order to maximise profits? Solution: In order to find the profit-maximising solution in any problem, the constraints which prevent the profit from being infinite must be identified; the greater the number of constraints the more difficult the problem is to solve. In the most simple case, where there is only one binding constraint, the profit maximising solution is found by maximising the contribution per unit of the scare recourse, i.e. the binding constraint. Linear programming may be used to solve the problem where more than one constraint is binding for some, but not all, feasible solutions. Where the number of products is limited to two, and such constraints are relatively few in number, the problem can easily be expressed graphically to reveal the profit maximising solution, and/or the problem can be expressed in the form of a set of simultaneous equations, as explained in Stage 2 Management Science Applications. As the number of potentially binding constraints increase, the use of a computer becomes the only feasible way to solve the necessary number of simultaneous equations. Maximum process time Y = 2 x 16 x 60 =1,920minutes Maximum process time Z = 12 x 60 =720minutes So the maximum number which could be produced of each of the two products is:

Products A Max units Y 1,920 = 192 10 720 20 = 36

Product B Max units 1,920 = 49.23 39 720 = 48 15

In the case of both products, the maximum number of units which can be produced in process Y exceeds the number which can be produced in process Z, and thus the capacity of process Y is not a binding constraint; the problem, therefore becomes one of deciding how to allocate the scare production capacity of process Z in such a way as to maximise profit.

294

Traditional approach maximizing the contribution per minute in process Z Contribution of A =K65 (selling price) less K20 (variable cost) = K45 Contribution of B =K52 (selling price) less K28 (variable cost) = K24 Contribution of A per minute in process Z = K45 = K2.25 20 Contribution of B per minute in process Z = K24 = K1.60 15 The profitmaximising solution is therefore to produce the maximum possible number of units of A, 36 giving a contribution of K45 x 36 =K1,620. Profit maximization It is clear, given their different solutions that the two approaches cannot both lead to profit maximization. A comparison of the two the traditional approach and the throughput approach shows that the former indicates that profits will be maximised by producing A only, while the latter indicates that product B alone should be produced. This dichotomy of prescription arises solely because the traditional method holds that in addition to materials, some other costs are also variable, whereas the throughput approach treats all costs, other than materials, as fixed. If these other costs that are identified as variable under the traditional approach really are variable in the short term, the profits will be maximized by producing A only, and the throughput solution is suboptimal. The calculation below shows this: Traditional method = 36 units of A, with a contribution of K1,620 K1,620 fixed costs = profit Throughput method = 48 units of B yielding K2, 016 K2,016 (variable labour cost + overhead) fixed cost = profit K2,016 48 (K9 + K9) fixed cost = profit K2,016) fixed cost = profit The fixed cost is common to both cases. Thus the throughput solution is suboptimal where there are costs, other than material, which are variable and identifiable with particular products in the short run. The throughput approach is, in fact, a special case of the traditional method of maximising contribution per unit of scarce resource in shortterm decision making. It is a special case in as much as contribution is measured after material

295

cost only. But, as has been urged, if this is an accurate representation of reality, the contribution should be measured in this way. If all costs other than material are, in fact, fixed, the traditional approach could be reworked to recognize this fact. The traditional approach would then be identical to the throughput approach, and the profit-maximising output would be recognized as the production of B only. Provision of additional resources to bottleneck The aim of throughput management is to focus attention on bottleneck resources, with the immediate aim of ensuring that such resources are utilized for 100 per cent of their capacity, and the further aim of alleviating the constraint. In this example, Z is the bottleneck resource. If management is able to find a way to enable this machine to work for one extra hour, the maximum number which could be produced of the two products becomes: Products A Max units Y 1,920 = 192 10 780 20 = 39 Product B Max units 1,920 = 49.23 39 720 = 52 15

Whether a particular constraint is binding now depends on the production plan. The capacity of Y limits production of B, whilst the capacity of Z limits production of A. Adoption of a linear programming approach (calculation not shown) reveals that the profit maximising output, if labour and variable overhead are truly variable, is to produce units of A only; if the only variable cost is material, the profit maximising output is to produce 48.57 units of B and 2.57 units of A. Thus, if one extra hour is provided to relieve the bottleneck at Z, the above analysis suggests that, where no costs other than material are variable (i.e. as assumed in the throughput approach), the effect is to alter the optimal production plan so that both A and B would be produced, rather than B alone. However, Y and Z both become bottlenecks in this case, as they are both utilized to 100 per cent of their capacity. Y: [48.57 x 39] + 2.57 = 1896.8 Z: [48.57 x 15] + [2.57 x 20] = 728.6 + 51.4 = 780mins

296

If costs other than material are variable (i.e. as assumed in the traditional approach), the provision of one extra hour at Z does alter the optimal production plan, except insofar as additional units of A can now be produced. Z remains a bottleneck, being used to 100 per cent of its capacity, whilst spare capacity continues to exist in Y. The quality of the decision regarding the appropriate production schedule to follow is thus crucially dependant upon the quality of the assumption on which the decision is based. Throughput accounting as a technique of production management The example above focused on the choice of product to product. It was shown that this choice is dependent on the assumptions that are made about the behaviour of costs. The actual profits which a company makes are clearly dependent on the accuracy of the data on which decisions are based. The throughput approach has been shown to be a specific application of the contribution per unit of limiting resource approach. It can therefore be argued that throughput accounting does not add anything to the accountants existing set of techniques. However, the example above is trivial in many respects. It relates to a company producing only two standard products, requiring only two production processes, and with a stable demand for the products is largely unpredictable. Such situations are difficult to model accurately, even with modern information technology, and it is completely beyond a textbook such as this to provide numerical examples to show how such situations should be managed in order to maximize profit. The contribution of the throughput accounting approach may lie in the insights it can offer in such chaotic, but realistic, production conditions. A global measure of throughput at the factory level may give a clear signal as to the efficacy of factory management. With a given level of resources, premises, machinery, employees etc., an increase in the throughput of the manufacturing unit period by period would give a simple measure improvement in the flow of goods through the factory and to the customer. By drawing attention to impediments to that flow- the bottleneck resources management will focus on alleviating problems which are inhibiting the profitability of the factory as a whole, rather than sub-units or particular product lines. Managing the throughput of a factory reflects the philosophy of management by walking about, i.e. bottleneck machines or processes are generally much more easily identified by direct observation than by relying on the output of conventional accounting reports. Traditional variance reporting may encourage the attainment of high levels of local efficiency at the expense of overall efficiency.

297

Criticisms of throughput accounting Throughput accounting has been criticised as not representing a profit maximising approach. The classical approach is illustrated below. As Figure 2.4 shows, when facing a downward-sloping demand curve, output should be limited in order to maximize profit. In attempting to maximize throughput, a company could find itself producing beyond the profitmaximising point-hence the criticism. This criticism may be regarded as unfair, however, since the diagram relates to a single product. For single-product firms as we have, a company has a range of products produced from common facilities. Advocates of throughput accounting would suggest that, by operating under the aegis of traditional techniques, which have as their objective profit maximization, it is impossible to realise that objective because output is invariably lower than the level which can be achieved using the throughput approach if we assume that output will generally not exceed 90 per cent of the profit-maximising output, owing to the problems associated with production scheduling, it can readily be imagined that the throughput approach will actually lead to the profit-maximising output being achieved in many cases, whereas adoption of the profit-maximising approach would result in lower level of profit. Furthermore, it has often been pointed out that maximisation of profit is a largely theoretical concept, and does not detract from the attractions of the throughput approach, which has been shown in a number of organisations to result in increasing profit from period to period. Figure 2.4 Profit maximisation

298

The philosophy underpinning throughput accounting is that the goal of manufacturing is to make money. Critics suggest that the approach is excessively short-term, in that all costs other than direct material are regarded as fixed. A further criticism suggests that the approach is excessively short-term in that all costs other than direct material are regarded as fixed. This approach may not be realistic, even in the short term. A further criticism is that, in concentrating only on direct material, it says nothing about why other costs are incurred, and therefore can do nothing to help their control. Nevertheless, it is an approach which focuses very clearly on measures designed to ensure that the production facility is responsive to the needs of the marketplace, and therefore fits in well with modern manufacturing creeds. In focusing on direct materials costs, the throughput approach could be argued to be either the direct opposite of, or the perfect complement to, the activity based costing approach with the latters focus labour and overhead costs.
Element 9.2 Target Costing
SOME VIEWS OF TARGET COSTING

The CIMA Terminology defines target cost as follows: A product cost estimate derived from a competitive market price. Used to reduce costs through continuous improvement and replacement of technologies and processes. The term target cost is not included in the terminology, and may be regarded as a misnomer. It is not a costing system as such, but rather refers to an activity whose aim, consistent with the Terminology definition of target cost, is that of reducing cost. The most widely held view of target costing can be summarised as follows: View 1 An activity whose aim is that of reducing the life cycle cost of new products, through the examination of all ideas for cost reduction of the product at the preproduction stage. The aim is to meet customer requirements, such as quality and reliability, at the minimum possible cost. This interpretation of target costing emphasis an important point made earlier in this chapter, namely that the ability to influence cost is greater at the product planning, research and development stage, rather than the production stage itself. View 1 sees target costing as moving the focus of cost-reduction efforts from the production phase of the life cycle to earlier phases in the cycle, where the opportunities for cost reduction efforts are greatest. However, it has been

299

argued that this view of target costing is too restrictive and an alternative interpretation may be expressed as follows: View 2 Target cost is an approach to cost reduction which can be applied to the production phase of the life cycle for both new and existing products. These different interpretations are in no way contradictory and could be applied in tandem. The reason for making the distinction between them is to clarify what may or may not be included in a particular discussion of target costing. This confusion in the terminology does not arise in Japan, where different words are used for the two versions: when target costing is being applied in the sense of View 1, it is known as Genka Kikaku; when it is applied in the sense of View 2, it is known as Genka Kaizen (Kato (1993); Yoshikawa et al (1993); Monden and Hamada (1991). Target costing for products has been employed by the Japanese industry for more than 30 years. Indeed, in assembly type environments 80 per cent of the major Japanese companies employ the technique. Unfortunately, the English translation of the Japanese term as target does not, in this context, fully capture the Japanese approach. The word target in English has connotations of something one aims for, or tries to achieve, rather than something which one is committed to achieving. In Japan, a target cost is a cost to which people are committed. Agreed target costs are final; they are never expected to change, other things being equal. However, different targets may be set for different phases of the development process, as Figure 3.5 shows.

Figure 3.5 Target Costing Target costing Target cost o Stepped strategy

o Single-target strategy
Concept Design Testing Process Prodn planning

300

Although target costing is most commonly applied to product costs, it can also be applied to other areas. The Design to Cost programme of the American Department of Defence in the mid 70s was an early Western example, and was applied over a wide range of expenses.

Element 9.2.1 Calculating Target Costs There are three ways of arriving at a target cost, and these are listed below in order of increasing sophistication: 1) The additional method, which is based on existing technology and cost data, and uses the current of existing or similar components or products to set a target cost for the new product. 2) The integrated method, which is a mixture of the addition method and thus derives some parts of the target cost from existing cost data- and the deductive/subtraction method (see below) 3) The deductive/subtraction method, which is based on the price of competitors products, and works backwards from the market price to derive the target cost. We shall limit our discussion to the last of these, which is the method most frequently encountered. The deductive /subtraction method is called because the target cost is simply the residual figure arrived at by deducting the target profit from the expected sales price, as follows: Expected sales price target profit = target cost (allowable cost) The starting point in this method will obviously be the establishment of an expected selling price.

Element 9.2.2 Establishing An Expected Sales Price New brands of existing product types, or minor varieties of existing products, will enter established market with knowledge of the relevant existing product market, and the place of the new good within it, should enable a competitive price to be set. However, in the case of a totally new product, by definition there will be no established market for it and therefore no existing market price that can be used as a guide. For companies, which are first to market, establishing an appropriate selling price is much harder than for those that follow. However, the potential profits are much greater for the former than the latter. To help with the pricing decision in such situations, many Japanese companies employ functional analysis (see section 3.6), and employ pricing by function. As we saw earlier, this approach views any product as a collection of individual functions, with the

301

consumer being willing to pay a price for each of them. By decomposing the new product into its separate functions- appearance, reliability, ease of operation and maintenance etc. and placing a value on each of this particular collection of functions can be established. This information can then be used in conjunction with the companys strategic plan for the product in terms of desired sales volume and market position, to establish an expected selling price.

Element 9.2.3 Establishing a Target Profit It is at this point that target costing provides a mechanism whereby the companys product planning can be fully integrated into the strategic plans of the organisation. The strategy of a business in the short, medium or long term will be reflected in its short-medium and longterm profit plans, and the target profit for any individual product will be a function of its place within those plans.

Element 9.2.4 The Residual: Target Cost The deduction of the target profit from the expected selling price will give the target cost. As the process described above makes clear, this cost will have been determined primarily by looking outward to the market. No estimate of the actual cost which will be incurred in the manufacture of the product will have been made up to this stage, and this must now be done. The costing should be based on the most cost-effective design, materials, and production processes, irrespective of whether the company currently has the capacity to put into practice the plans on which the costing is based. In the case of a modification of an existing product, management will obviously have the benefit of on-going cost data in building up the target cost. This cost will always be greater than the target profit, as opportunities for cost reduction will usually have been identified during the life of the existing product. As we noted earlier, once production has commenced, it is rarely possible to implement all the potentially benefited changes that come to managements attention, but companies should be able to calculate the cost that would reflect the position if the changes where incorporated in the design and production process. Even when this is done, the initial estimate will almost invariable be higher that the target post, the difference between the two representing the socalled cost gap, which must be bridged without sacrificing any of the ructions that were included in setting the expected selling price. Value analysis (see section 3.3) and functional analysis (see 3.6) can fruitfully be employed to assist this estimating process.

302

In the case of the totally new product, by definition the costing will be based on internal information relating to previously experience costs, and the historic costing records are thus limited in use in supplying the required data. In Japan, these data, and indeed data to support modified versions of the existing products, are often provided by cost tables, which are briefly described in the following section.

Element 9.2.5 Cost Tables Sato (1965) defines a cost table as follows: ...a measurement to decide cost and to be able to evaluate the cost of not only existing products but also the future products at the very beginning of the design processes. The purpose of cost tables is implicitly in the definition: i. ii. To help reduce cost To minimise the cost of new products.

Their use is thus consistent with the general principle of cost reduction, and a specific requirement to achieve a target cost. The measurement of the definition is derived from a comprehensive database of detailed cost information on alternative materials, labour, equipment and production costs, including those not currently used or experienced by the company. This database enables companies to establish stateof-the-art costs for new or existing products, even though these costs are not necessarily attainable with current facilities. Cost tables are very widely used in Japanese industry, and autonomous agencies exist to provide the relevant data for various industrial sectors, in the absence of sufficient in-house information. They can be assumed to play no small part in the ability of Japanese companies to estimate the final unit cost of a product at the planning stage to an accuracy of + 12 per cent. The integration of cost tables with a companys CAD system (see section2.3.1), and the incorporation of functional analysis (see section 3.6) into the manipulation of the database, ensure that the cost implications of changes in basic design and functions can be readily determined at the earliest stages of a products life. Cost tables thus allow Japanese companies to perform a vast number of what if? Calculations on all aspects of a product before it enter the production stage. This greatly enhances the likelihood of its acceptability to the consumer and its efficient manufacture- and hence its profitability. The dictates of world-class manufacturing mean that cost tables continue to be used throughout the life of an individual product, to test the validity of design modifications, whether internally or externally driven.

303

Element 9.3 Service Costing Service costing is cost accounting for specific services or functions e.g. canteens, maintenance, personnel, departments or functions. Therefore the services provided may be for sale e.g. public transport, hotel accommodation, restaurants, power generation etc or they may be provided within the organization e.g. maintenance, library and stores. A particular difficulty is to define a realistic cost unit that represents a suitable measure of the service provided. Frequently a composite cost unit is deemed the more relevant, for example, the hotel industry may use the occupied bed per night as an appropriate unit for cost. ASCERTAINMENT AND COST CONTROL Typical cost units used in service costing are shown below: Service Transport Hospitals Electricity Hotels Restaurants Colleges Possible Cost Units Tonne per kilometer, Passenger per kilometer Patient per day, Number of Operations. Kilowatt per hour Occupied bed per night Meals served Full time equivalent student

Each organization will have to determine what cost is most appropriate for use according to the nature of the business. Whatever cost unit is decided upon, the calculation of the cost per unit is done in a similar fashion to output costing i.e. Cost per service Unit = Total cost per period Number of service units supplied in the period

It will be realized that the calculations shown above is similar to the calculation of cost driver rates using activity based costing. Service costing using 304

homogenous service centres or function and cost units that are a good measure of the service provided is a form of activity based costing. Example Information has been collected about two hospitals over the last year: Hilltop Hospital Number of beds Number of in- patients Average stay Number of out patients visits 780 23,472 7 days 216,500 Copmed Hospital 500 8,165 * 63,920

*Not recorded but bed occupation percentage was 85%.

COST BREAKDOWN Hilltop Hospital In- patients K000 Direct Patient Care Supplies, drugs 1,821,520 Medical stores 8,729,100 Support services 2,210,500 Indirect Costs General services 3,524,470 16,285,590 2,563,700 1,845,380 1,591,620 3,308,950 6,832,700 1,975,050 693,600 1,551,350 285,450 out- patients K000 Copmed Hospital in- patients K000 outpatients K000

1,721,800 8,288,050

1,937,410 12,166,840

635,600 4,487,720

305

Required: Calculate: (a) Average length of stay in Copmed hospital (b) Bed occupation percentage in Hilltop hospital (c) Cost per in patient day for both hospitals (d) Cost per out- patient attendance for both hospitals and comment on the results.

Solutions: (a) Average stay in Copmed hospital. Potential in- patient days in a year; 500 beds x 365days = 182,500. Therefore; 85% occupancy = 182,500 x 0.85 = 155,125 in- patient days Therefore, average stay = 155,125 8,165 = 19 days. (b) Bed occupation percentage in hilltop; = Actual in- patient days x 100% Potential in- patient days = 23,472 x 7.5 x 100% 780 x 365 = 176,040 284,700

306

62%

(c) Costs per in- patient day

Costs for in- patients November of in- patient days Copmed Hospital K12,166,840,000 8,165 x 19 = K78,430

Hilltop Hospital K16,285,590,000 23,472 x 7.5 = K92,510

(d) Cost per out- patient attendance = Costs for out- patients Number of out patient attendances

Hilltop Hospital =K 8,288,050 216,500 = K38,280

Copmed Hospital K4,487,720 63,920 K70,210

It will be seen that a composite cost unit (i.e. in patient days) is used to calculate the costs.

Element 9.3.1 Use of Unit Costs In The Public Sector

307

The public sector organizations cover an enormous range. Examples include primary and secondary state education, local authorities, the national health services, police and so on. Costs are collected, related to some measure of throughput or output and a unit cost calculated as described above. These unit costs have three main uses. They serve as: (a) As indicators of relative frequency e.g. cost per pupil in different education authorities. - Cost per patient per day at various hospitals. - Cost per night in police cells. (b) As measures of efficiency over time. These can help to indicate whether efficiency is increasing or decreasing over time. (c) As an aid to cost control. The regular production of unit costs and comparison with the costs of other establishments in the same field helps to control costs and engenders a more cost conscious attitude.

Element 9.3.2 Limitations of The Cost Units (a) Quality of performance is usually ignored. (b) Throughputs are used rather than outcomes. Throughputs are numeric indicators where as outcomes are the impact which the activity has on the recipient of the service. (c) The throughput mix is likely to differ. For instance, the local authoritys costs to cater for the childrens home catering services for disturbed and disabled children will differ greatly to those homes catering for normal children. Like must be compared with like for the comparison to be fair.

Element 9.4 Life Cycle Costing

THE NATURE AND PURPOSE OF LIFE COSTING

It is appropriate that we finish this chapter on cost behaviour and cost reduction by looking at the topic of life cycle costing. In the section on pricing (see section 5.5), the reader will find a description of the product life (a concept introduced at stages 2 in the Management Science Applications paper), whereby products or services entering a market go through four stages: introduction, 308

growth, maturity and decline. From the suppliers point of view, the life cycle will obviously begin before the product is introduced to the marketing and distribution before the first unit of product is sold or the first service is delivered. The initial expenditure will invariably be lower in absolute terms than the manufacturing costs to produce and support the product, and thus the absolute level of cost incurred on a product will rise over its life, with a tendency for costs to follow the sales pattern- as sales increase, costs will increase, being largely the manufacturing and support costs mentioned above. The aim of any business must be to ensure that these costs rise at a rate which is less than proportionate to the actual increase in sales revenue. The interactions of the revenue curve and the cost curve measures the profitability of the product over its life. Although a relative decline in cost per unit may be expected from economics of scale and the experience curve (see section 3.3.4) once production commences, as we have stressed throughout this chapter, the actual profit associated with any individual product will have been largely determined before it is introduced to the market. We make no apology for reiterating that as much as 90 per cent of the future cost that will be incurred throughout the remaining life of the product is actually dictated by the fundamental decisions taken at the pre-introduction stage regarding functions, materials, components and the method of manufacture. Life cycle costing has much with value analysis (see section 3.5) and target costing (see section3.7 ), in that it recognises (albeit indirectly) the importance of understanding cost throughout the whole life of a product, and emphasises, as do the other techniques, the importance of early decisions in determining what these costs will be. Indeed, as was the case with value analysis, life cycle costing was taken up in the early 1960s by the American Department of Defence as part of a drive to increase the effectiveness of government procurement. However, as students of accounting are well aware, the mere recording of financial information does not of itself impact on the transactions which are undertaken, and it can only influence cost if it results into action. This reported association with increased effectiveness clearly indicates that life cycle costing is a process which goes beyond the simple recording of information. The Terminology definition of life cycle costing creates some confusion in this context, by defining it as: The practice of obtaining, over their lifetimes, the best use of physical assets at the lowest total cost to the entity (terotechnology). It is not clear how a costing method can itself be a practice that results in something being obtained, but clarification is fortunately provided in an explanatory sentence that appears after the definition, via:

309

This is achieved through a combination of management, financial, engineering and other disciplines. This indicates to the authors that life cycle costing of itself does not result in the reduction of cost, but when used in combination with other techniques, such as value analysis, its recognition of the changing cost structure of products over time provides a valuable tool; for management in gaining control over the firms activities. Horngren et al (1994) state that: Life cycle costing tracks and accumulates the actual costs attributable to each product from its initial research and development to its final customer servicing and support in the market place. When used in this sense, it can be seen that life cycle costing supplies the means whereby a company can establish whether the lower costs which were expected through the application of cost reduction techniques, both prior to and following a products introduction, have actually been delivered. The expected costs against which the actual costs are compared reflect the careful analysis and planning which should take place before the production stage of a product and the cost reductions expected during the production phase through the application of the firms decision making and control structure of these expected product cost changes throughout the products life is achieved by the process known as life cycle budgeting. As life cycle budget relates specifically to products or services, it can be appreciated that a life cycle budget cost for a product has much in common with a target cost, particularly in companies where different targets are established for different phases of the products life cycle. As costing terms have no legal validity, they do not necessarily require the precision of terms relating to financial (i.e. statutory) accounting, and no offence is committed if two companies follow exactly the same set of procedures and attach a different title to their common activities; a semantic debate as to the exact boundaries, if any, of life cycle costing, life cycle budgeting, not only will the production cost of a product be forecast, but those costs attributable to the product in respect of non-production overheads, such as marketing, distribution and customer service, will also be considered. Element 9.4.1 Life Cycle Budgeting and Resource Allocation The breakdown of the production costs predicted to occur over the life of a product will form the basis for the budgeted production cost of each period. However, a life cycle approach can also help managers in allocating resources to non-production activities: for example, a mature product requires less marketing support than a product in the introductory phase, and support may be withdrawn almost entirely from a product in the introductory phase, and support

310

required by a product, based on an understanding of its individual life cycle, can lead to a more effective allocation of resources, and represents an improvement of the traditional incremental approach to budgeting. Indeed, it could be used in support of decision packages in zero-base budgeting (see section 3.4.7). The life cycle costing/budgeting approach can thus be seen to allow the integration and expression within the traditional accounting system of a number of approaches to, and techniques for cost reduction, such as the learning curve (see section 3.3) and value analysis. However, life cycle costing reports require the tracking of costs and revenues throughout the entire life of a product, which represents a significant change to traditional accounting reporting, such in terms of focus and timing. For example, in traditional systems, many overhead costs are budgeted, recorded and reported by function customer service, research and development etc. and no attempt is made to attribute these costs particular products. In contrast, with life cycle costing, this identification of costs with particular products forms the whole basis of the system it is only by tracking these costs throughout the life of a product that the overall product profitability can be ascertained. Life cycle cost reports will thus normally be an addition to, rather than a substitute for, traditional accounting reports and practice. Reports produced in this way can be seen to have four clear benefits: 1) The costs of pre-production activities e.g. research, development and design and post production activities e.g. distribution, marketing and customer service are highlighted on a productline basis, a useful format which is not seen in traditional systems. 2) An understanding of the cost commitment/cost incurrence relationship is gained for different products. 3) The relationship between different cost areas/categories is highlighted. For example, reducing cost at the customer service stage. This may have been known implicitly, but life cycle costing makes the knowledge explicit. 4) The existence of life cycle reports facilities the conduct of postcompletion product audits, along the same lines as capital expenditure post-completion audits (see section 6.9). The knowledge gained from such audit reports can be fed into the companys decision making processes to improve future product decisions. Most companies are operating in an adraw manufacturing environment are finding that about 90% of a products life cycle cost is determined by decisions made early in the cycle. Management accounting systems should therefore be developed that aid the planning and control of product life cycle costs and monitor spending at the early stages of the life cycle.

311

Required: Explain the nature of the product life cycle concept and its impact on businesses operating in an advanced manufacturing environment. Explain life cycle costing and state what distinguisher it from more traditional management accounting practices. Compare and contrast life cycle budgeting with activity-based management identify and comment on any themes that two practices have in common.

Solution: The product life cycle (PLC) is shown in the diagram below:

When a product is first successfully introduced for the market, suggested by an expensive advertising campaign it will only achieve a relatively low sales volume. In an advance manufacturing technology (AMT) environment, a very large amount of fixed costs will already have been incurred in RAD designing the product and building or re-equipping the production line. In the growth stage sales increase and unit costs fall as the high fixed costs per unit decrease although new entrants may start to complete at this stage. This is the most profitable stage of the product life cycle. The product is said to be nature when sales demand levels off. In a static market price competition will reduce the profitability of each firm. Firms seek to differentiate their product at this stage. Eventually, the product will become obsolete and falling sales will ensure. This is the decline phase of the Plc. Firms will begin to pull out of the market have developed a replacement product, thereby incurring further large fined costs for R&D, design and new production facilities. In AMT environments the time period for the product life cycle is decreasing, for example the longest life cycle for a mass produced motor care has reduced from over 4 decades for both the VW beetle and the Morris minor less than 25 years for the Renaults which ceased production in 1996. However, most models must be renewed in much shorter time frames. Vauxhall is setting up new production facilities for manufacturing a revamped Corsa in the UK.

312

The Corsa was launched only a few years ago. The Plc concept enables dear strategies planning regarding the development of new products cashflows on marketing activities. Life Cycle Costing (LCC) involves collecting cost data for each product from inception through its useful life and including any end cost. These data are compared with the life cycle budgeted cost for the product. This comparison will show if the expected savings from using new technology or production methods etc.

The recognition of the total support required over the life of the product whereas traditional costing by function e.g. R&D, production, marketing and so on. This for manufacturers LCC makes explicit the relationship between design choice and production and marketing costs. The insights gained from company budgeted and actual life cycle costs may be used to refine future decisions. Consumer as well as producers may use LCC. A recent analysis has shown that the life cycle cost of purchasing a personal computer (PC) is around six times the purchase cost. Staff the training and extra software will cost three times the cost of the PC and maintenance will cost twice the purchase cost over the life of the PC. It has been recognized in AMT environment that up to 90% of the costs incurred throughout a product life cycle will be determined before the product reaches the market. Thus the early decisions regarding product design and production method are paramount and LCC attempts to recognize this situation. The high fixed costs of introducing a new product compared with reduced life cycle periods is a major challenge to profitability in AMT environments. LCC is used to improve management decision making in breach conditions. Activity based management (ABM) uses the understanding of cash drivers found from activity based costing (ABC) to make more informed decisions. In particular, this approach yields a better understanding of overhead costs in AMT environments compared to traditional absorption methods. ABM aims to improve performance by: 1. Eliminating waste 2. Minimizing cost drivers 3. Emulating best practice

313

4. Considering how the use of resources supports both operational and strategic decisions. This ABM seeks to consider all activities performed by the organisation in order to serve a customer or produce a product. Results of ABM in an AMT environment include: (vii) Increased production efficiency

(viii) Reduced production costs (ix) (x) Increase throughput Increased quality assurance

These gains may be realized by: iii. iv. v. vi. vii. Simplified product designs More use of common sub assembly Reduced set-up times Reduced material handling Better use of the workforce e.g.. Multi skilling

Their ABM is very similar to LCC in some respects. For example: viii. ix. Both attempt to increase management understanding of overhead costs Both consider how the use of resources supports strategic decisions, that is, both look at how resources inputs are used to obtain the required organizational outputs.

In an AMT environment both methods focus management attention on the need to produce simplified products using common components and common subassemblies and to maximize the output from expensive capital instruments.

314

LCC lied to major reviews at the major stages in a product life cycle, where as ABM is a continuous system that tries to drive down both short terms and long terms costs. Target costing Nsonsi Ltd is a company that manufactures mobile phones. This market is extremely volatile and competitive and achieving adequate product profitability is extremely important. Nsunsi is a mature company that has been producing electric equipment for many years and has all the costing system in place that one would expect such a company. These include a comprehensive overhead absorption system, annual budgets and monthly variance respects and the balance scorecard for performance measurements. The company is considering introducing. 1. Target costing: and 2. Life cycle costing systems. Solution The modern business encouragement terms to be an instate one and is rapidly changing in terms of customer requirement, economic factors, technology and so on. Nsunsi is in a particularly versatile business because technology is changing rapidly as digital telephones take over and tent messaging develops. Both target costing and life cycle costing are systems, which should help the company, lope with this. These systems help Nsunsy to complete in terms of cost to product development in the competitive telecommunicating market. Their specific advantages are as follows: 1. Target costing Target costing may replace and is often compared with traditional standard costing/variance analysis, which has long been in place in the historical world. Nuns may wish to replace standard costing/variance analysis with target costing for cost control and reduction for the following reasons 1. It puts pressure on cost it can be used as a cost reduction technical unlike standard costing and can incorporate a leaving effect. This is likely to be important in the manufacture of phones.

315

2. Traditional standards may be too rigid for cost control in reduction purpose for a company such as Nsunsy as they usually need to be set for a year at a time. Target costing is more flexible and target can charge/reduce from years to months. 3. It considers the market to price customers are prepaid to pay so it forces an originating to be outward rather than inward looking. Nsunsi needs to consider the final customer as well as the system supplier. 4. It should motivate staff if used contently and help. Break down any artificial functional barriers as it involves staff at all levels and in most functions and forces them to communicate. 5. It leads towards the use of other techniques, such as value analysis and value engineering, which should supply production methods and reduce costs. This is particularly important in an industry with shunt produce life cycles. 2. Life cycle costing 1. The life cycle of Nsunsus products are likely to be shunt because of charging technology, therefore, it is vital that the product begin to generate profits quickly. Estimating life cycle costs and revenue will highlight this 2. Research and development costs are likely to be quite high and must be recovered in a short period. 3. Many of Nsunsis costs are likely to be looked in during the design stage, say 94%, so it is important to control cash initially in order to maximize the profit over the products life. 4. It focuses on the time as well as money. Time to the market is often a key as money factor is generally profited. It is more important to measure time than money/cost it may be vital for Nsunsi to bring new products to market quickly and on time in order to achieve a product. 5. Monitoring a costs and benefits over the life cycle helps to stop a project early if events have changed or not turned out as planned. 6. It presents a different perspective that could be advantageous to Nsuni as it is not tied to period reporting.

316

Because of the above it would be advantage for the company to adopt both of these techniques. Information technology During 1990 a printing company defined and installed a management system that met the business news of a commercial environment which was characterized at that time by: 7. To unitary structure with one profit center. 8. Central education from senior managers. 9. 100% internal resoucing of ancihary seniors. Management information system

Element 9.5 Backflush Accounting

INTRODUCTION

In traditional accounting systems, the physical flow of materials and conversion costs is exactly mirrored in the costing system: the product flow beings with raw materials and other prime manufacturing costs, proceeds through work-inprogress to finished goods and finally ends with costs indeed, the traditional system has been referred to as one of sequential tracking. Such a system has two main benefits: i. Stock valuation. Companies may have stocks of raw materials, workin-progress and finished costs through these accounts, a valuation period. By tracking material and conversion costs through these accounts, a valuation can easily be placed on each for financial accounting purposes. This facility is important: although the disposition of the costs between the first two of these stock categories is of little consequence, financial accounting is concerned to draw a clear distinction between goods that have been sold in an accounting period, and the finished goods still remaining in stock at the end of the period. The reason for this concern is obvious: the latter will simply remain in the balance sheet.

317

ii.

Control of costs. Detailed tracking of costs allow a considerable level of control to be exercised, not only over costs in total, but also over the costs incurred by individual products or jobs. This benefit applies most obviously to situations in which job costing, rather than batch or process costing is the norm.

However, the traditional system is time-consuming and expensive to operate as it requires large volumes of documentation, such as material requisitions and time tickets, to support it. Furthermore, the benefits associated with it are less obvious in the modern manufacturing environment, in which low stock levels are becoming the general rule. In such a situation, all but an insignificant amount of any one periods costs of production will end up in cost of sales on the income statement, and thus the need to distinguish between the goods sold during a period and those on hand at the period end becomes largely redundant. Backflush costing is a system that has been developed in response to these concomitants of the traditional method and the change in the environment. The primary benefit offered by backflush costing is the considerable reduction in the clerical effort required to maintain it, both in terms of the number and frequency of entries to the accounting system, and the level of supporting data and documentation. It must be stressed from the start that it is not a more accurate system of costing than those traditionally employed. Indeed, it can be criticized as being less accurate. However, against the general background of low stock levels mentioned above, this reduction in accuracy is regarded by the systems advocates as relatively unimportant, and more than outweighed by the cost savings to be gained from its operation. A further point must be stressed: as backflush costing does not attach conversion costs to products until they are completed, or even sold, it follows that the system cannot be successfully operated in situations in which work-in-progress is significant and/ or fluctuates from period to period. In such situations (and, as we shall see, when the same situation applies to raw materials and finished goods in some variants), the use of backflush costing would lead to different results than would have been obtained under the traditional tracking systems, and would be inconsistent with the reporting requirements of financial accounting. Distinguishing features of backflush costing The Terminology defines backflush costing as follows: A method of costing, associated with a JIT production system, which applies cost to the output of a process. Costs do not mirror the flow of products through the production process, but are attached to output produced (finished goods, stock and cost of sales), on the assumption that such backflushed costs are a realistic measure of the actual costs incurred.

318

The recognition of the costs to be associated with products in the backflush system and thus their point of entry into the cost accounts, is triggered by certain events. Different triggers or trigger points can be employed in backflush accounting and therefore a number of variants of the system exist. However, the feature which distinguishes it from other systems, whatever variant is being considered, is that its focus is on output: costs are associated with output, and then flushed back through the system to attach to particular products. Although the treatment of material costs in backflush accounting differs from variant to variant, a further common feature, noted therefore, the identification of conversion costs with particular products cannot be used as an effective control mechanism during production. It follows from this that another prerequisite for successful introduction of backflush system is that management control of the production process is capable of being carried out effectively in the absence of costing information. In a modern manufacturing environment, it can be argued that effective operational control could be maintained through computer monitoring of the process, by the use of non-financial measures expressed in physical quantity terms and by direct observation of the operations themselves (for example, in the JIT environment in which backflush costing is most likely to be employed, a lack of raw materials would cause the production line to come to a standstill, and thus problems would be immediately evident to all concerned and solutions rapidly sought). Accounting entries in backflush costing Horngren et al (1997) describe three variants of a backflush costing system. The variant which differs least from traditional sequential accounting (method 1) has the following two trigger point- the purchase of raw materials or components and the completion of good finished units of product. The purchase of materials triggers a debit to the initial stock account and a credit to creditors for the cost of the materials purchased. The authors call this initial stock account raw and in process, rather than raw material, as it combines both the traditional raw material and work-in-progress accounts. The next trigger point is the production of finished goods: a debit is made to the finished goods account equal to the standard cost of the produced, and credits are made to the raw and in-process and conversion costs accounts, showing respectively the standard material value and conversion costs of the completed goods. The above text and Drury (1996) have qualified examples of this and the following variant. The simplest and most extreme version (method 2) has only one trigger point: the completion of good finished goods for the actual produced and conversion costs. This variant not only excludes from costing record any raw materials purchased but not yet used to produce a finished good, but also fails to record a creditor for material until the production process has been completed. It is not

319

clear to the present authors (nor, apparently, to the authors of the above two standard cost accountancy textbooks) how this latter point can be reconciled with the financial account requirement to recognize liabilities. Presumably, it would be feasible only where the throughput time of the manufacturing process is so fast that stocks of raw materials and work-in-process are non-existent a highly improbable situation (see the detailed criticism below for amplification of this point). Further, when the liability is eventually recognized, it appears to be recorded at standard rather than actual cost, and the mechanics for recording actual costs and calculating variances are also unclear. The third variant (method 3) again has a similar initial trigger point to the first (i.e. the purchase of raw materials or components), but takes as its second trigger point the sale, rather than the manufacture, of finished units and expenses all conversion costs immediately on sale. There is only one stock account merely called inventory- which contains only the outstanding material costs of raw materials, work-in-progress and finished goods. By charging all conversion costs to the income statements, this variant is intended to focus management attention on selling the products, as profit can no longer be bolstered by simply producing for stock. The analogy with throughput accounting should be obvious. Example of accounting for backflush costing (method 1) As 31 December a widget manufacturer has no stocks. The standard cost of a widget is: K Materials: 2kg at K10 per kg 20 Labour: 10minutes at K24 per hour 4 Overheads: K6 per kg of material 12 Total cost 36 Budgeted monthly production is 1,000 units. During January: Materials purchased and used: 2,100kg Labour: 175 hours Overheads incurred Finished goods produced Finished goods sold 20,580 4,410 11,500 1,050 units 1,000 units

The triggers for entry into the cost accounting ledgers are the purchase of materials and the completion of finished goods. The entries to record these transactions are as follows.

320

 When materials are purchased: DEBIT Raw and in process account CREDIT Creditors or cash with the actual cost of the materials. When the goods are completed: DEBIT Finished goods account with the standard cost of finished goods. CREDIT Raw and in process account with the standard cost of material CREDIT Conversion cost account with the standard cost of labour and overheads. DEBIT Conversion cost account with the actual cost of labour and overheads. CREDIT Creditors or cash With the actual cost of labour and overheads. When the goods are sold: DEBIT Cost of sales account CREDIT finished goods account with the standard cost of goods sold. The balance on the accounts are then: Cost variances written off to the profit and loss account; The value of closing stock at standard cost (permitted by the international accounting standards).

321

Raw and in process account K (1) Creditors/ cash (2) Standard cost of materials 20,580 (1,050 x 20) (5) Profit and loss account 21,000 420 21,000

21,000

Finished goods account K K (4) cost of sales (1,000 x K36) (3) Standard cost of production 36,000 (1,050 x K36) stock c/d 37,800 (5) Profit and loss account 1,800 420 37,800 37,800 (6) Stock b/d 1,800 Conversion account K K (4) Creditors/ cash (2) Standard cost of labour 15,910 and overheads (1,050x (4 12)) (5) Profit and loss account 16,800 890 16,800 16,800 Cost of sales account K (5) Finished goods (1,000 x 36) 36,000 Criticism of Backflush 322 K

As the introductory remarks to part of the appendix made clear, the virtue of backflush accounting is its sheer simplicity. However, it is axiomatic that simple systems provide rather less information than more complex systems. Several criticisms of backflush costing have been made passim, but a detailed critique can be found in Calvasina et al (1989). Among other things, they argue that elimination of raw material stocks is an impossibility and that the raw and inprocess account (RIP the acronym perhaps meant as a joke) is simply a misnomer. In a true JIT manufacturing system with a JIT purchasing system, material also goes directly into the production process and there is no need for a separate raw material inventory account. While this goal is achievable theoretically, raw material inventories never actually reach zero. Typically, the company at a minimum will receive items in a cost effective delivery size. For example, it will receive a truckload or a railcar load. Thus, a small but very real raw material inventory exists in an ideal situation. The name RIP is at best a cosmetic change. If there is no raw material inventory on hand, except what is needed to complete the work in progress, it would seem that the new situation is identical to the old situation when the appropriate title was work-in-process. They object to the late appearance of entries in the accounting system when backflush costing is used, and conclude their criticisms with the following remarks: Because of no reports from accounting on inventory, managers have to take a physical count. A job that contradicts one of the basic objectives of the JIT philosophy the elimination of wasteful, non-value- adding functions. The physical inventory counts not only increase overhead costs directly but also disrupt production that reduces efficient use of plant resources. The backflush system looks very similar to what used to be called a periodic system. In this system, accountants waited until the end of the fiscal period to take a physical count of the inventory. At that time, the appropriate numbers were derived from the ending inventory count. While the JIT presents management with less accounting and less information on which to base its decisions. One might be forgiven for a measure of puzzlement and confusion at all this. After all, traditional accounting has always backflushed costs from work-inprogress to finished goods when products are completed. On the other hand, traditional systems require the identification of products at different stages of completion in work-in-progress, which would involve considerably more physical stock counting then the envisaged in a backflush system.

323

While backflush costing will reduce the documentation flow-most obviously from raw materials to work-in-progress the combination of raw materials and work-in-progress in backflushs raw and in- process account does not allow the important distinction to be made between raw materials that are still available for use and those that have already been built into unsold products. However, if the manufacturing circumstances are such that high levels of stock are unavoidable, backflush costing becomes an impossibility anyway. The reader looking for prescriptive advice on the use and usefulness of backflush costing will be disappointed: the present authors must fall back on the truism that the circumstances of the particular operation under consideration will determine

Element 9.6 Element 9.6.1

ACTIVITY BASED COSTING Activity based costing (ABC) can be defined asan approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs. (CIMA) From the above terminology it is clear that ABC looks at activities as the causes of costs (cost drivers). Cost drivers are activities which give rise to costs. These may include, number of orders made (for ordering costs), number of production runs (for material handling costs). In addition ABC acknowledges the fact that by producing products, demand is created for the activities. Costs should therefore be allocated to products based on the activities that the products have consumed. Need for ABC The development of ABC was due to the limitations in the traditional product costing systems. The traditional product costing systems were established at a time when a number of firms were producing a narrow range of products. In addition the main cost elements were made up of direct materials and direct labour, as compared to overhead costs. Therefore distortions arising from overhead allocations were not as significant.

Element 9.6.2

Element 9.6.3

324

In contrast, firms today produce a range of products which do not need significant labour. Instead overhead costs are considerable. This mean that the traditional approach of overhead allocation using direct labour basis does not reflect a true picture. Therefore a more accurate cost allocation system becomes necessary and this was made possible with advancements in the cost information systems which reduced the cost of operating a more complex system. Element 9.6.4 Establishing an activity-based-Costing System There are basically FOUR steps involved: 1. Identifying the major activities that take place in an organization; 2. Determining the cost driver for each major activity; 3. Create a cost pool for each activity; 4. Assigning the cost of activities to products according to the products demand for activities. Traditional Vs ABC Systems In a typical traditional cost system there will be the usual two-stage cost allocation process. In the first stage the system allocates overheads to production and service departments and then reallocates service department costs to the production departments. In an ABC system overhead costs are assigned to each major activity instead of departments. A number of activity-based cost centres (cost pools) will therefore need to be established. Activities in an ABC system will be made up of a number of tasks. Such activities may include, set-up machines, materials purchasing, product inspections and production scheduling. Even though activity cost centres my be identical to traditional cost centres, ABC systems tent to have more activity cost centres. In a traditional cost system overheads are traced to products using a limited number of allocation bases which vary in direct proportion with production volume. The common bases used are direct labour hours and machine hours. For ABC systems, a number of cost drivers which will include non-production volume related are used. These will include, number of purchase orders and number of production runs. In addition traditional systems normally allocate service/support costs to production centres. These costs are added to the production cost centres cost. However, in ABC systems separate cost driver rates for support centres are

Element 9.6.5

325

established and support activities costs re assigned to cost objects without any reallocation to production centres. Element 9.6.6 It is therefore evident from the above that by having a number of cost centres and cost drivers, ABC systems can more accurately measure the resources consumed by cost objects. In contrast traditional cost systems tend to produce less accurate costs as most allocation bases used are not related to the cost objects. Other Considerations The cost/benefit of implementing an ABC system should be analysed. It is quite obvious that the more complex the ABC system is the more beneficial it will be in the organization. It is however a fact that, such a detailed and complex system will be more costly to a traditional costing system. Costs associated with an ABC system will include software and staff training which may be prohibitive. Consideration must be given to the poor decisions that will be made as a result of having an inaccurate traditional costing system. Poor decisions may relate to having to having unprofitable products and dropping profitable products. However its not always that an ABC system will greatly improve the quality of cost allocation nor is it the case that a traditional cost system will produce inaccurate cost reports. Therefore ABC must meet the cost/benefit criterion and improvements should be made in the level of sophistication of the costing system up to the point where the marginal cost of improvement equals the marginal benefit from improvement. Drawbacks of ABC Systems The following pitfalls of ABC Systems can be noted: a) The calculation of unit of costs under ABC faces the same disadvantages of the traditional cost system. This is so because to calculate unit costs of products, the batch level activity costs are divided by the number of units in the batch. This unitising approach is an allocation which yields a constant average cost per unit of output which vary depending on the level of activity. For decision-making there is a danger that what started out as a non-volume related.

Element 9.6.7

Element 9.6.8

326

b) It is not all costs which will be caused by activities that are measurable in quantitative terms and which can be related to production output. In such situations cost drivers can not be used. c) The behaviour of cost items in a cost pool cannot be explained by single cost driver. Element 9.6.9 following data is available for the month of February: A B Output (units) 800 800 Production runs 20 20 Direct Labour hrs per unit 2 6 Machine hrs per unit 2 4 Material cost per unit (K) 1000 4000 Labour cost per hour is K 8000 The following overheads were also incurred: K00 Production Scheduling 7 280 Material Handling 6 160 Set-up Costs 8 736 22 176 Calculate the cost of each Product using ABC and traditional cost system. ABC System: Under ABC system the overheads will be allocated to the Products using the number of production runs as the costdriver. A B C K000 K000 K000 Raw Materials 800 3200 2000 Direct Labour 12800 38400 32000 Production Scheduling 1040 1040 5200 Material Handling 880 880 4400 1248 6240 Set-up 1248 Cost per unit 16768 800 44768 800 49840 2000 C 2000 100 2 2 1000 EXAMPLE Chiatu Plc manufactures THREE products A, B and C. The

327

= K20.96

= K55.96

= K24.92

Traditional System: Raw Material Direct Labour Overheads A K000 800 12800 3412 17012 B K000 3200 38400 10235 51835 C K000 2000 32000 8529 42529

Workings: 1.Production Scheduling = K 7,280,000 = K 52,000 per run 140 2.Materials Handling = K 6160000 = K 44,000 per run 140 3.Set-up = K 8736000 = K 62,400 per run 140 4.Overheads absorption = K 2217600= K 2132.3 10400 NOTE: It can be seen that under ABC the allocation of overheads is more reflective of the actual activities in production since Product C, because of the many production runs, consumes more of those activities (Set-ups, Production runs and Production scheduling), than Products A and B. Under the traditional system Product B has been over-allocated with the overheads since the allocation is based on the number of labour hours. However, as stated earlier on, most modern firms have automated operations therefore the use of labour hours like in the case does not reflect the causes of the overheads.

328

Element 9.6.10 Other aspects of ABC Further approaches which revolve around ABC have been developed.Activity-based management (ABM): Activitybased management (ABM) is a system of management which uses activity-based cost information for variety of purposes including cost reduction, cost modelling and customer profitability analysis. Activity-based budgeting (ABB), this is a method of budgeting based on the activity framework and utilizing cost driver data in the budget-setting and variance feedback processes. Element 9.7 MANUFACTURING RESOURCE PLANNING (MRPII) Is an expansion of material requirements planning (MRPII) to give a broader approach than MRPI to the planning and scheduling of resources, embracing areas such as finance, logistics, engineering and marketing. MRPI evolved into MRPII. MRPII plans production jobs and also calculates resource needs such as labour and machine hours. It therefore attempts to integrate materials requirement planning, factory capacity planning, shop-floor and even marketing into single complete (and computerised) manufacturing control system. Most MRPII systems are a collection of computer programs that permit the sharing of information with and between departments in an organisation. MRPII is used by many companies for manufacturing planning but with the advent of JIT manufacturing, it has been eriheised as a planning system. Even so MRPII has advantages as a controlling system for planning and controlling manufacturing systems, especially when JIT methods are unsuitable.

Element 9.8

ENTERPRISE RESOURCE PLANNING (ERP) ERP systems are accounting oriented information systems for identifying and planning the enterprise-wide resources needed take, make, distribute and account for customer orders. ERP has been described as an umbrella term for integrated business software systems that power a corporate information structure, thus helping companies to control their inventory, purchasing, manufacturing, finance and personnel operators. Originally, ERP systems were simple extensions of MRPII systems , but their scope has now widened. They allow an

329

organization to automate and integrate most of its business processes, share common data and practices across the whole enterprise and produce and access information in a real-time environment. ERP may also incorporate transactions with organisations supplies. They help large national and multi-national in particular to manage geographically dispersed and complex operations. For example, an organisation in Zambia e.g. TATA sales office may be responsible for marketing, selling and servicing a bus assembled in India using parts from China. ERP enables the organisation to understand and mange demand placed on the plan in China. There are two groups of applications within an ERP: 1. CORE APPLICATIONS The applications that need to work in the organisation will be unable to function. They include production, sales, distribution and planning. These are fully integrated within the ERP system 2. Business analysis applications Examples include modelling, decision support, information retrieval, accounting, simulation and what if analysis. Some ERP software includes these. Some provide links into ERP system to third party software that performs tasks. Some advantages of ERP systems The advantage of ERP systems compared to traditional system architectures include: a) increased data consistency b) reduced data redundancy c) Greatly enriched data, including access to qualitative data by functions that do not typically have access to it. d) Greatly increased depth and breadth of data analysis e) Reduced response times to information requests f) Reduced need for manual intervention in data access and analysis g) Reduced risk of errors in data or in its analysis h) Greatly reduced lead times in report generation i) Greatly increased efficiency in materials ordering, requisition and deployment

330

Questions 1. What is enterprise resource planning? 2. What are the advantages of a ERP system 3. Why will those organisations that integrate their ERP systems with supply chain management benefit more than those that introduce only one or the other, or these two concepts?

331

STUDY UNIT 10.0 INFORMATION TECHNOLOGY AND MANAGEMENT ACCOUNTING

Learning Outcomes After studying this chapter, candidates are expected to: Highlight the impact of IT on management accounting Explain how information systems should be designed Should appreciate the use and limitations of personal computers. Should be able to explain the different communication technologies Should be able to discuss the application of computer aided design and manufacturing technologies Should explain the application of flexible manufacturing techniques and the technique of business process Re-engineering.

Element 10.1 Decision Support Systems There are various decision support systems that can be used in management accounting. The following are the common decision support systems in use.
(i) EXECUTIVE INFORMATION SYSTEM (EIS)

This system is usually used by the senior corporate executives in a corporation. It is designed to provide quick access to important information concerning both the company analysis and economic information such as forecast demand for the companies projects.
Characteristics of EIS

Outputs are very user friendly Utilizes graphed and other pictorial representations of data for ease of analysis and understanding Provides drill-down tools to help executives to perform some analysis of the information

332

(ii) DECISION SUPPORT SYSTEM (DSS) These are systems which help manages value decisions, themselves. Even EIS and Expert systems form part of the general decision support. Decision support system will be used where the decision to be made is unstructured i.e. where there are many potential input and output and the decision itself is made only infrequently. For instance, if a company may be considering launching a project in a new market sector. The decision support system could be used to analyze the market considering default of current products, market size, forecast programming; the effect of the company entering the new sector can be seen. (iii) EXPERT SYSTEMS. Expert systems are used in situations where there is a large volume of information about a particular subject and the information can be summarised as a set of rules. For example the taxation system of most countries is quite complex and there are few people who understand it completely. An expert system can be designed to incorporate the knowledge from some of these tax specialists in form of rules. Each rule will be given a set of possible answers or links to other rules so that finally a complete summary of the tax system is built up in the computer. A person with very little tax knowledge can then ask various questions about tax from the expert system. By a question and answer process, the expert system identifies the process, the problem and provides a solution. In effect the expect system allows an individual to consult a tax specialist without having to pay for the expensive time of the specialist. Expert systems can also be found in medical diagnosis and mineral prospecting (exploration) activities. Element 10.1.1 Management Information Design A business/organization will have several departments or business areas headed by different groups of people of the work force from specialized disciplines. Your studies of management and strategy should remind you of this. The summarized organization structure below shows what is being explained

333

MD

Finance Department

Sales Department

Research & Development Department

IT Department

Production Department

Different people will be working in the highlighted departments, finance department carrying out accounting related, finance, treasury related and tax related activities. Other functions will also be staffed with individuals from their discipline in the areas of their speciality. Managers and their subordinates will need different types of information to fulfil their jobs. The managers will obviously want to make sure that the information they get is appropriate to their various roles.

Element 10.1.2 Management Levels and Information Requirements Different levels of management in an organization will require different information to fulfil their roles. It is important to note at this stage that the determinations of information needed by managers will be the jobs which are described for them. At this stage therefore, let us examine the different levels of management and therefore look at the information requirement needed to some, at these different levels of management.

334

LEVELS OF MANAGEMENT

STRATEGIC MGT

TACTICAL MGT

OPERATIONAL MGT The three levels of management above are responsible for the following activities. i. STRATEGIC MANAGEMENT Strategic management will comprise a team of top-notch corporate executives involved in overall corporate planning, strategy formation and policy making in an organization. ii. TACTICAL MANAGEMENT Tactical management implement some strategic decisions and decisions involving the running of business units and section. iii.

OPERATIONAL MANAGEMENT

The operational management of an organization will be carrying out day-today basic work which will be the means by which the company earns its revenues. Each levels of management make different decisions; managers therefore need different types of information to help them make those decisions correctly. The information they use will come from two main sources: From within the company and outside the company i.e. internal and external information.

335

LEVELS OF MANAGEMENT

INTERNAL INFORMATION NEEDED - Board minutes - Production fore costs future periods

EXTERNAL INFORMATION NEEDED - Computer information - Market demand Summaries

STRATEGIC MANAGEMENT

TACTICAL MANAGEMENT

- Monthly output reports - Variance Analysis

- Computer prices - Raw materials prices

OPERATIONAL MANAGEMENT

- Daily production schedule - Absenteeism reports

- Computer factory layouts

For the various information to be useful to the users it needs to exhibit appropriate characteristics. . STRATEGIC INFORMATION Should have the following cardinal characteristics . Highly summarized Related to long-term of the planning horizon. Details of the company as a whole. Prepared as needed.

TACTICAL INFORMATION Should have the following characteristics Less summarized Relate to short / medium term in the planning horizon Retails on singular department It should be prepared regularly

336

OPERATIONAL INFORMATION Should have the below listed following characteristics It should be detailed It should relate to daily / hourly activity. Detailed down to individuals machine level It must be prepared continually.

Element 10.2

TRANSACTION PROCESSING SYSTEMS

Element 10.2.1 Transaction Processing Systems (TPS), process the frequent routine transactions. The transactions processed can either be internal or external. The transactions thus processed by a TPS provide operational level management with processed transaction information. A TPS therefore processes ecommerce transactions within a business and between the business and the third parties. Such transactions may include; the business placing orders for raw materials, customers ordering goods from the business. A TPS therefore is an important function in a business daily operations. Element 10.2.2 A TPS collects details of transactions in a number of ways, the common ones being; Keying in the on-screen data entry forms or the use of bar-code system. When the transaction data is input, it will usually be stored in a database management system. This entails that the stored data can easily be retrieved if the need arises. In a typical TPS transactions will occur within a local-area network within a firm, with real-time processing and data transfer occurring across a wide-area network with a central mainframe computer. However a local server can store transaction data, such as purchases in real time and then upload by a batch system later on to the mainframe computer. In addition, information such as supply requests can be transmitted on demand in real time. Electronic data interchange (EDI) can enable a link to be established with suppliers and customers. Information on transaction details can be accessed from the system on-line e.g. to check raw materials level or from the database. It is however, important to note that a TPS has serious effects when there is failure in the system. This is due to the fact that a TPS has direct effect on the daily routine transactions 337

conducted by the business. For example, if the TPS cannot provide stock levels information due to some system failure with a TPS, it can directly affect production or sales.

Element 10.2.3 Some common uses of TPS include: i. Improved operational efficiency by automatic links to suppliers and better information on product demand and availability. ii. Improved customer service through more choice, lower prices and better quality of produce. iii. Assessment of effectiveness product promotion through availability of better information. iv. Can improve stocking through EDI links between stores, warehouses, suppliers, banks and customers.

Element 10.3 Management Information Systems (MIS) A management information system is a computer system or a related group of systems, which collects and presents management information relating to a business in order to facilitate its control activities. Therefore a management information system should collect data from various sources and process it into the type of information that managers need to help them run the business. Assuming that different levels of management require information at different levels of details it is likely that no one management information system will be able to supply the total information requirements of a company. A number of smaller MIS may be needed to produce the information for the different levels of management.

Element 10.3.1 Characteristics of MIS All management information system have the following components or aspects. They should have (i) input of data (ii) processing of data (iii) output of information.
i. INPUTS OF DATA

338

Data will be received from a number of sources. These sources will vary depending on the final output that is required from the MIS. It is likely that data will be available from other systems within the company, such as the accounts department. Other data can be obtained from external sources so that manages have complete information for them to perform their roles well.
ii. PROCESSING OF DATA

The data which has been input will be processed in one way or the other. Again, the extent of the processing depends on the final output required. The processing that takes places in most MISs will take the form of, For example summarizing data or looking for exceptional items in a large amount of data.

iii.

OUTPUT OF INFORMATION

The final output from a MIS can take many forms. The output from the MIS will tailored to managements individual requirements. Some outputs will be quite summarized merely showing trends and exceptional items but at the operational level some very detailed outputs will be appropriate.

Element 10.4 Communication Technologies Outputs from information systems can and should vary greatly in terms of length, format of presentation and urgency of action required. This section investigates the relative merits of the different methods that can be used to disseminate information within a company, and the characteristics of effective information. Information Dissemination-Systems Information can be circulated in a number of different ways. The method chosen will depend largely on the urgency and volume of information to be distributed. Summarised below are the main methods of dissemination in a large company, together with an indication of their appropriateness in particular situations. Electronic mail E-mail is useful for sending short messages, particularly when the circulation involves a large number of people. Because recipients may not have the system switched on, it is not necessarily recommended for urgent communication. The

339

attachment facility means that other computer files can be distributed simultaneously for checking or review by recipients. E-mail is particularly suited to sending out agendas, or confirming meeting arrangements made on the telephone. Paper mail The amount of paper mail should decrease in companies where e-mail and voicemail have been introduced. Unfortunately, this is not always the case. If both e-mail and voicemail are available, the using of paper mail transfer should be restricted to the transfer of confidential documents (such as appraisal reports) that are not to be placed on the computer system, and the transmission of lengthy hand-written documents that would need re-typing before they could be sent. In this latter case, the use of a photocopier and internal mailing envelopes can be a much more efficient method than re-typing and e-mailing. Telephone The telephone is still the preferred communication medium for urgent messages. Assuming that those to be contacted are at their desks, a telephone ringing is almost guaranteed to interrupt anything they are doing and elicit a response. Unfortunately, in the absence of voicemail, messages cannot be left if the telephone is not answered, and messages left with a secretary may lose their urgency. A later call-back is always possible, although this will waste some time for the caller. Voicemail Voicemail is the alternative to frequent call-backs. If people are not at their desks, a personal answering service can be activated to take the message. If further communication is necessary, the onus is on the person receiving the message to call back, and the caller does not have to call again. Unfortunately, voice mail allows the use of the telephone as an urgent communication device to be subverted staff can activate voicemail while still at their desk, to avoid the telephone ringing. Computer printout Computer printouts are often still distributed though the internal mail system. However, this is a costly and slow communication method. A cheaper and quicker alternative is to distribute the computer file via e-mail. Personal call The best way to communicate an urgent message is a personal visit (assuming that the recipient is not far away). Few people ignore a personal caller, and the

340

two-way communication that results should resolve problems quickly and efficiently.

Element 10.4.1 Information Dissemination Effective Presentation of Information For information to be communicated efficiently, it is important that it is presented correctly. This rule applies particularly to information in a management report, whether in hard-copy form or displayed on a computer screen. To be effective, written (or non-screen) reports should: Be set at the correct level of detail - We have seen that different levels of management need reports to be at different levels of detail. Strategic management will expect reports to be in summary format, whilst operational management will require extremely detailed reports. Use exception reporting - exception reporting draws the attention of management to matters that are not proceeding as planned, and that might require action of some sort as a result. This is a much better use of management time than having to wade through pages of data, most of which is (hopefully) wholly unexceptional. Be timely - If management reports are to be of use in decision-making, they should be received within a time scale that enables effective management action to be taken on them. Be relevant - to the person receiving the report. Most managers receive too many reports. Care must be taken to ensure that reports are targeted at the correct manager(s). a scattergun approach, in which a report is sent to a number of different managers on the chance that one or more may want to see it, may be counterproductive. In this situation, the report may simply not be reviewed at all, because each manager on the circulation list assumes that another manager will deal with it. Use terms, presentation of numbers etc, consistently - if a report is to be read and understood quickly, the data should be presented clearly and consistently. For example, adverse variances could always be shown in brackets, to distinguish them from favourable variances (or vice versa) or, if numbers are large, they could be rounded to the nearest hundred or thousand. 341

Obviously, other qualities can be added to this list. The aim should be to produce a report from which the manager can quickly assimilate information, and be clear about the decisions that must be taken. Element 10.4.2 Uses and Limitations of PCs What is a PC? You will already have learnt about PCs in your Stage 1 studies. Rather than describe the computer hardware again, Figure 9.7 is designed to remind you of the important bits. Please refer back to your Stage 1 manuals for more information if any of these items are unfamiliar to you or you have forgotten what they do. Element 10.4.3 Uses and limitations of PCs in Management Accounting With the fall in price and size of computers over the last few years, it is likely that most accountants will have access to some form of computing resource. Uses of PCs in management accounting To provide assistance with information gathering PCs give management accountants access to a wide range of information. Assuming that the PC is networked and the companys central file servers are available, and there is also an internet connection, the information that can be retrieved from the system is almost endless. Some of the sources that may be useful to the accountant include: Internal data on production, financial accounts, stock reports etc. External information on competitors via competitors homepages or via specialist data collection agencies who have already obtained the Internet data. Reports from other offices

As a communications medium Computers make e-mail systems available which can be used to send messages quickly, cheaply and efficiently. Other applications can be used to provide discussion databases, particularly where a number of similar products are being produced across a series of locations. Using a type of bulletin board, managers can post questions into the 342

system. Other managers can then review these questions, add their own comments, and raise further queries. For reference material A large amount of reference material for accounting is now available on CD ROM, e.g.: Financial Reporting Standards Training material on management accounting topics Product directories and similar information to assist raw-material purchasing decisions

Limitations of PCs in management accounting Difficulty in checking the accuracy of management accounting information The management accounting information produced by many computer systems can be quite detailed, and contain a lot of supporting data. If part of the information looks incorrect, it can take a considerable time to check through all the detail and determine whether amendments are needed. This is a particular problem where spreadsheets have been used and the data have not been subject to the normal detailed checking routines (see 9.7.3). The management accountant ensures that all computer applications are adequately checked before they are used in live situations. Information overload One of the main problems with computerized systems is the temptation to produce more and more information, simply because the system can do this. The management accountant may find that the reports he has to review increase in both number and detail. There is therefore a need for an efficient data filtering system, so that the accountant can receive exception reports rather than detailed analysis. This is where an efficient and effective MIS can literally save the accountant hours of work each day. The cost of implementing such a system may well be insignificant when savings in management time are taken into account.

Element 10.5

COMPUTERISED MANUFACTURING SYSTEM

Element 10.5.1 Computerised manufacturing systems are systems which involves the use of computers directly to control production equipment and indirectly to support manufacturing operators. The use of computerised manufacturing systems has resulted in firms producing high-quality and low-priced goods. 343

Element 10.5.2 Computerised manufacturing systems encompass the whole production process from materials resource planning (see 9.8) up the point when finished products are due for distribution. One of the new tyes of manufacturing systems known as group technology ( or repetitive manufacturing) has emerged. This system has rearranged the production flow whereby groups of products with similar requirements are grouped together so that they can utilize the same facilities. This in effect reduces throughput times, scheduling is made easier, set-up costs and a reduction in work in progress. Element 10.5.3 In order for firms to compete effectively, there is the need to be more innovative and flexible in their manufacturing methods. In addition, they should be in a position to produce a range of product at reduced costs. To this effect, advanced manufacturing technology (AMT) has emerged. Advanced Manufacturing Technology (AMT) Advanced Manufacturing Technology (AMT) encompasses automatic production technology, computer-aided design and manufacturing, flexible manufacturing systems, including other innovative computer equipment. Element 10.5.4 COMPUTER AIDED DESIGN (CAD) Computer-aided design (CAD) provides interactive graphics that assist in development of product and service designs. It also connects to database to be recalled and developed easily. Using CAD new products can be designed on computer screen, designs can be assessed in terms of cost and simplicity and utilsation of materials. Element 10.5.6 COMPUTER-AIDED MANFACTURING (CAM) Computer-aided manufacturing (CAM) is the use of computers to control the physical production process. Direct CAM applications link a computer directly to production equipment in order to monitor and control the actual production process. An example is a computerised numerical control (CNC) machine which reads instructions for making parts. Indirect CAM applications include MRP, quality control and inventory control systems. Automated guided vehicles (AGV) are computerised materials handling machines can replace the traditional conveyor belts. Element 10.5.6 COMPUTER-INTEGRATED MANUFACTURE (CIM)

344

Computer-integrated manufacture (CIM) aims to integrate information for manufacturing and external activities, such as order product entry and accounting, to enable the transformation of a product idea into a delivered product at a minimum time and cost. It incorporates design activities such as CAD, CAM and operational activities such as MRP, FMS and inventory control.

Element 10.6 Computer Aided Design The introduction and wide dissemination of advanced manufacturing technologies (AMTs) has changed the face of the product development and production process- and its cost structure in most of the major manufacturing companies of the world, and aided manufacturers ability to compete on the dimensions of cost, quality and time. At the initial design stage of a product, the considerable space occupied by the drawing tables of a typical design office has been replaced by computer terminals, and the time taken to work through an initial engineering drawing and, more importantly, rework the drawing has shortened dramatically as a result of the software currently available. Computer aided design (CAD) allows huge numbers of alternative configurations to be analysed both for cost and simplicity. Simple designs lead to a more reliable product; and further, a simple product is easier to manufacture, thereby minimizing the possibility of production errors. Thus CAD allows quality and cost reduction to be built at the design stage of a product. The advanced graphics facilities of the typical CAD program enable the draughtsman not only to move parts around the design, and instantly appreciate the effect of these changes on the finished product, but also to manipulate the drawing, and view the design from any desired angle (and even, in the case of the latest generation of software, walk through it). The use of a database to match, where possible, the requirements of the new design with existing product parts, will enable the company to minimize stockholdings by reducing the total number of product parts required.

Element 10.7 Computer Aided manufacturing The manufacturing process is carried out by a range of machinery, which, together with its concomitant software, comes under the collective heading of computer aided manufacturing (CAM). Significant elements of CAM are computer numerical control (CNC) and robotics. CNC machines are programmable machines or bank of machines, facilitating a change in configuration in a matter of seconds via the keyboard; changes to existing

345

configurations and new configurations are easily accommodated. CNC therefore offers great flexibility, and dramatically reduced set up times. Furthermore, unlike human operators, who tire and are error prone, CNC machines are able to repeat the same operations continuously in an absolutely identical manner, to a completely consistent level of accuracy and machine tolerance; the implicational important benefits. The field of robotics applied to the manufacturing situation has produced a series of reprogramable multi-function devices designed to move materials, parts or tools through a variety of simple tasks without human intervention. They tend to be used to perform relatively straightforward, repetitive manufacturing functions, such as spot welding or painting, and to deliver stock to the required place within the production facility. In the case of the latter, the abbreviations AGV (automated guidance vehicles) and ASRS (automated storage and retrieval systems) are often worth noting. Two brief examples will serve to illustrate the dramatic impact of CAM on manufacturing flexibility, and the time taken to develop a product and bring it to the market. Nissan, the car producer, found that the time taken to completely retool car body panel jigs in their intelligent body assembly system (IBAS) fell from 12 months to less than 3 months by reprogramming the process machinery by computer and using computerized jig robots. Similar advances have been made in the resetting of machines and in the exchange of dies. These changes have reduced the changeovers time in moving from one process to another. Again it is a Japanese company, Toyota, which provides one of the best examples of the advances made in this area. The terminology used by Toyota has now been generally adopted: SMED stands for single minute exchange of dies and is used for all those changes which are less than 10 minutes in duration; OTED refers to one touch exchange of dies; and NTED to no touch exchange of dies. As the speed of production changeover increases under CAM, the possibility of producing smaller and smaller batch sizes at an economic cost also increases, so that the production schedule can be driven more and more by customer requirements, rather than the constraints of the traditional manufacturing process. The holy grail of CAM in this respect is a set up time of zero in such a situation, the cost advantage of mass production would disappear completely, and any batch size would be optimal in production cost terms, even a batch size of one unit. However, the benefits in terms of market flexibility of the ability to produce cost-efficient small batches are obvious.

Element 10.7.1 Computer Integrated Manufacturing

346

The ultimate extension and logical long-term direction- of AMT in the production environment is computer integrated manufacturing (CIM), which brings together all the elements of automated manufacturing and quality control into one coherent system. The ideal technological world of CIM the fully automated production facility, controlled entirely by means of a computer network with no human interference- is not yet with us (and indeed, with its overtones of ghost factories, would not necessarily be universally welcomed). A somewhat watered-down version of CIM is already with us, however, in the form of a flexible manufacturing system (FMS). In a FMS, a computer program coordinates a cell of CNC machines, handling mechanisms and robots in such a way as to synchronise workflow. An FMS produces a range of machines tools, conveyor belts that transfer the individual part being worked upon from machine tool to machine, and robots to transfer the parts from belt to tool and vice verse, all operating under synchronized computer control to ensure continuous work flow. The FMS also includes a facility for monitoring the quality of the parts being produced. The title aptly describes the systems strength its flexibility to produce a range of different components automatically, with the computer ensuring minimum changeover time and maximum built in quality. The FMS cell is often referred to as an island of automation.

Example: 1. Explain, with a relevant example, what is meant by a management information system (MIS). 2. State and explain some of the general qualities of good information.

Solution: Management information system is a set of formalized procedures designed to produce managers at all levels with appropriate information from all relevant sources (internal and external), to enable them to make timely and effective decisions for planning and controlling the activities for which they are responsible.

An example of a management information system can be seen in an airline business. At an operational level, check in procedures monitor which passengers have turned up and whether any stand-by seats are available. Baggage weight is

347

accommodated and external weather data will be used to plot the most economical and safest route. At tactical level, passenger destiny on each route will be monitored and analyzed. This will allow few structures and aircraft types to be determined. At strategic level overall profitability on each route will be monitored. In addition the outline will attempt to find out what other flights passengers may have used for part of their journeys. This may help the airline to decide whether to form alliances with other carriers (As recently delta 40 with virgin). The main qualities regarded of good information are: 1. Completeness. If a decision is being made, details of all possible options should be available for consideration. 2. Relevance Only that information which is useful to the decision making process should be included. 3. Timelines Unless the information is up to date and produced in time for the decision to be made, it is unlikely to be useful. 4. Accuracy The information must be sufficiently accurate for the purpose of the decision bringing made but any greater levels of precession may reduce its overall value. 5. Significance To ensure that the information is meaningful to the person using it should concentrate on the prompts, which are needed by the decision-maker. Decision support system The first computer systems were designed to produce cost effective replacement for routine electrical tasks. More recently developments are concerned with the provision of better information for management. i. Describe four common corporate administrative functions switched to computerization.

348

ii. Comment on management information and decision support systems in improving the efficiency of the management process.

Solution: Among the most commonly administrative functions are: computerized corporate

1. Sales accounting: Including input, delivery, note invoice, production transaction recording and the production transaction recording and the production of regular analysis of sales and debtors. 2. Stock control: Including the recording of receipts and issues the automatic generation of requisitions for stock falling below the reorder level and the production of stock lists and movement analysis. 3. Payroll production: Taking hours worked as input and producing pay slips coin analysis or bank transfer details and costing information. 4. Fixed asset accounting including the maintenance of registers, the recording of purchases and sales, the calculation of depreciation charge and the production of lists, analysis etc. Management information and decision support systems are linked by the data which they use to improve the efficiency of the management function in an organization. Both rely on data produced from the computerization of corporate administrative functions and both produce information to help managers fulfill their function and improve the quality of the decision making. The management information system normally uses the principal of exception reporting to highlight aspects of co-operational information, which is important for planning purposes. In order to keep up with changing circumstances within the organizations, and in its environment, the criteria used to select information should be constantly reviewed, or could be under the control of individual managers, who can request for the reports that they think necessary. Decision support systems use computer software to modern the behavior of parts of the organization and to allow the simulation of difficult decisions and their results. The most common example is the spreadsheet, although more specialize financial modeling software also exist. Given the background within which decision are made using information based on analyses and reports from the other components of the overall data processing system, different strategies

349

can be tried and their results examined and compared to aid in determining the optimum decisions. Management information systems and decisions support software can then be seen as integrating the information produced from the operational levels of the data processing function and analyzing and summarizing it to make it useful to managers in fulfilling their decision making and planning functions.

Element 10.8 Element 10.8.1

FLEXIBLE MANUFACTURING SYSTEMS (FMS)

Such a system is made up of a group of machines with programmable controllers linked by an automated materials handling system that enables a variety of parts with similar processing requirements to be manufactured. Element 10.8.2 FMS are most suited to batch production systems which have intermediate amounts of variety and volume of outputs. The system aims to use computer control to produce a variety of output quickly. Element10.8.3 The main features of an FMS include: i. Computerised-integrated manufacturing (CIM) ii. A just-in-time (JIT) system iii. Computerised material handling system iv. Computerised and automated storage and retrieval system for raw material and parts.

Element 10.9 Business Process Re-Engineering (BPR) Business process re- engineering involves focusing attention inwards to consider how business processes can be redesigned or re- engineered to improve efficiency. It can and should lead to fundamental changes in the way organizations function.

350

Business process re- engineering (BPR) is the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical contemporary measures of performance, such as cost, quality, services and speed. Key words in the phrase (a) Fundamental and radical; indicating that business process reengineering is somewhat akin to zero base budgeting. (b) Dramatic means that BPR should achieve quantum leaps in performance not just marginal, incremental improvements. (c) Process; BPR recognizes that there is a need to change functional hierarchies which have evolved into functional departments that encourage functional excellence but which do not work well together in meeting customers requirements. Key Term A process is a collection of activities that takes one or more kinds of inputs and creates output. Business process re- engineering involves the re- arranging of the business in order to deliver quality, reliability, cost efficiency and effectiveness.

A RE- ENGINEERED PROCESS HAS CERTAIN CHARACTERISTICS.

i. ii. iii. iv. v. vi. vii.

Often several jobs are combined into one Workers often make decisions The steps in the process are performed in a logical order. Work is performed where it makes most sense. Checks and controls may be reduced and quality built in. One manager provides a single point of contact. The advantages of centralized and decentralized operations are combined.

Element 10.9.1 Principles of Business Process Re-Engineering (BPR) a) Process should be designed to achieve a desired outcome rather than focusing on existing tasks. b) Personnel who use the output from a process should perform the process.

351

c) Information processing should be included in the work, which produces the information. d) Geographically dispersed resources should be treated as if they are centralized. e) Parallel activities should be linked rather than integrated. f) Doers should be allowed to be self-managing. g) Information should be captured once at source.

CHARACTERISTICS OF ORGANIZATIONS WHICH HAVE ADOPTED BUSINESS PROCESS RE- NGINEERING

(a) Work units change from functional departments to process teams, which replace the old functional structure. (b) Job change- it should tie in with job enlargement and job enrichment. (c) Peoples roles change. They are empowered to make decisions relevant to the process. (d) Performance measures concentrate on results rather than activities. Process teams create value which is measurable. (e) Organization structures change from hierarchical to flat (team) structures.

Element 10.9.2 Implications of BPR Management Accounting System

ASPECT (i) Performance measurement around

IMPLICATION Performance measure must be built

352

processes not departments; this may affect the design of responsibility centres. (ii) Reporting (iii) Activity (iv) Structure There is a need to identify where value is being added. ABC might be used to model the business processes Reports should be designed round the process teams and the whole reporting system should be centered around the organizational structure. New variances may have to be developed in addition to the existing traditional variances.

(v) Variances

EXAMPLE OF BUSINESS PROCESS RE- ENGINEERING

(a) A move from a traditional functional plant layout to a just in time cellular product layout is a simple example. (b) Elimination of non-value added activities. Consider a materials handling process, which incorporates scheduling production, storing materials, processing purchase order, inspecting materials and paying suppliers.

353

354