Chapter 1

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 (N !" #eal and normal interest rates ayback $nternal rate of return %ultiple $##s &ne'ual ro(ect appraisal ) Audit

INTRODUCTION *apital +udgeting involves the assessment of how much should be spent on assets or pro(ect and which assets should be ac'uired. +efore deciding which pro(ect,assets to invest in, corporations must compare the benefits to be derived from the ac'uisition,investment against the costs involved in the investment. The investment will not purely depend upon financial aspects but to a large e-tent, the strategic direction of the business. #emember the financial decisions fall with the long. term corporate strategy formulation process. Appraisal Methods The main methods of investment appraisal, which are normally in use, are: (a" (b" (c" (d" ayback $nternal 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. Net Present Value (NPV) The Net resent !alue of a pro(ect is the difference between the sum of the pro(ect discounted cash inflows and outflows attributable to a capital investment or other long. term pro(ect. The Net resent !alue approach holds that cash received in the future is less valuable than cash received today. $n the Net resent value computations, all cash flows are e-pressed 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". 0hen the present value of the inflows e-ceeds that of outflows (which includes any relevant ta-ation 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. $n contrast, if the present value of the outflows e-ceeds the present value of inflows, the net present value is negative and the investment should be re(ected. Discount Factors/ Interest Rate The interest rate, at which investors can borrow or lend money, is key to the Net resent !alue model (N !". 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. #eal assets will only be attractive to a rational investor if they offer a rate of return in e-cess of the cost of money (the rate at which the money has been borrowed". +y discounting the financial costs and benefits associated with real assets at this rate, the investor can determine whether a return in e-cess of discount rate 1r2 is available from the real asset in 'uestion. NPV and The Agency Theory 3enior managers of an organisation normally save the interests of shareholders and they are thereby employed to ma-imise the wealth of shareholders. 3ince Net present !alue models decision rule advocates that a pro(ect 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 ob(ective of business of ma-imisation of shareholder2s wealth through ma-imisation of returns from the pro(ect. Assumption in Net Present Value The Net resent !alue techni'ue is based on the following assumption. The Discount rate must be a measure of the opportunity cost of funds for wealth ma-imisation to result. erfect capital market and perfect information e-ists The model assumes that a single rate which reflects the opportunity cost for all individuals and companies. All 3hareholders have an ob(ective of wealth ma-imisation

Net Present Value, Ris and !ncertainty #isk management does not leave out pro(ect appraisal and evaluation process. ast e-periences 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 e-pected cashflows of a pro(ect for our N ! computations. $n the absence of past e-perience, we would have no basis upon which we can base our probability on. Advanced risk analysis and management are outside the scope of the te-t. Example Chaswe Engineering Consultants have been engaged in developing four (5" pro(ects on behalf of their client, Ninsh *orporation. 6owever, the pro(ect sponsors, Ninsh *orporation have asked their %anagement Accountant to evaluate the 5 pro(ects for their viability before it commits its finances to the pro(ects. The cost of funds for N$N36 *orporation is 78.

Required $n your capacity as %anagement Accountant of N$N36 *orporation, evaluate the viability of the four (5" pro(ects given that the cash inflows and cash outflows of the pro(ects are as shown below on the Net resent !alue basis. ro(ect: *apital (<utlay" year ; *ash $nflows / 4 9 5 Solution 3ince the company2s cost of capital is 78, thus will serve as the discount rate at which the pro(ect cashflow will be discounted. !ro"ect # $ear Discount %actor &'( Cash %lows *+,,, (5;,;;;" 4;,;;; 4;,;;; /;; /;; !resent )alue *+,,, (5;,;;;.;;" /?,;5=.;; /=,/5;.;; =>.9= =4.4@ (4,>59.97" A :2;;; (5;,;;;" 4;,;;; 4;,;;; /;; /;; + :2;;; (5;,;;;" 5;; 5;; 94,;;; 94,;;; * :2;;; (4;,;;;" /4,=;; /4,=;; 5;; 5;; D :2;;; (4;,;;;" ; ; ; 9>,;;;

; /.;;;; / ;.?745 4 ;.?;@; 9 ;.=>9= 5 ;.=44@ Net !resent )alue

!ro"ect $ear Discount %actor &'( Cash %lows *+,,, (5;,;;;" 5;; 5;; 94,;;; 94,;;; !resent )alues *+,,, (5;,;;;.;;" 9=;.?> 9>4.7; 4@,>5/.>; 4>,94>.5; /5,@//.@>

; /.;;;; / ;.?745 4 ;.?;@; 9 ;.=>9= 5 ;.=44@ Net !resent )alue

!ro"ect C $ear ; / 4 9 5 Discount %actor & ' ( /.;;;; ;.?745 ;.?;@; ;.=>9= ;.=44@ Cash %low *+,,, (4;,;;;" /4,=;; /4,=;; 5;; 5;; !resent )alues *+,,, (4;,;;;.;;" /4,/?;.@4 //,>;?.>; 457.74 94?.;= 5,5@5.?4

Net !resent )alue !ro"ect D $ear ; / 4 9 5 Discount %actor & '( /.;;;; ;.?745 ;.?;@; ;.=>9= ;.=44@ Cash %lows *+,,, (4;,;;;" ; ; ; 9>,;;;

!resent )alues *+,,, (4;,;;;.;;" ; ; ; 4?,>/@.4; ?,>/@.4;

Net !resent )alue

#N#L$SIS #ND CONCLUSION

ro(ect +, *, ) D are giving positive present values indicating that purely on financial information, they are viable and hence management of Ninsh *orporation should undertake the pro(ects in order to ma-imiAe shareholder wealth. ro(ect A is yielding a negative net present value and hence, purely on financial grounds, the pro(ect should not be undertaken as it is posed to destroy value of Ninsh *orporation. Internal Rate o" Return (IRR) $nternal rate of return is achieved by a pro(ect at which the sum of the discounted cash inflows over the life of the pro(ects is e'ual to the sum of the discounted cash flow. $n other terms, the $## 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 Aero. The $## of a pro(ect 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 pro(ect $##. /. The net present value of the pro(ect at Aero interest rate needs to be established. This must be a positive figure if an investment with conventional cashflows is to have a positive $##. 4. A positive discount rate should be selected and the Net resent value of the pro(ect at this rate is calculated. 9. The procedure under (4" should be repeated for one or more additional discount rates. The Net resent !alue profiles should be sketched and an appro-imate $## estimated. Example 3uppose a company has pro(ect B with the following cashflows to evaluate. Cstimate the $## of pro(ect B using the data given at a cost of capital of /58. !ro"ect $ Bear ; / 4 9 5 Cash %lows :2;;; (4;,;;;" 4;; 4;; />;,;;; />;,;;;

>

Solution $ears Cash%lows Discount .actors /01(2 /.;;; ;.=@@ ;.@>? ;.>@7 ;.7?4 !resent )alues *+,,, (4;,;;;.;;" /@=.5; /79.=; /;=,;;;.;; ?5,?4;.;; 03456'676,

*+,,, ; (4;,;;;" / 4;; 4 4;; 9 />;,;;; 5 />;,;;; Net !resent )alue

Decision #riteria In Internal Rate o" Return $n case the $##, the decision rule is to compare opportunity cost of funds and accept the pro(ect if the $## is greater than the company2s cost of money and re"ect it if it is not i.e. purely on financial grounds. This decision rule would always lead to the selection of an identical set of pro(ects as the application of N ! rule given the assumptions that have been made so far namelyD certainty, conventional cashflows and perfect capital markets and the additional assumption of independent pro(ects. The Rein$estment Assumptions The Net resent !alue techni'ue assumes that all cash flows from a pro(ect will be re. invested at the discount rate used in the calculation of the pro(ect2s net present value, which in a real,free world is the prevailing base interest rate. This assumption is realistic as application of the N ! rule means that all pro(ects offering a return in e-cess of the discount rate will be accepted and the marginal funds are invested at the prevailing interest rate. $n contrast $## assumes that all cash flows will be reinvested at the pro(ects own $##. There are not practical supporting reasons for this assumption though. This assumption will lead to favour pro(ects with concentrated cash flows in the early years of the pro(ect running than those with low cash flows in the early years of running. This can be illustrated by using an e-ample of 4 pro(ects % ) : and calculations of their terminal values. $n the early years of the pro(ect 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.

$n calculating the terminal values, interim cash flows must be pro(ected forward to the end of the investment2s 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. $t2s assumed below that the interim cashflows will be reinvested at 78.

!ro"ects $ears ; / 4 9 5 ro(ects $ears ; / 4 9 5

8 cash %lows :2;;; (/=,;;;" /5,;;; /4,;;; =,;;; /,;;;

* cash %lows :2;;; (/>,;;;" /,47; /4,;;; /4,;;; /4,;;;

% Terminal values Cash%lows *+,,, (/=,;;;" /5,;;; /4,;;; =,;;; /,;;; Rein9estment rate terminal 9alues '( *+,,, (/.;7"5 >7,95; (/.;7"9 9=,/44 (/.;7"4 44,5;5 (/.;7"/ @,>/> /.;; /,;;;

Conclusion and Analysis +y definition, the $## is the discount rate of Aero and you should not be surprised to see that it is also the discount rate which gives a net terminal value of Aero. This is clearly seen in the case of pro(ect :D the small positive NT! of % arises because 5?8 is a slight under estimate of the $## as perusal of the above analysis. Example 3eakwe Etd is considering which of two mutually inclusive pro(ects it should undertake. The finance director thinks that the pro(ect with the higher net present value should be chosen where the managing director thinks that one with the higher $## should be undertaken especially as both pro(ects have the same initial outlay and length of life. The company anticipates a cost of capital of /;8 and the cashflows of the pro(ects are as follows:

$ears

!ro"ect : *+,,,

!ro"ect $ *+,,, (5;;" 59> 4; 4; = >

; / 4 9 5 7 Required

(5;;" @; />; /=; /7; 5;

/. *alculate the Net resent !alue and internal rate of return of each pro(ect. 4. #ecommend with reasons, which pro(ect you would undertake. 9. C-plain the inconsistency in ranking of the two pro(ects in the light of the remarks of the two directors. 5. $dentify the cost of capital at which your recommendation in (4" would be reversed. Solution (/" B ; / 4 9 5 7 Factor /;8 /.;;; ;.?;? ;.=4> ;.@7/ ;. >=9 ;.>4/ Factor 4;8 /.;;; ;.=99 ;.>?5 ;.7@? ;.5=4 ;.5;4 ro(ect G (5;;" @; />; /=; /7; 5; resent value /;8 (5;;" >9.>9 /94./> /97./= /;4.57 45.=5 '3763 resent value 4;8 (5;;" 7=.9/ ///.;5 /;5.44 @4.9; />.;= /437,'2 ro(ect resent B value /;8 (5;;" (5;;" 59> 9?>.94 4; />.74 4; /7.;4 = 7.5> > 9.@4 4;7,1 resent value 4;8 (5;;" 9>9./? /9.== //.7= 9.=7 4.5/ /'7,32

Therefore as it has been noticed in the calculations. At /;8 the N ! of ro(ect G H *'3563,5,,, At /;8 the N ! of pro(ect B H *4;5,1,5,,, At 4;8 the N ! of ro(ect G H /*435,',5,,,2 At 4;8 the N ! of pro(ect B H /*'5,3,5,,,2

The $## of the two pro(ects are as follows: !ro"ect : /N !/ $## H #a I J/N !//I/N !4/ - (#b K #a"L :7=,4=;,;;; $## H /;8 I J:7=,4=;,;;; I :9=,;7;,;;; - (4;8. /;8"L H /;8 I >.;7;;9>9998 H />.;78 !ro"ect $ /N !/ $## H #a I J/N !//I/N !4/ - (#b K #a"L :9@,;5;,;;; $## H /;8 I J:9@,;5;,;;; I 7,;=;,;;; - (4;8. /;8"L $##H /;8 I =.@?9?44/4@ $##H /=.@?9?8 $##H/=.@?8 (4". The recommendation should be to undertake ro(ect G for the following reasons: ro(ect G has a positive Net resent !alue, showing that it e-ceeds the company2s cost of capital. $n addition, assuming that the company2s ob(ect is to ma-imise the resent !alue of future cashflows ro(ect G offers the higher Net resent !alue. ro(ect G indicates a higher N !, whereas pro(ect B offers a higher internal rate of return where such conflicting indications appear, it is generally appropriate to accept the Net resent !alue result, net present value being regarded as technically more sound than internal rate of return. The two pro(ects have radically different time profiles. ro(ects G2s cashflows are grouped in the three middle years of the pro(ect, while nearly ?;8 of B2s inflows come in the first year of the pro(ect, leading to a situation where pro(ect B shows a higher internal rate of return.

/;

#isk, uncertainty and timing if cashflows may be considered by the Directors in making the final investment decisions.
I

/;; I =; I >; I 5; I 4; ; /; . 4; . 5;

4;

9;

5;

>; Discount rateD 8

Although in the above illustration we have shown the graphical representation using straight lines, the true relationship between the Net resent !alue and discount rate is a cumulative one. %ultiple IRR (%ultiple &ields) At this point in time, we would want to appreciate that in cases where a pro(ect does not have conventional cashflows, there is a possibility of having multiple $## in the pro(ect whose cashflows are unconventional. +y a pro(ect having conventional cashflows, we mean that there will be a cash outflow followed by a stream of inflows. A pro(ect 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 pro(ect at different times, the $## computation might give rise to two or more internal rate of return rates. Example Eunga lc is proposing making a machine it will use in its manufacturing process, the cost of which will be paid in two stages. #evenue can be e-pected from its demonstration, although it will be e-pensive to break up and dispose of at the end of its useful life. The cashflows associated with the pro(ect are as follows.

$ears

Cash %lows *+,,,

//

; / 4 9 The appropriate discount rate is /78. Solution

(@,=4;" (4;,;;;" =;,;;; (79,;4;"

This pro(ect has two internal rates of return as shown below. $ears Cash %lows *+,,, ; (@,=4;" / (4;,;;;" 4 =;,;;; 9 (79,;4;" Net !resent )alue $ears Cash %lows *+,,, ; (@,=4;" / (4;,;;;" 4 =;,;;; 9 (79,;4;" Net !resent )alue >raphical Representation N ! $nvestment N ! M 4;; /;; ; (/;;" (4;;" (9;;" (5;;" Conclusion, Interpretation and Analysis 7 /; /7 4; 47 9; Discount rate, 8 Discount .actor /<(2 /.;;;; ;.?595 ;.=9;; ;.=9?> !) *+,,, (@,=4;" (/=,=>=" @/,4;; (5>,?;>" 0<5,,, !) *+,,, (@,=4;" /7,9=5 5@,99> 45,;95 ;35=41

Discount .actors /4,(2 /.;;;; ;.?595 ;.=9;; ;.=9?>

/4

As both $##s are e'ually valid, the decision whether or not to accept this investment cannot be made by reference to these rates alone. Therefore, N ! method can be used to get a clearer result. $f N ! shows that the N ! of the same pro(ect lower consideration is positive, then the pro(ect should be accepted as it shows that the net financial benefits far outweigh the financial costs of the pro(ect and hence demonstrating financial viability of the pro(ect. Internal Rate o" Return "or Pro'ects (ith !ne)ual lines 0hen two pro(ects or more mutually e-clusive investments with une'ual 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 *onsider two pro(ects $ears !ro"ect N ; *+,,, (>;,;;;" (>;,;;;" / *+,,, 5;,;;; @7,/;; 4 *+,,, 5;,;;; .

*ompute the $##s of the two pro(ects assuming a cost of capital of /;8. A comparison can be made over an e'ual time span for both investmentsD the lives of and N can be e'ualised by assuming that the company can invest in another pro(ect like N at the end of year /. The cashflows of two consecutive investments in N would be as follows: $ear ro(ect N ro(ect N repeated Total *ashflow (/" &sing unad(usted *ash flows (i.e. over 4 yrs and N over / yr" (4" *ashflow ad(usted to C'ualise pro(ect lives , *+,,, (>;,;;;" (>;,;;;" *+,,, N ! H 5,@// N !N H 5,;?; *+,,, N ! H 5,@// 0 *+,,, @7,/;; (>;,;;;" /7,/;; IRR 448 478 IRR 448 6 *+,,, . @7,/;; @7,/;;

/9

(i.e. over 4 yrs and N over 4years" Conclusion and anal?sis

N !N H @,=/;

478

#anking pro(ect and N on an $## basis makes pro(ect N the superior choice, irrespective of the period over which the comparison is made. $n conclusion, regardless of the pro(ect lives, the pro(ect with a higher $## should be chosen as the $## does not seem to be affected by the length of the pro(ect life or repeated reinvestment of the cash flows. TR#DITION#L #!!RO#C@ES TO !ROAECTSBC#!IT#L IN)EST8ENT #!!R#IS#L 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. Pay*ac Period %ethod *omputation of payback period of a pro(ect is the time re'uired for the cash inflows from a capital investment pro(ect to e'ual the cash outflows. $f we assume that cashflows are received at the end of each year, the payback period for the four pro(ects below will be: !ro"ects $nitial capital outlay *ash inflows $ears # *+,,, *+,,, (4;,;;;" 5;; 5;; />,5;; 94,5;; C *+,,, (/;,;;;" >,5;; /4,=;; /9,;;; /9,4;; D *+,,, (/;,;;;" ; ; ; /=,;;;

; (4;,;;;" / /;,;;; 4 4;,;;; 9 4;,7;; 5 4/,;;;

The pay back period for the pro(ects is as follows: !ro"ect A + * D !a?CacD period 4 years 5years 4years 5years

/5

$n 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 pro(ects. For instance if the company above has a corporate policy of only accepting pro(ect with payback period of 9 years only pro(ect A and * promise to payback a three year period. 6ence only pro(ect A and * would be accepted and be undertaken in this instance. Decision rule: <nly pro(ects with short payback periods are preferred. +imitations o" Pay*ac Period %ethod 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. Discounted Pay*ac Period $n 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 pro(ect is deferred using discounted cash flows as opposed to simple cashflows. Exercise lease compute the present values of the cashflows from the above 5 pro(ects A, +, * and D at a cost of capital of 78 and you will discover that the discounted payback (year" will be as follows: !ro"ect A + * D Discounted pa?CacD /?ears2 No ayback 5 years 4 years 5 years

This is a slightly more comprehensive evaluation that the crude simple method of using simple cash flows.

/7

The Accounting Rate o" Return (ARR) Computing Accounting Rate of Return A mathematical e-pression of: Average annual profit from an investment - /;; Average $nvestment Defines the input data to the model. To find the A## of an investment, the average profit over the life of the investment is calculated. This is then e-pressed as a return on either the initial or the average investment in the pro(ect. An acceptable A## must be specified by the decision maker in advance and pro(ects e-ceeding this return will be accepted and those falling short of the return will be accounting rate of return asD The model that employs accounting profits rather than cash flows from the pro(ect as the re(ected. To illustrate the mechanics of the method, the following illustration can be used. *onsider four pro(ects A, +, *, ) D with the following data. Example !ro"ect Name ro(ect life: # 5 5 C 5 D 5

*ash K$nflows: :4/, ;;;,;;; :94, 5;;,;;; :/9, 4;;, ;;; :/=, ;;;,;;; Deprecation: :4;, ;;;,;;; :4;, ;;;,;;; :/;, ;;;,;;; :/;, ;;;,;;; rofit: :/, ;;;,;;; :/4, 5;;,;;; :9, 4;;,;;; :=, ;;;,;;;

$n the above figures, we are assuming that the deprecation and profit figures shown are for total (aggregate" figures over the lives of the pro(ects. Average profits for the pro(ects Total rofit over 5 years H rofit per year ro(ect life years

/>

!ro"ects

A :/, ;;;,;;; 5yrs

+ :/4, 5;;,;;; 5yrs :9, /;;,;;;

* :9, 4;;,;;; 5yrs :=;;, ;;;

D :=, ;;;,;;; 5yrs :4, ;;;,;;;

H :47;, ;;;

*omputation of average capital investment: Assuming that all the resources invested in the pro(ect will be consumed and hence the investment at the end of the pro(ect life will reduce to Aero (;", the Average investments are calculated as a simple mathematical mean. !ro"ect # :4/, ;;;,;;; I :; 4 years *0,5 ',,5,,, !ro"ect C :/9,4;;,;;; I :; 4 years *<5 <,,5,,, The Accounting #ate of return: !ro"ects #: !ro"ects -: !ro"ects C: !ro"ects D: :47;, ;;; :/;, 7;;,;;; :9, /;;,;;; :/>, 4;;,;;; OO:=;;, ;;; :>, >;;,;;; :4, ;;;,;;; :?, ;;;,;;; H H H H 4.9=8 /?./58 /4./48 44.448 !ro"ect :94, 5;;,;;; I :; 4 years *0<5 6,,5,,, !ro"ect D :/=,;;;,;;; I :; 4 years *=5 ,,,5,,,

For the techni'ue to find use, the decision maker needs to specify a re'uired rate of return when A## is used as the pro(ect evaluation method.

/@

As mentioned under the payback period method, corporations need to establish and choose as a policy, an accounting rate of return percentage. #NNU#LISED EEUI)#LENT COSTS Example %pose lc is considering the purchase of a new track, which will be re'uired to travel 7;,;;; kilometers per year. Two suitable models are available details of which are as follows: The :enworth having a life of four (5" years and a price of :4;;,;;;,;;; the running cost is initially :4,;;; per kilometer but this will rise by :9;; per kilometer for each year the truck is in service. 3cania will incur the following cost over > years $ears ; / 4 9 5 7 > *+,,, 97;,;;; @7,;;; ?;,;;; /;7,;;; /4;,;;; /97,;;; /7;,;;;

The cost of capital for %pose lc is /48 Required C-plain which truck (between the :enworth and the 3cania" should be purchased. Solution As we can see the comparison of the two pro(ects is complicated by their une'ual lines. 0e are going to use annualiAed costs to compare the two pro(ects. Therefore the annualiAed cost of the :enworth is: $ear ; / 4 9 5 Costs *+,,, 4;;,;;; /;;,;;; //7,;;; /9;,;;; /57,;;;

The annualiAed cost of the :enworth Truck

/=

$ear ; / 4 9 5 Totals:

Costs *+,,, 4;;,;;; /;;,;;; //7,;;; /9;,;;; /57,;;;

06( DC. /.;;; ;.=?9; ;.@?@; ;.@/4; ;.>9>; 47,43

!resent 9alue *+,,, 4;;,;;; =?,9;; ?/,>77 ?4,7>; ?4,449 '<'5;4'

The annualiAed e'uivalent of :7>7,@97 :7>7,@97 9.;9= F *03<560=5''6 This is determined by calculating the Net resent !alue of ac'uiring and operating a :enwork truck over four years and converting it an e'ual annual e'uivalent cost by dividing the Net resent !alue by 9.;9@. The annualiAed cost of the 3cania truck isD $ear ; / 4 9 5 7 > Totals: Costs *+,,, 97;,;;; @7,;;; ?;,;;; /;7,;;; /4;,;;; /97,;;; /7;,;;; /.;;;; ;.=?9; ;.@?@; ;.@/4; ;.>9>; ;.7>@; ;.7;@; 17006 06( DC. !resent 9alue *+,,, 97;,;;; >>,?=; @/,49; @5,@>; @>,94; @>,77; @>,;7; ;=053=,

The annualiAed e'uivalent of :@?/, =?;,;;; is : @?/,=?;,;;; 5.//4 F *0=65 '3,56'67=, Therefore in conclusion, the :enworth Truck is the best option with a lower annualiAed cost.

/?

PREFERENCE FOR APPRAISA !E"#OD

$nvestment Appraisal method #d9antages and disad9antages o% In9estment #ppraisal 8ethods PAYBACK PERIOD METHOD #d9antages (a" $t is easily understood and interpreted, especially to non.financial managers, and its implications for li'uidity are clear. (b" $t can be used as preliminary pro(ect appraisal screening method, before scientific methods (discounted cash flows are applied for the appraisal process". Disad9antages (a" $t ignores cash flows beyond the payback period and it does not take into account of the time value of money. NET PRESENT VALUES #d9antages (a" $t takes account the timing of cash flows. (b" $t takes proper account of the siAe and duration of pro(ects. (c" $t takes into account the greater uncertainty of later years2 cash flow by using a higher discount rate for these years. Disad9antages (a" $t produces a number which is less familiar to management than a rate of return. (b" $tPs comple- in its mechanics. (c" Not easily understood by non.financial managers. INTERNAL RATE OF RETURN #d9antages (a" $t takes into account of the timing of the cash flow. (b" $t is easily compared to a given return, which pro(ect owners are looking for, in assessing a pro(ect2s viability.

4;

Disad9antages (a" $t does not take account of the siAe of the pro(ect, so a small pro(ect with a high return looks better than a large pro(ect with a lower return, even through the latter will contribute more to earnings. (b" The $nternal #ate of #ate ($##" cannot evaluate properly the duration of pro(ects. This is because $## takes no account of what happens to the returns after they are achieved. (c" Another potential difficulty, which may sometimes arise, is the possibility of two or more solutions to the $## calculation. This usually happens when a pro(ect has unconventional cash flows, meaning that cash flows with negative and positive signs may come through during the life of the pro(ect. Capital Replacement *orporations will most times want a specific type of capital asset for a period of time which e-ceeds 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 e-tend into the indefinite future, whereas the life of the machine re'uired 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 horiAon rather than other. *onsider the e-ample 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. $nitial purchases price: Annual running cost (average per year" #e.sale value if sold after: 4yrs 9yrs 5yrs 7yrs *+,,, 7;,;;; 4;,;;; 9;,;;; 47,;;; /7,;;; 7,;;;

4/

3ince the company re'uires the cars to e-tend into future, a replacement policy must be decided upon. $f the company would like to minimise the overall cost of operating its fleet of cars, cars should be replaced at the point in time at which this cost is minimised. For ease of e-position we would assume that the annual operating cost is independent of the age of the car and that the data given above will remain valid indefinitely. As the annual operating cost is constant, irrespective of the replacement cycle it can be ignored for the purposes of setting the replacement policy. Therefore what needs to be considered are the purchase price of the car and the resale value. Although, the purchase price itself is not variable the total e-penditure of the company is variable as it depends on the sale of the cars, which in turns depends on the replacement cycle. The net cost of the investment in each car is given by the initial outlay less the present value of the sale proceeds. Assuming a cost of capital of 78, the computation would be as below. Sc$edule %
$ear Resale )alues Discount %actor /'(2 !resent 9alues *+ ,,, !urchase price *+ ,,, Net !resent cost *+ ,,, *+ ,,,

4 9 5 7

9;,;;; 47,;;; /7,;;; 7,;;;

;.?;@; ;.=>9= ;.=44@ ;.@=97

4@,4/; 4/,7?7 /4,95/ 9,?/=

(7;,;;;" (7;,;;;" (7;,;;;" (7;,;;;"

(44,@?;" (4=,5;7" (9@,>7?" (5>,;=4"

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. $n order to make such a comparison, the cost must be e-pressed 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 e-pression as an annual figure of a cost or income occurring on a regular but not annual basis. For e-ample taking the figures in the first row of the schedule, the :44,@?;,;;; spent today is e'uivalent to an e-penditure of *0656'<5<16 (44,@?;,;;;,/.=7?5" for each of the ne-t two years at the discount rate is 78, we would be indifferent as to which spending pattern we incurred.

44

Sc$edule & Replacement C?cle /?ears2 4 9 5 7 Net !resent Cost /a2 *+,,, (44,@?;" (4=,5;7" (9@,>7?" (5>,;=4" #nnuit? %actor /'(2 /C2 /.=7?5 4.@494 9.757? 5.94?7 #nnual Equi9alent Cost /aBC2 *+,,, (/4,7>@" (/;,59/" (/;,>4;" (/;,>55)

Conclusion and analysis $t can be seen that the minimum annual e'uivalent cost is *0,5 1405,,, the cost of replacing the cars on a three.year cycle. <ther things being e'ual the company should adopt a three.year replacement policy. The concept of annual e'uivalent costs can be used to facilitate the comparison of assets with une'ual lives, providing the assumption can be made that assets will be re'uired for a period which is a complete multiple of each pro(ects own life. Capital Rationing $n some instances, the amounts of capital which an organiAation can invest in its long. term pro(ects are limited and so a choice must be made between a number of different pro(ects. $n financial wisdom, managers of the business will want to select and choose pro(ects that will give the greatest return on the total investment, assuming that pro(ects are in line with the long.term corporate strategic ob(ectives. The illustration below shows the mechanics of capital rationing !ro"ects $ear ; / 4 9 G *5 ,,, (4;;,;;;" 5;,;;; /;;,;;; /5;,;;; : *5 ,,, (/4;,;;;" (=;,;;;" =;,;;; /5;,;;; $ *5 ,,, (45;,;;;" /4;,;;; ?;,;;; ?;,;;; H *5 ,,, (/>;,;;;" (4;;,;;;" 4;;,;;; 44;,;;;

$f we suppose that the company with these four (5" pro(ects aboveD 0, G, B, and Q has a cost capital of 78 and that the funds available in year ; (i.e. in the current year", at the time of decision.making are :5;;, ;;;,;;;.;;, it is clear that even if the net present values are positive the organiAation cannot invest in all four pro(ects.

49

&sing the profitability inde- techni'ue of ranking pro(ect will be employed to rank pro(ects. The first step is to calculate the net present values of the pro(ects and then e-press them as a percentage of the pro(ect outflow so that comparable returns are obtained. The computation below shows the return from each pro(ect and their rankings. Discount Rate & '( Bear ; / 4 9 /.;;; ;.?74 ;.?;@ ;.=>5 G *5 ,,, (4;;,;;;" 5;,;;; /;;,;;; /5;,;;; : *5 ,,, (/4;,;;;" (=;,;;;" =;,;;; />;,;;; $ *5 ,,, (45;,;;;" /4;,;;; ?;,;;; ?;,;;; H *5 ,,, (/>;,;;;" (/4;,;;;" 4;;,;;; 44;,;;;

Discounted cash %lows $ear $r ; / 4 9 N!) /.;;; ;.?74 ;.?;@ ;.=>5 G *5 ,,, (4;;,;;;" 9=,;=; ?;,@;; /4;,?>; 1=5;1, : *5 ,,, (/4;,;;;" (@>,/>;" @4,7>; /9=,45; 015<1, $ *5 ,,, (45;,;;;" =7,>=; =/,>9; @@,@>; '5,;, H *5 ,,, (/>;,;;;" (/?;,;;;" /=/,5;; /?;,;;; 605,,,

The returns on the pro(ects are as followD 0 :5?, @5;,;;; :4;;, ;;;,;;; 45.=@8 #anking /st Analysis and comment As it can be seen above, all pro(ects have positive net present values and so they would be accepted if funds allowed. G :/5, >5;,;;; :/4;, ;;;,;;; /4.4;8 5th B :7, ;@;,;;; :45;, ;;;, ;;; /5.;48 4nd Q :4/, ;;;,;;; :/>;, ;;;,;;; /9./=8 9rd

45

0ith only :5;;, ;;;,;;; to invest, pro(ect 0 would be chosen and 7,> of pro(ect B, assuming that the investments are divisible. $n many circumstances, divisibility of pro(ects might not be possible, so decisions will have to be made based on net present value techni'ue. *apital rationing is not really a practical approach for the ma(ority of organiAations. $t usually works very well if the company in 'uestion is not an $nvestment *ompany but for most of organiAations providing a service or manufacturing products, this solution will not be very helpful. Effects of Taxation on In estment Appraisal Although in many instances we are assuming that there are no ta-es in perfect financial markets, in reality ta-es are usually levied on income earned from investment. The section aims to show the effects of ta-ation on investment appraisal. 6owever, the section starts by looking at basics of discounting future cashflows, which is going to be used widely in capital investment appraisal. Discounting %ethods Time 9alue o% mone? *ash 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.

$ears ; / 4 9 5

! !resent 9alue

Discounting

F! .uture 9alue

resent value ( !" is the cash e'uivalent now of money received,payable at some future date.

47

Exercise *hoose between Bear ; (now" :/;,;;;,;;;,;;; Bear 7 :7,;;;,;;;,;;;

The discount rate is /;8 lease make your decision by first discounting and then compounding. Discounting $ear , /now2 :/;,;;;,;;;,;;; :?,9/7,;;;,;;; H !) F .) x /, (/Ir" n Compounding !) /0 I r2 n F .) Bear ; (now" /;,;;;,;;;,;;; R (/./"7 H Bear 7 :/>,/;7,/;;,;;; Bear 7 ;.>4/ - :/, 7;;,;;;,;;;

Therefore we would choose the :/;,;;;,;;;,;;; now with both methods, please note that discounting is the preferred method of comparison in 3F%. The Discount .actor

.ormula / (/./;"7 Annuities

H,7<60

or

TaCles /gi9en in exam2 Bou can simply find discount factor from the present value table, by locating the discount factor at the /;8 column and the 7.year row i.e. ,7<60

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.

4>

Exercise Immediate #nnuit? 0hat is the present value of :/;; earned each year from years /./;, if the discount rate is //8S / 4 9 5 7 > @ = ? /;

The annuity factor at year ten adds together all the present value factors for the first ten years. $n fact the annuity is 'uite often called the cumulative present value factors. The annuity factors assume that the first cash%low occurs at the end o% ?ear one i7e7 the %irst present 9alue %actor added in an annuit? %actor is %or ?ear one7 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 Pan immediate annuity2. #nswer Exercise !) F *0,, : '733= F *'337= De%erred #nnuit?

0hat is the present value of :4;; incurred each year from years 9.> the discount rate is 78S #nswer /0 ; / 4 4;; ! The annuity factor brings all the cash flows to one year before the first cashflow arises. #s the %irst cash %low is in ?ear 45 all the cash %lows ha9e Ceen Crought to ?ear 67 To find the present value (year ;" of the annuity, which is currently valued in year two we must multiple it by the present value factor for year two. 9 4;; 5 4;; J 7 4;; 12 >

4@

#nswer F #ppl? the structured approached to de%erred annuities /. #nnual cash %low 4. #nnuit? %actor for two years / to 5 9. !resent 9alue %actor for year 4 resent value of deferred annuity Perpetuities !erpetuit? is an annual cash %low %ore9er7 $t is the simplest cash flow model known to man. Toddard often implies perpetuity by simply stating, UThe cash flows will occur for the foreseeable futureV. The ,asic Perpetuity ! of a perpetuity H o F annual cash %low r annual cash %low !o :4;; G 9.75> G ;.?;@ *<14

Discount rate Exercise

0hat is the ma-imum amount you would pay for perpetuity of : 47,;;; per annum, if the discount rate is /;8S #nswers o H :47, ;;; /; H :47;, ;;; r H 47,;;; 47;,;;; H ;./;

Perpetuity -ith #onstant .ro-th erpetuity 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 H growth e-pressed as a decimal. !) o% perpetuit? K !o H Cash .low $ear ,K /0I g2 rLg

Discount rate in a perpetuit? L r

H Cash .low $ear ,K /0 I g2 !o

Ig

4=

Exercise 0hat is the ! of perpetuity of : 47,;;;,;;;,;;; per annum increasing at an annual rate of 78, if the discount rate is /;8 and the first payment is in year /S #nswer ! of erpetuity H 47,;;;,;;;,;;; W (/ I ;.;7" ;./ . ;.;7 H *'6'5 ,,,5,,,5,,,

Exercise < #n N!) calculates with Coth de%erred annuit? and a de%erred perpetuit?7 The Financial Director of A plc has prepared the following schedule (e-cluding inflation" to enable her appraise a new pro(ect. The pro(ect2s real 0A** is /;8. 3he wants to calculate the N ! using two different assumptions regarding the pro(ect duration. The assumptions are as follows: a" That the real annual cash flow will be : 47;,;;;,;;;,;;; from year to the foreseeable future (deferred perpetuity". b" That the real annual cash flow will be :47;, ;;;,;;;,;;; from year to year eighteen (deferred annuity". #nswer $ear Net Cash .low !resent 9alue %actors !resent 9alue N!) L perpetuit? N!) L annuit? The Net Present Value Format Bear , :2;;; 0 :2;;; 6 :2;;; 4 1 :2;;; :2;;; , :;;; 4,;;;, ;;; /.;;; 4,;;;,;;; 0 :;;; 55;,;;; ;.?;? 5;;,;;; 6 :;;; 9>9,;;; ;.=4> 9;;,;;; 4 :;;; 47;,;;; ;.@7/ 9;;,;;; 1 L 03 :;;; 47;,;;;

4?

Receipts L /or cost sa9ings2 !a?ments 0ages %aterials !ariable , Fi-ed overheads Administration , Distribution e-pense Capital #llowancesBTax allow dep TaxaCle !ro%its F E-IT Tax Add back: *apital Allowances Initial outla? Net RealisaCle )alue 0orking capital (G"

G (G" (G" (G" (G" (G" G /:2 G

G (G" (G" (G" (G" (G" G /:2 G

G (G" (G" (G" (G" (G" G /:2 G

G (G" (G" (G" (G" (G" G /:2 G :

(G" G G : G G : G G :

G G G :

Net Cash .lowsB.ree Cash .lows (G" Discount rate /:(2 !resent 9alue G /:2

Net !resent )alue :/:2 A positive N ! is when the e-pected return on a pro(ect more than compensates the investor for the perceived level of (systematic" risk i.e. that the e-pected is greater than the re'uired return. Decision Rules 3ingle ro(ect: ositive or Aero N !: +ased on the estimates it appears that the pro(ect is financially viable. Negative N !: +ased on the estimates it appears that the pro(ect is not financially viable. %utually e-clusive pro(ect (A or +": (an absolute decision not a relative decision" 3imply pick the pro(ect with the highest positive N !.

9;

The Rele$ant #ash Flo-s A key concept HX include relevant , incremental cash flows in the N ! calculations.
.UTURE C#S@ .LOGS T@#T #RISE #S # CONSEEUENCE O. T@E DECICSION

1.

$gnore all sunD costs incurred prior to the decision. $gnore all sunk revenues generated prior to the decision. 3unk costs are costs which have already been incurred prior to the decision. They are therefore irrelevant to the decision making process. Exercise #ID of :/;;, ;;; was incurred last year.

2.

$gnore all nonJcash %lows7 C.g. depreciation. Exercise A company is considering investing in a pro(ect, which re'uires an immediate investment of :>m. This pro(ect will last for five years and at the end of the pro(ect the plant will have a scrap value of :/m. The company depreciates plant on a straight.line basis over a five.year period. 0hat are the relevant cash flowsS #nswer 3imply when you buy and a fi-ed asset.

3.

$gnore all overheads in e-istence prior to the decision i.e. non.incremental cash flows. The allocation , apportionment of fi-ed costs already present prior to the decision are ignored. Exercise A manufacturing company is considering the production of a new type of widget. Cach widget will take two hours to make. Fi-ed overheads are allocated on the basis of :/ per labour hour. $f the new widgets are produced the company will have to employ an additional superior at a salary of :/7, ;;; per annum. The company will produce /;,;;; widgets per annum. 0hat are the relevant cash flowsS #nswer The :/7,;;; salary only. Exam .ocus $f you are calculating an N ! in relation to the purchase or sale of a company you should include all e-isting fi-ed costs because to the purchaser , seller they represent future cash flows will commence , cease sale.

4.

Ignore interest payments and t$eir ta' effects as implicit in t$e 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 e-ample ignores ta- relief on interest.

9/

8arDet 9alues Equit? DeCt /,;;; /,;;; 4,;;;

#nnual cash .lows required 4;; /;; 9;;

Cost o% Capital 4;8 *e /;8 *d /78 Gacc

Effects of Inflation on In estment Appraisal N!) C#LCUL#TION Bears /8 Sales 3pecific 58 Gages 98 8aterials >8 O9erheads Net cash flow Teneral inflation ; / G (G" (G" (G" G 4 G (G" (G" (G" G 9 G (G" (G" (G" G 5 G (G" (G" (G" G 7 (G" (G" (G" (G" G

48 Discount rate L %actors resent value N. .!

94

Two t?pes o% in%lation

Speci%ic in%lation rates Applies to all the individual cash flows items

>eneral in%lation Applies to the discount rate This is because the investors in a ro(ect are interested in their ability to buy a basket of general goods. Not only one particular good. The two methods

Includes the two types inflation

Excludes the inflation

8one? or normal Terms Discount UmoneyV cash flows at money discount rate

Real terms Discount UrealV cash flows at real discount rate #eal term cash flows are *ashflows at current prices or year Aero

99

E:#8 .OCUS Ghen to use the mone? or Real method Is there one rate o% in%lation in the questionM

No

K$es

8one? B Nominal 8ethod C.g. 0ages 98, %aterials 58 and Teneral inflation 78 Real Terms Real 8ethods

I% the cash %lows are in 8one? Terms 8one? 8ethods

K $f there is one rate of inflation in the 'uestion both the real and money method will give the same answer. 6owever it is easier to ad(ust one discount rate, rather than all the cash flows over a number of years. Thus the form of the cash flows defines the method to be used. Ad'usting the Discount Rate $nvariably Toddard will give you the cash flows in one form and the discount rate in the other form. 3o you will have to ad(ust the discount rate. *ash flows in real terms Discount rate in money terms Deflate to find the real discount rate *ash flows in money terms Discount rate in real terms $nflate up to find money discount rate

Real discount rate to mone? discount rate The %isher Equation /0 I mone? rate2 F /0 I real rate2 x /0 I general in%lation rate2

95

Exercise $f the real rate of return is /;8 and general inflation is 78, what is the money rate of returnS #nswer J(/./;" (/.;7"L . / H /./77 therefore /7.78 Exercise $f the real rate of return is =8 and general inflation is 58, what is the money rate of returnS #nswer 8one? 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: De%late 0 I mone? rate F 0I real rate 0I general in%lation Exercise $f the money rate return is /5.58 and general inflation is 58, what is the real rate of returnS #nswer //./55,/.;5" . / H ;./ say /;8 Exercise $f the money rate of return is /9.548 and general inflation is 98, what is the real rate of returnS #nswer (/./954,/.;9" K / H ;./; say /;8 C#S@ .LOGS DE.INE T@E 8ET@OD ES!ECI#LL$ G@EN T@ERE IS #N #NNUIT$

97

Exercise A+* plc provides the following pro(ected data for the ne-t ten years e-cluding inflation. ; (/,@;;" / /;; 4 4;; 9 K /; 9;;

Net cash flows

The rate of inflation is 98 and the market return is //.458 Calculate the present 9alue o% the cash %lows o9er the 0,J?ear period7 Real 8ethod J cash flows are in real termsD simply deflate the money discount rate to get the real rate. Real discount rate Real cash %lows Net cash flows Annuity factor Discount factor resent value N!) , (/,@;;" /.;;; /05;,,2 0 /;; ;.?4> =4 16 6 4;; ;.=7@ 0;0 4 L 0, 9;; 7.@5@ ;.=7@ 051;3 (/.//45,/.;9" . / H ;.;= say =8

8one? 8ethod J calculate the money cash flows for each year and discount by the money discount rate.
Bears Net cash ; / 4 9 5 7 > @ = ? /;

(/,@;;" /;9 4/4

94=

99=

95=

97=

9>?

9=;

9?/
;.9=9 /7;

5;9
;.957 /9?

Disc F: / Y //.458 !

;.=?? ;.=;= ; .@4> ;.>79 ;.7=@ ;.74= ;.5@5 ;.54> /@/ 49= 44/ 4;5 /=? /@7 />4

(/,@;;" ?9

N!) #NSGER CO88ENT

16

UThe understanding assumption that the general inflation rate is e'ual to the specific inflation rates for all the cash flows items is somewhat simplistic. $n reality each cash

9>

flow item would probably have a different specific rate of inflation, thus re'uiring the money method approach.V Example Twincle lc 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 have on its sales. Twinkle lc 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 :7;;,;;;,;;; and is e-pected to have a life of four (5" years with a scrap value of :4;,;;;,;;; in addition an investment of :@;,;;;,;;; in working capital will be re'uired initially. The following forecast annual trading account has been prepared for the pro(ect: 3ales %aterials Eabour !ariable overheads Depreciation Annual profit *+,,, 5;;,;;; (=;,;;;" (>;,;;;" (4;,;;;" (5;,;;;" 4;;,;;;

The company2s cost of capital is /;8. *orporation ta- is charged at 9;8 and is payable 'uarterly, in the @th and /;th months of the year in which the profit is earned and the / st and 5th month of the following year. A writing down allowance of 478 on a reducing balance is available on capital e-penditure. Required Advise the management of Twinkle technology lc on whether they should invest in the new

Bour recommendation should be supported with relevant calculations. Solution Griting down allowances
Bear Asset !alue :2;;; 7;;,;;; 9;8 Ta:2;;; Bear / :2;;; Bear 4 :2;;; Bear 9 :2;;; Bear 5 :2;;; Bear 7 :2;;;

9@

Br/ 478 0DA Br4 478 0DA Br9 478 0DA Br5 3crap value Br 5 +al ad(usted

(/47,;;;" 9@7,;;; (?9,@7;" 4=/,47; (@;,9/9" 4/;,?9@ (4;,;;;" /?;,?9@

9@,7;; 4=,/47 4/,;?5

/=,@7;

/=,@7; /5,;>9 /5,;>9 /;,75@ /;,75@

7@,4=/ /=,@7; 94,=/9 45,>/; 9?,/== 4=,>5/

NET !RESENT )#LUE C#LCUL#TIONS

Bear %achine 0,*apital :2;;; (7;;,;;;" (@;,;;;" /=,@7; 94,=/9 45,>/; 9?,/== 4=,>5/ 45;,;;; 45;,;;; 45;,;;; 45;,;;; 45;,;;; (9>,;;;" (@4,;;;" (@4,;;;" (@4,;;;" (9>,;;;" Ta- relief on 0DA :2;;; *ontrib. ution Ta- on contribution :2;;; Net cash flow :2;;; D*F /;8 resent value :2;;;

;
/ 4 9 5 7

4;,;;; @;,;;;

(7@;,;;;" 444,@7; 4;;,=/4 /?4,>;= 4?@,/=> (@,9>;"

/.;;; ;.?;? ;.=4> ;.@7/ ;.>=9

(7@;,;;;" 4;4,5=; />7,=@; /55.>5= 4;4,?@= (5,7@;" /5/,5;>

Net resent !alue of new technology investment. *ontribution H Annual rofit I Depreciation H :4;;,;;;,;;; I :5;,;;;,;;; H :45;,;;;,;;;

Therefore purely on financial grounds, management of Twincle lc should invest in the new technology, as the Net resent !alue of the new technology is positive. DIFFERENT NPV FORMATS Exercise DCF plc provides the following pro(ect financial data for the ne-t 5 years, including inflation. Bear / :2;;;s /,;;; (>;;" Bear 4 :2;;;s ?7; (777" Bear 9 :2;;;s ?;; (79;" Bear 5 :2;;;s ?;; (7;;"

3ales Eess *osts

9=

The rate of inflation is 98 and the real discount rate is >.=;8. %achinery cost :=;;, ;;; life 5 years, ta- allowance depreciation is at straight line and the ta- rate is 9;8. Calculation o% the present 9alue o% the cash %lows7 Note: <nly one inflation rate and cash flows are in money terms therefore use the money method. Therefore need to calculate money discount rate i.e. (/.;9" - (/.;>=" H /./;. i.e. /;8. "A)A* E PROFI"S APPROAC# + !E"#OD % Bear ; 3ales Eess *osts Less tax allowance depreciation TaxaCle pro%its Tax #dd CacD tax allowance depreciation $nitial outlay (=;;" / 4 9 5 /,;;; ?7; ?;; ?;; (>;;" (777" (79;" (7;;" /6,,2 /6,,2 /6,,2 /6,,2 6,, 0=' 0;, 6,, 6,, /<,2 6,, /'=2 6,, /'02 6,, 95? .>=9 495 7

/<,2

Net cash flow (=;;" 5;; 997 9// Discount rate (/;8" / .?;? .=4> .@7/ resent values (=;;" 9>5 4@@ N!) 6;< "A)A* E CAS# F O, APPROAC# + !E"#OD & Bear 3ales Eess *osts TaxaCle cash %lows ; / /,;;; (>;;" 1,, 4 ?7; (777" 4=' /06,2 <, 5;;
.?;?

(>;" .>4/ 49=

(9@"

9 ?;; (79;" 4;, /00=2 <, 9//

.@7/

5 ?;; (7;;" 1,,

Tax Tax relie% on depreciation $nitial outlay (=;;" Net cash flow (=;;" Discount rate (/;8" / resent values (=;;" N!) CAPI"A A Exercise O,ANCE

/0002 /06,2 <, <, 95?

>=9

997
.=4>

(>;"
.>4/

9>5

4@@ 6;<

495

49=

(9@"

9?

*ost :4;;,;;;, 3crap value :9;,;;;, Eife 7 years, %ethod 478 reducing balance method and the ta- rate is 9;8. #nswer *ost :2;;;2s 4;; 478 0.D.A.23 :2;;;23 7; ', x ,7;' F 43 9= - ;.@7 4= 4/ +alancing Allowance (/@; ./9@" H Total ClaimaCle T@E INTERN#L R#TE O. RETURNJIRR $## is the discount rate, which gives a Aero N ! i.e. the actual rate of return on investment. 99 /@; 4;; K 9; H /@; Bear

/ 4 9 5 7

ESTI8#TIN> T@E IRR )I# LINE#R INTER!OL#TION *alculate the N ! at two different discount rates and then use the following formula: $## H #ate I / N ! / W (#ate . #ate" N !.N ! 4 / / 4

$f the first N ! is positive, choose a higher rate for the ne-t calculate to get negative N !. Exercise 0; *alculate the $## (the e-pected return" of the following pro(ect: Bear ; investment : (5;, ;;;"

5;

/ 4 9 5 #nswer: Bear ; / 4 9 5 N!) *ash flow (5;, ;;;" />, ;;; />, ;;; />,;;; /4,;;;

cash inflow U U U

/>,;;; />,;;; />,;;; /4,;;;

Dis Factor Y /;8 / .?;? .=4> .@7/ .>=9

! (5;, ;;;" /5,755 /9,4/> /4, ;/> =, /?> ;5=;6

Dis Factor Y ! 4;8 / (5;,;;;" .=99 /9,94= .>?5 //,/;5 . 7@? ?,4>5 .5=4 7,@=5 /'6,2

$## H /;8 I Exercise -recDhall plc

@,?@4 W (4;8 . /;8" H /?.9?8 @,?@4 I 74;

Assume that you have been appointed finance director of +reakall plc. The company is considering investing in the production of an electronic security device, with an e-pected market life of five years. The pervious finance director has undertaken an analysis of the proposed pro(ectD the main features of analysis are shown below. !roposed electronic securit? de9ice pro"ect Bear ; Bear / Bear 4 Bear 9 Bear 5 :2;;; :2;;; :2;;; :2;;; :2;;; $nvestment in depreciable Fi-ed assets 5,7;; *umulative investment in 0orking capital 9;; 5;; 3ales 9,7;; %aterials Eabour <verhead $nterest Depreciation 797 /,;@; 7; ?;; Bear 7 :2;;;

7;; 5,?;; @7; /,7;; /;; 7@> ?;;

>;; 7,94; ?;; /,=;; /;; 7@>

@;; 7,@5;

@;; 7,94; ?;; /,=;; /;; 7@> ?;;

/,;7; 4,/;; /;; 7@> ?;; ?;;

7@>

5/

Ta-able profit Ta-ation rofit after ta-

9,/9/ 9?> /4? 4>@

9,4=> /,;@5 9@> >=?

5,4@> /,;55 9>7 >@?

5,4@> /,;/5 977 >7?

5,4@> /,;55 9>7 >@?

Treatment of Leasing and !ire P"rchase Transactions Introduction Eeasing is a techni'ue used to finance the use of an asset. $t is an alternative to outright purchase, financing by using e-isting cash reserves or by borrowing. The motivation for choosing leasing rather than purchasing is often ta- 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.

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 re'uirements for ta- purchases. Ad$antages o" +easing There are two significant reasons for a company to lease assets rather than buying outright. /. Ta- benefits 4. Fle-ibility , cash flow 9. Access to additional sources of li'uidity as a result of increased debt capacity. Ta/ ,ene"its to the +essor Ta- saving was the original drive or motivation behind the development of the leasing market. $n many countries legal ownership of a 'ualifying asset entitles the owner (e.g. a bank" to amortiAe the capital cost over the life or the lease period of the asset for tapurposes. This gave valuable cash flows benefits to those with the ta-able capacity to sketcher their ta- allowances.

54

Earge commercial banks usually had such ta- shelter, which they could use as lessors passing on to the lessee some of the economic benefits of ta- relief cash flows. Ta/ ,ene"its to the +essee 0hile the ta- charges reduce the benefits of leasing, the ability of lessors to pass on capital allowance ta- benefits to lessees still makes leasing attractive for entities which have no ta- capacity themselves. The circumstances in which some entities might not have ta- capacity and hence can benefit from leasing would include the followingD /. 4. $n a situation where a loss making business is still creditworthy 0here we have start.up pro(ects or businesses, which may not move into profits for several years such as most +iotechnology companies and start.up information technology ($T" companies. For institutions which do not pay corporation ta- e.g. local authorities universities and colleges. $n a situation where a profitable corporation, with large continuing capital e-penditure and conse'uent large capital allowances but with low profits available as ta- shelter.

9. 5.

.LE:I-ILIT$ #ND EN@#NCE C#S@ .LOGS 0hilst the availability of ta- allowances continues to be important the users of the leasing market rely increasingly on the advantages of cash flows and fle-ibility. Eease structures can be fle-ible and innovative and the payment schedules can be tailored to fit the pro(ected cash flows arising from the underlying business. For some types of assets such as aircrafts computers, containers and rail wagons, comple- structures have been developed which facilitate the marketing of asset reconciling the news of the buyer and setter on their deliveries. Types o" +eases There are two main types of lease: /. Finance leases 4. <perating leases Finance +ease

59

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 e-tent transferred are as fellows: The full use of assets owner it2s economic $dle capacity +reakdowns <bsolescence

The conductance below usually acts as criteria for testing a finance lease. $n many laitance of a lease is going to be classified as a finance lease. /. The present value of retails for the leased asset usually e-ceeds the value of the asset. 4. $n a situation where the primary contact parole is somewhat e'ual or appro-imately e'ual to the useful economic life of the asset in 'uestion. 9. 0here the retorm is margin over the lessor2s 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.

0perating +ease +y 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. &sually in operating lease the present value of the rentals is way below the asset value. &sually the lease life (tenure" is less than the assets useful economic life. <perating leases may be a sales aid for the product manufacture, distributor. 6owever, if the manufacturer does not have the finance or ta- capacity to act as lessor it may engage the services of a finance institution to act on its behalf. Features o" +eases . Lease rentals7 &sually e'ual, but can be translated to sort the lessees cash flow if value contract is large enough to (ustify the effort.

55

. Usuall? underl?ing interest rate &sually fi-ed interest rates are used smaller items for simplicity and a floating rate for large items if the lessee re'uires it. . Insurance and maintenance $n 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 0ith finance leases the lessee is usually responsible for relocating the asset to the lessors2 instructions at the end of the lease contract so it can be sold. . Sale proceeds $n most situations the ma(or part of the sales proceeds are typically passed to the original lessee as a refund of the lease rentals.
LE#SE RENT#L CO8!UT#TIONS E:#8!LE L TRE#T8ENT O. LE#SIN> #ND @IRE !URC@#SE TR#NS#CTIONS

3inga Etd owns 4; print and computer shops in :itwe. At present it hires its 97 photocopying machines from #ent.a.copier Etd at an annual #ental fee of ://,4;;,;;; each, payable monthly (assume that cashflows occur at the year end". The rental agreement covers a 45 hour repair service which assists 3inga Etd to maintain high reputation for a 'uick and reliable service. 3inga estimates that each machine generates :/7,4;;,;;; of contribution each year. Gero company sells photocopier machines and is trying to break into the :itwe market and offers to sell to 3inga Etd new machines for :9>,;;;,;;; each payable on installation. 3inga Etd is considering this and has found some research that suggests that each machine stands a ;.@ 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 / will still be reliable at the end of year 5. $f a machine proves reliable, 3inga Etd will keep it for four (5" years in total and it will generate a contribution of :/>,;;;,;;; each year after which time it will be scraped and sold for :/,4;;,;;;. $f the machine proves unreliable, it will be scrapped after year one (/" and sold for :=;;,;;;. An unreliable machine is e-pected to generate a contribution of :/;,;;;,;;; each year. The company2s annual cost of capital is =8. The management of 3inga Etd consider that a time horiAon of no longer than > years should be used when evaluating decisions on photocopiers, as beyond the date photocopier machines are likely to be outdated technology. Required

57

a"

repare computations to show whether a rented or purchased machine is the financially better option. b" Gero *ompany has now made an alternative introductory, once only, offer. $t will buy back 9;8 of the machines at the end of either the first or second year if, re'uired. The buy K back price will be >;8 of the original purchase price at the end of year / and 7;8 at the end of year 4. 3inga Etd must nominate in advance which replacement option it prefers. $f 3inga Etd agrees to either of Gero company2s proposals, it would remain with the company during the life of the purchased and replaced photocopiers. +ecause most shops have two photocopiers available, the management of 3inga Etd has now agreed that further replaced photocopiers available, the management of 3inga Etd has now agreed that further replacements after either year / or year 4 would be unnecessary. Required Advice 3inga Etd whether or not it should accept the revised offer. . 6aving prepared the calculations in (a" and (b" you now realiAe that the effect of ta-ation should have been considered. The corporation ta- rate is 9;8. $t is payable in four 'uarterly 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 e'uipment will 'ualify for a 478 annual reducing balance writing down allowance. Assume that the =8 cost of capital is the after ta- rate for part (c".

Required C-plain and illustrate with calculations the impact of ta-ation on the financial appraisal of: a rented machine a purchased reliatie machine (that is one that is kept for 5 years". Solution (a" +uying a single machine: :2;;; Bear ; cost #eliable: Bear /.5 (:/>, ;;;,;;; - 9.9/4" Bear 5 (:/, 4;;,;;; - ;.@97" 74,??4 ==4 9>,;;; :2;;; (9>,;;;"

5>

99,=@5 - ;.@ &nreliable Bear / (:/;, ;;;,;;; - ;.?4>" :=;;, ;;; - ;.?4> ?,4>; @5/ /;,;;/ - ;.9

9@,@/4 /,@/4

9,;;; 5,@/4

#enting machine over corporate time period: ;.@ robability of machine kept for 5 years. H (:/7, 4;;,;;; . ://,4;;,;;;" H :5,;;;,;;; : 5,;;;,;;; - ;.@ - 9.9/4 H :?,4@9,>;; ;.9 robability of a machine kept for / year: 5,;;;,;;; - ;.9 - ;.?4> H *orporate figure for renting :/,///,4;; /;,9=5,=;;

Therefore the rented machine is definitely the better option: :/;,9=5,=;; K :5,@/4,;;; H :7,>@4,=;; /. Assume a faulty photocopier. Bear / replacement over year 4: Bear / *ashflow (:2;;;" 4/,>;; (9>,;;;" 5,4;; W/ (/=,;;;" 9>,;;; 7 > /,;=; W 4 (/,;=;" Discount rate ;.?4> ;.=7@ ;.=7@ ;.>=/ resent value (:2;;;" (/9,995" (cash received a
new purchase price"

9,>;; /7,54> @97

(net benefit of new machine over 4 yrs option" (saving by net replacing in year 4"

(sale of machine"
(sale income forgone"

5@

(/5,4;;" 4,;;; ;.>9;

(Eoss income"

of

additional

years

(@,/;>"(income from renting included

for companion"

W/ ;.@ - :/>,;;;,;;; H ://,4;;,;;; ;.9 - :/;,;;;,;;; H : 9,;;;,;;; :/5,4;;,;;; K :/;,;;;,;;; H :5,4;;,;;; W4 ;.@ - :/,4;;,;;; H :=5;,;;; ;.9 - :=;;,;;; H :45;,;;; :/,;=;,;;; Therefore replacement at the end of year 4 is better. #enting over a > (si-" year cycle: Br /.> : 97 machines - :5,;;;,;;; - 5.>49 H :>5@,44;,;;; #eplacing in year 4 K assuming a full > year cycle for comparison (in years 7 ) >, some machines will have to be rented, that is 97 machines - ;.@ H 45.7"
$ea r ; / 4 9 5 7 Initial in9estment *+,,, (/,4>;,;;;" #nnual in%low ReliaCle machines *+,,, *+,,, #nnual in%low UnreliaCle machines *+,,, Sale !rice *+,,, Total *+,,, (/,4>;,;;;" 5?@,;;; /=?,;; ; 9/,7; ; 9/,7; ; 9/,7; ; 9/,7; ; /.9// /4=,5@= >55,45; //,95; 4?,5;; 75/,/;; 7@;,7;; /5?,/;; />,55; ;.@?5 ;.@97 ;.>=/ ;.>9; 54?,>5; 5/?,94; /;/,75; /;/,;=; 9;=,;;; DC. Rate *+,,, /.;;; ; ;.?4> ;.=7@ N!) *+,,, (/,4>;,;;;" 5>;,44; 4>9,?>;

9?4,;; ; 9?4,;; ; 9?4,;; ; 9?4,;; ; //@,>; ; //@,>; ; //@,>; ; //@,>; ;

/;7,;; ; /;7,;; ;

>

5=

#ental: 7 ) > 45.7 machines - :5,;;;,;;; Therefore, renting still remains the better option by a small margin. 4. The amount of ta-ation paid will be affected by the profit earned, business e-penses and the purchase of assets. 9. %achine rented Ta-ation will be levied on the profit earned but the e-pense of renting a machine can be set against this, so the ta-ation calculation for renting a machine becomes (:/7,4;;,;;; K ://,4;;,;;;" - 9;8 H :/,4;;,;;; per year. 6alf of the ta- 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 5 years by :/,4;;,;;; - 9.9/4 H :9,?@5,5;; appro-imately, ignoring the time factor (lag". 5. %achine purchased $f the machine is purchased ta- will still be paid on the profit earned but there will be no rented e-pense to set against this (increase in ta- ://,4;;,;;; - ;.9 H :9,9>;,;;; each year for a reliable machine". 6owever, 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 478 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. $ears $ear 0 *+,,, urchase price 9>,;;; / (?,;;;" 4@,;;; 4 >,@7; 4;,47; 9 7;>4 /7,/== 5 (sale /,4;; price" #esidual /9,?== value Ta6 *+,,, 5,7;; 9,9@> @,=@> 4 *+,,, 5,7;; 9,9@> 4,794 7,?;= 4,794 1 *+,,, ' *+,,,

>,??5 /,97; 4,9>4 ?,74> /,@@4

>,??5

5?

Y9;8 Total N ! (:2;;;": (:/,47; I :4,;45 I :/,5;> I :4,/;; I :/,54=" : :=,4;=,;;; Eease rental calculations are very similar to a discounted cash flow e-ercise as you could have seen it early in this chapter. #ental calculation assumptions for an e-ample, which we will work, though are summariAed below. $n the illustration below the ta- effect the e-treme case of /;;8 in the first year allowance and 7;8 ta- rate is used. Cost#$enefit Anal%sis $n many situations where senior managers of a business make decisions, the decisions made can either be structured or unstructured. 1tructured and !nstructured Decisions $n structured decisions managers use standard procedures in an outlined manner to deal with situations in a prescribed way. $n unstructured decision.making, managers use the least pool of e-perience and intellect to make sound (udgments, which are in the best interest of the company or organiAations. .oal #ongruence and Decision %a ing All decisions which are made should be consistent with the corporate ob(ectives. 0e should realiAe 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 e-cess of the costs involved, than the costs involved in carrying them out. Therefore, in whatever conte-t 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. Nature o" #ost2 ,ene"it 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.

7;

Therefore, a cost.benefit analysis will involve a comprehensive comparison of the net benefits e-pected to accrue to an organiAation by pursuing a chosen strategy against the costs which are to be incurred in pursuit of the strategy. lease note that the benefits and costs can be either 'uantitative and , or 'ualitative at the same time. 6owever, as we mentioned earlier where, the 'ualitative costs and benefits might be more difficult to establish due to the grey nature of the 'ualitative conse'uences of our actions. #ost2 ,ene"it Analysis Techni)ues There are a lot of techni'ues used to undertake cost benefit analyses. 3ome of the methods include the following: Pro"ita*ility/ Net #ash2FloTypically and usually when carrying out a cost benefit analysis, most business list the financial and 'uantitative revenues which the business is likely to earn against the total costs likely to be incurred in the pursuing the strategy. 1coring and Ran ing Another commonly used techni'ue for carrying out a cost.benefits analysis is by the use of scoring and ranking of several capital investments available to the business. #anking 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. %echanics o" 1coring and Ran ing $n 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 ; / 4 9 5 7 > @

Bou can choose @ (seven" as the best score and choose ; as the worst scenarios possible. %ost importantly, the decision maker should list possible benefits and the likely costs to be incurred as a result pursuing a given strategy. 7/

Cventually 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. Eets illustrate with a simple situation to show how ranking and scoring can be done. Assume that *hinsa Etd has been e-periencing low sales of its product, the %ane-. As a result the entire management is concerned deeply and they have the following views: The %arketing Director has suggested that the company should invest heavily in the marketing activities. 6owever, the Finance Director is a bit sceptical concerning the likely benefits of this hefty e-penditure on the marketing campaign. As a result, the *C< has re'uested you in your capacity as management accountant to carry out a comprehensive cost.benefit analysis. 3uggested illustration STE! 0 3et and establish a rating scale or the purpose of this illustration assuming that / represents the worst situation and 7 represents the best scenario. R#TIN> SC#LE / 0orst STE! 6 Eist 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 e-haustive -ene%its . Tood corporate image . +igger client base . $ncrease profits STE! 4 Assign weightings or ratings from the scale to each benefit and each cost -ene%its Rating Costs . 6uge financial outlay . C-pected continued advertising 4 9 5 +est

74

/. Tood corporate image 4. +igger client base 9. $ncrease profits Total scores %or Cene%its costs: (i" (ii" 6uge financial outlay C-pected continued advertising

9 5 4 = 5 5 3

Total scores %or the costs STE! 1 *ompare the total scores for benefits and the one for costs. +enefits *osts Difference ? = /

As can be seen above, the analysis and comparison show that the benefits of staging a massive campaign will gives *hinsa Etd more of benefits than costs. 3o purely following the scoring and ranking we e-pect *hinsa Etd to benefit greatly from the marketing campaign, and so the decision to invest in it should be upheld. This is only a simplistic approach. 6owever, in practice so many factors are likely to be taken into consideration and the management accountant will need to carryout the analysis with a great amount of help from marketing professionals and other business personal who may make work as researchers and general #)D employees with *hinsa Etd. $t should be noted that in the above e-ercise, the scores represent both the 'ualitative and 'uantitative benefits, which are associated to the various benefits and costs identified by the management accountant and his team. Post Pro'ect #ompletion Audit From the onset of the chapter we have only been looking at evaluation of pro(ects, which is only a part of the investment process.

79

To conclude the chapter, lets look at an e'ually important aspect of pro(ect evaluation and management. This is the aspect of ost.completion Audit. The post completion audit of pro(ects provide the mechanism whereby e-perience of past pro(ects can be fed into the firm2s decision.making process as an aid to the improvement of further pro(ects. ,ene"its o" Post 3#ompletion Auditing There are a number of benefits that stand out so clearly from a pro(ect post K completion audit. The benefits can be classified in two main categories. "ype % Those benefits that relate to the performance to the current pro(ect i.e. the pro(ect under review. %echanics o" Post 3 #ompletion Audit A post K audit small team, typically professionals such as an engineer who had some involvement in the pro(ect, usually carries out completion audit. The post K completion audit reviews all aspects of a completed pro(ect, to assess whether it lived up to initial e-pectations in term of revenues and costs and analyse the causes of deviations from planned results. $ts main purpose is to enable the e-periences, good or bad gained during the life of one pro(ect to be made available for the benefit of future pro(ects. 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. "ype & The second and final category of benefits relates to the additional information concerning the choice and performance of future pro(ects and the main benefits are given below.

$t improves the 'uality of decision making by providing a mechanism whereby past e-perience can be made readily available to decision makers. $t encourages greater realism in pro(ect appraisal by providing a mechanism where past inaccuracies in forecasts are made public. $t highlights reasons for successful pro(ects, which may be important in achieving greater benefits from future pro(ects.

75

Chapter &
PRICIN' T!E(R)
Learning Outcomes At the end of this chapter candidate 3hould identify and discuss market situations which influence the pricing policy adopted by an organiAation 3hould e-plain and discuss the variations that influence demand of a product or service 3hould be able to calculate prices using full cost and marginal cost as the pricing base 77

3hould be able to compare the use of full costing pricing and marginal cost pricing as planning and decision making aids 3hould be able to appreciate the concept of transfer pricing and its mechanics.

De%inition o% price <rganiAations 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 ob(ective 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. The following are the main factors that influence price of services or products. (a" Nuality

This is an aspect of price perception. $n the absence of other information, customers tend to (udge 'uality by price. Thus a price rise may indicate improvements in 'uality, a price reduction may signal reduced 'uality. (b" C-istence of intermediaries $f an organiAation 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" *ompetitor Activities

$n the same industries, pricing moves in unison. $n others, price changes by one supplier may initiate a price war. *ompetition is discussed in more detail below. (d" $nflation

$n periods of inflation the organiAation may need to change prices to reflect increases in the prices of supplies, labour, rent and so on. Traditional ricing +ases

7>

The two main traditional methods of pricing one (i" (ii" full.cost pricing marginal cost pricing

Cost plus Pricing 0ith 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 (ustified to customers. <n the other side, the full cost pricing method takes no account of the market or demand conditions. $t may also re'uire arbitrary decisions about absorption of costs. The cost accountants may also have problems in determining the accurate profit mark. ups. %arginal Pricing 0ith 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 1mark.up2 pricing. $t draws management attention to contribution, and the effects of higher or lower sales volumes on profit. $n 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. 6owever, again it takes no account of market or demand conditions. $n practice as you already know, pricing decisions cannot ignore fi-ed costs in the long term. Example %uti Etd has begun to produce a new product, product G, for which the following cost estimates have been.

7@

Direct materials Direct labour: 5 hours at :7,;;; per hour !ariable production overheads %achining, Z hour at :>,;;; per hour

: 4@,;;; 4;,;;; 9,;;; 7;,;;;

roduction fi-ed overheads are budgeted at :9;;,;;; per month and because of the shortage of available machining capacity, the company will be restricted to /;,;;; hours of machine time per month. The absorption rate will be a direct labour rate, however, and budgeted direct labour hours are 47,;;; per month. $t is estimated that the company could obtain a minimum contribution of :/;,;;; per machine hour on producing items other than product G. The Direct *ost estimates are not certain as to material usage rates and direct labour productivity, and it is recogniAed that the estimates of direct materials and direct labour costs may be sub(ect to an error of I /78. %achine time estimates are similarly sub(ect to an error of I /;8. The company wishes to make a profit of 4;8 of full production cost from product G. 0hat should the full cost based price beS The following solutions have been developed based on four (5" assumptions. (a" C-clude machine time opportunity costs: $gnore possible costing errors Direct materials Direct labour (5 hours" !ariable production overheads Fi-ed production <verhead (:9;;,;;;,;;; H :/4,;;; per 47,;;; direct labour hour Full production cost rofit mark.up (4;8" : 4@,;;; 4;,;;; 9,;;;

5=,;;; ?=,;;; /?,>;;

7=

3elling price per unit of product G (b" $nclude machine time opportunity costs: $gnore possible costing errors. Full production cost is in (a" <pportunity cost of machine time (*ontribution forgone (Zhr - :/;,;;;" Ad(usted full cost rofit mark.up (4;8"

//@,>;;

: ?=,;;; 7,;;; /;9,;;; 4;,>;; /49,>;;

(c"

C-clude machine time opportunity costs but make full allowance for possible under.estimates of costs. Direct materials Direct labour ossible error (/78" !ariable production <verheads Fi-ed production <verheads (5 hrs - :/4,;;;" ossible error (labour time" (/78" otential full production cost rofit mark.up (4;8" : 4@,;;; 4;,;;; 5@,;;; @,;7; 75,;7; 9,;;; 9,;;; 5=,;;; @4,;;; 77,4;; //4,77; 44,7/; /97,;>; :

(d"

$nclude machine time opportunity costs and make a full allowance for possible under.estimates of cost.

7?

otential full production cost as in (c" <pportunity cost of machine time ( otential contribution forgone" (Zhr - :/;,;;; - //;8" rofit mark.up (4;8" 3elling price per unit of product G Full #ost Versus %arginal #ost Pricing

: //4,77;

7,7;; 49,>/; /5/,>>;

The most important and common criticism of full cost pricing is that it fails to recogniAe that since sale demand may be determined by sales price, there will be a profit K ma-imiAation combination of price and demand. A full cost based approach to pricing will be most unlikely, e-cept by coincidence or luck to arrive at the profit.ma-imising price. $n contrast a marginal costing approach to looking at costs and prices would be more likely to help with identifying a profitK ma-imising price. Example Euangwa Etd has budgeted to make 7;,;;; units of its product, the Euan. The variable cost of a Euan is :7,;;; and annual fi-ed costs are e-pected to be :/7;,;;;,;;;. The Finance Director of Euangwa Etd suggested that a profit margin of 478 on full cost should be charged for every product sold. The %arketing Director has challenged the wisdom of this suggestion, and has produced the following estimates of sales demand for the Euan. rice per unit : ?,;;; /;,;;; //,;;; /4,;;; /9,;;; Required Demand &nits 54,;;; 9=,;;; 97,;;; 94,;;; 4@,;;;

>;

(a" (b"

*alculate the profit for the year if a full cost price is charged. *alculate the profit.ma-imising price. Assume in both (a" and (b" that 7;,;;; units of the Euan are produced regardless of sales volume.

Solution (a" (i" The full cost per unit is :7,;;; variable cost plus :/7;,;;;,;;; H :9,;;;[unit 7;,;;; units hence i.e. :=,;;; (:7,;;; I :9,;;;" in total. A 478 mark.up on this cost gives a selling price of :/;,;;; per unit so that sales demand would be 9=,;;; units. (production is given as 7;,;;; units". (ii" rofit (absorption costing" : ;;; 3ales *osts of production (7;,;;; units" !ariable (7;,;;; - :7,;;;" Fi-ed (7;,;;; - :9,;;;" 47;,;;; /7;,;;; 5;;,;;; Eess increase in stocks (/4,;;; units - =" *ost of sales rofit (i" (?>,;;;" 9;5,;;; @>,;;; :;;; 9=;,;;;

rofit using marginal costing instead of absorption costing so that fi-ed overhead costs are written off in the period they occur, it would be as follows (the 9=,;;; unit demand level is chosen for comparison purposes". :

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*ontribution (9=,;;; - :(/;,;;; K 7,;;;" Fi-ed costs rofit

/?;,;;; /7;,;;; 5;,;;;

3ince the company go on indefinitely producing an output volume in e-cess of sales volume, this profit figure is more indicate of the profitability of the Euan in the longer term. (b" A profit.ma-imising price is one which gives the greatest net (relevant" cash flow, which in this case is the contribution.ma-imising price. rice : ?,;;; /;,;;; //,;;; /4,;;; /9,;;; &nit *ontribution : 5,;;; 7,;;; >,;;; @,;;; =,;;; Demand units 54,;;; 9=,;;; 97,;;; 94,;;; 4@,;;; Amount : />=,;;; /?;,;;; 4/;,;;; 445,;;; 4/>,;;;

The profit ma-imiAing price is :/4,;;; with annual sales demand of 94,;;; units. This e-ample shows that a cost based price is unlikely to be the profit K ma-imiAing 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 K ma-imiAing price ought to be. Acti$ity ,ased Pricing (A,P) Activity based costing provides an opportunity for organiAations that use cost.based 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. &nder the A+* 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 A+* is used. Example A+ Etd makes two products, G and B with the following cost patterns. roduct G : roduct B :

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Direct materials Direct labour at :7,;;;,hr !ariable production <verheads at :>,;;; er hour

4@,;;; 4;,;;;

45,;;; 47,;;;

9,;;; 7;,;;;

>,;;; 77,;;;

roduction fi-ed overheads total :9;;,;;;,;;; per month and these are absorbed on the basis of direct labour hours. +udgeted direct labour hours are 47,;;; hours per month. 6owever, the company has carried out an analysis of its production support activities and found that its fi-ed costs actually vary in accordance with non volume.related factors. Activity 3et.ups %aterial $nspection *ost driver roduction runs roduction runs $nspections roduct G 9; 9; ==; roduct B 4; 4; 9,74; Total *ost : ;;; 5;,;;; /7;,;;; //;,;;; 9;;,;;;

+udgeted production is /,47; units of product G and 5;;; units of product B. Required: Tiven that the company wished to make a profit of 4;8 on full production cost, calculate the prices that should be charged for products G and B 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: !roduct : * !roduct $ *

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!ariable costs

7;,;;;

77,;;;

Fi-ed production <verheads W:9;;,;;;,;;;[47,;;; H /4,;;;[hr" 5=,;;; ?=,;;; rofit mark.up (4;8" 3elling price (b" /?,>;; //@,>;;

>;,;;; //7,;;; 49,;;; /9=,;;;

&sing activity based costing, overheads will be allocated on the basis of cost drivers. roduct G : ;;; 3et ups (9;:4;" %aterial 6andling (9;:4;" $nspections (==;:9,74;" 45,;;; ?;,;;; 44,;;; /9>,;;; /,47; :/;=,=;; roduct B : ;;; />,;;; >;,;;; ==,;;; />5,;;; 5,;;; :5/,;;; Total :;;; 5;,;;; /7;,;;; //;,;;; 9;;,;;;

+udgeted units <verhead cost per unit

Therefore the price then calculated as before roduct G : !ariable costs 7;,;;; roduction overhead /;=,=;; /7=,=;; rofit mark.up (4;8" 9/,@>; /?;,7>; (c" *ommentary roduct G : 77,;;; 5/,;;; ?>,;;; /?,4;; //7,4;;

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The results in (b" are radically different from those in (a". <n this basis it appears that the company has previously been making a huge loss on every unit of product G sold for ://@,>;;. $f the market will not accept a price increase, it may be worth considering leasing production of product G entirely. $t also appears that there is scope for a reduction in the price of product B and this would certainly be worthwhile if demand for the product is elastic. 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 customer2s views. Techni'ues such as value analysis are used to change production methods and or reduce e-pected 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. Target cost management has been defined as a system that is effective in managing costs in new product design and development stages. $t 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. 0hat 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. %anagerial Thin ing to 1upport Target #osting and Pricing Target costing re'uires 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 e-pected standard production cost of that product and then set a selling price[probably based on cost" with a resulting profit or loss. *osts 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"

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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. *ontinuous cost reduction techni'ues must therefore be employed. The Target *osting rocess Step % Analyse the internal environment to ascertain what customers re'uire and what competitors are producing. Determine the product concept, the price customers will be willing to pay and thus the target cost. Step & 3plit the total target cost into broad cost categories such as development, marketing, manufacturing and so on. 3plit 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. $f a functional product area cannot be made within the target costs, then a cost gap e-ists 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 techni'ues and close collaboration with suppliers, to enhance the product (in terms of service, 'uality, durability and so on" and reduce costs. Step <nce it is decided that it is feasible to meet the total target costs, detailed cost sheets will be prepared and processes formaliAed. Final Commentary on "arget 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. Life Cycle Pricing Eife cycle costing assists in the planning and control of a product2s life cycle by monitoring spending and commitments to spend during a product2s life cycle. Eife 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.

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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 product2s or pro(ect2s profitability on a periodic basis. Eife cycle costing, on the other hand, considers a product2s[pro(ect2s entire life. Eife cycle costing tracks and accumulates actual costs and removes attributable costs to each product or pro(ect over the entire product[pro(ect life cycle. The total profitability of any given products[pro(ect can therefore be determined. Traditional management accounting systems usually total all non.production costs and record them as a period e-pense. &sing life cycle costing, such costs are traced to individual products over complete life cycles. (a" (b" (c" (d" The total of these costs for each individual product can therefore be reported and compared with revenues generated in the future. The visibility of such costs is increased. $ndividual product profitability can be more fully understood by attributing all costs to products. As a conse'uence, more accurate feedback information is available on the organisation2s success or failure in developing products. $n today2s competitive environment were the ability to produce new and updated versions of products is paramount to the survival of an organiAation, this information is vital.

The strong force which supports life cycle costing is that generally for organiAations operating within the manufacturing technology environment, its found that appro-imately ?;8 of a product2s life cycle cost is determined by decisions made early within the cycle at the design stage. Eife cycle costing is therefore particularly suited to such organiAations and products, monitoring spending and commitments to spend during the early stages of a product2s life cycle. Eife 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 'uestion. #emember the product life cycle you learnt in management.

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$llustration of product life cycle

3ales revenue

introduction

growth

maturity

decline

sales

Time Other Pricing Methods 0rder Pricing A special order is a one.off revenue earning opportunity. These may arise in the following situations. (i" 0hen a business has a regular source of income but also has some spare capacity allowing it to take on e-tra work if demanded. For e-ample NkwaAi +reweries might have a capacity of 7;;,;;; barrels per month but only producing and selling 9;;,;;; barrels per month. $t could therefore consider special orders to use up some of its spare capacity. (ii" 0hen a business has no regular source of income and relies e-clusively on its ability to respond to demand.

A building firm is a typical e-ample as are many types of subcontractors.

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$n the case of (i" pricing for special orders need therefore take account of unavoidable fi-ed 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. 6owever, in the case of (ii" where the special order is the only source of income, all costs incidental to the special order and the fi-ed unavoidable cost should be incorporated in the special order pricing. %inimum 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" $t is based on 1relevant costs2 #elevant costs are incremental costs plus the opportunity costs of making and selling the product or providing a service. (b" $t is unlikely that a minimum price would actually be charged because if it were it would not provide the business with any incremental profit.

$f there are no scarce resources, and a company has spare capacity, the minimum price of a product would be an amount which e'uals the incremental cost of making it. $f there are scarce resources and a company makes more than one product, minimum prices would include an allowance for the opportunity cost of using the scarce resources to make and sell the product. %ar et Penetration Pricing enetration 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" 0hen the firm wishes to discourage new entrants into the market.

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(b" (c" (d"

0hen the firm wishes to shorten the initial period of the product2s life cycle in order to enter the growth and maturity stages as 'uickly as possible. 0hen demand is highly elastic and so would respond well to low prices. 0hen there are significant economies of scale to be achieved from a high volume of output.

%ar et 1 imming Pricing rice skimming involves charging high prices when a product is first launched in order to ma-imiAe short K term profitability. $nitially 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 1cream2 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 product2s life. 6igh unit prices makes it more likely that competitors will enter the market, that is if lower prices were to be charged. 3o market skimming pricing would be appropriate in the following cases. (a" (b" (c" 0hen 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. 0hen high prices in the early stages of a product2s life might generate high initial cash flows. A firm with li'uidity problems may prefer market.skimming for this reason. 0here products may have a short.life cycle, and so need to recover their development costs and make a profit relatively 'uickly. C-amples of products to which market skimming pricing policy could be applied would include latest versions of products such as (i" (ii" (iii" *alculator !ideo recorders Desktop computers and other technology based products.

Di""erential Pricing The use of differential pricing means that the same product can be sold at different prices to different customers. This can be very difficult to implement in practice because it relies for success, on the continued e-istence of certain market conditions.

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0e can e-ercise differential pricing on the following cases: (i" (ii" (iii" +y market segment e.g. services such as cinemas and hair dressing are often available at lower prices to (uveniles and old age pensioners. +y product version e.g. many car models have 1Add on2 e-tras which enable one brand to appeal to a wider cross.section of customers. +y 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. +y time e.g. this is perhaps the most popular type of differentiating pricing.

(iv"

C.g. *eltel charges less for its air time or credit in off peak period and vice versa. rice 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 Trans%erring >oods at marDet price A company has two profit centresD A and +. *entre A sells half of its output on the open market and transfers the other half to +. *osts and e-ternal revenues in a period are as follows. A + Total :2;;; :2;;; :2;;; C-ternal sales =,;;; 45,;;; 94,;;; *osts of production /4,;;; /;,;;; 44,;;; *ompany profit /;,;;; Required 0hat are the conse'uences of setting a transfer price at market priceS $f the transfer price is at market price, A would be happy to sell the output to + for :=, ;;;, ;;;, which is what A would get by selling it e-ternally. A :2;;; :2;;; %arket sells Transfer sales Transfer costs =,;;; =,;;; />,;;; =,;;; + :2;;; :2;;; 45,;;; . 45,;;; Total :2;;; 94,;;;

@/

<wn costs rofit

/4,;;; /4,;;; 5,;;;

/;,;;; /=,;;; >,;;;

44,;;; OOOOO /;,;;;

"$e conse.uences, t$erefore, are as follo/s; (a" (b" A earns the same profit on transfers as on e-ternal sales. + must pay a commercial price for transferred goods. A will be indifferent about selling e-ternally or transferring goods to + because the profit is the same on both types of transaction. + can therefore ask for and obtain as many units as it wants from A.

Ad'usted %ar et Price $nternal transfers in practice are often cheaper than e-ternal sales, with savings in selling and administration costs, bad debt risks and possibly transported,delivery costs. $t would seem reasonable for the buying division to e-pect a discount on the e-ternal market price. $f profit centres are established, however, and unit variable costs and sales price are constant, there are two possibilities. (a" (b" 0here the supplying division has spare capacity the ideal transfer price will simply be the standard 9ariaCle cost o% production7 0hen 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.

#ost2*ased approaches to trans"er pricing CostJCased approaches to trans%er pricing are often used in practice, because there is often no e-ternal market for the product that is being transferred or because, although there is an e-ternal market, it is an imperfect one because there is only limited e-ternal demand. Trans%er prices Cased on %ull cost &nder this approach the full standard cost (including fi-ed overheads absorbed" that is incurred by the supplying division in making the product is charged to the receiving division. $f a full cost plus approach is used, a profit margin is also included in this transfer price.

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A company has 4 profit centers, A and +. *entre A can only sell half of its ma-imum output e-ternally because of limited demand. $t transfers the other half of its output to + which also faces limited demand. *osts and revenues in a period are as follows. A + Total :2;;; :2;;; :2;;; C-ternal sales =,;;; 45,;;; 94,;;; *osts of production in the division /4,;;; /;,;;; 44,;;; (Eoss", rofit (5,;;;" /5,;;; /;,;;; $f the transfer price is at full cost, A in our e-ample would have 1sales2 to + of :>,;;;,;;; (i.e. half of its total costs of production". This would be a cost to +, as follows.

A :2;;; <pen market sales Transfer sales Total sales, inc Transfers Transfer costs <wn costs Total costs, inc Transfers rofit :2;;; =,;;; >,;;; :2;;;

+ :2;;; 45,;;; .

Total :2;;;

/5,;;; /4,;;; /4,;;; 4,;;;

45,;;; >,;;; /;,;;; />,;;; =,;;; OOOOO /;,;;;

The transfer sales of A are self.cancelling with the transfer costs of + so that total profits are unaffected. The transfer price simply spreads the total profit of :/;,;;;,;;; between A and +. 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. Trans%er prices Cased on %ull cost plus $f the transfers are at cost plus a margin of, say, 478, A2s sales to + would be :@,7;;,;;;. A + :2;;; :2;;; :2;;; :2;;; <pen market sales =,;;; 45,;;; Transfer sales @,7;; . /7,7;; 45,;;; Transfer costs @,7;;

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<wn costs rofit

/4,;;; /4,;;; 9,7;;

/;,;;;

44,;;; /@,7;; >,7;;

*ompared to a transfer price at cost, A gains some profit at the e-pense of +. 6owever, A makes a bigger profit on e-ternal sales in this case because the profit mark.up of 478 is less than the profit mark.up on open market sales, which is (:=,;;;,;;; K :>,;;;,;;;", :>,;;;,;;; H 998. The transfer price does not give A fair revenue or charge + a reasonable cost, and so their profit performance is distorted. $t would seem to give A an incentive to sell more goods e-ternally and transfer less to +. This may or may not be in the best interests of the company as a whole. Division A2s total costs of :/4,;;;,;;; will include an element of fi-ed costs. 6alf of division A2s total costs are transferred to division +. 6owever from the point of view of division + the cost is entirely variable. 3uppose that the cost per unit to A is :/7,;;; and that this includes a fi-ed element of :>,;;;, while division +2s own costs are :47,;;; per unit, including a fi-ed element of :/;,;;;. The total variable cost is really :?,;;; I :/7,;;; H :45,;;; but from division +2s point of view the variable cost is :/7,;;; I :/7,;;; H :9;,;;;. This means that division + will be unwilling to sell the final product for less than :9;,;;; whereas any price above :45,;;; would make a contribution. Changes in price le9els *hanges in price levels are a common scenario in the operations of company. The change in the price levels may be due to e-ternal 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 company2s products or services. $t is important to relate the price changes to both production costs and selling price of the product or service. 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. 3ince price level changes represent decision.making under conditions of risk and uncertainty, it is important to analyse the e-pected outcome for each price level. Any price change is bound to affect the demand and therefore the variable costs giving varying possible outcomes. Example %wine manufacturing company has come up with a new soap product, +uta detergent. From the preliminary studies the following analysis has been madeD

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3elling price : =,7;; <utcomes Demand robable 5;,;;; Eess robable 9;,;;; %ost robable >;,;;; Outcomes

3elling price : /;,; robability Demand ;.> 7;,;;; ;./ 4;,;;; ;.9 9;,;;;

robability ;./ ;.7 ;.5

At 3elling rice : =,7;;

Demand 5;,;;; =;,;;;,;;; ?;,;;;,;;; 9;,;;; >;,;;;,;;; /=;,;;;,;;; >;,;;; /4;,;;;,;;; 7;,;;;,;;; @;,;;;,;;; /5,@;;,;;; 79,7;;,;;; 7;,;;;,;;; /;,;;;,;;; @;;,;;; //,@;;,;;; 7;,;;;,;;; /9;,;;;,;;; 7;,;;;,;;; 7;,;;;,;;; 9;,;;;,;;; 5;,;;;,;;; /4,>;;,;;; /,4;;,;;; *ontribution Fi-ed *ost /4;,;;;,;;; 7;,;;;,;;; Net rice @;,;;;,;;; C-pected !alue /4,>;;,;;;

At 3elling rice : /;,;;; C-pected

Demand 7;,;;; /@7,;;;,;;; ?;,;;;,;;; 4;,;;; @;,;;;,;;; /97,;;;,;;; 9;,;;; /;7,;;;,;;; 7;,;;;,;;; 77,;;;,;;; /7,5;;,;;; 74,>;;,;;; 7;,;;;,;;; 7;,;;;,;;; 4;,;;;,;;; =7,;;;,;;; @,;;;,;;; /;,4;;,;;; 7;,;;;,;;; 7;,;;;,;;; /47,;;;,;;; 5;,;;;,;;; =,@7;,;;; >,;;;,;;; *ontribution 447,;;;,;;; Fi-ed *ost 7;,;;;,;;; Net rice /@7,;;;,;;; !alue 7,47;,;;;

From the outcome it is evident that chosing the selling price of : =7;; gives a higher e-pected value, even though the difference is not so significant. $n 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. Transfer Pricing Theory

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This is the price at which goods and services are transferred between different units of the same company. $f those business units are located within different countries, the term international transfer pricing is used. Transfer prices are a way of promoting divisional autonomy, ideally without pre(udicing the measurement of divisional performance or discouraging overall corporate ma-imiAation. The management accountant therefore has to devise a transfer pricing method that meets the following criteria: C'uity (provides a fair measure of divisional performance" Neutrality (avoids the distortion of business decision making" Administrative simplicity

The transfer price should provide an UartificialV 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 1commerciallyV. This means that the transfer price should be a fair commercial price. "ransfer pricing /it$ a constant unit 0aria1le costs and sales price: An ideal transfer price should reflect the opportunity cost. 0here a perfect e-ternal market e-ists and unit variable costs and sales are constant, the opportunity cost of transfer will be one or other of the following C-ternal market price C-ternal market price less savings in selling costs.

Example A company has two profit centers, A and +. *enter A sells half of its output on the open market and transfers half to +. *osts and e-ternal revenues in a period are as follows. A : C-ternal sales *osts of production *ompany profits Required @> =,;;;,;;; /4,;;;,;;; + : 45,;;;,;;; /;,;;;,;;; Total : 94,;;;,;;; (44,;;;,;;;" 0,5,,,5,,,

0hat are the conse'uences of setting a transfer price at the market priceS Trans%er prices Cased on 9ariaCle 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 A2s cost per unit is :/7,;;;, of which :>,;;; is fi-ed and :?,;;; variable. A + :2;;; :2;;; :2;;; :2;;; %arket sales =,;;; 45,;;; Transfer sales at variable cost 9,>;; OOO . (?,;;; ,/7,;;; - >,;;;" //,>;; 45,;;; Transfer costs 9,>;; <wn variable costs @,4;; >,;;; <wn fi-ed costs 5,=;; 5,;;; Total costs and transfers /4,;;; /9,>;; (Eoss", rofit (5;;" /;,5;; The problem is that with a transfer price at variable cost the supplying division does not cover its fi-ed costs. Trans"er prices *ased on opportunity costs $t has been suggested that transfer prices can be set using the following rule. Trans%er price per unit H standard 9ariaCle cost in the producing division plus the opportunity cost to the organiAation of supplying the unit internally. The opportunity cost will be one of the following. (a" (b" (a" The ma-imum contriCution %oregone by the supplying division in transferring internally rather than selling e-ternally The contriCution %oregone by not using the same facilities in the producing division for their ne-t best alternative use $f there is no e-ternal market for the item being transferred, and no alternative uses for the division2s facilities, the transfer price H standard variable cost of production $f there is an e-ternal market for the item being transferred and no alternative use for the facilities, the transfer price H the market price.

(b"

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Trans"er pricing -hen unit $aria*le costs and sales prices are not constant 0hen unit variable costs and,or unit selling prices are not constant there will be a profit. ma-imising level of output and the ideal transfer price will only be found by careful analysis and sensible negotiation. (a" (b" The starting point should be to establish the output and sales 'uantities that will optimise the profits of the company or group as a whole. The ne-t step is to establish the transfer price at which both profit centers, the supply division and the buying division, would ma-imiAe 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 ma-imiAe their individual profits and the profits of the company as a whole. Any price within the range would then be 1ideal2.

(c"

Pro*lems in trans"er pricing (a" $f transfer prices are set at %ull cost, the transferring division makes no profit. (b" $f %ull cost plus is used the problem is how to set the margin at a level that all parties perceive as being fair. (c" $f 9ariaCle cost is used the transferring division does not cover its fi-ed costs but two.part prices (the variable cost transfer price plus a fi-ed 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" <n the other hand, standards may become out of date so it is advisable to have an agreement to revise them periodically. Negotiated trans"er prices 0hen authority is decentraliAed to the e-tent that divisional managers negotiate to transfer prices with each other, the agreed price may be finaliAed from a mi-ture of accounting arithmetic, politics and compromise. $nter.departmental disputes about transfer prices are likely to arise and these may need the intervention of head office to settle the problem.

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(a" @ead o%%ice imposition. 6ead office management may impose a price that ma-imiAes the profit of the company as a whole. (b" <n the other hand, head office management might restrict its intervention to the task of Deeping negotiations in progress until a transfer price is eventually settled. 0here 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" Identi%?ing the outer Counds o% the trans%er price. $n 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 profitS (b" )ariaCilit?. At each transfer price, compare each division2s e-pected profits and the variability of the profits. (c" $ncorporate risD attitudes in a fair transfer price, so that the profit.share between divisions takes the riskiness of the pro(ect into consideration. International trans"er prices 0hen firms transfer goods and services not only internally, but also internationally, the transfer price mechanism allows them to mo9e 9alue %rom one countr? to another without actually engaging in trade. +earing in mind the difficulty discussed above of establishing the level at which a transfer price should be set, we may say that a 1low2 price effectively moves value into the receiving country, while a 1high2 one moves it into the transferring country. !sing trans"er prices This ability to decide in which country value (and particularly profit" is created is e-tremely useful. (a" (i" (ii" (iii" (b" (c" $t can be used to manage taxationN rofit can be minimiAed in states with high profit ta-es 3elling prices can be minimiAed in states with high levels of irrecoverable !AT (and similar ta-es" The value imported into countries with high tariff levels can be minimiAed $t can be used to mo9e pro%its to the home countr? from states with restrictions on repatriation of profits or on currency e-change. $t can be used strategically

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(i" (ii"

$t can disguise the attracti9eness of an operation to competitors by reducing profits. $t can enable a lowJprice strateg? aimed at dri9ing out competition without arousing the suspicions of the local ta- authorities by declaring a very low level of profit. 6owever, this course of action is likely to lead to accusations of dumping.

#entrally determined trans"er 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" #utonom?. *entrally determined transfer prices can seriously affect the ability of national managers to in%luence the per%ormance o% their di9isions. 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 aper 7 but it is also relevant to aper >. $n terms of transaction cost economics, a centrally determined, non.market based transfer price makes an implicit assumption that the hierarch? solution is the best one. 6owever, 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 approach. The crucial 'uestion is whether the business should actually be operating any given national subsidiary at all, whether its services should be bought in.

(b"

The 4ccles matri/ R J Eccles suggests that the method of setting transfer prices should reflect the organisation2s degree o% di9ersi%ication and its degree o% 9ertical integration. (a" (b" 0here both diversification and integration are low, as, for e-ample, in the relationship between two shops in a retail chain, a transfer price may not even be re'uired, but if it is, it can be set collaboratively. 0here diversification is low, but vertical integration is high, as in the relationship between two different stages of product assembly, co.operation 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 division2s costs are covered.

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(c"

0here 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 subsidiary2s trade.

Nevertheless, where diversification and integration are both high, as may be the case when there is e-tensive trade along a supply chain combined with similarly e-tensive market.based e-changes, once again, the transfer price should be set collaboratively.

Chapter *
C(ST ANAL)SIS
Learning outcomes After studying this chapter, a student would be able to understand the behaviour and reduction of costs in both traditional and advanced manufacturing environments. The chapter in particular looks at: the learning curve in theory and practice the e-perience curve 1traditional2 cost.reduction methods focused cost.reduction programmes value.added and non.value.added activities =/

Aero.base budgeting systems ( value analysis (!A" value engineering (!C" functional analysis target costs and costing cost tables life cycle costing life cycle budgeting

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INTRODUCTION The well.known economists2 short and long.run cost 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 processesD 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 e-cessive demands are placed on a particular plant, illustrating the economist2s 1law of diminishing marginal returns2 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 fi-ed 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, referred to as economics of scale. The economists2 diagram is a static representation of costs, given a particular set of materials, technologies etc. $t is accepted in economics that not all firms will en(oy the same level of success in actually attaining the minimum cost levels possible for a particular negotiated bulk discounts with suppliers, but firms can e-perience 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. 3imilarly, the economist2s 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 'uickly follow suit, but may be permanent if it allows the innovator to cut prices and gain market share at the e-pense of slower moving competitors, who may be driven out of business as a result. $t will always be beneficial for a firm to be able to produce goods at a lower cost than the competition and firms will therefore strive constantly to achieve cost reduction. The *$%A Te !"#olo$% defines cost reduction as:

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1the reduction in unit cost of goods or services without impairing suitability for the use intended2. As the economists cost curves indicate, a reduction in unit cost can be achieved simply by increasing the volume of production. $n the present conte-t, 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. $n reality, many firms have a less than 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. $f companies are able to reduce total cost, whilst maintaining current output, cost reduction will certainly have been achieved. $f output is increased, but there is also an increase in cost, the position is less clear. $f 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. 6owever, this may not reflect a great achievement on the party of the company: the cost reduction may simply have arisen as an inevitable conse'uence of the economies of scale, which the increased production has facilitated. $f an e-panding 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 conse'uence of increased volume, and those which arise through management action. %anagement 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. <ne of the economies of scale en(oyed by firms as output increases may be attributable to the 1learning curve2. This phenomenon, known as the 1cost reduction curve2, is discussed below.

T@E LE#RNIN> CUR)E

THE NATURE OF THE LEARNIN& CURVE

According to learning curve: 1The mathematical e-pression of the phenomenon that, when comple- 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 time2. The recognition of the so.called learning curve phenomenon stems from the e-perience of aircraft manufacturers, such as +oeing, during 0orld 0ar $$. They observed that the time taken to assemble an individual aircraft declined as the number of aircrafts assembled: as workers gained e-perience of the process, their proficiency, and hence speed of working increased. The 1learning2 gained on the assembly of one plane was translated into the faster assembly of the ne-t. (This is phenomenon to which any reader who has never put together a number of flat.pack items of furniture will readily relate". =9

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. $t was found that cumulative average time per unit decreased by a fi-ed percentage each time the cumulative production doubled. $n the aircraft industry, the percentage by which the cumulative average time per unit declined was typically =; percent. 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. Eet us take as an e-ample a learning rate of ?; percent. $n this case, if the first batch of a product is produced in /;; hours, the cumulative average time taken to produce two batches (a doubling of the cumulative production" would be ?; hours giving a total production time of 4; - ?; H /=; hours. The actual time taken to produce the second batch (the batch being the unit of measure in this case" will thus be =; hours the cumulative total time taken to produce two batches K =; hours K less the time taken to produce the first batch./;; hours. As a doubling of cumulative production is re'uired, 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.

.I>URE 470 CU8UL#TI)E D#T# >R#!@S *umulative data graph Eog of cum. average time per batch, hours

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Eog of no. of batches (or units" $n constructing table /, it was assumed that we already knew the learning rate, which applied to this particular situation. 6owever, it must be appreciated that, in the real world, this rate can only be established by observation. #ecords must be kept of the number of units,batches produced and the associated time taken, in order to construct the e'uivalent of Table / (although it is likely that fewer observations would actually be taken". $t is then the (ob of the engineer or accountant to deduce the learning rate from these observations, which will re'uire the specification of an e'uation to fit the data. For e-ample, the observation in Table / is plotted in Figure 9./, and can be described by the e'uation: B- H aGb C'n / 0here: (i" (ii" (iii" (iv" B- is the cumulative average time per unit, batch taken to produce a *umulative numbers of units, batches GD 1a is the time re'uired to produce the first unit,batchD G is the cumulative number of units,batches under consideration The e-ponent 1b2 is the inde- of learning.

This is known as the cumulative average.time learning model. *onsideration of the formula in e'uation / shows that it is the value of 1b2 which determines the shape of the learning curve. $f no learning effect were present, the time taken to produce any unit would be e'ual to the time re'uired to produce the first unit, i.e. B- H a And the learning 1curve2 would be a straight line, as all units would take the same timer to produce. *onsideration of e'uation / shows that this can only be true if GbH/. And, as -, by definition, is greater than / for all e-cept the first unit, b must e'ual ; if Gb is to e'ual /(G;H/", i.e. no learning is present. Any value of b greater than ; would result in B- increasing as - 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 Aero, i.e. b must be a negative number. $f we assume that a positive learning effect is present, at one unit,batch of outputD B/Ha *onsider now the effect of doubling the output, i.e. G H 4, then

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B4HB/- learning rate andD B4 H a - learning rate +ut from C'uation/, B4Ha4b, thereforeD A - learning rate H a4b Eearning rate H4b Eog (learning rate"Hb (log4" Therefore bHlog (learning rate" Eog4 3o, for a ?;8 learning rate, bH log ;.? log 4 All numbers less than Aero have a negative logarithm, while all numbers greater than Aero 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: BH 0here: (i" (ii" (iii" (iv" B is the average time taken per unit,batch to produce a cumulative number of units,batches 1a2 is the time re'uired to produce the first unitD - is the cumulative number of units to be producedD 1+2 is the coefficient of learning. a G\

The + in the Terminology is thus e'ual to.b in C'uation /, and the two formulae are mathematically e'uivalent (students should note that, in e-aminations, yet another variant of C'uation / is often given, i.e. the learning curve is e-pressed as". a B H -n $n this case, n is e'ual to both + as defined in the Terminology and Kb as in C'uation /. Eet us apply the formula in C'uation / to the operations of the manufacturer whose data is recorded in Table / and whose learning rate is ?; per cent, by checking the cumulative average time which we would e-pect will be necessary to produce >5 batches: B- H aGb C'n (/"

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b H log ;.? H .;./74; log 4 B- H aG.;./74; B- H/;; - >5 .;./74; B- H 79./5 0hich agrees with Table / above. $n the e-ample above, 1b2 e'uals K;./74;, giving learning rate of ;.?;. The learning rate can take any value, but only values of less than one imply that learning is taking place. Eearning rates greater than / imply that the time taken per unit,batch is increasing as production increases, a value of e-actly / 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. C'uation / is not normally used to check earlier calculations in the way that we have (ust done, but is rather used to assess the time which will be re'uired 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 e-ample, let us assume that the manufacturer above has the opportunity to bid for a contract to produce /; 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. $f the cumulative total production of his product to date is 94 batches e'uation / can be employed to calculate the cumulative average time per batch to produce 54 batches K the 94 already produced plus the /; under consideration: B- H aGb B- H /;; - 54 .;./74; B- H/;; - ;.7>>> B- H 7>.>> i.e. the average time per batch to produce 54 batches is 7>.>> hours, giving a total production time of 7>.>> - 54 H 4,9=; hours. $nspection of Table / above reveals that the average time per batch to produce 94 batches is 7?.;7 hours, with a total production time of /,=?; hours. The total time taken to produce the /; batches under consideration will thus be 4,9=; K /,=?; H 5?; hours, i.e. an average time of 5? hours for each of the batches 99 to 54. This may be compared with the average of (9,5;/ K /,=?;",94 H 5@.4; hours indicated by Table / for the ne-t doubling of a full 94 batches from 99 to >5. obviously, if the current level of production does not lie on a table such as Table /, that particular average time, and the corresponding cumulative hours to date, will need to be calculated from the same formula.
USES O. T@E LE#RNIN> CUR)E

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$n circumstances where the learning curve is likely to operate i.e. in compleassembly operations, knowledge of the rate of learning can help in price setting. 0hen setting budgets, the effects of the learning curve should be taken into account. 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: . . . Eearning curves chart the reduction in time per unit as e-perience is gainedD they do not measure a reduction in cost per se. 6owever, if hourly wages are constant, the labour cost per unit will decline as a result of the learning curve phenomenon. $n 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 e-pected to decline as a result of the learning curve. Eearning is likely to be greatest in comple- assembly environments, of which aircraft assembly is a prime e-ample. $f 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 e-ist. 6owever, the e-perience which plant managers gain in scheduling work in such an environment may result in a reduction in the direct labour hours re'uired for a given level of production. The learning rate, which is a function of workers2 learning, is not something which can be positively fostered as a cost Kreduction techni'ue.

T@E E:!ERIENCE CUR)E

$t has been stressed that the learning curve was derived from observations of the reduction in direct labour time taken to complete successive repetitive but compleassembly tasks that have fre'uently been determined by fitting curves to total tasks. 6owever, learning rates have fre'uently been determined by fitting curves to total cost per unit data. For e-ample, Depuy (/??9" used this method to ascertain for the &3 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 e-pressed in constant dollar terms, and thus was not distorted by changing price levels. The slope of the learning curves derived ranged from ;.@/= to /.;4/, with a mean of ;.=7=. This data suggest that defence contractors typically en(oy a reduction of /5 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 1e-perience curve2, rather than the learning curve as strictly defined. The 1e-perience curve2 e-tends the learning curve approach to areas other than direct labour. #ather than relating indirectly to cost via time, an e-perience curve relates directly to cost, and is a function which shows how total cost per unit declines as output increases. Total cost in e-perience curves includes all overhead types K production, marketing and distribution K

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and thus cost reductions arising from factors such as factory siAe, production, technology, substitution of materials and design modifications are reflected in an e-perience curve. C-perience 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 ]apanese, is that these curves should be taken as an e-pression of what is desirable, and hence what should be striven for. The improvement Koriented ]apanese typically aim actively to foster a >@ per cent learning curve, as against the =; per cent curve more usually found in the 0est. %oses (/??/" has pointed out that the accounting policies adopted by companies can have a significant impact on learning rates derived from e-perience curves, and so the results must be treated with caution. Cost Reduction
INTRODUCTION

An appreciation of the relationship between cost and volume is important in many business decisions, of which pricing is a prime e-ample. 0hen average total unit cost is measured against volume, a measurement is being made which allows a long.run average cost curve to be graphed. 0here learning or e-perience curves are used to predict future costs, there is an implicit assumption that the e-perience 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. $ndeed, knowing that the learning curve has led to cost reductions in the past could give rise to a dangerous complacency on management2s 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. <rganisations 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. <bviously, the scope for cost reduction will be dependent on the type of cost under consideration, and the time scale involved. 5Traditional6 #ost2Reduction Programmes 1Traditional2 cost reduction programmes have been characteriAed as 1a collection of crash programs that focus on cutting costs by reducing payrolls and eliminating (obs2 (shields and Boung (/??4". $t is suggested that such programmes are typically triggered in reaction to an immediate threat, such as poor performance, loss of contracts, or price reductions K 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 ob(ective. Fisher (/??/" cites two surveys on this point: half the managers in the first survey (representing corporations accounting for 4> per cent of &3 TN " said that the cost Kcutting or restructuring programmes had failed to meet their ob(ectivesD the =?

second survey of managers from /,;;7 corporations found that more than half the corporations had failed to meet their cost K reduction targets. %arket pressure to reduce costs could lead companies to attempt a 1blanket2 approach to cost cutting, particularly for overheads. For e-ample, in an attempt to reduce costs by, say 7 per cent, a company may take a decision to cut all departmental budgets by the same 7 per cent. This might achieve some short Kterm savings but it is likely to be at the e-pense of the long.term health of the organisation. A blanket cut will affect all activities e'ually, which means that some areas which were of value to customers will inevitably suffer. $n a commercial organisation, this will lead to some loss of business, which may lead to an increase in unit cost, as fi-ed overheads (albeit reduced by 7 per cent in our e-ample" are spread over a smaller number of units sold. A successful cost reduction programme will seek to reduce the unit cost of the good or service at all volumes of output. This can be achieved by reducing either direct costs or overhead costs, and ideally reducing both, but without destroying value to the customer. The blanket cut strategy to achieving this is ineffective in the long term. Firms must adopt approaches which enable them to pinpoint and realiAe specific opportunities for cost savings. 4/amination o" #urrent Acti$ities The starting point for cost reduction programmes often is the e-amination of e-isting activities. Any organisation can be seen as a collection of activities designed to lead to a desired result. $n 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 company2s consumption of resources is e-cessive. C-amination of current operations may reveal that this over Kconsumption of resources arises from one or a combination of the following three reasons: /. <ver K resourced activities 4. $nefficiently managed activities 9. &nnecessary (non.value added,diversionary" activities Cach of these reasons will be looked at in turn and the effectiveness of a blanket cut in resources to achieve cost reduction in these circumstances will be considered. 0$er2Resourced Acti$ities An activity is over Kresourced when the same ob(ective could be achieved with less resource consumption. For e-ample, in a production department, shop floor manning levels may have remained within the same processes. The current position may be one in which a separate operative is assigned to each machine. 6owever, if the process re'uires 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.

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A blanket cut in resources may provide the spur to such reorganiAations, although the industrial relations implications of reduced staffing levels may make attainment of the most cost. effective arrangement difficult to achieve. Ine""iciently %anaged Acti$ities Activities are inefficiently managed when current standards of achievement are not being attained. Eoss of material through pilferage, e-cessive overtime working necessitated by poor production scheduling and e-cessive time spent on rework through failure to identify problems at the earliest opportunity would all provide e-ample which highlight variances from standards. #egular monitoring will identify these deficiencies and should lead to their elimination. 6owever, a blanket cut in resources may provide an additional impetus to improvement. Value Added and Non2Value Added Acti$ities The concept of a value. added activity revolves around the customer. !alue 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 conse'uence of, and are sustained, by, a company2s e-isting policies and organisational structure. $t is only possible to eliminate such non. value added activities if changes are made to the current policies and structure. For e-ample, 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 department2s activities will increase the costs of the business, but are non. value added as far as the consumer is concerned. The e-istence 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. 6owever, 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. roblems with products are thus both a cost to company and an inconvenience to the costumer. 3elf 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 'uality of the materials used and the manufacturing processD 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. $f 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 customers. customers 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

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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 e-istD (b" the services they provideD (c" there relationship to other areas of the business. $n other words, it is necessary to adopt a cross.functional attitude to the e-amination of the business processes. Activity.based cost management adopts this approach, as we shall see in the ne-t chapter. <ther approaches to overhead cost reduction, which eliminates the disadvantages of blanket approach to cost, cutting, is Aero.base (priority.base" budgeting, to which we now turn. 7ero2,ase ,udgeting Eike all budgeting techni'ues, Aero.base budgeting (Q++" is designed to be used in setting levels of future e-penditure. As all cost reduction techni'ues 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 ine-tricably entwined. The Terminology defines Aero.base,priority.base budgeting as: 1A method of budgeting which re'uires each cost element to be specifically (ustified, as though the activities to which the budget relates were being undertaken for the first time. 0ithout approval, the budget allowance is Aero2. The reference to 1funds available2 is particularly pertinent in public sector organisations, where funds are determined by ta- revenues and government grants and allocations, i.e. the income of the organisation, is e-ogenously set. The aim of the fundholder is to achieve the best service levels possible within the given budget. $n traditional budgeting, e-isting e-penditure levels form the base line for discussions about future e-penditure. $mplicit in the traditional approach is an assumption and acceptance that current e-penditure is adding value to the customer, and the focus of its attention is simply the (ustification of any proposed increases in the e-penditure K it therefore adopts an incremental philosophy to budgeting. The re(ection of this base line as a starting point is what gives Aero.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 re'uires all activities to be (ustified and prioritised before the decision to devote resources to particular ones is taken. All activities are sub(ected to the most basic scrutiny and answers sought to such fundamental 'uestions as:

?4

(a" 3hould the activity be undertaken at allS (b" $f the company undertakes, how much should be done and how well should it be done (for e-ample, should an economy or a de.lu-e service level be provided"S (c" 6ow should the activity be performed. in house or sub KcontractedS (d" 6ow much would the various alternative levels of service and provision costS $n order to answer these 'uestions, all e-isting and potential organisational activities must be described and evaluated in a series of 1decision packages2, giving the following four. step process to a Q++ e-ercise: /. Determine the activities, which are to be used as the ob(ect of decision packages K the provision of home support for the elderly or provision of catering facilities for the work force, for e-ample . and identify the manger responsible for each activity. 4. #e'uest the managers identified in (/" above to prepare a number of alternative decision packages normally re'uested: one which sets out what could be delivered =; per cent of the current level and one for an enhanced level of funding, (e.g. /4; per cent of the current level". 9. #ank the decision packages in order of their contribution towards the organisation2s ob(ectives. 5. Analyse alternatives, and go for these those with the greatest cost benefit in term of the ob(ectivesD 7. 3ystematically implement the selected alternatives.

3ome e-planation of these steps is necessary. Cffectiveness can be (udged only against predetermined benchmarks set by the organisation. Bet the activities performed by public Ksector and not.for.profit organisations are often difficult to measure in a tangible way, and can take several years to be measurable, while re'uired to overcome these difficulties. %any 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 'uestions regarding the legitimacy of casual relationships when measuring these results: particular outcomes could be brought about by the actions of more than one programme, given the nature of public Ksector and not for profit organisations and their ob(ectives. <n a more positive note, one feature of +3 that should be particularly beneficial is that managers making budget re'uests are e-pected to be able to state clearly what would happen if their re'uests were cut by, say /; 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 e-ample, or re'uire that the grass in public parks be cut every ten days instead of once a week. This feature of +3 is, in its result, somewhat similar to Q++, since different levels of service are associated with each level of re'uested funding.

?9

The interest in +3 probably owes much to an increasing public demand for accountability by public and other not.for.profit organisations: ta-payers appear to have become dissatisfied with the performance of central and local government agenciesD and donors to charitable causes have e-pressed concern about the proportion of contributed funds devoted to administrative e-penses. +3 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 #lpha >roup The Alpha 3ufferers Troup is a national charity offering support to sufferers and funding medical research. Bou have been invited to attend a trustees2 meeting at which the following report on this year2s performance and ne-t year2s 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 1programme K planning budgeting system2 and wonders if it would be useful in their not.for profit.organisation. *riticise the current method of budgeting and e-plain the application (give specific e-amples" and possible advantages of +3 to such an organisation. /?G9 Actual /=,;;; 4;;,;;; 55;,;;; >7=,;;; >;,;;; =,;;; 99,;;; 54,;;; 94;,;;; /4,;;; 49;,;;; 49;,;;; @97,;;; /?G5 Actual

+udget $ncome 3ubscription Donations received Fund K raising C-penditure Cmployees remises <ffice e-penses Administration #esearch rinting #oom #ental Donations made 4;,;;; />;,;;; 7;;,;;; >=;,;;; >;,;;; =,;;; 4=,;;; 9;,;;; 9;;,;;; 47,;;; /7,;;; 4;;,;;; >>>,;;;

+udget

4;,;;; 44;,;;; 5=5,;;; @45,;;; >;,;;; =,;;; 9;,;;; 5;,;;; 97;,;;; 47,;;; /7,;;; 4>;,;;; @==,;;;

C-cess of income over e-penditure /5,;;; @@,;;; (>5,;;;" Timing and Focus o" #ost 3 Reduction Programmes

?5

$t is a-iomatic that, in searching for cost savings, the greatest effort should be e-pended in investigating those costs which provide the greatest opportunities for savings. 6owever, these opportunities are related to time. As +erliner and +rimson (/?==" have pointed out, and as Figure 9.9 illustrates, up to ?; per cent of a product2s costs will be fairly limited for an e-isting 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. rogrammes 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. #ather than aiming to meet the manufacturer2s own internal specification at least cost, they involve a thorough e-amination of customer re'uirements, in order that these can be satisfied at least cost. <ne techni'ue of cost reduction, which recognises the importance of concentrating effort on the design and conceptual stage, is 1value analysis2 (also known as 1value engineering2", which is discussed below.

COST CONTROL *ost 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. $n order to come up with an effective cost control system, a methodical approach is re'uired. To this effect, the following approach can be used: Stage 0 Target Setting Any cost control system re'uires targets to be fi-ed for costs. The target so set must, however, be revised continuously in order to keep them in line with the current cost efficiencies. Stage 6 8easure the #ctual Results There must be an effective and up.to.date system to measure actual results. The actual results should be measured as fre'uently as possible. Stage 4 Comparison Cetween Targets and #ctuals

?7

This stage involves comparing the targets with the actuals. $t is important that any differences between the targets and the actuals are analysed into sufficient details. #easons for the differences must be identified. Stage 1 Identi%?ing the causes %or the di%%erences Stage ' #ction to pre9ent 9ariances 6aving 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. The common types of cost control systems are the budgeting control systems and the standard costing systems. Value Analysis The disruption of normal supply lines to American manufacturers in 0orld 0ar $$ necessitated a search for substitute materials and alternative designs. !alue analysis (!A" evolved as a result of these e-periences. The approach was championed by Teneral Clectric of America, and is associated with two employees in particular: 6arry Crlicher and Eawrence %iles. Crlicher, 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 cost. At the ceassation of hostilities, therefore, he decided to maintain and institutionalise the search for substitute materials and methods. $n /?5@, the task of putting this into practice was assigned to %iles, who was then a staff engineer. The result was value analysis, which combines a number of pre.e-isting techni'ues with its own particular procedural approach. Teneral Clectric adopted the approach as a company standard, and it was subse'uently taken up by other companies and organisations, including the American military. $n /?75, the Navy +ureau of 3hips, aided by %iles set up a !A programme, in which the term (!C" rather than 1value engineering programme was established in /?7> by the Army <rdnance corps, and the Air Force began investigating the techni'ue in /?>/, having been stimulated by the success of suppliers, such as Teneral Clectric, in its operation. $ndeed, the &3 Defence Department became so convinced of the benefits to be gained from !C that 3ecretary of Defence %cNamara referred to it in /?>4 as a key element in the drive to reduce defence costs. The Armed 3ervice rocurement #egulations made the use of !C mandatory, and defined it as: 1 A systematic effort directed at analysing the functional re'uirement of the Department of Defence systems, e'uipment, facilities and supplies for the purpose of achieving essential functions at the lowest total cost, consistent with the needed performance, reliability and maintainability2.

?>

This definition can be seen to be consistent with the *$%A Terminology definition of 1value analysis2, which is taken from +3 9/9=: Although the term 1value engineering2 is used by purists to refer to the applicant of the ideas of value analysis, %iles used the two terms synonymously, and they will be treated as such throughout the remainder of this chapter. The techni'ue is regarded primarily as a means of achieving cost reduction, and can be applied to e-isting or new products at any stage of the life cycle. 6owever, 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 !A offers the greatest cost reduction opportunities.

.igure 476 OOOOOOOOOOOOOO A *ost content attributable to the product A.* %inimum amount that must be spent to make the product + 0ork added by &nnecessary design and specification features

!alue analysis Aone

?@

Total cost Associated with the product (under absorption system" A.D D

0ork added by inefficient methods of manufacture

%ethod study Aone

<verhead carried because man or machine or both are

roduction control Aone

$n the search for cost reduction, the concept of minimum cost is a dynamic, not a static one. $t alters with changes in design, volume, materials and technology etc. Figure 9.4, adapted from Tage (/?>@", provides a useful description of the focus of a number of cost. reduction techni'ues. There is a strong inter.relationship between the Aones in Figure 9.4, 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 K the value analysis Aone K and until the method of manufacture. A simultaneous consideration of the two (1simultaneous engineering2" is likely to lead to lower Kcost solutions rather than a se'uential consideration (1over.the. wall engineering2". !alue analysis seeks to facilitate this simultaneous approach. $t aims to ensure that the product brief is tightly specified, in terms of the functionality re'uired, and that design and production engineers not only understand the brief, but contribute simultaneously to it. A team approach is thus crucial to the !alue Analysis philosophy. The !alue Analysis team must ponder the following si- basic 'uestions when applying !alue Analysis to any product or service:

/. 4. 9. 5. 7. >.

0hat is itS 0hat does it doS 0hat is it worthS 0hat does it costS 0hat else would workS 0hat does that costS

Alternatives that reduce the design comple-ity of a product, and lower its bulk or weight and,or the number and variety of parts re'uired in its manufacture, are fre'uently associated with reduced cost. The accountant clearly has a role to play in determining the cost of these alternatives. %iles (/?@4" has suggested thatD ... %eaningful costs may be obtained from a variety of sources or from a combination of sources:

?=

+ut 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 (ob2(emphasis added". %iles suggests that cost estimates do not need to be of a high degree of accuracy, particularly in the initial stages of !alue Analysis, 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 processes of which the firm may have no direct e-perience is therefore a valuable one. The first two of the si- 'uestions above relate to the functions of the product or service. 1Functional re'uirements2 were mentioned in the definition of !alue Cngineering above, and we have talked of 1functionality2 in the conte-t of the re'uirements of the product brief. The concept of product or service function is thus a key element in the !alue Analysis approach, and it2s to this concept that we now turn. Functional Analysis Functional analysis (FA" is a systematic approach to the e-amination of the specified purpose of a product or service. $n functional analysis, the cost ob(ect 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 ob(ect 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 ob(ect. As an e-ample of functional analysis, let us consider a domestic telephone. This has as its ma(or function the facilitation of communication between individuals who are physically separated. 0hen e-pressed 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 K tele-, fa-, the postal system etc. Functional analysis can be applied in a number of ways. $t 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. $n value analysis, for e-ample, 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 Keffective way. Functional analysis can also be used to assist in the determination of e-pected selling prices, as consumers may be e-pected to pay particular prices for particular functions. $n this conte-t, functional analysis can be seen to underpin target costing, which we will discuss in the ne-t section of this chapter. Boshikawa et al (/??9" suggest that the si- basic 'uestions listed in !alue Analysis section can be answered by following the nine basic steps set out below:

??

/. 4. 9. 5. 7. >. @.

choose the ob(ect of analysis, such as product, service or overhead areaD select the members of the teamD gather informationD define the functions of the ob(ectD draw a functional family treeD evaluate the functionsD suggest alternatives, and compare these with the target cost choose the alternatives (for manufacturing etc"D =. review the actual results. The range of options for consideration under step @ 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 fi-ed. !alue 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. <n the other hand, when a company is analysing a defence contract, the re'uired 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. !C undertaken at the research and development phase is something referred to as 1Aero look !C2, that undertaken in the trial production phase as 1first look !C2, and that in the trial production phase as 1second look !C2. 3econd look !C can be used when design changes are being made to e-isting products. These descriptions illustrate the iterative nature of cost.reduction techni'ues. )#LUE EN>INEERIN> As discussed above is also called value analysis. Definition: This is a systematic interdisciplinary e-amination of factors affecting the cost o' a ( o)*ct or service in order to devise means of achieving the specified purpose at the re'uired standard of 'uality and reliability at target cost. Aim of 2alue Engineering The aim of value engineering is to achieve the assigned target cost by i. $dentifying improved product designs that reduce the product2s cost without sacrificing functionality and ii. Climinating unnecessary functions that increase the product2s costs and for which customers are not prepared to pay e-tra for.

!alue engineering re'uires the use of functional analysis. This process involves decomposing the product into its many elements or attributes. Example

/;;

$n the case of automobiles, functions might consist of 3TBEC, *<%F<#T, 3 CCD, #CE$A+$E$TB, N&AE$TB, *<E<&# etc (:AT< /??9". 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. $f the cost of the function e-ceeds 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 e-ceed its cost. Also by focusing on the product2s 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. Activity based costing
INTRODUCTION

A core accounting activity is the analysis of costs. *osting systems accumulate costs by broad classifications K material, labour, power etc. . and these costs are then further analysed by assigning them to cost ob(ects. A cost ob(ect is defined as anything for which a separate measure of costs is desired, and thus the range of possible cost ob(ect is vast K from individual product to department, customer, service, brand or pro(ect. The costing system will routinely collect information about some but by no means all, possible cost ob(ects. *osting information is needed for a variety of reasons: (i" (ii" (iii" 3tock valuation for financial accounting purposesD *ost control and performance evaluationD Decision.making, e.g. product pricing, drop a product, make or buy etc.

The selection of cost ob(ects for the routine collection of information has implications for each of the above three purposes. $t is common to find departments, cost centres and products as cost ob(ects in costing systems. *onsiderable dissatisfaction has been e-pressed at the information provided by 1traditional2 costing systems for purposes (ii" and (iii", and particular attention has been directed to finding the 1true2 cost of producing a product to supply information for (iii". 6owever, it is important to emphasise that the concept of a 1product2 as a cost ob(ect needs amplification. Example *ost management is as important for the automobile industry in the /??;s as what 'uality control was in the /?@; and /?=;s. (e-tract from ) corporate annual report"

/;/

Required (i" (ii" (iii" C-plain the meaning of the 1cost management2, which is sometimes known as cost management information. Discuss why it might be considered important in today2s world. Discuss how a management accountant might use investment appraisal techni'ues to analyse customers in order to aid cost management.

Solution (i" *ost 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 isD The application of management accounting concepts, methods of data collection, analysis and presentation, in order to provide the information re'uired to enable costs to be planned, monitored and controlled. (ii" $t 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 /?=;s, ]apanese car companies such as Toyota paid a great deal of attention to 'uality K consider, for e-ample, the development of the Ee-us model targeted at the &3A 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. (iii" 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 pro(ects. For organisations with high customer set.up cost such as financial institutions such as mortgage leaders, it2s important that they retain all customers they have. +y studying the increased revenue and decreased costs generated by an 1old2 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 (ust as (obs,contracts might be ranked.

/;4

Cost Reduction Example $t has been suggested that much of the training of management accountants is concerned with cost control where as the ma(or emphasis should be on cost reduction. Required (a" (b" Distinguish between cost control and cost reduction. Tive three e-amples of the techni'ues and principles used for: (i" (ii" (c" cost control and cost reduction.

Discuss the proposition contained in the statement.

Solution (a" *ost 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. *ost 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 'uality and,or effectiveness. This is a dynamic rather than routine process, often only carried out at infre'uent intervals. (b" A wide range of e-amples can be given here: /. +udgetary control 4. 3tandard costing 9. 3etting of e-penditure limits by levels of management in an organisation 5. rocedure for formal authoriAation of recruitment.

7. *ost reduction >. Target costing

/;9

@. !alue analysis and value engineering =. 0ork studies ?. <perational research /;. $nvestment appraisal //. Qero K base budgeting /4. roduct life cycle costing /9. !alue for money analysis and audits etc. (c" The cost control techni'ues of standard costing and budgetary control would tend to support the proposition. 6owever, a study of operation research techni'ues2 and of recent developments would lead to the conclusion that current practice is not purely control, but active cost reduction. There has been considerable interest in a range of topics relating to new manufacturing techni'ues and to ]apanese methods. Nuality management, 'uality costs, ]$T stock and production control, fle-ible manufacturing systems and computer integrated manufacturing, target costing and life cycle costing. There has also been interest in a range of innovations in $T 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 techni'ues.

Example #-C Limited7 A+* Etd produces a large number of products including A and +. A is a compleproduct of which /,;;; are made and sold in each period. + is a simple product of which 47,;;; are made and sold in each period. A re'uires one direct labour hour to produce and + re'uires ;.> direct labour hours to produce.

/;5

A+* Etd employees produce salaried support. 3taff is engaged in three activities. 3iemployees engaged in receiving 47,;;; consignments of components per period, three employees engaged in receiving /;,;;; consignments of raw materials for per period and three employees engaged and materials for 7,;;; production runs per period. roduct A re'uires, 4;; component consignments, 7; raw materials consignments and ten production runs per period. roduct + re'uires /;; component consignments, eight raw material consignments and five product runs per period. Required $dentify appropriate cost drivers and calculate an activity based costing system. Solution The three appropriate cost drives are: (i" (ii" (iii" #eceiving components #eceiving raw materials Disbursing kits of components and raw materials

#elating 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" #eceiving components > Number of staff receiving material 9 Number of staff disbursing kits 9

Total number of staff /4 Therefore the total amount of overhead e-penditure relating to each of the activities is as follows: (d" #eceiving components: >,/4 - :7;;,;;;,;;; H :47;,;;;,;;;

/;7

(e" #eceiving material: 9,/4 - :7;;,;;;,;;; H :/47,;;;,;;; Disbursing kits: 9,/4 - :7;;,;;;,;;; H :/47,;;;,;;; *ost driver rates #eceiving components:

Total component receiving costs divided by Number of consignments received H :47;,;;;,;;;, 47,;;; H :/;,;;; per component #eceiving materials

Total component receiving costs divided by Number of consignments received H :/47,;;;,;;;, /;,;;; H :/4,7;; Disbursing kits

Total disbursing costs divided by Number of issues :/47,;;;,;;;, 7,;;; H :47,;;;

Total costs attracted by product A

/;>

4;; component consignments - :/;,;;; H :4,;;;,;;; 7; material consignments /; production runs :/4,7;; H :>47,;;; :47,;;; H :47;,;;; :653;'5,,, Total costs attracted by product + /;; component consignments - :/;,;;; H :/,;;;,;;; = raw material consignments - :/4,7;; H : /;;,;;; 7 production runs :47,;;; H : /;;,;;; *056,,5,,, 3ummary of unit cost roduct Total cost H Excercise +ean roducts Etd manufactures two types of bean bags K the standard and the Delu-e. +oth bean bags are produced on the same e'uipment and use similar process. The following budgeted data has been obtained for the year ended 9/ December 4;-4. !roduct roduction 'uality Number purchase orders Number of sets Kups #esources re'uired per unit Direct labour Direct labour (hours" %achine time (hours" 47,;;; /; 7 >4,7;; /; 7 Standard 47,;;; 5;; /7; Deluxe 4,7;; 4;; /;; A 4,=@7,;;; /,;;; units of A :4, =@7,units + /,4;;,;;; 47,;;;units of + :5=, unit

/;@

+udgeted roduction overheads for the year has been analysed as follows: !olume related overheads urchases related overheads 3et up related overheads 4@7,;;;,;;; 9;;,;;;,;;; 747,;;;,;;;

The budgeted wage rate is :4;,;;; per hour. The company currently uses an absorption costing method of recovering overheads. 6owever, 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: !olume related overheads urchase related overheads 3et up related overheads Required (4" *alculate the unit costs for each type of bean bag using the proposed activity based costing approach. TOT#L EU#LIT$ 8#N#>E8ENT /TE82 Today2s business environment is remarkably different from the Cnvironment of many years or so go. *ompanies are becoming customer driven and making customer satisfaction an overriding priority. *ustomers are demanding ever. improving level of service regarding costs, 'uality, reliability, delivery and the choice of innovative new products. Nuality 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 'uality of products and services and activities that produce them. N&C3T$<N. 0hat is 'ualityS Total qualit? management de%ined Nuality. Uthe degree of e-cellence of a thingV K 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 'uality is something that re'uires care on the part of the provider b" That 'uality is largely sub(ective. $t is in the eye of the beholder, the customer. machine hours number of purchase orders number of set.ups

/;=

The management of 'uality is the process of: a" Cstablishing standards of 'uality for a product or service. b" Cstablishing procedures or production methods which ought to ensure that these re'uired standards of 'uality are met in a suitably high proportion of cases. c" %onitoring actual 'uality d" Taking control action when actual 'uality falls below standard. Nuality management becomes (Total 'uality management (TN%" when it is applied to everything a business does. <ne aspect of ]apanese management is the approach of Uget it right first timeV. $n this spirit, total 'uality management (TN%" has the customer as its focal point. TN% 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 'uality standards in products and services. 3uch costs could arise through loss of customers, claims for refunds in respect of defective supplies and the work of putting right mistakes. $f costs can be controlled through TN%, then profits will increase. Through TN% it is possible to obtain defect.free work first time on consistent basis. Though this looks like an idealistic target but to have such a target encourages a culture where prevention of error is a key feature of operations. COST O. EU#LIT$ This activity of improving 'uality to improve profits will itself cause cost to be incurred. The term cost of 'uality is a collective name for all costs incurred in achieving a 'uality product or service. A cost of 'uality report should be prepared to indicate the total cost to the organiAation of producing products or services that do not conform with 'uality re'uirements. Four categories of costs should be reported. (a" Cost o% con%ormance K is the cost of achieving specified 'uality standards and include: (i" Cost o% pre9ention K are costs incurred in preventing the production of products that do not conform to specification. They include cost of preventative maintenance, 'uality planning and training and the e-tra costs of ac'uiring higher 'uality raw materials. #ppraisal cost K are costs incurred in order to ensure that outputs produced meet re'uired standards. They include costs of inspecting purchased parts, work in process and finished goods, 'uality audits and field tests.

(ii"

/;?

(b"

Cost o% nonJcon%ormance. is the cost of failure to deliver the standard of 'uality and include: (i"

re'uired

Cost o% internal %ailure K are costs associated with materials and products that fail to meet 'uality 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. Cost o% external %ailure K 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.

(ii"

T?pical Cost o% Eualit? Note that some of the items in the report will have to be estimated e.g. forgone due to sales lost because of poor 'uality 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" +y e-pressing each cost category as a percentage of sales revenue, comparisons can be made with previous periods, divisions within the group or other organiAations, thereby highlighting problem areas. A comparison of the proportion of e-ternal failure costs to sales revenue with the figures of other organiAations, for e-ample, can provide some idea of the level of customer satisfaction. (b" $t can be used to make senior management aware of how much is being spent on 'uality.related costs. (c" $t can provide an indication of how total 'uality costs (d" $t could be reduced by a more sensible division of costs between four categories. For e-ample, an increase in spending on prevention costs should reduce the costs of internal and e-ternal failure and hence reduce total spending.

//;

COST O. EU#LIT$ RE!ORT $E#R ENDED DECE8-ER 6,,<

:2;;; #C!CNT$<N *<3T3 Nuality training Nuality engineering reventive maintenance A #A$3AE *<3T3 $nspection of materials received $nspection of 0$ Testing e'uipment Nuality audits $NTC#NAE FA$E&#C *<3T3 3crap #e.work Downtime #etesting 7;; 4;; 5;; /,/;; >;; >;; 4;; 5;; /,=;; 7;; /;;; 9;; 5;; 4,4;; CGTC#NAE FA$E&#C *<3T3 #eturns /;;; 6andling customer complaints /7;; *ontribution figure from lost sales 4;;; 9,7;; =,>;; /@.7 59 //.; ?.; 7.7 :2;;; *<3T A3 8 <F ANN&AE T&#N<!C# :4; %$EE$<N

TN% ideas are widely practiced and there are many non.financial 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 'uality.

///

Chapter +
MEAS,RES (- PER-(RMANCE
Learning Outcomes After studying this chapter, candidates should be able to e-plain the different reasons of performance as shown below: The balanced scorecard !alue for money measures The growth in non.financial performance measures +ench marking $nvestment centres #eturn on investment #esidual income The measurement of assets and related problems +ehavioural aspects of performance measurement

*alanced Scorecard .ro-th in non2"inancial measures $n a traditional sense, profit has been the far greatest measure of business performance. This to a large e-tent can be attributed to the fact that theory has it that business2s sole ob(ective is ma-imisation of shareholder2s wealth through payment of high streams of dividend2s and growing the invested capital in the business through raising the share price of a corporation from good economic performance. 6owever, in the modern world, due to e-panded corporate managements2 focus, it is essential to include non.financial measures in performance evaluations.

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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. 3o in order to effectively manage a business, we need information to a large e-tent which is not financial in nature to aid our actions which will result in running an organiAation smoothly and ultimately result (lead" to good financial performance. The main non.financial measures of performance which are commonly applied and used are: . $nnovation . Fle-ibility . 3hort.lead times . Nuality . *ost 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. ,alanced 1corecard in Detail The incorporation of non.financial information along side financial information has become known as the balanced scorecard approach. This was e-emplified by :aplan and Norton. The balanced scorecard is an approach to the provision of information to management to assist strategic policy formulation and achievement. $t emphasises the need to provide the user with a set of information which addresses all relevant areas of performance in an ob(ective 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 $nnovation and learning perspective.

:aplan and Norton gave e-amples of the types of measures used to assess performance under the four perspectives. +y providing all this information in a single report, management is able to assess the impact of particular actions on all perspectives of the company2s activities.

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&sually, determining the specific items to be included in a balanced scorecard re'uires a business to e-amine its operations carefully, in order to address the following considerations. (i" (ii" (iii" $dentity of the company2s critical success factors 3election 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 organiAational processes in order to facilitate the improvement of performance against the critical success factors.

$t should be noted that critical success factors of a business may change, following changes which are taking place in their market place. The Four Perspecti$es (a" The .inancial !erspecti9e

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. Therefore, the main aims and ob(ectives which the financial perspective will have attached to are:. (ii Sur9i9al o% the Cusiness The survival of the corporation will be to a large e-tent be measured by level of cashflow or how healthy cashflows are. (iii Success o% the -usiness The success of the business will usually be gauged by the sales growths being e-perienced and the operating income trickling down to the business. (iiii !rosperit? The prosperity of the business is going to be measured by the breakthrough of increases in market share and the return on e'uity which the business is giving on investor2s capital. (b" The Customer !erspecti9e The customer perspective looks at customer satisfaction.

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The customer perspective looks at how customers see the providers of a service (businesses". $n 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 e-isting products,services. The key measures in this regard would be the percentage of sales coming from the sale of the new products. (ii" Responsi9eness to Suppl? 6ow does the corporation handle its supply chain systemS The main measure would be on.time delivery as defined by customers. (iii" Customer !artnership 6ow cemented and integrated are the relationships between the business and its customers. This partnership can be measured by the number of cooperative engineering efforts. /c2 The Internal -usiness !erspecti9e The internal business perspective looks at what the business e-cels at if it has to deliver shareholder value. $n 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 (: $s". /i2 Technolog? capaCilit? The company should have cut.edge technology. This can be measured in terms of the corporate manufacturing geometry versus competition being faced.

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/ii2

The manu%acturing excellence The manufacturing e-cellence must be e-plained though the perceived value of the organisation2s activities different consumers. The key measures to measure this would include measures such as cycle times, e-act cost of manufacturing and yield.

/iii2

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.

/d2

Inno9ation and learning perspecti9e This perspective looks at whether we can continue to improve and create value for clients or not. $n 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. /i2 Technolog? 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 ne-t generation of the product. /ii2 Time to 8arDet 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.

+elow is a typical diagrammatic representation of the balanced scorecard for an imaginary communication utility company to illustrate the application of the balanced scorecard.

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.igure 170 The -alanced Scorecard and its application in per%ormance e9aluation

O9er9iew o% operations o% Communications Utilit?

$dentification of key Activities and the !alue *reation rocess

*ategorising activities into the four (5" perspectives

Financial erspective

*lient (consumer" erspective

$nnovation and new services perspective

$nternal process perspective

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Develop :ey erformance $ndicators (: $s"

Cstablish a performance evaluation system

,it$ permission from !pang/e 3asonso4&556 Value For Money Perfor!ance Measures For "ot#For Profit Organisation$ Nature o" a Not2For Pro"it 0rganisation At this point in your studies you should appreciate that organiAations can e-ist as business or non.business. Not for profit organiAations are organiAations, which have not been set up with the view to generating profits. C-ample of these organiAations would include churches or religions organiAation, Non.Tovernmental <rganisations (NT<s", and local government e.t.c. Cven if these organiAations 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 organiAations they subscribe to are operating. The key stakeholders to an NT< for e-ample would be the donors, employees and the local or domestic governments in which the NT<s are operating. $n case of local government the can have the following as the key stakeholders /. olitical leaders 4. *itiAens 9. Ta- payers e.t.c
N#TURE O. !ER.OR8#NCE 8E#SURE8ENT

0hether in case of a business or a not for profit organiAation, performance measurement looks at an e-ercise of comparing the actual performance level attained by an organiAation against the set ob(ectives and set performance parameters (standards". Therefore we can have several and different performance measures depending on the nature of business or activities of an organiAation. Nature o" Per"ormance %easurement in Not2For Pro"it 0rganisations

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$n not for profit organiAation (NF <s", the performance will be measured by comparing performance standards set out against the actual performance attained by the organiAation. 6owever, since these organiAations do not e-ist to make profits, it will not be a priority to ensure that the profit measure does not come up as a very important or paramount matter. 6owever, most NF <s aim to have a surplus (an e-cess of income over their e-penditure" as they are not e-pected to continue pestering and e-erting pressure on donor funds or tight government fiscal and monetary policies. The Three 4s (4""ecti$eness, 4""iciency and 4conomic) The three Cs are used as the main primary measures of performance in not for profit <rganiAations. 07 E..ECTI)ENESS Cffectiveness refers to the organiAations ability to attain its set out ob(ectives. 3o, is a measure that aims to asses whether organiAations are achieving their corporate ob(ectives or not. *are must be taken to realiAe that in effectiveness we do not give a lot of consideration to the resources we are putting into use when pursing the organiAational goals. 67 E..ICIENC$ Cfficiency is a measure of how well organiAations utiliAe their available resources. Therefore, efficiency looks at a comparison between the 'ualities of resources used in a particular activity to the level of output produced using the resources. $n some cases efficiency can be measured by using some efficiency ratios. lease refer to the ratios as illustrated in chapter = under variance accounting. 47 ECONO8$ The economy aspect aims to measure the value for money for the service the organiAation is serving to its clients. Cconomy 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 ta- payers will want to hold government official accountable and they will make independent assessments as to whether the ta-es paid are being used according to public e-pectation or not. $n 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

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before consulting the doctors are abbreviate and reduced. $n addition they would like to see that the hospital is stocked with drugs re'uired to cure various diseases.
*E$ !ER.OR8#NCE INDIC#TORS /*!I+S2

The mostly used key performance indicates in assessing performance in not for profit organiAation will include the following and depending on the nature of business an organiAation is involved in: /. 4. 9. 5. 7. Eength of waiting time. *ourtesy of employees toward, clients2. Number of clients complaints $nnovation levels. Financial discipline through financial surplus posted.

$f a not for profit organiAation is not performing according to stakeholders e-pectations we would want to utiliAe benchmarking as a way of trying to enhance the performance of a given not for profit organiAation (you should remember that you will look at the sub(ect of benchmarking in section 5.> of this chapter". .IN#NCI#L !ER.OR8#NCE 8E#SURE There is substantial evidence from a large number of studies that the e-istence of a defined 'uantitative goal or target is likely to motivate higher levels of performance than when no such target is stated. eople 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 K output relationship b" Targets derived from historical data and c" Targets derived from negotiations between superiors and subordinates %ngineered Targets These can be used when there are clearly defined and stable inputs K output relationships such that the input re'uired can be estimated directly from product specifications. For e-ample, in a fast.food restaurant for a given output of hamburgers it is possible to estimate the inputs re'uired because there is a physical relationship between the ingredients such as meats, buns, condiments and packaging and the number of hamburgers made. 0here clearly defined input.output relationships do not e-ist, other approaches must be used to set financial targets. <ne approach is to use historical targets derived directly from the results of previous periods. revious results plus an increase for e-pected 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 /;8. The /4;

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 ne-t period. Negotiated Targets Are set based on negotiations between superiors and subordinates. The ma(or advantage of negotiated targets is that they address the information asymmetry gap that can e-ist between superior and subordinate. This gap arises because subordinates have more information than their superiors on the relationship between outputs and inputs and the constraints that e-ist at the operational level, whereas superiors have a broader view of the organiAation 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. !er%ormance 8easurement 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 %erchant (/??;" Umost companies set their annual profit budgets targets at levels that are highly achievable. Their budget are set to be challenging but achievable say =; K ?; 8 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. #esearch evidence suggests that setting specific difficult budget targets leads to higher task performance than setting specific moderate or easy targets (3tedry and :ay /?>>". 6owever 6irst (/?=@" has advocated that the benefits arising from setting specific difficult budget goals are dependent on the level of task uncertainty. 6e suggests that where uncertainty is low, setting specific difficult budget goals will promote performance, and the subse'uent use of difficult budget goals to measure performance will minimiAe the incidence of dysfunctional behaviour such as falsifying accounting information. A fle-ible budget therefore is an important tool in performance measurement as it ensures that the cost targets used as a basis for comparison are fle-ible as levels of output change. NONJ.IN#NCI#L !ER.OR8#NCE 0ithin 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 'uality 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 who does not sell the goods or services directly and does not purchase the input material. /4/

To ensure that the motivation of employees is consistent with the profit ob(ectives of the organiAation, it may be necessary to use non.financial performance measures to indicate what is re'uired to achieve the overall financial targets. &sing non.financial 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 is more readily identifiable by a particular employee or group of employees. Eualit? 8easures As stated under financial performance measures, a fle-ible budget is important in ensuring that the cost targets used as a basis for comparison are fle-ible as levels of output change. This is essential in order to avoid a sense of in(ustice in the application of management accounting techni'ues. 6owever, it may not be sufficient to motivate employees directly in understanding and meeting the targets e-pected of them. The accounting numbers have to be converted to some measure of 'uantity which relates more closely to the individual. $f 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. Illustration o% the proClems o% per%ormance measurement in a ser9ice Cusiness Take a school as an e-ample, where activities are subdivided by sub(ect area. The primary measure of activity will be the number of pupils taught, but the individual department will have no control over that number. $f teaching staff are appointed on permanent contracts, so that salary costs are largely fi-ed 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 e-aminations. For them, e-amination 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 would therefore, emphasise first of all the non. financial performance in terms of e-amination success but would then additionally report the cost implications so that the conse'uences of achieving high or low success rate could be linked to the cost of that activity. Eualit? 8easures The ultimate measure of 'uality is customer satisfaction. The important aspect of 'uality is the process undertaken by the organisation to achieve 'uality. This

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is so important that an e-ternal agency (often the auditors" may be employed to provide independent certification of the 'uality of the process. 3econdly, 'uality is measured also in terms of the inputs to the process, where inputs may be materials, labour and capital e'uipment. Nuality of inputs may be controlled directly by imposing standards on suppliers, or may be monitored by reviewing the rate of return on unsatisfactory goods. The non.productive time incurred because of faulty e'uipment or the reliability of delivery dates and 'uantities. 3ome specific e-amples of on.financial measures are: /. in respect of demand for products: a" b" the number of en'uires per advertisement placed and percentage of customers who remember the advertisementD

4. 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 soldD and c" time between receiving customer order and supplying the goods or services Example Qesco an electricity company provided the following information about non. financial performance over a one year period.
#C3T<#C 3& #C3T<#C 3& EB $N T6#CC 6<&#3 TA#TCT ?;8 C#F<#%AN*C ?4.=8 EB $N 45 6<&#3 TA#TCT ??8 C#F<#%AN*C ??.?8 TA#TCT ?78 C#F<#%AN*C ?>.@8 TA#TCT C#F<#%AN*C ?;8 =>8

%<!$NT A %CTC# $N3$DC /7 0<#:$NT DAB3 #C EB T< TCEC 6<NC *AEE3 0$T6$N /; 3C*<ND3

#CTI)IT$ 0rite out any non.functional performance measures which could be reported by an organiAation which delivers parcels to the general public and businesses. &ivisional Perfor!ance Measures

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$n an organiAationD the degree of authority delegated by top management to lower level operating management can be viewed as an issue. $n some organiAations, control can be centraliAed, where senior management at head office e-ercise control over complete activities of the organiAation. $n some cases senior management at head office can delegate to divisional managers to branches and divisions of the company. $n this case the company will be running a decentraliAed control system. $n the later case it will become necessary to provide program measures which will serve as guides and targets for performance e-pected of the various divisions operating under head office. Therefore at this point, we want to e-amine the different performance measures we can use to assess performance of divisions.
-#C*>ROUND IN.OR8#TION /*NOGLED>E2

At this point we would like to remind all candidates about the concept of *ost.centres rofit.centres $nvestment centres.

/a2 # Cost Centre A cost centre according to the *$%A official terminology can be an ability location machine or business unit in relation to which cost are included /C2 !ro%it 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 /c2 In9estment centre An investment centre can be an activity location machine or business unit where managers are responsible for cost containment, revenue generation and the ac'uitting and disposal of the ob(ects used to support the centre2s activities $n different cases the division can be treated as any or in light of the above.mentioned centres. The two commonly used financial measures of divisional performance in such cases are return on investment and residual income.

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6owever divisional and corporate performance nowadays can be assessed by use of other modern performance measures such as Cconomic !alue Added (C!A" a trademark from 3tern and *o . an American consulting company 6owever we are not going to consider the modern performance measures of Cconomic !alue Added (C!A", and %arket 3hareholder !alue Added in this te-t.
RETURN ON IN)EST8ENT /ROI2

This is the divisional e'uipment of the generally known as the on capital employment measure used in financial statement analysis and simply e-presses percentage of the funds invested in the particular sub.unit. The return on investment can be calculated using the formula: #eturn on H $nvestment Divisional profit - /;;8 Divisional $nvestment

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 'uestion. As it will be seen by concentrating on a percentage return rather than the absolute if the divisional profit, #eturn on investment adopt an efficiency criterion which recogniAes the critical relationship , connection between a divisional income and the assets employed in generating the income. For instance a profit of :5;;,;;;,;;; on an investment of :4,;;;,;;;,;;; gives a return on investment of 4;8 This represents a more efficient use of assets than a profit of :=;;,;;;,;;; of an investment of :/;,;;;,;;;,;;;, all other things being e'ual. 0e 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 e-ceeds that which could be obtained from an alternative use of the invested finances.
-RE#* DOGN O. RESIDU#L INCO8E7

$n order to have fair insight into a divisions performance the basic formula as broken down by means of the so called Du oint method of probability analysis into the product of the investment tomour and profitability ratio: As you could have read further the Du oint *ompany of &.3.A did 'uite a lot of work around the sub(ect of divisional performance assessment and assessment measures.

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Divisional 3ales Division investment H #eturn on investment.

Division profit H Divisional sale

Divisional profit Divisional $nvestment

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 e-ample will show. Example 3ounds investments Etd sells music records through its own, in.town street stores and through its agents out.of.town. +oth businesses through agents and through own stores yield the same return on investment of /78 but this is earned in 'uite difficult ways. Through Agents Division profit Division $nvestment Divisional sales Through Agents the #<$ isD #<$ H Divisional profit H Divisional investment :>;;,;;; G /;;8 :5,;;;,;;; Divisional profit Divisional sales H /78 :>;;,;;; :5,;;;,;;; :=,;;;,;;; Through own stores :?>;,;;; :>, 5;;,;;; :/?,4;;,;;;

+reak Down

H Divisional sales G Divisional $nvestment

H :=,;;;,;;; G :5,;;;,;;;

:>;;,;;; H 4 - @.78 H /78 :=,;;;,;;;

Through own.stores #<$ H Divisional rofit H Divisional $nvestment : ?>;,;;; - /;; H/78 :>,5;;,;;;

+reak Down H Divisional sale

G Divisional rofit Divisional investment Divisional sales

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H :/?,4;;,;;; :>,5;;,;;;

:?>;,;;; :/?,4;;,;;;

H 9 - 78 H /78

Cven if the +usiness through agents earn a higher profit on the sales of @.78 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 7;8, which generator a higher sales volume leading to an investment tomour of three (9" Example East year, ep stores of *hipata produced a profit of :>;;,;;;.;; on sales of :4,;;;,;;;. The investment in the division was :5,;;;,;;; #<$ H Divisional rofit - /;;8 Divisional $nvestment H :>;;,;;; - /;;8 :5,;;;,;;; H /78
-RE#* DOGN

Divisional 3ales Divisional $nvestment :4,;;;,;;; :5,;;;,;;; -

Divisional rofit Divisional sale

:>;;,;;; :4,;;;,;;;

H ;.7 - 9;8 H /78

$n the current year the divisional manager has reported an increase in his #<$ to /=8. 6ow is this to be interpretedS First sight it is an un'ualified improvement but review of the figure reveal that the /=8 comes from a profit of :/,;=;,;;; on sales of :4,5;;,;;; generated by an investment of :>,;;;,;;; #<$ H :/,;=;,;;; :>,;;;,;;; +reak Down H :4,5;;,;;; :>,;;;,;;; :/,;=;,;;; H :4,5;;,;;; ;.5 - 578 H /=8 G /;;8 H /=8

From the analysis it can be seen that a dramatic increase in the profit margin (form 9;8 to 578" which has fortunately more than affected a marked determination in the investment tumors (from ;.7 to ;.5" leading to the overall increased #<$. $f however the /4@

determination in the investment tumors was causes by an undesirable and e-pensive hand.up of stocks of finished goods due to e-cessive production during the current period and the dramatic rise in profit 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 fi-ed manufacturing costs to a later period then the improvement in #<$ is no case for congratulation. The breakdown of #<$ into investment tumors and profitability ratio provides top management with two additional criteria with which to measure a division2s performance. Further at the divisional level by highlighting the different factors, which contribute to #<$, it can provide a local manager with limits as to the type of action that would be necessary to improve the sub.limit return. For e-ample if all other factors were held constant, #<$ 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 fi-ed or variable costs. A reduction in the level of divisional investment.

Actions (i" to (iii" will increase the profitability ratio and hence the #<$D action (iv" will do likewise by increasing the investment tumors. $t is obvious that any combination of (i" to (iv" will also improve the #<$ 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 e-ample looked at under behavioural implication of using divisional measures of performance. 'ench!ar(ing The term benchmarking refers to the establishment through data gathering of target and comparators through whose use relation levels of performance can be identified. +y 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. 1teps In ,enchmar ing 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 siAe and therefore showing as good comparator.

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In"ormation .athering +enchmarking starts with obtaining the information re'uired in order to benchmark against competitors Financial 1tatement and Re$erse 4ngineering 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 company2s files,archives. Non.financial information about competitors and their products can be obtained by reverse engineering. #everse engineering insists buying a competitors products and dismantling it in order to understand its content and configuration 0ther 1ources o" In"ormation $n order to obtain information about their competitors we would use the following sourcesD (i" (ii" roduct literature Trade associations and press comments

6owever we should realiAe that a product is only the end result of the process, which a business follows, and thus effective benchmarking re'uires an understanding of the actual basic process of their businesses. As noted above obtaining information about competitor2s processes is much more difficult than getting information about their products. For e-ample, how do competitors process their customer orders, deal with customer en'uiries, conduct their relationships with suppliers and other keep stakeholdersS Types o" ,enchmar ing The e-ercise of benchmarking can be classified in different types. 6owever in our studies here we want to classify benchmarking in two parts. $nternal benchmarking

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 C-ternal benchmarking $nter.industry benchmarking /a2 Internal CenchmarDing 0ith 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. /C2 External CenchmarDing 0ith e-ternal benchmarking, we compare the performance of the company against the performance of others in the same line of business, for e-ample we can compare the performance of 3hoprite *heckers against the performance of Tame stores in a given control period. C-ternal benchmarking does not only apply to corporate performance but e-ternal benchmarking mighty also include the comparisons of departments in organiAation 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 3hoprite, Tame stores and %elissa against the performance of a top performing finance department in the chain store industry. /c2 InterJ industr? CenchmarDing $n inter. industry benchmarking we compare the performance of our corporation against the top in the class (or top" performing corporations regardless of the industry in which the top performing company originates from. Therefore to successfully carry out this, we need to identify a non. competing business, however, with similar processes and risk to participate in the benchmarking e-ercise. For instance, computer connection, a distributor of personal computers may approach a distributor of 6$. F$ e'uipment as 6$. F$ *ity, to establish a benchmarking relationship. ,ene"its o" ,enchmar ing The benefits of benchmarking are 'uite obvious, however we can dwell on these few:

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 +enchmarking enables the corporation to benefit from the e-perience of the others and thereby establishing 1best practice2 in their common business processes. +y collaborating with other companies in a benchmarking e-ercise, the corporation can improve its performance by learning from the e-perience of others. Pit"alls o" ,enchmar ing 0e should be mindful of that benchmarking might give planned results sometimes The planned results can be obtained in the following situations: $n a situation where a comparative competitor is not right or comparable siAe and background, the comparisons might be flawed. $n 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 1one eyed person operating as king among the blind2 and this is not going to help the lagging companies or departments to make 'uantum leaps in terms of their performance improvement. -E@#)IOUR#L #S!ECTS O. !ER.OR8#NCE 8#N#>E8ENT The human aspects of controls in relation to performance measurement is a key factor in evaluating the control system. A control system2s ob(ective is primarily to enable the organiAation achieve its ob(ectives. This means that employees must be motivated to achieve those targets. 6owever, controls can sometimes result in employees2 behaviour which works against the ob(ectives of the organiAation. *onse'uently such behaviour will lead to the non.achievement goal congruence. $t 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 ob(ectives are impacted negatively. $n general, performance measurement should result in desirable behaviour which will enable the organiAation to meet its corporate ob(ectives. !ER.OR8#NCE INDIC#TORS erformance measures must be in such a way as to help the organiAation achieve it2s ob(ectives. 6owever, 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 organiAational behaviour. $t is also important that employees do not concentrate only on what is measured

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even if it does not ultimately lead to achieving goal congruence. This should therefore encourage the organiAation to incorporate other control measures which are not necessarily specified in 'uantitative terms. $n evaluating performance, a fair appraisal system must be used which should create a positive attitude in employees. $t 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. erformance indicators should always provide for controllable and uncontrollable factors. $t is common practice for uncontrollable factors to be e-cluded from employee performance measurements. 6owever, this does not mean that uncontrollable items should not be reported. $t is also important not to make Departmental 6eads accountable for areas where they do not seem to have significant influence. -UD>ETS #ND !ER.OR8#NCE 8E#SURE8ENT +udgets 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. $t is however, practically difficult to reach a consensus as the ideal financial targets without some managers being dissatisfied. $t 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. 6owever, 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 ma-imise employee performance and motivational levels. $n a study carried out by 6ofstede concerning the budget difficulties, the following conclusions are made: a" +udgets have no motivational effect unless they are accepted by the managers involved as their own personal budgets. b" &p 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 e-ists. The use of departmental meetings was found helpful in encouraging managers to accept budget targets.

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e" %anagers2 reactions to budget targets were affected both by their own personality and general cultural and organiAational norms.

Chapter .
/ECISI(N MA0IN' TEC!NI1,ES
Learning outcomes After studying this chapter students should be able to: &nderstand risk Demonstrate various ways of assessing risk and uncertainty Demonstrate full knowledge of sensitivity analysis Draw and prepare decision tree diagrams.

)ensitivity Analysis 3ensitivity 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. De%inition 3ensitivity analysis is a term used to describe any techni'ue whereby decision options are tested for their vulnerability to changes in any 1variable2 such as e-pected 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 G8 higher than estimated, or estimated revenues B8 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.

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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 e-amination of other chapters in this book, you will actually discover that sensitivity analyses are included through the following e-ercises. (i" (ii" (iii" (iv" 0hat if analysis under information systems (chapter ?" using spreadsheets". Einear programming in chapter 7 under linear programming. Fle-ible budgeting can also be a form of sensitivity analysis see chapter > under fle-ible budgets. 3ensitivity analysis is one method of analyAing the risk surrounding a capital e-penditure pro(ect and enables an assessment to be made of how responsive the pro(ect2s N ! (net present value" is to changes in the variables that are used to calculate the net present values (N !".

Example 3CN3A (Q" Etd has estimated the following sales and profits for a new product which it may launch on to the market. :2;;; 3ales (4,;;; units" !ariable *osts: material 4,;;; (>,;;;" *ontribution Eess: incremental (/,>;;" rofit Required Analyse the sensitivity of the pro(ect. Solution (a" $f incremental fi-ed costs are more than 478 above estimate, the pro(ect would make a loss. 5;; 4,;;; fi-ed 5,;;; :2;;; =,;;; labour

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(b" $f unit costs of materials are more than /;8 above estimate the pro(ect would make a loss. (c" 3imilarly, the pro(ect would be sensitive to an increase in unit labour cost of more than 4;8 above estimate. %anagement would then be able to (udge more clearly whether the pro(ect is likely to be profitable. The items to which profitability is most sensitive to in this e-ample are the selling price and material costs. 3ensitivity analysis can help to concentrate management attention on the most important forecasts. Example B&:AA E* is considering a pro(ect with the following most likely cash flows $ears costs :2;;; ; / 4 (@,;;;" 4,;;; 4,7;; >,;;; @,;;; :2;;; !urchase costs :2;;; Running Sa9ings

The cost of capital for the pro(ect is =8. Required %easure the sensitivity (in percentages" of the pro(ect to changes in the levels of e-pected costs and savings. Solution The present values of the cash flows are as follows $ear .actor =8 ; / 4 /.;;; ;.?4> ;.=7@ discount present 9alue o% plant cost :2;;; (@,;;;"

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OOOOOOO (@,;;;"

!resent 9alues o% Running costs :2;;;

!resent )alues o% Sa9ings :2;;;

!resent )alues o% Net Cash .low :2;;; (@,;;;"

(/,=74" (4,/59" (9,??7"

7,77> 7,??? //,777

9,@;5 9,=7> 7>;

The pro(ect has a positive N ! and would appear OOOOOOOOOOOOO. The changes in cash flows which would need to occur for the pro(ect to break even (N ! H ;" are as follows. (a" lant costs would need to increase by present value of :7>;,;;; that is by:

:7>;,;;; - /;;8 H =8 :@,;;;,;;; (b" #unning costs would need to increase by present value of 7>;,;;; that is by: :7>;,;;; - /;;8 H /58 :9,??7,;;; (c" 3avings would need to fall by a present value of :7>;,;;; that is by: :7>;,;;; - /;;8 ://,777,;;; H 5.= Pro*lems -ith sensiti$ity analysis (a" The method re'uires that changes in each key variable are isolated but management is more interested in the combination of the effects of changes in two (4" or more key variables.

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Eooking at factors in isolation is unrealistic since they are often interdependent. (b" 3ensitivity analysis does not e-amine the probability that any particular variation in costs or revenues might occur. Example DCF (Q" Etd is considering the launch of a new product, the Delta. $f /;,;;; units per annum are sold, the net present value over five years will be :/,7>;,;;;,;;;, but if 4;,;;; units are sold per annum the net present value over the same period will be :4,=@7,;;;,;;;. Required *alculate the minimum annual sales volume that will (ustify the launch of the delta. Solution The minimum sales volume is the volume that produces a net present value of Aero. This occurs at a volume of /;,;;;units I H /9,7/@ units 3ensitivity 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. <f 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 (ust to instruct decisions. For instance it can be used in con(unction with break.even analysis to ascertain by how much a give factor can change before the pro(ect ceases to make a profit. $n sensitivity analysis a single input factor is changed at a time, while all other factors remain at their original estimate. 0e can approach sensitivity analysis from two perspectives. /. 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 Aero i.e. the indifference point. :/,7>;,;;;,;;; /;,;;; units :/,7>;,;;;,;;; I :4,=@7,;;;,;;;

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4. Alternatively specific charges can be calculated, such as the sales decreasing by 78, in order to determine the effect on the net present value. Example The e-ample below shows how sensitivity analysis works in practice. %uponga Etd is contemplating investing in a pro(ect which will need initial capital investment of : /;;, ;;;, ;;;. $t is estimated that this will generate sales of /;,;;; units per annum for four years. The contribution per unit is e-pected to be :>, ;;; and the fi-ed costs are e-pected to be : 4>, ;;;, ;;; per annum. The cost of capital is 78. Required i. ii. *alculate the net present value +y how much can each factor change before the company becomes indifferent to the pro(ectS

Suggestion Solution i. :2;;; Total *ontribution H : >, ;;; - /;, ;;; &nits H >;,;;; Eess: fi-ed costs Net cash inflow per year N!) Bears ; /K5 <utlay annual cash $nflow *ash flow :2;;; (/;;,;;;" 95, ;;; H (4>, ;;;" 95, ;;; D*F Y 78 /,;;; 9.75> ! :2;;; (/;;, ;;;" /4;, 7>5 4;, 7>5 ii. Net present value can fall by :4;,7>5,;;; before the indifference point is reached. This implies that the annual cash flows can change by G - 9.75> H : 4;,7>5,;;; G H : 7,=;;,;;; Therefore, the costs can fall by : 7,=;;,;;; to :4;,4;;,;;;

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Application o" 1ensiti$ity Analysis in Pro'ect Appraisal 0e dealt with capital investment appraisal chapterD we assumed that all the 'uantitative factors in the investment decision i.e. cash flows and the discount factors or costs of money were known with certainly. 6owever, most practical investment decisions are married with a great deal of uncertainty. $n order to give decision makers a clearer understanding of the problem without providing definitive guidance though, we have many approaches to deal with this. 3ensitivity 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. 3ensitivity analysis can be used as an attention K directing techni'ue as it directs attention to those factors that have the most significant impact on the outcome of a given ro(ect. 6owever in most pro(ects the various variables will have interdependences amongst themselves. Therefore, we cannot (ust take a simplistic approach to assume that each variable has to be considered in isolation. Example A company is contemplating investing in a new productD the net present value of the investment is : 4, ;;;, ;;;, ;;;. 6owever, this is not a certain net present valueD it has not been calculated with data on the 1most likely2 value of each of the four variables affecting the decision. These variables are listed below. Cach of the factors has a significant influence on the profitability of the proposed pro(ect. Linear Progra!!ing
-#SIC 8EC@#NICS O. LINE#R !RO>R#88IN>

At this stage you are e-pects for know how to use basic linear programming techni'ue to handle situation where you have two constraints limiting the undertaking of an entity.
STE!S IN LINE#R !RO>R#88IN>

S"EP %: Esta1lis$ t$e o17ecti0es function $n business, corporations are there to make profits as they wish to ma-imise the wealth of shareholders. The profits will be ma-imiAed by either increasing turnover of the company or by minimiAing costs of operations, since profit is a function of #evenue against e-penditure. rofit H #evenue K C-penses. Therefore, at any given point in time a business will want to either minimiAe cost or ma-imiAe profits and therefore shareholders wealth. Therefore, the first step in linear programming will initiate the establishing of an ob(ective function, which usually will /9?

aim at minimiAing costs of operations or ma-imiAing revenues from operations. $f the aim is to ma-imum profits from two products G and B, we would construct an e'uation showing the total profit we would earn from the sale of one unit of G and one &nit of B. 3upposing that one unit of G gives us a unit profit of : /7, ;;; and a unit of B gives us a profit of : 4;, ;;;, we would construct the total profit e'uation as follows: Total profit H rofit from I rofit from one one unity of G unit of B. Therefore, total profit H :/7, ;;; G I : 4;, ;;; B This will serve as the ob(ective function in a situation where a business aims to ma-imiAe profits. $n a case where an organiAation would like to minimiAe costs, we would construct a similar ob(ectives function which would however aim to minimiAe the costs of operating. Assuming that we have the same two products G and B in our product catalogue at which each unit of the products income to that cost of production is :4;, ;;; and : 4=,;;; respectively, how would we construct the ob(ectives functionS Total cost H cost of manufacturing I cost of manufacturing <ne unit of G one unit of B Total cost H : 4;, ;;; G I : 4=, ;;; B. Therefore in this case the above e'uation will be the ob(ective function in a case where the company aims to minimiAe the costs of operating. S"EP &: Ine.ualities( The ne-t step in linear programming is the establishment and determination of ine'ualities which show the different constraints. $n most manufacturing situations raw materials, skilled labor, factory capacity and many more factors might act as constraints limiting factors. Therefore the ine'ualities are constructed according to the constructs shown in the scenario. 6aving established the ine'ualities you will need to convert them into e'uations, where we will replace the ine'uality signs (e.t.c" by the e'ual sign (H" S"EP -: Esta1lis$ Non8 Negati0ity e.uations( At this stage we want to realiAe 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 'uadrant which has both positive G and B variables on the graph as represented below.

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IB

.G

IG

The shaded area shows the region where we will e-pect ourselves to have the linear programming results as this is the area where both the G and B variables will be positive on the graph. The non.negativity e'uation therefore aims to form a block or boundary within which the graph has to be drawn. 0e cannot have negative figures coming from the graph as optional solutions. The non.negativity e'uation will be: G ^ And B ^ < <

These will further need to be convert into e'uation, and the resulting e'uations will be G H < and B H < respectively S"EP 9: Plot t$e e.uation lines on t$e grap$( S"EP :: Determine t$e Optimum position mi' or com1ination( 3ince this is brought forward knowledge. Try the e-ample below and see if you can remember your basic linear programming techni'ue.

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Euestion %anAi *o makes two components, :/ and :4 and has the following constraints on a monthly production. <perative time #aw material A #aw material + 45; man.hours. 7;; :g 5;; Eitres

:/ uses man.hour, 7:g of A and 7 litres of + to make each unit. :4 uses man.hours, 7 :g of A and 5 litres of + to make each unit. The contribution to profit from each unit of :/ and :4 are : /7;,;;; and : /;;, ;;; respectively. $t is known that all production can be sold. Required #epresent the above situation as a linear programming model, if the ob(ective is to ma-imiAe total monthly profit.
T@E SI8!LE: 8ET@OD

A linear programming problem with more than two constraints or decision varieties cannot be plotted on the two a-es of the graph i.e. the G and B a-es. Therefore were need different method of solving the problem: i.e. the simple- method. The simple- method begins in the same way as the ordinary linear programming operation, by setting up e'uation for the ob(ectives function and the constraints. $n illustration below will e-plain the simple- method properly. Example %ulobeAi timber table re'uire 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.

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@OUR REEUIRED .OR T#-LE

CONTRI-UTION O. E#C@ T#-LE

T#-LE 3mall %edium Earge C-tra large Available *harge $n 6ours

CUTTIN> 4 4 / > 9,;;;

#SSE8-L$ 7 5 9 4 ?,;;;

.INIS@IN> / 5 7 9 5,?7;

*+,,, >; /49 /97 ?;

Due to other commitments no more than a total of /,=;; coffee tables can be made in any given year. $n addition market analysis reveals that the annual demand for the company2s small coffee table is at least =;;. The company wishes to determine how many of each type of coffee table it should produce in the coming year to ma-imiAe contribution. The detailed linear programmes procedure described above can be applied to the molobeAi scenario as a linear programme. The ob(ective variables are stated as: Eet Q H total contribution earned in the coming year in kwacha from the production of the coffee tables. The 'uantities 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, Eet G/, G4, G9, G5 H the number of small, medium large and e-tra, large coffee tables to be producing in the coming year. The company wishes to ma-imum contribution so the ob(ective function is: %a-imiAe Q H : >;, ;;;G/ I : /49, ;;;G4 I : /97, ;;;G9 I : ?;, ;;;G5 The 'uantities 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 e-ceed that which is available. These are written as: 4G/ I 4G4 I /G9 I >G5 _ 9, ;;; /59

7G/ I 5G4 I 9G9 I 4G5 _ ?, ;;; /G/ I 5G4 I 9G9 I 9G5 _ 5, ?7; The total of the 5 decision varieties cannot e-ceed /,=;; there is a ceiling (ma-imum" on the total number of coffee tables to be manufactured. Thus the following constraint must be included in the model: G/ IG4 I G9 I G5 _ /, =;;. The re'uirement that at least =;; small coffee tables must be produced can be e-pressed in a mathematical e'uation as G/ _ =;; Finally, non.negatively conditions (e'uations" must be states for the other three decision varieties i.e. G4, G9, G5 ^ ; The complete model for %ulobeAi, timber2s linear program is therefore %a-imiAe Q H : >;,;;;G/ I : /49,;;;G4 I : /97,;;;G9 I : ?;,;;;G5 3ub(ect to: 4G/ I 4G4 I /G9 I >G5 _ 9,;;; 7G/ I 5G4 I 9G9 I 4G5 _ ?,;;; /G/ I 5G4 I 7G9 I 9G5 _ 5,?7; G/ I G4 I G9 I G5 I _ /,=;; G/ ^ =;; G4, G9, G5 ^ ;. As it can be seen, this model cannot be solved graphically as there are more than 4 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 simple- method. 6owever, a computer package that incorporators this method has been used and this will typically yield the information as shown below:

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<b(ectives function !ariable (Q" H:/>=,@7;,;;; !ariable G/ G4 G9 G5 !alue ?7;,;;; 47;,;;; >;;,;;; ;,;;;; #elative Eoss. ;,;;;; ;,;;;; ;,;;;; 5=,;;;

*onstraint / 4 9 5 7 /.

3lack , surplus ;,;;;; /,57;,;;; ;,;;;; ;,;;;; /7;,;;;;

0orth. ?,;;; ;,;;;; 4/,;;; 4/,;;; ;,;;;

The Va "a+le and ,al*e columns mean that G/ H ?7;D G4 H 47;D G9 H >;;D G5 H;. Therefore to ma-imiAe contribution in the coming year, %ulobeAi, should manufacture ?7; small coffee tables, 47; medium one and >;; large one and none (nil" of the e-tra large coffee table Q H : />=, @7;, ;;;, 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 e'ual to constraints and the surplus values for any 1greater than or e'ual to2 constraints. From your studies of linear programming we know that a slack variable is the amount of resource which will be unused in a

4. 9.

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specific linear programming solution and a surplus is the e-tra that is produced above the minimum re'uirement in a greater than or e'ual to constraint. a" *onstraint 5 is _ and refers to cutting time. $t slack to Qero showing that all availability cutting time will be used. b" *onstraint Q is _ and refers to assembly time the slack here e'uals /, 57; and this there will be /, 57; unused hours of assembly time. This assembly time is not a binding constraint. c" *onstraint 9 is _ and refers to finishing time. $ts slack is Aero indicating that all of this resource will be used. d" *onstraint 5 is _ and refers to the ceiling on the total number of coffee tables produced of /,=;;. The slack is Aero. 3howing that this ceiling has been met e-actly. e" *onstraint 7 is ^ and specifies that at least =;; small coffee tables will be made. $t has a surplus e'ual to /7;, indicates that production is /7; above the minimum re'uirement, so ?7; of these tables are made. (This can be seen by the fact that G/ H ?7;".
GORT@ #ND REL#TI)E LOSS INTER!RET#TION

$n 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 e-tra hour of cutting time would increase contribution by : ?,;;; and e-tra hour of finishing time would increase contribution by :4/,;;;.
N#TURE O. RIS*

$t 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. #isks e-ist where several alternative outcomes are possible, but previous e-pense enables the decision maker to give (assign" a probability to the likely outcome of each alternative. &ncertainty on the other hand refers to a situation where a decision maker has no previous e-perience and therefore no statistical evidence on which to base his predictions.

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6owever, 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 e-pected value (C!". A risk neutral decision maker ignores variability and is concerned only with the e-pected values of outcomes. #isk seekers prefer of two outcomes with the same e-pects 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. #n oC"ecti9e %unction7 i.e. the 'ualification of the company2s ob(ectives in a particular situation. Typically, this would be the ma-imiAation of profits as it is the belief that the sole ob(ective of a business is ma-imiAation of profits. # set o% alternati9e causes o% action These can be adopted in order to achieve the desired ob(ectives. This set must be collectively e-haustive i.e. all alternative must be considered and mutually e-clusive i.e. one course of action precludes any other. # set o% the alternati9e states of nature that e-ist in respect of the situation together with the probability of each ones occurring. Again this set must be collectively e-hausted and mutually e-clusive (and the probabilities must sum up to /.;" # set o% outcomes Cach outcome associated with a particular course of action and state of nature. # set o% pa?Jo%%s5 each one associated with a particular outcome. ay.offs are e-pressed in terms of the ob(ectives of the function.

A risk neutral decision.maker would accept the alternative course of action that ma-imiAes 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. Example 6

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N*ET# Ltd buys in sub.assemblies for the manufacture of it2s 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:
INS!ECT OR NOT INS!ECT7

No alternatives are possible (i.e. they are collectively e-haustive", and the adoption of one precludes the other. (i.e. they are mutually e-clusive" only two alternative states of nature e-ists, with the same characteristics either the sub.assembly comes up to the re'uired 'uality standard (which it is likely to do ?;8 of the time" or it fonts to do so (which occurs /;8 of the time" Four outcomes are possible: /" $nspect and find no problems. 4" $nspect and find problems. 9" Do not inspect and no problem e-ists 5" Do not inspect and problems do e-ist. Cach outcome can be assessed in terms of it2s pay.off. $n the case of: (/" (4" (9" (5" &nnecessary inspection reduces contribution by : /;,;;; per unit, under $nspection and necessary modification reduces contribution by :4;,;;;D under There is no loss of contribution and under C-tensive rework at the finished goods stage reduces contribution by :5;,;;;

As we already introduced the concept of e-pected value (C!"D the e-pected value of each course of action in this particular e-ample is as followsD
E:!ECTED REDUCTOIN IN CONTRI-UTION

$N3 C*T J;.?- :/;,;;;L I J;./- :4;,;;;L H (://,;;;" D< N<T $N3 C*T J;.?- :;L I J;./ - (:5;,;;;"L H (:5,;;;" Taken over a long period of time, a policy of not carrying out an inspection would lead to contribution being on average :@,;;; higher for each sub.assembly purchased. <n a purely 'uantitative analysis, therefore it is the correct policy to adopt. /5=

6owever in the real world, we could have seen a high level of failures incompatible with a re'uirement for a 'uality product and the concept of continuous improvement. $t would be more useful to ask the supplier some basic 'uestions regarding his 'uality management in order to bring about a fundamental shift towards outcome (9" rather than simply adopt a policy on the basis of such an uncritical situation. The e-tra e-ample below introduces a further consideration. Example 6 An efficient middle.aged Qambian businesswoman is considering backing the production of a new musical in the west midlands. $t would cost :/;;,;;;,;;; to stage for the first month if it is well received by the critics and will be kept for a further > months in which case a profit of :47;,;;;,;;; over and above the initial investment of :/;;,;;;,;;; would be made. $f the critics dislike it, it will close at the end of the :/;;,;;; initially invested. There is a 7;,7; chance of a favourable review using e-pects value leading to a decision to back the pro(ect as it2s shown in the computation belowD Decision to back the musical J;.7- :47;,;;;,;;;L I J;.7- (:/;;,;;;,;;;"L H :@7,;;;,;;; Decision not to back the musical J;.7-:;L I J;.7- :;L H :; 6owever e-pected 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. 3uch as thisD obviously, the e-pected profit of :@7,;;;,;;; is not a feasible outcome of this particular decision, the only feasible outcomes of this would be a profit of :47;,;;;,;;; or a loss of :/;;,;;;,;;;. 0hilst almost everybody welcomes a profit of :47;,;;;,;;;, few individuals would afford to sustain a personal loss of :/;;,;;;,;;;. %any investors would be risk averse in such a situation they would not consider that a 7;8 chance of making :47;,;;;,;;; was worth an e'ual 7;8 percent risk (chance of losing :/;;,;;;,;;;, 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.

/5?

The two e-amples below as earlier include only single.point outcomes. *onformity with present 'uality standard or non.conformity in e-ample / and a successful show or a flop in e-ample 4. 0hile it is obvious that the two outcomes of the former represent the only possible alternative and 'ualification of the related pay.offs along the lines of our e-ample appear reasonable, it is e'ually obvious that the profit of :47;,;;;,;;; predicts for a successful show in the latter is far too precise than a figure. $t 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. Cvery 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. ay.off will vary according to the actual mi- achieved. $f probabilities are attached to each estimate, the e-pected 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 4 This e-ample is a build up on C-ample 4. <utcome probability : : /7;,;;;,;;; ;.47 47;,;;;,;;; 9;;,;;;,;;; 97;,;;;,;;; ;./; /.;; ;./; 7;,;;;,;;; ;.5; ;./7 /;;,;;;,;;; 57,;;;,;;; 97,;;;,;;; 457,;;;,;;; e-penditure value /7,;;;,;;; 47;,;;;,;;;

Although the e-pected 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 e-pected value of a decision to back the pro(ect: (;.7 - :457,;;;,;;;" I J;.7 - (:/;;,;;;,;;;"L H : @4,7;;,;;;. 3till on economically non.superficial outcome for this uni'ue pro(ect. The statement of ranging possible outcomes and their assigned probabilities is known as a probability distribution. $ts presentation to management in this form allows two further useful inferences to be drawn from the data:

/7;

/" The most likely outcome (being the outcome with highest probability a profit of :47;,;;;,;;; in our e-ample 4" The probability of an outcome being above or below a particular figure (e.g. by summary the probabilities for pay.offs of :/7;,;;;,;;;, :4;;,;;;,;;; and :47;,;;;,;;; we can conclude that there is a @78 probability that profit will be :47;,;;;,;;; or less if the musical is successful and summarising those for :9;;,;;;,;;; and :97;,;;;,;;; allows us to say that the probability of a profit of :9;;,;;;,;;; or more in the event of success is only 478". $n practice a grater number of alternative course of action may e-istD uncertainly may be associated with more than one variable and value of variables may be interdependent giving rise to many different outcomes. $n the following e-ample we want to understand the application of the probability two or more states of nature occurring together. $t 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 7;8 probability of the musical in e-amples 4 and 9 being well recurred and a 5;8 probability of its making a profit of :47;,;;;,;;; (as opposed to any other profit figure" if it is well recurred then the probability of promoting a successful musical which makes a profit of :47;,;;;,;;; is ;.7 - ;.5 H ;.4 or 4;8. Example 1 %usa Etd manufactures a product called the chumbu. <ne batch of the chumbu is produced and sold each 'uarter. $t is not possible to hold stocks of the chumbu for any significantly long period of time. At a batch siAe of 45,;;; units, the variable cost of a unit of the *humbu is :9;,;;;. The variables costs are all labour.related and the production of *humbu involves an =;8 learning curve. %arket research has it that demand for the 'uarter of the *humbu relates as shown below to the selling price per unit. 3elling price per unit (:" 3ales of the *humbu 7;,;;;, 49,;;; >;,;;; 49,;;; @;,;;; /@,7;; =;,;;; /7,;;; ?;,;;; /4,;;; There is a complete discontinuation between the batches as regards learning effects. Bou may assume that the variable cost per *humbu (h" on an =;8 learning curve may be obtained from the following formulaD where + is the batch siAe and is a constant. h H OOOOaOOOO + ;.944

/7/

Re.uirements:

*alculate the optimum batch siAe for the *humbu production. Suggested solution For as long as the candidate knows the mechanics of the learning curve effect, then it is 'uite straight forward to calculate the total variable costs at different batch siAes. $t does not make a difference that is e-pressed in kwacha (monetary" terms rather than hours. <nce you have calculated the variable cost at different batch siAes, it is a simple matter to identify the batch siAe which ma-imiAes contribution using revenue analysis. From the formula given and using information supplied in regard to the batch siAe of :45, ;;; units it may be deduced that 1a2 H :@@9, 59@.>@ as it can be seen from the calculation belowD

0hen + is 45,;;;, h is :9;,;;;, thereforeD :9;, ;;; H OOOOOaOOOOOO 45,;;; ;.944 log 45, ;;; H 5.9=;4//454 5.9=;4//454 G ;.944 H /.5/;54=;4 Antilog of /.5/;54=;4 H 47.@4?9;4?/ a H :9;,;;; G 45,;;; unit *;;45 14;7<; Re0enue Analysis:

/74

Sales re9enue )ariaCle costs ContriCution %or the -atch siOe /units2 * P,,, *P,,, Catches * P,,, 49, 7;; /, /@7, ;;; @//, 44= 5>9, @@4 49, ;;; /, 9=;, ;;; @;;, ?99 >@?, ;>@ /@, 7;; /, 447, ;;; 7=4, 9@= >54, >44 /7, ;;; /, 4;;, ;;; 745, 7=5 >7@, 5/> /4, ;;; /, ;=;, ;;; 57;, ?9/ >4?, ;>? *omputation of the variable cost per batch h H : @@9, 59@.>@ : /4, ;;; ;.944 h H : @@9, 59@.>@ 4;.7=45/;57 h H : 9@, 7@@.>; As it can be seen, the batch, where contribution is being ma-imiAed is at the : 49, ;;; batch units of the *humbu. &ecision Trees The decision tree is one way or method of analyAing 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 techni'ue is usually used to evaluate alternative investment plans. The illustration below gives a simple e-ample to illustrate a diagrammatic representation of the decision tree. Illustration; #eturn in $nvestment * Br / 5;, ;;; Br 4 /4;, ;;;
Expected 3,5 ,,,

robabilities $nvestment D ;.7 (4;, ;;;" ;.7 /=;, ;;;

robabilities ;.5 ;.@

0<,5 ,,, net pro%its

0hen the e-pected profit is calculated, it appears that plan D would be the best option. +ut the plan has a ;.5 chance of a loss : 4;,;;;,;;; whereas plan * will always generate a profit of some point.

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Notation o" A Tree Diagram The tree diagram has s'uares and circles as symbols that take on e-traordinary meaningD The s'uare represents a point at which a decision is madeD in this case there is only one decision to be made K the choice between plan * 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 se'uence between possible outcomes. The values under the profit heading in the diagram below represent the possible outcomes. The UpayoffV 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 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 followingD The time value of money. This is dealt with under &nit / where you studied capital investment appraisal methods in great detail. The assumption of risk neutrality. /75

Again we might need to consider the level of risk involved in any given pro(ect as in practice all pro(ects have some level of risk attached to them. This is dealt with under sensitivity analysis and management is outside the scope of this te-t. $n practice, other grey areas might be inherent in the analysis to be made. Therefore, these cannot be over looked, they need to be considered in the investment evaluation process as well.

ExampleN %unda corporation is considering launching a new product. There are ;.9 chances that the demand for the product will be strong and ;.4 chance that the demand will be weak. Two strategies for the launch are under consideration. 3trategy A involves high promotion e-penditure and it is likely to generate a net cash inflow of :45;,;;;,;;; if demand proves to be strong. <n the other hand, if demand proves to be weak, then a net *ashflow of (>;,;;;,;;;" will result. 3trategy + involves low promotion e-penditure. $f the demand proves to be strong, then this will generate a net cash inflow of only :/>;,;;;,;;; but if the demand proves to be weak, then the net cash inflow of :5;,;;;,;;; is still e-pected to be generated. Required (a" (b" Draw a decision tree and advise which course of action generates the greatest e-pected profit. 0hat is the ma-imum amount that should be paid for market research to determine with certainty whether demand will be strong or weakS Figure 7./

Conclusion and analysis; As it can be seen from the tree diagram above, strategy, A should be adopted purely on financial grounds as its insights that it will generate a higher e-pected value of :>;,;;; as opposed to strategy + which will only promise to generate :7>,;;;,;;; as the net e-pected value. $f the research predicts that the demand would be strong then strategy A would be adopted giving a cash inflow of :45;,;;;,;;;. $f the research predicts that the demand would be weak, then strategy + would be adopted, giving a cash inflow of :5;,;;;,;;;. Therefore, the e-pected cash inflow outcome with research, will be :=;,;;;,;;;, that is J(:45;,;;;,;;; G ;.9" I (:5;,;;;,;;; G ;.4"L The e-pected cash inflow outcome without research is :/4;,;;;,;;;. Therefore, the value of the research with certainty would be :4;,;;;,;;; i.e. (:=;,;;;,;;; K :>;,;;;,;;;". /77

The ma-imum amount that the decision making e-penditure should pay for the research is therefore :4;,;;;,;;;.

RELE)#NT COSTIN>

A relevant cost is a future cash flow arising as a direct conse'uence 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.
RELE)#NT COSTIN> TER8INOLO>$

A0aila1le 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 e-ist. Opportunity Costs An opportunity cost is the benefit forgone by choosing an opportunity instead of the ne-t best alternative. Non8Rele0ant 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. Sun< Cost A sunk cost is used to describe the cost of an asset which has already been incurred, but which has as significant realiAable value and no income value from any other alternative purpose. Committed Costs A *ommitted *ost is a future cash outflow that will be incurred anyway, whatever decision is taken now about alternative opportunities. They may e-ist because of contracts already entered into by the organiAation, which it cannot get out of.

/7>

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 e-pense is incurred. C-amples 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. #ssumptions in Rele9ant Costing (i" (ii" *ost behaviour patterns are known. $t follows that, if a department closes, say, the attributable fi-ed cost savings would be known. The amount of fi-ed costs, unit variable costs, sales price and sales demand are known with certainty. $t is assumed that it is possible to apply risk and uncertainty analysis to decisions and so recogniAe that what will happen in the future is not certain. (iii" The ob(ective of decision.making in the short.run is to ma-imiAe 1satisfaction2.

3atisfaction is often regarded as 1short.term profit2. 6owever, there are many other 'ualitative 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.

8ualitati$e Factors In Decision %a ing Nualitative factors in decision.making will inevitably vary with the circumstances and nature of the opportunity being considered. 6ere are some e-amples: .actor Availability of cost Comment An opportunity may be profitable, but there must be sufficient cost to finance any purchase of e'uipment and build up working capital Any decision involving the shutdown of plant,

Cmployee

/7@

charges in work procedures and so on will re'uire acceptance by employees, and out to have regard to employee welfare. *ompetitors 3ome 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. 3uppliers2 long.term goodwill may be damaged by a decision. Decisions to change the specifications for bought.out components, or to change stockholding policies so as to create patchy, uneven demand, might put a strain on suppliers. $f a company is the supplier2s main customer, a decision might dime the supplier out of business Feasibility A proposal may look good on paper, but managers may have some reservations about their ability to carry it out in practice. A decision might occasionally be deferred or reflected because of doubts about the legality of the proposed action.

3uppliers

Eegal #estraints

Identi"ying and #alculating Rele$ant #osts As defined earlier, an opportunity cost is the benefit forgone by choosing one opportunity instead of the ne-t best alternative. 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 e-ist for making profitable use of the resource e-ceed the amount of the resource available. 3o 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 in another way must be forgone. Example 3uppose 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 e'uipment for 7 (five" hours and its running costs would be :4;,;;; per hour.

/7=

6owever, your company faces heavy demand for usage of the e'uipment which earns a contribution of :@;,;;; per hour from this other work. $f 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 1internal2 opportunity cost". 3ince the e'uipment can earn :@;,;;; per hour in an alternative use, the contract under consideration should also be e-pected to earn at least the same amount. This can be accounted for by charging :@;,;;; per hour as an opportunity cost to the contract and the total relevant cost of 7 hours of e'uipment time would beS Solution #unning *osts (7 hrs - :4;,;;;" $nternal <pportunity *ost (7 hrs - :@;,;;;" Rele9ant Cost : /;;,;;; 97;,;;; 1',5,,,

$t is important to note that the variable running costs of the e'uipment are included in the total relevant costs. Rule %or identi%?ing the rele9ant costs o% a scarce resource7 The total relevant cost of a scarce resource is the sum of the contribution,incremental profit foregone from the ne-t best opportunity for using the scarce resource and the variable cost of the scarce resource (that is, the cost e-penditure to purchase the resource". Identi%?ing Rele9ant Costs $n 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 'uestion. First some general points about machinery, labour and materials that often catch people out will be considered. 8achiner? User costs <nce a machine has been bought its costs is a sunk cost. Depreciation is not a relevant cost, because it is not a cash flow. 6owever, 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

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NQ Etd is considering whether to undertake some contract work for a customer. The machine re'uired 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". 6ire charges for this machine are :@7,;;; per month, with a minimum hire charge of :9;;,;;;. All other machinery re'uired in the production for the contract have already been purchased by the organiAation on hire purchase terms. The monthly hire purchase payments for this machine are :7;;,;;;. This consists of :57;,;;; for capital repayment and :7;,;;; as an interest charge. The last hire purchase payment is to be made in two months time. The cost price of this machinery was :?,;;;,;;; two years ago. $t is being depreciated on a straight.line basis at the rate of :4;;,;;; per month. 6owever, it still has a useful life that will enable it to be operated for another 9> months. Required $dentify the relevant costs Solution (a" (b" The cutting machine will incur an incremental cost of :9;;,;;;. The minimum hire charge. The historical cost of the other machinery is irrelevant as a past costD depreciation is irrelevant as a non.cash costD 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 :4;;,;;; through use. This 1user.cost2 will not arise until the machinery is eventually resold and the :4;;,;;; should be discounted to allow for the time value of money. 6owever, discounting is ignored here, as they have already discussed in *hapter /. Summar? o% rele9ant costs $ncremental hire costs &ser cost of other machinery : 9;;,;;; 4;;,;;; ',,5,,, LaCour <ften 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

(b"

/>;

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 specialiAed and is unlikely to be re'uired for other more profitable (obs over the period during which the contract work would be carried out. Although there is no immediate market for selling this machine, it is e-pected that a customer might be found in the future. $t is estimated that the machine would lose :4;;,;;; in its eventual sale value if it is used for the contract work. Required 0hat is the relevant cost of machinery for the contractS 8aterials 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. $f 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 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. $f 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.

/>/

#re the materials alread? in stocD5 or contracted to Cu? in a !urchase #greementM BC3 N< Are the materials regularly used and replaced with fresh supplies when stocks run outS BC3 N< #elevant cost H future,current purchase cost of materials Do the materials have an alternative use, or would they be scrapped if not usedS <ther use available #elevant *ost H higher of value in other use or scrap value,disposal value

#elevant cost H future,current purchase cost of materials

3crapped $f not &sed

#elevant *osts H 3crap value, Disposal value

/>4

Decision 8aDing Techniques Example A customer who would like a special (ob to be done for him has approached %uma Etd, and is willing to pay :44,;;;,;;; for it. The (ob re'uires the following materials:
%aterials A + * D Total units re'uired /,;;; /,;;; /,;;; 4;; &nits already in stock ; >;; @;; 4;; +ook value of units in stock :,unit . 4,;;; 9,;;; 5,;;; #ealisable value :,unit 4,7;; 4,7;; 4,7;; >,;;; #eplacement cost :,unit >,;;; 7,;;; 5,;;; ?,;;;

(a" (b"

%aterial + is used regularly by %uma Etd, and if units of + are re'uired for this (ob, they would need to be replaced to meet other production demand. %aterials * 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 *, but the units of material D could be used in another (ob as substitute for 9;; units of material C, which currently costs :7,;;; per unit (of which the company has no units in stock at the moment". Required 0hat are the relevant costs of material, in deciding whether or not to accept the contractS Solution

(a" (b"

%aterial A is not owned and would have to be bought in full at the replacement cost of :>,;;; per unit. %aterial + is used regularly by the company. There are e-isting stocks (>;; units" but if these are used on the contract under review a further >;; units would be bought to replace them. #elevant cost therefore, /,;;; units at the replacement cost of :7,;;; per unit.

/>9

%aterial *: /,;;; units are needed and @;; are already in stock. $f used for the contract, a further 9;; units must be bought at :5,;;; each. The e-isting stocks of @;; will not be replaced. $f they are used for the contract, they could not be sold at :4,7;; each. The realiAable value of these @;; units is an opportunity cost of sales revenue forgone. %aterial 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 e-isting stocks for :>,;;; per unit (:/,4;;,;;;" or avoid other purchases (of material C", would cost 9;; - :7,;;; H:/,7;;,;;; 3ince substitution for C is more beneficial, :/,7;;,;;; is the opportunity cost. Summar? o% Rele9ant Costs %aterial A (/,;;; - :>,;;;" %aterial + (/,;;; - :7,;;;" %aterial * (9;; - 5,;;;" I (@;; - 4,7;;" %aterial D Total : >,;;;,;;; 7,;;;,;;; 4,?7;,;;; /,7;;,;;; 0'51',5,,,

-RE#* E)EN #N#L$SIS

This is the term given to the study of the interrelationships between costs, volume and profit at various levels of activity. Fre'uently 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 K the break.even point K although the behaviour of costs and profits at other levels is usually of much greater significance. +ecause of this on alternative term, cost. volume.profit analysis or *.!. analysis, is fre'uently used and is more descriptive.
USES O. C7)7!7 #N#L$SIS

*.!. . analysis uses many of the principles of marginal costing and is an important tool in short term planning.

/>5

$t e-plores the relationships that e-ists between costs, revenue, output levels and resulting profit and is more relevant where the proposed changes in the levels of activity are relatively small. $n these cases the established cost patterns are likely to continue, so *.!. . analysis may be useful for decision.making. <ver greater changes of activity and in the longer.term e-isting cost structures e.g. the amount of fi-ed costs and the marginal cost per unit, are likely to change, so *.!. . analysis becomes less appropriate. Typical short.run decisions where *.!. . analysis can be useful includeD choices of sale mi-, pricing policies, multi.shift working and special order acceptance.
#SSU8!TION -E@IND C7)7!7 #N#L$SIS

+efore any formulae are given or graphs drawn, the ma(or assumptions behind *.!. . analysis must be stated. These are: (a" (b" (c" (d" (e" (f" (g" All costs can be resolved into fi-ed and variable elements. Fi-ed costs will remain constant and variable costs vary proportionately with activity. <ver 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 articularly for graphical methods that the analysis relates to one product only or to a constant product mi-. 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.

$t is because of this that *.!. . analysis can only be an appro-imate 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.

/>7

-ROU>@T .ORG#RD *NOGLED>E

C7)7!7 #nal?sis C? %ormula *.!. . 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 e-amples. (a" (b" +reak.even point H ($n units" fi-ed costs contribution,unit Fi-ed costs - sale price,unit *ontribution,unit H Fi-ed *ost (c" *ontribution,sale ratio H contribution,sales ratio - /;;8 contribution,unit /

+reak.even point (: sales" H

sales price per unit (d" Eevel of sales to result in target profit (units" H (e" Fi-ed costs I Target profit *ontribution,unit

Eevel of sales to result in target profit H Fi-ed costs I Target profit *ontribution,unit

(f"

Eevel of sales to result in target profit (: sales" H (Fi-ed cost I Target profit" - 3ales price,unit *ontribution,unit

NOTE The above formulae relates to a single product firm or one with an unvarying mi- of sales. 0ith a multi.product firm it is possible to calculate the break.even point as follows: +reak .even.point H Fi-ed costs - sales value (: sales" *ontribution />>

8ULTIJ!RODUCT C@#RT

Traphs and computations of a mi- of products can be derived from appropriate data. Example A company which has fi-ed costs of :7;,;;;,;;; per annum and has three products, the sales and contribution of which are shown below. !roduct G B Q Required lot the products on a profit chart and show the break.even sales Solution The a-es on the profit chart are drawn in the usual way and the contribution from the products, in the se'uence of their *,3 ratio i.e. B, Q, G drawn on the chart. Sales *+,,, /7;,;;; 5;,;;; >;,;;; ContriCution *+,,, 9;,;;; 4;,;;; 47,;;; CBS ratio 4;8 7;8 548

I7;,;;;

I47,;;;

7;,;;;

/;;,;;;

/7;,;;;

4;;,;;; 47;,;;;

Q
.47,;;;

B
.7;,;;;

/>@

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 mi- and *,3 ratios. #eading from the graph the break.even point is appro-imately. :/@;,;;;,;;;. The e-act figure can be calculated as follows: roduct G B Q 3ales :2;;; /7;,;;; 5;,;;; >;,;;; 6',5,,, <verall *ontribution,3ales #atio H @7,;;; 47;,;;;,;;; 9;8 Fi-ed costs *,3 ratio :7;,;;; 9;,/;; :7;,;;;,;;; ;.9 *0<<5<<<5<<; *ontribution :2;;; 9;,;;; 4;,;;; 47,;;; ;'5,,, G /;;8

H +reak.even point H H H H

/>=

LI8IT#TIONS O. -RE#*JE)EN C@#RTS #ND #N#L$SIS

(a"

The *.!. . charts assume that fi-ed costs are always unaffected by activity, but in actual fact, they can e-hibit features of stepped fi-ed 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. The charts and *.!. . 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 *.!. . analysis.

(b"

(c"

RIS* #ND UNCERT#INT$ #isk arises in situations where several possible outcomes are e-pected and where past e-perience provides statistical evidence which can be used to predict the possible outcomes. &ncertainty 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. Nuite often, most business decisions fall in the uncertainty category. !REDICTIN> !OSSI-LE OUTCO8ES redicting possible outcomes makes use of probabilities. robability is the likelihood that an event will occur. 0here several possible outcomes are e-pected, 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. robability can either be ob(ective probabilities or sub(ective probabilities. <b(ective probabilities are probabilities which are established mathematically or compiled from past data e.g. Tossing a coin. 3ub(ective probabilities are probabilities which are established by (udgement rather than past data. %ost business decisions involve sub(ective probabilities since many past observations or repeated e-periments for particular decisions are not possible. 3ub(ective probabilities are based on an individual2s e-pert knowledge, past e-perience and observations of current variables which are likely to have an impact on future events. 6owever, sub(ective probabilities have the advantage />?

of providing more meaningful information, unlike stating the most likely outcome. !RO-#-ILIT$ #ND E:!ECTED )#LUE C-pected value is a simple way of showing the effects of uncertainty into decision.making. C-pected value is the average value of an event which has several possible outcomes. The e-pected value of a decision represents the long. run average outcome that is e-pected to occur if a particular course of action is under.taken several times. .or example A company is to make a decision to manufacture two products G and B and the decision is repeated several times, the e-pected values can be calculated thus: #<D&*T G : <utcome rofits :2;;; 5,=;; 7,>;; >,5;; @,4;; =,;;; #<D&*T B : <utcome rofits :2;;; 9,4;; 5,=;; >,5;; =,;;; ?,>;; robability ;.;@ ;.;= ;.9= ;.4@ ;.4; 0eighted Amount :2;;; 445 9=5 4,594 4,/>; /,?4; @,/4; robability ;.;? ;.4/ ;.57 ;./7 ;./; 0eighted Amount :2;;; 594 /,/@> 4,==; /,;=; =;; >,9>=

From the above, we can conclude that if a decision was made to produce G and B several times repeatedly, G will produce profits of :>,9>=,;;; and B will produce profits of :@,/4;,;;;. $t is important to note that the e-pected values are the averages of the possible outcomes based on management estimates. $t is therefore very possible for the actual results to be different from the e-pected values.

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8E#SURIN> DE>REE O. UNCERT#INT$ The degree of uncertainty can be measured by calculating the standard deviation. This is the conventional measure of the dispersion of a probability distribution. &sing the data in 7.7.> the standard deviation of roduct G and roduct B can be calculated: #<D&*T G rofit Amount (:2;;;" 5,=;; 7,>;; >,5;; @,4;; =,;;; Deviation from (:2;;;" . /,7>= .@>= 94 =94 /,>94 3tandard deviation (:2;;;" 4,57=,>45 7=?,=45 /,;45 >?4,445 4,>>9,545 robability 0eighted amount (:2;;;" ;.;? ;.4/ ;.57 ;./7 ;./; 44/,4@> /49,=>9 5>/ /;9,=95 4,>>9,954 9,//4,@@>

3tandard Deviation H `9 //4 @@> ;;; H : /,;?7,557 #<D&*T B rofit Amount (:2;;;" 9,4;; 5,=;; >,5;; =,;;; ?,>;; Deviation from (:2;;;" . 9,?4; . 4,94; . @4; ==; 4,5=; 3tandard deviation (:2;;;" /7,9>>,5;; 7,9=4,5;; 7/=,5;; @@5,5;; >,/7;,5;; robability 0eighted amount (:2;;;" /,;@7,>5= 59;,7?4 /?>,??4 4;?,;== /,49;,;=; 9,/54,5;;

;.;@ ;.;= ;.9= ;.4@ ;.4;

3tandard Deviation H `9 /54 ;;; H : /,@@4,>=/ 3o 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 roduct B which has a higher e-pected value, but at the same time has risk (standard deviation" higher than roduct G.

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DECISION L TREE #N#L$SIS 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. To illustrate how decision tree can be considered the following e-ample will be used: Example :oko lc is a manufacturing company. The company is considering launching a product. The following estimates have been made: rofit estimate :2;;; 59,4;; =,;;; 94,;;; robability ;.7; ;.9; ;.4;

$n addition the company has estimated an amount of :/5,5;;,;;; as the investment needed. The probability that the pro(ect will succeed is ;.> and ;.5 for failure. 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.

Cstimated
(;.7" EA&*6 3&*CCD3

robability

C-pected rofit (:2;;;" 59,4;; =,;;; 94,;;; /5,5;;

;.9 ;./= ;./4 ;.5

!alue (:2;;;" /4,?>? /,55; 9,=5; 7,@>;

FA$E3

/@4

;
N<T DC!CE<

; 5,=;;

For two events to occur together, there must be (oint probability. For e-ample, the probability of the development succeeding and the company making a profit of :=,;;;,;;; is made up of the probability that the launch will succeed ( H ;.>" and the probability that a profit of :=,;;;,;;; will be achieved ( H ;.9", hence giving a (oint probability of ;.9 W ;.> H ;./= $t is also worth noting that if the decision was repeated several times, an average e-pected profit of :5,=;;,;;; will be achieved. $n theory this means that the decision to develop the product should be favoured as it results in n average profit of : 5,=;;,;;; as compared to the decision not to develop the product as it gives Aero profit. #VP ANA+&1I1 IN A %!+TIP+4 PR0D!#T 4NVIR0N%4NT <rganisations typically produce and sell a variety of products and services. To perform *! analysis in a multi.product organisation, however, a constant product sales mix must Ce assumed. $n other words, we assume that whatever - units of product A are sold, y units of products + and A units of product * are also sold. 3uch an assumption allows us to calculate a weighted a9erage contriCution per mix, the weighting being on the basis of the 'uantities of each product in the constant mi-. This means that the unit contribution of the product that takes up the largest proportion of the mi- has the greatest impact on the average contribution per mi-. The only situation when the mi- of products does not affect the analysis is when all o% the products ha9e the same ratio o% contriCutions to sales /CBS ratio27 'rea(even point is 5The le$el o" acti$ity at -hich there is neither pro"it nor loss6 CIMA Official Ter!inology$ $REA0EVEN P(INT -(R M,LTIPLE PR(/,CTS This calculation is e-actly the same as that for single products but the single product is the standard mi-. Eets look at an e-ample. %*AMPL%+'R%A,%V%" POI"T FOR M-LTIPL% PRO&-CT 3uppose that Etd produces and sells two products. The % sells for :@ per unit and has a total variable cost of :4.?5 per unit, while the N sells for : /7 per

/@9

unit and has a total variable cost of :5.7; per unit. The marketing department has estimated that for every five units of % sold, one unit of N will be sold. The organisation2s fi-ed costs total :9>,;;;. 10+!TI0N 0e calculate the breakeven point as follows: Step 07 *alculate contriCution per unit 3elling price !ariable cost *ontribution Step 67 *alculate contriCution per mix H (: 5.;> W 7" I (: /;.7; W /" H : 9;.=; Step 47 *alculate the CreaDe9en point in terms of the numCer o% mixes H fi-ed costs,contribution per mi- H : 9>,;;;,: 9;.=; H /,/>? mi-es (rounded" Step 17 *alculate the CreaDe9en point in terms of the numCer o% units o% the products H (/,/>? W 7" 7,=57 units of % and (/,/>? W /" /,/>? units of N (rounded" Step '7 *alculate the CreaDe9en point in terms of re9enue F ( 7,=57 W : @" I (/,/>? W : /7" H : 5;,?/7 of % and : /@,797 of N H : 7=,57; in total $t is important to note that the breakeven point is not :7=,57; of revenue, whatever the mi- of products. The breakeven point is :7=,57; provided that the sales mi- remains 7:/. Eikewise the breakeven point is not at a production,sales level of (7,=57 I /,/>?" @,;/5 units. #ather, it is when 7,=57 units of % and /,/>? units of N are sold, assuming a sales mi- of 7:/. C(NTRI$,TI(N T( SALES 2C3S4 RATI( -(R M,LTIPLE PR(/,CTS An alternative way of calculating the CreaDe9en point is to use the average contribution to sales (*,3" ratio for the standard mi-. As you should already know, the *,3 ratio is sometimes called the !ro%itB 8 : per unit @.;; 4.?5 5.;5 N : per unit /7.;; 5.7; /;.7;

/@5

9olume ratio or !B) ratio. 0e can calculate the breakeven point of Step 07 *alculate re9enue per mix F (7 W :@" I (/ W :/7" H :7; Step 67 *alculate contriCution per mix H :9;.=; Step 47 *alculate a9erage CBS ratio H (:9;.=;,:7;.;;" W /;;8 H >/.>8 Step 17 *alculate CreaDe9en point (total" Fi-ed costs a *,3 ratio H:9>,;;;,;.>/> H:7=,554 (rounded" Step '. *alculate re9enue ratio mix H97:/7, or @:9 Step <7 Calculate CreaDe9en sales +reakeven sales of % H : 7=,554 W @,/; H :5;,?;? (rounded" +reakeven sales of N H :7=,554 W 9,/; H :/@,799 (rounded" Alternatively you might be provided with the individual *,3 ratios of a number of products. For e-ample if an organisation sells two products (A and +" in the ratio 4:7 and if the *,3 ratio of A is /;8 whereas that of + is 7;8, the average *,3 ratio is calculated as follows. Average *,3 ratio H (4 W /;8" I (7 I 7;8" 4I7 EUESTION #9erage CBS ratio T$% Etd produces and sells two products, the %: and :E. The company e-pects to sell / %: for every 4 :Es and have monthly revenue of :/7;,;;;. The %k has a *,3 ratio of 4;8 whereas the :E has a *,3 ratio of 5;8. +udgeted monthly fi-ed costs are :9;,;;;. 0hat is the budgeted breakeven sales revenueS A :/7;,;;; + :9;;,;;; * :?;,;;; D :7;,;;; ETD as follows:

/@7

#nswer The correct answer is C7 Average *,3 ratio H (4;8 W /" I (5;8 W 4"H 99 /,98 9 3ales revenue at the breakeven point H fi-ed cost H :9;,;;; H :?;,;;; *,3 ratio ;.999 The *,3 ratio is a measure of how much contribution is earned from each :/ of sales of the standard mi-. The *,3 ratio of 99 /,98 in the 'uestion above means that for every :/ of sales of the standard mi- of products, a contribution of 99.99 ngwee is earned. To earn a total contribution of, say, :4;,;;; sales revenue from the standard mi- must therefore be: :/ W :4;,;;; H :>;,;;; 99.99n

!oints to Cear in mind #n? change in the proportions o% products in the mix will change the contriCution per mix and the a9erage CBS and hence the CreaDe9en point a" $f the mi- 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" $f sales are at the specified level but not in the specified mi-, there will be either a profit or a loss depending on whether the mi- shifts towards products with higher or lower contribution margins. SALES3PR(/,CT MI5 /ECISI(NS <ne use of the methodology we have been looking at is to determine the most pro%itaCle sales mix option of number open to management.

/@>

E:#8!LE S#LES 8I: DECISIONS ]% Etd makes and sells two products, the ] and %. The budgeted selling price of the ] is :>; and that of the %, :@4. !ariable costs associated with producing and selling the ] are :9; and, with the m, :>;. Annual fi-ed production and selling costs of ]% Etd are :9,9>?,>;;. ]% Etd has two production,sales options. The ] and the m can be sold either in the ratio two ]s to three %s or in the ratio one ] to two %s. 0e can decide on the optional mi- by looking at breakeven points. 0e need to begin by determining contribution per unit. ] % : per unit : per unit 3elling price >; @4 !ariable cost 9; >; *ontribution 9; /4 8ix 0 *ontributions per 7 units sold H (:9; W 4" I (:/4 W 9" H :?> +reakeven point H :9,9>?,>;; H 97,/;; sets of five units :?> ] % +reakeven point: $n units (97,/;; W 4" @;,4;; $n : (@;,4;; W :>;" :5,4/4,;;; Total breakeven point H ://,@?9,>;; 8ix 6 *ontribution per 9 units sold H (:9; W /" I (:/4 W 4" H :75 +reakeven point H :9,9>?,>;; H >4,5;; sets of three units. :75 ] % +reakeven point: $n units (>4,5;; W /" >4,5;; (>4,5;; W 4" /45,=;; $n : (>4,5;; W :>;" :9,@55,;; (/45,=;; W : @4" :=,?=7,>;; Total breakeven point H :/4,@4?,>;; (97,/;; W 9" /;7,9;; (/;7,9;; W : @4" :@,7=/,>;;

/@@

$gnoring commercial considerations, mi- / is preferable to mi- 4. 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 mi- / is :/?.4; :?> a 7". $n mi- 4 it is :/= (:75 a 9". %i- / contains a higher proportion (5;8 as opposed to 99 /,98" of the more profitable product. The following 'uestion looks at the e%%ect on the o9erall CBS ratio o% a productBsales mix7 EUESTION C@#N>IN> T@E !RODUCT 8I: A Etd sells three products K C-e, 0hy and Qed K in e'ual 'uantities and at the same selling price per unit. The *,3 ratio is 778. 3uppose the product mi- is changed to C-e 4;8, 0hy 7;7 and Qed 9;8. Required *alculate the revised total contribution,total sales ratio. SOLUTION Original proportions *,3 ratio %arket share C-e ;.7 W/,9 ;./>@ 0hy ;.> W/,9 ;.4;; Qed ;.75? (04" W/,9 ;./=9 (0/" Total ;.77

-o ."#$s /. The total *,3 ratio is the sum of the weighted *,3 ratios and so this figure is calculated as: ;.77 K ;./>@ K ;.4 H ;./=9 4. This figure is then calculated as ;./=9 a /,9 H ;.75?

Re9ised proportions *,3 ratio (as above" %arket share C-e ;.7 W;.4 ;./ 0hy ;.> W;.7 ;.9 Qed Total ;.75? W;.9 ;./>5@ ;.7>5@

The total *,3 ratio will increase because of the inclusion in the mi- of proportionately more of 0hy, which has the highest *,3 ratio.

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T#R>ET !RO.ITS .OR 8ULTI!LE !RODUCTS At breakeven point, sales revenue (3" is e'ual to variable costs plus fi-ed costs (! I F", and there is no profit: SF)F. 3uppose an organisation wishes to achieve a certain level of profit ( " during this period. To achieve this profit, sales must cover all costs and leave the re'uired profit: 3H!IFI therefore 3K!HFI

3o total contribution re'uired H F I <nce we know the total contribution re'uired 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. E:#8!LE T#R>ET !RO.ITS .OR 8ULTI!LE !RODUCTS A company makes and sells three products, F, T and 6. The products are sold in the proportion F:T:6 H 4:/:9. The company2s fi-ed costs are :=;,;;; per month and details of the products are as follows. roduct F T 6 3elling price : per unit 44 /7 /? !ariable cost : per unit /> /4 /9

The company wishes to earn a profit of :74,;;; ne-t month. *alculate the re'uired sales value of each product in order to achieve this target profit. Solution *alculate contriCution per unit F T : per unit : per unit 3elling price 44 /7 !ariable cost /> /4 *ontribution > 9 Step 67 *alculate contriCution per mix H (:> W 4" I (:9 W /" I (:> W 9" H :99 Step 47 *alculate the required numCer o% mixes Step 07 6 : per unit /? /9 >

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H (Fi-ed costs I re'uired profit",contribution per miH (:=;,;;; I :74,;;;",:99 H 5,;;; mi-es Step 17 *alculate the required sales in terms of the numCer o% units o% the products and sales re9enue o% each product 3ales 3elling revenue roduct price re'uired &nits : per unit : F T 6 Total 5,;;; W 4 35,,, 5,;;; W / 15,,, 5,;;; W 9 065,,, 44 /7 /? /@>,;;; >;,;;; 44=,;;; 5>5,;;;

The sales revenue of :5>5,;;; will generate a profit of :74,;;; if the products are sold in the mi- 4:/:9 Alternatively the *,3 ratio could be used to determine the re'uired sales revenue for a profit of :74,;;;. The method is again similar to that demonstrated earlier when calculating the breakeven point. E:#8!LE USIN> T@E CBS R#TIO TO DETER8INE T@E REEUIRED S#LES 0e will use the data given on target profits for multiple products e-ample: Step 07 Calculate re9enue per mix H (4 W :44" I (/ W :/7" I (9 W :/?" H ://> Step 67 Calculate contriCution per mix H :99 (from aragraph 7.>./;.5" Step 47 Calculate a9erage CBS ratio F (: 99,: //>" W /;;8 H 4=.578

Step 17 Calculate required total re9enue H re'uired contribution a *,3 ratio H (:=;,;;; I :74,;;;" a ;.4=57

/=;

H :5>9,?@4 Step '7 Calculate re9enue ratio o% mix H (4 W :44": (/ W :/7": (9 W :/?" H 55:/7:7@ Step <7 Calculate required sales #e'uired sales of F H 55,//> W :5>9,?@4 H :/@7,?=? #e'uired sales of T H /7,//> W :5>9,?@4 H :7?,??> #e'uired sales of 6 H 7@,//> W :5>9,?@4 H :44@,?@=? 0hich, allowing for roundings, is the same answer as calculated in solution to e-ample. 8#R>IN O. S#.ET$ .OR 8ULTI!LE !RODUCTS $t should not surprise you to learn that the calculation of the margin of safety for multiple products is e-actly the same as for single products, but the single product is the standard mi-. The easiest way to see how it is done is to look at an e-ample. 8#R>IN O. S#.ET$ .OR 8ULTI!LE !RODUCTS ] Etd produces and sells two products. The 0 sells for := per unit and has a total variable cost of :9.=; per unit, while the # sells for :/5 per unit and has total variable cost of :5.4;. For every five units of 0 sold, si- units of # are sold. ] Etd2s fi-ed costs are :59,=?; per period. +udgeted sales revenue for ne-t period is :@5,5;;, in the standard mi-. SOLUTION To calculate the margin of safety we must first determine the CreaDe9en point7 Step 07 *alculate contriCution per unit 3elling price !ariable cost *ontribution Step 67 *alculate contriCution per mix H (:5.4; W 7" I (: ?.=; W >" H :@?.=; Step 47 *alculate the CreaDe9en point in terms of the numCer o% mix 0 : per unit =.;; 9.=; 5.4; # : per unit /5.;; 5.4; ?.=;

/=/

H fi-ed costs,contribution per miH :59,=?;,:@?.=; H 77; mi-es Step 17 *alculate the CreaDe9en point in terms of the numCer o% units o% the products H (77; = 7" 4,@7; units of 0 and (77; W >" 9,9;; units of #

Step '7 *alculate the CreaDe9en point in terms of revenue H (4,@7; W :=" I (9,9;; W :/5" H :44,;;; of 0 and :5>,4;; of # H :>=,4;; in total Step <7 *alculate the margin o% sa%et? H budgeted sales K breakeven sales H :@5,5;; K :>=,4;; H :>,4;; sales in total, in the standard miOr, as a percentage H (:@5,5;; K :>=,4;;",:@5,5;; W /;;8 H =.98 of budgeted sales 8ULTI L !RODUCT C)! C@#RTS -reaDe9en charts *E$ TER8 A CreaDe9en chart is 1A chart which indicates appro-imate profit or loss at different levels of sales volume within a limited range2. /CI!A official "erminology> A very serious limitation of breakeven charts is that they can show the costs, revenues, profits and margins of safety for a single product only, or at best for a single Psales mix+ o% products7 For e-ample suppose that Farmyard Etd sells three products, G, B and Q which have variable unit costs of :9, :5 and :7 respectively. The sales price of G is :=, the price of B is :> and the price of Q is :>. Fi-ed costs per annum are :/;,;;;. A breakeven chart cannot be drawn, because we do not know the proportions of G, B and Q in the sales mi-. There are a number of ways in which we can overcome this problem, however. Output in * sales and a constant product mix

/=4

Assume that budgeted sales are 4,;;; units of G, 5,;;; units of B and 9,;;; units of Q. A breakeven chart would make the assumption that output and sales of G, B and Q are in the proportions 4,;;; : 5,;;; : 9,;;; at all levels of activity, in order words that the sales mi- is 1fi-ed2 in these proportions. 0e begin carrying out some calculations.
B*)$ete) costs !arible costs of G (4,;;; W : 9" !arible costs of B (5,;;; W : 5" !arible costs of Q (9,;;; W : 7" Total variable costs Fi-ed costs Total budgeted *osts Re,e#*e : : >,;;; G (4,;;; W : =" />,;;; />,;;; G (4,;;; W : >" 45,;;; /7,;;; G (4,;;; W : >" /=,;;; 9@,;;; /;,;;; 5@,;;; +udgeted revenue 7=,;;;

The CreaDe9en chart can now be drawn.

The CreaDe9en point is appro-imately :4@,7;; of sales revenue. This may either be read %rom the chart or computed mathematicall?7 a" The budgeted *,3 ratio for all three products together is contribution,sales H :(7=,;;;.9@,;;;",: 7=,;;; H 9>.4/8

/=9

b" The re'uired contribution to break even is :/;,;;;, the fi-ed costs. The breakeven point is :/;,;;;,9>.4/8 H :4@,7;; (appro-" in sales revenue. The margin of safety is appro-imately :(7=,;;; K 4@,7;;" H :9;,7;;

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Chapter 6
Ad anced Variance Anal%sis
Learning Outcomes After reading this chapter candidates should be able to: #econcile budgeted and actual profits through use of variance analysis *alculate and interpret variances and yield variance *alculate and interpret fi-ed production overhead variances *alculate and interpret planning and operational variances Appreciate principal sources of variances Appreciate and use rule of thumb investigation model &se statistical models in investigation Cstablish relationship of variances

-rought .orward *nowledge At this point in your studies, you should know and appreciate how to calculate basic variances. The main categories of these basic variances are: rice (a" %aterial variances &sage (b" Eabour variances $dle time Cfficiency #ate !ariable overhead efficiency variances !ariable overhead e-penditure variance Fi-ed production overhead e-penditure Fi-ed production volume

(c"

<verhead variances

*andidates must be able to make reconciliations of budgeted and actual profits in any given control period using the variances mentioned above. /=7

0orking backwards is another area that candidates must demonstrate strong knowledge of. Example 0 A company has the following standards for a mi- to produce 7;;kg of product :: Input A + *g 4;; 5;; >;; CostB*g * /,;;; /,>;; Total cost o% mix * 4;;,;;; >5;,;;; =5;,;;;

>;;kg of input should produce 7;;kgs of : at a standard cost of :/,>=?,kg. :/,>=;,kg H :=5;,;;; 7;;kg $n a particular period, the actual results of the process were as follows: Actual input A + :g 9;; 9;; Actual cost,kg : /,;;; /,>;; Total actual cost : 9;;,;;; 5=;,;;;

Actual output of : was 5;; kg. lease note that in the above shown data, there is no direct material price variance, as the actual cost per kilogramme of inputs A and + 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 5;;kg of : (5;; - :/,>=; H :>@4,;;;" and the output cost of :@=;,;;;. This gives an adverse direct material usage variance of :/;=,;;;. The direct material mi- variance is defined as: U0here substitutes within the mi- of materials input to a process are possible, the mi- variance measures the cost of any variation from the standard mi-. The variance for each input, is based on :V (a" The change in its weighting within the overall mi-,

/=>

(a" 0hether 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 mi- variance is calculated using the formula Direct material mi- variance: Total material G $nput in a standard miprices standard . Actual material G prices

The standard price per kilogramme of the standard input mi- is :=5;,;;; OOOOOOOO >;; kg H :/,5;;

Applying the formula above, the mi- variance is then: (>;; - :/,5;;" K J(9;; - :/,;;;" I (9;; - :/,>;;"L :=5;,;;; K :@=;,;;; H :>;,;;; (F" The mi- yield is favourable as we have used less mi-ture of material than the standard proportion,mi8I: )#RI#NCE 0hen a product re'uires two or more raw materials in it2s make up it is often possible to sub.analyse the materials usage variance into materials mi- and materials yield variances. Adding a greater proportion of one material (therefore a smaller proportion of a different material" might make the materials mi- cheaper or more e-pensive. For e-ample, the standard mi- materials for a product might consist of the following: %i(4,9" 4 :g of material A Y :/,;;; per :g (/,9" / :g of material + Y :7;; per :g : 4;;; 7;; 47;;

$t may be possible to change the mi- so that one kilogram of material A is used and two kilograms of material +. The mi- would be cheaper.

/=@

%i(/,9" / :g of material A Y : /,;;; per :g (4,9" 4 :g of material + Y : 7;; per :g

: /;;; /;;; 4;;;

+y changing the proportions in the mi-, the efficiency of the combined material usage may change. $n our e-ample, in making the proportions of A and + cheaper, at /:4, the product may now re'uire more than three kilograms of input for it2s manufacture, and the new materials re'uirement per unit of product might be 9.> kilograms. %i(/,9" /.4 :g of material A Y : /,;;; per :g 4,9" 4.5 :g of material + Y : 7;; per :g : /4;; /4;; 45;;

$n establishing a materials usage standard, management may therefore have to balance the cost of a particular mi- of materials with the efficiency of the yield of the mi-. <nce the standard has been established it may be possible to e-ercise control over the mi-. Calculating the 9ariances 1. The mi- variance for each material input is based on the following: a" The change in the materials weighing within the overall mib" 0hether the materials unit standard cost is greater or less than the standard weighted average cost of all the materials input. 2 0hen to calculate the mi- and yield variances. %i- 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" 0here proportions of materials in the mi- are changeable and controllable. $f the mi- is different in units, say, kilograms and litres, they are obviously completely different and can not be substituted for each other.

/==

b" 0here the usage variance of individual materials is of limited value because of the variability of the mi-. $t would be totally inappropriate to calculate a mi- variance where the materials in the Umi-V are discrete items. For e-ample, 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. .ormula %or the materials mix 9ariance (Actual 'uantity in standard mi- proportions K Actual 'uantity used" W 3tandard price Example A company manufactures a chemical used for eradicating rats called U%beba :illerV, using two compounds %iseshi and +ondwe. The standard materials used and cost of one unit of %beba :iller are as follows: : %iseshi 7 :g Y : 4;;; per :g /;,;;; +ondwe /; :g Y : 9;;; per :g 9;,;;; /7 :g 5;,;;; $n a particular period, =; units of %beba :iller were produced from 7;; :g of %iseshi and @9; :g of +ondwe. Required *alculate the materials usage, mi- and the yield variances. SOLUTION /a2 Usage 9ariance %iseshi +ondwe =; units of %beba :iller should have used 5;; :g =;;:g but did use 7;; :g @9; :g &sage variance (:g" /;; :g (A" @; :g (F" W 3tandard cost per :g W :4;;; :9;;; &sage variance in : :4;;,;;; (A" :4/;,;;; (F" Total usage variance :/;,;;; (F" The total usage variance can be analysed into mi- and yield variances.

/=?

/C2 8ix 9ariance Actual input H (7;; I @9;" :g H /,49; :g Actual usage in standard proportionsD %iseshi /,9 W /,49; :g H 5/; :g +ondwe 4,,9 W /,49; :g H =4; :g /49; :g Actual proportions %iseshi +ondwe Total $nput should have been 5/; :g =4; :g /49; :g +ut was 7;; :g @9; :g /49; :g !ariance in :g ?; :g (A" ?; :g (F" W 3tandard price W : 4;;; W: 9;;; !ariance in : :/=;,;;; (A" :4@;,;;; (F" :?;,;;; (F" The total difference of mi- variance in :gs must always be Aero as the mi- variance measures the change in the relative proportions of the actual total input. The favourable total variance is due to the greater use in the mi- of the cheaper material, %iseshi. (c" $ield 9ariance

Cach unit of output U%beba :illerV re'uires 7 :g of %iseshi H :/;,;;; and /; :g of +ondwe H : 9;,;;; /,49; kg 3hould have yielded (/7 :g" +ut did yield Bield variance in units W 3tandard cost per unit of output Bield variance in : =4 units of %: =; units of %: 4 units (A" W : 5;,;;; :=;,;;; (A"

The address yield variance is due to the output from the input being less than standard. &ield Variance Direct material yield variance is defined as the measures of the effect on cost of any difference between the actual material usage and that (ustified by the output produced, it is a subdivision of the direct material usage variance. Calculation o% 8aterial $ield )ariance

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(3tandard 'uantity of materials specified for actual production G standard prices"

(Actual total material input in standard proportions G standard prices" &sing the formula above, the yield variance is: J(5;; - >,7" - :/,5;;L K J(>;;" - :/,5;;L H /4; - :/,5;; H :/>=,;;; Adverse Again, a tabular representation could also be used as an alternative presentation.
Actual 'uantity *ost of Actual Actual 'uantity *ost of *olumn 3tandard $nput $nput at 3tandard $nput at at standard 'uantity for actual %istandard actual output *olumn / 9;; 9;; *olumn 4 :9;;,;;; :5=;,;;; *olumn 9 4;; 5;; *olumn 5 :4;;,;;; :>5;,;;; *olumn 7 />; 94; *ost at of $nput output standard

*olumn > :/>;,;;; :7/4,;;;

Remem1er t$at: Figures in columns 9 and 5 can only be calculated only after the other columns have been completed. Direct material mix 9ariance7 Total *olumn 5 K Total *olumn 4 H :=5;,;;; K :@=;,;;; H :>;,;;; (F" Direct material Bield variance K Total *olumn 5 H :>@4,;;; K :=5;,;;; H :/>=,;;; (A" $n both cases, the sum of the direct material mi- variance and the direct material yield variance can be seen to be :/;=,;;; adverse, which in the absence of a direct material price variance, is e'ual to the total direct material variance. The direct material mi- and yield variances must be interpreted into core, as there is a very strong interrelationship between them. $f we consider the concept of a standard mi-, it is clear that such a mi- will represent the combination of inputs which provides an acceptable 'uality of output at the least possible.

/?/

$f some other combinations of inputs could produce a lower cost output without detriment to 'uality, then this alternative would have been selected as the standard. Any change in the input mi- must therefore be e-pected to have an impact on the yield from the process, as well as on the price of the input mi-. $t is highly unlikely that any meaningful control can be e-ercised over the output from a process independent of the input to it, and thus the two variances should be considered simultaneously. 8ix LaCour )ariances The same logic applied to the calculation of material mi- and yield variances can be used or applied to labour cost mi- ) yield variances as well. 0hen different classes of labour are engaged then the labour efficiency variance can be split into mi- and yield components. 0e can demonstrate this by use of a simplistic e-ample below: Example :AN3< lc produces product 7. The standard labour input associated with the production of one unit is as follows: 5 hours of skilled labour paid at :/7,;;; per hour. > hours of unskilled labour at :/;,;;; per hour. The standard labour cost of one unit is J(:/7,;;; - 5 hours" I (:/;,;;;,hour - > hours"L H :/4;,;;;. The total labour input associated with production of one unit is /; (ten" hours at an average hourly rate of :/4,;;; i.e. :/4;,;;; /; hours H :/4,;;;

$t can also be established that the standard labour mi- is 5; per cent skilled and >; percent unskilled.

/?4

W5;8 H 5 hours - /;;8 /; hours (total" H 5;8 W>;8 H > hours /; hours H >;8 LaCour $ield )ariances During period 5 the following performance level was achieved: 47 units were produced ?7 hours of skilled labour was used /@7 hours of unskilled labour are used. :9,4>@,7;; in wages was paid. Required *ompute the labour cost variance and analyse this into labour rate and labour efficiency component variances. $n addition, analyse the labour efficiency variance into labour mi- and labour yield components. Stage %: . *ompute labour cost variance This is the difference between the standard labour cost of producing 47 units and the actual labour costs incurred. : Actual labour cost incurred 9,4>@,7;; 3tandard labour cost of 47 units (47 - :/4;,;;;" Eabour cost variance 9,;;;,;;; OOOOOOOO 4>@,;;; (A" - /;;8

/?9

Stage &: . *alculation of labour rate and labour efficiency variances The labour rate variance is the difference between the actual hours worked - standard rate and the actual wages paid. The labour efficiency variance is the standard hours re'uired for output achieved K actual hours Stage -: LaCour mix 9ariance For 4@; hours actually worked: Trade Actual 6ours
3killed ?7 (5;8"

3tandard %i- variance 3tandard %i%i- of hours 6ours rate per hour !ariance
/;= />4 4@; /9 (F" /9 (A" :/7,;;; :/;,;;; :/?7,;;; (F" :/9;,;;; (A" : >7,;;; (F"

&nskilled /@7 (>;8" 4@;

a1our ?ield 2ariance

4@; hours of work should yield: (4@; hours a /; hours,unit" +ut did yield $n money terms: 4 units - standard cost per unit (:/4;,;;;" H :45;,;;; (A" Bield variance H :45;,;;; (Adverse". Analysis and Interpretation: H H 4@ units 47 units 4 units (A"

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The analysis carried out above, in stage 9 indicates that a cost advantage has been attained by substituting unskilled labour for skilled labour in the production process. 6owever, the advantage has been more than offset by a cost disadvantage coming from the diminished efficiency of the entire workforce. Nkungu Etd uses two (4" grades of labour that work together to produce product C. The standard composition of each team is five grade A employees paid at :>,;;; per hour and three (9" grade + employees are paid at :5,;;; per hour. <utput is measured in standard hours and e-pected output is ?7 standard hours for /;; hours worked in total. During the last period, 4,4=; standard hours of output were produced using /,7;; hours of grade A labour costing :?,@7;,;;; and =74 hours of grade + labour costing :4,?=4,;;;. Required *alculate the labour efficiency variance, the mi- and yield labour variances. Suggested solutions reliminary work (calculation" Calculation of standard rate per $our of output(
LaCour >rade No7 o% emplo?ees in each team @ourl? laCour rate Total cost per group per hour

A +

7 9

:>, ;;; :5, ;;;

H H

:9;, ;;; :/4, ;;; *165 ,,,

Eess 78 at = hours: = hours K ;.5 hours H @.>; hours /;; hours K ?7 standard hours H 7 hours . . . 7 hours - /;;8 /;; hours H 78 . . . the standard rate per hour of output is

/?7

H :54,;;; H :7,74>.9; per standard hour @.> hours i" Direct labour efficiency variance: Trade A 6ours 44=; standard hours of output 3hould take an input of (44=; a ;.?7 R b" +ut did take Cfficiency variance in hours G standard rate per hour Trade + 6ours

/,7;; (44=; a ;.?7Rb" ?;; /,7;; . R:>,;;; OOOOO . =74 5= (F" R:5,;;; :/?4,;;; (F"

Now we can further analyAe the labour efficiency variances to its two subsidiary i.e. the Eabour mi- variance (team composition variance" and the labour yield (team productively varies". (i" Eabour %i- !ariance Total actual hours H /,7;; hrs I =74 H 4,974 hours. 3tandard mi- of actual input Trade A: Trade +: c - 4, 974 hrs b - 4, 974 hrs H H 6ours /,5@; ==4 OOOOOO 4, 974

Trade A %i- should have been but was G standard rate per hour /,5@; hrs /,7;; hrs 9; hrs (A" - : >, ;;;,hrs

Trade + ==4 hrs =74 hrs 9; hrs (F" : 5, ;;;

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OOOOOOOOOO :/=;,;;; (A" (ii" Eabour yield variance (team productivity" 4974 hours of work should have produced - (;.?7" standard hours +ut did produce hours Team productivity variance in hours hours (F" G standard rate standard hour Eabour yield variance Try the following e-ercise:

OOOOOOOO :/4;, ;;; (F"

4,495.5; 4,4=;.; OOOOOOOOO

standard

57.> standard :7, 74>.9; OOOOOOOOOOOOO :474, ;;; (F"OO

# consultancy has established the following standard composition of a team of its staff performing the year and audit as follows: Standard hours per%orm audit Audit manager ]unior Auditor Auditor clerk 9; /4; 7; OOO 4;; Rate per * 57;,;;; /@;,;;; 7;,;;; Standard hour to cost o% audit /9,7;;,;;; 4;,5;;,;;; 4,7;;,;;; OOOOOOOOOO 9>, 5;;, ;;;

A year.end audit has not been completed for :0AQ$ breweries and the hours recorded in respect of each grade of staff are as follows: #ctual hours to per%orm the audit Audit %anager ]unior Auditor Audit clerks 4@ /47 7= 4/;

/?@

Required *alculate the following labour variance for the :0AQ$ year end audit. /" The labour efficiency. 4" The labour yield variance. 9" The labour mi- variance. Capacit? 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. 0e are only going to highlight the three main ratios to be appreciated here. 07 .ull capacit? The output (e-pressed 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. 67 !ractical capacit? Full capacity less an allowance for known unavailable volume losses. 47 -udgeted capacit? The standard hours planned for a period, taking into account budgeted sales, supplies, workforce availability and efficiency e-pected. Example A corporation has the following information: Full capacity standard hours ractical capacity standard hours /;; ?7

/?=

+udgeted capacity standard hours (+udgeted input hours ?;, at ?;8 efficiency" Actual input hours 3tandard hours produced From the information above, it can be seen that the (i"

=/ =7 >=

$dle capacity H ractical capacity K budget capacity - /;;8 ractical capacity H ?7 K =/ - /;;8 ?7 H 0'(

This means that the budgeted activity level would not utiliAe /78 of the practical capacity. (ii" roduction volume ratio H 3tandard hours produced - /;;8 +udgeted capacity >=O - /;;8 =/ H 31(

This means that actual output achieved amounted to only =58 of the budgeted output: Cfficiency ratio H H 3tandard hours produced -/;;8 Actual hours >= - /;;8 =7

H 3,( This means that an =;8 efficiency level was achieved, compared to a budget of ?;8 efficiency. This ratio may be measured in either direct labour or machine hours as appropriate. .I:ED O)ER@E#D )#RI#NCES Fi-ed overhead variance and variable overhead variance are defined in the same

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manner as over head variance as they represent the difference between the standard specified and the actual incurred. Fi-ed overhead variances are a product of the overhead absorption process. Fi-ed overhead variance depends on two i.e. the fi-ed e-prense incurred and the volume of production obtained. The volume of product is in turn dependant upon the capacity the factory works. $t is also important to note that overhead rates are calculated from estimates of e-penditure and activity levels. Further more, it2s common for overhead absorption to be based on labour hours and therefore any variation in labour efficiency will directly affect the overhead variance. T?pes o% %ixed o9erhead 9ariances .ixed o9erhead total 9ariance This is the difference between the standard cost of fi-ed overhead absorbed in the production achieved, and the fi-ed overhead attributed and charged for that period. The fi-ed overhead total variance is made up of fi-ed overhead e-penditure variance and the fi-ed overhead volume variance. .ixed o9erhead expenditure 9ariance This is the difference between the budget cost allowance for production for a specified period and the actual e-penditure charged for that period. $t is therefore the difference between actual fi-ed overheads and allowed or budgeted fi-ed overheads. .ixed o9erhead 9olume 9ariance This is the part of the fi-ed production overhead variance which is the difference between the standard cost absorbed in the production achieved and the budget cost allowance for the period. $t is worth noting that the volume variance is due to the actual volume of production differing from the planned volume. This 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". .ixed o9erheads e%%icienc? 9ariance This is the difference between the budget cost allowance and the actual labour hours worked valued at the standard hourly absorption rate. .ixed o9erhead e%%icienc? 9ariance This is the difference between the standard cost absorbed in the production achieved and the actual direct labour hours worked valued at the standard

4;;

hourly absorption rate.

.ixed o9erhead total 9ariance 3* K A*

C-penditure !ariance +F< K AF<

!olume !ariance (A K + " R 3#

*apacity !ariance (A6 K +6" R 3# Example

Cfficiency !ariance (36 K A6" R3#

The following data relates to ] Etd: <ctober budgeted activities: Direct labour hours /> 5;; hours 3tandard hours of production /> 5;; hours Fi-ed overheads :7,@5;,;;; The actual results were as follows: Actual direct labour hours 3tandard hours produced Fi-ed overheads SOLUTION Fi-ed overhead absorption rate H :,7,@5;,;;; />,5;; H : 97;,hour Fi-ed overhead total variance 3tandard cost K Actual cost H ( />,/7; R :97; " K :>,;7;,;;; H 7,>74,7;; K >,;7;,;;; H :9??,7;; (A" /7,@7; hours />,/7; hours :>,;7;,;;;

4;/

Fi-ed overhead e-penditure +udgeted fi-ed overheads K Actual fi-ed overheads H :7,@5;,;;; K :>,;7;,;;; H :9/;,;;; (A" Fi-ed overhead volume variance (Actual 3tandard hours K +udgeted 3tandard fours" R 3tandard rate H (/>,/7; hrs K />,5;; hrs" R :97; H :=@,7;; (A" Fi-ed overhead capacity variance (Actual hours K +udgeted hours" R 3tandard rate H (/7,@7; hrs K />,5;; hrs" R :97; H >7; hrs R : 97; H : 44@,7;; (A" Fi-ed overhead efficiency variance (3tandard hours K Actual hours" R 3tandard rate H (/>,/7; hrs K /7,@7; hrs" R :97; H 5;;hrs R :97; H : /5;,;;; (F" 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 organisation2s operations. The ratios which can be calculated are: !olume ratio H 3tandard labour produced R/;; +udgeted labour hours *apacity ratio H Actual labour hours R /;; +udgeted labour hours Cfficiency ratio H 3tandard hours produced R /;; Actual labour hours Example *alculate the volume, capacity and efficiency ratios from the data below: +udgeted: Actual #esults: Eabour hours /=,;;; hrs Eabour hours />,;;; hrs

4;4

3tandard hours /=,;;; hrs

3tandard hours /@,;;; hrs

!olume ratio H /@ ;;; R /;; /= ;;; H ?58 *apacity ratio H /> ;;; R /;; /= ;;; H =?8 Cfficiency ratio H /@ ;;; R /;; /> ;;; H /;>8 %le!ent ./0 1ales 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 e-plain the application of the sales variances. Example E&NA *o. manufactures a single product. +udget and actual data for the latest pencil is as follows: +udget 3ales and production volume 3tandard selling price 3tandard variation cost 3tandard fi-ed cost The actual results were as follows: 3ales ) production volume Actual selling price =4,5;; units :7@,;;;,unit =/,>;; units :7?,;;;,units :45,;;;,units :5,;;;,units

4;9

Actual variable costs Actual fi-ed cost &sing the above data *alculate the (i" 3elling price variance (ii" 3ales volume (profit" variance (i"

:49,;;;,unit :>,;;;,unit

3elling price variance H +udgeted - 3tandard profit . Actual sales - std profit per unit
sales units profit per unit units

3elling price per unit should have been +ut was Actually &nits sold (=4,5;;" 3elling price variance

:7?,;;; :7@,;;; : 4,;;; (Adverse"

:/>5,=;;,;;; (Adverse"

The adverse variance shows that the actual selling price was lower than the standard price. Sales )olume )ariance This variance calculates the profit differences which is caused by selling a different 'uantity from that budgeted. &nits +udgeted sales volume Actual sales volume W3tandard profit per &nit (:7?,;;; K :45,;;; K :5,;;;" H :9/,;;; 3ales volume variance :45,=;;,;;; (F" =/,>;; =4,5;; =;; (favourable"

The favourable variance shows that the increased sales volume could have increased profit by :45,=;;,;;; i.e. if the selling price and the cost per unit had been e'ual to the standards. 4;5

$t is important to note that the sales volume variance is e-pressed in terms of the standard profit lost or gained as a result of change in the sales volume. Planning Variances 3ome variances can arise from changes in factors internal to the business and may therefore be referred to as planning variances. De"inition o" 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 %anagement 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. lanning variances may arise from faulty standard K setting, but the responsibility for this lies with senior rather than operational management. *6$30C Etd estimates that the standard direct labour cost for N3CEC, its only product should be :5;,;;; (= hours - :7,;;;,hr" actual production of /,;;; unit of the N3CEC took /4,5;; hours at a cost of :5@,>;;,;;;, in retrospect, it is realiAed that the standard cost should have been /4 hours - :5,;;; per hour, i.e :5=,;;; per unit. Required *alculate the: i. ii. lanning variance <perational variance

4;7

Solution (i" <perational variance 6ours /,;;; units should take at /4 hrs,unit but did take - revised standard cost per hour /4, ;;; /4, 5;; 1,, hours (A" :5,;;;,hour /,>;;,;;;.;; (A" (ii" /4,5;; hours should cost Y :5,;;;,hr +ut did cost (iii" *heck Actual costs #eceived standard cost (/;; - :5=, ;;;" Total operation variance (:/, >;;, ;;; (A" I :4, ;;;, ;;; (F"" (b" lanning !ariance : #evised standard cost /,;;; units - /4hrs - :5,;;;,hr <riginal standard cost of /,;;; units - = hours - :7,;;;,hr 5=,;;;,;;; 5;,;;;,;;; 35 ,,,5 ,,, (A" H H H H 5?,>;;,;;; 5@,>;;,;;; 4,;;;,;;; (F" : 5@,>;;,;;; 5=,;;;,;;; 5;;,;;; (F"

I8!ORT#NCE O. !L#NNIN> #ND O!ER#TION#L )#RI#NCES

Ad0antages of a system of planning and operational /. The analysis highlights those variances, which are controllable and those, which are non.controllable.

4;>

4. %anager2s 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. 9. The planning and standard setting process should improveD standards should be more accurate, relevant and appropriate. 5. <perational variances will provide a fairer2 reflection of actual performance.
LI8IT#TIONS O. !L#NNIN> #ND O!ER#TION#L )#RI#NCE

/. $t is many times difficult to decide in hindsight what the realistic standard should have been. 4. Cstablishing realistic revised standards and analyAing the total variance into planning and operational variances can be a time consuming task even if a spreadsheet package is devised. 9. Cven 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. *areful presentation and e-planation will be re'uired until managers are used to the concepts.

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Chapter 7 IN-(RMATI(N TEC!N(L(') AN/ MANA'EMENT ACC(,NTIN'

Learning Outcomes After studying this chapter, candidates are e-pected to: 6ighlight the impact of $T on management accounting C-plain how information systems should be designed 3hould appreciate the use and limitations of personal computers. 3hould be able to e-plain the different communication technologies 3hould be able to discuss the application of computer aided design and manufacturing technologies 3hould e-plain the application of fle-ible manufacturing techni'ues and the techni'ue of business process #e.engineering.

&ecision )upport )yste!s There are various decision support systems that can be used in management accounting. The following are the common decision support systems in use.
/i2 E:ECUTI)E IN.OR8#TION S$STE8 /EIS2

This system is usually used by the senior corporate e-ecutives in a corporation. $t is designed to provide 'uick access to important information concerning both the company analysis and economic information such as forecast demand for the companies2 pro(ects.
Characteristics o% EIS

<utputs are very user friendly &tiliAes graphed and other pictorial representations of data for ease of analysis and understanding

4;=

rovides drill.down tools to help e-ecutives to perform some analysis of the information

/ii2

DECISION SU!!ORT S$STE8 /DSS2

These are systems which help manages value decisions, themselves. Cven C$3 and C-pert systems form part of the general decision support. Decision support system will be used where the decision to be made is unstructured i.e. where there are many potential input and output and the decision itself is made only infre'uently. For instance, if a company may be considering launching a pro(ect in a new market sector. The decision support system could be used to analyAe the market considering default of current products, market siAe, forecast programmingD the effect of the company entering the new sector can be seen. /iii2 E:!ERT S$STE8S7 C-pert systems are used in situations where there is a large volume of information about a particular sub(ect and the information can be summarised as a set of rules. For e-ample the ta-ation system of most countries is 'uite comple- and there are few people who understand it completely. An e-pert system can be designed to incorporate the knowledge from some of these ta- specialists in form of rules. Cach rule will be given a set of possible answers or links to other rules so that finally a complete summary of the tasystem is built up in the computer. A person with very little ta- knowledge can then ask various 'uestions about ta- from the e-pert system. +y a 'uestion and answer process, the e-pert system identifies the process, the problem and provides a solution. $n effect the e-pect system allows an individual to consult a taspecialist without having to pay for the e-pensive time of the specialist. C-pert systems can also be found in medical diagnosis and mineral prospecting (e-ploration" activities. %anagement In"ormation Design A business,organiAation will have several departments or business areas headed by different groups of people of the work force from specialiAed disciplines. Bour studies of management and strategy should remind you of this. The summariAed organiAation structure below shows what is being e-plained

%D %D #esearch4;? ) Development Department

Finance Department

3ales Department

$T Department

roduction Department

#esearch ) 3ales $T Finance roduction Development Department Department finance Department Department Different people will be working in the highlighted departments, department Department carrying out accounting related, finance, treasury related and ta- related activities. <ther functions will also be staffed with individuals from their discipline in the areas of their speciality. %anagers and their subordinate2s will need different types of information to fulfil their (obs. The managers will obviously want to make sure that the information they get is appropriate to their various roles. %anagement +e$els and In"ormation Re)uirements Different levels of management in an organiAation will re'uire different information to fulfil their roles. $t is important to note at this stage that the determinations of information needed by managers will be the (obs which are described for them. At this stage therefore, let us e-amine the different levels of management and therefore look at the information re'uirement needed to some, at these different levels of management. LE)ELS O. 8#N#>E8ENT

STR#TE>IC 8>T

T#CTIC#L 8>T

O!ER#TION#L 8>T The three levels of management above are responsible for the following activities. . STR#TE>IC 8#N#>E8ENT 3trategic management will comprise a team of top.notch corporate e-ecutives involved in overall corporate planning, strategy formation and policy making in an organiAation. . T#CTIC#L 8#N#>E8ENT

4/;

Tactical management implement some strategic decisions and decisions involving the running of business units and section. . O!ER#TION#L 8#N#>E8ENT The operational management of an organiAation will be carrying out day.to.day basic work which will be the means by which the company earns it2s revenues. Cach levels of management make different decisionsD 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 e-ternal information. LE)ELS O. 8#N#>E8ENT INTERN#L IN.OR8#TION NEEDED . +oard minutes . roduction fore costs Future periods . %onthly output reports . !ariance Analysis . Daily production schedule . Absenteeism reports E:TERN#L IN.OR8#TION NEEDED . *omputer information . %arket demand 3ummaries . *omputer prices . #aw materials prices . *omputer factory layouts

3T#ATCT$* %ANATC%CNT TA*T$*AE %ANATC%CNT < C#AT$<NAE %ANATC%CNT

For the various information to be useful to the users it needs to e-hibit appropriate characteristics. i7 STR#TE>IC IN.OR8#TION 3hould have the following cardinal characteristics ii7 6ighly summariAed #elated to long.term of the planning horiAon. Details of the company as a whole. repared as needed.

T#CTIC#L IN.OR8#TION 3hould have the following characteristics 4//

 iii7

Eess summariAed #elate to short , medium term in the planning horiAon #etails on singular department $t should be prepared regularly

O!ER#TION#L IN.OR8#TION 3hould have the below listed following characteristics $t should be detailed $t should relate to daily , hourly activity. Detailed down to individuals machine level $t must be prepared continually.

TR#NS#CTION !ROCESSIN> S$STE8S Transaction rocessing 3ystems (T 3", process the fre'uent routine transactions. The transactions processed can either be internal or e-ternal. The management with processed transaction information. A T 3 therefore processes e.commerce transactions within a business and between the business and the third parties. 3uch transactions may includeD the business placing orders for raw materials, customers ordering goods from the business. T 3 therefore is an important function in a business2 daily operations. A T 3 collects details of transactions in a number of ways, the common ones beingD :eying in the on.screen data entry forms or the use of bar.code system. 0hen 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. $n a typical T 3 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. 6owever 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. $n addition, information such as supply re'uests can be transmitted on demand in real time. Clectronic data interchange (CD$" can enable a link to be established with suppliers and customers. $nformation on transaction details can be accessed from the system on.line e.g. to check raw materials level or from the database. $t is however, important to note that a T 3 has serious effects when there is failure in the system. This is due to the fact that a T 3 has direct effect on the daily routine transactions conducted by the business. For e-ample, if the T 3 cannot provide stock levels information due to some system failure with a T 3, it can directly affect production or sales.

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3ome common uses of T 3 include: (i" $mproved operational efficiency by automatic links to suppliers and better information on product demand and availability.

(ii" $mproved customer service through more choice, lower prices and better 'uality of produce. (iii"Assessment of effectiveness product promotion through availability of better information. (iv" *an improve stocking through CD$ links between stores, warehouses, suppliers, banks and customers. %anagement In"ormation 1ystems (%I1) 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 re'uire information at different levels of details it is likely that no one management information system will be able to supply the total information re'uirements of a company. A number of smaller %$3 may be needed to produce the information for the different levels of management. #haracteristics o" %I1 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.
. IN!UTS O. D#T#

Data will be received from a number of sources. These sources will vary depending on the final output that is re'uired from the %$3. $t is likely that data will be available from other systems within the company, such as the accounts department. <ther data can be obtained from e-ternal sources so that manages have complete information for them to perform their roles well.
. !ROCESSIN> O. D#T#

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The data which has been input will be processed in one way or the other. Again, the e-tent of the processing depends on the final output re'uired. The processing that takes places in most %$3s will take the form of, For e-ample summariAing data or looking for e-ceptional items in a large amount of data.

OUT!UT O. IN.OR8#TION

The final output from a %$3 can take many forms. The output from the %$3 will tailored to management2s individual re'uirements. 3ome outputs will be 'uite summariAed merely showing trends and e-ceptional items but at the operational level some very detailed outputs will be appropriate. Co!!unication Technologies <utputs from information systems can and should vary greatly in terms of length, format of presentation and urgency of action re'uired. 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. In%ormation DisseminationJS?stems $nformation 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. 3ummarised below are the main methods of dissemination in a large company, together with an indication of their appropriateness in particular situations. Electronic mail C.mail is useful for sending short messages, particularly when the circulation involves a large number of people. +ecause recipients may not have the system switched on, it is not necessarily recommended for urgent communication. The attachment facility means that other computer files can be distributed simultaneously for checking or review by recipients. C.mail is particularly suited to sending out agendas, or confirming meeting arrangements made on the telephone. !aper mail The amount of paper mail should decrease in companies where e.mail and voicemail have been introduced. &nfortunately, this is not always the case. $f 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. $n this latter case, the use of a photocopier and

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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. &nfortunately, 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. )oicemail !oicemail is the alternative to fre'uent call.backs. $f people are not at their desks, a personal answering service can be activated to take the message. $f further communication is necessary, the onus is on the person receiving the message to call back, and the caller does not have to call again. &nfortunately, voice mail allows the use of the telephone as an urgent communication device to be subverted K staff can activate voicemail while still at their desk, to avoid the telephone ringing. Computer printout *omputer printouts are often still distributed though the internal mail system. 6owever, this is a costly and slow communication method. A cheaper and 'uicker alternative is to distribute the computer file via e.mail. !ersonal call The best way to communicate an urgent message is a personal visit (assuming that the recipient is not far away". Few people ignore a personal caller, and the two.way communication that results should resolve problems 'uickly and efficiently. In"ormation Dissemination 3 4""ecti$e Presentation o" In"ormation 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: *e set at t$e correct le0el of detail . 0e have seen that different levels of management need reports to be at different levels of detail. 3trategic management will e-pect reports to be in summary format, whilst operational management will re'uire e-tremely detailed reports.

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@se e'ception reporting / e-ception reporting draws the attention of management to matters that are not proceeding as planned, and that might re'uire 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 une-ceptional. *e timely . $f 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. *e rele0ant / to the person receiving the report. %ost managers receive too many reports. *are must be taken to ensure that reports are targeted at the correct manager(s". A 1scattergun2 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 counter.productive. $n 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. @se terms, presentation of num1ers etc, consistently . if a report is to be read and understood 'uickly, the data should be presented clearly and consistently. For e-ample, 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.

<bviously, other 'ualities can be added to this list. The aim should be to produce a report from which the manager can 'uickly assimilate information, and be clear about the decisions that must be taken. !ses and limitations o" P#s in %anagement Accounting 0ith the fall in price and siAe of computers over the last few years, it is likely that most accountants will have access to some form of computing resource. Uses o% !Cs in management accounting To ( o,")e ass"sta#ce 0"t1 "#'o !at"o# $at1e "#$ *s give management accountants access to a wide range of information. Assuming that the * is networked and the company2s central file servers are available, and there is also an internet connection, the information that can be retrieved from the system is almost endless. 3ome of the sources that may be useful to the accountant include: $nternal data on production, financial accounts, stock reports etc. C-ternal information on competitors via competitors2 homepages or via specialist data collection agencies who have already obtained the $nternet data. #eports from other offices

As a co!!*#"cat"o#s !e)"*! *omputers make e.mail systems available which can be used to send messages 'uickly, cheaply and efficiently.

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<ther applications can be used to provide discussion databases, particularly where a number of similar products are being produced across a series of locations. &sing a type of bulletin board, managers can post 'uestions into the system. <ther managers can then review these 'uestions, add their own comments, and raise further 'ueries. Fo e'e e#ce !ate "al A large amount of reference material for accounting is now available on *D #<%, e.g.: Financial #eporting 3tandards Training material on management accounting topics roduct directories and similar information to assist raw.material purchasing decisions Limitations o% !Cs in management accounting D"''"c*lt% "# c1ec."#$ t1e acc* ac% o' !a#a$e!e#t acco*#t"#$ "#'o !at"on The management accounting information produced by many computer systems can be 'uite detailed, and contain a lot of supporting data. $f 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 sub(ect to the normal detailed checking routines (see ?.@.9". The management accountant ensures that all computer applications are ade'uately checked before they are used in 1live2 situations. I#'o !at"o# o,e loa) <ne of the main problems with computeriAed 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 e-ception reports rather than detailed analysis. This is where an efficient and effective %$3 can literally save the accountant hours of work each day. The cost of implementing such a system may well be insignificant when savings in management time are taken into account. CO8!UTERISED 8#NU.#CTURIN> S$STE8 *omputerised manufacturing systems are systems which involves the use of computers directly to control production e'uipment and indirectly to support manufacturing operators. The use of computerised manufacturing systems has resulted in firms producing high.'uality and low.priced goods. *omputerised manufacturing systems encompass the whole production process from materials resource planning up the point when finished products are due for distribution. <ne of the new types 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

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re'uirements are grouped together so that they can utiliAe the same facilities. This in effect reduces throughput times, scheduling is made easier, set.up costs and a reduction in work in progress. $n order for firms to compete effectively, there is the need to be more innovative and fle-ible in their manufacturing methods. $n addition, they should be in a position to produce a range of product at reduced costs. To this effect, Advanced %anufacturing Technology (A%T" has emerged. Advanced %anufacturing Technology (A%T" Advanced %anufacturing Technology (A%T" encompasses automatic production technology, computer.aided design and manufacturing, fle-ible manufacturing systems, including other innovative computer e'uipment. CO8!UTER L#IDED DESI>N /C#D2 *omputer.aided design (*AD" provides interactive graphics that assist in development of product and service designs. $t also connects to database to be recalled and developed easily. &sing *AD new products can be designed on computer screen, designs can be assessed in terms of cost and simplicity and utilsation of materials. CO8!UTERJ#IDED 8#NU.#CTURIN> /C#82 *omputer.aided manufacturing (*A%" is the use of computers to control the physical production process. Direct *A% applications link a computer directly to production e'uipment in order to monitor and control the actual production process. An e-ample is a computerised numerical control (*N*" machine which reads instructions for making parts. $ndirect *A% applications include %# , 'uality control and inventory control systems. Automated guided vehicles (AT!" are computerised materials handling machines can replace the traditional conveyor belts. CO8!UTERJINTE>R#TED 8#NU.#CTURE /CI82 *omputer.integrated manufacture (*$%" aims to integrate information for manufacturing and e-ternal 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. $t incorporates design activities such as *AD, *A% and operational activities such as %# , F%3 and inventory control. Co!puter Aided &esign The introduction and wide dissemination of advanced manufacturing technologies (A%Ts" has changed the face of the product development and production process. and its

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cost structure K in most of the ma(or manufacturing companies of the world, and aided manufacturers2 ability to compete on the dimensions of cost, 'uality 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 K and, more importantly, rework the drawing Khas shortened dramatically as a result of the software currently available. *omputer Kaided design (*AD" allows huge numbers of alternative configurations to be analysed both for cost and simplicity. 3imple designs lead to a more reliable productD and further, a simple product is easier to manufacture, thereby minimiAing the possibility of production errors. Thus *AD allows 'uality and cost reduction to be built at the design stage of a product. The advanced graphics facilities of the typical *AD 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, 1walk through2 it". The use of a database to match, where possible, the re'uirements of the new design with e-isting product parts, will enable the company to minimiAe stockholdings by reducing the total number of product parts re'uired. #omputer Aided manu"acturing 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 (*A%". 3ignificant elements of *A% are computer numerical control (*N*" and robotics. *N* machines are programmable machines or bank of machines, facilitating a change in configuration in a matter of seconds via the keyboardD changes to e-isting configurations and new configurations are easily accommodated. *N* therefore offers great fle-ibility, and dramatically reduced set Kup times. Furthermore, unlike human operators, who tire and are error prone, *N* machines are able to repeat the same operations continuously in an absolutely identical manner, to a completely consistent level of accuracy and machine toleranceD 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 re'uired place within the production facility. $n the case of the latter, the abbreviations AT! (automated guidance vehicles" and A3#3 (automated storage and retrieval systems" are often worth noting. Two brief e-amples will serve to illustrate the dramatic impact of *A% on manufacturing fle-ibility, and the time taken to develop a product and bring it to the market. Nissan, the car producer, found that the time taken to completely re.tool car body panel (igs in their intelligent body assembly system ($+A3" fell from /4 months to less than 9 months by reprogramming the process machinery by computer and using computeriAed (ig robots. 3imilar advances have been made in the resetting of machines

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and in the e-change of dies. These changes have reduced the changeovers time in moving from one process to another. Again it is a ]apanese company, Toyota, which provides one of the best e-amples of the advances made in this area. The terminology used by Toyota has now been generally adopted: 3%CD stands for 1single minute e-change of dies2 and is used for all those changes which are less than /; minutes in durationD <TCD refers to 1one touch e-change of diesD and NTCD to 1no touch e-change of dies2. As the speed of production changeover increases under *A%, the possibility of producing smaller and smaller batch siAes at an economic cost also increases, so that the production schedule can be driven more and more by customer re'uirements, rather than the constraints of the traditional manufacturing process. The holy grail of *A% in this respect is a set Kup time of Aero K in such a situation, the cost advantage of mass production would disappear completely, and any batch siAe would be optimal in production cost terms, even a batch siAe of one unit. 6owever, the benefits in terms of market fle-ibility of the ability to produce cost.efficient small batches are obvious. #omputer 3 Integrated %anu"acturing The ultimate e-tension K and logical long.term direction. of A%T in the production environment is computer Kintegrated manufacturing (*$%", which brings together all the elements of automated manufacturing and 'uality control into one coherent system. The 1ideal2 technological world of *$% K the fully Kautomated 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 1ghost factories2, would not necessarily be universally welcomed". A somewhat watered.down version of *$% is already with us, however, in the form of a fle-ible manufacturing system (F%3". $n a F%3, a computer program coordinates a cell of *N* machines, handling mechanisms and robots in such a way as to synchronise workflow. An F%3 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 synchroniAed computer control to ensure continuous work flow. The F%3 also includes a facility for monitoring the 'uality of the parts being produced. The title aptly describes the systems strength K its fle-ibility to produce a range of different components automatically, with the computer ensuring minimum changeover time and ma-imum built in 'uality. The F%3 cell is often referred to as an 1island of automation2. Example /. C-plain, with a relevant e-ample, what is meant by a management information system (%$3". 4. 3tate and e-plain some of the general 'ualities of good information.

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Solution %anagement information system is a set of formaliAed procedures designed to produce managers at all levels with appropriate information from all relevant sources (internal and e-ternal", to enable them to make timely and effective decisions for planning and controlling the activities for which they are responsible. An e-ample 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 1stand.by2 seats are available. +aggage weight is accommodated and e-ternal 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 analyAed. This will allow few structures and aircraft types to be determined. At strategic level overall profitability on each route will be monitored. $n addition the outline will attempt to find out what other flights passengers may have used for part of their (ourneys. This may help the airline to decide whether to form alliances with other carriers (As recently delta 5; with virgin". The main 'ualities regarded of good information are: 07 Completeness7 $f a decision is being made, details of all possible options should be available for consideration. 67 Rele9ance <nly that information which is useful to the decision making process should be included. 47 Timelines &nless the information is up to date and produced in time for the decision to be made, it is unlikely to be useful. 17 #ccurac? 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. '7 Signi%icance 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 s?stem

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The first computer systems were designed to produce cost effective replacement for routine electrical tasks. %ore recently developments are concerned with the provision of better information for management. i. Describe four common computeriAation. corporate administrative functions switched to

ii. *omment on management information and decision support systems in improving the efficiency of the management process.

Solution Among the most commonly computeriAed corporate administrative functions are: /. 3ales accounting: $ncluding input, delivery, note invoice, production transaction recording and the production transaction recording and the production of regular analysis of sales and debtors. 4. 3tock control: $ncluding the recording of receipts and issues the automatic generation of re'uisitions for stock falling below the re.order level and the production of stock lists and movement analysis. 9. ayroll production: Taking hours worked as input and producing pay slips coin analysis or bank transfer details and costing information.

5. Fi-ed 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. %anagement information and decision support systems are linked by the data which they use to improve the efficiency of the management function in an organiAation. +oth rely on data produced from the computeriAation of corporate administrative functions and both produce information to help managers fulfill their function and improve the 'uality of the decision making. The management information system normally uses the principal of e-ception reporting to highlight aspects of co.operational information, which is important for planning purposes. $n order to keep up with changing circumstances within the organiAations, and in its environment, the criteria used to select information should be constantly reviewed,

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or could be under the control of individual managers, who can re'uest for the reports that they think necessary. Decision support systems use computer software to modern the behavior of parts of the organiAation and to allow the simulation of difficult decisions and their results. The most common e-ample is the spreadsheet, although more specialiAe financial modeling software also e-ist. Tiven 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 can be tried and their results e-amined and compared to aid in determining the optimum decisions. %anagement 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 analyAing and summariAing it to make it useful to managers in fulfilling their decision making and planning functions.

.LE:I-LE 8#NU.#CTURIN> S$STE8S /.8S2 3uch a system is made up of a group of machines with programmable controllers linked by an automated materials handling system that enables a variety of parts with similar processing re'uirements to be manufactured. F%3 are most suited to batch production systems which have intermediate amounts of variety and volume of outputs. The system aims to use computer control to produce a variety of output 'uickly. The main features of an F%3 include: i.*omputerised.integrated manufacturing (*$%" ii.A (ust.in.time (]$T" system iii.*omputerised material handling system iv.*omputerised and automated storage and retrieval system for raw material and parts. 'usiness Process Re#%ngineering 'PR$ +usiness process re. engineering involves focusing attention inwards to consider how business processes can be redesigned or re. engineered to improve efficiency. $t can and should lead to fundamental changes in the way organiAations function. +usiness process re. engineering (+ #" is the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical contemporary measures of performance, such as cost, 'uality, services and speed. :ey words in the phrase

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(a" Fundamental and radicalD indicating that business process re. engineering is somewhat akin to Aero base budgeting. (b" Dramatic means that + # should achieve 1'uantum leaps in performance2 not (ust marginal, incremental improvements. (c" rocessD + # recogniAes that there is a need to change functional hierarchies which have evolved into functional departments that encourage functional e-cellence but which do not work well together in meeting customers2 re'uirements. 3ey "erm A process is a collection of activities that takes one or more kinds of inputs and creates output. +usiness process re. engineering involves the re. arranging of the business in order to deliver 'uality, reliability, cost efficiency and effectiveness.
# REJ EN>INEERED !ROCESS @#S CERT#IN C@#R#CTERISTICS7

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

<ften several (obs are combined into one 0orkers often make decisions The steps in the process are performed in a logical order. 0ork is performed where it makes most sense. *hecks and controls may be reduced and 'uality built in. <ne manager provides a single point of contact. The advantages of centraliAed and decentraliAed operations are combined.

Principles o" ,usiness Process Re24ngineering (,PR) a" b" rocess should be designed to achieve a desired outcome rather than focusing on e-isting tasks. ersonnel who use the output from a process should perform the process.

c" $nformation processing should be included in the work, which produces the information. d" Teographically dispersed resources should be treated as if they are centraliAed. e" arallel activities should be linked rather than integrated.

f" Doers should be allowed to be self.managing. g" $nformation should be captured once at source.

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C@#R#CTERISTICS O. OR>#NIH#TIONS G@IC@ @#)E #DO!TED -USINESS !ROCESS RE J N>INEERIN>

(a" 0ork units change from functional departments to process teams, which replace the old functional structure. (b" ]ob change. it should tie in with (ob enlargement and (ob enrichment. (c" eople2s roles change. They are empowered to make decisions relevant to the process. (d" erformance measures concentrate on results rather than activities. rocess teams create 1value2 which is measurable. (e" <rganiAation structures change from hierarchical to flat (team" structures. Implications o" ,PR 3 %anagement Accounting 1ystem #S!ECT (i" erformance measurement I8!LIC#TION erformance measure must be built around processes not departmentsD this may affect the design of responsibility centres. There is need to identify where value is being added. A+* might be used to model the business processes #eports should be designed round the process teams and the whole reporting system should be centered around the organiAational structure. New variances may have to be developed in addition to the e-isting traditional variances.

(ii" #eporting (iii" Activity (iv" 3tructure

(v" !ariances

E:#8!LE O. -USINESS !ROCESS REJ EN>INEERIN>

(a" A move from a traditional functional plant layout to a (ust in time cellular product layout is a simple e-ample.

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(b" Climination of non.value added activities. *onsider a materials handling process, which incorporates scheduling production, storing materials, processing purchase order, inspecting materials and paying suppliers.

C@#!TER 3 -UD>ETIN> IN T@E !U-LIC SECTOR

Introduction Eike in the private sector, planning is an important management function in the public sector. *ontrol is e'ually important to ensure that plans are achieved. The budget provides the link between the two activities. The budget e-presses what is to be undertaken in the ne-t year and authoriAes the financial resources that will be needed. Two important budgets in the conte-t of public sector budgeting process are capital and revenue e-penditure. Learning outcomes After reading this chapter you should be able to: Define a budget. <utline the ob(ectives of public sector budgeting. Distinguish revenue budgets from capital budgets. Describe the key approaches to public sector budgeting.

-UD>ETIN> IN T@E !U-LIC SECTOR A budget plays a very important role in the managerial planning and control of public sector organisations. Although Eong.term and medium term plans are important in well run organisations, they are only an e-pression of intentions. $t is only when these intentions are incorporated into annual budgets that they become firm commitments with funds being allocated to enable their achievement. The annual budget e-presses what is to be undertaken during the ne-t year and authoriAes the financial resources that will be needed. +udgets are invariably e-pressed in financial terms, although other measures should ideally be incorporated.

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$t is also important to make a clear distinction between capital income,e-penditure and revenue income, e-penditure and to prepare separate annual revenue budgets and annual capital budgets. T@E O-AECTI)ES O. #NNU#L -UD>ET !RE!#R#TION The ob(ectives of the annual budgetary process within the public sector are discussed below. The estaClishment o% the required income le9els7 The income in the public sector comes from ta-ation, fees and charges levied by the government. +udgeted income for the forth coming year is arrived at by e-amining the current levels of income and by looking at the levels of e-penditure planned for the coming year. The desire to minimiAe ta- increases, while increasing 'uality and 'uantity of services, provide the dynamics and stresses of the budgetary process. !lanning ser9ice expenditure le9els <ne of the most important ob(ectives of public sector budgeting is to assist in the planning of service e-penditure levels and the levels of service provision. The total of service e-penditure has to be accommodated within the total income raisedD but within this total, choices have to be made between e-penditure on various items. #uthoriOation o% expenditure The budget authoriAes the e-penditure of public funds on those services and to the total of those service e-penditure levels which are agreed in the budget. %oney should be spent on what has been authorised in the annual budgetD and one guideline for subse'uent decisions is to en'uire whether an item of e-penditure is included under a budget e-penditure head The control o% expenditure The budget provides a basis for control of e-penditure. At its crudest total annual e-penditure should not be e-ceed the budget. This philosophy can be applied throughout the organisation, to the e-penditure of services and within services, to e-penditure on sub services and to detailed heads. # communication de9ice The budget is an e-cellent communication deviceD service managers are informed through out the budget not (ust of the annual e-penditure allocation but also of service level proposed.

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.ocus attention The budget process focuses attention on the futureD it thus forces a consideration by managers of the ob(ectives, methods and costs of service delivery. 8oti9ation o% managers Though the link between budgeting and motivation is comple- it is possible that managers are well motivated and form an attachment to the budget, when they have played a role in helping to formulate it. -UD>ETS !RE!#RED IN T@E !U-LIC SECTOR #evenue income budget #evenue e-penditure budget *apital income budget *apital e-penditure budget

For most public sector bodies income and e-penditure of a revenue nature is usually much greater than the capital income and e-penditure in any given year. RE)ENUE -UD>ETS Annual budgets have been developed as attempt by the parliament to e-ercise control over the activities of the central government. $t is an established practice that the total government and the appropriations of e-penditure for particular purposes have to be approved for each financial year by parliament. The most compelling reason for a revenue budget is to determine the levels of income and e-penditure. For ta- funded services this would enable the government fi- levels of ta-ation and for the charges funded services, the government would be able to set the level of charges. LineJItem -udget Eine budgets are budgets which place considerable emphasis on the nature of the income and e-penditure e.g income from grants, fees, sales or e-penditure on salaries, materials traveling etc. At its most e-treme, a line budget would appear as shown below: Example o% summarised line item Cudget
Local #uthorit? -udget %or $ear Ended 40 8arch

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Expenses
Cmployees remises costs Transport costs 3upplies and services 3upport services *apital financing costs Total *osts Income Tovernment grants 3ales Fees and charges #ent $nterest %iscellaneous income Total $ncome +alance to be met from council taGGG GGG GGG GGG GGG GGG

:P;;;

GGG

GGG GGG GGG GGG GGG GGG GGG GGG

The main disadvantage with the above approach is that the statement cannot identify the amount allocated to each individual service and would therefore fail to reflect the planned level of activity for each service. !RO>R#88E -UD>ET STRUCTURE This is a budget approach which places emphasis on the purpose of the e-penditure such as crime prevention, mental health care, refuse disposal etc. its argued that the programme budgeting approach as illustrated below should lead to better managerial planning and control because resources could be allocated more precisely to specific activities and actual achievements could be monitored more effectively. #n example o% a programme Cudget %or a police authorit?
!olice #uthorit? -udget *rime control and detection *rime prevention advice Traffic control *rowd control olice training court work rison duties #ehabilitation of offenders Administration #esearch and planning Total :P;;; GGG GGG GGG GGG GGG GGG GGG GGG GGG GGG

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C#!IT#L -UD>ETIN> $f a public sector organisation is to be successful in achieving its fundamental aims and ob(ectives it is necessary to give careful consideration to the planning of capital e-penditure re'uirements. T@E .OR8 O. C#!IT#L -UD>ETIN> Although capital budgets may be prepared for one year only, the long term nature of capital schemes suggest that budgets for several years a head will usually be more appropriate. A useful approach to the problem of planning and controlling capital e-penditure is to develop capital programmes which e-press the overall plan of short, medium and long term capital schemes, and reveal the allocation of priorities between different parts of the organisation. IN.OR8#TION IN # C#!IT#L !RO>R#88E Title of capital scheme The committee, department and officer responsible A description of the scheme The priority rating The schemes in progress. cost to.date lus estimated future costs

#!!RO#C@ES TO T@E -UD>ET#R$ !ROCESS 0e now consider different models of the budgetary process within the public sector. 0e shall particularly consider four models that may be regarded as paradigms that any public sector organisation can choose from. IncrementalB departmental &nder this approach, the budget for each year takes as the starting point the budget for the previous year and adds or subtracts marginally from the base. 3uch systems tend to emphasiAe the ob(ectives of the individual services and departments. RationalB corporate These approaches are less concerned with the budget base and the past but are more concerned with using resources to meet currently established ob(ectives. $n addition these 49;

approaches foster a corporate view, taking into account inter service aspects and the ob(ectives of the whole organisation. 0e now move on to consider two models within the incremental model and two models within the rational model.

The Cid s?stem Stage 0J Separate estimate preparation 3eparate departments or services prepare ne-t years estimates in isolation adopting as a starting point the current years e-penditure and service levels (the base budget" Stage 6 J #ggregation and comparison The separate estimates, or bids (similar to an auction" are then aggregated and the total is compared with what can be raised via ta-ation and charges. %ore often than not total estimated e-penditure e-ceeds total estimated income. Stage 4 J Reductions in estimated expenditure le9els At this stage proposals are made to marginally increase the income from ta-es, fees and charges in order to reduce the gap between income and e-penditure. 6owever the gap is reduced mainly by reducing the proposed e-penditure by a given percentage. Stage 1 L Detailed estimate reduction Faced by the prospects to make substantial cuts in proposed e-penditure, the following guidelines are often used: roposed *apital e-penditure is dealt with first where measures taken may include: *utting out new pro(ects Delaying progress on part completed pro(ects ostpone start of pro(ects

#evenue e-penditure is reduced by: New services are cut before e-isting services New services are delayed Eevel of service reduced 3ervice deferred to following year

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CRITICIS8 O. T@E -ID S$STE8 Little re9iew o% the Case Cudget 0ithin the bid system there is little review of the base budget. This is not desirable because any public sector organisation is faced with a comple- network of changing needs and problems which should be incorporated in the budgeting process. # departmental orientation The system views the departmental estimates and allocations as the focus of the budgetary process. The problem created by this approach is that the interest of a group, say old people may not be thoroughly addressed by a single department. Outcomes are ignored The system places more emphasis on the financial control of inputs with little attempt to relate these to the outputs that emanate from the e-penditure. Single ?ear emphasis The system emphasises the annual budget yet one year is too short for effective planning. .IN#NCI#L !L#NNIN> S$STE8S Features which distinguish financial planning systems from the bid systems include: Their multi. year nature The issue of e-penditure guideline The (oint consideration of capital and revenue budgets A more helpful specification and classification in the budget document 8ULTIJ $E#R N#TURE &nder this system in addition to the annual budgets are considered, medium term plans say 4.9 years commitments and forecasts are considered. The annual budget is seen as the first year of a rolling budget in which each year, one additional year is added on as the past year is dropped off. E:!ENDITURE >UIDELINE An e-penditure guideline, a target growth percentage or even an e-penditure limit is established for each service prior to the preparation of detailed estimates for a department.

494

AOINT CONSIDER#TION O. C#!IT#L #ND RE)ENUE -UD>ETS There is a simultaneous consideration of capital and revenue estimates due to the fact that estimates are considered for several periods.

DET#ILED S!ECI.IC#TION #ND CL#SSI.IC#TION %uch greater specificity is introduced into the budget process. $n place of a bid system2s base e-penditure plus incremental we now have: +ase e-penditure I $nflation K #eductions I committed growth I new growth GE#*NESSES O. T@E .IN#NCI#L !L#NNIN> S$STE8S No (ustification of the base budget Cmphasis placed not on ob(ectives but department Cmphasis is on input and not output

!L#NNIN> !RO>R#88IN> -UD>ETIN> S$STE8S /!!-S2 +3 was introduced into the federal government of the &nited 3tates of America by president ]onson in /?>7. The goals of the +3 are:

The careful identification and e-amination of goals and ob(ectives in each area of government activity Analysis of the output of a given programme in terms of its ob(ectives %easurement of the total cost of specific programmes not (ust for one year but for several years into the future. The formation of ob(ectives and programmes e-tending beyond one year to relate a annual budgets to long term ob(ectives. Analysis of alternatives to find the most efficient ways of reaching programme ob(ectives for least cost The ob(ectives of analytical procedures to serve as a systematic part of the budget reviews process

499

!rogramme de%ined A programme is a set of activities which encompasses all organisational efforts to achieve a specific ob(ective. A programme such as care for the elderly would cross departmental boundaries.

Lmitations o% !!-S approach The attraction of the +3 has faded due to:

*omple-ity of programme structures. technical problems are encountered in constructing programme structures The benefits of incremental policy making. +3 completely ignores incremental approach which is key to reducing conflict. the base or stating point is ob(ective. ressure on participants in the process articipants should need to have knowledge of several specialiAed areas and this tends to create pressure on them.

HERO -#SED -UD>ETIN> /H--2 Q++ is a techni'ue whereby the total cost of every item included in a proposed budget must be (ustified and approved. No bare or minimum e-penditure level should be accepted for any activity. The approach is to re'uire to a re.evaluation of all e-penditure and of all activityD activities start from Aero base. $n reality many government organisation may retain functions or goals which have lost their usefulness as the environment has changed. Q++ seeks to e-pose such e-penditure. Athough Q++ is an appealing concept, it is difficult to appraise all activities due to: Time factor 3ome e-penditure are politically motivated 3ome e-penditure are as a result of past commitments which are supported by some legislation. %ay generate too much information which decision makers cannot comfortably handle.

Despite these draw backs it is clear that there is need to e-pose public sector e-penditure

495

to systematic review. This can be achieved by: Ad hoc efficiency studies The use of virement policy <ption budgets

#D @OC E..ICIENC$ and e%%ecti9eness STUDIES 3uch studies which scrutiniAes the effectiveness of current operations may be motivated by internal reviews or the may be sparked by the activities of e-ternal review agents such as the auditors. T@E USE O. )IRE8ENT !OLIC$ This is a policy which allows discretionary savings to be switched by service by service managers to e-penditure heads according to the department2s priorities. This system is attractive as it is an inducement to those for those closest to the service delivery who are most likely to be able to deliver efficiency savings to search out those savings. 0here savings are lost there may be little incentive to search for them. O!TION -UD>ETS &nder this system the priorities of a department are evaluated by testing the effect on a department when the budget allocation is increased e.g what is the effect on the service if: /;8 cut in e-penditure 78 cut in e-penditure /8 cut in e-penditure

3uch options force a service to consider policies and operating procedures.

497

C@#!TER = -UD>ET !RE!#R#TION IN T@E !U-LIC SECTOR

Introduction 6aving discussed the various approaches and types of budgets in the public sector, this chapter will proceed to demonstrate the preparation of a budget. Learning out come After studying this chapter you should be able to: repare forecast for the remainder of the current year repare a budget for the forth.coming year

TGO STE!S IN -UD>ET !RE!#R#TION The preparation of a budget in the public sector involves the following two stages: Cstimated out.turn for the current year Cstimate for the ne-t year

!RO-#-LE OR ESTI8#TED OUTJTURN The first step involves forecasting the out turn for the current year which forms the budgetary base for the construction of the budget for ne-t year. ESTI8#TE .OR NE:T $E#R The ne-t step is to pro(ect the e-penditure and income for the forth coming year based on the probable or estimated out.turn. TGO STE!S IN -UD>ET !RE!#R#TION The preparation of a budget in the public sector involves the following two stages: Cstimated out.turn for the current year Cstimate for the ne-t year

!RO-#-LE OR ESTI8#TED OUTJTURN The first step involves forecasting the out turn for the current year which forms the budgetary base for the construction of the budget for ne-t year.

49>

ESTI8#TE .OR NE:T $E#R The ne-t step is to pro(ect the e-penditure and income for the forth coming year based on the probable or estimated out.turn. DETERMININ& THE PROBABLE OUT/TURN FOR THE CURRENT FINANCIAL YEAR2 The process involved in calculating the probable out.turn for the current year is : establishing the actual to date. Adding estimated e-penditure for the remainder of the current year. In estimating the expenditure %or the remainder o% the ?ear5 the %ollowing should Ce considered The proportion of the year remaining. The anticipated inflation for the remainder of the year. $mpact of pay awards on staff costs. *ost of new products to be commenced in the current year.

E:#8!LE !RE!ER#TION O. OUTJTURN .OR T@E $E#R The following information relates to costs of a government funded prisoners2 rehabilitation centre for a nine month period ending 9/st December 4;;5.
.ormer !risoners RehaCilitation Centre :2;;; Income =15',, Cmployees #unning e-penses Asset rents and capital charges Total Expenditure Net Expenditure ?/,=;; 4@4,7;; 9@,7;; 1,053,, 4,;54,,

The following assumptions is the basis for preparing estimated out.turns Income No changes are e-pected in the pattern of income in the ne-t three months Emplo?ees Cmployees will receive an increment of 58 in the ne-t 'uarter

49@

Running expenses 478 of the running cost is e-pected to be fi-ed while and the variable component is e-pected to rise by >8. #sset rents and capital charges Asset rents and capital charges is the actual payments made to 9;th 3eptember 4;;7 Required repare a statement of the estimated out.turn as at 9/st march 4;;7.

Solution
!risoners RehaCilitation Centre Income Cmployees #unning e-penses Asset rents and capital charges Total Expenditure Net Expenditure :P;;; 0orkings =15',, ?57;;,9-5 ?/,=;; ?/=;;I (?/=;;,9-/.;5" 4@4,7;; see working below 9@,7;; 9@7;;,4-5 1,053,, 4,;54,, Cstimated out. turn 4@4,7;; >=,/47 4;5,9@7 ?;,=99 4@>,7== 4<;5160 Cstimated out. turn :P;;; /4>,;;; /49,>45 9>@,54/ @7,;;; '<<5,1' 11,5,1'

0orking Running cost Fi-ed 478 !ariable @78

DETER8ININ> T@E ESTI8#TE .OR T@E NE:T $E#R reparing e-penditure for the coming year involves the following: Take the probable e-penditure prepared in step (4.4 above" one above

49=

#dd the %ollowing i" The full.year effect of any e-penditure, notably employee costs, where a part.year effect in the current year is to be converted into a full year effect for ne-t yearD for e-ample the pay increase for step one above would now be for the whole year. The part year effect of ne-t years estimated pay award. Cstimated price inflation for consumables, energy, transport, etc Any committed growth for ne-t yearD whether this be due to salary increments, the full year effect of completed schemes and so on. Finally, add in new or discretionary growth.

ii" iii" iv"

Deduct the %ollowing i" ii" Any non.recurring e-penditure in the current year which will not be repeated ne-t year. Any savings which are estimated to accrue ne-t in the ne-t year

Additional re'uirements for the 'uestion above Charges i" *harges to residents are e-pected to increase by /;8 with effect from /st April 4;;7 Emplo?ees ii" $t is e-pected that a wage award of >8 will be made with effect from /st <ctober 4;;7 Running expenses iii" The fi-ed costs are e-pected to increase by /;8 p.a with e-ception of 7;; iv" !ariable costs are e-pected to increase by @.78 with effect from /st %arch 4;;7

#sset rents and capital charges v" The e-pected amount for the whole year is :/4 million Required &sing this information prepare a budget for the ne-t year.

Solution

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!risoners RehaCilitation Centre -udget %or 40st 8arch 6,,< $ncome Cmployees #unning e-penses Asset rents and capital charges Total C-penditure Net C-penditure :P;;; /9=,>;; /99,>9> 9?@,45= /4;,;;; >7;,==7 7/4,4=7

GorDings $ncome Cmployee /4>;;;-/./ ?/=;;,9-/.;>-4 >5=@4-/.;> :2;;; 0435<,, >5,=@4 >=,@>5 0445<4< ??,?/> 4?@,994 4=;5613

Total #unning e-penses Fi-ed costs /./-?;=99 !ariable /.;@7 - 4@>7== Total

End o% chapter questions The following information relates to a police authority for the si- months to 9; 3eptember /?G?:
Central !ro9ince Criminal Records o%%ice :P;;; 497,7; Cmployees ; remises 5=,;;; 3upplies and services 4?,@7; Transport @,>;; *entral department and technical support 97,9;; %iscellaneous e-penses 4@,7;;

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Asset rents and capital charges Total

/7,;;; 9?=,>7 ;

Note a" Cmployees received a pay award of 78 during the first half of the year and payable with effect from 9; ]une /?G? b" 6alf of premises costs for the first half.year comprises space heating costsD space heating costs in the last 5 months of the year are e-pected to e'ual total costs for the first = months of the year. c" Asset rents and capital charges are payable on 9; 3eptember and 9/st %arch. d" Due to increase in the price of fuel, transport costs will be 4.78 higher in the second half of the year. e" 3upplies and services includes a non.recurring payment of :7million made in ]une /?G?

Required repare a statement giving the estimated out.turn for the year ended 9/st %arch /?G; SOLUTION
GOR*IN>S G0 Emplo?ees - I /.;7- H 497,7;; 4.;7- H 497,7;; -H //5,=@= pay in 'uarter 4 H /.;7 - //5,=@= 06,5<66 G6 !remises Non 3pace heating costsH /,4 - 5=,;;; 3i- months Ne-t 9 months H 45;;;,> - 4 Cstimate for the = months Cstimate for the ne-t 5 months Total space heating cost Total premises costs G4 Supplies and ser9ices 45,;;; 45,;;; =,;;; 94,;;; 94,;;; >5,;;; 335,,,

45/

#ecurring H (4?@7;.7;;",>-/4 Non recurring Total Transport 3i- %onths ne-t si- months /.;47 - @,>;; Total *entral department and technical support si- months to 9; september si- months to 9/ %arch Total G< Asset and capital charges 3i- months to 9; 3eptember 3i- months to 9ist %arch <ut turn %iscellaneous e-penses 4@,7;;,>-/4 Central !ro9ince Criminal Records o%%ice :P;;; /4;,>44 ==,;;; 7?,;;; /7,9?; 97,9;; 77,;;; 9;,;;; 1,45406

7=,7;; 7;; '=5,,,

G1

@,>;; @,@?; 0'54=,

G'

97,9;; 97,9;; ;,5<,,

/7,;;; /7,;;; 9;,;;;

G;

''5,,,

Cmployees remises 3upplies and services Transport *entral department and technical support %iscellaneous e-penses Asset rents and capital charges Cstimated out.turn

454