CAT T7 Planning Control

& Performance Management

Key notes
Use this notes together with study guide if you want. The underlined sentences are the one
that follow study guide’s requirement. This note works best together with textbook.

Chapter 1: Accounting for management

Functions of management
Planning – setting objectives, selecting strategies
Controlling – measure and act, need to have performance measurement system
Organizing – establish sequences of tasks
Motivating – influence others’ behavior
Decision-making – making choices between alternatives

Objective of management accounting information is to help managers in planning, control,

decision making and performance measurement.

Role of management accountant is to provide the manager with assistance in planning,

controlling, organizing, motivating and decision-making.

Useful management information is ACCURATE:

Accurate
Complete
Cost-beneficial
User-targeted
Relevant
Authoritative
Timely
Easy to use

Limitations of management information

Fail to:
(i) Meet requirements of good information
(ii) Determine relevant costs and revenues
(iii)Account for non-financial information
(iv) Account for external information

Cost accounting systems can be maintained and improved by making sure that it is:
(i) Forward looking
(ii) Take into account internal and external information

1
 (iii)Account for quantitative and qualitative matters
(iv) Analysed(detailed)

Chapter 2: Absorption Costing

Application of AC
AC is an overhead recovery system which involves 4 steps:
(i) Allocation – Assign costs which are not shared to departments
(ii) Apportionment – Sharing of cost on an equitable basis
(iii)Reapportionment – Transfer of service department cost to production department
(iv) Absorption – calculate overhead absorption rate(OAR) and charge cost to products
according to full production cost
OAR=Budgeted overhead/Budgeted level of activity

AC can be applied to job costing, batch costing, contract costing (long-term of job costing),
service costing and process costing. The cost per unit will be charged on full production cost
basis.

When our actual production units are higher than normal production, over-absorption exists
and this needs to be adjusted to gross profit figure.

Preparation of management accounts and cost estimates using AC

Profit Statement
Revenue
Less: Full Production costs
Opening inventory (at full cost)
Production costs (variable + absorbed fixed overhead)
Less: Closing inventory (at full cost)
=Gross profit
+over-absorption/ (under-absorption)
=Adjusted gross profit
Less: Other cost
=Net profit

Evaluation of AC
Advantages:
(i) An acceptable system of recovering inevitable fixed overheads
(ii) Complies with matching concept
(iii)Complies with financial statement need to include fixed overhead in inventory
(iv) Provides a practical way of job costing for estimating prices and profit analysis
Disadvantages:
(i) Overhead allocations and apportionment are arbitrary and can be misleading
(ii) Increase or decrease of inventory can distort income statements
(iii)Under/Over absorption obscures true reasons for inefficiencies, making overheads
difficult to control
(iv) Unit costs are distorted by absorption rates
(v) Cannot be used for decision-making because fixed cost is irrelevant

2
Chapter 3: Marginal Costing

Use of marginal costing in an organization is for short-term decision-making.

MC is applicable to costing situations just as AC, but the cost per unit is charged on marginal
(variable) production cost basis.

Cost behavior is manner in which a cost will react to changes in the level of activity. Costs
may be viewed as variable, fixed, stepped or mixed (semi-variable).
Preparation of management accounts and cost estimates using MC
Profit Statement
Revenue
Less: Variable Production costs
Opening inventory (at variable cost)
Production costs (variable overhead)
Less: Closing inventory (at variable cost)
Less: other variable cost
=Contribution
Less: fixed cost
=Net profit

Reconcile marginal costing and absorption costing profits

At marginal costing, closing inventories are valued at marginal production cost.
At absorption costing, closing inventories are valued at full production cost.
If inventory level increases, absorption costing reports higher profit because fixed overheads
included in closing inventory.
If inventory level decreases, marginal costing reports higher profit.
Reconciliation
Absorption costing profit
+ (Closing inventory-opening inventory) x fixed OAR per unit
=Marginal costing profit

Evaluation of MC
Advantages:
(i) Appropriate for decision-making as it highlights those costs and revenues which will
change as a result of the decision.
(ii) Fixed costs are all treated as period costs and charged into income statement which
avoids distortion in reported profit. Profit will be more realistic.
Disadvantages:
(i) Cost behaviour must be known
(ii) In longer term, all cost must be covered by revenue of the organisation if it is to make
a profit
(iii)Pricing decisions based on marginal costing principles may be harmful to the business
in longer term.

Use of absorption and marginal costing

Absorption costing is used for inventory valuation and financial reporting.

3
Marginal costing is used for short-term decision making and CVP analysis.
Chapter 4: Activity Based Costing

Reason for development of ABC is because modern manufacturing environment:

(i) More automated than labour intensive
(ii) Fixed costs become a larger proportion of total costs
(iii)Overhead is a lot higher than direct costs

Select appropriate cost pools and cost drivers and calculate product costs using ABC.
Cost drivers are any factors which causes a change in activity cost (cost pools). It might be
better to think of it as the “cost causer”.
Steps involve in calculating cost are:
1. Identify a cost
2. Identify cost drivers
3. Calculate cost driver rates (cost pool/cost driver)
4. Multiply cost driver rates with activities consumed
5. Trace the cost into the units produced
Example: Cost of goods inwards department totalled $10000. Cost driver for goods inwards
activity is number of deliveries. During 20X0 there were 1000 deliveries. 200 of these
deliveries related to product X. 2000 units of product X were produced.
Answer: Cost driver rate = $10000/1000deliveries = $10 per deliveries
Total cost of product X = $10 x 200 deliveries=$2000
Cost per unit of product X = $2000/2000units=$1

Application of ABC
Alternative to AC and MC in a job, batch, contract, service or process costing system.
ABC is also useful in costing of services.

Evaluation of ABC
Advantages:
(i) Unit costs should more accurately reflect the activities performed
(ii) Effectively used in identifying unprofitable customers and unprofitable products and
company can concentrate on profitable
(iii)Identify those activities that add more to value
(iv) Better understanding of how product is derived
(v) Avoid arbitrary cost apportionment
Disadvantages:
(i) Unknown technique and not widely accepted
(ii) More complex and costly technique to set up and operate
(iii)Unlikely to relate all overheads to specific activities
(iv) Cost drivers might be difficult to identify

Use of AC, MC and ABC

Absorption costing is used for inventory valuation and financial reporting.
Marginal costing is used for short-term decision making and CVP analysis.
Activity based costing is used for inventory valuation, financial reporting, long-term decision
making, produce budgets (activity based budget) and aid in planning and control.

4
Chapter 5: Collection of Information

Sources of information include internal and external. Internal sources may be obtained from
data recorded from standard costing, budgeting and performance measurement control system.
Main sources of external information are government sources, suppliers and customers, trade
associations and trade journals, financial and business press and other media.

Sources of information from suppliers and customers

Customers can provide information such as:
(i) Product that they want
(ii) Quality required
(iii)Delivery periods required
(iv) Preference of packaging and distribution methods
Suppliers may be able to provide information on:
(i) Quantity discounts and volume rebates which may help decision on order size
(ii) Availability of products and services
(iii)Alternative products or services which may be available
(iv) Technical specifications of their product

Sources of information from government, trade associations and financial press

Government publishes statistical data covering many aspects of the nation’s economy.
Trade associations publish their trade journals which will contain useful news and other
information.
Financial press provides statistics and financial reviews as well as business and economic
news and commentary.

Sampling techniques and when they are appropriate to use

Purpose of sampling is to gain as much information as possible about the population by
observing only a small proportion of that population i.e. by observing a sample.

In random sampling, sample is taken in such a way that every item of the population has
equal chance of being selected. It is useful if population is known and not big.

Systematic sampling involves selecting every nth item after a random starts, only first item is
selected randomly. For example, if the population contains 50000 items and a sample size of
500 is required, then 1 in every 100 items is selected. The first item is determined by
choosing randomly a number between 1 and 100, eg. 67, then the second item will be 167th,
the third will be 267 th up to 49967th item. This method is useful if population is logically
same type but will introduce bias if population has a repetitive pattern.

Stratified sampling involves selecting random samples from well defined groups (strata), eg.
men and women, smokers and non-smokers. The method is often used by auditors to choose
a sample to confirm receivables balances. This method requires prior knowledge of each
population item.

Multistage sampling involves dividing population into sub-populations and small random
sample is selected from sub-populations. It is useful if the population is large.

5
Cluster sampling involves dividing population into sub-populations and small random sample
is selected from sub-populations, then every items in the random sample are investigated. It is
useful if the population is large.

In quota sampling, investigators are told to interview all the people they meet up to a certain
quota. This may be very biased because they choose how to fill the quota.

Benchmarking is a process where organisations gather information outside the organisation to

use as comparisons and for setting targets.

Types of benchmarking
Internal benchmarking refers to comparisons being made between different departments or
functions within an organisation.

Functional benchmarking (also known as operational or generic benchmarking) involves

comparisons with the performance of external practitioners of similar functions. These
practitioners need not be in the same industry.

Competitive benchmarking involves comparisons with the performance of a direct competitor.

Strategic benchmarking takes place at the highest levels of performance measurement (such
as company-wide return on capital employed, market share etc) and is aimed at prompting
strategic change. Strategic benchmarking seeks to compare the strategies of the originator
with those of competitors, in order to more closely identify where competitive threats and
opportunities may lie in the longer term.

Advantage of benchmarking
(i) Flexibility so can be used in private and public sectors
(ii) Identifies processes to improve
(iii)Aids cost reduction
(iv) Focus on planning
(v) Improves effectiveness of operations
Disadvantage of benchmarking
(i) It can be complex and needs a lot of work
(ii) Benchmarking reveals the standards attained by competitors but does not consider the
circumstances under which the competitors attained such standards

Chapter 6: Presentation of information and use of indices

Prepare written reports representing management information in suitable formats according to
purpose
Typical report structure will include:
To:

6
From:
Subject:
Date:
Introduction
Analysis (use an underlined heading for each sub section)
Conclusion
Appendices (show calculations in detail)

Present information using tables, charts and graphs (bar charts, histograms, frequency
polygons) and interpret
Purpose is to summarise the information and present it in a more understandable way.
Table
Eg. Alpha Products Plc
Changes in labour force (20X0-20X1)
20X0 20X1
Depart Depart Total Depart Depart Total
A B A B
Wages bill ($) 218000 295000 513000 224000 313000 537000

Number employed 30 42 72 25 43 68
When interpreting, write down what you see. For example, in 20X1, total wages are
$537000 which is higher than in 20X0.
Charts
There are three types of charts:
Simple bar chart – Only one variable is being illustrated.
Component bar chart – Gives breakdown of each total into its components.
Compound/Multiple bar chart – Two or more separate bars are used to present sub divisions
of information.
Histogram
It is similar to bar chart but used to represent the frequencies in a grouped frequency
distribution. Area of the bar represents the frequency rather than height of the bar. Therefore
if the class intervals are unequal then the height relationships of the bars will differ. The bars
touch each other, there are no gaps.
Frequency polygons
If the midpoints of the tops of the rectangles in a histogram are joined by straight lines, we
get our frequency polygon.

Calculate price and quantity indices on Laspeyres' and Paasche bases

Laspeyre price index-weighted by base year quantities
Paasche price index-weighted by current year quantities
Laspeyre quantity index-weighted by base year price
Paasche quantity index-weighted by current year price

Eg. Laspeyre price index

Item 20X2 20X3 20X2 price X 20X3 price X
Price Quant. Price Quant. 20X2 quantity 20X2 quantity
Product A $6.50 10 $6.90 5 $6.50x10=$65 $6.90x10=$69
Product B $2.20 30 $2.50 40 $2.20x30=$66 $2.50x30=$75
Total $131 $144

7
Laspeyre price index= (sum of current price X base quantity)/(sum of base price X base
quantity) X 100=$144/$131 X 100=110

Discuss advantages and disadvantages of Laspeyres' and Paasche indices

Advantages:
(i) Ease of calculation. Laspeyres price index is based upon the baseline quantities, only
the current year’s prices are required for the calculation of the index. For the
Paasche price index then the current year quantities and prices are required.
Laspeyres price index is slightly easier to calculate and can be obtained in
situations where the current year’s quantities are unknown.
(ii) Relevance. Paasche price index uses current quantities so more relevant and topical,
especially where the quantities may have changed dramatically.
Disadvantages:
(i) Long series of data. Paasche price index has to be recalculated each period new data
comes along as the current period will have changed. When quantity changes then the
previously calculated Paasche price indices may take substantially different values from the
newly calculated ones based upon the new current year quantities. Laspeyres price index does
not need to be recalculated as the base period remains the same.

Adjust raw data using appropriate indices

Index can be used to adjust past costs and revenues data into current values.
For example, 2010 price index is 140, 2009 price index is 125 and revenue is $1250, when
we need to adjust 2009’s revenue value using 2010 price, we can simply take 2010 price
index divided by 2009 price index and multiply 2009 revenue:
140/125 X $1250=$1400
$1400 is the revenue for 2009 if it was 2010’s price level.

Chapter 7: Forecasting

Use the high-low method to estimate the fixed and variable elements of a cost
Step 1: Calculate difference between cost of highest and lowest level and then divide it with
units of highest and lowest level to get variable cost per unit.
Step 2: Calculate fixed cost by fixed cost= total cost – (variable cost per unit x units)
Step 3: Summarise the relationship by making an equation, eg. Fixed cost=$600, variable
cost per unit=$0.2, equation will be y=a+ bx, so y=600+ 0.2x.

8
Advantages and disadvantages of the high-low method
Advantages:
(i)A simple, non-technical method
(ii)Can be used with a minimum of data
Disadvantages:
(i)Uses past data to attempt to forecast future costs
(ii)Uses only two points
(iii)Assumes the cost relationship is linear

Construct scatter diagrams and lines of best fit

Step 1: Collect data of past volumes of output costs.
Step 2: Plot cost and output data on a graph.
Step 3: Draw a “line of best fit” through the middle of the plotted points.
Step 4: Fixed costs=intercept on vertical axis.
Step 5: Variable cost per unit= [total cost (read from graph)-fixed cost]/activity level

Use of linear regression analysis in the analysis of cost data

A more mathematical technique to improve the accuracy of the line of best fit. It is based on
working out an equation for the line of best fit (not required in T7). General equation for a
straight line can be expressed as: y=a + bx.

Use linear regression coefficients to make forecasts of costs and revenues

The value of a and b will be given in exam, eg. a=27.49 and b=14.18, equation will be
y=27.49+14.18x, but this equation can mean different thing according to different types of
question, for example, if y is the annual maintenance cost and x is the years of machine and
required to estimate the maintenance cost of a machine that is 10 years old, then the forecast
of cost will be 27.49 X (14.18 X 10).

Adjust historical and forecast data for price movements

The method of adjustment will be the same as previous at chapter 6 last part, using our
forecast price index to adjust for past sales value.

Advantages and disadvantages of linear regression analysis

Advantage:
(i)Provides a more reliable approach as it arrives at the equation of the regression line from
the use of mathematical principles known as least squares method.
(ii)A large number of observations can be built into regression line and this is likely to make
the relationship derived more accurate.

Disadvantage:
(i) Only valid where the relationships involved are linear.
(ii)Uses past data
(iii) More complex technique to apply.

Principles of time series analysis

Trend is the general direction in which a graph of sales goes.
Seasonal variation is short-term fluctuations.
Random variation is irregular fluctuations that cannot be identified or eliminated.

9
Calculate moving averages
When the time series is not approximately linear, we can use a technique known as moving
averages. However it requires a lot of time and will not required in T7.

Determination of trend, including the use of regression analysis

We can determine the trend by using linear regression formula, for example S=110+10T
where T=1 denotes for first quarter, Quarter 1 of 2000, T=2 denotes for Q2 of 2000 and so on,
then our trend value for Q2 of 2001 will be 110+10X6.
We can also determine the trend by extending the trend line on the graph and reading off the
relevant figures. This is also known as “extrapolation”.

Use trend and seasonal variation (additive and multiplicative) to make budget forecasts
Additive model: Forecast sales (A) = Trend (T) + Seasonal variation (S)
Multiplicative model: A = T X S
Eg. Additive model: Seasonal variations are Quarter (Q) 1=(52), Q2=24, Q3=116, Q4=(88),
after we determined our trend value for next year, we can forecast our sales, let say our trend
values for next year are Q1=215, Q2=218, Q3=222, Q4=227, our forecast sales for Q1 next
year will be 215 – 52.
Multiplicative model: Seasonal variations are Q1= (40%), Q2= 20%, Q3= 30%, Q4= (10%),
trend values for next year are as above, then our forecast sales for Q1 next year will be 215 X
60%.

Advantages and disadvantages of time series analysis

Advantage:
(i)Able to make accurate forecast of sales
(ii)Simple to use
Disadvantage:
(i)Assumes past trends will continue indefinitely but competitors may influence the sales of
products which cause the trends to change.

Concept of the product lifecycle and its implications for sales forecasting
The product lifecycle model shows how sales of a product can be expected to vary over time.
If an organisation knows where a product is in its lifecycle, they can plan the marketing of
that product more effectively and derive an approximate forecast of its sales from knowledge
of the current position of a product in its lifecycle.
Standard lifecycle model for a product has 4 stages: introduction (sales are at low level),
growth (sales increase rapidly), maturity (growth in sales will probably stop) and finally
decline (sales will fall).

Chapter 8: Budgetary planning

Planning and control cycle in an organisation

This involves 7 steps:
Step 1: Identify objectives
Step 2: Identify alternative courses of action (strategies)
Step 3: Gather data about alternatives
Step 4: Select course of action
Step 5: Implement the long-term plan in the form of annual budget
Step 6: Monitor actual results

10
Step 7: Respond to differences from plan, go back to step 2 if needed or control and go to
step 5 again.

Explain how the design of the planning and control system will be affected by organisational
structure, business objectives, the organisation's administrative procedures and the nature of
the product/service market
Different organisation structure definitely influenced the way managers are going to design
the planning and control system as it is the pattern which all managers follow. The business
objectives are the first step of planning and control cycle, so when it is changed, every steps
below will also change. The design of planning and control system will also be affected by
the procedures of the administration because the implementation of budget strongly depends
on it. Different products will affect the way managers chose to get profit from it.

Compare short-term and long-term business plans and explain how they are related
Short-term plan is 1 year or than 1 year plan. Long-term plan could be 2-5 years plan. Short-
term plan is there to assist the success of long-term plan.

Describe principal budgetary factor and its importance in constructing budget

Principal budgetary factor is also known as limiting factor, it is a factor that places limit of
the activity of the business. It is the first thing to consider before constructing the budget, it
may be labour hour, machine hour or material that restrict us from achieving the demand,
therefore we start our budgeting by identifying principal budgetary factor first, then construct
budgets.

We need to be able to identify principal budget factor in specific situations. For example
company A has maximum demand of 150000 units but it can only produce maximum of
100000 units, the company’s principal budget factor would be materials or labour hours.

Describe the order of budget construction relating to a specific limiting factor

If the limiting factor is sales, our order of budget construction will be as follow:
Step 1: Sales budget
Step 2: Production budget
Step 3: Cost of goods sold budget (raw material, labour and factory overhead budget)
Step 4: Non-production overhead budget (eg. selling and distribution budget)
Step 5: Budgeted income statement-Master budget
Step 6: Cash budget-Master budget
Step 7: Budgeted balance sheet-Master budget

Budget preparation timetable is a timetable that described the preparation process of budget.
Budgetary process involves the following stages:
1. Communicating details of budget policy and budget guidelines
2. Determining limiting factor
3. Preparation of sales budget
4. Initial preparation of other budgets
5. Negotiation of budgets with superiors
6. Coordination of budgets
7. Final acceptance of budgets
8. Budget review

11
Describe relevant documentation produced and the management accountant’s role in its
production
Document produced will be the budget manual which is a collection of instructions governing
the responsibilities of persons and the procedures, forms and records relating to the
preparation and use of budgeting data. Management accountant will act as an budget officer,
who is secretary to the budget committee and is responsible for seeing that the timetables are
followed and provide necessary specialists assistance to functional managers in drawing up
their budgets and analysing results.

Describe the involvement of staff at all levels in the organisation in the budget preparation
process and the effect on employee motivation of the approach adopted
The staff involves would be chief executive, the management accountant and functional
heads (head of departments). This can improve employees’ motivation as they have a target
to achieve.

Sources of information required for budget preparation and their likely limitations
Information required would be previous year’s actual results, other internal sources, statistical
data and external sources. But there are limitations, external information may not be accurate
which can cause wrong decision made. Uncertain economic climate may cause the
information collected from internal sources and past data to be not useful.

Management might plan for variations in capacity levels by increasing advertising, incur
promotion expenditure, makes improvements to the product and more.

Prepare budgets under varying capacity levels

The way of using limiting factor analysis will be finding out contribution per limiting factor
for each products and then rank each products, the highest contribution per limiting factor
means the highest return, produce the product which is ranked no.1 first.

Prepare sales budgets

Take the budgeted sales units multiply by the selling price per unit.

Prepare functional budgets (production, raw materials usage and purchases, labour, fixed
overheads)
Production budget = sales units + closing inventory – opening inventory
Raw material usage budget = production units x material usage per unit
Material purchases budget = material usage + closing inventory (material) – opening
inventory (material)
Labour budget – production units X labour hour per unit=total labour hour, total labour hour
X labour cost per hour= total labour cost
Fixed overheads budget – if the production overhead is absorbed based on labour hour, fixed
production overhead/total labour hour=fixed OAR

Discuss the preparation of discretionary expense budgets

Some possible approaches such as:
(i)Based this year’s budget figure on last year’s budget, adjust for inflation.

12
(ii)Based this year’s budget figure on last year’s actual expenses, adjust for inflation.
(iii) Managers using their knowledge and experience to set a budget.
(iv)Output based budgeting-based on the output of management accounting department.

Prepare capital budgets and cash budgets

Not really required in T7, it will be covered in T10.

Prepare master budgets (profit and loss account and balance sheet)
Especially budgeted income statement, using AC or MC, the method will be the same like
chapter 2 and 3.

Main features of zero-based budgeting

ZBB involves preparing a budget for each cost centre from a zero base. Every item of
expenditure has to be justified first before included in budget.

Advantages and limitations of zero-based budgets

Advantage:
(i)Identifies and removes inefficient and obsolete operations.
(ii)Encourages innovation
(iii)Removes budgetary slack
(iv)Takes changes in the business environment into account
Limitation:
(i)Involves time and effort and is costly
(ii)Information systems may not be able to provide suitable information

Compare the use of incremental and zero-based budgeting systems

Incremental budgeting involves adding a certain percentage to last year’s budget to allow for
growth/inflation. But it has disadvantages such as out of date, budgetary slack and so on.
ZBB would be useful in preparing budget but it has certain limitations.

Describe when zero-based budgets are commonly used

ZBB is useful in service industries, support expenses, non-profit-making organizations and
discretionary costs.

Main features of a rolling budget

Rolling budget is a continuously updated budget by adding a future accounting period when
the earliest accounting period has expired. It takes into account the latest information.

Role of spreadsheet models in budget construction

Spreadsheets are of great use in budgeting and decision making as it can manipulate a large
amount of data very quickly.

Prepare simple spreadsheet formulae for budget construction

In spreadsheet, the intersection of each row and column is referred to as cell. Columns are
referenced alphabetically and rows numerically with the result that a cell reference is a
combination of these. For example, A1*A5 means column A row 1 multiply by column A
row 5. A1=cell.

Describe financial modeling software

13
It is software that allows organization to build up an overall financial plan including a
detailed set of budgets.

Describe “what if” analysis and scenario planning

“What if” analysis is a form of sensitivity analysis, which allows the effects of changing one
or more data values to be quickly recalculated. It is useful to test uncertain situation and it can
be assisted by using spreadsheet.
Scenario planning is strategic planning method that some organizations use to make flexible
long-term plans. Scenarios are descriptions of vividly different, contrasting and relevant
future environment in which the business may have to operate.

Chapter 9: Budgetary control

The importance of flexible budgets in control

Variance report based on a flexible budget compares actual costs with the budgeted costs
which is based on actual activity level achieved. Variances can be calculated in a more
meaningful way.

Disadvantages of fixed budgets in control

Fixed budgets are based on estimated cost per unit and estimated activity level. Therefore,
when actual is compared with fixed budgets, we can’t find anything other than knowing the
differences with actual result, it will not show the price or activity variances.

Identify situations where fixed or flexible budgetary control would be appropriate

Fixed budgets are generally used for planning and define the broad objectives of the
organization. It is a starting point for the on-going budgeting process.

14
Flexible budgets can be drawn up to show the effect of the actual volumes of output and sales
differing from budgeted volumes at the planning stage. At the end of a period, actual results
can be compared to flexed budget as a control procedure.

Flex a budget to a given level of volume and prepare formulae appropriate for flexing a
budget
Take budgeted cost per unit (original budgeted cost/budgeted volume) x actual volume to get
flexed value. Fixed costs will remain the same. Semi-variable costs need to be split into their
fixed and variable components using high-low method.

Prepare flexed budgets at various output levels and estimate profit at various output levels
Eg. Budgeted revenue is $1500000 and budgeted sales are 50000 units. Actual units sold
were 37500 units and actual revenue is $1075000, find the flexed revenue budget.
Solution: flexed revenue= (1500000/50000) x 37500= $1125000, actual is $50000 less than
flexed, therefore it is an adverse variances because actual revenue is lower.

Calculate sales price and sales margin volume variances

Cover later in Chapter 10: Standard Costing.

Explain the meaning of budget variances

A variance is the difference between actual result and an expected result. Price variances
simply mean the differences of budgeted price and actual price. Activity/Production volume
variances mean differences of budgeted activity level and actual activity level.

Analyse the potential causes of budget variances

Potential causes of budget variances may be due to incorrect records of actual costs, random
events, poor budgeting, machines breakdown and so on.

Prepare control reports suitable for presentation to management and discuss the relative
significance of variances
Report will have to be understandable to the person who read it, it should be prepared based
on the format covered in chapter 6 and in the analysis part, discuss the significance of
variances, telling the management whether the variances are important or not, a big variances
will be significant.

Potential actions to eliminate variances and advantages and disadvantages of particular

actions
These actions may be done by management to get desired performance so it might include
manipulation. But the disadvantages are much exceeds advantages, they cannot understand
the problems and control is not taken which will cause long-term problems.

Discuss the use of spreadsheets in flexing budgets and prepare spreadsheet formulae for
budget flexing
Spreadsheet is useful as it can manipulate the activity level of fixed budget very quickly and
make it flexed. The thing that needs to be changed could be just one cell in the spreadsheet
formulae which already exists.

15
Define the concept of responsibility accounting
Responsibility accounting is a system of accounting that separates revenue and costs into
areas of personal responsibility in order to monitor and assess the performance of each part of
an organisation.

Explain its significance in control

We are able to know about the performance of each responsibility centre and therefore be
able to control each centre more effectively.

Evaluate the responsibility of managers in a given situation

Manager of cost centre will be responsible to costs only, manager of revenue centre will be
responsible to revenue only, manager of profit centre will be responsible to revenue and cost,
manager of investment centre will be responsible to return on investment.

Explain the problem of joint responsibility

In joint responsibility, manager’s responsibility increases and this may cause de-motivation
as there is pressure in following the responsibility.

Design reports appropriate to a given responsibility structure

Again the report should follow the format covered in chapter 6.

Identify costs to be collected for a given responsibility structure

For example, production department’s costs would be overtime pay.

Explain the concepts of controllable and uncontrollable costs

Controllable cost is a cost that can be controlled, typically by a cost, profit or investment
centre manager. A cost which is not controllable by a junior manager might be controllable
by a senior manager. A cost which is not controllable by a manager in one department may be
controllable by a manager in another department.
Distinguish between controllable and uncontrollable costs in a given situation
Non-controllable costs could be increases in expenditure items due to inflation. Some costs
are controllable but only in long term (eg production costs may be reduced if new machinery
is purchased).

Define cost centres, revenue centres, profit centres and investment centres
Cost centre is a collection place for certain costs before they are analysed further.
Revenue centre is similar to cost and profit centre but accountable for revenues only.
Profit centre is any unit of an organisation to which both revenues and costs are assigned.
Investment centre is a profit centre which particularly deals with investment returns.

Discuss performance measures appropriate to each type of responsibility centre

Cost centre – variances analysis, efficiency measures
Revenue centre- comparison of budget with actual revenue
Profit centre- profit
Investment centre- return of capital employed (ROCE) and residual income

Calculate controllable profit, traceable profit, return on investment and residual income in a
specific situation
ROCE=profit before interest and tax/capital employed
Residual income=profit before tax – notional interest charged on investment

16
Distinguish between managerial performance and business unit performance
Managerial performance will be the performance of the manager. Business unit performance
is the performance of one department and it is actually depended on manager’s performance.

Define motivation
Motivation is what makes people behave in the way that they do.

The importance of motivation in performance management

Individuals will be motivated by personal desires and interests. These may be in line with
organisation’s objective and that’s why motivation improves the performance.

Identify factors in a budgetary planning and control system that influence motivation
Factors include the level at which budgets and performance targets are set, manager and
employee reward systems and the extent to which employees participate in the budget setting
process.

The impact of targets upon motivation

If a budget target is set too easy, then actual performance will be a little better than the budget
but it will not be optimised. If a budget is set too difficult, managers become discouraged as it
is unattainable standard and may be de-motivated.

Evaluate managerial incentive schemes

A good incentive schemes is fair, motivational, understandable, consistently applied and
objective (not bias).

Discuss the advantages and disadvantages of a participative approach to budgeting

Participative budgeting is a budgeting system which all budget holders have chance to
participate in setting their own budgets.
Advantage:
(i)More realistic budgets
(ii)Motivation improved
(iii)Knowledge is pulled together
Disadvantage:
(i)Consume more time
(ii)Does not suit some employees
(iii)Managers may set easy budgets to ensure that they are achievable

Explain top down, bottom up, and budget challenging approaches to budgeting
Top down budgeting is an imposed style of budgeting, only top management will prepare
budget.
Bottom up budgeting is participative approach to budgeting.
Budget challenging/Negotiated budget is a budget which are set largely on the basis of
negotiations between budget holders and their superiors.

Define goal congruence and dysfunctional decision making

Goal congruence is the state which leads individuals or groups to take actions that are in their
self-interest and also the best interest of the organisation.

17
Dysfunctional decision making is a situation where managers take decisions that promote
their self-interest but not organisation’s interest.

The importance of goal congruent behaviour

With goal congruent behaviour, organisation can continue to grow and sustain.

Discuss causes of dysfunctional decision-making

Formal reward and performance evaluation systems can cause this problem.

Identify dysfunctional behaviour in a specific situation

It can be identified in a situation where manager/employee obtained his goal but organisation
is not improving.

Amend budgeting procedures to encourage goal congruent behaviour

A well-designed control system which encourage continuous feedback and have good
performance evaluation system can ensure goal congruence.

Describe ideal, attainable, current and basic standards

Ideal standard is based on perfect operating conditions.
Attainable standard is based on the hope that a standard amount of work will be carried out
efficiently, some allowance made for wastage and inefficiencies.
Current standard is based on current working conditions.
Basic standard is kept unchanged over a long period of time, may be out of date.

Chapter 10: Standard costing

Explain the operation of a standard costing system

Standard costing is a control technique which compares standard costs (planned unit costs)
and revenues with actual results to obtain variances which are used to stimulate improved
performance. At the very beginning, it will involve setting the standards for material price
and usage, labour rate and efficiency, overheads and selling price and margin. It can be used
in many situations such as to value inventory and cost production and to act as a control
device using variance analysis.

Discuss the advantages of standard costing and variance analysis, evaluate the
appropriateness of standard costing in a specific situation and discuss the value of standard
costing in a modern manufacturing and service environment
The greatest benefit from its use can be gained if there is a degree of repetition in the
production process. It is therefore most suited to mass production and repetitive assembly
work. However, a standard cost can be calculated per task if there is a similarity of tasks. In
this way standard costing can be used by some service organizations. Setting standards for
cost control involves dealing with people. A standard costing system will only be effective if
it is designed with full understanding of its potential behavioural effects.

Define standard absorption and standard marginal costing

18
Standard absorption costing is a system of cost ascertainment and control which is based on
full production cost whereas standard marginal costing is based on marginal production cost.

Discuss the advantages and limitations of standard marginal and standard absorption costing
Standard marginal costing is helpful in decision making but not pricing. Standard absorption
costing is helpful in pricing but not decision making.

Prepare standard cost cards (product specification) for standard marginal and standard
absorption costing
Standard cost card (MC)
Direct materials
Direct labour
Variable production overheads
=Standard marginal cost of production

Standard cost card (AC)

Direct materials
Direct labour
Variable production overheads
Fixed production overheads
=Standard full cost of production

Calculate material price and usage variances (price variances to be based upon usage or
purchases)
Material price variances – standard cost (cost per kg x actual material used) compare with
actual cost (similar to flexed budget compare with actual).
Material usage variances – standard usage compare with actual usage (in kg), if in $, multiply
another standard cost per kg.
Material total variance = material price variance + material usage variance

Calculate labour rate and efficiency variances

Labour rate variances – standard cost compare with actual cost.
Labour efficiency variances – standard hours compare with actual hours (in hour), if in $,
multiply another standard cost per hour.
Labour total variance = labour rate variance + labour efficiency variance

Calculate fixed overhead expenditure, volume, capacity and efficiency variances

Fixed overhead expenditure variances – budgeted fixed overhead expenditure compare with
actual fixed overhead expenditure.
Fixed overhead volume variance – budgeted cost compare with standard cost.
Fixed overhead capacity variances – budgeted hours compare with actual hours (in hours), if
in $, multiply another standard cost per hour.
Fixed overhead efficiency variances – standard hours compare with actual hours (in hour), if
in $, multiply another standard cost per hour.
Fixed overhead total variance – fixed overhead absorbed compare with actual fixed overhead
incurred.

19
Calculate variable overhead expenditure and efficiency variances
Variable overhead expenditure variances – standard cost compare with actual costs.
Variable overhead efficiency variances – standard hour compare with actual hour (in hour), if
in $, multiply another standard cost per hour.

Calculate sales margin volume and sales price variances

Sales margin volume variances/Sales volume profit variance – standard sales profits compare
with budgeted sales profits.
Sales price variances – standard revenue compare with actual sales revenue.

My tips on variances calculation

It may seem like there are a lot of formula to memorize, but no. I would say there are
only a few things to remember and you will be success in these areas. Standard cost
means budgeted cost per unit x actual unit. Whenever you see price variance, think of
flexed (standard price per unit x actual units) compare with actual price. When you see
capacity variance, it is about budgeted hour compare with actual hour. When you see
efficiency variance, it is about standard hour (budgeted hour per unit x actual units)
compare with actual hour. When you see volume variance, it is about standard cost
compares with budgeted cost. Understand rather than memorize, make it common
sense.

Undertake entries in a standard cost bookkeeping situation

Adverse variances are debited in the relevant variance account; favourable variances are
credited in the relevant variance account.

Prepare a reconciliation of standard to actual cost for an absorption costing system

In AC system, cost reconciliation statement reconciles the standard full cost of production in
a period with the actual costs.
Cost reconciliation statement (AC)
$
Standard full costs of production (units produced x standard full cost/unit)
Cost variances F ($) A ($)
Direct material price
Direct material usage
Direct labour rate etc

Less total cost variances

=Actual total cost

Prepare a reconciliation of standard to actual cost for a marginal costing system

Similar to AC, except that the statement reconciles standard variable costs to actual variable
costs. The cost variances will only include variable cost variances. If needed to show actual
total cost, less another actual fixed overhead (budgeted fixed overhead compare with fixed
overhead expenditure variance).

Prepare a reconciliation of budgeted to actual profit for an absorption costing system

Similar to cost reconciliation statement, except that they also include sales price and sales
margin volume variances. If in marginal costing profit reconciliation statement, it will
includes fixed overhead expenditure variance after the actual variable cost.
Standard costing operating statement (AC)

20
 $
Budgeted profit
Sales variances – price
-volume
Standard profit from actual sales
Cost variances F ($) A ($)
Direct material price
Direct material usage
Direct labour rate etc

Less total cost variances

=Actual profit

Prepare a reconciliation of budgeted to actual profit for a marginal costing system

Similar to AC, but it will start from budgeted contribution and after adjusting with sales
variances, you will get standard contribution from actual sales. After adjusting standard
contribution with variable cost variances, you will get actual contribution, then less the actual
fixed cost (budgeted fixed overhead compare with fixed overhead expenditure variance) to
get actual profit.

Prepare control reports suitable for presentation to management

Reports to an individual manager should only include figures relating to his own area of
responsibility. Top management is likely to be concerned only with significant variance, a
form of exception reporting can be used, only specifying significant variances. The reports
should be presented according to the format in chapter 6.
Subdivide variances to reflect responsibility structures
Before we prepare the variance report, we need to consider the responsibility of the manager
and subdivide variances and include only relevant variances figure. For example, purchasing
manager is responsible for material price variance, so material price variance should be sent
to purchasing manager.

Calculate idle time variances

Idle time variance = standard cost per hour x idle hours (always adverse)

Analyse variances into controllable and non-controllable elements

For example, material price variance is non-controllable for production manager but is
controllable for purchasing manager.

Discuss the causes of variances in general

In general, it includes poor budgeting, incorrect record of actual costs, random events,
unrealistic standards and inefficient operation.

Identify potential causes of variances in a specific situation

Variances Possible causes
Favourable material price – unforeseen discounts, material standard changed
Adverse material price – price increase, careless purchasing
Favourable material usage – higher quality material, effective use of material
Adverse material usage – defective material, excessive wastage
Favourable labour rate – lower rate paid, overtime/bonus different from plan
Adverse labour rate – wage rate increases, unexpected pay award

21
Favourable labour efficiency – motivated staff, change in working procedures
Adverse labour efficiency – lack of training, unexpected idle time
Favourable variable and fixed overhead – cost savings, favourable labour efficiency
Adverse variable and fixed overhead – excessive use, adverse labour efficiency
Favourable sales price – price increases due to improved quality
Adverse sales price – price cuts to increase sales
Favourable sales volume – price cutting
Adverse sales volume – poor product quality
Idle time (always adverse) – machine breakdown, illness/injury

Explain the potential interrelationships between variances

An adverse variance might be offset by a favourable variance, for example cutting of selling
price (adverse sales price variance) for increase sales (favourable sales volume variance) or
favourable material price from buying lower grade material might cause adverse material
usage due to more wastage.

Discuss the meaning and significance of variances

For example, favourable sales price variance means price of sales was higher than expected
and this variances help management to understand that sales manager is doing a good job.

Explain the significance of cost of investigation, cost of correction, benefit of correction, and
probability of successful correction in variance investigation
If the cost of correcting the problem is likely to be higher than the benefit, then there is little
point in investigating further. If a cost or revenue is outside the manager’s control then there
is little point in investigating its cause.

Calculate the expected benefit of variance investigation

Take expected benefit of correction less cost of correction, if it is positive, we can investigate
the variance.

Discuss the role of control charts in variance investigation

Control charts provide a visual representation of the variation of actual costs around standard.
Management can set control limits in the control charts and only variances outside these
limits will be reported. Control charts also give clear picture of trends in variances.

Explain potential courses of action to correct a variance and evaluate courses of action to
correct a variance in specific circumstances
The exact nature of the control actions taken will depend on the cause of the variance and the
most suitable actions for dealing with them. For example, a significant adverse material price
variance would be dealt by looking for cheaper price or take advantage of bulk purchase
discount.

Tips
Standard costing has 4 parts, calculation of variances, cost and profit reconciliation,
causes of variances and control of variances. The one that need to be emphasized on is
the calculation of variances as you can see there are different types of variances to
calculate, but it is not difficult once you know the pattern of it, try some past year

22
questions on it. For cost and profit reconciliation, it is straightforward, you just need to
calculate or sometime given and put into the format. For causes of variances, it is
common sense, don’t try to memorize anything, write in your own words about why this
variance is favourable or adverse. For control, you do not need to do much thing but to
understand when to control by taking into account of the cost, you may also see from
the control chart whether it has reached control limit or not.

Chapter 11: Performance measurement

Discuss the purpose of mission statements and their role in performance measurement
The mission statement shows the vision of top management, what they are trying to achieve,
and how they wish to achieve it. It is an important part of the process of controlling the whole
organisation.

Discuss the purpose of strategic and operational and tactical objectives and their role in
performance measurement
Strategic objectives are senior management responsibility and measured by indicators that
reflect the overall organizational performance.
Tactical objectives are middle management responsibility and measures are used to
summarize departmental or divisional performance.
Operational objectives are concerned with day-to-day organizational running and are often
physically measured.

Discuss the impact of economic, market conditions and government regulation on

performance measurement
External factors may be an important influence on an organisation’s ability to achieve
objectives. Market conditions and government policy will be outside of the control of
organisation’s management and will need to be carefully monitored to ensure forecasts
remain accurate.

Discuss and calculate measures of financial performance – profitability, liquidity and gearing
Profitability ratio (measuring ability to generate profit)
Profit margin=profit before interest and tax (PBIT)/sales x 100%
Gross profit margin=gross profit/sales x 100%
Asset turnover=Sales/capital employed
Return on capital employed/Return on Investment=PBIT/capital employed x 100%

23
Operating margin=various expenses/sales x 100%
Liquidity ratio (measuring the company’s ability to pay liability, liquidity position)
Current ratio=current assets/current liabilities
Quick (or acid test) ratio= (current assets – inventory)/current liabilities
Inventory period=average inventory/cost of sales x 365days
Receivables period=average receivables/credit sales x 365days
Payables period=average payables/credit purchases x 365days
Gearing ratio (measuring risks)
Gearing ratio=non-current liabilities/capital employed
Interest cover=PBIT/interest payable

Discuss the importance of non-financial performance measures

Non-financial performance measures can be seen as drivers of profit. They can encourage
managers to take a long-term view rather than focus on short-term financial targets. They are
also leading indicators of financial performance.

Discuss the relationship between short-term and long-term performance

Effort to reduce costs in order to generate higher profit in short-term may affect the long-term
profitability. For example, cutting the training cost can earn more profit in short-term, but
staff may leave or become less efficient in long-term.
Discuss the measurement of performance in service industry situations
Service industries do not produce a physical product, they provide services. The performance
measures could be resource utilisation measures, quantitative and qualitative measures.

Discuss the measurement of performance in non-profit seeking and public sector

organisations
They lack of profit measure and competitors, they also have multiple objectives and it is
difficult to define the objectives. The measurement could be judgement in terms of inputs,
judgement by experts, comparisons and judgement in terms of ‘value for money’ (discuss
later).

Discuss measures that may be used to assess managerial performance and the practical
problems involved
Measures which reflect the performance of the units that manager managed may not reflect
the performance of the manager. Some possible management performance measures include
judgement of outsiders, upward appraisal and accounting measures.

Discuss the role of benchmarking in performance measurement

Through benchmarking, organisations can learn about their own business practices and the
best practice of others.

Produce reports highlighting key areas for management attention and recommendations for
improve
Calculations of performance measures are best presented in an appendix at the end of the
report. Remember to follow the format of report as in chapter 6.

Discuss the advantages and limitations of the balanced scorecard

Balance scorecard is a device for planning that enables managers to set a range of targets
linked with appropriate objectives and performance measures. The framework looks at the
strategy and performance of organisation from four points of view, known in the model as

24
four perspectives: financial (focus on satisfying shareholder value), customer (measure
customer satisfaction), process efficiency (measure organisation’s output in terms of
technical excellence and consumer needs) and growth (focus on the need for continual
improvement of existing products).
Advantage:
(i)Managers are unlikely to be able to distort the performance measure.
(ii)Bad performance is more difficult to hide.
(iii)It looks at performance from four perspectives, not just from the narrow view of the
shareholders as traditional analysis would.
Disadvantage:
(i)It can involve large number of calculations which may make performance measurement
time-consuming and costly to operate.
(ii)The selection of performance indicators under each of the four perspectives is subjective.

Describe performance indicators for financial success, customer satisfaction, process

efficiency and growth
Financial – Return on capital employed (ROCE), sales margin
Customer – Customer loyalty, delivery speed, customers support cost as % of sales
Process efficiency/internal business processes – Total quality measurement, unit costs,
training cost as % of total production cost
Learning and growth – sales of new product as % of total sales

Discuss critical success factors and key performance indicators and their link to objectives
and mission statements and establish critical success factors and key performance indicators
in a specific situation
Critical success factors (CSFs) are the factors which contribute to success of business.
Key performance indicators are indicators which are used to indicate CSFs. If the
organisation fails to perform well on a range of non-financial CSFs, it is unlikely to be
performing satisfactorily in financial terms.
Some examples are as follow:
CSFs KPI
Competitiveness – sales growth by product or service, relative market share position
Customer satisfaction – speed of response to customer needs
Innovation – % of new products and services to old ones
Quality of output – returns from customers, reject rates, reworking costs
Flexibility – product/service introduction flexibility, delivery flexibility

Explain the concepts of economy, efficiency and effectiveness

Value for money (VFM) concept has been developed as a useful means of assessing financial
performance in an organisation which is not seeking profit. VFM concept revolves around 3E:
Economy measures the relationship between money spent and the inputs.
Efficiency is the usual relationship between inputs and outputs.
Effectiveness looks at outputs compare with objectives of the organisation.
Ultimately VFM relates money spent to objectives achieved.

Describe performance indicators for economy, efficiency and effectiveness

Economy – use budgets and variances

25
Efficiency – difficult to measure because output can seldom be measured accurately
Effectiveness – measured by comparison of outputs with targets

Establish performance indicators for economy, efficiency and effectiveness in a specific

situation
For example, hospital:
Economy – money spent for different types of doctors (input)
Efficiency – patients’ satisfaction (output) with the doctors (input)
Effectiveness – Customer satisfaction (target) will be compared with patients’ satisfaction
(output)

Discuss the meaning of each of the efficiency, capacity and activity ratios
These are related to measuring performance using standard hour.
Efficiency ratio is related to speed.
Capacity ratio is related to ability.
Activity ratio is related to volume.
Calculate the efficiency, capacity and activity ratios in a specific situation
Efficiency ratio=standard hour/actual hour x 100%
Capacity ratio=actual hour/budgeted hour x 100%
Activity/volume ratio=standard hour/budgeted hour x 100%
Note that the above is a bit related to variance calculation that I had noted in the tips (chapter
10), now you can see why efficiency variance is standard hour compare with actual hour and
so on.

Describe performance measures which would be suitable in job, batch, contract and process
costing environments
Job costing – cost per printed page, ratio of chargeable time to total time
Batch costing – quantity of material loss, level of inventories held
Contract costing – levels of idle time, material wastage rate, inventory levels
Process costing – levels of abnormal loss, production time

Describe measures of performance utilisation in service and manufacturing environments and

establish measures of resource utilisation in a specific situation
Measures of performance utilisation in manufacturing environments include wastage rate,
rate and efficiency variance of labour and machine hours.
For service industries, 3E is useful and also the service quality.

Calculate return on investment and residual income

Return on investment (ROI)/ROCE=PBIT/capital employed x 100%, capital
employed=equity + non-current liabilities
Residual income (RI) =Profit before tax – notional interest charged on investment

Advantages and limitations of return on investment and residual income

Advantage:
(i)Major measure of efficiency of profit-making organisations
(ii)ROI is a relative measure so can compare centres
Limitation:
(i)RI uses an estimated cost of capital
(ii)Increase as assets get older
(iii)RI is an absolute measure so can’t compare centres

26
(iv)Depreciation rates and inventory valuation policy affect ROI

Distinguish performance measurement issues in service and manufacturing industries,

describe performance measures appropriate for service industries and establish performance
measures for a service business in a specific situation
Most are discussed above, just refer back. Because it is difficult to trace many common costs
to different units of output and because of high level of stepped fixed costs, detailed financial
ratio analysis is of limited use for service industries.

Discuss the importance of quality in organisations and establish measures of quality in a

specific situation
One feature of modern business environment is the switch in emphasis from quantity to
quality. The measures of quality can include staff efficiency, equipment faults, customer’s
complaint and so on.

Chapter 12: Pricing and demand

Describe the factors which may influence an organisation’s pricing policy

The 4Cs as the main factors to consider in pricing:
Cost – primary factor which accountants will consider.
Customers – the higher the price, the smaller the quantity demanded by customers.
Company – when launching new product, company may adopt market skimming approach
(charge high prices when product launched) or market penetration approach (low prices when
product launched) to pricing.
Competition – if a monopoly (one seller who dominates many buyers), it may be able to use
the lack of competition to charge higher prices. If on the other hand, the company is facing
perfect competition (many buyers and sellers, one product), these competitive measures may
mean the company has to charge a lower price.
Other factors include suppliers, inflation, quality, incomes and product life cycle.

Prepare and justify cost based approaches to pricing using absorption costing, marginal
costing and opportunity costing approaches
When using AC based pricing (full cost plus pricing), a share of fixed cost is added to arrive
at a full production cost then a mark-up is added. When using MC based pricing (marginal
cost plus pricing), prices are set using variable costing by determining the target contribution
per unit. Opportunity cost (benefit foregone) based pricing is based on the opportunity costs
of the resources consumed added to full cost and then mark-up. ABC based pricing uses a full
cost based on ABC rather than AC and mark-up. The method to calculate cost is covered in
earlier chapter, you will just need to add a mark-up or margin on the cost and you can get the
price.

Discuss the merits and limitations of cost based approaches to pricing

Merit:
(i)Simple system, using available internal data
(ii)Once cost plus policy is set, it can be delegated
(iii)Price increases can be justified in terms of cost increase
Limitation:
(i)Ignores customer and the market demand influences on prices
(ii)Ignore competitive state of the market

27
Describe the procedure for preparing cost estimates for fixed price quotations and tenders
Under market uncertainty it is sometimes possible to reverse the normal process of offering
goods for sale. The goods may instead be advertised as being for sale and interested buyers
are asked to tender (make an offer and indicate the price they are willing to pay). An open
auction is a market where those wishing to tender are brought together so that they can do so
in open competition with each other. At the other extreme to the open auction, a buyer may
ask for sealed bids in which tenders are invited but kept secret (not disclosed to seller) until a
particular day and time when they are opened and decisions made as to which tender is to be
accepted. The process may be administered by a trusted third party.
Alternatively, the price may be quoted (offered) by the sellers themselves. This will involve
cost analysis for relevant cost then mark-up or margin to get a minimum price. This minimum
price will then be quoted to the buyers.

Chapter 13: Cost management

Explain in general terms the costs of quality (prevention, appraisal, internal failure and
external failure)
Total quality management (TQM) is the process of applying a zero defect philosophy to the
management of all resources and relationships within the firm as a means of developing and
sustaining a culture of continuous improvement which focuses on meeting customers’
expectations. Two basic principles of TQM are getting things right first time and continuous
improvement. Quality management becomes TQM when it is applied to everything a
business does.
Prevention costs – costs of any action taken to investigate, prevent or reduce defects and
failures.
Appraisal costs – costs of monitoring and inspecting products in terms of specified standards
before products are released.
Internal failure costs – costs arising within the organisation of failing to achieve the required
level of quality.
External failure costs – costs arising outside the organisation (after product is delivered to
customer) of failing to achieve the required level of quality.

Establish measures of the cost of quality in specific situations

Measures that might be used to control and improve quality of performance include:
(i)Quality assurance (supplier guarantees quality)
(ii)Inspection of output
(iii)Monitoring customer reaction (involves monitoring complaints in the form of letters,
returned goods, requests for servicing and so on)

Calculation of the costs and benefits of quality initiatives

You might just need to know the theory in TQM, but here I discuss some of the issues about
costs and benefits of controlling quality. If the prevention and appraisal costs are not
sufficiently incurred, there may be failure costs which will cause the company to incurred
replacement cost, new marketing cost and so on. Therefore, arriving a good quality product
will bring benefits to the organisation.

Compare cost control and cost reduction

28
Cost control is concerned with regulating the costs of operating a business and keeping costs
within acceptable limits. Cost control techniques include budgeting, standard costing and
responsibility accounting.
Cost reduction is a planned and positive approach to reducing expenditure.
Cost control aims to reduce costs to budget or standard level, cost reduction aims to reduce
costs to below budget or standard level.

Describe and evaluate cost reduction methods

Reducing material costs – eg. reduce costs of wastage, obtain lower prices for purchases,
improve stores control and use alternative materials.
Standardisation of product – a range of products may be basically standardised but with
minor differences between models.
Other techniques include value analysis, work study and Organisation and methods (O&M).
The real aim of work study and O&M is to decide the most efficient methods of getting work
done. More efficient methods and tighter standards will improve efficiency and productivity,
and so reduce costs.
Describe and evaluate value analysis
Value analysis is a planned, scientific approach to cost reduction, which reviews the material
composition of a product and the product’s design so that improvements can be made which
do not reduce the value of the product to the customer. The aim is to get rid of all
unnecessary costs (costs that do not add value).
Benefit:
(i)Many customers will be impressed by the interest shown in their requirements and this will
lead to increased sales.
(ii)Firms which adopt this approach are likely to attract better staff
(iii)Economic and financial benefits arising from the elimination of unnecessary complexity
and the better use of resources.

Describe life cycle costing

Life cycle costing is the accumulation of costs over a product’s entire life. (4 stages described
in chapter 7)

Discuss the benefits of life cycle costing in a specific situation

The manager is able to have full understanding of individual product profitability, able to get
more accurate feedback information and more opportunities for cost reduction.

Describe target costing

Target costing involves setting a target cost by deducting a desired profit margin from a
competitive market price. (Target price – desired profit margin = target cost)

Discuss the link between target costing and pricing

Target costing is a top down approach where it starts with a target price and derives a cost
from that price. The essential idea behind target costing is that where the price of a product is
determined by the market place, costs have to be reduced (target cost) to enable the product
to be sold at that price. Value analysis and value engineering is used to help business achieve
that target cost.

Discuss the role of value engineering in target costing

Value engineering attempts to design the best possible value at the lowest possible cost into a
new product which can then be used in a target costing system. Various techniques for value

29
engineering can be employed such as using standard components wherever possible, training
staff in more efficient techniques, acquiring more efficient technology, using cheaper staff,
cutting out non-value-added activities and so on.

30