Business Management Department

Management Accounting (MBM701)

Lecturer: Mr S. Mavhiki
mavhikis@staff.msu.ac.zw
 Course Outline
Objectives:

The module covers concepts of managerial

accounting for internal decision-making in a variety
of organisational settings. It aims to develop
students’ professional competencies such as
strategic thinking, risk analysis, decision making,
ethical reasoning and communication.
1. Accounting Information for Decision Making
• Characteristics of financial accounting and
managerial accounting information
• Decision making in organisations
• Relevant costs in decision making
• Classification of costs
2. Cost-Volume Profit (CVP) Analysis
• The cost-volume-profit relation
• CVP analysis and profit planning
• CVP and operating risk
• Decision making in the short term
3. Reporting and assigning costs for income statements:
• Absorption costing
• Variable costing
• Throughput costing

4. Activity-Based Costing (ABC) and Activity Based

Management (ABM)
• Hierarchy of ABC costs and cost drivers
• Assigning costs using ABC systems
• Decision usefulness of ABC systems
• Activity-Based Management (ABM)
5. Budgeting
• Objectives of budgeting
• Preparing a master budget
• Budgets as performance benchmarks
• Budgets, incentives and rewards
• Budget responsibility
• Operating budgets
6. Standard Costs and Variance Analysis
• Establishment of standards
• Types of standards
• Use of standards
• Interpreting and using cost variances
• Non-financial controls
7. Joint Management of Revenues and Costs
7.1 Continuous Cost Improvement
• Value Chain Analysis
o Value added and non-value added activities
o Supply chain analysis
o Just in Time production
o Using the internet to improve inventory supply
• Building desired profit into decisions
o Target costing
o Kaizen costing
o Life cycle costing
7.2 Price Management
• Pricing Methods
o Cost based pricing
o Market based pricing
o Other pricing methods
Peak load pricing
Price skimming
Penetration pricing
Price gouging
Transfer prices
• Government regulations and pricing
o Predatory pricing
o Collusive pricing
o Price discrimination
o Dumping
8. Performance Evaluation and Compensation
• Assigning responsibility for decision
making
o Centralised and decentralised
organisations
o General versus specific knowledge
o Technology and globalisation
• Responsibility Accounting
o Cost centres
o Revenue centres
o Profit centres
o Investment centres
• Income based performance evaluation
o Return on investment
o Residual income
o Economic value added
• Motivating performance with
compensation
o Bonus system incentives
o Long term incentives

• Transfer price policies

o Transfer prices and conflicts among
managers….
o Setting an appropriate transfer price
Cost based
Activity based
Market based
Dual rate
Negotiated
o Additional transfer price considerations
International income taxes
Transfer prices for support services
Setting transfer prices for internal services
Transfer of corporate overhead costs
Assessment:
Coursework 40%
Final Exam 60%
Reading Texts
1. Eldenburg, L.G., & Wolcott, S. K. (2005). Cost management:
Measuring, monitoring and motivating performance. Wiley:
Hoboken, NJ.
2. Balakrishnana, R., Sivaramakrishnan, K. & Sprinkle, G.B.
(2009). Managerial accounting. Wiley and Sons.
3. Bhattacharyya, D. (2010). Management accounting.
Pearson: India.
4. Davis, C.E., & Davis, E. (2011). Managerial accounting. John
Wiley & Sons.
5. Any other textbook on management
 ONE
Accounting Information for Decision Making
Management Accounting
• The process of gathering, summarising and reporting
financial and non-financial information used by managers
to make decisions
• It differs from financial accounting in that it has an internal
orientation while FA has an external orientation
• FA is the process of preparing and reporting financial
information used most frequently by decision makers
outside the organisation, e.g. shareholders and creditors
• It also differs from cost accounting in that CA is a method
for determining the cost of a product, project, process or
thing
2. Objectives of Management Accounting
The main objective is to assist managers in
carrying out their duties efficiently in order to
maximise profit or reduce losses.
Its main objectives are
• To formulate plans and policy such as
forecasting, setting goals, framing polices and
plans of action
• To assist in decision making: cost, price and
profit is collected and analysed to provide a
basis for decision making. It aims to satisfy the
information needs of decision makers inside the
firm, e.g.,
What products or services to offer?
What prices of services or products to
charge?
What equipment to purchase etc.?
• To help in control eg product costs are
controlled through standard costing and
department costs through budgetary control
• To provide reports to management so that
they are informed about the latest position of
the organisation. Managers are then able to
make quick and proper decisions
• Facilitates coordination of operations for
example through the use of budgets
 3. Comparison of Financial Accounting and
Management Accounting
Financial Accounting Management Accounting
Users are persons external to the Users are internal to the organisation e.g.
organisation e.g. investors managers

Emphasises information reliability, Relevance of information is valued most

sometimes at the expense of relevance

Governed by GAAP Data is collected, reported and analysed as

needed, reports do not follow GAAP.
Focus on past financial data Collects, reports and uses all available data,
including estimates on future performance

Is mandatory i.e. a statutory requirement Not mandatory

4. Decision Making
A decision is simply choosing one option from a set
of options to achieve a goal. Decision making
generally consists of the following steps:

Specify the decision problem, including the

decision makers’ goals.
• Decisions help managers to accomplish goals
• Its important to understand factors that
influence the decision makers’ goals and their
relative importance in making effective decisions
 Identify options
• Business decisions frequently have numerous
options and managers frequently distinguish themselves
by their ability to identify the most promising options

Measure benefits and costs to determine the

value of each option:
• Every option presents a unique trade-off between
benefits and costs
• Choose an option that will maximise value (profit)
e.g. a price cut means more sales but less money and
advertising means more sales but costs money!
• The value of an option equals its benefits less costs
(Revenue less expenditure)
• Whenever managers make decisions, there is
opportunity cost ie the next best alternative forgone
• Effective decision makers ensure that the value of the
chosen decision option exceeds its opportunity cost
• Every decision involves trading off what we get with
what we give up.

Make the decision

• The best choice is the option with the highest value to
the decision maker
 Decision Making in Organisations
• Profit is the dominant goal of commercial
organisations
• These organisations primarily evaluate decisions by
their impact on the bottom-line
• However, organisations do not make decisions, but
the people who comprise the organisation do
• Individual goals might differ from organisational
goals leading to actions which are not in the firms’ best
interests
• A lack of alignment in goals is usually the case
when organisational goals are unclear. What can firms do
to align individual and organisational goals?
 5. Relevant Costs in Decision Making
• Cost is the amount of resource given up in
exchange of some good or services. It is the
amount of expenditure incurred on or
attributable to a specified thing or activity
• Managers should focus on the controllable
costs and benefits (revenue) that differ across
decision alternatives i.e. they should ignore
items that are common (among the options) and
irrelevant
• The relevant cash flows are incremental cash flows
which occur under one course of action, but not under
another.
• Also called avoidable cash flows (are avoided if a
decision is not taken)
• Irrelevant cash flows (unavoidable) occur regardless of
the course of action taken e.g. whether a company leases or
builds office space, it will still incur electricity costs (irrelevant)
• To identify relevant cash flows, an incremental
approach is used e.g. in the lease or build decision, identify
any additional cash inflows and outflows that would occur if
new facilities were built and compare them to the inflows and
outflows for the lease option.
6.Classification of Costs
There are different bases of classifying costs

1. Classification on the bases of time

a) Historical costs:
• costs ascertained after they are incurred
eg after production of a good.
• Are objective and can be verified
b) Predetermined Costs:
• are calculated before they are incurred based on all
factors affecting the cost. The costs may be
i. Estimated cost, before goods are produced
ii. Standard costs and these involve
• Setting up standard costs for each cost element
and product
• Comparison of standard with actual to find
variations
• Identifying causes for the variations and take
corrective action
2. By nature or Elements
a) Material.
• This is the substance from which the product is
known. It can be direct or indirect.
Direct materials:
• are materials which are a major part of the finished
product, and can be easily traced to the units eg all
materials specifically purchased for a particular job or
process.
Indirect costs:
• materials used for purposes ancillary to production
and can be conveniently be allocated to units produced
eg oil, printing and stationary.
b) Labour cost can be direct or indirect
Direct labour cost:
• wages paid to workers who are engaged in
the production process whose time can be
conveniently and economically traceable to units of
products
Indirect labour cost:
• labour employed for purposes osf carrying
out tasks incidental to goods or services provided,
and can not be traced to units of products.
c) Expenses can be direct or indirect
Direct expenses:
• are incurred on a specific cost unit and
identifiable with the cost unit
Indirect
• can not be directly, conveniently and
wholly allocated to cost units eg rent
3. By degree of traceability to products
Costs can be direct or indirect
Direct costs:
• easily traceable to cost unit or activity eg cost
of flour for baking.
• Called traceable costs
Indirect costs:
• are common to several products and are
difficult to trace.
• Called common costs.
 4. Association with the product
Costs can be product or period costs
Product cost:
• are traceable to products and are used in
valuing inventory eg direct materials, direct
labour and manufacturing overheads
Period cost:
• are incurred on the basis of time eg rent,
salaries selling and admin, to keep the business
running.
• They are charged to the period in which
they are incurred. Why are selling and admin
costs treated as period costs?
NB: The net income of a business is affected by
both product and period costs. Product costs are
included in the cost of the product and do not
affect income till the product is sold. Period
costs are charged to the period in which they
are incurred.
5. By changes in Activity, or Volume
Costs can be classified as fixed, variable or semi variable

Fixed costs:
• costs which do not change with changes in volume
or level of activity within the relevant range eg rent. They
arise due to contractual obligations and management
decisions. Arise with the passage of time and not
production. FC can be classified as
a) Committed costs:
• costs incurred to maintain certain facilities and
cannot be quickly eliminated eg rent, insurance.
Management has little or no discretion in this cost.
b) discretionary costs:
• costs which can be controlled by management and not
related to the operations.
• can be eliminated or reduced to desirable levels at the
discretion of management.
• Reflect periodic decisions about the maximum amount
that will be spent on costs for activities such as advertising,
executive travel, R&D etc.
• Expenditures are often based on past profitability and
can be altered during the period, depending on cash flows
• The past behaviour of discretionary costs might not be
relevant to their future behaviour
c) Policy and Managed costs:
• policy costs are incurred to implement certain
management policies eg housing. Costs are
discretionary.
• Managed costs are incurred to ensure
operating existence of a company eg staff services.
d) Step costs:
• are constant for a given level of output, and
then increase by a fixed amount at a higher level of
output.
Variable costs:
• change directly and directly with the level of
output. The variable cost per unit remains constant but
the total cost changes with output level.

Semi-variable (semi fixed) cost:

• contain fixed and variable elements. They fluctuate
with volume (VC element), but do not change in direct
proportion to output.
• Change in the same direction as output but not in
the same proportion.
6. Functional classification of costs
Companies perform a number of functions, and
the costs can be classified as:
a) manufacturing/production
b) selling and distribution
c) administration
d) research and development etc
 7. Costs for Analytical and Decision
Making Purposes
a) Opportunity cost:
• the cost of the next best alternative
forgone.
b) Sunk cost:
• a cost that has already been incurred and
cannot be avoided by decisions taken in the
future. Not useful for decision making as past
costs are irrelevant.
c) Differential cost:
• is the difference in total cost between alternatives,
calculated to assist in decision making eg adding or
dropping a product.
• Useful in planning and decision making eg
additional profit to be generated from an additional
investment.
d) Common costs:
• are incurred for more than one product or cost
object, and are generally apportioned. Management
decisions influence the incurrence of common costs
 REVISION QUESTIONS
1. “Management accounting is concerned
with accounting information which is useful to
management”. Comment.
2. Explain briefly the role of a management
accountant.
3. What are the limitations of management
accounting? How can these limitations be
eliminated?
4. What are:
a) Imputed costs
b) Marginal costs
c) Uniform costs
d) Replacement costs
5. Explain the significance of decision-making
costs. Briefly explain the various type of costs
used by the management in decision-making.
 TWO
Cost-Volume Profit (CVP) Analysis
1. Introduction
• A technique that examines changes in profits
in response to changes in sales volume and costs
• Used to plan future levels of operating activity
and provide information about:
a) What products or services to emphasise?
b) The volume of sales needed to achieve a targeted
profit whether to increase fixed costs.
c) Amount of revenues required to avoid losses etc.
2. Profit Equation
• The CVP begins with the basic profit equation
• Profit= Total Revenue (TR) - Total Costs(TC)
=TR- (FC + VC)
= Px- (a+bx) where P= selling price per unit
x=number of units
a=fixed cost
b=variable cost per unit
3. Contribution Margin
• Shows how much revenue from units sold
can be applied toward fixed costs. Once enough
units have been sold to cover fixed cost, then
the contribution margin becomes profit.
• Is the Total revenue less Total variable cost
• Contribution margin per unit = selling price
per unit – variable cost per unit
4. CVP and Profit Planning
• CVP analysis is used by managers to estimate profit
at different sales volumes
• Companies must generate enough business to
avoid making a loss, and make profit.
• There are four ways in which profit performance of
a business can be improved:
(a) by increasing volume;
(b) by increasing selling price;
(c) by decreasing variable costs; and
(d) by decreasing fixed costs.
 Break Even Sales Volume:
• is the sales volume at which profit is equal to
zero i.e. TR-TC=0
• a firm is profitable if the quantity sold
exceeds the break-even volume, and makes a loss if
sales go below the break-even volume
• to make a profit a firm must:
have a positive unit contribution margin and
sell enough units so that the contribution
covers at least the FC
•the break-even point units = Fixed Cost

Contribution margin per unit

• Break even revenues are the sales dollars needed

to break even. Obtained as follows:
Break-even point units x selling price per unit
OR
Fixed Cost
Contribution Margin ratio
• Organisations report TR and cost data and do not
often report the unit level data, and this makes it difficult
to compute the unit contribution margin or price.
 The Contribution Margin Ratio
• Also called the contribution sales ratio
• It is the percent by which the revenue (selling price/unit)
exceeds the total variable costs (or variable cost per unit)
• Alternatively, it is the contribution margin as a percent of
revenue.

Unit level = Contribution per unit

Selling price per unit

Total revenue and cost data= Total contribution margin OR TR-VC

Total revenues TR
 Target Profit
• Companies frequently specify profit goals (annual,
quarterly, or monthly) for their product managers
• These goals guide managers’ actions during the period
• The sales volume to achieve a targeted profit is
obtained as follows:

Sales (Units) = FC + Targeted Profit

Contribution margin per unit

Sales (Revenue) = FC + Targeted Profit

Contribution margin ratio
Targeted Profit after Tax

Sales (Units) = FC + Targeted Profit

(1-Tax Rate)
Contribution margin per unit

Sales (Revenue) = FC + Targeted Profit

(1-Tax Rate)
Contribution margin ratio
5. CVP Analysis and Operating Risk
Margin of Safety (MOS)
• Is the excess of an organisation’s expected
future sales (in either revenues or units) above the
break-even point
• Indicates the amount by which sales could
drop before profits reach the break-even point
• MOS = actual/estimated sales- BEP units OR
= actual/estimated revenue- revenue at BEP
• To evaluate future risk when planning, use
estimated sales
• To evaluate actual risk when monitoring
operations, use actual sales
• If the MOS is small, managers may put
emphasis on reducing costs and increasing sales to
avoid losses i.e. ↓FC→↓BEP=↑MOS
• The higher the MOS the lower the risk of a
loss should actual sales fall short of expectations.
Margin of Safety Percentage or Ratio
• This is the MOS divided by the actual or
estimated sales, either in units or revenue
•MOS Ratio = MOS Units (Revenue)
Actual/estimated units (revenue)
 Operating Leverage
• Is a measure of how sensitive income is to percentage
changes in sales
• Relates to the level of fixed versus variable costs in a
firm’s cost structure
• Firms with a relatively high proportion of FC relative to
VC in their cost structure are said to be highly leveraged and
vice versa
• Companies with high operating leverage incur more
risk of loss when sales decline. This is because FC maybe
difficult to reduce quickly if activity levels fail to meet
expectations. On the other hand, when operating leverage is
high, an increase in sales (once FC are covered) contributes
quickly to profit
• Operating leverage acts as a multiplier on net
income in the same direction as sales changes

Degree of Operating Leverage = Contribution Margin

Net Income
OR
= Fixed Cost + 1
Net Income
• Managers use operating leverage to gauge the risk
associated with their cost structure and to calculate the
sensitivity of profit to changes in sales (units or revenue)
Example
Example 1
A company has the following information relating to
sales and costs
VC/ unit $16.40
FC $119 009
Selling price/unit $60
Sales (units) 3 800
Required:
The degree of operating leverage using
a) Use the Contribution Margin approach
b) FC formula
c) comment
Example 2
A company manufactures and sells a product for $40
each. The estimated income statement for 2017 is as
follows:
Sales: $2 000 000
Variable cost: 1 100 000
Contribution margin: 900 000
Fixed cost: 765 000
Profit before tax 135 000
a) Compute the contribution margin per unit?
b) How many units must be sold to break even?
c) Suppose the margin of safety was 5 000 in 2016.
Are operations more or less risky in 2017 as
compared to 2016? Explain.
d) Compute the contribution margin ratio. Calculate
the breakeven point using the contribution margin
ratio.
e) What is the margin of safety in revenue?
f) Suppose next year’s revenue estimate is $200 000
higher, what would be the profit before tax?
g) Assume a tax rate of 30%, how many units must
be sold to earn a profit after tax of $180 000?
h) Calculate additional sales volume to meet $90 000
additional fixed cost.
i) Calculate the degree of operating leverage and
comment.
 6. Decision Making in the Short Term

Characteristics of Short Term Decisions

Fixed Supply of Capacity

• Capacity is the maximum volume of activity a company
can sustain with available resources
• The decision of how much capacity to put in place is a
long term decision. Once P.P.E is installed, it is not easy to
change the capacity levels
• In the short-term, business must do the best with the
capacity that they have when dealing with fluctuations in
demand
 Demand Changes Frequently
• Sometimes demand exceeds supply (excess demand),
while at the other times available supply exceeds demand
(there is excess capacity)

Short-term decisions to deal with excess supply:

• Processing special orders
• Using extra capacity to make some production inputs
in-house ( making vs purchasing them from an outsider)
• Running special promotions
• Reducing prices to meet demand
Short-term decisions to deal with excess
demand:
• Altering production mix to focus on the
most profitable ones.
• Meeting additional demand by
outsourcing production
• Increasing prices to take advantage of
favourable demand conditions
7. Constrained Resources

• Constraints are bottlenecks in the

production process which affect the profitability
of the company
• the Theory of Constraints (TOC) by
Goldratt (1984) is an approach to production
and constraint management
The Five-Step Process of TOC
Step 1: Identify the binding constraint
• first identify the bottleneck or binding
constraint that affect production
• most companies have binding constraints
unless capacity in all departments exceeds demand
for the company’s products
• the department that is the bottleneck is
equated to a “drum” since it “beats a rhythm” that
coordinates the production in other departments
Step 2: Optimise use of the constraint
this requires the company to use the constraint to
produce products with the highest margin per unit of the
constraint
Step 3: Subordinate everything else to the constraint
it means managers should focus their attention on
trying to loosen the constraint and not concentrate on
process improvements in other departments. Why, for
example, should managers work to improve processes A,
B, or C if they are not limiting production?
Step 4: Break the constraint
• The general rule is that managers would be willing
to incur a cost to relax the constraint if cost is less than or
equal to the sum of CM per unit of constrained resource
and the current per unit cost of the resource.
• This can be accomplished in many ways
Purchase goods or services from an outside
supplier
Use the constrained resource more efficiently eg
process reengineering ( redesigning manufacturing or
service delivery process)
 Increasing available resources eg asking workers
to work overtime, hiring new employees or
temporary labour etc
Add internal capacity or redesign products and
processes to use existing capacity more efficiently
purchase additional equipment
hire additional workers
train workers etc
 managers must be willing to give up some or entire
contribution margin per unit of constrained resource. As
the VC/unit approaches the selling price, managers
become indifferent to purchasing more of the constrained
resource for continued production. This rule is valid under
the following assumptions;
o Organization will forego sales if the resource constraint is
not relaxed
o Fixed costs are not affected by short-term decisions to
relax constraints
o Managers want to maximize profit in the short-term
o Sales of one product do not affect sales of other products
 Step 5: Identify a new binding
constraint
• once the constraint is broken identify a new binding
constaint in other departments
• if the company has excess capacity, it should focus its
attention on building demand

1. Product Emphasis
• When demand is high and a resource is in scarce
supply, a company can:
a) Emphasise a product with highest CM per unit and
b) If resources are constrained, emphasise production
with highest contribution margin per unit of scarce resource
Example:
A company manufactures and sells toy
aeroplanes. It manufactures three different
kinds of planes: Fighterjet, Jumbojet and
Superjet. The demand for toys is highest during
the months of October and November. The
company’s operating data is as follows:
 Jumbojet Fighterjet Superjet
Demand for Nov (units) 100 000 200 000 60 000
Unit Price $60 $40 $80
Variable cost per unit $35 $25 $40
Contribution margin/unit $25 $15 $40
Production rate (units/hour) 25 50 15

Available production hours in November 9 000

Total monthly fixed cost $4 000 000
Required:
Advise the company.
 Qualitative factors to consider
Whether product emphasis agree to strategic
plans?
Are sales of one product likely to affect sales of
other products?

However, there are major uncertainties in the decision

How accurate are the contribution margin
estimates?
How reliable are the product demand forecasts.
8. Product Line and Business Segment
(Keep or Drop)
• Companies with multiple products must
periodically review their operating results for each
product, group of products (product line) or
business segment and decide whether to keep or
drop the product, product line, or segment

Rule: Discontinue a product, product line or

segment if its total contribution does not cover
avoidable fixed cost (fixed costs that are eliminated
if a product is dropped)
Example:
Dolly makes 3 sweets: the mixtures, the sweeteners
and the gobsuckers:
Mixtures (100 000 @ 50c) $50 000
Sweeteners ( 200 000 @ 20c) $40 000
Gobsuckers (400 000 @ 10c) $40 000
130 000
Costs:
Direct materials $50 000
Direct labour 40 000
Variable overheads 20 000
Fixed overheads 10 000
Total Costs 120 000

Net Profit 10 000

The variable costs are split between the products: 50% to
mixtures, 25% to sweeteners and 25% to gobsuckers. Are all
these products profitable? If not what is the effect on profit of
dropping the unprofitable one?
 Qualitative Factors to Consider
Will dropping one product affect sales of other
products?
Will layoffs affect workers’ morale?
Are the conditions which make the product
unprofitable temporary or permanent?

Uncertainties
How accurate are revenue and costs estimates
How will customers respond to the dropped
product?
 9. Insource or Outsourcing (Make or
Buy)
General rule:
• Choose the option with the lowest relevant
cost
• Costs for insourcing also include opportunity
costs (sometimes the extra space or capacity from
outsourcing can be converted to other uses.)
Example:
A company must decide whether to make or buy some
of its components from an outside supplier. The cost of
producing 50 000 components is $110 000 broken down
as follows:
 Direct materials 60 000
Direct labour 30 000
Variable manufacturing overheads 12 000
Fixed manufacturing overheads 8 000

Instead of making the components at an average cost of

$2.20, the company has an opportunity to buy the
components at $2.15 per unit. If the components are
purchased all variable costs and half of the fixed cost will be
eliminated. Should the company make or buy the
components? Will your answer be different if the released
productive capacity will generate additional income of
$25 000?
  Qualitative Factors to consider

• Product / Service Quality: To ensure high quality

negotiate outsource contracts that stipulate
specific performance criteria eg product specifications
and timeliness
Use multiple outsource suppliers to avoid
overreliance on any one supplier. However, sometimes
organisations outsource because
a) They find it difficult to ensure high quality
internally
b) Rapid growth may prevent an organization from
developing sufficient expertise in-house
• Managers do not consider an activity to be a core
competency, and will not expend resources to improve quality
• Will delivery be timely?
• Are there uncertainties about the suppliers’ ability to
meet contractual obligations?
• Is this activity a core competency?
• Is the external price sustainable over time?
• Do you want to be dependent on an external provider?
• Are you able to take action against the external
provider if there is a deficient service?
• Consequences of awarding a contract externally for
morale, a staff turnover.
10. Special Orders

• Orders which are not part of the

organisations’ normal operations
• One time sale of a specified quantity
of goods or services and often at a
reduced price

Rule: The company must be better off after

accepting the order than before it accepted it.
Example:
A company manufactures high quality basketball
@ its plant, which has a production capacity of
50 000 basketballs per month. Current
production is 35 000 per month. The
manufacturing costs of $24 per basketball are
categorized as follows:
 FC/unit @
VC/unit 35000/unit TC/unit

Mf Costs
DM 12 00 12
DL 2 00 2
Mf O/H 0.5 9.50 10
TC to Mf 14.50 9.50 24
Sales com 1.00 00 1
A not-for-profit organization wants to buy basketball for
disadvantaged youth. It asks the company to sell it 5000
balls @23 per ball or $115000 for the entire order. All FC
are related to a capacity level of 50 000 units and will not
change if part of idle capacity of 15 000 is used. However,
once production exceeds 40 000 balls, bottlenecks occur
and production process will slow down and cause
inventory levels to congest the plant, sometimes causing
overtime to be paid.
Required
a) Should the company accept the order?
b) Qualitative factors to consider in making the decision.
 Qualitative Factors
How other customers are likely to react
Will the order lead to improved brand
name recognition?
Can we deliver without disrupting current
schedules?
REVISION QUESTIONS
1. What is contribution? How it is related to profits?
2. Explain the role of contribution technique in
decision making, giving suitable illustrations.
3. “Fixed costs do not change with changes in volume
and it is difficult for management to control them”.
Discuss.
4. “While variable costs are fixed per unit of output,
the fixed costs are variable per unit of output although all
costs tend to be variable in the long run”. Explain.
5. What do you understand by Profit Volume
(P/V) ratio? Discuss the importance of P/V ratio and
state how P/V ratio can be improved?
6. “The effect of a price reduction is always to
reduce the P/V ratio to raise break-even point and
to shorten the margin of safety”. Explain and
illustrate by numerical examples.
7. (a) What do you understand by break-even
point?
(b) Explain the concept of break-even analysis.
8 (a) Distinguish between P/V ratio and break-even
point?
(b) Explain the uses of profit volume analysis.
(c) What are the limitations of break-even
analysis?
9. Explain how an understanding of the distinction
between fixed cost and variable cost can be useful
to managers.
10. Discuss several methods that can be used to
relax constrained resources
11. Clover Nursery is a large nursery that has always
raised the bedding plants it sells. The managers
recently decided to buy bedding plants from a
wholesale nursery in another town.
i. List the quantitative factors that might
encourage the managers to buy from another
grower
ii. List qualitative factors that might encourage
the managers to grow their own plants.
12. A business provides three different services, the details of which
are as follows:
Service (code name) A1 A2 A3.
Selling price per unit ($) 50 40 65
Variable cost per unit ($) 25 20 35
Labour time per unit (hours) 5 3 6

The market will take as many units of each service as can be provided,
but the ability to provide the service is limited by the availability of
labour, all of which needs to be skilled. Fixed cost is not affected by the
choice of service provided because all three services use the same
facilities. What is the most profitable schedule?
 13. BL Ltd can render three different types of service (Alpha,
Beta and Gamma) using the same staff. Various estimates for
next year have been made as follows:
Service Alpha Beta Gamma
Selling price ($/unit) 30 39 20
Variable material cost ($/unit) 15 18 10
Other variable costs ($/unit) 6 10 5
Share of fixed cost ($/unit) 8 12 4
Staff time required (hours) 2 3 1
Fixed cost for next year is expected to total $40,000.
(a) If the business were to render only service Alpha next year,
how many units of the service would it need to provide in
order to break even? (Assume for this part of the question
that there is no effective limit to market size and staffing
level.)
(b) If the business has a maximum of 10,000 staff hours next
year, in which order of preference would the three services
come?
(c) If the maximum market for next year for the three services
is Alpha 3,000 units Beta 2,000 units Gamma 5,000 units what
quantities of which service should the business provide
 next year and how much profit would this be expected to yield?
14.A company produces a single product. It sold 25 000 units last
year with the following results:
Sales $625 000
Variable costs 375 000
Fixed costs 150 000
Income before taxes 100 000
Income tax (45%) 45 000
After tax profit 55 000
In an attempt to improve its product, the company’s
managers are considering replacing a component
part that costs $2.50 with a new and better part
costing $4.50 per unit during the coming year. A
new machine would also be needed to increase
plant capacity. The machine would cost $18 000.
a) What was the company’s break-even point in
units last year?
b) How many units of product will the company
have to sell in the past year to earn $77 000 in after
tax profit?
c) If the company holds the sales price constant and
makes the suggested changes, how many units of product
must be sold in the coming year to break even?
d) If the company holds the sales price constant and
makes suggested changes, how many units of product will
the company have to sell to make the same after tax
profit as last year?
e) If the company wishes to make the same
contribution margin ratio, what selling price per unit of
product must it charge next year to cover the increased
materials cost?
15.The following income statements are available for
ABC Company and XYZ Company.
ABC Company XYZ Company
Sales $500 000 $500 000
Variable costs $280 000 $180 000
Contribution margin $220 000 $320 000
Fixed Costs $180 000 $280 000
Net income $ 40 000 $ 40 000
a) Compute the break-even point and the margin of
safety ratio for each company.
b) Compute the degree of operating leverage for
each company and interpret your results.
c) Determine the effect on each company’s net
income if sales increase by 20% and if sales
decrease by 10%. Do not prepare income
statements.
d) Discuss how the cost structure of these two
companies affects their operating leverage and
profitability.
16. a“Break-even analysis is of limited use to
management because a company cannot survive by just
breaking even.” Do you agree? Explain.
b) How might managers use the margin of safety concept
in decision making?

17.ABC Plumbing Products produces a variety of valves,

connectors and fixtures used in commercial and
residential plumbing applications. Recently, a senior
manager walked into the cost accounting department and
asked Nancy to tell her the cost of D50 valve. Nancy
replied, “Why do you want to know?” Noticing that the
manager appeared startled by this question, she
explained, “The cost information you need depends on
how you will use it. You might be thinking of increasing a
scheduled production run of 3 000 D50s by 100 units or
scheduling an additional production run, or you might
even be thinking of dropping the product. For each of
these decisions, the cost information that you need is
different.”
Expand on Nancy’s response of “Why do you want to
know?” What cost information would be relevant to a
decision to drop the product that would not be relevant
to a decision to increase a production run by 100 units
18.A large electrical contracting firm provides services
to building construction projects. The company has 2
000 employees. Recently, the company experienced
large losses due to a downturn in the economy and a
slowdown in construction. Management thinks the
losses were particularly large because the company has
too much fixed cost.
a) Expand on the management’s thought. How are the
large losses related to fixed costs?
 THREE
MEASURING AND ASSIGNING COSTSFOR INCOME
STATEMENTS

1. Introduction
• There is no single measure of inventory and
cost of goods sold that is best for all situations
• For example, short term decision making
requires only incremental costs (VC) while
managers use both FC and VC to monitor
operations.
2. Absorption Costing
• Both fixed and variable production costs are
treated as product costs when valuing inventory and cost
of goods sold
• The direct costs (VC) are traced to products and
manufacturing overheads are allocated to products using
a budgeted allocation rate. The overhead allocation rate
is determined as follows:

OAR = Budgeted overheads

Budgeted units of the absorption rate
(eg labour hours, units produced etc)
• All production costs are expensed as cost of
goods sold to match them against revenues when units
are sold
• Non production costs such as administration,
marketing and distribution costs are treated as period
costs.

The Absorption Cost of Production

 $
Opening inventory xx
Product Costs:
Direct material xx
Direct labour xx
Variable overhead xx
Fixed overhead xx
Goods available for sale xx
Closing inventory (xx)
Cost of goods sold xx
 Absorption Cost Income Statement $
Revenue xxx
Cost of goods sold (xx)
Gross profit xx
Non production costs (selling, admin (xx)
& other)
Operating income xx
3. Variable Costing
• Also called marginal or direct costing
• Only variable production costs such as direct
materials, direct labour and variable production
overheads are the product costs
• FC are treated as period costs which is written off
against income for the period in which they are incurred
• All the VC (production and non-production) are
subtracted from revenues to arrive at the contribution
margin and then all FC (production and non-production)
are subtracted to determine operating income.
 Variable Cost of Production $
Opening inventory xxx
Product Costs:
Direct materials xx
Direct labour xx
Variable manufacturing O/H xx
Goods available for sale xx
Closing inventory (xx)
Cost of goods sold xxx
 Variable Costing Income Statement
Revenue xxx
Production cost (VC) (xx)
Non production cost (VC) (xx)
Contribution margin xxx
Fixed Costs:
Fixed production cost (xx)
Fixed non-production cost (xx)
Operating Income xx
Example
A company produces and sells a single product. The selling price is $100 000 and the
company incurred the following costs:
Variable Cost per unit:
Direct materials $20 000
Direct labour 15 000
Variable production overheads 5 000
Variable selling overheads 10 000
Fixed Costs per month:
Fixed production overheads 60 000
Fixed admin overheads 10 000
Production and Sales quantities:
April May June
Production 1 2 2
Sales 1 1 3
Fixed production overheads are allocated on the basis of number of units produced.
Required:
a) The total cost of goods sold and income
statements using:
i. Absorption costing
ii. Variable costing
b) A reconciliation of absorption and variable
costing incomes.
Conclusion
• When production is equal to sales, then the same
amount of fixed manufacturing overhead is expensed under
both methods, and they will show the same profit levels.
• When production is in excess of sales, there will be
closing stock. Higher profit will be reported by absorption
costing because less overheads are charged to the income
statement. A portion of fixed manufacturing cost ($30 000)
will remain tied up in closing stock.
• When sales are greater than production, variable
costing will show a higher profit since less fixed manufacturing
overhead will be charged under variable costing.
4. Arguments in Support of Variable Costing
• Makes it easier to control the different
elements that make up cost since VC can be
controlled per unit and FC can be controlled in total.
• The allocation of FC and the dangers attached
to over costing and under costing of FC to certain
products can be eliminated.
• Provides more useful information for short
term decision making, as FC are irrelevant for most
decisions.
• Useful for measuring managerial
performance. If absorption costing income
statements are used, managers may deliberately
alter their stock levels to alter their profits.
• Avoids overheads being capitalised in
unsellable stocks. For example in periods when
demand is falling, a company may end up with
surplus stocks on hand, and if these stocks cannot
be sold, the profit calculation for the accounting
period will be misleading since FC will have been
deferred to the next accounting period.
5. Arguments in Support of Absorption Costing
• The method does not fail to recognise the
importance of FC. Variable costing ignores FC which
must be met in the long run eg pricing.
• Prevents reporting fictitious losses, eg
seasonal businesses where stocks are built up
outside the sales season to be sold in the following
season, FC are deferred and no losses will be
reported.
• Required by GAAP and is used for external
reporting.
6. Throughput Costing

• Is a modified form of variable costing that treats direct

labour and variable overheads as period costs
• Only direct materials are regarded as truly variable, and
all other costs are treated as fixed within the relevant range eg
direct labour costs are fixed per week, fortnight or per month.
• Throughput contribution is defined as Revenue less direct
material costs for units sold.
• Useful for short term capacity decision making. It
focusses managers attention on reducing labour and overhead
cost because they are considered operating costs instead of
product costs.
• It also reduces the incentives for managers to build up
inventory to inappropriate levels as profit is more a function of
sales than production.
 Throughput Cost of Production
Opening inventory $xx
Product costs:
Direct materials xx
Goods available for sale xx
Closing inventory (xx)
Cost of goods sold xx
 Throughput Costing Income Statement:
Revenue $xxx
Production cost (direct materials) (xx)
Throughput contribution xx
Production costs (labour, fixed and var. o/h) (xx)
Non production (fixed, variable, selling &admin) (xx)
Operating income xxx
REVISION QUESTIONS

1 The volume of production in a period has an

effect on income calculated using absorption
costing but has no effect on income calculated
using variable costing. Explain.
2.What is the difference between a cost that is
variable and variable costing?
3.What is variable costing? What are its advantages
and disadvantages?
4. What is absorption costing? What are its
advantages and disadvantages?
5. In a normal year, Wilson Industries has $20 000 of fixed
manufacturing costs and produces 50 000 units. In the
current year, demand for its product has decreased and it
appears the company will only be able to sell 40 000 units.
Senior managers are concerned, in part because their
bonuses are tied to reported profit. In light of this, they are
considering keeping production at 50 000 units. Explain why
increasing production beyond the needed quantity for the
current sales (40 000 units) will increase profit and calculate
the impact of increasing 10 000 “extra” units (from 40 000
to 50 000). Is the managers’ proposed action in the best
interest of shareholders?
• Impact is the profits will go up by $4000, because
of the $4000 fixed manufacturing overhead is
tied up in the closing stock.
• These are window-dressed accounts.
• There is an agency problem.
• There is a problem when it comes to the actual
payment of the dividend because there is no
actual cash.
 FOUR
ACTIVITY BASED COSTING (ABC) AND ACTIVITY
BASED MANAGEMENT (ABM)
1. Activity based costing (ABC)
• It’s a system that assigns overhead cost to specific activities
performed in a manufacturing or service delivery process
• An activity is a type of task or function performed in an
organisation
• ABC attempts to trace costs more accurately to cost objects
than traditional systems
• Under the traditional cost system, manufacturing production
overheads are assigned to individual products in inventory and cost of
Goods sold, and non-manufacturing overheads are recognised as
period costs which are merely charged to the income statement eg
inspection, setup costs, purchasing etc.
• ABC recognises that these activities are necessary for
the final product to be produced, thus they are cost drivers
which need to be considered when costing inventory.

2. Features of ABC
• It is a two stage process in which costs are first
assigned to activities and then to products based on each
product’s consumption of activities.
• The cost pools in the 2-stage process accumulate
activity related costs.
• Based on the principle that products consume
activities and the activities consume costs.
3. Objectives of ABC
• Improves product costing
• Identify non-value adding activities
• Provides information for decision making
• Reduces non-essential use of common resources
• Used to evaluate the efficiency of internally
provided services
• Gives full cost of products for financial reporting
and determining cost based prices
3. Types of Activities

Unit level activities

• Activities to produce individual units of goods or services
• The activities are performed for every unit of good or service
• The cost is proportional to production/sales eg material
handling wages.
Batch level activities
• Activities performed for each batch of product and is not
related to the number of units in the batch
• Examples: direct labour cost for new setup at the beginning of
a batch, and carriage costs for batches
 Product sustaining activities
• Activities performed to support the production and
distribution of a single product or line of products
• Activities are not related to units or batches, but to individual
products or product lines e.g. product advertising, depreciation of
equipment used to manufacture one type of product.
Customer sustaining
• Activities undertaken to service past, current and future
customers
• Costs vary with the needs of individual customers or group of
customers
• For example customer sales reps salaries and customer market
research costs.
 Facility sustaining
• Activities related to overall operations of a
facility and are not affected by the number of
customers served or by quantities of products,
batches, or units.
• An example is manufacturing plant managers’
salary.
• The costs are typically not allocated except
when the organisation needs to allocate all product
costs for a particular purpose.
 Organisation sustaining
• Activities are related to overall
organisation and are not affected by number
and types of facilities and customers or by
volumes of products, batches or units
• Costs are not allocated because they do
not vary with activity volume
• Examples are admin salaries and
information system salaries.
4. Assigning costs using an ABC system
• Identify the relevant cost object
• Identify activities
• Assign costs to activity based cost pools
• For each ABC cost pool, choose a cost driver
• For each ABC cost pool, calculate an allocation
rate
• For each ABC cost pool, allocate activity costs to
the cost object.
Example
Having attended a seminar on ABC, you decide to experiment by
applying the principles of ABC to the four products currently made and
sold by your company. Details of the four products are:
A B C D
Output (units) 120 100 80 120
Cost per unit ($):
Direct materials 40 50 30 60
Direct labour 28 21 14 21
Machine hours per unit 4 3 2 3
The four products are similar and are usually
produced in production runs of 20 units and sold in
batches of 10. Production overhead is currently
absorbed on a machine hour rate and production
overhead data for the period is listed below:
Machine department $10 430
Set up 5 250
Stores receiving 3 600
Inspection 2 100
Material handling 4 620
Cost drivers are ascertained as follows:
Cost Pool Cost driver
Set up Number of production runs
Inspection Number of production runs
Stores receiving Number of requisitions
Material handling Number of orders executed

The requisitions raised were 20 per each product and the

number of orders executed was 42, each order being a
batch of 10 of each product.
Required:
a) Calculate the total cost per each product if all
overheads are absorbed on a machine hour
basis.
b) Calculate the total cost per product using
ABC.
c) Calculate the unit cost for each product using
the traditional approach and ABC and make
comments for management.
 5. Activity Based Management (ABM)
• The process of using ABC information to
evaluate the costs and benefits of production
and internal support activities
• Helps to identify and implement
opportunities for improvement in profitability,
efficiency and quality within an organization.
 Managing customer profitability
• ABC information can be used to identify
characteristics that cause some customers to be
more costly than others.
• Some customers are more demanding,
requiring more of organization’s time and
resources. Selling to these customers at the same
price would yield lower profit.
• To examine the profitability of
customers/segments, we use the customers or
market segments as the cost object
• Controllable capacity costs are then allocated to
various customers, rather than products, in proportion to
their relative use of the capacity resources
• This customer focused analysis is important
because sales and administration costs associated with
acquiring services and retaining customers often account
for a significant portion of the total cost
• Customer costs include the unit, batch, customer
and product level costs consumed by specific customers
 Unit level costs are proportional to customers’ order
volume. Include items such as packaging and freight/
carriage
Batch level costs relate to customers’ frequency of
ordering or order sizes
Product level costs may include the cost of tailoring a
product to customer desires
Facility level costs include warehousing of customer
products

• By analyzing ABC information, customers can be

classified as Low profit and High profit customers
Low profit customer High profit customers

o Small order sizes o Large order sizes

o Unpredictable ordering pattern, hard to plan for o Predictable ordering pattern, easy to plan for

o Frequent order change requests o Minimal order change requests

o Need to carry inventory to satisfy customer demands o Minimal inventory requirements

o Demand immediate delivery o Planned deliveries

o Require more customisation o Require minimal customization

o Not paying on time o Pays on time

o Demand immediate and frequent after sales service o Less after sales service support

o Rigid requirements o Flexible relationship

• As costs of serving specific customers are
determined, managers can choose different strategies for
different types of customers e.g., some customers need
very little service, but are price sensitive, these customers
are profitable if costs are kept low.
• Customers can price extra service and let
customers pick the services they are willing to pay for.
• Managers can identify profitable customers and
compete for best customers by offering discounts, special
services or other sales service when necessary
 Why don’t firms simply get rid of
unprofitable customers and increase profits?
o Generally, its poor business practice to turn away
customers
o Sometimes serving unprofitable customers is an
unavoidable cost of doing business
o Effective management entails working with
undesirable customers to convert them to desirable
ones
Example:
Four clients account for all Medical Supplies’ business.
Two of the clients are small pharmaceutical stores, and
the remaining two clients are large pharmacies. The firm
prices its products at 25% above variable cost, although
all 4 customers demand and receive a sizable discount off
the list price. The following data are available for the
most recent quarter of operations. In addition to this,
management of the firm informs you that they can trace
$18 000 of general admin costs to small pharmaceutical
stores and $43 000 of general admin costs to large
pharmacies.
 Small Pharmacies Large pharmacies
Item Dolan Ryan MegaMart Bilo Activity Rate
No. of orders 20 45 30 15 $150
Order size $8 000 $4 000 $85 000 $80 000 N/A
Average discount 5% 10% 18% 12% N/A
Regular deliveries 20 45 30 15 $75
Expedited deliveries 10 0 10 0 $250
Required:
a) Prepare a customer profitability report that shows
the profit from each customer and each customer
channel.
b) Based on your analysis, recommend how the
company could improve profit.
 Managing product and process design
• A close analysis of the organization’s activities can
improve managers’ understanding of how resources are
used, which enable managers to improve operations and
profit
• Managers can focus resources on value added
activities which increase the worth of an organisation’s
goods or services to customers
• Managers can reduce or eliminate non-value added
activities which are unnecessary, and because waste
resources.
• As ABC systems are implemented,
activities can be categorized as follows:
Required to produce a product and cannot be
eliminated at this time
Required but the process can be improved or
simplified
Not required to produce a good or service and
can eventually be eliminated
Not required and can be eliminated changing a
process or a procedure
 Managing quality
• Part of organizational strategy is the choice of
product quality levels eg some organizations strive to
maintain reputation for high quality products while
other companies seek only to maintain the quality of
their competitors
• ABC can be used to determine the costs of
quality and to help refine quality strategies.
Categories of Quality Activities
o Prevention activities:
Activities performed to ensure defect-free
production e.g.
Design and process engineering
Routine equipment maintenance
Inspection of incoming raw materials
Quality training and meetings
o Appraisal activities
Activities performed to identify defective units
e.g.
Inspection of products
Inspection of manufacturing processes
Monitoring of service delivery process
Testing
o Production activities
Activities undertaken in the production or
rework of failed units eg
Producing spoiled units
Reworking spoiled units
Repairing machine and equipment
Re-engineering and re-designing
o Post Sales Activities
Activities undertaken after the product has been
sold to remedy problems caused by defects and
failed units eg
Product recalls (replace both good and defective
units)
Warranty repair work
Replacing defective units
Liability lawsuits
These activities minimizes the opportunity cost that
arise when customers have problems with defective
units or low quality services which affect reputation
and market share.
Managers should consider measuring the costs and
benefits of proposed quality initiatives and should
make decisions about the trade-off of investing in
different categories of quality activities
 Managing environmental costs
• ABC systems can be designed to identify
activities involved in environmental protection and
to develop costs of those activities
• Analyzing overhead activities help managers
identify opportunities for improved environment
performance or to eliminate non-value added
activities e.g. disposal/cleaning activities
• Managers need to value the benefits and costs of
developing environmentally friendly practices.
 Managing constrained resources
• If an organization faces capacity constraints, ABC can
help identify each product’s use of constrained
resources.
• By analyzing the activities within the constraints,
efficiency improvements can be proposed and tested
• ABC help managers identify the best way to relax
constraints
• The information can be used to design products or
manufacturing or service delivery process that minimizes
use of constrained resources.
 Outsourcing-Insourcing
• Outsourcing can be done if a firm is
incurring higher overhead cost than the external
supplier
 REVISION QUESTIONS
1.What is Activity Based Costing? Why is it needed?
2.What is a ‘Cost Driver’? What is the role of cost driver in tracing cost
to products?
3 Explain briefly the stages in developing activity based costing.
4. How are activities grouped in a manufacturing company?
5. Distinguish between traditional costing system and activity based
costing.
6.What are the benefits of activity based costing?
7. Briefly explain each of the following categories in activity based
costing by giving
examples:
(i) Unit level activities
(ii) Batch level Activities
(iii) Product level activities
(iv) Facility level activities

8. Explain the usefulness of ABC information to the

management of a company. What are the problems of
using activity based costing?
9. A company makes two products using the same
production method and equipment for each. A
conventional product costing system is used at the
present although an ABC system is being considered.
Details of the two products for the period are given as
follows:
Details Product B Product C
Labour hours/ unit 1.5 2
Machine hours per unit 2 3
Material cost / unit $15 $20
Volume (units) 2 000 10 000

Direct labour cost is $ 5 / hour. Production overheads are

absorbed on a machine hour basis and the rate for the period is
$20 per machine hour. Further analysis showed that the total of
production overheads can be divided as follows:
Set up 10%
Inspection 25%
Machinery 35%
Material handling 30%

The following total activity volume are associated with the

product lines for the period as a whole:
Details Product B Product C
Number of set ups 150 250
Number of movements of material 15 25
Number of inspections 100 500
The cost per unit of each product using
a) The conventional costing system
b) Activity based costing.

10. Bright Light Ltd manufactures two products – Bright

and Delight, using the same equipment and similar
processes. The following information is extracted from
the production department pertaining to the two
products for the year ending 31 December 2016.
Particulars Bright Delight
Quantity produced (units) 1 000 1 500
Direct labour hours per unit 2 4
Machine hours per unit 3 1
Number of set-ups in the period 20 80
Number of orders handled in the period 30 120
Total production overheads recovered for the period has been
analysed as follows:
Particulars $
Relating to machine activity 450,000
Relating to production run set-ups 40,000
Relating to handling of orders 90,000
Required:
a) Calculate the production overheads to be allocated to
the two products using the following costing methods:
i. A traditional absorption costing approach, using
direct labour hours to absorb overheads.

ii. An ABC approach, using suitable cost drivers to

trace overheads to products.

b) Explain any three ways in which managers can use ABC

information to improve operations of their organisations.
 FIVE

Budgeting

• Is a formalized financial plan for operations of an

organization’s financial roadmap, it reflects
management’s forecast of the financial effect of
an organization’s plans for one or more future
time periods
• It is important that the budgeting process is
followed up by comparing the actual results to
the budgets so that corrective action can be
taken in future budgets and strategic plans
1. Objectives of budgeting
Developing and communicating organizational
strategies and goals for the entire organization as well as
for each segment, division or department
Assigning decision rights (ie authority to spend and
responsibility for decision outcomes)
Motivating managers to plan in advance
Co-ordinating operating activities such as sales and
production.
Measuring and comparing expected and actual
outcomes and investigating variances when necessary
 Motivating managers to provide appropriate
estimates to meet expectations and use resources
more efficiently
Means of allocating resources where they are
requires
2. The Budget Cycle
• Is a series of steps that organizations follow to
develop and use budget

Diag
3. Master budget
• Is a comprehensive plan for upcoming financial
period, usually a year
• It includes all the individual budgets for each part of
the company aggregated into one overall budget for the
entire company
• The master budget includes the operating budget –
which represent management’s plans for revenues,
production and operating costs
• Preparation of the operating budget begins in the
organization’s strategies which in turn lead to sales
forecast and revenue budgets
• The volume of production is next forecast and
the production budget will lead to budgets for DM,
DL and manufacturing overheads
• Operating budget also include budget for
individual support departments
• The Master Budget also include financial
budgets. This reflects management’s plans for capital
expenditures, long-term financing and cashflows
leading to a budgeted balance sheet, statement of
cashflows and the cash budget
• A Master Budget is developed using a set of
budget assumptions. These are plans and
predictions about next period’s operating activities
eg Revenues are budgeted assuming a particular
forecast of sales volumes and prices or assuming an
estimated %age change from the prior year
• Costs are budgeted assuming a Fixed amount to
spent, or a percentage of revenues or a percentage
from the prior year or some other basis
4. Features of budgets
It should reflect the managerial plans and
policies to achieve business goals and objectives
It is expressed either in monetary or in
quantitative terms
It is a comprehensive plan for a definite future
period
Provides a basis for performance evaluation and
control
5. Budgets as performance benchmarks
• Budgets are used to monitor operations by
comparing actual results to the original budget forecasts
• The comparisons serve as benchmarks for
performance and help managers to evaluate whether
strategies and operations are meeting expectations
• The difference between budgeted and actual results
is called budget variance
• If Actual revenue > the budgeted or Actual cost <
Budgeted Costs, ie variance is categorise as favourable
and vise versa
• Variances occur for two reasons
Actual activities might not follow plans
Unanticipated increases or decreases in input
factors such as prices of raw materials. This makes
the budget an inappropriate benchmark for for
costs, because its necessary to revise budget
benchmarks to take into account new information
6. Static and flexible budgets
• A static budget is a budget based on forecasts of
specific volumes of production/services. If a static
budget is compared to results for a different level of
volume, the budgeted VC are overstated when fewer
units/services are produced. Similarly VC are
understated if more units or services are provided, thus
there is need for a flexible budget
• A flexible budget reflects a range of operations. It
clearly seperates FC and VC to more accurately reflect
the effect of activity level on costs
 • Flexible budgets are used when
a) Planning – are used to study the sensitivity of
budgeted revenues and costs to different volume levels
b) Evaluating actual results at the end of the period as
they are set and the actual sales or production volume.

7. Budgets, Incentives and Rewards

• Budgets are used to assign decision rights to
individual managers within an organization – managers
are given authority over resources and then held
responsible for meeting budget benchmarks
Top Down Budgeting
• Reflects an authoritarian style of management
• Senior managers finalise the budget with limited
input from lower organizational levels
• Allows senior managers to set difficult budget
targets and push the company in new directions
• Approach is not time consuming.
However,
• Budgets do not use organization – wide input,
hence does not take advantage of superior information
that individuals at lowerlevels in the organization
possesses
• Employees may lack commitment and motivation
to achieve budget goals because lack of involvement
• Approach is not most suitable in smaller
organisations with a narrow and manageable range of
products and services and centralized decision making.
Top managers are likely to possess detailed enough
information for budgeting purposes
• However, when employees set targets, incentives exist
to set them low so that goals can be met easily. In contrast if
to management set targets incentives exist to raise targets to
induce productivity
• If targets are too low or too high – easily met or
unachievable – employees have little motivation to improve
performance

• Because of this negotiations are required over a period

of time prior to setting the final budget
• Some organisations implement a combination of the
two methods where some aspects of the budget are top –
down and other aspects are bottom – up.
8. Zero based budgeting
• Some managers simply add an adjustment
increasing last year’s budget to plan for the next
period. This practice discourages them from seeking
ways to use organization’s resources more efficiently
• Most organisations have adopted policies so that
depatments lose authority over unspent budget
costs, and because receive lower future budgets if
actual costs are lower than the current budget
• This encourages managers to spend all of their budgeted
funds to avoid future cut backs
• To reduce the above problems, managers may adopt zero
based budgeting
• This is a method of budgeting whereby all activities are
revaluated each time a budget is set
• Managers justify budgeted amounts as if no information
about budgets or costs from prior budget cycles was available
• Each functional budget starts with the assumption that
the function does not exist and as at zero cost
• Encourages managers to cut costs and improve quality
• Time consuming
9. Budget manipulation
• If performance evaluation and bonuses are based on
achieving budgeted results, managers have incentives to
manipulate budgets to meet targets more easily – budgetary
slack
• Budget slack – is the practice of intentionally setting
revenue budgets too low and cost budgets too high
• This denies organisations of more precise information
which would result in better strategies and operating plans
• Its not easy for top managers or shareholders to identify
and remedy budgets that have been manipulated
The practice can be minimized by
Using independent sources eg consultants and marketing
experts to prepare forecasts. If employees know that their
estimates are being scruitnised, they will try to come up with
more realistic forecasts
Giving bonuses for accurate forecasts as well as operating
within the budget
Giving bonuses based on a combination of department
results and overall organization profitability. This is because in
large organisations, managers tend to focus only on not
consider the organization as a whole. They then submit
biased budget requests – misallocation of resources among
competing departments or projects
10. Budget responsibility
• Budgets give managers authority over use of an
organization’s resources, and it seems reasonable to hold
managers responsible for meeting budget benchmarks
• However, use of budget variances present challenges for
both managers being evaluated and the managers conducting
the evaluation:
1. Resentment
• Occurs when managers are held responsible for costs
over which they have no control eg allocated support
department costs may be too high because of poor
management in support departments
2. Isolating performance of individual managers
• Due to interdependency among departments eg
product quality (production department) affects the ability of
the sales department to meet future revenue targets.
3. Management turnover
• New manager is responsible for old manager’s budget
decisions
4. Employee turnover
• When there are delays in hiring process or a
recruitment freeze occurs
5. Uncontrollable external factors
11. Budget and variance adjustment
• Because managers budgets often include items not under
their control, the following adjustments can be made when
budgets are used to measure manager’s performance:
Use a flexible budget to determine expected revenues
based on budgeted prices and actual volumes
Use a flexible budget to determine expected VC based on
budgeted VC rates and actual volume
Remove allocated costs that are not controllable by
managers in the departments receiving allocations
Update costs for any anticipated price changes in DM, DL
and overheads related resources
12. The Principal Budget Factor (the key factor)
• In any organization, certain factors determine the
limits of all relevant activities eg availability of capital,
location, labour etc
• A key factor is a factor that limits or restrict an
activity
• It must always be considered when preparing
budgets
• Necessary for management to determine the factor
that restricts activity as this is the point at which the
annual budgeting process should begin
13. Operating Budgets
• Relate to the different activities or operations of a
concern
• Plans of the expected revenues and costs of an
organization

a) Sales Budget
• An estimate of expected sales during a budget period
expressed in terms of both sales units and sales value ($)
• Is the key budget that lead to the preparation of
all the other operation budgets
Eg Sales Budget for the year ended xxx
Product Units Selling price ($) Total Revenue ($)
A xx xx xx
B xx xx xx
xxx
Can be prepared monthly, quarterly or yearly
b) Production Budget
• A plan of the quantities to be produced to meet the
planned sales/revenue and it must be in quantities only

Production Budget for the year ended xxx

Expected sales xx
+ Planned Closing stock xx
= Total requirements xx
- Planned opening stock (xx)
Units to be produced xx
Example
The company has budgeted the sales of its products over the next 4
months as follows:
Month Sales (Units)
January 50 000
February 40 000
March 60 000
April 65 000
End of year month’s inventory must be equal to 10% of the next
month’s sales. The inventory at the end of December was 5000 units.
Required
Production Budget for January, February and March and the total of
the three months
c) Direct Material Purchase Budget
• Plan of the quantities to be purchased as well as the cost of
the purchases

D.M Purchases Budget for the year ending xxx

Units to meet production xx
+ Planned c/s xx
= Total requirements xx
- Planned o/s (xx)
Number of units to be purchased xx
Purchase price per unit x
Purchases xxx
Example
A company manufactures a product which requires two
components in its manufacturing. The components cost $5
each. The company has developed a production budget for
2016 and the first quarter of 2017
2016 2017
1st 2nd 3rd 4th 1st
Budgeted Units 5000 8000 14000 6000 6000

The inventory of components at the end of the quarter must

be equal to 10% of the following quarters’ production. Some
1000 components will be available to start the 1st quarter of
2016. Prepare a material purchases budget for 2016.
d) Direct Labour Budget
• Estimate of direct labour hours required to meet the
planned production, and the labour cost required for
budgeted production.
Budgeted production (units) xx
Labour hours/unit x
Total budgeted hours xx
Hourly wage Rate ($) x
Total budgeted wages xx
Factory overhead Budget
• Plan of the overheads to be incurred
• Determined by the OAR as follows
OAR = Total budgeted overheads
Units of the absorption rate
e) The Cash Budget
• Plan showing how cash resources will be acquired
and used over a period of time
• The objective is to ensure that sufficient cash is
available at all times to meet the organization’s
commitments as outlined in other budget.
• Help managers to avoid cash resources surplus to a
firm requirements (it has a cost)
• Cash deficiencies can be identified in advance to
ensure that finance will be available to meet any
temporary cash deficiencies
Example
The following information relates to Clare Bishop’s business
for the six months 1 July
to 31 December:
(i) Opening cash balance 1 July will be overdrawn by $1,000.
(ii) Sales at $30 per unit:
April May June July August Sept. Oct. Nov. Dec.
Units 110 120 130 140 150 160 170 180 190
Debtors will pay one month after they have bought the goods.
(iii) Production in units:
April May June July August Sept. Oct. Nov. Dec. Jan.
Units 100 130 120 150 140 170 160 170 200 200
(iv) Raw materials costs of $8 per unit are delivered in the
month of production and will be paid for two months after the
goods are used in production.
(v) Direct labour of $5 per unit will be payable in the same
month as production.
(vi) Other variable production expenses will be $3 per unit.
One-third of this cost will be paid for in the same month as
production and two-thirds in the month following production.
(vii) Other expenses of $150 per month will be paid
one month in arrears. These expenses have been at
this rate for the past two years.
(viii) A van will be sold in September. It is estimated
that it will fetch $4,400. A replacement van will be
purchased in the same month for $9,000.
(ix) Clare Bishop plans to borrow $3,300 from a
relative in November. This will be banked
immediately.
Required:

• Prepare schedules for expected collections and

expected payments for the business.
• Prepare Clare Bishop’s cash budget 1 July to 31
December, and
• Using your projections, advise Clare Bishop how
she might improve her cash management.
 REVISION QUESTIONS

1.What is budgeting ? What are its objectives?

2. What are the essentials of a good budgetary
system?
3. What is budgetary control? Discuss the various
preliminaries required for adoption of a system of
budgetary control.
4. What are the main steps in budgetary control?
State the main objectives of budgetary control.
5. What factors generally determine a budget
period? Give examples?
6. Distinguish between ‘fixed budget’ and ‘flexible
budget’.
7. What do you understand by master budget?
8. What is a principal budget factor? Give a list of such
‘principal budget factors’ and state the effect of the
existence of two or more budget factors in a business.
9. Write a note on (i) zero base budget and (ii)
Increamental budget.
10. Actual events rarely unfold exactly as expected,
particularly in complex scenarios. Thus, budget
assumptions are likely to be proven wrong as actual
events unfold. What then is the value of a budget?
11. “Our biggest customer had a fire in their plant, torpedoing all
of our sales projections. We will be lucky if we can come in at 80%
of the budget. Yet, Carrie refuses to adjust the budget, destroying
my bonus and sales morale. I pleaded with Carrie to give a little but
she flat out refused and even threatened to replace me!” This
outburst from Jim, neatly summarises the dispute at Simmons and
Company. Carrie, the founder’s granddaughter, has been managing
the business for 15 years. Her hard-nosed approaches to budget
targets and aggressive tactics have earned her the nickname
“Cutthroat Carrie.” When you approach Carrie, she readily admits
that the current targets are now unrealistic. Yet she says that
making one revision will start the firm down a slippery slope where
there is no accountability for estimates.
Evaluate the costs and benefits of revising budget targets.
12. The uses of budgets for control purpose imply that
current management performance is compared with
some yardstick. What is wrong with comparing actual
performance with past performance, or the performance
of others, in an effort to exercise control?
13. Sales forecasts and overhead estimates are the two
activities that consume the most time during the
budgeting process. Discuss why this is the case.

14. Babcock Ice Cream is a producer of dairy products.

Babcock prepares monthly cash budgets and the relevant
data from assumed operating budgets for 2017 are:
 January February
$ $
Sales 460 000 412 000
Direct materials purchases 185 000 210 000
Direct labour 70 000 85 000
Manufacturing overhead 50 000 65 000
Selling and adm expenses 85 000 95 000
Babcock sells dairy products to local stores. Collections
are expected to be 75% in the month of sale and 25% in
the month following sale. Babcock pays 60% of direct
materials purchases in cash in the month of purchase,
and the balance due in the month following the
purchase. All other items above are paid in the month
incurred. (Depreciation has been excluded from
manufacturing overhead and selling and administrative
expenses.)
Other data:
i. Sales: December 2016, $320 000.
ii. Purchases of direct materials: December 2016, $175
000.
iii. Other receipts: January 2017-Donation received,
$2000 February 2017-Sale of used equipment,
$4 000.
iv. Other disbursements: February 2017-Purchased
equipment, $10 000
The company’s cash balance on January 1, 2017 is
expected to be $50 000.
Required:
a) Prepare schedules for (1) expected collections
from customers and (2) expected payments for
direct materials purchases for January and February
2017.
b) Prepare a cash budget for January and February
2017 in columnar form.
c) How does a cash budget contribute to good
management?
 budgets lead organisations to place too much emphasis on
financial performance and not enough emphasis on the
qualitative and non-financial aspects of performance

Budgets do not capture

• It ignores customer satisfaction,
• Quality of products
• Staff morale and motivation
• The environment, political, social, economic
• Business ethics
 SIX
Standard Costs and Variance Analysis

• A standard is a benchmark, a norm or target which

is used to measure performance
• Improves the ability of managers to plan
operations and monitor performance
• A standard cost is the cost managers expect to
incur to produce goods or services under operating
assumptions such as:
Volume of production activity
Production process and efficiency
Process and quality of inputs
• A standard cost is a system that enables
management to analyse deviations from the
budget so that future costs can be controlled
more effectively
• The standard cost for a unit of output is
the sum of standard costs for the resources used
in production
• The resources include DM, DL, Fixed
overheads and variable overheads
2. Uses of standards
• Provides targets which motivate individuals to
attain them
• Used in the budget setting process and
performance evaluation
• Provides mechanism for control and helps
managers to take action where operations get out of
control
• Provide data for the purpose of measurement
3. Types of standards Types of standards

Basic standards
• Constant standard which remain unchanged
over long period of time
• Provide a base for comparison between the
standard and the actual performance overtime
• However, do not represent current targets
especially in a changing environment
Ideal standards
• Standards set for a perfect operating environment
• Normally not achievable because they do not give
allowance for normal disruptions eg unavoidable set up time
• Using such standards can demotivate employees as
they cannot be met

Current attainable standards

• Standards set under efficient operating conditions
• Although difficult/challenging, they are achievable
• Preferable for cost control and budget preparations
4. Developing standard costs
• Managers make use of:
the most recent year’s data
Evaluate and incorporate historical trends
Industrial engineers who estimate the quantities and
costs for DM, DL and O/H.
benchmarking
• Standards should be set at a level that is
attainable, but without much slack to encourage
employees to achieve planned productivity
5. Variance analysis
• Process of calculating variances and then investigate
the reasons they occurred
• A standard cost variance is the difference between a
standard cost and an actual cost
• Variance analysis can be used whether or not an
organization uses a standard costing system.
• The process requests only the ability to compare actual
results with some type of benchmark which might be:
o Standard costs
o Budgeted costs
o Or some other measure of expectation
• The value of variance analysis is not in calculating the $
amount of the variance but in identifying the reasons for the variance,
and then using that information to improve future decision making
• Variance analysis is time consuming. Managers should
investigate variances they consider important. Importance is
established in two ways:
The variance that will be calculated and chosen need to be
identified
For the identified variance, manager must decide whether a
variance is large enough to justify investigation. However, other factors
can also justify investigating eg if variance trends are increasing,
establish the cause of the trend.
5.1 Direct Material Cost Variance
• Two components : - Price Variance
- Quantity/efficiency variance

a) Direct Material Price Variance

• Difference between standard price and actual price
of the actual quantity used in production
(Std price – Act Price) × Act Qty of Materials used
A company buys 110kg of soda@$1.25 per kg. The std
cost is $1/kg. The price variance is---?
Reasons for DM Price Variance
• Change in price paid for materials caused by
o A change in the quality of materials purchased
o A change in the quantity purchased, leading to a
change in purchase discount
o A new supplier
• Unreasonable materials price standard
• Poor purchasing practices
• Actions of other departments eg poor inventory
control by stores department
b) Direct Material Quantity variance
• Shows how economically DM were used in
production
• Compares the standard amount of materials that
should have been used to the amount of materials
actually used
(std qty for act. Output – Act. Qty for act. Output) ×
standard price
Reasons
• Normal fluctuation in material usage
• Change in production process, causing a change in
quantity of materials used
• A change in production of materials spoiled caused by
o a change in the quality of materials
o A change in equipment, technology or other aspects of
production process
o Equipment malfunction
o Intentional worker damage
• Theft of RM
• Unreasonable materials qty standard
c) Total Direct Material Cost Variance
Difference between SC of materials and actual cost i.e SC-AC
SC = no. of units produced × std qty of materials req/unit × Std Price

Example
Office Traders makes filing cabinets. Here are the details of its May
production:
Estimated Actual
Number of filing cabinets 15,000 16,000
Kilos of metal 120,000 140,000
Price per kilo ($) 70 75
Calculate the: (i) Overall direct materials cost variance
(ii) Direct materials price variance
(iii) Direct materials quantity variance
5.2 Direct Labour Variances
a) Wage Rate / DL Price Variance
• Compares the actual price with the standard price of labour
(std Labour Price – Act. Labour Price) × Act. Hours used
Reasons
• A change in average wages paid to employees caused by
o New union contract
o A change in average experience or training of workers
o Minimum wages regulation changes
• Unanticipated overtime hours
• Unreasonable labour price std etc
b) Direct labour efficiency variance
• Compares the std amount of labour hours that
should have been used to the amount actually used
(std hrs for Act. Output – Act. Hrs for Act. Output) ×
std price
Where:
Std hours = No. of units produced × std hrs required
/ unit
Reasons
• Normal fluctuation in labour hours
• Change in average labour time caused by
o A change in equipment, technology or other
aspects of the production process
o Change in average worker experience
• Improved performance from effective training
programs
• Change in employee turnover
• Intentional work slow down
• Unreasonable labour hours
c) Total Direct Cost Variance
• Is the difference between the standard cost and
the actual cost of labour ie
• SC-AC where
• SC= No. of units x standard hours/unit x standard
rate

Example
Rest Easy makes armchairs. There are the following
details of direct labour used to make
armchairs for June:
(a) Standard: 600 armchairs at 4 hours at $5.80
per hour
(b) Actual production: 700 armchairs at 3,000
hours for $16,500
Calculate the: (i) Overall direct labour cost
variance
(ii) Direct labour price variance
(iii) Direct labour quantity variance.
6. Overhead Variances
• To monitor O/H costs, a std O/H allocation rate is created @
the beginning of each period
• O/H are allocated using an O/H allocation base such as units,
labour hours, labour costs or machine hours

6.1 Variable O/H variance

Variable O/H Expenditure Variance:
• Is the difference between the total expected var O/H costs for
that level of output and the actual var O/H costs for that level of
output
• Var O/H vary with activity and the calculation for the variance
takes into account the actual volume of activities
• Determined as
Budgeted Var O/H – Act. Var O/H
Example
A company allocation base for Var O/H is direct
labour hour. The normal volume of direct laobour
hours is 500 000 units × 0.15 hrs/unit = 75 000 hrs.
The standard var O/H allocation rate is $2 per direct
labour hour. Suppose actual variable O/H costs total
$14 700 and actual labour hours are 74 000 hrs.
What is the variable O/H spending Var.?
Reasons
• Unanticipated change in prices paid for variable O/H resources
caused by
o Variation in prices for supplies or indirect labour
o New supplier or labour contract
• Out of control or improved efficiency in variable O/H cost
spending
• Change in type or extent of variable O/H resources used eg
o Change from inhouse to outsourcing equipment maintenance
services
o Increase or decrease in normal spoilage, rework or scrap
Variable O/H Efficiency Variance
• Difference between std hrs and actual hrs worked
valued at the std var O/H rate
• It is the var O/H variance caused by the level of
efficiency of the labour force
= (std hrs – Act hrs) × Std Var O/H rate
Example
498 000 kg of a product was produced. The standard
number of direct labour hours for actual production is 74
700hrs (498 000kg @ 0.15hrs/kg) and 74 000 actual hrs
were used. The std var O/H allocation rate is $2. Var
Efficiency variancy ?
Variable Overhead Cost Variance
• Difference between the std var O/H cost and the
actual var O/H cost
Var O/H cost var = std var o/h cost – actual o/h cost

6.2 Fixed O/H cost Variance

Fixed O/H Expenditure Var
• Difference between budgeted Fixed O/H and the
actual Fixed O/H
= Budgeted Fixed O/H costs – Act. Fixed O/H costs
Reasons
• Unanticipated change in prices for fixed O/H
resources caused by
o Change in estimated asset life for department
o Change in electricity, other utility
• Out of control or improved efficiency in Fixed O/H
cost spending
• Change in activity level to a new relevant range,
requiring change in fixed resources such as
Hire or lay off a supervisor
Fixed O/H Variance (Production)
Caused by the difference between the budgeted and the
actual production
= (Budgetes production – Act. Production) × standard rate
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐹𝑖𝑥.𝑂/𝐻
Where std rate = std Fixed O/H Absorption rate =
𝐴𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛 𝐵𝑎𝑠𝑒

Reasons
• Improved production process
• Normal fluctuation in volume of allocation base

NB if Act. Production < Budgeted, there is under absorption of fixed

O/H charged to products abd var will be adverse and if Act. Production
> Budgeted production (over absorption)
Example
Std data:
Production 10 000 units
D. Wages 5hrs @ $3/hour
Fixed production O/H are absorbed @ 200% of Direct wages
Actual Data:
Production and sales 9 500 units
Fixed production O/H incurred $290 000
Required
Fixed O/H variance
1. Fixed O/H Exp var
2. 2. Fixed O/H Vol var
3. F O/H Cost Variance
 REVISION QUESTIONS

1. Define ‘Standard Cost’ and ‘Standard Costing’.

2. What are the applications of standard costing?
3. Discuss the importance and limitations of standard costing.
4. Discuss the various types of standards.
5. Define ‘Variance analysis’.
6. The setting of standards is critical to the effective use of
standards in evaluating performance. Explain the following:
a) The comparative advantages and disadvantages of ideal versus normal
standards.
b) The factors that should be included in setting the price and quantity
standards for direct materials, direct labour and manufacturing overhead.
7. “Standard costing is good for planning and control, but
unless great care is taken can often be very demotivational.”
Discuss.
8. “Setting the standards is the most difficult part of
standard costing.” What considerations should be taken into
account when setting standards?
9. Standard costing involves comparing the standard sales
and costs against the actual sales and actual costs to
determine variances. These variances are then split into
controllable and uncontrollable variances. Those responsible
for controllable favourable variances should be rewarded, but
those responsible for controllable unfavourable variances
should be punished’. Discuss.
10. How may a manager achieve a favourable
direct materials price variance but in doing so
would create problems for a business?
11. Lee Manufacturing makes bookcases. The
company has the following details for its June
production.
Budgeted Actual
Number of bookcases 10 000 11 000
Metres of wood 100 000 120 000
Price per metre $0.50 $0.49
 Calculate:
i. Overall direct materials cost variance
ii. Direct material price variance
iii. Direct materials quantity variance
iv. Discuss the variances
12.a) Sweatshop has the following details of direct
labour used to make tracksuits for July:
Standard: 550 sweatshirts at 2 hours per sweatshirt at
$5.50 per hour.
Actual production: 500 sweatshirts at 1 050 hours for
$5 888.
Calculate:
i. Overall direct materials cost variance and
comment.
ii. Direct labour price variance and comment.

iii. Direct labour quantity variance and comment.

13.Case Study
Evaluating a proposal for measuring performance.
Benx Industries has been in business for 30 years. The
firm’s major product is a control unit for elevators. The
firm has a reputation for manufacturing products of
exceptionally high quality, resulting in higher prices for
its units than competitors charge. Higher prices in turn,
have meant that the firm has been comfortably
profitable. A major reason for the high product quality is
a loyal and conscientious workforce. Production
employees have been with the firm for an average of 18
years.
 Recently, the firm hired a management
accountant from the local university. After a few
months at the firm, the new accountant proposed a
performance measurement report consisting of two
parts. The first part will report the actual number of
units started during each month, the target number
that should have been started, and a variance. The
second part will calculate an actual cost per good
unit completed during each month, the target cost
per unit, and a variance.
The new accountant provided the following additional
information concerning the performance report: The first
part of the report concentrates on units started because
many units are scrapped in the manufacturing process (to
maintain high quality). Therefore, the best measure of effort
expended is the number of units on which work was begun.
The target number of units to be begun in a month is the
number of units started in the corresponding month last year
plus 5%. In the second part of the report, actual costs per unit
will be calculated by dividing total production cost incurred
during the month by the number of good units completed
during the month. The target cost per unit is the average cost
for manufacturing this kind of product as determined from
industry newsletters.
The proposal concluded with the following comments: “This report should be
prepared and distributed quarterly. For maximum benefit, I suggest that a
bonus be awarded whenever units started exceeds target and costs are below
target. This system will result in substantially improved profits for the firm. It
should be implemented immediately.”

Required:
a) Explain what the managers might learn by monitoring each of the variances
in the proposed performance measurement system.
b) Discuss possible reasons why the company did not previously use a
variance system to monitor and motivate worker performance.
c) Describe weaknesses in the proposed performance measurement system.
d) If you were the Managing Director, how would you respond to the new
management accountant’s proposal? Discuss whether you agree with the
proposal.