MALec Batch 4

University Of London
Management Accounting
Lecture Notes
Lecture 16
Topics Covered
Budgeting 2
Readings: Horngren Chapter 15

This lecture deals mainly with the preparation of a flexible budget. Pay
attention to the technique of preparing a flexible budget as flexible budget
is a popular Section A question in the exam.
The parts on Kaizen Budgeting and Responsibility Accounting are also

popular section B questions in the exam.
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Fixed Versus Flexible Budgets
Fixed (Static) Budgets
A fixed budget is prepared based an estimated volume of production and sales.

The master budget (Lecture 15) prepared before the beginning of the budget
period is known as a fixed budget. It is generally used in the planning phase to
define the objectives(targets).
A fixed budget is a planning budget and is used to set the target performance.
Flexible Budgets
A flexible budget recognises how variable cost changes as activity levels changes.
The flexible budget is prepared for the level of activity actually achieved.
At the end of the actual budget period, actual results should be compared to flexible
budgets for variance analysis as part of performance measurement.
Flexible budgets are used to measure performance of individuals and

departments.
Steps In the preparation of the flexible budgets
Step 1 – Analyse all cost into fixed & variable category
Step 2 - Break up semi- variable cost into fixed & variable cost if necessary
using the high-low method
Step 3 - Flex the variable cost. Do not flex the fixed cost.
Step 4 – Prepare the Flexible Budget (Performance Statement )
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Why prepare a flexible budget?
A flexible budget is necessary to evaluate performance relative to the budget.
For example, is the following performance report meaningful?

Performance Report – Production Manager
Budget Actual Variance You are comparing
Units 10,000 20,000 “apples to oranges”
Total Cost $ $ here!
Variable cost 30,000 60,000 30,000(A)
Fixed cost 50,000 55,000 5,000(A)
Total 80,000 115,000 35,000(A)
Should the Production manager be held responsible for the adverse variance of $35,000
Answer:
Variance represents a deviation from the desired target performance. In Management
accounting, it is important to recognise that performance must only be evaluated based
on controllable factors. A manager must not be held responsible for any factor that is not
controllable by him this will be very frustrating and demoralising.
The adverse variance means here means that the production manager has due to
inability to control cost caused the actual profit to be lower than the budgeted profit by
$35,000.
But this is obviously not the case here as the budget is only for 10,000 units of
production when 20,000 units were actually produced. Hence, the comparison of the
cost is not logical as you not comparing “apples to apples”. We cannot expect the
production manager to produce 20,000 units using the variable cost resources for
10,000 units. Its simply not possible to do this. You can’t produce 20,000 cars with
10,000 engines!
The production budget above is actually a fixed budget as the volume(units) is not the
same as the actual units produced. It should only be used at the planning stage (before
the year starts) to communicate the expected level of performance. In this case, based
on the demand expected, the company planned to produce 10,000 units this was the
forecast demand. But it seems like the actual demand was much higher at 20,000 units
and hence the production manager has done well as he did produce the expected
demand and satisfied the customer’s requirement.
Hence, to judge his ability to control cost, a flexible budget should be used to compute
controllable variances. The variable cost in the budget should be doubled to $60,000 to
reflect that 20,000 units were actually produced. No change to the total fixed cost as
total fixed cost is constant over the relevant range.
Performance Report – Production Manager
This is a more meaningful
Flexible Actual Variance
comparison of “apples to
Budget
apples”
Units 20,000 20,000
Total Cost $ $ Do not change the actual
Variable cost 60,000 60,000 0 amounts the actual
Fixed cost 50,000 55,000 5,000(A) amounts are based on
Total 110,000 115,000 5,000(A) actual transactions300
Don’t flex the total fixed cost already incurred.
Preparing a flexible budget
Remember, when you flex the budget you only making changes in the total variable cost
and the total sales amounts, no change to total fixed cost. Total sales and total variable
cost are linear functions, with a constant gradient or slope.
Total sales Total variable cost
Total sales
Total variable cost
Units sold Units produced
Hence, the total variable cost and the total sales amounts in the flexible budget is only a
“change in proportion” as compared to the fixed budget. No need to compute the selling
price per unit or the variable cost per unit to compute the flexible budget amounts.
Example, assume the following information. Compute the total variable cost, total fixed
cost and the total sales amount for 60% capacity.
Capacity Total sales Total variable cost Total fixed cost
$ $ $
40% 140,000 60,000 100,000
60%
Total sales
Total variable cost
Total Variable cost
$140,000
40% 60%
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Lecture Illustration 1
The Noble restaurant that is only open in the evenings, on six days of the week.
It has eight restaurant and kitchen staff, each paid a wage of $8 per hour on the
basis of hours actually worked. It also has a restaurant manager and a head
chef, each of whom is paid a monthly salary of $4,300. Noble’s budget and actual
figures for the month of May was as follows:
Budget Actual
Number of meals 1,200 1,560

$ $ $ $
Revenue: Food 48,000 60,840
Drinks 12,000 11,700
60,000 72,540
Variable costs:
Staff wages 9,216 13,248
Food costs 6,000 7,180
Drink costs 2,400 5,280
Energy costs 3,387 3,500
(21,003) (29,208)
Contribution 38,997 43,332
Fixed costs:
Manager’s and chef’s pay 8,600 8,600
Rent, rates and depreciation 4,500 4,500
(13,100) (13,100)
Operating profit 25,897 30,232
The budget above is based on the following assumptions:
1) The restaurant is only open six days a week and there are four weeks in a
month. The average number of orders each day is 50 and demand is evenly
spread across all the days in the month.
2) The restaurant offers two meals: Meal A, which costs $35 per meal and Meal
B, which costs $45 per meal. In addition to this, irrespective of which meal the
customer orders, the average customer consumes four drinks each at $2·50 per
drink. Therefore, the average spend per customer is either $45 or $55 including
drinks, depending on the type of meal selected. The May budget is based on
50% of customers ordering Meal A and 50% of customers ordering Meal B.
3) Food costs represent 12·5% of revenue from food sales.
4) Drink costs represent 20% of revenue from drinks sales.
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5) When the number of orders per day does not exceed 50, each member of
hourly paid staff is required to work exactly six hours per day. For every
incremental increase of five in the average number of orders per day, each
member of staff has to work 0·5 hours of overtime for which they are paid at the
increased rate of $12 per hour. You should assume that all costs for hourly paid
staff are treated wholly as variable costs.
5) Energy costs are deemed to be related to the total number of hours worked by
each of the hourly paid staff and are absorbed at the rate of $2·94 per hour
worked by each of the eight staff.
Required:
Prepare a flexed budget for the month of May. What is the % increase
Flexible Budget - May in the number of meals?
_______________.
No of Meals 1,560
$
As long as you use the
Revenue: Food right technique, you can
actually ignore the
Drink information given in
item 2) above
Total Revenue 78,000
Variable Cost
Staff Cost (plus overtime)
Food Cost
Drinks Cost
Energy Cost
Total Variable Cost 27,826
Total Contribution 50,174
Less: Fixed Cost
Salary
Rent, Depreciation
Operating Profit
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Exam Tip
Adopting the right technique is important in the preparation
of the flexible budget.
You need to structure the flexible budget immediately after

reading the question based on the same format as the fixed
budget.
There lots of easy marks to get for the flexible budget

preparation, so do the easy parts first.
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Working
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Lecture Illustration
Blue Skies Promotions Ltd organises trade exhibitions around the UK. It
concentrates on medium sized cities providing medium sized exhibition facilities.
Typically, a location provides 1,000 square metres of ‘stand’ space which Blue
Skies offers to exhibitors as ‘small’ stands of 4 square metres or ‘large’ stands of
6 square metres. Companies needing even larger stands can take up multiples of
either. For a normal two day exhibition the list price for 2020 is £1,200 for a small
stand and £1,680 for a large stand. Discounts are offered to companies which
book early, or take larger stands. If an exhibition runs for 3 or 4 days a pro-rata
daily rate of £600 for a small stand and £840 for a large stand applies.
Each location provides the exhibition hall, heating and lighting, cleaning, car
parking and catering facilities, etc. Blue Skies handles planning, advertising and
publicity, exhibition preparation, liaison with exhibitors and the running of the
exhibition.
Blue Skies plan to run one 2-day exhibition each week. From January 1st 2020
the management is establishing a budgeting system for the exhibition activities.
Shown below is the standard revenue and cost sheet for a 2-day exhibition:
Per Exhibition
£ £
Revenue
Small ( 4 metres) Stand
100X £1,200 X 0.90 X0.85 91,800
Lage (6 metres) Stand
100 X £1,680 X 0.9 X 0.85 128,520
Total Revenue 220,320
Direct Exhibition Cost

Hall Hire 78,000
Advertising & Publicity
Directed at exhibitors 60,000
Directed at visitors 60,000
Set-up & Dismantling
10 X 3 X £156 4,680
Exhibition & Administration
8 X 2 X £ 168 2,688
Standard operating cost 205,368
Contribution to Head office expenses 14,952
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Lots of details here but
mostly not required to
prepare the required
The above standard was prepared using the following assumptions: budgets
• Blue Skies will be able to let 90% of the available stand space and early
booking discounts, etc., will be 15% of the full list price.
• There will be an equal number of large and small stands.
• Hall hire will average £39,000 per day.
• Advertising directed at exhibitors is incurred for each exhibition and is not

dependent on the length of the event. However, advertising directed at
visitors varies with the number of days of each event.
• 10 freelance fitters and electricians take a total of 3 working days to set up

the exhibition and dismantle the stands after the event. They are normally
paid £120 each per day and their travelling, subsistence, etc. averages £36
each per day.
• While the exhibition is running Blue Skies will need to provide an

organiser’s office to monitor admissions etc. This will normally require 8 staff
who are paid an average of £96 each per day. Since several exhibitions are
open in the evening, travelling, subsistence and hotel expenses are higher
at £72 each per day.
• Blue Skies’ Head Office budget for 2020 is £432,000.
Blue Skies is now embarking on a detailed analysis of the most recent quarter’s
(January-March 2020) activities. During that quarter it actually ran eight 2-day
exhibitions, plus one of 3 days and one of 4 days. The analysis reveals:
• Income was £2,570,400 made up of 2,100 exhibition days of small stalls at

an average daily price of £540 and 1,900 exhibition days of large stalls at
an average daily price of £756.
Direct exhibition expenditure was: The actual cost given here not relevant to
the preparation of the required budgets
• Hall hire £870,000.
• Advertising and publicity aimed at exhibitors - £636,000 Advertising and

publicity aimed at visitors - £732,000 .
• Set up and dismantling £55,080 (270 man days at £204).
• Exhibition administration £32,640 (170 man days at £192).
• Head Office expenses for the quarter amounted to £111,600.
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Exam Tip:
For the exam, always assume that there are 52
weeks in a year, unless mentioned otherwise.
Required:
Prepare a table (down to company operating profit) showing: Fixed budge
I. A budget for the quarter based on the original planned activity.

II. A flexed budget based on the actual activity of the quarter.
Flexible budget
UOL Adapted 2009 Zone A Question 3
Need to track the number of
days also as
Budget for the 1st Quarter 2020 Not all actual exhibition
Fixed (i) Flexible (ii) conducted is for 2 days and
Description Budget Budget some cost varies with the
number of exhibition and
No. of Exhibitions
some cost varies with the
number of days
No. of Days
£ £
Revenue
Small
Large
Total Revenue 2,864,160 2,533,680
Less: Cost
Hall Hire
Advertising
Exhibitor
Visitors
Setup
Administration
Divisional Controllable Cost
Division controllable profit
Allocated HQ Cost
Division Profit
Note:
This question is not as difficult as it seems as long as you
adopt the right technique.
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This is a Japanese budgeting concept.Good
Kaizen budgeting for 5 marks question in Section B of exam.
Kaizen budgeting is a budgetary process that explicitly incorporates
continuous improvement during the budget period.
A significant aspect of kaizen budgeting is employee input or The Japanese tend to

suggestion. Objective is to create a culture in which employees value their employees
suggestions are valued, recognised and rewarded. more as compared to
western cultures.
They believe the older
Companies that implement kaizen budgeting believe that employees the employee, the more
involved in the manufacturing, sales, or distribution process have the experience, hence more
best information and knowledge on how the job can be done better. valuable.
Many companies that have cost reduction as a strategic focus use

Kaizen budgeting to continuously reduce cost.
The Japanese are not

Much of the cost reduction associated with Kaizen budgeting arises
great inventors, they
from small improvements rather than quantum leaps.
just good at making
already invented ideas
Flexible Budgets & Budgetary Control better.
Individual managers are responsible for investigating variances between

budgeted and actual results for their individual areas of responsibility and to take
the necessary corrective action.
This should be done by comparing the actual results to the flexible budgets
instead of the fixed budgets as the fixed budgets do not reflect the different
volumes achieved.
Budgeting & Responsibility Accounting
Organization structure is the arrangement of lines of responsibility within the

organization. Organizations can be structured by business function or product
line, or geographically.
In a centralised organisation, decision making authority and responsibility resides
with top management
In a decentralised organisation, decision making authority and responsibility is

given to lower levels of management
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A responsibility centre is a decentralised subunit of an organization whose
manager is accountable for a specified set of activities.
In any responsibility centre, it is important to ensure that

• Activities and performance should be clearly defined;
• Managers should have control over activities for which they are responsible
for.
Responsibility accounting assigns authority and responsibility to managers of

sub-units and then measuring and evaluating their performance
Cost centres do not
generate revenue,
hence cannot be
There are four types of responsibility centres: responsible for revenue
and profit
1) Cost centre, in which the manager is responsible only for costs.
For example, accounting department would be accounted for as a cost centre.
2) Revenue centre, in which the manager is accountable only for revenues only.
For example the sales department could be a revenue centre because the
sales manager is responsible primarily for revenue.
3) Profit centre, in which the manager is accountable for revenues and costs.
For example, the shoe department in a department store may be accounted
for as a profit centre
4) Investment centre, in which the manager is accountable for revenues and

costs, but also the investment (or assets) under his control.
A division within the company may be accounted for as an investment centre

because the division manager is responsible for determining the amount to be
invested in the division and also for the profit generated by the division.
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The following table highlights the differences between cost centre, profit centre
and investment centre.
Type of Centre Manager has Principal

control over performance
Responsible to measure
Cost Centre Controllable cost Minimise cost Cost Variance

Analysis
Profit Centre Controllable cost Maximise profit Profit Variances

Sales Volume
Sales Prices
Investment Controllable cost, Maximise ROI Return on

Centre revenue and Investment
investment (ROI)
Revenue Sales revenue Maximise sales Revenue variances

Centre
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Examples
How the choice of the responsibility centre effect the manager’s behaviour
The choice of the type of responsibility centre determines what the manager is
accountable for and thereby affects the manager’s behaviour. For example, if a
revenue centre is chosen, the manager will focus on revenues, not on costs.
The choice of a responsibility centre type guides the variables to be included in

the budgeting exercise. The choice of the type of responsibility centre determines
what the manager is accountable for and thereby affects the manager’s
behaviour.
Refer back to the Noble Restaurant. What is the appropriate responsibility centre?
The restaurant manager has influence over revenue generated and cost incurred,
hence should be designated a profit centre as this will bring about the right
behavior, as outline below.
Behaviour
Cost centre The manager will focus only on Wrong behaviour
cost control, ignoring revenue
generation.
Revenue Centre The manager will focus only on Wrong behaviour
revenue generation, ignoring
cost control.
Profit Centre The manager will focus on Right behaviour
revenue generation and cost
control as this will maxmise 312
profit
The type of responsibility centre also depends on the organisational structure.
1) Functional work units. Functional work units focus of work unit is on a

specific function such as marketing, production, finance.
Such work units are either cost centres or revenue centres
2) Business (Market-based) work units. The Focus of business work unit is a

specific market as defined by either geography, customer or product
Such work units are either profit centres or investment centres as they
operate autonomously with minimal interference by head-office.
Refer to the above chart and designate the departments as appropriate

responsibility centres.
Department (work unit) Responsibility Centres

Operations
Marketing
R&D
Sales
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Example: Business work units
Refer to the above chart and designate the divisions as appropriate responsibility
centres.
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Choice of types of responsibility centres depends on:
• size of organisation
• nature of organisation
• organisational structure.
Functional work units tend to be cost or revenue centres, for example production
and sales departments.
Business (market-based) work units tend to be profit or investment centres
The basic principle in responsibility accounting is that a manager should only be

held responsible for factors that are within his control. A manager cannot be held
responsible for cost or revenue that he cannot control.
The most important thing to remember is that responsibility should

be assigned only when there is controllability.
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Homework Questions - Lecture 16
Question 1
Whitewater Promotions Ltd organises trade exhibitions around the UK. It
concentrates on medium sized cities and uses medium sized exhibition facilities.
Typically, a location provides 1,000 square metres of ‘stand’ space which

Whitewater offers to exhibitors as ‘small’ stands of 4 square metres or ‘large’
stands of 6 square metres. Companies needing even larger stands can take up
multiples of either. For a normal two day exhibition the list price for 2009 is
£1,000 for a small stand and £1,400 for a large stand. Discounts are offered to
companies which book early, or take larger stands. If an exhibition runs for 3 or 4
days a pro-rata daily rate applies.
Each location provides the exhibition hall, heating and lighting, cleaning, car
parking catering facilities, etc. Whitewater handles planning, advertising,
publicity, exhibition preparation, liaison with exhibitors and the running of the
exhibition.
Whitewater plan to run one 2-day exhibition each week. From January 1st 2009
the management is establishing a budgeting system for the exhibition activities.
Shown below is the standard revenue and cost sheet for a 2 day exhibition:
Whitewater Promotions - Standard per Two Day Exhibition
Per Exhibition
Revenue £ £
Small (4 sq metres) stands
100 x £1,000 x 0.90 x 0.85 76,500
Large (6 sq metres) stands
100 x £1,400 x 0.90 x 0.85 107,100
Standard Revenue 183,600
Direct Exhibition Costs

Hall hire 65,000
Advertising and publicity
Directed at exhibitors 50,000
Directed at visitors 50,000
Set-up and dismantling
10 x 3 x £130 3,900
Exhibition administration
8 x 2 x £140 2,240
Standard Operating Costs 171,140
Contribution to Head Office Expenses 12,460
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The above standard is prepared using the following assumptions:
• Whitewater will be able to let 90% of the available stand space and early
booking discounts, etc. will be 15% of the full list price.
• There will be an equal number of large and small stands.
• Hall hire will average £32,500 per day.
• Advertising directed at exhibitors is incurred for each exhibition and is
not dependent on the length of the event. However advertising directed
at visitors varies with the number of days of each event.
• 10 freelance fitters and electricians take a total of 3 working days each to
set up the exhibition and dismantle the stands after the event. They are
paid £100 each per day and their travelling, subsistence, etc. averages
£30 each per day.
• While the exhibition is running Whitewater provides an organiser’s office
to monitor admissions, etc. This requires 8 staff each paid an average of
£80 for each day of the exhibition. Since several exhibitions are open in
the evening, travelling, subsistence and hotel expenses average £60
each per day.
• Whitewater’s Head Office budget for 2009 is £360,000.
Whitewater is now embarking on a detailed analysis of the most recent quarter’s

(January - March 2009) activities. During that quarter it actually ran eight 2-day
exhibitions, plus one of 3 days and one of 4 days. The analysis reveals:
• Income was £2,142,000 made up of 2,100 exhibition days of small stalls

at an average price of £450 and 1,900 exhibition days of large stalls at
an average price of £630;
• Direct exhibition expenditure was:
- Hall hire £735,000
- Advertising and publicity aimed at exhibitors
- £530,000 -Advertising and publicity aimed at visitors
- £610,000 -Set up and dismantling £45,900 (270 man days at £170)
- Exhibition administration £27,200 (170 man days at £160)
• Head Office expenses for the quarter amounted to £93,000
Required:
(a) Prepare a table (down to company operating profit) showing:
i. A budget for the quarter based on the original planned activity.

ii. A flexed budget based on the actual activity of the quarter.
iii. The actual income and expenditure for the period. (10 marks)
(b) Provide an analysis of all possible variances and show a reconciliation of

the original budgeted profit with the actual profit for the period. (10 marks)
(c) Discuss the significance of the variances you have calculated. What further
information would be useful and are there any further variances which could be
calculated?
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(5 marks) – UOL adapted Zone B 2009 Question 3
Question 2
A Charity is extending its budgetary control and responsibility accounting systems
to all departments. One such department concerned with public health and welfare
is called “Elderly”. The department consists of staff who visit elderly “clients” in
their homes to support them with their basic medical and welfare needs.
A monthly cost control report is to be sent to the department manager, a copy of

which is also passed to the Director who controls a number of departments. In the
system, which is still being refined, the budget was set by the Director and the
manager had not been consulted over the budget or the use of the monthly control
report.
Shown below is the first months’ cost control report for the Homecare department.
Cost Control Report - Elderly Department
Month ending May 2012
Budget Actual (Overspend)/Und

erspend
Visits 10,000 12,000 (2,000)
£ £ £
Department
expenses:
Supervisory 2,000 2,125 (125)
salary
Wages 2,700 2,400 300
(Permanent staff)
Wages (casual 1,500 2,500 (1,000)
staff)
Office equipment 500 750 (250)
depreciation
Repairs 200 20 180
Travel expenses 1,500 1,800 (300)
Consumables 4,000 6,000 (2,000)
Administration 1,000 1,200 (200)
and telephone
Allocated 2,000 3,000 (1,000)
administrative
costs
15,400 19,795 (4,395)
In addition to the manager and permanent members of staff, appropriately qualified

casual staff are appointed on a week to week basis to cope with fluctuations in
demand. Staff use their own transport and travel expenses are reimbursed. There
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is a central administration overhead charge over all departments. Consumables
consist of materials which are used by staff to care for clients. Administration and
telephone costs are costs of keeping in touch with the staff who often operate from
their own homes.
As a result of the report, the Director sent a memo to the manager of the Elderly
department pointing out that the department must spend within its funding
allocation and that any spending more than 5% above budget on any item would
not be tolerated. The Director refused an immediate explanation for the serious
overspend.
You work as the assistant to the Directorate Management Accountant. On seeing

the way the budget system was developing he made a note of points he would
wish to discuss and develop further, but was called away before these could be
completed.
Required:
Develop and explain the issues concerning the budgetary control and
responsibility accounting system which are likely to be raised by the
management accountant. You should refer to the way the budget was prepared,
the implications of a 20% increase in the number of visits, the extent of
controllability of costs, the implications of the funding allocation, social aspects
and any other points you think appropriate. You may include numerical
illustrations and comment on specific costs, but you are not required to produce
the cost control report.
Question 3
(a) Draw a diagram to show the separate budgets necessary to produce
complete operating budgets and financial budgets for a manufacturing
organisation. You should indicate the inter-relationships between budgets, where
appropriate. (10 marks)
(b) In relation to the use of variance analysis in responsibility accounting, briefly

explain the following:
i. Controllable and uncontrollable variances and how these can be identified;
ii. Performance measurement using variances;
iii. Organisational learning using variances. (15 marks)
(UOL adapted 2010 Zone B Question 6, 25 marks)
Question 4
Explain how the choice of the type of responsibility centre affects behavior.
The End- Lecture 16
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Management Accounting
Lecture Notes
Lecture 17 & 18
Topics Covered
Standard Costing Variances
Readings: Horngren Chapters 16 & 17
Lecture 17 & 18
These lectures are on standard costing variance analysis.
The first part is a review of standard costing variances as done in POA as its
important to be familiar with the basic variances before being able to understand
the advanced variances.
The part on advanced variances is more important for the exam as it is

frequently tested in the exam. Pay attention to the techniques used to compute
the variances.
320
Standard Costing Defined
A standard cost is a predetermined calculation of how much cost should be

under specified working conditions. It is a planned cost or budgeted cost
expressed on a per unit basis. Standard cost is a target cost that should be
attained.
Purpose:
1) Act as a control device

The main purpose of standard costing is cost control. Variances highlight the
deviations from targets so that corrective action can be taken.
2) Motivate employees to achieve set standards which act as targets.
3) In manufacturing companies, standard costing may be used for valuing

ending inventory and cost of sales account.
4) Standard cost could be used in the development of budgets. Standard costs

are in effect the building blocks of periodic budgets.
5) Standard costs are predicted future cost which can be used to support
decision making, for example, in making pricing decisions.
Generally, standard cost system not
Usefulness of Standard Costing Systems useful for service industries
Standard Costing systems are the most useful in mass production (for example
process costing) or repetitive assembly line work and less suited for specific
order costing environment such as job costing.
Standards Versus Budgets
Both concern setting expected performance level for control purpose.
Differences:
1) Standard is unit concept, applied to a product or to individual operations.
2) Budget is a total concept applied to department or to the company.
3) Standard cost used for developing budgets
4) Budgets are revised on an annual basis whereas standards only revised as

appropriate.
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Flexible Budget Variances
A variance is the difference between the budgeted amount and the actual
amounts.
When computing cost variance, it is essential that flexible budgets are

compared to the actual amounts to determine variances for control purposes
as the flexible budget represents that amount of resources that should have
been used for the actual production level.
Variance formula
Source: UOL Management Accounting AC 2097 Subject Guide 2017
Note: SQ is standard quantity (hours) for actual production.
Quantity refers to the usage of materials or labour hours.
322
This illustration is a review of the basic variance analysis that
was done for POA.
It is important to understand the basic variance computation
Lecture Illustration before proceeding to the advanced variance analysis.
Bench Ltd makes quality wooden benches for both indoor and outdoor use.
The standards set for the last month were as follows:
Production & Sales 4,000 units

Selling Price 220 per unit
Wood 25 Kg per unit at £3.20 per Kg
Labour 4 hours per unit at £8 per hour
Variable Overheads 4 hours per unit at £4 per hour
Fixed overheads 4 hours per unit at £16 per hour
Overheads are absorbed using labour hours and the company uses an
absorption costing system. There were no inventory at the beginning of the
month. Inventory is valued at standard cost.
Actual results for the month were as follows:
Wood 80,000 Kg @ £3.50 £280,000

Labour 18,000 hours @ £7 126,000
Variable Overheads 60,000
Fixed Overheads 196,000
Total Production Cost (3,600 benches) 662,000
Closing Stocks (400 benches £192) 76,800
Cost of sales 585,000
Sales (3,200 benches) 720,000
Actual profit 134,800
Required:
Calculate all possible variances and reconcile the actual profit with the
budgeted profit using absorption costing.
Note:
There are many methods to compute these variances and
you can use any method as long as you show your working
and get the right answers.
323
Cost Variance
D. Material
Price Variance =
Usage Variance
SQ for Actual Production units
= SQ per Unit X Actual Production Unit
Usage Variance =
D. Labour
Rate (Price) Variance =
Efficiency Variance
SQ for actual production units =
Efficiency Variance =
Variable Overhead
Price (Spending) Variance
=
=
=
Efficiency Variance
=
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Fixed Overhead
Spending Variance
Efficiency Variance
Capacity Variance
Interpretation
AQ hrs > BQ hrs = F
AQ hrs < BQ hrs = A
Fixed Overhead Volume Variance = Efficiency Variance + Capacity

Variance
=
Sales Variance
Price Variance =
AC Volume Var =
MC Volume Var =
Difference between Absorption costing and Marginal costing for variance

analysis:
The two difference between the Absorption costing (AC) and Marginal
costing (MC) approach are:
1) MC does not involve the absorption of fixed production overheads
into products, hence there is no capacity and efficiency variance,
only spending variance for fixed overhead.
2) The sales volume variance is computed using gross profit margin

for AC. MC uses the contribution margin instead.
325
Reconciliation of Budgeted Profit and Actual Profit (Absorption costing)
£ £
Budgeted Profit (Fixed Budget)
4,000 units @£28 per unit 112,000
Add (Less): Sales Variance
Price Variance 16,000(F)

Volume Variance (AC) 22,400(A)
Total sales variance (6,400) (A)
Profit before cost variance 105,600
Production Cost Variance
Direct Material variance

Price Variance 24,000(A)
Usage Variance 32,000(F)
Total Direct Material variance 8,000 (F)
Direct Labour variance

Rate Variance 18,000(F)
Efficiency Variance 28,800(A)
Total Direct Labour variance (10,800) (A)
Variable Overhead
Spending Variance 12,000(F)
Total Variable overhead variance (2,400) (A)
Fixed Overhead
Spending Variance 60,000(F)
Capacity Variance 32,000(F)
Total Fixed overhead variance 34,400 (F)
Actual Profit 134,800
Reconciliation (Rule)
(F) Var = Add
(A) Var = Deduct
Responsibility for variances:
Since a variance represents a deviation from the plan, responsibility

must be assigned for them to the respective managers so that their
performance can be evaluated.
Manager responsible
Sales Variance Sales manager
Production variance Production manager
Material Price variance Purchasing manager
326
Exam Tip
Advanced Variance Analysis This area on advance variance are most likely to
Material Usage Variance be tested in the exam.
Material usage variance equals:
(Standard usage for actual production Less Actual Usage) X Standard Price per Kg
The material usage variance can be subdivided into a material mix variance
and a material yield variance when more than one material used in the
production process.
Note the mix and yield variance only
relevant when more than one type
DIRECT MATERIAL USAGE VARIANCE of materials are used in the
production process. One material
used, no mix and yield variance.
Mix Variance Yield Variance
A mix variance occurs when the actual mix differs from the standard mix.
A yield variance is the difference between the standard usage that should
have been used for the output achieved and the actual usage.
A feature of such processes is the existence of process losses through for

example evaporation (normal loss) which affects the yield from the process.
Formulas Over the years I have used many methods of expressing

these variances but this methods is by far the most
Mix Variance = intuitive and most time efficient.
(Standard cost per unit@ standard mix Less Standard cost per unit@ actual mix) X Actual
Total Usage
Yield Variance =
(Actual total Usage Less Standard Total Usage) X Standard cost per unit@ standard mix
Question
Which the 2 process have a better yield?
Process 1 Process 2
Total Input 110KG 150KG
Total output 100KG 100KG
Answer:_________________________________________________
________________________________________________________
________________________________________________________
327
A fertilizer is made by mixing and processing three ingredients, P, N & Q. The

standard cost data are as follows:
Note: If as a production manager
Ingredients Standard Mix Standard Cost you are allowed to substitute
P 50% $20 per tonne materials, which material would
N 40% $25 per tonne you rather use more?
Q 10% $42 per tonne Answer:____________________
___________________________
A standard process loss of 5% is anticipated. _____________
In the period, the actual output was 93.1 tonnes and the inputs were as follows:
Ingredients Actual Usage Actual price Actual cost $

P 49 tonnes $16 per tonne 784
N 43 tonnes $27 per tonne 1,161
Q 8 tonnes $48 per tonne 384
Total 100 tonnes Total 2,329
Required:
Calculate the mix and yield variances for direct material and the total direct
material usage variance.
328
Answer:
Ingredients Standard Mix Actual Mix % Standard Cost

P 50% 49/100 =49% $20 per tonne
N 40% 43/100 = 43% $25 per tonne
Q 10% 8/10 =8% $42 per tonne
Mix Variance
Step 1 Compute the two average standard cost
a) Average Standard cost per tonne@ standard mix =
______________________________________________________________
b) Average Standard cost per tonne@ actual mix =
Step 2 Identify the actual total usage
Answer:_______________________________________________________
Step 3 Compute the mix variance using the formula above
Mix Variance =
______________________________________________________________
Note:
Variance
1)Standard cost per tonne @actual mix < Standard cost per tonne @standard mix (F)
2)Standard cost per tonne @actual mix > Standard cost per tonne @standard mix (A)
Logic of the above is that the objective is to lower actual direct

material cost compared to the standard cost and this is achieved
when the actual mix results in a lower actual average cost per unit
compared to the standard average cost per unit.
329
Yield variance
Step 1 Compute the Standard Total Usage:

Standard total usage for actual production output (93.1 tonnes)
Actual yield = 93.1 tonnes or 93.1%
Standard yield = 100 – 5% = 95 %
Standard total usage = 100%

This figure represents what you should have used to produce the actual
output of 93.1 tonnes
Therefore, use the % above to compute the tonnes you should have
used to produce 93.1 tonnes of output
95% = 93.1 tonnes
Standard total usage 100% =
Standard Total usage

!""
= #$%&'%(' *+,-' " #$%&'( %)%'( )&%*&% Memorise this for exam
Standard yield = 100 Less standard loss
Step 2 identify the actual total usage
Answer:____________________________________________________
Step 3 Compute the yield using the formula above
Yield Variance =
__________________________________________________________
Note:
Variance Note:
1)Actual Total Usage < Standard total usage (F) If use less total material compared
to standard = Good(F)
2)Actual Total Usage > Standard total usage (A) Use more total material compared to
standard = No good(A)
Total direct Material usage variance = Mix V + Yield V

=______________________________
330
This can be confirmed as correct by computing the sum individual usage
variance for the three ingredients.
Usage Variance = (SQ – AQ) X SP
P = (49 tonnes – 49 tonnes ) X @20 = $0 (F)
N = (39.2 tonnes – 43 tonnes ) X @25 = $95(A)
Q = (9.8 tonnes – 8 tonnes ) X @42 = $76(F)

Total usage variance = $19(A)
Note : SQ= Standard usage for actual production @ standard mix
P = 98 tonnes X 0.5 = 49 tonnes
N = 98 tonnes X 0.4 = 39.2 tonnes
Q = 98 tonnes X 0.1 = 9.8 tonnes
Note: You don’t need to do this in exam, just add Mix + Yield = Usage
variance
331
Interpretation of the above variances:
Why is the mix variance favourable?
Because the average standard cost per tonne at actual mix ($23.91) lower
than the average standard cost per tonne at standard mix ($24.20).
Since the average standard cost per tonne at actual mix is lower
compared to average standard cost per tonne at standard mix, it implies
that proportionately more of the cheaper material P & N were used (92%)
in the actual production process as compared to only 90%( standard mix)
that was supposed to be used in the standard production process.
Why is the yield variance adverse?
1)Well, that is obvious as the actual loss was higher than the standard
loss.
If the actual loss is higher, it also implies that the actual yield was lower.
The actual yield was 93.1% whereas the standard yield should be higher
at 95%. (100 – 5% Loss)
Actual Loss = 6.9 tonnes/ 100 tonnes = 6.9%

Actual yield = 93.1/100 tonnes = 93.1%
2) The yield is interpreted as the relationship between input and output.
Favourable variance arises when you use less total material input
(compared to the standard input) to produce the actual output.
Adverse variance arises when you use more total material input
(compared to the standard input) to produce the actual output.
Hence the yield variance is adverse as you used a total 100 tonnes
instead of 98 tonnes to produce the actual total output of 93.1 tonnes.
332
Best Cakes make cakes, which are sold directly to the public. The new
production manager wants to use only high quality materials in cake production.
In the month just ended, the following data was extracted:
Standard cost card for one cake (not adjusted for the high quality ingredients
change)
Ingredients Kg $
Flour 0·10 0.12 per
kg
Eggs 0·10 0·70 per
kg
Butter 0·10 1·70 per
kg
Sugar 0·10 0·50 per
kg
Total input 0·40
Normal loss (10%) (0·04)
Standard weight of a cake 0·36
Standard sales price of a cake 0·85
Standard contribution per cake after all variable 0·35
costs
The budget for production and sales in April was 50,000 cakes. Actual
production and sales was 60,000 cakes in the month, during which the following
occurred:
Ingredients Kg $
Flour 5,700 $741
Eggs 6,600 $5,610
Butter 6,600 $11,880
Sugar 4,578 $2,747
Total input 23,478 $20,978
Actual loss (1,878)
Actual output of cake mixture 21,600
Actual sales price of a cake $0.99
All cakes produced must weigh 0·36 kg as this is what is advertised.
Required:
Calculate the material usage, mix and yield variances.
333
Answer:
Mix Variance
Step 1 Compute the two average standard cost
a) Average Standard cost per kg @standard mix =
______________________________________________________________
b) Average Standard cost per kg @actual mix =
Step 2 Identify the actual total usage
Answer:_______________________________________________________
Mix Variance =
______________________________________________________________
Yield Variance
Step 1 Compute the Standard Total Usage:
Standard total usage for actual production output (93.1 tonnes)
Standard Total usage

!""
= #$%&'%(' *+,-' " #$%&'( %)%'( )&%*&%
Step 2 identify the actual total usage
Answer:____________________________________________________
Step 3 Compute the yield using the formula above
Yield Variance =
__________________________________________________________
Total direct Material usage variance = Mix V + Yield V

=______________________________
334
Interrelationship between the mix, yield variance and other variances
A change in the mix of materials, for example using relatively cheaper materials
may cause adverse yield variance as actual losses may increase due to the
cheaper (lower quality) material used.
Also, using cheaper materials may compromise the overall quality of the
product, thus having an adverse effect on sales variances. This will have
implications on the performance of the sales manager, even though the
decision to use cheaper material was taken (controllable) by the production
manager.
Sales Mix & Quantity Variance
Sales Margin Volume Variance equals
(Budgeted sales units Less Actual sales units) X Standard margin per unit
The sales margin volume variance can be subdivided into a mix variance and
a quantity variance where multiple products are sold.
Sales Margin Volume Variance
Sales Mix Variance Sales Quantity Variance
Sales Mix Variance
Indicates the effect on budgeted profit of changing the mix of actual sales from
the standard mix.
Sales Margin Quantity Variance
Indicates the effect on budgeted profits of selling a different total quantity

compared to the budgeted total quantity.
335
Formulas:
Mix Variance =
(Standard margin per unit@ standard mix Less Standard margin per unit@ actual mix) X
Actual total units sold
Note:
Variance
1)Standard margin per unit @actual mix < Standard margin per unit @standard mix (A)
2)Standard margin per unit @actual mix > Standard margin per unit@ standard mix (F)
Logic of the above is that the objective is increase total actual

sales volume compared to budgeted sales volume and this is
achieved when the actual mix results in higher actual average
standard margin per unit compared to the standard margin per
unit.
336
Quantity Variance =
(Actual total units sold Less Budgeted Total Usage sold) X Standard margin per unit@
standard mix
Note:
Variance Logic:
1)Actual total units sold < Budgeted total units (A) If sell more compared to budget =
Good (F)
2)Actual total units sold > Standard total units (F) If sell less more compared to budget
= No good (A)
337
A company makes 3 different products W, X, Y . During the period the budgeted

and actual results are as follows:
Budgeted
Product Volume Price Margin Total Margin

W 500 10 2 1,000
X 300 15 3 900
Y 200 20 4 800
Total 1,000 2,700
Actual
Product Volume Price Margin Total Margin

W 550 10 2 1,100
X 250 16 4 1,000
Y 100 19 3 300
Total 900 2,400
Calculate the relevant sales mix and quantity variance.
338
Answer:
Mix Variance
Step 1 Compute the two average standard margin
a) Average standard margin per unit @standard mix =
______________________________________________________________
b) Average standard margin per unit @actual mix =
Step 2 Identify the actual total unit sold
Answer:_______________________________________________________
Mix Variance =
______________________________________________________________
Quantity Variance
Step 1 Identify the actual total quantity and the budgeted total
Quantity sold
Actual total quantity =
Budgeted total quantity =
Step 2 Compute the quantity variance using the formula above
Quantity variance =
__________________________________________________________
Total sales volume variance = Mix V + Quantity V

=______________________________
339
A company makes 2 different products A and B. During the period the budgeted
and actual results are as follows:
Budgeted
Product Volume Margin

W 100 20
X 400 2
Actual
Product Volume Margin
W 50 21
X 550 2.50
Calculate the sales volume variance including the mix and quantity variance
340
Recall that the basic principle in responsibility accounting is that a manager
cannot be held responsible for any activity that he/she cannot control.
Hence, if a variance is due to uncontrollable factors, he/she cannot be held
responsible for that variance.
Planning Versus Operational Variances
In line with responsibility accounting, the total variance may be subdivided into
planning and operational variance to account for any uncontrollable factors.
Planning variance compares the original standard with the revised standard
that should have been used if planners had known in advance what was going
to happen.
Planning variance are caused mainly by unforeseen changes for example

increases in cost(inflation) that were not anticipated when the original standards
were developed.
They are uncontrollable by operational managers and therefore should not be

used to evaluate the performance of operational managers.
An operational variance compares the actual result with the revised, more
realistic standards. These variances are controllable and therefore can be used
to evaluate performance.
Computing Material & Labour planning/operational variance
Price Planning variance = (Revised price – Std Price) X Actual Units
Price Operation variance = (Actual Price- Revised Price) X Actual Units
Usage Planning Variance= (Revised Usage – Std Usage) X Std Price
Usage Operation Variance= (Actual Usage – Revised Usage) X Std Price
Planning and operational variance- Summary
Planning V = Revised Less Standard Not controllable No responsibility assigned
Operational V = Actual Less Revised Controllable Responsibility assigned
341
The following relates to Shea Company for April when 2000 units of Ceramics
were produced.
Standards: 2 KG per unit of output at $15.00 per KG

3 hours per unit at $10 per hour
Actual Direct Materials used 4,400 KG for total cost of $72,600. During the
period, the world prices of the material increased to $16.00.
It was also subsequently discovered that the standard allowance for material at
2 kg per unit did not incorporate a normal loss allowance of 10%.
It was subsequently discovered that the standard allowance for labour at 3

hours per unit did not incorporate an idle loss allowance of 5%.
Actual direct labour hours used was 5,500 hours for a total cost of $60,500. It
was also subsequently discovered that 300 hours used was due to equipment
malfunction that was beyond the control of the production manager.
Required: Calculate material and labour variances and show the

breakdown between the planning and operational variance.
Note:
1) The increase of world prices to $16 would therefore make the
standard cost of $15 per kg no longer realistic, hence the
benchmark price to compute controllable variance should be
$16, not $15.
2) The material loss allowance & idle time allowance should have
been incorporated into the original standard cost to make the
standard cost more realistic and these are also not controllable
by the production manager.
342
D. Material
Actual Direct material Price Variance =

=
Price Planning =
Price Operational =
Actual Material Price Variance =
Actual Material Usage Variance
343
Actual Labour Usage Variance
SQ for actual production =
344
Computing sales planning & operational variance
Price Planning variance = (Revised price – Std Price) X Actual Units
Price Operation variance = (Actual Price- Revised Price) X Actual Units
Volume Planning Variance= (Revised volume – Std volume) X Std margin
Volume Operation Variance= (Actual volume – Revised volume) X Std margin
The following budgeted data for a particular period was available for a
company selling two products:
Sales price Variable cost Sales volume
per unit per unit in units
Product A $24 $8 15,840
Product B $24 $11 10,560
The actual results for the period were as follows:
Sales price Variable cost Sales volume
per unit per unit in units
Product A $22 $8 14,200
Product B $26 $11 12,500
For product A, with the benefit of hindsight, is was realised that the budgeted
sales price of $24 per unit was hopelessly optimistic and a price of $21 was
more realistic.
For product B, it was discovered that the market size had unexpected
increased by 10% and in hindsight, this fact should have been incorporated
into the budget.
Required:
a) Compute the sales price variance for product A and show the
b) Compute the sales volume variance for product B and show the
Notes:
1) The budgeted price of $24 is therefore not realistic and hence
responsibility assigned only to achieve the price of $21.
2) The market size increase of 10% is due to changes in the

market place, not controllable by the sales manager but is also
means that he/she should be able to sell 10% more.
345
Product A
Actual Price Variance =
Price Planning Variance =
Price Operational Variance =
Planning + Operation = Actual price Variance
+ = $
Product B
Actual Sales Volume Variance
Planning + Operational = Actual sales volume variance
346
Factor to consider in decision to investigate variances
Investigation of variances:
The decision to investigate variances will depend the following factors:
These include:
1) The materiality and the trend of the variance.
Large amount of variance are generally more serious and should be

investigated. Both material favourable & unfavourable variance should
be investigated. Because standard cost are only estimates of average
cost it would be incorrect to treat them as rigid. Tolerance limits should
be set and only variances which exceed a control limit should be
reported as significant and investigated.
Ways to establish control limit:

Management may establish a rule that any variance should be deemed
significant if it exceed a certain percentage of standard. For example,
variance of 10 % or more of standard maybe considered material.
2) Benefit versus cost of investigation

Variance should be investigated only if the benefit exceeds the cost of
the investigation.
3) Controllable or non controllable variance

A controllable (operational) variance is more serious as it has impact
on performance. If the cause of the variance is controllable, action can
be taken to correct the variance in the future.
Uncontrollable variance may require a revision to the standard cost or

be classified as planning variance.
Why do we need to investigate favourable variance also?
Because sometimes variances are favourable but for the wrong reasons.
For example, the material price variance is favourable due to the fact that
the purchasing manager, in order to enhance his own performance
purchased a lower grade of material at a price lower than the standard
price. Even though this will result in some saving buying the materials, the
lower grade materials may cause adverse material usage and adverse
labour efficiency variance as follows:
$
Direct material price variance 100,000 (F)
Problem:
Direct material usage variance 200,000 (A)
Labour efficiency variance 50,000 (A)
Net Loss of profit 150,000___
Hence, the saving from buying the lower grade material resulted in loss of
profit overall.
347
Homework Questions Lecture 17 & 18
Short answer questions
Q1
The standard variable production overhead cost of product is as follows:
4 hours at £1.50 per hour
During the period the production of product Z amounted to 400 units. The
labour force worked 1,600 hours, of which 30 hours were recorded as idle
time. The variable overhead cost incurred was £2,500.
Required:
a) What is the variable overhead expenditure variance?
b) What is the variable overhead efficiency variance?
Q2
A company manufactures a number of products and here is the information:
Budgeted Actual
Sales 25,500 units @ £20 each 24,000 units @ £18 each
Production: 26,000 units 25,000 units
Direct materials 3 kg @ £2 per kg 3.5 kg @ £1.5 per kg
Direct labour 5 hrs @ £1 per hour 4.5 hrs @ £1.5 per hour
Fixed production overhead £104,000 £110,000
Absorbed at direct labour hour
Required
(a) Calculate the selling price variance.
(b) Calculate the direct material price variance.
(c) Calculate the direct labour efficiency variance.
(d) Calculate the fixed production overhead volume variance.
(e) Give two explanations for the direct labour efficiency variance calculated in part
(c).
348
Question 1
Standard costs and objectives
(a) Outline the uses of standard costing and discuss the reasons why standards
have to be reviewed.
(b) Standard costs are a detailed financial expression of organisational

objectives. What non-financial objectives might organisations have?
Question 2
Discuss the issues to be considered when setting standard product costs.
Explain the ways in which standards may be affected by changes in
technology. (10 marks)
(UOL adapted 2008 Zone A Question 6a)
Question 3
Williams Soft Drinks Ltd is a small company manufacturing high energy drinks
which are sold to retailers in cases of 100 bottles. The production operates on
a Just In Time system. The company installed a standard absorption costing
system in May 2008.
The standard cost per case was set as follows:

Per case £ £
Standard selling price 30.00
Materials – ingredients 5Kg @ £2 (variable) 10.00

Labour – 0.2 hours x £8 (variable) 1.60
Fixed overhead allocated based on 8,000 labour hours* 5.00 16.60
Standard profit 13.40
*Budgeted monthly fixed overheads were:

Factory £170,000
Advertising and selling £ 30,000
The performance report for May 2008 has been produced and is being
discussed by the executives:
May 2008 variance report Favourable Adverse

Sales volume variance 13,400
Materials price variance 6,200
Labour efficiency variance 800
Labour rate variance 395
Fixed overhead variances
Expenditure 2,000
Capacity 5,000
Total variances 27,795
349
The following observations are made:
Managing Director
‘What’s the point of a fixed overhead capacity variance? The overheads are
fixed aren’t they? By the way what were the actual results?’
Sales Manager
‘We were badly hit in the final week of this month by a promotion from our
largest competitor. They reduced prices by 20% just for that one week. We
responded with additional point of sale advertising costing an extra £2,000 but
it obviously was not enough. Industry sales were down by 8%.
In the first week, factory machine faults led to slower production, so the
factory provided us with 500 less cases than were budgeted.’
Purchasing Manager
‘The materials price variance is the result of a tax increase of 5%. I managed
to prevent our supplying company from passing on the whole increase
because we are their best customer. I negotiated it down to a 2% increase.
Anyway I don’t think I should be judged on such a tight standard.’
Production Manager
‘I had to pay the employees for the hours they waited while machine faults
were being repaired by the manufacturers.
I don’t know why there is a labour rate variance, we paid employees the
£8.05 per hour which was negotiated on 1st May.
I am sure I didn’t spend more than the budgeted overheads.’
Required:
(a) Calculate the budgeted and actual results for May 2008 and present them
as a profit and loss statement. (8 marks)
(b) Explain how the fixed overhead capacity variance should be interpreted.
(4 marks)
(c) Calculate the financial impact of the reasons given by the sales,
purchasing and production managers and provide a more informed report for
the executives, showing which variances have been explained by their
comments and indicating the unexplained variances. (13 marks)
(UOL adapted 2008 Zone B Question 3, 25 Marks)
THE END – Lecture 17 & 18
350
Management
Accounting
Lecture Notes
Lecture 19
Topics Covered
Divisional Performance Measurement

Lecture 19
This lecture is on the measuring the performance of decentralised division

that are considered in investment centres.
Questions from this lecture can appear in both Section A and B of the
exam. The computation questions in Section A for this lecture are fairly
easy to do in the exam.
Important financial performance measures such as ROI, Residual Income

and EVA are discussed here and you need to understand the limitations of
these financial performance measures as discussed on page
351
Each division is
operating
autonomously as if
the division is a mini
business itself.
Hence decision
making becomes
decentralised and
division managers
will make decisions
about the operations
of the division.
This becomes a
problem if the division
manager do what’s
good for the division
but bad for the
company as
managers tend to act
in self-interest.
Divisions as profit or investment centres
In a divisionalised organisational structure, the company is split into divisions.
Where the division manager cannot control the investment and is only
responsible for profits obtained from operating the assets assigned to the
division, then that division is a profit centre.
Where the divisional manager is responsible for profits and making capital
investment decisions, then that division is an investment centre, given
responsibility to maximise the Return on Investment.
352
Who will be better able to customize a burger to suit the local taste buds in
Singapore, an American manager located in the USA or the local
Singapore manager?_____________________
___________________________________________________________
_____________________________
Advantages of Division (decentralised) organisational Structures
1. Creates greater responsiveness to local needs and knowledge.
Given that subunits managers have access to more information and

their access is quicker; they will be better able to respond to the needs
of local customers better.
2. Leads to better & quicker decision-making.

Decisions do not need to be referred to head office which enables the
division to respond quickly to local conditions.
3. Increases motivation.
Allowing sub-units managers to exercise initiative is motivational to
them.
4. Aids management development and learning & sharpens the focus of

sun-unit managers
Giving managers more responsibility promotes the development of an

experienced pool of management talent, a pool that the organisation
can draw from to fill higher level management positions.
5. Sub-unit managers can take advantage of local knowledge and local

training can be done.
Disadvantages of division (decentralised) organisational structures
1) Leads to potential sub-optimal decision making whereby the

division managers act in their own self-interest instead of the
interest of the company overall. Division manager will be interested to get the
maximum bonus which depend on division
performance
2) Results in duplication of effort.
Division managers may duplicate efforts in activities such as
research and development leading to unhealthy competition instead
of co-operation.
3) Decreases loyalty towards the organisation as a whole.
353
Different Performance Measures of Divisions
Distinguising the performance of the overall division and performance of

a division manager.
The purpose of the performance measure must distinguish between the overall
performance of a division as an economic unit and the performance of an
individual divisional manager.
These two measures may be quite different.
For example a good manager may be assign to an ailing division to improve its
performance.
The ailing division may still be unprofitable because of industry factors such as
declining demand which is beyond the control of the division manager
personally.
Hence, even though the future of the division as an economic unit is uncertain,
the division manager may still be promoted as a result of personal outstanding
performance.
Factors to be considered in designing financial performance measures

for evaluating the performance of a divisional manager
To evaluate the performance of a division manager, only those items

controllable by the manager should be included in the performance measure.
Hence, allocation of central (HQ) services cost that are not controllable by the
division manager should not be included in the computation of division profit.
354
1) Return on investment (ROI) is the most popular performance measure.
Return on Investment = Controllable Profit Remember,

------------------------- Responsibility= Controllability
Controllable Investment(asset)
Why use ROI as a performance measure (PM)?

Assume the following
Division 1 Division 2
Net Profit $1 Million $10 million
Question: Which division has performed better?_________________________
Assume next Division 1 Division 2

Assets employed $ $
ROI
Conclusion:_____________________________________________________
______________________________________________________
______________________________________________________
To Maximise ROI:
1) Maximise sales
2) Minimise expenses
3) Minimise investment(assets)
Hence, if you can lower the assets used, you can also increase ROI,
without increasing profit.
355
Companies use a variety of definition profit and investment to compute ROI
Definition of Profit
PM = Performance measure
$
Controllable revenue x
Less controllable cost x
1. Controllable Profit x 1. PM of division manager(personal)
Less non-controllable avoidable costs x
2. Divisional Profit contribution x 2. PM of division as sub-unit
Less Allocated corporate expense x
3. Divisional Profit before taxes x 3. PM of division for comparison purpose
There are three alternative profit measures to evaluate the division managers
performance or the performance of the division as an economic unit.
These are:
1)Controllable Profit
Controllable Profit is the most appropriate measure of a divisional manager
personal performance as it represents the contribution made be the division
manager to HQ profit.
2) Divisional Profit contribution
This is a useful measure to measure the performance of the overall division

but not the performance of a division manager because it includes cost that
are not controllable by the division manager.
Divisional profit contribution represents the contribution that the overall

division is making to the overall corporate profit, hence a useful measure of
divisional performance.
3) Division profit before tax
This measure would include allocated corporate expenses such as legal and
consulting fees.
The allocation of the HQ expense is an approximation of the cost that the

division will incur if it was a separate, independent company.
Hence division profit before tax would be an appropriate measure when

comparing the economic performance of a division to the performance of
similar independent company in the same industry.
356
Definition of Investment (Assets)
Four common definition of investment include:
1) Total controllable assets available which includes all assets regardless

of their intended purposes
2) Total assets employed.

= Total assets available less idle assets +assets purchased for future
expansion
This may be an appropriate measure when HQ directs division

managers to carry idle assets. We deduct the idle assets to be fair to
the division manager as HQ made
3) Total asset available less current liabilities. decision to carry the idle assets
One negative measure of defining Investment this way is that it

encourages managers to use excessive current liability financing as
this reduces the asset amount and hence increase ROI.
Not right to use current liability such as bank
4) Shareholder’s equity
overdraft to finance purchase of non-current
assets.
Total assets may be measured using:
1) Historical cost
Historical-cost- based measures of ROI compute the asset base as the
original purchase cost at gross book value or at Net book value.
Gross book value is the original purchase cost before deduction of

accumulated depreciation whereas net book value is the purchase cost
less accumulated depreciation.
Use of historical cost is useful as it is a convenient source of

information as information is directly available from the company’s
financial statements.
2) Current cost
This represents the cost of purchasing the assets today.
Compared to historical cost ROI, current cost ROI better measures the
current economic return of the division.
However, it may be difficult to obtain the current cost of certain assets

as the financial statements only report historical cost.
357
ROI may be decomposed into its two components using the du-pont method
as follows:
Maximise Sales Minimise expense = Maximise Profit
ROI = Asset Turnover X Profit Margin
Sales Profit = Profit

--------------- X ---------------- ---------------
Assets Sales Investment
Note: Profit margin is also termed the Return on sales.

Advantage of ROI
a) Easy to understand and widely used in the business community to appraise
the performance of companies.
b) Ratio can be subdivided into a series of explanatory ratio using the du-pont
method for further analysis as stated above.
Disadvantages of ROI
a) The different measure of profit or investment involves elements of
subjectivity and lack of consistency. Also, the use of different measures will
impair the comparability of ROI across sub-units due to the lack of
consistency.
b) If historical cost accounting is used to measure the investment base,

managers will be reluctant to invest in new non-current assets as these will
reduce ROI in the early years due to cost of the new non-current assets
ROI = Profit/ Assets, hence higher asset amount will lower ROI.
But we want the division manager to invest in new, more efficient

non-current assets to increase productivity!
c) The ROI measure only focuses on performance in one year. Managers may
take actions which will improve short-term ROI but impair future performance.
This is particularly likely if a manager receives bonuses based on the annual
division ROI.
We want managers to increase profit by doing the right actions such as eliminating non-value added
activities.
We don’t want managers in increase profit by doing the wrong actions such as
1) Post-pone important Research and development and training
2) Decrease equipment maintenance
Why would a manager do 1) and 2)? Because doing these activities increases annual expense
and reduces the annual profit and hence annual ROI. This means lower bonus.
d) Managers may reject good investment opportunities that would improve the
company’s overall performance but will lower the ROI of the division leading
to sub-optimal decision.
This will be illustrated on page 357

358
A sub optimal decision is a decision taken that benefits the division but is not in
the best interest of the company overall.
Goal congruence exist where managers work to achieve the company’s goals.
Invest in Finance By
Assets = Liability + Equity
2) Residual Income (RI) ROI Cost of capital
Residual income = Profit ($) – (Required Rate of return X Investment($))
RI motivates managers to concentrate on maximising dollar profit rather

than a percentage (ROI).
Goal congruence (between managers and the company) is promoted

more with RI compared to ROI as a measure of division manager's
performance.
Why use RI as a performance measure (PM)?
Assume the following

Division 1 Division 2
ROI 20% 10%
Question: Which division has performed
better?_________________________
Assume next Division 1 Division 2
Cost of capital
Conclusion:________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
______________________________________________________
Areas where residual income is an improvement on ROI
______________________________________________________
Residual income uses the same figures as ROI for the computation of profit
and investment. Hence same disadvantages apply to RI as for ROI.
RI makes the cost of capital more visible compared to ROI. ROI tends to
ignore the cost of capital.
359
Residual Income also helps in resolving the problem of managers rejecting
new investment opportunities which have a return that would improve the
company’s overall profit but is lower than the ROI of the division as along as
the RI of a potential investment is positive, the RI of the division will also
increase.
The Bravo division of a company currently has capital employed of $100,000
and earns an annual profit $18,000. The divisional manager is considering an
investment of $10,000 in an asset that will earn a constant annual profit of
$1,600. The company’s cost of capital is 15%.
Calculate the following and comment on the results.
i. The return on divisional investment, before and after the new investment
ii. The divisional residual income before and after the new investment.
iii. Discuss the implication of using the above measures of performance on

the actions of the division managers.
(i)
New Investment ROI =
Therefore, division manager should accept the new investment

as the investment ROI of greater than the company’s
cost of capital of 15%.
Before After
Division ROI $18,000

$100,000
(ii)RI Before After

$ $
Profit
Less:Cost of capital
Residual income
360
New investment increases residual income by
iii) Implications
1) If ROI is used to evaluate the performance of the division
manager, the manager will reject the good investment even though
the ROI of 16% greater than the company’s cost of capital of 15%.
2) This is a sub-optimal decision because the manager is acting in the
interest of the division at the expense of the company leading to
dysfunctional behaviour (no goal congruence).
3) He rejects the good investment opportunity because he is
comparing the ROI of the investment of 16% to the existing division
ROI of 18%, instead of comparing it to the company’s cost of capital of
15%.
4) To prevent such dysfunctional behaviour associated with ROI, use
RI instead, because as long as the ROI of the new investment is
greater than cost of capital, the RI of the division will increase,
leading to acceptance of the good investment hence a goal
congruent decision.
361
Lecture Illustration 2
Smart Kitchens PLC is a divisionalised company making kitchen products. The

company has three divisions, Small electrical appliances Utensils and
Crockery. Each division makes products which are sold to many retail
companies.
Financial data for the three divisions for the year ended 31st March 2014 are
shown below:
Income statement for year ended 31 March 2014

Note turnover= sales
362
Exam tip:
Notice in this question that you are essentially repeating the same
calculation 4 times for easy marks. Hence, in the exam do the
computation fast.
Required:
(a) For each of the divisions and the company as a whole calculate:
I. Return on Investment using both divisional controllable net income

and divisional net income before tax.
II. Calculate the residual income for each division based on net income
after tax using an after-tax capital charge of 8%. (8 marks)
(b) Comment on the divisional performance shown in your results in (a)(4

marks).
UOL adapted 2014 Zone A Question 4
£’000
Appliance Utensils Crockery Company
ROI
Controllable 1,830 6,000 14,330

Net Income 5,850 9,500 35,550
31.3% 63.2% 40.3%
Income BF 1,365 4,550 10,565

Tax 5,850 9,500 35,550
23.3% 47.9% 29.72%
ii) RI £’000
Appliance Utensils Crockery Company
Profit after tax 887 2,958 6,867
Less:Cost of Capital
@8% (468) (760) (2,844)
RI +£419 +£2,198 +£4,023
363
b) Comments
1) Overall, Crockery division is the best performing division on both
performance measures.
2) Crockery RI is significantly higher than the other divisions even

though its asset base is smaller than the Appliance division.
3) Appliance and Utensil ROI is similar, but Appliance Residual

Income much higher at £1,406,000 compared to Utensil as it is a
Bigger division in terms of net assets.
4) However, using the turnover to allocate HQ cost is unfair to the

Appliance division whose sales are the highest, unless the benefit
provided by HQ is highly correlated with the turnover.
Exam Tip:
Note the presentation of the answer above. The ratios should be well
tabulated in columns so that you can analyse them quickly. This is the
expectation in the exam.
364
Note the 2 ROI above and their respective purpose:
1) ROI based on controllable net income used to evaluate the

performance of the division manager as it represents the
contribution he/she has made to the company’s overall profit .
2) ROI based on net income before tax used to evaluate the

performance of the division as an economic unit for comparison
against similar independent companies in the same industry.
Economic Value Added

In the 1990s Residual income was refined and renamed Economic
Value Added (EVA) by the Stern Stewart consulting firm.
EVA is a specific type of residual income calculation that has recently

gained popularity.
The EVA measure aims at producing an overall financial measure that

encourages senior managers to deliver shareholder value.
Adjusted After Tax Profit – (WACC X (Total assets – Current Liability)
Weighted average cost of capital equals the after-tax average cost of

capital on all long-term funds in use and uses the Capital Asset Pricing
Model (CAPM) to compute the cost of equity.
The EVA concept extends the traditional residual income measure by

incorporating adjustment to the operating profit computed using
financial accounting rules. Financial accounting rules require that
research and development be expensed when incurred but such
expenditure are value enhancing and hence should be capitalised as
assets.
Adjustment are made to the conventional historical cost profit in order

to equate it to economic profit.
A total of 160 adjustments were listed to convert historical cost profit to

a sound measure of economic profit but most companies will normally
only need to make about ten of these adjustments.
The adjustment result in the capitalization(treat as asset) of many

discretionary expenditures such as research and development,
advertising, restructuring cost by spreading these costs over the period
in which the benefits are received.
Note:
EVA is a refined version of RI as the formula to compute EVA is
similar to RI, except its more specific. For example, it defines the
cost of capital used as the WACC and the profit should be
adjusted after-tax profit.
365
The adjustments are necessary to recognise value enhancing
expenditure that should not be expensed.
Advantages of EVA
a) EVA is similar to the residual income measure,hence compared to

ROI, EVA is more likely to encourage goal congruence in terms of asset
acquisition decisions.
b) Generally, projects with positive EVAs have positive NPVs. The EVA rule is
(usually) consistent with the NPV rule.
c) EVA sends a message to managers that says invest only if the profit from
the project is sufficient to cover the cost of capital.
d)EVA makes the cost of capital visible to operating managers. Managers can
increase EVA either by increasing profits or by reducing capital employed.
e) EVA makes managers think carefully about the possibility of reducing

unnecessary investments in redundant assets.
Disadvantages of EVA
a) It is based on annual profit and can still result in managers taking decisions
to boost only annual profit at the expense of long term performance.
c) It is a lagging indicator of performance and a financial performance

measure and hence ignores any non-financial consequences such as
customer satisfaction.
d) Numerous adjustments are required to operating profit and assets and

hence very complex
A lagging performance measure means that is measures

past performance.
366
Assume the following information for the two divisions of a company:
The company uses Economic Value Added (EVA) with a capital charge of
12% to appraise divisions and makes the following adjustments to net income:
Research and development is capitalised and written off over 3 years

including the year of spending.
Launch marketing is regarded as a prepayment and charged in the year of

launch.
Required:
Calculate the EVA for 2015 for each division using the EVA method adopted
by the company. (5 marks)
UOL adapted Zone A 2015 Question 3
367
£’000 £’000
EVA Motor Products
Accounting Profit 250 640
Adjustment EVA
R & D Capitalise
Launch Market
Economic Profit 650 740
Less: Capital Charge
EVA +133 +99
Motor more efficient in generating Return in terms of EVA.
Summary – Divisional Performance (PM) measures
The three major divisional financial PMs are: ROI, RI, EVA.
Problems with all three divisional PM:
1) Laggard(Past)measure of performance.
2) Subjective by nature as use accrual profit.
3) They are subject to manipulation.
4) They have a short-term focus.
368
Determining which assets should be included in the investment base
In computing ROI, RI, EVA, the assets to be included in the investment base
must depends on the purpose of the performance measure.
If the purpose is to evaluate the performance of the division manager, then

only include the assets that are controllable by the division manager. Assets
managed by HQ (for example cash or accounts receivables) should be
excluded in determining controllable investment
If for some reason, the divisional manager can influence the non-controllable
assets, then these assets should be included in the investment base also. For
example, if the accounts receivable is excluded from the investment base,
then the divisional manager may increase divisional sales by granting overly
generous credit terms. Hence he will obtain the rewards from the additional
sales without being charged the additional cost of capital incurred for the
higher accounts receivables balances.
If the purpose is to evaluate the economic performance of the division, the

profitability of the division will be overstated if controllable investment is used.
This is because the division has benefitted from the corporate assets such as
building and cash. Hence the investment base should include an allocation of
the corporate assets that have benefitted the division.
369
Homework Question Lecture 19
Question 1
Whites Ltd, a well established company, has operated in a good but static
market for many years where it has been the dominant supplier. Over the past
two years it has developed two new product areas unrelated to each other
and to the original business.
Whites Ltd has organised the operation of its three activities on a divisional
basis with each divisional general manager having responsibility for all
aspects of running their Division. Division A is the original operation, Division
B is in a high risk, high technology area where it is expected to improve
profitability over the next three years and Division C is in a high growth but
low risk area.
Head Office operating costs were £1.2 million in 2007. The company’s cost of
capital is 16%. The results for the Divisions for the year ended 31 December
2007 are as follows:
A B C
£M £M £M
Annual trading profit after charging Head Office costs 4.1 1.2 1.3
shown below.
Net asset value at year end (non-current assets are

valued at historical cost less depreciation). 23.5 9.5 6.0
Head Office costs charged in calculating trading profit 0.4 0.4 0.4
Annual Sales 110 31.0 18.0
Annual wages & salary cost 60.0 15.0 8.0
Required:
(a)Calculate the Return on Investment and the Residual Income for each
Division.(6 marks)
(b)The divisional manager of Division B has complained about the amount of

the Head Office costs charged to his division. He suggests reallocating Head
Office costs based on using either:
i)profit before Head Office costs, or,
ii)sales, or,
iii) wage and salary costs.
Calculate Residual Income based on each of these suggestions. (6 marks)
(c) Explain the ways in which the information calculated in (a) and (b) above
would be used by the management of Whites Ltd and indicate, with reasons,
370
which calculation of Residual Income would be most equitable. (7 marks)
(d) Discuss ways in which the profits and asset values of the Divisions could
be adjusted to provide fairer measures of performance. (6 marks)
(UOL adapted 2008 Zone A Question 3)
Question 2
Discuss the issues that arise in designing appropriate financial measures of
performance in a multi-divisional company where divisions are sub-divided
into departments.
(25 marks)
The End –Lecture Notes Lecture 19
371
Management
Accounting
Lecture Notes
Lecture 20
Topics Covered
Transfer Pricing

Lecture 20
This lecture is on the transfer pricing which is related to the

performance of a divisions in the company.
Transfer pricing question do appear frequently in Section A of the

exam, so this is a good topic to focus on for Section A of the exam.
372
Transfer Pricing (TP)
A transfer price is the price charged by one division to another division for
any intercompany transfer of goods or services.
The transfer price creates revenue for the selling unit and purchase cost for
the buying unit, affecting operating profit of both divisions which are normally
considered investment centres.
Why is Transfer pricing an issue

Transfer pricing is an issue because it could lead to dysfunctional behaviour.
Managers have incentives to set transfer prices and make sourcing decisions
to maximise their own division’s profit not organisational profit as they act in
their own self- interest. Seller
Division A
Remember manager performance is measured and rewarded based on
divisional profit as the divisions are investment centres.
The transfer price represents one manager’s revenue and another manager’s
cost and hence the potential for conflict also exist as the selling division wants Buyer
a high transfer price whilst the buyer division wants a low transfer price. Division B
To maximise
Objectives of transfer pricing system their division
profit, A want
1. Provide information for performance evaluation of the divisions involved a high TP, B
which are normally investment or profit centres. want a low TP
2. The transfer price should promote a high degree of autonomy(freedom) in

decision-making particularly when division are considered decentralised
investment centres.
3. The transfer price should motivate managers to make good economic

decisions which improve the reported profits of the company. For
example, the transfer price set should reinforce the right sourcing decision
from the company perspective.
4. To intentionally move profits between international divisions to achieve

various company objective such as to minimise taxes paid.
Assume the following:

Division A (In Europe Tax Rate = 50%_
Division B (In Singapore Tax Rate 15%)
Division A “sells goods to division B. 373

Would you prefer to use a high or low transfer price to lower
world wide taxes paid?
__________________________________________________
__________________________________________________
Alternative transfer price methods:
1. Market based transfer prices.

This allows the transfer at the external price that a subunits charges to
outside customers.
2. Full/marginal cost plus a mark-up

This involves setting the transfer price based on the cost of producing the
product in question plus a mark-up. Examples of cost include variable cost,
full product cost.
These cost based methods do not encourage cost control as the
transferring division knows that its cost will be covered. Hence, the use of
standard costs rather than actual costs is recommended.
3. Hybrid or Negotiated Transfer prices
This type of transfer price considers both the cost and the market price.
They also involve allowing the subunits the freedom to negotiate the
transfer prices between themselves promoting a high degree of autonomy
for the divisions.
4. Dual Transfer Price

There is seldom a single transfer price that will meet all the four objectives
of a system of transfer price.
Hence, some companies use two transfer prices to price transfers from
one unit to another. For example, allowing the selling division to use the
(high TP)market price and allowing the buying division to use the cost
based(low TP) as a transfer price.
374
Transfer Pricing decisions
There are two basic issues in a transfer pricing decision:
1. The Sourcing Decision

This involves the best most profitable decision to buy/sell internally
(transfer) or buy/sell in an external market.
The optimal sourcing decision must be made from the perspective of
the company.
This is done by comparing the relevant cost of transfer to the buy in
price
Relevant costs of transfer equals:

Incremental costs arising from manufacture plus opportunity costs
from any lost external sales caused by transfer.
2. The Transfer Price Decision

The transfer price should be set in such a way to encourage managers
to make the optimal sourcing decision.
375
Lecture Illustration - Transfer Price
A component is being transferred internally between two divisions, Division A
to Division B, both being autonomous investment centres.
The component is then used in the manufacture of the final product by
Division B after adding an additional $4 of cost to it.
The following cost information for division A & B:

Per Unit Division A Division B Div A seller
Material 5 -
Variable labour 3 2
Fixed manufacturing
costs allocated Div B buyer
2 2
Full Cost 10 4
Selling Price 15 25
Required:
a) Assume that Division A is currently not operating at full capacity.
Full capacity is 100,000 units per month. Currently, Division A is only
producing 60,000 units per month to satisfy external demand.
Division B requires 30,000 units per month and can purchase all its
requirements on the external market for $9 per unit or purchase it from
Division A.
Determine if Division B should be allowed to source the component
from the external market?.(Make or buy decision)
b) Assuming next the demand for Division A’s component in the external
market was 100,000 units. That is, Division A could actually produce and
sell all its full production capacity for $15.00 per unit to the external market.
Determine the optimal sourcing decision?
376
c) Compute the division and company’s profit per unit assuming a
transfer price of $10 and $15 per unit and comment on your results.
(a)
Division A has excess Capacity of

100,000 - 60,000 = 40,000 units
Division B want 30,000 units
Excess capacity available to satisfy B requirement, hence no opportunity

Cost for Division A.
Make or Buy Decision

Per unit
$
Division B -Buy In Price
Relevant(variable) cost to make
Savings to Make
Right Sourcing Decision:
377
(b)
Div. A (Seller) No Excess Capacity = Hence, it will incur an opportunity
cost to transfer to Division B
Make or Buy Decision
Per unit
$
Buy in Price 9.00
Relevant cost to make
Incremental(variable) cost
Add: Opportunity Cost

= lost contribution to Division A
Cost to Make
Savings to Buy
Right Sourcing Decision:

1) Division A to sell 100,000 units to external market @ $15 per unit.
2) Division B to buy in 30,000 units @ $9 per unit.
378
(c)
Transfer Price per unit

Low High
Transfer price $10 $15
Division A
Sales
Full Cost (10) (10)
Profit
Division B
Transfer In Cost
Full Cost 4 4
Total Cost
Selling Price 25 25
Profit (Loss)
Company Profit
Note:
1)TP has no impact on co. profit aa profit constant @ $11 per unit.
Only impact divisional profit.
2) Division, A wants a high TP @ $15 per unit

Division B wants low TP@ $10 per unit
379
A General guideline for transfer –pricing situations
The minimum transfer price should be set at:
Minimum transfer price
Equal: Incremental cost plus opportunity cost per unit to the seller division
This should work out to:

1. Market-based transfer prices should be used when there is no idle or
excess capacity.
2. Where the seller division has idle capacity, its opportunity cost of
transferring the product internally is zero because the seller division does
not forgo any external sales and hence does not forgo any contribution
from transferring internally.
In this case the minimum transfer price = incremental cost.
380
Assume the same information as Illustration 1, determine an appropriate
transfer price for situation a) and b).
(a) Excess Capacity
Minimum TP $
Incremental cost
+ Opportunity Cost
Minimum TP
At TP of $8 per unit Division B “happy” but Division A manager will not

cooperate as he is earning zero profit from the transfer.
Need a TP where both Division A & B manager co-operate to transfer
internally as this is best for the company.
Range: Minimum Maximum
$8 $9
Don’t go below $8 as Division A will not agree to transfer
Don’t go above $9 as Division B will buy from outside, wrong sourcing
decision.
Recommend $8 + $9 = $8.50
2
Div. A “happy” make profit $0.50

Div. B “happy” save $0.50
(b) No Excess Capacity

Minimum TP
$
Incremental Cost
Opportunity Cost
Minimum TP
Division B manager will reject internal transfer and prefer to buy from the
outside market and this is also right sourcing decision from the
company’s perspective.
1) Division A to sell 100,000 units to external market @ $15 per unit.
2) Division B to buy in 30,000 units @ $9 per unit.
381
Lecture Ill 3: Super Mechanics plc has various divisions making equipment for the building trade. Division D
makes complex electronic components that recognise dampness in wood and concrete structures.
These are sold to outside customers and to Division M. Division M uses the components in the
production of damp meters which it sells to outside customers.
The market price for each electronic component sold by Division D is £800 and the transfer price to
Division M has been set at market price, in line with company transfer pricing policy.
Division D’s production capacity is 2,400 units per month, but current sales are only 1,000 units per
month to external customers and 600 units per month to Division M.
D
Division M sells the completed meters for £1,500 each.
Other data relevant to the operation are:

Division D M
£ £ M
Variable costs of manufacture (excluding transfer price) 400 200
Fixed costs per month 300,000 150,000
Division M wishes to expand sales and has performed market research to determine the effect of
demand to changes in price. The results are as follows:
Price per Estimated Note:

meter sales units This is a linear demand function
£1,600 450 Price
£1,500 600
£1,400 750
£1,300 900
£1,200 1050
£1,100 1200
£1,000 1350 Quantity Demanded
Required:
(a) i. Prepare estimated profit statements for one month at current output for each division
based on the transfer price of £800 per component.
ii. Calculate the total profits earned by the two divisions. (5 marks)
(b) Determine the quantity and price at which Division M should sell the damp meter:
i. to maximise Divisional M’s profit at the existing transfer price.
ii. to maximise the profit of Super Mechanics plc. (10 marks)
(c) Prepare estimated profit statements for one month for each division and for the impact on the
profits of Super Mechanics plc as a whole, based on your answers to (b) ii. above.
(3 marks)
(d) Provide a considered view of the effectiveness of company’s existing transfer pricing policy
(using market price) and discuss one other alternative basis that can be used.
UOL adapted 2010 Zone A Question 3 (4 marks)
Note: 382
Profit maximising price equal to the price that
maximises total contribution, this was done in
Lecture 10 & 11(pricing decision) page number 190
Exam Tip:
In this question, better to do a MC Profit Statement Exam Tip: Note the
as the total fixed cost and variable cost information presentation of the
given in the question separately. answer to Part a,
(ai) Profit Statement tabulated in column
Division form
D M
£’000 £’000
Sales:
D to external market
D To M
M to external market:
Less: Variable Cost

D:
M:
Total contribution
Less: Fixed Cost
Net Profit
(aii) Company Profit =
(bi) Price to maximise Division M profit (use the Division M variable cost)
Variable Contribution Total

Price Unit per Unit per Unit Contribution
£ £ £ £000
1,600 450
1,500 600
1,400 750
1,300 900
1,200 1,050
1,100 1,200
1,000 1,350
Profit Maximising Price
for
383
(bii) Price to maximise company’s profit
(use the company’s variable cost)
Variable Contribution Total

Price Unit per Unit per Unit Contribution
£ £ £ £000
1,600 450
1,500 600
1,400 750
1,300 900
1,200 1,050
1,100 1,200
1,000 1,350
Profit Maximising Price
for
Note:
This past exam question actually integrated two topics, pricing
decision and transfer pricing issues.
384
c) Profit Statement
Division
D M
£’000 £’000
Sales:
D to external market
D To M
M to external market:
Less: Variable Cost

D:
M:
Total contribution
Less: Fixed Cost
Net Profit
Company Profit =
d)
1) Transfer price only impact profit at the division level, no impact on the
company’s profit overall.
2) Market based transfer price is most transparent and easy to justify.
3) Alternative transfer price is at variable cost or full cost.
4) Since Division D is operating with excess capacity, its opportunity cost

of selling to Division M is zero. Hence, an appropriate transfer price
would be the variable cost of £400 per unit plus a mark-up.
385
International Transfer Pricing
The problem of setting transfer prices is compounded when dealing with
international divisions. Several more factors need to be taken into
consideration.
A common problem that exists is confrontation between the multinational

organisation and host country government. This arises due to manipulation
of profits using transfer pricing.
Additional factors to consider with international transfer pricing

1) Minimising the global tax liability.
Multinational companies can and do use their transfer pricing policies
to move profits around the world and thereby minimise their global tax
liabilities in terms of corporate income tax and import duties.
2) Dividend repatriation restrictions.
Some countries restrict the repatriation of dividends. By increasing the

prices of goods or services transferred into divisions in these countries,
firms can increase the dividends repatriated out of these countries
without violating dividend restriction.
Governments are well aware of the measures companies can adopt to
minimise taxation and maximise dividend repatriation.
Hence, a common approach taken by governments to deal with the problem
is to specify that transfers must be priced at “arms-length” price in line with
OECD guidelines.
Arms-length price refers to the price that would have been used between
two unrelated parties.
386
Homework Question Lecture 20
Question 1
Outback Corp has manufacturing divisions in Australia. It also has marketing

divisions worldwide which sell Outback Corp products and similar products for
other manufacturers. The manufacturing division in Melborne produces one
product, the G12 for which the following cost and revenue information is
available:
Australian tax rate on Australian divisions’ operating income 40%

Variable manufacturing cost of product G12 A$170
Full manufacturing cost of product G12 A$250
Normal Market price in Australia. A$325
The Melborne division, in order to fill capacity, is discussing with a local

customer the regular sale of 2,000 units of product G12 at a discounted price
of A$290 per unit.
One of Outback Corp’s marketing divisions is in Poland. It currently buys a

product similar to G12, from a local supplier for A$300* and sells it for A$400*.
The following information relates to Outback Corp trading in Poland:
Polish tax rate on Polish division’s operating income 20%

Polish import duty (based on import price) 6%
Selling price of G12 in Poland A$400*
*All prices in Poland quoted at the A$ equivalent.
The Australian and Polish tax authorities only allow transfer prices between
the full manufacturing cost per unit and the Australian market price of A$325.
Import duty paid to the Polish authorities is a deductible expense in
calculating Polish tax due.
Required:
(a) Calculate the increase in Outback Corp’s after-tax profit if the Melbourne
division sells 2,000 units in Australia for A$300 and the Polish division sells
2,000 units of the G12 equivalent in Poland. (4 marks)
(b) Outback Corp’s Head office wants the two divisions to trade with each
other. Calculate the after-tax income earned by the Australian and Polish
divisions if they transferred 2,000 units of product G12 at either the highest or
the lowest price allowed by the tax authorities. Explain what transfer price,
complying with the rules, would be most profitable for the company as a
whole.(10 marks)
387
(c) If divisional managers acted autonomously to maximize their own
division’s after-tax income, discuss the likely range within which the transfer
price will lie, given the restrictions imposed by the tax authorities. (6 marks)
(d) Briefly discuss how companies trading internationally can maintain
divisional autonomy and maximize profits relating your answer to the
circumstances in the question. (5 marks)
(UOL Adapted 2008 Zone A Question 1)
388
Question 2
Fine Clays plc extracts and refines china clay. It is organised into two trading
divisions: The Industrial Clays Division handles wholesale business and the
Clay Shops Division sells to retailers.
The Industrial Clays Division extracts moulding clay and sells it to external
customers and to the Clay Shops Division. The external wholesale market
price is £1,800 per tonne. The transfer price per tonne has been set at market
price, in line with company transfer pricing policy.
The Industrial Clays Division’s production capacity is 2,000 tonnes per month,
but current sales are only 1,000 tonnes per month to external customers and
600 tonnes per month to Clay Shops Division.
The Clay Shops Division produces 100 bags of refined clay from each tonne
of moulding clay, which it sells at £40 per bag.
Other data relevant to the operation are:
Division Industrial Clays Clay Shops

£ £
Variable costs per tonne (excluding transfer price)1,000 400
Fixed costs per month 700,000 400,000
The Clay Shops Division wishes to expand sales and has performed market
research to determine the effect of changes in price on demand.
The results are as follows:
Price per bag Estimated sales (bags)

£42 50,000
£40 60,000
£38 70,000
£36 80,000
£34 90,000
£32 100,000
£30 110,000
Required:
(a) Prepare estimated profit statements for one month for each division
and for Fine Clays plc as a whole, based on transfer price of £1,800
per tonne at current output.
(5 marks)
389
(b) Determine the quantity and price at which the Clay Shops Division
should sell the
bags:
i. to maximise Clay Shop’s divisional profit at the existing transfer price.
ii. to maximise Fine Clay plc’s overall profit. (10 marks)
(c) Prepare estimated profit statements for one month for each division
and for Fine Clays plc as a whole, based on your answers to (b) i. and
ii. above. (6 marks)
(d) Provide a considered view of the effectiveness of company’s existing

transfer pricing policy (using market price) and discuss one other
alternative basis that could be used.
(4 marks) (UOL adapted 2010 Zone B Question 1, 25 marks)
The End –Lecture 20
390
Management
Accounting
Lecture Notes
Lecture 21
Topics Covered
Cost Management, Strategic Performance Measures
Readings: Horngren Chapters 20, 21& 22.

Lecture 21
This lecture deals mainly with strategic management

accounting issues.
The concepts in this lecture will mainly be tested in Section B

of the exam.
391
Main idea in benchmarking is that to improve and
achieve optimal performance, we need to compare
Benchmarking ourselves to the best performers.
Benchmarks enable goals to be set that may be based on either external

measures of ‘best practice’ organisations or internal cross-functional
comparisons which exhibit ‘best practice’.
A primary aim of the traditional budgeting process is the setting of realistic

targets that can be achieved within the budget period.
The setting of realistic targets means that the extent of underperformance

against ‘best practice’ is not visible.
In traditional budgeting, there is very little real incentive to seek out

benchmarks which may be used to raise budgeted performance targets.
Often trade or industry associations will publish benchmarks enabling each

company to see how they stand and, if necessary adopt better practices.
Benchmarking is also used in public sector organisations. Public sector

organisations goals are efficiency and effectiveness in delivering the service
required hence comparing with others is one way of setting standards and
encouraging better performance.
Problems with benchmarking
1. In order to produce proper benchmarks, output measures must be

identified. These may be too simplistic since many aspects of
performance cannot be objectively measured. For example, is
good grades the only measure of the quality of school. There are
other importance measures involved which cannot be quantified
such as nurturing confidence and providing a holistic education.
2. There may also be external factors which influence the performance of

the organisation that are beyond the control of the management. For
example, the grades of the students may be low due to a difficult
examination in a particular year.
392
Quality as a competitive tool
Quality can be used as a competitive tool by a company.

Quality is defined as the total features and characteristics of a product or
service made or performed according to specifications to satisfy customers at
the time of purchase and during use.
Costs of quality (COQ) fall into four broad categories:

The direct financial measure of quality is termed the cost of quality.
These are the costs incurred as a result of producing products that do not
meet quality standards and costs incurred to prevent the production of such
products.
Cost of Quality classified into four categories

1) Prevention costs are costs incurred to prevent the production of products
that do not conform to their specifications. Example of such cost will be
employee training, preventive equipment maintenance, supplier evaluations.
To be most effective, prevention activities should be built into routines at the Prevention
same time as manufacturing processes are being designed. &
Appraisal
cost are
2) Appraisal costs are costs incurred to detect units that do not meet investment
specifications. Example of appraisal cost would be Inspection, testing, and in quality to
audits. prevent
failure
cost.
As with prevention cost company should encourage continuous improvement.
This may include analysis of main areas of poor work which can be rectified. “An once
of
prevention
3) Internal failure costs are costs incurred on defective products before they better than
are delivered to customers. Example of these costs include rework, scrap a pound of
troubleshooting. cure”
To prevent internal failure cost, inspection at intervals in the process may be

most effective as specific poor work can be identified and reworked; otherwise
it may cause delays or poor work further along the process.
4) External failure costs are costs incurred on defective products after they
are delivered to customers. Example of these costs warranty cost, and
customer support.
Example:
Prevention & Appraisal cost = $4 million
Avoid: Failure cost = $10 million 393
Net Benefit = $ 6 millon
This is the most important failure because it affects customer attitudes and the
company’s long-term reputation. All other activities are aimed at minimising
this failure.
Prevention and appraisal cost are also referred to as cost of quality
conformance and internal and external failure cost are considered cost of non-
conformance or non-compliance.
Lecture Illustration 1- Cost of quality
Ambrose industries manufactures and sells two models of commercial air

conditioners, Frostaire and Coolaire. Information on the models is as follows.
The labour rate for design is £80 per hour and the rate for testing and
inspection is £50 per hour.
Required:
a) Calculate the cost of quality for Frostaire and Coolaire, classifying them
into prevention, appraisal, internal failure and external failure costs.
b) For each model, calculate the percentage of revenue of each cost of

quality category.
c) Compare and comment on the cost of quality for each model.
Source: UOL 3097 Subject Guide 2017
394
a&b Frostaire Coolaire
£‘000 % £‘000 %
Revenue:
20,000 X £1,500 100

40,000 X £500 100
Prevention Cost
Design cost:
Frostaire
Coolaire
Appraisal
Testing cost:
Frostaire:
Coolaire:
Internal Failure
In Plant Rework
Frostaire:
Coolaire:
External Failure
Site Repair
Frostaire:
Coolaire:
Lost Contribution(Sales)
Frostaire:
Coolaire:
Total cost of quality
395
(c )
1) Coolaire has a higher cost of quality (11.8%) compared to
Frostaire (8.6%)
2) Hight cost of quality for Coolaire mainly due to inadequate

investment in prevention and appraisal cost (2.5%) giving rise to
high failure cost of 9.3% (11.8% less 2.5%).
Advantages of cost of quality measures

1) They focus attention on the costs of poor quality and hence create
awareness of this cost.
2) They allow the company to evaluate the trade-offs among prevention costs,
appraisal costs, internal failure costs, and external failure costs.
3) They assist in problem solving by comparing costs and benefits of different

quality-improvement programs.
396
Just in time (JIT) systems
Aim of JIT is to reduce waste by producing the required item, at the required
quality and in the required quantity at the precise time at which they are
required.
It works by a ‘demand pull system’ which focus on producing only what

demanded. Each operation produces what is necessary to meet the demand
of the following operations
The demand pull starts from the customer demand for the finished product all
the way back to the demand for direct materials that arrive just in time to be
used in the production process.
External suppliers must be prepared to deliver in small batches directly on to

the production line of the company.
Long term contracts with suppliers are necessary, to facilitate the detailed
planning necessary.
Relationship must be built between key suppliers to ensure a reliable quality

supply of inventory
The whole system needs to be implemented in the context of total quality

management and a redesign of factory layout and production methods (e.g.
‘dedicated cell’ production).
The ‘dedicated cell layout’ concept is to train employees in sufficient skills so

that they can make a product from start to finish unlike the assembly line
system.
Employees are referred to as ‘multi-skilled operatives’. The employees are

then organised in teams by product type instead of by production process.
Each of these teams, which specialises in a type of product, is known as a
‘dedicated cell’.
Hence employees will be more competent, motivated and flexible and require
less supervision.
There will be reduction in idle time and machine breakdown as employees

will be able to undertake routine maintenance to their own machine
Overall the quality of goods is likely to be higher with fewer rejects.
397
Advantages
1. Costs of inventory holding are greatly reduced.
2. Responsibility for ensuring high quality of raw materials and components

is passed to the supplier hence reducing prevention and appraisal cost
associated with materials purchased.
3. Need for quality inspection at the raw material stage is eliminated, thus
saving further costs.
4. Faults caused by defective components are greatly reduced. Hence:

less idle time in production, a more reliable finished product and an
increase in customer confidence.
Disadvantages
1. Because inventory is never received in bulk, unit purchase price will

probably be higher than under a conventional system.
2. Total reliance on the supplier to be able to deliver exactly as and when

required.
Problems with implementing JIT systems
• Represents a fundamental shift in culture internally.
• Building relationship and trust with suppliers will take time
• Also takes a lot of time to change employee’s mindset to do multi task

and take on more decision making authority.
398
BPR very similar in concept to
Business Process Re-engineering (BPR) ABM
BPR is a radical and dramatic redesign of a business process to achieve
dramatic improvements in critical contemporary measure of performance such
as cost, quality, service and speed.
A process is a collection of activities that generally involves more than 1

department and which requires multiple input to create an output. For
example order processing.
BPR is focussed on business processes, the value chain, not department

activities and how to redesign these processes to improve efficiency.
Main features of BPR include:
• Fundamental rethinking and radical redesign. BPR is not a gradual

process of redesign. It is a totally new way of doing things.
• Dramatic improvement. BPR aims to achieve huge improvements in

performance rather than marginal or incremental.
• Focus is on cost, quality and service. Thus, BPR requires the adoption
of new management techniques and philosophies such as JIT, TQM,
ABC to create major changes in the processes involved and improve
performance.
Common characteristics of a reengineered process.
1. Often several jobs are combined into one, thus avoiding duplication.
2. Workers are often empowered to make decisions.
3. The steps in the process are performed in a logical order.
4. Work is centered around value adding activities.
5. Checks and controls may be reduced whilst quality is built-in.
6. Often IT is used to make processes more efficient and better integrated

with other processes.
399
Lean accounting
Lean accounting is a costing method that supports creating value for the
customer by creating value stream, not just individual products thereby
eliminating waste in the accounting process.
Proponents of lean accounting argue that by focusing on the specific value

stream and allocating all other unnecessary costs that do not directly
contribute to the value stream, those other costs (the waste) will be
highlighted in a way that will cause managers to reduce these costs.
Hence, the focus of lean accounting is on creating a value-added supply

chain.
Supply chain simply the movement of products from production to customers.
Supply Chain as a Value Stream
Manufacturer Retailer Customers
Value streams seek to reduce waste and add value.
Value refers to cost that a customer is willing to pay for.
Waste is any addition to cost that the customer is not willing to pay for.
Example of value-added cost includes cost that increases efficiency and

lowers response time.
Examples of waste include over-production leading to over stocking, higher

scrap or rework due to inefficiency and unnecessary waiting time.
Lean Accounting will therefore encourage managers to improve their value

streams efficiency and effectiveness by reducing costs and increasing
revenues.
There are many strategic management accounting tools to create value.

These include Just in time inventory systems, Target costing, Kaizen costing.
Limitations of the lean accounting:

(1) It does not full compute costs for products as if focus on value added cost
only. This may restrict its value for certain types of decisions.
(2) It excludes many of the support costs as it focuses only on value added
cost.
(3) It does not account for inventories under generally accepted accounting
principles as do normal accounting methods such as absorption costing.
400
Environmental Accounting
Environmental cost management is becoming an increasing important issue

for many companies.
There are three main reasons why the management of environmental costs is
becoming increasingly important in companies.
1) Society as a whole has become more environmentally aware hence

companies are finding that they can increase their appeal to customers by
portraying themselves as environmentally responsible.
2) Environmental costs are becoming huge for some companies, particularly

those operating in highly industrialised sectors such as oil production. In some
cases, these costs can amount to more than 20% of operating costs. Such
significant costs need to be managed.
3) Regulation is increasing worldwide at a rapid pace, with penalties for non-

compliance also increasing accordingly.
The categories of environmental costs would be as follows:
a)Environmental prevention costs: the costs of activities undertaken to

prevent the production of waste. Examples include introducing processes to
reduce pollution, training employees.
b)Environmental detection costs: costs incurred to ensure that the

organisation complies with regulations and voluntary standards. Examples
include auditing environmental activities, performing pollution test.
c) Environmental internal failure costs: costs incurred from performing

activities that have produced contaminants and waste that have not been
discharged into the environment. Examples include cost of disposing toxic
material and recycling scrap.
d) Environmental external failure costs: costs incurred on activities performed

after discharging waste into the environment. Examples include, cleaning up
oil spills, fines and loss of reputation.
The key idea with managing environmental cost is that it is better to incur a
smaller amount of prevention & detection cost to avoid a larger failure cost.
(“An once of prevention better that a pound of cure”)
401
Why is the management of environmental cost difficult
It is difficult to identify the environmental cost because most of the costs is

“hidden” under the overhead cost category. For example, the cost of waste is
not separately identified in the overhead category.
These costs need to be controlled but this can only be done if they have been
separately identified in the first place and traced to the responsible products
and processes.
The fact that environmental costs are often ‘hidden’ in this way makes it
difficult for management to identify opportunities to cut environmental costs.
Accounting For environmental costs
Measuring environmental performance.
Many companies are under increasing pressure to measure all aspects of

environmental performance for statutory or voluntary disclosure requirements.
Environmental ABC to control environmental cost

Using ABC concepts, environmental cost should be accumulated by separate
cost pool and traced to the responsible products and processes. The relevant
cost drivers also need to be identified. The knowledge of the amounts and
categories of the environmental and their causes will allow management to
manage this cost more effectively.
Life cycle costing

Within the context of environmental accounting, lifecycle costing is a
technique which requires the full environmental consequences and cost
arising from production of a product to be taken account across its whole
lifecycle, ‘from cradle to grave’ and not just at the manufacturing stage. For
example, the cost of disposal of toxic materials at the decommissioning of the
nuclear plant should be taken into consideration when making a decision to
build the plant.
402
Strategic Performance Measurement
Strategic Performance measurement is a vital part of the management control
system.
The phrase ‘What gets measured gets done’ is an important concept in

designing management control systems.
Incorporating a wider set of financial as well as non-financial performance

measures is important in directing efforts towards achieving strategic goals.
Lead and lag measures
Lead measures are the actions which drive future performance. Examples of
lead measures include product innovation and customer satisfaction.
When they are performed they do not guarantee a specific outcome but if they
are not performed there will be no outcome at all.
Lag measures are the outcomes that arise as a result of lead measures. The
outcomes are usually measured in financial terms, such as profit or return on
investment.
Managers should be encouraged to make decisions that will enhance the

future as well as the present – in other words, lead activities should be
encouraged.
This means that the strategic management system must direct, measure and
reward activities which implement strategy and enhance present and future
performance.
403
The Balance Scorecard (BSC)
The Balance Scorecard integrates financial and non-financial performance
measures that are linked to the company strategy.
The BSC aims to translate the firm’s vision and strategy into operational
objectives and performance measures using four perspectives as follows:
1) Financial- How do we add shareholder value – Lag Measures
Objectives Measures
1) Revenue growth % of revenue from new products
Sales growth %
2) Cost Reduction Profit margins

% reduction in cost per unit
3) Optimise Asset Utilisation Asset Turnover

Return on Investment
2) Customer - How do our customers see us – Lead measures

Identifies targeted customer and market segments and measures the
company’s success in these segments in meeting the needs of its
customers so that the target revenue can be achieved.
The main objective here will be to increase market share and improve
customer core value propositions.
Objectives Measures
1) Core: Increase Market share Market share
Increase customer retention % of existing customers retained
Increase customer acquisition Sales to new customers
Increase customer satisfaction Customer satisfaction rating
Increase customer profitability Customer profitability analysis
2) Core: Customer value propositions

Improve product functionality Product functionality ratings
Reduce price relative to competitors Price relative to competitors
Improve product quality % returns from customer
Improve delivery time % on-time delivery
404
3)Internal business process-What must we excel at – Lead measures
Focuses on internal processes that the company must excel in achieving
its strategy.
Critical processes should be identified that are required to achieve the

customer and financial objectives.
Firms must excel in three processes here namely the innovation process,
operation process and the post sales process. Examples given below:
Objectives Measures
1) Innovation process
Increase the number of new products % of sales from new poducts
2) Operations process
Improve process efficiency output/inputs ratio
3) Post sales process

Increase service quality % of customer request handled by
a single cell
3) Learning & Growth- How do we continue to improve and create

Value- Lead measure
The firm and its employees must keep learning and developing in order to
create long-term growth and improvement.
The firm must invest in its infrastructure in term of its employees, systems
and organisational procedures in order to achieve the other three
perspectives.
Three enabling perspective have been identified here as:

• employee capability
• Information systems capability
• Organisation climate for motivation, empowerment and alignment.
405
Examples given below:
Objectives Measures
1) Increase employee capability Employee satisfaction survey
ratings
2) Increase Information systems % of processes with real time

capability feedback capability
3) Increase motivation, empowerment Number of suggested

and alignment improvement per employee
The scorecard is balanced and comprehensive in the sense that managers

are required to think in term of four perspectives, to prevent improvement
being made in one area at the expense of the other.
Important features of this approach are as follows.
1) It looks at both internal and external matters concerning the

organisation.
2) Includes both financial and non-financial measures that are linked

together.
3) It includes past, present and future performance. Hence, they

include lead and lag measures. Lead measures are the actions
which drive future performance. Lag (past performance) measures
are the outcomes that arise as a result of lead measures. Lag
measures are usually measured in financial terms, such as net
profit or return on investment.
406
Lead and Lag measures in the BSC
Lag measures fall within the financial perspective and are the result of
past actions.
The lead measures ‘are the drivers of future financial performance.

They cause the outcomes.
Lead measures tend to be non-financial measures relating to customer,

internal business process and learning and growth perspectives.
The Important point to take note is that the balance scorecard is used to
ensure that management takes the right action (processes) in order to
increase profit (outcome). Hence, management is being evaluated on
both outcome and processes.
If only financial performance measures are used, then theres the risk
that management will try to increase profit (outcome) by gaming
important processes. For example, increasing profit by postponing
important maintenance of equipment.
Features of a good Balanced Scorecard

1) It should communicate a sequence of cause-and-effect relationships—
the links among the various perspectives that describe how strategy will
be best implemented.
2) It should help communicate the strategy to employees by translating the

strategy into coherent and linked set measurable targets.
3) It must motivate managers to take actions that eventually result in

improvements in financial performance.
4) There should be a limited the number of measures only, hence only the
most critical ones should be used.
407
Criticisms of the balanced Scorecard
1) There is an absence of a time dimension as to when the “cause and
effect” relationship will take place.
2) Causal linkages between the non-financial driver and financial outcomes

are not clearly specified nor well understood.
3) It omits other important perspectives such as the environment and

society perspectives.
Example of a BSC strategy map for a low cost airline:
408
Fitzgerald and Moon- Performance Measures for service industries
Fitzgerald and Moon developed a framework for a performance measurement

system appropriate for service industries that covers three areas: Dimensions
of performance, standards to be set and the reward systems.
Dimensions of performance measurement
Management should develop a set of performance measures in each of these

dimensions to ensure the company’s progress towards achieving its goals and
objectives.
Similar to the BSC concept,
The six dimensions include: Downstream results are lag measure
Upstream determinants are lead measure
Source: Management Accounting Subject Guide 2017
Like the BSC, this framework recognises that the lag measures of competitive
performance and financial performance (downstream results) will be achieved
or driven by the activities described as upstream determinants, the lead
measures.
Standards
These are ownership, achievability and equity.
a) To ensure that employees take ownership of standards, they need to

participate in the budget and standard-setting processes.
b) Standards need to be realistic for them to be achievable.
c) Standards need to be fairly applied in order to be equitable..
409
Rewards
Rewards system should have clarity, motivation and controllability.
a) The organisation’s objectives need to be clearly understood by those

whose performance is being appraised.
b) Individuals should be motivated to work in pursuit of the organisation’s

strategic objectives.
c) Responsibility should be assigned in line with controllability.
410
Performance measurement for not-for-profit making organisations
(NPO’s)
Non-profit- making organisations (NPO’s) cannot by definition be judged by

profitability so other methods of assessing performance have to be used.
The problems of performance measurement with NPO’s are:
(a) NPOs tend to have multiple objectives, so it is not possible to say which is
the most important objective.
(b) Outputs cannot be measured meaningfully. For example, is having more

patients in hospital implies that the hospital is achieving its objective.
(c) Public sector organisations are subject to many political influences and
legal constraints.
Their performance is usually judged in terms of inputs & outputs and this ties
with the ‘value for money’ criteria that are often used to access NPOs.
Value for money

Value for money applied to the NPOs means providing a service in a way in
which is economical, efficient and effective.
Economy
Economy deals with the costs of inputs, and it is achieved by obtaining those
inputs at the lowest acceptable cost.
Efficiency
Efficiency means maximizing output for a given input or using the minimum
input for a given output,
Effectiveness
Effectiveness means success in achieving objectives.
Effectiveness is the relationship between an organisation's outputs and its

objectives
Efficiency is the relationship between inputs and outputs.
Economy equates to cost control and cost minimisation.
411
Some possible Solutions to the above problems:
a) Inputs
One possible solution is to judge performance in terms of inputs.
b) Judgment
A second possibility is to accept that performance measurement must to
some extent be subjective. Judgment can be made by experts.
c) Comparisons
Most NPO’s do not face competition but this does not mean that all NPO’s are
unique. Bodies like local governments, health services and so on can judge
their performance against each other and against the historical results of their
predecessors.
Unit cost measurements like 'cost per patient day' or 'cost of borrowing one
library book’ can be established to allow organisations to assess whether they
are doing better or worse than their counterparts.
412
Strategic consideration in the Theory of Constraints (TOC)
Theory of Constraints (TOC) describes methods to maximize operating

profit when faced with bottleneck operations.( see lecture 12)
Balanced scorecard measures can be utilized to illustrate how financial

and nonfinancial measures of time relate to one another, reduce delays,
and increase output of bottleneck operations.
These are:
a. Financial measures—revenue losses or price discounts due to delays;
carrying cost of inventories; throughput contribution minus operating costs.
b. Customer measures—customer-response time; on-time performance.
c. Internal-business-process measures—average manufacturing time for key

products; manufacturing cycle efficiency for key processes, idle time at
bottleneck operations; defective units produced at bottleneck operations;
average reduction in setup and processing times at bottleneck operations.
d. Learning-and-growth measures—employee satisfaction; number of

employees trained in managing bottleneck operations
Note the cause-and-effect linkages across the measures. For example, better
training leads to better management of bottlenecks, which leads to better
customer-response times and higher throughput contributions.
413
Customer profitability analysis
Many companies can identify their customers clearly, either because they
have a supply chain relationship with them or because most customers have
repeat purchases. The customer profitability analysis requires sales, product
costs, delivery costs, discounts, etc. to be traced to each customer for each
accounting period.
This enables the profit to be analysed by customer as well as product and

region.
Customer Profitability Analysis can be identified by:
a) The percentage of total sales represented by each customer. This can

indicate possible dependence on a few customers.
b) The trend in sales per customer. This could indicate that the customer
relationship is getting stronger or weaker and can lead to investigation of
customer satisfaction.
c) The amount of profit which is earned from each customer.
d) Whether some types of customer are more demanding than others, e.g. in
requiring higher discounts, longer or inconvenient delivery times, etc. Here
Menu Pricing may be applied where the price charged to customer mat
depend on the complexity of the order.
If databases are appropriately designed, management should be able to

extract this information easily.
414
Decision Making Process and Strategic Management Accounting
Given that (strategic) management accounting aims at providing the decision

makers with information useful for making decisions in an informed way, it is
worth applying these techniques to the five-step decision-making framework.
Note:
Management accounting (MA)
Strategic management accounting (SMA)
Step one – identify the problem and uncertainties
MA identifies specific short-term operational problems
Example: is it worth marginally reducing the volume of production?
SMA considers broader cross-departmental problems
Example: how to re-organise the organisation’s activities and issues such

appropriate organizational structure.
Step two – obtain information
MA focus on easily measurable short-term variables Example: short run

variable and fixed costs.
SMA takes broader, long term perspective by considering all relevant

variables and aspects such as life cycle cost and use of target costing
techniques to consider impact on competition.
Example: production, marketing, operations fall-out effects of modifying the

activities, competitors reactions.
Step three – make predictions about the future
MA makes simple predictions based on simple formulae.
Example: cost volume profit analysis
SMA considers complex alternative scenarios including competitors’

reactions.
Example: changes in portfolio of outputs, customers’ perceptions, customer

targets
Step four – make decisions by choosing among alternatives
MA focus on clear results highlighting the best options or at least clear-cut

alternatives. However, no decisions should be taken solely based on short
415
term management accounting results such as lower or higher annual profit.
SMA makes decision based on cost/benefit analysis of each scenario, where

several aspects are evaluated such as impact on long-term reputation and
responsibility of the company to customers.
Example: A loss making product may be in the short term but presents
because it necessary to do so to protect the reputation in the long run.
Step five – implement the decisions, evaluate performance and learn
MA focus on measuring its effects and learn from any unexpected result in the
short run.
Example: fixed costs have changed and variable were more than proportional.
SMA focus on evaluation based on the new lead measures created by the
new scenario, learning from unexpected results and be ready to create two or
more scenarios.
Example: competitors reacted less than expected and the market share
increased more than expected. Logistics have been strained. Investors
appreciated the clear steer towards more corporate social responsibility but
are still more prudent than expected, i.e. expect higher returns than
envisaged, affecting the firm’s economic value added (EVA®).
416
Homework Questions Lecture 21
Question 1
a)
High Quality Toys Ltd manufactures and sells model train sets. The following
table presents information pertaining to the company’s analysis of quality.
Year 2007 2008

£000 £000
Revenues 20,000 25,000
Quality costs
Inspection of production 180 170
Design engineering 240 600
Cost of returned goods 160 300
Product-testing labour and equipment 490 200
Customer support 100 85
Scrap and rework costs 690 650
Preventative equipment maintenance 120 230
Incoming materials inspection 70 100
Breakdown maintenance 180 70
Warranty repair 1,200 635
Supplier evaluation 70 220
Required:
i)Classify the items in the table into the four cost of quality categories.
(8 marks)
ii)Calculate the percentage of the sum of each cost of quality category to

revenues in 2007 and 2008.(4 marks)
iii)Discuss the trends in costs of quality between 2007 and 2008.(3 marks)
b)
High Quality Toys Ltd has just acquired a patent to produce a replica of the
Japanese bullet train using a different type of track from its previous models.
This will require new design, new jigs and staff training. The financial
information concerning the new train set is as follows: Investment costs will be
– patent £0.5 million, design cost £2.6 million, jigs cost £2.0 million, training
costs £0.5 million.
The company expects to earn a pretax return on initial investment of 40%.

Market analysis shows that the company can sell 10,000 units in the first year.
To achieve this level of sales, the firm forecasts that the selling price cannot
exceed £600 per bullet train.
Variable selling commissions will be £30 per unit.

Fixed administrative cost for this activity is estimated to be £80,000 for the
year.
417
Required:
i.) Calculate the target production cost per bullet train in order that High
Quality Toys Ltd can achieve its return on investment objectives. (5 marks)
ii)Briefly explain the difference between target costing and traditional product
costing. ( 5 marks)
Question 2
a) Discuss the advantages and limitations of using financial measures to
monitor and appraise the performance of sections of a business. (12 marks)
b) Some companies have considered using the Balanced Scorecard for

performance appraisal. Give reasons for using this approach and indicate the
problems in using the method which have been uncovered by research.
(13 marks)
Question 3
Describe the four different categories into which the costs and benefits of
activities to improve quality within organisations are often divided. Give
examples of the costs which would appear in each category. Explain how
benefits can be quantified financially and describe how non - financial benefits
can be identified and measured.
(UOL adapted 2010 Zone A Question 6, 25 marks)
418
Question 4
Sweets Galore Ltd has three production divisions in different parts of the
country. The divisional financial reports on a historical cost basis for the year
ended 31st March 2009 for each division are as follows:
Division E F G
£000 £000 £000
Income Statement
Revenues 500 700 920
Less: operating expenses 294 412 541
straight-line depreciation 84 120 160
Net profit 122 168 219
Balance Sheet values

Fixed Assets Cost 840 1,200 1,600
Accumulated depreciation 756 480 160
Net book value 84 720 1,440
Net Current Assets 200 250 300
Net total assets 284 970 1,740
Divisions fixed assets acquired when price index 136 160 170
was
Price index at 31.3.09 = 180

The company appraises the divisions using three measures: Return on net
total assets, Net total asset turnover and Net profit percentage.
Required:
(a) Using the historical cost approach to asset valuation, calculate the three
measures indicated above for each division and discuss the performance of
the divisions as revealed by the calculations. (4 marks)
(b) The manager of Division G feels that the method of assets valuation for
is unfair and requests that a current cost accounting approach be applied to
Fixed Asset valuation and depreciation charges. It is agreed that the net
current assets figures represent current values and the price index should be
used to revalue the fixed assets. For each of the divisions, calculate the three
measures calculated in a) but using current cost accounting. Discuss the
performance of the divisions as revealed by the calculations. (8 marks)
419
(c) A new member of the head office accounting staff argues that a fairer
method would be to ignore depreciation completely and calculate the ratios
using EBITDA/historical gross fixed assets plus net current assets. He argues
that this measure most closely represents the original investment decision.
The manager of Division G would prefer this measure to use current cost
valuations. Calculate the ratios using these two bases and discuss the
performance of the divisions as revealed by the calculations. (8 marks)
(d) Briefly explain which of the methods in (a) - (c) above seems fairest for
evaluation purposes. (5 marks)
Question 5
What is meant by the balanced scorecard approach to management
information? Outline and discuss the four perspectives which are normally
identified in the balanced scorecard. Are there any further perspectives that
you might identify, and why?
(25 marks)
Question 6
Explain why quality is important to businesses and the difficulties in
measuring quality costs. For each of the four categories of quality
measurement indicate the accounting records which are required to collect
quality costs and indicate complementary non-financial measures which can
be used. (15 marks)
(UOL adapted 2008 Zone B Question 5a)
Question 7
Theories of managerial performance measurement vary from advocating a
single all encompassing figure such as Economic Value Added to
recommending a wide variety of measures such as those seen in the
Balanced Scorecard.
Explain the two terms ‘Economic Value Added’ and ‘Balanced Scorecard’ and
critically evaluate their different approaches to performance evaluation.
(25 marks)
420
Question 8
(a) Greenwood Ltd manufactures and sells car accessories. The following
table presents information pertaining to the company’s analysis of quality.
Year 2007 2008

£000 £000
Revenues 20,000 25,000
Quality Costs
Inspection of production 220 170
Design engineering 210 600
Cost of returned goods 120 300
Product-testing labour and equipment 530 250
Customer support 80 65
Scrap and rework costs 720 670
Preventative equipment maintenance 110 200
Incoming materials inspection 50 80
Breakdown maintenance 180 80
Warranty repair 1,000 635
Supplier evaluation 80 200
Required:
i. Classify the items in the table into the four cost of quality categories.
(8 marks)
ii. Calculate the sum of each category of cost of quality and the total as a
percentage of the revenues in each year, 2007 and 2008. (4 marks)
iii. Comment on the trends in costs of quality between 2007 and 2008.
(3 marks)
(b) Greenwood Ltd has just acquired a patent on an antifreeze recycler which
filtersa car’s used antifreeze to remove dissolved chemicals, and returns it to
the car.
The financial information concerning the new recycler is as follows:-
Investment costs will be – patent cost of £2.2 million, plant cost of £9.6 million,
and additional working capital of £3.0 million.
The company expects to earn a pretax return on the initial investment of 20%.
Market analysis shows that the company can sell 2,960 units in the first year.
To achieve this level of sales, the firm forecasts that the selling price cannot
exceed £2,500 per recycler.
421
Variable selling commissions will be £70 per unit.
Fixed administrative cost for this activity is estimated to be £740,000 for the
year.
Required:
i. Calculate the target production cost per recycler in order for Greenwood Ltd
to achieve return on investment objectives. (5 marks)
ii. Briefly explain the difference between target costing and traditional product
costing. (5 marks)
(UOL adapted 2008 Zone B Question 4 ,25 Marks)
Question 9
Describe ways in which the financial information provided by lifecycle costing
can be used in strategic planning, decision making and control
The End –(All) Lecture Notes- FINALLY
422

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University Of London

Readings: Horngren Chapter 15

The parts on Kaizen Budgeting and Responsibility Accounting are also

Fixed (Static) Budgets

A fixed budget is prepared based an estimated volume of production and sales.

Flexible budgets are used to measure performance of individuals and

Steps In the preparation of the flexible budgets

Step 1 – Analyse all cost into fixed & variable category

Step 4 – Prepare the Flexible Budget (Performance Statement )

A flexible budget is necessary to evaluate performance relative to the budget.

For example, is the following performance report meaningful?

Units sold Units produced

Total variable cost

Total Variable cost

Number of meals 1,200 1,560

The budget above is based on the following assumptions:

3) Food costs represent 12·5% of revenue from food sales.

4) Drink costs represent 20% of revenue from drinks sales.

Staff Cost (plus overtime)

Total Variable Cost 27,826

Total Contribution 50,174

Less: Fixed Cost

You need to structure the flexible budget immediately after

There lots of easy marks to get for the flexible budget

Direct Exhibition Cost

• There will be an equal number of large and small stands.

• Hall hire will average £39,000 per day.

• Advertising directed at exhibitors is incurred for each exhibition and is not

• 10 freelance fitters and electricians take a total of 3 working days to set up

• While the exhibition is running Blue Skies will need to provide an

• Blue Skies’ Head Office budget for 2020 is £432,000.

• Income was £2,570,400 made up of 2,100 exhibition days of small stalls at

• Advertising and publicity aimed at exhibitors - £636,000 Advertising and

• Set up and dismantling £55,080 (270 man days at £204).

• Exhibition administration £32,640 (170 man days at £192).

• Head Office expenses for the quarter amounted to £111,600.

I. A budget for the quarter based on the original planned activity.

Total Revenue 2,864,160 2,533,680

Divisional Controllable Cost

Division controllable profit

A significant aspect of kaizen budgeting is employee input or The Japanese tend to

Many companies that have cost reduction as a strategic focus use

The Japanese are not

Individual managers are responsible for investigating variances between

Budgeting & Responsibility Accounting

Organization structure is the arrangement of lines of responsibility within the

In a decentralised organisation, decision making authority and responsibility is

In any responsibility centre, it is important to ensure that

Responsibility accounting assigns authority and responsibility to managers of

4) Investment centre, in which the manager is accountable for revenues and

A division within the company may be accounted for as an investment centre

Type of Centre Manager has Principal

Cost Centre Controllable cost Minimise cost Cost Variance

Profit Centre Controllable cost Maximise profit Profit Variances

Investment Controllable cost, Maximise ROI Return on

Revenue Sales revenue Maximise sales Revenue variances

The choice of a responsibility centre type guides the variables to be included in

1) Functional work units. Functional work units focus of work unit is on a

Such work units are either cost centres or revenue centres

2) Business (Market-based) work units. The Focus of business work unit is a

Refer to the above chart and designate the departments as appropriate

Department (work unit) Responsibility Centres

Business (market-based) work units tend to be profit or investment centres