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STUDYNOTES
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Table of Contents
Foreword 3
Performance Management 13
Exam Overview 13
Revision of Management Accounting 14
Syllabus Area B: 20
Specialist Cost and Management Accounting Techniques 20
Activity-Based Costing: 21
Target Costing 26
Life-Cycle Costing 30
Throughput Accounting 33
Environmental Accounting 40
Syllabus Area C: 45
Decision Making Techniques 45
Cost Volume Profit Analysis (CVP) 46
Relevant Cost Analysis 58
Make-or-Buy and Other Short-Term Decisions 63
Limiting Factors 71
Pricing Decisions 81
Dealing with Risk and Uncertainty 95
Syllabus area D: 108
Budgeting and Control 108
Budgeting and Quantitative Analysis 109
Quantitative Analysis in Budgeting 121
Learning Effect 138
Standard Costing and Advanced Variances 142
Transfer Pricing and Divisional Performance Measurement 171
Syllabus Area A andE: 182
Performance Measurement and Control 182
Performance Measurement in Private and Public Sector 183
Performance Analysis in Not-for-Profit Sector 198
External Consideration and I.T. 203
Foreword 2
Exam and Exam Formulae
Exam duration
The exams are computer based. They are for 3 hours and 15 minutes and are for 100 marks. Prior to
that, students will get 10 minutes to read the exam instructions.
Exam format
Section Style Description Marks
A MCQS 15 x 2 30
B Case MCQs 3 x 10 30
(5 questions of 2marks)
C Constructed 2 x 20 40
100
Exam formulae
1. Demand Curve
P = a-bQ
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
b = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
a = price when Q=0
MR = a-2bQ
2. Learning Curve
Y = axb
Where Y = cumulative average time per unit to produce x units
a = the time taken for the first unit of output
x = the cumulative number of units
b = the index of learning (logLR/Log 2)
LR = the learning rate as a decimal

Foreword 3
Foreword
‘By the ACCA, for the ACCA’
These notes are designed with a simple mission, to fill the gap for Indian students who don’t find
comfort in studying from notes that are framed in a complex manner. Our priority at Zell is to improve
the results our students achieve by providing all that they need, be it quality education, state of the
art infrastructure and techniques or the next step, the content that perfectly fits in making the trifecta
or the winning formula.
Here at Zell, we don’t worry about the background, prior knowledge or preferences someone has. The
aim is simple, by the time a student is done with a paper, they are on the same page as anyone else
and that for us, should be enough knowledge to be able to call them a professional truly.
Keeping all this in mind, we bring to you these notes, created by us, for you, to truly help make the
difference and turn your journey of ACCA into an even better one. This is just the beginning; there is
more in store.
Thank you
Credits:
Authored by:
Kalpesh Naik
Bianca Bakhai
Designed by:
Ravi Gupta
Harshita Shah
Last updated: May 2022

Foreword 4
The Best Way to Study
Planning how to study
Before starting the preparation for any paper, you should always make a macro level plan on how to
go about preparing for the exam. Understand what is expected of you to be able to clear the exam
with high scores. It is important to set targets and stick to them, to ensure that you stay on track and
progress in your ACCA journey.
Have a plan from the beginning about where you want to be at the end of the month or two months,
then work backwards and understand what you must do to stay on track. Then, at the start of every
week, make a brief plan about how much needs to be covered every day, resulting in the timely
completion of the exam.
Break your macro plan intro studying along with the professor/recordings, examination month and
final revision. Plan how many hours can you give every day and make a schedule accordingly. Ensure
that you can give quality hours without distractions. The quantity of hours doesn’t matter.
How to approach the exam
Knowing how much importance ACCA places on application-based learning is important. You must
understand that rote learning in any exam for any concept will mostly amount to zero marks being
scored.
Students leave minimal time to their core exam preparation and directly jump into mock exams
without finishing the exam kit. Leave the exam month for core practice of questions available to you,
ensure you finish the conceptual understanding before starting to do so.
The ideal approach is to watch/attend lectures and keep up with the pace, practicing 40% of the
question bank alongside, to cement conceptual understanding. Once classes conclude, ensure the
remaining 60% of the question bank is solved, followed by at least three mock examinations before
attempting the main exam.
Exam month
• In the exam month, ensure that you finish the portion as soon as possible and shift all focus
to completing the question bank. Remember, completing the textbook alone is not enough,
whereas completing the question bank gives you a higher chance of clearing the exam.
• If you are done with your question bank, repeat the question bank or key questions you
marked before the exam. Only 40% of your total time should be allocated to building a
conceptual understanding, the remaining 60% to solve questions.
• You must practice newly launched past exam questions available on the ACCA website at the
end to ensure you can solve questions of the rigor expected from you.
• Ensure you do not get into the habit of reading a question and then reading the answer. This
approach will make you seek answers in the exam and not seek solutions on your own. Read
a question, solve it on your own, check the answer. If it is incorrect, solve the question again
to get another answer, rather than reading the explanation to understand what you did
wrong. That should always be the last resort.
• For subjective questions, do not simply read the answer and make notes. Type the answer or
solve it on a spreadsheet before checking the solution. Practicing on a computer for a
computer-based exam can make the difference for you in finishing the exam.
Foreword 5
• Familiarize yourself with the scientific calculator, the CBE exam platform and other tools to
ensure you are comfortable with the same in the actual exam.
• Ensure you complete 100% of the portion. Do not skip anything as the exam will test you on
a range of interconnected topics, and leaving parts of the portion will guarantee you are
losing certain marks.
Exam strategy
There are certain things to be kept in mind before attempting the main exam.
1. Remain calm before the exam. Do not study at the last moment, as going into the exam with
a fresh mind will allow you to tackle the questions more easily.
2. There is no negative marking in the exams. Ensure that you attempt 100% of the paper to
ensure that some of your educated guesses score some marks even in the worst case.
3. The examination is 3 hours 15 minutes long, which means you have 195 minutes for 100
marks, or simply 1.95 minutes per mark. Ensure you don’t get overboard with the time you
take to solve a question at hand.
4. Ensure you read the question very carefully. Don’t assume that you faced a similar question
in the past and jump to solving it as the requirements can vary even in small concepts
causing you to lose easy marks.
5. Read the requirements carefully. Pay attention to the verb used, Define, explain, calculate,
evaluate etc., to understand what the examiner is seeking to ensure you answer on those
lines.
6. Do not go for quantity when you are answering subjective questions. The examiner will
award one mark per valid statement and one mark only per valid point. Do not elaborate on
points to simply write more.
7. The options are set up so that even answers derived using the wrong steps are available as
options. Do not jump to the conclusion that your answer has to be correct because it is
available as an option.
8. If there is a tricky question that you can’t solve, make an educated guess by eliminating the
one’s you definitely know are wrong, flag the question and move ahead. If you finish the
paper and have remaining time, revisit the flag questions to score full marks.
9. Do not sit and recalculate the answer you got more than twice, as you are likely to calculate
it in the same way you did previously, by repeating the same mistake if any. This is a massive
waste of your crucial time. Rather move faster and revisit key questions at the end,
recalculating your answers at that point will possibly reveal mistakes and allow you to rectify
them, thus scoring more marks.
Foreword 6
Elements
Syllabus wise study material
The study material is curated in a manner where the syllabus provided by ACCA has been covered in
vast depth, and the order is set in a way that the flow of concepts within the material suits a
student.
Apply Your Knowledge
Various AYK style questions test the student on their ability to remember and understand concepts
thoroughly before moving to analytical questions.
Quiz
Further, there are primarily application-based quiz questions, introducing the student to analytical
and evaluative questions to bring the student one step closer to actual exam-style questions.
Recap
After the end of every main chapter, there is a recap summarizing all the important topics, formulae
etc., to enable ease of revision for the student.
Mind Maps
Mind maps are flowcharts that summarise the information visually, making it more likely for a
student to retain the knowledge and build upon it. These are present at the end of the book to
enable last-minute revision by simply spending time on those pages.
Foreword 7
Nimbus™ Preparation tools
Interactive notes with gamification
The articulated version of the notes is available on the platform, allowing students to get fully
immersed in their learning and complete more in less or equivalent time they spend reading the
book.
Case studies
Case studies are specifically tailored to address the audience commonly using these notes. Having
interesting case studies based on current affairs, covering key organisations etc., contribute to
further professional development.
Technical articles
ACCA’s technical articles are placed strategically in the material, allowing students to understand
when they are supposed to go through these all-important technical articles.
Exam experience
The system mimics the exam experience to ensure that the student has conceptually and technically
mastered the paper before appearing for the exam. This includes various objective questions, live
spreadsheets and word processors to practice typing, presentation and most importantly, time
management.
Question Bank & Test Series
The students have access to unit tests, half portion tests, progressive tests, mock tests and unlimited
practice tests with all performance data allowing them to know where they stand, the
improvements required before the exam day arrives.
Flashcards and Interactive mind maps for revision
Flashcards help students quiz themselves, which is more effective as a revision technique than
simply reading through pages. Interactive mind maps allow the student the power to take a detailed
glance through a whole chapter or large concept in minutes while revising at the same time.
Check the last page of this book for more information on Nimbus™ LMS by Zell
Foreword 8
ACCA support
Examining team guidance/Exam technique & reports
The examiners’ reports are an essential study resource. Read them to learn about mistakes that
students commonly make in exams and how to avoid them.
Practice tests
Practice Tests are an interactive study support resource that will replicate the format of all the
exams available as on-demand computer-based exams (CBEs). They will help you to identify your
strengths and weaknesses before you take an exam.
As well as giving you an insight into a live exam experience, Practice Tests will also provide feedback
on your performance. Once you complete the test, you will receive a personalised feedback diagram
showing how you have performed across the different areas of the syllabus.
Specimen exams
The specimen exam indicates how the exam will be assessed, structured and the likely style and
range of questions that could be asked. Any student preparing to take this exam should familiarise
themselves with the exam style.
Technical articles
There is a range of technical articles available on ACCAs website under ‘Study support resources’.
These include a range of simplified articles on complex topics, study support videos, articles on exam
technique etc. making it an important tool to be practised when nearing the exam.
FAQs
Various commonly asked questions about the style of the examination, the coverage, computer-
based exam setup etc., are covered here to allow a student to stay up to date and ensure their
understanding is aligned with that of the ACCA body.
Question practice – ACCA practice platform
Question practice is a vital part of exam preparation. Practising in the CBE environment provides a
fantastic opportunity to get fully prepared for the real exam.
The ACCA Practice Platform contains a range of content that allows you to attempt questions to time
and then mark and debrief your answers. It also contains a blank workspace that allows you to
answer constructed response questions from other sources in the CBE environment.
Past Exam library
Past exams are made available to view and become familiar with the styles of questions that you
may face in your exam.
Make sure you log into the ACCA Practice Platform early in your studies - completing your practice in
the CBE environment is the only way to prepare for your exam fully.
Foreword 9
CBE Support
Getting ready for your CBE includes getting familiar with the CBE functionality and how to use it to
your advantage in the exam. You should be thinking about your exam approach well before exam
day itself.
There are series of videos that will help you get ready for your exam. It includes what to think about
before your exam day, exam strategy, how to manage your CBE workspace effectively and
techniques you could use to plan and complete your answers.
Foreword 10
Syllabus
Introduction to the syllabus
The aim of the syllabus is to develop knowledge and skills in the application of management
accounting techniques to quantitative and qualitative information for planning, decision-making,
performance evaluation, and control.
The syllabus for Performance Management (PM), builds on the knowledge gained in Management
Accounting (MA) and seeks to examine candidates’ understanding of how to manage the performance
of a business. It also prepares candidates for more specialist capabilities which are covered in
Advanced Performance Management (APM).
The syllabus then introduces more specialised costing and management accounting topics. There is
some knowledge assumed from Management Accounting (MA) – primarily overhead treatments. The
objective here is to ensure candidates have a broader background in management accounting
techniques.
The syllabus then considers decision-making. Candidates need to appreciate the problems
surrounding scarce resources, pricing and make-or-buy decisions, and how this relates to the
assessment of performance. Risk and uncertainty are a factor of real-life decisions and candidates
need to understand risk and be able to apply some basic methods to help resolve the risks inherent in
decision-making.
Budgeting is an important aspect of many accountants’ lives. The syllabus explores different budgeting
techniques, including quantitative techniques, and the problems inherent in them. The behavioural
aspects of budgeting are important for accountants to understand, and the syllabus includes
consideration of the way individuals react to a budget. The preparation of fixed, flexible and
incremental budgets is assumed knowledge from Management Accounting (MA).
Standard costing and variances are then built on. All the variances examined in Management
Accounting (MA) are assumed knowledge in Performance Management (PM). Mix and yield variances
and planning and operational variances are explored here, and the link is made to performance
management. It is important for accountants to be able to interpret the numbers that they calculate
and discuss what they mean in the context of performance.
The syllabus concludes with performance measurement and control. This is a major area of the
syllabus. Accountants should appreciate the importance of both financial and non-financial
performance measures in management and should also appreciate the difficulties in assessing
performance in divisionalised businesses and the problems caused by failing to consider external
influences on performance. This section leads directly to Advanced Performance Management (APM).
The syllabus begins by focusing on the information needs, technologies and systems required by
organisations to manage and measure performance in the modern, competitive environment. It is
vital for an accountant to understand how information systems and developments in technology
influence the management accounting techniques employed and how vital information systems are
in the mechanisms of managing and controlling an organisation.
All of the subject areas covered in this syllabus could be examined in either a public sector or private
sector context.
Foreword 11
Section F of the syllabus contains outcomes relating to the demonstration of appropriate digital and
employability skills in preparing for and taking the PM examination. This includes being able to interact
with different question item types, manage information presented in digital format and being able to
use the relevant functionality and technology to prepare and present response options in a
professional manner. These skills are specifically developed by practicing and preparing for the PM
examination, using the learning support content for computer-based examinations available via the
practice platform and the ACCA website and will need to be demonstrated during the live examination.
Main capabilities
On successful completion of this exam, candidates should be able to:
A. Identify and discuss the information, systems and developments in technology required for
organisations to manage and measure performance.
B. Explain and apply cost accounting techniques.
C. Select and appropriately apply decision-making techniques to facilitate business decisions and
promote efficient and effective use of scarce business resources, appreciating the risks and
uncertainty inherent in business and controlling those risks.
D. Identify and apply appropriate budgeting techniques and methods for planning and control
and use standard costing systems to measure and control business performance and to
identify remedial action.
E. Assess the performance of an organisation from both a financial and non-financial viewpoint,
appreciating the problems of controlling divisionalised businesses and the importance of
allowing for external aspects.
F. Demonstrate required employability and technology skills.
ACCA Performance Objectives
Objective Chapter in Text
PO1 Ethics and professionalism Performance analysis in Not-for-profit sector
PO12 Evaluate management accounting systems External Considerations and I.T.
PO13 Plan and control performance Performance measurement in Private and

public sector
PO14 Monitor performance Transfer pricing and divisional performance

measurement
PO22 Data analysis and decision support Dealing with risk and uncertainty
Foreword 12
Exam structure
The syllabus is assessed by a three-hour computer-based examination. Prior to the start of the exam
candidates are given an extra 10 minutes to read the exam instructions.
All questions are compulsory. The exam will contain both computational and discursive elements.
Some questions will adopt a scenario/case study approach.
Candidates are provided with a formulae sheet.
Section A of the exam comprises 15 objective test questions of 2 marks each.
Section B of the exam comprises of three case style questions. These each contain five objective test
questions of two marks each which are based around a common scenario.
Section C of the exam comprises two 20 mark constructed response questions. The two 20-mark
questions will come from the decision-making techniques, budgeting and control and/or
performance measurement and control areas of the syllabus. These questions may also include
requirements related to the information systems area of the syllabus. The section A questions and
the questions in section B can cover any areas of the syllabus.
Total 100 marks

Exam Overview 13
Performance Management
Exam Overview
Let us begin with understanding the actual meaning of the title of our course, which is ‘Performance
Management’.
What is performance?
There is no fixed way of defining what is performance. Performance is a subjective term and differs
from organization to organization. For e.g., Performance for a tuition provider may be the number of
students passing a particular exam, Performance for a hospital may be the number of patients
treated, Performance for a producer may be the number of goods produced and so on. You may
even think of your own performance measures for the above organization; thus, it can be concluded
that performance is subjective.
What is performance management?
Performance management is the process of improving the performance of any organization. This
could be an increase in productivity, efficiency, innovation etc. It is also an ongoing process of
communication between a supervisor and an employee that occurs throughout the year in support
of accomplishing the objectives of the organization.
How does performance management differ from performance measurement?
Performance measurement is the knowledge about where we are currently standing that is our
current position, and performance management is about where we want to go that is our future
goals and aims. Both the processes are important and interlinked. For e.g., one cannot improve if
one doesn’t know where he currently stands.
Throughout the exam, you will need to put yourself into the shoes of a Management Accountant and
think like one. The syllabus for Performance Management (PM), builds on the knowledge gained in
Management Accounting (MA) and seeks to examine candidates’ understanding of how to manage
the performance of a business. It also prepares candidates for more specialist capabilities which are
covered in Advanced Performance Management (APM).
Revision of Management Accounting
1. Absorption Costing
Let’s take a look at how costing of a product would be done using absorption costing:
Cost Card $
Direct materials X
Direct labour X
Direct expenses X
Variable production overhead X
Fixed production overhead (OAR) X
Full production cost XX
As we can see, we value our inventory at full production cost. Note that non-production costs such
as selling and administration expenses are excluded from the inventory valuation and are added
later when calculating profit. That’s simply because we want to know how much it costs us to
produce the inventory.
This full production cost is what is used to value closing inventory, if any, at the end of the year.
Now, it is important to remember that overheads absorbed and actual overheads incurred are
different. Hence, once we have actual overheads, we need to account for them.
This is how a cost statement looks when we use absorption costing:
$ $
Sales X
Less: Cost of sales
Opening inventory X
Variable cost of production X
Fixed overhead absorbed X
Less: Closing inventory (X) (X)
X
(under)/over absorption (X)/X
Gross profit X
Less: Non-production costs (X)
Profit/Loss X
You might wonder, why do we remove under absorption? Doesn’t under absorption mean we
absorbed less than the actual cost? You are correct. What you need to understand is we’re removing
it from the profit. A decrease in profit or increase in expense is the same thing.
To summarize;
Under absorption (which means we spent more than we budgeted/absorbed) is removed or

deducted from the profit.
Actual overhead > Absorbed overhead = Under absorption = -Profit
Over absorption (which means we spent less than we budgeted/absorbed) is added to the profit as
we spent less.
Actual overhead < Absorbed overhead = Over absorption = +Profit
Apply Your Knowledge: (Absorption costing)
Chair Co produces chairs:

Direct materials: 3kg ($5/kg)
Direct labour: 5 hours ($2/hour)
Variable production overhead: $4/unit
Budgeted activity level: 15,000 units/month

Budgeted fixed production overhead: $30000/month
Actual fixed production overhead for the month: $27000
Selling price: $50/unit

Variable non-production cost: $1/unit
Fixed non-production cost: $2500/month
For March:
Production: 16000 units
Sales: 14000 units
There is no opening inventory
Prepare the following:

a) Cost card
b) Profit/loss statement for the month of March
Solution:
a) The cost card under absorption costing will be:
Cost Card $
Direct materials ($3 x 5kg) 15
Direct labour ($2 x 5hours) 10
Variable production overhead (Given) 4
Fixed production overhead (OAR) 2
Full production cost 31
OAR = Budgeted fixed production/budgeted activity level

OAR = $30000/15000 =$2
b) Profit/Loss statement under Absorption costing

$ $
Sales ($50 x 14000) 700000
Less: Cost of sales
Opening inventory -
Variable cost of production ($29 x 16000) 464000
Fixed overhead absorbed ($2 x 16000) 32000
Less: Closing inventory ($31 x 2000) (62000) (434000)
266000
Over absorption (Note) 5000
Gross profit 271000
Less: Non-production costs (2500 + ($1 x 14000)) (16500)
Profit/Loss 254500
Notes:
Actual fixed overhead =$27000
Overhead absorbed =$32000
More overhead is absorbed than actually incurred, meaning there is over absorption. Profit will
increase as we removed 5000 more earlier, now we add it back.
Over absorption =$32000-$27000 =$5000
2) Marginal Costing
Variable cost increases as units increase, meaning it’s an additional cost that we incur. Total variable
cost of production includes direct material, direct labour, direct expenses and variable production
overheads.
Absorption costing values inventory at full production cost, marginal costing values inventory at
marginal or variable production cost.
Before we dig deeper, we need to understand the concept of contribution.
Contribution
As we understood, marginal cost takes into account all variable costs, but not fixed costs. Obviously,
what remains can’t be termed as profit. Profit is calculated after all costs are deducted. Hence, the
term contribution.
Contribution = Sales price – all variable costs (production & non-production)
Simply put, a contribution is an amount that the product will contribute towards the recovery of
fixed costs.
How much ‘money’ do we have to ‘contribute’ towards paying for the fixed costs.
If this money, (known as contribution) is more than fixed costs, we have a profit. If it is less, it means
we did not earn enough to recover fixed costs and hence made a loss.
Contribution per unit therefore remains constant, profit varies as the more we sell, the more total
contribution we’ll have to recover fixed costs from.
This can be demonstrated in the cost statement below:

$ $
Sales X
Less: Cost of sales
Opening inventory X
Variable cost of production X
Less: Closing inventory (X) (X)
X
Less: Other variable costs (X)
Contribution X
Less: Fixed costs (X)
Profit/Loss X
As we can see, we directly deduct the actual fixed cost as a period cost in the end. Hence, the
complicated under or over absorption issues don’t arise here.
Apply Your Knowledge: (Marginal costing)
Chair Co produces chairs:

Direct materials: 3kg ($5/kg)
Direct labour 5 hours: $2/hour
Variable production overhead $4/unit
Budgeted activity level: 15,000 units/month

Budgeted fixed production overhead: $30000/month
Actual fixed production overhead for the month: $27000
Selling price: $50/unit

Variable non-production cost: $1/unit
Fixed non-production cost: $2500/month
For March:
Production: 16000 units
Sales: 14000 units
There is no opening inventory
Prepare the following:

a) Cost card
b) Profit/loss statement for the month of March
Solution:
a) Cost card under marginal costing
Cost Card $
Direct materials ($3 x 5kg) 15

Direct labour ($2 x 5hours) 10
Variable production overhead (Given) 4
Variable production cost 29
b) Profit/Loss statement under marginal costing

$ $
Sales ($50 x 14000) 700000
Less: Cost of sales
Opening inventory -
Variable cost of production ($29 x 16000) 464000
Less: Closing inventory ($29 x 2000) (58000) (406000)
294000
Less: Other variable costs ($1 x 14000) (14000)
Contribution 280000
Less: Fixed costs (Actual=$27000+$2500) (29500)
Profit/Loss 250500
Note:
Contribution can also be calculated by calculating contribution per unit

Sales $50
Variable production costs $29
Variable non-production costs $1
Contribution $20
Sales units 14000

Total contribution 280000
3) Standard Costing:
Until now, we’ve learnt absorption and marginal costing, now we’ll be learning standard costing.
While standard costing is not another method, it is more like a complement to the other two
methods, as it uses the two methods as well.
A standard cost is basically a planned ‘target’ cost of a product or a service, or how much should the
cost have been. These are set beforehand during the planning process and represents how much the
cost should be. But in reality, the cost will slightly differ.
Such a difference is called a variance, in standard costing we’ll be studying why variances occur, how
to calculate and justify the difference in cost or variance. We have seen basic variances in budgeting,
when we compare flexed budgets, but still, we need to know:
A profitable or a positive variance is known as a favorable variance. If we ended up spending less

than we budgeted, it will be known as a favorable movement and hence a favorable variance.
A costly or a negative variance is known as an adverse variance. If we ended up spending more than
we budgeted, it will be known as an adverse movement and hence an adverse variance.
For such budgeting, we use marginal and absorption costing.
Types of cost standards
The standard cost we discussed, can be based on one of the following four standards:
● Basic standards
A basic standard is a long-term unchanged standard. Their use is fairly limited and are the
least useful type of standard. They are mainly used to show a change in cost prices over
time.
● Ideal standards
These standards are based on perfect operating conditions. Where there is no wastage,
labor is fully trained and efficient, machine breakdowns are impossible etc. These aren’t
possible to achieve in reality, but can be set to compare how far currently we are.
● Attainable standards
These are the standards at a level which the production can reach with over time. Conditions
which will be efficient, however not perfect. These are the most frequently used standards.
They are set above current standards and are constantly updated once achieved.
● Current standards
These standards are based on current levels of production efficiency. Where we stand
currently. These are obviously required and necessary. Comparing these with attainable
standards is where we find the areas to optimize. Current standards include allowances for
breakdowns, idle time etc. and are easily achievable, hence they should not be used to set
targets, but to close the gap with targets.
Syllabus Area B:
Specialist Cost and Management Accounting Techniques

Activity-Based Costing:
Syllabus Area B1 a-b-c

- Identify appropriate cost drivers under ABC.
- Calculate costs per driver and per unit using ABC.
- Compare ABC and traditional methods of overhead absorption based on production units,
labour hours or machine hours.
Introduction:
In earlier exams, we have seen that there are two traditional methods of costing, which are
absorption and marginal costing. Even though absorption costing tries to absorb the fixed
production overheads into the product cost, it fails to do it accurately.
E.g., If a factory produces 50 units of product A and 100 units of product B and the total machine set
up costs are $1500. According to normal absorption costing, this cost will be absorbed as $500 in
product A and $1000 in product B according to the number of units produced. This would be
completely wrong if product A required more set-ups than product B.
This problem is solved by Activity based costing. Activity based costing (ABC) is a method of costing
which involves identifying the costs of the main support activities and the factors that 'drive' the
costs of each activity. Overheads are charged to products by absorbing cost on the basis of the
product's usage of the factor driving the overheads that is using the cast drivers. Cost drivers are
factors that influence the level of cost.
Process of Activity Based costing can be divided into the following steps
1) Identify the major activities that give rise to overheads (e.g., machining), that is the cost pools. A
cost pool is an activity which consumes resources and hence for which costs are identified and
allocated.
2) Determine what causes the cost of each activity – the cost driver (e.g., machine hours). A cost
driver is a factor that influences the level of cost
3) Calculate a cost driver rate for each activity, and this is calculated in the same as absorption
costing i.e., OAR.
4) Absorb the activity costs into the product that is using the cost driver rate of the activity
calculate cost per unit.
5) Calculate the full production cost per unit and/or the profit/loss for each product.
Example of cost pool and its cost drivers
1) Machine set up costs- Number of machines set ups

2) Ordering costs- Number of orders
3) Dispatch costs- Number of orders dispatched
Apply Your Knowledge:
Continuing on our previous example:
If a factory produces 50 units of product A and 100 units of product B and the total machine set up
costs are $1500. Product A requires 10 set ups and product B requires 10 set ups in total.
Find the overhead cost of the products
Step 1: Identify the cost pool/activity
Here the cost pool/activity is machine set up costs.
Step 2: Calculate the total cost of the activity.
Here it is given that the total machining costs are $1500
Step 3: Identify the cost driver.
In the given scenario, it is easy to identify that the cost driver will be the number of machines set
ups.
Step4: Calculate the overhead absorption rate. (OAR)
This can be done by dividing the total cost by the total activity of the driver
=Total cost of machine set-ups/ Total number of set ups.
=1500/20
=75 per set up.
Step 5: Absorb the activity costs into the product
This is done by multiplying the overhead absorption rate (OAR) by the level of activity of the cost
driver required by each product.
= OAR*No. of set ups per product
For A For B
=75*10 =75*10
=750 =750
Step 6: Calculate the overhead cost per unit for each product
=Total overhead cost from step 5/ Total number of products

For A
=750/50
=15 per unit
For B
=750/100
=7.5 per unit
In this way, activity-based costing helps us to accurately allocate costs to products on the basis of
the activity levels. This would not be possible if we would have used the volume of products as the
cost driver like in the earlier example.
Comparison between Traditional Methods and ABC
Traditional ABC
Costs are not allocated to cost pools as this All costs are first allocated to cost pool which
method assumes that products consume all represents a particular activity.
activities in proportion to their production
volumes.
Overheads are absorbed on the basis of units, Overheads are absorbed on the basis of cost
labour hours or machine hours. drivers.
Same overhead absorption rate is used to absorb Absorption rate for different activities is different.
all overheads.
Traditional ways of costing are easy and simple to ABC is difficult to implement and to explain
explain
Advantages and Disadvantages of Activity Based Costing
Advantages:
1) More accurate prediction of a product’s cost. This further helps in better decision making,
and hence any organisation can stop producing loss making products.
2) Better understanding of what drives costs due to identification of cost driver. Thus, one can
plan to reduce the total cost by reducing the use of that particular driver.
3) Due to the above two reasons, it becomes easier to control overhead costs.
4) ABC can be applied to all overhead costs and not just production overheads.
5) Easier to apply in service costing when compared to traditional costing methods.
Disadvantages:
1) Complex and costly to implement as the information system that is necessary for running
the ABC model is expensive. Thus, the costs may not justify the benefits obtained.
2) Difficult to explain the method to stakeholders as they make lack technical knowledge.
3) Problems in identifying appropriate cost drivers and cost pools. This can happen when there
is more than one cost driver.
4) Limited benefit if the cost is primarily volume driven and thus traditional method would be
more appropriate.
5) It may be impossible to allocate all overhead activities to cost drivers.
In the exam you may be required to perform any given step. Make sure you understand the
logical flow of the ABC process. If it is examined in section C of the exam you may be asked to
give the pros and cons of ABC so ensure you can integrate the above points into the given
scenario.
1) Which of the following statements is true?

i) ABC can calculate realistic costs and hence can be used in complex business
environment.
ii) ABC can be only used by manufacturing companies.
a) Statement i
b) Statement ii
c) Both statements
d) None
2) Sydney co makes two products

Product A Product B Total
Budgeted units 1,000 4,000 5,000
Labour hours 8 10 48,000
Production runs 13 15 28
Number of inspections 5 3 8
Total production set up costs $140,000

Total inspection costs $ 80,000
Other overhead costs $ 96,000
Labour hours is the cost driver for other overhead costs.
Using ABC, what is the budgeted overhead cost per unit of product B?
a) 42.5
b) 44.25
c) 46.25
d) 48
Answers: 1-a, 2-c

Target Costing 26
Target Costing
Syllabus Area B2a-b-c

- Derive a target cost in manufacturing and service industries
- Explain the difficulties of using target costing in service industries
- Suggest how a target cost gap might be closed.
Introduction:
In the earlier costing methods, we calculated the total cost by adding all the direct costs and
overheads. The price of the good was decided on the basis of this calculated cost (by adding a
margin). But, in real life business scenarios, we are often the price takers and not price makers.
Which means that the price we charge to our customers should reflect the current prevailing
market price for a similar product. E.g., If you decide to sell a packet of chips, you will find that most
of the competitors are selling them at ₹10 per packet. This means that, for you to remain
competitive, you too need to sell them at ₹ 10.
Now to get a desired profit margin on this selling price, you will need to maintain a target cost,
which will be arrived at after deducting a desired profit margin. So, if want ₹ 2 of profit per packet,
your target cost will be₹ 8.
Steps involved in calculation of target cost.
1) Determine the product you want to sell

2) Determine the selling price of the product i.e., the price prevailing in the market
3) Decide the profit margin.
4) Calculate target cost = Selling price - Desired profit.
5) Estimate the current cost of the product.
6) Calculate cost gap = estimated current cost – Target cost
7) Make efforts to close the gap.
Target Costing 27
Example: Ray stationery wants to calculate the target cost and the cost gap for its new product
Razer which will sell at Rs 20. Ray wishes to make a profit of 20% on it and estimates that it will
currently cost Rs 17.
Let’s go according to the above steps:
1) Ray wants to sell a pen

2) ₹ 20 is the selling price
3) Required profit is 20%, i.e., ₹4
4) Target cost = 20-20% =₹16
5) Estimated cost=₹ 17
6) Cost gap= 17-16=₹ 1
7) Efforts should be made to close the above cost gap
How to Close a Cost Gap?
You must be wondering what exactly do we mean by taking efforts to close a target cost gap. We can
take the following steps to reduce the cost gap.
1) Reconsider the design of the project. We should look for any possible changes which can be
made to reduce the use of any element. Also, eliminating any extra process will reduce the
cost.
2) Source cheaper but similar quality materials from another supplier if available.
3) Try to remove features or elements which are not valued by customers(Value analysis).
E.g: A metallic body for a pen may not be valued by customers when they can get a lighter
plastic body. Care must be taken that the selling price of the product does not fall due to
this.
4) Costs can be reduced by reducing wastage of materials and idle time of employees.
5) We can achieve cost reductions through economies of scale by increasing the level of
production. Use of machines can help to reduce production cost.
6) Some parts of production can be outsourced to external parties who can give similar quality
at a reduced price due to better experience.
Target Costing 28
A section C question may ask ways to reduce a cost gap. You should be aware of the above
general techniques and should be able to integrate them in the given scenario of the
question.
Target Costing in Service Industries:
The key characteristics of a service industry are as follows.
1) Intangibility (It cannot be seen or touched)

2) Perishability (It cannot be stored)
3) Simultaneity (Produced and consumed at the same time)
4) Heterogeneity (There will be variations in the provision of the same service)
5) No transfer of ownership.
Due to the above characteristics, the following problems arise in the calculation of target costing:
1) Due to intangibility, it is difficult to define the service, and its costs as a large amount of
indirect costs are involved. Hence limiting the consistency with which the costs can be
calculated.
2) Due to the simultaneity feature, the customer will need to be present when the service is
provided to him, and this may be difficult. No service can be produced without the presence
of the customer.
3) Due to the perishability feature, one cannot store the service for the future and thus, there
will be demand-supply problems and hence increasing the difficulty of charging the desired
price.
4) Due to the heterogeneity feature, it is difficult to determine the market price as the quality
and consistency of the service varies.
5) As there is no transfer of ownership, the customer only gets a right to use the
facility/service.
Target Costing 29
1) Which of the following statements are true?

i. Target costing is a guarantee that company will make desired profits.
ii. Target costing is market driven approach.
a) Statement i
b) Statement ii
c) Both
d) None
2) The selling price of the product AMB is $2000. The producer requires a profit margin
of 40%. Its material costs are $550, labour costs are $750 and overheads are $150.
What is the cost gap for product AMB?
a) 200
b) 300
c) 275
d) 250
Answers: 1- b, 2-d
Life-Cycle Costing
Syllabus Area B3a-b-c

- Identify the costs involved at different stages of the lifecycle
- Derive a life-cycle cost or profit in manufacturing and service industries
- Identify the benefits of life-cycle costing.
Introduction:
All products have a particular life in which it is developed and sold. This life can be divided into 5
different stages:
1. Development:
In this stage, research and development costs are incurred but no revenue is generated.
2. Introduction:
The product is actual introduced into the market. Advertising expenses are high so as to
create awareness in the market.
3. Growth:
The product gains a bigger market due to an increase in demand. Revenue increases and the
product begins to make a profit. Per unit costs fall due to economies of scale.
4. Maturity:
Eventually, the rate of growth declines and demand slows down. Still, the product remains
profitable as sales volume is at its peak. Due to increased competition, marketing expenses
will increase.
5. Decline:
At this stage, the product reaches its saturation point. The demand for a product starts to
fall and hence the prices need to be reduced. Eventually, the product starts making losses.
Additional development costs may be incurred to refine the model to extend the life cycle of
the product.
The above diagram can help you explain the life cycle of a product.
How to calculate life cycle cost of a product?
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑜𝑣𝑒𝑟 𝑖𝑡𝑠 𝑙𝑖𝑓𝑒 𝑐𝑦𝑐𝑙𝑒

Life cycle cost =
𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠
Life cycle costing helps us to understand whether a product will be profitable or not by considering
its overall life cycle. That is, take its total costs that the product will incur over its whole life into
consideration. Sometimes a product delivers a loss in the initial stages but is profitable in its later
stages. Hence through life cycle costing, we can fairly appraise the products.
Traditional costing that is based on annual periods may give a misleading impression of the costs
and profitability as a product’s costs are not evenly spread through its life, and this is taken into
account by the life cycle costing method.
Following is the information regarding the total units produced and the various costs incurred. Find
out the life cycle cost of a product.
Years 0 1 2 3 4
Units manufactured 1000 12000 20000 5000
R&D cost 10,00,000
Marketing costs 100000 80000 55000 15000
Total production cost 100000 1200000 20000 500000
Disposal cost 350000
Total cost 10,00,000 2,00,000 12,80,000 75,000 8,65,000
Total cost 3420000

Total units 38000
Total cost per unit =3420000/38000=90
Benefits of Life Cycle Costing:
1) All the costs right from cradle to grave of an individual product are considered. This ensures
that the costing of a product includes all relevant costs.
2) As products entire life is considered, it ensures that all the products can be appraised in a
fair manner. This means products which are profitable later in life are also considered.
3) Better pricing decisions can be made on the basis of the life cycle costs.
4) Efforts can be made to reduce elements of cost to make the product more profitable.
5) 90% of the products lifecycle costs are determined by the decisions taken early in the cycle.
Hence, total costs can be reduced by proper planning.
6) It encourages long-term thinking and forward planning.
1) Which of the following statements are correct?
a) It is difficult to realistically estimate product’s costs at a start of products life.

b) Life cycle costing is useful for companies producing products with long life cycle and low
initial costs
Ans: Only a) Life cycle costing is useful for products with shorter life and high initial costs.
Throughput Accounting
Syllabus Area B4a-b-c-d

- Discuss and apply the theory of constraints.
- Calculate and interpret a throughput accounting ratio
- Suggest how a TPAR could be improved
- Apply throughput accounting to a multiproduct decision-making problem
Introduction:
The Theory of Constraints is a methodology for identifying the most important Constraint (Limiting
factor), which is standing between our way of achieving our goal. The theory also deals with
systematically managing this constraint until it no longer puts a limit on the output one can produce.
In manufacturing, the constraint is often referred to as a bottleneck.
E.g., An Ice-cream factory produces a particular type of ice cream, which passes through three
stages whose maximum output per day is given below-
Machine 1 Machine 2 Machine 3

100 units 80 units 120 units
The ice cream producer has a demand of 100 units of ice-cream per day, but he is unable to meet
that demand as Machine 2 has a lower capacity. Hence machine 2 is a bottleneck.
Bottleneck resource is also known as a binding constraint.
Throughput Accounting:
‘’Throughput is the rate of converting raw materials and purchased components into products sold
to customers. Throughput accounting (TA) is an approach to production management which aims to
maximise sales revenue less materials cost, whilst also reducing inventory and operational
expenses’’. In simple words, we need to arrange our production in such a way that we can make
maximum use of our capacity.
𝑇ℎ𝑟𝑜𝑢𝑔ℎ𝑝𝑢𝑡 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑅𝑎𝑤 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙

Important aspect in Throughput Accounting:
1) In the short run mainly, all costs such as labour etc. are fixed except for material costs. These
fixed costs are called Total Factory Costs.
2) Throughput accounting is in line with the Just-in-time philosophy of inventory management,
which aims to keep zero level of inventory.
How do we actually apply theory of constraints?
There is a simple five step process to deal with constraints.
Step 1: Identify systems bottlenecks
Step 2: Decide how to exploit the bottleneck
Step 3: Subordinate everything else to decision in step 2
Step 4: Elevate the system's bottlenecks
Step 5: If, in the previous steps, a bottleneck is broken start again
First of all, we find out what is limiting us in achieving maximum output. Then we decide how to
overcome the limiting factor. Then we arrange all our other activities in a way which helps us
achieve step 2. As a theory of constraints is a continuous process, we look to completely overcome
the bottleneck by using a better machine, better technique etc. If the bottleneck is removed, we
repeat the process again and find another bottleneck. Hence TOC is a never-ending process.
Throughput Accounting Ratio (TPAR)
There are three important ratios to measure performance where there is a bottleneck resource.
𝑇ℎ𝑟𝑜𝑢𝑔ℎ𝑝𝑢𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

1) Throughput(return) per factory hour =
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑠 𝑡𝑖𝑚𝑒 𝑜𝑛 𝑡ℎ𝑒 𝑏𝑜𝑡𝑡𝑙𝑒𝑛𝑒𝑐𝑘 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒
𝑇𝑜𝑡𝑎𝑙 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑐𝑜𝑠𝑡

2) Cost per factory hour =
𝑇𝑜𝑡𝑎𝑙 𝑡𝑖𝑚𝑒 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑡𝑡𝑙𝑒𝑛𝑒𝑐𝑘 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒
The total factory cost is same for the entire factory and hence only needs to be calculated
once.
𝑅𝑒𝑡𝑢𝑟𝑛 𝑝𝑒𝑟 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 ℎ𝑜𝑢𝑟

3) Throughput accounting Ratio =
𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 ℎ𝑜𝑢𝑟
Interpretations of TPAR:
If TPAR>1, it suggests that throughput exceeds operating costs, so the product will make a profit.
Priority should be given to products on the basis of how high their TPAR is.
If TPAR<1, it suggests that throughput is less than operating cost, and it will result in a loss. Such
products should be stopped.
When we are comparing products in the same factory looking at their return per factory hour
is enough. But when we are comparing products in different factories, we need to compare
them using TPAR. This is because the cost per factory hour will be different for different
factories.
Criticisms of TPAR:
● Throughput assumes that production is in the short run and the factors of production, which
are the bottlenecks are fixed. This is not the case in most businesses as they have variable
factors.
● It is difficult to apply TPAR to the long term when all the costs are variable, hence BC is more
appropriate.
Amanda Co manufactures a product A and sells it for $20 per unit. The material cost for each
product is $6. Total factory costs are $100000.
Labour hours are the constraint and are limited to 40,000 hours. Product A takes 4 hours to
assemble. Calculate the TPAR for product A.
Throughput per factory hour = (20-6)/4 hours = 3.5
Cost per factory hour = 100,000/40,000 = 2.5
Throughput accounting ratio = 3.5/2.5 = 1.4
As the TPAR is above 1.4 we can say that the product is profitable.
Ways to improve TPAR
● Increase sales price

● Reduce variable cost (material cost)
● Reduce cost per factory hour by reducing the total factory cost.
● Try to increase the total time available of bottleneck resource, i.e., increase the productivity
of the bottleneck resource.
Multi-product Decision Making:
Throughput accounting can be used to take multi-product decisions. Here we try to maximise the
profits available. This is done by ranking the most profitable products and producing them first.
Following steps are applied for making multi-product decisions:
Step1: Identify the bottleneck constraint
Step 2: Calculate throughput per unit of each product
Step 3: Calculate throughput per hour of bottleneck resource of each product
Step 4: Rank the products according to step 3 calculation.
Step 5: Allocate resources using the ranking

Indigo co manufactures four products W, X, Y, Z. Details of these products is given below
W X Y Z
Units Units Units Units
Demand per week 4000 4000 5000 3000
$ $ $ $
Sales price 2.8 1.6 2.4 5.6
Materials cost 1.2 0.6 1.2 2
Direct labour cost 0.8 0.4 0.8 2
Minutes Minutes Minutes Minutes

Machine time per unit 10 4 6 12
Labour time per unit 2 1 2 10
The bottleneck resource is machine time, and its maximum capacity is 1600 machine hours a week.
Total factory costs are $10880 each week. Direct labour cost is $ 24 per hour.
Required:
1) Determine the optimum level of quantity which should be manufactured to maximise weekly
profit
2) Calculate the TPAR for the above level.
Solution
1)
Step 1: Determine the bottle neck constraint
The bottleneck resource is machine time
Step 2: Calculate throughput per unit of each product

W X Y Z
$ $ $ $
Sales price 2.8 1.6 2.4 5.6
Materials cost 1.2 0.6 1.2 2
Throughput 1.6 1 1.2 3.6
Step 3: Calculate throughput per minute of each product

Minutes Minutes Minutes Minutes
Machine time per unit 10 4 6 12
Throughput per minute 0.16 0.25 0.2 0.3
Step 4: Rank
Rank 4th 2nd 3rd 1st
Step 5: Allocate resources

Product Units Machine Throughput Total
minutes per unit throughput
$ $
Z 3000 36000 3.6 10800
X 4000 16000 1 4000
Y 5000 30000 1.2 6000
W (Balancing 1400 14000 1.6 2240
figure)
Total 96000 23040
Operating exp 10880

Profit 12160
b)
Throughput per machine 23040/1600
hour=
$14.40
Cost per machine hour= 10880/1600

$6.80
TPAR= $14.40/$6.80
$2.12
1) A company manufactures product A

Machine time required per unit-4 hours
Selling price- $130
Direct material cost- $50
Labour cost- $40
Overhead- $20
Total machine time available-16 hours per day

Total demand per week – 50 units
Total Operating expenses - $560 per week
What is the TPAR?
a) 0.57
b) 8
c) 4
d) 2
Answer - 1) c
Return per factory hour- (130-50)/4 =$20
Cost per factory hour – 560/ (16*7) = $5
TPAR= $20/$5 = $4
40
Environmental Accounting
Syllabus Area B5a-b

- Discuss the issues business face in the management of environmental costs.
- Describe the different methods a business may use to account for its environmental costs.
Introduction to Key Concepts:
Environmental Accounting: Environmental accounting is a broader term that encompasses the

provision of environment-related information both externally and internally. It focuses on reports
required for shareholders and other stakeholders, as well of the provision of management
information
Environmental Management accounting: Environmental management accounting (EMA) is the

identification, collection, analysis and use of two types of information for internal decision making.
The first is physical information on the use, flows and rates of energy, water and materials (including
wastes). The second is monetary information on environment-related costs, earnings and savings.
So, in this exam, we are mainly concerned with environmental management accounting.
What is Environmental management accounting?
Environmental management accounting is simply a specialised part of management accounts that

focuses on things such as the cost of energy, water, the disposal of waste and effluent. It is
important to note that at this point, the focus of environmental management accounting is not
purely on financial costs. It includes consideration of matters such as the costs/benefits analysis of
buying from suppliers who are more environmentally aware or the effect on the public image of the
company from failure to comply with environmental regulations.
Importance of managing environmental costs:
1) Increasing awareness: Social awareness about ‘carbon footprint’ is increasing. People

are slowly becoming more aware of the harmful consequences of environmental
mismanagement.
2) Increase in volume: For companies using the natural resources, environmental costs
have become a major part of their total costs. This calls for better management of such
costs.
3) Increased regulation: Due to the increasing awareness, governments have started

regulating companies thus, resulting in higher-risk of non-compliance and penalty
payments.
Classification of Environment cost according to:
1) Hansen and Mendoza

a) Environmental prevention cost- cost to prevent the production of waste. E.g., cost of
training employees and improving processes
b) Environmental detection cost- cost incurred to ensure that firm complies with regulations
and that environmental waste is detected beforehand. E.g., cost of inspection
c) Environmental internal failure cost- cost incurred before discharging waste into the
environment. E.g., disposing toxic material
d) Environmental external failure cost- Cost incurred on activities after discharging waste into
the environment. E.g., cleaning up after oil spills etc.
2) US environmental protection agency:

a) Convention cost- Raw material and energy cost
b) Potentially hidden cost- cost recorded by accounting system but remain hidden in general
overheads
c) Contingent cost- Cost to be incurred in the future
d) Image and relationship costs- Costs incurred to maintain a reputation or image.
3) The UN Division for sustainable development:

a) Cost incurred to protect environment- E.g., Measures taken to prevent pollution.
b) Cost of wasted material labour etc.
Environmental Management Accounting Techniques
1) Input/output analysis:
This technique is very simple and tries to balance the inflows and outflows. It states that
what has gone in must come out.
Example, you purchased 200 kg of cotton to produce cloth. Only 170 kg of cloth has been
produced. This means that the remaining 30 has been wasted.
In this way, we can measure waste in physical quantities as well as in monetary terms by
simply multiplying the cost by the quantity wasted.
2) ‘Flow cost accounting:

This technique uses not only material flows but also the organizational structure. It makes
material flows transparent by looking at the physical quantities involved, their costs and
their value. It divides the material flows into three categories: material, system and delivery
and disposal.
The values and costs of each of these three flows are then calculated. The aim of flow cost
accounting is to reduce the quantity of materials which, as well as having a positive effect on
the environment, should have a positive effect on a business's total costs in the long run.
3) Activity-based costing
ABC tries to allocate costs to cost centers and cost drivers on the basis of the activities that
give rise to them. Here ABC helps in distinguishing between environment-related costs
which, are caused by the company, e.g., waste and environment-driven costs caused by the
environment such as heating due to cold weather.
Environment-related costs can be attributed to joint cost centers.
4) Life cycle costing:

Simply this refers to the calculation of all environment related costs right from the
introduction or start of production to the disposal of a product. This helps us in identifying
which products are more environmentally costly.
All the above techniques can be examined mainly in section B. Out of the five sub-questions
there will be one or two theory questions. As these will be tricky its necessary to know your
theory well and note the questions you get wrong and practice them again. This ensures that
you don’t repeat your mistakes.
1) Which environmental management technique involves analyzing cost into three categories
of material, system and delivery and disposal?
a) ABC
b) Life-cycle
c) Input-output analysis
d) Flow cost accounting
2) True or false?
a) Majority of environmental costs that are identified by accounting system but it is

difficult to categorize them.
b) Input/output classifies output as finished product, scrap and waste.
Answers:
1 D
2 True and True

ABC steps:
1. Identify the major activities (the cost pool) that give rise to overheads
2. Calculate the total cost for each activity
3. Determine what causes the cost of each activity i.e., cost driver
4. Calculate an absorption rate for each cost driver
5. Apportion costs on the basis of cost drivers and calculate total overhead costs for each
product
6. Calculate the overhead cost per unit for each product.
Target costing steps:

1. Determine the product you want to sell
2. Determine the selling price of the product in order to achieve desired market share.
3. Decide how much profit you want to make on the product.
4. Calculate: Target cost = Selling price - Desired profit.
5. Estimate the current cost of the product.
6. Calculate: Cost gap = Current estimated cost – Target cost
7. Make efforts to close the gap
Life cycle costing stages:

1. Development
2. Introduction
3. Growth
4. Maturity
5. Decline
Throughput accounting:
𝑇ℎ𝑟𝑜𝑢𝑔ℎ𝑝𝑢𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

1) Throughput(return) per factory hour=𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑠 𝑡𝑖𝑚𝑒 𝑜𝑛 𝑡ℎ𝑒 𝑏𝑜𝑡𝑡𝑙𝑒𝑛𝑒𝑐𝑘 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒
𝑇𝑜𝑡𝑎𝑙 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑐𝑜𝑠𝑡

2) Cost per factory hour= 𝑇𝑜𝑡𝑎𝑙 𝑡𝑖𝑚𝑒 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑡𝑡𝑙𝑒𝑛𝑒𝑐𝑘 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑝𝑒𝑟 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 ℎ𝑜𝑢𝑟

3) Throughput accounting Ratio= 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 ℎ𝑜𝑢𝑟
TPAR >1 – Profitable
TPAR<1- Not profitable
Environmental costing:
1) Input output analysis

2) Flow cost accounting
3) ABC
4) Lifecycle costing
Syllabus Area C:
Decision Making Techniques

Cost Volume Profit Analysis (CVP)
Syllabus C2a-b-c-d-e-f
- -Explain the nature of CVP analysis
- -Calculate and interpret the break-even point and margin of safety
- -Calculate the contribution to sales ratio, in single and multi-product situations, and
demonstrate an understanding of its use.
- -Calculate target profit or revenue in single and multi-product situations, and demonstrate an
understanding of its use.
- -Interpret break-even charts and profit volume charts and interpret the information contained
within each, including multi-product situations.
- -Discuss the limitations of CVP analysis for planning and decision making.
Introduction:
Cost volume profit analysis, as the name suggests is the analysis of cost, volume and profits of an
organisation. It looks to measure the effect of changes in variables such as volume, variable costs
etc., on future profits.
Cost volume profit analysis is also known as breakeven analysis.
Breakeven is the point where there is no profit or no loss.
Breakeven units are the number of units required to cover all the fixed costs and put us in a position
of no profit no loss.
𝑇𝑂𝑇𝐴𝐿 𝐹𝐼𝑋𝐸𝐷 𝐶𝑂𝑆𝑇𝑆
Breakeven level = 𝐶𝑂𝑁𝑇𝑅𝐼𝐵𝑈𝑇𝐼𝑂𝑁 𝑃𝐸𝑅 𝑈𝑁𝐼𝑇
It is widely used in real business scenarios as a ‘what if’ analysis. Businesses use it to know how
much profit will they be making from a given level of activity.
It can also be used to find out the level of activity required for achieving a certain level of profit. This
can be done with the following formula-
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡+𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠

Level of activity to earn desired profit =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
Example:
Suppose you start a new fast-food chain which sells only one product, i.e., Hot dogs. A single hot dog
has a selling price of $10. The variable costs per unit is $5. The total fixed costs are $100. So, at what
point do you breakeven?
To find that, you need to understand contribution per unit first
Contribution = Selling price – Variable costs
In this case, it is =$10-$5 =$5

𝑇𝑂𝑇𝐴𝐿 𝐹𝐼𝑋𝐸𝐷 𝐶𝑂𝑆𝑇𝑆
Breakeven level in units =
𝐶𝑂𝑁𝑇𝑅𝐼𝐵𝑈𝑇𝐼𝑂𝑁 𝑃𝐸𝑅 𝑈𝑁𝐼𝑇
=$100/$5 =20 units
This suggests that you need to produce 20 units to cover your fixed costs and attain a position of no
profit no loss (breakeven).
Now suppose if you want to earn a profit of $1000. How many products would be needed to be
produced to earn this level of profit?
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡+𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
Level of activity to earn desired profit =
= ($1000+$100)/$5
= 220
This means that you need to produce 220 units to earn a desired profit of $1000.
Margin of Safety:
Margin of safety tells us the extent to which the sales can decrease before we start making loses.
This is the amount of excess budgeted units over the breakeven level.
Calculation of margin of safety-
In terms of sales revenue
Margin of safety = Budgeted sales – Breakeven sales
In terms of percentage
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠−𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠
Margin of safety % = × 100
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠
Continuing our example above:
Suppose you plan to make 50 units, and the breakeven output is 20 units. What is the margin of
safety?
In terms of sales revenue:
Margin of safety = Budgeted sales – Breakeven sales
= (50*10) -(20*10)
= 500-200
=300
In terms of percentage= × 100
= (50-20)/50 * 100
= 60%
Single and Multi-Product situations
1) Contribution to sales ratio:

It is very important for us to determine how much each $ of revenue contributes to fixed
costs. This can be found out by using the C/S ratio.
For single product situation

C/S ratio =
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
Or for multi-product situation
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Weighted average C/S ratio =
𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
Then this C/S ratio can help us in calculating breakeven as follows:
For single product situation:
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
Breakeven = 𝐶
𝑅𝑎𝑡𝑖𝑜
𝑆
For multi-product situation:
Breakeven=𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝐶/𝑆 𝑟𝑎𝑡𝑖𝑜
Required revenue
The formula below can be used to determine the required revenue to earn a target profit
For single product situation:
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠+𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡

= 𝐶
𝑆
For multi-product situation:
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠+𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡

= 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝐶/𝑆 𝑟𝑎𝑡𝑖𝑜
Tomori co produces two products A and B. Fixed overhead costs are $400,000 every year. The
information regarding products is as follows
A B
Sales price $100 $120
Variable price $60 $90
Contribution per unit $40 $30
Budgeted sales (in units) 40,000 20,000
i) Calculate the breakeven for the above products.
ii) Calculate required revenue to earn a profit of $100,000

Solution:
i) First calculate the weighted average C/S ratio
= Total contribution/Total revenue
= (40,000*$40+20,000*$30)/ (40,000*$100+20,000*$120)
= 0.34375
= 34.38%
Breakeven = Fixed costs/(Average c/s ratio)
= $ 400,000/0.3437
= $ 1163636.364
Breakeven revenue = $ 1,163,636
ii) Revenue required = (Fixed costs+ Required profit)/ Average C/S ratio
= ($400,000+$100,000)/0.3437
= $ 14,54,757.06
Margin of Safety for Multiple Product
Step 1: Calculate contribution per unit

Step 2: Calculate contribution per mix
Step 3: Calculate breakeven point in terms of number of mixes
Step 4: Calculate breakeven point in terms of the units of the product
Step 5: Calculate the breakeven point in terms of revenue
Step 6: Calculate margin of safety
Using the data of our previous example
Additional information - for every 2 product As sold, one product B is sold.
Step 1- Contribution per unit
A B
Contribution $40 $30
Step 2- Calculate contribution per mix
= ($40*2 A’s) +($30*1B's)

= $110
Step 3- Calculate breakeven point in terms of number of mixes
Breakeven point = Fixed cost/contribution per mix

= 400,000/110
= 3636.363636
= 3636 units
Step 4- Calculate breakeven point in terms of units of product (3636 mixes)

A = 3636*2
= 7272
B = 3636*1
= 3636
Step 5- Breakeven in terms of revenue
= (7272*$100) + (3636*$120)
= $ 11,63,520.00
Step 6- Calculate margin of safety
Budgeted sales = (40,000*$100) +(20,000*$120)

= $ 64,00,000.00
Margin of safety = Budgeted sales- Breakeven sales

= $64,00,000-$11,63,636
= $5236364
As a percentage = ($64,00,000-$11,63,636)/ ($64,00,000)

= 82%
Break-even chart:
Profit
Variable cost
Margin of safety
The above graph is a typical break-even chart. The x-axis shows the number of units sold, and the y-
axis shows the revenue and costs in $.
In the above example, the fixed costs are $200,000 and hence is shown as a straight line. The line
showing total costs starts from $200,000 as any variable expenditure will be over and above the
fixed costs.
The gap between the fixed costs and total costs is the variable costs.
The point where the revenue line intersects the total costs line is the Breakeven point. At this point,
there is no profit no loss.
The gap between total revenue and total costs is the profit, and any production beyond the
breakeven point is the margin of safety.
Contribution breakeven chart
As only fixed costs and total costs lines are present on the simple break-even graph, it becomes
difficult to measure contribution. Hence, we plot another graph called the contribution breakeven
chart.
Here the gap between the total revenue and variable cost is the total contribution. Rest of the things
remain the same.
Multi-Product Profit Volume Charts
In a multi- product situation, there are two lines. First which shows a constant mix of products (i.e.,
all products are produced together) and the other where the most profitable product is sold first and
then the next most profitable product and so on.
In order to find the most profitable product, we use C/S ratio.
Let us understand how to plot such a graph with the help of the following example.
X Y Company A (total)
Sales price 50 60
Variable cost 30 45
Contribution 20 15
Budgeted sales(units) 20,000 10,000
Total contribution 4,00,000 1,50,000 5,50,000
Total revenue 10,00,000 6,00,000 16,00,000
C/s ratio 0.40 0.25 0.34
Product ranking 1 2
Fixed costs -2,00,000
revenue contribution cumulative profit/loss
none -2,00,000
X 10,00,000 4,00,000 2,00,000
Y 16,00,000 1,50,000 3,50,000

The red line shows product X, which is our most valuable product being produced first, and then
product Y. Whereas, the grey line shows the results if both the products are produced in a constant
mix. The breakeven point is when the lines cut the X-axis. As you can see, when the products are
produced in the order of their profitability, we are able to Breakeven at a lower level of sales.
Limitations of CVP Analysis
The major limitations of CVP analysis lie in its assumptions. The following underlying assumptions
will limit the precision and reliability of a given cost-volume-profit analysis.
1. The behavior of total cost and total revenue has been reliably determined and is linear over
the relevant range.
2. All costs can be divided into fixed and variable elements.
3. Total fixed costs remain constant over the relevant volume range of CVP analysis.
4. Total variable costs are directly proportional to volume over the relevant range.
5. Selling prices are to be unchanged.
6. Prices of the factors of production are to be unchanged.
7. Efficiency and productivity are to be unchanged.
8. The analysis either covers a single product or assumes that a given sales mix will be
maintained as total volume changes.
9. Revenue and costs are compared on a single activity basis.
10. Perhaps the most basic assumption of all is that volume is the only relevant factor affecting
cost. Of course, other factors also affect costs and sales. Ordinary CVP analysis is a crude
simplification when these factors are unjustifiably ignored
11. The volume of production equals the volume of sales, or changes in the beginning and
ending inventory levels are unjustifiably ignored.
Remember that the limitations of any model mostly lie in its assumptions. If you don’t
remember the limitations of any model during exam then use the assumptions as points to
frame your answer.
● Cost volume profit analysis is also known as breakeven analysis.

● Breakeven is the point where there is no profit or no loss.
● For single product situation:
● Breakeven = 𝐶
𝑆
● For multi-product situation:
● Breakeven=𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝐶/𝑆 𝑟𝑎𝑡𝑖𝑜
● Margin of safety tells us the extent to which the sales can decrease before we start making
loses. This is the amount of excess budgeted units over the breakeven level.
● Margin of safety = Budgeted sales – Breakeven sales
● In terms of percentage
● Margin of safety % = × 100
● C/S =
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
Or for multi-product situation
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
● = 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠+𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡
● Sales revenue required to earn target profit= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶/𝑆 𝑟𝑎𝑡𝑖𝑜
58
Relevant Cost Analysis
Syllabus C1a-b-c
- Explain the concept of relevant costing.

- Identify and calculate relevant costs for a specific decision situation from given data.
- Explain and apply the concept of opportunity costs.
Introduction:
In any business situation, before making a decision, we want to know the possible outcomes which
may arise from it. For calculating these outcomes, we consider the cash flows which are going to
arise. The cash flows which are directly affected by a decision are considered to be the relevant
ones.
Characteristics of relevant costs:
1) Future: Only future costs and revenues are considered to be relevant. Historical costs which
have already been incurred are not relevant.
2) Incremental: This means that relevant costs are those which will be incurred over and above
the current costs if the decision is taken. The costs, which are already incurred even without
making the decision are irrelevant.
3) Cash flows: Relevant costs are always in the form of cash flows. Non-cash expenditure such
as depreciation are ignored.
● The costs which are already incurred before making the decision are called as sunk costs.
E.g., Research costs. Sunk cost and committed cost are not relevant.
● Avoidable costs and controllable-cost are relevant.
Example:
1) Ajax Ltd is planning to rent a new machine for producing product XYZ. The rental payments
will be $500 per month, and the maintenance cost will be $50 per month.
- In this case, the rental payments and the maintenance cost both will be relevant costs as
they are future incremental cash flows.
2) Jenga co has appointed a market researcher to research on potential markets, Jenga could
explore. He is paid a salary of $10,000 per month. He found a new market, and Jenga wants
to know whether his salary is a relevant cost while making the decision to enter the market?
- No, the salary is going to be incurred irrespective of the decision. Hence it is not
relevant. The salary will be considered as a sunk cost.
Opportunity Cost
Definition:
“The value of the benefit sacrificed when one course of action is chosen, in preference to an
alternative. The opportunity cost is represented by the foregone potential benefit from
the best rejected course of action."
In simple words, opportunity costs are the benefit which we lost, by not undertaking the next best
alternative.
Example: Binod makes $100 by selling newspapers. He could have made $40 by selling milk at the
same time. Hence the $40 is the opportunity cost that is the next best alternative forgone.
*All opportunity costs are relevant.
Example: If a company has a machine which helps it earn a contribution of $200. If the company
decides that the same machine should be used in a different process, the relevant cost of making
this decision will also include the opportunity cost of $200.
Relevant Cost of Materials:
Material
In stock Out of stock
In regular use and will be Relevant cost= current

replaced Will not be replaced
purchase price
Relevant cost= current Relevant cost= oppotunity

purchase price cost
Is there an alternative use

for the materials?
Yes: Relevant cost= higher

of value in use or scrap NO: Relevant cost= scrap
value value
*The opportunity cost of material that will not be replaced is the lost scrap value or lost
contribution.
Relevant Cost of Labour:
Labour
Full capacity
Spare capacity
Can hire more Can't hire more
Relevant cost= nil
Relevant cost= extra cost of Relevant cost = opportunity

labour cost of diverting labour
*The opportunity cost of diverting labour is the sum of lost contribution and extra labour cost.
Relevant cost of machines:
● Purchase price of any new machinery required.

● Opportunity cost = scrap value of machine which would have been sold but is instead used.
● Cash received on sale of a new asset bought.
● If a machine of another department is used which is not replaced, then the lost contribution
is the relevant cost.
Irrelevant cost of machines
● Depreciation (not a cash flow)

● Profit or loss on sale of asset (only scrap proceeds are relevant)
● Original purchase price of an existing asset (sunk cost)
● NBV of existing machinery
1) Alex co is undertaking a new project which will last one year. Alex will require four skilled
workers. They can be hired for one year at a cost of $10,000 per worker. Or the company
can use its existing workers who are currently paid $8,000 per worker. The extra training
cost would be $2000 per worker. The replacement cost of these workers will be $20,000 in
total.
What is the total relevant cost of labour for one year?
a) 40,000
b) 28,000
c) 60,000
d) 20,000
2) Alex co for the above project will require 1,500kg of material X. Currently, it has 945 kg of X
in inventory which was bought at $4.5 per kg. If an inventory is not used for this order it
would be sold for $2.75 per kg. The current price of X is $4.5 per kg.
What is the total relevant cost of material X?

$_________
Answer:
1) $28,000 (The company can hire new workers for $40,000 or can use existing workers at an
incremental cost of $20,000+$8,000=$28,000. The cheaper option will be the relevant one.
Current salary of employees is fixed cost and irrelevant)
2) $5096.25
(Cost of new material required = 555 * 4.5=$2,497.5
Opportunity cost of quantity in hand = 945*2.75 = $2,598.75
Total= $ 5096.25)
Make-or-Buy and Other Short-Term Decisions
Syllabus C5a-b-c-d
- Explain the issues surrounding make vs buy and outsourcing decisions.

- Calculate and compare “make” costs with “buy-in” costs.
- Compare in-house costs and outsource costs of completing tasks and consider other
issues surrounding this decision.
- Apply relevant costing principles in situations involving shut down, one-off contracts
and the further processing of joint products
Introduction:
Sometimes businesses need to make a decision on if they need to produce components on their own
or to buy the components from someone, and just focus on their core activities. This is mainly seen
in the electronics industry, where a majority of components are manufactured in China and then
distributed all over the world.
The major quantitative factor while making such a decision is cost. If we can buy a particular product
at a lower rate from outside rather than producing it on our own at a higher rate, we can save costs.
Two types of make vs buy decisions:
1) Make or buy decisions with no limiting factors.

2) Make or buy decisions with limiting factors.
Make or Buy Decisions with No Limiting Factors:
In this case, the relevant costs are the differential costs between the two options. Decisions are
made as below:
Cost to make > Cost to buy= Buy
Cost to make < Cost to buy=Make

Determine whether FRA ltd should maintain its own accounting records or use other firm's services from the
given information
Internal Services Cost

Accounting staff cost $12,000 p.a.
Accounting stationery $1,000 p.a.
Accounting software $5,000 p.a.
External services Cost Volume

Processing of sales records $1 per record 3000
Processing of purchases records $1 per record 2000
Reconciliation $2 3500
Other $4500 p.a.
Solution
Total cost of internal services $18000
Total cost of external services

Processing of sales records= $1*3000 =$3000
Processing of purchases records= $1*2000 =$2000
Reconciliation= $2*3500 =$7000
Other = =$4500
Total $16500
As we can see, the total cost of using external services is lower than the internal services, we should buy
those services from outside.
Make or Buy Decisions with Limiting Factor
When a limiting factor is present, a step-by-step approach should be followed.
Step 1: Calculate saving per unit.
Saving= External cost - Variable cost to make
Step 2: Divide savings by the amount of scare resource used by a product to find saving per unit of
limiting factor.
Step 3: Rank the products according to the saving per unit of the limiting factor. Priority should be
given to products with higher savings.
Step 4: Allocate the scarce resource according to the ranking
Step 5: Any product which does not get the resource can be bought from outside.
Montana co produces four products which are manufactured by the same labour force. The
following data is available regarding the production cost and labour hours required.
A B C D
Production cost: $ $ $ $
Direct material 24 36 30 16
Direct labour 50 30 20 16
Variable overhead 16 14 10 8
Fixed overhead 20 12 8 6
Total 110 92 68 46
Labour hours per unit 6 10 8 12

External price $114 $110 $108 $100
Montana needs to produce 3000 units of each component every month. Total labour hours
available are limited to 88,000 per month.
How many units should be bought, and how many should be produced?
Solution
We need to follow the step-by-step approach.
Step 1: Calculate saving

A B C D
External Price $114 $110 $108 $100
Variable cost to make $90 $80 $60 $40
Saving $24 $30 $48 $60
Step 2: Saving per unit of labour hours

A B C D
Saving $24 $30 $48 $60
Labour hours 6 10 8 12
Saving per unit of labour hours $4 $3 $6 $5
Step 3: Rank
A B C D
Savings per unit of labour hours $4 $3 $6 $5
Rankings 3 4 1 2
Step 4: Allocate scarce resource

Products Rank Units produced Labour

hours used
C 1 3000 24000
D 2 3000 36000
A 3 3000 18000
B (Balancing figure) 4 1000 10000
Total hours available 88000
Only 1000 units of B can be produced because of limited resource
Step 5: Products to be brought from outside
As 2000 units of B cannot be produced internally, they should be bought from outside at a price of
$110 per unit
Total cost of external purchase =2000*$110

$220000
Other issues in a make or buy decision:
If production is required to be outsourced, the following issues should be considered.
1) Trust and reliability of external supplier: The company needs to decide whether the
supplier can provide them with the necessary quality and quantity within the required time
frame at a suitable price.
2) Skills and competencies: Does the supplier have the necessary skills and competencies to
carry out a particular job which may be complex?
3) Alternative uses of resources: Outsourcing will free up some resources, which then can be
used for other processes.
4) Stakeholder’s reaction: Stakeholders such as governments and local bodies won’t be

particularly happy with the decision to outsource as people will lose jobs.
5) Legality and confidentiality: Company’s need to analyze whether outsourcing will harm any
contractual obligations or result in supplier receiving confidential information.
Advantages and Disadvantages of Outsourcing:
Advantages Disadvantages
Use of supplier’s economies of scale Increased dependence on supplier
Less investment required Loss of control over production
Increased flexibility Possibility of late deliveries
Concentration on core activities Quality may be compromised
Shut Down Decisions
These decisions are regarding the closure of a department or a product. While making such
decisions, we have to consider both financial and non-financial factors.
Financial Factors: If the benefits arising from the shutdown are greater than the relative costs, then
we must shut down. This decision should be taken after considering non-financial factors as well.
Some of the relevant costs and benefits are as follows.
Relevant Costs: Cost of lost contribution from the product or department being closed, cost of
reorganization due to closure, redundancy costs etc.
Relevant Benefits: Savings achieved due to closure such as fixed costs and the benefit from the
alternative use of resources.
Non-Financial Factors:
1) Impact of the closure on other products in portfolio.

2) Redundancy of employees may harm the company’s reputation.
3) Alternative uses of freed up resources may not be available.
4) Customers and investors may think of the shut down in a negative manner.
1) Alexo co. is deciding whether to shut down one of its products. It earns a contribution of
$1000 from it. The shutdown will result in a payment of $450 as redundancy costs. The
fixed costs savings will amount to $1200.
Is shutting down a beneficial decision?
Answer: No, it is not a good decision to shut down as the relevant cost ($1450) of the
closure are greater than the relevant benefit ($1200) resulting from it.
One-Off Contracts
One-off contracts are contracts which are not concerned with the day-to-day business of an entity.
Hence, the company does not have the relevant knowledge to price these products accurately.
Therefore, the company uses principles of relevant costing to set a minimum price for the contract.
Minimum price of the contract = Sum of all the relevant cash outflows.
At this price, the company will have no profit no loss. Any price higher than this means that
company is making profits and should accept the contract.
Other considerations:
● The minimum price ignores the fixed costs and hence can only be used for one-off
contracts.
● Company may not accept the minimum price, thinking that other customers may also
demand a lower price for other contracts.
● If there is a possibility to obtain further contracts, an entity may even quote a price lower
than the minimum. This would result in a loss but may bring in further revenue in the
future.
Further Processing Decisions
When production of one product indirectly leads to the production of another product, they both
are called joint products.
The point at which these products can be identified individually is called a split-off point. All costs
before the split-off are joint costs and are apportioned between the joint products.
The basis of apportionment of joint costs to products is usually one of the following-
1. Sales value of production (Market value)
2. Production units
3. Net realizable value
After This split-off point, the company needs to decide whether to process the products further or to
sell it immediately.
This decision is made on the basis of future incremental costs. If the extra revenue earned is more
than the extra costs incurred, we go ahead with the decision of further processing.
Example:
Kompany produces two joint products A and B. The joint costs incurred till spilt off point was 10 per
unit for both the products. The current selling price and selling price after processing is as follows.
After processing, the products are converted into A1 and B1.
Should Kompany go ahead with further processing?
A B
Joint cost 10 10
Current selling price 12 12
Further processing costs 15 17
Selling price after processing 30 28
(A1, B1)
Solution:
Current profit for A =12-10= 2

Expected profit from A1=18-15= 3
Current profit from B= 12-10= 2

Expected profit from B1= 16-17=-1
Kompany should process product A and sell A1 however, Kompany should not process product B any
further and just sell it in its current form.
● Relevant costs are future, incremental cash flows.

● Opportunity costs are the benefit which we lost, by not undertaking the next best
alternative.
● Make or buy decision:
● cost to make > cost to buy= Buy
● cost to make < cost to buy=Make
● Make or buy with multiple limiting factors: Follow the steps
● One-off contracts: Minimum price of the contract = Sum of all the relevant cash outflows.
Consider both financial and non-financial factors while taking decision.
Limiting Factors 71
Limiting Factors
Syllabus C3-a-b-c-d-e
- Limiting Factors
- Identify limiting factors in a scarce resource situation and select an appropriate
technique.
- Determine the optimal production plan where an organisation is restricted by a single
limiting factor, including within the context of make-or-buy decisions.
- Formulate and solve multiple scarce resource problems using both linear programming
graphs and using simultaneous equations as appropriate.
- Explain and calculate shadow prices (dual prices) and discuss their implications on
decision-making and performance management.
- Calculate slack and explain the implications of the existence of slack for decision-
making and performance management.
Introduction:
In the short run, some of our resources are limited. This means that even if we want to produce
more products, but due to some limitation, we are not able to. The limiting factor may be: Labour,
materials, factory space, machinery etc.
Now, as management accountants, we have to decide how do we maximize contribution with this
limiting factor in place.
To maximize the use of the limiting factor, we need to produce the products which make the best
use of the scarce resource, i.e., the limiting factor. This topic is somewhat similar to throughput
accounting which we have seen earlier.
Sometimes there may be a single limiting factor, and sometimes there will be multiple limiting
factors. We will see how to maximize the contribution in both the above situations.
Single Limiting Factor
When there is a single limiting factor, we follow a simple 5 step process.
1) Step 1: Identify the limiting factor. To find this, multiply the number of products needed to
be produced by the resource required and check whether we have sufficient resources to
meet the demand. If any resource is not sufficient to fulfill the demand, it is the limiting
factor.
2) Step 2: Calculate contribution per unit.
Contribution=Sales price- Variable cost
3) Step 3: Calculate contribution per unit of limiting factor for each product
=
𝑈𝑛𝑖𝑡 𝑜𝑓 𝑠𝑐𝑎𝑟𝑐𝑒 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒 𝑢𝑠𝑒𝑑
4) Step 4: Rank the products based on the contribution per unit of limiting factor.
Limiting Factors 72
5) Step 5: Allocate the limited resource to the products using this ranking. Start producing the
products with the highest contribution per unit of limiting factor until all the scarce
resource is used up.
Production information regarding products X, Y, Z are given below. Labour hours are limited to 12,000
hours and the demand for all products is unlimited.
Product X Y Z
Sales price 40 30 50
Variable cost 24 20 26
Labour hours required 4 2 8
What is the maximum contribution that can be achieved?
Step 1: Labour hours is the limiting factor
Step 2: Contribution per unit

X Y Z
Contribution 16 10 24
Step 3: Contribution per unit of limiting resource

X Y Z
Contribution 16 10 24
Labour hours 4 2 8
Contribution per labour hour 4 5 3
Step 4: Rank the products

X Y Z
Rank 2 1 3
Step 5: Allocate resources

As there is unlimited demand for all products, we will produce the most profitable product which is
product Y
Maximum production of Y =12000/2

=6,000
Maximum contribution =6000*10

=$60,000
Limiting Factors 73
Shadow Price
What can we do when we have a limiting factor but still want to produce more products?
The obvious answer is we can buy more of the limiting resource. But at what price?
To find out the price that one is willing to pay, we need to understand the concept of shadow price
first.
Shadow price (dual price) is the additional contribution which one more unit of limited resource
would generate. For example, in our previous example, the contribution per limited resource for
product Y is $5. This means that we can generate $5 if one more labour hour is available. Hence $5 is
the shadow price of one more labour hour.
As the resource is limited, to get another unit, we will need to pay some premium. hence the
maximum price that one would be willing to pay would be as follows-
Maximum price = Original cost of product + Shadow price.
Continuing on our last example: Suppose one labour hour originally costs us $4.
The maximum price for one more unit of labour = Original price + Shadow price
= $4+$5
= $9
Hence, $9 is the maximum price we will be ready to pay for one more unit of a limited resource, i.e.,
Labour hours.
Multiple Limiting Factors

When there are two or more factors which are limited, then we need to find the optimum
production plan by linear programming.
Linear programming can be used for:
1) Maximizing contribution or
2) Minimizing cost (This is also called as the objective function)
Following are the steps involved in formulating a linear program in two variables:
Limiting Factors 74
Step 1: Define
the variable
Step 2: Define
and formulate
the objective
Step 3:
Formulate the
constraints
Step 4: Draw a
graph
identifying the
feasible region
Step 5: Solve
for the optimal
production
plan
Step 6: Answer
the question
SG co. produces two products, cricket bats and hockey sticks. Both the products need to pass through two
departments, cutting and polishing. The following information is provided.
Departmental time (Hours)
Cutting Polishing
Cricket bats 3 2
Hockey sticks 4 6
There are 4,800 hours available at each department.

Annual production of cabinets must not exceed 1,200 units. Apart from this all items can be produced and sold.
The contribution of cricket bat is $100 and hockey stick are $150
Required:
Calculate the optimal product mix which will maximise the total contribution to profit.
Solution:
Step 1-Define the variables
Let x= Number of Cricket bats produced per annum

y= Number of hockey sticks produced per annum
C= Total contribution to profit
Step 2- Define and formulate the objective function.
The function is to maximise the total contribution. As the cricket bats and hockey sticks contribute $100 and $150
respectively, the function is:
C= 100x + 150y
Step 3- Formulate constraint
1) 4,800 hours of cutting are available. Cricket bats require 3 hours and hockey sticks require 4 hours per unit
3x+4y≤ 4,800
2) 4,800 hours of polishing are available. Cricket bats require 2 and hockey sticks require 6
2x+6y≤4,800
3) Production of cricket bats must not exceed 1,200 units:

x≤ 1,200
4) Non-negative constraints. (As production cannot be negative)

x≥0, y≥0
Summary
The model is therefore: Maximise C = 100x + 150y
Subject to: 3x + 4y ≤ 4,800
2x + 6y ≤ 4,800
Limiting Factors 76
x ≤ 1,200
x, y ≥ 0
Step 4- Present graphically
Plotting lines on a graph

1. Find the point where each line crosses the y axis, by setting the value of x to 0.
2. Fine the point where each line crosses the x axis by setting the value of y to 0.
3. Draw a straight line between each of the points
For cutting hours:

If x = 0 then 4y = 4,800 ⇒ y = 1,200
If y = 0, then 3x = 4,800 ⇒ x = 1,600
For polishing hours:
If x = 0 then 6y = 4,800 ⇒ y = 800
If y = 0 then 2x = 4,800 ⇒ x = 2,400
Feasible region
<With the given constraints, all possible values for x and y lie in the boxed area of the graph
0ABCD, called the relevant or feasible region. The point within this area i.e., the feasible area
must now be found where the contribution to profit (C) has the maximum value.
Step 5- Solve for the optimum production plan
To plot C = 100x + 150y a value is assumed for C which will allow the line to be easily plotted on
the axes.
For example, below, the line 100x + 150y = 150,000 has been plotted.
The value chosen is irrelevant. It is the gradient of the line which is important, because other
Limiting Factors 77
values for C would just be lines parallel to that drawn. Rule of thumb: choose a value which is a multiple of the
coefficients of x and y. This line is also called the iso-contribution line.
The highest possible value is at a point which lies furthest away from the origin on the edge of the feasible region. In
this case it is point B. Hence, we should solve the equation of two lines intersecting at point B.
Step 6- Solve
Step 6—Solve
B is at the intersection of the two lines:
3x + 4y = 4,800
and 2x + 6y = 4,800
Solving simultaneously:
3x + 9y = 7,200 (new equation)
3x + 4y = 4,800 (original equation)
5y = 2,400
Therefore y = 480
Substitute for y in (1):
3x + 1,920 = 4,800
3x = 2,880
Therefore x = 960
The optimal solution is to produce 960 cricket bats and 480 hockey sticks
This will give a contribution of C = 100x + 150y = ($100 x 960) + ($150 x 480) = $168,000
Using Simultaneous Equation:
After we find the feasible region, we can use the above steps to find the point of maximum
contribution, or we can also solve the simultaneous equation for all the points of the feasible region.
The point which gives us the maximum contribution will be the optimal solution.
If the question does not ask you to present the equation of a graph, you can find the optimal
solution just by solving the simultaneous equation. However, this is a lengthy process.
Shadow Price in Multiple Limiting Factors
We can find the shadow price in linear programming by following some simple steps:
Step 1: Take equations of the straight lines that intersect at the optimal point. Add one unit to the
constraint concerned, while leaving the other critical constraint unchanged.
Step 2: Find a new optimal solution using a simultaneous equation.
Step 3: Calculate the revised contribution.
Step 4: Find the shadow price by subtracting the original contribution from the revised contribution.
Limiting Factors 79
Calculate shadow price for labour hours
Maximize the objective function C=80x+75y
Constraints are:
1)Labour hours: 20x+25y≤500
2) Finishing time: 40x+25y≤800
Optimal solution: x=15, y=8
Solution:
Step 1: Increase the labour hour constraint by 1
20x+25y≤501
Step 2: Solve to find new solution
20x+25y≤501 …. (i)
40x+25y≤800 …. (ii)
Solving these, we get x=14.95
Substituting x in (i) we get y= 8.08
Step 3: Calculate revised contribution
= (14.95 × $80) + (8.08 × $75)
= $1802
Step 4: Calculate shadow price
Original contribution = (15 × $80) + (8 × $75) = $1,800.
Shadow price =Revised contribution - Original contribution
=$1802-$1800
=$2
Therefore, the shadow price is $2.

Limiting Factors 80
Slack
Slack simply means to underutilize something. In linear programming problem, slack stands for the
constraints which are not used to their full potential.
The constraints which intersect to form the optimal solution are called critical constraints. These
critical constraints do not have slack.
However, the other constraints which were not a part of the optimal solution are not utilized fully
and have some slack.
For example:
In our Apply Your Knowledge regarding linear programming, the optimal solution lied between
the lines: 3x + 4y = 4,800
and 2x + 6y = 4,800
and we got x= 960 and y= 480
The third constraint was x≤1200
But as we now know that x= 960
This means that the third constraint was underutilized by 240(1200-960)
Hence 240 is the slack for the non-critical constraint.
● Shadow price: Shadow price (dual price) is the additional contribution which one more unit
of limited resource would generate.
● Maximum price= original cost + shadow price
● Slack is underutilization of resources

Pricing Decisions
Introduction:
In this sub-section, we will be learning about how different products and services are assigned a
price. We will also understand the factors which have to be considered before taking any pricing
decision. From exam perspective, it is of utmost importance that you understand the factors
influencing demand, calculation of optimum selling price and the different pricing strategies.
Factors Influencing the Price
1) Demand for the product:

Demand is the quantity of a good or a service which consumers want and are willing to pay
for. Price and demand have an inverse relationship, which means that when prices of goods
rise, demand for the goods fall. Firms can only afford to charge a higher price if their product
has demand.
2) Product life cycle:

As we learnt in life-cycle costing that there are different types of costs at different stages of
the product life cycle, similarly the products need to be priced differently at different levels.
For e.g. When apple introduces a new iPhone, it is priced at a premium but as the model
gets old, the prices start to go down.
3) Competitors:
Price also depends on the level of competition. E.g., if you open a stationary shop, there will
be immense competition in the market, and you will be the price taker. This means that you
will need to accept what the competitors charge and use the same price for your products to
be competitive. But if you have a monopoly, i.e., you are the sole seller in the market, you
can charge any price you want.
4) Customers:
If an organization’s sales are dependent on a single firm or a small group of firms then, it will
find it difficult to increase prices as the risk of losing them will be high. However, if there are
many customers, it’s easy to increase prices.
5) Price elasticity of demand:

Elasticity of demand means how sensitive is the demand of the product to a change in its
price. Here we try to calculate by how much a product’s demand will change if we increase
or decrease the price of the product.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠 𝑑𝑒𝑚𝑎𝑛𝑑

𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
If the price elasticity is more than 1 (PED>1) then the demand is said to be elastic. This means that
the change in demand is more than the change in price.
If the price elasticity is less than 1(PED<1) then the demand is said to be inelastic. This means that
the change in demand is less than the change in price.
If the demand for a product is 200,000 at a price of $3
If the price increases to $3.5 annual demand is 160,000
What is the price elasticity of demand?
% change in demand= ((200,000-160,000)/ (200,000)) *100 = (40,000/200,000) *100= -20%
% Change in price = ((3.5-3)/3)) *100= (0.5/3) *100=16.67%
Price elasticity of demand= 20/16= 1.2
As we are looking at absolute change, we ignore the negative sign.
As PED>1 we can say that the demand is elastic.
Three Broad Approaches to Pricing
1. Demand based approaches (tabular and algebraic approach)

2. Cost based approaches
3. Marketing based approaches
Syllabus C4c-d
- Derive and manipulate a straight-line demand equation. Derive an equation for the
total cost function
- Calculate the optimum selling price and quantity for an organisation, equating
marginal cost and marginal revenue
Demand Equation
As we discussed earlier, the relationship between price and demand is an inverse one. This means
that demand rises when the price falls, and demand fall when the price rises. This can be
represented in the following form.
Price
Quantity demanded
This demand curve can be expressed as an equation:
𝑷 = 𝒂 − 𝒃𝑸
Where:
P = price
Q = the quantity demanded
𝑎 (intercept)= price where demand is 0

𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
𝑏 (gradient of the line) =
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
The above given demand equation can be used to find the quantity demanded at a given price or the
price at a given level of quantity demanded (after substituting the other variables)
Total Cost Function
To decide a profit maximizing price we also need to consider costs. The total cost (TC) can be
presented in a simple linear equation form:
Total costs = fixed costs + variable costs
y=a+bx
y= total costs
a= fixed costs
b= variable costs
x= number of units
This equation can be graphically presented as follows

Total cost
Variable cost
Fixed cost (a)
Number of units
Sometimes suppliers offer discounts on bulk purchases. In such situation, the total cost equation can
be used to derive the total costs.
Fixed costs are $50,000. Variable costs are $10 per product up to 1,000 products. Any number of
products after that are given 10% discount.
a = $50,000
b= $10
If x≤1000 products, y= 50,000 + 10x
If x≥1001 products, y = 50,000 + 9x (i.e.,10-10%=9)
Optimum Selling Price and Quantity (The Economists’ Viewpoint)
The optimum level of output and selling price is the point where the profit is maximum. This Is also
called as theory of profit maximization.
This theory states that the firm’s profit is maximized when the marginal cost=marginal revenue.
Marginal cost is the extra cost which is incurred by producing one more unit. This will simply be
variable cost per unit.
Marginal revenue is the extra revenue earned by selling one more product. It is also described as
change in total revenue/change in number of units sold.
The gradient of MR is twice the gradient of the demand function: -
MR= a-2bQ
The theory suggests that if a firm chooses to maximize its profits, it must choose that level of output
where Marginal Cost (MC) is equal to Marginal Revenue (MR). In other words, it must produce at a
level where MC = MR.
if Marginal Cost < Marginal Revenue, then for each additional unit produced, revenue will be higher
than the cost so that you will generate more.
And if Marginal Cost > Marginal Revenue, then for each extra unit produced, the cost will be higher
than revenue so that you will create less.
Thus, optimal quantity produced should be at MC = MR
Using this, we can find the optimum price Pn and optimum quantity Qn as given below:
$ per unit
MC
Optimum
price (Pn)
MR=MC Demand curve
MR
Optimum quantity (Qn) Quantity

Steps to Find the Optimum Price
Establish the linear relationship between price and quantity demanded that is P= a-bQ.
1. Double the gradient to find the marginal revenue – MR= a-2bQ.

2. Establish the Marginal cost MC. This will simply be the variable cost per unit.
3. To maximize profit, Equate MC and MR and solve to find Q.
4. Substitute this value of Q into the price equation to find the optimum price.
5. It may be necessary to calculate the maximum profit.

The sales director of MVP Co. has suggested that if a price of $250 is charged for product A, demand
will be 12,000 units, and He also mentioned that demand will rise or fall by 5 units for every $1
fall/rise in the selling price. The marginal cost of product G is $80.
Required
What is the profit maximising selling price?
Solution:
P=a-bQ
First, we need to find the gradient 'b'
b= change in price/ change in quantity
=-1/5= -0.2
a=250+((12,000*0.2) = 2,650
MR= a-2bQ
MR=2,650-(2*0.2) Q = 2650-0.4Q
As we know, profits are maximised when MC=MR

Therefore, 80=2650-0.4Q
Q= (2650-80)/0.4=6425
This is the profit maximising quantity
If we substitute these values into the demand curve equation, we will be able to find the profit
maximising sales price
P=a-bQ
P=2650-(0.2×6,425)
Profit maximising price = 2650-1285= $1365

Syllabus C4e-f
- Evaluate a decision to increase production and sales levels, considering incremental

costs, incremental revenues and other factors
- Determine prices and output levels for profit maximization using the demand-based
approach to pricing (both tabular and algebraic methods)
Tabular Approach
We have already seen how to determine the optimum price and quantity using algebraic method,
now we will learn to do it by an alternative method which is the tabular approach.
In this method, we lay out the information regarding the average cost and average revenue at each
level of production in a table. Then we calculate the total cost and marginal cost at each level of
demand. Then calculate the profit at each level of demand and determine the optimum price and
quantity.
When data in the exam is given in tabular form, and there is no indication about the demand
function, and/or where there is no simple linear relationship between output and profit – The
tabular approach is likely to be the best to define optimum profit and the associated selling price.
From the following data determine the optimum level of price and quantity
Total production units Sales price per unit (AR) Total cost (TC)
0 0 0
1 50 44
2 47 56
3 44 71
4 41 85
5 38 95
6 35 110
7 32 122
8 29 135
9 26 145
Solution:
Total production Price Total Marginal Total Marginal Profit

units revenue revenue cost cost
0 0 0 0 0 0 0
1 50 50 50 44 44 6
2 47 94 44 56 12 38
3 44 132 38 71 15 61
4 41 164 32 85 14 79
5 38 190 26 95 10 95
6 35 210 20 110 15 100
7 32 224 14 122 12 102
8 29 232 8 135 13 97
9 26 234 2 145 10 89
Here we can again see that profit is maximized when 7 units are produced at a price of $32. This is
also the point where MC is closest to MR. (It is not exactly equal).
Decision to Increase Production and Sales:
This is a simple process of decision making where we have to decide whether we should increase the
number of products produced and sold. This decision is taken by considering the incremental costs
and revenues as a result of that decision.
If the incremental revenue is going to be greater than the incremental cost, we decide to increase
the production.
Lola co produces 120 units of Cola at a cost of $80 per unit and sells it at a cost of $120. It has
received an offer to supply 30 more products for $100. Lola will need to pay overtime to its workers
to meet the demand, and hence the cost of producing these products will be $101.
Should she go ahead with the decision of producing extra units?
Solution:
Incremental cost of producing 30 units: 3030
Incremental revenue by producing 30 units: 3000
As Incremental cost > incremental revenue, Lola should not produce the extra units.
Syllabus C4g-h
- Explain different price strategies, including:[2] i) All forms of cost-plus ii) Skimming iii)
Penetration iv) Complementary product v) Product-line vi) Volume discounting vii)
Discrimination viii) Relevant cost
- Calculate a price from a given strategy using cost- plus and relevant cost
Types of Pricing Strategies
In this section, we will learn about the various strategies which companies use to set a price for their
products. We will also learn what influences their decision in choosing a particular strategy. The
pricing strategies are as follows.
1) Cost plus pricing

This is a simple type of pricing where we calculate the costs and add a profit mark-up/margin
to it.
● A mark-up is the profit expressed as a percentage of cost, i.e., the cost is 100%
● A margin is the profit expressed as a percentage of the sales price, i.e., sales is 100%
Which cost to use?
i) Actual cost
One can use the actual costs of production to calculate the price of the product.
The main advantage of using actual cost is that the profit is guaranteed. However, there
is less incentive for the producer to control the costs of the product.
ii) Standard cost

The advantage of using standard cost to calculate the cost of the product is that prices
can be set in advance and fixed for the period concerned. This makes planning easier.
However, if significant variances occur, then the price may have been set too low, and a
loss occurs.
iii) Relevant costs

Relevant costs can be used to arrive at the minimum tender price for a one of tender or
contract. The minimum price should be equal to the total of all relevant cash flows.
iv) Full cost-plus pricing

In this method, we calculate the full cost of a product, including all fixed and variable
cost.
Example: If the complete cost of a product is $10 and has a markup of 20%. Then the
selling price will be 12 (10+2)
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

(𝑇𝑜𝑡𝑎𝑙 𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 + 𝑇𝑜𝑡𝑎𝑙 𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑛𝑜𝑛 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 + 𝑀𝑎𝑟𝑘 − 𝑢𝑝)
=
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑢𝑛𝑖𝑡𝑠
v) Marginal cost-plus pricing

Here we only consider the variable cost of products.
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

(𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 + 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑛𝑜𝑛 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 + 𝑀𝑎𝑟𝑘𝑢𝑝)
=
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑢𝑛𝑖𝑡𝑠
Widely used and accepted Ignores economic relation between price and
demand
Simple to calculate No attempt to establish optimum price
Selling price decision can be delegated to junior Does not guarantee a profit
staff
Justification for price increases Leads to circular reasoning
E.g., a price increase will reduce volume, thus
increasing costs which leads to an increase in
price
May encourage price stability No flexibility in pricing
2) Market-skimming:
Market skimming is used when a new product is launched. Literally, it means to skim the
cream customers or the loyal customers. Here a very high price is set initially, assuming that
the loyal customers will buy the product regardless of the price.
For example: When apple launches a new iPhone, it charges a very high price to its
customers. It is mainly done to recover its development costs. Eventually, the prices are
lowered. This is an example of market-skimming.
3) Penetration pricing
Market penetration is almost the opposite of market skimming. Here when a new entrant
launches a product, they price it at a very low rate in order to obtain market share. Once they
achieve a customer base, they can slowly increase their prices.
Example: When Reliance launched JIO, they initially offered free internet to everyone. When
they captured a large number of customers, they were able to increase the prices.
4) Complementary pricing
In this type of pricing, the price of one product is linked to another related product. Example:
The price of printers (major product) is usually very low, however the cartridges used in these
printers are expensive. Hence the margin lost on printers is recovered by selling cartridges.
Another type is where the major product is expensive, but the subsequent purchases are of
relatively low prices.
This type of pricing requires the understanding of the impact that one product’s price change
has on the other.
Product-line pricing
A product line is a range of products that are related to one another. Product line pricing
occurs when setting the price steps between various products in a product line based on –
● Cost differences between the products
● Customer evaluations of different features
● Competitors prices
In simple words, product line pricing occurs when a company must decide the price
differences between the upgrades of a product or service.
5) Volume discounting:
In this type, customers are encouraged to buy more by offering discounts. E.g., This mainly
happens in shopping outlets where offers like Buy two get one free or buy two get 50% off
are used. This is done to lure the customer into buying another product thus increasing their
net spend.
6) Price discrimination
Price discrimination is about charging different prices in different markets. This is done to
extract the maximum selling price from each market. For this to happen, there must be strict
market barriers, or customers may just simply buy from a cheaper market.
Price discrimination can also take place at individual level. E.g., students are given a special
discount on Netflix subscription while others aren’t.
7) Relevant cost pricing

This builds upon what we learned in the previous chapters. In relevant cost pricing, we find
out the relevant cost by using relevant pricing principles. Then we add a mark-up/margin to
the cost, before selling it to the consumer.
Again, this may not be a long-term strategy of pricing products as fixed costs may be treated
as a sunk cost and hence will be ignored.
You may be asked a theory question regarding the types of pricing or factors influencing
pricing decisions. To tackle such questions, it is necessary for you to understand all types of
pricing methods and the factors that influence it.
'Cost plus pricing methods involve adding a given margin to the cost of a product. The cost may be
the marginal cost, the full cost or even the relevant cost.
Full cost-plus pricing is a long-term pricing method. It ensures that prices cover all variable and fixed
costs.
With return-on-investment pricing, prices are set to achieve a target percentage return on the
capital invested in production.
Opportunity cost pricing (relevant cost pricing) is a short-run pricing method.
Cost plus methods of pricing:

• do not consider external factors (e.g., what the market will pay for a product);
• may not lead to the maximisation of profit, revenue or market share; and
• may lead to a price which is completely different from what competitors are charging.
In the economist's model, price is a function of the quantity supplied. As the quantity supplied rises,
the price falls. The quantity provided is determined as the point at which the marginal cost =
marginal revenue.
Marginal revenue is the increase in total revenues resulting from selling one more unit of a product
or service.
For the exam, marginal cost is equal to variable cost per unit (at least until full capacity
is reached).
The price elasticity of demand is the degree of sensitivity of demand for a good to changes in the
price of that good.
Pricing is a strategic decision, and in practice, there are several pricing strategies which may be
adopted.’
Dealing with Risk and Uncertainty
Syllabus C6-a-b-c
- Suggest research techniques to reduce uncertainty e.g., focus groups, market research
- Explain the use of simulation, expected values and sensitivity
- Apply expected values and sensitivity to decision-making problems
Introduction:
In this sub-section, we will understand how to take decisions under risk and uncertainty. We will also
learn some common frameworks regarding decision making under risk. This section is frequently
tested and is a very scoring topic.
Risk: Risk refers to the situation where probabilities can be assigned to a range of expected
outcomes, and the likelihood of each outcome occurring can therefore be quantified.
Uncertainty: Uncertainty refers to the situation where there are several possible outcomes, but
probabilities cannot be assigned to the expected outcomes.
The main factor differentiating risk and uncertainty is probability.
Risk management is the process of understanding the risks which an entity faces and taking efforts
to reduce them.
Research Techniques to Reduce Uncertainty:
1) Focus groups:
The most common type of uncertainty that companies face around the globe is regarding
the success and failure of new products. To reduce this uncertainty, focus groups are formed
to understand the opinion of the target market.
Focus groups are simple, informal group of 8-10 people who are selected as a sample of
broader population.
This group is asked to give their opinion on a certain product. They are given the freedom to
express what they really think about the product.
Their opinions are noted, and then the company decides whether to go ahead with the
product.
2) Market research:
Market research aims to collect information about customers, competitors and the market
overall.
It is also used by companies to make decisions about the advertisement and marketing of
new products. The earlier the market research is conducted, the easier it is to reduce
uncertainty.
It can be based on both primary and secondary data. Market research can be done in two
ways:
1) Desk research (secondary research): It is based on collecting information from
secondary sources. It is inexpensive but may not cater to specific needs.
2) Field research (primary research): This involves directly contacting the target
customers. This is more specific but costly.
It can be divided into two parts that is-
● Motivational research- The objective is to understand the factors that influence why
consumers do or do not buy particular products.
● Measurement research- The objective here is to build on the motivation research by
trying to quantify the issues involved.
Use of Simulation, Expected Value and Sensitivity Analysis
Simulation:
Simulation is a modelling technique. In simulation, computers are used to simulate real life
scenarios. The models help in predicting the range of outcomes possible from a given decision.
Simulation allows more than one variable to change, and hence a varied number of outcomes can be
obtained.
Due to technology, the cost of obtaining this information is decreasing, and the benefits derived
from it are large.
After a certain point, models can become very complex due to many variables.
It is often used in capital investment appraisal.
E.g. For any given information regarding selling price, demand, costs etc., simulation can assign
random values to the above variables and calculate the profit which will be earned in each expected
scenario.
A common simulation method is the “Monte Carlo” method.
It allows more than one variable to change. Models can be extremely complex.
More number of outcomes can be derived. It is just a technique to get more information
about possible outcomes and not to make any
decision.
It helps in solving complex problems It relies on the probability estimates of
variables which are highly subjective in nature.
Sensitivity Analysis
Sensitivity analysis tries to calculate the sensitivity of the outcome to the change in the variables
used to calculate it.
It does so by calculating the % change required in a variable before the profit turns into a loss.
The lower the %, the higher the sensitivity of the variable.
E.g., if only 1% of the change in sales price will turn a profit into a loss then, the outcome is highly
sensitive to the variable (Sales price).
In this way, by using sensitivity analysis the critical variables are determined.
In most cases sensitivity = Profit/Variable*100

Sensitivity analysis in decision making:
Amigos co has presented the following information regarding a new product. It wants to know the
sensitivity of the decision to its variables.
$
Sales 8,000
Material cost 4,000
Labour cost 2,000
Contribution 2,000
Fixed costs 1,200
Profit 800
Solution:
Sensitivity of:
1) Sales = 800/8,000
= 10%
2) Materials cost = 800/4000

= 20%
3) Labour cost = 800/2000

= 40%
4) Fixed cost = 800/1200

= 67%
The decision is most sensitive to sales as only a more than 10% change in sales price will turn the
$800 profit into loss. Hence sales are the most important variable, and Amigo co should focus more
on it.
Expected Values:
Expected value represents the average outcome that would be achieved if a decision were to be
repeated many times.
This method is used by a ‘Risk neutral’ decision maker
Expected value is calculated by multiplying the value of each possible outcome by the probability
and then adding all the results together.
EV=∑px
p= probability of the outcome

x= the possible outcome
Following are the possible outcomes from a decision along with probabilities.
Find the expected value of the decision.
Profit Probability Expected value (Profit*probability)
5,000 0.3 1500
6,000 0.4 2400
7,000 0.3 2100
E.V. 6000
Hence the weighted average of all possible outcomes is 6,000.
Limitations of Expected Value:

1) The expected value of a decision may never occur. It is just a long-run average.
2) It is only useful for decisions which are repeated many times. It’s not useful for one-off
decisions.
Syllabus C6d-e-f
- Apply the techniques of Maximax, maximin, and minimax regret to decision-making

problems including the production of profit tables.
- Interpret a decision tree and use it to solve a multi-stage decision problem
- Calculate the value of perfect and imperfect information.
Payoff Tables:
Payoff table, also known as the payoff matrix, shows all possible ‘payoffs’ which will result from a
decision-makers chosen strategy. A payoff matrix is constructed as follows:
A café sells biscuits for Rs 30, and it costs them Rs 10. Due to safety reasons, they have to dispose of
all the leftover biscuits. The level of demand and probability is given as below.
Number of biscuits sold 20 40 60

Probability 0.3 0.5 0.2
*Row- factor you can control e.g., supply

*Column- factor you cannot control e.g., Demand
Profit table can be written as follows

supply size
Probability Demand 20 40 60
0.3 20 400 200 0
0.5 40 400 800 600
0.2 60 400 800 1,200
If order q=20 demand=20, profit= (20*30) -(20*10) =400
If order q=40 demand=20, profit= (20*30) -(40*10) = 200
Similarly, we can find the payoff for remaining matrix
Attitudes Towards Risk by Individuals
There are 3 possible attitudes towards risk:
Risk seeker: These are the people who will seek the riskier alternative with an objective to earn
more rewards.
Risk averse: Risk averse people are those who are too scared to lose and hence accept low risk for a
low reward.
Risk neutral: These people are indifferent to risk

3 Decision Rules
Let’s understand the 3 decision making rules, with example.
MAXIMAX:
In Maximax, the quantity which provides the highest pay-off is selected.
This approach is used by a risk seeker. He tries to achieve maximum gains.
MAXIMIN:
In maximin, we try to maximize the minimum outcome from all variables. In simple words, we find
the minimum payoff from all the possible options, and then we select the option which is the highest
of these minimum payoffs.
This approach is selected by risk averse people.
MINIMAX REGRET:
This strategy is used to minimize the maximum regret.
First, we need to find the regret by subtracting all the payoffs of an option from the highest payoff
from that particular option.
Then we find the maximum regret from all the options available.
Then we select the option with the lowest “maximum regret”.
A sore loser uses the minimax regret strategy because, as the name suggests, he is a sore loser.
Apply Your Knowledge: Maximax and Maximin
This is the payoff table we used during the last example
Order
size
Demand 20 40 60
20 400 200 0
40 400 800 600
60 400 800 1,200
Maximax:
According to Maximax, we select the option giving the highest payoff. In this highest pay-off is 1,200.
Hence Maximax approach suggests that we choose to produce 60 products.
Maximin:
According to maximin, we will find out the minimum payoff of all options first
Order 20 40 60
size
Minimum payoff 400 200 0
Now we select the option with the highest option from these minimum values. In this case, 400 is
the highest “minimum payoff” hence we select the order size as 20.
Minimax regret:
First, we deduct all the possible payoffs from the maximum payoff for a given demand. Then we find
the maximum regret
Order size
Demand 20 40 60
20 0 200 400
40 400 0 200
60 800 400 0
Maximum 800 400 400

regret
Now we select the option with the lowest maximum regret. In this case, there are two options (400)
hence we can select any of the two, i.e.,40 or 60.
Decision Tree
Many times, the decision-making process involves multi stage decisions. This means that we need to
take one decision depending upon the output of another decision taken.
Decision tree is a graphical representation of the decision-making process. It helps us in visualizing

the entire process.
Decisions are made using decision trees using two stages:
1) Drawing a decision tree and;

2) Evaluation of a decision tree
After that, an option is selected.
1) Drawing a decision tree:

A decision tree is drawn from left to right. Every square in a decision tree is a decision point.
This is the point where we have the control to make a choice between two outcomes. All
trees must start with a decision point, i.e., a square.
A circle in the decision tree is used to show a chance or an outcome point. These circles are
not within our control, and the value of these circles are derived from the branches which
have their values and probabilities labelled. All branches have probabilities attached to
them.
2) Evaluating a decision tree:

We evaluate a decision tree from right to left. We solve and calculate the expected value at
each point by multiplying probabilities by their cash flows. We choose the most favorable
option at a square (decision point). Then the option which gives the highest expected value
is chosen.
A decision tree looks like this: $1000
0.6
0.4 $3000
B
$1000
A
0.5
0.5 $2000
C
This tree will be evaluated by finding the values of B and C and then choosing the most favorable
option and hence solving A.
Value of Perfect Information
Perfect information is when the forecast of the future outcome is always a correct prediction that is,
the information received is 100% accurate.
In our previous example, if suppose the café owner is able to obtain 100% accurate information
about the demand for its products, then he will be able to undertake the most beneficial course of
action for that prediction. Now the question arises about how much one is willing to pay to obtain
such perfect information.
Value of perfect information= E.V. with the perfect information-E.V. without the perfect
information.
Following our example about the café.
Order size
Probability Demand 20 40 60
0.3 20 400 200 0
0.5 40 400 800 600
0.2 60 400 800 1,200
EV 400 620 540
If we had perfect information we will produce exactly as per the demand i.e., 20 products when
demand is 20.
Hence E.V. with information= (0.3*400) +(0.5*800) +(0.2*1200) =760
Without information we would choose to produce 40 biscuits giving us an E.V. of 620
Hence the value of perfect information= 760 - 620 =$140
Value of Imperfect Information
In real life, finding perfect information is not always possible. Information sources cannot provide us
with perfect information, and thus we must use information that would be reasonably accurate.
Thus, the question arises how much would it be worth paying for such imperfect information?
A news agent has to decide how many newspapers to buy each day. Demand is uncertain and
can either be high, with a probability of 60%, or low, with a probability of 40%. A profit table
shows the profits for the possible combinations of order supply and demand:
Order supply
large small
Demand High 1000 400
Low -200 400
EV without information
Without any additional information, the news agent would order the quantity which gives the
highest expected profit:
Expected outcome of placing a large order: $520 ((1,000 × 0.6) + (-200 × 0.4)).
Expected outcome of placing a small order: $400 ((400 × 0.6) + ((400) × 0.4)).
EV with imperfect information

The news agent can conduct a survey to find out what the demand will be on a particular
day. If demand will be high on a particular day, then he will place a large order;
if it says demand will be low on a particular day, he will place a small order. There is a 60%
chance that the surveyor will say demand is high and a 40% chance that the surveyor will say
demand is low. The surveyor
is not always correct, but there is a 90% chance that it will be correct.
If the news agent appoints the surveyor, then the following can be calculated.
Profit ($) Probability

Surveyor says-
demand is high and is correct 1,000 0.54 (0.6 × 0.9)
demand is high and is incorrect (200) 0.06 (0.6 × 0.1)
demand is low and is correct 400 0.36 (0.4 × 0.9)
demand is low and is incorrect 400 0.04 (0.4 × 0.1)
EV with imperfect information = (1,000 × 0.54) + ((200) × 0.06) + (400 × 0.36) +

(400 × 0.04) = $688.
The value of imperfect information in this case is:
$
EV with the survey 688
EV without the survey 520
Value of imperfect information 168
● Decision making techniques:

1) Risk seeker-Maximax
2) Risk averse-maximin
3) Sore loser-minimax regret
4) Risk neutral-Expected value.
● Value of perfect information= E.V. with the perfect information-E.V. without the perfect
information
PO22 – DATA ANALYSIS AND DECISION SUPPORT
Description
You use commercial acumen to articulate business questions to resolve problems, exploit
opportunities and identify and manipulate relevant data requirements; deeply analysing data by
applying appropriate techniques. You draw clear conclusions and present your findings to enable
relevant stakeholders to make sound business decisions.
Elements
a. Identify any relevant financial and non-financial data and use it to provide insights to answer
important business questions and provide solutions for your organisation.
b. Use appropriate analytical tools to process, manipulate and analyse data. These tools could
include spreadsheet applications or more technical statistical analysis software.
c. Apply modelling techniques to deliver specific types of analysis, which may include: scenario
analysis, forecasting, optimisation problems or cost-benefit analysis.
d. Use data and resulting information ethically and responsibly, analysing and interpreting data
sceptically to draw appropriate conclusions and make recommendations to support effective
decision-making.
e. Communicate the recommendations to relevant stakeholders in a way they can easily visualise
and understand, to exploit business opportunities, manage risk and evaluate performance.
Syllabus area D:
Budgeting and Control

109
Budgeting and Quantitative Analysis
D1: BUDGETING SYSTEMS AND TYPES OF BUDGETS
Syllabus D1-1a
- Budgetary systems and types of budgets

- Explain how budgetary systems fit within the performance hierarchy
Introduction:
When we talk about any organisation, before carrying out its activities, they need to plan how to go
about things. In the planning phase, it needs to decide how much of the resources should be
allocated to specific divisions, how many products should we produce, how much profit should we
expect to make etc.
When this plan is put down on paper and expressed in terms of money, we call it as a budget.
A budget can be defined as ‘a quantitative detailed plan prepared for a specific time period. It is
normally expressed in financial terms and prepared for one year.’
As you may have already understood that the figures used in the budget are estimates of what is
going to happen in the next period/year. The process of calculating these estimates based on
judgement and experience is called as Forecasting.
Following are the objectives of preparing a budget:
1) Planning:
Budgets force organizations to plan for the upcoming year. This prevents managers from
taking on the spot decisions which are not good for the organisation.
2) Control:
At the end of the year, the actual performance is compared to the budgets, and hence
appropriate control action can be taken beforehand. This is also called as variance analysis.
3) Communication:
Budgets act as a medium of communication between different levels of management. Top
level managers can communicate what is expected from lower levels through budgets.
4) Co-ordination:
As budgets are prepared for various activities of the organisation, which are dependent on
each other, they help to achieve goal congruence.
5) Evaluation:
Evaluation of employees and managers is done by comparing the actual performance with
the budgets. They are appraised on the basis of their performance against a budget.
6) Delegation:
The delegation of setting the budget to the managers can add to their responsibility and
thus help them motivate. Also, using the manager’s knowledge can help set more realistic
budgets.
7) Authorization:
The budgets act as a formal way of authorizing different activities of the organisation such as
hiring staff, buying materials etc.
8) Motivation:
Having a target helps in motivating the managers compared to having no target at all. But
care must be taken to keep the budget achievable.
A budget is mainly concerned with the implementation of the long-term plans in the budget period.
These long-term plans are often derived from the mission statement of the organisation. The
following process is followed:
Corporate Business unit

Mission Long term plans Budgets
objectives Objectives
The mission statement of the company states the purpose for which the company exists. The
corporate objectives are the objectives of a group as a whole. The business units are companies of a
group, and these units have their own objectives.
Long term plans are set out by the units to achieve its objectives. Now, these plans are further
broken down into yearly or half-yearly plans known as budgets.
Achievements of these budgets helps in the achievement of long term-plans of a company. These
long-term plans help in achieving the objectives of the business units and groups, thus ultimately
achieving the company’s mission.
Process of Budgeting and Control:
Just setting out a budget is not enough. The actual performance of the company needs to be
monitored and also find variances. These variances should be tracked down to the source, and
corrective action must be taken. This entire process is called Budgeting and Control.
Planning and Monitoring of Taking corrective

Finding variances
budgeting actual results action
Syllabus D1b-c-d
- Select and explain appropriate budgetary systems for an organisation, including top-
down, bottom-up, rolling, zero-based, activity- based, incremental and feed-forward
control
- Describe the information used in budget systems and the sources of the information
needed
- Indicate the usefulness and problems with different budget types (including fixed,
flexible, zero-based, activity based, incremental, rolling, top-down, bottom-up,
master, functional)
Types of Budgetary Systems
Here we will study about the different ways in which the budgets are set. These are based on the
level of participation by the lower-level management.
1) Top-down:
In this type of budgetary system, the budgets are prepared by the senior level managers.
These budgets are imposed onto the junior level managers who are required to operate
within these budgets.
This type of budgeting is used in an autocratic environment such as the Military.
Organizations that have such a system, have many levels of managerial hierarchy.
Saves time as budgets are prepared by fewer Employee morale may go down, and they may
people. not be motivated to pursue the targets.
Senior level management has the experience There will be a communication gap between
and skill required to prepare budgets. different levels of management if budgets are
imposed.
Fewer chances of slack building up. The Budgets won’t be able to incorporate
ground level issues.
2) Bottom-up:
In the bottom-up style of budgeting, the budgets are prepared through the participation of
the junior level employees. Here, first, the junior managers prepare drafts for the budget,
and then these are discussed by the senior management before accepting it. Changes may
be made to align the budgets to the overall objectives.
Such systems are followed in a participative environment. Such organizations have few
levels of management and are flat.
The managers will get a chance to participate in the Will use up valuable time of management as a greater
setting of targets and allocation of resources and hence number of people will be involved. It is a time-consuming
will be motivated. process
Employees are more responsive towards the There is a possibility of managers building up slack.
achievement of targets.
The budgets will be often realistic and will incorporate The lower level of managers won’t have the skills or
ground reality. motivation to participate.
If the participation is only pseudo participation, then this

will result in dissatisfaction among the lower-level
management and thus demotivate them.
Types of Budgets
1) Rolling Budgets:
In a rolling budget, the budget period (usually a year) is kept constant. This is done by
continuously updating the accounting period by adding another accounting period to it
(month or quarter) as and when a month or quarter expires so that the budgets are always
available for the coming budget period (usually a year)
For example, If we are preparing rolling budgets for a year starting from January 2020 to
December 2020. When the month of January 2020 expires, we will add the month of January
2021 to the budget. This will ensure that the budgets length remains 12 months.
This system takes the help of modern technology by obtaining cheap and reliable
information at a faster rate. Cash budgets usually operate as a rolling budget as cash is
required throughout the year and need to be planned for efficient management.
This type of budgeting is suitable for industries which are prone to major external changes,
and hence budgets need to be updated regularly.
The budget is updated to reflect external changes and Time consuming as it is a continuous process
hence is more relevant.
There is always a budget for the next budget period, Unnecessary in a stable environment and would simply
i.e., usually 12 months increase the budgeting work, thus led to less control of
the actual result.
Planning and control will be based on a more accurate Budgets may be updated incorrectly to hide
budget. inefficiencies.
2) Incremental budgeting:
In this form of budgeting, the previous period’s budget or actual results are used as a base,
and a percentage of increment is added/subtracted to adjust for factors such as inflation.
This type of budget is suitable for organisation’s which do not go under significant change
year after year. Stable organisations would prefer to use Incremental budgeting.
Easy to prepare, and there is stability and greater No motivation to develop new processes and to reduce
understandability. costs.
Change is gradual, and hence managers get time to Inefficiencies are built into the budget and are never
adapt removed.
Conflicts are reduced as every department is treated in There is a possibility that managers will build slack into
a similar way the budget and have a ‘use it or lose it attitude.’
Managers can run their department in a consistent way. It is unrealistic as it assumes activities and methods will
continue to work in the same way.
3) Activity – Based Budget:
Activity based budget basically follows the principles of activity-based costing in the reverse
order.
We do activity-based budgeting in the following order.
1) Estimate the production output of each product.
2) Calculate the number of units of that activity needed to produce the products, e.g.,
Number of production set-ups etc.
3) Then calculate the resources needed to support the activity cost drivers, e.g., hours of
maintenance required to complete set ups etc.
4) Match the available resources against available capacity and adjust for any increase or
decrease required.
Activity Based Costing (ABB) is suitable for businesses who have a large amount of overhead
costs.
Efficient allocation of resources due to ABC principles Difficult and complex to implement and run
Avoids slack in budgeting. Not suitable where most of the costs are variable or
where only a single product is produced
Most of the support costs are treated as variable Many overhead costs are not controllable and hence
costs dependent on the activity levels hence making may change with differing volume, thus making
the budgets realistic. comparison less relevant.
Acts as a base to compare the actual cost of activities Difficult to identify clear individual responsibilities for
and the budgeted costs of activities. activities.
Zero Based Budgeting:
Zero Based budgeting, as the name suggests is the budget based on zero. In simple words, we start
each budget from scratch. So, every time a manager asks for money, he has to justify whether it is
actually needed or not.
This is the complete opposite of incremental budgeting. Here no inefficiencies can be carried
forward.
ZBB is done using the following steps:
1) Managers should specify, for their responsibility centers, those activities that can be
individually evaluated.
2) Activities are identified and are then described in a ‘decision package’. This includes the
costs, revenue, purpose, importance and alternatives of the activity. This package will show
the minimum number of resources needed for the activity. Further modifications can be
done to add extra features and costs.
3) These activity packages are then ranked by the management on the basis of which is the
most beneficial for the organisation.
4) Finally, the resources are allocated to the packages on the basis of the rank and resources
available.
All the costs are justified, and hence unnecessary Its time consuming and expensive as it takes a lot of
expenditure is reduced. management time.
Develops a questioning attitude Conflicts may arise due to different treatment to

different divisions
No budget slack is created Short-term benefits may be given importance over long
term objectives
Managers are motivated to find alternatives and Managers may get demotivated if their packages are
cheaper ways to do things. rejected.
Trivia: In the pandemic, many companies adopted Zero Based Budgeting so as to focus and spend
only on such activities, which were of extreme importance for the company. In this way, each cost
has to be justified, and hence companies were able to save a lot of money and survive the pandemic.
Feed-Forward Control:
In the feedback, we compare the actual historical result with the budget and give feedback. In feed-
forward, we compare the actual and planned outcomes even before the event has occurred. This is
done as a step to prevent variances in the first place.
It acts as a warning signal to managers. Time consuming
It helps in solving problems before they occur. Expensive system may be needed to make reliable
forecasts.
Cost of preventing something is always less than taking In stable situations, it may be unnecessary.
the correct action hence it helps in saving costs
Fixed Budget:
It is a budget created before the start of the budgeting period and is never changed during the
course of the period. This budget does not change with a change in the volume of goods actually
produced.
This type of budgeting is suitable for businesses where the output and costs can be estimated with
certainty.
Flexible Budget:
In this type of budget, the figures change according to a change in volume to incorporate the
additional variable expenditure and variance.
This is suitable for businesses where the volume of production and sales fluctuates.
Functional Budget:
These are the budgets prepared for each department or function. E.g., Sales budget, production
budget etc.
Here the principal budgeting factor is a starting factor. Example, in most cases, Sales is the principal
budgeting factor hence its budget is created first, followed by production and so on.
Master Budget:
This is merely a consolidation or grouping of all the functional budgets. This budget includes a
budgeted Statement of Profit or loss, Financial position and cash flows.
1) Which type of budgeting is more suitable for a pandemic like situation?
a) Incremental
b) ZBB
2) Which type of budgeting technique always ensures that a fixed budget period is
maintained?
a) Rolling Budgets
b) ABB
c) ZBB
Answer:
1) b) ZBB.
2) a) Rolling
Flexed Budget
This is a budget which tells us what the revenue and costs should have been for a given level of
activity. It adjusts for the actual volume produced.
E.g., At the start of the year, we forecast that we will produce 100 products and these will need
1000kg of material. But in reality, we produce 120 products and use 1300 kg of material.
Now, if we have to compare like for like we must know how much of material should have been used
for 120 products. We can do this by first finding out the quantity required per product I.e., 10 kg
(1000/100). Then we find out what the quantity should have been for 120 products, that is 1200 kg
(120*10).
Now we can say that for 120 products, 1200 kg of material should have been used. This is a flexed
budget.
Syllabus D1f-g-h-i-j
- Explain the beyond budgeting model, including the benefits and problems that may be
faced if it is adopted in an organization
- Discuss the issues surrounding setting the difficulty level for a budge
- Explain the benefits and difficulties of the participation of employees in the
negotiation of targets
- Explain the difficulties of changing a budgetary system or type of budget used
- Explain how budget systems can deal with uncertainty in the environment
Information Used in Budget Systems

During budgeting, it is vital to use past information. Past information can be a starting point from
where other additional things can be build up.
Some of the main sources of information used during the preparation of budgets are:
1) Previous year’s actual result and variance analysis

2) Other internal sources such as manager’s knowledge
3) External information mainly relating to demand and competitors.
4) Estimated costs of a new product or service.
5) Models such as EOQ may be used to forecast inventory levels
Setting the Difficulty Level of Budgets
Budgets are used to motivate employees by giving them targets to achieve. But setting the targets at
the correct difficulty level is important to actually motivate the employees.
Targets that are too easy or too difficult will demotivate employees. Instead, targets which are
moderately difficult but at the same time achievable are motivating for employees.
Difficulties in Changing a Budgetary System
Mainly the budgeting system used in companies is incremental. But when they move towards ABB or
ZBB due to changing circumstances, they have to face the following difficulties:
● Resistance to change by employees and managers due to the requirement of additional

work.
● Benefits of changing the system may not be understood by non-financial professionals.
● The staff will need to be trained to adapt to the new system. This may add to the cost of the
organisation.
● ABB will require a technologically advanced information system in place, which will be
expensive to install and maintain.
Dealing with Uncertainty in Budgets
Budgets are prepared on the basis of estimates, and hence there is a certain level of uncertainty.
This uncertainty may arise due to various factors such as:
1) Changing market conditions

2) Changing economic environment
3) Customers may find a different supplier
4) Employees may not be motivated to work hard as expected.
5) Machines may break down
6) Technological advances may take place
There are many such reasons why uncertainty exists. This uncertainty can be reduced by
continuously updating the budgets. This can be done by using a rolling and flexible form of
budgeting.
Like we studied in the previous section, we can also use tools such as expected value using
probabilities.
Beyond Budgeting:
‘Beyond budgeting is a set of guiding principles to enable an organisation to manage its performance
and decentralise decision-making process without the need for traditional budgeting.’
Traditional budgeting currently has some criticisms such as:
● It takes too much time.

● It is too out of date for the modern business environment.
● Managers try to make life easy for them.
● Instant decisions cannot be taken due to constraints set by budgets.
● Less focus on creating value and more on reducing costs.
● Flexibility is reduced.
Beyond budgeting tries to solve these problems by providing an alternative way to go about things.
Following are the characteristics/principles of Beyond Budgeting:
● Replace financial targets with KPI (Key Performance Indicators) based targets. For e.g.,
instead of having a target profit, we should focus on lower customer complaints.
● Appraisals should be done on the basis of comparison with peers and benchmarks. This
means that there are no formal targets. People are expected to perform better than
competitors.
● Have decentralization of power and responsibility. This means that lower-level managers are
given autonomy to take decisions.
● Keep updating forecasts and compare your performance against such forecasts rather than
comparing with budgets.
● Information support systems should be transparent and ethical.
Managers will be more motivated due to Senior management may not approve of this
increased autonomy. Managers are incentivised style as they will be used to command and
to perform better than their competitors. control type of centralised type of
management.
More focus is on value creation and on being Not of any use in public sector or charities as
customer/supplier focused, thus improved funding is limited.
customer and supplier loyalty.
Performance is based on KPI rather than Working without any target may prove to be
financial targets, which enables the underlying risky as managers may put their own interests
success of a business. over the company.
This section is widely tested in the exam. You must understand how the various budgeting
systems work and where they can be suitably used. It is also important to understand the
advantages and disadvantages of budgeting systems. You may be asked to write a descriptive
answer for the same.
Quantitative Analysis in Budgeting
Syllabus D2a
- Analyze fixed and variable cost elements from total cost data using high/low method
Total cost of producing a given number of units will include the fixed as well as the variable cost. The
fixed cost will remain unchanged, but the variable element will change according to the volume of
units produced.
Now how do we find the fixed and the variable cost from total cost?
= By using the high-low method.
Hence, by using the high/low method, we compare two semi-variable costs for two different activity
levels to find out the variable cost element. Then we simply subtract this from the total cost to arrive
at the fixed cost element. This is explained in more detail using the following steps and
Step 1
Select the highest and lowest activity levels, and their respective costs.
Step 2
Calculate the VC per unit:
VC per unit: Cost at high level of activity - cost at low level of activity
High level activity - low level activity

Step 3
We now use this variable cost to find out the fixed cost by substituting it in either high level or low-
level activity
Using the formula-Total fixed cost + (Variable cost per unit x level of activity)
Step 4
After you have found out the fixed cost and variable cost elements, by making a cost equation, you
can estimate costs for different data levels.
Let’s try and apply this to another example, with various data points.
The following costs have been incurred by a factory in various production runs.
Output (Production) Total cost ($)
600 71000
400 64000
900 81000
700 74400
500 67600
Using the high/low method analyses the total cost into fixed cost and variable cost elements and
estimate the cost of production to satisfy demand is 1200 units.
Solution:
Remember to pick the highest and lowest activity levels, not the highest and lowest costs or first and
last levels.
VC per unit = (81000-64000) / (900-400)
=17000/500 =34
FC per unit (900 units) = 81000 – (34 x 900)
= 81000 – 30600 = 50400
Estimated cost for 1200 units: 50400 + (34 x 1200) i.e., 50400 + 40800 i.e., $91200
Advantages of high/low method
1. Simple to calculate
2. Easy to explain
Disadvantages of high/low method
1. Relies on historical data

2. It only uses two values, hence random variations are ignored
3. Bulk discounts etc. distort the calculations
Syllabus D2b
- Explain and apply analysis techniques including correlation, regression and time series
Least Squares Regression Analysis
This method finds out the line of best fit mathematically instead of estimating a line on a graph,
hence we know it’s built around the same equation.
y = a + bx
The formulae to find out ‘a’ and ‘b’ are:

𝑛 ∑ 𝑥𝑦− ∑ 𝑥 ∑ 𝑦
b= 2
𝑛 ∑ 𝑥 2 −(∑ 𝑥)
∑𝑦 𝑏∑𝑥
a= − or 𝑦̅ − 𝑏𝑥̅
𝑛 𝑛
Where ‘n’ is number of pairs of data.
👩‍🏫 Apply Your Knowledge:
John’s bookstore is a small chain of bookstores having 5 stores. Each store advertises in their area’s
billboards, and the marketing director is interested in finding if the revenue is actually affected by
the advertising, by how much. The following information is provided:
Store Advertising expenditure (x) Revenue (y)

1 100 400
2 230 700
3 50 275
4 170 620
5 25 150
∑x = 575
∑y = 2145
∑xy = 323900
∑x2 = 94925
∑y2 = 1132525
Calculate the line of best fit using regression analysis.
Solution:
𝑛 ∑ 𝑥𝑦− ∑ 𝑥 ∑ 𝑦
b= 2
𝑛 ∑ 𝑥 2 −(∑ 𝑥)
5∗323900−575∗2145
b= 5∗94925−5752
b = 2.68
a = 𝑦̅ − 𝑏𝑥̅
2145 575
a= 5
− 2.68 ∗ 5
a = 120.8
Line of best fit: y = 120.8 + 2.68x
This means that if no money is spent on advertisements, the revenue would still be $120.8, then
for every additional $1 of advertisement expense, the revenue would increase by $2.68.
Linear Regression in Budgeting
Continuing on what we’ve learnt so far, next we’ll understand how this helps us in budgeting.
Once we establish the line of best fit equation, we can use it for estimation purposes. Simply put, the
equation y = 120.8 +2.68x can be used to find out what revenue (y) would be at any other
advertisement cost (x).
We can predict the value of ‘y’ for any given ‘x’ value.
When we take an ‘x’ value that is included in the given original data, the prediction is known as
Interpolation.
When we take an ‘x’ value that is not included in the given original data, the prediction is known as
Extrapolation. In general, interpolation is much safer than extrapolation.
Linear Regression in Budgeting
Continuing on what we’ve learnt so far, next we’ll understand how this helps us in budgeting.
Once we establish the line of best fit equation, we can use it for estimation purposes. Simply put, the
equation y = 120.8 +2.68x can be used to find out what revenue (y) would be at any other
advertisement cost (x).
We can predict the value of ‘y’ for any given ‘x’ value.
When we take an ‘x’ value that is included in the given original data, the prediction is known as
Interpolation.
When we take an ‘x’ value that is not included in the given original data, the prediction is known as
Extrapolation. In general, interpolation is much safer than extrapolation.
The Correlation Coefficient
As we understand various things related to the relationship between data, we need to understand
how strong is the correlation. Like a scatter diagram can also be calculated mathematically, the
correlation can be calculated too.
By correlation, we mean whether the relationship is perfect, partial, or there is no correlation.
Such degree of correlation can be calculated using the Pearsonian correlation coefficient known as
‘r’
𝑛 ∑ 𝑥𝑦−∑ 𝑥 ∑ 𝑦
r=
√(𝑛 ∑ 𝑥 2−(∑ 𝑥)2 )√(𝑛 ∑ 𝑦 2 −(∑ 𝑦)2)
‘r’ must always be between -1 and +1
If r = +1, there is perfect positive correlation.
If r = 0, there is no correlation.
If r = -1, there is negative positive correlation.

For other values, a partial correlation can be said to exist, however, if it’s above 0.8 or -0.8, only then
it’s said to be strong.
If ∑x = 720, ∑y = 4075, ∑x2 =139950, ∑y2 =4161325, ∑xy =743150 and n is 4, then the value of ‘r’ to a
two decimal place is:
𝑛 ∑ 𝑥𝑦−∑ 𝑥 ∑ 𝑦
r=
√(𝑛 ∑ 𝑥 2−(∑ 𝑥)2 )√(𝑛 ∑ 𝑦 2 −(∑ 𝑦)2)
4∗743150−720∗4075
r=
√(4∗139950−7202 √(4∗4161325−40752 )
r = 0.95
1) Which of the following is not a valid value for ‘r’?
a) 0.9
b) -1
c) 0
d) 1.3
Answer:
1) d) ‘r’ can only be between -1 and +1

The Coefficient of Determination
Lastly, let’s understand the coefficient of determination, r2. This is calculated to find out how much
of the change in y is due to change in x. Basically, if the coefficient of determination is 95%, it means
that 95% of changes in y were due to changes in x.
Let us calculate the coefficient of determination for the Apply Your Knowledge above:
r = 0.95
r2 =90.25%
This means that 90.25% changes in ‘y’ are caused by ‘x’.
And for regression analysis, that’s a wrap! For more practice, do the few quizzes given below:
Learning Regression Calculations on a Scientific Calculator
Now we’ll learn how to do regression analysis by using a scientific calculator. This is a useful trick
which eliminates the need to remember and apply proper formulae with those messy brackets. It is
recommended that one knows how to apply those formulae, but in the real world, the calculation is
what matters.
ACCA will provide you with the formulae in the exam, however, to gain an edge by saving significant
time and ensuring you’re left with an accurate answer, learning how to do it over a scientific
calculator is beneficial.
Note: The calculator that we’ve used for demonstration purposes is allowed in an Acca exam, and
similar scientific calculators will also have functions helping out with regression analysis.
Model: Casio fx-991es plus
Now we’ll learn how to do regression analysis by using a scientific calculator. This is a useful trick
which eliminates the need to remember and apply proper formulae with those messy brackets. It is
recommended that one knows how to apply those formulae, but in the real world, the calculation is
what matters.
ACCA will provide you with the formulae in the exam, however, to gain an edge by saving significant
time and ensuring you’re left with an accurate answer, learning how to do it over a scientific
calculator is beneficial.
Note: The calculator that we’ve used for demonstration purposes is allowed in an Acca exam, and
similar scientific calculators will also have functions helping out with regression analysis.
Model: Casio fx-991es plus
Step 1: The first thing we need to do, is input our data into the calculator, for
this particular demonstration, let’s input the following table of data into the
calculator:
x y
-1 0
0 2
1 4
2 5
Turn on your calculator by pressing the button ‘ON’ on the top right corner,
and press the ‘MODE’ button besides it.
Step 2:
On pressing mode, the following will pop up on your display. Here,

we select the ‘STAT’ option, by pressing the numeric key, 3.
At this point, the following display will be displayed.

Here, we’ll select the second option, ‘A+BX’, which represents our
cost equation y=a+bx, by pressing the numeric key, 2.
Step 3:
Now, what should hopefully pop up is an empty table, with two columns, headed as ‘x’ and ‘y’, as
shown in the picture below.
Here, we fill our data, as provided in step 1, by simply entering the

numbers in the relevant boxes. To navigate across the table, we use
the arrow keys provided at the center of the calculator.
Once, this is done, your table should look like this:
Once, you’ve inputted the data, simply press the ‘AC’ button, your
data will be saved until you clear the data.
This brings us to the end of data entry, and also, 90% of the work is
done, wasn’t it simple?
Step 4:
All that’s left now, is to check the regression values.
Simply press ‘SHIFT’ and then ‘1’ to move to the STAT menu, as
shift enables you to move to the areas written in yellow on your
calculator. The screen will now display the following:
Here is where all your answers lie.
Press 2 to edit the data in the table,
Press 3 to find out values such as ∑x, ∑y, ∑xy etc.
Press 5 to find out regression data, such as ‘A’,’B’ and ‘r’
In the next step, we’ll demonstrate how to do it.
Step 5:
Let’s try and find out the value of ‘A’ in this particular scenario. By pressing 5, the following options
will show up:
Here, to find out the value of ‘A’ we simply press the number denoting
it, 1. After this, press the ‘=’ sign to find out the value of ‘A’. It’s that
simple. It should be displayed as:
In our example, the answer to A is 1.9. This can be cross verified by

manual calculations; however, it is safe to say that the powerful
calculator would always be correct. With practice, regression
questions can be solved in less than a minute, where as they’re
allocated 2 ½ minutes or more. If you receive a Section B question, half
your work will be done on the calculator. If you’re one who double
checks, a regression question when done manually would take 5
minutes, whereas rechecking the calculator answer is not necessary,
one can check the data for correct inputs.
1) y = a + 0.92x with six pairs of data.

Preliminary calculations have established that ∑x = 120 and ∑y = 240.
What is the value of a in the equation?
a) 12.60
b) 13.80
c) 21.60
d) 16.20
2) Which of the following are correct with regards to regression analysis?
a) In regression analysis the n stands for the number of pairs of data.

b) Σx2 is the same as (Σx)2
c) Σxy is calculated by multiplying the total value of x and the total value of y
3) Which of the following is NOT a feasible value for the correlation coefficient?
a) +1.2
b) +0.6
c) 0
d) –0.9
Answer:
1) c) 21.6
∑𝑦 𝑏∑𝑥
Using the least squares method, the value of a equals: 𝑛
− 𝑛
In the question there are six pairs of data and b = 0.92
Therefore: a = 21.6 (240 / 6) - (0.92 x (120 / 6))
2) a)
3) a)
Time Series Analysis
A time series analysis, as the name suggests is a series of figures recorded over time. Figures such as
revenue, staff turnover etc.
It is used to identify any trends or patterns, which are then used to then make forecasts by
extending such patterns.
Why are these forecasts so important? Because a company has to reliably estimate how much
output it will require to meet demand, or how many employees will stay to help achieve this etc. If
an accurate and reliable forecast is in place, a company can plan their activities accordingly.
We need to understand 4 Components of time series analysis.
1. The Trend
All events faced by a company, usually follow some trend in the long run, if such a pattern
can be found out, it can be used to benefit the company. The trend can be found out by
inspecting a graph, by regression analysis, or by moving average calculation, which we’ll
learn later in the course.
2. Seasonal Variations
These variations occur due to the regular rise and fall over shorter periods of time.
For example, umbrella sales are likely to be higher than average every winter and lower than
average every summer.
3. Cyclical Variations
These variations are long term in nature and happen due to changes in the economy. To
accurately make a forecast, data of at least 6-7 cycles would be required, each cycle being of
uncertain long periods. Hence, it is unlikely that cyclical variations are analyzed.
4. Residual or Random Variations
These variations happen due to random or unexpected events, hence cannot be predicted.
There are two models that can be used to forecast figures, including the seasonal variations.
1. Additive Model:
Here the seasonal variation is expressed as an absolute amount to be added on to the trend
to find the actual result, e.g. ice cream sales in summer are expected to be $200,000 above
the trend.
Forecast =Trend + Seasonal variation
2. Multiplicative Model:
Here the seasonal variation is expressed as a ratio/proportion/percentage to be multiplied
by the trend to arrive at the actual figure, e.g. ice cream sales are expected to be 50% more
than the trend
Forecast =Trend x Seasonal variation

Let’s see how each of these models are applied with the help of this following Apply Your
Knowledge.
The following are the results of a business in the year.
Year Quarter Units sold

20X9 1 45
20X9 2 65
20X9 3 65
20X9 4 70
The trend is expected to increase by 10 units per month, and is estimated to be 50 units at the start
of Q1.
Make forecasts for all quarters of 20Y0 using
a) Additive model
b) Multiplicative model
Solution:
We can draw the following table:
Year Quarter Units sold Trend a) Variation b) Variation

20X9 1 45 50 -5 10%
20X9 2 65 60 +5 -8.33%
20X9 3 65 70 -5 -7.14%
20X9 4 70 80 -10 -12.5%
These variations can be applied to trend projections for 20Y0. Forecasts using both methods are:
Year Quarter Trend Forecast (a) Forecast (b)

20Y0 1 90 90+5=95 90x1.1=99
20Y0 2 100 100-5+95 100x0.92=92
20Y0 3 110 110-5=105 110x0.93=102
20Y0 4 120 120-10=110 120x0.875=105
Note: The factor for Q2 of 0.92 in (b) is 1-0.0833 as the trend is negative. The factors for Q3 and Q4
have been calculated similarly.
Moving Averages
In reality, it would be unlikely that trends are easily obtained or set, hence we use moving averages,
to find out trends. A moving average is a series of averages calculated from historical time series
data.
A moving average can be 3-point, 4 point or 5 point. In the Apply Your Knowledge below, we use a 3-
point moving average.
Let us look into this Apply Your Knowledge and learn how a moving average is calculated.
A business is forecasting the sales value of the first quarter of the coming year, using moving
averages. Current year values are:
Month Sales Revenue

June 851
July 771
August 916
September 935
October 855
November 1000
December 1019
Solution:
Step 1: Calculate 3 month moving average.
Simply add the sale revenues of three months, and divide them by 3 to arrive at a moving average
trend.
Month Sales Revenue Moving average total Trend $

June 851
July 771 2538 846
August 916 2622 874

September 935 2706 902
October 855 2790 930
November 1000 2874 958
December 1019
Step 2: Compare the trend to the sales revenue, and find the variation.
Month Sales Revenue Trend $ Variation

June 851
July 771 846 -75
August 916 874 42
September 935 902 33
October 855 930 -75
November 1000 958 42
December 1019
Step 3: Extrapolate the trend. Like in this example, the trend is increasing by $28 each month.
Then apply the seasonal variations to arrive at the forecast values
Month Trend $ Seasonal Variation Forecast Sales Value

September 902 33
October 930 -75
November 958 42
December 986 33
January 1014 -75 939
February 1042 42 1084
March 1070 33 1103
That’s how forecasts are estimated using moving averages in time series analysis.
Time series analysis can also be done using regression analysis, that’s right, what we learnt
previously does indeed have practical applications.
The period or quarter represents the independent variable, and the dependent variable usually
represents the output. Let’s take a look at this Apply Your Knowledge to understand this:
A company uses a multiplicative time series model to forecast sales. The trend in sales is linear and is
described by the following equation:
Trend = 250 + 20T
Where T = 1 denotes the first quarter of 20X0
T = 2 denotes the second quarter of 20X0 etc.
The average seasonal variations are as follows:

Quarter 1 2 3 4
% Variation -19 +6 +15 -2
What is the sales forecast for Quarter 3 of 20X2?
Solution:
First, we find out which quarter in period no. is Q3 of 20X2, that represents T
T = 11 (4 quarters in 20X0 plus 4 quarters in 20X1 plus 3 quarters in 20X2)
The trend, therefore, by using regression analysis is, 250 + (20x11) =470 units.
Multiplicative variation for quarter 3 = + 15%
Sales forecast = 540 units (470 x 1.15)
Advantages of time series analysis
• Forecasts are based on clearly understood assumptions.

• Accuracy can be improved with experience.
• Trend lines can be updated and compared, to improve reliability.
Disadvantages of time series analysis
• Past events may not be a true guide for future events.

• Assumes that a straight-line trend exists.
• Assumes seasonal variations are constant, hence predictable.
1. A company uses additive time series model to forecast sales. The trend in sales is linear and
is described by the following equation:
Trend = 1000 + 120T
Where T = 1 denotes the first quarter of 20X0
T = 2 denotes the second quarter of 20X0 etc.
The average seasonal variations are as follows:
Quarter 1 2 3 4
Variation -190 +60 +115 -75
What is the sales forecast for Quarter 4 of 20X1?
a) 1885
b) 2035
c) 1405
d) 2365
2. B company is preparing its forecast sales information for the end of current year. The actual
sales information for the first nine months of 20X7 is given below:
Month Sales Volume (units)

January 95000
February 69100
March 58750
April 85250
May 74800
June 107500
July 81600
August 71250
September 97750
What is the monthly trend when using a 5-point moving average?
a) 250
b) 25000
c) 2500
d) 25
Answer:
1) -a) 1885
First, we find out which quarter in period no. is Q4 of 20X1,that represents T

T = 8 (4 quarters in 20X0 plus 4 quarters in 20X1)
The trend therefore, by using regression analysis is, 1000 + (120x8) =1960 units.
Additive variation for Q4 = -75
Sales forecast = 1885 (1960-75)
2) -c) 2500
Month Sales Volume (units) 5 point moving Trend

average
January 95000
February 69100
March 58750 382900 76580
April 85250 395400 79080
May 74800 407900 81580
June 107500 420400 84080
July 81600 432900 86580
August 71250 382900 76580
September 97750
As we can notice, the trend each month is increasing by 2500 units. (79080-76580=2500)
Learning Effect 138
Learning Effect
Syllabus D2b-c-d
- Estimate the learning rate and learning effect

- Apply the learning curve model to a budgetary problem, including calculations on
steady states
- Discuss the reservations with the learning curve model
Imagine you are asked to prepare a paper toy. The first time you do it, you are learning, and hence it
takes more time. The second time you do it, you get better at it. As you make more paper toys, you
get more efficient, and you take less time to make the product. Now in this section, we will try to
find out the rate at which you are learning, i.e., how fast are you producing the product.
‘The learning curve theory states that as cumulative output doubles (e.g., from two units to four
units), the cumulative average time taken per unit will fall to a given percentage of previous
cumulative production. This percentage is known as the learning rate.’
The theory states that repetition of the task will bring more efficiency as people will become
confident and better at it, and hence the time required will reduce.
Eventually, this fall will stop as the product cannot be produced any faster. This position will
stabilize.
Learning effects are more likely to be seen if -
● The process is Labour intensive

● The product is new
● The product is complex
● Production is repetitive, and there are no breaks in production.
A product will take 100 hours for the first unit, and an 80% learning curve applies
Units Cumulative Cumulative Incremental Incremental Incremental

average time total time units total time Average time
per unit
1 100 100 1 100 100

2 80 (80% of 160 1 60 60
(Double of 1) 100)
4 64 (80% of 256 2 96 48
(Double of 2) 80)
8 51.2 (80% of 409.6 4 153.6 38.4
(Double of 4) 64)
16 40.96 (80% of 655.36 8 245.76 30.72
(Double of 8) 51.2)
Learning Effect 139
As we can see over here, as the production doubles, the cumulative average time falls by 80%.
The problem with using the tabular approach is that we cannot find the average for all levels of
production. The tabular approach is useful if the output keeps on doubling but this is not very likely
in real world scenario thus, one makes use of the learning curve formula.
Learning curve formula
𝑦 = 𝑎𝑥 𝑏
Where y = cumulative average time per unit to produce x units
a = time taken to produce the first unit of output
x = the cumulative number of units produced
b = the index of learning (log LR/log 2)
LR = the learning rate as a decimal.
Using our previous Apply Your Knowledge, let’s find the cumulative average time for 8 units
where b is given as -0.3219. (log 0.8/log 2)
𝑦 = 𝑎𝑥 𝑏
Y=100×8-0.3129
= 100×0.512=51.2 hour
Steady State:
As output increases, the time required to produce falls. But this fall is limited to a certain limit. After
that limit, the time taken per unit reaches a steady state and every product after this will take the
same amount of time.
Learning Effect 140
Calm colour co. produces paints. The mixing department in Cal colour co. is labour intensive.
A new kind of paint “Roman grey” will be launched next month. As it’s a new paint the labourers in the mixing
department will need to learn how to mix the paint properly.
The time taken to mix the first container is expected to be one hour. A learning rate of 85% is expected. The
learning effect is expected to stop after 30 units have been produced and all the units after that will take the
same time to produce.
Calm colour co. has budgeted to produce 100 containers of Roman grey.
b=-0.2345
Required:
a) Calculate the labour time per unit which will apply for the 30th and subsequent units.
b) Calculate the total labour time to make the first 100 units of the Roman grey.
a)
Y=axb
b=-0.2345
a=1
For the first 30 units:

Cumulative average time per unit, Y=30-0.2345, =0.45042
Total time (30*0.45042) = 13.513
For first 29 units

Cumulative average time per unit, Y=29-0.2345
Total time (29*0.45401) =13.166
Total time taken to make first 30 units 13.513

less: Total time taken for 29 units 13.166
Time taken to make 30th and subsequent units 0.347
Hence the time taken to produce the 30th unit and all units after it is 0.347
b) Total time for 100 units
Total time taken to make the first 30 units 13.51

Time taken to produce next 70 units (70×0.347) 24.29
Time taken to make first 100 units 37.8
Learning Effect 141
Weaknesses of the learning curve:
These are the weaknesses of using the learning curve
1. Where workers are protected by labour unions, there may be a go-slow agreement between
them. In this way, they can collude to not work at their full potential.
2. It is assumed that the learning curve which existed for products in the past will continue for
a new product as well. This assumption makes the calculation less realistic as the new
products will have different features, and hence workers will require more or less time to
produce it.
3. It is only useful in situations where continuous production takes place. If there are breaks
due to unforeseen circumstances such as the pandemic situation due to the corona-virus
outbreak, the workers may forget their skill and hence the trend of the learning curve will
break.
4. In today’s economy, products are tailor-made to customers’ requirements and hence mass
production of similar items is less common.
142
Standard Costing and Advanced Variances
D3 Standard Costing
Syllabus D3a-b-c-d
- Explain the use of standard costs.

- Outline the methods used to derive standard costs and discuss the different types of
cost possible
- Explain and illustrate the importance of flexing budgets in performance management
- Explain and apply the principle of controllability in the performance management
system
Budgeting and forecasting our future production help us to predict the total costs which we are
going to incur. We can then calculate an estimated cost per unit.This estimated cost per unit is called
as a standard cost.
Uses of Standard Cost
1. Standard costs can be used to value inventories. We know that inventories are valued at
lower of cost or NRV. The cost used over here are standard costs.
2. The standard costs can be used to budget production costs. If we know the cost per product,
we can find total costs for n number of products easily.
3. We can find out variances through the use of standard costs. Variances are differences
between the budgeted and the actual result. We will learn about these in the coming
chapters. These variances help us control our production processes.
4. In a nutshell, standard cost can be used as a threshold for the costs of the organisation.
Standard cost card
Product Roman green
Direct materials Cost Requirement $

X $4 per kg 6 kg 24
Y $6 per kg 2 kg 12
Z $8 per kg 1 litre 8
Direct labour
Grade A $ 6 per hour 3 hours 18
Variable production overhead $1 per hour 4 hours 4
Fixed production overhead $3 per hour 2 hours 6
Standard cost of production 72

As you can see in the above cost card how a standard is set for each cost element, i.e., only 3 hours
of grade A labour will be used etc. This is how a standard cost per product is calculated.
There are four approaches to setting standards:
1) Ideal standard:
It assumes 100% efficiency. It is too difficult to achieve, and hence it is demotivating. It

includes zero wastage, scrap, breakdowns etc.
Using ideal standards as targets causes loss of employee’s morale and confidence
2) Basic standard:
It is the average standard which has been in place for a long time. It may become out of date
too quickly thus become too easy to achieve, hence may actually demotivate the employees.
3) Attainable standard:
It Is based on normal efficiency. They allow for employee fatigue, machine breakdowns etc.
These standards are motivating as they are achievable.
4) Current standard:
This is when the standard is based on the current conditions of the organisation. When the
standard of performance is not challenging, employees and their managers might be content
simply to achieve the standard without trying to improve their current performance
Importance of Flexible Budgeting in Performance Management
‘A flexible budget is one which recognizes different cost behavior patterns and changes as the
volume of the activity changes.’
E.g., Natarajan co plans to produce 100 pencils. For producing 100 pencils, the budgeted total cost is
$200. This comprises of $100 fixed costs and $100 variable costs.
What will be the total cost if 120 units are produced?
The budget was for 100 pencils, but in reality, we produced 120. Now we need to find the budgeted
costs for 120 units.
As fixed costs are fixed and do not change as per the level of volume, they will remain the same, i.e.,
$100.
Variable cost per unit can be calculated as Total variable cost/number of units
=100/100 =1
For 120 products total variable cost = 1*120 =120
Hence the total cost = fixed + variable
=120+100 =220
Hence 120 units will have a total cost of 220.
Why flexible budgeting is important?
In the above example, let’s say the actual cost of producing 120 units came to $210. If we had
compared this to the fixed budget, there would have been an increase in cost by $10, which would
have given us an adverse variance.
But how can we compare the actual cost of 120 products and the budgeted cost of 100 products?
Yes, your question is absolutely correct. That is the reason why we make use of flexible budgeting
and find the budgeted cost of 120 pencils, so we can fairly compare with the actual production of
120 pencils.
Principle of Controllability
‘The principle of controllability states that managers of a responsibility center should only be held
accountable for costs over which they have control.’
Imagine you are a manager of a sales division, but your performance is appraised on the basis of
how all divisions perform. Is this fair?
No, because you don’t have control over the other divisions. You should be appraised on the basis of
how your division performs.
In Responsibility accounting, revenues and costs are divided into areas of personal responsibility
(responsibility centers). In the above example, the sales division is your responsibility center.
We do this to monitor and appraise the performance of each division separately and fairly.
Controllable and Non-Controllable cost
Controllable costs are those over which the manager has control. E.g., purchasing manager has
control over the variable cost of the material. This is decided by the manager, and hence he has
control over it.
Non-controllable costs are those which are not under the manager’s control. E.g., an increase in fuel
prices due to war in gulf countries is not in manager’s control.
D4 Material Mix and Yield Variances
Syllabus D4a-b-c-d
- Calculate, identify the cause of, and explain material mix and yield variances
- Explain the wider issues involved in changing material mix, e.g., cost, quality and
performance measurement issues
- Identify and explain the relationship of the material usage variance with the material
mix and yield variances
- Suggest and justify alternative methods of controlling production processes
Revision of Management accounting topics:

Material Variances
The two main reasons of material variances are:
● We used more material per unit than budgeted
● We paid more for the material than we budgeted
Let’s understand how these lead to variances:
Material Price Variances
If we budgeted that, we’ll have to pay $10 per kg for the material used, and we ended up paying $12
per kg, hence it means that we paid more for the materials than we budgeted. This will give rise to
an adverse variance. Thus, it can be concluded that material price variances are calculated as the
difference between the actual price paid and the budgeted price. Hence, if the actual price exceeds
the budgeted price then there will be an adverse variance and vice versa. Thus, material price
variance can be calculated as follows-
(Actual price – budgeted price) x Actual quantity purchased
Material Usage Variance
No matter the reason, if we use more or less material than we budgeted, it will give us a variance.
For example, to make 100 units, we budgeted 5kgs per unit, but ended up using 6kgs per unit due to
wastage, we’ll end up using 100kgs more to produce 100 units. Thus, material usage variance can be
calculated as follows-
(Actual quantity – budgeted quantity) x Standard price
In conclusion, material price variances tell us if each unit of material cost more or less than
expected, and material usage variance tells us if actual production use more or less units of materials
than expected.
Till now, we have seen that total material variance is divided between Usage and Price now, we go a
step further and divide material usage variance into Mix and Yield variances.
This is commonly tested in the exam. You should expect a calculation-based question in
section C of the exam.
Material Mix Variance
The standard mix of materials is the proportion of materials we expect, or we have budgeted to use
while producing a product. E.g., to make one glass of chocolate milk, you will need 200 ml milk, 2
spoons of sugar, 2 spoons of chocolate powder. This is the standard mix to make one glass of
chocolate milk.
A material mix variance identifies the impact on profit of a change in the mix of materials.
How to calculate mix variance?
The material mix variance is calculated as the difference between the actual total quantity used in
standard mix and the actual quantities used in the actual mix multiplied by the standard material
prices. The following pro forma can be used.
Material Actual quantity, Actual quantity, Difference @ standard price Variance in $

actual mix (AQAM) Standard mix (difference*
(AQSM) standard price)
M1 X kgs A kgs (X-A) Kgs $x1/kg $Var (F/A)
M2 Y kgs B kgs (Y-B) Kgs $x2/kg $Var (F/A)
M3 Z kgs C kgs (Z-C) Kgs $x3/kg $Var (F/A)
Sum(X+Y+Z) Sum(A+B+C) Total = 0 $ total Variance

AQAM – Actual input of each material (will be given in the question)
AQSM – Actual total quantity split in the standard mix that is take the sum total of each material’s
actual quantity used and then multiply by the standard quantity proportions.
Adverse and favorable material mix variances-
A favorable material mix variance arises when a higher proportion of cheaper material is used in the
actual input than is indicated in the standard. This reduces the overall cost of the product. Use of
cheap quality material may result in poor quality of the product and may result in loss of reputation
and goodwill in the long term.
An adverse material mix variance arises when a higher proportion of expensive material is used in
the actual input than is indicated by the standard mix. This increases the overall cost of the product.
Material Yield Variance
When a different output is produced from the given number of inputs than standard, it gives rise to
material yield variances. It measures the efficiency of turning the inputs into outputs.
It is calculated as the difference between the actual quantity using standard mix proportions and the
standard quantity using the standard proportions.
Proforma-
Material Actual quantity, standard quantity, Difference @ standard Variance in $ (difference*

standard mix (AQSM) Standard mix (SQSM) price standard price)
M1 X kgs A kgs (X-A) Kgs $x1/kg $Var (F/A)
M2 Y kgs B kgs (Y-B) Kgs $x2/kg $Var (F/A)
M3 Z kgs C kgs (Z-C) Kgs $x3/kg $Var (F/A)
Sum(X+Y+Z) Sum(A+B+C) Sum(X+Y+Z) $ total Variance

-
Sum(A+B+C)
AQSM- calculated in the same way as for material mix variances

SQSM- Material quantity used from standard cost card * total actual output produced/ material
output quantity produced by the standard cost card.
A favorable material yield variance arises when more output is produced from given inputs than
expected by the standard. Possible reason for the increase in yield is the increase in the number of
skilled workers employed and more efficient labour practices and can also be due to higher quality
materials used.
An adverse material yield variance arises when less output is produced from the given input than
expected by the standard. This may be due to unskilled labour or wastage of material due to
inefficient production process and can also be due to lower/cheap quality materials used.
When do we calculate both these variances?
We can only calculate and interpret material mix and yield variances if quantities in standard mix can
be varied.
It is also said that calculating yield variance for individual materials used is not useful as yield is
related to the overall output.
Inter-relationship between mix and yield variance
Using cheaper materials gives rise to a favorable mix variance however, using cheaper material may
result in increased wastages resulting in adverse yield variances.
Similarly, when we use more of expensive material, it will result in an adverse mix variance. But due
to better quality, there will be less wastages, and hence yield variance will be favorable.
The standard material cost of a product X is as follows:

Quantity Price/kg Total
Material A 2kg $3 6
Material B 1kg $2 2
3 8
The actual production of X was 5,000 units and the materials used were
Material A 9900
Material Y 5300
Calculate the material mix and material usage variance

Material mix variance

Actual quantity Actual Difference(B Variance
quantity in -A) (Differenc
standard e×
mix standard
cost)
Material A 9900 10,133 233 699
Material B 5300 5067 -233 -466
Total 15200 15200 233 Favourable
*Actual quantity in standard mix is calculated as

Material A=
15200×2/3=10133
Material B=
15200×1/3=5067
Hence, material mix variance is 233 Favourable
Material yield variance
Actual quantity in Standard Difference(A Variance

standard mix input quantity in -B) $(Differen
standard ce ×
mix standard
cost)
Material A 10133 (5000×2) 10000 -133 -400
Material B 5067 (5000×1) 5000 -67 -133.333
Total 15200 15000 -533 Adverse
Hence, material yield variance is $533 adverse
Issues Involved in Changing the Mix
Sometimes we may think of changing our standard mix due to the following reasons:
1) Price of materials may change making them cheaper or expensive to use.

2) Measurements of inputs may change
3) We intentionally want to use cheaper mix to get a favorable mix variance
Although we can use a cheaper mix, the following are the broader issues we need to consider.
● Having a favorable mix variance may lead to an unfavorable yield variance. When
performance is assessed, both the variances are considered together, and if the overall
variance is favorable as a result, then it would be appropriate to use a cheaper mix
● Using a cheaper mix may result in poor quality of the final product. As a result, the sales
would decrease in the long run due to customer dissatisfaction.
● This will also affect the sales volume variance in the long term.
● Hence, before changing the mix the manager should consider the overall impact of the
change on the business.
Controlling Production Process
As we saw earlier, if managers performance is appraised on the basis of yield and mix variances, it
results in managers using cheap materials and thereby sacrificing quality.
To overcome this problem, we can find alternative ways to appraise a manager’s performance and
thus control the production process.
Other performance measures which can be used are:
1) Quality rating of the final product

2) Total wastage of materials
3) On time production of products
4) Customer satisfaction
Sales Mix and Quantity Variances
Syllabus D5a-b
- Calculate, identify the cause of, and explain sales mix and quantity variances
- Identify and explain the relationship of the sales volume variances with the sales mix
and quantity variances
Revision of management accounting:
1. Sales variances
There are two reasons why sales variances may arise:
● The actual selling prices were different than the budgeted selling prices
● The actual sales volume (no. of units sold) was different than the budgeted sales volume
Sales price variance
This deals with the impact that a different selling price than that budgeted will have on the business.
So, if our actual selling price was more than our budgeted selling price, we’ll have a favorable price
variance as we sold at a higher price. Similarly, if we charged a lower price, the variance will be
adverse. The formula hence is,
(Actual price – budgeted price) x Actual quantity sold
Sales volume variance
Above, we took the actual quantity sold. Here we find out the variance due to the difference
between budgeted sales volume quantity and actual quantity sold. If we sell more, our variance will
be favorable. If we sell less, our variance will be adverse. Remember, we need to show the variances
in monetary ($) terms and not quantity terms.
The formula for this variance will therefore be different in absorption and marginal costing.
Absorption costing
(Actual quantity sold – budgeted sales) x profit per unit
Marginal costing
(Actual quantity sold – budgeted sales) x contribution per unit
The costs deducted from contribution are fixed and hence will not differ even if quantity or volume
of sales change thus is excluded when finding the sales volume variance using marginal costing.
In Performance management, we further divide the sales volume variance into sales mix and
quantity variance.
When a company sells more than one product, the budget includes budgeted sales volume of each
product. When a volume variance is present, it is either because of sales mix variance and/or sales
quantity variance.
Sales mix variance:
This measures the impact on profit of a change in the sales mix of the products sold that if more of
the expensive products are sold, then there will be a favorable variance however, if more of the
cheaper product is sold, then there will be an adverse variance. This difference is called as sales mix
variance.
Calculating sales mix variance:
It is calculated as the difference between actual sales in actual mix and actual sales in the budgeted
mix multiplied by the standard margin.
(Absorption costing – Profit and Marginal Costing – Contribution)
The following proforma can be used for calculation.

Product Actual sales Actual sales Difference @ standard Variance in $

quantity, quantity, price (difference*
actual mix Standard mix standard
(AQAM) (AQSM) price)
P1 X units A unit (X-A) units $x1 $Var (F/A)
P2 Y units B units (Y-B) units $x2 $Var (F/A)
3 Z units C units (Z-C) units $x3 $Var (F/A)
Sum(X+Y+Z) Sum(A+B+C) Total = 0 $ total

Variance
An adverse sales mix variance means that our customers are buying less of higher-margin product
and more of lower-margin product. We can assume that there is a substitution of one product for
another. Hence, it does not reduce the overall quantity of goods sold.
A favorable sales mix variance means that people are buying more of high-margin products than
lower-margin products.
Sales quantity variance
A sales quantity variance indicates the effect on profit of selling a different total quantity from the
budgeted quantity. For example, if a company budgeted to sell 1000 units of product A and B in the
standard mix but ended up selling 1200 units of product A and B in the standard mix, then there will
be a favorable sales quantity variance.
The following proforma can be used for calculation.
Product Actual sales Budgeted Difference @ standard Variance in $

quantity, sales price (difference*
Standard mix quantity, standard
(AQSM) Standard mix price)
(BQSM)
P1 X units A unit (X-A) units $x1 $Var (F/A)
P2 Y units B units (Y-B) units $x2 $Var (F/A)
P3 Z units C units (Z-C) units $x3 $Var (F/A)
Sum(X+Y+Z) Sum(A+B+C) Sum(X+Y+Z)- $ total

Sum(A+B+C) Variance
BQSM- same as SQSM in material usage variance
An adverse quantity variance may arise due to a decline in demand due to poor economic condition
or a new competitor.
A favorable quantity variance may arise due to an increase in demand due to a growing market or a
reduction in demand of substitute products.
Inter-relationship between variances:
An adverse sales mix variance may occur when the company offers attractive discounts on the
products with already low margins. This will mean that people would switch from higher margin
products to lower margin products.
But the offers will also attract more customers and thus result in a favorable quantity variance.
When do we calculate these variances?
A company may have a variety of products which are interrelated. They may be substitutes or
compliments. The budgeting department may have set a fixed mix and an expected sales quantity
while preparing the budget.
Hence, they will be eager to know by what amount did the actual mix and quantity differ. In such
situations, calculation and analysis of these variances is useful.
A company sells three related products which are X, Y and Z.

The sales mix is X-50%, Y-25%, Z-25%
Budget X Y Z
Unit 200 100 100
Price $20 $25 $30
Margin $3 $4 $6
Actual
Unit sales 180 150 170
Prices $22 $22 $26
Calculate sales mix and quantity variance
Solution:
Mix variance
Product Actual Actual Difference Standard Sales mix

sales sales margin variance
units units in
budgeted
mix
A B A-B C (A-B) ×C
X 180 250 -70 3 -210
Y 150 125 25 4 100
Z 170 125 45 6 270
Total 500 500 0 160
Hence, the sales mix variance is $160

favorable.
Sales quantity variances:
Product Actual Budgeted Difference Standard Sales

sales in sales margin quantity
budgeted variance
mix
A B A-B C (A-B) ×C
X 250 200 50 3 150
Y 125 100 25 4 100
Z 125 100 25 6 150
500 400 100 13 400
Hence, the sales quantity variance is $400 favorable

Working note
The actual sales in budgeted quantity are calculated as
X=500*50%=250
Y=500*25%=125
Z=500*25%=125
D6 Planning and Operational Variances
Syllabus D6a-b-c-d
- Calculate a revised budget

- Identify and explain those factors that could and could not be allowed to revise an
original budget
- Calculate, identify the cause of and explain planning and operational variances for: [2]
i) sales, including market size and market share; ii) materials; iii) labour, including the
effect of the learning curve
- Explain and discuss the manipulation issues involved in revising budgets
Introduction:
When we study variances, we are able to identify what kind of variances arose and what was the
reason for it to some extent. In this sub-section, we will understand who is actually responsible for
the variance.
We will have to decide whether it was the manager’s fault or it was a planning fault which means the
budgets were unrealistic, and hence managers should be held responsible.
To do that. we try and divide the traditional variance into two parts:
Planning Variance:
Planning variances arises due to fault in planning and standard setting process.
To find planning variance, we compare the original budget with a revised budget that should have
been in place instead of the original budget.
Planning variance are not under the managers control, and hence according to the principle of
controllability, they should not be held responsible for them.
Operational Variance:
Operational variance arises due to manager’s performance.
To find the operational variance, we compare the revised budget to the actual results.
These variances are in the managers control, and hence they are considered to be responsible for
them.
Original budget
Planning variances
Revised budget
Operating variances
Actual results
Revising Budgets:
A revised budget is the one which should have been there in the first place but was not in place due
to faulty planning.
A delivery man makes regular deliveries to a particular place. The company

estimated that the total cost of fuel for one deliver should be calculated as 40
litres of fuel at $4 per litre. Due to changes in the fuel prices, it was
retrospectively decided that the total cost of fuel should be 36 litres at $5 per
litre.
Required:
Calculate the original and revised budget if 7 deliveries are made within the
period
Original flexed budget
7×40×4 $ 1,120
Revised flexed budget

7×36×5 $ 1,260
While revising budgets, care must be taken that both the original and the revised budget are flexed
for the actual quantity level. (The way we multiplied the original fuel cost by 7).
Factors which should and should not be revised for calculation of revised budget.
We should only revise budgets if:
● Some situation which was beyond manager’s control occurred, and as a result, the original
budget will not be a reliable measure of the current situation thus would be unachievable.
As a result, the original budget should be revised.
● The revisions are approved by the senior management
Management should not revise budgets just to hide their inefficiency in not meeting the original
budget.
For which of the following situations the budget needs to be revised?
a) Due to dissatisfied employees, there was a strike which reduced the production of goods
b) Material prices rose due to international shortage
c) Operations stopped due to an earthquake.
d) Material wastage increased due to cheap quality of labour.
Answer: Budget should only be revised for points 2&3. Dissatisfied employees and cheap quality of
labour are clearly in management’s control, and hence budget should not be revised.
Calculations of planning and operational variances:
1) Labour rate and material price variances
We can use the same proforma to calculate the materials price and labour rate variance.
For material quantity, use quantity of materials and for labour hours, use labour hours
Traditional price/rate variance $
Actual quantity × Actual price X

Actual quantity × Standard price X
Price variance X
This variance can be further calculated as planning and operational
Planning price variance $
Actual quantity × Original standard price x

Actual quantity × Revised standard price x
Planning price variance x
This variance compares the actual and revised standard costs. The variance is favorable if the
revised standard is lower than the original. The variance turns adverse if revised price is
higher than the original.
Operational price variance $
Actual quantity × Actual price x

Actual quantity × Revised Standard price x
Operational price variance x
Here we compare the actual price to the revised standard. If the actual cost is more than
revised, the variance is adverse. If actual is lower, then the variance is favorable.
The standard cost of product A is $8 per kilo. During the year 5000 kilos were purchased at a total cost
of $42,500
The revised price of A is $8.5 per kilo.
Required:
Find traditional, planning and operational price variance
Traditional price/rate variance $
Actual quantity × Actual price Given 42,500

Actual quantity × Standard price (5000*8) 40,000
Price variance Adverse 2,500
Planning price variance $
Actual quantity × Original standard price (5000*8) 40000

Actual quantity × Revised standard price (5000*8.5) 42500
Planning price variance Adverse 2500
Operational price variance $
Actual quantity × Actual price Given 42500

Actual quantity × Revised Standard price (5000*8.5) 42500
Operational price variance 0
Usage and efficiency variance:
Again, the planning and operational variances for material usage and labour efficiency variance can
be calculated in a similar way. The following pro-forma can be used.
Traditional usage/efficiency variance Kilos/hours
Actual quantity used x

Standard quantity for actual product x
Difference x
Multiply by standard price per unit/rate per hour $x
Materials usage/ Labour efficiency variance $x
Planning usage/efficiency variance Kilos/hours
Original standard quantity for actual output x

Revised standard quantity for actual output x
Difference x
At a standard price per unit/rate per hour $x
Materials usage/labour efficiency planning variance $x
The variance will be favorable if the original standard quantity is more than the revised quantity. It
will be adverse if a revised standard is more than the original standard.
Operational usage/efficiency variance
Actual quantity used x

Revised standard quantity for actual output x
Difference x
At standard price per unit/rate per hour $x
Materials usage/labour efficiency operational variance $x
This variance will be adverse if the actual quantity is more than the revised standard and vice versa.
Learning Curve in Labour Variances
It is not possible to set a standard time required for production when there is a learning curve. This
happens because the standard rate keeps decreasing every time production doubles.
A standard labour cost can only be established when a steady state is reached.
We can use standard costing and learning curve in the following way to find standard and
operational variance
1) Set an original standard labour cost per unit, ignoring the learning effect.
2) Calculate the revised labour cost per unit using the learning curve formula.
3) Now we have original and revised standards. We can use these to find planning and
operational variance. The planning variance will always be positive due to the learning
curve effect
Standard material cost/unit 8 kgs at $5=$40

Budgeted output 40,000 units
Actual output: 44,000 units
Actual material used 358,000 kg at $6
Revised standard 7.5kg at $5.6
Calculate material usage planning and operational variance
Planning usage variance Kilos/hours
Original standard quantity for actual output (44000*8) 352000

Revised standard quantity for actual output (44000*7.5) 330000
Difference 22000
At standard price/rate per unit/hour $5
Materials usage/labour efficiency planning variance Favorable $ 1,10,000
Operational usage/efficiency variance
Actual quantity used Given 3,58,000

Revised standard quantity for actual output (44000*7.5) 330000
Difference 28,000
At standard price/rate per unit/hour $5
Materials usage/labour efficiency operational variance Adverse $ 1,40,000
Sales volume variances
The sales volume and sales price variance can be divided into two parts:
1) Sales volume variance -

● Sales volume planning variance: This variance is caused by external factors such as
economic growth. It is also called as market size variance or market volume
variance.
● Sales volume operational variance: This variance is caused by internal factors. It

calculates by how much the market share was different from the budget; hence it is
also known as market share variance.
2) Sales price variance –

● Sales price planning variance: This variance is again created due to external factors
such as sudden drop in demand due to recession.
● Sales price operational variance: This is created due to internal factors such as the
managers decide to sell the products at a lower price to increase demand.
Managers can only control market share variance and not market size variance.
Calculation of market volume variance:
Budgeted sales quantity x

Revised budgeted quantity x
(Actual market size x Budgeted market share)
Difference x
X Standard contribution/profit per unit x
Market size variance x
Calculation of market share variance
Actual sales quantity x

Revised budgeted quantity x
(Actual market size x Budgeted market share)
Difference x
X Standard contribution/profit per unit x
Market share variance x

Emiway plans to sell 1750 units at a contribution of $20. The total sales in the market were expected to be 35000
with Emiway having a 5% market share.
Actual sales of Emiway were 1840 and that of industry was 37000
Calculate market volume and market share variance:
Solution
Market volume variance/ sales planning variance
Budgeted sales quantity 1750

Revised budgeted quantity 1850
(37000 x 5%)
Difference 100
x standard contribution 20
Market volume variance Favorable $ 2,000
Market share variance/ sales operational variance
Actual sales quantity 1840

Revised budgeted quantity 1850
Difference 10
x standard contribution 20
Market share variance Adverse $ 200
● A sales planning variance will be favorable when the revised quantity is more than the
originally budgeted quantity and vice versa.
● A sales operational variance will be favorable when the actual quantity sold will be more
than the revised budgeted quantity.
Advantages and Disadvantages of Planning and Operational Variances
Differences between the two variances can be Time consuming and expensive as data
found requirements increase
Planning variances are used to update standards May be used by companies to hide inefficiencies
to current conditions
Principle of controllability increases motivation All variances may be blamed on external factors.
Similarly, sales price variances can be divided into planning and operational variances using the same
concepts.
Issues Relating to Manipulation:
Budgets and standard are prepared at the start of the year and may need revision at the end of the
year. Due to this, managers may try and revise the budgets in such a way that operational variances
are reduced, and planning variances are increased. This may be done to show better efficiency and
performance.
The reasons for poor planning variances may be blamed on external factors. These situations give
rise to the manipulation of management accounting information. Hence, the decision to revise
budgets should be approved by senior level managers.
This section is frequently examined so ensure that you get the concept and are confident in
solving practical as well as theory-based questions.
D7 Performance Analysis
Syllabus D7a-b-c-d
- Analyze and evaluate past performance using the results of variance analysis
- Use variance analysis to assess how future performance of an organisation or business can be
improved
- Identify factors which influence performance
- Discuss the effect that variances have on staff motivation and action
In this sub-section, we will discuss how do we use variances to evaluate performance. Then we will
study how to improve future performance by understanding the factors which influence
performance.
Performance evaluation using variances:
To evaluate performance and improve it, we can follow a step-by-step process.
1) Identify the cause of the variance

2) Find the person responsible
3) Decide whether the standard set was achievable
4) Consider non-financial factors
5) Take steps to improve future performance
Now let us look at these steps in detail.
1) Identify the cause of variance:

The first step to evaluate performance is to identify the cause of the variance.
We have already seen why certain variances arise. Such as material usage variances may
arise due to the use of poor quality of raw materials.
After identification, we should also check whether the variance had an effect on other
variances. For e.g., a favorable labour rate variance may be a result of using more of
unskilled labour at a cheap rate. This may, in turn affect the labour efficiency variance.
All the variance caused due to similar factor should be grouped together and then
considered for further analysis.
2) Identify who should be held responsible for the variance:
Now when we have identified the cause of the variance, it becomes easy to identify who is
responsible. The principle of controllability can be used to identify the person responsible
and also distinguish between planning and operational variance.
The following operational variances are normally the responsibility of the following
managers:
i) Materials price variance – The purchasing department is usually responsible for

materials price variance as they have the responsibility to negotiate prices with
suppliers.
ii) Labour rate variances – This variance may be the responsibility of the Human
Resource department or the general production manager, depending on who takes
the decision of recruiting the workers.
iii) Labour efficiency variance - This variance is the responsibility of the person
managing workers working under him/her. This could be the supervisor or the
production manager.
iv) Material usage variance - These are related to production and hence are under the
control of the production manager.
v) Sales variances - These variances are usually the responsibility of the sales and
marketing department.
Now, these managers can be appraised appropriately according to their respective

performances.
3) Are the standards set achievable?

Some standards set become impossible to achieve due to external factors. Thus, such
standards cannot be achieved due to factors beyond the manager’s control.
Such standards should be revised.
4) Non-financial factors:
All the variances which we calculate are based on financial information.
Thus, it only considers financial factors. But, to perform a fair job appraisal, we should also
consider factors such as quality, employee satisfaction etc. These are the factors which have
a long-term effect on a company’s performance.
5) Take steps to improve future performance:

Now that we have identified the cause of the variance and the person responsible, we can
take control action to improve performance.
If the variances were caused due to improper planning, the management can focus on
proper and systematic planning.
Manager’s performance should be assessed on:

a) Financial factors
b) Non-financial factors
c) Both
d) None
Answer:
c) Both. Because both factors are important.
Effect on Staff Motivation and Action:
Positive effects:
● Variance analysis act as a tool to control the variability of performance. This encourages
managers to stick to the budgets as far as possible. This challenge increases motivation as
they have a target to aim for.
● As the appraisal happens after considering controllability, managers tend to accept the
appraisal in a positive way and work towards improving their performance.
● If there is more participation of the lower-level managers, they will feel more responsible
thus try to focus on achieving targets more than if the targets were imposed on them.
● Pay can be used as a motivator where bonuses can be attached to the achievement of
targets.
Negative effects:
● It is often found that adverse variances attract investigations and censure, but there is no
incentive to achieve favorable variances due to lack of appreciation. This may result in a loss
of morale.
● Workers may act unethically by not working at their full potential thus, this leads to the
building of slack, making the process of standard setting more difficult.
● The goals of the organisation set using budgets may not be the same as the individual goals
of the managers giving rise to Dysfunctional behavior.
● Managers who prepare budgets may not have detailed knowledge of a particular part of the
business and thus could set unrealistic budgets, which may result in loss of morale.
Syllabus D7e-f
- Describe the dysfunctional nature of some variances in the modern environment of JIT
and TQM
- Discuss the behavioral problems resulting from using standard costs in rapidly
changing environments
Variances in Just-in-time and Total quality management environment:
‘Just-in-time also known as JIT is an inventory management method whereby labour, material and
goods (to be used in manufacturing) are re-filled or scheduled to arrive exactly when needed in the
manufacturing process.’
‘Total Quality Management (TQM) is a management framework based on the belief that an
organization can build long-term success by having all its members, from low-level workers to its
highest-ranking executives, focus on improving quality and, thus, delivering customer satisfaction.’
The key features of operating in JIT and TQM environment are as follows:
1) Very high level of automation resulting in high levels of overheads

2) Customized product according to customer preference
3) Low inventory levels
4) Importance is given to quality
Variance analysis may lead to dysfunctional behaviour due to the following reasons:
1) Variance analysis mainly concentrates on financial factors. Whereas JIT and TQM both give
importance to customer satisfaction, employee morale and quality.
2) As customization of products is a major feature in both the environments, standardization is
of very little importance.
3) In JIT, we try to build a close relationship with the suppliers and the material prices are also
fixed at the start of the year. Hence there is no material price variance.
4) JIT and TQM state that we should continuously try and innovate to meet customer demands.
However, standard costing is done on the basis of already existing standards.
Which factors are given more importance in JIT and TQM?
a) Qualitative
b) Quantitative
c) Both
d) None
Answer:
1) Qualitative factors.
Behavioural Problems in Rapidly Changing Environment:
As we saw earlier, standard costs are more suitable to industries which do not change rapidly. Now
we will try to go deeper and understand the reason behind the same:
1) Standard costing is internally focused. If companies are not able to adapt to changing
business environment, they may soon become irrelevant.
2) Achieving standards is not enough to ensure the long term success of the firm. We need to
ensure that we innovate to build and maintain a competitive advantage.
3) In the changing environment, as we move towards increasing automation, our overheads
increase, and direct labour costs decrease, making variances such as labour efficiency
irrelevant.
4) Standard costing gives too much importance to reducing costs and achieving short-term
goals whilst ignoring qualitative factors which create long term value for companies such as
quality etc.
In today’s world, companies such as Dell, Apple, Tesla etc., are successful because they focus
on providing a quality product to their customers. Similarly, they have also been able to
integrate standard costing along with focusing on the qualitative factors.
Transfer Pricing and Divisional Performance Measurement
E2: Divisional Performance and Transfer Pricing
Syllabus E2a-b-c-d
- Explain and illustrate the basis for setting a transfer price using variable cost, full cost
and the principles behind allowing for intermediate markets
- Explain how transfer prices can distort the performance assessment of divisions and
decisions made
- Explain the meaning of, and calculate, Return on Investment (ROI) and Residual
Income (RI), and discuss their shortcomings
- Compare divisional performance and recognize the problems of doing so
Introduction:
Tata steel and Tata motors are part of the same group Tata Sons. Steel produced by Tata steel is
required in the production of cars produced by Tata motors. Now the question is at what price
should the steel be transferred to the other department, i.e., Tata Motors.
The answer is it should be transferred at transfer price.
‘Transfer Price is the price at which one division transfers goods and services to another division
within a company or from one subsidiary to another within the same group’.
Objectives of Transfer Pricing:
1) Goal Congruence:
Transfer prices should encourage managers to take decisions which are in the best interest
of the organisation and not just in the best interest of their division.
It aims to create a win-win situation for both the buying and selling division.
2) Autonomy:
Divisional managers should have the freedom to set their own prices. This means that the
intervention by the head office is minimal.
3) Divisional Performance Evaluation:

The transfer price set should enable us to do a fair assessment of both the divisions.
Setting of Transfer Price:
1- Market Based Approach:

If there is an external market for the product being transferred, then the selling division can
charge a selling price equal to the external market price.
This price will be considered fair by both the managers External market price may not exist.
as there will be no difference between buying or selling
internally or externally.
The overall group’s profits are not impacted as the The external price may not be the same. For e.g., some
internal selling price is the same as the external selling customers may be getting a discount on bulk purchases.
price
When selling externally, the selling division incurs selling

and delivery cost, which are saved and hence these
savings should be adjusted for when transferring
internally.
2- Cost Based Approach:

The selling division can supply the goods at a cost-plus profit. In this method, a standard cost
is chosen, and the desired profit mark-up is added.
Standard cost should be used instead of actual costs as using actual costs won’t encourage
selling divisions to control cost, and hence inefficiencies of one department will be
transferred to another.
In this approach, the standard cost could be
● Total cost
● Variable cost
● Opportunity cost
A group has two companies X and Y. Centre X supplies center Y with a part-finished product. Centre Y
completes it and sells further for $35 per unit. There is no external market for Centre X semi-finished
product.
Budgeted data
Company X Company Y
Units transferred/sold 20,000 20,000
Material cost/unit $4 $2
Other variable cost/unit $1 $3
Fixed costs $120000 $60,000
Calculate budgeted annual profit if the transfer price is set as:

a) Full cost + 10%
b) Marginal cost +10%
Solution: a)
Company X Company Y Total
Revenue -
Internal (20,000x12.1) 2,42,000 - 2,42,000
External 7,00,000 7,00,000
Cost
Transfer cost (From internal 2,42,000 2,42,000
sales)
Variable cost 1,00,000 1,00,000 2,00,000
Fixed cost 1,20,000 60,000 1,80,000
Profit 22,000 2,98,000 3,20,000
b)
Company X Company Y Total

Revenue
Internal (20,000 x 5.5) 1,10,000 1,10,000
External 7,00,000 7,00,000
Cost
Transfer cost 1,10,000 1,10,000
Variable cost 1,00,000 1,00,000 2,00,000
Fixed cost 1,20,000 60,000 1,80,000
Profit -1,10,000 4,30,000 3,20,000
Workings:
1)Total cost + 10%
Material cost 4
Variable cost 1
Fixed cost per unit 6
Total cost 11
10% 1.1
Transfer price 12.1
2) Marginal cost +10%

Material cost per unit 4
Variable cost per unit 1
Total variable cost 5
10% 0.5
Transfer price 5.5
In the above Apply Your Knowledge, we can see that company X makes a profit when full cost-
plus pricing is used and makes a loss when marginal costs are used. This means that company X will
be inclined towards the use of total-cost plus pricing.
But Company Y will be favourable towards the use of variable cost-plus pricing as its profit increases.
Hence a conflict arises, and we need to negotiate a price between the two.
This brings us to towards a more realistic approach of transfer pricing.
The general rule approach:
The limit in which transfer prices should lie are as follows:
Minimum - The sum of selling division’s marginal cost and the opportunity cost of the item.
Maximum – The market price at which the buying division can buy the item less any cost savings.
The opportunity cost included in the minimum price will be one of the following:
● The maximum contribution forgone by selling internally instead of externally

● The contribution forgone by not using the production resources for producing the next best
alternative.
Division A produces product ABB which has an external market and sells at a price of $200. The
marginal cost required to produce the product are $150. If ABB is transferred internally, a
contribution of $25 is forgone.
What will be the transfer price range?
Minimum: This will be the sum of marginal cost and the opportunity cost, which is 150+25= $175.
Maximum: This will be the external selling price, i.e., $200
Understand these general principles as the next principle will be built upon these principles.
Transfer price at full and spare capacity:
We can best understand this using an Apply Your Knowledge:
Rey co focused on making cartridges for gel pen and ball pens. It sold these cartridges to pen
manufacturers. Some months ago, Rey co decided to use its brand value and start manufacturing
ball pens as well. Now the company has two different divisions Refill and Ball pen division.
The Refill division makes cartridges for ball and gel pens, and Ball pen division makes ball pens. The
Ball pen division buys its cartridges externally, but now they are thinking of sourcing them internally
from the Refill division.
The contribution margin for each division when Ball pen division buys from outside is as follows:
Ball Pen division

Selling price of 10
pen
Variable cost (excluding refills) 4.5
Cost of refills purchased externally 2.5
Contribution per 3
unit
Refill division
Selling price of 2.8
refill
Variable cost of 2.1
refill
Contribution 0.7
Per unit
What will be the transfer price if the Refill division transfers refills to the Ball pen division?
Solution:
The transfer price of this transaction will depend on whether there is spare capacity.
No spare capacity:
When there is no spare capacity in the Refills division, it means that they are able to sell their entire
production externally. If it has to transfer to Ball pen division, the transfer price at least needs to be
the marginal cost-plus opportunity cost. In this case, the opportunity cost is the contribution forgone
which is 0.7. Hence, the transfer price is 2.8 (2.1+.7)
Spare capacity:
If the Refills division has spare capacity, then the opportunity cost of that spare capacity is zero as
there will be no contribution forgone. This means that the minimum transfer price for the spare
capacity of goods will only be the marginal cost. Hence minimum transfer price is 2.1.
The maximum transfer price will be equal to the external purchase price, i.e., 2.5. Now the transfer
price can be negotiated between 2.1-2.5.
Divisional Performance Measurement
There are four different types of divisions. The objective of each division is different, and the
measures used to assess their performance are also different.
Type of Division Objective Performance Measures

Revenue centre To focus only on revenue generation ● Total revenue
● Revenue per unit
● Sales variances
Cost centre To focus only on costs and not on the ● Total cost
revenue stream ● Cost per unit
● Cost variances
● Quality & productivity
Profit centre To focus on both revenue generation and ● Profit

costs. ● Market share
Manager cannot make investment ● Working capital ratios
decision. ● NFPI: Customer satisfaction&
Productivity
● Plus, all the above measures
Investment centre These have both revenue and cost. ● ROI

Manager can make investment decisions ● RI
● Plus, all the above measures.
In the previous sections, we have studied the performance measures of cost, revenue, and profit
centre. In this chapter, we will discuss the performance measures of the Investment centre, which
are ROI and RI.
Return on Investment (ROI)

𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑙𝑎𝑏𝑙𝑒 𝑝𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐼 = 𝑥 100
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Controllable profit is usually the profit after depreciation but before tax. In the exam, you may or
may not be given a controllable profit figure. You should find out the figure which is closest to
controllable profit. If a profit figure is given, assume that it is controllable unless told otherwise.
Capital employed is taken as total assets less current liabilities. You should use net assets if capital
employed is not given.

Following are the assets and liabilities of an investment centre
$
Non-current assets 2,00,000
Inventory 40,000
Trade receivables 60,000
Trade payables -16,000
Capital employed 2,84,000
The profit for the year is $56,000

Calculate ROI
Solution
ROI = (Controllable profit/ Capital employed) x 100

=56,000/2,84,000
19.7%
Note- if suppose the centre manager is not responsible for the payment of debts, then the trade
payables should not be taken into account when calculating ROI thus, in this case, the ROI will be
18.6% (56000/300000*100).
It is in line with ROCE and hence is widely used. ROI increases as assets get old. Hence, managers are
reluctant to replace old assets.
It is a comparative measure, and hence we can Profit figures can be manipulated to improve ROI.
compare ROI of different divisions Different accounting policies limit comparison.
ROI can be broken down into other ratios like It may promote dysfunctional behaviour. (Explained
profit margin and asset turnover. below)
Dysfunctional Behaviour while using ROI.
Sometimes the ROI figure may lead to managers taking decisions which will be favourable for their
division but not for the company as a whole.
For e.g., If a division has an ROI of 20% and the ROI of the company as a whole is 15%. If division A is
offered a project which has a ROI of 17%, then the manager of A division may reject the project as
the project will reduce the Division’s ROI.
This would have been a correct decision in isolation, but when we see the company’s ROI, it is 15%.
Thus, this means that the project has a higher ROI than the company’s average ROI and hence the
project should have been selected.
This conflict gives rise to dysfunctional behaviour.
Residual Income
𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑙𝑎𝑏𝑙𝑒 𝑝𝑟𝑜𝑓𝑖𝑡 − 𝑁𝑜𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡

Residual income tries to calculate the notional cash which will be retained after deducting the cost
of capital.
Controllable profit is calculated in a similar way as ROI.
Notional interest = Capital employed x Interest rate


The net assets of an investment centre are $100,000. It made a profit of $160,000.
The notional cost of capital is 12%
Calculate RI.
RI= Controllable profit - Notional interest
Notional interest= 100000 x 12% $12000
RI=$160,000 – $12000 $148000
RI encourages managers to invest if they add to RI. It is an absolute measure and hence RI of different
divisions cannot be compared.
The use of notional interest makes the managers more RI uses profit figure which can be manipulated by using
aware of the cost of assets under their control. different accounting policies.
Risk factor in an investment decision can be incorporated
in the interest rate.
Advantages and Disadvantages of ROI-
If both ROI and RI are used together, there is a possibility of dysfunctional behaviour. This happens
because a project may add to the RI of division but may reduce its ROI, and hence the proposal will
be rejected. Even in this case, there is a negative impact on the company as a whole.
● Transfer pricing occurs between a selling division and a buying division in the same company
or among subsidiaries in the same group. Transfer pricing can affect divisional managers'
behavior.
● Appropriate transfer pricing aligns divisional goals with an organisation's strategic objectives
while allowing an objective assessment of divisional performance.
● A division with no external market or ample spare capacity has zero opportunity cost
because transfers do not reduce the contribution from external sales. Its marginal cost
would serve as an appropriate transfer price.
● A division with an external market or no spare capacity would lose external sales by an
internal transfer. Its marginal cost plus the lost contribution would serve as an appropriate
transfer price.
● Controllable profit will measure profit as if calculated using only costs under the manager's
control. From controllable profit, the organisation can determine profits traceable to the
division by subtracting divisional costs outside the manager's control.
● ROI in the context of measuring divisional returns will equal either controllable (manager) or
traceable (divisional) profit divided by capital employed. Profit will be profit before interest
and tax.
● Divisional ROI will increase as the manager approves projects with higher project ROI.
● Residual income equals controllable profit after an imputed interest charge. Incongruent
decisions also can be minimized when a firm accepts projects with positive residual income.
● The major drawback of the residual income approach is measuring returns from divisions of
different sizes.
● Definition of capital employed, effects of different accounting policies, and window dressing
affect both ROI and residual income.
PO14 – MONITOR PERFORMANCE
Description
You measure and assess departmental and business performance.
Elements
a. Identify the key external factors, including financial factors, affecting organisational
performance.
b. Analyse and provide appropriate information to measure performance.
c. Identify and use performance measurement techniques.
d. Monitor and evaluate individual and departmental performance to identify areas for
development.
e. Advise on appropriate ways to maintain and improve performance.
Syllabus Area A andE:
Performance Measurement and Control

Performance Measurement in Private and Public Sector
E 1 Performance Analysis in Private Sector Organizations
Syllabus E1a-b-c
- Describe, calculate and interpret financial performance indicators (FPIs) for

profitability, liquidity and risk in both manufacturing and service businesses. Suggest
methods to improve these measures.
- Describe, calculate and interpret non-financial performance indicators (NFPIs) and
suggest methods to improve the performance indicated.
- Analyze past performance and suggest ways for improving financial and nonfinancial
performance
Introduction:
Now we have reached the last section of our Performance Management journey. Till now, we have
seen the various costing techniques, decision making techniques and budgeting. In this section, we
will learn how to measure performance with various measures and models. We will also see how
performance can be improved.
We try to measure performance in order to see how successful we are in achieving our objectives. It
also serves as a medium to appraise managers’ performance and reward them for their work.
We can use performance indicators to measure an entity’s performance. These measures can be
financial and non-financial.
Financial measures are measures relating to revenue, costs, profits, return etc. Actual figures from
financial statements can be used to find these measures.
Non-financial measures can relate to various areas of business such as: quality, customer
satisfaction, Innovation etc.
Financial Performance Indicators
Financial performance measurement mainly deals with ratio analysis. These ratios can be compared
with ratios from last year to identify trends or can also be compared with competitors. The financial
rations can be divided into profitability ratios, liquidity ratios and risk related ratios.
A) Profitability Ratios:
These ratios help us in determining how profitable an organisation is. We can then compare
these figures with our competitors or previous years.
1) Gross Profit Margin:

𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑥 100
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
● Gross profit margin reflects the performance of the company’s products and
how well are the production costs kept under control.
● A falling GP margin suggests that either the selling price of products is
decreasing or the cost of sales is increasing and vice versa.
● This ratio can be improved by selling products with a higher margin, using tools
such as target costing to control the cost of sales of the product etc.
2) Net Profit Margin:

𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑥 100
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
● This shows overall profit as a percentage of sales, and it depends on how well
the non-production costs are kept under control.
● A falling ratio suggests that non-operating costs are increasing and vice versa.
● This ratio can be improved by having better control over non-operating costs
such as administration costs, distribution costs etc.
3) Return on Capital Employed:
𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 = 𝑥 100
Profit before interest and tax= Operating profit

Capital employed= Shares + reserves + long-term liabilities
OR
Capital employed= Total assets – Current liabilities
● This calculates the return generated as a percentage of capital employed. This

ratio is often used to make comparisons with competitors.
● This ratio measures how much the company earns per $ invested.
A decline in ROCE can be caused by:
● A fall in profit margin

● Reducing asset turnover
● Decline in both ratios
4) Asset Turnover Ratio:

𝑆𝑎𝑙𝑒𝑠
● This ratio tells us the how much revenue was generated in relation to capital
employed. This tells us how much turnover is generated from each $1 invested.
● This ratio can be improved by selling underutilized non-current assets,

recognizing impairments and improving working capital management by, for
e.g., reducing inventory level and having a better credit control system in place.
Relation Between the Ratios:
ROCE = Asset turnover x Net profit Margin
Hence it can be concluded that all three ratios are interconnected, and thus any changes in one of
them would lead to a change in the other two ratios.
1) If administration costs increase which ratio will deteriorate?
a) Gross profit margin

b) Net profit margin
2) How can we increase ROCE?
a) Increase profit levels

b) Repay long term debt
c) Both
Answers:
1) B Net profit margin. As it is an indirect cost and hence will reduce net profit and not
gross profit.
2) C Both
B) Liquidity Ratios
These ratios help us understand whether the entity has the ability to pay off its current liabilities
as they become due, e.g., payables, interest payments etc.
It is important to know the liquidity status of a company because if it’s not able to pay off its
liabilities, it can go into liquidation that is, it can no longer be considered as a going concern.
1) Current Ratio:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
It measures the organisation’s ability to meet its current liabilities as they fall due.
A ratio of more than 1 is desirable. That is, its current assets are more than its current
liabilities.
A ratio of less than 1 means its current liabilities exceed its current assets, and hence it could
mean that it is suffering from liquidity problems, but it also depends on the nature of the
business.
2) Quick ratio/ Acid test ratio:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
As it is said that inventory is not easily convertible into cash, it should be ignored. Hence, we
make use of another ratio which is similar to the current ratio, but it excludes inventory from
current assets.
If the ratio is more than 1, the company can meet its short-term liabilities with the help of its
liquid assets, however, if it’s less than 1 It indicates that there aren’t enough liquid assets to
pay off the current liabilities when they fall due. Although, we need to do further analysis of
the same to judge its liquidity.
Both these ratios can be improved by improving the working capital management.
Which of the following is considered least liquid?

a) Receivables
b) Cash
c) Prepaid expenses
d) Inventory
Answer: D Inventory
These ratios are important from a working capital management point of view.
3) Receivables Collection Period:

𝐷𝑒𝑏𝑡𝑜𝑟𝑠
𝑥 365
𝑆𝑎𝑙𝑒𝑠
This measures the time taken by the debtors to pay off their debt. An increase in the period
suggests that the efficiency of the credit control process is deteriorating.
4) Payables Payment Period:

𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
𝑥 365 𝑑𝑎𝑦𝑠
𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
This measures the length of the credit period taken from suppliers on an average. An
increase in this ratio could mean that we are obtaining favorable payment terms from
suppliers or we are struggling to pay off our debts.
5) Inventory Holding Period

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝑥 365 𝑑𝑎𝑦𝑠
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
The holding period of inventory suggests the average number of days the inventory items
are held for. The ratio may increase may increase due to:
1) Increase in inventory storage due to increasing demand
2) Increase in cash tied up in inventory due to obsolete inventory
Efficiency level of credit control department can be found by which ratio?
a) Receivables collection period

b) Inventory holding period
c) Payables payment period
Answer: A Receivable collection period.
D) Risk
These ratios are used to measure the financial risk of the company.
1) Financial Gearing
𝐷𝑒𝑏𝑡
𝑥 100
𝐸𝑞𝑢𝑖𝑡𝑦
OR
𝐷𝑒𝑏𝑡
𝑥 100
𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦
● This ratio tries to explain the level of risk by comparing the level of debt to equity.
● Gearing ratio needs to be compared to the industry level to check whether our
gearing is within acceptable levels.
● Generally, higher gearing suggests higher risk.
● This ratio can be decreased by using equity to raise finance rather than debt.
2) Interest Cover
𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑
● This ratio tells us the number of times we can pay our current interest payments
through our profit.
● The higher the number, the less risky an organisation is.
3) Dividend Cover
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑎𝑛𝑑 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑

𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
● This ratio tells us how many times the dividend can be paid out of the profit that is,
how much profit is available to the shareholders.
4) Operating Gearing:
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠
● This is the measure of the company’s fixed cost as compared to total costs.
● The risk increases with an increase in the fixed costs. This is because even a small
change in revenue can make a lot of difference on the profits of a company as the
majority of costs are fixed.
● Organizations in service industries generally have high operating gearing as majority
of the costs are fixed.
Risk increases as gearing ____?
a) Increases
b) Decreases
Answer: A Increases
Problems with using only financial indicators for performance measurement
● FPI’s may give excessive attention only to cost reductions while ignoring the actual drivers of
the business.
Companies may refrain from investing in long-term projects if they are not profitable
initially. This will enhance short term profitability at the expense of long-term wealth
creation.
For e.g., to increase current period’s profit a company may look to reduce expenditure on
staff training. In the short term, this will mean an increase in profits, but in the long term,
the quality of their product or service is bound to decrease due to a lack of trained staff.
● FPI’s fail to measure the main drivers of business such as: Quality, delivery, customer
satisfaction etc.
If only FPI’s are used to appraise a manager’s performance, they will be inclined to
manipulation of financial statements to ensure that they receive their variable pay (bonuses
etc.).
Non-Financial Performance Indicators
In traditional management accounting, only financial performance was evaluated. But as businesses
have started to become more customer focused and value conscious, NFPIs are getting more and
more importance.
Due to the limitations of financial performance indicators, analysis of NFPIs is important. These
measures are related to entity performance but are not expressed in monetary terms. We can set
NFPI’s by first understanding CSF (Critical success factors) and KPI’s (Key performance indicators)
Critical Success Factors:
As the name suggests, these are the factors which determine the success of the organisation. Critical
success factors will be different for every company and every industry.
E.g., For a tuition provider’s CSFs could be high pass rates, high quality education, student/customer
satisfaction, high rating etc.
These are the factors on which tuition provider must focus on in order to succeed.
Key Performance Indicators:
Now that we have established CSFs, how do we know that they are being achieved?
Yes, we keep a track of these CSFs by establishing KPI’s.
KPIs measure how well an organisation meets its CSFs.
E.g., for the above example, KPIs will be a percentage of students passing, tutor reviews given by
students etc.
(CSFs AND KPIs can be both financial as well as non-financial)
Hence NFPIs can now be established for any given industry by understanding the CSFs of an
organisation. The following table provides guidance on how NFPIs can be established.
Critical success factor NFPI
Customer satisfaction Customer satisfaction scores.
Product quality Number of sales returns.
Product delivery Percentage of orders delivered on time.
After-sales service Percentage of after sales service complaints resolved.
Syllabus E1d-e-f
- Explain the causes and problems created by short-termism and financial manipulation
of results and suggest methods to encourage a long-term view.
- Explain and interpret the Balanced Scorecard, and the Building Block model proposed
by Fitzgerald and Moon
- Discuss the difficulties of target setting in qualitative areas
Problems of Short-Termism and Manipulation
Short-termism is when the managers are focused towards short-term performance rather than long-
term.
Short termism takes place when the managers are appraised on short-term performance rather than
long term
Some managers hence try to manipulate accounts and window-dress the financial statements to get
a better appraisal. They may also try to cut down cost by reducing activities which are crucial for
long term success, such as employee training. This is done in the following ways:
1) Cutting employee training expenditure.

2) Reduction in quality control procedures.
3) Postponing repairs of assets.
4) Reduction in Research and Development costs.
Measures to Encourage Long-term View:

● Setting of targets which are based on both financial and non-financial indicators.
● Providing share options to managers. This means giving managers an option to buy a
company’s shares after a certain number of years say 3 years. This motivates the managers
to think long-term that is will lead to goal congruence.
● Manager’s performance should be appraised on the basis of both short-term and long-term
objectives.
● Providing managers with guidance regarding the trade-offs they are making by taking a
particular decision.
Difficulty in Setting Targets in Quantitative Areas
● Identifying appropriate drivers for improving performance.

● Inability to measure some factors such as staff friendliness. To overcome this, we can use a
ranking system.
● Difficulty in the communication of such targets and giving appropriate weightage to
different NFPIs is difficult, e.g., deciding what is more important, quality product or delivery
time?
● Setting difficulty level. The level should not be too easy or too difficult to achieve.
The Balanced Scorecard
Organisations in the 1980’s got introduced to non-financial performance measures. They got popular
instantly, and people started over-using NFPIs while ignoring financial measures altogether. To
overcome this problem and to have a balanced appraisal of performance, Kaplan and Norton
developed the balanced scorecard.
The balanced scorecard is a model through which we can measure and control performance. The
speciality of this model is that it tries to cover all the relevant areas of a business. It focuses of the
following four perspectives:
While setting performance measures for these perspectives, we need to ask the following questions:
1) Customer – What do our customers value about us?

2) Internal – What processes must we excel at to achieve our financial and customer objective?
3) Innovation and learning – How can we improve and create future value?
4) Financial – How do we create value for our shareholders?
If we are trying to prepare a balanced scorecard for a low-cost airline, it would be as follows.
Perspectives CSF KPI

Customer perspective Customer loyalty Customer ratings
Customer complaints Number of repeat customers
Compensation payments
Internal business process Punctuality Adherence to schedule

Avoid delays Percentage of flights on time
Innovation and growth Route network development % of profitable new routes

Training of employees Expenditure on training
Financial perspectives Profitability ROCE

Low costs Average cost-per-seat kilometer
You may get a section C question in exam to build a balanced scorecard for an organisation.
To tackle such questions, imagine that you are the manager of the company and think what
should be the CSFs for each of the perspectives. After stating the objectives think how can
you measure these objectives.
It leads to a broader view of the performance of an The selection of measures will be difficult.
organisation.
It links performance measurement to the goals and There may be information overload due to too many
objectives of the organization measures.
It provides internal and external information Some measures may be conflicting. E.g., profitability
and training costs will conflict with each other.
Building Block Model
The balanced scorecard model is a good model for measuring performance in the manufacturing
sector. However, it is not efficient for the service industry.
The characteristics of the service industry is:
1) Inseparability
2) Perishability
3) Heterogeneity
4) No transfer of ownership
5) Intangibility
The model is as follows:
The three building blocks are as follows:
1) Dimension
2) Standard
3) Reward
Dimensions:
Profit
Competitiveness
Quality
Resource utilisation
Flexibility
Innovation
Standards: Rewards:
Ownership Clarity
Achievability Motivation
Equity Controllability
1) Dimension:
These are the goals of the business. For each of the dimensions, a suitable measure should
be developed. These are the areas which focus on specific performance metrics.
The six dimensions can be split into two categories:

● Downstream results – Competitive and financial performance
● Upstream determinants – Quality of service, flexibility, resource utilization and
innovation.
The achievement of upstream determinants will determine the achievement of downstream

results.
2) Standards:
These include ownership, achievability and equity
The standards, i.e., the targets set for the metrics, should have the above three qualities,
i.e., ownership, achievability and equity.
● Employees should be allowed to participate in target setting, which will increase

their acceptability of the targets.
● Standards should not be set so high that employees find them unachievable.
● All the departments should have equitable standards(equal)
3) Rewards:
Rewards motivate the employees to achieve the targets, and thus they help ensure the
achievement of the targets set. The reward system needs to have clarity and be able to
motivate and control.
● The targets and rewards should be clearly understood by the employees.
● Employees should feel motivated for working towards their target.
● Managers should only be held accountable for the things they can control.
Performance Dimension Performance Measure

Competitive performance Market share
Sales growth
Financial performance Profitability

Liquidity
Quality of service Reliability

Competence
Flexibility Volume flexibility

Delivery speed
Resource utilisation Productivity

Efficiency
Innovation Ability to innovate

New ideas generated
Traditional performance measurement systems focus on financial measures. There are many
different financial indicators. The most important categories are:
● Profitability ratios
● Liquidity ratios
● Risk related ratios
Financial measures exclude important factors that determine the performance of an organisation.
Thus, NFPIs should be used in addition to financial measures.
NFPIs attempt to measure non-financial aspects of performance (e.g., quality, customer satisfaction
and staff morale).
The balanced scorecard approach to performance measurement aims at using various performance
measures that support the overall strategy of the business.
The balanced scorecard looks at performance from four perspectives—customer; internal processes;
learning and growth; and financial.
Performance measurement in the service sector is more difficult to measure than in the
manufacturing sector, due to:
● Simultaneity
● Perishability
● Heterogeneity
● Intangibility
In the Fitzgerald and Moon Building Block model, performance in service businesses can be
measured based on six dimensions that are:
● Financial performance
● Competitiveness
● Quality of service
● Resource utilization
● Flexibility
● Innovation
PO13 – PLAN AND CONTROL PERFORMANCE
Description
You plan business activities and control performance, making recommendations for improvement.
Elements
a. Contribute to setting objectives to plan and control business activities.

b. Coordinate, prepare and use budgets, selecting suitable models.
c. Regularly review your progress against plans.
d. Use appropriate techniques to assess and to evaluate overall performance against plans.
e. Advise on business performance and recommend improvements.
Performance Analysis in Not-for-Profit Sector
Syllabus E3a-b-c-d
- Comment on the problems of having non-quantifiable objectives in performance

management
- Comment on the problems of having multiple objectives in this sector
- Explain how performance could be measured in this sector
- Outline Value for Money (VFM) as a public sector objective.
In this chapter, we will discuss the process of performance management in a not-for-profit

organisation and the problems faced while measuring their performance.
Objectives of NPO’s (Non-profit organisations)
● Qualitative Objectives
As we know, profit maximisation is not an objective of NPOs. We cannot measure their performance
by using traditional measures of financial performance such as profit margins and return on capital
employed.
The objectives of NPOs are often related to social welfare. For example, the objectives of a local
hospital will focus on ‘improving health of a locality’ Or the objective of a Police station will be to
‘maintain law and order in the locality’.
The problem with this kind of objectives is that these are qualitative and not quantitative. How do
we measure the improvement in people’s health?
Multiple Stakeholders
Another problem with NPOs is that they have multiple stakeholders and these stakeholders have
their own objectives. For e.g., if we think of a government funded school, the stakeholders will be
students, teachers, government and the community as a whole.
In this case, the teachers may demand a higher pay and better working conditions and facilities, and
on the other hand, the government would like to provide quality education at a low cost. This
creates a conflict of objectives amongst the stakeholders, and hence performance management
becomes difficult.
Other Problems with Performance Measurement of NPOs
● Varied nature of service:

A local municipal corporation performs a variety of functions. Hence it is difficult to set
service cost for each type of service.
● No use of profit measures:

As the objective of NPOs is not to make profits, we cannot use profitability measures such as
ROI and RI.
● Problems in raising finance:

NPO’s may often face financial constraints, and there are also limitations in the way they can
raise finance.
● Measurement of output:
As most of the objectives are qualitative such as quality teaching, there is difficulty in
measuring the output generated.
● Political interference:
In the case of public sector NPOs, there is a lot of interference by the government, and
hence the independence of the organisation is compromised, and the principle of
controllability does not apply.
Performance Measurement in Not-for-Profit Organisation:
Performance of NPOs is judged on the basis of inputs, conversion of inputs into outputs and whether
objectives are met.
For this, we can use the Value for Money framework to measure performance.
Value for Money (VFM)
Value for money tries to measure how well the organisation has achieved its objectives using the
funding it received.
The three indicators of VFM are:

1) Economy
2) Efficiency
3) Effectiveness
1) Economy:
It is concerned about attaining the appropriate quantity and quality of input at the lowest
cost.
Hence, it is an input measure.
2) Efficiency:
Efficiency is concerned with maximizing the outputs with the given input. It is the
relationship between input and output.
3) Effectiveness:
This is an output measure concerned with measuring whether the objectives of the
organisation are met.
Let’s see how can we apply VFM criteria to a college.
Economy:
As this is an input measure, we will try to measure the cost and quality of input resources.
These input resources would include books, computers, teachers etc. We need to understand that
we should not compromise on the required quality to achieve resources at a lower cost.
E.g., if we buy computers at a low cost but if they are not of the required standard, then this does
not help us in achieving our objectives of higher pass rate, for example.
Efficiency:
This will measure the efficiency with which we are using our inputs.
Here we could measure:
How many hours of teacher’s workday are spent on teaching?
How many students are able to use the computers?
Effectiveness:
This will measure whether the organisation is able to meet its objectives.
Typically, any college will have the following objectives
1) To provide quality education to students

2) To have a high number of students graduating from college.
These objectives can be measured by using NFPI such as:
% Of students graduating out of total number of students
% Of students graduating with a higher pass mark
VFM acts as a structure for performance measurement of NPO’s

Syllabus E3f-g-h
- Discuss the difficulties of target setting in qualitative areas

- Analyze past performance and suggest ways for improving financial and nonfinancial
performance
- Explain the causes and problems created by short-termism and financial manipulation
of results and suggest methods to encourage a long-term view
*Some of the above learning objectives are covered in previous chapters and hence not repeated.
Potential Problems:
1) Myopia (Short-sightedness): This means maximizing short-run performance by sacrificing

long term success. This could mean not spending enough on learning and development,
which will eventually have long term effects.
2) Gaming: This means building slack into budgets. This increases inefficiency in operations.
3) Dysfunctional behavior: The goals of the organisation may not be in line with those of the
divisions and the divisional managers.
4) Tunnel vision: When we focus too much on the performance measures, our vision gets fixed
on them, and we try to improve on only those measures hence ignoring the rest.
Objectives of NPO:
1) Non-quantifiable
2) Multiple
3) Conflicting
4) Have political interference
Performance measurement in NPO’s
Use of NFPI’s
Use of VFM:
1) Economy – Acquiring inputs at a lower cost

2) Efficiency – Producing maximum output from given input
3) Effectiveness – Ensuring organizational objectives are met
PO1 – ETHICS AND PROFESSIONALISM
Description
The fundamental principles of ethical behaviour mean you should always act in the wider public
interest. You need to take into account all relevant information and use professional judgement, your
personal values and scepticism to evaluate data and make decisions. You should identify right from
wrong and escalate anything of concern. You also need to make sure that your skills, knowledge and
behaviour are up-to-date and allow you to be effective in your role.
Elements
a. Act diligently and honestly, following codes of conduct, taking into account – and keeping up-
to-date with – legislation.
b. Act with integrity, objectivity, professional competence and due care and confidentiality. You
should raise concerns about non-compliance.
c. Develop a commitment to your personal and professional knowledge and development. You
should become a life-long learner and continuous improver, seeking feedback and reflect on
your contribution and skills.
d. Identify, extract, interrogate and evaluate complex data to make reliable, informed decisions.
e. Interrogate, critically analyse and assess data and other information with professional
scepticism. You should challenge opinion and facts through corroboration and robust testing.
Example activities
• Applying legislation appropriately to client needs.

• Continually reviewing legislation and regulation that affects your working environment.
• Briefing a team on a new standard and how to apply it.
• Keeping sensitive information confidential and disclosing only to those who need it or when
disclosure is legally required.
• Recognising unethical behaviour and telling your line manager about what you have seen.
• Avoiding situations where there may be any threat to your professional independence.
• Deciding what information is important and reliable, using it to support your decision making.
• Completing all the code of conduct and/or professional ethics training provided by your
organisation.
• Checking transactions and supporting documents to verify the accuracy of accounting records.
• Use digital technology responsibly to analyse and evaluate data from a variety of sources,
ensuring the integrity and security of this data.
External Consideration and I.T.
External Considerations and Impact on Performance
Syllabus E4a-b-c
- Explain the need to allow for external considerations in performance management,

including stakeholders, market conditions and allowance for competitors
- Suggest ways in which external considerations could be allowed for in performance
management
- Interpret performance in the light of external considerations
Stakeholders:
Any business will have stakeholders. Stakeholders are people or organisations having a financial or
non-financial interest in a business. Some of these stakeholders, along with interest also have power
over the organisation.
Hence, we need to ensure that the demands of such stakeholders are satisfied. We have previously
seen that the demands of such stakeholders can be conflicting hence we should try and prioritise
these demands.
There are basically three broad types of stakeholders:
● Internal stakeholders who work for the organisation, such as employees and managers.
● Connected stakeholders such as shareholders, suppliers, customers etc.
● External stakeholders such as government, pressure groups etc.
The internal stakeholders run the organisation and have a high level of power and influence over it.
They are interested in the continuous growth and survival of the organisation. Thus, goal congruence
between internal stakeholders and the company is very crucial for the success of the company.
Connected stakeholders may have varied wants. Shareholders would like to see an increase in their
share value and dividends received, customers would like a quality product for a lower price,
suppliers and lenders will want a good credit standing of the company.
The external stakeholders like the government would like us to pay taxes on time and follow the
rules and regulations, pressure groups would like us to be environment friendly etc.
As discussed earlier, we should rank these stakeholders wants in the degree of their influence and
power over the company.
Market Conditions and Competitors:
Market conditions will have a major impact on performance. E.g., a boost in the economy would
mean a rapid increase in sales and vice-versa. It is thus important to differentiate performance
changes due to changes in external conditions and changes in internal capabilities. We have already
done this by dividing variances between planning and operational variances.
Competitors actions also impact our performance. For e.g., if our competitors reduce prices, then
our demand is bound to fall. These conditions should also be considered while appraising
performance.
Group Objectives Performance measures

Employees ● Satisfactory remuneration ● Employee morale index
● Good working conditions ● Staff turnover
Customers ● Good quality product ● Product returns

● Lower prices ● Sales growth
Shareholders ● Dividend payments ● Dividend yield
● Increase in share price ● % share growth
General public, ● Environmental Impact ● Carbon footprint

Government ● Potential employment ● Tax fines etc.
SYLLABUS A: Information, technologies and systems for organisational performance
Syllabus A1a-b-c
- Explain the role of information systems in organisations.

- Discuss the costs and benefits of information systems
- Explain the uses of the internet, intranet, wireless technology and networks
A1 Managing information
Introduction:
‘Data is the new oil!’ You must have heard this phrase several times now. The phrase simply means
that in today’s world, the most valuable commodity any organization can have is DATA. This data
can be sold further or can be processed into information to gain a competitive advantage. Due to
this importance, it becomes imperative for management accountants to know the potential of data
and how to manage it.
An information system is a collection of hardware and software used by an organisation to collect

data, process it, present and store it as information.
Information system is required for the following functions:
1) Record Transaction: Transactions need to be recorded for accounting purpose, as an evidence

and to create management reports.
2) Planning: Planning requires information regarding the available resources, be it financial,

human, technological resources. This information is provided by the systems.
3) Decision Making: The information forms a base for any decision taken by the management.
Systems can provide both internal and external information.
4) Measurement of Performance: After a particular period, performance needs to be evaluated by

making comparisons between what has actually happened and what should have happened. The
information required for this can be collected and presented by the information systems.
5) Improve Processes: Having a system in place speeds up the process of information transfer. This
boosts the efficiency of processes performed by various departments. It also helps in efficiently
dealing with people outside the organisation, such as suppliers and customers.
Management information systems have an external focus?

a) True
b) False
Answer: False. They have an internal focus
Benefits of Information System:
● Faster transfer of information

● Ability to make informed decisions
● Flexibility in accessing information. E.g., Information can be accessed by one click
Costs of Information Systems
● Costs incurred to purchase hardware and software

● Training costs
● Maintenance costs
Types of Networks
When two or more devices are connected to each other to share information, they are for a
network.
1) Internet:
● The internet is a global network which connects millions of electronic devices all over the
world.
● As the internet is a public network, it can be used by organisations to connect and
communicate with people outside the organisation, such as customers, suppliers,
shareholders etc.
2) Intranet:
● Intranet is a network which connects devices within an organisation.
● It is limited to the organisation. It can act as a private network.
● Intranets are used to share internal information like total sales, available inventory,
hours worked by employees etc.
(The firewall surrounding an intranet fends off unauthorised access from outside the organisation)
3) Extranet:
● Extranet is a type of intranet which allows certain external users to join the internal
network. E.g., any organisation may expand its intranet to include suppliers to
communicate with them speedily and efficiently.
4) Wireless Technology:
● Wireless technology helps connect devices and people located in geographically
dispersed locations. The world wide web is a type of wireless technology which connects
computers all over the world.
● This has enabled people to work remotely, even from the comfort of their homes. It
saves costs of connecting computers through cables.
Who will be a part of an intranet?
a) Customer
b) Government
c) Employee
d) Supplier
Answer: C Employee
Syllabus A1d-e
- Discuss the principal controls required in generating and distributing internal

information
- Discuss the procedures which may be necessary to ensure the security of highly
confidential information that is not for external consumption
Internal information is confidential, and hence every organisation needs to have some controls over
the way information is generated and distributed within the organisation. These controls reduce the
risk of data being lost.
Controls over Generating Internal Information:
A) Controls for routine report:

● Carry out a cost-benefit analysis which ensures that the benefit received from the report
will exceed the cost required to prepare it.
● A consistent format should be used for reports.
● The creator of the report should be easily identifiable. This helps in solving queries
quickly.
● Usefulness of the report should be assessed regularly to ensure that the report is
necessary.
● Validation can be used to ensure the accuracy of data.
B) Controls for ad-hoc (Immediate) reports:

● Carry a cost benefit analysis
● Ensure that the information doesn’t already exist in another format.
● Only relevant information should be provided.
● Report writers should be given the most up to date information.
Controls over distribution of information:
● Procedure manual should be maintained, which will include information regarding the
format, receiver, time period in which reports should be created and the medium through
which they should be sent to the receiver.
● Employees should be made to sign non-disclosure agreements so that they don’t divulge
internal information.
● Email policy should be set up which allows or prohibits a certain type of information to be
sent through it.
● Only the required people should be allowed to access information in the organisation.
Firewalls should be used to restrict external people to access internal information.
Procedures to Ensure Security of Confidential Information
Management accountants often need to deal with highly confidential information such as
information regarding research & development, employee records, management plans etc. If this
information is divulged to unauthorised people from outside the organisation, it can be misused, and
the organisation may even lose its competitive-advantage.
Hence it becomes of utmost importance to have such information secured. This can be done through
the following ways:
1) Passwords: All the confidential files should be password protected. These passwords should
be kept unique and updated regularly.
2) Logical Access Systems: These systems are designed to provide access to only a certain
group of individuals to a certain set of records. E.g., People from the Human resource
department only can access employee records.
3) Encryption: This is a security control which encodes a message when it is sent and decodes it
when it is received. This ensures that no information is intercepted in the middle of a
transfer.
E.g., Personal WhatsApp messages are encrypted.
4) Firewalls and Anti-virus: As the name suggest, these software’s act as walls to prevent any
external person, software enter into the internal network. E.g., A firewall will detect and
stop if any one tries to hack into a system by sending a mail to an employee of the
organisation.
5) Authentication and Dial-back: This ensures that only required people are granted access to
information. For e.g., you will need permission from the owner of a google drive to access
information from it.
Find the odd one out

a) Encryption
b) Firewall
c) Validation
d) Logical access system
Answer: C Validation All others are security controls.

A2 Sources of Information
Syllabus A2a-b
- Identify the principal internal and external sources of management accounting

information.
- Demonstrate how these principal sources of management information might be used
for control purposes.
Information can be collected from a number of sources which are internal or external to the
organisation. A management accountant is expected to be aware of which sources to look up for
collecting a certain piece of information. For e.g. The cost of a particular asset can be found in the
asset register of the company.
Internal Sources
The accounting records of an organisation like the sales ledger, cash books etc., are useful in
providing information regarding the transactions of the information.
The various information system which are present in various departments, such as payroll systems,
the inventory system can be used to extract information such as employee records, goods sold,
inventory wasted etc. Similarly, data can be extracted regarding production from the relevant
system.
Sales invoices can provide customer related information such as which products are sold, in what
quantity and who are our most important customers. Sometimes specialised customer management
software is also available which keeps a record of all customer transactions.
Apart from the above internal information can also be collected from people within the
organisation. It can be in the form of questionnaires etc. Minutes of board meetings can also be an
important source of information.
External Sources
Reports published by banks and other financial institutions which provide insights on a particular
industry. Educational institutes such as ACCA to provide with insights regarding the current
economic scenario and sectoral changes.
Governments regularly communicate changes in policies through television or newspapers, or even

individual publications.
Information of suppliers, customers, financers can be collected through their websites and social
media pages. News articles, press releases and annual reports can also be used to for the same.
Although the internet provides a huge scope of collecting a lot of information regarding any subject,
accountants need to be aware that only relevant and useful information is collected.
Information collected from a published magazine about a particular product is internal

information.
a) True
b) False
Answer: B False
Use of information for Control Purposes.
Control is used to analyse whether the actual performance was as desired and what changes can be
made for improvement. To do this, we need to compare two sets of data to find differences
between them.
E.g., By using internal information regarding the budgeted production of units and the actual
production of units, we can find the difference (variance) between the two and then take an
appropriate control action.
Similarly, we can use external information to compare our performance against our competitors. For
e.g., we can compare the profitability of our company to the industry standard or with our
competitors. This is also known as benchmarking.
Syllabus A2c-d
- Identify and discuss the direct data capture and process costs of management
accounting information.
- Identify and discuss the indirect costs of producing information.
Cost of Information
The cost required to collect, process, and present information can be divided into three types: Direct
data capture, processing and indirect cost of information.
1)Direct Data Capture:
These are the costs which are directly attributable to the activity of collecting or capturing
information. Examples are as follows:
a) Cost required for coding and scanning of barcodes while checking out from a supermarket.
b) Cost of time spend recording minutes of a meeting.
2) Processing Costs:
These are the costs incurred to analyse the data collected and process it further into information to
take decisions. For e.g., Cost of finding out the profitability of a product.
3) Indirect Costs:
These costs cannot be directly attributed to the collection or processing of information but are still
incurred due to inefficiency in the process. E.g., Cost incurred to collect information which was not
needed, duplication of efforts by collecting the already available information again, loss in value of
information due to delay etc.
Costs involved in preparation of annual reports is?

a) Direct data capture
b) Processing
c) Indirect costs
Answer: B Processing costs It is the cost of turning raw data into information.
A3: Information System and Data Analytics
Syllabus A3a
- Identify the accounting information requirements and describe the different types of
information systems used for Strategic planning, management control and operational
control and decision-making.
Introduction:
Before moving any further, let us understand what is the difference between data and information.
Data is a collection of raw facts and figures. For e.g., Sales figures.
Information is data which has been processed to make some meaningful analysis. The information
then can be used for decision making. E.g., Sales per month can be analysed to make marketing
decisions.
Information system does the work of processing data into information. This information is used by
the managers to take decisions.
Levels of Planning and Control and their Key Characteristics.

Takes place at the top of the organisation.

Strategic Concerned with setting long-term targets.
level
Takes place at the middle level.

Generally concerned with using resources efficiently to
Tactical level meet strategic targets.
Takes place at the bottom level.

Operational Concerned with day to day implementation of plans.
level
As the characteristics of the three levels of management differ their needs for information are also
different. These requirements are as follows
Strategic Planning:
As strategic planning takes place at the top level of the organisation, the information required for it
has to be highly summarised.
As they need to take decisions regarding products by studying markets, they need to have an
external focus; hence they need to have more of external information.
As strategic planning involves planning for three to five years in the future, it requires futuristic
information such as forecasts etc.
Management Control:
Management control mainly deals with achieving the targets set by the strategic level management
by efficiently using the available resources. Hence, they mainly use internally generated information.
The tactical managers need a mixture of summarized and detailed information. This allows them to
take better decisions at a faster speed.
Operational Control:
This is at the bottom level of management and mainly implements day to day plans. Hence the
information required by them is mostly internally generated.
As this level actual tasks are performed, they need to have information that is extremely detailed.
Syllabus A3b
- Define and discuss the main characteristics of transaction processing systems;

management information systems; executive information systems; enterprise
resource planning systems and customer relationship management systems.
Types of Information System:
1) Transaction Processing System (TPS):

Transaction processing systems are used to perform and record the day-to-day transactions
of a business. They are built to handle large volumes of data which is often repetitive. E.g.,
sales invoices, purchase orders etc.
It is mainly used by the operational managers to make basic decisions. Types of TPS system
include- sales system, manufacturing production system, financial/accounting system.
TPS can then be further processed into Batch transaction processing (BTP) which collects
information at one point and then processes it later, and Real time transaction processing
(RTTP) which collects and analyses information in real time.
2) Management Information System: (MIS)

Management information system converts internal and external data into useful information
which can then be used by managers of all levels to make informed decisions.
It collects information from individual transactions and then collates it together to form
reports for middle level managers.
Customer purchases can be summarized into reports to identify the products and customers
providing the most revenues.
3) Executive Information Systems: (EIS)

It provides strategic managers with flexible access to information from the entire business. It
also provides relevant information from external sources.
EIS gives the support to senior managers to easily assess the entire business and helps them
to take informed strategic decision.
These systems are menu-driven and interactive. They help the managers to visualize
business situations.
4) Enterprise Resource Planning System (ERP)
It integrates the data from all operations within the organisation, e.g., operations, sales and
marketing, human resources and purchasing, into one single system.
It ensures that everyone is working off the same system and includes decision support
features to assist management with decision making.
ERP systems provides real time updates and standardisation of data.

Software companies like SAP, Tally and Oracle have specialised in the provision of ERP
systems across many different industries.
5) Customer Relationship Management Systems (CRM):
Currently, almost all business has switched to being customer focused. This means they are
striving hard to build and maintain long term relationships with customers. This aim is
supported by CRM systems.
CRM systems store information regarding the customer’s order history, personal
information such as age, gender etc. This information can then be used for targeted
marketing purposes. E.g., you must be often getting emails starting with your name, this is
done by CRM software.
Although CRM software’s can potentially provide many benefits, they are costly to
implement and run and hence a cost-benefit analysis should be done prior to using CRM.
Which of the following information system is used mainly by senior managers:

a) MIS
b) EIS
c) TPS
Answer: B EIS
Syllabus A3c-d-e
- Describe the characteristics (volume, velocity, variety) of big data.

- Explain the uses and benefits of big data and data analytics for planning, costing,
decision-making and performance management.
- Discuss the challenges and risks of implementing and using big data and data analytics
in an organization.
What is Big data?
Big data, in simple words is an extremely large amount of data sets relating to business information
which cannot be processed by normal computer applications. This information can be as simple as
how many products are brought by customers in a month.
By using Big Data, companies try to find patterns in unstructured data. Then they try to use these
patterns to turn them into business opportunities.
For e.g., Applications like YouTube record the user’s activity on their app or website. Then they
analyse this information and based on what other people have watched they give you video
recommendations.
In a supermarket, the shopping cart of a customer is analysed to know which products are frequently
bought together. Hence items relating to breakfast like milk, eggs and bread are kept close to each
other.
Characteristics of big data: 3V’s
Volume, Velocity, Variety
Volume: The volume of data collected is huge. Due to technological advancements, we have been
able to place data receivers/ sensors in many of our devices right from your car to virtual assistant
technology such as Alexa in your house. This has resulted in a large pool of data available for
companies to procure and use.
Velocity: Velocity refers to the speed at which data can be analysed. In a fast-moving world it
becomes very important to react quickly to changing conditions. This need is supported by big data
as it can analyse and find patterns in data at a great speed by using tools like data analytics.
Variety: As information is collected from almost everywhere, it is not necessarily in a structured

format. As data may not necessarily be structured, a very wide variety of sources can be used, which
help in reflecting the actual business scenario.
Some of the common uses of Big Data are:
● Discovering consumer shopping habits

● Personalized marketing
● Fuel optimization tools for the transportation industry
● Monitoring health conditions through data from wearables
● Live road mapping for autonomous vehicles
● Streamlined media streaming
Benefits of Big Data:
● Cost Savings: Some tools of Big Data like Hadoop and Cloud-Based Analytics can bring cost
advantages to business when large amounts of data are to be stored, and these tools also
help in identifying more efficient ways of doing business.
● Time Reductions: The high speed of tools like Hadoop and in-memory analytics can easily
identify new sources of data which helps businesses analyzing data immediately and make
quick decisions based on the learnings.
● New Product Development: By knowing the trends of customer needs and satisfaction
through analytics, you can create products according to the wants of customers.
● Understand the Market Conditions: By analyzing big data, we can get a better
understanding of current market conditions. For example, by analyzing customers’
purchasing behaviors, a company can find out the products that are sold the most and
produce products according to this trend. By this, it can get ahead of its competitors.
Risks of Big data
● Security of Data: It becomes difficult to store such huge amounts of data. It is under a
constant threat of theft due to its value.
● Privacy Issues: People’s privacy is under a threat if they are not aware that the data is being
recorded.
● Bad Data: Big data will give results on the basis of the information it receives. If incorrect
information is provided, the result will be incorrect as well.
● Costs Involved: As Big Data analytics needs significant investment in hardware as well as
software. Hence, there is always a risk of the costs exceeding the benefits achieved from big
data.
● Sources of information can be of two types: Internal (From within the organisation) and
External (from outside the organisation)
● Cost of information:1) Direct data capture 2) Processing costs 3) Indirect costs.
● Three levels of management are: Strategic(top), Tactical(middle), Operational(lower)
● Type of information system: transaction processing systems; management information
systems; executive information systems; enterprise resource planning systems and customer
relationship management systems
● Characteristics of Big Data: Volume, velocity, variety
PO12 – EVALUATE MANAGEMENT ACCOUNTING SYSTEMS
Description
You apply different management accounting techniques using appropriate technologies in different
business contexts to effectively manage and use resources.
Elements
a. Evaluate management accounting techniques and approaches in an organisation.

b. Apply appropriate costing techniques to products and services.
c. Assess and advise on the effectiveness of an organisation’s management accounting and ICT
systems.
d. Contribute to developing and improving management accounting systems and internal
reporting recognising the impact of emerging technologies.
e. Monitor new developments in management accounting and consider their potential impact
on performance and systems.
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Exam and Exam Formulae

Section Style Description Marks

a = price when Q=0

Where Y = cumulative average time per unit to produce x units

a = the time taken for the first unit of output

x = the cumulative number of units

b = the index of learning (logLR/Log 2)

LR = the learning rate as a decimal

Last updated: May 2022

The Best Way to Study

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Interactive notes with gamification

Question Bank & Test Series

Flashcards and Interactive mind maps for revision

Examining team guidance/Exam technique & reports

Question practice – ACCA practice platform

Past Exam library

Introduction to the syllabus

On successful completion of this exam, candidates should be able to:

ACCA Performance Objectives

Objective Chapter in Text

PO1 Ethics and professionalism Performance analysis in Not-for-profit sector

PO12 Evaluate management accounting systems External Considerations and I.T.

PO13 Plan and control performance Performance measurement in Private and

PO14 Monitor performance Transfer pricing and divisional performance

Some questions will adopt a scenario/case study approach.

Candidates are provided with a formulae sheet.

Section A of the exam comprises 15 objective test questions of 2 marks each.

Total 100 marks

What is performance management?

How does performance management differ from performance measurement?

Revision of Management Accounting

This is how a cost statement looks when we use absorption costing:

Under absorption (which means we spent more than we budgeted/absorbed) is removed or

Actual overhead > Absorbed overhead = Under absorption = -Profit

Actual overhead < Absorbed overhead = Over absorption = +Profit

Apply Your Knowledge: (Absorption costing)

Chair Co produces chairs:

Budgeted activity level: 15,000 units/month

Actual fixed production overhead for the month: $27000

Selling price: $50/unit

There is no opening inventory

Prepare the following:

a) The cost card under absorption costing will be:

OAR = Budgeted fixed production/budgeted activity level

b) Profit/Loss statement under Absorption costing

Actual fixed overhead =$27000

Overhead absorbed =$32000

Over absorption =$32000-$27000 =$5000

Before we dig deeper, we need to understand the concept of contribution.

Contribution = Sales price – all variable costs (production & non-production)

This can be demonstrated in the cost statement below:

Apply Your Knowledge: (Marginal costing)

Chair Co produces chairs: