Absorption Costing and Marginal Costing Chapter 1

CHAPTER 1 ABSORPTION COSTING AND MARGINAL COSTING

1 ABSORPTION COSTING IN OUTLINE  In absorption costing, the cost of a product or service is established by adding a share of fixed production overheads to direct costs. It is consistent with the requirements for stock valuation in financial reporting. It is usual to absorb production overheads only into product costs. Other overheads are written off as an expense when they arise.  Production overhead costs are first allocated, then apportioned and finally absorbed into production costs (or service costs). – Overhead allocation. Indirect production costs are allocated to cost centres or codes. Allocation is the process of charging a cost directly to the source of the expenditure. – Overhead apportionment. The overhead costs that have been allocated to cost centres and codes other than direct production departments are then apportioned to direct production departments. Apportionment is the process of sharing on a fair basis. – Overhead absorption. An absorption rate is calculated for each production department as follows: Total overhead costs (allocated and apportioned) Production volume  Where the department produces a single product, production volume can be measured as the number of units produced, and the absorption rate would be a rate per unit produced.

FTC FOULKS LYNCH 1 CHAPTER 1 ABSORPTION COSTING AND MARGINAL COSTING

 Where organisations produce different products or carry out non-standard jobs for customers production volume may then be measured as one of the following: – direct labour hours worked – the absorption rate is a rate per direct labour hour worked – machine hours worked – the absorption rate is a rate per machine hour operated – the cost of direct labour – the absorption rate is a percentage of direct labour cost.  It is possible to calculate absorption rates using actual overhead costs and actual production volume but the normal practice is to absorb based on budgeted overhead expenditure and budgeted production volume.  An absorption costing system might distinguish between fixed and variable overheads. – Variable overhead costs – where the total expenditure is expected to rise in direct proportion to the volume of output. – Fixed overhead costs – where total expenditure is a constant amount in a given period, regardless of the output volume.  In absorption costing, inventories of work-in-progress and finished goods are valued at their full production cost.

2 MARGINAL COSTING IN OUTLINE  Marginal costing is another method of costing products or services and measuring profitability. Products or services are valued at their marginal cost (variable cost) only. Inventories of work-in-progress and finished goods are valued at their variable production cost. All fixed costs are treated as period costs and charged against profit in the period to which they relate.

2 FTC FOULKS LYNCH ABSORPTION COSTING AND MARGINAL COSTING CHAPTER 1

 Contribution is the difference between sales and the variable cost of sales: Contribution = Sales – Variable cost of sales Contribution is short for ‘contribution to fixed costs and profits’.  In a marginal costing system, the measure of product profitability is the total contribution earned by each product, without charging any fixed costs to the product. In absorption costing, product profitability is measured as sales income from each product minus the full absorption costs of the product.  Changes in the volume of sales, or in sales prices, or in variable costs will all affect profit by altering the total contribution. Marginal costing techniques can be used to help management to assess the likely effect on profits of higher or lower sales volume, or the likely consequences of reducing the sales price of a product in order to increase demand, and so on.  Example A company sells a single product for £9. Its variable cost is £4. Fixed costs are currently £70,000 per annum and annual sales are 20,000 units. There is a proposal to make a change to the product design that would increase the variable cost to £4.50, but it would also be possible to increase the selling price to £10 for the re- designed model. It is expected that annual sales at this higher price would be 19,000 units, and fixed costs should fall by £1,000. How would the re-design of the product affect annual profit? Solution Before After £ £ Sales (20,000 × £9) 180,000 (19,000 × £10) 190,000 Variable costs (20,000 × £4) 80,000 (19,000 × £4.50) 85,500 Contribution 100,000 104,500 Fixed costs 70,000 69,000 Profit 30,000 35,500

FTC FOULKS LYNCH 3 CHAPTER 1 ABSORPTION COSTING AND MARGINAL COSTING 3 INCOME STATEMENTS FOR ABSORPTION AND MARGINAL COSTING  Absorption costing is used to provide inventory valuations for financial statements. Either marginal or absorption costing can be useful for internal management reporting.  Example Hound produces a single product and has the following budget: Budget per unit $ Selling price 10 Direct materials 3 Direct wages 2 Variable overhead 1 Fixed production overhead is $10,000 per month; production volume is 5,000 units per month. Required: Show income statements for the month if sales are 4,800 units and production is 5,000 units under: (a) absorption costing (b) marginal costing. Solution (a) Absorption costing The fixed overhead cost per unit is $2 (= $10,000/5,000 units). The full cost per unit produced is therefore $8 (3 + 2 + 1 + 2).

Income statement: absorption costing $ $ Sales (4,800 at $10) 48,000 Opening inventory - Costs of production (5,000 × $8) 40,000 40,000 Less: Closing inventory (200 × $8) 1,600 Cost of sales (38,400) Profit 9,600 (b) Marginal costing If marginal costing is used, units of closing inventory are valued at $6 (3 + 2 + 1) Income statement: marginal costing $ $ Sales (4,800 at $10) 48,000 Opening inventory - Variable costs of production (5,000 × $6) 30,000 30,000 Less: Closing inventory (200 × $6) 1,200 Variable cost of sales (28,800 ) Contribution 19,200 Fixed costs 10,000 Profit 9,200 The two profit figures can be reconciled as follows: $ Absorption costing profit 9,600 Add: fixed costs included in opening inventory 0 Less: fixed costs included in the closing (400) inventory (200  $2) Marginal costing profit 9,200

 The basic rule The basic rules for reconciling absorption costing profit to marginal costing profit are (AC = absorption costing, MC = marginal costing): – If closing inventory is more than opening inventory, AC profit > MC profit. – If closing inventory is less than opening inventory, AC profit < MC profit. – If opening and closing inventory are the same, AC profit = MC profit.  Under- or over-absorbed overhead – Under- and over-absorption of fixed overheads occur in absorption costing, and are reported in the income statement. – It occurs because the absorption rate is a predetermined rate. – The amount of under- or over-absorbed overhead is: $ Production overhead absorbed into product costs X Actual production overhead expenditure Y Under- or over-absorbed overhead (X – Y) – When the overhead absorbed (X) is more than the overhead expenditure incurred, there is over-absorption. – When the overhead absorbed (X) is less than the overhead expenditure incurred, there is under-absorption.

 Proforma income statements Absorption costing $ $ $ Sales X Opening inventory (full production X cost) Production costs: Direct materials X Direct labour X Production overheads absorbed X X X Less closing inventory (full production (X) cost) Production cost of sales: (X) X Production overhead absorbed X Production overhead incurred X Over-absorbed/(under-absorbed) X or (X) overheads X Administration overheads incurred X Selling and distribution costs incurred X (X) Profit X Marginal costing $ $ $ Sales X Opening inventory (marginal production X cost) Variable production cost incurred: Direct materials X Direct labour X Variable production overheads X X X

FTC FOULKS LYNCH 7 CHAPTER 1 ABSORPTION COSTING AND MARGINAL COSTING Less closing inventory (marginal (X) production cost) Variable production cost of sales X Variable selling and distribution costs X Total variable cost of sales (X) CONTRIBUTION X Fixed costs (period costs) Fixed production costs X Fixed administration costs X Fixed selling and distribution costs X Total fixed costs (X) Profit X

4 BATCH COSTING AND JOB COSTING  In batch costing, production costs are recorded for each batch of items produced. Direct materials costs and direct labour costs are recorded for the batch as a whole, and in absorption costing, fixed overheads are then absorbed into the cost of the batch at the predetermined rate. A cost per unit of output is then calculated by dividing the full production cost of the batch by the number of output units in the batch.  In job costing, each job carried out for a customer is costed separately. A job cost card is used to record the direct materials and direct labour costs of the job as it progresses, and there might also be some direct expenses chargeable. In absorption costing, production overheads are added to the cost of the job at the predetermined rate.  When marginal costing is used, there is no absorption of fixed overheads into the cost of batches or jobs, and only the variable production costs are recorded.

5 MARGINAL AND ABSORPTION COSTING COMPARED Advantages of absorption costing  Fixed production costs can be a large proportion of the total production costs incurred. Unless production overheads are absorbed into product costs, a large proportion of cost would be excluded from the measurement of product costs.  Absorption costing follows the matching concept (accruals concept) by carrying forward a proportion of the production cost in the inventory valuation to be matched against the sales value when the items are sold.  It is necessary to include fixed production overhead in inventory values for financial statements; absorption costing achieves this.  In job costing, absorption costing can help to decide on the price to quote to a customer for a job. The job cost estimate includes a share of overhead cost, and the price can be decided by adding a profit margin to this estimated cost. This method of ‘cost plus pricing’ can help to ensure that sales income is sufficient to cover all costs, fixed as well as variable.  Analysis of under-/over-absorbed overhead may be useful for identifying inefficient utilisation of production resources.  There is an argument that in the longer term, all costs are variable, and it is appropriate to try to identify overhead costs with the products or services that cause them. This argument is used as a reason for activity-based costing (ABC). Disadvantages of absorption costing  The apportionment and absorption of overhead costs is arbitrary.

 Profits vary with changes in production volume. For example, by increasing output, more fixed overhead is absorbed into production costs, and if the extra output is not sold, the fixed overhead costs are carried forward in the closing inventory value. Advantages and disadvantages of marginal costing  Marginal costing has several advantages: – Simpler costing system, there is no requirement to apportion and absorb overhead costs. – Variable production cost is a more realistic estimate of inventory value than full production cost. – Marginal costing reflects the behaviour of costs in relation to activity, i.e. when sales increase, the cost of sales rise only by the additional variable costs  However, marginal costing has weaknesses: – When fixed costs are high relative to variable costs, and when overheads are high relative to direct costs, the marginal cost of production and sales is only a small proportion of total costs. A costing system that focuses on marginal cost and contribution might therefore provide insufficient and inadequate information about costs and product profitability. Marginal costing is useful for short- term decision-making but not over the longer term. – The treatment of direct costs as a variable cost item is often unrealistic. When direct labour employees are paid a fixed wage or salary, their cost is fixed, not variable.  Since both absorption costing and marginal costing have advantages and weaknesses as methods of measuring the costs and profitability of products and services, neither can be regarded as superior to the other.

10 FTC FOULKS LYNCH ABSORPTION COSTING AND MARGINAL COSTING CHAPTER 1 In view of the recognised weaknesses in both costing methods, new approaches to costing have been devised.

FTC FOULKS LYNCH 11 CHAPTER 2 COST LEDGER ACCOUNTING

1 THE COST LEDGER  In financial accounting, the nominal or general ledger contains accounts for assets, liabilities, income, expenses and capital used for recording financial transactions.  Some organisations also have a cost ledger.  The financial accounting ledger and cost accounting ledger can be integrated into a single ledger. When they are separate, the two systems must reconcile with each other, and the system is referred to as an ‘interlocking’ accounting system.  There are different types of cost accounting system. – For manufacturing businesses, the costing system could be for a batch production system, for a production system based on doing non-standard jobs to customer specifications, and for a continuous process manufacturing system. – The costing system might use absorption costing or marginal costing. – The costing system might use actual costs or standard costs.  Within a cost ledger for a manufacturing business, there should be accounts for recording transactions relating to: – inventory (a stores ledger control account) – labour costs (a wages and salaries control account) – production costs (a work in progress control account) – overhead costs

FTC FOULKS LYNCH 12 COST LEDGER ACCOUNTING CHAPTER 2 – unsold completed production (a finished goods account) – the cost of sales – sales.  There are three accounts that record opening and closing inventory: the stores ledger control account (raw materials), the work-in-progress control account (unfinished production) and the finished goods account (unsold completed production).  In an absorption costing system, there could be an account for recording the under- or over-absorbed production overheads.  There is an account for calculating the profit or loss for the period. In an interlocking accounts system, the cost accounting profit might differ from the profit in the financial accounting system, for example because inventory values might differ between the systems. The account in the cost ledger will be referred to as the costing income statement, although a different name might be given.  In an interlocking accounts system, the cost ledger does not have accounts for non-current assets, bank, receivables, payables, long-term liabilities, capital or depreciation. The cost accounts also exclude financial transactions such as investment income, interest costs, and dividends to shareholders.  Transactions in the cost ledger are recorded using double entry book-keeping. In an interlocking accounting system, when the corresponding credit or debit entry would be to an account that does not exist in the cost ledger, the credit or debit is recorded in a financial ledger control account in order to maintain the integrity of the double entry accounting system.

FTC FOULKS LYNCH 13 CHAPTER 2 COST LEDGER ACCOUNTING 2 THE DOUBLE ENTRY SYSTEM IN COST ACCOUNTING  The following rules apply for an interlocking accounts system and absorption costing. – Additions to cost are recorded as a debit entry in the appropriate account. – Costs of indirect materials and indirect labour are recorded as a debit entry in the appropriate overhead account. The

14 FTC FOULKS LYNCH COST LEDGER ACCOUNTING CHAPTER 2

debit side of the overhead control accounts is therefore used to build up the total cost of overheads actually incurred. – The cost of production is recorded by means of debit entries in the work-in-progress control account. (i) The cost of direct materials is recorded as a debit entry in work-in-progress, and the credit entry is in the stores ledger control account. (ii) The cost of direct labour is recorded as a debit entry in work-in-progress, and the credit entry is in the wages and salaries control account. (iii) In an absorption costing system, production overheads absorbed in the cost of production are recorded as a debit entry in work-in-progress, and the credit entry is in the production overhead control account.  The work-in-progress control account is a total account representing the accumulated production costs recorded within the costing system for products, jobs or batches produced.  Completed production is recorded as a credit entry in the work in progress control account and as a debit entry in either the finished goods account or the cost of sales account.  In the work-in-progress control account, the debit side therefore records the cost of items going through production, and the credit side records the cost of the completed output.  Transfers of inventory are recorded as a credit entry in the inventory account from which the transfer is made and the debit entry is to the account representing the cost or value of where the inventory was transferred to. (i) Transfers of raw materials from stores are recorded as a credit entry in the stores ledger control account and as a debit entry in the work-in-progress control account (direct materials) or the appropriate overhead control account (indirect materials).

(ii) Transfers of finished output from work-in-progress is recorded as a credit entry in the work-in-progress account, with the debit entry in either the finished goods account or cost of sale account. (iii) Transfers of finished goods, when they are sold to customers, are recorded by a credit entry in the finished goods account, with the debit entry in the cost of sales account.  The cost of sales is recorded by means of debit entries in the cost of sales account. (i) The production cost of goods sold is recorded as a debit in cost of sales, and the credit entry is in either the work-in- progress control account or the finished goods account. (ii) The cost of administration overhead and sales and distribution overhead is debited to cost of sales, with the credit to the appropriate overhead account.  Sales are recorded as a credit in the sales account and the debit entry is in the financial ledger control account (since there is no account in the cost ledger for receivables or cash/bank).  Under- or over-absorbed overhead. The production overhead control account records overhead costs incurred on the debit side and overhead costs absorbed into production cost on the credit side. The difference between the total costs debited and absorbed costs credited is the under- or over- absorbed overhead.  Costing profit or loss. A costing profit and loss account is used to calculate the profit or loss for a period. (i) Sales are credited in this account, with the debit entry in the sales account. (ii) The cost of sales is debited in this account, with the credit entry in the cost of sales account.

(iii) Under-absorbed overhead is debited in the account, with the matching credit in either the under/over-absorbed overhead account or the production overhead control account. (iv) Over-absorbed overhead is credited in the account, with the matching debit in either the under/over-absorbed overhead account or the production overhead control account.  Opening and closing inventories. The value of opening inventory is a debit balance brought forward. The value of closing inventory is shown on the credit side of the account, as a closing balance carried forward. The double entry system in T account format  FLCA stands for financial ledger control account. WIP stands for the work-in-progress control account. The figures are to illustrate only. Stores ledger control account $ $ Opening balance 4,000 (2) Direct materials used b/f (1) Purchases - 50,000 – WIP 40,000 FLCA (3) Indirect materials used – production 9,000 overhead – admin overhead 1,000 – sales overhead 1,000 Closing balance c/f 3,000 54,000 54,000 Opening balance 3,000 b/f

Work in progress control account $ $ Opening balance 8,000 (6) Finished output 93,000 b/f (2) Direct materials 40,000 – Finished goods a/c used – stores ledger control (4) Direct labour cost 25,000 – wages and salaries control (5) Production 25,000 Closing balance c/f 5,000 overhead absorbed – prod’n overhead account 98,000 98,000 Opening balance 5,000 b/f

Finished goods account $ $ Opening balance 4,000 (7) Finished goods sold 86,000 b/f (6) Completed 93,000 – Cost of sales a/c production (unsold) –WIP Closing balance c/f 11,000 97,000 97,000 Opening balance 11,000 b/f

Wages and salaries control account $ $ (8) Total cost of 82,000 (4) Cost of direct labour 25,000 wages and - WIP salaries - FLCA Indirect labour cost: (9) Production overh’d 7,000 (9) Admin overh’d 20,000 (9) Sales and dist’n 30,000 oh’d 82,000 82,000

Production overhead control account $ $ (3) Cost of indirect 9,000 (5) Absorbed overhead 25,000 materials – – WIP stores ledger control (9) Cost of indirect 7,000 (11) Balance: under- 2,000 production absorbed overhead labour – wages and salaries (10) Indirect 11,000 production expenses – FLCA 27,000 27,000

Administration overhead control account $ $ (3) Cost of indirect 1,000 (12) Cost of sales 26,000 materials – stores ledger control (9) Cost of indirect 20,000 labour – wages and salaries (10) Indirect 5,000 administration expenses - FLCA 26,000 26,000

Sales and distribution overhead control account $ $ (3) Cost of indirect 1,000 (13) Cost of sales 43,000 materials – stores ledger control (9) Cost of indirect 30,000 labour – wages and salaries (10) Indirect 12,000 sales/distn. expenses - FLCA 43,000 43,000

Cost of sales account $ $ (7) Production cost 86,000 (14) Costing profit and 155,000 of sales – loss account finished goods (12) Administration 26,000 overhead (13) Sales/distributio 43,000 n overhead 155,000 155,000

Sales account $ $ (17) Costing profit 180,000 (16) Sales – FLCA 180,000 and loss account 180,000 180,000

Under/over-absorbed overhead account $ $ (11) Under-absorbed 2,000 (15) Costing profit and 2,000 overhead – loss account production overhead account 2,000 2,000

Costing profit and loss account $ $ (14) Cost of sales 155,000 (17) Sales 180,000 (15) Under-absorbed 2,000 overhead (18) Profit – FLCA 23,000 (balancing figure) 180,000 180,000

Financial ledger control account $ $ (16) Sales 180,000 Opening balance 16,000 b/f (1) Stores ledger 50,000 control account (8) Wages and 82,000 salaries control (10) Production 11,000 overhead control (10) Admin overhead 5,000 (10) Sales/distribution 12,000 overhead Closing balance 19,000 (18) Profit – costing 23,000 c/f profit and loss 199,000 199,000 Opening balance 19,000 b/f  The opening credit balance of $16,000 on the financial ledger control account matches the total of the opening debit balances on the three inventory accounts: $ Stores 4 ledger control Work-in- 8 progress control Finished goods 1

 Similarly, the closing credit balance of $19,000 on the financial ledger control account matches the total of the closing balances on the three inventory accounts: $

22 FTC FOULKS LYNCH COST LEDGER ACCOUNTING CHAPTER 2 Stores 3 ledger control Work-in- 5 progress control Finished 1 goods 1

3 MARGINAL COSTING AND THE COST LEDGER  The entries in the cost ledger for a marginal costing system are different from those shown above. – Fixed production overheads are charged directly to the cost of sales: Debit Cost of sales Credit Production overhead account (fixed production overheads) – If there are any variable production overhead costs, these must be added to the cost of production in the WIP account. Debit Work in progress Credit Production overhead account (variable production overheads).  In marginal costing, there is no under- or over-absorbed overhead, and so this account does not appear in a cost ledger for marginal costing.

4 THE WORK IN PROGRESS CONTROL ACCOUNT  The work in progress control account is an account for recording the total cost of all items produced.

FTC FOULKS LYNCH 23 CHAPTER 2 COST LEDGER ACCOUNTING – In batch costing, the WIP control account is the sum of all the recorded entries in the cost accounts for the individual batches produced. – In job costing, it is the sum of all the recorded entries in the cost accounts for the individual jobs produced.

FTC FOULKS LYNCH 25 CHAPTER 3 PROCESS COSTING

1 THE CHARACTERISTICS AND APPLICATION OF PROCESS COSTING  Process costing is a method of product costing for continuous processing manufacture. The distinctive features are: – losses during processing – continuous processing. Process manufacturing does not come to an end, there is always some opening and closing work in process – in some industries, more than one product is output from the same process and there could be joint products or a by-product.  Costs cannot be attributed to individual jobs or batches. Instead, costs are attributed to individual processes. In process costing, there is a work-in-process (work-in-progress) account for each individual process, and: – in absorption costing, costs are recorded by charging direct materials, direct labour and absorbed fixed production overhead costs to each process – in marginal costing, costs are recorded by charging direct materials, direct labour and variable production overhead costs to each process – in a continuous processing system, there might be several sequential processes.  In a simple process account, where there are no losses in production and no opening or closing work-in-process, costing is straightforward. The total cost of the process is divided by

FTC FOULKS LYNCH 26 PROCESS COSTING CHAPTER 3 the number of units produced to calculate a cost per unit produced.

2 LOSS IN PROCESS  Losses are measured as the difference between: – input units of materials, and – units of output and closing inventory.  A distinction is made between the expected and the unexpected loss. Expected loss is called normal loss. Any unexpected loss (= loss in excess of the expected loss) is called abnormal loss.  Normal loss, where loss has no scrap value The costs of production are shared between the expected units of output. The reason that normal loss is given a zero cost is that since the loss is expected, it should be allowed for in product costing.  Normal loss, where loss has a scrap value The scrap value of the normal loss is treated as a deduction from the cost of processing. In ledger accounting, this is done by: Debit Scrap account, with the scrap value of the normal loss Credit Process account The cost per unit of output is calculated as: Total process costs minus scrap value of normal loss Expected units of output

 Abnormal loss: loss has no scrap value – When actual loss exceeds normal loss, the difference is abnormal loss. – When loss has no scrap value, the full cost of the abnormal loss is written off as a cost in the income statement for the period.

FTC FOULKS LYNCH 27 CHAPTER 3 PROCESS COSTING – The cost per unit of output and the cost per unit of abnormal loss are calculated as the total process cost divided by the expected number of units of output.  Abnormal loss, where loss has a scrap value If loss has a scrap value, the cost to the business of abnormal loss is reduced by its scrap value. However, this adjustment is made in the scrap and abnormal loss accounts. – The process account is credited with the scrap value of the normal loss only. – A cost per expected unit of output is calculated for output units and abnormal loss units, in the same way as described previously. – In the abnormal loss account and scrap account, the scrap value of the abnormal loss is recorded by: Debit Scrap account Credit Abnormal loss account – The balance on the abnormal loss account is written off as a charge to the income statement for the period. – The balance on the scrap account is matched by a debit entry in the cash/bank account (where integrated accounting is used) or the financial ledger control account (where interlocking accounts are used).

3 ABNORMAL GAIN  Sometimes, the actual loss in a process will be less than the expected or normal loss. When this happens the difference is called an abnormal gain. This is treated in the same manner as an abnormal loss however the gain is a benefit rather than a charge to the income statement.

28 FTC FOULKS LYNCH PROCESS COSTING CHAPTER 3 4 WORK-IN-PROCESS AND EQUIVALENT UNITS  In process manufacturing, there is usually some unfinished work-in-process at the beginning and end of each period. – Closing work-in-process is given a value that is carried forward.

– Opening work-in-process is completed during the period, and transferred either to the next process or to finished goods.  There needs to be a method in process costing for: – putting a value to closing work-in-process, and – calculating the cost of completed units when some units are partly finished at the beginning of the period.  The method used is to estimate the equivalent number of units of finished output represented by closing and opening inventory. An equivalent unit is an amount equal to one completed unit of output.  Inventory, output and losses are valued in process costing by first of all calculating a cost per equivalent unit. Rules to remember 1 One full unit of production equals one equivalent unit. 2 If loss is assumed to occur at the end of processing, one unit of abnormal loss or abnormal gain equals one equivalent unit. Normal loss = 0 equivalent units. Abnormal loss equivalent units are added to the total of equivalent units. Abnormal gain equivalent units are subtracted from the total of equivalent units. 3 Labour costs and overhead costs are usually treated together as conversion costs. 4 Closing stock has to be converted from actual units to equivalent units.  If there are two or more direct materials in the process, and one material is added in full at the start of the process and the other is added gradually throughout the processing, it is necessary to calculate an equivalent units figure for each direct material.

30 FTC FOULKS LYNCH PROCESS COSTING CHAPTER 3

5 If loss has a scrap value, it is usual to subtract the scrap value of normal loss from the total cost of direct materials. 6 The cost per equivalent unit of conversion cost = Total conversion costs/Total equivalent units of conversion cost 7 The costs per equivalent unit are used to value finished output, abnormal loss or abnormal gain and closing work-in- process.  Example A manufacturer starts processing on 1 April. During April, the following costs were incurred in Process 1: $ Direct materials (20,000 litres) 78,000 Direct labour 43,000 Production overhead absorbed 86,000 207,000 Normal loss is 5% of input materials and loss has a scrap value of $2 per litre. There was no work-in-process at the beginning of April. During April, output to Process 2 totalled 15,800 litres. Closing work-in- process at the end of April was 2,400 litres, which were 100% complete for direct materials but only 25% complete for conversion costs. Required: (a) Calculate the cost of finished output during April. (b) Calculate the value of closing work-in-process. Solution 1 Calculate the amount of abnormal loss or gain. 2 Calculate the number of equivalent units of output. 3 Calculate a cost per equivalent unit for materials and conversion costs. Remember that the scrap value of normal loss, if there is any, is deducted from the total cost of the direct materials before calculating a cost per equivalent unit.

FTC FOULKS LYNCH 31 CHAPTER 3 PROCESS COSTING 4 Use the costs per equivalent unit to put a value to finished output, closing work-in-process and abnormal loss/abnormal gain. Abnormal loss/abnormal gain litres Finished output 15,800 Normal loss (5% of 20,000) 1,000 Closing WIP 2,400 19,200 Input materials 20,000 Difference = abnormal loss 800 Number of equivalent units Total Equivalent units units Direct Conversio materials n costs Finished output 15,800 15,800 15,800 Normal loss 1,000 0 0 Abnormal loss 800 800 800 Closing WIP 2,400 (100%) 2,400 (25%) 600 20,000 19,000 17,200

Total cost $ $ Cost 78,000 129,000 Less scrap value of normal loss (2,000) - 76,000 129,000

Cost per equivalent unit $4.00 $7.50 Evaluation Direct materials Conversion costs Total Equivalent Cost Equivalent Cost cost units $ units $ $ Finished output 15,800 63,200 15,800 118,500 181,700 Abnormal loss 800 3,200 800 6,000 9,200 Closing WIP 2,400 9,600 600 4,500 14,100 19,000 76,000 17,200 129,000 205,000

32 FTC FOULKS LYNCH PROCESS COSTING CHAPTER 3 (Note: The cost of finished output could be calculated more quickly as: 15,800 equivalent units × ($4 + $7.50) = $181,700. Similarly, the cost of abnormal loss = 800 equivalent units × ($4 + $7.50) = $9,200.)

5 THE AVCO METHOD  When there is opening work-in-process at the start of a period, the inventory has a brought forward value from the previous period, there is a cost to completion during the current period. There are several methods of calculating the value of completed opening work-in-process including: – the weighted average cost method or AVCO method – first in, first out method (FIFO) – standard cost.  Using the AVCO method, it is assumed that all production units during a period have the same unit cost. A unit of part- completed opening WIP, on completion, has the same cost as a unit of output started and finished in the current period. Rules to remember 1 Every unit of finished output during a period counts as one full equivalent unit of production. 2 Total costs for direct materials are: (a) direct materials value of opening WIP, plus (b) direct materials costs incurred in the current period, minus (c) scrap value of normal loss. 3 Total conversion costs are: (a) conversion cost value of opening WIP, plus (b) conversion costs incurred in the current period.

 The total equivalent units are calculated and a cost per equivalent unit. This is then used to put a value to finished output, abnormal loss or abnormal gain and closing WIP.

6 THE FIFO METHOD  The FIFO method is based on the assumption that the first units of materials input to a process are the first items to be completed.  The rules for the FIFO method are: 1 The equivalent units of opening WIP are the equivalent units of work to complete production. 2 Units started and finished in the current period are one equivalent unit each. 3 The cost per equivalent unit is the total costs incurred in the current period divided by the total equivalent units for the current period. 4 If normal loss has a scrap value, this is usually deducted from the cost of the materials input to the process during the period. 5 The cost of finished output is calculated in two parts. (a) Opening WIP, completed during the current period. The cost of this output is the value of the equivalent units in the current period plus the value of the opening WIP. (b) Other units started and completed during the current period.

7 BY-PRODUCTS  The output from a process might include a by-product in addition to the main product. A by-product is manufactured as an unavoidable result of the process. Although it has some sales value, its value is small in comparison.  There is no information value in calculating a cost for a by- product or measuring its profitability. The accounting treatment of a by-product in process costing is similar to the treatment of normal loss.

8 JOINT PRODUCTS  Joint products are two or more separate products output from a common process, each having a sales value large enough to justify the treatment of the product as a main product.  The cost of each joint product is a share of the common processing costs up to split-off point. Split-off point is the point during processing where the separate joint products are produced.

The apportionment of common costs between joint products  There are four broad methods of apportioning: – on the basis of units of each joint product – on the basis of the market values at the split-off point – on the basis of the eventual market value after deducting further processing costs on the separate joint product after the split-off point – on the basis of a technical estimate of the relative ‘usage’ of common processing resources  Example The output from a process consists of two joint products, JP1 and JP2, and a by-product BP. The following data relates to November: Opening WIP (1,500 units) $16,000 Materials input (20,000 units): cost $151,000 Conversion costs $89,500 Normal loss (1,000 units): scrap value $500 Abnormal loss: (500 units) $7,000 Output: By-product BP (2,000 units): sales value $6,000 Joint-product JP1: 10,000 units Joint-product JP2: 5,000 units Closing WIP (3,000 units): value $33,000 The units of JP1 output from the process have a sales value of $220,000. The units of JP2 output from the process have a sales value of $250,000 after further processing costs of $50,000 are incurred. Required: Calculate the output value of each joint product assuming that common processing costs are shared on the basis of: (i) units produced

36 FTC FOULKS LYNCH PROCESS COSTING CHAPTER 3 (ii) sales value at split-off point/ eventual sales value less further processing costs.

Solution Units $ $ Opening WIP 1,500 16,000 Direct materials 20,000 151,000 Conversion costs - 89,500 21,500 256,500 Scrap value of normal loss 1,000 500 By-product sales income 2,000 6,000 Abnormal loss 500 7,000 Closing WIP 3,000 33,000 6,500 46,500 Cost of finished output 15,000 210,000

JP1 JP2 Total (i) Units produced 10,000 5,000 15,000 Cost per unit $14 $14 ($210,000/15,000) Apportionment of $140,000 $70,000 $210,000 common costs (ii) Sales value 220,000 250,000 Less further processing - (50,000) costs Net sales value 220,000 200,000 420,000 Cost per $1 net value $0.50 $0.50 ($210,000/$420,000) Apportionment of $110,000 $100,000 $210,000 common costs

FTC FOULKS LYNCH 39 CHAPTER 4 THROUGHPUT ACCOUNTING

1 THE ORIGINS OF THROUGHPUT ACCOUNTING AND DEFINITIONS  Throughput accounting emerged in the 1980s and 1990s. It is associated with the work of Dr Eli Goldratt, who developed the Theory of Constraints (TOC).  Dr Goldratt described the approach of traditional accounting systems as ‘Cost World’, in which product cost is the main way to understand value. Costs are categorised as fixed and variable costs, and in absorption costing overheads are charged to labour time or to products using many arbitrary assumptions that have no commercial relevance. Even in marginal costing, it is assumed that direct labour costs vary with the activity level, and that fixed costs are the same for a given time period, regardless of the activity level.  Throughput accounting challenges these assumptions. – Direct labour costs are not wholly variable. Skilled workers are paid fixed salaries, and so their cost does not vary directly with output volume. – Fixed costs are ‘less fixed’ than they might have been in the past. – The only totally variable cost is the purchase cost of raw materials and components that are bought from external suppliers. – According to the throughput accounting approach, a business makes its money by selling goods (or services). Until it makes the sale, there is no added value.

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Throughput  Throughput is ‘the rate of production of a defined process over a stated period of time. Rates may be expressed in terms of units of products, batches produced, turnover or other meaningful measurements’.  Value is created from throughput. In money terms, throughput can therefore be defined as the extra money that is made for an organisation from selling its products: THROUGHPUT = REVENUE – TOTALLY VARIABLE COSTS  Throughput brings fresh money into the business from outside.  Since totally variable costs are normally just raw materials and bought-in components, it is often convenient to define throughput as: REVENUE – RAW MATERIAL COSTS Inventory (or investment)  This is defined as all the money the business invests to buy the things that it intends to sell, or all the money tied up in assets so that the business can make the throughput. Inventory therefore includes unused raw materials, work-in-progress and unsold finished goods. Operating expenses  Operating expenses are defined as all the money a business spends to produce the throughput It is not correct to think of operating expenses as fixed costs. They are costs that are not totally variable.

2 MEASURING PROFIT AND INVENTORY VALUE IN THROUGHPUT ACCOUNTING Net profit  Since a business makes its money from throughput, management accounting systems should focus on the value of throughput created. Profit should therefore be reported as follows: $

Revenue 750,000 Raw materials costs (totally variable costs) 200,000 Throughput 550,000 Operating expenses 400,000 Net profit 150,000  Throughput accounting has been described as a form of ‘super- variable costing’ because the concept of throughput has similarities to the concept of contribution. In throughput accounting, the concept of product cost is rejected. The throughput earned by individual products is calculated, but no attempt is made to charge operating expenses to products. The value of inventory  Inventory should be valued at the purchase cost of its raw materials and bought-in parts.  It should not include any other costs, not even labour costs. No value is added by the production process, not even by labour, until the item is sold.

42 FTC FOULKS LYNCH THROUGHPUT ACCOUNTING CHAPTER 4

3 THE THEORY OF CONSTRAINTS  The theory of constraints is a development of system theory and applies to all types of system. – Every system has inputs. – The inputs are brought together within the system and are processed to produce outputs. – Within a system, there are many different processes or sub-systems that react with each other and that are interdependent. – A system can also be affected by external factors in its environment.

Inputs System Outputs

 Outputs are affected by: – the design of the system – controls within the system – external constraints on the system. System goals  Every system must have a clear goal such as to maximise profit. Complexity of systems  All complex systems are just a number of simple systems interacting with each other. Problems and constraints  Problems can occur within systems, and every system has one or more core problems or constraints. The existence of constraints within a system is self-evident. If there were no

FTC FOULKS LYNCH 43 CHAPTER 4 THROUGHPUT ACCOUNTING constraints, the output from the system would be either zero or it would continue to grow indefinitely.  Constraints could be caused by: – weaknesses in the system’s design and the way in which its different parts link together – weaknesses in the controls within the system – external factors such as a limit to the volume of customer demand.  In physical systems, such as manufacturing processes, constraints can be identified as bottlenecks in the system. A bottleneck is something that sets a limit to throughput through the system.  The approach recommended by the theory of constraints is to concentrate effort on the key constraint that limits the performance of the system as a whole. – Every system has a weakest link, which is its core constraint. – Strengthening any link in the chain that is not the weakest link does nothing to improve the performance of the system as a whole. – Physical constraints are the easiest to identify but there can also be policy constraints. A policy constraint might be caused by a hidden conflict, and to resolve the problem, it is necessary to identify the assumptions underlying the conflict and to challenge at least one of them.  In a manufacturing business, constraints on throughput could be: – selling prices that are too high, limiting the volume of sales demand – selling prices that are too low, limiting total sales revenue

44 FTC FOULKS LYNCH THROUGHPUT ACCOUNTING CHAPTER 4 – unreliable product quality, which causes losses due to wastage and scrapped items, or items returned by dissatisfied customers – unreliable supplies of key raw materials, so that production cannot be scheduled in a reliable way – a shortage of a key production resource, which creates a bottleneck in the production process.  Goldratt’s five steps to dealing with constraints Step 1 Identify the key system constraints. Step 2 Decide how to exploit the system constraint or relieve the bottleneck. . Until the constraint can be overcome, every effort should be made to make the most efficient use possible of the constraining resource. Step 3 Make everything else subordinate to the requirement to exploit the system constraint or relieve the bottleneck. The work rate for all non-constrained resources must be tied to the rate at which the constraining resource operates. This is to avoid a wasteful build up of unnecessary work in progress. Step 4 Elevate the system constraints. The constraint should be removed. Step 5 If the constraint is now broken, go back to Step 1. In other words, when the original constraint is no longer a bottleneck, start the procedure again by finding the new bottleneck.

4 THE THEORY OF CONSTRAINTS AND THROUGHPUT ACCOUNTING  Goldratt and others used the theory of constraints to suggest throughput accounting as an alternative to cost accounting systems.

Throughput accounting and cost accounting  Cost accounting systems are based on the idea that costs should be attributed to products.  Throughput accounting is different, because costs are not attributed to products and there are no measurements of product profitability. Product profit does not exist. ‘Products are not profitable or unprofitable, businesses are’ (Waldron).  Different decisions might be taken by management when throughput accounting is used as a basis rather than cost accounting. This is because in throughput accounting, we look at the system as a whole and how to maximise output from the global system. In contrast, cost accounting encourages management to look at ways of optimising local sub-systems.

5 DECISION-MAKING WITH THROUGHPUT ACCOUNTING  Using throughput accounting, the aim should be to maximise throughput, on the assumption that operating expenses are a fixed amount in each period. – If the business has more capacity than there is customer demand, it should produce to meet the demand in full. – If the business has a constraint that prevents it from meeting customer demand in full, it should make the most profitable use that it can of the constraining resource. This means giving priority to those products earning the highest throughput for each unit of the constraining resource that it requires.  Example A business makes four products, W, X, Y and Z. Information relating to these products is as follows:

W X Y Z Sales price/unit €20 €25 €18 €40 Materials required/unit €10 €15 €11 €22 Labour hours/unit 4 5 2 6 Monthly sales demand 500 800 1,000 400 (units) There is a limit to the availability of labour, and only 8,000 hours are available each month. Required: What products should the business produce? Solution The business should seek to maximise total throughput. W X Y Z € € € € Sales price/unit 20 25 18 40 Materials required/unit 10 15 11 22 Throughput/unit 10 10 7 18 Labour hours/unit 4 5 2 6 Throughput/labour hour €2.5 €2.0 €3.5 €3.0 Priority 3rd 4th 1st 2nd The production volumes that will maximise throughput and net profit are: Product Units Labour hours Throughput € Y 1,000 2,000 7,000 Z 400 2,400 7,200 W 500 2,000 5,000 6,400 X (balance) 320 1,600 3,200 8,000 22,400

FTC FOULKS LYNCH 47 CHAPTER 4 THROUGHPUT ACCOUNTING 6 PERFORMANCE MEASUREMENT WITH THROUGHPUT ACCOUNTING  Performance measurement with throughput accounting should relate to: – throughput, operating expenses and net profit, and – inventory/investment. Profit reporting  Throughput may be reported for each product. However, operating expenses should not be attributed to individual products unless they are entirely attributable to the product.  However, for control purposes, local operating expenses should be attributed to the operating unit that has full control over the cost. Managers of those units should be made accountable for the actual operating expenses incurred by the unit. Return on investment  The return on investment can be measured as: (Throughput  Operating expenses) Return on investment  Inventory Other performance measures  Inventory turns This is the ratio of throughput in a period to the average investment in inventory. An increase in the inventory turns ratio should result in a higher return on investment. Throughput in the period Inventory turns  Inventory  Productivity Productivity can be measured as the ratio of throughput to operating expenses. Throughput in the period Productivity  Operating expenses in the period

Throughput accounting ratio  When there is a bottleneck resource, performance can be measured in terms of throughput for each unit of bottleneck resource consumed.  There are three inter-related ratios: – throughput per unit of the bottleneck resource – operating expense per unit of the bottleneck resource – throughput accounting ratio. This is the ratio of throughput per unit of bottleneck resource to operating expenses per unit of bottleneck resource.  Units of bottleneck resource are typically measured in hours (labour hours or machine hours), therefore: Throughput per hour of bottleneck resource Throughout accounting ratio  Operating expenses per hour of bottleneck resource

7 A CRITICISM OF THROUGHPUT ACCOUNTING  A criticism of throughput accounting is that it concentrates on the short term, when a business has a fixed supply of resources and operating expenses are largely fixed.  This criticism suggests that although throughput accounting could be a suitable method of measuring profit and performance in the short term, an alternative management accounting method, such as activity based costing, might be more appropriate for measuring and controlling performance from a longer-term perspective.

FTC FOULKS LYNCH 49 CHAPTER 5 ACTIVITY-BASED COSTING

1 WEAKNESSES OF TRADITIONAL ABSORPTION COSTING AND MARGINAL COSTING Problems with absorption costing  The assumption underlying this method is that overhead expenditure is connected to the volume of production activity. – This assumption was valid years ago, when production systems were based on labour-intensive or machine-intensive mass production of fairly standard items. Overhead costs were also fairly small relative to direct materials and direct labour costs. – The assumption is not valid in a complex manufacturing environment, where production is based on smaller customised batches of products, indirect costs are high in relation to direct costs, and a high proportion of overhead activities are not related to production volume.  The criticism of absorption costing is that it cannot calculate a ‘true’ product cost. Overheads are charged to departments and products in an arbitrary way, and the assumption that overhead expenditure is related to direct labour hours or machine hours in the production departments is no longer realistic. Problems with marginal costing  The main criticisms of marginal costing as a method are: – variable costs might be small in relation to fixed costs – ‘fixed’ costs might be fixed in relation to production volume, but they might vary with other activities that are not production-related.

FTC FOULKS LYNCH 50 ACTIVITY-BASED COSTING CHAPTER 5

 In many manufacturing and service environments, it is therefore inappropriate to treat overhead costs as fixed period costs, and indirect costs should be charged to products or services in a more meaningful way.

2 CONCEPTS AND ASSUMPTIONS IN ACTIVITY- BASED COSTING  Activity-based costing (ABC) is an alternative approach. It is a form of absorption costing, but its approach is to link overhead costs to the products or services that cause them by absorbing overhead costs on the basis of activities that ‘drive’ costs (cost drivers) rather than on the basis of production volume.  The concepts or assumptions underlying ABC are: – In the long run, all overhead costs are variable. Some overheads are variable in the short run. However, overhead costs do not necessarily vary with production volume or service level. – Products, services and other cost objects consume activities. – Activities consume resources. – The consumption of resources drives cost.  Products incur overhead costs because of the activities that go into providing the products or services, and these activities are not necessarily related to the volumes of the product that are manufactured. Direct labour hours and machine hours are not the drivers of cost. When is ABC relevant?  Activity-based costing could provide much more meaningful information about product costs and profits when: – indirect costs are high relative to direct costs – products or services are complex

FTC FOULKS LYNCH 51 CHAPTER 5 ACTIVITY-BASED COSTING – products or services are tailored to customer specifications – some products or services are sold in large numbers but others are sold in small numbers.

3 THE STEPS IN ACTIVITY-BASED COSTING  There are five basic steps: Step 1 Identify activities that consume resources and incur overhead costs. Step 2 Allocate overhead costs to the activities that incur them. Step 3 Determine the cost driver for each activity or cost pool. Step 4 Collect data about actual activity for the cost driver in each cost pool. Step 5 Calculate the overhead cost of products or services. This is done by calculating on overhead cost per unit of the cost driver. Overhead costs are then charged to products or services on the basis of activities used for each product or service. Definitions  A cost pool is an activity that consumes resources and for which overhead costs are identified and allocated. For each cost pool, there should be a cost driver.  A cost driver is a unit of activity that consumes resources or ‘any factor which causes a change in the cost of an activity’.

4 COMPARING ABC WITH TRADITIONAL ABSORPTION COSTING  It is important to recognise that with ABC, the total amount of overheads charged to products or services can be significantly

52 FTC FOULKS LYNCH ACTIVITY-BASED COSTING CHAPTER 5 different from the overhead costs that would be calculated with traditional absorption costing.

 Example A company manufactures two products, P and Q. Monthly data relating to production and sales are as follows: Product P Product Q Direct material cost per unit $15 $20 Direct labour hours per unit 1 hour 2 hours Direct labour cost per unit $20 $40 Sales demand 100 units 950 units Production overheads are $200,000 each month and are absorbed on a direct labour hour basis. The overhead absorption rate is $100 per direct labour hour. Other monthly information: Activity Total Cost driver Total Product Product cost number P Q $ Setting up 20,000 Number of 4 1 3 set-ups Machining 80,000 Machine 2,000 100 1,900 hours Order 20,000 Number of 4 1 3 handling orders Quality 20,000 Number of 5 1 4 control inspections Engineering 60,000 Engineering 1,000 500 500 hours 200,000 Required: Calculate the costs, in total and per unit, for Product P and Product Q, using: (a) traditional absorption costing (b) activity-based costing.

54 FTC FOULKS LYNCH ACTIVITY-BASED COSTING CHAPTER 5

Solution (a) Traditional absorption costing Product P Product Q $ $ Direct material cost/unit 15 20 Direct labour cost/unit 20 40 Overhead (at $100 per hour) 100 200 Total cost /unit 135 260

Number of units 100 950 Total cost $13,500 $247,000 Cost per unit $135 $260 (b) Activity-based costing Activity Total Cost driver Product Product cost P Q $ $ $ $ Setting up 20,000 Cost per 5,000 5,000 15,000 set-up Machining 80,000 Cost per 40 4,000 76,000 machine hour Order 20,000 Cost per 5,000 5,000 15,000 handling order Quality 20,000 Cost per 4,000 4,000 16,000 control inspection Cost per Engineering 60,000 engineering 60 30,000 30,000 hour 200,000 48,000 152,000

Product P Product Q $ $ Direct materials 1,500 19,000 Direct labour 2,000 38,000 Overheads 48,000 152,000 Total cost 51,500 209,000

FTC FOULKS LYNCH 55 CHAPTER 5 ACTIVITY-BASED COSTING Product P Product Q $ $ Number of units 100 950 Cost per unit $515 $220 With activity-based costing, the unit cost of Product P is much higher, because the overhead cost reflects its comparatively high activity levels for set-up, order handling, quality control and engineering for each unit produced and sold. It could be argued that: – the product costs provided by ABC are much more realistic than those calculated with traditional absorption costing – ABC gives management better insights into how products should be priced – ABC also gives management better insights into how overhead costs might be controlled. For example, the unit costs of Product P might be reduced, at least in the longer term, by focussing on how to reduce the engineering hours or the number of inspections each month.

5 IDENTIFYING ACTIVITIES AND COST DRIVERS  A business must identify the key activities that consume resources and the cost driver for each of those activities. – There might be a large number of different activities, but in an accounting system it is usually necessary to simplify and select a fairly small number of activities. – There might be just one cost driver or several different cost drivers. Where there are several cost drivers, it might be appropriate to select just one for the purpose of ABC analysis.

 A useful approach to identifying suitable activities within a business is to consider four different categories of activity or transaction: – Logistical transactions. These are activities or transactions concerned with moving materials or people, and with tracking the progress of materials or work through the system. – Balancing transactions. These are concerned with ensuring that the resources required for an operation are available. – Quality transactions. These are concerned with ensuring that output or service levels meet quality requirements and customer expectations. – Change transactions. These are activities required to respond to changes in customer demand, a change in design specifications, a scheduling change or a change in production or delivery methods.  For each selected activity, there should be a cost driver. The chosen cost driver must be: – relevant – easy to measure.  Often, the cost driver is the number of transactions relating to the activity. For example: – the cost of setting up machinery for a production run might be driven by the number of set-ups (jobs or batches produced) – the costs of purchasing might be related to the number of purchase orders made – the costs of quality control might be related to the number of inspections carried out, or to the incidence of rejected items.

 In selecting the appropriate cost driver for an activity, it might be necessary to relate consumption of resources to the appropriate level of activity. There may be a hierarchy of activity levels, and the appropriate level should be selected. For manufacturing businesses, four levels of activity can be identified:

Activity level The consumption of resources Examples and costs depend on Unit Production or sales volume Machine running costs Batch The number of batches Set-up costs produced Product The number of different Product design and products sold re-design costs Facility The business being in Factory rental existence  Many overhead costs are incurred at the batch or product level, rather than at the unit level.

6 ADVANTAGES AND CRITICISMS OF ABC ABC has a number of advantages.  ABC gives management a much better insight into what drives overhead costs.  ABC recognises that overhead costs are not all related to production and sales volume, but they are nevertheless variable and controllable, at least over the longer term.  In many businesses, overhead costs are a significant proportion of total costs, and management needs to understand the drivers of overhead costs.  It can be applied to derive realistic costs in a complex business environment.

 ABC can be applied to all overhead costs, not just production overheads.  ABC can be used just as easily in service costing as in product costing.  Product costs and product profitability are measured more realistically. This helps management to identify which products are most profitable and which are unprofitable.  ABC can be used by management to identify ways of reducing overhead costs in the longer-term. This is because ABC shows the nature of resource-consuming activities, the costs incurred by each activity and the cost drivers for those activities.  ABC analysis can also be used to identify activities and costs that do not add value.  ABC can also be used to analyse the profitability of individual customers or categories of customer.  If products or jobs are priced on a cost-plus basis, ABC can help management to make sensible pricing decisions.  ABC can be used as a basis for budgeting and longer-term forward planning of overhead costs. There are some criticisms of ABC.  It is impossible to allocate all overhead costs to specific activities, because some costs are incurred at a facility level, such as factory rental costs. These have to be charged to products on an arbitrary basis.  The selection of just a few activities and one cost driver for each activity means that ABC costs are based on assumptions and simplifications.  The benefits obtained from ABC might not justify the costs.

60 FTC FOULKS LYNCH CHAPTER 6 PRODUCTION SYSTEMS AND ENVIRONMENTS

1 MRP I: MATERIALS REQUIREMENTS PLANNING  Many manufacturing organisations use computerised systems to help with production planning and scheduling, and production control.  A manufactured product might consist of many components or sub-parts, and each sub-part might consist of many components and inventory items. Components and sub-parts take differing amounts of time (‘lead times’) to produce, and they might need to be available in a specific sequence in order to assemble the end product.  Materials Requirements Planning, now known as MRP I, is a computer system for production planning, purchasing and inventory control, for use in complex manufacturing systems. It is particularly appropriate for batch manufacturing systems. Three important elements  Master production schedule – a plan summarising the volume and timing of end-products required. ‘The master production schedule (MPS) is the most important planning and control schedule in a business, and forms the main input to materials requirements planning…. In manufacturing, the MPS contains a statement of the volume and timing of the end products to be made; this schedule drives the whole operation in terms of what is assembled, what is manufactured and what is bought. It is the basis of planning the utilisation of labour and equipment and it determines the provisioning of materials and cash’ (Operations Management, Slack, Chambers and Johnston).

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 Bills of materials – lists in detail the parts that make up the product and their production lead time. It also shows the relationship between the parts in the end-product. Using the bills of materials for each product, the master production schedule is ‘exploded’ to work out: – the number of sub-assemblies that are needed, and the quantities of raw materials and parts – the time by which they are needed, and therefore – the time by which their manufacture must begin or the purchase orders must be placed. The scheduling is based on an assumption that lead times for purchasing and manufacture are constant and predictable.  Inventory records – which relate to all raw material items, components and sub-assemblies as well as finished goods items. MRP I and capacity planning  An MRP I system does not provide for capacity planning.  A closed loop MRP I system does have a capacity planning feature. The system makes checks against available capacity to establish whether the production plan is feasible, and where there is insufficient capacity at certain times, it will re-schedule production. Output from an MRP I system  The output from an MRP I system is an overall production schedule, and in addition it produces purchase orders and works orders.  A significant benefit of MRP systems is that if any change is necessary to the manufacturing schedule a new production schedule can be prepared in a very short time, together with new purchase orders and works orders.

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 It should reduce inventory levels. Through reliable scheduling of production requirements, it should be possible to avoid producing items that are not required in the foreseeable future.

MRP I and accounting  An MRP I system is not integrated with other related systems within the organisation. It cannot produce a production cost budget or a materials purchases budget.  However, the system does provide information that can be used by accountants. – The master production schedule provides the basis for drawing up a production cost budget. – The schedule of materials purchase requirements can be used to prepare a materials purchases budget, by applying expected purchase prices to the quantities of purchases required. – A bill of materials for each product can be used to construct a standard cost or budgeted cost for products.

2 MRP II: MANUFACTURING RESOURCE PLANNING  Manufacturing Resource Planning, or MRP II, is an extension of MRP I to other areas of the business. MRP II and accounting  MRP II systems offer integration between the production planning, inventory control and purchasing systems and the accounting system.  It is possible for the system to produce: – a production cost budget from the master production schedule – a materials purchases budget – elements of a cash budget – a standard cost for each unit produced.

64 FTC FOULKS LYNCH PRODUCTION SYSTEMS AND ENVIRONMENTS CHAPTER 6 3 ERP: ENTERPRISE RESOURCE PLANNING  An enterprise resource system is a powerful system that integrates information from all parts of the organisation. It is an extension of the MRP philosophy, but provides more integration between different parts of the organisation.  An ERP system is expensive to acquire and install. It includes modules for: – manufacturing: production planning and control, materials purchasing, plant maintenance, quality management – sales and distribution: sales order management, customer management, distribution, transportation and shipping – accounting: accounts receivable, accounts payable, budgeting, standard costing – human resources: recruitment and workforce scheduling, payroll, training and development.

4 JUST IN TIME (JIT) MANAGEMENT  Just-in-time is an approach to operations management based on the idea that goods and services should be produced only when they are needed. – It can be described as a ‘pull through’ system responding to customer demand. – This contrasts with a ‘push’ system, in which items are produced, and if there is no immediate demand, inventories build up.  The JIT philosophy sees inventory as a cost burden, and the ideal inventory level is zero.

 At the same time, products (or services) must be delivered to the customer at the time the customer wants them (‘just in time’). To be able to do this with no inventory, the production

cycle must be short, and there can be no hold-ups in production due to defective items, bottlenecks or inefficiency. – ‘Just-in-time production is a production system that is driven by demand for finished products, whereby each component on a production line is produced only when needed for the next stage.’ – ‘Just-in-time purchasing is a purchasing system in which material purchases are contracted so that the receipt and usage of material, to the maximum extent, coincide.’ Requirements of JIT  The operational requirements for the successful implementation of JIT production are as follows: – high quality – speed – flexibility – lower costs.  The most suitable conditions for applying JIT management are where: – there are short set-up times and low set-up costs – there are short lead times and low ordering costs for buying raw materials from suppliers – work flow is fairly constant over time, and customer demand is not uneven and unpredictable – production throughput time is very short – there are no downtimes due to poor quality or stock- outs. The JIT philosophy  The JIT philosophy is based on: – continuous improvement (‘kaizen’)

FTC FOULKS LYNCH 67 CHAPTER 6 PRODUCTION SYSTEMS AND ENVIRONMENTS – the elimination of waste.

 Waste is defined as any activity that does not add value. Examples of waste are: – overproduction – waiting time – unnecessary movement of materials or people – waste in the process – inventory is wasteful – complexity in work processes – defective goods – inspection time.  A JIT production system is usually operated with a Kanban system for stock replenishment. ‘Kanban’ is a Japanese word for ‘signal’ and the system uses printed cards containing specific information such as part name and description.  The cards are used to signal a requirement to re-order inventory or production units, and the system works on the basis that replacement inventory or units will be delivered in a specified short period .

5 TOTAL QUALITY MANAGEMENT (TQM)  Total Quality Management (TQM), is a customer-focussed approach to management that focuses on achieving high standards of performance through quality.  There are several inter-related aspects to TQM. – Customer focus. The aim should be to meet the needs and expectations of customers. – Internal customers and internal suppliers. A TQM approach uses the concept of the internal customers and internal suppliers at each stage of the process chain from

raw materials procurement to providing the end product or service to the customer. – Getting things right first time. – Continuous improvement. Quality costs  Quality costs are incurred because the quality of production or a service is not perfect. The aim of TQM is to minimise quality costs. There are four categories of quality costs. – Prevention cost – incurred in advance to prevent sub-standard quality and defects. – Inspection cost – incurred after a product has been made, to check that the output meets the required quality standard and to identify defects. – Internal failure cost – arising from inadequate quality, where the problem is identified before the product or service is delivered to the customer. – External failure cost – arising from inadequate quality, where the problem is identified after the customer has received the product or service.  A ‘traditional’ approach to quality management is that a balance can be reached between the benefits of achieving a certain quality standard and the costs of reaching this standard.  The TQM approach in contrast is that the target should be zero defects. The TQM view is that: – Prevention costs and inspection costs are controllable items of expense, and subject to management discretion. It is better to spend money on prevention, before failures occur, than on inspection to detect failures. – Internal and external failure costs are the consequences of management efforts to control quality through prevention and appraisal. Giving more attention to prevention will reduce internal failure costs.

– The TQM philosophy is also based on establishing quality systems, which should be thoroughly documented. For example, the ISO 9000 quality system is a set of standards for quality management systems.

6 BACKFLUSH ACCOUNTING  Backflush accounting can be applied in mature JIT systems where: – the speed of throughput (or ‘velocity’ of throughput) is high, and – inventories of raw materials, work-in-progress and unsold finished goods are very low. In these conditions, it is doubtful whether the traditional approach to product costing is worthwhile.  Backflush accounting offers a simplified approach to costing by getting rid of ‘unnecessary’ costing records. Instead of building up product costs sequentially from start to finish of production, backflush accounting calculates product costs retrospectively, at the end of each accounting period.  A backflush accounting system differs from traditional cost accounts in several ways. – There is a combined account for production materials and work in progress called the Raw Materials and In-Progress account (or RIP account). – All costs of production labour and overhead are therefore combined as conversion costs. – The backflush costing system might use a conversion costs account to record these costs. Alternatively, conversion costs are charged in full as they are incurred as an expense in the Cost of Goods Sold account.

 During an accounting period, production costs are recorded simply by: – recording the cost of raw materials purchased in the RIP account, and – recording conversion costs incurred as a cost of goods sold.  At the end of the accounting period, there is a physical stock count of inventories which should be low.  A value is then estimated for the inventory and ‘backflushed’ from the cost of goods sold account to the RIP account. Any finished goods inventory is backflushed from the cost of goods sold account to a finished goods account.  This produces a figure for the actual production cost of goods sold and for closing inventory levels.  The advantages of using backflush accounting are: – It is a simple costing system. – It avoids the need to record production costs sequentially as items move through step-by-step operations in the production process. – When inventory levels are low or constant, it yields the same results as traditional costing methods would.  It is therefore appropriate in a mature JIT environment where there is a short production cycle and low inventories.  The disadvantages of backflush accounting are: – It is not appropriate for manufacturing environments where inventory levels are high, due to the problems of counting and valuing the inventory. – It is inappropriate for production systems with a long production cycle. It is preferable to record the production costs as the work passes sequentially through each stage of the production system. – It provides less detailed management information than traditional costing systems.

FTC FOULKS LYNCH 73 CHAPTER 7 STANDARD COSTS

1 DEFINITIONS  Whenever identical operations are performed or identical products are manufactured many times over, it should be possible to decide in advance not merely what they are expected to cost, but also what they ought to cost. – A standard is ‘a benchmark measurement of resource usage, set in defined conditions’ (CIMA Official Terminology). – A standard cost for a product or service is a predetermined (planned) unit cost, based on a standard specification of the resources needed to supply it and the costs of those resources. – A standard price for a product or service is the expected price for selling the standard product or service. When there is a standard sales price and a standard cost per unit, there is also a standard profit per unit (absorption costing) or standard contribution per unit (marginal costing).  Standard costs can be prepared using either absorption costing or standard marginal costing. A simplified standard cost card (standard cost specification) using absorption costing for a manufactured product might be as follows: $ $ Direct materials: Material A 2 litres at $3 per litre 6.00 Material B 1.5 kilos at $4 per 6.00 kilo

FTC FOULKS LYNCH 74 STANDARD COSTS CHAPTER 7

$ $ Direct labour: 12.00 Grade I 0.75 hours at $10 7.50 per hour Grade II 1.5 hours at $8 per 12.00 hour 19.50 Variable production 2.25 hours at $1 per 2.25 overhead hour Fixed production 2.25 hours at $12 27.00 overhead per hour Full standard 60.75 production cost  An important concept in standard-setting and standard costing is the standard hour. A standard hour represents the amount of work that is achievable, at standard levels of efficiency, in one hour.

2 THE PURPOSE OF STANDARDS AND STANDARD COSTING  They are used to set standards of performance, which can be used as targets for achievement. Setting standards provides a platform for finding ways of improving efficiency and minimising waste.  They are used in planning. Having established the targets for performance, these can be used to prepare plans and schedules of resource requirements.  They are used for monitoring actual performance. Actual performance is compared against the standards, and differences are reported as favourable or adverse variances. By comparing actual performance against standard and investigating the reason for variances, management can exercise control over operations.

 Standard costs can be used to set selling prices. Prices can be decided by adding a profit margin or contribution margin to the standard cost.  Standard costs are also used in the costing system to measure inventory values.  Standard costing has been defined as ‘a control technique that compares standard costs and revenues with actual results to obtain variances that are used to stimulate improved performance’ (CIMA Official Terminology).

3 SETTING STANDARD COSTS IN MANUFACTURING  Standard costs are derived by establishing a standard quantity of materials or labour for each unit of product and a standard price or rate for each unit of the resource. Standards for direct materials usage and direct labour time  Standards for direct material usage are established from product specifications. These should be detailed; for example, the usage standards might be specified within the bill of materials for each product within a MRPI or MRPII system. Whenever product specifications are altered, the standard materials usage within the standard cost should also be changed.  When there is loss or wastage in production, the standard material usage should make allowance for the expected or normal loss.  Example In a process manufacturing system, normal loss is 5% of input direct materials. To produce one unit of good output will require 1.0526 units of input (1/0.95 units), and the standard materials usage should therefore be 1.0526 units.

76 FTC FOULKS LYNCH STANDARD COSTS CHAPTER 7

 Standards for direct labour time (labour efficiency) can be established by work study. The standard time per unit which is an average expected time, might have to allow for periodic activities such as machine-setting, clearing up and on-line quality inspections.  Standards for material prices and labour rates In setting material price standards, it will often be found that a particular item of material is purchased from more than one supplier, and at slightly different prices. When there are several different suppliers for an item of material, a standard price can be derived in any of three ways: – use the price charged by the major supplier – use the lowest of the prices charged by any of the suppliers – use an estimated weighted average price.  Standard labour rates should be based on official rates of pay.  Standard costs for overheads In traditional standard product costing, it is assumed that production overhead costs are related to direct labour time. 1 When variable production overhead costs are measured, it is assumed that these costs vary in direct proportion to active direct labour time. 2 In standard absorption costing, the standard production overhead cost per unit is usually calculated as the standard direct labour hours per unit multiplied by a predetermined absorption rate per direct labour hour. Different types of standard  Standards are used to set targets for performance and monitor actual results by comparing them with the standard. A problem

FTC FOULKS LYNCH 77 CHAPTER 7 STANDARD COSTS with setting standard costs is to decide how demanding or challenging the standards should be.

78 FTC FOULKS LYNCH STANDARD COSTS CHAPTER 7

 Any of four different approaches can be taken to standard- setting, and there are four different types of standard. Basic standard A basic standard is a standard that is established for use over a long period of time. Ideal standard An ideal standard is one that is set at an ideal level of performance, that makes no allowance for normal losses or expected wastage rates and machine down-time. Attainable standard ‘Standards may be set at attainable levels which assume efficient levels of operation, but which include allowances for normal loss, waste and machine downtime (CIMA Official Terminology). Current standard A current standard is the standard of performance that is currently being achieved.

4 CRITICISMS OF STANDARD PRODUCT COSTING  Standard product costs are associated with traditional manufacturing systems producing large quantities of standard items. Standard costing in manufacturing has often been criticised, for reasons largely connected to the fact that this type of manufacturing environment is not as common today as it has been in the past. – Standard product costs apply to manufacturing environments in which quantities of an identical product are output from the production process. They are not suitable for manufacturing environments where products are non-standard or are customised to customer specifications.

FTC FOULKS LYNCH 79 CHAPTER 7 STANDARD COSTS – It is doubtful whether standard costing is of much value for performance setting and control in automated manufacturing environments. – The significance of variances for management control purposes depends on the type of standard cost used. For example, adverse variances with an ideal standard have a different meaning from adverse variances calculated with a current standard. – Standard costing is inconsistent with the concept of continuous improvement, which is applied within Total Quality Management and JIT environments. – When standard costing was first devised, the main elements of product costs were direct materials and direct labour. In modern manufacturing, production overheads costs are often a high proportion of total production costs.

5 STANDARD COSTS FOR SERVICES  Although standard costing was originally devised for manufacturing and product costs, it also has applications in service industries.  Efficiency improvements are typically achieved: – by replacing labour with machinery as much as possible, and – by standardising the service for all customers, with no customisation.  This approach to service provision is well illustrated by the concept of McDonaldization. This comes from the successes of the fast food company. The term was defined by George Ritzer (1996) as ‘the process by which the principles of the fast-food restaurant are coming to dominate more and more sectors of American society, as well as the rest of the world.’  Ritzer identified four dimensions to McDonaldization which are critical to the success of the model.

80 FTC FOULKS LYNCH STANDARD COSTS CHAPTER 7 – Efficiency. This means choosing the optimum means to achieve a given end. – Calculability. This means the ability to produce and obtain large quantities of something very quickly. – Control. There should be effective controls over both employees and customers. – Predictability. Customers (and employees) should know exactly what they are going to get at any service point anywhere in the world.  Other principles on which McDonaldization is based are that: – When goods and services are more uniform in quality, quality will be better. – Standardisation of services is less expensive than customisation. – Customers like familiarity, and feel that it is safer to do things within a controlled regime. – People like to be treated in the same way as everyone else.  This approach has made McDonalds successful, and generated huge profits.  The relevance of standard costing to services of this nature should be apparent. Management should be able to set accurate standards for what is takes, in terms of materials and time, to provide standard items to customers. This in turn means that costs are both minimised and predictable, and with predictable costs, it becomes possible to set prices that customers see as fair (or even better) and still make a large profit.

 Diagnostic related groups are another application of standards in a service industry. The concept was developed in US healthcare in the early 1980s as a means of controlling the costs of the Medicare health service. In broad terms, patients are placed into one of several standard categories of condition and treatment, and the amount that Medicare will pay the hospitals providing the treatment is based on a standard price for that category.  A diagnostic related group (DRG) is a category of disease or medical condition for which diagnosis and treatment are similar. For each DRG, a standard cost is calculated for diagnosis and treatmentbased on estimates of the standard consumption of hospital resources required and the expected length of stay in hospital. This uniform cost for each DRG is then used by Medicare and other medical insurers as the basis for payments to the hospitals.  Since the system sets a maximum amount that will be paid for the care of Medicare patients, it provides an incentive to hospital management to meet the standards and keep their costs down.

82 FTC FOULKS LYNCH CHAPTER 8 VARIANCE ANALYSIS

1 STANDARD COSTING VARIANCES  Where standard costing is used, variance analysis can be an important aspect of performance measurement and control.  Variance reports comparing actual results with the standards or budget are produced regularly, perhaps monthly. Cost variances  A hierarchy of cost variances is shown below. Total cost variances

Direct Direct Variable Fixed material labour cost overhead overhead cost variance cost variance cost variance variance

Price Usage Rate Efficiency Expenditure Efficiency Expenditure Volume

Mix Yield Mix Yield Notes  This table of variances is for a standard absorption costing system. In a standard marginal costing system, there is no fixed overhead volume variance.  Mix and yield variances are only calculated when there is more than one direct material in the product or more than one grade or type of labour.

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2 DIRECT MATERIALS COST VARIANCES Direct materials total cost variance  The total cost variance for direct materials is the difference between the actual and standard direct materials costs of the output. It is calculated as follows: Direct materials cost: $ Actual quantity of output should cost (standard) X did cost Y Total cost variance X – Y Direct materials price variance  A direct materials price variance is the difference between: – the actual price of the direct materials purchased or used, and – their standard price.  It is calculated as follows: Direct materials price $ variance: Quantity of materials should cost (standard X purchased/used price) did cost (actual purchase cost) Y Direct material price X – Y variance Direct materials usage variance  A direct materials usage variance is the difference between: – the actual quantity of direct materials used to produce the actual output in the period, and – the standard quantity that should have been used to produce the actual output.

84 FTC FOULKS LYNCH VARIANCE ANALYSIS CHAPTER 8

 It is calculated as follows: Direct materials usage variance: Materia l quantity (units) Actual output produced should use (standard X quantity) did use (actual quantity) Y Direct material usage (in material quantity) X – Y variance × Standard price per unit of material $P Direct material usage $P × (X – Y) variance

3 DIRECT LABOUR COST VARIANCES Direct labour total cost variance  The total cost variance for direct labour is the difference between the actual and standard direct labour costs of the output produced.  It is calculated as follows: Direct labour cost: $ Actual quantity of output should cost (standard) X did cost Y Total cost variance X – Y This variance is favourable (F) if the actual cost is less than the standard cost, and adverse (A) or unfavourable (U) if the actual cost is higher than the standard cost. Direct labour rate variance  A direct labour rate variance is the difference between: – the standard rate for the hours actually worked, and – the actual cost of the labour.

 It is calculated as follows: Direct labour rate $ variance: Number of hours worked should cost (standard rate) X did cost (actual cost) Y Direct labour rate variance X – Y Direct labour efficiency variance  A direct labour efficiency variance is the difference between: – the actual direct labour hours to produce the actual output in the period, and – the standard number of hours to produce the actual output. This difference is measured first of all in labour hours and is then converted into a money value at the standard rate per direct labour hour.  It is calculated as follows: Direct labour efficiency variance: Hours Actual output produced should take (standard X hours) did use (actual hours) Y Direct labour efficiency (in hours) X – Y variance

× Standard rate per hour $R Direct labour efficiency $R × (X – Y) variance Idle time and idle time variances  The purpose of an efficiency variance should be to measure the efficiency of the work force in the time they are actively

86 FTC FOULKS LYNCH VARIANCE ANALYSIS CHAPTER 8 engaged in making products or delivering a service. During a period, there might be idle time.  When this occurs, and if it is recorded, the efficiency variance should be separated into two parts: – an idle time variance – an efficiency variance during active working hours.  An idle time variance is always adverse, because it represents money ‘wasted’.

4 VARIABLE OVERHEAD COST VARIANCES  In standard product costing, a variable production overhead total cost variance can be calculated, and this can be analysed into an expenditure or rate variance and an efficiency variance.  With service costing, a variable overhead total cost variance can be calculated, but this might not be analysed any further. Variable production overhead total cost variance  The total cost variance for variable production overhead is the difference between the actual and standard direct variable overhead costs of the output produced.  A variable production overhead total cost variance is calculated as follows: Variable production overhead cost: $ Actual quantity of output should cost (standard) X did cost Y Total cost variance X – Y Variable production overhead expenditure variance  A variable production overhead expenditure variance is the difference between:

FTC FOULKS LYNCH 87 CHAPTER 8 VARIANCE ANALYSIS – the standard variable overhead cost for the hours worked, and – the actual variable overhead cost.  A variable production overhead expenditure variance is calculated as follows: Variable production overhead expenditure variance: $ Number of hours worked should cost (standard X rate) did cost (actual cost) Y Variable production overhead expenditure variance X – Y Variable production overhead efficiency variance  A variable production overhead efficiency variance is the difference between: – the actual direct labour hours to produce the actual output in the period, and – the standard number of hours to produce the actual output.  This difference is measured first of all in labour hours and is then converted into a money value at the standard variable overhead rate per direct labour hour.  A variable production overhead efficiency variance is calculated as follows: Variable production overhead efficiency variance: Hours Actual output produced should take (standard X hours) did use (actual hours) Y Efficiency variance (in hours) X – Y

× Standard variable overhead rate per hour $R Variable production overhead efficiency variance $R × (X – Y)

88 FTC FOULKS LYNCH VARIANCE ANALYSIS CHAPTER 8 Idle time variances and variable production overhead  The analysis of variable production overhead variances is affected by the existence of idle time.  The variable production overhead efficiency variance is calculated in the same way that the direct labour efficiency variance is calculated when there is idle time.  The variable production overhead expenditure variance, when there is idle time, is the difference between: – the standard variable overhead cost of the active hours worked, and – the actual variable overhead cost.

5 FIXED OVERHEAD COST VARIANCES: ABSORPTION COSTING Fixed production overhead: total cost variance  The total cost variance for fixed production overhead variances is the amount of over-absorbed or under-absorbed overhead. The amount of overhead absorbed for each unit of output is the standard fixed overhead cost per unit. The total cost variance is therefore calculated as follows: Fixed production overhead total cost variance: $ Overheads absorbed (actual output × standard X fixed cost per unit) Actual fixed overhead incurred Y Fixed production overhead total cost variance X – Y  The fixed overhead cost per unit is based on estimates of the budgeted fixed overhead expenditure for the period and the volume of production. The fixed production overhead total cost variance can be analysed into two subsidiary variances: – a fixed overhead expenditure variance, and

FTC FOULKS LYNCH 89 CHAPTER 8 VARIANCE ANALYSIS – a fixed overhead volume variance.

Fixed overhead expenditure variance  A fixed overhead expenditure variance is the difference between the budgeted fixed overhead expenditure and the actual fixed overhead expenditure. Fixed overhead expenditure variance: $ Budgeted fixed overhead X Actual fixed overhead incurred Y Fixed overhead expenditure variance X – Y  A similar variance can be calculated (if required) for other fixed overhead costs: – a fixed administration overhead expenditure variance – a fixed sales and distribution overhead expenditure variance. Fixed production overhead volume variance  A fixed production overhead volume variance represents the amount of fixed overhead that has been under- or over- absorbed due to the fact that actual production volume differed from the budgeted production volume. Fixed production overhead volume variance: Units Actual output produced X Budgeted output Y Volume variance (in units) X – Y × Standard fixed overhead rate per unit $F Fixed production overhead volume $F × (X – Y) variance

FTC FOULKS LYNCH 91 CHAPTER 8 VARIANCE ANALYSIS 6 FIXED OVERHEAD VARIANCES: MARGINAL COSTING  In marginal costing, fixed overheads are not absorbed into the cost of production. For this reason, there is no fixed overhead volume variance.  The only fixed overhead variance reported in standard marginal costing is a fixed overhead expenditure variance. This is the difference between actual and budgeted fixed overhead expenditure, as described above for absorption costing.

7 SALES VARIANCES  Sales variances explain the effect of differences between: – actual and standard sales prices, and – budgeted and actual sales volumes. Sales price variance  A sales price variance shows the effect on profit of the difference between the standard sales prices for the items sold in a period and the actual sales revenue achieved.  It is calculated as follows: Sales price variance $ Units sold should have (units sold × standard sales X sold for price per unit) Budgeted output Y Sales price variance X – Y Sales volume variance  The sales volume variance is the difference between actual and budgeted sales volumes. It can be measured in any of the following ways:

92 FTC FOULKS LYNCH VARIANCE ANALYSIS CHAPTER 8 – if there is only a single product or service, as the difference between actual and budgeted units of sale – as the difference in standard sales revenue between actual and budgeted units of sale: (standard sales revenue = units sold at their standard sales price, not their actual sales price) – as the difference in standard profit between actual and budgeted sales volumes – as the difference in standard contribution between actual and budgeted sales volumes.  A sales volume variance measured either in units or standard sales revenue has to be calculated first. Sales volume variance Units of Units of sale × sale standard sales price units $ revenue Budgeted sales volume X S × X Actual sales volume Y S × Y Sales volume variance X – Y S × (X – Y) (where S is the standard sales price per unit)  A sales volume variance expressed in terms of standard profit or standard contribution is called a sales volume margin variance. Sales volume profit variance (standard absorption costing) Units of sale × Units of sale standard sales price units $ revenue Budgeted sales X S × X volume Actual sales volume Y S × Y Sales volume X – Y S × (X – Y) variance × Standard profit × Standard × Standard profit/sales profit per unit ratio = Sales volume profit margin variance

Sales volume profit variance (standard marginal costing) Units of sale × Units of sale standard sales price Units $ revenue Budgeted sales X S × X volume Actual sales volume Y S × Y Sales volume X – Y S × (X – Y) variance

× Standard × Standard × Standard contribution contribution contribution /sales ratio per unit

= Sales volume contribution margin variance

8 STANDARD COSTING IN COSTING SYSTEMS  Standard costing can be applied within cost ledger systems.  Only cost variances are recorded in the cost ledger.  Variances are recorded within the double entry system using either a single cost variances account, or a separate variance account for each type of cost variance.  In the variance account, an adverse variance is a debit entry and a favourable variance is a credit entry.  The double entry is recorded as follows: (i) materials price variance: in the stores ledger control account (materials account) (ii) direct labour rate variance: in the wages and salaries control account (iii) materials usage variance and direct labour efficiency variance: in the WIP control account

FTC FOULKS LYNCH 95 CHAPTER 8 VARIANCE ANALYSIS (iv) production overhead variances: in the production overhead account.  At the end of an accounting period, the balances on the cost variance accounts are transferred to the income statement.

96 FTC FOULKS LYNCH CHAPTER 9 MIX AND YIELD VARIANCES

1 THE NATURE OF MIX AND YIELD VARIANCES  Mix variances might be calculated when there is a mix of two or more items, and the mix is regarded as controllable by management. Materials Labour usage efficiency

Materials Materials Labour Labour mix yield mix yield  If the mix cannot be controlled, it is inappropriate to calculate a mix and yield variance. Instead, a usage variance should be calculated for each individual material or an efficiency variance should be calculated for each individual type or grade of labour. In other words, if the mix cannot be controlled, the usage or efficiency variance should not be analysed into a mix and yield variance. The nature of a mix variance  Measures whether the actual mix that occurred was more or less expensive than the standard mix. The nature of the yield variance  Assumes that the mix of materials or labour can be controlled.  The material usage should therefore be assessed for all the materials combined, not for each item of material separately.

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 Similarly, the labour efficiency variance should be assessed for the labour team as a whole, not for each grade of labour separately.  A yield variance is therefore an overall usage variance or efficiency variance for all the items in the mix.

2 MATERIALS MIX AND YIELD VARIANCES  A materials yield variance is similar to a materials usage variance. However, instead of calculating a usage variance for each material separately, a single yield variance is calculated for all the materials as a whole. The yield variance is calculated first of all in terms of units of material, and is converted into a money value at the weighted average standard price per unit of material. Units of material Actual output produced should use (in total, for all X materials) It did use (in total, for all materials) Y Yield variance in units of material X – Y × Weighted average standard price per unit of P material Yield variance = P (X – Y)  As with the usage variance, the yield variance is favourable if the actual quantity of materials used is less than standard, and adverse if actual usage is more than standard. Materials mix variance: individual basis of valuation method  There are two ways of calculating the mix variance: – an individual basis of valuation method – an average valuation basis method.  Both methods produce exactly the same total figure for the mix variance. Both methods compare the actual mix of materials with the standard mix.

98 FTC FOULKS LYNCH MIX AND YIELD VARIANCES CHAPTER 9 – The actual mix = the actual quantities of materials used (for each material individually and in total). – The standard mix = the actual total quantity of materials used, with the total divided between the individual materials in the standard proportions. – The mix variance in units of material is the difference between the actual mix and the standard mix. A mix variance is calculated for each individual material in the mix.  Using the individual basis of valuation method: – a mix variance is adverse if the actual quantity of materials used is more than the quantity in the standard mix – a mix variance is favourable if the actual quantity of materials used is less than the quantity in the standard mix – the total of the mix variances for all the materials, in units of material, is always 0.  For each material individually, a mix variance is calculated at the standard price for the material. The total mix variance is the sum of the mix variances for the individual materials. Actual Standard Mix Standard Mix materia mix variance price per variance l usage unit of material Units of Units of Units of $ material material material Material 1 A D (A – D) P1 P1 (A – D) Material 2 B E (B – E) P2 P2 (B – E) Material 3 C F (C – F) P3 P3 (C – F) Total mix X X 0 Y variance Notes (1) The total actual usage of materials and the total of the standard mix are the same.

FTC FOULKS LYNCH 99 CHAPTER 9 MIX AND YIELD VARIANCES (2) Using the individual basis of valuation method, the total mix variance in units of material is always 0. Materials mix variance: average valuation basis method  The average valuation basis method of calculating a mix variance reaches exactly the same total figure for the mix variance, but using a different method.  Using this method: – A mix variance for an individual material is adverse if the actual proportion of the material in the mix indicates that the actual mix will be more expensive than the standard mix. This means that if there is less of a cheaper material in the actual mix than in the standard mix, the mix variance for that material is adverse. – Similarly, a mix variance for an individual material is favourable if the actual proportion of the material in the mix indicates that the actual mix will be less expensive than the standard mix. This means that if there is more of a cheaper material in the actual mix than in the standard mix, the mix variance for that material is favourable. – The mix variance is converted from units of material to a money value at the difference between the standard price for the individual material and the weighted average standard price for all the materials in the mix. Actual Standar Mix Rate Mix variance material d mix variance usage Units of Units of Units of $ $ material material material Material 1 A D (A – D) P1 – AP (P1 – AP) (A – D) Material 2 B E (B – E) P2 – AP (P2 – AP) (B – E) Material 3 C F (C – F) P3 – AP (P3 – AP) (C – F) X X Y

100 FTC FOULKS LYNCH MIX AND YIELD VARIANCES CHAPTER 9 AP = the weighted average standard price of the materials in the standard mix.

FTC FOULKS LYNCH 101 CHAPTER 9 MIX AND YIELD VARIANCES

Rules for the mix variance in units Mix variance is:  Actual usage more than standard mix usage, for a material costing more than Adverse the weighted average cost  Actual usage less than standard mix usage, for a material costing more than Favourable the weighted average cost  Actual usage more than standard mix usage, for a material costing less than Favourable the weighted average cost  Actual usage less than standard mix usage, for a material costing less than Adverse the weighted average cost As a result, the total mix variance in units does not necessarily add up to 0.

3 LABOUR MIX AND YIELD VARIANCES  Labour mix and yield variances are calculated in the same way as materials mix and yield variances.  The labour mix might be controllable where a job is done by a team of individuals with differing skills or experience. – The budgeted cost for the job might be based on a standard mix of the different types of labour. – Management might control the composition of the team by using a greater or lesser proportion of cheaper labour to do the work. – The actual mix of labour used to do the work might therefore differ from the standard or budgeted mix.  A labour yield variance is sometimes called a team productivity variance. It measures the efficiency of the team as a whole, rather than the efficiency of each grade of labour separately.

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 A labour mix variance is sometimes called a team composition variance. It measures whether the actual composition of the labour team was more or less expensive than the standard mix.  Example An audit team consists of senior auditors, junior qualified auditors and unqualified student accountants. The fee for audit work is agreed in advance with the client, and is based on the expected labour cost of the audit team. The expected time required to carry out an audit for client AB was as follows: Grade Expected Rate/cost Total cost hours per hour £ £ Senior auditor 16 280 4,480 Junior qualified 160 120 19,200 Students 64 50 3,200 240 26,880 The actual time spent on the audit work was: Grade Actual hours

Senior auditor 30 Junior qualified 190 Students 50 270 Required: (a) Calculate the labour yield variance. (b) Calculate the labour mix variance, using both the individual basis of valuation method and the average valuation basis method. (c) Show that the labour yield and mix variances add up to the labour efficiency variance. Solution

FTC FOULKS LYNCH 103 CHAPTER 9 MIX AND YIELD VARIANCES (a) The weighted average labour rate per hour is £26,880/240 hours = £112 per hour. Hours Expected time, in total 240 Actual total time 270 Yield variance in hours 30 (A)

× Weighted average standard rate per hour £112 Labour yield variance = £3,360 (A) (b) Labour mix variance: individual basis of valuation method Grade Actual Standard mix Mix Standard Mix hours variance rate per variance hour hours hours hours £ Senior 30 (6.7%) 18 12 (A) £280 3,360 (A) auditor Junior 190 (66.7%) 180 10 (A) £120 1,200 (A) qualified Student 50 (26.7%) 72 22 (F) £50 1,100 (F) 270 270 0 3,460 (A) Labour mix variance: average valuation basis method Actual Standar Mix Rate Mix variance hours d mix variance hours hours hours $ Senior 30 18 12 (A) £(280 – 112) 2,016 (A) Junior 190 180 10 (A) £(120 – 112) 80 (A) Student 50 72 22 (A) £(50 – 112) 1,364 (A) 270 270 3,460 (A)

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(c) Reconciliation to the labour efficiency variance Senior Junior Student hours hours hours Expected time 16 160 64 Actual time 30 190 50 Efficiency variance 14 (A) 30 (A) 14 (F)

× Rate per hour £280 £120 £50 Efficiency variance = £3,920 (A) £3,600 (A) £700 (F) Total labour efficiency variance = £6,820 (A). This equals the sum of the labour yield variance (£3,360 (A)) and the labour mix variance (£3,460 (A)). In this type of situation, management might find the information on mix and yield more useful for control purposes than the efficiency variances for each grade of labour separately.

4 LIMITATIONS OF MIX VARIANCES  Mix and yield variances can provide useful control information, but only where the mix of materials or labour is controllable, and where the information about total yield is more useful than usage/efficiency variances for the individual materials or labour grades separately.  Using mix variances also has some other limitations. – It is often found that the mix and yield variances are interdependent, and one variance cannot be assessed without also considering the other. – If management is able to achieve a cheaper mix of materials or labour, without affecting yield, the standard becomes obsolete. The cheaper mix should become the new standard mix.  Control measures to improve the mix by making it cheaper are likely to affect the quality of the output or the work done. Analysing mix and yield variances for control purposes does not take quality issues into consideration.

FTC FOULKS LYNCH 105 CHAPTER 10 VARIANCE REPORTING AND BENCHMARKING

1 OPERATING STATEMENTS  Variances should be reported to management as soon as possible at the end of each control period. There might be a hierarchy of control reports: – a top level report reconciling budgeted and actual profit – variance reports prepared for managers with responsible for a particular aspect of operations.  An operating statement is a top-level variance report, reconciling the budgeted and actual profit for the period. A suggested format for an operating statement is: Operating statement (absorption costing) for (month) $ $ $ Budgeted profit 35,000 Sales variances (F) (A) Sales price variance 1,000 Sales volume (profit) variance 2,000 3,000 (A) Actual sales less the standard 32,000 cost of sales Cost variances Direct materials price 900 Direct materials usage 8,200 Direct labour rate 4,600 Direct labour efficiency 8,000 Variable production overhead 1,200 expenditure Variable production overhead 1,500

FTC FOULKS LYNCH 106 VARIANCE REPORTING AND BENCHMARKING CHAPTER 10 efficiency Fixed production overhead 2,700 expenditure

$ $ $ Fixed production overhead 1,000 volume Administration overhead 4,500 expenditure Sales and distribution overh’d _____ 3,000 expenditure 14,300 21,300 7,000 (A) Actual profit 25,000

Operating statement (marginal costing) for (month) $ $ $ Budgeted profit 35,000 Budgeted fixed costs 80,000 Budgeted contribution 115,000 Sales variances (F) (A) Sales price variance 1,000 Sales volume (contribution) 3,000 variance 4,000 (A) Actual sales less the standard 111,000 cost of sales Cost variances Direct materials price 900 Direct materials usage 8,200 Direct labour rate 4,600 Direct labour efficiency 8,000 Variable production overhead 1,200 expenditure Variable production overhead 1,500 _____ efficiency 11,600 12,800 1,200 (A)

108 FTC FOULKS LYNCH VARIANCE REPORTING AND BENCHMARKING CHAPTER 10

Actual contribution 109,800 Budgeted fixed costs 80,000 Fixed cost expenditure variances Fixed production overhead 2,700 expenditure Administration overhead 4,500 expenditure Sales and distribution overh’d ____ 3,000 expenditure 2,700 7,500 4,800 (A) Actual profit 25,000

2 INTERPRETATION OF VARIANCES  For control purposes, management might need to establish why a particular variance has occurred: – to prevent an adverse variance continuing in the future, or – to repeat a favourable variance in the future, or – to bring actual results back on course to achieve the budgeted targets.  If the budget or standard is reasonable, possible operational causes of variances are as follows: Variance Possible cause Material price  Using a different supplier, who is either cheaper or more expensive.  An unexpected increase in the prices charged by a supplier.  Unexpected buying costs.  Efficient or inefficient buying procedures.  A change in material quality.

Material usage  A higher-than-expected or lower-than- expected rate of scrap or wastage.  Better quality control.  More efficient work procedures, resulting in better material usage rates.  Changing the materials mix. Labour rate  An unexpected increase in basic rates of pay.  Payments of bonuses, where these are recorded as direct labour costs.  A change in the composition of the work force, and so a change in average rates of pay. Labour efficiency  Taking more or less time than expected to complete work.  Improved working methods.  Industrial action by the work force  Poor supervision.  Unexpected lost time due to production bottlenecks and resource shortages. Overhead  Fixed overhead expenditure adverse variances variances are caused by spending in excess of the budget.  Variable production overhead efficiency variances: the causes are similar to those for a direct labour efficiency variance. Sales price  Higher-than-expected discounts offered to customers to persuade them to buy, or due to purchasing in bulk.  The effect of low-price offers during a marketing campaign.  Unexpected price increases.

Sales volume  Successful or unsuccessful direct selling efforts.  Successful or unsuccessful marketing efforts (for example, the effects of an advertising campaign).  Unexpected changes in customer needs and buying habits.  Higher demand due to a cut in selling prices, or lower demand due to an increase in sales prices. Possible interdependence between variances  In many cases variances are inter-related.  Some examples of interdependence between variances are: – Using cheaper materials will result in a favourable material price variance, but using the cheaper material in production might increase the wastage rate (adverse material usage) and cause a fall in labour productivity (adverse labour and variable overhead efficiency). – A more expensive mix of materials (adverse mix variance) might result in higher output yields (favourable yield variance). – Using more experienced labour to do the work will result in an adverse labour rate variance, but productivity might be higher as a result (favourable labour and variable overhead efficiency). – Changing the composition of a team might result in a cheaper labour mix (favourable mix variance) but lower productivity (adverse yield variance).

3 THE CONTROLLABILITY PRINCIPLE IN VARIANCE REPORTING  Controllability means the extent to which a specific manager can control costs or revenues. This means that variances should be reported to the managers who are in a position to control the costs or revenues to which the variances relate. Composite variances  Sometimes a variance might be caused by a combination of two factors – a composite variance. To apply the controllability principle, the variance should be reported to each of the managers who is in a position to control one of the factors.

4 THE SIGNIFICANCE OF VARIANCES  In order to interpret a variance, management must carry out some investigations, which will cost time and money.  Variances should only be investigated if they seem to be significant, so that it is worth trying to establish their cause with a view to taking control action. – Reporting by exception – particular attention is given to the aspects of performance that appear to be exceptionally good or bad. – Cumulative variances and control charts – a method of identifying significant variances only if the cumulative total for the variance over several control periods exceeds a certain limit.  The reason for this approach is that variances each month might fluctuate, with adverse variances in some months and favourable variances in the next. Provided that over time, actual results remain close to the standard, monthly variances might be acceptable.

112 FTC FOULKS LYNCH VARIANCE REPORTING AND BENCHMARKING CHAPTER 10 Control chart Cumulative variances $ Favourable Control Limit

MONTHS

Control Limit Adverse Month £2,000 (A) £3,000 (F) £5,000 (A) £1,000 (F) £6,000 (A) Cumulative £2,000 (A) £1,000 (F) £4,000 (A) £3,000 (A) £9,000 (A)  In this example, the cause or causes of this variance will not be investigated until the cumulative total of variances exceeds the control limit of £8,000 adverse. (This type of control chart might be called a cusum chart. ‘Cusum’ stands for ‘cumulative sum of the variances’.)

5 BEHAVIOURAL IMPLICATIONS OF SETTING STANDARD COSTS  The aims of setting standards include: – setting a target for performance – motivating the managers responsible to achieve those targets – holding these managers accountable for actual performance – perhaps rewarding managers for good performance and criticising them for poor performance.

 Managers and employees might respond in different ways to standard setting.

Standards as a target for achievement  Individuals might respond to standards in different ways, according to the difficulty of achieving the standard level of performance. – When a standard level of performance is high, for example an ideal standard, employees and their managers will recognise that they cannot achieve it. Since the target is not achievable, they might not even try to get near it. – When the standard of performance is not challenging (for example, a current standard), employees and their managers might be content simply to achieve the standard without trying to improve their performance. – An attainable standard might be set that challenges employees and their managers to improve their performance. If this attainable standard is realistic, it might provide a target that they try to achieve. Standard costs and motivation  An argument in favour of setting attainable standards is that they can be used to motivate employees and their managers to improve performance. – If the standard is too difficult, it could have the opposite effect and de-motivate individuals. – Even if the standard is attainable, individuals will not necessarily be motivated to achieve it. It might be necessary to provide motivation in the form of a bonus or other type of reward for achieving the standard. – Individuals might prefer standards to be set at a low level of performance, in order to avoid the need to work harder.

Participation in standard setting  It has been suggested that if managers and employees can participate in the standard setting process, their motivation will improve.  Arguments in favour of Arguments against participation participation It could motivate employees Senior management might be to set higher standards for reluctant to share responsibilities achievement. for budgeting. Staff are more likely to accept The standard-setting process standards that they have been could be time-consuming. involved in setting. Morale and actual Staff might want to set standards performance levels might be that they are likely to achieve, improved. rather than more challenging targets. They might try to build some ‘slack’ into the budget. Staff will understand more The standard setting process clearly what is expected of could result in conflicts rather them. than co-operation and collaboration. Staff might feel that their suggestions have been ignored. Pay as a motivator  If standards are used as a way of encouraging employees to improve their performance, motivation could be provided in the form of higher pay (or other rewards) if targets are reached or exceeded.  However, if employees are offered a bonus for achieving standard costs, this could increase their incentive to set low standards of performance, and include ‘slack’ in the standard cost.

Behavioural aspects of adverse variances  It should also be remembered that individual managers might respond in different ways to performance reports that contain adverse variances.  If there is a culture of ‘blame’ when adverse variances occur, managers might try to disguise their poor results.  The response to adverse variances needs to be more positive. The aim of reporting adverse variances is to indicate problems that might have occurred, and encourage managers to take action to deal with their cause.

6 BENCHMARKING  In addition to monitoring performance through variance analysis, or as an alternative to variance reporting, organisations might use benchmarking to: – monitor their performance, and – set targets for improved performance.  Benchmarking was pioneered by Xerox Business Systems in the late 1970s as a tactical planning tool, in response to the challenge from rival Japanese producers of photocopier machines.  The reasons for benchmarking might be summarised as: – to receive an alarm call about the need for change – learning from others in order to improve performance – gaining a competitive edge (in the private sector) – improving services (in the public sector). Different types of benchmarking  Internal benchmarking – against other units in the department.

 Competitive benchmarking – the most successful competitors are used as the benchmark.  Functional benchmarking – comparisons are made with a similar function in other organisations that are not direct competitors.  Strategic benchmarking – a form of competitive benchmarking aimed at reaching decisions for strategic action and organisational change.  Companies in the same industry might agree to join a collaborative benchmarking process, managed by an independent third party such as a trade organisation. The benchmarking process  Identify gaps in performance through comparisons with other organisations.  Seek a fresh approach to achieve an improvement in performance where significant gaps are found. This does not necessarily mean copying what the other organisation does.  Implement the improvements.  Monitor progress.  Repeat the process.  Benchmarking should be a continual process, not a ‘one-off’ exercise. Performance measures  Gaps in performance are identified by comparing an organisation’s own performance with the performance of the organisation acting as the benchmark.  Several measures of performance will be used. Each measure should be a key performance measure, critical to the success of the organisation.

 Performance measures can be financial or non-financial.  Ideally performance should be quantifiable and measurable, although qualitative assessments and comparisons might be necessary.  The information available for comparison will depend on whether it has been provided voluntarily by the benchmark. Co- operative benchmarking should provide more extensive information.

FTC FOULKS LYNCH 119 CHAPTER 11 PLANNING AND OPERATIONAL VARIANCES

1 EX ANTE AND EX POST STANDARDS  Planning and operational variances are a method of reporting variances where a fault in the standard or budget has been identified retrospectively, and the original budget or standard is considered to be inappropriate. – The ex ante standard (or budget) is the original standard (or budget). – The ex post standard (or budget) is a realistic standard (or budget) that is established retrospectively, as something that should realistically have been achievable.  Variances can then be reported using these two standards that separate the effects on performance of: – getting the original standard or budget wrong (a planning variance), and – variances due to operational factors (operational variances).  Example A business might estimate that it should take 2 hours of direct labour to make one unit of product T33 at a rate of $8 per hour. The standard direct labour cost is therefore $16 per unit of T33. During the course of the accounting period, it might be recognised that due to a change in working methods, it should require only 1.5 hours of direct labour to make one unit, and that a realistic direct labour cost should be $12 per unit, not $16. Management might therefore decide that variances for the period should be reported as planning and operational variances. – The ex ante direct labour standard cost is 2 hours × $8 = $16 per unit.

FTC FOULKS LYNCH 120 PLANNING AND OPERATIONAL VARIANCES CHAPTER 11 – The ex post direct labour standard cost is 1.5 hours × $8 = $12 per unit.  There must be a good reason for deciding that the original standard cost is unrealistic. Deciding in retrospect that expected costs should be different from the standard should not be an arbitrary decision, aimed perhaps at shifting the blame for poor results from poor operational management to poor cost estimation. A good reason for a change might be: – a change in one of the materials used to make a product – an unexpected increase in the price of materials due to a rapid increase in world market prices – a change in working methods and procedures that alters the expected direct labour time for a product or service – an unexpected change in the rate of pay to the work force.

2 OPERATIONAL VARIANCES  Operational variances are variances that are assumed to have occurred due to operational factors. These are materials price and usage variances, labour rate and efficiency variances, variable overhead efficiency variances, overhead expenditure variances, and sales variances.  Operational variances are calculated with the ‘realistic’ ex post standard.

3 PLANNING VARIANCES  A planning variance measures the difference between the budgeted and actual profit that has been caused by errors in the original standard cost. It is the difference between the ex ante and the ex post standards.

 A planning variance is favourable when the ex post standard cost is lower than the original ex ante standard cost.  A planning variance is adverse when the ex post standard cost is higher than the original ex ante standard cost.  For example, when the ex ante direct labour standard cost is 2 hours per unit and the ex post standard is 1.5 hours, the effect of the change is to make the standard cost lower, since the production time is shorter. The planning variance would therefore be favourable, and actual profit should be higher than the budgeted profit as a consequence.  Example The ex ante standard marginal cost of product T33 is as follows: $ Direct materials: 2 kilos at $7 per kilo 14 Direct labour: 2 hours at $8 per hour 16 30 The standard sales price per unit is $70, giving a standard contribution per unit of $40. Budgeted production and sales were 1,000 units. It was subsequently recognised that due to a change in operating procedures, the standard time to produce a unit of T33 should have been 1.5 hours. Actual production and sales were 1,100 units, and other actual results were: $ $ Sales revenue at $70 per unit 77,000 Direct materials: 2,200 kilos at $7.50 per 16,500 kilo Direct labour: 1,800 hours at $8 per hour 14,400 Total variable costs 30,900 Actual contribution 46,100 Required:

122 FTC FOULKS LYNCH PLANNING AND OPERATIONAL VARIANCES CHAPTER 11 Calculate the planning and operational variances for the period.

Solution Operational variances These are calculated using the realistic ex post standard. The only operational variances in this example are for materials price and labour efficiency, since actual materials usage (2 kilos per unit) and the actual labour rate ($8 per hour) and sales price per unit ($70) were the same as the ex post standard. However, there is also a sales volume contribution margin variance, and this is calculated using the original (ex ante) standard contribution of $40 per unit. $ 2,200 kilos should cost (× $7) 15,400 They did cost 16,500 Materials price variance 1,100 (A)

Hours 1,100 units of T33 should take (× 1.5 hours) 1,650 They did take 1,800 Direct labour efficiency variance (in hours) 150 (A) Standard rate per hour $8 Direct labour efficiency variance $1,200 (A)

Units Budgeted sales of T33 1,000 Actual sales of T33 1,100 Sales volume variance (in units) 100 (F) Ex ante standard contribution per unit $40 Sales volume contribution variance $4,000 (F)

124 FTC FOULKS LYNCH PLANNING AND OPERATIONAL VARIANCES CHAPTER 11

Planning variance The planning variance is based on actual units produced. Per unit hours Ex ante standard per unit 2.0 Ex post standard per unit 1.5 Planning variance per unit 0.5 (F)

Units produced × 1,100 Standard rate per hour × $8 Total planning variance $4,400 (F) The planning and operational variances together explain the difference between the budgeted and actual contribution. Operating statement $ Budgeted contribution (1,000 units × $40) 40,000 Sales volume variance 4,000 (F) 44,000 Planning variance 4,400 (F) Actual sales volume at ex post standard 48,400 contribution (1,100 units × $44) Operational variances Material price 1,100 (A) Labour efficiency 1,200 (A) Actual contribution 46,100

4 MORE THAN ONE DIFFERENCE BETWEEN THE EX ANTE AND EX POST STANDARDS  In these circumstances, the rules for calculating planning and operational variances are as follows: – Operational variances are calculated using the ex post standard. – The planning variance is the difference between the ex ante and the ex post standard cost per unit, multiplied by the number of units.

FTC FOULKS LYNCH 125 CHAPTER 11 PLANNING AND OPERATIONAL VARIANCES – It might be possible to analyse the planning variance into the amount of planning variance caused by each of the differences between the ex post and ex ante standard.  Example A company budgeted to make and sell 2,000 units of its only product, for which the standard marginal cost is: $ Direct materials: 4 kilos at $2 per kilo 8 Direct labour: 3 hours at $6 per hour 18 26 The standard sales price is $50 per unit and the standard contribution $24 per unit. Budgeted fixed costs were $30,000, giving a budgeted profit of $18,000. Due to severe material shortages, the company had to switch to a less efficient and more expensive material, and it was decided in retrospect that the realistic (ex post) standard direct material cost should have been 5 kilos at $3 per kilo = $15 per unit. Actual results were as follows: Actual production and sales: 2,400 units $ $ Sales revenue 115,000 Direct materials: 12,300 kilos at $3 per kilo 36,900 Direct labour: 7,500 hours at $6.10 per hour 45,750 Total variable costs 82,650 Actual contribution 32,350 Actual fixed costs 32,000 Actual profit 350 Required: Prepare an operating statement with planning and operational variances that reconciles the budgeted and actual profit figures.

Solution Operational variances $ 12,300 kilos should cost (× $3) 36,900 They did cost 36,900 Materials price variance 0 Kilos 2,400 units of product should use (×5 kilos) 12,000 They did use 12,300 Direct materials usage variance (in kilos) 300 (A)

Standard price per kilo (ex post) $3 Direct materials usage variance $900 (A) $ 7,500 hours should cost (× $6) 45,000 They did cost 45,750 Direct labour rate variance 750 (A) Hours 2,400 units of product should take (× 3 7,200 hours) They did take 7,500 Direct labour efficiency variance (in hours) 300 (A)

Standard rate per hour $6 Direct labour efficiency variance $1,800 (A) $ 2,400 units should sell for (× $50) 120,000 They did sell for 115,000 Sales price variance 5,000 (A) $ Budgeted fixed costs 30,000 Actual fixed costs 32,000 Fixed cost expenditure variance 2,000 (A)

FTC FOULKS LYNCH 127 CHAPTER 11 PLANNING AND OPERATIONAL VARIANCES Units Budgeted sales 2,000 Actual sales 2,400 Sales volume variance (in units) 400 (F)

Ex ante standard contribution per unit $24 Sales volume contribution variance $9,600 (F) Planning variance Material costs Per unit $ Ex ante standard per unit (4 kilos × $2) 8.0 Ex post standard per unit (5 kilos × $3) 15.0 Planning variance per unit 7.0 (A)

Units produced × 2,400 Total planning variance $16,800 (A)

The planning variance is due to changes in the standard for both the material usage per unit of product and the material price per kilo. This could be analysed as follows: Planning variance due to: $ Change in material usage: 4,800 (A) 1 kilo per unit × $2 per kilo × 2,400 units Change in material price: $1 per kilo × 4 kilos per unit × 2,400 units 9,600 (A) Composite variance: $1 per kilo × 1 kilo per unit × 2,400 units 2,400 (A) Total planning variance 16,800 (A) In this example, since the change in both the material usage and material price are inter-related, the total planning variance only is reported in the operating statement below.

$ $ Budgeted profit 18,000 Budgeted fixed costs 30,000 Budgeted contribution 48,000 Sales volume contribution variance 9,600 (F) 57,600 Planning variance 16,800 (A) 40,800 Operational variances Sales price 5,000 (A) Materials usage 900 (A) Direct labour rate 750 (A) Direct labour efficiency 1,800 (A) Actual contribution 32,350 Budgeted fixed costs 30,000 Fixed cost expenditure variance 2,000 (A) Actual fixed costs 32,000 Actual profit 350

5 PLANNING AND OPERATIONAL VARIANCES AND LEDGER ACCOUNTING  When an organisation has cost ledger accounts with standard costs, it will continue to use the original ex ante standard cost in the ledger accounts. Planning and operational variances are used for reporting and control purposes, not in the ledger accounts.  However, if a change in the standard cost is likely to be permanent rather than temporary, the organisation might decide to revise its standard cost.

Using planning and operational variances  Planning and operational variances analyse the difference between budgeted and actual results that appear to be due to: – planning mistakes or unforeseen changes, and – operational factors.  The aim of variance reporting should be to: – identify responsibilities for performance, and – attempt to put a realistic value to the costs or benefits arising from that performance.

130 FTC FOULKS LYNCH CHAPTER 12 THE BUDGETING FRAMEWORK

1 REASONS FOR FORECASTING AND PLANNING BY ORGANISATIONS  A forecast is an estimate of what is expected to happen in the future. – It can be either qualitative or quantitative. – It could be either financial or non-financial in nature, or a combination. – Forecasts can be short-term, medium-term or long- term. Forecasts over the short term should be more reliable than longer-term predictions.  Organisations need to prepare forecasts in order to: – look to the future, and – assess what they must do to meet the future challenges or opportunities they face. If any problems are foreseen, they can take measures in advance to deal with them. Forecasts provide a basis for planning. The reasons for planning  A plan is a chosen course of action, decided in advance. – A plan might be based on forecasts for the future. – The purpose of a plan should be to achieve an objective or several objectives. – As a result of the action plan, the forecasts might be changed.

FTC FOULKS LYNCH 131 CHAPTER 12 THE BUDGETING FRAMEWORK

 When a plan is decided, the current forecasts and the planned outcome should be the same. Subsequently, however, forecasts might be revised and differ from the planned outcome.  Planning is a formalised process, and the main reasons why organisations plan are to: – establish objectives – set targets for meeting these objectives over time – communicate the objectives and targets – establish how the targets should be achieved – co-ordinate the efforts of everyone in the organisation, to work towards the common objectives, over the short, medium and long term – assess what resources will be required to achieve the targets and ensure that these should be available – give authority to managers within the organisation to take certain actions – monitor progress towards objectives, by comparing actual results against the plan – measure performance standards, by comparing them with the plan.

2 BUDGETING AND THE PURPOSES OF BUDGETING  A budget can be defined as a written statement of management plans for a specified time period, expressed in financial terms. The budget period is typically the financial year of the organisation. (Longer-term budgets are prepared for capital expenditure, but are usually reviewed and revised annually.)  The purposes of budgets are: – Planning. A budget is a medium-term plan, setting targets for achievement over the financial period. Management use budgets to quantify the amount of

132 FTC FOULKS LYNCH THE BUDGETING FRAMEWORK CHAPTER 12 resources that will be needed and check that they expect the resources to be available. – Communication. A budget is a formal written document that can be communicated to everyone involved in putting the plan into practice. Individual managers are told what is expected of them and how much they are able to spend to meet their targets. – Co-ordination. A budget provides a means of co- ordinating the efforts of everyone within the organisation, because individual targets are set within the framework of the plan for the organisation as a whole. – Motivation. It could be argued that budgeting can motivate individuals, by setting challenging targets and offering the prospect of rewards for achieving them. – Authorisation. When a budget is agreed, the managers of responsibility centres should be authorised to spend the money and obtain the resources permitted by the budget. – Control. A budget can be used for control purposes. – Evaluation. Budgets can be used to measure and evaluate performance, by comparing actual results with the budget targets.

3 FUNCTIONAL BUDGETS AND THE MASTER BUDGET  A master budget for the entire organisation brings together the departmental or activity budgets for all the departments or responsibility centres within the organisation.  Most start with: – Sales budget – future sales, expressed in revenue terms and possibly also in units of sale. – Production budget – follows on from the sales budget, since production quantities are determined by sales volume. The production volume will differ from sales

FTC FOULKS LYNCH 133 CHAPTER 12 THE BUDGETING FRAMEWORK volume by the amount of any planned increase or decrease in inventory.  In order to express the production budget in financial terms (production cost), subsidiary budgets must be prepared for materials, labour and production overheads.  These stages in budgeting are illustrated in the following diagram. Budget preparation

Step 1 SALES BUDGET

Step 2 PRODUCTION BUDGET

Step 3 RAW MATERIALS LABOUR FACTORY OVERHEAD

COST OF GOODS SOLD BUDGET

SELLING AND GENERAL AND Step 4 DISTRIBUTION EXPENSES ADMINISTRATION BUDGET EXPENSES BUDGET

MASTER BUDGET

Step 5 BUDGETED INCOME STATEMENT

CAPTIAL EXPENDITURE Step 6 CASH BUDGET BUDGET

Step 7 BUDGETED BALANCE SHEET

134 FTC FOULKS LYNCH THE BUDGETING FRAMEWORK CHAPTER 12

Principal budget factor  It is usually assumed in budgeting that sales demand will be the key factor setting a limit to what the organisation can expect to achieve in the budget period. H however, there might be a shortage of a key resource, such as cash, raw material supplies, skilled labour or equipment. If a resource is in restricted supply, and the shortage cannot be overcome, the budget for the period should be determined by how to make the best use of this key budget resource.  When a key resource is in short supply and affects the planning decisions, it is known as the principal budget factor or limiting budget factor. Other budgets  The budgets illustrated above relate to profitability and the balance sheet. Other budgets are: – A cash budget is a plan of cash flows during the budget period. Cash management is a critical area of financial management. – A capital expenditure budget is a plan for spending on capital items over a planning horizon of several years, and which is reviewed and updated annually.

4 RESPONSIBILITY ACCOUNTING  A master budget is built up from the budgets of different departments or operating groups within the organisation. For example: – a total sales budget brings together the sales budget for each sales area or region, or for each product or service – a total production budget brings together the production budget for each production centre or department, as well as for each product

FTC FOULKS LYNCH 135 CHAPTER 12 THE BUDGETING FRAMEWORK – overhead budgets bring together the planned spending budgets for many different departments or activities.

Budget centres and responsibility accounting  It is usual in budgeting to apply the principles of responsibility accounting where a manager is given the responsibility for a particular aspect of the budget, and within the budgetary control system and is then made accountable for actual performance.  The area of operations for which a manager is responsible might be called a responsibility centre. Within an organisation, there could be a hierarchy of responsibility centres. – If a manager is responsible for a particular aspect of operating costs, the responsibility centre is a cost centre. – If a manager is responsible for revenue as well as costs, the responsibility centre is a profit centre.  There could be several cost centres within a profit centre, with the cost centre managers responsible for the costs of their particular area of operations, and the profit centre manager responsible for the profitability of the entire operation. – If a manager is responsible for investment decisions as well as for revenues and costs, the responsibility centre is an investment centre. There could be several profit centres within an investment centre.  Each cost centre, profit centre and investment centre should have its own budget, and its manager should receive regular budgetary control information relating to the centre, for control and performance measurement purposes. Responsibility accounting and controllable costs  If the principle of controllability is applied, a manager should be made responsible and accountable only for the costs (and revenues) that he or she is in a position to control. A controllable cost is a cost ‘which can be influenced by its budget holder’. Controllable costs are generally assumed to be: – variable costs, and

– directly attributable fixed costs. These are fixed costs that can be allocated in full as a cost of the centre.  It is important to make managers responsible and accountable for costs they can control. Without accountability, managers do not have the incentive to control costs and manage their resources efficiently and effectively. The controllability of costs  A common assumption in management accounting is that controllable costs consist of variable costs and directly attributable fixed costs. Uncontrollable costs are costs that cannot be influenced up or down by management action.  This assumption should be used with caution. – Some items treated as variable costs cannot be influenced or controlled in the short term. Direct labour costs are treated as a variable cost, but in reality, the direct labour work force is usually paid a fixed wage for a minimum number of working hours each week. Without making some employees redundant the direct labour cost cannot be reduced in the short term because it is really a fixed cost item. – An item that is uncontrollable for one manager could be controllable by another. – In the long term, all costs are controllable. At senior management level, control should be exercised over long- term costs as well as costs in the short term.  A useful distinction can be made between: – committed fixed costs, which are costs that are uncontrollable in the short term, but are controllable over the longer term, and – discretionary fixed costs, which are costs treated as fixed cost items that can nevertheless be controlled in the short term, because spending is subject to management discretion.

5 KEY METRICS IN THE BUDGET  An organisation should have certain targets for achievement. Targets can be expressed in terms of key metrics. A budget should not be approved by senior management unless budgeted performance is satisfactory, as measured by the key metrics. Actual performance should then be assessed in comparison with the targets.  The term ‘key performance indicators’ might be used.  Key areas of financial performance are: – profitability – liquidity – asset turnover.  A key metric for profitability might be: – the profit/sales ratio (profit margin), or – contribution/sales ratio (contribution margin). Liquidity  A key metric for liquidity might therefore be: – the current ratio (which is the ratio of current assets to current liabilities), or – the quick ratio or acid test ratio (which is the ratio of current assets excluding inventories to current liabilities).  A low liquidity ratio could indicate poor liquidity and a risk of cash flow difficulties. The appropriate minimum value for a liquidity ratio varies from one industry to another, because the characteristics of cash flows vary between different industries.  On the other hand, a business can have excessive liquidity, with too much capital tied up in working capital.

Asset turnover  Asset turnover is a measure of productivity in the use of assets. When asset turnover is fast, a business is making efficient use of its assets. Turnover can be measured in relation to any category of assets, such as: Non-current asset turnover, which is measured as: Sales revenue in the period Non-current assets Total asset turnover, which is measured as: Sales in the period Net assets Net assets = Net non-current assets + (Current assets – Current liabilities)

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1 INCREMENTAL BUDGETING  Incremental budgeting is a method of budgeting that starts with the current year’s budget and ‘builds’ on this to produce the budget for next year.  Fairly small changes are made to the current year’s budget.  A check is then made to ensure that the budget produced in this way meets the performance targets of the organisation.  There a several criticisms of incremental budgeting. – The main disadvantage is that it assumes that all current activities should be continued at the current level of operations and with the same allocation of resources. – It is backward-looking in nature, since next year’s budget is based on what has been expected in the past. In a dynamic and rapidly-changing business environment, this approach to planning is inappropriate. – It is often seen as a desk-bound planning process, driven by the accounts department. – The performance targets in the budget are often unchallenging, based on past performance. – When there are excessive costs in the budget for the current year, these will be continued in the future.  There are some advantages of incremental budgeting. – It is a simple, low-cost budgeting system. – If the business is fairly stable, the budgets produced by this method might be sufficient for management needs.

FTC FOULKS LYNCH 142 ALTERNATIVE APPROACHES TO BUDGETING CHAPTER 13 – There are some items of cost where an incremental budgeting approach is probably the most practical, for example telephone expenses.

2 ZERO-BASED BUDGETING (ZBB)  In ZBB, all activities and costs are budgeted from scratch (a zero base).  The starting point for preparing a zero-based budget is to develop a decision package for each activity.  A decision package is a document that: – analyses the cost of the activity (costs may be built up from a zero base, but costing information can be obtained from historical records or last year’s budget) – states the purpose of the activity – identifies alternative methods of achieving the same purpose – assesses the consequence of not doing the activity at all, or performing the activity at a different level – establishes measures of performance for the activity.  In this way, each decision package can be evaluated. They should then be ranked in order of priority, based on the cost- benefit analysis. – Individual managers of responsibility centres must rank the activities for which they are responsible. – Senior managers will then rank the activities of the various responsibility centre managers reporting to them.  The final stage in ZBB is to decide which activities should be approved for the budget, and resources should be allocated accordingly. The decision is based on the priorities that have been established for the decision packages. Benefits of ZBB

 It helps to create an organisational environment where change is accepted.

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 It helps management to focus on company objectives and goals. It moves budgeting away from number-crunching, towards analysis and decision-making.  It focuses on the future rather than on the past.  It helps to identify inefficient operations and wasteful spending, which can be eliminated.  Establishing priorities for activities provides a framework for the optimum utilisation of resources.  It establishes a measure of performance for each decision package.  It involves managers in the budgeting process. Disadvantages of ZBB  It is a time-consuming exercise. It is unlikely that an organisation will have the time to carry out a ZBB exercise every year.  There is a temptation to concentrate on short-term cost savings at the expense of longer-term benefits.  It might not be useful for budgeting for production activities or service provision, where costs and efficiency levels should be well-controlled, so that budgets can be prepared from forecasts of activity volume and unit costs.  It might require skills from management that the management team does not possess.  The ranking process can be difficult, since widely-differing activities cannot be compared on quantitative measures alone

3 ACTIVITY-BASED BUDGETING (ABB)  ABB is defined as: ‘a method of budgeting based on an activity framework and utilising cost driver data in the budget-setting and variance feedback processes’ (CIMA Official Terminology).  The key elements to this definition are: – budgets are for activities rather than departments – budgeted costs for each activity are estimated using the cost driver or cost drivers for that activity – actual results are monitored – by comparing the actual and budgeted costs for each activity.  Whereas ZBB is based on budgets (decision packages) prepared by responsibility centre managers, ABB is based on budgeting for activities.  The basic approach of ABB is to budget the costs for each cost pool or activity. (1) The cost driver for each activity is identified. A forecast is made of the number of units of the cost driver that will occur in the budget period. (2) Given the estimate of the activity level for the cost driver, the activity cost is estimated. Where appropriate, a cost per unit of activity is calculated. ABB activity matrix  An activity-based budget can be constructed by preparing an activity matrix. This identifies the activities in each column, and the resources required to carry out the activities in each row.

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Advantages of activity-based budgeting  The advantages of ABB are similar to those provided by activity-based costing.  It draws attention to the costs of ‘overhead activities’. This can be important where overhead costs are a large proportion of total operating costs.  It provides information for the control of activity costs, by assuming that they are variable, at least in the longer term.  It provides a useful basis for monitoring and controlling overhead costs.  It also provides useful control information by emphasising that activity costs might be controllable if the activity volume can be controlled.  ABB can provide useful information for a total quality management programme, by relating the cost of an activity to the level of service provided.

4 ROLLING BUDGETS (CONTINUOUS BUDGETS)  A rolling budget is ‘a budget continuously updated by adding a further accounting period (month or quarter) when the earliest accounting period has expired’ (CIMA Official Terminology). Rolling budgets are also called continuous budgets.  Rolling budgets are for a fixed period, but this need not be a full financial year.  The reason for preparing rolling budgets is to deal with the problem of uncertainty in the budget, when greater accuracy and reliability are required.  A common example is cash budgeting.

Advantages and disadvantages of rolling budgets Advantages Disadvantages  They reduce uncertainty in  Preparing new budgets budgeting. regularly is time- consuming.  They can be used for cash  It can be difficult to management. communicate frequent budget changes.  They force managers to look ahead continuously.  When conditions are subject to change, comparing actual results with a rolling budget is more realistic than comparing actual results with a fixed annual budget.

5 ‘WHAT IF’ SCENARIOS  A budget is based on a large number of assumptions about what is likely to happen in the future. For example: – Sales budgets might be based on forecasts of sales, assuming favourable market conditions, no significant activity by competitors, no significant change in customer demand and given a budgeted amount of spending on advertising and marketing.  ‘What if’ analysis looks at what the budgeted results would be if certain assumptions or values in the budget were different. Risk and risk analysis  Risk refers to the probability that actual results might turn out different from expected results, for reasons outside

148 FTC FOULKS LYNCH ALTERNATIVE APPROACHES TO BUDGETING CHAPTER 13 management control. Risk can be assessed and evaluated in terms of: – what is the probability of a particular ‘outcome’, and – what will be the effect on profitability and cash flow if the outcome does occur.  Risk can be assessed and evaluated within the budgeting process, using computer modelling such as spreadsheets for preparing the budget. Budgeting for different outcomes  One approach to the problem of risk and uncertainty is to prepare several budgets, each based on a different set of assumptions about future conditions.  One scenario is selected as the master budget, but if conditions turn out different from those assumed in the budget, management can switch to using one of the other scenario models as its revised budget.  Scenario planning also helps management to evaluate risk when the budgets are being prepared, and consider what might be done to keep the risk within acceptable limits. Sensitivity analysis  Another approach to ‘what if’ budgeting, using a computer model, is to alter one or more of the assumptions or ‘variables’ in the budget, and prepare a revised budget on the basis of the new assumptions. This is sensitivity analysis, which can be described as an analysis of the effect on output results of changes in one or more key variables.  With a spreadsheet model or other budget model, each ‘what if’ question can be evaluated easily and quickly, simply by altering the value of the relevant variable in the model.

 Example A company makes and sells two products, X and Y, for which the budgeted sales price and variable costs per unit are: Product X Product Y Variable cost $2 $4 Sales price $5 $8 Budgeted fixed costs are $140,000. Budgeted sales are 30,000 units of Product X and 15,000 units of Product Y. Required: (a) Calculate the budgeted profit. (b) Calculate how profit would be affected in each of the following separate circumstances: (i) if the variable cost of Product Y were 25% higher than expected (ii) if sales of Product X were 10% less than budgeted (iii) if sales of Product X were 5% less than budgeted and unit variable costs of X were 10% higher than budgeted (iv) if total sales revenue is the same as in the original budget, but the sales mix (by revenue) is 50% of Product X and 50% of Product Y. Solution The original budget and ‘what if’ budgets can be constructed quickly using a marginal costing approach. Product X Product Y Total $ $ $ Budgeted sales 150,000 120,000 270,000 Variable costs 60,000 60,000 120,000 Contribution 90,000 60,000 150,000 Fixed costs 140,000

150 FTC FOULKS LYNCH ALTERNATIVE APPROACHES TO BUDGETING CHAPTER 13 Budgeted profit 10,000

(b) (i) Product Product Total X Y $ $ $ Budgeted sales 150,000 120,000 270,000 Variable costs 60,000 (+ 25%) 75,000 135,000 Contribution 90,000 45,000 135,000 Fixed costs 140,000 Budgeted loss (5,000) (ii) Product Product Total X Y $ $ $ Budgeted sales (- 10%) 135,000 120,000 255,000 Variable costs (- 10%) 54,000 60,000 114,000 Contribution 81,000 60,000 141,000 Fixed costs 140,000 Budgeted profit 1,000 (iii) Product Product Total X Y Sales units 28,500 15,000 $ $ $ Budgeted sales (at $5) 142,500 120,000 262,500 Variable costs (at $2.20) 62,700 60,000 122,700 Contribution 79,800 60,000 139,800 Fixed costs 140,000 Budgeted loss (200)

(iv) Product Product Total X Y Sales units (135,000/5) 27,000 (135,000/8) 16,875 $ $ $ Budgeted sales (50%) 135,000 (50%) 135,000 270,000 Variable costs (at $2) 54,000 (at $4) 67,500 121,500 Contribution 81,000 67,500 148,500 Fixed costs 140,000 Budgeted profit 8,500

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1 BUDGETS FOR CONTROL  Defined as ‘the establishment of budgets relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objectives of that policy or to provide a basis for its revision’ (CIMA Official Terminology).  In other words, budgetary control involves: – setting targets or performance standards for individuals (budget holders) – comparing actual performance against the budget – expecting the budget holder to use this information to take action where necessary to make sure that the budget is achieved – where necessary, changing the budget targets or performance standards.  Budgetary control is based on a feedback control system.

2 FEEDBACK CONTROL  Feedback control is defined as ‘the measurement of differences between planned outputs and actual outputs achieved, and the modification of subsequent action and/or plans to achieve future required results’ (CIMA Official Terminology).  Within the context of a business: – the business is a system

FTC FOULKS LYNCH 153 CHAPTER 14 BUDGETARY CONTROL – the system receives inputs (resources, such as cash, labour, materials and equipment) – the system uses the inputs to produce outputs (products, services) – some of the outputs of the system are measured (costs, revenues, and so on) – this measured information is reported back to management as feedback – management use the information, by comparing it with a plan or objective to decide whether control action is required – where control action is appropriate, management alter the inputs to the system, to affect the future outputs.  A feedback control system is illustrated in the following diagram:

Plan/budget

Controller

Inputs Feedback System Outputs

 Corrective action that brings actual performance closer to the target or plan is called negative feedback.  Corrective action that increases the difference between actual performance and the target or plan is called positive feedback.

154 FTC FOULKS LYNCH BUDGETARY CONTROL CHAPTER 14 3 FEED-FORWARD CONTROL  Feed-forward control information is an alternative approach to control using feedback.  Whereas feedback is based on a comparison of historical actual results with the budget for the period to date, feed-forward looks ahead and compares: – the target or objectives for the period, and – what actual results are now forecast.  Feed-forward control is defined as ‘the forecasting of differences between actual and planned outcomes and the implementation of actions before the event, to prevent such differences’ (CIMA Official Terminology).

4 FIXED AND FLEXIBLE BUDGETS  A fixed budget is a budget prepared for a planned level of activity. The master budget of an organisation could be described as a fixed budget, based on a given level of activity and sales.  A flexible budget is a budget that can be adjusted to allow for changes in the volume of activity. Within a flexible budget, a distinction is made between fixed and variable costs. Flexible budgets and variance analysis  Budgetary control using flexed budgets is a form of feedback control system. – In many respects, it is similar to standard costing variance reporting, although the level of detail in variance reports might be less with flexible budgets. – Actual results should be compared with a flexible budget based on the same volume of activity and sales. – Although it is possible to prepare flexible budgets based on absorption costing, it is more sensible to produce flexible budgets using marginal costing principles.

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 Example A software company has the following annual budget: $ $ Sales 480,000 Materials 48,000 Labour costs 200,000 Other expenses 180,000 428,000 Budgeted profit 52,000 – Sales are expected to be a constant amount each month. – Material costs vary with sales. – 30% of labour costs are variable with sales, and the rest are fixed costs. – Other expenses are part-fixed and part-variable. Variable expenses are 10% of sales. At the end of month 6, the following report is prepared for the six months to date: Budgeted and actual results for the first six months Original Actual Difference budget results $ $ $ Sales 240,000 200,000 40,000 (A) Materials 24,000 16,000 8,000 (F) Labour costs 100,000 94,000 6,000 (F) Other expenses 90,000 89,000 1,000 (F) 214,000 199,000 15,000 (F) Profit 26,000 1,000 25,000 (A) This comparison of actual results with a fixed budget does not provide useful control information. A more useful control report would be prepared by comparing actual results with a flexible budget.

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Original Flexible Actual Difference budget budget results $ $ $ $ Sales 240,000 200,000 200,000

Materials 24,000 20,000 16,000 4,000 (F) Labour costs 100,000 95,000 94,000 1,000 (F) (see W1) Other expenses 90,000 86,000 89,000 3,000 (A) (see W2) 214,000 201,000 199,000 2,000 (F) Profit 26,000 (1,000) 1,000 Workings for the flexible budget: (W1) Labour costs: $ Budgeted labour costs, original budget 200,000 Budgeted variable costs (30%) 60,000 Budgeted fixed costs 140,000 $ Fixed cost budget for the first six months (× 6/12) 70,000 Flexible budget variable costs (60,000/480,000 × 25,000 $200,000) Total labour costs in the flexed budget 95,000 (W2) Other expenses $ Budgeted other expenses, original budget 180,000 Budgeted variable costs (10% of $480,000) 48,000 Budgeted fixed costs 132,000 $ Fixed cost budget for the first six months (× 6/12) 66,000 Flexible budget variable costs (10% × $200,000) 20,000 Total labour costs in the flexed budget 86,000

Reconciling budgeted and actual profit: sales variance  In order to reconcile the budgeted profit for a period with the actual profit or loss, a sales volume margin variance has to be calculated. If the flexible budget is prepared using marginal costing, the sales volume variance should be a contribution margin variance.  In the example above, the budgeted contribution margin should be calculated as a budgeted contribution/sales ratio: $ $ Sales 480,000 Materials (all variable) 48,000 Variable labour costs 60,000 Variable other expenses 48,000 Budgeted variable costs 156,000 Budgeted contribution 324,000 Budgeted contribution/sales ratio = (324,000/480,000) = 0.675 or 67.5%. The sales volume contribution margin variance is calculated in the same way as a sales volume margin variance in standard costing: $ Budgeted sales for the 6 months 240,000 Actual sales for the 6 months 200,000 Sales volume variance (revenue) 40,000 (A) Budgeted contribution/sales ratio 67.5% Sales volume contribution variance $27,000 (A) There is no sales price variance, because there is no standard sales price. Reconciling budgeted and actual profit: operating statement  An operating statement can be used to present the reconciliation of budgeted and actual profit. This is similar to an operating statement with standard costing variances, although the variances might be presented as total cost variances, rather than calculated in further detail.

 For the example above, the operating statement might be: $ Budgeted profit for the 6 months 26,000 Variances (F) (A) $ $ Sales volume contribution 27,000 Materials costs 4,000 Labour costs 1,000 Other expenses costs ____ 3,000 5,000 30,000 25,000 (A) Actual profit 1,000 Comparing variance analysis with flexible budgets and standard costs  There are similarities between variance analysis with flexible budgets and standard costs. Both approaches to variance analysis compare the actual costs for a given volume of activity with the expected costs for that volume of activity. The differences are cost variances.  The differences between the two approaches are as follows. – With standard costing, all products (or all services) are valued at standard cost. With flexible output is costed using normal costing methods. – With standard costing, all products or services have a standard sales price. With flexible budgeting, standard selling prices are unlikely to be used. Unless there are standard sales prices, there can be no sales price variance. – With standard costing, there is a standard profit or standard cost for every unit of product or service. With flexible budgeting, a sales volume margin variance is calculated by assuming that all sales should earn the same contribution/sales ratio (or profit/sales ratio). The sales volume margin variance is therefore the difference between budgeted and actual sales, multiplied by the budgeted

FTC FOULKS LYNCH 159 CHAPTER 14 BUDGETARY CONTROL contribution/sales ratio (or profit/sales ratio, if absorption costing is used for the flexible budget). – With standard costing, variable costs are analysed into material usage quantity and price per material unit, or labour hours and cost per labour hour. With flexible budgeting, there is unlikely to be an analysis of costs in such detail. Reported cost variances are therefore likely to be total cost variances.

5 OVERHEAD COST VARIANCES AND FLEXIBLE BUDGETS  When a budget is prepared, overhead costs might be analysed into fixed overheads and variable overheads. However, when actual costs are recorded, it might be impossible to separate actual fixed overhead costs from actual variable overhead costs.  A total overhead cost variance can be calculated by comparing: – total actual overhead costs, with – a flexible budget consisting of budgeted fixed overheads and the expected variable overheads for the actual volume of activity. Overhead costs and the high-low method of cost estimation  There are various techniques for estimating fixed and variable overhead costs for a flexible budget. You will be expected to know the high-low method, and how it might be used for variance analysis with flexible budgeting.  The high-low method is a technique for analysing a total cost into its fixed cost and variable cost components.  The analysis is based on historical cost records, for total costs in different time periods and the volume of activity associated with those costs.

 The high-low analysis takes just two of these historical cost records: the highest volume of activity in any of the periods and its associated cost, and the lowest volume of activity in any of the periods and its associated cost.  The variable cost per unit of activity is found by taking the difference between the high activity and the low activity. Since fixed costs are the same at both volumes of activity, the difference between the two costs must consist of variable costs only.  Taking the difference between the high and the low therefore gives a variable cost for a given number of units of activity (high volume units minus low volume units), from which a variable cost per unit is calculated. The value of performance evaluation with fixed and flexed budget reports  Provided that an estimate can be made of fixed and variable costs, it is possible to compare actual results for a period with expected results (a flexible budget) and to reconcile the original expected profit with the actual profit or loss.  This can provide useful information for control purposes, but the quality of the control information is lower than for standard costing variances: – The cost variances are usually total cost variances for materials, labour and other costs, without a further analysis into price and usage variances or rate and efficiency variances. Total cost variances do not give any indication of the reason for the variance. – Estimates of expected fixed and variable costs for flexible budgeting are probably subject to a greater estimation error than with standard costing (where expected costs are prepared in greater detail).

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1 INTRODUCTION: BUDGETS AND HUMAN BEHAVIOUR  The aims of budgeting are to: – set objectives and targets for the business – communicate these objectives and targets – co-ordinate the activities of different parts of the organisation – plan for the future – motivate individuals to set challenging targets and then achieve them – allocate resources and authorise spending – provide a system for control – measure and evaluate performance.  Individuals react to the demands of budgeting and budgetary control in different ways, and their behaviour can damage the budgeting process.

2 PROBLEMS WITH BUDGET OBJECTIVES AND TARGETS  A criticism of budgeting is that the objectives and targets that are set for the organisation: – are short-term in outlook and ignore the longer term

FTC FOULKS LYNCH 163 CHAPTER 15 BUDGETING: BEHAVIOURAL ASPECTS AND CRITICISMS – focus on financial targets to the exclusion of non- financial issues.

3 TOP-DOWN AND BOTTOM-UP BUDGETING  Budgeting is a planning system for the entire organisation, and the management style within the organisation will be evident in the way the budget is prepared. Two extreme styles of budgeting are top-down and bottom-up. – Top-down budgeting is ‘a budget allowance which is set without permitting the ultimate budget holder to have the opportunity to participate in the budgeting process’ (CIMA Official Terminology). – Bottom-up budgeting is ‘a budgeting system in which all budget holders are given the opportunity to participate in setting their own budgets’ (CIMA Official Terminology).  Between these two extremes is the negotiated budget. Advantages of bottom-up Disadvantages of bottom-up budgeting budgeting  Budgets should be  There could be problems realistic. They are with co-ordinating the formulated by budget planning process. Budget holders who are familiar holders might be concerned with the area of about their particular area of operations. responsibility, rather than about the objectives of the organisation.  Participation in setting  The concerns of budget budgets should motivate holders might differ from budget holders and those of senior encourage them to raise management.

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targets.  They should increase the  Senior management is acceptance and responsible for setting and commitment of budget achieving targets for the holders to the organisation. organisation’s objectives.

 The knowledge that is  Bottom-up planning is more spread across the time-consuming than top- management of the down planning. organisation can be brought together in the planning process.  The communication  Changes to the budget between managers within decided by senior the organisation should management might cause improve as they discuss resentment. the budget.  Budget holders should be  Unless budget holders are motivated to achieve motivated to improve targets that they have performance, they might helped to set. build ‘slack’ into their budget allowance.  Participation in budgeting  Many budget holders might helps to avoid a split be poor at budgeting, between senior and junior especially if they lack management. financial knowledge.  Participation in decision-  Some individuals react making leads to greater better to an imposed budget. job satisfaction and a lessening of job-related tensions and stress.

4 MANAGEMENT POLITICS AND BUDGETING  Top-down budgeting can give senior management an opportunity to impose their ideas.

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 With top-down budgeting, senior management can impose targets for achievement on budget holders/responsibility centre managers.

 Budget holders might see the budgeting process as a competition with other budget holders to obtain a share of the spending budget. Budgeting is therefore: – an opportunity for ‘empire-building’ and trying to obtain a larger share of the money and resources in the budget, or – trying to avoid cuts in authorised spending.  Budget holders might take a ‘use it or lose it’ approach to spending. Goal congruence  Barriers to goal congruence are: – The managers of responsibility centres will focus on achieving a good performance for their particular area of responsibility. – Sometimes, improving performance in one area can result in poor performance somewhere else. – This behavioural problem in budgeting and budgetary control is probably unavoidable. Individual managers will focus on their own performance and results.

5 BUDGET SLACK  Budget slack is a deliberate over-estimation of expenditure and/or under-estimation of revenues in the budgeting process.  The following are possible reasons for the creation of budget slack: – Where budget holders are rewarded for keeping spending within the budget limit, or achieving budgeted sales targets, slack in the budget can help them to achieve their target and earn their rewards. – Slack in the budget provides some ‘insurance’ against the risk of results not going according to plan.

FTC FOULKS LYNCH 167 CHAPTER 15 BUDGETING: BEHAVIOURAL ASPECTS AND CRITICISMS – Slack in the budget takes away the pressure to ‘perform’.

6 BUDGETS AND PERFORMANCE EVALUATION  The extent to which managers are judged on their success in meeting financial targets in the budget might affect their attitudes and behaviour.  Research was carried out by Hopwood (1973) into the manufacturing division of a US steelworks. Hopwood identified three distinct styles of using budgetary information to evaluate management performance. – Budget constrained style – Here, the main emphasis in performance evaluation is the manager’s success in meeting budget targets in the short term, with no consideration for other aspects of performance that are not targeted in the budget. – Profit conscious style – The performance of a manager is measured in terms of his ability to increase the overall effectiveness of his area of responsibility, in relation to meeting the longer term objectives of the organisation. – Non-accounting style – With this style, performance evaluation is not based on budgetary information, and accounting information plays a relatively unimportant role.  Hopwood’s research suggested that each style of performance evaluation had the following behavioural effects. – With the budget constrained style, much attention was given to costs and there was a high degree of job- related pressure and tension. This often led to the manipulation of data in accounting reports. – With the profit-conscious style, there was still a high involvement with costs but less job-related pressure.

168 FTC FOULKS LYNCH BUDGETING: BEHAVIOURAL ASPECTS AND CRITICISMSCHAPTER 15 Consequently, there was less manipulation of accounting data. Relationships between managers and their colleagues and superiors were also better than with a budget- constrained style. – With the non-accounting style, the results were very similar to the profit conscious style, except for a much lower concern with cost information.  Hopwood found some evidence that better managerial performance was achieved where a profit conscious or non- accounting style was in use.  Subsequent studies by Otley (1978) involving profit centre managers in the UK coal mining industry contradicted Hopwood's findings showing a closer link between the budget- constrained style and good performance. The manager evaluated on a rather tight budget-constrained basis tended to meet the budget more closely than if it was evaluated in a less rigid way.

7 NON-FINANCIAL PERFORMANCE INDICATORS (NFPIS)  If a company focuses entirely on the aim of maximising short- term (budgeted) profits, it will probably damage its longer-term prospects for: – sustained profit growth, and – shareholder wealth maximisation.  The longer-term objective of a company should be shareholder wealth maximisation, but in order to achieve this financial objective, management should give attention to a range of non- financial issues as well as to profitability.  If a business is to thrive, it must produce the goods or services that customers want, at a price they are willing to pay, to a quality standard they expect and on time. Factors such as innovation, efficiency and customer satisfaction are non-

FTC FOULKS LYNCH 169 CHAPTER 15 BUDGETING: BEHAVIOURAL ASPECTS AND CRITICISMS financial issues that have to be recognised as essential ingredients of longer-term success.

 Tom Peters, the American management guru, recommended that targets should be set and monitored for a wide range of non-financial performance indicators, such as: – the percentage number of customer orders processed on the same day the order is received – the percentage number of customer orders processed without error – the number of new products launched per period – the number of ideas taken from competitors in each period – the number of customer complaints – the number of product defects – suppliers’ product quality.  Non-financial factors are the causes of success.  Profit is the consequence or effect of success.  For example, customer satisfaction is a major cause of success, whereas profits simply measure the effects of the success that has been achieved.

8 THE BALANCED SCORECARD  In the 1990s, Kaplan and Norton recommended a balanced scorecard approach to setting performance targets, using both non-financial as well as financial targets.  The approach focuses on four different aspects of performance, and management must address a key question for each. Aspect of performance Key question Customer perspective What do customers want from us? Internal business perspective What processes must we excel at to achieve our objectives?

Innovation and learning perspective How can we learn and improve and create value? Financial perspective How do we create value for our shareholders?  The main monthly performance report should then be a balanced scorecard report, not a traditional budgetary control report.  The targets for each perspective in the balanced scorecard should be quantifiable and measurable, so that actual performance can be compared with the target.  Examples of possible targets are as follows:

Financial perspective Economic value added (EVA) Profit target Operating cash flow target Cost reduction target Customer perspective Target for new customers Percentage of orders met within x days Market share target Internal business Percentage of tenders accepted by perspective customers Percentage of items produced that have to be re-worked Production cycle time Innovation and Number of new products launched learning perspective Target for employee productivity Percentage of total revenue coming from new products Possible problem with a balanced scorecard approach  Kaplan and Norton argued in favour of a balanced scorecard approach over traditional budgeting that: – accounting figures are unreliable and are easily manipulated

172 FTC FOULKS LYNCH BUDGETING: BEHAVIOURAL ASPECTS AND CRITICISMSCHAPTER 15 – changes in the business and market environment do not show up in the financial results of a company until much later.  There is a risk, however, that when performance targets are selected for each of the four perspectives: – The targets for the different perspectives could be contradictory and inconsistent with each other. – Non-financial performance targets could become an end in themselves, rather than a means towards the overall financial objective of maximising shareholder wealth. – Setting targets and measures are a guide to achieving the key financial objective, and are not themselves the main objective. – A problem with the balanced scorecard approach in practice is that the targets for each item on the balanced scorecard might be seen as key objectives in their own right.  Instead of supporting the main financial objective, balanced scorecard targets can become a part of a political process for promoting the competing interests of each stakeholder group.

9 BEYOND BUDGETING  The argument for abolishing budgets, referred to as ‘beyond budgeting’, was put forward by Hope and Fraser (Management Accounting December 1997). The basis of their argument was as follows. – To compete in the information age, companies must go beyond budgeting. – Many companies have most of their value in intellectual assets, such as ‘know-how’. Maximising the value of these assets will do more for shareholder value than maximising the value of tangible assets.

– In the information age, the business environment is constantly changing. Front-line managers are expected to act like entrepreneurs, strategists and decision-makers. – The budgeting system is too rigid. It acts as a barrier to change because managers are expected to conform to budget. – Planning should be based on maximising value, using techniques and philosophies such as Total Quality Management, Business Process Re-engineering, decentralisation, empowerment of employees and a balanced scorecard.  Their criticisms of budgeting are: – Budgets are a commitment. They therefore act as a constraint on doing anything different. – Traditional budgets are seen as a mechanism for top-down control by senior management. – Traditional budgets restrict flexibility because individuals feel they are expected to achieve the budget targets. This is a deterrent to continual improvement . – Budgeting reinforces the barriers between departments, instead of encouraging a sharing of knowledge across the organisation. – Budgets are bureaucratic, internally-focused and time-consuming. Planning and control ‘beyond budgeting’  Hope and Fraser referred to examples of companies in Scandinavia that had successfully gone ‘beyond budgeting’. The features of an appropriate system of planning and control might be as follows.

174 FTC FOULKS LYNCH BUDGETING: BEHAVIOURAL ASPECTS AND CRITICISMSCHAPTER 15 – Managers should prepare rolling plans. However, the purpose of these plans should be for cash forecasting, not cost control. – These forecasts should be revised more frequently if necessary. – Performance measures to senior management should not be based on actual versus budget, but on: (1) achieving strategic milestones, and (2) using relative measures of performance, for example by comparing actual results against a benchmark. (3) The emphasis should be on adding value, rather than managing costs down.

176 FTC FOULKS LYNCH CHAPTER 16 FORECASTING TECHNIQUES: TIME SERIES AND LINEAR REGRESSION

1 FORECASTS IN BUDGETING  Budgets are based on forecasts. Forecasts might be prepared for: – the volume of output and sales – sales revenue (sales volume and sales prices) – costs using a number of forecasting models, methods or techniques.

2 TIME SERIES ANALYSIS  A time series is a set of observations or measures taken at equal time intervals.  Examples of time series might include the following: – annual overhead costs over a number of years – daily production output over a month.  A time series can be drawn as a graph, with the horizontal axis representing time.  A graph of a time series showing quarterly production figures is shown below.

FTC FOULKS LYNCH 177 CHAPTER 16 FORECASTING TECHNIQUES: TIME SERIES AND LINEAR REGRESSION

Production

Production (Tonnes)

90 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 Quarter/Year 20X2 20X3 20X4 20X5

Forecasting with time series analysis  Time series analysis is a term used to describe techniques for analysing a time series, in order to: – identify whether there is any underlying historical trend and if there is, measure it – use this analysis of the historical trend to forecast the trend into the future – identify whether there are any seasonal variations around the trend, and if there is measure them – apply estimated seasonal variations to a trend line forecast in order to prepare a forecast season by season.

178 FTC FOULKS LYNCH FORECASTING TECHNIQUES: TIME SERIES AND LINEAR CHAPTER 16 REGRESSION

Additive model  Using time series analysis and an additive model, the value of the item being measured can therefore be stated as: Time series value = Trend line value +/- Seasonal variation +/- Random variation.  For forecasting purposes, the random variations are ignored. Forecast value = Trend line value +/- Seasonal variation Multiplicative model  Using time series analysis and a multiplicative model, the value of the item being measured can therefore be stated as: Time series value = Trend line value × Seasonal variation × Random variation.  For forecasting purposes, the random variations are ignored. Forecast value = Trend line value × Seasonal variation

3 MEASURING THE TREND LINE: MOVING AVERAGES  A trend line can be estimated from a historical time series and used to prepare a forecast. The underlying assumptions are: – there has been a trend in the past – this trend is identifiable and measurable, and – the trend will continue at the same rate into the future over the full planning period.  There are several methods of measuring a trend line from a time series. These include: – moving averages, and

FTC FOULKS LYNCH 179 CHAPTER 16 FORECASTING TECHNIQUES: TIME SERIES AND LINEAR REGRESSION – linear regression analysis.

The moving average time period  Where there is a regular cycle of time periods, it would make sense to calculate the moving averages over a full cycle.

4 MEASURING SEASONAL VARIATIONS  The technique for measuring seasonal variations differs between an additive model and a multiplicative model. The additive model method is described here.  Seasonal variations can be estimated by comparing an actual time series with the trend line values calculated from the time series.  For each ‘season’ the seasonal variation is the difference between the trend line value and the actual historical value for the same period.  A seasonal variation can be calculated for each period in the trend line.  An average variation for each season is calculated.  The sum of the seasonal variations has to be 0 in the additive model. If they do not add up to zero, the seasonal variations should be adjusted so that they do add up to zero.  The seasonal variations calculated in this way can be used in forecasting, by adding the seasonal variation to the trend line forecast if the seasonal variation is positive, or subtracting it from the trend line if it is negative. Seasonal variations: multiplicative model  When a multiplicative model is used to estimate seasonal variations, the seasonal variation for each period is calculated

FTC FOULKS LYNCH 181 CHAPTER 16 FORECASTING TECHNIQUES: TIME SERIES AND LINEAR REGRESSION by expressing the actual sales for the period as a percentage value of the moving average figure for the same period.

 In time series analysis with seasonal variations: – the trend line value might be referred to as the de- seasonalised value – the forecast is therefore the de-seasonalised value adjusted to allow for the seasonal variation.

5 STRENGTHS AND WEAKNESSES OF FORECASTING WITH TIME SERIES ANALYSIS  The advantages of forecasting using time series analysis are that: – forecasts are based on clearly-understood assumptions – trend lines can be reviewed after each successive time period, when the most recent historical data is added to the analysis – forecasting accuracy can possibly be improved with experience.  The disadvantages of forecasting with time series analysis are that: – there is an assumption that what has happened in the past is a reliable guide to the future – there is an assumption that a straight-line trend exists – there is an assumption that seasonal variations are constant, either in actual values using the additive model or as a proportion of the trend line value using the multiplicative model.  None of these assumptions might be valid.

 However, the reliability of a forecasting method can be established over time.

6 LINEAR REGRESSION ANALYSIS  Linear regression analysis is a statistical technique for identifying a ‘line of best fit’ from a set of data.  If it is assumed that there is a linear relationship between two ‘variables’, the technique can be used to quantify this relationship using historical data. The relationship is expressed in the form: y = a + bx where y is the value of the dependent variable x is the value of the independent variable a and b are values obtained from a statistical analysis of historical data for values of x and y.  This is the equation for a straight line, which can be shown in graphical form as follows. This is a graph for y = a + bx.

x 0 1 2 3 4 5 6 7 8 9 10

Examples of linear relationships for budgeting  Linear regression analysis can be used to make forecasts or estimates whenever a linear relationship is assumed between two variables, and historical data is available for analysis.  Two such relationships are: – A time series and trend line. Linear regression analysis is an alternative to calculating moving averages to establish a trend line from a time series. . The independent variable (x) in a time series is time. . The dependent variable (y) is sales, production volume or cost, etc. – Total costs, where costs consist of a combination of fixed costs and variable costs. Linear regression analysis is an alternative to using the high-low method of cost behaviour analysis. It should be more accurate than the

FTC FOULKS LYNCH 185 CHAPTER 16 FORECASTING TECHNIQUES: TIME SERIES AND LINEAR REGRESSION high-low method, because it is based on more items of historical data. . The independent variable (x) in total cost analysis is the volume of activity. . The dependent variable (y) is total cost. . The value of a is the amount of fixed costs . The value of b is the variable cost per unit of activity.  When a linear relationship is identified and quantified using linear regression analysis, values for a and b are obtained, and these can be used to make a forecast for the budget. Least squares linear regression  To calculate the line of best fit, the following formulae may be used. These will be provided on a formula sheet in your examination. You do not need to know how the formulae are derived, only how to apply them to historical data.  y b  x  a = y  bx = n n n  xy -  x  y 2 2 b = n x ( x)  Example The management accountant of Artful has obtained the following historical data of monthly costs of order processing. Total costs are assumed to vary with the number of orders processed. Month Orders processed Total costs $000 March 100 144 April 120 163 May 140 176 June 157 110

186 FTC FOULKS LYNCH FORECASTING TECHNIQUES: TIME SERIES AND LINEAR CHAPTER 16 REGRESSION July 70 115 Required: Use least squares regression analysis to estimate the fixed and variable costs of order processing. Solution The first step in a solution is to obtain all the values needed to calculate the value of b. A table should be prepared with columns containing the historical data for orders processed (x values) and associated costs (y values).

Additional columns should be included, one for  x² and one for xy. Orders Total costs processed $000 X y x² xy 100 144 10,000 14,400 120 163 14,400 19,560 140 176 19,600 24,640 157 12,100 17,270 110 70 115 4,900 8,050 540 755 61,000 83,920 These working give the values needed to calculate b. – n is 5, the number of pairs of data used – x is the sum of the values in the x column, which is 540. – y is the sum of the values in the y column, which is 755. – x² is the sum of the values in the x² column, which is 61,000. – xy is the sum of the values in the xy column, which is 83,920. Putting these values into the formula for b: b = 5 (83,920) – (540)(755) 5 (61,000) – (540)²

= 419,600 – 407,700 305,000 – 291,600 B = 11,900/13,400 = 0.888.

This value for b can now be used to calculate the value of a.

y = the average of the values for y

x = the average of the values for x a = 755 – 0.888 × 540 5 5 a = 151 – 0.888 (108) = 151 – 95.9 = 55.1 The line of best fit is: y (in $000) = 55.1 + 0.888x y = 55,100 + 888x.  The alternative formula for calculating b is: b = Covariance (xy) Variance (x) To find these values, we need to:

– Calculate x and y , i.e. the average values for x and y in the data. – Calculate the difference between each value for x in the data and x , to obtain (x – x ), and calculate the difference between each value for y in the data and y , to obtain (y – y ). – Variance (x) is found by squaring the values for (x – x ), and finding the total of these values.

FTC FOULKS LYNCH 189 CHAPTER 16 FORECASTING TECHNIQUES: TIME SERIES AND LINEAR REGRESSION – Covariance (xy) is found by multiplying each value for (x – x with the corresponding value for (y – y ), and finding the total.

7 STRENGTHS AND WEAKNESSES OF LINEAR REGRESSION ANALYSIS  Linear regression analysis is a technique for establishing a line of best fit, using available historical data. It is based on assumptions. – There is a linear relationship between the two variables represented by x and y. – This relationship in the future can be predicted from the relationship in the past. Interpolation and extrapolation  A line of best fit might be calculated using regression analysis, and this might then be used to predict a value between the two extreme values (the high and the low values) that were used to calculate the line. This is known as interpolation.  As a general rule, forecasts based on interpolation are more reliable than extrapolations. Adjusting forecasts for inflation  The accuracy of forecasting is affected by the need to adjust historical data and future forecasts to allow for price or cost inflation. Correlation  An advantage of linear regression analysis is that it is possible to calculate the strength of the connection (or correlation) between the two variables. The stronger the connection, the more reliable the line of best fit should be for forecasting.

 The strength of the connection can be measured by a correlation coefficient, r. n  xy -  x  y r = (n x2 ( x)2)(n y2 ( y)2)

 You might be expected to understand correlation and the significance of the correlation coefficient r.  The value of r must lie between –1 and + 1.  The closer the value of r to + 1 or – 1, the greater is the correlation and the more reliable the line of best fit. Coefficient of determination, r²  The degree of correlation between x and y can be measured in even more detail using the coefficient of determination r², which is the correlation coefficient squared.  The value of r² indicates the proportion of the variations in the value of the dependent variable y that can be ‘explained by’ variations in the value of the independent variable x.

8 EXPECTED VALUES  Forecasts might have to consider risk and uncertainty. – Risk arises out of the situation that is being forecast. Future events might not be certain. However, it might be possible to predict the likelihood that each possible outcome will occur. – Uncertainty arises from a lack of reliable information. The future cannot be predicted because there is not enough information to make a confident forecast.

 When a forecast or budget is prepared under conditions of risk or uncertainty, the forecaster might use probability estimates of different possible outcomes.  An expected value is a weighted average value of expected outcomes. Strengths and weaknesses of forecasting with expected values  The main advantage of forecasting with expected values is that it is a useful method of deriving an expected average. If the probability estimates are reliable, the expected value should be a reliable average measure of future outcomes.  The potential disadvantages of forecasting with expected values are that: – the probability estimates might be unreliable, especially when they are determined by judgement rather than an objective mathematical analysis – an expected value does not have a practical meaning when it is used to forecast a ‘one-off’ outcome.

FTC FOULKS LYNCH 193 CHAPTER 17 COST CENTRES, PROFIT CENTRES AND INVESTMENT CENTRES

1 RESPONSIBILITY CENTRES AND ORGANISATION STRUCTURE  A cost centre is a unit of an organisation where the manager responsible for the centre is made accountable for the costs of the centre.  A revenue centre is a unit of the organisation where the manager responsible for the centre is accountable for the sales revenue earned by the centre.  A profit centre is a unit of the organisation where the manager responsible for the centre is made accountable for the profitability of the centre’s operations.  An investment centre is a unit of the organisation where the manager responsible for the centre is responsible for both the profit of the centre and its profitability in relation to the capital invested.  Responsibility centres provide a system for: – measuring performance – motivating centre managers to improve performance – control over performance by comparing actual results against budget or targets. Measures of performance for responsibility centres  The main measures of performance are: – cost control for cost centres

FTC FOULKS LYNCH 194 COST CENTRES, PROFIT CENTRES AND INVESTMENT CHAPTER 17 CENTRES – total revenue for revenue centres – profit for profit centres, and – return on capital employed or something similar for investment centres. Responsibility centres and the effect of decentralisation  Decentralisation has both advantages and disadvantages. – The main benefit of decentralisation is that it gives the management of responsibility centres the authority to use their initiative and make their own decisions. – The main problem with decentralisation is that ‘local’ managers will inevitably give priority to the performance of their own centre, even if an improvement in their own performance causes a worse performance in another centre. The interests of the organisation as a whole are subordinated to the interests of the responsibility centre.

2 COST CENTRE REPORTING  For cost centres performance reporting should recognise both the variability of costs and the controllability of costs.  Variability of costs. Costs should be analysed into their fixed and variable cost elements, and the expected costs for a period should be based on a flexed budget.  Controllability of costs. Cost centres might be charged with an apportioned share of central overhead costs, but for control purposes, a distinction should be kept between costs that the centre manager should be in a position to influence and costs that the manager cannot influence.

 A cost centre report might therefore be presented as follows: Expected Actual Variance costs costs (flexed budget) $ $ $ Variable costs: Materials 50,000 54,600 4,600 (A) Other costs 15,000 12,600 2,400 (F) 65,000 67,200 2,200 (A) Controllable fixed costs: Labour 64,000 60,000 4,000 (F) Other 45,000 53,000 8,000 (A) 109,000 113,000 4,000 (A)

Apportioned central 35,000 34,000 1,000 (F) costs

Total costs 209,000 214,200 5,200 (A)

3 PROFIT CENTRE REPORTING  The profitability of profit centres and investment centres should be reported in a way that identifies the ‘contribution’ to profit from the centre in each reporting period. The principles of marginal costing should be applied to derive a figure for contribution. Controllable fixed costs or attributable fixed costs should then be deducted from contribution to obtain a figure for profit attributable to the profit centre.  A share of central overhead costs might then be charged to the centre, to obtain a net profit figure.

196 FTC FOULKS LYNCH COST CENTRES, PROFIT CENTRES AND INVESTMENT CHAPTER 17 CENTRES

 Actual profit might be reported as follows. $ $ Sales 250,000 Variable costs: Materials 54,600 Other variable costs 12,600 Total variable costs 67,200 Contribution 182,800 Controllable fixed costs: Labour 60,000 Other fixed costs 53,000 113,000 Controllable profit 69,800 Apportioned central costs 34,000 Net profit 35,800

4 PERFORMANCE MEASURES FOR INVESTMENT CENTRES  The profitability of investment centres should be measured in the same way as for profit centres. However, the overall performance of an investment centre, where the centre manager has responsibility for capital expenditure decisions should take into consideration both profits and the amount of capital employed.  A range of performance measures have been developed for investment centres: – return on investment (ROI) – residual income, and – economic value added or EVA®.

5 RETURN ON INVESTMENT (ROI)  The return on investment (ROI) for an investment centre is similar to the return on capital employed (ROCE) for an organisation as a whole. It is calculated for a particular period as follows:

Profit before interest and tax ROI =  100 Operations management capital employed

 Profit before interest and tax is the reported profit of the investment centre. However, the distinction between controllable profit and net profit might be applied, and return on investment could be measured using either or both controllable profit and net profit before interest.  Operations management capital employed is the capital employed for which the centre manager is responsible and accountable.  Non-current assets might be valued at cost, net replacement cost or net book value.  The value of assets employed could be either an average value for the period as whole or a value as at the end of the period. An average value for the period is preferable. Secondary performance ratios  ROI, like ROCE, can be analysed further into the secondary ratios: profit margin and asset turnover. ROI = Divisional profit × Divisional sales Divisional sales Divisional capital employed

ROI = Profit margin × Asset turnover

Advantages of using ROI  It is an easily-understood measure that focuses on both profit and capital employed.  It can be used to compare the performance of two investment centres of different sizes.  It provides an incentive to management to increase profits and also to reduce or keep under control the amount of capital employed. Disadvantages of using ROI  When assets are valued at net book value, reported performance improves with time.  Since ROI improves as non-current assets get older, there is a disincentive to invest in new assets.  If an investment centre manager takes investment decisions on the basis of short-term ROI, he will be reluctant to make any new capital investment where the first-year ROI is lower than the current annual ROI for the rest of the investment centre.  It is difficult to assess the significance of ROI.  With ROI, there is scope to manipulate the value of profit and capital employed.

6 RESIDUAL INCOME  The biggest criticism of ROI as a measure of divisional performance is that it discourages new investment. Residual income (RI) is an alternative measure of investment centre performance.

 Residual income is a measure of the profitability of an investment centre after deducting a notional interest cost for the cost of the capital invested in the division. Residual income = Accounting profit – Notional interest on capital Advantages of residual income  Compared to using ROI as a measure of performance, residual income has several advantages.  It encourages investment centre managers to make new investments if they add to residual income. A new investment might add to residual income but reduce ROI. In such a situation, measuring performance by residual income would persuade an investment centre manager to invest, when using ROI would make him reluctant to invest. Residual income can therefore help to reduce the potential problem of under- investing.  Making a specific charge for interest helps to make investment centre managers more aware of the cost of the assets under their control.  The notional interest charge might be a reasonably good measure of the economic cost of the capital employed in the investment centre. Disadvantages of residual income  As a measure of investment centre performance, residual income shares many of the weaknesses of ROI.  It is based on accounting measures of profit and capital employed.  New investments should not be evaluated using accounting measures of performance, because they are unreliable.

 It encourages investment centre managers to think in the short- term, about how to increase next year’s residual income for the investment centre.

7 ECONOMIC VALUE ADDED (EVA®)  The basic concept of EVA is that the performance of a company as a whole, or of investment centres within a company, should be measured in terms of the value that has been added to the business during the period.  EVA attempts to measure the true economic profit that has been earned.  It is a measure of performance that is directly linked to the creation of shareholder wealth.  The measurement of EVA is simple – to add to its economic value, a business must make an economic profit in excess of the cost of the capital that has been invested to earn that profit.  Economic profit is defined as NOPAT – the net operating profit after tax.  The cost of the capital employed is the economic value of the business assets multiplied by the business cost of capital = (cost of funding, both debt capital and share capital). EVA = NOPAT minus Capital charge Capital charge = Economic value of business assets × Cost of capital (%). Comparing EVA and residual income  The major difference between EVA and residual income is that:  residual income is calculated using accounting profit and an accounting value for capital employed

 EVA is calculated using an estimated value for economic profit and an estimated economic value of capital employed.  Economic profit and economic value of capital employed are estimated by making adjustments to accounting profit and accounting capital employed. The principle underlying EVA  The principle underlying EVA can be stated as follows.  The objective of a company is to maximise shareholder wealth.  The value of a company depends on the extent to which shareholders expect future economic profits to exceed the cost of the capital invested.  A share price therefore depends on expectations of EVA.  Current performance (EVA) is reflected in the current share price, so in order to increase the share price a company must achieve a sustained increase in EVA. Measuring EVA  The difficulties in applying EVA in practice arise from the problem of establishing the economic profit in a period, and the economic value of capital employed. Adjustments to calculate NOPAT  To calculate NOPAT from accounting profit, the following adjustments might be made: Accounting profit after depreciation and amortisation

+ Adjustment for economic depreciation + Any goodwill amortised + Any increase ( – any decrease) in the provision for doubtful debts + Any increase in net capitalised development costs + Implied interest expense on operating leases

202 FTC FOULKS LYNCH COST CENTRES, PROFIT CENTRES AND INVESTMENT CHAPTER 17 CENTRES – Cash payments for tax on operating profits

= NOPAT Adjustments to calculate the economic value of capital employed  To calculate the economic value of capital employed from the accounting value of capital employed, the following adjustments might be made: Total assets (non-current assets + current assets) in the balance sheet

– Non-interest-bearing liabilities, such as trade payables and tax payable

+ Adjustments to allow for the net replacement cost of tangible non-current assets + Cumulative amortised goodwill + Economic value (= net book value) of capitalised development costs + Economic value (= net book value) of capitalised operating leases + Provision for doubtful debts

= Capital invested Cost of capital  The cost of capital used in the EVA computation should reflect the weighted average cost of the company’s share capital and debt capital, including short-term interest-bearing debt such as bank overdrafts. Using EVA  Economic value added can be used to:  set targets for performance for investment centres (divisions) and the company as a whole

 measure actual performance  plan and make decisions on the basis of how the decision will affect EVA.  When EVA is used to measure performance divisional managers should be:  given training to understand the principles of EVAinformed about the interest cost that will be applied for the capital charge  taught how to calculate EVA for decision-making purposes  given a pay incentive based on a bonus for achieving or exceeding a target EVA.  EVA can also be used for control purposes, by encouraging managers to:  identify products and services that provide the greatest EVA, and concentrate resources on them  identify customers who provide the greatest EVA, and give priority to serving them  identify and eliminate activities that do not add to EVA  identify capital that is not providing a sufficient return to cover its capital cost and seek to reduce the capital investment. Advantages of EVA  It is a performance measure that attempts to put a figure to the increase (or decrease) that should have arisen during a period from the operations of a company or individual divisions within a company.  Like accounting return and residual income, it can be measured for each financial reporting period.  It is easily understood by non-accountants.

 It is based on economic profit and economic values of assets, not accounting profits and asset values.

8 OTHER PERFORMANCE INDICATORS  The main measures of performance for cost centres, revenue centres, profit centres and investment centres are financial measures, relating to costs, revenues, profits or returns on capital.  However, performance might also be measured in other ways, using non-financial indicators or monetary measures related to efficiency.  The basic principles for establishing non-financial performance indicators are that:  there should be key targets for achievement  the performance metric should be suitable for assessing the success or failure in achieving the key target  the metric selected should be easily measurable, so that actual performance can be compared against target.

FTC FOULKS LYNCH 205 CHAPTER 18 TRANSFER PRICING

1 DECENTRALISATION AND PROFIT CENTRES AND INVESTMENT CENTRES  The purposes of decentralisation are to:  give autonomy to local centre managers in decision-making  to motivate centre managers to improve performance  through performance enhancement at a profit centre level, to achieve better results for the organisation as a whole.  Decentralisation can create tension between local centre managers and head office management.  The performance of the managers of profit centres and investment centres will be assessed, and the managers themselves will be rewarded, on the basis of the results of their particular centre. Profit centre managers will therefore be motivated to optimise the results of their own division, regardless of other profit centres and regardless of the organisation as a whole.  When head office management believe that a profit centre manager is taking decisions that improve the profit centre performance, but are damaging for the interests of the organisation as a whole, they might want to step in and either: . alter the decisions that have been made at profit centre level, or . make new decisions for the profit centre.

FTC FOULKS LYNCH 206 TRANSFER PRICING CHAPTER 18

2 INTER-DIVISIONAL TRADING AND TRANSFER PRICING  In an organisation with profit centres and investment centres, there will almost certainly be some inter-connection between them. Some profit centres will supply goods and services to others.  Inter-divisional transfers must therefore be priced.  The price of the transfer is the transfer price.  The transfer is treated as an internal sale and an internal purchase within the organisation.  The sales income of one division is offset by the purchase cost of the other division. The transfer therefore affects the profits of the two divisions individually, but has no effect on the profit of the organisation as a whole.

3 SETTING A TRANSFER PRICE: INTER-DIVISIONAL TRADING POLICY  The transfer price for inter-divisional transactions is significant because:  it determines how the total profit is shared between the two divisions, and  in some circumstances, it could affect decisions by the divisional managers about whether they are willing to sell to or buy from the other division.  Both divisions must benefit from the transaction if inter- divisional sales are to take place.  Transfer prices have to be established and agreed.  They could be imposed by head office.

 Alternatively, they could be decided by commercial negotiation between the profit centre managers.  Inter-divisional trading should take place within a broad company policy, that:  for a ‘selling division’, given the choice between making a sale to an external customer or supplying goods or services to another division within the group, the preference should be to sell internally  for a ‘buying division’, given the choice between purchasing from an external supplier or from another division within the company, the preference should be to purchase internally.  However, a division should be allowed to sell externally rather than transfer internally, or buy externally rather than internally, if it has a good commercial reason. Good commercial reasons would include:  an external customer offering a higher price, or  an external supplier offering a lower price.  The following guidelines should always be considered.  The transfer price should be a price that will ensure that the profits of the company as a whole are maximised. One profit centre should not make profits at the expense of another profit centre.  Goal congruence is achieved when all profit centres maximise their profits by operating at levels of output and prices that ensure the maximisation of profit for the company as a whole.  The transfer price should provide for a fair division of the total profit between the selling and the buying division, and so should provide a fair basis for measuring profit centre performance.

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 The transfer price should motivate the profit centre managers to trade with each other so as to maximise the profits of the company as a whole.  Transfer pricing decisions should ideally be set at the ‘local’ level, in negotiations between the profit centres, rather than imposed by head office.

4 THE BASES FOR SETTING TRANSFER PRICES  In broad terms, there are three bases for setting a transfer price:  market-based prices  cost-based prices  negotiated prices.  A market-based transfer price might be agreed when there is an intermediate market for the transferred item. An intermediate market is a term to describe an external market for the goods or services of the selling division.

5 THE INTERMEDIATE MARKET  The intermediate market for the products or services of a selling division could be perfect or imperfect. A perfect intermediate market  Where all suppliers to the market are able to sell all their output at the prevailing market price. There are no restrictions on sales demand at that price, and no individual supplier dominates market supply. An imperfect intermediate market  Where the selling division is unable to sell all its output externally at the same market price. This can happen when the division is a dominant influence in the market, and monopoly or oligopoly conditions apply.

 The rule of market prices is that the total market demand for an item varies with the sales price. If the relationship between sales price and sales demand is linear, a demand curve could be expressed by the formula: P = a – bQ where P is the sales price Q is the quantity Values can be established for a and b. When the price is a, Q should be 0.  Marginal revenue is the extra revenue that will be earned by selling one additional unit in the market. In a perfect market, the marginal revenue for a company is always the market price of the item. When the market is imperfect, marginal revenue is always lower than the market price. The demand curve gives a value for P: P = a – bQ. Total revenue = P × Q Substituting, we get: total revenue = (a – bQ) × Q Total revenue = aQ – bQ² Marginal revenue is found by differentiating aQ – bQ². Without going into the details of the arithmetic: Marginal revenue (MR) = a – 2bQ.  In an imperfect market, profits are maximised by selling output up to a volume where marginal revenue = marginal cost. When there is no external market for the products or services of a profit centre, all the output of the centre is sold to one or more divisions within the company or group.

6 FINDING THE IDEAL TRANSFER PRICE  The ideal transfer price is a price for inter-divisional sales that will:  maximise the profits of both the selling and the buying division, and  maximise the profit of the company as a whole.  The technique for identifying the ideal transfer price (or range of transfer prices) is as follows.  Start by identifying the profit-maximising output for the firm as a whole. Then take the buying and the selling division in turn.  Identify a transfer price that will motivate the division manager to produce and sell this profit-maximising quantity. This transfer price must ensure that the division will maximise its own profit.  Ideal transfer price = Marginal cost + Opportunity cost where:  Marginal cost is the marginal cost for the selling division to make and sell the product item or provide the service  Opportunity cost is the benefit forgone by the selling division if it transfers internally rather than sells externally.

7 THE IDEAL TRANSFER PRICE: PERFECT INTERMEDIATE MARKET  When there is a perfect intermediate market for the output of the selling division, the ideal transfer price is a market-based transfer price.

Perfect intermediate market and no variable selling costs  If there are no variable selling costs or buying costs in the intermediate market ) the ideal transfer price is the market price. Perfect intermediate market, but with variable selling costs  If there are variable selling costs or buying costs in the intermediate market:  it will cost the selling division more to sell externally than to transfer internally, or  it will cost the buying division more to purchase from an external supplier than to buy internally.  It is therefore cheaper and more profitable to transfer internally than to sell or buy externally. The cost savings can be reflected in an adjustment to the transfer price, so that both divisions share the benefit.

8 THE IDEAL TRANSFER PRICE: NON-EXISTENT INTERMEDIATE MARKET  When there is no intermediate market for a transferred product or service, the transfer price will be based on cost.

9 THE IDEAL TRANSFER PRICE: IMPERFECT INTERMEDIATE MARKET  The features of an imperfect intermediate market might vary, but the procedures to apply in order to identify an ideal transfer price, or range of transfer prices, are:  begin by identifying what output volumes and sales prices will maximise total company profit

 next, taking each profit centre in turn identify a transfer price or range of transfer prices at which the centre’s own profit would be maximised at this same output level  finally, compare the transfer prices for each division, and identify a price or range of prices at which the profits of both centres as well as the total company profit will be maximised.

10 TRANSFER PRICES WHEN THE SELLING DIVISION HAS SPARE CAPACITY  A situation might arise where a profit centre has an intermediate market for its output, and also sells internally, but:  there is a limit to the amount that it can sell externally, and  it has spare capacity.  In such a situation, the opportunity cost of transferring units internally would be nil, and the ideal transfer price would be based on cost, not the external market price.  The opportunity cost of transferring units internally is nil because the selling division can meet external demand in full, and still have excess capacity for making inter-divisional sales.

11 NEGOTIATED TRANSFER PRICES  On occasions, a transfer price might be negotiated. With decentralisation of authority to profit centres, centre managers will negotiate transfer prices for inter-divisional sales, but the price will usually be based on external market price or cost. When the intermediate market is imperfect, the transfer price might be based on an analysis of marginal costs and revenues, and this would require careful analysis and negotiation.  Other examples of negotiated transfer price are:  a two-part tariff

 dual price where the difference is subsidised by head- office.

Difficulties with negotiated transfer prices  There are two main difficulties with negotiated transfer prices.  Identifying a suitable transfer price is not always straightforward, and a price might have to be imposed on the profit centres by head office.  If the divisional managers are given the authority to negotiate their transfer prices, there is a risk that the negotiations could turn into a power struggle between the divisional managers.

12 INTERNATIONAL TRANSFER PRICING  Transfers within an international group will often be cross- border, between divisions in different countries. Other factors need to be considered. Different tax rates  A multinational company will seek to minimise the group’s total tax liability. One way of doing this might be use transfer pricing to:  reduce the profitability of its subsidiaries in high-tax countries, and  increase the profitability of its subsidiaries in low-tax countries.  Changes in the transfer price can redistribute the pre-tax profit between subsidiaries, but the total pre-tax profit will be the same. However, if more pre-tax profit is earned in low-tax countries and less profit is earned in high-tax countries, the total tax bill will be reduced. Government action on transfer prices  Governments are aware of the effect of transfer pricing on profits, and in many countries, multinationals are required to justify the transfer prices that they charge. Multinationals could

FTC FOULKS LYNCH 215 CHAPTER 18 TRANSFER PRICING be required to apply ‘arm’s length’ prices to transfer prices: in other words, they might be required under tax law to use market-based transfer prices, to remove the opportunities for tax avoidance.  It is also possible that some countries wishing to attract business might have tax laws that are very favourable to business. A country with the status of a ‘tax haven’ might offer:  a low rate of tax on profits  a low withholding tax on dividends paid to foreign holding companies  tax treaties with other countries  no exchange controls  a stable economy  good communications with the rest of the world  a well-developed legal framework, within which company rights are protected.

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