Ebook Management and cost accounting (8th ed): Part 2

Ebook Management and cost accounting (8th edition): Part 2 includes the following content: Chapter 15 the budgeting process; chapter 16 management control systems; chapter 17 standard costing and variance analysis 1; chapter 18 standard costing and variance analysis 2: further aspects; chapter 19 divisional financial performance measures; chapter 20 transfer pricing in divisionalized companies; chapter 21 strategic cost management; chapter 22 strategic management accounting; chapter 23 cost estimation and cost behaviour; chapter 24 quantitative models for the planning and control of inventories; chapter 25 the application of linear programming to management accounting.

PART FOUR INFORMATION FOR PLANNING, CONTROL AND PERFORMANCE MEASUREMENT 15 The budgeting process 16 Management control systems 17 Standard costing and variance analysis 18 Standard costing and variance analysis 2: Further aspects 19 Divisional financial performance measures 20 Transfer pricing in divisionalized companies T he objective in this section is to consider the implementation of decisions through the planning and control process Planning involves systematically looking at the future, so that decisions can be made today which will bring the company its desired results Control can be defined as the process of measuring and correcting actual performance to ensure that plans for implementing the chosen course of action are carried out Part Four contains six chapters Chapter 15 considers the role of budgeting within the planning process and the relationship between the long-range plan and the budgeting process The budgeting process in profit-oriented organizations is compared with that in non-profit organizations Chapters 16 to 18 are concerned with the control process To fully understand the role that management accounting control systems play in the control process, it is necessary to be aware of how they relate to the entire array of control mechanisms used by organizations Chapter 16 describes the different types of controls that are used by companies The elements of management accounting control systems are described within the context of the overall control process Chapters 17 and 18 focus on the technical aspects of accounting control systems They describe the major features of a standard costing system: a system that enables the differences between the planned and actual outcomes to be analyzed in detail Chapter 17 describes the operation of a standard costing system and explains the procedure for calculating the variances Chapter 18 examines more complex aspects relating to standard costing Chapters 19 and 20 examine the special problems of control and measuring performance of divisions and other decentralized units within an organization Chapter 19 considers how divisional financial performance measures might be devised which will motivate managers to pursue overall organizational goals Chapter 20 focuses on the transfer pricing problem and examines how transfer prices can be established that will motivate managers to make optimal decisions and also ensure that the performance measures derived from using the transfer prices represent a fair reflection of managerial performance 15 THE BUDGETING PROCESS LEARNING OBJECTIVES • • • • • • • • • I After studying this chapter, you should be able to: explain how budgeting fits into the overall planning and control framework; identify and describe the six different purposes of budgeting; identify and describe the various stages in the budget process; prepare functional and master budgets; describe the use of computer-based financial models for budgeting; describe the limitations of incremental budgeting; describe activity-based budgeting; describe zero-based budgeting (ZBB); describe the criticisms relating to traditional budgeting n the previous seven chapters we have considered how management accounting can assist managers in making decisions The actions that follow managerial decisions normally involve several aspects of the business, such as the marketing, production, purchasing and finance functions, and it is important that management should coordinate these various interrelated aspects of decision-making If they fail to this, there is a danger that managers may each make decisions that they believe are in the best interests of the organization when, in fact, taken together they are not; for example, the marketing department may introduce a promotional campaign that is designed to increase sales demand to a level beyond that which the production department can handle The various activities within a company should be coordinated by the preparation of plans of actions for future periods These detailed plans are usually referred to as budgets Our objective in this chapter is to focus on the planning process within a business organization and to consider the role of budgeting within this process 358 THE STRATEGIC PLANNING, BUDGETING AND CONTROL PROCESS THE STRATEGIC PLANNING, BUDGETING AND CONTROL PROCESS To help you understand the budgetary process we shall begin by looking at how it fits into an overall general framework of planning and control The framework outlined in Figure 15.1 provides an overview of an organization’s planning and control process The first stage involves establishing the objectives and supporting strategies of the organization within the strategic planning process Strategic planning process Before the budgeting process begins, an organization should have prepared a long-term plan (also known as a strategic plan) Strategic planning begins with the specification of objectives towards which future operations should be directed Johnson, Scholes and Whittington (2010) identify a hierarchy of objectives – the mission of an organization, corporate objectives and unit objectives.1 The mission of an organization (see Exhibit 15.1 for an illustration) describes in very general terms the broad purpose and reason for an organization’s existence, the nature of the business(es) it is in and the customers it seeks to serve and satisfy It is a visionary projection of the central and over-riding concepts on which the organization is based Corporate objectives relate to the organization as a whole Objectives tend to be more specific, and represent desired states or results to be achieved They are normally measurable and are expressed in financial terms such as desired profits or sales levels, return on capital employed, rates of growth or market share Objectives must also be developed for the different parts of an organization Unit objectives relate to the specific objectives of individual units within the organization, such as a division or one company within a holding company Corporate objectives are normally set for the organization as a whole and are then translated into unit objectives, which become the targets for the individual units It is important that senior managers in an organization understand clearly where their company is going, and why and how their own role contributes to the attainment of corporate objectives The strategic planning process should also specify how the objectives of the organization will be achieved Strategic planning process (specification of objectives and strategies) Creation of long-term plan to implement strategies Preparation of the annual budget within the context of the long-term plan Monitor actual results Respond to deviations from plan FIGURE 15.1 Strategic planning, budgeting and control process 359 360 CHAPTER 15 THE BUDGETING PROCESS EXHIBIT 15.1 EasyJet mission statement ‘To provide our customers with safe, good value, point-to-point air services To effect and to offer a consistent and reliable product and fares appealing to leisure and business markets on a range of European routes To achieve this we will develop our people and establish lasting relationships with our suppliers.’ Source: Easyjet.co.uk/en/about/index.html Creation of long-term plan The term strategy is used to describe the courses of action that need to be taken to achieve the objectives set When management has identified those strategic options that have the greatest potential for achieving the company’s objectives, long-term plans should be created to implement the strategies A long-term plan is a statement of the preliminary targets and activities required by an organization to achieve its strategic plan, together with a broad estimate for each year of the resources required and revenues expected Because long-term planning involves ‘looking into the future’ for several years ahead (typically at least five years) the plans tend to be uncertain, general in nature, imprecise and subject to change Preparation of the annual budget within the context of the long-term plan Budgeting is concerned with the implementation of the long-term plan for the year ahead Because of the shorter planning horizon, budgets are more precise and detailed Budgets are a clear indication of what is expected to be achieved during the budget period, whereas long-term plans represent the broad directions that top management intend to follow The budget is not something that originates ‘from nothing’ each year – it is developed within the context of ongoing business and is ruled by previous decisions that have been taken within the long-term planning process When the activities are initially approved for inclusion in the long-term plan, they are based on uncertain estimates that are projected for several years These proposals must be reviewed and revised in the light of more recent information This review and revision process frequently takes place as part of the annual budgeting process, and it may result in important decisions being taken on possible activity adjustments within the current budget period The budgeting process cannot therefore be viewed as being purely concerned with the current year – it must be considered as an integrated part of the longterm planning process Monitor actual outcomes and respond to deviations from planned outcomes The final stages in the strategic planning, budgeting and control process outlined in Figure 15.1 are to compare the actual and the planned outcomes, and to respond to any deviations from the plan These stages represent the control process of budgeting Planning and control are closely linked Planning involves looking ahead to determine the actions required to achieve the objectives of the organization Control involves looking back to ascertain what actually happened and comparing it with the planned outcomes Effective control requires that corrective action is taken so that actual outcomes conform to planned outcomes Alternatively, the plans may require modification if the comparisons indicate that the plans are no longer attainable The corrective action is indicated by the arrowed lines in Figure 15.1 linking stages and and and These arrowed lines represent feedback loops They signify that the process is dynamic and stress the interdependencies between the various stages in the process The feedback loops between the stages indicate that the plans should be regularly reviewed, and if they are no longer attainable then alternative courses of action must be considered for achieving the organization’s objectives The loop between stages and also stresses the corrective action that may be taken so that actual outcomes conform to planned outcomes THE MULTIPLE FUNCTIONS OF BUDGETS A detailed discussion of the control process will be deferred until the next chapter Let us now consider the short-term budgeting process in more detail THE MULTIPLE FUNCTIONS OF BUDGETS Budgets serve a number of useful purposes They include: planning annual operations; coordinating the activities of the various parts of the organization and ensuring that the parts are in harmony with each other; communicating plans to the various responsibility centre managers; motivating managers to strive to achieve the organizational goals; controlling activities; evaluating the performance of managers Let us now examine each of these six factors Planning The major planning decisions will already have been made as part of the long-term planning process However, the annual budgeting process leads to the refinement of those plans, since managers must produce detailed plans for the implementation of the long-range plan Without the annual budgeting process, the pressures of day-to-day operating problems may tempt managers not to plan for future operations The budgeting process ensures that managers plan for future operations, and that they consider how conditions in the next year might change and what steps they should take now to respond to these changed conditions This process encourages managers to anticipate problems before they arise, and hasty decisions that are made on the spur of the moment, based on expediency rather than reasoned judgement, will be minimized Coordination The budget serves as a vehicle through which the actions of the different parts of an organization can be brought together and reconciled into a common plan Without any guidance, managers may each make their own decisions, believing that they are working in the best interests of the organization For example, the purchasing manager may prefer to place large orders so as to obtain large discounts; the production manager will be concerned with avoiding high inventory levels; and the accountant will be concerned with the impact of the decision on the cash resources of the business It is the aim of budgeting to reconcile these differences for the good of the organization as a whole, rather than for the benefit of any individual area Budgeting therefore compels managers to examine the relationship between their own operations and those of other departments, and, in the process, to identify and resolve conflicts Communication If an organization is to function effectively, there must be definite lines of communication so that all the parts will be kept fully informed of the plans and the policies, and constraints, to which the organization is expected to conform Everyone in the organization should have a clear understanding of the part they are expected to play in achieving the annual budget This process will ensure that the appropriate individuals are made accountable for implementing the budget Through the budget, top management communicates its expectations to lower level management, so that all members of the organization may understand these expectations and can coordinate their activities to attain them It is not just the budget itself that facilitates communication – much vital information is communicated in the actual act of preparing it 361 362 CHAPTER 15 THE BUDGETING PROCESS Motivation The budget can be a useful device for influencing managerial behaviour and motivating managers to perform in line with the organizational objectives A budget provides a standard that under certain circumstances, a manager may be motivated to strive to achieve However, budgets can also encourage inefficiency and conflict between managers If individuals have actively participated in preparing the budget, and it is used as a tool to assist managers in managing their departments, it can act as a strong motivational device by providing a challenge Alternatively, if the budget is dictated from above, and imposes a threat rather than a challenge, it may be resisted and more harm than good We shall discuss the dysfunctional motivational consequence of budgets in Chapter 16 Control A budget assists managers in managing and controlling the activities for which they are responsible By comparing the actual results with the budgeted amounts for different categories of expenses, managers can ascertain which costs not conform to the original plan and thus require their attention This process enables management to operate a system of management by exception which means that a manager’s attention and effort can be concentrated on significant deviations from the expected results By investigating the reasons for the deviations, managers may be able to identify inefficiencies such as the purchase of inferior quality materials When the reasons for the inefficiencies have been found, appropriate control action should be taken to remedy the situation Performance evaluation A manager’s performance is often evaluated by measuring his or her success in meeting the budgets In some companies bonuses are awarded on the basis of an employee’s ability to achieve the targets specified in the periodic budgets, or promotion may be partly dependent upon a manager’s budget record In addition, the manager may wish to evaluate his or her own performance The budget thus provides a useful means of informing managers of how well they are performing in meeting targets that they have previously helped to set The use of budgets as a method of performance evaluation also influences human behaviour, and for this reason we shall consider the behavioural aspects of performance evaluation in Chapter 16 CONFLICTING ROLES OF BUDGETS Because a single budget system is normally used to serve several purposes there is a danger that they may conflict with each other For instance, the planning and motivation roles may be in conflict with each other Demanding budgets that may not be achieved may be appropriate to motivate maximum performance, but they are unsuitable for planning purposes For these a budget should be set based on easier targets that are expected to be met There is also a conflict between the planning and performance evaluation roles For planning purposes budgets are set in advance of the budget period based on an anticipated set of circumstances or environment Performance evaluation should be based on a comparison of actual performance with an adjusted budget to reflect the circumstances under which managers actually operated In practice, many firms compare actual performance with the original budget (adjusted to the actual level of activity, i.e a flexible budget), but if the circumstances envisaged when the original budget was set have changed then there will be a planning and evaluation conflict THE BUDGET PERIOD The conventional approach is that once per year the manager of each budget centre prepares a detailed budget for one year The budget is divided into either twelve monthly or thirteen four-weekly periods for control purposes The preparation of budgets on an annual basis has been strongly criticized on the ADMINISTRATION OF THE BUDGETING PROCESS grounds that it is too rigid and ties a company to a 12-month commitment, which can be risky because the budget is based on uncertain forecasts An alternative approach is for the annual budget to be broken down by months for the first three months, and by quarters for the remaining nine months The quarterly budgets are then developed on a monthly basis as the year proceeds For example, during the first quarter, the monthly budgets for the second quarter will be prepared; and during the second quarter, the monthly budgets for the third quarter will be prepared The quarterly budgets may also be reviewed as the year unfolds For example, during the first quarter, the budget for the next three quarters may be changed as new information becomes available A new budget for a fifth quarter will also be prepared This process is known as continuous or rolling budgeting, and ensures that a 12-month budget is always available by adding a quarter in the future as the quarter just ended is dropped Contrast this with a budget prepared once per year As the year goes by, the period for which a budget is available will shorten until the budget for next year is prepared Rolling budgets also ensure that planning is not something that takes place once a year when the budget is being formulated Instead, budgeting is a continuous process, and managers are encouraged to constantly look ahead and review future plans Furthermore, it is likely that actual performance will be compared with a more realistic target, because budgets are being constantly reviewed and updated The main disadvantage of a rolling budget is that it can create uncertainty for managers because the budget is constantly being changed Irrespective of whether the budget is prepared on an annual or a continuous basis, it is important that monthly or four-weekly budgets are normally used for control purposes ADMINISTRATION OF THE BUDGETING PROCESS It is important that suitable administration procedures be introduced to ensure that the budget process works effectively In practice, the procedures should be tailor-made to the requirements of the organization, but as a general rule a firm should ensure that procedures are established for approving the budgets and that the appropriate staff support is available for assisting managers in preparing their budgets The budget committee The budget committee should consist of high-level executives who represent the major segments of the business Its major task is to ensure that budgets are realistically established and that they are coordinated satisfactorily The normal procedure is for the functional heads to present their budget to the committee for approval If the budget does not reflect a reasonable level of performance, it will not be approved and the functional head will be required to adjust the budget and re-submit it for approval It is important that the person whose performance is being measured should agree that the revised budget can be achieved; otherwise, if it is considered to be impossible to achieve, it will not act as a motivational device If budget revisions are made, the budgetees should at least feel that they were given a fair hearing by the committee We shall discuss budget negotiation in more detail later in this chapter The budget committee should appoint a budget officer, who will normally be the accountant The role of the budget officer is to coordinate the individual budgets into a budget for the whole organization, so that the budget committee and the budgetee can see the impact of an individual budget on the organization as a whole Accounting staff The accounting staff will normally assist managers in the preparation of their budgets; they will, for example, circulate and advise on the instructions about budget preparation, provide past information that may be useful for preparing the present budget, and ensure that managers submit their budgets on time The accounting staff not determine the content of the various budgets, but they provide a valuable advisory service for the line managers 363 364 CHAPTER 15 THE BUDGETING PROCESS Budget manual A budget manual should be prepared by the accountant It will describe the objectives and procedures involved in the budgeting process and will provide a useful reference source for managers responsible for budget preparation In addition, the manual may include a timetable specifying the order in which the budgets should be prepared and the dates when they should be presented to the budget committee The manual should be circulated to all individuals who are responsible for preparing budgets STAGES IN THE BUDGETING PROCESS The important stages are as follows: communicating details of budget policy and guidelines to those people responsible for the preparation of budgets; determining the factor that restricts output; preparation of the sales budget; initial preparation of various budgets; negotiation of budgets with superiors; coordination and review of budgets; final acceptance of budgets; ongoing review of budgets Let us now consider each of these stages in more detail Communicating details of the budget policy Many decisions affecting the budget year will have been taken previously as part of the long-term planning process The long-range plan is therefore the starting point for the preparation of the annual budget Thus, top management must communicate the policy effects of the long-term plan to those responsible for preparing the current year’s budgets Policy effects might include planned changes in sales mix, or the expansion or contraction of certain activities In addition, other important guidelines that are to govern the preparation of the budget should be specified – for example the allowances that are to be made for price and wage increases, and the expected changes in productivity Also, any expected changes in industry demand and output should be communicated by top management to the managers responsible for budget preparation It is essential that all managers be made aware of the policy of top management for implementing the long-term plan in the current year’s budget so that common guidelines can be established The process also indicates to the managers responsible for preparing the budgets how they should respond to any expected environmental changes Determining the factor that restricts performance In every organization there is some factor that restricts performance for a given period In the majority of organizations this factor is sales demand However, it is possible for production capacity to restrict performance when sales demand is in excess of available capacity Prior to the preparation of the budgets, it is necessary for top management to determine the factor that restricts performance, since this factor determines the point at which the annual budgeting process should begin Preparation of the sales budget The volume of sales and the sales mix determine the level of a company’s operations, when sales demand is the factor that restricts output For this reason, the sales budget is the most important plan in the annual budgeting process This budget is also the most difficult plan to produce, because total sales STAGES IN THE BUDGETING PROCESS revenue depends on the actions of customers In addition, sales demand may be influenced by the state of the economy or the actions of competitors Initial preparation of budgets The managers who are responsible for meeting the budgeted performance should prepare the budget for those areas for which they are responsible The preparation of the budget should be a ‘bottom-up’ process This means that the budget should originate at the lowest levels of management and be refined and coordinated at higher levels The justification for this approach is that it enables managers to participate in the preparation of their budgets and increases the probability that they will accept the budget and strive to achieve the budget targets There is no single way in which the appropriate quantity for a particular budget item is determined Past data may be used as the starting point for producing the budgets, but this does not mean that budgeting is based on the assumption that what has happened in the past will occur in the future Changes in future conditions must be taken into account, but past information may provide useful guidance for the future In addition, managers may look to the guidelines provided by top management for determining the content of their budgets For example, the guidelines may provide specific instructions as to the content of their budgets and the permitted changes that can be made in the prices of purchases of materials and services For production activities standard costs (see Chapter 17) may be used as the basis for costing activity volumes which are planned in the budget Negotiation of budgets To implement a participative approach to budgeting, the budget should be originated at the lowest level of management The managers at this level should submit their budget to their superiors for approval The superior should then incorporate this budget with other budgets for which he or she is responsible and then submit this budget for approval to his or her superior The manager who is the superior then becomes the budgetee at the next higher level The process is illustrated in Figure 15.2 Sizer (1989) describes this approach as a two-way process of a top-down statement of objectives and strategies, bottom-up budget preparation and top-down approval by senior management The lower-level managers are represented by boxes 1–8 Managers and will prepare their budgets in accordance with the budget policy and the guidelines laid down by top management The managers will submit their budget to their supervisor, who is in charge of the whole department (department A) Once these budgets have been agreed by the manager of department A, they will be combined by the departmental manager, who will then present this budget to his or her superior (manager of plant 1) for approval The manager of plant is also responsible for department B, and will combine the agreed budgets for departments A and B before presenting the combined budget to his or her supervisor (the production manager) The production manager will merge the budget for plants and 2, and this final budget will represent the production budget that will be presented to the budget committee for approval At each of these stages the budgets will be negotiated between the budgetees and their superiors, and eventually they will be agreed by both parties Hence the figures that are included in the budget are the result of a bargaining process between a manager and his or her superior It is important that the budgetees should participate in arriving at the final budget and that the superior does not revise the budget without giving full consideration to the subordinates’ arguments for including any of the budgeted items Otherwise, real participation will not be taking place, and it is unlikely that the subordinate will be motivated to achieve a budget that he or she did not accept It is also necessary to be watchful that budgetees not deliberately attempt to obtain approval for easily attainable budgets, or attempt to deliberately understate budgets in the hope that the budget that is finally agreed will represent an easily attainable target It is equally unsatisfactory for a superior to impose difficult targets in the hope that an authoritarian approach will produce the desired results The desired results may be achieved in the short term, but only at the cost of a loss of morale and increased labour turnover in the future The negotiation process is of vital importance in the budgeting process, and can determine whether the budget becomes a really effective management tool or just a routine to follow If managers are successful 365 ANSWERS TO REVIEW PROBLEMS holding cost ỵ ordering cost ẳ (b) Revised EOQ ¼ (ii) 300  12 000  135 ỵ ẳ 600 300 DO QH 150 000 360 3:00 10 000 ỵ ẳ ỵ Q 10 000 ẳ $5 400 ỵ $15 000 ¼ $20 400 The relevant cost is Additional inventory management cost if 10 000 components are purchased = $2 400 Value of the discount is (150 000  $2.00)  per cent = $3 000 It is therefore worthwhile to purchase 10 000 components and take the quantity discount 231 12 000 80 ỵ ẳ 772 231 The relevant cost using the original EOQ of 300 units but with an incremental ordering cost of Ê80 is holding cost ỵ ordering cost ẳ 300 12 000 80 ỵ ẳ 2867 300 Cost of prediction error ¼ £95 (£2 867 À £2 772) (c) The annual costs of purchasing, ordering and holding the materials consist of: Special offer at £86: holding cost ỵ ordering cost ỵ purchase cost 000 12 ỵ ẳ 000 86 ẳ Ê368 000 Normal price of £90: 300  12 000 135 ỵ ỵ 000 90 ẳ £363 600 300 Additional cost of specific offer £4 400 Therefore the purchase of 000 units at £86 is not recommended (d) Actual (£) Material cost 360 000 344 000 (4 000  £90) (4 000  £86) Ordering cost 800   D ÂO Q Variance (£) 16 000F 800F 17 800F It can be seen that favourable variances would appear on the performance report, and goal congruence would not exist The performance evaluation system conflicts with the EOQ decision model This is because the purchasing officer is not charged for the use of capital but the EOQ model includes a charge for the use of capital Therefore if an imputed capital charge is not included in the performance report, there is a danger that goal congruence will not exist The revised performance report including a capital charge is shown below: Material cost Ordering cost Holding cost 24.15 (i) Total cost of inventory management using 10 000 units is: sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi    000  80 ¼ 231 12 Budget (£) Budget (£) Actual (£) 360 000 800 800 344 000 24 000 Variance (£) 16 000F 800F 22 200A 400A EOQ rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi  150 000  360 ¼ 000 units 3:00 Total cost of inventory management using EOQ is: Cost of ordering inventory ỵ cost of holding inventory DO QH 150 000  360 3:00 000 ỵ ẳ ỵ Q 000 ẳ $9 000 ỵ $9 000 ẳ $18 000 769 24.16 (a) Month Total Demand Std hours 100 700 000 300 600 980 Average Inc/(Dec) in Closing Basic inventory inventory Inventory inventory production cost $ Std hours Std hours Std hours Std hours 780 780 780 780 780 780 680 80 (220) 480 180 (1 200) 680 760 540 020 200 340 720 650 780 110 600 040 320 900 680 660 600 25 200 Note that because production occurs evenly throughout the month average inventory standard hours are equal to opening inventory plus closing inventory divided by two With the JIT system of not maintaining inventories, demand in months and will require overtime working since there is a shortfall in output of 220 standard hours in month and 1200 hours in month The calculation of the overtime cost is as follows: Month ¼ 220 std hours /0.96 ¼ 229.17 labour hours  $15 ¼ 437.55 Month ¼1 200 std hours /0.96 ¼ 250.00 labour hours  $15 ¼ 18 750.00 22 187.55 The net saving for the six-month period with the JIT system is $3012.45 (b) The following factors should be considered: need for a commitment to quality since sub• The standard output cannot be replaced from inventories • that are maintained as a safety net to guard against inferior production The need to ensure that staff are trained in multi-tasking in order to respond immediately with any problems that occur in the production process since JIT production is dependent on a constant production flow 24.17 (a) The question requires the calculation of the optimum number of units to be manufactured in each production run in order to secure the lowest annual cost In Chapter 24 we noted that the formula for the optimum number of units to be manufactured (Q) is as follows: ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi s ffi 2DS Q¼ H where D ¼ total demand for period, S ¼ set-up costs and H ¼ holding cost per unit The set-up costs and holding cost per unit to be used in the formula are relevant or incremental costs Those costs that will not change as a result of changes in the number of units manufactured in each batch should not be included in the analysis These costs include: (i) Skilled labour costs (Skilled labour is being paid idle time Its total cost will not alter as a result of the current decision.) 770 ANSWERS TO REVIEW PROBLEMS (ii) Fixed overheads (These costs are independent of the batch size.) Therefore the relevant cost of producing product Exe is as follows: We now compare the cost savings with the increased holding costs from increasing the quantity purchased from the EOQ of 500 units to the lowest purchase quantity at which Wye can be purchased at £19.80 per unit (i.e 000 units): (£) Raw materials À external suppliers Dee standard cost: 13 Raw materials Unskilled labour Variable overheads Unskilled labour Variable overheads Incremental cost of production 15 40 The relevant decision variables for the formula are as follows: Annual demand of Exe (D) ¼ 000 units Set-up costs (S) ¼ £70 (skilled labour of £66 is not an incremental cost) Annual holding costs ¼ £14 [cost of storage (£8) plus cost of capital tied up in stocks (£6)] Storage cost per unit (0.40 m2  £20) ¼ £8 Incremental interest tied up in each unit of Exe stock (15%  £40 incremental cost of Exe) ¼ £6 Applying the above figures to the formula, we have: sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi    000  £70 Q¼ £14 (£) Savings in purchase price (10 000 annual purchases at £0.20) Saving in ordering costa DO DO 10 000  100 10 000  100 À ¼ À Qd Q 000 500 Total savings ðQd À QÞH ð1 000 À 500ị Ê8 ẳ ẳ Ê2 000 2 Therefore a saving of £1 000 is made if the firm purchases in quantities of 000 units at a price of £19.80 per unit We now follow the same procedure in order to determine whether it would be better to purchase in quantities of 000 units: (£) Savings in purchase price (10 000 annual purchases at £0.40) 000 Saving in ordering cost DO DO 10 000  100 10 000  100 À ¼ À Qd Q 000 500 500 Total savings 500 280 Holding costs (average stocks  unit holding cost) 000 000  £14 Total cost 280 Cost of optimum policy Set-up costs [(4000/200) production runs at £70] 1400 Holding costs (average stocks  unit holding cost) 200 400  £14 Total cost 800 Annual savings (£7 280 À £2 800) £44 80 Q¼ Buying in larger quantities in order to take advantage of bulk discounts results in the following savings: (i) (ii) The additional holding cost if we purchase in 000-unit quantities instead of 500-unit quantities is as follows: ðQd À QÞH ð2 000 500ị Ê8 ẳ ẳ Ê6 000 ẵ2 Therefore an additional £500 will be incurred if the firm purchases in 000-unit batches compared with purchasing in 500-unit batches The above analysis indicates that Pink should purchase in batches of 000 units at a price of £19.80 per unit ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi s  DO H where D ¼ annual demand, O ¼ incremental ordering cost per order, H ¼ holding cost per unit For producing Wye: sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi  ffi  10 000  £100 Q¼ ¼ 500 units £8 a saving in purchase price for the period consisting of the total amount of the discount for the period; a reduction in total ordering cost because of fewer orders being placed to take advantage of bulk discounts The above cost savings must be compared with the increased holding costs resulting from higher stock levels 000 The additional holding cost if the larger quantity is purchased is calculated as follows: (£) (b) 000 Note a Qd represents quantity ordered to obtain discount and Q represents EOQ ¼ 200 units Cost of current policy Set-up costs (4 production runs at £70) 000 (c) Limitations include the following: It is very difficult to obtain relevant data Incremental holding, ordering and set-up costs are very difficult to estimate in practice In addition, many of the fixed costs that were excluded in the analysis may not be fixed over the whole range of output Some fixed costs may increase in steps as the quantity purchased is increased (ii) Model assumes certainty A more sophisticated approach is required where the demand and the cost structure are uncertain (iii) Model assumes that demand is constant throughout the year In practice, there may be seasonal variations in demand throughout the year (i) ANSWERS TO REVIEW PROBLEMS 24.18 (a) Safety stock Stockout 500 400 300 100 200 100 300 200 100 400 300 200 100 500 400 300 200 100 200 100 Stockout cost at £10 (£) Probability Expected cost (£) 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 0.04 0.04 0.07 0.04 0.07 0.10 0.04 0.07 0.10 0.13 0.04 0.07 0.10 0.13 0.16 40 80 70 120 140 100 160 210 200 130 200 280 300 260 160 Demand lead time Total (£) Frequency Probability 106 104 102 100 98 96 94 40 150 10 16 40 14 14 100 360 771 Expected value 0.04 0.10 0.16 0.40 0.14 0.14 0.02 1.00 4.24 10.40 16.32 40.00 13.72 13.44 1.88 100.00 It is assumed that the reorder point will be set at 100 units (expected value) The expected costs for various levels of safety stock are as follows: 700 200 Safety stock Stockout cost (£) Holding cost (£) Total cost (£) 100 200 300 400 500 200 700 360 150 40 0 100 200 300 400 500 200 800 560 450 440 500 The optimal safety stock is 400 units (b) The probability of being out of stock at an optimal safety stock of 400 units is 0.04 ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi s  sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi 24.19 (a) 2DO  10 000  25 EOQ ¼ ¼ 100 units ¼ H ð45 þ 5Þ Total Safety Reorder Stockout Stockout Probability Expected Holding a c point per order per year stock stockout cost of expected b d stockout cost (£) cost (£) (units) (£) (units) (units) (units) 106 104 102 100 2 4 200 200 400 200 400 600 0.04 0.10 0.04 0.16 0.10 0.04 80 200 160 320 400 240 270 180 270 260 90 450 960 Notes a During the year 100 orders will be made (10 000 units annual demand/EOQ of 100 units) Stockout per year in units is calculated by multiplying the stockouts per order by 100 orders b Expected stockout costs ¼ annual stockout in units  probability of stockout  £10 lost contribution c Holding cost ¼ safety stock  (holding cost of £50 À saving of 10% on purchasing manager’s bonus) d It is assumed that stockout costs are equal to the lost contribution on the lost sales Conclusion Costs are minimized if a safety stock of units is maintained (d) The following items should be included in the report: The disadvantages of ordering from only one supplier (e.g vulnerability of disruption of supplies due to strikes/production difficulties or bankruptcy); (ii) Failure to seek out cheap or alternative sources of supply; (iii) It is assumed no large price increases are anticipated that will justify holding additional stocks or that the stocks are not subject to deterioration or obsolescence; (iv) It is assumed that lead time will remain unchanged However, investigations should be made as to whether this, or other suppliers, can guarantee a shorter lead time; (v) The need to ascertain the impact on customer goodwill if a stockout occurs The answer to (c) assumes that the company will merely lose the contribution on the sales and long-term sales will not be affected if a stockout occurs (i) (b) Without any discount prices the EOQ ¼ sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi  10 000  25 ẳ 99:99 units 45 ỵ 5:01ị Thus it is preferable to purchase 100 units at £50 rather than pay £50.10 for purchasing 99 units To ascertain whether it is worthwhile increasing the purchase quantity from 100 to 200 units we must compare the total costs at each of these quantities: (£) Total costs with a reorder quantity of 100 units Annual holding cost (100/2  £50) Annual ordering costs (10 000/100  £25) 500 500 000 Purchasing manager’s bonus (10%  £5 000) 500 Annual purchase cost (10 000  £50) 500 000 505 500 Total annual costs Total costs with a reorder quantity of 200 units Annual holding costs (200/2  £49.99) 999 Annual ordering costs (10 000/200  £25) 250 249 Purchasing manager’s bonus (10%  (£10 000 À £6 249)) 375 Annual purchase cost (10 000  £49.90) 499 000 Total annual costs 505 624 The optimal order quantity is still 100 units (c) The probability distribution of demand over the three day lead time is as follows: CHAPTER 25 25.10 Where the objective function is to minimize total costs the potential optimal solutions will be at the points closest to the origin that fall within the feasible region Therefore the optimal solution will be at either points E or D Note that total costs are lower for E compared with A since E and A entail the same output of U units but E has a lower output of A units Answer ¼ (c) 772 ANSWERS TO REVIEW PROBLEMS 25.11 (a) Let M ¼ number of units of Masso produced and sold Let R ¼ number of units of Russo produced and sold The linear programming model is as follows: Maximize Z ẳ 40M ỵ 50R (production contributions) subject to M ỵ 2R 2.5M ỵ 2R M R M R ≤ ≤ ≤ ≤ ≥ ≥ 700 (machining capacity) 000 (assembly capacity) 400 (maximum output of Masso constraint) 400 (maximum output of Russo constraint) 0 The constraints are plotted on the graph as follows: Machining constraint: line from (M ¼ 700, R ¼ 0) to (R ¼ 350, M ¼ 0) Assembly constraint: line from (M ¼ 400, R ¼ 0) to (R ¼ 500, M ¼ 0) Output of Masso constraint: line from M ¼ 400 Output of Russo constraint: line from R ¼ 400 The values for M and R when the above equations are solved are M ¼ 199.33 and R ¼ 250.83 Therefore Russo is increased by 0.83 units and Masso is reduced by 0.67 units and the change in contribution will be as follows: Increase in contribution from Russo (0.83  £50) ¼ 41.50 Decrease in contribution from Masso (0.67  40) ¼ (26.80) Increase in contribution 14.70 (£) 000 12 500 20 500 17 000 500 The optimum output can be determined exactly by solving the simultaneous equations for the constraints that intersect at point B: 2:5M ỵ 2R ẳ 000 M ỵ 2R ẳ 700 M ỵ 2R ẳ 701 revised machining constraintị 2:5M ỵ 2R ẳ 000 ðunchanged assembly constraintÞ (£) At the optimum point (B in the graph) the output mix is as follows: 200 units of Masso at a contribution of £40 per unit ¼ 250 units of Russo at a contribution of £50 per unit ¼ Total contribution Less fixed costs (£7 000 ỵ Ê10 000) Profit (b) Machining capacity If we obtain additional machine hours, the line M ỵ 2R ẳ 700 will shift upward Therefore the revised optimum point will fall on the line BD If one extra machine hour is obtained, the constraints M ỵ 2R ẳ 700 and 2.5M ỵ 2R will still be binding and the new optimal plan can be determined by solving the following equations: ð1Þ ð2Þ Hence the value of an independent marginal increase in machine capacity is £14.70 per hour Assembly capacity With an additional hour of assembly capacity, the new optimal plan will be given by the solution of the following equations: M ỵ 2R ẳ 700 unchanged machining constraintị 2:5M ỵ 2R ẳ 001 revised assembly constraintị The values for M and R when the above equations are solved are M ¼ 200.67 and R ¼ 249.67 Therefore Masso is increased by 0.67 units and Russo is decreased by 0.33 units, and the change in contribution will be as follows: (£) Increase in contribution from Masso (0.67  £40) ¼ 26.80 Decrease in contribution from Russo (0.33  £50) (16.50) Increase in contribution 10.30 500 D 400 Hence the value of an independent marginal increase in assembly capacity is £10.30 per hour (c) The assumptions underlying the above calculations are: R = 400 linearity over the whole output range for costs, revenues and quantity of resources used; (ii) divisibility of products (it is assumed that products can be produced in fractions of units); (iii) divisibility of resources (supplies of resources may only be available in specified multiples); (iv) the objectives of the firm (it is assumed that the single objective of a firm is to maximize short-term contribution); (v) all of the available opportunities for the use of the resources have been included in the linear programming model A M = 400 R (RUSSO) (i) 300 B 5M 200 + M+ = 2R 100 2R 00 10 =7 00 C 100 200 400 300 M Masso 500 600 700 Objective function line Z = 10 000 (arbitrarly chosen contribution figure) Feasible region = OABC 25.12 (a) The calculation of the contribution per cue is as follows: Subtract equation (2) from equation (1): 1:5M ¼ 300 M ¼ 200 Substituting in equation (1): 2:5 200 ỵ 2R ẳ 000 R ¼ 250 Selling price Material cost at $40/kg Craftsmen cost at $18/hr Other Variable cost Contribution per cue Pool cue $ Snooker cue $ 41.00 (10.80) (9.00) (1.20) 20.00 69.00 (10.80) (13.50) (4.70) 40.00 ANSWERS TO REVIEW PROBLEMS (b) Let P and S be the number of pool and snooker cues made and sold in any three-month period and C represent the contribution earned in any three-month period The linear programming model is formulated as follows: Maximize C ẳ 20P ỵ 40S Subject to: shadow price of labour we examine the impact of an additional labour hour so that: 0.5P ỵ 0.75S ẳ 12 001 Substituting S ẳ 12 000 0:5P ỵ 0:7512 000ị ẳ 12 001 0:5P ỵ 000 ẳ 12 001 0:5P ẳ 001 P ẳ 002 Craftsmen: 0.5P ỵ 0.75S 12 000 Ash: 0.27P ỵ 0.27S 400 Demand levels – Pool cues P ≤ 15 000 – Snooker cues S ≤ 12 000 Non negativity: P, S ≥ This would result in an extra $40 contribution (2  $20) so the shadow price is $40 per extra hour of craftsmen time (d) The company would be better off accepting the offer since the rate of pay is less than the shadow price but before accepting the company should try and negotiate a lower rate Buying more craftsmen hours will extend the line outwards until it reaches point F, so that materials will become the binding constraint and there would be no point buying additional labour hours At point F: Reference to the diagram indicates that the feasible region is inside area OABCDE Within this feasible region a contribution line is inserted for a combination of pool and snooker cues that results from an arbitrarily selected contribution value The contribution line is extended outwards to determine the last corner point within the feasible region This is point D where the lines S ẳ 12 000 and 0.5P ỵ 0.75S ẳ 12 000 intersect 0.27P ỵ 0.27S ẳ 400 S ¼ 12 000 Substituting S ¼ 12 000 in the above equation Substituting S ¼ 12 000 in equation (2) 0:5P ỵ 0:75 12 000ị ẳ 0:5P þ 000 ¼ 0:5P ¼ 0:5P ¼ P ¼ 0:27P ỵ 0:2712 000ị ẳ 0:27P ỵ 240 ẳ 0:27P ¼ P ¼ 12 000 12 000 12 000 À 000 000 000 Therefore the maximum contribution is earned when 000 pool cues and 12 000 snooker cues are made and sold in a three month period The contribution earned is C ¼ ð20  000ị ỵ 40 12 000ị C ẳ 120 000 ỵ 480 000 C ẳ $600 000 P 24 Craftsmen Feasible region = OABCDE Optimal point at point D 22 400 400 160 000 Point F falls where S ¼ 12 000 and P ¼ 000 so the craftsmen hours needed at this point are (0.5 000) ỵ (0.75 12 000) ¼13 000 hours Therefore Higgins should only buy 000 hours (13 000 À 12 000) 25.13 (a) The resources required to meet the demand are as follows: Maximum demand (units) Direct labour (hours) Direct material (kg) Machine hours Direct material is the limiting factor Linear programming graphical solution for HC 773 Product L M Total 400 600 800 400 700 400 300 400 000 100 800 L $ M $ Max S Unit selling price Variable costs per unit: Direct labour ($7 per hour) Direct material ($5 per kg) Machine hours ($10 per hour) Contribution per unit Contribution per kg Ranking Output (units) Materials used (kg) Contribution 20 Max contribution 18 16 A B Max P 14 C 12 10 70 28 10 10 22 11 400 800 800 90 14 45 20 11 1.22 577 193 347 F Total contribution ¼ $15 147 (b) Maximize C ¼ 22L Subject to: Direct labour Direct material Machine hours D contribution 10 12 14 16 18 Ash 20 S E (c) For an explanation of shadow prices see ‘shadow prices’ in Chapter 25 There are unused resources of ash at the optimal output level Given that the resource is not scarce the shadow price is zero To determine the ỵ 11M 4L ỵ 2M 300 2L ỵ 9M 550 1L ỵ 2M 100 (c) The value of 400 represents the optimum number of units produced for product L and the other value of zero for product L is the unsatisfied demand of zero because maximum demand is also 400 The entry of 194 for product M and the other value of 506 refers to an optimum production of 194 units of M and the 506 to the unsatisfied sales demand of L (700 maximum demand 774 ANSWERS TO REVIEW PROBLEMS less 194 units optimum production) The value of 312 for direct labour and machine hours indicates that there are 312 unused machine hours and 312 unused labour hours This can be proved by, for machine hours, comparing the outputs to the machine hours available: 400 units of L use hour each ¼ 194 units of M use hours each ¼ Total hours used Hours available Hours unused 400 388 788 100 312 hours hours hours hours hours A similar proof could have been provided for labour hours The value of $1.22 is the shadow price of the direct materials This is the maximum additional price that should be paid for an extra kg of direct material above the current cost of $5 per kg The fact that there is a shadow price for this resource indicates that it is a binding constraint This shadow price can be proved because extra kg of direct material would be used to increase the output of product M Each unit of M requires kg so 0.11 additional units of M could be produced from extra kg of material Each unit of M yields a contribution of $11 so 0.11 units yields $1.22 contribution The entry of 312 for direct labour hours represents the number of unused labour hours and the value of $10 934 is the contribution earned from the optimum production plan consisting of 400 units of L at $22 each ¼ $8 800 plus 194 units of M at $11 each ¼ $2 134 25.14 (a) Traditional (T) contribution per unit ẳ Ê55.50 (Ê100 (0.5 Ê25 ỵ 0.4 Ê30 overheads ỵ Ê20 timber)) Hightech (H) contribution per unit ¼ £49 The linear programming model is as follows: Maximize 55.5T ỵ 49H (contribution) Where 0:5T ỵ 0:3H ẳ 400 capacityX ị 0:4T ỵ 0:45H ẳ 840 capacityY ị 4T ỵ 4H ẳ 34 000 timber availableÞ subject to ≤ T ≤ 000 and ≤ H ≤ 10 000 The maximum contribution is shown as £444 125 and is derived as follows: Traditional ¼ 250 units  £55.50 ¼ £235 875 Hightech ¼ 250 units  £49.00 ¼ £208 250 (ii) The shadow prices indicate the extra contribution that can be obtained for each extra metre of timber (£9.8125) or additional machine group X hour (£32.50) Machine group Y has a zero shadow price because there is still some available capacity (slack) which has not been utilized (3 840 hours available – 612.5 hours allocated ¼ 227.5 unused hours) (iii) There is no surplus capacity for machine group X and 227.5 hours surplus capacity for machine group Y giving an additional contribution of £6 825 (227.5 hours  £30 ¼ £6 825) (iv) The adjustable cells table show the sensitivity of the plan to changes in the contribution per unit of each product For the ‘Traditional’ product the contribution would have to be greater than £81.67 (i.e an increase of £26.17) or less than £49 (i.e a decrease of £6.50) for a change in the planned sales mix to occur For the ‘Hightech’ product the (b) (i) contribution would have to exceed £55.50 (i.e an increase of £6.50) or be less than £33.30 (i.e a decrease of £15.70) for a change in the planned sales mix to occur (v) For each additional metre an extra contribution of £9.8125 can be obtained but the parameters of the existing model indicate that this applies only for an extra 733.33 metres of timber The additional contribution from an extra 733.33 metres of timber is £17 008 (1 733.33  £9.8125) (vi) A total of 35 733.33 metres (34 000 ỵ 733.33) will be allocated to production The timber requirements for producing ‘Hightech’ are 14 400 metres resulting in 21 333.33 metres (35 733.33 – 14 400) being available for ‘Traditional’ This will result in the production of 333.33 units of ‘Traditional’ (c) The following should be considered as a means of overcoming the capacity constraints: alternative sources of supply for the • Investigate timber Such supplies may only be obtainable at • • • • additional costs (e.g purchasing from overseas suppliers) Increase the operating hours of the machinery This may result in additional overtime payments to operators or require the appointment of extra staff Increase the output per machine hour This may result in additional labour payments and an increase in maintenance costs Acquire additional machinery To ascertain whether this is worthwhile, a capital investment appraisal should be undertaken that incorporates the cash flow consequences over the whole life of the machinery Sub-contract some of the production to outside companies This is likely to be more expensive than the internal incremental production costs and may also create quality control problems (d) Only variable costs are included in the model Therefore product specific (avoidable) fixed costs are not taken into account Such costs may be relevant if they are avoidable or involve step functions Examples include staff dedicated to a single product such as marketing costs attributable to only one of the products Customer specific costs may differ between customers For example distribution costs may vary according to the location of customers or some customers may rely on many small volume frequent orders whereas others may rely on large volume infrequent orders The costs of servicing the latter category of customers are likely to be less than the former Life cycle costs represent the costs incurred over a product’s life cycle from the introduction, growth, maturity and decline stages Costs may vary at the different stages If one of the products is at the introductory stage it may incur additional marketing costs in order to promote it Thus costs may differ between the two products if they are subject to different stages within their life cycles INDEX ABB (activity-based budgeting) 377–9, 385 ABC see activity-based-costing ABC classification of inventories 643–4, 648 ABCM (activity-based cost management) 549–52, 569 ABM (activity-based management) 549–52, 569 abnormal gains 108–9, 123 abnormal losses 105–06, 107–8, 122, 123 absorption costing cost assignment 46 definition 244 pricing decisions 235 profit function 158–9 standard 442–4 variable costing 150–2, 154–5 accounting definition users of information 5–6 accounting rate of return 316–7, 321 action controls 394–5, 399, 413 activities activity-based-costing 57, 253 definition 70, 270 hierarchy of 259–60 identification of 257–8 activity cost centres 57, 70 activity cost drivers 258, 270 activity measures 609, 624 activity-based budgeting 377–9, 385 activity-based cost management 549–52, 569 activity-based management 549–52, 569 activity-based-costing 46, 48, 251–68 activity hierarchies 259–60 cost allocation 57–60 cost drivers 257–9 cost management 267–8 cost versus benefit considerations 266 database reviews 265 definition 70 emergence of 254–5 profitability analysis 260–2 return on investment 264 service organizations 265–7 standard costing 472–4 system design 257–9 transfer pricing 522 actual profit 442 administration budgets 373 agriculture 543 aircraft industry 554 airlines 31, 47, 587 allocation bases 45, 70 AmBev 377 annual percentage rate 310, 321 annuities 307, 321 appraisal costs 559, 569 APR (annual percentage rate) 310, 321 arbitrary allocation 45, 70 aspiration levels 408, 413 assignable causes 471, 475 attribute costing 583, 597 auto manufacturers 177, 213 average costs 83, 96 avoidable costs 32, 37 BAA group 366 backflush costing 93, 96 balanced scorecards 497, 584–95, 597 balancing allowances 334, 346 balancing charges 334, 346 Bank of Ireland 208 banking 208, 498 batch costing 118, 123 batch production functional layouts 554–5, 569 batch-related activities 259, 270 behavioural controls 394–5, 413 benchmarking 14, 553, 569 beta 340, 346 beyond budgeting 383, 385 bill of materials 427, 449 blanket overhead rates 49, 70 775 776 INDEX Boeing 554 bottleneck activities 655, 668 see also scarce resources bottleneck operations/resources 666, 668 bottom-up budget setting 408, 413 BP 558 brand value budgeting 583, 597 brand value monitoring 583, 597 brand-sustaining expenses 261, 270 break-even charts 174–6, 186 break-even point 168, 186 budget committees 363 budget manuals 364 budgeted activity 156, 160 budgeted costs 423, 449 budgeted overhead rates 60–2, 70 budgeted profit 442 budgeting 358–83 activity-based 377–9 administration of 363–4 communication 361 computerized 376–7 control 362 control processes 360–1 coordination 361 criticisms of 383 definition 385 functions of 361–2 illustration of 368–70 motivation 362 non-profit-making organizations 380–1 participation in 408–9 performance evaluation 362 periods 362–3 planning 361 process stages 364–8 roles 362 zero-based 381–2 budgets 8–9, 358, 385 Bushmills Irish Whiskey 107 business process re-engineering 553, 569 business-sustaining activities 260, 270 by-products 129–31, 137–8, 140 capacity usage ratio 589, 597 capital allowances 332, 346 capital asset pricing model 340, 346 capital investment 300–19, 329–44 performance measurement 317–8, 495–7 post-completion audits 344 projects 343–4 qualitative factors 318–9 capital market line 339, 346 capital rationing 330–2, 346, 667 CAPM (capital asset pricing model) 340, 346 case studies 676–9 cash budgets 376, 385 cash flows 309–10, 311–2, 335, 344 cause-and-effect allocations 45–6, 70 CBA (cost-benefit analysis) 318, 322 cellular manufacturing 555, 569 China 406 cloud computing 230 coefficient of determination 616, 624 coefficient of variation 283, 616, 624 committed costs 544, 569 committed resources 262, 270 communication 361 competitive position monitoring 582, 597 competitor cost assessment 583, 597 competitor performance appraisal 583, 597 compounding interest 302–4, 322 constant gross profit percentage method 134–5, 140 construction projects 88 consumer medical devices 11 consumption ratios 256, 270 contingency theory 410–1, 413 continuous budgeting 363, 385 continuous improvement 14, 20–1 contract costing 80, 96 contribution graphs 176, 186 contribution margin 172, 186 contribution margin ratio 173–4, 186 control accounts 83–4, 97 control processes 360–1, 386 control(s) 9, 393–411 definition 413 harmful side-effects 397–8 controllability principle 403–6, 413 controllable investment 493, 500 controllable losses 105–06, 107–8, 118–22, 123 controllable profit 488, 500 convergence of management accounting practices 15–6 conversion costs 25, 123 corporate objectives 359, 386 correlation coefficient 616, 624 cost accounting 17, 21 cost allocation 45 see also cost assignment activity-based-costing 57–60 definition 37, 70 first stage allocation bases 52, 70–1 indirect costs 26 joint costs 131–6 sequential method 70, 72 service departments 66–71 step method 70, 72 traditional costing systems 52–6 two-stage process 50–60 INDEX cost assignment 43–72 see also cost allocation blanket overhead rates 49 cost centres 258 decision-making 60 direct costs 45–6 indirect 65 indirect costs 45–6 non-manufacturing organizations 63–5 plant-wide rates 49 purposes of 46–7 two-stage allocation process 50–60 cost behaviour 29–31 cost centres 50–1, 400–1 cost assignment 258 definition 413 cost coding 36 cost drivers 45, 253, 255–9, 609, 624 cost efficiency 13 cost estimation 607–23 cost function 609, 624 cost increases 47 cost management activity-based-costing 267–8 strategic 542–66 value chains 564–6 cost objects 23–4 definition 37 direct costs 48 cost of capital 302 definition 322 weighted average 340 cost of quality reports 559, 569 cost of resources supplied 262, 270 cost of resources used 262, 270 cost of the economic order quantity 648 cost of the prediction error 637, 648 cost of unused capacity 262, 270 cost plus a mark-up transfer pricing 511–5 cost pools 50–1, 70 cost-benefit analysis 318, 322 cost-plus pricing 230, 237–8, 244 cost-volume-profit analysis 168–85 assumptions 183–4 curvilinear relationships 169–70 information technology 184 linear relationships 170–2 multi-product 178–80 numerical approach to 172–3 semi-variable costs 184–5 costing profit and loss account 91 costing systems 47–8, 252–3 costs of non-conformance 559, 569 costs of quality conformance 559, 570 crime-fighting targets 399 cultural controls 395, 398–9, 414 customer orientation 13 customer perspective 587–8, 597 customer profitability analysis 239–41, 244 customer satisfaction 3, 13–4 customer value propositions 588, 597 customer-sustaining activities 260, 270 CVP see cost-volume-profit analysis cycle time 13, 21 DCF (discounted cash flow) 302–4, 322 decision packages 382, 386 decision trees 285–6, 291 decision-making common fixed costs 195 cost assignment 60 costing systems 252–3 discontinuation 207–9 equipment replacement 202–3 joint costs 136–7 non-financial factors 195–6 outsourcing 204–6 pricing 227–41 process 7–9 product mix 200–3 qualitative factors 195–6 special pricing decisions 196–200 decreasing returns to scale 170, 186 degree of operating leverage 180–1, 186 demand planning 377 denominator activity levels 155–7 departmental budgets 374 dependent variables 609, 625 depreciation 494 depreciation tax shields 332, 346 differential calculus 242–3 differential cash flows 195, 216 differential costs 35, 37 direct cost tracing 45, 70 direct costing 46 see also variable costing definition 244 pricing decisions 235 direct costs 24–5 cost assignment 45–6 cost objects 48 indirect costs 26 direct labour budgets 372 direct labour costs 25 definition 37 relevant 210 standard 428 direct labour hour rates 55, 70 777 778 INDEX direct material costs 24–5 definition 37 relevant 209–10 standard 427–8 direct materials mix 463–7 direct materials purchase budgets 372 direct materials usage budgets 371 discontinuation 207–9 discount rates 302 definition 322 risk adjusted 337–40 discounted cash flow 302–4, 322 discounted payback method 315, 322 discounted present value 303, 322 discounted rate of return 307, 322 discounting 303, 322 discretionary costs 382, 386 discretionary expense centres 401, 414 diversification strategy 289, 291 divisional net profit before taxes 489, 500 divisional profit contribution 488 divisionalized organizational structures 485–98 asset base 492–4 definition 500 economic value added (EVA(TM)) 492–7 financial performance measures 497–8 performance evaluation 486–7 profit measures 488–9 residual income 491–2 return on investment 490–1, 495 surveys of practice 489–90 transfer pricing 508–25 downloadable products 35 driver tracing 45, 70 dual-rate transfer pricing 519–20, 532 duration drivers 258–9, 270 Dutch Sandwich 524 e-books 10, 633 e-business 12, 21 easyJet 15 economic order quantity 634–8 economic value added (EVA(TM)) 492–7, 500 employee empowerment 14, 21 empowerment 14 energy generation 301 engineered targets 408, 414 engineering methods 610–1, 625 engineering studies 426–7, 449 enterprise resource planning systems 12, 21, 428 environmental accounting 563 environmental cost management 562–4 environmental detection costs 562–3, 570 environmental external failure costs 563, 570 environmental impact 319 environmental internal failure costs 563, 570 environmental issues 12–3 environmental prevention costs 562, 570 EOQ (economic order quantity) 634–8 equipment replacement 202–3 equivalent production 110, 123 ERPS (enterprise resource planning systems) 12, 21, 428 ethical behaviour 14–5, 21 EVA(TM) see economic value added (EVA(TM)) events 279–80, 291 ex post budget adjustments 405, 414 ex post variance analysis approach 469–70, 475 expected value of perfect information 287, 291 expected values 282, 286–7, 291 expense centres 400–1, 414 external failure costs 559, 570 facility-sustaining activities 260, 270 facility-sustaining costs 195, 216 factory overhead budgets 372–3 feed-forward controls 396–7, 414 feedback controls 396–7, 414 feedback loops 360, 386 FIFO (first in, first out) 82–3, 97 final products 510, 532 financial accounting 6–7, 21 financial performance targets 408–9, 497–8 financial perspective 587, 597 financial services 288 first in, first out 82–3, 97 first stage allocation bases 52, 70–1 fixed costs 29–30, 37 fixed overhead expenditure variance 439, 449 flexible budgets 404, 414 flexible resources 262, 270 food prices 34 full cost 231, 244 full cost transfer pricing without a mark-up 516 full costing see absorption costing functional analysis 545–6, 570 further processing costs 130, 140 Garrett Automative Ltd 213 general rate of inflation 336, 346 global competition 9–10 goal congruence 397, 414 gold mining 130 goodness of fit 616, 625 Google 524 government expenditure 33 graphical method 612–3, 620–1 INDEX hard capital rationing 330, 346 healthcare 266 high-low method 184, 613–4, 625 highway construction contracts 198 historical targets 408, 414 holding costs 634, 648 human resources professionals increasing returns to scale 169, 186 incremental budgeting 379, 386 incremental budgets 381 definition 386 priority-based 382 incremental cash flows 195, 216 incremental costs 35, 37, 622 incremented hours 622 independent variables 609, 625 indirect cost assignment 65 indirect costs 25–6 cost assignment 45–6 definition 37 inflation 335–7 information technology 12 Inktomi 181 innovation 14 inspection of accounts method 611–2, 625 Insteel Industries 551 integrated cost accounting 97 interest rate 302, 322 interlocking accounting 92–3, 97 intermediate products 510, 532 internal business perspective 588–90, 597 internal failure costs 559, 570 internal rate of return 307–9 definition 322 net present value 310–2 international transfer pricing 523–5 internet commerce 12, 21 inventory control 81, 632–46 inventory valuation 36, 156–7 investment centres 402, 485, 500 iPhones 238 IRR see internal rate of return irrelevant costs and revenues 32, 37 Japanese earthquake 645 JIT see just-in-time job cards 48, 72 job-order costing systems 44–5 see also cost assignment definition 72 service organizations 91–2 jobs completed 91 joint costs 131–7, 136–7 779 joint price usage variances 435 joint products 129–31, 140 just-in-time and management accounting 557 manufacturing 93–4, 553–7 purchasing 556, 645–6 648 kaizen costing 549, 570 Kanbans 555, 570 labour cost accounting 87–9, 97 labour efficiency variances 436–7, 449 lag measures 592, 597 last in, first out 82–3, 97 lead measures 592, 598 lead time 640, 648 lean manufacturing systems 12, 21 learning and growth perspective 591–2, 598 learning curves 619–20, 625 learning-curve effect 619–20 least-squares method 614–5, 625 life-cycle costing 543–4, 570 LIFO (last in, first out) 82–3, 97 limiting factors 200–1, 216 line item budgets 380–1, 386 linear programming 655–66, 668 liquefied natural gas (LNG) 105 local government 267, 381 locked-in costs 544 London Metropolitan Police 436 long-run cost 231, 244 long-term plans 359–61, 386 machine hour rates 55, 72 management accounting alternative uses of information 411 and just-in-time 557 convergence of practices 15–6 definition 21 differences from financial accounting 6–7 functions of 16–7 history of 17–8 meaning of 6, 17 strategic 578–95, 598 management accounting control systems 400–11 management by exception 9, 362, 386 management control systems 393–411, 414 managerial interdependency 410, 414 manufacturing cycle efficiency 589, 598 manufacturing organizations 24 manufacturing overheads 88–9 manufacturing technologies 12 margin of safety 174, 175, 186 marginal cost plus opportunity cost transfer prices 517 780 INDEX marginal cost transfer pricing 515–6 marginal costing 160 see also direct costing; variable costing marginal costs 35, 37 marginal rate of substitution 661, 668 marginal revenues 35 mark-up percentages 236–7 market portfolios 337, 346 market-based transfer pricing 511 Marks and Spencer 81 master budgets 9, 367, 374–5, 386 material mix variances 464, 475 material price variances 431–4, 449 material usage variances 434, 449, 466–7 material variances 431 materials issue pricing 81–2 materials issue recording 87 materials purchase budgets 372 materials purchase recording 84–6 materials recording 81–2 materials requirement planning 645 materials requisition 48, 72 materials usage budgets 371 materials yield variances 465–6, 476 mathematical method 621–2 maximax criteria 288, 291 maximin criteria 288, 291 MCE (manufacturing cycle efficiency) 589, 598 merchandising companies 24 minimum required rate of return 302, 322 missions 359–60, 386 mixed costs 30–1, 37 money rates of return 335, 346 Montclair Papers 440 motivation 362 MRP (materials requirement planning) 645 multicollinearity 623, 625 multiple regression 609, 625 multiple regression analysis 624 mutually exclusive projects 312, 322 negotiated targets 408, 414 negotiated transfer prices 516–7 net marginal revenue 514–5, 527, 532 net present value 304–7 definition 322 internal rate of return 310–2 net realizable value method 133–4, 140 nominal cash flows 335, 346 nominal rates of return 335, 346 non-financial factors 195–6 non-linear cost functions 617–8 non-manufacturing overheads 63, 90–1 non-profit-making organizations 380–1 non-value added activities 13–4, 550, 570 non-volume-based cost drivers 255–7, 270 normal activity 156, 160 normal losses 105, 106–7, 118–22, 123 NPV see net present value objective function 656, 668 objective probabilities 280, 291 objectives 359 identification of 7–8 oil and gas exploration 341 operating leverage 180–1, 186 operation costing 118, 123 opportunity costs 33–4, 200, 661 definition 38, 216 668 of investment 301–2, 322 OPT (optimized production technology) 212, 216 optimal selling prices 242–3 optimized production technology 212, 216 order quantities 643–4 ordering costs 634, 648 organizational structures, divisionalized 485–6 output controls 395–6, 414 outsourcing 204–6, 216 over-recovery of overheads 62, 72 overhead analysis sheets 52, 72 overheads 25 see also indirect costs blanket rates 49 budgeted rates 60–2 definition 72 fixed 155 manufacturing 88–9 non-manufacturing 63, 90–1 plant-wide rates 49, 72 recovery of 62, 72 standard 428–9 paper industry 153, 465 paper-mill sludge 138 Pareto analysis 240, 244 participation 408–9, 414 payback method 313–6, 322 payroll accounting 87–9, 97 penetration pricing policy 239, 244 perfectly competitive markets 511, 532 performance evaluation 362, 409–10 divisionalized organizational structures 486–7 relative 405 performance measurement 317–8, 495–7 performance reports 9, 21 period cost adjustments 150, 160 period costs 27–8, 38 personnel controls 395, 398–9, 414 pharmaceutical industry 465, 522 INDEX physical measures method 131–3, 140 planning 7, 361 plant-wide overhead rates 49, 72 police services 205 post-completion audits 344, 346 practical capacity 155–6, 160 precautionary motive 633, 648 prediction error, cost of the 637, 648 present value capital investment 303 definition 322 of £1 after N years 698–9 of an annuity of £1 received annually for N years 700–1 prevention costs 559, 570 previous process cost 111–2, 123 price setters 228, 244 price takers 228, 244 price-skimming policy 238–9, 244 pricing decisions 227–41 pricing policies 238–9 prime costs 25, 38 priority-based budgeting 381–2, 386 priority-based incremental budgets 382, 386 probability 279–81, 291 probability distributions 280, 281–2, 291 probability theory 641–3 process costing 102–23 FIFO method 115–7 flow of production and costs 101–4 opening inventories 111–7 output complete 103–9 output partially complete 109–12 losses 117, 118–22 service organizations 117 weighted average method 114–5 product costs 27–8, 38, 46–7 product diversity 61 product flow lines 555, 570 product life cycles 10, 239, 244 product line-sustaining expenses 261, 270 product mix 200–3, 233–4 product-sustaining activities 259–60, 270 production budgets 371 production cells 555, 570 production efficiency ratio 589, 598 products sold 91 profit, reconciliation of budgeted to actual 442 profit centres 401–2, 500 profit function 158–9 profit maximization 7–8 profit-volume graphs 177–8, 186 profit-volume ratio 173–4, 186 profitability analysis 260–2 781 profitability index 331–2, 346 publishing 175 pull manufacturing systems 554, 570 purchasing efficiency variance 470, 476 purchasing planning variance 469, 476 push manufacturing systems 555, 570 qualitative factors 195–6, 216 quality 13 quality cost management 557–62 quantity discounts 638–40 random factors 471, 476 rare earth metal prices 469 re-order point 640, 648 real cash flows 335, 346 real rate of return 335, 346 regression equations 609, 612–5, 625 regret criteria 288–9, 291 reinvestment 312 relative performance evaluation 405, 414 relevant costs and revenues 32, 195, 216 relevant range 171–2, 174, 186, 617–8 reliability tests 615–7, 625 research funding 330 residual income 491–2, 500 resource consumption models 262–4, 270 resource cost drivers 258, 270 responsibility accounting 36, 402, 414 responsibility centres 36, 400, 401 definition 38, 414 standard costing 424–5 responsibility cost control 406 results controls 395–6, 399, 414 retail operations 201 return on capital employed see accounting rate of return return on investment see also accounting rate of return activity-based-costing 264 definition 322 divisionalized organizational structures 490–1, 495 revenue centres 401, 414 reverse engineering 545, 570 risk 279 see also uncertainty attitudes to 283–4 definition 291 reduction 288–9 risk adjusted discount rates 337–40 risk neutral 283, 292 risk premiums 337, 346 risk-averters 283, 291 risk-free gilt-edged securities 302, 322 risk-seekers 283, 292 road gritting 641 782 INDEX ROI see return on investment rolling budgeting 363, 386 safety stocks 640–3, 648 Sage accounting software 92 sales budgets 365–6, 370–1 sales margin mix variance 467, 476 sales margin price variance 441, 442, 467, 476 sales margin volume variance 441–2, 467, 476 sales quantity variance 467–9, 476 sales value at split-off point method 133, 140 sales variances 439–40 sales volume variance 468 SAP 401, 665 scarce resources 200–3, 655, 666 scattergraph method 612–3 security market line 340, 346 selling budgets 373 semi-fixed costs 30, 38 semi-variable costs 30–1 cost-volume-profit analysis 184–5 definition 38 sensitivity analysis 184, 340–3, 346, 667 sequential allocation method 70, 72 service departments 55, 66–71, 72 service industries 10–1 service organizations 24 activity-based-costing 265–7 job-order costing systems 91–2 process costing 117 service-sustaining activities 259–60, 270 shadow prices 661, 668 see also opportunity costs Siemens AG 487, 488, 591 simple regression 609, 625 simplex method 662–4, 668 single most likely estimate 282, 292 slack variables 662, 668 SNP (supply network planning) 665 social controls 395, 414 soft capital rationing 330, 346 solar energy 314 South Africa 523, 579 Southwest Airlines 587 special pricing decisions 196–200 special studies 194–5, 216 speculative motive 633, 648 split-off point 130, 140 stakeholders standard absorption costing 442–4 reconciliation of budgeted and actual profits 446 standard cost centres 400, 414 standard costing 423–40 activity-based-costing 472–4 actual costs 426 purposes of 430 responsibility centres 424–5 variance analysis 425–6 standard costs definition 449 recording of 458–63 standard deviation 282–3, 292 standard direct labour costs 428 standard direct material costs 427–8 standard hours 429, 449 standard hours produced 429–30, 449 standard overheads 428–9 states of nature 279–80, 292 statistical control charts 471–2, 476 statistical quality control charts 561–2, 570 steady-state production level 621, 625 step allocation method 70, 72 step-fixed costs 30, 38 stockout costs 641–3, 648 stores ledger accounts 81, 97 stores requisitions 81–2, 97 strategic control 394, 414 strategic cost management 542–66 strategic costing 583, 598 strategic management accounting 578–95, 598 strategic plans 359–61, 386 strategic positioning 581, 598 strategic pricing 582 strategy 8, 21, 360, 386 subjective judgements 405–6, 414 subjective probabilities 280, 292 sunk costs 33, 195, 216 supply chain management 566, 570, 665 supply network planning 665 support departments 55, 72 target costing 233, 543–8, 570 target rate of return on invested capital 236, 244 target-setting 407–9 task uncertainty 410, 414 taxation 332–4 tear down analysis 545, 570 tests of reliability 615–7, 625 Teva Pharmaceutical Industries Ltd 522 theoretical maximum capacity 155, 160 theory of constraints 212–6 throughput accounting 215–6 time sheets 48, 72 time value of money 304, 312, 322 time-based measures 13–4 TOC (theory of constraints) 212–6 top-down budget setting 408, 414 total fixed overhead variance 444, 449 total labour variances 437, 449 INDEX total material variances 435, 449 total quality management 13, 556, 557–8, 570 total sales margin variance 441, 467, 476 total variable overhead variances 437, 449 Toyota 558 TQM (total quality management) 13, 556, 557–8, 570 traditional costing systems 46, 52–6, 72, 253 transaction drivers 258, 270 transactions motive 633, 648 transfer pricing 508–25 activity-based-costing 522 conflicts 518–21 cost plus a mark-up 511–5 cost-based methods 517–8 dual-rate 519–20, 532 economic theory of 526–31 full cost without a mark-up 516 international 523–5 marginal cost 515–6 marginal cost plus opportunity cost 517 market-based 511 negotiated 516–7 recommendations 521–3 two-part 520–1 variable cost 515–6 variable cost plus opportunity cost 517 two-part transfer pricing 520–1, 532 UHT milk production 117 unavoidable costs 32, 38 uncertainty 279, 640–1 see also risk definition 292 measurement of 282–3 uncontrollable factors 471 uncontrollable losses 105, 106–7, 122, 123 under-recovery of overheads 62, 72 unit objectives 359, 386 unit-level activities 259, 270 value added activities 550, 570 value analysis 545–6, 570 783 value engineering 545–6, 570 value-based-management 492, 500 value-chain analysis 564–6, 581–2, 598 value-chain costing 583, 598 variable cost plus opportunity cost transfer prices 517 variable cost transfer pricing 515–6 variable costing 146–9, 151–4 see also direct costing absorption costing 151–2 definition 160 variable costs 29–30, 38 variable overhead efficiency variances 438, 449 variable overhead expenditure variances 438, 449 variance 400, 414 variance analysis 404, 431–46 definition 414 ex post approach 469–70 standard costing 425–6 variances formulae 449 investigation of 470–2 VBM (value-based- management) 492, 500 volume capacity variances 445, 449 volume efficiency variances 444–5, 449 volume variances 62, 156, 442, 444, 449 volume-based cost drivers 255–7, 270 wage rate variances 436, 449 waste recycling 170 WDA (writing-down allowances) 332, 346 weighted average cost of capital 340, 346 whiskey 107 wind energy 314 World Cup 229 writing-down allowances 332, 346 written down values 203, 216 yield variances 463–7 zero-based budgeting 381–2, 386 zero-defects policy 559–60, 570 ... 0 .20 0.80 1 .20 0.40 0.40 122 400 122 400 61 20 0 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