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Cost and Management Accounting Textbook Softcopy.

The document outlines the third edition of 'Cost and Management Accounting: Operations and Management', a southern African textbook designed to align with current accounting curricula and professional standards. It includes updated content, local case studies, and extensive support materials for lecturers, emphasizing ethical principles and modern management techniques. The editor, Ferina Marimuthu, brings over two decades of experience in the field, enhancing the textbook's relevance and educational value.

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Cost and Management Accounting Textbook Softcopy.

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Cost and Management Accounting

Operations and Management – A southern African approach

Cost and Management Accounting: Operations and Management is a southern African text which supports the
latest curriculum offered by major accounting professional bodies and higher education institutions. In its

Operations and Management – A southern African approach

third edition, Cost and Management Accounting: Operations and Management has been carefully updated to

Cost and Management Accounting

ensure that it precisely fits the latest course and examination requirements. Moreover, it utilised local case
studies, a strongly encouraged practice during the decolonisation of the curriculum.

The third edition has been updated to cover current developments in management accounting, and includes:
• Updated illustrative examples and test-yourself questions
Operations and Management – A southern African approach
• Updated exercises including additional professional body questions
• Ethical principles and values within the decision-making process
• New case studies based on real-life scenarios
• Further explanations of modern management accounting techniques
• Budgeting in a digital age: Big data analytics
• Revamped divisional performance and transfer pricing chapter.

Its carefully developed pedagogical approach, offering a balance between the technical and the conceptual,
combined with its focus on the requirements of professional bodies, gives students a solid exposure to
the cost and management accounting profession while simplifying the learning process and developing
conceptual skills.

Extensive support material is available to lecturers at prescribing institutions via the website www.juta.co.za.
This includes:
• Comprehensive solutions to exercises in the text
• Additional questions and solutions
• PowerPoint slides.

About the editor

Ferina Marimuthu is a senior lecturer in Management Accounting at the Durban University of Technology.

Copyright © 2021. Juta & Company, Limited. All rights reserved.

She has extensive lecturing experience, spanning over two decades, in Cost and Management Accounting at
both the undergraduate and postgraduate levels. Ferina’s esteemed authoring expertise in the accounting
discipline combined with her academic experience blends theory and practice in her writing. She has authored
several accounting textbooks and reviewed for both local and international publishing houses.

Ferina Marimuthu
General editor:

General editor: Ferina Marimuthu

Contributing authors: Melanie Cloete
Elda du Toit | Gina Fouché
www.juta.co.za Marimuthi, F.. Cost and Management Accounting: Operations and Management : A Southern African Approach, Juta & Company, Limited,
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Cost and Management
Accounting
Operations and Management – A southern African approach

THIRD EDITION

General editor: Ferina Marimuthu

Contributing authors: Melanie Cloete, Elda du Toit
and Gina Fouché
Copyright © 2021. Juta & Company, Limited. All rights reserved.

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Cost and Management Accounting
Operations and Management – A southern African approach

First published in 2014 as Cost and Management Accounting: A southern African approach for
third and fourth year students
Second edition 2017
Third edition 2021

Juta and Company (Pty) Ltd

First floor, Sunclare building, 21 Dreyer street, Claremont 7708
PO Box 14373, Lansdowne 7779, Cape Town, South Africa
www.juta.co.za

© 2021 Juta & Company (Pty) Ltd

ISBN (Print): 978 1 48513 122 9

ISBN (WebPDF): 978 1 48513 123 6

All rights reserved. No part of this publication may be reproduced or transmitted in any
form or by any means, electronic or mechanical, including photocopying, recording, or
any information storage or retrieval system, without prior permission in writing from
the publisher. Subject to any applicable licensing terms and conditions in the case of
electronically supplied publications, a person may engage in fair dealing with a copy of this
publication for his or her personal or private use, or his or her research or private study.
See section 12(1)(a) of the Copyright Act 98 of 1978.

Print production specialist: Seshni Kazadi

Proofreader: Inge du Plessis
Cover designer: Drag and Drop
Typesetter: Lebone Publishing Services
Indexer: Language Mechanics

Typeset in 10 pt on 12 pt ITC Legacy Serif Std

The author and the publisher believe on the strength of due diligence exercised that
this work does not contain any material that is the subject of copyright held by another
person. In the alternative, they believe that any protected pre-existing material that may be
comprised in it has been used with appropriate authority or has been used in circumstances
that make such use permissible under the law.

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Contents
About the authors��xiii
How to use this book�� xiv
Foreword�� xvi
Acknowledgements��xviii
Metric conversion chart�� xx
1 Basic cost accounting, cost classification, behaviour and estimation�� 1
Introduction........................................................................................................................................................1
Fields in accounting..........................................................................................................................................2
Why do we care about costs?....................................................................................................................2
Fundamental aspects of cost accounting .............................................................................................2
Classification of costs........................................................................................................................................3
Cost elements...............................................................................................................................................3
Direct and indirect costs............................................................................................................................4
Product and period costs...........................................................................................................................4
Cost behaviour.............................................................................................................................................4
Cost estimation..................................................................................................................................................8
Scatter graph method.................................................................................................................................9
High-low method......................................................................................................................................10
Least squares method (regression analysis)........................................................................................11
Total cost statement........................................................................................................................................12
Summary............................................................................................................................................................13
Test-yourself solutions....................................................................................................................................14
Review questions..............................................................................................................................................15
Exercises..............................................................................................................................................................16
Reference list.....................................................................................................................................................21
2 Costing systems for decision making��23
Introduction......................................................................................................................................................24
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Marginal costing..............................................................................................................................................25
The principles of marginal costing.......................................................................................................25
Uses of marginal costing.........................................................................................................................26
Absorption costing..........................................................................................................................................29
Principles of absorption costing............................................................................................................30
Analysis of traditional costing systems......................................................................................................31
The effect of marginal and absorption costing on inventory values and profit........................31
Conversion of financial statements......................................................................................................33
The strengths and weaknesses of marginal and absorption costing............................................36
Activity-based costing.....................................................................................................................................38
How does activity-based costing work?...............................................................................................38
When is it feasible to introduce activity-based costing?..................................................................38
A comparison between activity-based costing and traditional costing.......................................39
Design of costing systems..............................................................................................................................39
The evolution of costing systems..........................................................................................................39
Summary............................................................................................................................................................40

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iv

Test-yourself solutions....................................................................................................................................41
Review questions..............................................................................................................................................42
Exercises..............................................................................................................................................................42
Reference list.....................................................................................................................................................49
3 Cost-volume-profit analysis��51
Introduction......................................................................................................................................................52
Cost-volume-profit analysis using formulae.............................................................................................52
Contribution..............................................................................................................................................52
Breakeven point in units and rands......................................................................................................52
Sales required to make a target profit in units and rands ..............................................................53
Margin of safety in units, rands and as a percentage.......................................................................53
Cost-volume-profit analysis using the algebraic equation method....................................................57
What-if analysis (sensitivity analysis)..........................................................................................................58
Percentage change in an item........................................................................................................................62
Cost-volume-profit analysis and graphs....................................................................................................63
Breakeven graph........................................................................................................................................64
Contribution graph..................................................................................................................................67
Profit-volume graph..................................................................................................................................68
Problems associated with the graphs...................................................................................................68
The economist’s view of breakeven graphs.........................................................................................69
Multiple-product breakeven analysis..........................................................................................................69
Profit-volume graph for multiple products........................................................................................73
Cost structure...................................................................................................................................................75
Operating leverage....................................................................................................................................76
Changeover point......................................................................................................................................76
Assumptions of cost-volume-profit analysis.............................................................................................78
Summary............................................................................................................................................................79
Test-yourself solutions....................................................................................................................................80
Review questions..............................................................................................................................................82
Exercises..............................................................................................................................................................82
Reference list.....................................................................................................................................................90
4 Relevant costs and revenues for decision making��91
Introduction......................................................................................................................................................91
Relevant costs and revenues..........................................................................................................................92
Relevant direct material costs.......................................................................................................................94
Irrelevant costs..................................................................................................................................................99
Non-financial indicators............................................................................................................................. 102
Types of short-term decisions.................................................................................................................... 103
Utilisation of a single constrained resource (key factor/limiting factor)................................. 104
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Make or buy (outsourcing) decision.................................................................................................. 107

Closure or deletion of a business segment....................................................................................... 111
Special-order decision........................................................................................................................... 115
Minimum pricing decision.................................................................................................................. 118
Joint product and further processing decisions............................................................................. 121
Sell at split-off point or process further........................................................................................... 126
Strategic implications of short-term decisions..................................................................................... 129
Short-term decisions and ethics................................................................................................................ 129
Summary......................................................................................................................................................... 129
Test-yourself solutions................................................................................................................................. 131
Review questions........................................................................................................................................... 136
Exercises........................................................................................................................................................... 136
Reference list.................................................................................................................................................. 148

Cost and Management Accounting

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v

5 Linear programming�� 149

Introduction................................................................................................................................................... 149
Constraints..................................................................................................................................................... 150
Single resource constraints.................................................................................................................. 150
Multiple resource constraints............................................................................................................. 150
Assumptions of linear programming................................................................................................ 151
The graphical method.................................................................................................................................. 151
The optimal solution................................................................................................................................... 153
Finding the optimal solution..................................................................................................................... 153
Shadow prices.......................................................................................................................................... 158
Calculating shadow prices................................................................................................................... 159
Implications of shadow prices............................................................................................................. 159
Slack........................................................................................................................................................... 160
The simplex method..................................................................................................................................... 160
Different uses for linear programming................................................................................................... 164
Relevant cost calculations.................................................................................................................... 164
Selling different products.................................................................................................................... 164
Maximum payment for scarce resources.......................................................................................... 164
Control...................................................................................................................................................... 164
Capital budgeting................................................................................................................................... 164
Sensitivity analysis................................................................................................................................. 165
Limitations of linear programming......................................................................................................... 165
Summary......................................................................................................................................................... 166
Test yourself solutions................................................................................................................................. 167
Review questions........................................................................................................................................... 171
Exercises........................................................................................................................................................... 171
Reference list.................................................................................................................................................. 180
6 Cost and pricing management for competitive advantage�� 181
Introduction................................................................................................................................................... 181
Factors influencing pricing......................................................................................................................... 182
Price sensitivity........................................................................................................................................ 183
Compatibility with other products.................................................................................................... 183
Competitors............................................................................................................................................. 183
Price perception...................................................................................................................................... 183
Quality-..................................................................................................................................................... 183
Incomes..................................................................................................................................................... 183
Suppliers................................................................................................................................................... 184
Inflation.................................................................................................................................................... 184
Review of economic principles of pricing and demand....................................................................... 184
Copyright © 2021. Juta & Company, Limited. All rights reserved.

The profit maximisation price model............................................................................................... 185

Product life-cycle pricing............................................................................................................................. 188
Introductory phase................................................................................................................................ 189
Growth phase.......................................................................................................................................... 189
Maturity phase........................................................................................................................................ 189
Decline phase........................................................................................................................................... 189
Market-based pricing strategies................................................................................................................. 189
Target cost and target price approach............................................................................................... 190
Cost-based pricing strategies..................................................................................................................... 191
Determining the mark-up to be added to cost............................................................................... 192
Alternative pricing strategies...................................................................................................................... 195
Penetration pricing................................................................................................................................ 196
Price skimming....................................................................................................................................... 196
Premium pricing..................................................................................................................................... 196
Price differentiation............................................................................................................................... 196

Contents

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vi

Loss leader pricing.................................................................................................................................. 196

Product bundling................................................................................................................................... 197
Price discounting.................................................................................................................................... 197
Controlled prices.................................................................................................................................... 197
Summary......................................................................................................................................................... 197
Test yourself solutions................................................................................................................................. 198
Review questions........................................................................................................................................... 199
Exercises........................................................................................................................................................... 200
7 The modern business environment�� 207
Introduction................................................................................................................................................... 208
Value chain analysis...................................................................................................................................... 208
Supply chain management.................................................................................................................. 210
Total quality management.......................................................................................................................... 211
The costs of quality................................................................................................................................ 214
Cost of quality report............................................................................................................................ 215
Quality accreditation and ISO 9000.................................................................................................. 217
Total quality management and target costing................................................................................ 217
Total quality management and just-in-time systems.................................................................... 217
Total quality management and Kaizen costing.............................................................................. 217
Kaizen costing................................................................................................................................................ 218
What is continuous improvement?.................................................................................................... 218
Eliminating waste................................................................................................................................... 218
Target costing................................................................................................................................................. 219
Four stages in the target costing process ........................................................................................ 220
Reasons for using target costing........................................................................................................ 220
Just-in-time..................................................................................................................................................... 222
The difference between the traditional ‘push system’ and the just-in-time ‘pull system’.... 223
The benefits of just-in-time.................................................................................................................. 224
Just-in-time production........................................................................................................................ 224
Just-in-time purchasing........................................................................................................................ 225
The problems of just-in-time............................................................................................................... 225
Throughput accounting.............................................................................................................................. 226
Bottlenecks............................................................................................................................................... 227
The three concepts of throughput accounting............................................................................... 227
Throughput accounting measures.................................................................................................... 228
Throughput accounting and just-in-time........................................................................................ 228
Throughput accounting and the theory of constraints............................................................... 228
Life-cycle costing........................................................................................................................................... 230
Benchmarking................................................................................................................................................ 231
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Backflush accounting................................................................................................................................... 233

Advanced manufacturing technology...................................................................................................... 235
Computer-aided design......................................................................................................................... 235
Computer-aided manufacturing........................................................................................................ 235
Electronic data interchange................................................................................................................. 236
Advanced manufacturing technology in South Africa................................................................. 236
World-class manufacturing........................................................................................................................ 236
Business process re-engineering................................................................................................................ 237
How business process re-engineering works................................................................................... 237
How organisations use business process re-engineering.............................................................. 237
The five stages of business process re-engineering......................................................................... 238
Keywords in business process re-engineering.................................................................................. 238
Summary......................................................................................................................................................... 238
Test-yourself solutions................................................................................................................................. 240

Cost and Management Accounting

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vii

Review questions........................................................................................................................................... 242

Exercises........................................................................................................................................................... 242
Reference list.................................................................................................................................................. 247
8 Activity-based costing and management�� 249
Introduction................................................................................................................................................... 250
History and development of activity-based costing...................................................................... 250
Accounting for overheads.................................................................................................................... 250
Reasons for ineffectiveness of traditional approaches.................................................................. 250
Overview of the activity-based costing process...................................................................................... 251
Activity-based costing terminology................................................................................................... 251
Determining costs using activity-based costing.................................................................................... 256
The process of determining costs using activity-based costing.................................................. 256
Applying activity-based costing in service organisations............................................................. 263
Product and customer profitability analysis.......................................................................................... 266
Activity-based management....................................................................................................................... 272
Uses of activity-based costing/activity-based management............................................................... 273
Activity-based budgeting...................................................................................................................... 273
Activity-based management accounting.......................................................................................... 274
Benefits and criticisms of activity-based costing................................................................................... 275
Benefits of activity-based costing....................................................................................................... 275
Criticisms of activity-based costing................................................................................................... 275
Summary......................................................................................................................................................... 276
Test-yourself solutions................................................................................................................................. 277
Review questions........................................................................................................................................... 278
Exercises........................................................................................................................................................... 278
Reference list.................................................................................................................................................. 292
9 Cost estimation and forecasting techniques�� 293
Introduction................................................................................................................................................... 294
Forecasting techniques................................................................................................................................ 294
Least squares method (regression analysis)..................................................................................... 294
Tests of reliability................................................................................................................................... 297
Measures of correlation........................................................................................................................ 298
Time series analysis....................................................................................................................................... 299
The effect of learning in organisations.................................................................................................... 303
The learning curve formulae............................................................................................................... 304
The graphical method........................................................................................................................... 305
The mathematical method................................................................................................................... 306
The experience curve.............................................................................................................................. 308
Different uses for the learning curve........................................................................................................ 309
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Pricing decisions..................................................................................................................................... 309

Work scheduling..................................................................................................................................... 309
Setting standards or budgets............................................................................................................... 309
Summary......................................................................................................................................................... 309
Test-yourself solutions................................................................................................................................. 310
Review questions........................................................................................................................................... 312
Exercises........................................................................................................................................................... 312
Reference list.................................................................................................................................................. 321
10 Budgets�� 323
Introduction................................................................................................................................................... 323
Stages in the budget planning process.................................................................................................... 324
Purpose of budgeting................................................................................................................................... 324
Planning.................................................................................................................................................... 324
Coordination........................................................................................................................................... 324

Contents

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viii

Control...................................................................................................................................................... 324
Communication..................................................................................................................................... 325
Motivation................................................................................................................................................ 325
Performance evaluation........................................................................................................................ 325
Authorisation.......................................................................................................................................... 325
Conflicts with the purposes of budgeting........................................................................................ 325
Principles of budgeting................................................................................................................................ 326
The budget committee.......................................................................................................................... 326
The budget period.................................................................................................................................. 326
Behavioural considerations................................................................................................................. 327
The budget structure.................................................................................................................................... 328
Comprehensive budgeting illustrated............................................................................................... 329
Sales budget.................................................................................................................................................... 332
Production budget................................................................................................................................. 333
Manufacturing budgets: Direct materials budget......................................................................... 333
Manufacturing budgets: Direct labour budget.............................................................................. 334
Manufacturing budgets: Factory overhead budget....................................................................... 335
Selling and administration budget.................................................................................................... 335
Beginning and ending inventories budget....................................................................................... 336
Budgeted cost of goods manufactured and sold statement........................................................ 337
The master budget........................................................................................................................................ 337
Cash budget............................................................................................................................................. 338
An example of an alternative cash budget ....................................................................................... 339
Budgeted statement of comprehensive income.............................................................................. 341
Budgeted statement of financial position........................................................................................ 341
Budgetary control through flexible budgets.......................................................................................... 344
Fixed budgets, flexible budgets and performance reports........................................................... 345
Alternative approaches to budgeting....................................................................................................... 347
Incremental budgeting.......................................................................................................................... 347
Zero-based budgeting............................................................................................................................ 348
Activity-based budgeting...................................................................................................................... 349
Budgeting in a digital age .......................................................................................................................... 349
Big data .................................................................................................................................................... 349
Big data analytics ................................................................................................................................... 350
Summary......................................................................................................................................................... 350
Test-yourself solutions................................................................................................................................. 352
Review questions........................................................................................................................................... 357
Exercises........................................................................................................................................................... 357
Reference list.................................................................................................................................................. 371
Copyright © 2021. Juta & Company, Limited. All rights reserved.

11 Standard costing�� 373

Cost and Management Accounting

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ix

Fixed production overhead variances................................................................................................ 392

Marginal costing fixed production overhead variances................................................................ 392
Absorption costing fixed production overhead variances............................................................ 392
Sales variances......................................................................................................................................... 395
Reconciliation......................................................................................................................................... 398
Reporting of variances................................................................................................................................. 400
The interrelationship of variances............................................................................................................ 400
Investigation of variances............................................................................................................................ 401
Standard costing’s relationship with budgetary control.................................................................... 401
Flexible budgets and standard costing.................................................................................................... 401
Recording of standard costs....................................................................................................................... 402
Planning and operational variances......................................................................................................... 407
Summary......................................................................................................................................................... 409
Test-yourself solutions................................................................................................................................. 411
Review questions........................................................................................................................................... 414
Exercises........................................................................................................................................................... 414
12 Dealing with risk and uncertainty in decision making�� 429
Introduction................................................................................................................................................... 429
Decision making based on risk.................................................................................................................. 430
Payoff tables, probabilities, expected values, and conditional profits...................................... 432
Standard deviation and coefficient of variation............................................................................. 433
Perfect and imperfect information.................................................................................................... 435
Decision trees................................................................................................................................................. 438
Nodes used in designing a decision tree........................................................................................... 438
Steps in designing a decision tree....................................................................................................... 438
Limitations of decision trees............................................................................................................... 442
Decision making based on uncertainty................................................................................................... 442
Decision-making criteria...................................................................................................................... 443
Summary......................................................................................................................................................... 445
Test-yourself solutions................................................................................................................................. 446
Review questions........................................................................................................................................... 449
Exercises........................................................................................................................................................... 449
Reference list.................................................................................................................................................. 460
13 Network analysis�� 461
Introduction................................................................................................................................................... 462
Procedure for network analysis................................................................................................................. 463
Critical path method.................................................................................................................................... 463
Network diagrams.................................................................................................................................. 463
Rules for constructing network diagrams........................................................................................ 466
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Critical path............................................................................................................................................. 467

Slack........................................................................................................................................................... 467
Network acceleration............................................................................................................................. 469
Program evaluation and review technique............................................................................................. 473
Estimating the expected duration of activities............................................................................... 474
Standard deviation................................................................................................................................. 475
Advantages of network analysis................................................................................................................. 476
Limitations of network analysis................................................................................................................ 476
Summary......................................................................................................................................................... 476
Test-yourself solutions................................................................................................................................. 477
Review questions........................................................................................................................................... 480
Exercises........................................................................................................................................................... 480
Reference list.................................................................................................................................................. 492

Contents

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x

14 Investment appraisal�� 493

Introduction................................................................................................................................................... 493
Capital budgeting......................................................................................................................................... 494
Capital budgeting process.................................................................................................................... 494
Categories of capital budgeting projects.......................................................................................... 495
Capital budgeting techniques.................................................................................................................... 495
Payback method...................................................................................................................................... 495
Discounted payback method............................................................................................................... 497
Net present value ................................................................................................................................... 499
Internal rate of return .......................................................................................................................... 501
Profitability index .................................................................................................................................. 505
Modified internal rate of return ........................................................................................................ 506
Accounting rate of return .................................................................................................................... 508
Relevant project cash flows......................................................................................................................... 509
Initial investment................................................................................................................................... 510
Proceeds from sale of asset................................................................................................................... 510
Working capital....................................................................................................................................... 510
Net operating cash profit..................................................................................................................... 510
Opportunity cost.................................................................................................................................... 510
Taxation.................................................................................................................................................... 511
Capital allowance................................................................................................................................... 511
Recoupment............................................................................................................................................. 511
Other items.............................................................................................................................................. 511
Capital rationing........................................................................................................................................... 514
Single-period capital rationing........................................................................................................... 515
Multi-period capital rationing............................................................................................................ 517
The effects of inflation................................................................................................................................. 518
Overview of the time value of money....................................................................................................... 519
Time value of money concepts............................................................................................................ 519
Formulae used in time value of money............................................................................................. 520
Present value of a single cash flow...................................................................................................... 520
Present value of an ordinary annuity................................................................................................ 520
Future value of a single cash flow....................................................................................................... 522
Future value of an ordinary annuity................................................................................................. 522
The weighted average cost of capital........................................................................................................ 522
When can weighted average cost of capital be used?..................................................................... 523
Post completion audit ................................................................................................................................. 524
Summary......................................................................................................................................................... 524
Test-yourself solutions................................................................................................................................. 524
Review questions........................................................................................................................................... 528
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Cost and Management Accounting

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xi

Performance measurement in investment centres......................................................................... 550

Economic value added.......................................................................................................................... 555
Performance evaluation and the balanced scorecard.................................................................... 558
Transfer pricing............................................................................................................................................. 560
General guidelines for setting transfer prices................................................................................. 562
External markets..................................................................................................................................... 563
The process of determining transfer prices..................................................................................... 566
Resolving transfer pricing problems................................................................................................. 569
International transfer pricing............................................................................................................. 569
Incentive schemes in South Africa............................................................................................................ 570
Share option plans................................................................................................................................. 570
Restricted share schemes...................................................................................................................... 571
Phantom share schemes (share appreciation rights)..................................................................... 571
Share purchase schemes....................................................................................................................... 571
Deferred bonus schemes....................................................................................................................... 572
Summary......................................................................................................................................................... 572
Test-yourself solutions................................................................................................................................. 573
Review questions........................................................................................................................................... 575
Exercises........................................................................................................................................................... 575
Reference list.................................................................................................................................................. 585
16 Inventory management�� 587
Introduction................................................................................................................................................... 588
Why companies hold inventory................................................................................................................. 588
Relevant cost of inventory policies........................................................................................................... 588
The economic order quantity..................................................................................................................... 591
Formula method..................................................................................................................................... 591
Tabulation method................................................................................................................................ 593
Graphical method.................................................................................................................................. 594
Other calculations and concepts related to the EOQ.......................................................................... 594
Uncertainty and safety inventory....................................................................................................... 596
Quantity discounts and other factors...................................................................................................... 598
Other factors to consider when deciding on ordering quantity................................................. 600
Assumptions underlying the economic order quantity................................................................ 600
Classification of inventory to keep control............................................................................................ 600
Planning for materials requirements....................................................................................................... 601
Materials requirement planning systems......................................................................................... 601
Enterprise resource planning systems............................................................................................... 602
SAP............................................................................................................................................................. 603
E-commerce............................................................................................................................................. 603
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Managing suppliers...................................................................................................................................... 603

The value of close relationships with suppliers.............................................................................. 603
Using activity-based techniques to analyse supplier costs........................................................... 604
Evaluating supplier relationships from the perspective of the supplier and the
organisation............................................................................................................................................. 605
Just-in-time systems..................................................................................................................................... 606
The elements of just-in-time systems................................................................................................ 607
The benefits of just-in-time inventory systems............................................................................... 608
Evaluating just-in-time production performance.......................................................................... 609
Summary......................................................................................................................................................... 609
Test-yourself solutions................................................................................................................................. 611
Review questions........................................................................................................................................... 612
Exercises........................................................................................................................................................... 613

Contents

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xii

17 Environmental management accounting and other developments�� 621

Introduction................................................................................................................................................... 622
Corporate social responsibility.................................................................................................................. 622
Corporate social responsibility in South Africa............................................................................. 623
Environmental management accounting............................................................................................... 624
Environmental management accounting techniques................................................................... 624
Benefits of environmental management accounting.................................................................... 625
Steps for implementing environmental management accounting............................................ 626
Why it is difficult to recognise and measure social and environmental costs............................... 626
What are environmental costs?........................................................................................................... 627
Using the quality cost framework for environmental costs........................................................ 627
Integrating environmental costs into information for decision making................................. 628
Environmental costing using activity-based costing........................................................................... 629
The environmental impact of the supply chain............................................................................. 629
The impact of suppliers........................................................................................................................ 629
The impact of customers...................................................................................................................... 629
Measures to assess social and environmental performance............................................................... 630
Social auditing............................................................................................................................................... 631
South African government’s green economic development agenda................................................ 633
Greenhouse gas inventory........................................................................................................................... 634
Summary......................................................................................................................................................... 635
Test-yourself solutions................................................................................................................................. 636
Review questions........................................................................................................................................... 636
Exercises........................................................................................................................................................... 637
Reference list.................................................................................................................................................. 642
18 Case studies�� 643
Case study 1: Cost-volume-profit analysis.............................................................................................. 643
Case study 2: Divisional performance, transfer pricing and standard costing.............................. 645
Case study 3: Linear programming........................................................................................................... 649
Case study 4: Budgeting.............................................................................................................................. 653
Case study 5: Budgeting, financial and non-financial information................................................. 656
Case study 6: Relevant costs, divisional performance, break-even analysis and direct costing..... 661
Case study 7: Relevant costs and expected values................................................................................. 664
Case study 8: Integrated case study on inventory management....................................................... 666
Case study 9: Relevant costing, standard costing, transfer pricing.................................................. 667
Case study 10: Short-term decision making.......................................................................................... 669
Case study 11: Capital investments; pricing........................................................................................... 671
Case study 12: Transfer pricing, divisional performance, breakeven analysis and learning curves.... 673
Case study 13: Relevant costing and pricing.......................................................................................... 676
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Case study 14: Relevant costing and cost-volume-profit analysis.................................................... 677

Case study 15: Short-term decision making.......................................................................................... 679
Appendices�� 685
Index�� 689

Cost and Management Accounting

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Aboutthe
About theauthors
authors
Melanie Cloete is a lecturer in the Management Accounting Department at the Durban
University of Technology whose experience in academia spans almost three decades. Her
qualifications include a Higher Diploma in Education (Economic Science), Bachelor’s
degree in Technology: Cost and Management Accounting, and a Master of Accounting
degree. She is currently a PhD candidate at the University of KwaZulu-Natal. Her lecturing
experience includes financial accounting, cost accounting, and management accounting at
the undergraduate and postgraduate levels. She is driven by her passion for teaching and
uses innovative teaching methods to empower students with the critical thinking skills
required by the fourth industrial revolution. Her publications include articles on critical
thinking and assessments in DHET accredited journals and the co-authorship of a book
titled Basic Accounting for Non-Accountants (Van Schaik publishers).

Elda du Toit is an associate professor in the Department of Financial Management at the

University of Pretoria, where she has been lecturing in cost and management accounting
and research for more than 10 years. She obtained her BCom Informatics degree in 2002,
her BCom Hons (Financial Management Sciences) in 2003 and her MCom (Financial
Management Sciences) in 2004. She received her DCom degree in 2012 and is still actively
involved in research and has published numerous peer-reviewed academic articles. She is
also an academic Professional Accountant (PA(SA)) and Associate Chartered Management
Accountant (ACMA/CGMA). She has co-authored several undergraduate financial textbooks.

Gina Fouché has 30 years’ industry experience in management accounting and 20 years’
lecturing experience. She is currently a senior lecturer at the Vaal University of Technology.
Her qualifications include an MTech Cost and Management Accounting, Post Graduate
Diploma in Higher Education, Professional Accountant (SA), General Tax Practitioner (SA)
and Business Accountant (SA).
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Ferina Marimuthu is a senior lecturer in the Department of Management Accounting at

the Durban University of Technology. She has extensive lecturing experience, spanning
more than two decades, in accounting and finance from undergraduate to postgraduate
levels. Her qualifications include a PhD in Finance and a Master’s degree in Business
Administration, for which she received the Top Management Accounting Student award.
Ferina takes a keen interest in the development of learning materials and in adding value to
students’ learning experience in the classroom through the use of innovative teaching and
learning methods. She has also co-authored several undergraduate accounting textbooks,
has been the general editor on other accounting textbooks, and has reviewed several books,
both locally and internationally. She is actively involved in research in the accounting
discipline and has published several peer-reviewed articles.

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How to use this book
Mind maps – Each chapter begins with a mind map that creates a mental image of the
chapter, helping you to focus on the parts that are important.

Learning objectives – These follow on from the mind maps, introducing topics covered
and summarise what you should have learnt by the end of the chapter. You can use these to
view the key issues that are covered in the chapter. You can also test yourself at the end of
each chapter on whether these learning objectives have been realised.

Illustrative case studies – Each chapter contains a case study with questions. These allow
you to apply your understanding of the concepts, issues and techniques within a broader
organisational context.

Illustrative examples – The key areas in management accounting have been clearly
explained using illustrative examples. These examples are concise and focus on a particular
key concept within the chapter.

Test-yourself questions with solutions – These questions enable you to check your
understanding and identify the areas in which you need to do further work. The solutions
to these questions appear at the end of the chapter.

Summaries – The key points addressed in the chapter are pulled together to provide a
useful reminder of the topics covered. The summary links with the learning outcomes of
the chapter.

Key concepts – Each chapter concludes with a list of the main concepts defined, explained
and illustrated in the chapter.

Review questions – Short questions encourage you to review and critically discuss your
Copyright © 2021. Juta & Company, Limited. All rights reserved.

understanding of the main topics and issues covered in each chapter.

Exercises – This section of the chapter consists of a set of comprehensive questions mostly
adapted from CIMA examinations. The inclusion of professional questions will prepare
students with the required level of competency that is necessary to sit for some of the
professional examinations. The ability to understand these questions will indicate a high
level of understanding of the topic. Fully worked solutions to the exercises are available on
the website to institutions that prescribe the book.

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xv

Case study problems – Chapter 18 consists of problem-based cases. Each case study
integrates topics from several chapters, allowing you to apply your understanding of the
concepts, issues and techniques within a broader organisational context, and to develop
your critical thinking and analytical skills. There are a significant number of professional
examination questions from CIMA.

Lecturer supplements
● Complete, downloadable solutions to end off chapter exercises.
● Questions and solutions in Excel.
● Additional questions and solutions on each chapter.
● Suggested solutions to all illustrative case study problems.
● Editable PowerPoint slides organised by chapter, allowing you to provide a lecture or
seminar presentation and/or print handouts.
● Videos relating to various chapters.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

How to use this book

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Foreword
One of the most significant contributions to manufacturing and the business world in
general came from post World War II Japan – the kaizen philosophy. Simply put, the term
‘kaizen’ means ‘good change’ and the philosophy as it is applied in the business world today
refers to the constant small improvements that organisations regularly apply to improve
the efficiency of their operations.

I’ve tagged onto this concept because in so much as it applies to the business world – which
you will learn about in this textbook – I think that the philosophy can easily be applied
to our personal lives in describing the steps we take to develop ourselves and improve our
skills.

While reviewing Cost and Management Accounting: Operations and Management – A southern
African approach, I saw a kaizen-like good change in how the text is written and the impact
it will make on students’ knowledge of the cost and management accounting subject area,
as well as on the profession.

In the current business context, with competition in the market increasing, organisations
can no longer afford not to have efficient cost control systems and optimal decision-making
techniques in place. Efficient cost control systems in this context refer to all the models,
formulae and techniques that would provide information to management regarding the cost
of products and services, budgets and related variances, the optimal selling price, resources
required, etc. Applying an appropriate decision-making technique requires knowing what
a company’s cost of capital is and whether or not investing in a specific project would bring
in a return greater than the cost of capital, what the effects of short-term and long-term
decisions are, how many units of a product should be sold in order to break even, and so on.

So, given the realities of the current business environment, management accountants are
trained to add value to an organisation through efficient cost control systems and optimal
Copyright © 2021. Juta & Company, Limited. All rights reserved.

decision making, with a strong focus on the strategic direction of the company. This
technical knowledge would thus put management accountants in a position where they
can strategically influence the organisation’s policies from within.

Cost and Management Accounting: Operations and Management – A southern African approach is
closely aligned to the CIMA (Chartered Institute of Management Accountants) syllabus,
and would add value to students studying towards the CIMA qualification. It covers the
topics required by CIMA in terms of the P1 and P2 examination papers, and also includes
case studies to aid students in understanding the academic content. The textbook is
written in easily understandable language, without losing sight of the technical concepts.

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xvii

Throughout the chapters there are examples to work through to reinforce the theory,
with review questions at the end of each chapter. All in all, the textbook gives students
the necessary technical knowledge contextualised to what plays out in practice within the
management accounting profession.

I hope that you build on the insights and knowledge shared in this textbook and that you
become the ‘good change’ in every organisation you encounter.

Rona Louwrens CA(SA), ACMA

Programme Leader: Management Accountancy and Senior Lecturer
North-West University – Potchefstroom Campus
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Foreword

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Acknowledgements
The authors and publisher gratefully acknowledge permission to reproduce copyright
material in this book. Every effort has been made to trace copyright holders, but if any
copyright infringements have been made, the publisher would be grateful for information
that would enable any omissions or errors to be corrected in subsequent impressions.

Case study: Factors influencing effective cost management within South Africa’s
retail banking sector on page 24. Mistry, KS. Used by permission

Case study: Unilever’s balancing act on pages 56–57. Hughman J. Investors Chronicle 2009.
© The Financial Times Limited 2016. All rights reserved

Case study: Production bottlenecks on pages 101–102. ‘Toyota plant resumes production
after supplier strike’ Creamer Media Engineering News: 24th October 2012 By: Megan van
Wyngaardt – Creamer Media Contributing Editor Online http://www.engineeringnews.
co.za/article/toyota-plant-resumes-production-after-supplier-strike-2012-10-24/rep_
id:4136

Case study: Activity-based costing at UNISA on pages 233–234. Pityana, NB. Address
for the UNISA seminar on activity-based costing for organisations and higher education
institutions, 30–31 August 2005. (Case adapted from the address)

Case study: British Airways on pages 391–393. Public Domain: www.britishairways.com/

cms/global/microsites/ba_reports0809/pdfs/Risks.pdf

Case study: Reduction in Capex on page 471. Mining Weekly. © Copyright Creamer Media.
http://www.miningweekly.com/article/anglo-cuts-15bn-group-capex-promises-200m-
platinum-cut-by-year-end-2012-07-27 Mining Weekly is a product of Creamer Media. www.
creamermedia.co.za
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Text from Ernst & Young on page 623. 2015. A survey of integrated reports of South Africa’s top
100 JSE-listed companies. http://www.ey.com/ZA/en/Issues/EY-integrated-reporting-2015-
award. Copyright © 2013 EYGM Limited

Text from Environmental Management Accounting (EMA) on page 624. ‘Integrated

Reporting South Africa. Article: Earth in the balance sheet’. http://www.integrated
reportingsa.org/SustainabilityReporting/EnvironmentalAccounting.aspx

Figure 17.1: A model of how the supply chain works in a ‘green’ framework on
page 630. © and permission of PriceWaterhouseCoopers

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xix

Figure 17.2: The process of social auditing on page 632. Simon S. Gao, Jane J. Zhang,
(2006) ‘Stakeholder engagement, social auditing and corporate sustainability’, Business
Process Management Journal, Vol. 12 Issue 6, pp. 722–740 © Emerald Group Publishing
Limited

Case study: Biodiversity planning tool on pages 632–633. International Institute for
Environment and Development (IIED). N.d. ‘Mining for common ground: putting biodiversity
on South African mining companies’ agendas’. http://www.iied.org/mining-for-common-
ground-putting-biodiversity-south-african-mining-companies-agendas

Case study: Acsa well on its way to reducing its carbon footprint on page 634. Petersen,
T. 2016. http://www.news24.com/SouthAfrica/News/acsa-well-on-its-way-to-reducing-its-
carbon-footprint-20160510 Tammy Petersen, News24 © Gallo Images

Case study: Linear Programming on page 653. Munzir S, Ikhsan M, Amin Z. Linear
Programming for Parking Slot Optimization: A Case Study at Jl. T. Panglima Polem Banda Aceh 2010;
6th IMT-GT Conference on Mathematics, Statistics and its Applications (ICMSA2010)
Universiti Tunku Abdul Rahman, Kuala Lumpur, Malaysia: available from: http://research.
utar.edu.my/CMS/ICMSA2010/ICMSA2010_Proceedings/files/statistics/ST-Munzir.pdf

Case study: Coca-Cola: A case study in sustainability on page 639–641. Wong Derek.
Environmental Leader 2011. Published by Business Sector Media LLC. http://www.
environmentalleader.com/2011/08/08/coca-cola-a-case-study-in-sustainability/ Used by
permission

Exercises throughout the text adapted from CIMA and ACCA examinations. Used by
permission
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Acknowledgements

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Metric conversion chart
METRIC LENGTH CONVERSIONS
1 centimetre = 10 millimetres 1 cm = 10 mm
1 decimetre = 10 centimetres 1 dm = 10 cm
1 metre = 100 centimetres 1m = 100 cm
1 metre = 10 decimetres 1m = 10 dm
1 kilometre = 1 000 metres 1 km = 1 000 m

METRIC AREA CONVERSIONS

1 sq. centimetre = 100 sq. millimetres 1 sq. cm = 100 sq. mm
1 sq. metre = 10 000 sq. centimetres 1 sq. m = 10 000 sq. cm
1 hectare = 10 000 q. metres 1 ha = 10 000 sq. m
1 sq. km = 100 hectares 1 sq. km = 100 ha
1 sq. km = 1 million sq. metres 1 sq. km = 1 000 000 sq. m

METRIC VOLUME CONVERSIONS

1 cubic centimetre = 1 000 cubic millimetres 1 cu cm = 1 000 cu mm
1 cubic decimetre = 1 000 cubic centimetres 1 cu dm = 1 000 cu cm
1 cubic metre = 1 million cubic centimetres 1 cu m = 1 000 000 cu cm
1 cubic metre = 1 000 cubic decimetres 1 cu m = 1 000 cu dm

METRIC WEIGHT CONVERSIONS

1 gram = 1 000 milligrams 1g = 1 000 mg
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1 decagram = 10 grams 1 dag = 10 g

1 kilogram = 1 000 grams 1 kg = 1 000 g
1 tonne (1 megagram) = 1 000 kilograms 1 tonne (1 Mg) = 1 000 kg
1 gigagram = 1 000 megagrams 1 Gg = 1 000 Mg

METRIC LIQUID VOLUME (CAPACITY) CONVERSIONS

1 centilitre = 10 millilitres 1 cl = 10 ml
1 decilitre = 10 sq. centilitres 1 dl = 10 cl
1 litre = 1 000 millilitres 1l = 1 000 ml
1 litre = 10 decilitres 1l = 10 dl
1 kilolitre = 1 000 litres 1 kl = 1 000 l

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1 Basic cost accounting,
cost classification,
behaviour and estimation

Basic cost accounting Cost classification Cost estimation

Definitions Element Behaviour Scatter graph Least squares

Fields in
(regression
accounting
analysis)

Assignment Timing High-low

Learning objectives
After studying this chapter, you should be able to:
● Explain cost object and cost centre
● Calculate the total cost of a cost object
● Classify costs according to element, assignment, timing and behaviour
● Describe the nature and behaviour of variable, fixed and semi-variable, and stepped
costs
● Prepare a total cost statement
● Apply different methods of estimating costs.
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Introduction
The main aim of the management of an organisation is maximising shareholder value.
Even not-for-profit organisations need to be managed as efficiently as possible. In order to
achieve this aim, management needs to carry out three main tasks:
1. Decision making
2. Planning
3. Control.

In order to carry out these tasks, there is a need for costs to be collected, classified and
analysed, enabling management to know and understand the cost of the product or service
the organisation delivers.

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2

Fields in accounting
Accounting must accumulate financial data for both external and internal reporting
purposes. Accounting consists of many fields, of which financial accounting, management
accounting and cost accounting are examples. Financial accounting is primarily used for
external reporting. It provides financial data about the organisation in the form of periodic
statements and reports to external stakeholders – that is, users of accounting information
who have an interest in the organisation but do not take part in the day-to-day management
of the organisation. Stakeholders include shareholders, the South African Revenue Service
(SARS), creditors, banks, suppliers and employees. The information provided by financial
accounting reports on the performance and financial position of the organisation.
Management accounting is the process of identifying, collecting, measuring, analysing,
interpreting and communicating useful information in order to achieve the organisation’s
objective of value creation. Management accounting is intended for internal reporting to
meet the needs of those who are actively engaged in the management of the organisation.
The following information is provided by management accounting in order to assist in
the main areas of decision making, planning and control:
● Data is collected and analysed about alternative courses of action available to the
organisation to provide management with information that can be used to make
informed decisions.
● Planning in the short term consists mainly of the budgeting process. Budgets are
quantified plans that need to be followed in order to achieve the organisation’s goals.
● Performance can be monitored and controlled by preparing performance reports that
compare planned performance with actual performance. Variances, as well as possible
reasons thereof, are identified so that appropriate action can be taken to address them.

Cost accounting is a system of accounting for costs where costs of products and services
are ascertained and controlled. It also involves arranging data for purposes of control and
guidance of information to management for decision-making purposes.

Why do we care about costs?

In order to maximise shareholder value a company needs to be profitable. A profit results
when sales revenue exceeds the total costs incurred. Usually, sales revenue is only one line
in the statement of profit or loss and consists of units sold multiplied by the selling price.
Both the units sold and the selling price are largely limited by what the competition is
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doing. The rest of the statement of profit or loss mainly consists of costs. Costs, therefore,
have a very big influence on the profitability of the company and need to be understood if
profitable decisions are to be made.

Fundamental aspects of cost accounting

A cost is any resource that has been given to achieve a particular objective. Usually, costs
are measured in monetary terms. Costs are incurred to achieve future benefits. If the benefit
extends beyond the current accounting period, then it is recorded as an asset; however, if
the benefit has been used or expired, then it is recorded as an expense. An expense is the
cost that is normally used up in the generation of sales revenue. An important function
of management accounting is to measure the costs of a cost object. A cost object is a
term used to describe something to which costs are assigned. Examples of cost objects are
a product line, service, department, geographic division, customer, or anything else for

Cost and Management Accounting

which management would like to quantify cost. Costs must be charged to specific sections
of the organisation. According to the principle of controllability, managers are only
accountable for what they can control. The areas of the organisation where managers are
held accountable for activities and performance are referred to as responsibility centres.
There are four types of responsibility centres:
● Cost centre: A cost centre is a section in an organisation where the manager is
responsible for costs. The performance of the cost centre is measured according to cost
control. Examples of cost centres may include academic departments at a university, the
factory in a furniture manufacturing organisation and the laundry section in a hotel.
● Revenue centre: A revenue centre is a section of an organisation where the manager
is responsible for the income generated by the centre. Managers are mainly held
accountable for financial outputs which are normally in the form of sales revenues. An
example of a revenue centre is the sales department of a car dealership.
● Profit centre: A profit centre manager is accountable for both costs and revenues, thus
profit. Performance here is measured on the level of profit generated. Profit centres are
generally assessed as separate businesses and could be something like a product line.
● Investment centre: An investment centre manager is responsible for costs, revenues
and investment in assets. Performance here is measured based on return on the capital
employed. An investment centre can be segregated for reporting purposes as a separate
operating entity, for example a subsidiary company, a manufacturing department and a
division, and therefore has its own financial statements.

Classification of costs
All costs must be classified by arranging them into logical groups. Thereafter an efficient
system must be devised in order to collect and analyse the costs. Costs can be classified
based on the following:
● Element: manufacturing (material, labour and overheads) and non-manufacturing
● Assignment: direct or indirect costs
● Timing: product and period costs
● Behaviour: variable, fixed, mixed or step costs.

Cost elements
Cost elements are divided between manufacturing costs and non-manufacturing costs.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Manufacturing costs are all the costs that relate to the manufacturing process. Included under
manufacturing costs are material, labour and overheads. Any material or labour that cannot
be traced to the cost objects, are included under overheads. Non-manufacturing costs include
other expenses that do not relate to the manufacturing process, for example marketing
expenses, research and development costs, executive salaries and administrative expenses.
The total manufacturing costs are calculated by adding the cost elements as follows:

R
Direct material xx
Direct labour xx
Manufacturing overheads xx
Total cost xxx

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The cost per unit manufactured can now be calculated by dividing the total cost from the
table by the total number of units manufactured.

Direct and indirect costs

Direct costs are costs incurred during the production process and can be specifically
identified with a given cost unit. They can be easily traced to products or services as they
relate directly to such products or services. Such costs normally include direct materials
and direct labour. These costs constitute the prime costs. Direct material costs are the costs
of material that are consumed in the manufacturing process to produce a cost object. The
cost can be traced to each cost object in an economic manner, such as costs of the cloth,
buttons and zipper in a clothing factory. Direct labour costs would include all the costs of
the employees who were involved in the production of the cost unit, in this case, the dress.

Direct material + Direct labour = Prime cost

All material, labour and other costs that cannot be traced specifically and exclusively to a
particular cost object are classified as indirect costs. The total of indirect costs is known as
overheads. Overheads can be broken down into production overheads, marketing overheads
and administration overheads. Examples of production overheads include the salary of the
factory supervisor or rent on the factory. Sometimes direct costs are treated as indirect
costs, because the cost of tracing these costs directly to the cost object is not cost efficient,
for example glue used in the manufacturing of a desk. Classifying a cost as direct or indirect
also depends on the cost object, as the cost can be treated as a direct cost for one object,
but the same cost may be treated as an indirect cost for another object. The fuel cost for an
airline, for example, is direct if the cost object is a specific flight route, but indirect if the cost
object is a passenger on a flight.

Direct labour + Manufacturing overheads = Conversion costs

Product and period costs

Financial accounting standards and tax law require that when the costs of products are
calculated, only manufacturing costs are included. Therefore, costs are classified as product
costs and period costs. Product costs are costs incurred in the manufacturing of the
product. They consist of direct materials, direct labour and production overheads. These
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costs are not necessarily expensed in the period in which they are incurred, but rather, they
are assigned to inventory and treated as an expense when the product is ultimately sold.
Period costs include all the costs that are not included in the inventory valuation and as a
result are treated as expenses in the period in which they are incurred.

Cost behaviour
An understanding of how costs and revenues will vary with different levels of activity or
volume is essential for decision making. Cost behaviour is the relationship between a cost
and the level of activity. The cost behaviour of a cost item can be determined through
cost estimation, which will be discussed later in the chapter. It is very important to note
that, while costs can be classified by the way they behave in the short term and within a
relevant range of activity levels, all costs will be variable in the long term, because capacity
can be altered, thereby increasing or decreasing fixed costs. Outside of a certain range of

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activity level, cost behaviour might change due to, for example, bottlenecks in production
or capacity being exceeded. The different cost behaviour patterns include the following:
● Variable costs
● Fixed costs
● Mixed costs
● Step costs.

Variable costs are costs that, in total, change in direct proportion to changes in the activity
(output) level. This means that the variable cost per unit stays constant within the relevant
range of activity level. Examples of such costs include direct material costs and direct
labour costs.

Illustrative example 1.1

An organisation has the following budgeted costs for the production of one unit of an
oak chair:
Table 1.1 Total cost per chair
Budgeted costs R
Direct materials (5m of wood at R1.50 per metre)
2
7.50
Direct labour (2 hours at R6.00 per hour) 12.00
Total cost 19.50

What would the total variable costs be at output levels for 1 000 chairs, 2 500 chairs
and 3 000 chairs?

Solution:
Total variable cost is calculated as follows:
Table 1.2 Total variable cost at various output levels
Output levels (chairs): 1 000 2 500 3 000
R R R
Variable cost per chair: 19.50 19.50 19.50
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Total variable costs 19 500 48 750 58 500

Total variable cost = Variable cost per unit of output × Total number of units produced
One would realise that as the number of chairs increases, the total variable costs also
increase. This is because one chair uses 5 m2 of wood and the cost of wood per metre is
R1.50. Therefore, with more chairs being produced, more metres of wood are needed.
The same applies to labour hours: one chair can be produced in two hours, therefore,
the more chairs produced, the more labour hours are needed at R6 per hour.
Therefore, we can come to the following conclusions regarding variable costs:
● Variable costs in total are variable. That is, the total variable cost increases in direct
proportion to increases in the output level. ➤➤

Basic cost accounting, cost classification, behaviour and estimation

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● Variable cost per unit is fixed. That is, it does not matter how many units are produced,
the cost per unit that is variable stays the same. If we refer to the example, our variable
cost per unit at all output levels (ie 1 000, 2 500 and 3 000) is R19.50.

Therefore, variable costs could be represented in a graph as shown in Figure 1.1.

Total cost (R)

Variable cost

Number of units

Figure 1.1 Variable costs

Fixed costs are costs that remain constant in total within a relevant range of output,
irrespective of changes in the level of activity. Examples of fixed costs include depreciation
of machinery, factory supervisor’s salary and factory rental. The fixed cost per unit decreases
as output increases, and vice versa.
Fixed costs can be represented on a graph as shown in Figure 1.2.
Total cost (R)

Fixed cost
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Number of units

Figure 1.2 Fixed costs

Fixed costs will be fixed over a relevant range. The relevant range is defined by the production
capacity within which the organisation normally operates. For example, if the activity level
stays within the factory’s capacity level, fixed costs will not change. At the organisation’s
present capacity level of 6 000 units, the rental charge for the factory is R15 000 per month.
When this capacity level increases to 7 500 units, it means the organisation will have to find
more factory space, and this will lead to the organisation having to pay more in terms of
factory rent.
Mixed costs (also sometimes referred to as semi-variable costs) consist of a fixed
component and a variable component. For example, the total telephone bill will reflect a

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fixed charge such as line rental, and a variable charge that will depend on the number and
duration of phone calls.

Mixed cost = Fixed cost + Variable cost

The variable cost component will be calculated by taking the variable cost per unit multiplied
by the number of units. Figure 1.3 shows how a mixed cost can be represented on a graph.

Variable
cost
Total cost (R)

Mixed
cost
Fixed
cost

Number of units

Figure 1.3 Mixed costs

It is important for managers to know how much of a mixed cost is fixed and how much is
variable. Only once this is done will they be able to estimate the cost to be incurred at relevant
activity levels. The methods that are discussed in the next section under cost estimation can
be used to separate the total mixed cost into the fixed and variable components.
Step costs are costs that are fixed within specified activity levels for a period of time, which
then increase or decrease by a constant amount at critical activity levels. Step costs are also
sometimes referred to as semi-fixed costs, as well as step-fixed costs or step-variable costs,
depending on the frequency of the increases/decreases. An example of a step cost that is closer
to a fixed cost than a variable cost (sometimes referred to as a step-fixed cost) is a company
that rents a truck for R5 000 per month to transport its products between the factory and the
distribution centre. The truck has enough capacity to transport 10 000 units per month. If
the monthly transporting capacity of the truck is exceeded, another truck needs to be rented
at an additional R5 000 per month. An example of a step cost that is closer to a variable cost
than a fixed cost (sometimes referred to as a step-variable cost) is printer ink cartridges at a
printing company. Each cartridge costs R500 and can print 1 000 pages. As the pages (activity
level) increase, so does the ink cartridge cost. Due to the large number of pages printed in a
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year, and therefore the frequency of replacing cartridges, this step cost will look more like a
variable cost than a fixed cost. Figure 1.4 shows how step costs are represented on a graph.
Total cost (R)

Activity level
Figure 1.4 Step costs

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Test yourself 1.1

Fabulous Furniture manufactures custom-designed wood furniture and sells it through
its factory stores. The company operates two factories, one in Gauteng and one in
Durban. Several costs incurred by the company are listed below. For each cost, indicate
which of the classifications best describe the cost. More than one classification may
apply to the same cost item.

Cost classifications:
A. Variable
B. Fixed
C. Mixed
D. Period
E. Product
F. Direct
G. Indirect
H. Administrative
I. Manufacturing

Cost items (cost object):

1. Cost of wood used in manufacturing the furniture (one unit of furniture)
2. Cost of electricity used by machines at the Gauteng factory (one unit of furniture)
3. Cost of electricity used by machines at the Durban factory
4. Wages of carpenters at Gauteng factory (one unit of furniture)
5. Salary of supervisor at Gauteng factory
6. Depreciation of the cutting machine at the Durban factory (one unit of furniture)
7. Depreciation of the cutting machine at the Durban factory
8. Depreciation of the accounts department computer system at head office
9. Salary of the chief executive officer.

Cost estimation
In order to forecast costs for decision making, planning and control, costs must be separated
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into fixed and variable costs. Cost classification and cost estimation are achieved by using
one of the following computational methods:
● Graphical or scatter graph method
● High-low method
● Least squares method (also known as simple regression analysis).

Besides using these methods for separating fixed and variable components of mixed costs,
they are also used to determine whether a particular cost is entirely fixed or variable within
the relevant range of activity. It is not easy to predict costs, as they behave differently under
different circumstances, for example depreciation is usually classified as a fixed cost, but it
can also be variable if the asset’s value declines in direct proportion to usage.

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Illustrative example 1.2

As an illustration, assume that the following cost observations have been given for Cam
Ltd, a manufacturing organisation:
Table 1.3 Total costs at various output levels
Month Units produced Cost (R)
January 35 4 375
February 45 5 025
March 20 3 400
April 25 3 725
May 40 4 700
June 25 3 725
July 50 5 350
August 30 4 050
September 15 3 075
October 30 4 050
November 35 4 375
December 37 4 505

The scatter graph method and the high-low method will now be illustrated using the
information from Cam Ltd.

Scatter graph method

A scatter graph is a graphical approach used to estimate costs, whereby cost and activity
levels are plotted on a graph. A line is drawn through the middle of the plotted points. This
line is known as a line of best fit. Fixed cost is shown on the y-axis as the intercept of the line
of best fit. This method takes into account all available data and is simple to use. However,
it is prone to inaccuracies that may arise due to subjectivity.
The scatter graph is generally used to establish whether there is a linear relationship
between the activity and the cost. If all the dots are more or less in a straight line, there is a
linear relationship. If the dots are more scattered, the relationship is weak or non-existent
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and the activity cannot be used to estimate the cost.

The advantage of the scatter graph is that it is quick and simple to perform and to
understand, but the disadvantage is that the line of best fit is subjective and therefore less
reliable than the other methods.

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Illustrative example 1.2 (cont.)

Using the illustrative example of Cam Ltd, the scatter graph would be drawn as follows:

R6 000

R5 000

R4 000
Total cost

R3 000

R2 000

R1 000

R0
0 10 20 30 40 50 60
Volume (units produced)

Figure 1.5 Scatter graph of Cam Ltd

The point where the total cost line crosses the vertical axis (y-axis) is the fixed cost
element. The fixed cost from the scatter graph is R2 100, which is in agreement with the
fixed cost calculation from the high-low method as a linear relationship exists between
the volume and the total cost.

The variable cost can be calculated as:

Variable cost (January) = Total cost – Fixed cost

= R4 375 – R2 100
= R2 275
Variable cost
Variable cost per unit =  __________
Volume
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R2 275
=  ______
35
= R65 per unit

High-low method
The high-low method uses the highest and lowest observations in terms of activity level
(volume) in the relevant range, and the corresponding costs. The line between these two
points is assumed to represent the cost behaviour pattern. The slope of this line represents
the variable cost per unit and is calculated by dividing the change in cost (between the two
observations) by the change in activity level.

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Illustrative example 1.2 (cont.)

To calculate the variable cost per unit, we need to calculate the difference in the total
cost and the difference in the total output as shown in Table 1.4.
Table 1.4 Net amounts of output levels and total costs
Month Output Total cost (R)
Highest July 50 5 350
Lowest September 15 3 075
Difference 35 2 275

To calculate the fixed cost component, we can use either the high output level figure or
the low one. If we use the high figure:

Fixed cost = Total cost – Variable cost

= R5 350 – (R65 × 50 units)
= R5 350 – R3 250
= R2 100

Use the information for the low output level to calculate the fixed cost component.

The advantages of the high-low method are that it is quick and simple to perform, and it
is more accurate than the scatter graph method. The disadvantage is that it ignores all the
other observations, and may therefore not be representative of the population. A further
shortcoming is the fact that the highest or lowest observation may be an outlier, which will
result in a line that does not represent the majority of observations in the sample.

Least squares method (regression analysis)

In terms of the least squares method, the a and b values have to be calculated mathematically
by solving the following two equations:
∑xy = a∑x + b∑x2
∑y = na + b∑x
Where:
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y = dependent variable (total cost)+

a = fixed cost and the intercept on the y-axis
b = variable cost per unit and the slope of the line
x = independent variable (activity level)
n = number of observations

This approach will result in the most reliable values for a and b being obtained in comparison
to the high-low method and the scatter graph method. The high-low method will render
accurate results for a and b if all the points lie on the same straight line, which occurs when
there is a perfect correlation.
Once the a and b values have been calculated, they can be substituted into the straight-
line equation:
y = a + bx.

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A more detailed explanation of the least squares method, as well as instructions on the
calculations, are presented in Chapter 9.

Test yourself 1.2

Deshayne Logistics has the following data, showing total cost per kilometres travelled
for their fleet of vehicles:

Month Petrol cost per month (R) Number of kilometres travelled in a month
January 6 900 800
February 7 175 850
March 7 560 920
April 7 835 970
May 8 055 1 010
June 8 440 1 080
July 8 550 1 100

For August, it is estimated that the total kilometres travelled will be 1 250 km. Estimate
the total cost for the month of August using the high-low method.

Total cost statement

In order to bring all the costs involved in producing the output of an organisation together,
we must prepare the total cost statement. Table 1.5 gives the layout to be followed when
preparing such a statement.
Table 1.5 Total cost statement
R
Direct materials costs x
Add: Direct labour costs x
PRIME COST x
Add: Production overheads (Indirect costs) x
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PRODUCTION COST x
Add: Non-production overheads x
TOTAL COST x

From the table, we can see that all the direct costs (direct materials and direct labour)
constitute what is known as the prime cost. If we add production overheads to the prime
cost, we get a total cost known as production cost. Production cost plus non-production
overheads, which cannot be directly attributed to each unit of output, gives us the
total cost.

Cost and Management Accounting

Case study: Managing costs at a hospital

It was approaching the middle of the 2015 financial year. The financial director of a
private hospital, Mr Mokoena, had just completed another monthly management
report. As always, the outsourced pathology expenses were at the top of the list, and yet
again, they were far over budget. Because of pressure from investors, it was important
for the hospital to ensure that it did its utmost to stay within the budget. Mr Mokoena
pondered how he could better manage the pathology expenses.
Required:
1. Classify the costs of the hospital into direct and indirect costs, giving at least five
examples of each.
2. Determine examples of cost objects that can be included in the hospital’s top 20
goods and services.
3. What do you think are the reasons why the hospital always runs over budget?
Discuss what the hospital could do to stay within budget.

Summary
The cost accounting system provides the management of an organisation with essential
cost information in order to assist them with the decision-making, planning and
control processes. To be effective in running the entire organisation, managers are given
responsibilities to run various sections of the organisation. These sections could either
be a cost centre, revenue centre, profit centre or an investment centre. If an organisation
produces a product or delivers a service, it needs to identify a unit of cost. This will enable the
organisation to charge costs directly to the cost unit or to the cost centre. An organisation
can classify costs by element, assignment, timing and behaviour.

Key concepts
Cost is any resource that has been given up to achieve a particular objective.
Cost accounting is a system of accounting for costs where costs of products and services
are ascertained and controlled. It also involves arranging data for purposes of control
and guidance of information to management for decision-making purposes.
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Cost centre is a responsibility centre in an organisation where the manager is responsible

for costs. The performance of the cost centre is measured according to cost control.
Cost object is something to which costs are assigned, and can be a product, service,
department or customer.
Direct costs are costs that can be specifically traced to a given cost object. These costs
constitute the prime cost.
An expense is the cost that is normally used in the generation of sales revenue.
Financial accounting is primarily used for external reporting. It provides financial data
about the organisation in the form of periodic statements and reports to external
stakeholders – that is, users of accounting information who have an interest in the
organisation but do not take part in the day-to-day management of the organisation.
➤➤

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Fixed costs are costs that stay the same in total, despite changes in the level of activity.
Indirect costs are costs that cannot be specifically traced to a given cost object. These
costs are also known as overheads.
Investment centre is a section of an organisation where the profit generated by a profit
centre can be compared with the amount of funds invested in the centre.
Management accounting is intended for internal reporting to meet the needs of those
who are actively engaged in the management of the organisation in the areas of decision
making, planning and control.
Mixed costs consist of a fixed cost component and a variable cost component.
Non-production overheads are not incurred in the production process and include
selling and distribution costs, and administration costs.
Period costs are not assigned to inventory, but rather to expenses during the period in
which it is incurred.
Prime cost is the total direct cost of manufacturing the output of an organisation.
Product costs are incurred in the production process and are assigned to inventory.
These costs are only expensed during the period in which inventory is sold.
Production cost is the organisation’s prime cost (total direct costs), plus factory
overhead costs, also known as production overheads.
Production overheads are manufacturing costs that must be incurred in the production
process but cannot be traced directly to a specific unit produced.
Profit centre is a section of an organisation to which revenue can be identified and costs
can be charged.
Responsibility centre is a part of the organisation for which a particular manager is
responsible.
A revenue centre is a section of an organisation where the manager is responsible for the
income generated by the centre.
Step costs are costs that are fixed within specified activity levels for a period of time,
which then decrease or increase by a constant amount at critical activity levels.
Total cost is composed of production cost and non-production cost. Variable cost plus
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fixed costs also equate to total cost.

Variable costs are costs that (in total) change in direct proportion to changes in output
levels.

Test-yourself solutions
Test yourself 1.1
1. A, E, F, I.
2. C, E, F, I.
3. C, E, G, I.
4. A, E, F, I.

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5. B, E, G, I.
6. B, E, F, I.
7. B, E, G, I.
8. B, D, G, H.
9. B, D, G, H.

Test yourself 1.2

The total cost using the high-low method can be calculated as follows:
R8 550 − R6 900
_____________
Variable cost per unit =    
1 100 − 800 units
  

= R5.50

To calculate the fixed cost component, we can use either the high output level figure or the
low one. If we use the high figure:

Fixed cost = Total cost − Variable cost

= R8 550 − (R5.50 × 1 100 units)
= R2 500
The straight-line equation:
y = a + bx
y = R2 500 + R5.50 (x)
Predicted total cost for the month of August will be:
y = 2 500 + 5.50 (1 250)
y = 2 500 + 6 875
y = 9 375

Review questions
1.1 Define a cost object.
1.2 Distinguish the difference between a cost centre, profit centre and investment
centre.
1.3 What is meant by prime cost?
1.4 How would the cost of depreciation of plant and machinery be classified on a
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production statement?
1.5 If a business incurs fixed costs of R255 000, what would be the fixed cost per
unit if production levels are:
(a) 25 000 units
(b) 150 000 units?
1.6 Explain the difference between product cost and period cost.
1.7 Determine the major elements of product costs in a manufacturing organisation.
1.8 Which methods can be used for cost estimation?
1.9 What might be the reason why, as output level increases, the cost per cost
object decreases?
1.10 Define the following terms: mixed cost, indirect cost and production cost.

Basic cost accounting, cost classification, behaviour and estimation

Exercises
1.1 The electricity bill of the company is set out in the following table. The cost
behaviour pattern remained the same from month to month.
Month Usage Total cost Inflation
(kWh) (R) index
April 18 000 72 680 1.15
May 19 500 75 295 1.10

Required:
Calculate the variable cost per unit for June at an inflation index of 1.20.
1.2 A private hospital group operates 13 hospitals across the country as separate
divisions. Three major costs include drugs, specialist doctors’ salaries and
electricity. The specialist doctors travel between the 13 hospitals as there is not
enough demand yet for a full-time specialist at each hospital.

Required:
For each of the costs, indicate whether it is a direct cost or an indirect cost if the
cost object is a single:
(a) Patient
(b) Hospital.

1.3 A company that manufactures and sells chocolate bars redesigns the wrapper
of the bars each time a production run is sold out in order to retain customer
interest. The design of the wrapper is outsourced to a local graphic designer.
Briefly explain the cost behaviour of the design cost.
1.4 A company’s telephone bills for the past six months are presented in the
following table:

Month Number of calls Total duration of Cost (R)

calls (in minutes)
March 230 1 150 2 975.00
April 124 174 550.20
May 423 2 961 6 960.30
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June 223 1 004 2 459.20

July 156 936 2 302.80
August 401 3 208 7 528.40

Required:
Calculate the total telephone cost that should be expected in September, using
the high-low method when the total duration of phone calls is expected to be
1 080 minutes.
1.5 A company manufactures aluminum roof racks for off-road enthusiasts. During
the 20X1 financial year, 1 800 units were manufactured. The selling price is
R8 500 per unit.

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17

Cost per unit:

Aluminum: 5 m2 @ R600 per metre
Labour (R120 per hour): R1 800
The following additional costs relate to the 20X1 financial year:

R
Manufacturing equipment depreciation 117 500
Salaries of administrative staff 620 550
Office manager’s salary 480 000
Factory electricity 30 000
Office electricity 24 000
Factory rent 224 000
Marketing expenses 36 000

There was no opening or closing inventory during the period.

Required:
(a) Prepare a total cost statement clearly showing the prime cost, production
cost and total cost.
(b) Prepare a profit statement for the period.

1.6 Several years ago, a mineworker started manufacturing leather briefcases in his
spare time. He obtained the leather free of charge from his brother and virtually
had no overheads. Within three years he had managed to save a significant
amount of money, and had a market that was still expanding. What initially was
intended to be a hobby for extra income had developed into a profitable business.
A year ago, inspired by his financial success, he quit his job to enter the leather
industry on a full-time basis. His business had grown to the extent that he was
not coping with his full-time job and trying to meet the demand for his cases.
He withdrew all his savings, rented a workshop in the Phoenix industrial area,
and bought the necessary equipment. After trading for 10 months on the new
premises, he enthusiastically summarised his financial results as follows:

Month Number of briefcases Total costs (R) Total sales (R)

manufactured and sold

May 60 2 907 2 640
June 75 3 358 3 300
July 80 3 509 3 520
August 70 3 208 3 080
September 85 3 659 3 740
October 80 3 376 3 520
November 90 3 810 3 960
December 95 3 971 4 180
January 80 3 484 3 520
February 75 3 327 3 300
790 34 609 34 760

Basic cost accounting, cost classification, behaviour and estimation

He was horrified by these results. After considering all the relevant facts, he
reached the conclusion that he has to increase his turnover. Due to insufficient
equipment, his turnover is currently limited, and he cannot meet the demand
for briefcases. The demand for his product is almost triple that of the existing
turnover. By acquiring the desired equipment, the monthly fixed costs will
increase by R500. At the same time, the production capacity will increase to
double the average production capacity of the past 10 months. His savings are
exhausted and his only means of financing the purchase price of new equipment
is to obtain a loan from Business Partners Limited.
He has obtained the necessary application forms from Business Partners
Limited. They require, inter alia, an analysis of the cost structure and a projected
income statement of the business. He has approached you for assistance as he
has a very poor knowledge of bookkeeping and management accounting.
Required:
(a) Calculate the variable and fixed elements of the total costs (before acquiring
the new equipment) by using the high-low method.
(b) Calculate the monthly net income if the new equipment is acquired by using
the information as calculated in (a) above.
1.7 Joe’s Car Wash reported the following total costs for the past six months:
Month Number of cars Total cost
washed (R)
1 203 13 105
2 201 13 035
3 241 14 435
4 198 12 930
5 211 13 385
6 201 13 035

Required:
Calculate the estimated total cost for month 7 if it is expected that 200 cars will
be washed. Use the high-low method.
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1.8 A local air charter company operates one aeroplane and flies between
Johannesburg and Skukuza once a day. The following total direct costs were
reported for the first half of the financial year:
Month Number of Total cost
passengers (R)
March 60 81 000
April 78 87 300
May 65 82 750
June 69 84 150
July 45 75 750
August 66 83 100

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19

Required:
Use the high-low method to calculate the following:
(a) Variable cost per passenger
(b) Fixed cost per month
(c) Estimated total cost for September if 70 passengers are expected.

1.9 Your friend recently started a new business. The following table shows the
number of units produced and the costs for the first two months:

Units produced 150 200

Month 1 Month 2
(R) (R)
Direct materials 37 500 50 000
Labour 16 250 20 000
Electricity 3 150 4 150
Depreciation 5 000 5 000
Rent 8 000 8 000
Total costs 69 900 87 150

Required:
(a) Classify the costs according to fixed, variable and mixed costs.
(b) Classify any mixed costs into their fixed and variable components.
(c) Use the cost structure in (a) and (b) above and calculate the total production
cost for 250 units.
(d) Calculate the cost per unit for the three output levels above.
(e) Explain why the cost per unit behaves in the way it does in (d) above.

1.10 Bean Bag Ltd has recorded the following total costs for their red bean bag over
six months:

Month Production in units Total cost (R)

January 1 000 19 000
February 1 900 32 500
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March 2 500 41 500

April 2 700 44 500
May 3 200 52 000
June 3 500 56 500

Required:
Using the high-low method, estimate the total cost for the month of July if 4 000
bean bags were produced.

Basic cost accounting, cost classification, behaviour and estimation

1.11 Costs can be classified based on how they change in relation to a change in the
activity level.
A mobile coffee stall incurred the following costs to make cappuccinos at a market:

Coffee and milk Each cup requires 20 g of ground coffee beans and 100 ml of milk
Electricity Electricity consists of a fixed monthly charge of R150 and usage is
charged at R2.05 per kWh.
Maintenance The espresso machine needs to be serviced after every 2 000 cups
of espresso for the warranty to remain valid.
Depreciation Depreciation on the espresso machine is R2 000 per month. The
machine is expected to last for 5 years.

Required:
For each of the costs above, identify whether it is a variable, fixed, mixed or step cost.
1.12 Kelly wants to start a printing company in Cape Town that specialises in printing
large canvasses for customers from their photos. Initially she will only print full-
colour size A1 canvasses. Kelly is busy with market research to determine the
feasibility of her printing business.
As part of her research, Kelly visited her brother’s printing shop in Johannesburg.
She paid R2 780 for a return flight on A1 Airlines. Kelly’s brother let her have
two months’ accounting records to use for estimating her costs. She plans to
operate the same type of shop offering the same single product.
The accounts of Kelly’s brother’s shop are as follows:

Number of units 120 140

January (R) February (R)
Canvas 9 000 10 500
Wood 9 600 11 200
Ink 12 000 14 000
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Shop rental 12 000 12 000

Electricity 510 570
Telephone 1 200 1 200
Total costs 44 310 49 470

Additional information:
1. The ink cartridges can print 20 size A1 canvasses before it has to be replaced.
2. The rental contract is signed for a year in advance.
3. Kelly’s brother uses a cellphone. He has a contract and has a certain number
of free minutes per month. He never goes over the call limit, but usually
reaches the limit by the last day of the month.

Cost and Management Accounting

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21

Required:
(a) Classify each of the costs according to its behaviour within the relevant time
frame of one year. Motivate each classification clearly.
(b) Calculate the variable and fixed cost component for electricity.
(c) Calculate the estimated profit at an activity level of 250 canvasses and a
selling price of R350 per canvas.

Reference list
CIMA Study Text. 2001. Management Accounting: Performance Management. 2nd edition.
London: BPP Publishing Limited.
Drury, C. 2012. Management and Cost Accounting. 8th edition. London: Brendan George.
Seal, W. 2011. Management Accounting for Business Decisions. New York: McGraw-Hill.
Upchurch, A. 1998. Management Accounting – Principles & Practice. London: Pitman Publishing.
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2 Costing systems for
decision making

Costing systems for decision making

Comparison Evolution
Traditional Contemporary
of costing of costing
systems systems
systems systems

Marginal Absorption Analysis of

ABC costing
costing costing costing systems

Learning objectives
After studying this chapter, you should be able to:
● Understand the different types of cost systems
● Differentiate between marginal and absorption costing
● Distinguish between the different income statement formats
● Calculate how different levels of inventory affect the profit calculated
● Convert from marginal to absorption costing and vice versa
● Explain the strengths and weaknesses of marginal and absorption costing
● Define activity-based costing (ABC)
● Identify the various steps in ABC
● Compare ABC with absorption and traditional costing methods
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● Explain the strengths and weaknesses of ABC

● Understand the cost versus benefit considerations in the design of a cost system
● Name the various costing methods into which costing methods have evolved to
reflect the manufacturing philosophy.

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24

Introduction
A cost accounting system is used to estimate the cost of goods and services as well as the
cost of the organisation’s units, such as departments. Cost accounting systems can be
categorised as follows:
● Traditional costing systems estimate the costs of goods and services as well as
departmental costs. The assumption is made that production volume is the only factor
that can cause costs to change.
● Contemporary costing systems estimate the cost of the individual activities performed
in the organisation and use this information to cost goods and services, departments,
customers and other items. Contemporary systems recognise that production volume
can cause costs to change as well as a range of other factors.

Regardless of which method is used, the system will still employ the basic cost accounting
principles such as cost classification, analysis, allocation and apportionment. Cost
accounting systems are chosen on the basis of how well they are perceived to help achieve
organisational goals in relation to the costs of implementing those systems and the context
within which they are to operate. Costing systems can vary in terms of which costs are
assigned to which cost objects and depending on their level of sophistication.
The costing systems that will be discussed in this chapter are the following:
● Marginal costing systems
● Traditional absorption costing systems
● Activity-based costing systems.

Case study: Costing systems in South African banks

Qualitative research was conducted to uncover how the South African banks currently
use costing principles. The research focused on three out of the ‘big four’ banks – Absa
Bank, Standard Bank, First National Bank and Nedbank. The following methodologies
are practised at three of the big four: activity-based costing, full absorption costing
and standard costing. In many of the cases, a hybrid of methodologies is practised.
The practice of philosophies, methodologies and management varied within the three
organisations. Based on the maturity of the practices, they could range from having a
dynamic view of the levels of cost to just a full absorption method. In all three samples, it
was evident that ABC is the predominant and desired practice. Since personnel expenses
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represent the largest single component of non-interest expense in financial institutions,

these costs must also be attributed more accurately to products and customers. Activity-
based costing, although originally developed for manufacturing, may even be a more
useful tool for doing this.
The researcher concluded that cost management is not practised adequately within
the banking sector of South Africa. However, over time, the banks are beginning to
realise that time is an important factor in cost management. It is also a factor which
defines fixed costs and variable costs. Due to the high ratio between fixed and variable
costs, it was concluded that managing costs is a gradual medium- to long-term time
dependent process.
Source: Mistry (2010)

Cost and Management Accounting

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Marginal costing
Also known as direct costing or variable costing, marginal costing can be defined as a cost
accounting method which charges products with only variable costs, and the fixed costs are
expensed against the contribution for the period and written off as a period cost. It is the
preferred reporting format for management accounting, because of its prudent approach
to measuring profit, as all fixed costs will be charged as an expense. This method is simple
to use and provides the best information for decision-making purposes. The same cost
information is used, but it is presented in a different format. Fixed manufacturing costs
are treated as period costs and are therefore not absorbed into the cost of the product.
Fixed costs are more closely related to the ability to produce than to the production of
specific units. All variable costs are deducted in the income statement before arriving at the
contribution. Fixed costs are deducted after the contribution has been calculated.
Marginal costing focuses on costs that are relevant for decision making in the short
term. Therefore, fixed costs are irrelevant, because they cannot be altered in the short term.
Fixed costs are treated as period costs below the contribution line. The costs above the
contribution line are the only costs that are relevant for decision-making purposes. Thus
the impact of management decisions is more accurate where volume is changing. Variable
costs are also the basis of breakeven analysis. This will be discussed in more detail in
Chapter 3. The marginal costing system is the only system that accurately reflects the profits
of an organisation because fixed manufacturing costs are written off in the year incurred
and not carried forward to the balance sheet. The marginal cost per unit can be summarised
using a cost card as given in the table below.
Table 2.1 Marginal cost card
Costs per unit R
Direct material xx
Direct labour xx
Variable production overheads xx
Variable production cost xx

The principles of marginal costing

● Marginal costs are the part of the cost of one unit of product or service that would
be avoided if the unit was not produced, or that would increase if one additional unit
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was produced.
● The effect of manufacturing one additional unit will be as follows:
◆ Income will increase by the sales value of the item or service sold.
◆ Costs will increase by the variable costs of one unit.
◆ Profit will increase by the contribution amount of the one additional item.
◆ Period fixed costs will remain constant.

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Uses of marginal costing

Internal uses
Marginal costing is preferred by managers and executives because of its planning, control,
and analytical potential. Variable unit costs and the contribution margin per unit remain
constant at all levels of activity. Profits and losses bear a relationship with sales revenue and
are not affected by inventory or production variation.
Marginal costing is easy to understand and is the preferred method for most types of
internal analysis. Cost data for internal purposes is readily available from the accounting
records and additional record keeping and analysis is not necessary.
In automated manufacturing environments where variable costs make up only a small
portion of total costs, one may think that marginal costing would be of no use. Fixed costs
make up the largest share of total costs, and including them in the cost of the product
causes bigger changes in product cost as the production volume fluctuates.

External uses
Those in favour of marginal costing believe that the separation and separate accounting of
fixed and variable costs simplifies the understanding of the income statement as well as the
assignment of costs to inventories.
The accounting records should reflect variable and fixed costs recorded in separate
accounts, as well as two overheads control accounts: one for fixed costs and one for variable
costs. In the case of predetermined rates being used, an account called applied variable
factory overheads will then be credited. The variance between the actual and applied
variable overheads is the spending variance. If standard costing is used, the variance will
be a controllable variance. Fixed costs are not charged to work in process, and are therefore
excluded in the calculation of the predetermined rate. The total fixed costs that have been
recorded in the factory overheads control account are charged directly to the income
statement.
The decision as to whether or not to use marginal costing for external reporting purposes,
is dependent on what the product costs comprise. If the product cost is made up of prime
costs plus all indirect manufacturing costs, then marginal costing will not be appropriate,
because inventories of work in process and finished goods as well as the working capital
position will be understated in the balance sheet. Costs and revenue will also be improperly
matched in the income statement. The proper classification of non-variable costs as period
costs makes marginal costing an acceptable accounting practice.
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For years those in favour of marginal costing have been fighting a losing battle to have
marginal costing accepted for external reporting purposes. To date, marginal costing
has not been widely accepted for external reporting purposes. A growing number of
organisations have been using marginal costing for internal reporting purposes because
of the advantages it has to offer, and for external reporting they convert their financial
statements to absorption costing.

Cost and Management Accounting

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Illustrative example 2.1

Inventory, production and sales data for the Superlight soccer balls manufactured by
Bafana Limited are given in Table 2.2.
Table 2.2 Inventory, production and sales data for the Superlight soccer balls
manufactured by Bafana Limited
Year 1 Year 2 Year 3 Year 4
Units produced 30 000 35 000 27 500 32 500
Units sold 30 000 27 500 32 500 35 000
Opening inventory (units) – – 7 500 2 500
Closing inventory (units) – 7 500 2 500 –

The financial data for an activity level of 30 000 Superlight soccer balls is given in Table 2.3.
Table 2.3 Financial data for an activity level of 30 000 Superlight soccer balls
Cost per ball (R)
Direct material 5.00
Direct labour 7.00
Production overheads are 200% of direct labour 14.00
Total cost per ball 26.00

Selling price per ball is R36.00. Administrative overheads are fixed at R100 000 per
period and half of the production overheads are fixed.
Required:
Prepare a statement of comprehensive income using marginal costing principles for the
four years.

Solution:
First calculate the amount of fixed production overheads per period when the cost data
is based on an activity level of 30 000 balls.
Labour for 30 000 balls = R210 000
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Total production overheads: 200% of direct labour = R420 000

Fixed production overheads = R420 000 ÷ 2 = R210 000

The variable overheads recovery rate is 100% of direct wages. The variable cost per ball
is calculated as given in Tables 2.4 and 2.5.
Table 2.4 Variable cost per unit
R
Direct material 5.00
Direct labour 7.00
Variable overhead 100% of direct labour 7.00
19.00 ➤➤

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Table 2.5 Annual Statements of Comprehensive Income for Bafana Limited

Bafana Limited
Annual Statements of Comprehensive Income
Marginal costing basis
Year 1 (R) Year 2 (R) Year 3 (R) Year 4 (R)
Sales 1 080 000 990 000 1 170 000 1 260 000
Less: Variable cost of sales (570 000) (522 500) (617 500) (665 000)
Opening inventory – – 142 500 47 500
+ Variable production costs 570 000 665 000 522 500 617 500
570 000 665 000 665 000 665 000
Less: Closing inventory – 142 500 47 500 –
Less: Variable selling, – – – –
distribution and admin
costs
Contribution 510 000 467 500 552 500 595 000
Less: Fixed costs (310 000) (310 000) (310 000) (310 000)
Production 210 000 210 000 210,000 210 000
Selling distribution and admin 100 000 100 000 100 000 100 000
Profit/(loss) 200 000 157 500 242 500 285 000

Although there are many arguments in favour of marginal costing as a tool for decision
making, absorption costing is used extensively for general accounting purposes and
inventory valuation. Fixed production costs should be charged to cost units in a fair way.
Identifying the best method of allocating these costs is a central problem in cost accounting.
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Test yourself 2.1

The information given in the following table is available for Cheetah Limited, the
manufacturer of Super Cool shirts.

R
Sales price per unit 12.50
Variable production cost per unit 7.50
Variable administration sales and distribution per unit 1.00

➤➤

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Total marginal cost per unit 8.50

Fixed production costs 37 500
Fixed administration sales and distribution 18 750
Opening inventory in units 2 500
Units produced 25 000

At the beginning of December 20X1, there were 2 500 units in inventory.

Required:
Draw up a statement of comprehensive income according to marginal costing principles
for three different levels of sales, for the month of December.
(a) 12 500 units
(b) 18 750 units
(c) 25 000 units.

Absorption costing
Absorption costing is a product costing approach that treats both variable and fixed
manufacturing costs as product costs. The aim of an absorption costing system is to
determine the full production cost per unit. In modern industries the fixed cost component
of a product or service is substantial and increases in proportion to variable costs. Production
is not possible without incurring fixed costs, and therefore they form an unavoidable part
of the cost of production and should be included in stock valuations. When production is
constant and sales fluctuate, net profit fluctuations are less with absorption costing.
Fixed manufacturing overheads are allocated to the product by using a predetermined
fixed overhead rate, and are only expensed when the product is sold. The overheads absorption
rate is based on the normal level of production for the period. If actual production varies
from the normal level of production, there may be an under- or over-absorption of fixed
production costs for the period. This amount is written off against the absorption costing
profit for the period. IAS 2 (International Accounting Standard 2) is the accounting standard
that regulates inventories. Paragraph 10 of this standard defines the cost of inventories as
‘… including all costs of purchase, costs of conversion and other costs incurred in bringing
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the inventories to their present location and condition’ (IFRS, 2012:56). The costs of
conversion are further explained in paragraph 12 to include ‘a systematic allocation of fixed
and variable production overheads that are incurred in converting materials into finished
goods’ (IFRS, 2012). From this paragraph, three key principles emerge:
1. Fixed overheads must be included in the cost of inventories.
2. Only overheads that are incurred in converting materials into finished goods are to be
included.
3. Fixed overheads must be split between manufacturing and non-manufacturing, and
only the manufacturing component must be included in the cost of inventories.

The absorption cost per unit can be summarised using a cost card as shown in Table 2.6.

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Table 2.6 Absorption cost card

R
Direct material per unit xx
Direct labour per unit xx
Variable production overhead per unit xx
Fixed production overhead per unit xx
Absorption cost per unit xx

Principles of absorption costing

The principles of absorption costing are as follows:
● Fixed production costs are part of the production costs of a product and should be
absorbed into the product costs.
● Inventories are valued at their full production cost, which includes absorbed fixed
production costs.

Illustrative example 2.2

Using the previous example of Bafana Limited, draw up the Statement of Comprehensive
Income using absorption costing principles.

Solution:
Table 2.7 Annual Statements of Comprehensive Income for Bafana Limited
Bafana Limited
Annual Statements of Comprehensive Income
Marginal costing basis
Year 1 (R) Year 2 (R) Year 3 (R) Year 4 (R)
Sales 1 080 000 990 000 1 170 000 1 260 000
Less: Cost of sales (780 000) (715 000) (845 000) (910 000)
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Opening inventory – – 195 000 65 000

+ Production cost 780 000 910 000 715 000 845 000
780 000 910 000 910 000 910 000
Less: Closing inventory – 195 000 65 000 –
(Under)/over absorption of – 35 000 (17 500) 17 500
overheads
Gross profit 300 000 310 000 307 500 367 500

➤➤

Cost and Management Accounting

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Less: Selling, distribution and

admin costs (100 000) (100 000) (100 000) (100 000)
Variable – – – –
Fixed 100 000 100 000 100 000 100 000
Net profit/(loss) 200 000 210 000 207 500 267 500

Test yourself 2.2

Using the example of Cheetah Limited in Test yourself 2.1, prepare the Statement of
Comprehensive Income using absorption costing principles for the month of December.
Assume the following:
● Normal level of activity is 25 000 Super Cool shirts per month.
● Fixed production costs were R37 500 for the month.

Analysis of traditional costing systems

The effect of marginal and absorption costing on inventory values and
profit
When all units produced are sold in the same period, then this implies that no inventory is
held. When no opening or closing inventory is held, then profit reported according to the
absorption costing and marginal costing is the same. When opening inventory is present,
the portion of fixed manufacturing overheads included in opening stock would increase
the cost of sales and consequently decrease profit. When closing inventory is present, the
portion of fixed manufacturing overheads included in closing stock would decrease the
cost of sales and consequently increase profit. The total effect on profit would be
the difference between the value of fixed manufacturing overheads included in opening
and closing inventory.
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Illustrative example 2.3

Using the previous example of Bafana Limited, a reconciliation of the difference in profit
is illustrated in Table 2.8.
Table 2.8 Reconciliation
Year 1 (R) Year 2 (R) Year 3 (R) Year 4 (R)
Difference in profit – (52 500) 35 000 17 500

➤➤

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Change in inventory
Marginal costing – 157 500 242 500 380 000
Absorption costing – 210 000 207 500 362 500
Difference in inventory change – (52 500) 35 000 17 500
The calculations below show that the total effect on profit would be the difference between
the value of fixed manufacturing overheads included in opening and closing inventory.
Year 2 R
Income reported under marginal costing 157 500
Add fixed manufacturing costs in inventory build-up 7 500 @ R7.00 per unit 52 500
Income under absorption costing 210 000

Year 3 R
Income reported under marginal costing 242 500
Less fixed manufacturing costs in inventory reduction 7 500 − 2 500 = 5 000 @
R7.00 per unit 35 000
Income under absorption costing 207 500

Year 4 R
Income reported under marginal costing 380 000
Less fixed manufacturing costs in inventory reduction 2 500 @ R7.00 per unit 17 500
Income under absorption costing 362 500

In the example, profit was higher with absorption costing in Year 2 than with marginal
costing. The difference in profit was due to the fixed production overheads incurred
being carried over in the closing inventory to be set off against sales in the following
period, thus reducing the cost of sales. As soon as inventory levels decrease under
absorption costing, the profit will be lower, due to the fixed overheads which were
brought forward in the opening balance from the previous period and included in the
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cost of sales, as can be seen in Year 3 and Year 4. When the sales volume equalled the
production volume, the profit amount remained the same under both methods, as can
be seen in Year 1. Changes in inventories during a specific period will result in different
profit amounts under marginal and absorption costing.

Test yourself 2.3

Using the previous example of Cheetah Limited (Test yourself 2.2) and the Statement of
Comprehensive Income, reconcile the profits.

Cost and Management Accounting

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Summary of the effect on profit

Under marginal costing, the profit always moves in the same direction as sales volume.
Under absorption costing, the reported profit behaves unsteadily depending on changes
in inventory, sometimes moving in the opposite direction to sales. When sales exceed
production and inventory is reduced, marginal costing shows a higher profit. This is due to
a part of fixed costs of a previous period being brought forward as opening inventory and
charged to income through the cost of sales under absorption costing.
When production exceeds sales and there is a build-up of inventory, then absorption
costing reports higher profits. The reason for this is due to a portion of the fixed costs being
deferred to the following period as ending inventory, that is, the absorption method reflects
a higher ending inventory value. Under marginal costing, the total fixed costs are charged
against income.

Conversion of financial statements

The following section illustrates how financial statements can be converted from marginal
costing to absorption costing and vice versa.

Conversion of financial statements from marginal to absorption costing

An organisation that prefers using marginal costing to ensure that it benefits from all its
advantages can do so for internal reporting purposes. At the end of the financial period, the
financial statements can be converted to absorption costing by a few simple adjustments.

Illustrative example 2.4

Using the previous example of Bafana Limited for Year 3, convert the financial statements
from marginal costing to absorption costing.

Solution:
Table 2.9 Marginal costing conversion to absorption costing
Marginal costing Year 3 (R) Absorption costing Year 3 (R)
Sales 1 170 000 Sales 1 170 000
Less: Variable cost of sales (617 500) Less: Cost of sales (845 000)
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Opening inventory 142 500 Opening inventory 195 000

Add: Variable production costs 522 500 Add: Production cost 715 000
665 000 910 000
Less: Closing inventory 47 500 Less: Closing inventory 65 000
Less: Variable selling, distribution and admin
costs − (Under)/over absorption (17 500)
Contribution 552 500 Gross profit 307 500
Less: Fixed costs (310 000) Less: Selling, distribution and admin costs (100 000)
Production 210 000 Variable −
Selling distribution and admin 100 000 Fixed (100 000)
Profit/(loss) 242 500 Net profit/(loss) 207 500

➤➤

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Calculations of unit cost used in variable Calculations of unit cost used in production
production costs, opening and closing inventory: R cost, opening and closing inventory: R
Direct material 5.00 Direct material 5.00
Direct labour 7.00 Direct labour 7.00
Variable overhead 7.00 Variable overhead 7.00
Total 19.00 Fixed overhead 7.00
Total 26.00

When we convert from marginal costing to absorption costing, the cost per unit must
include the fixed manufacturing cost of R7.00 when calculating the value of the opening
and closing stock as well as the production costs. In this example the normal activity
is 30 000 units. In Year 3, 27 500 units were produced, so the under-absorption of
R17 500 (2 500 units x R7.00 fixed manufacturing overheads per unit) must be included
before the gross profit is calculated.

Conversion of financial statements from absorption to marginal costing

Converting from absorption to marginal costing can pose an academic challenge when all
the information is not available. In our previous example we were given units manufactured
and sold, but this may not always be the case. We will now look at an absorption costing
statement where standard costing was used, and it must be converted to marginal costing.

Illustrative example 2.5

Use the following information to convert the financial statements from absorption to
marginal costing.

This statement was prepared for a period where 8 000 units were sold; the production
for the period has not been given.
Table 2.10 Income under absorption costing
R R
Sales (8 000 × R11.00) 88 000
Cost of sales (standard) 56 000
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Gross profit (standard) 32 000

Selling and admin expenses 19 000
Net profit (standard) 13 000
Unfavourable variances from standard costs: 1 600
Indirect manufacturing costs volume 1 000
Material usage 100
Labour efficiency 200
Indirect manufacturing costs budget 300
Net income (actual) 11 400

➤➤

Cost and Management Accounting

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Additional information:
1. Variable selling and administrative expenses are 5% of sales revenue.
2. Indirect manufacturing costs are applied on a standard capacity of 10 000 units per
period.
3. Inventories are carried at standard cost. The balances were: opening 1 000 and
closing 2 500.

Solution:
To do this conversion, the costs must be separated into fixed and variable components.
The fixed manufacturing costs can be determined through the volume variance. To
enable us to do this, we need to find the number of units manufactured for the period:
Table 2.11
R
Closing inventory 2 500
Add sales for the period 8 000
Available for sale 10 500
Less: Opening inventory (1 000)
Units manufactured for the period 9 500

We are now able to calculate that the organisation was operating at 95% of its standard
capacity (9 500 ÷ 10 000). The volume variance is 5% of the fixed manufacturing costs
budgeted for the period. The fixed costs for the period must be R20 000 (R1 000 ÷ 5%).
The fixed cost application rate is R2.00 per unit. We can now subtract the fixed cost
from the total cost to arrive at the variable manufacturing cost per unit:
Table 2.12
R
Total cost per unit 7.00
Less: Fixed cost (2.00)
Variable cost 5.00
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Selling and administrative expenses are split as follows:

Table 2.13
R
Total expense recorded 19 000
Deduct variable component 5% × 88 000 (4 400)
Fixed expense for the period 14 600

➤➤

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The marginal costing statement can now be set up as given in the table below:
Table 2.14
R R
Sales (8 000 × R11.00) 88 000
Variable costs to make and sell at standard: 44 400
Manufacturing (8 000 × R5.00) 40 000
Selling and admin (8 000 × R0.55) 4 400
Marginal contribution (at standard) 43 600
Fixed costs 34 600
Manufacturing 20 000
Selling and admin 14 600
Net profit (standard) 9 000
Unfavourable variances from standard costs: 600
Material usage 100
Labour efficiency 200
Fixed manufacturing costs budget 300
Net profit (actual) 8 400

Reconciling the profits can now serve as a check on the solution:

Table 2.15
R
Income reported under marginal costing 8 400
Add fixed manufacturing costs in inventory build-up (1 500 × R2.00) 3 000
Income under absorption costing 11 400

The strengths and weaknesses of marginal and absorption costing

Although marginal costing is the preferred method from a management accounting
perspective, absorption costing is widely used for accounting and inventory valuation
purposes. A central problem in cost accounting is to identify the best method of attributing
these costs.
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Table 2.16 Strengths and weaknesses of marginal costing

Absorption costing
Strengths Weaknesses
● Under- and over-absorption is avoided. ● Marginal costing does not comply with IAS 2
● It is simple to operate. and can therefore not be used in external
● Fixed costs like salaries, rent and reporting.
depreciation are period costs and should be ● The contribution earned per product cannot
charged against the income for the period in be calculated, because fixed production
which they were incurred. overheads are not accounted for in unit
● There is no apportionment of indivisible costs, costs.
such as the marketing manager's salary.
➤➤

Cost and Management Accounting

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Absorption costing
Strengths Weaknesses
● Because period costs are fixed, it makes sense ● Over-production is encouraged, because
to charge them in full for the specific period. reported profits can be increased by
● Because the cost to produce one extra unit increasing inventory levels.
is the variable production cost, the value of ● Due to the fluctuations in inventory, when
closing inventory is more realistic. sales increase, the profits do not necessarily
● In decision making, marginal costing increase.
provides the best information. ● It is not as suited for internal use as
● It does not encourage over-production, marginal costing.
because reported profits cannot be
increased by increasing inventory levels.
● It is the preferred method for performance
measurement, because manipulation
through changes in inventory cannot take
place.
● It is the preferred method for management
accounting purposes.
● Closing inventory values include a share of
fixed production overheads as is required by
IAS 2.
● Because it is based on a global standard, it
ensures consistency and comparability of
financial information.
● Absorption costing takes into account
that fixed costs are a real cost and absorbs
overheads into production.
● Absorption costing is consistent with the
accruals concept, as a portion of the costs
of production are carried forward to be
offset against future sales.
● Fixed production costs are incurred in order
to produce. Therefore it is fair to charge
production with a share of these costs.
● When absorption costing is used, the total
cost per unit can be calculated. This can
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be used in decisions regarding mark-up

percentage on cost, and it can be used to
ascertain whether the product earns enough
contribution to cover other non-production
costs.
● Not using absorption costing would mean
that a large portion of expenditure is not
accounted for in unit costs, especially when
fixed production overheads are a large
portion of total production costs.

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Activity-based costing
By the 1980s, the standard cost systems designed during the scientific management
movement 75 years earlier no longer reflected the current economic reality. This led to the
introduction of activity-based costing (ABC) and the correction of serious deficiencies
in traditional standard cost systems. ABC may be used in common idiom to indicate a
degree of simplicity, but as a short form for activity-based costing, it introduces some of
the most revolutionary and fundamental changes in management accounting theory and
practice. What originally appeared to be simply a new method of tracing costs to products
has led to the development of an entirely new philosophy. As the direct labour content of
products decreased through automation and industrial engineering-driven efficiencies, the
percentage of total costs represented by the somewhat arbitrary allocations of overheads
had continually increased during the twentieth century. In addition, many companies
had shifted from mass production strategies to those that offered customers more variety,
features and options.
ABC is the modern alternative to absorption costing. Absorption costing was developed
during a period when most organisations produced a narrow range of products. Overhead
costs were only a small portion of total costs. Traditional costing systems assume that all
products consume all resources in proportion to their production volumes, and therefore
tend to allocate too great a portion of overheads to high volume products. ABC costing
attempts to overcome this problem. In an environment where advanced manufacturing
technology (AMT) is increasingly being used, and where direct labour only accounts for as
little as 5% of a product’s cost, it became difficult to justify the use of direct labour as the
basis for absorbing overheads. Non-volume related support activities have increased due
to AMT. These support activities are necessary to manufacture a vast range of products
efficiently and are not generally affected by changes in production volume. In the long term
they may vary according to the range and complexity of the product manufactured rather
than the volume. Examples of non-volume related support activities that can be identified
in an AMT production environment include engineering, ordering, material handling,
machine set-up, production scheduling, machining, assembling, inspection, quality
assurance, packaging and dispatching.

How does activity-based costing work?

ABC is a methodology that can be used to measure the cost of cost objects and the
performance of activities. According to CIMA official terminology, ABC can be defined ‘as
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an approach to the costing and monitoring of activities which involves tracing resource
consumption and costing final outputs. Resources are assigned to activities and activities
to cost objects based on consumption estimates. The latter utilise cost drivers to attach
activity costs to outputs.’
The theory behind ABC emphasises that activities such as those mentioned above cause
costs − the demand for these activities are caused by the products being produced. Costs are
therefore allocated to a product on the basis of the product’s consumption of the activities.
ABC is covered in more depth in Chapter 8. Although ABC was first used in a manu-
facturing environment, it can also be used successfully in service and retail organisations.

When is it feasible to introduce activity-based costing?

ABC should only be introduced if the additional information provided by the system will
result in an action that will increase the organisation’s overall profitability.

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The telltale signs of an outdated system would be the following:

● The product line has expanded to include a wide variety of products.
● Production overheads are the biggest component of total product cost.
● There is a variety of overheads resource inputs across the product range.
● The overheads resource consumption is driven by drivers other than just the product
volume.

A comparison between activity-based costing and traditional costing

The differences between the ABC and traditional costing methods are summarised in
Table 2.17.
Table 2.17 Comparison between ABC and traditional costing

ABC Traditional costing methods

Allocation Separate cost pools for support activities Service department costs absorbed on
of such as inspection and dispatching. labour- or machine-hour basis and are
overheads Costs are assigned to products through apportioned to production departments
cost driver rates. No secondary in a secondary apportionment.
apportionment required.
Absorption Uses many cost drivers as absorption Two absorption bases, labour hours
of bases (number of orders, number of and/or machine hours, are used to
overheads dispatches, etc). Absorption rates are charge overheads to products.
more closely linked to the causes of the
overhead costs.
Cost drivers Attention is focused on what causes Allow overheads to be related to
costs to increase, that is, the cost drivers. products in more subjective ways, which
The costs that vary with production produce less accurate product costs.
volume are traced to products using
volume-related cost drivers.

Design of costing systems

The design of cost systems should be based on a cost versus benefit consideration. In theory,
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a system should only be designed if the costs of designing it are less than the benefits or
value to be derived from its use. For example, the costs of designing and implementing a
costing system should bring benefits such as increased revenue, reduced costs and strategic
advantage. The monetary value of these benefits should be far greater than the costs of
designing and implementing the system.

The evolution of costing systems

Costing systems evolved in time as follows:
● Just-in-time (JIT) is a pull system that originated at Toyota. It originally described how
material should be processed and moved in order to arrive ‘just in time’. In other words,
making only what is needed, when it is needed, and only the quantity needed. In contrast
with traditional costing methods, inventory is kept at a minimum or not at all. The
system is committed to continuous improvement and the elimination of waste.

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● Throughput accounting (TA) is a principle-based and comprehensive management

accounting approach. It provides managers with support in decision making regarding
profitability improvement. This approach identifies factors that limit an organisation
in reaching its goals.
● Life-cycle costing accumulates and manages costs over a product’s life cycle. A product’s
life cycle is the time from the start of a project to the end. Product life cycles can be
divided into four stages: product planning and initial concept design, product design
and development, production, and distribution and customer support. Target costing
is used by organisations as a pricing method. It is defined as a cost-management method
for reducing the overall cost of a product over its entire life cycle. The target cost of a
product is the maximum amount of cost that can be incurred, while still enabling the
organisation to earn the required profit margin from the product at a particular selling
price. In the traditional cost-plus pricing method, materials, labour and overhead costs
are calculated, and a desired profit is added to determine the selling price.
All these methods will be discussed in greater detail in Chapter 7, the modern business
environment.

Summary
Profit measurement should be based on an analysis of total contribution, which is sales
value less the variable cost of sales. If the opening and closing inventory volumes and values
are the same, marginal costing and absorption costing will report the same profit. For a
given level of sales, marginal costing will report the same level of profit, whatever the level
of production. In contrast, absorption costing will report higher levels of profit for the same
level of sales if production levels are higher. The difference in reported profit is equal to the
change in inventory volume multiplied by the fixed production overheads rate per unit. In
the long run, the total reported profit will be the same, whether marginal or absorption
costing is used. Fixed production overheads costs are absorbed into the product unit costs
using a predetermined overheads absorption rate, based on the normal level of production
for the period. Inventories are valued at their production cost including absorbed fixed
overheads production costs. If inventory levels increase, absorption reports a higher profit
than marginal costing. If inventory levels decrease, the reported profit will be lower under
absorption costing. Activity-based costing involves the identification of cost drivers which
cause the costs of an organisation’s major activities. Support department overheads costs
are charged to products on the basis of their usage of an activity.
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Key concepts
Absorption costing means that all manufacturing costs are assigned to products: direct
material, direct labour, variable and fixed manufacturing overheads.
Activity-based costing (ABC) is a methodology that can be used to measure the cost of
cost objects and the performance of activities.
Costing system – a system that estimates the cost of goods and services, as well as the
cost of organisational units, such as departments.
Marginal costing means that only variable costs are assigned to products: direct
material, direct labour and variable manufacturing overheads.
Period costs are costs that are expensed in the accounting period in which they are incurred.

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Test-yourself solutions
Test yourself 2.1
Marginal Costing Statement for Cheetah Limited
Super Cool shirts
Different levels of sales 12 500 18 750 25 000
R R R
Sales 156 250 234 375 312 500
Less: Variable cost of sales (93 750) (140 625) (187 500)
Opening inventory 18 750 18 750 18 750
+ Variable production costs 187 500 187 500 187 500
206 250 206 250 206 250
Less: Closing inventory (112 500) (65 625) (18 750)
Less: Variable selling, distribution and admin costs (12 500) (18 750) (25 000)
Contribution 50 000 75 000 100 000
Less: Fixed costs (56 250) (56 250) (56 250)
Production 37 500 37 500 37 500
Selling, distribution and admin 18 750 18 750 18 750
Profit/(loss) (6 250) 18 750 43 750
Profit/(loss) per unit (0.50) 1.00 1.75
Contribution per unit 4.00 4.00 4.00

The profit per unit varies at different levels of sales, because the average fixed overheads cost
per unit changes with the volume of units produced and sold. The contribution per unit is
constant at all levels of production and sales. The best way of calculating the expected profit
at any level of production and sales is to calculate the total contribution and then deduct
fixed costs as a period cost in order to find the profit.

Test yourself 2.2

Absorption Costing Statement for Cheetah Limited
Super Cool shirts
Different levels of sales 12 500 18 750 25 000
R R R
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Sales 156 250 234 375 312 500

Less: Cost of sales (112 500) (168 750) (225 000)
Opening inventory 22 500 22 500 22 500
+ Production cost 225 000 225 000 225 000
247 500 247 500 247 500
Less: Closing inventory (135 000) (78 750) (22 500)
(Under-)/over-absorption – – –
Gross profit 43 750 65 625 87 500
Less: Selling, distribution and admin costs (31 250) (37 500) 43 750)
Variable 12 500 18 750 25 000
Fixed 18 750 18 750 18 750
Net profit/(loss) 12 500 28 125 43 750

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Test yourself 2.3

Sales Super Cool shirts
12 500 18 750 25 000
R R R
Marginal costing profit/(loss) (6 250) 18 750 43 750
Absorption costing profit 12 500 28 125 43 750
Difference in profit 18 750 9 375 0

The absorption profit was higher because of the increase in inventory level and because
the fixed production overheads were carried forward to the next month. The occurrence
of changes in inventories will result in different profit figures. If inventories increase under
absorption costing the profit will be higher, and if inventories decrease the profit will be
lower. When opening and closing inventories remain the same, the profit will remain the
same under both costing systems.

Review questions
2.1 Distinguish between conventional and contemporary costing systems.
2.2 Discuss the principles of marginal costing.
2.3 Discuss the principles of absorption costing.
2.4 Discuss the strengths and weaknesses of marginal costing.
2.5 Discuss the strengths and weaknesses of absorption costing.
2.6 Define activity-based costing (ABC).

Exercises
2.1 SecaCom has budgeted to produce 4 000 units of Component Y per month. The
opening and closing inventories of Component Y for next month are budgeted
to be 1 400 units and 900 units respectively. The budgeted selling price and
variable production costs per unit are R20 and R3.50 respectively. Direct costs
of Component Y are expected to be R6 per unit.
The total budgeted fixed production overheads are R29 500 per month. The
company absorbs fixed production overheads based on the budgeted number
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of units produced. The budgeted profit for Component Y for next month, using
absorption costing, is R21 437.50.

Required:
Prepare a marginal costing statement which shows the budgeted profit for next
month and explain, using appropriate calculations, why there is a difference
between the profit figures for the month using marginal costing and using
absorption costing.

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2.2 Marite Manufacturers (Pty) Ltd, who produces standard, small skateboards,
has recently been taken over by Teboho Ltd. Whereas Marite reports its manu-
facturing and trading results using a costing method which values inventory at
full production cost, Teboho Ltd favours a variable (marginal) costing approach.
At the end of May, which was the first month of operation after the take-over,
Marite recorded the following results:
Sales 16 000
Production 20 000

Normal monthly capacity is 15 000 units. During May a large, unexpected order
was received for delivery in June.
Other relevant information is as follows:
Data per unit
Sales price R60
Direct materials cost R20
Direct labour cost R10
Variable selling expenses 10% of sales value
Variable production overhead R5

Fixed costs budgeted and incurred:

Production overheads R105 000
Selling expenses R15 000
Administrative expenses R25 000

There was no inventory at 1 May.

As management accountant of Marite, you have been asked to consider the
effect on profits if the change to Teboho’s method of costing is implemented.
Required:
(a) Prepare a profit statement for May using:
(i) Marite’s costing method
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(ii) Teboho’s costing method.

(b) Compare the profit calculated in (a) above and explain how the difference,
if any, arose.
2.3 At the beginning of May 20X3, LB held an inventory of 1 680 units of Product C.
On 30 April 20X4 the inventory level was 1 120 units. The standard cost of
Product C is as follows:
Material (15 kg × R6) R90
Labour (4 hours × R11) R44
Variable overheads (4 hours × R20) R80
Fixed overheads (4 hours × R32) R128
R342

Costing systems for decision making

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44

The profit reported in the management accounts for the 12 months ended
30 April 20X4 was R1 219 712. If LB used marginal costing, calculate what the
profit would have been for the period.
2.4 Corona Limited manufactures and sells a product. The fixed manufacturing
overheads are allocated based on machine hours. It takes a ¾ machine hour to
produce one product.
The standard allocation rate is R15.00 per machine hour. There were 11 500
products in the finished goods storeroom on 1 September 20X1. Corona
Limited manufactured 35 000 products during September 20X1 and sold
34 500 products during that month. Actual cost for September is as follows:

Direct material per unit R10.00

Direct labour (total) R420 000
Variable manufacturing overheads (total) R105 000
Variable administration cost (per unit) R3.25
Fixed administration cost R90 000
Fixed manufacturing overheads R390 000
Variable marketing cost (per unit) R2.20
Sales price R44.30

Required:
(a) Compile an income statements for September 20X1, using the direct and
absorption costing methods. Indicate the unit cost per product for each
method.
(b) Reconcile the difference in profit (if any) between the two methods for
September 20X1.
2.5 Alpha (Pty) Ltd commenced manufacturing on 1 January 20X6. Cash flow
projections for the first year included budgeted fixed overheads as follows:

Fixed production costs R35 000

Fixed selling and administration R25 000
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Normal production activity was planned to be 5 000 units per annum. Inventory
is valued on an absorption costing basis, and predetermined overhead recovery
rate is used for this purpose.
Actual results for the first year were as follows:

Units produced 4 800

Units sold 2 900
Selling price per unit R40

Cost and Management Accounting

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45

Variable costs per unit:

Direct materials R9
Direct labour R5
Production overheads R4
Selling and administration R3

Selling and administration varies with units sold.

Fixed costs:
Production overheads R36 000
Selling and administration R24 000

Required:
(a) Determine the product cost per unit under absorption costing and variable
costing.
(b) Prepare income statements showing the results of trading for 20X6, using
absorption costing and variable costing.
(c) Reconcile the absorption costing and variable costing profits or losses
calculated in (b) above.
2.6 A company has budgeted to produce 5 000 units of Product B per month. The
opening and closing inventories of Product B for next month are budgeted to
be 400 units and 900 units respectively. The budgeted selling price and variable
production costs per unit for Product B are as follows:

(R) per unit

Selling price 20.00
Direct costs 6.00
Variable production overheads costs 3.50

Total budgeted fixed production overheads are R29 500 per month.
The company absorbs fixed production overheads based on the budgeted
number of units produced. The budgeted profit for Product B for next month,
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using absorption costing, is R20 700.

Required:
(a) Prepare a marginal costing statement which shows the budgeted profit for
Product B for next month.
(b) Using appropriate calculations, explain why there is a difference between
the profit figures for the month using marginal costing and absorption
costing.
(c) Explain the arguments for the use of traditional absorption costing rather
than marginal costing for profit reporting and inventory valuation.

Costing systems for decision making

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46

2.7 Match the most appropriate cost driver to each cost.

a) Short run variable costs (i) Number of orders executed
b) Materials handling and despatch (ii) Number of production runs
c) Set-up costs (iii) Number of machine hours

2.8 A company manufactures two products, A and B, using the same equipment
and similar processes. An extract from the production data for these products
in one period is shown below.

A B
Quantity produced (units) 5 000 7 000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set-up in the period 10 40
Orders handled in the period 15 60

R
Overhead costs:
Machinery activity R220 000
Production run set-up R20 000
Handling of orders R45 000
Total R285 000

Required:
Calculate the production overheads to be absorbed by one unit of the products
using the following costing methods:
(a) A traditional absorption costing approach using a direct labour rate to
absorb overheads.
(b) An activity-based costing approach, using suitable cost drivers to trace
overheads to products.
2.9 Mabe Limited produces a product using 1.75 machine hours per product. In
a typical month, Mabe produces 6 000 units. Budgeted fixed manufacturing
overheads are R136 500 per month.
During October 20X5, Mabe produced 5 900 products.
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Other actual information available:

Units sold 5 200
Units in opening inventory 200
Direct material cost per unit R11 000
Direct labour cost per unit R21 500
Variable manufacturing overheads per unit R5 000
Total fixed manufacturing overheads R128 200
Total fixed marketing cost R120 000
Total sales revenue R494 000
Commission paid 5%
Packaging cost per unit R3.20

Each unit produced must be wrapped in special packaging.

Cost and Management Accounting

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47

Required:
(a) Compile income statements using the marginal and absorption costing
approaches.
(b) Reconcile the differences in net profit between the two methods.

2.10 The information extracted from BCG & Co’s budget is given in the following table:

R
Unit selling price 280
Variable production costs per unit 90
Fixed production costs per unit 64

The budgeted fixed production cost per unit was based on a normal capacity of
22 000 units per month. Actual details for March and April were as follows:

March April
Production volume (units) 20 000 23 000
Sales volume (units) 19 600 22 400
R R
Selling price per unit 270 280
Variable production cost per unit 90 90
Total fixed production costs 1 290 000 1 400 000

Required:
(a) Calculate the actual profit for March and April using absorption costing.
Assume that any under- or over-absorption of fixed overheads is debited/
credited to the income statement every month.
(b) The actual profit figure for the month of March using marginal costing
was R2 238 000. Using appropriate calculations, explain why there is a
difference between the actual profit figures for March using marginal
costing and absorption costing.
Source: CIMA (adapted)
2.11 Duplo (Pty) Ltd makes a single product and uses a fully integrated absorption
Copyright © 2021. Juta & Company, Limited. All rights reserved.

costing system for both internal and external reporting purposes, where
inventory is valued at the appropriate budgeted cost per unit.
At the beginning of the financial year, management declared their intention of
making a profit equal to 25% of sales revenue in the forthcoming financial year.
The budget assumed that production would equal sales. There was no budgeted
opening inventory of raw materials, work-in-progress or finished goods.

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The following information is relevant to the budget:

1. The budgeted selling price per unit of R1 000 at the budgeted sales and
production level of 120 000 units is broken down as follows:
Production 57.5%
Administration and selling 17.5%
Profit 25.0%
Total 100%
2. The organisation’s budgeted profit-volume ratio (contribution margin ratio)
is 50%.
3. The total budgeted fixed cost amounted to R30 000 000, of which 50% is
production overheads and 50% administration and selling.
4. The organisation’s budgeted sales and production units were equal to its
normal operating capacity.
The management team is currently reviewing the actual results. The production
director is confused. ‘Our selling price and production costs were exactly as we
budgeted. Despite actual sales units being less than budget sales units by 15%, we
have maintained our profit target of 25% of sales revenue. I would have expected it
to have declined relative to our original target. This does not make any sense to me.’

Required:
(a) Prepare Duplo (Pty) Ltd’s actual results according to their existing method.
(b) Prepare Duplo (Pty) Ltd’s actual results according to variable costing principles.
(c) Reconcile the respective profits derived in (a) and (b) above.
(d) Using cost-volume-profit (CVP) principles, show how Duplo (Pty) Ltd
calculated the budget sales units that provided a profit of 25% of sales revenue.
(e) Provide a brief explanation as to why the profit has not behaved in line with
the production director’s expectations.
2.12 On 1 April 20X7, Bond Ltd formed a wholly owned subsidiary company, Brosnan
(Pty) Ltd, for the sole purpose of manufacturing and selling Product 007. Bond
Ltd’s board approved the following budget at normal activity at that date.
Brosnan (Pty) Ltd
Budget forecast for the year ended 31 March 20X8
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Total Per unit

Sales R2 020 000 R20.20
Direct materials R700 000 R7.00
Direct labour R400 000 R4.00
Variable production overheads R100 000 R1.00
Fixed production overheads R360 000 R3.60
Variable selling and administration overheads R160 000 R1.60
Fixed selling and administration overheads R250 000 R2.50
Total costs R1 970 000 R19.70
Profit R50 000 R0.50

Cost and Management Accounting

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The following data is relevant for the period up to 31 March 20X8:

Sales for 20X7 90 000 units at R20.20 each

Opening inventory –
Closing inventory raw materials –
Work-in-progress –
Closing inventory: Finished goods 8 000 units

Actual costs incurred during the period were as per budget.

The management accountant of Brosnan (Pty) Ltd had prepared a profit
statement on 31 March 20X8 on a variable costing basis, which showed a loss.
Bond Ltd’s group accountant had, however, prepared a profit statement on an
absorption costing basis on the same date, which showed Brosnan (Pty) Ltd
earning a profit.
The operations director of Bond Ltd is reviewing both profit statements and is
somewhat perplexed: ‘You can never rely on these accountants to give you the
right figures,’ he mutters angrily under his breath as he reaches for his telephone.

Required:
(a) Draft a profit statement on the absorption costing basis.
(b) Draft a profit statement on the variable costing basis.
(c) Reconcile and explain the differences between the two statements given for
(a) and (b) above to the director in such a way as to eliminate his confusion.
State why both statements may be acceptable.
(d) Discuss the arguments put forward for the use of a variable costing system.

Reference list
IFRS Foundation. 2012. Technical summary IAS2 inventories. Available: http: //www.ifrs.
org/Documents/IAS2.pdf (Accessed 18 December 2016).
Mistry, K.S. 2010. Factors influencing effective cost management within South Africa’s
retail banking sector. Research submitted in partial fulfilment of the requirements for the
Copyright © 2021. Juta & Company, Limited. All rights reserved.

degree Master’s in Business Administration at the Gordon Institute of Business Science.

Pretoria: University of Pretoria, 10 November 2010.

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3 Cost-volume-profit
analysis

Breakeven analysis Cost structure Assumptions

Single products Multiple products

Algebraic What-if Graphical

Formulae
equations analysis approach

Learning objectives
After studying this chapter, you should be able to:
● Understand the importance of cost behaviour in cost-volume-profit (CVP) analysis
● Separate mixed costs into fixed and variable portions
● Apply CVP techniques in both single-product and multiple-product contexts
● Apply sensitivity analysis to CVP analysis
● Choose the most profitable cost structure for an organisation using the change-
over point
● Recognise and describe the assumptions on which CVP analysis is based.
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Introduction
Cost-volume-profit analysis is often referred to as breakeven analysis. However, the term
cost-volume-profit analysis (CVP analysis) is more explanatory, because it suggests an
important relationship between costs, volume and profits. It is an important tool used to
assist management in planning and decision making. It looks specifically at the relationship
between the following five elements: product prices, product mix, variable cost per unit,
total fixed costs and the level of activity. It aims to improve profitability by identifying the
best combination of these five elements. It helps managers to answer some of the following
questions: What if we increase our fixed costs and sales volume? What impact would this
have on our contribution and net profit?
Since CVP analysis is concerned with short-term decision making, a thorough
understanding of cost behaviour, discussed in Chapter 1, is vital. In the short term, only
the variable costs are relevant, since it is these costs that change. The marginal costing
statement, which is discussed in Chapter 2, is useful to managers when making decisions
regarding changes to profits, costs and volume, since it groups costs according to their
behaviour. Table 3.1 shows the basic format of the marginal costing statement which will
be dealt with in this chapter.
Table 3.1 Format of marginal costing statement
R
Sales XX
Less: Total variable costs XX
Contribution XX
Less: Total fixed costs XX
Net profit XX

Cost-volume-profit analysis using formulae

Contribution
Contribution is defined as sales less total variable costs and is what we have left to cover
fixed costs and make a profit. Contribution can be expressed on a rand per unit basis, in rand
total and as a percentage. An increase in contribution would lead to an increase in profits if
Copyright © 2021. Juta & Company, Limited. All rights reserved.

fixed costs do not change, and vice versa. Organisations with a high contribution per unit
can spend more on fixed costs to increase sales and ultimately profits, while organisations
with a low contribution per unit can spend less on fixed costs. Ultimately, any decision
made under CVP analysis will be based on whether or not the contribution increases
or decreases.

Breakeven point in units and rands

Breakeven point is the point at which an organisation covers all its costs and makes zero
profit. It can be expressed in units or in rands. The breakeven point in units indicates the
number of units that must be sold in order to cover all costs, while the breakeven point in
rands indicates the rand sales that must be generated in order to cover all costs.

Cost and Management Accounting

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Sales required to make a target profit in units and rands

The main objective of all businesses is to make a profit. We can therefore adapt the breakeven
formulae to include a target or required profit, in units and in rands. This target profit, or
required profit, refers to the net profit before taxation.

Margin of safety in units, rands and as a percentage

Margin of safety indicates how close the business is operating to the breakeven point. It
tells the business by how much sales can decrease before the breakeven point is reached. The
margin of safety can be expressed in units, rands or as a percentage. Organisations that have
a high margin of safety are less likely to make a loss, while organisations that have a low
margin of safety are more susceptible to losses.

Illustrative example 3.1

Kirsty Ltd manufactures Uninterrupted Power Supplies (UPSs) for desktop computers.
The purpose of the product is to ensure that the desktop computer continues to run
even when there is a power failure. The company was established in 2009 and supplies
their only product to both local and overseas markets. The factory is located in Epping,
Cape Town, and is approximately 2 000 to 3 000 square metres in size. Table 3.2 shows
the marginal costing statement of the company for April.
Table 3.2 Marginal costing statement for the month of April
Rand totals Per unit Percentage
Sales (1 650 power supplies) 825 000 ? 100%
Less: Total variable costs 495 000 ? ?
Contribution 330 000 ? ?
Less: Total fixed costs 130 000
Net profit 200 000

Assume a tax rate of 30%.

Required:
Calculate the following formulae and give a brief explanation of each calculation:
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(a) Contribution per unit and as a percentage

(b) Breakeven point (in units and rands)
(c) Sales in units and rands, assuming the company wants to make a target profit of
R250 000 before tax
(d) Rand sales and sales in units, assuming the company wants to make a target profit
of R175 000 after tax
(e) Margin of safety (expressed in units, rands and as a percentage).
➤➤

Cost-volume-profit analysis

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Solution:
(a) Contribution per unit
= Selling price per unit − Variable costs per unit
= R500 (R825 000 ÷ 1 650 units) − R300 (R495 000 ÷ 1 650 units)
= R200
For every UPS sold, the company must generate R200 contribution towards covering
fixed costs and making a profit. If they sell five UPSs, they generate a contribution of
R1 000 (5 × R200), and if they sell 10, they generate R2 000 (10 × R200), and so on.
Contribution as a percentage of sales (contribution margin ratio)
= Contribution ÷ Sales × 100
= R330 000 ÷ R825 000 × 3 100
= 40% or
= R200 ÷ R500 × 100
= 40%
For every rand generated in sales, the company generates 40 cents’ contribution
towards fixed costs and profits.
Note: You can either use rand per unit figures or total figures to calculate the
contribution ratio as indicated above.
(b) Breakeven point in units
= Fixed costs ÷ Contribution per unit
= R130 000 ÷ R200
= 650 units
The breakeven point in units indicates the number of units that must be sold to
cover all costs. Kirsty Ltd would have to sell 650 units in order to break even.
Breakeven point in rands
= Fixed costs ÷ Contribution margin ratio
= R130 000 ÷ 40%
= R325 000
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Or breakeven point in units × Selling price per unit

= 650 × R500
= R325 000
The breakeven point in rands is the total rand sales that the company must generate
to cover all its costs.

➤➤

Cost and Management Accounting

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Proof:
Table 3.3 Marginal costing statement for April (indicating breakeven point)
Rand total Per unit Percentage
Sales (R500 × 650 power supplies) 325 000 500 100%
Less: Variable costs (R300 × 650) 195 000 300 60%
Contribution 130 000 200 40%
Less: Fixed costs 130 000
Net profit 0

(c) Sales in units to make a target profit before tax

= (Fixed costs + Target profit) ÷ Contribution per unit
= (R130 000 + R250 000) ÷ R200
= 1 900 units
Kirsty Ltd would have to sell 1 900 units to generate a net profit of R250 000 before tax.
Sales in rands to make a target profit
= (Fixed costs + Target profit) ÷ Contribution ratio
= (R130 000 + R250 000) ÷ 40%
= R950 000
Kirsty Ltd would have to generate rand sales of R950 000 to obtain the target profit
of R250 000.
Proof:
Table 3.4 Marginal costing statement (indicating target profit)
Rand total Per unit Percentage
Sales (R500 × 1 900 power supplies) 950 000 500 100%
Less: Variable costs (R300 × 1 900) 570 000 300 60%
Contribution 380 000 200 40%
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Less: Fixed costs 130 000

Target net profit 250 000

(d) Sales in units to make a target profit after tax

The after-tax profit must first be converted to the net profit before tax. This can be
done by dividing the net profit after tax by 100% less the tax rate.
= [Fixed costs + Target profit after tax ÷ (100% – Tax rate)] ÷ Contribution per unit
= [R130 000 + (R175 000 ÷ 70%)] ÷ R200
= 1 900 units
Kirsty Ltd would have to sell 1 900 units to generate a net profit of R175 000 after tax.
➤➤

Cost-volume-profit analysis

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Sales in rands to make a target profit after tax

= [Fixed costs + (Target profit after tax ÷ 70%)] ÷ Contribution margin ratio
= [R130 000 + (R175 000 ÷ 70%)] ÷ 40%
= R950 000
Kirsty Ltd would have to generate rand sales of R950 000 in order to obtain a net
profit of R175 000 after tax.
(e) Margin of safety in units
= Budgeted sales in units − Breakeven sales in units
= 1 650 − 650
= 1 000 units
Margin of safety in rands
= Budgeted sales in rand − Breakeven sales in rand
= R825 000 − R325 000
= R500 000
Margin of safety as a percentage (margin of safety ratio)
The margin of safety as a percentage can be calculated by using either the unit sales
or rand sales.
(Budgeted sales units − Breakeven sales units)
= _________________________________
 
        
Budgeted sales in units   100
× ___ 1
(1 650 − 650)
= ___________
  1 650   100
× ___ 1
= 61%
or
(R825 000 − R 325 000) 100
= ___________________
 
     
R825 000 ×  ___
1
= 61%

Case study: Unilever’s balancing act

According to John Hughman, Unilever’s sales declined in the first quarter of the year, due
to a price increase. The company however had managed to find the balance between
volume and price and performed well in the second quarter of the year, reporting an
increase in sales. He indicated that price competitiveness is essential in the current
economic conditions where customers are willing to trade down to cheaper products.
Paul Polman, the Chief Executive Officer of Unilever, said that ‘the group was still at risk
from value conscious consumers and altered consumption patterns were likely to persist
even after the recession ends’.
It has been a few years since this article was written, but the situation outlined in the
article is still very relevant to the current economic situation that the majority of South
African companies face. There seems to be a shift away from the ‘brand loyal’ consumer
to the ‘value conscious’ consumer. Customer retention has now become an integral part
of South African companies’ long-term strategy.
➤➤

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Required:
1. Discuss how Unilever can use CVP analysis to assist them in maintaining a good
balance between costs and sales volume.
2. Unilever has managed ‘to hang on to market share in a tough market’ as a result of
their competitive pricing strategy. Discuss.
3. Can CVP analysis be linked to a company’s pricing strategy?
4. CVP analysis simplifies the real-world conditions that Unilever will have to face;
however, this technique is based on various underlying assumptions. Discuss these
assumptions.
Source: Hughman (2009)

Cost-volume-profit analysis using the algebraic equation

method
This is a quick-and-easy method to determine the breakeven point. The algebraic equation
used is derived from the marginal costing statement.

Net profit = Sales − (Total variable costs + Total fixed costs)

This equation can be rearranged as follows, depending on what you are required to calculate,
for example:

Sales = Total variable costs + Total fixed costs + Profit

Total variable costs = Sales − Total fixed costs − Profit

Total fixed costs = Sales − Total variable costs − Profit

Illustrative example 3.2

Refer to Illustrative example 3.1 and calculate the following, using the algebraic equation
method:
(a) Breakeven point in units
(b) Sales in units, assuming the company wants to make a target profit of R250 000
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before tax
(c) Sales in units assuming the company wants to make a target profit of R175 000
after tax.

Solution:
(a) The breakeven point in units can be calculated using the algebraic equation method
as follows:
Let sales units = x (Profit = 0 at breakeven point)
Sales = Total variable costs + Total fixed costs + Profit
500x = 300x + R130 000 + 0
200x = R130 000
x = 650 units ➤➤

Cost-volume-profit analysis

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(b) Let sales units = 5x

Sales = Total variable costs + Total fixed costs + Profit
500x = 300x + R130 000 + R250 000
200x = R380 000
x = 1 900 units
(c) Let sales units = 5x (note that the target profit is R175 000 after tax)
Sales = Total variable costs + Total fixed costs + Profit
500x = [300x + R130 000 + (R175 000 ÷ 70%)]
200x = R380 000
x = 1 900 units

What-if analysis (sensitivity analysis)

What-if analysis (sensitivity analysis) investigates the sensitivity of a product to changes
in price, mix, variable cost per unit, total fixed costs and level of activity. It looks at the
impact that these changes have on the breakeven point, margin of safety and profits. It also
helps managers to expand their view of the possible results and to deal with uncertainty in
a CVP context. What is uncertainty? Uncertainty is the possibility that the actual profits will
be different from the expected profits. There are numerous computer software packages
available on the market to assist managers in conducting what-if analyses. Another approach
to uncertainty, besides a what-if analysis, is to calculate expected values using probability
distribution (see Chapter 12).

Illustrative example 3.3

Refer to Illustrative example 3.1 to address the following questions:
(a) What impact would an increase in fixed costs and sales volume have on con-
tribution and profit?
Assume that Kirsty Ltd is trying to increase their market share, and have embarked on an
advertising campaign which would cost the company R10 000. This increased advertising
will increase sales volume by 10%. Advise Kirsty Ltd regarding the implementation of the
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advertising campaign.

Solution:
This question can be answered in one of three ways.
Method 1 (redraft the marginal costing statements)
Redraft the marginal costing statement, taking the above changes into account.
➤➤

Cost and Management Accounting

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Table 3.5 Marginal costing statement (indicating changes in fixed costs and
sales volume)
Original Change in fixed costs Difference % of sales
and sales volume (R) (R) (R)
Sales (@ R500 per UPS) 825 000 907 500* 82 500 100%
Less: Total variable costs 495 000 544 500 49 500 60%
(@ R300 per UPS)
Contribution 330 000 363 000 33 000 40%
Less: Total fixed costs 130 000 140 000* 10 000
Net profit 200 000 223 000 23 000

* 1 650 + 10% = 1 815 × R500

* 130 000 + 10 000

If we implement the change in the fixed cost and sales volume, the profit would increase
by R23 000.
Method 2 (incremental analysis)
Incremental analysis only takes into account the differences, that is, the changes. The
contribution per unit will remain the same, since there is no change in the selling price
per unit and variable cost per unit; only the fixed costs increase.
Table 3.6 Incremental approach
R
Expected total contribution (R907 500 × 0.40) 363 000
Present total contribution (R825 000 × 0.40) 330 000
Incremental contribution 33 000
Change in fixed costs (incremental advertising expense) 10 000
Increase in net profit 23 000

Method 3 (algebraic equation)

The algebraic equation will be rearranged in order to calculate the net profit.
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Let net profit = x

Net profit = Sales − (Total variable costs + Total fixed costs)
x = [(1 650 + 10%) × R 500] − {[(1 650 + 10%) × R 300] + [130 000 + 10 000]}
= 223 000

Decision: The advice to Kirsty Ltd is to undertake the advertising campaign since it
would result in an increase in net profit of R23 000 (R223 000 − R200 000).
Note that the incremental approach is a shorter approach and will be used for all
subsequent changes under the sensitivity analysis.
➤➤

Cost-volume-profit analysis

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(b) What impact would an increase in variable costs and sales volume have on con-
tribution and profit?
Kirsty Ltd is having a problem with the suppliers of one of the components for the
UPS, that is, the cooling fans, and has managed to source another supplier for the
component. The new supplier charges more for the component because it is of a higher
quality, resulting in an increase in the variable cost of R25 per component. The higher
quality component ultimately will increase the overall quality of the UPS and result in an
increase in sales by 180 UPSs per month. Advise Kirsty Ltd on whether or not the higher
quality component should be used.

Solution:
Table 3.7 Incremental approach
R
Expected total contribution (1 830* × R175*) 320 250
Present total contribution (1 650 × R200) 330 000
Incremental contribution (9 750)
Change in fixed costs 0
Decrease in net profit (9 750)

* 1 650 + 180 = 1 830

* R500 − R325 = R175
Decision: Kirsty Ltd should not purchase the high-quality component since profits
would decrease by R9 750.
(c) What impact would a change in fixed cost, selling price and sales volume have on
contribution and profits?
The marketing manager has done extensive market research and estimates that a
decrease in the selling price of R50 per unit would result in an increase in sales of 40%.
However, to make customers aware of the price decrease, the advertising budget would
have to be increased by R15 000 for the month. Advise Kirsty Ltd on whether or not to
implement these changes using the algebraic approach.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Solution:
Algebraic approach:
Net profit 5 Sales − (Total variable costs + Total fixed costs)
x 5 [(1 650 + 40%) × (R500 − R50)] − {[(1 650 + 40%) × R300] + [130 000 + 15 000]}
5 R1 039 500 − (R693 000 + 145 000)
5 R201 500
The decrease in the selling price per unit will cause the contribution per unit to decrease,
but the overall profit would increase.
Decision: Kirsty Ltd should implement the above changes since profits would increase
by R1 500 (R201 500 − R200 000). ➤➤

Cost and Management Accounting

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(d) What impact would a change in variable cost, fixed cost and sales volume have on
contribution and profits?
The marketing manager believes that, because the sales representatives earn a fixed
salary of R7 000 per month, they are not motivated to sell as many UPSs as possible.
After extensive negotiations with the human resources department, they have agreed
to change the sales representatives’ remuneration from a fixed salary to a commission
basis of R10 for every UPS sold. This change is expected to increase sales by 15% per
month. Advise Kirsty Ltd on whether or not to implement the above changes.

Solution:
Table 3.8 Incremental approach
R
Expected total contribution (1 898* × R190**) 360 620
Present total contribution (1 650 × R200) 330 000
Incremental contribution 30 620
Add: Change in fixed costs salaries avoided 7 000
Increase in net profit 37 620

* 1 650 + 15% = 1 898

** R500 − (R300 + R10) = R190
Decision: Kirsty Ltd should implement the above changes since profits would increase
by R37 620.

Test yourself 3.1

A company manufactures and sells a single product. The marginal costing statement for
last year is as follows:
Rand total Per unit Percentage
Sales (22 500) 1 800 000 80 100%
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Less: Total variable costs 1 350 000 60 ?

Contribution 450 000 20 ?
Less: Total fixed costs 360 000
Net profit 90 000

Required:
(a) Calculate the contribution margin ratio and the variable expense ratio.
(b) Calculate the breakeven point in units and rands (using the algebraic equation
method).
(c) The company would like to earn a minimum profit of R120 000 before tax. How
many units would have to be sold in order to earn this profit?
➤➤

Cost-volume-profit analysis

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(d) Calculate the margin of safety in rands and as a percentage.

(e) Calculate the change in the net profit if sales increase by R600 000 (using the
contribution ratio, and assuming that the cost behaviour relationship remains the
same).
(f) Management believes that they could increase sales by 30% if they improve the
quality of the product. To increase the quality of the end product, they would have
to use a better quality raw material. This would increase the variable cost by R4.50,
and they would also have to employ an additional quality inspector who is paid R60
000 for the year.
Draft a marginal costing statement for next year, taking the changes into account.
Your statement must include all information in rand totals, per unit as well as
percentages. Based on this marginal costing statement:
(i) Calculate the new breakeven point in units and rands (using the formulae
method)
(ii) Advise the company as to whether or not the changes should be implemented.

Percentage change in an item

Another way of looking at how profits are affected if one or more of the variables change in
the marginal costing statement is to measure the percentage change (increase or decrease)
in an item. These include changes in the selling price, sales volume, variable costs per unit
and fixed costs.
The percentage change can be determined using the following formula:
____   100
  A B− B × ___ 1
Where:
A = Latest figure
B = Earliest (or previous) figure

If the answer is positive, it means that an increase occurred; whereas if the answer is negative,
a decrease occurred. The percentage increase/decrease can also be referred to as a relative
increase/decrease and is a measure of the item’s sensitivity to change. The numerator of the
formula is referred to as absolute increase/decrease. This method can be applied whenever
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you are required to calculate a percentage change.

Illustrative example 3.4

SCEK (Pty) Ltd sells Lego kits. The following information is available for the month
ended 31 January 20X1:

Variable costs R400 000

Fixed costs R300 000
Profit R300 000

The management of SCEK (Pty) Ltd wants to increase its profits for the month by 10%.
➤➤

Cost and Management Accounting

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Required:
By what percentage must the selling price per Lego kit increase in order to increase
profits by 10%? Assume that no change in sales volume, variable cost or fixed cost
occurs.

Solution:
Required change in unit selling price
Required increase in profit = R300 × 10% = R30 000
Previous sales amount = Variable cost + Fixed cost + Profit
= 400 000 + 300 000 + 300 000
= R1 000 000

The R30 000 increase in profit required can only be achieved if the sales amount
increases by R30 000 since no change in sales volume, variable cost or fixed cost occurs.

Therefore:
New sales amount = Previous sales + Increase
= 1 000 000 + 30 000
= R1 030 000

 1 030   
000 − 1 000 000 ___
_________________
Percentage change in the selling price =    1 000 000 ×   100
1
= 3%

Therefore, a 3% increase in sales should be attributable to an increase in the selling

price per Lego kit. As sales volumes did not change, the required percentage increase in
selling price per unit would be equal to the percentage increase in total sales revenue.
We did not need to know the selling price per unit in order to calculate the increase in
selling price.

Test yourself 3.2

Using the information from Illustrative example 3.4, determine what the effect will be
on profit (in percentage terms) if the selling price per Lego kit increases by 5%. (Assume
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that no change in sales volume, variable cost or fixed cost occurs.)

Cost-volume-profit analysis and graphs

Graphs are useful for decision making because they summarise important information in a
diagram. They are also easier to understand, especially for individuals with no accounting
background. CVP analysis uses line graphs to show information such as the breakeven
point, margin of safety, etc. A line graph is a graph that uses points joined by a line to show
information. A line graph consists of five components: a title, a scale, points, lines, and
labels. However, it may not be necessary to draft these graphs by hand, since the majority of
statistical analysis computer packages can be used to produce graphs.

Cost-volume-profit analysis

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Breakeven graph
Illustrative example 3.5 demonstrates the steps involved in drawing a breakeven line graph
and the interpretation of the graph.

Illustrative example 3.5

A company produces a product called Widgets, which it sells to various manufacturing
concerns. Widgets are used in the manufacturing of electrical equipment.
Selling price per unit R100
Variable cost per unit R50
Total fixed costs R50 000
Budgeted sales 2 000 units

Required:
Using graph paper, draft the following graphs and clearly indicate the breakeven point
on each graph:
(a) Breakeven graph
(b) Contribution graph
(c) Profit-volume graph.

Solution:
Steps involved in drawing a breakeven line graph are outlined below. Note that any
graph needs a title that explains what the graph is about, for example ‘Breakeven graph
for Widgets’.

Step 1: Determine the scale

The x-axis is the horizontal axis where we record the units (activity level).
The y-axis is the vertical axis where we record the rand totals.
Scale: x-axis (units) 2 cm = 200 units
y-axis (rands) 1 cm = R25 000

R' 000
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200
175
150
125
100
75
50
25

0 200 400 600 800 1 000 1 200 1 400 1 600 1 800 2 000
Units

Figure 3.1 Breakeven graph (axes) ➤➤

Cost and Management Accounting

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Step 2: Plot the points and draw in the lines to join the points
There are three lines to be drawn. The first line is the fixed cost line. Plot the fixed cost
point on the y-axis, that is, R50 000, and then draw in a straight line parallel to the
x-axis (because fixed costs do not change with the level of activity).

R' 000

200
175
150
125
100
75
50
Fixed
25
costs
0 200 400 600 800 1 000 1 200 1 400 1 600 1 800 2 000 Units

Figure 3.2 Breakeven graph (fixed cost line)

The second line to be drawn is the total cost line. Plot the total cost point. The total cost
that would be incurred is as follows:
Variable costs (2 000 × R50) R100 000
+ Fixed costs R50 000
= Total cost R150 000

Plot R150 000 on the y-axis and 2 000 units on the x-axis. From the x-axis follow the
2 000 units with your ruler upwards, and from the y-axis follow the R150 000 with your
ruler across and plot the point where the two meet on the graph. Draw in the total cost
line, starting from R50 000 to the point where rands and units meet on the graph.

R' 000

200
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175
150
125
Variable
100
cost Total
75
50 cost
Fixed
25
costs
0 200 400 600 800 1 000 1 200 1 400 1 600 1 800 2 000 Units

Figure 3.3 Breakeven graph (total cost line)

➤➤

Cost-volume-profit analysis

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The third line to be drawn is the sales revenue line. Plot the sales revenue points. The total
rand sales that would be generated is R200 000 (2 000 × R100). Plot R200 000 on the
y-axis and 2 000 units on the x-axis. From the x-axis follow the 2 000 units with your
ruler upwards and from the y-axis follow the R200 000 with your ruler across, and plot
the point where the two meet on the graph. Draw in the sales revenue line starting from
0 to the point where rands and units meet on the graph.

R' 000 Total

revenue
200 line
175
150
125
100
75 Total
50 cost
25

0 200 400 600 800 1 000 1 200 1 400 1 600 1 800 2 000 Units

Figure 3.4 Breakeven graph (total revenue line)

Step 3: Label all the lines that you have drawn on the graph

R' 000

200
175 Breakeven point
PROFIT
150
125 Variable
100 cost
75 Total
50 cost
LOSS
Margin of safety Fixed
25
costs
0 200 400 600 800 1 000 1 200 1 400 1 600 1 800 2 000 Units
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Figure 3.5 Breakeven graph (labelling)

Interpretation of the breakeven line graph

The point where the sales revenue line and the total cost line intersect is known as the
breakeven point. If we follow the point of intersection down to the x-axis, it represents the
breakeven point in units, that is, 1 000 units. If we follow the point of intersection back
across to the y-axis, it represents the breakeven point in rand, that is, R100 000. If our
rand sales are below the breakeven point, we are making a loss, and if the rand sales are
above the breakeven point, we are making a profit. The margin of safety is reflected on the
graph as well, that is, the difference between the budgeted sales and the breakeven sales.
We can check the accuracy of the graph by using the breakeven formulae.
➤➤

Cost and Management Accounting

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Breakeven point in units:

= Fixed costs ÷ Contribution per unit
= R50 000 ÷ (R100 − R50)
= 1 000 units

Breakeven point in rand:

= BEP units × Selling price
= 1 000 × R100
= R100 000

Contribution graph
Essentially, a contribution graph is very similar to a breakeven graph. The main purpose of
a contribution graph is to show contribution at various levels of activity. The importance of
contribution was discussed at the beginning of the chapter. There are three lines drawn on
the graph, that is, the variable cost line (this line replaces the fixed cost line), total cost line
and sales revenue line.

Illustrative example 3.6

Refer to Illustrative example 3.5. The total cost line and the sales revenue line will be drawn
on the graph as before. The variable cost line can be drawn as follows. Plot the variable
cost points. The variable costs that would be incurred are R100 000 (2 000 × R50).
Plot the R100 000 on the y-axis and plot the 2 000 units on the x-axis. From the x-axis
follow the 2 000 units upwards and from the y-axis follow the R100 000 across and plot
the point where the two meet on the graph. Draw the variable cost line starting from 0
to the point where the rands and units meet on the graph.

Solution:

R' 000

200
175
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PROFIT
150 Fixed
125 Breakeven point
Contribution costs
100 Total
75 cost
Variable
50 LOSS cost
25
Units
0 200 400 600 800 1 000 1 200 1 400 1 600 1 800 2 000

Figure 3.6 Contribution graph

Cost-volume-profit analysis

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Profit-volume graph
A profit-volume graph looks at profit generated at various levels of activity. This graph
consists of only one line, that is, the profit line.

Illustrative example 3.7

Refer to Illustrative example 3.5. The x-axis (horizontal axis) records the activity level
in units. The y-axis (vertical axis), which records the rand totals, extends above zero to
indicate profits and below zero to indicate losses. The profit line can be drawn in as
follows. If our activity level is zero, then our loss equals our fixed costs, since we still have
to cover our fixed costs whether or not we produce any units. The first point plotted is
therefore the fixed cost of −R50 000 at zero activity level. The second point plotted is
the breakeven point of 1 000 units on the x-axis. The profit line is then drawn joining
these two points.

Solution:

200
175
150
Profit R' 000

125
100
75 Breakeven point
50
25 PROFIT
0 Units
–25 200 400 600 800 1 000 1 200 1 400 1 600 1 800 2 000
LOSS
–50
Loss R' 000

–75
–100
–150
–175
–200
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Figure 3.7 Profit-volume graph

A profit-volume graph is particularly useful for sensitivity analysis, since the changes in
revenue and costs can also be indicated on the graph by merely drawing in additional
lines. These additional lines indicate what impact these changes have on the profit as
well as the breakeven point.

Problems associated with the graphs

There are various limitations associated with graphs that must be taken into account since
they affect the reliability of graphs for planning and decision making. For example:
● Graphs are not 100% accurate since they only indicate possible performance within the
relevant range, that is, the expected range of activity. Relevant range looks at both the

Cost and Management Accounting

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minimum and maximum activity levels within which the company expects to operate,
that is, the operating capacity of the company. Outside this range they are more than
likely to be inaccurate.
● Fixed costs are more than likely to be stepped and not a straight line, because fixed cost
may change if the activity level rises beyond the maximum expected range.
● Variable costs and sales are more than likely to take on a curved shape instead of a
straight line. This takes into account possible discounts on sales, payments for overtime,
charges for delivery, etc.
● The graphs only indicate the relationships in the short term and are therefore not
reliable for long-term planning.
● All variable costs will vary or change with either production level or sales level.

The economist’s view of breakeven graphs

The economist’s graph (see Figure 3.8) has a smoothed curved shape, in comparison to
the accountant’s line graphs. The total cost line decreases initially as the output increases,
indicating economies of scale, that is, the more units we produce, the lower the fixed cost per
unit, since there are more units to share the fixed cost. It then increases upwards indicating
diminishing returns. The revenue line curves downward, indicating the need to reduce the
selling price, that is, discounts in order to increase sales volume.

Rand Breakeven point (ii)

Total cost

Breakeven point (i)

Total sales
PROFIT

LOSS

Units

Figure 3.8 The economist’s view of a breakeven graph

Interpretation of the graph

The graph shows the point of profit maximisation. It has two breakeven points. The first
breakeven point is very similar to the accountant’s graph and falls within the relevant range,
whereas the second breakeven point falls outside the relevant range. The economist’s graph
highlights the fact that the revenue and cost assumptions at the extreme high and low levels
of activity are unreliable. Within the relevant range, however, the differences between the
economist’s and the accountant’s graphs are minimal.

Multiple-product breakeven analysis

The CVP principles covered previously looked only at organisations that produce and
sell single products. These principles can be modified to include organisations that sell
multiple products. In the breakeven analysis for multiple products the contribution figure
is replaced with a weighted average contribution figure. The main assumption of CVP analysis

Cost-volume-profit analysis

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for multiple products is that the organisation sells their products according to a specified mix
(sales mix). The sales mix refers to the amount of each of the products sold in proportion to
total sales. It can be expressed as a ratio (eg 2:2:1) or as a percentage (eg 40%, 40% and 20%).
Different products have different profit margins, that is, there are high-margin products
and low-margin products. If the organisation increases the sales on their products which
have a high margin and decreases sales on their products with a low margin, then profits
increase. If the organisation increases the sales on their products which have a low
margin and decreases sales on their products with a high margin, then profits decrease.
Consequently, managers strive to sell a combination of products that will maximise profits.
Changes in the sales mix cause profits to change.

Illustrative example 3.8

Kirsty Ltd currently manufactures and sells UPSs for desktop computers. Due to the
current electricity shortages, power cuts have resulted in many companies losing
valuable data. After extensive market research, the company has decided to extend its
product range to include UPSs for data centres as well. These UPSs are emergency power
generators that are instantaneous or near instantaneous, allowing time for equipment
to shut down properly and therefore ensuring that valuable data is not lost. Currently
fixed costs are R130 000. With the production of the UPSs for data centres, the fixed
costs would increase by a further R260 000. This includes additional supervisory
salaries, additional equipment leased, etc.

The UPSs for desktop computers sell for R500 per unit and have a total variable cost per
unit of R300, while the UPSs for data centres sell for R1 250 per unit and have a variable
cost per unit of R625. For every one UPS for desktops sold, the company sells two UPSs
for data centres. The budgeted sales revenue for the next period is R5 637 500.

Required:
Calculate the following:
(a) Breakeven point in units
(b) Breakeven point in rands
(c) Sales in units and rands, assuming the company wants to make a profit of R3 million
before tax
(d) The margin of safety in rands and as a percentage.
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Round off your final answer to the nearest whole number.

Solution:
Steps involved in calculating the breakeven point in units for multiple products:

Step 1: Calculate the contribution per unit

UPSs for desktops UPSs for data centres
(R) (R)
Selling price 500 1 250
Less: Variable cost 300 625
Contribution per unit 200 625
➤➤

Cost and Management Accounting

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Step 2: Calculate the contribution per mix (weighted average contribution per unit)
= (200 × 1) + (625 × 2)
= R1 450

Step 3: Calculate the breakeven point in terms of the number of mixes

= Fixed costs ÷ Contribution per mix (weighted average contribution)
= R390 000 ÷ R1 450
= 269 mixes (rounded)

Step 4: Calculate the breakeven point in units for each product

= Breakeven point in terms of the number of mixes × Sales mix per product
(269 × 1) = 269 units of UPSs for desktops
(269 × 2) = 538 units of UPSs for data centres

(b) The breakeven point in rands for multiple products can be calculated in two ways,
that is, using the breakeven point based on the number of units of the product or
using the weighted average contribution margin ratio.
Breakeven point based on the number of units of the product:
Breakeven point in units for each product × Selling price per unit
269 units of UPS for desktops × R500 = R134 500
538 units of UPS for data centres × R1 250 = R672 500
Total revenue = R807 000
Or
Breakeven point based on weighted average contribution margin ratio:
Contribution per mix (weighted average contribution per unit) ÷ Revenue per mix × 100
= R1 450 ÷ [(500 × 1) + (1 250 × 2)] × 100
= R1 450 ÷ R3 000 × 100
= 48% rounded
Breakeven point in rands (total)
= Fixed costs ÷ Weighted average contribution margin ratio
= R390 000 ÷ 0.48
= R812 500 represents the total rand sales that must be generated to cover costs
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and make no profit.

To calculate the breakeven point in rands for each product, the revenue ratio mix
must be calculated first:
UPSs for desktops (1 × 500) = R500
UPSs for data centres (2 × 1 250) = R2 500
Revenue ratio mix 500:2 500
Breakeven point in rands for each product:
UPSs for desktops R812 500 × (500 ÷ R3 000) = R135 417
UPSs for data centres R812 500 × (2 500 ÷ R3 000) = R677 083
➤➤

Cost-volume-profit analysis

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Note: The answers in both methods for calculating the breakeven point in rands would
differ slightly due to rounding.

The breakeven point is dependent upon the sales mix. If the sales mix changes, the
breakeven point in rands would also change. Market share and customer preferences
can cause the sales mix to change.
(c) Sales in units to earn a target profit
= (Fixed costs + Target profit) ÷ Weighted average contribution per unit
= (R390 000 + R3 000 000) ÷ R1 450
= 2 338 mixes
Sales in units per product to earn the target profit:
(2 338 × 1) = 2 338 units of UPSs for desktops
(2 338 × 2) = 4 676 units of UPSs for data centres
Sales in rands to earn a target profit
= (Fixed costs + Target profit) ÷ Weighted average contribution margin ratio
= (R390 000 + R3 000 000) ÷ 0.48
= R7 062 500 represents the total rand sales that must be generated to earn the
required target profit of 3 million. The target profit required per product can be
calculated as follows:
Target profit in rands for each product:
UPSs for desktops R7 062 500 × (500 ÷ R3 000) = R1 177 083
UPSs for data centres R7 062 500 × (2 500 ÷ R3 000) = R5 885 417

(d) Margin of safety in rands

= Budgeted sales – Breakeven sales
= R5 637 500 – R812 500
= R4 825 000
Margin of safety as a percentage
= (Budgeted sales – Breakeven sales) ÷ Budgeted sales × 100
= [(R5 637 500 – R812 500) ÷ R5 637 500] × 100
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= 86%
Note: The margin of safety is calculated in the same way for both single and multiple
products.

Cost and Management Accounting

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Test yourself 3.3

A company produces and sells three product ranges, X, Y and Z. You have been
provided with the following information for the next financial year:
Product range Product range Product range Total (R)
X (R) Y (R) Z (R)
Sales 450 000 675 000 675 000 1 800 000
Less: Variable costs 234 000 409 500 526 500 1 170 000
Contribution 630 000
Less: Fixed costs 216 000 265 500 148 500 202 125
Net profit 427 875

Required:
Calculate the following formulae and give a brief explanation of each:
(a) Weighted average contribution margin ratio
(b) Breakeven point in rands.

Profit-volume graph for multiple products

The profit-volume graph for multiple products consists of two lines, a straight line and a
bent line. The straight line is the profit line where we assume that the products are sold in a
specified mix, and the bent line is where we assume that the organisation sells the product
with the highest contribution ratio first, and so on.

Illustrative example 3.9

A company produces three products, Widgets, Gadgets and Fidgets. Fixed costs amount
to R100 000 for the year. Information relating to the three products is given in the
following table.
Table 3.10 Multiple-product information
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Widgets (R) Gadgets (R) Fidgets (R) Total (R)

Sales 300 000 120 000 80 000 500 000
Less: Variable costs 200 000 70 000 30 000 300 000
Contribution 100 000 50 000 50 000 200 000
Contribution ratio 33% 42% 63%

Required:
Draft a multiple-product profit-volume graph indicating the breakeven sales.
➤➤

Cost-volume-profit analysis

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Solution:
Figure 3.9 shows the completed graph.

Step 1: Determine the scale

The x-axis (horizontal axis) records the rand sales. The y-axis (vertical axis) records rand
totals and extends above zero to indicate profits, and below zero to indicate losses.
Scale: x-axis 1 cm = R50 000
y-axis 1 cm = R50 000

Step 2: Plot the points and draw in the profit line

The fixed cost point is plotted on the y-axis at –R100 000. The breakeven rand sales is
plotted on the x-axis at R250 000, and the profit point is plotted at +R100 000 above
the x-axis. The straight line is drawn from the –R100 000, passes through the breakeven
point in rands on the x-axis, and extends towards the profit point of R100 000. The
breakeven point in rands of R250 000 is derived as follows:
Fixed costs ÷ Weighted average contribution margin ratio (CM ratio ÷ Sales mix)
5 R100 000 ÷ 40%*
5 R100 000 ÷ 0.40
5 R250 000
*(0.33 × 0.60) + (0.42 × 0.24) + (0.63 × 0.16) = 0.3996 or 40% rounded
Profit of R100 000 is derived as follows:
Contribution – Fixed costs
= R200 000 – R100 000
= R100 000

Step 3: Plot the points and draw in the bent line

Rank the products in order of the product with the highest contribution margin ratio,
that is, Fidget 63%, Gadget 42%, and Widget 33%. The products must be produced in
this order. We plot the points for product Fidget first. The first point plotted is the rand
sales for product Fidget of R80 000 on the x-axis, and the second point plotted is the
contribution of –R50 000 (fixed costs R100 000 – R50 000 contribution from Fidget)
on the y-axis. Note the –R50 000 is derived as follows: This R50 000 represents the
fixed costs that are still to be covered before profits are generated. Draw in the bent line
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starting from the fixed costs of –R100 000 extending to where the R80 000 contribution
and –R50 000 meet. This is the first part of the bent line. We plot the points for product
Gadget next. The first point plotted is the rand sales of R200 000 (R80 000 + R120 000
Fidget and Gadget sales) on the x-axis and the second point plotted is the contribution
of R0 on the y-axis (R50 000 contribution from Gadget less fixed costs of R50 000 still
to be covered). Fixed costs have been covered, so the company can begin to generate
profits. The two points are joined to form the second part of the bent line. Lastly, we
plot the points for product Widget. The first point plotted is the rand sales of R500 000
(R80 000 + R120 000 + R300 000 for Fidget, Gadget and Widget sales) on the x-axis
and the second point plotted is the contribution of R100 000 on the y-axis. R100 000 is
the profit generated, since fixed costs have already been covered in full. The two points
are joined to form the last part of the bent line. ➤➤

Cost and Management Accounting

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R' 000
200

150
Profit

100

50
W

0 R' 000
50 100 150 200 250 300 350 400 450 500
G
–50 F
Breakeven point
Loss

–100
F 5 Fidget
G 5 Gadget
–150 W 5 Widget

–200

Figure 3.9 Profit-volume graph for multiple products

Interpretation of the graph

The dotted straight line indicates the profit generated from the specified sales mix, while
the solid bent line assumes that the organisation sells the most profitable product first,
and so on. As indicated on the graph, the breakeven point in rands is R250 000.

Cost structure
The cost structure of an organisation is the ratio of fixed and variable costs that exist within
the organisation. It can be changed, for example, if the organisation changes from being
labour intensive to capital intensive. The chosen cost structure has a direct impact on
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profits. What is the best cost structure for an organisation? There is no clear-cut answer, since there
are various factors that influence this decision, for example the long-term trends in sales,
changes in the level of sales and the attitude of the owners towards risk. A cost structure
decision is essentially a trade-off between risk and return.
Types of cost structures are as follows:
● Organisations with higher fixed costs and lower variable costs will experience greater changes
in profits. If sales increase, then profits will increase dramatically, and if sales decrease,
profits will decrease dramatically.
● Organisations with lower fixed costs and higher variable costs will experience greater stability
in profits. They will generate less income in the good years, but are protected from losses
in bad years.

Cost-volume-profit analysis

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Operating leverage
The term operating leverage is used as a measure of the sensitivity of profits to changes
in sales. The degree of operating leverage can be used to forecast changes in profits. It
measures how the net income is affected by changes in sales. A company with a higher
proportion of fixed costs in their cost structure, will have a higher operating leverage. High
levels of operating leverage lead to higher risk arising from highly volatile profits, but the
increase in risk also provides the potential for higher profit levels when sales are increasing.
It is calculated as: contribution ÷ net income.
When the operating leverage is high, a small percentage increase in sales can yield a large
percentage increase in net income. When the operating leverage is low, a large percentage
increase in sales can yield a small percentage increase in net income.

Changeover point
The organisation would be faced with the option of choosing a cost structure, that is, either
higher fixed costs with lower variable costs, or lower fixed costs with higher variable costs. The output
volume will help determine the best cost structure.
The changeover point is the output volume where the total costs of each option are
equal. At this volume of output, it does not matter which cost structure you choose.
However, if the output volume is below the changeover point, the option of lower fixed costs
with higher variable costs will generate a higher net income. If the output volume is above
the changeover point, the option of higher fixed costs with lower variable costs will generate
a higher net income. The changeover point can be calculated as follows:

Changeover point = (F2 − F1) ÷ (V1 − V2)

Where: F2 = total fixed cost of option with the higher fixed costs
F1 = total fixed cost of option with the lower fixed costs
V1 = variable cost per unit of option with the lower fixed costs
V2 = variable cost per unit of option with the higher fixed costs

Illustrative example 3.10

Two companies in the same industry have two different cost structures – one company
is highly automated and capital intensive, while the other is labour intensive. Last year
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both companies generated the same rand sales and net profit.
Table 3.11 Marginal costing statement of Company A and Company B
Company A % Company B %
Labour intensive Capital intensive
(R) (R)
Sales (R200 per unit) 150 000 100 150 000 100
Less: Total variable costs 90 000 60 45 000 30
Contribution 60 000 40 105 000 70
Less: Total fixed costs 45 000 90 000
Net profit 15 000 15 000
➤➤

Cost and Management Accounting

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Required:
Calculate the following and comment on each calculation:
(a) Operating leverage for both companies
(b) Changeover point
(c) Net income before tax for both companies, assuming that there is a 10% increase in
sales with no change in fixed costs
(d) Net income before tax for both companies, assuming that there is a 10% decline in
sales and fixed costs remain unchanged.

Solution:
(a) Operating leverage = Contribution ÷ Net income

Company A: R60 000 ÷ R15 000 = 4

Company B: R105 000 ÷ R15 000 = 7
Company A’s net income grows four times faster than its sales, while Company
B’s net income grows seven times faster than its sales. This is due to the fact that
Company B has a higher proportion of fixed costs in their cost structure.
F2 2 F1
(b) Changeover point =  ______
V1 2 V2
= (R90 000 − R45 000) ÷ (R120 − R60)
= R45 000 ÷ R60
= 750 units
(V1 = 200 × 0.60 and V2 = 200 × 0.30)
Choice of cost structure:
If the output volume is below 750 units, Company A’s cost structure will generate a
higher net income.
If the output volume is above 750 units, Company B’s cost structure will generate a
higher net income.
(c) Net income with 10% increase in sales, no change in fixed costs:

Table 3.12 Workings

% increase in sales Degree of 5 % increase in

operating leverage net income
X
Company A 10% 4 40%
Company B 10% 7 70%

With an increase of 10% in sales, Company A’s net income will increase by 40%:
R15 000 × 40% = R6 000 increase, so new net income will be R21 000. With an increase
of 10% in sales, Company B’s net income will increase by 70%: R15 000 × 70% =
R10 500 increase, so new net income will be R25 500.

➤➤

Cost-volume-profit analysis

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Proof:
Table 3.13 Marginal costing statement
Company A % Company B %

Labour intensive (R) Capital intensive (R)

Sales 165 000 100 165 000 100
Less: Total variable costs 99 000 60 49 500 30
Contribution 66 000 40 115 500 70
Less: Total fixed costs 45 000 90 000
Net profit 21 000 25 500

In line with the changeover point, if sales increase by 10%, Company B’s cost structure
would be preferable.
(d) With a decrease of 10% in sales, Company A’s net income will decrease by 40%:
R15 000 × 40% = R6 000 decrease, so new net income will be R9 000.
With a decrease of 10% in sales, Company B’s net income will decrease by 70%:
R15 000 × 70% = R10 500 decrease, so new net income will be R4 500.
Proof:
Table 3.14 Marginal costing statement
Company A % Company B %

Labour intensive (R) Capital intensive (R)

Sales 135 000 100 135 000 100
Less: Total variable costs 81 000 60 40 500 30
Contribution 54 000 40 94 500 70
Less: Total fixed costs 45 000 90 000
Net profit 9 000 4 500

In line with the changeover point, if sales decrease by 10%, Company A’s cost structure
would be preferable.
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Assumptions of cost-volume-profit analysis

There are various assumptions associated with CVP analysis. These assumptions affect the
reliability of CVP analysis for planning and decision making. For example:
● As the activity level changes, the price of a product or service will remain the same,
within the relevant range.
● Within the relevant range, costs are linear and can all be accurately divided into their
fixed or variable elements. The variable costs are constant per unit, and the fixed cost
remains fixed within the relevant range.
● All variable costs will vary or change with only either production level or sales level.

Cost and Management Accounting

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● In organisations that sell various products, the sales mix is constant.

● The cost structure of an organisation is constant within the relevant range.
● In manufacturing organisations there is no stock − the number of units produced equals
the number of units sold.

Taking cognisance of the above assumptions, the risk or danger is when a manager is
considering a change in activity level outside the relevant range.

Summary
CVP analysis is an important tool used to assist management in planning and short-term
decision making. It assists managers with profit maximisation by finding the most profitable
combination of product prices, product mix, variable cost per unit, total fixed costs and the
level of activity. It highlights important aspects such as breakeven point, target profit and
margin of safety, using either algebraic equations, formulae or graphs. It can be applied
to organisations that sell single as well as multiple products. Managers can also deal with
uncertainty by using what-if analysis (sensitivity analysis) in a CVP context. By using the
changeover point, the organisation can determine the best cost structure to ensure profit
stability. CVP analysis is based on various assumptions, which inhibit its reliability, and
managers need to be fully aware of these limitations in the decision-making context.

Key concepts
Breakeven point is the point at which an organisation covers all its costs and makes
zero profit.
Changeover point indicates the output volume where the total costs of each option are
equal. At this volume of output, it does not matter which cost structure you choose.
Contribution equals sales less total variable costs and is what is left to cover fixed costs
and to make a profit.
Degree of operating leverage can be used to forecast changes in profits and measures
how the net income is affected by changes in sales.
Margin of safety indicates how close the business is operating to the breakeven point. It
tells the business by how much sales can decrease before the breakeven point is reached.
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Relevant range is the expected range of activity. The relevant range looks at both the
minimum and maximum activity levels within which the company expects to operate,
that is, the operating capacity of the company.
Sales mix is how much of each of the products are sold in proportion to total sales. It
can be expressed as a ratio or as a percentage.
What-if analysis (sensitivity analysis) investigates the sensitivity of a product to changes
in price, mix, variable cost per unit, total fixed costs and level of activity. It looks at the
impact that these changes have on the breakeven point, margin of safety and profits.

Cost-volume-profit analysis

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Test-yourself solutions
Test yourself 3.1
(a) Contribution margin ratio:
Contribution ÷ Sales × 100
= 450 000 ÷ 1 800 000 × 100
= 25%
Variable expense ratio:
Variable costs ÷ Sales × 100
= 1 350 000 ÷ 1 800 000 × 100
= 75%
(b) Let sales units = x; note the profit is 0
Sales = Total variable costs + Total fixed costs + Profit
80x = 60x + R360 000 + 0
20x = R360 000
x = 18 000 units (BEP units)
Breakeven point in rands
= 18 000 units × R80
= R1 440 000
or
Breakeven point in rands
Sales = Total variable costs + Total fixed costs + Profit
1x = 0.75x + R360 000 + 0
0.25x = R360 000
x = R1 440 000
(c) Sales in units
= (Fixed costs + Target profit) ÷ Contribution per unit
= (360 000 + 120 000) ÷ 20
= 480 000 ÷ 20
= 24 000
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(d) Margin of safety in rands

= Budgeted sales in rands − Breakeven sales in rands
= R1 800 000 − R 1 440 000
= R360 000
Margin of safety ratio
= (Budgeted sales − Breakeven sales) ÷ Budgeted sales × 100
= (1 800 000 − 1 440 000) ÷ 1 800 000 × 100
= 360 000 ÷ 1 800 000 × 100
= 20%
(e) Increase in sales R600 000
× CM ratio 25%
Expected increase in net profit R150 000

Cost and Management Accounting

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(f) Increase in sales (22 500 + 30%) = 29 250 units

The marginal costing statement is shown in the following table:

Total (R) Per unit Percentage
Sales (29 250) 2 340 000 80 100%
Less: Variable costs 1 886 625 64.50 81%*
Contribution 453 375 15.50 19%*
Less: Fixed costs (360 1 60) 420 000
Net profit 33 375

(i) Breakeven point in units and rands

= Fixed costs ÷ Contribution per unit
= R420 000 ÷ R15.50
= 27 097 units rounded
27 097 × R80 = R2 167 760
(ii) No, the changes should not be implemented as the net profit decreases by R56 625
(90 000 − 33 375) and the company would have to sell an extra 9 097 units in order
to break even (27 097 − 18 000).

Test yourself 3.2

Impact on profit
Profit = Sales − Variable costs − Fixed costs
A 5% increase in selling price will lead to a 5% increase in sales value if the sales volume is
unaffected.
Therefore:
New profit = (1 000 000 × 1.05) − 400 000 − 300 000
= R350 000
Increase = (New profit − Old profit) ÷ Old profit
= (350 000 − 300 000) ÷ 300 000
= 16.67% rounded

Test yourself 3.3

(a) Weighted average contribution ratio:

CM ratios
X 48% [(216 000 ÷ 450 000) × 100]
Y 39% [(265 500 ÷ 675 000) × 100]
Z 22% [(148 500 ÷ 675 000) × 100]
Sales mix
X 25% [(450 000 ÷ 1 800 000) × 100]
Y 37.5% [(675 000 ÷ 1 800 000) × 100]
Z 37.5% [(675 000 ÷ 1 800 000) × 100]
(0.48 × 0.25) + (0.39 × 0.375) + (0.22 × 0.375) = 0.35 or 35% rounded
The weighted average contribution margin ratio is 35% based on the specified sales mix.

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(b) Breakeven point in rands

= Fixed costs ÷ Weighted average contribution ratio
= R202 125 ÷ 35%
= R577 500
The breakeven point is dependent upon the sales mix. The breakeven point in rands is
R577 500, provided that the sales mix does not change.

Review questions
3.1 What is the objective of CVP analysis?
3.2 Define the breakeven point.
3.3 List the various approaches to CVP analysis.
3.4 Explain the concept of contribution.
3.5 Explain the concept of margin of safety.
3.6 Explain the term sensitivity analysis and give four examples.
3.7 What is the main assumption of CVP analysis for multiple products?
3.8 Define operating leverage.
3.9 Explain what is meant by changeover point.
3.10 List and explain the assumptions associated with CVP analysis.

Exercises
3.1 ABC Ltd currently sells all three of its products A, B and C in equal quantities and
at the same selling price per unit. The contribution to sales ratio for product A is
40%; for product B it is 50% and the total is 48%. If fixed costs are unaffected by
mix and are currently 20% of sales, determine the effect of changing the product
mix to: A 40%, B 25% and C 35% on the total sales ratio.
Source: CIMA (adapted)

3.2 The total costs incurred at various output levels for a process operations in a
factory, have been measured as follows:
Output units Total cost (R)
11 500 102 476
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12 000 104 730

12 500 106 263
13 000 108 021
13 500 110 727
14 000 113 201

Required:
(a) Using the high-low method, analyse the costs of the process operation into
fixed and variable components.
(b) Calculate and comment on the breakeven output level of the process
operations in (a) above, based on the fixed and variable costs identified
and assuming a selling price of R10.60 per unit.
Source: ACCA (adapted)
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3.3 A company manufactures a single product. Budget and standard cost details
for next year includes the following:
Selling price per unit R24.00
Variable production cost per unit R8.60
Fixed production cost R650 000
Fixed selling and distribution cost R230 400
Sales commission 5% of selling price
Sales 90 000 units

Required:
(a) Calculate the breakeven point in units.
(b) Calculate the percentage by which the budgeted sales can fall before the
company begins to make a loss.
The marketing manager has suggested that the selling price per unit can be
increased to R25.00 if the sales commission is increased to 8% of selling price
and a further R10 000 is spent on advertising.
(c) Calculate the revised breakeven point based on the marketing manager’s
suggestion.
Source: CIMA (adapted)

3.4 PQR Ltd produces and sells three products, P, Q and R. It has contracts to
supply products P and Q, which will utilise all of the specific materials that are
available to make these two products during the next period. The revenue these
contracts will generate and the contribution to sales (c/s) ratios of products P
and Q are as follows:
Product P Product Q
Revenue R20 million R40 million
c/s ratio 15% 10%

Product R has a c/s ratio of 25%. The total fixed costs of PQR Ltd are R11 million
during the next period and management have budgeted to earn a profit of
R2 million. Calculate the revenue that needs to be generated by product R for
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PQR Ltd to achieve the budget profit.

Source: CIMA (adapted)

3.5 Leisure Ltd produces two types of bicycles, the leisure bicycle and the mountain
bicycle. The leisure bike is a popular family bicycle, while the mountain bike
is an all-terrain bicycle popular with sportspeople. Data relating to the two
bicycles is as follows:
Selling price per unit Variable
(R) manufacturing cost
per unit (R)
Leisure bicycle 1 000 450
Mountain bicycle 2 200 1 210

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Sales representatives receive a commission of 5% on the mountain bike and

a 3% commission on the leisure bike. Annual fixed costs total R180 000. The
company has recently embarked on a marketing campaign of ‘car-free living’,
which has seen the sale of its leisure bikes increase dramatically, with 80% of the
company’s sales coming from the leisure bicycle.

Required:
(a) Calculate the contribution per unit for each bicycle.
(b) Assuming a constant sales mix, calculate:
(i) The weighted average contribution per unit
(ii) The weighted average contribution margin ratio
(iii) The breakeven point in rands
(iv) The number of leisure and mountain bikes that must be sold in order to
generate an after-target profit of R500 000 (assume a tax rate of 30%).
3.6 Alpha Limited has prepared a budget for the next 12 months when it intends to
make and sell four products, A, B, C and D. Details are shown in the table.

Product Sales in units Selling price per unit (R) Variable cost
(thousands) per unit (R)
A 10 20 14.00
B 10 40 8.00
C 50 4 4.20
D 20 10 7.00

Budgeted fixed costs are R240 000 per annum and total assets employed are
R570 000.

Required:
(a) Calculate the total contribution by each product and their combined total
contribution.
(b) Plot the data of your answer to (a) above in the form of a contribution to
sales graph (sometimes referred to as a profit-volume graph) on graph paper.
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(c) Explain your graph to management, comment on the result shown and
state the breakeven point.
(d) Briefly describe three ways in which the overall contribution to sales ratio
could be improved.
Source: CIMA (adapted)

3.7 A local authority operates a holiday home in one of their holiday resorts on the
Cape west coast. The home, which is open for 30 weeks each year, is let to visiting
school groups from around the country. The children are accompanied by their
own house mother/father who supervises them throughout their holiday. From
6 to 15 people can be accommodated at a rate of R100 per person per week.
No differential charges are charged for adults and children.

Cost and Management Accounting

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85

Weekly costs incurred by the host authority are as follows:

(R per guest)
Food 25
Electricity for heating and cooking 3
Domestic (laundry, cleaning, etc) expenses 4
Use of minibus 10

Seasonal staff supervise and carry out the necessary duties at the home at a cost
of R11 000 for the 30-week period. This provides sufficient staffing for 6 to 10
guests per week, but if 11 or more guests are to be accommodated, additional
staff at a total cost of R200 per week are engaged for the whole of the 30-week
period. Rent, including rates for the property, is R4 000 per annum and the
garden is maintained by the council’s recreation department at a nominal fee of
R1 000 per annum.

Required:
(a) Tabulate the appropriate figures to show the breakeven point(s), and
comment on your figures.
(b) On graph paper, draw a chart to illustrate your answer to (a) above.
(c) Identify and briefly discuss five assumptions underlying CVP analysis.

Source: CIMA (adapted)

3.8 A local government authority owns and operates a leisure centre with numerous
sporting facilities, residential accommodation, a cafeteria and a sports shop.
The summer season lasts for 20 weeks, including a peak period of six weeks
during the school holidays. The following budgets have been prepared for the
next summer season:
Accommodation
60 single rooms are let on a daily basis. 35 double rooms are let on a daily basis
at 160% of the single room rate. Fixed costs are R29 900. Variable costs are R4
per single room per day and R6.40 per double room per day.
Sports centre
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Residential guests pay R2 per person per day and casual visitors R3 per person
per day to use the facilities.
Fixed costs are R8 250.
Cafeteria
Estimated contribution of R1.50 per person per day. Fixed costs are R12 750.
During the summer season, the centre is open seven days a week, during which
the following activity levels are anticipated:
● Double rooms fully booked for the whole season
● Single rooms fully booked for the peak periods, and at 80% of capacity
during the rest of the season
● 30 casual visitors per day on average.

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Required:
(a) Calculate the charges for the single and double rooms, assuming the
authority wishes to make a R10 000 profit on accommodation.
(b) Calculate the anticipated total profit for the leisure centre as a whole for
the season.
(c) Advise the authority whether an offer of R250 000 from a private leisure
company to operate the centre for five years is worthwhile, assuming that
the authority uses a 10% cost of capital and operations that continue as
outlined above.
Source: CIMA (adapted)

3.9 Denzil Smith, aged 50, has a passion for fishing. He has a skipper’s licence
and wants to buy a fishing boat. He is convinced that his passion can generate
additional income, and maybe he can even retire early. He has been able to
secure a loan from the bank and has found a boat that he likes. The boat can
fit 12 people comfortably and will cost him R250 000. The loan agreement
requires that an instalment of R50 000 be paid annually in arrears, together
with 12% interest per annum on the outstanding balance. One repayment has
already been made. He would like to investigate the possible income that could
be generated from deep-sea fishing and backline fishing. The two options are as
follows:
Option 1: Deep-sea fishing
You can catch extremely big fish so the boat needs to be equipped with heavy-
duty fishing equipment, for example reels, rods, and a Garmin fish finder which
uses sound waves to locate the fish. A maximum of six people per trip can be
accommodated, and the duration of the trip would be 12 hours. He would
charge each person R1 250 per trip. Due to the duration of the trip, the boat
would only do one trip per day. The variable cost per trip is R375 per person
(inclusive of fuel costs, cost of bait, etc).
Option 2: Backline fishing
This is done just off the coast in the area where the water changes from muddy
brown to clear. A maximum of ten people per trip can be accommodated, and
the duration of the trip would be three hours. He would charge each person
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R250 per trip. The boat can only do four trips per day. The variable cost per
trip is R80 per person (inclusive of fuel costs, cost of bait, etc). On all trips he
would have to supply the bait. He has assumed that he will be working at 100%
capacity at all times, and fishing trips can be arranged for every day of the week.
Assume there are 365 days in the year. Estimated operating costs for the next
financial period consist of the salary of R72 000 for a boat hand, and R1 000
a week for repairs and maintenance. The boat will be checked weekly to ensure
that it is in good working order – the safety of the passengers is vital.

Required:
For both the deep-sea fishing and backline fishing options, determine the following:
(a) The number of fishing trips that can be made per year (assume 365 days in
the year)

Cost and Management Accounting

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(b) The number of trips required in order to break even

(c) The number of trips that would generate a profit of R200 000 for the year
(comment on your findings)
(d) The margin of safety ratio
(e) The profit that can be generated for each option. Denzil has done market
research and has realised that 100% capacity utilisation is only possible over
the festive period. Similar businesses only achieve around 60% utilisation.
Based on this, calculate the following for both options:
(i) Profit that can be generated (draft a marginal costing statement
including rand totals and percentages)
(ii) Margin of safety ratio
(iii) Degree of operating leverage.
(f) Comment on questions (e) (ii) and (iii), and advise Denzil as to the most
profitable option.
(g) Identify other factors besides profitability that should be taken into account
before making a decision.
3.10 The statements of comprehensive income of XYZ Ltd retailers for August and
September are as follows:

August (R) September (R)

Sales 80 000 90 000
Less: Cost of sales 50 000 55 000
Gross profit 30 000 35 000
Less: Operating expenses
Selling and distribution 8 000 9 000
Administration 15 000 15 000
Net profit 7 000 11 000

Required:
(a) Use the high-low method to identify the behaviour of the following:
(i) Cost of sales
(ii) Selling and distribution costs
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(iii) Administration cost.

(b) Draw a contribution breakeven chart and identify the monthly breakeven
sales values and area of contribution.
(c) Assuming a margin of safety equal to 30% of the breakeven value, calculate
the company’s annual profit.
(d) The company is now considering opening another retail outlet selling the
same products. It plans to use the same profit margins in both outlets
and has estimated that the specific fixed costs of the second outlet will be
R100 000 per annum. XYZ Ltd also expects that 10% of its annual sales from
its existing outlet would transfer to this second outlet if it were to be opened.
Calculate the annual value of sales required from the new outlet in order to
achieve the same annual profit as previously obtained from the single outlet.

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(e) Briefly describe the cost accounting requirements of organisations of

this type.
Source: CIMA (adapted)

3.11 Sports Ltd is a company engaged solely in the manufacture of sporting

apparel. Present sales are direct to retailers, but in recent years there has been
a steady decline in output because of increased foreign competition. In the last
trading year, the accounting report indicated that the company produced the
lowest profit in 10 years. The forecast for next year indicates that the present
deterioration in profits is likely to continue. The company considers that a profit
of R80 000 should be achieved to provide an adequate return on capital. The
managing director has asked for a review of the present pricing and marketing
policies. The marketing director has completed this review, and passes the
proposals on to you for evaluation and recommendation, together with the
profit and loss account for year ending 31 December last year.
Sports Ltd’s profit and loss account for year ending 31 December is as follows:

R R R
Sales revenue (100 000 sweaters at R10) 1 000 000
Factory cost of goods sold:
Direct materials 100 000
Direct labour 350 000
Variable factory overheads 60 000
Fixed factory overheads 220 000 730 000
Administration overheads 140 000
Selling and distribution overheads:
Sales commission (2% of sales) 20 000
Delivery costs (variable per unit sold) 50 000
Fixed costs 40 000 110 000 980 000
Profit 20 000

The information to be submitted to the managing director includes the following

three proposals:
1. To proceed on the basis of analyses of market research studies which
indicate that the demand for sporting apparel is such that a 10 % reduction
in selling price would increase demand by 40%.
2. To proceed with an enquiry that the marketing director has had from
a mail-order company about the possibility of purchasing 50 000 units
annually if the selling price is right. The mail-order company would
transport the sports apparel from Sports Ltd to its own warehouse
and no sales commission would be paid on these sales by Sports Ltd.
However, if an acceptable price can be negotiated, Sports Ltd would be
expected to contribute R60 000 per annum towards the cost of producing
the mail-order catalogue. It would also be necessary for Sports Ltd to
provide additional packaging at a cost of R0.50 per item. The marketing

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director considers that for the next year sales from business would remain
unchanged at 1 000 000 units, based on a selling price of R10 if the mail
order is undertaken.
3. To proceed on the basis of a view by the marketing director that a 10 %
price reduction, together with a national advertising campaign costing
R300 000, may increase sales to the maximum capacity of 160 000 items.

Required:
(a) Calculate the breakeven sales value based on the accounts for last year.
(b) Provide a financial evaluation of proposal 1 and a calculation of the number
of units Sports Ltd would need to sell at R9 each for a profit of R80 000.
(c) Calculate the minimum prices that would have to be quoted to the mail-
order company, first, to ensure that Sports Ltd would at least break even
on the mail-order contract, second, to ensure that the same overall profit is
earned as in proposal 1 and, third, to ensure that the overall target profit is
earned.
(d) Provide a financial evaluation of proposal 3.

Source: CIMA (adapted)

3.12 A company manufactures five products in one factory. The company uses a
just-in-time (JIT) production system. The company’s budgeted fixed costs for
the next year are R300 000. The following table summarises the budgeted sales
and contribution details for the five products for the next year.

Product A B C D E
Unit selling price (Rs) 40 15 40 30 20
Total sales (R’000) 400 180 1 400 900 200
Contribution/sales ratio (%) 45 30 25 20 (10)

The following profit-volume graph for multiple products has been prepared to
summarise the budget figures:

R
500
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400
300
200
100
0
×
500 1 000 1 500 2 000 2 500 3 000 3 500 Units
–100
–200
–300
–400

Cost-volume-profit analysis

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After the graph had been prepared, the marketing director said that Products A
and E are complementary products. The budget assumes that there are no sales
for Product A without also selling Product E, and no sales for Product E without
selling Product A.

Required:
(a) (i) Give two reasons why the graph does not provide a useful summary of
the budget data provided. Explain your reasons.
(ii) Explain the meaning of point X on the graph.
(b) Calculate the breakeven revenue for the next year using the budgeted sales
mix. Show all your workings.
Source: CIMA (adapted)

Reference list
Hughman, J. 2009. Unilever’s balancing act. Investors Chronicle [serial online], [cited 2012
Nov 23] Aug 07, 2009. Available: https://www.investorschronicle.co.uk/2011/09/09/
shares/news-and-analysis/unilever-s-balancing-act-G2SVLU5dNovlKPlHvLsmPJ/article.
html. (Accessed 8 January 2021).
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Cost and Management Accounting

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4 Relevant costs and
revenues for decision
making

Short-term decision making

Relevant costs: Irrelevant costs: Non-financial

➢ Discretionary fixed costs ➢ Sunk costs indicators and ‘ripple
➢ Future costs and revenues ➢ Common costs effect’
➢ Differential costs and revenues ➢ Committed costs
➢ Opportunity costs ➢ Depreciation
➢ Relevant direct material costs ➢ Notional costs
➢ Relevant direct labour costs ➢ Arbitrary allocated costs
➢ Relevant overhead costs

Types of short-term decisions:

➢ Utilisation of a single constrained resource
➢ Make or buy
➢ Dropping a product line or department
➢ Special orders
➢ Minimum price decisions
➢ Joint product and further processing decisions

Learning objectives
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After studying this chapter, you should be able to:

● Understand the importance of cost behaviour in short-term decision making
● Differentiate between relevant and irrelevant information
● Recognise non-financial indicators that could impact on the short-term decisions
● Distinguish and quantify relevant costs and revenues in various short-term decisions.

Introduction
Decision making occurs in all facets of our lives and can be classified as either long term
or short term in nature. The fundamental differences between long-term and short-term
decision making are summarised in Table 4.1.

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Table 4.1 Fundamental differences between long-term and short-term decision making

Long-term decisions Short-term decisions

These decisions span over more than a year. These decisions span over less than a year.
They are strategic in nature and are aligned to They are operational in nature and are aligned
the company’s corporate objectives and goals, to the short-term goals of the company, that is,
that is, profit maximisation resulting from the profit maximisation resulting from the optimum
optimum use of resources in the long term. use of resources in the short term. These types
of decisions are often reactionary in nature, that
is, they are initiated as a response to problems
that have arisen in the business environment.
These decisions involve a large capital These decisions involve a small amount of money
investment. in comparison to the long-term decisions.
Incorrect long-term decisions can have a major Due to the time frame and monetary value it is
impact on the company’s financial position. It is relatively easier to change a short-term decision,
therefore essential that managers take their time that is, withdraw from activities if there are
and conduct all the relevant feasibility studies changes in the business environment. With
before undertaking long-term decisions. short-term decisions managers need to respond
quickly since delaying a decision can have
financial implications for the company.

This chapter will focus on short-term decision making, while long-term decision making
will be discussed in more detail in Chapter 14. For the manager, decision making looks
at maximising profits by making the best use of existing facilities. In the short term the
variable costs are relevant, as well as any part of the fixed cost that changes as a result of the
decision. The marginal costing statement is useful for short-term decision making, because
it groups costs according to their behaviour. In this chapter we shall consider cost concepts
that are useful in decision making. The various concepts are discussed in the first part of the
chapter, and application of these concepts are illustrated in the latter part of the chapter.
The circumstances will determine which costs are relevant to a particular decision. The
same cost, given different circumstances, may in one instance be relevant and in another
irrelevant.

Relevant costs and revenues

Relevant costs and revenues are costs and revenues that have an impact on the decision at
hand. Relevant costs and revenue include the following:
● Discretionary fixed costs are considered relevant, because they can be managed.
Managers can choose not to incur these costs again with immediate effect. Examples
include advertising, research and development.
● Future costs and revenues are considered relevant, because they are cash flows that
arise out of the decision taken. They must be future cash flows, that is, they must not
have been incurred as yet. If they have already been incurred, they are considered past
costs (sunk costs) which are irrelevant to the decision at hand. They must involve the
physical flow of cash and not merely be an accounting adjustment, for example non-cash
costs such as depreciation and notional costs, etc. These non-cash costs are considered
irrelevant to the decision at hand.

Cost and Management Accounting

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● A differential cost is the difference in the costs between the alternatives being considered,
and differential revenue is the difference in revenue between the alternatives being
considered. For the manager, decision making involves choosing between alternatives.

Illustrative example 4.1

A company is considering changing their marketing method from direct marketing to
internet marketing. Internet marketing has become increasingly popular since it allows
the business to reach its target audiences online, thereby decreasing advertising costs.
Information relating to the two marketing methods is provided in Table 4.2.
Table 4.2 Direct marketing versus internet marketing
Present direct Proposed internet
marketing (R) marketing (R)
Revenues 1 500 000 2 500 000
Cost of goods sold 750 000 1 250 000
Commission 75 000 0
Advertising 75 000 38 000
Warehouse depreciation 50 000 50 000
Other expenses 60 000 60 000
Total 1 010 000 1 398 000
Net income 490 000 1 102 000

Should the company change their marketing method?

Solution:
Using the differential analysis approach, the differential costs and revenues can be
calculated as shown in Table 4.3.
Table 4.3 Differential costs and revenues
Present direct Proposed internet Differential costs
marketing (R) marketing (R) and revenues (R)
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Revenues 1 500 000 2 500 000 1 000 000

Cost of goods sold 750 000 1 250 000 500 000
Commissions 75 000 0 (75 000)
Advertising 75 000 38 000 (37 000)
Warehouse depreciation 50 000 50 000 0
Other expenses 60 000 60 000 0
Total 1 010 000 1 398 000 388 000
Net income 490 000 1 102 000 612 000

The company should change to internet marketing since this would result in a positive
differential net income of R612 000.

Relevant costs and revenues for decision making

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● Opportunity cost is the possible revenue that is lost because of choosing one course of
action over the other. With an opportunity cost, there has to be at least two competing
courses of action, and the manager will be required to choose one. Choosing one course
of action results in your having to give up the other course of action and all the possible
revenue attached to it. For example, Peter is a farmer whose land is only big enough to
hold one crop, so he must decide whether he should grow cabbages or potatoes. At the
end of the season the cabbages can be sold for R4 000 and the potatoes for R4 500. If he
chooses to grow cabbages, the R500 is the lost revenue resulting from not choosing to
grow potatoes.

Illustrative example 4.2

ABC Ltd has sufficient capacity to manufacture 500 units per month of product Casa.
The normal demand for the product is 400 units per month. The normal selling price is
R40 per unit. Fixed costs are R5 000 per month and are recovered at a rate of R12.50
per unit, based on normal demand. Variable manufacturing cost is R20 per unit. An
opportunity to sell 150 units of the product at a price of R30 per unit presented itself.
The order must be delivered in full next month and will not affect the normal demand
for the product.

Required:
Quantify the opportunity cost.

Solution:
The company has surplus capacity to manufacture 100 units (500 − 400 units). Should
the order be accepted, 50 units of the normal demand will not be available for sale.
The company would therefore forfeit the contribution on the 50 units and not the 150
units. The opportunity cost relevant to the acceptance of the order will be the forfeited
contribution of R1 000 [50 × (R40 − R20)].

Relevant direct material costs

There are six special circumstances relating to how the direct material cost should be treated
in the decision-making context.
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1. Material that is used regularly will have to be replenished/replaced. The replenishment/

replacement cost would be the relevant material cost. This entails a cash outflow to
purchase or replenish the material that has been used up.
2. Extra material that is in stock from a previous contract or job. This material will not be
used on other jobs or contracts and will be sold. If the organisation decides to use the
material instead of selling it, the cash foregone from the sale of the material is the net
realisable value.
3. Old material that is in stock for a long time has no value and can be scrapped. It will cost
the organisation nothing if it uses this material on a current job or contract. The original
cost of the material is a past cost and is therefore irrelevant to the decision at hand.
4. Material that is in demand for use on different jobs or contracts. By using this material
on one job or contract would mean that the organisation will forego profits that could

Cost and Management Accounting

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have been generated from using the material on another job or contract. The relevant
cost in this case would be the contribution lost on the other jobs or contracts.
5. Special material for a job or contract. If the organisation has to purchase material for a
specific job or contract, the outflow of cash is considered relevant to the decision at hand.
6. Toxic material could be very expensive to dispose of. If the organisation uses it instead,
the cash saved would be relevant to the decision at hand.

Is material available in the storeroom?

No Yes

Since material is not available in Is the material in the storeroom used

the storeroom, it would have to be regularly?
purchased. The relevant cost is therefore
the cost of acquiring material at the
current market prices. No Yes

Since the material in the storeroom

Does the material in the storeroom have
is used regularly, it would need to be
an alternative use?
replaced. The relevant cost is therefore
the replacement cost of the material at
No Yes
the current market prices.

Since the material does not have an Since the material has an alternative
alternative use, the relevant cost would use, the relevant cost would be the cash
be either the disposal value or sales value foregone from the sale of the material, ie
of the material. the opportunity cost associated with the
alternative use.

Figure 4.1 Decision-making model for isolating the relevant direct material costs

This decision-making model can be applied to decisions relating to both direct and indirect
materials.
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Illustrative example 4.3

Stocks Ltd produces a variety of products. It has recently received an urgent order for
one of its products which requires three types of raw material: W1, W2 and W3. The
company has sufficient capacity in terms of labour and machine hours to meet the order
requirements.
Raw material W1 is used on a regular basis by the company to produce its products.
Currently there is 27 300 kg in stock, which was purchased previously at a price of
R3.25 per kg. The new order requires 1 950 kg. The company would need to replenish
stock. The current replenishment price is R3.45. However, if the order is accepted, the
reorder point would have to be accelerated by two weeks, and at this point in time the
replenishment price is estimated to be R3.52 per kg. ➤➤

Relevant costs and revenues for decision making

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Raw material W2 is not currently used on any other product. It was purchased previously
at a price of R1.11 per kg and there is 1 300 kg in stock. This raw material can be
replaced at a current price of R1.24 and the new order requires 1 040 kg. The company
has an option of either selling the stock or using it for the new order. Trade enquiries
showed that the raw material in stock could be sold at R0.72 per kg.

Raw material W3 − was purchased two years ago at a price of R13 per kg for a product
that has subsequently been discontinued by the company. There is 2 600 kg of this raw
material in stock. In its present state it can be scrapped for R3.90 per kg or used on
the new order. It can also be modified at a cost of R2.60 per kg for use on one of the
company’s existing products, which has a replacement cost of R11.70 per kg.

Required:
Determine the relevant costs for the order for each type of raw material per kilogram
and in total.

Solution:
Raw material W1 → the relevant cost is R3.52 per kg
The original historical purchase price of R3.25 is sunk and is therefore irrelevant. The
relevant cost is the replenishment/replacement price at the time of purchase.
R3.52 × 1 950 kg = R6 864

Raw material W2 → the relevant cost is R0.72 per kg

The original historical purchase price of R1.11 is sunk and is therefore irrelevant. There
is sufficient raw material in stock in order to meet the requirements of the new order,
and consequently the company would not incur a replenishment/replacement cost. If
they use the raw material that is in stock, it would cost them nothing. However, by using
the raw material, they are incurring an opportunity cost, that is, the cash foregone from
the sale of the raw material.
1 040 kg × R0.72 = R748.80

Raw material W3 → the relevant cost is R9.10 per kg

If the company does not take on the order, the other courses of action would be:
Sell the raw material as scrap and generate income of:
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2 600 kg × R3.90 = R10 140

or
Modify the raw material and use it to manufacture an existing product:
Replacement value – Modification costs = Savings × Number of kilograms
R11.70 − R2.60 = R9.10 × 2 600 kg
= R23 660

Of the two options, the modification option yields the greatest saving for the company.
Should the company decide to take on the order, they would be foregoing the R23 660
savings made from the modification option. The R23 660 is therefore the relevant cost.

Cost and Management Accounting

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Relevant direct labour cost is the cash paid for labour used − it is inclusive of overtime.
How the direct labour cost is treated within the decision-making context, will be dependent
upon the following conditions:
● Idle time/surplus capacity: Surplus capacity exists when the labour hours currently
being used are less than the available labour hours. When surplus capacity is available,
the relevant labour cost would be the incremental cost of using the surplus labour hours.
● Overtime and additional staff requirement: When no surplus capacity exists, the
additional labour requirements may be met either by the current workers working
overtime or by hiring new workers. The relevant labour cost in this case would be the
total cost of the extra labour hours utilised.
● Displacement of current production: When no surplus capacity exists and additional
workers cannot be obtained, the current workers would have to be removed from
the current production to complete the new project. The relevant labour cost in this
case would be the variable cost of the labour being used on the new project, plus the
lost contribution caused by the discontinuation of the current production. This lost
contribution represents the opportunity cost of displacing current production by using
current labour on the new project.

Is surplus capacity available?

Yes No

Since there is surplus capacity available,

Is it possible to employ more workers?
the existing workforce can meet the
production requirements. The relevant
labour cost would be the variable cost of
the labour that would be used. Yes No

Since it is possible to employ more Since it is not possible to employ more

workers, the production requirement can workers, existing workers would have to
be met either by employing more workers be removed from current production.
or by existing workers working overtime. The relevant labour cost would be the
The relevant labour cost would therefore variable cost of the labour that would
be the total cost of employing new be used plus the lost contribution from
workers or the total cost of the overtime displaced production.
worked.
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Figure 4.2 Decision-making model for isolating the relevant direct labour costs

Indirect labour refers to employees who are not directly involved in the production process.
The relevant costs for indirect labour is the additional cost that results directly from the
decision taken. Unlike direct labour, the indirect labour costs are often fixed in nature
because these workers are normally salaried.

Relevant costs and revenues for decision making

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Illustrative example 4.4

A company that manufactures a single product has received a once-off order that
requires 130 skilled labour hours. Information relating to the company’s only product
is as follows: selling price of R78 per unit and variable costs of R50 per unit. The variable
costs include direct labour of R17.50 per unit. Skilled workers take an hour to produce
one unit and are paid R17.50 per hour. Below are three independent scenarios relating
to the treatment of direct labour for the once-off order.

Scenario 1: Surplus capacity is available to meet the requirements of the once-off order.
Scenario 2: Surplus capacity does not exist, and the current workers would have to
be paid overtime at a rate of time and a half in order to complete the once-off order.
Alternatively, the company could employ new workers at a rate of R22.50 per hour.
Scenario 3: Currently the company is working at maximum capacity. If the company
wants to take on the once-off order, the skilled workers would have to be removed from
the production of the company’s only product.

Required:
Calculate the relevant labour cost per hour and in total, for the once-off order based on
each of the scenarios.

Solution:
Scenario 1 → the relevant labour cost per unit is R17.50 and R2 275 in total
= R17.50 per hour × 130 hours
= R2 275

Scenario 2 → the relevant cost per unit is R22.50 and R2 925 in total
The overtime cost associated with utilising the current workers must be compared to the
cost of hiring new workers.

Overtime cost of current workers

= (R17.50 × 1.5) × 130 hours
= R26.25 × 130
= R3 412.50
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Relevant cost per unit is R26.25 and R3 412.50 in total.

Cost of hiring new workers

= R22.50 × 130 hours
= R2 925
Based on these calculations, it is cheaper to hire new workers to complete the once-off
order. ➤➤

Cost and Management Accounting

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Scenario 3 → the relevant cost per unit is R45.50 and R5 915 in total
The existing product earns a contribution of R28 (R78 − R50). The relevant cost would
be the contribution foregone plus the direct labour cost of the once-off order.
= R28 + R17.50
= R45.50 per unit ÷ 1 hour
= R45.50 per labour hour

The special order requires 130 hours, therefore the total relevant labour costs would be:
= 130 hours × R45.50
= R5 915

Relevant overhead costs are those overhead costs that change as a result of the decision
taken. The relevance of an overhead cost is dependent upon the circumstance, that is, an
overhead cost may be relevant in a particular situation and irrelevant in another.

Is the change in the overhead costs caused directly by the decision taken?
Yes No

Since the change in the overhead costs Since the change in the overhead costs
are caused directly by the decision taken, are not caused directly by the decision
the relevant overhead costs would be taken, they are irrelevant to the decision
the total increase or total decrease in at hand. Consequently they must be
the overhead costs resulting from the excluded from the decision-making
decision taken. process.

Figure 4.3 Decision-making model for isolating the relevant overhead costs

Irrelevant costs
Irrelevant costs are costs that do not affect the decision at hand and can consequently be
excluded from the decision-making process. These costs include:
● Sunk costs are past costs, and no decision made now or in the future can change these
costs. They have already been incurred and are consequently irrelevant to the decision at
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hand. A common misconception is that fixed costs are always regarded as sunk costs. A
fixed cost that must be incurred in order to provide infrastructure that is directly related
to the situation under consideration certainly represents a relevant cost. For example,
a few years ago a company purchased a machine valued at R100 000. This machine was
used to produce one of the products in their product line. Customer preferences have
changed and consequently there is no longer a market for the product. The product has
now been discontinued. The R100 000 is considered a sunk cost, since it represents the
original cost of the machine, which cannot be recovered. It is irrelevant and therefore
can be ignored in the decision-making process.
● Common costs are costs that are present under both options and, consequently, whether
we leave them out or put them in, they will not affect the decision at hand. Fixed costs
that remain the same, that is, do not increase or decrease, are considered irrelevant. For
example, Jeffrey must decide to drive his car to work or to use public transport. The

Relevant costs and revenues for decision making

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car licence is R500 for the year and is common to both options. Whether he drives his
vehicle to work or not, he still has to purchase a licence. The R500 is therefore considered
irrelevant to the decision at hand.
● Committed costs are costs that will be incurred in the future but have originated from a
decision made in the past and therefore cannot be changed by any decision made now or
in the future. Committed costs are irrelevant in the short term but may become relevant
in the long term. For example, an organisation has seen the benefits of a just-in-time
inventory system and has decided to implement it. Consequently, they have entered
into a six-month contract with a raw material supplier. The contract stipulates that the
supplier must supply 100 000 units of raw material at a cost of R2 per unit and delivery
must be made on request. The contract is for a six-month period. The cost of R200 000
(100 000 × R2) cannot be avoided until the six-month period is over and is therefore
considered irrelevant to the decisions at hand.
● Depreciation is a historical cost, which is dependent upon past purchases and arbitrary
depreciation rates. It is an irrelevant cost since it does not involve the physical flow of
cash and is merely an accounting adjustment, which spreads the cost price of the asset
over its useful life. Net book values are also considered irrelevant since they arise from
historical revaluations and depreciation.
● Notional costs/speculative costs, such as notional rent and notional interest, are
irrelevant costs. The main purpose of these costs is to make internal decision making
more accurate, since they allow managers to benchmark competitors’ product costs.
For example, if an organisation purchased their premises instead of renting them, each
responsibility centre could be charged rent based on market value notional rent. This
helps managers make the optimum use of the space. If there is surplus space available,
it can be sold or rented out. Notional rent only becomes relevant if the organisation had
the option to rent out their premises. The lost rental is considered an opportunity cost
of choosing to use the premises for manufacturing purposes.
● Arbitrary allocated costs are organisational overheads which are allocated to products
or divisions on an arbitrary basis, for example marketing and administration costs.
These costs are recovered from individual products or divisions on a selected basis, such
as floor space occupied, turnover generated, and so on. They are always irrelevant, as
they will be reallocated to the remaining products or divisions should any one of them
be discontinued or shut down.

The use of relevant costs and revenues for decision making is known as relevant costing.
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Relevant costing together with the contribution approach are valuable tools for short-term
decision making. A decision made in one area of an organisation may have a positive or
negative impact on another part of the organisation. This is known as the ‘ripple effect’.

Illustrative example 4.5

A company produces the subcomponents for its main product within a separate
manufacturing facility. This facility is rented out at a cost of R25 000 per month under
a lease agreement which covers a one-year period. It is currently the start of the second
quarter of the year and the company is considering buying these components from an
external supplier instead of manufacturing them in-house. The following scenarios are
applicable to the lease agreement: ➤➤

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Scenario 1: An early exit option from the lease agreement is not possible.
Scenario 2: An early exit option from the lease agreement is not possible, but the facility
can be used for alternative purposes.
Scenario 3: An early exit option from the lease agreement is possible provided a month’s
notice is given.

Required:
For each of these scenarios, indicate whether the rental cost is relevant or irrelevant to
the make or buy option which the company is currently considering.

Solution:
Scenario 1 → irrelevant cost
The current rental cost is committed and cannot be changed. It is therefore irrelevant to
the make or buy decision.

Scenario 2 → irrelevant cost

The current rental cost is committed and cannot be changed, irrespective of whether
the facility can be used for an alternative purpose or not. It is therefore irrelevant to the
make or buy decision.

Scenario 3 → R200 000 saving is relevant and R100 000 rental incurred is irrelevant
It is currently 1 April, the start of the second quarter. One month’s notice would end on
1 May. The rental cost would therefore be saved from May to December.
R25 000 × 8 months’ savings = R200 000. This saving would be relevant to the make or
buy decision.
The rental incurred from January to April is a past cost/sunk cost and would be
considered irrelevant to the make or buy decision.
R25 000 × 4 months’ rental incurred = R100 000

Case study: Production bottlenecks

Toyota North America, August 2012

According to a Toyota America spokesperson, the topic of discussion at an automotive
conference held in August 2012 was production bottlenecks and how suppliers were
running a six-day week to keep up with demand.

Toyota’s North American purchasing chief said ‘the company was dispatching platoons
of engineers to help laggard suppliers straighten out their production schedules’.
➤➤

Relevant costs and revenues for decision making

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Toyota South Africa, October 2012

In South Africa, we have the same situation unfolding with a Toyota supplier going on
strike in October 2012. According to Engineering News Online, production at Toyota South
Africa Motors’ (TSAMs’) plant in Durban resumed on Wednesday after a strike at one
of its suppliers was resolved. The strike at Toyota Boshoku, which supplies the vehicle
assembler with car seats and door linings, started on October 17, bringing production
at the TSAM Prospecton plant to a standstill.

Toyota South Africa spokesperson told Engineering News Online that the strike at Boshoku
led to loss of production of 700 cars a day. ‘This calculates to about 3 500 cars in the
striking period. Half of these are meant for the export market, and right now we are
going to try and make up for the lost time, but it might take some time,’ he added.

Toyota Boshoku spokesperson said they had reached an amicable agreement with the
workers, who downed tools over a R1 500 allowance given to artisans through a court
ruling in 2009.

‘I cannot go into the details of the solution, as we are still in discussions with our own
employees, but everything is back to normal,’ the Toyota Boshoku spokesperson added.

Required:
1. Discuss how Toyota would calculate the cost of the strike.
2. Optimised production technology (OPT) aims at increasing profits by increasing
plant throughput. Discuss this statement.
3. Toyota employs a just-in-time system, which has been emulated around the world.
For this system to be successful, it requires a tight-knit supply chain. Discuss this
statement.
4. Discuss how a company can manage production bottlenecks effectively.

Sources: Sedgwick (2012); Wait (2012)

Non-financial indicators
The financial indicators are the relevant monetary benefits derived from the decision
taken. Non-financial indicators are the non-quantifiable issues, such as the impact of the
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decision on the long-term profitability of the organisation, employee morale, quality of

the product produced, customer long-term satisfaction, legal aspects, ethical aspects, social
responsibilities, etc. Non-financial factors include both internal and external factors that
impact on the decision at hand.
Internal non-financial factors include the following:
● The availability of cash. An opportunity may be viable, but the company needs to
assess if it has sufficient cash available to purchase equipment or to build up working
capital that may be required.
● Employees and trade unions. Decisions pertaining to shutting down a plant or
introducing an additional shift have a direct impact on employees. Consequently, any
decision that involves changes to the employees’ conditions of service, procedures and
location must be acceptable to the employees and their trade unions.

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● Timing. There may be a time factor attached to a decision to accept or reject a contract.
For example, a contract may be acceptable now or at a later stage.
● Feasibility. An opportunity may be financially viable. However, the company’s managers
and technical teams may have uncertainties regarding its ability to carry out the work.
● Flexibility and internal control. Decisions such as long-term contracts and sub-
contracting work could lead to inflexibility and lack of control for companies. Hence, it
would be beneficial for companies to build in elements of flexibility in such decisions.
● Unquantified opportunity costs. Even when opportunity costs are not specified, it is
likely that other opportunities may exist in the market to utilise resources more profitably.
It is therefore important to indicate that a given project would be a viable option based
on the assumption that there are no other profitable opportunities available.

External non-financial factors include the following:

● Inflation. Inflation affects the prices on various items and therefore needs to be
considered, particularly when the decision being taken relates to a fixed-price contract.
The income generated by the contract is fixed, but the costs related to the contract
increase with inflation. Hence, this would have a negative impact on the profitability
of the contract, as profits would be overstated if inflation were not taken into account.
● Customers. Customer loyalty and demand is important to consider when undertaking
decisions related to the production of new products, product closures, quality of output
and after-sales service. It is important for the company to take cognisance that decisions
which affect one product may influence customer attitudes towards a range of products.
● Competitors. In a competitive market, decisions relating to the introduction of a new
product or changes in the selling price of existing products could result in a response
by competitors.
● Suppliers. Decision that could impact on supplier relations and goodwill such as changes
in component specifications, changes in inventory policies and temporary closures are
extremely important, particularly if the company is the supplier’s main customer. A
delay in payment or reduced demand can cause suppliers to go out of business.
● Political pressure. Government may compel large companies to make certain invest-
ment and disinvestment decisions.
● Legal and ethical constraints. Legal and ethical implications must always be considered.
Viable opportunities may be rejected based on their legal and/or ethical implications.

Before arriving at a final decision, the impact of both the financial and non-financial
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indicators needs to be examined. Sometimes the non-financial indicators outweigh the

economic benefit of the decision. Good decision making therefore requires the use of a
range of tools, that is, financial as well as non-financial indicators, together with the sound
judgement of the manager, based on his or her experience.

Types of short-term decisions

The decision rule for all short-term decisions is to choose the alternative that has the
highest contribution. For each short-term decision, you will be provided with various steps
to help guide you through the decision-making process. There is no ‘one size fits all’ in
decision making; every decision and circumstance that surrounds the decision is different
and should therefore be treated as such. You will be required to think critically and to base
your decision on both the financial as well as non-financial indicators.

Relevant costs and revenues for decision making

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Utilisation of a single constrained resource (key factor/limiting factor)

A constraint is something that prevents the organisation from meeting their sales demand
and consequently has an impact on the profitability of the organisation. Examples of
constraints are limited machine hours, limited labour hours, limited raw materials, limited
floor space, etc. These constraints could cause bottlenecks in a production environment.
Managers are faced with the decision as to how best to utilise the constrained resource in
order to maximise profits. Fixed costs are not normally affected by such decisions. Managing
constraints effectively can increase profits.

Illustrative example 4.6

A timer is a specialised clock that is used to indicate or control the time for a specific
event. We use timers on a daily basis − the watch on our arm, the clock on our bedroom
wall, and the stoves in our kitchens are a few examples of timers that we encounter in
our daily lives. Time It Ltd is a company that produces timers. They were established in
the early 1990s and are based in Springfield Park, Durban. Their product range consists
of two types of timers, that is, the analogue microwave timer, and the electronic geyser
timer. The geyser timers have become increasingly popular and their demand has
doubled in the last month. Geysers increase electricity consumption drastically, and
with the increase in the cost of electricity, most residences want to install geyser timers
in an attempt to reduce their electricity cost. The information relating to these two
products for the last month is given in Table 4.4.
Table 4.4 Product information for last month
Microwave Geyser
timer (R) timer (R)
Selling price per unit 100 500
Less: Variable cost per unit 40 300
Contribution per unit 60 200

Time required to produce one unit on the assembly machine 0.75 hours 3.25 hours
Maximum sales demand 4 000 units 8 500 units

The operating time for the assembly machine is limited to 30 000 hours. This machine
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is a bottleneck since it restricts production.

Required:
Based on this constraint, calculate the product mix that will maximise profits and the
value of the profit generated.
Note: Where necessary, round off to two decimal places.
➤➤

Cost and Management Accounting

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Solution:
Steps involved in determining the optimum utilisation of a single constrained resource
(key factor/limiting factor):
Step 1: Calculate the contribution earned per unit of each product based on the
constrained resource.
Step 2: Rank the products in order of which product has the highest contribution
earned per unit of the constrained resource.
Step 3: Based on the ranking in step 2, calculate how the constrained resource will be
utilised, that is, the product mix that will maximise profits. Also indicate which
product or products will not be fully supplied.
Step 4: Calculate the total profit generated in terms of the sales mix that was
determined in step 3.

Step 1: The contribution earned per unit of the constrained resource is R80 for the
microwave timer and R61.54 for the geyser timer. This indicates that for every machine
hour spent on manufacturing the microwave timer, R80 is generated in contribution, and
for every machine hour spent on manufacturing the geyser timer, R61.54 is generated
in contribution.
Table 4.5 Contribution
Microwave Geyser
timer timer
Contribution per unit 60 200
÷ Constrained resource (machine hours of assembly machine) ÷ 0.75 ÷ 3.25
Contribution earned per unit per machine hour R80 R61.54

Step 2: Ranking: The microwave timer generates the greater contribution per machine hour
and is therefore ranked as number 1, and the geyser timer would be ranked as number 2.

Since the microwave timer makes the best use of the available machine hours, the
company should first spend the available machine hours producing the microwave timer
according to demand. The machine hours that are left will be used to manufacture the
remaining product, that is, the geyser timer.

Step 3: Consequently, the production mix would be as described in Table 4.6.

Table 4.6 Production mix

Total machine hours available 30 000
Less: Hours used for microwave timer (4 000 × 0.75) 3 000
Hours available for production of geyser timer 27 000
Hours used for production of geyser timer (8 307* × 3.25) 26 997.75*
Machine hours left 2.25

*27 000 ÷ 3.25 hours = 8 307.69 geyser timers. This must be rounded down to 8 307
geyser timers so that the machine hours will be sufficient to produce this quantity of
production. Should this be rounded up to 8 308 geyser timers, the available machine
hours will be insufficient. ➤➤

Relevant costs and revenues for decision making

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106

Time It Ltd should therefore produce 4 000 microwave timers and 8 307 geyser timers.
This will use up almost all the 30 000 machine hours available. The geyser timer will
therefore not be fully supplied in terms of the demand. Therefore, 193 geyser timers will
not be supplied (8 500 − 8 307).

Step 4: Calculation of total profit/contribution generated is described in Table 4.7.

Table 4.7 Total profit/contribution
Microwave timer Geyser timer Total
Units sold 4 000 8 307
× contribution per unit 60 200
Total contribution R 240 000 R1 661 400 R1 901 400

The company is losing R38 600 (193 × R200) contribution by not fully supplying the
geyser timer.

In the illustrative example, the machine that is limiting output is known as the ‘bottleneck’.
The main aim is for the bottleneck machine to run as long as possible, since time lost on a
bottleneck machine can never be recovered and consequently profit is lost. Managers can
increase the capacity of the bottleneck machine in various ways:
● Run the machine longer at optimum running speed by letting machine operators work
overtime or implement an extra shift.
● Train workers to ensure that they can be moved around from non-bottleneck processes
to assist with the bottleneck process, thereby ensuring that the bottleneck machine is
never idle. Subcontract part of the processing that would be done at the bottleneck (see
the section ‘Make or buy (outsourcing) decision’ further on in this chapter).
● Invest in more machinery.
● Focus on total quality management and business process re-engineering by:
◆ ensuring that there is always sufficient stock on hand to keep the machine going
◆ reducing or minimising set-up time
◆ reducing defective units
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◆ monitoring the machine cycles to know when it is due for maintenance − this reduces
reworking or poor-quality products.

Most bottlenecks can be controlled and improved without extra capital. Various
manufacturing information systems software is available on the market to assist managers
in controlling bottlenecks. Bottlenecks are discussed in more detail in Chapter 7. The
maximum contribution per unit of constrained resource can only be used when a single
constraint exists. Where multiple constraints exist concurrently, a quantitative technique
called ‘linear programming’ can be used to determine the optimum production mix. Linear
programming is covered in Chapter 5.

Cost and Management Accounting

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107

Test yourself 4.1

XT Ltd supplies the wholesale industry with two products, X and T. These products
need one raw material for production and go through a labour-intensive process to
be converted into finished products. Product X requires 5 litres of raw material and
8 labour hours, while Product T requires 10 litres of raw material and 4 labour hours.
Additional information relating to the unit costs of the two products for the last period
is as follows:
Product X Product T
Sales demand in units 250 250
Selling price R250 R300
Direct materials R45 R90
Direct labour R60 R30
Variable overheads R105 R120

Required:
Determine the most profitable production mix under each of the following independent
circumstances:
(a) Only 1 500 litres of raw material are available
(b) Only 1 250 labour hours are available.

For decisions about make versus buy, dropping a product or department, and special orders,
it is important to look at each cost involved and indicate if the cost is relevant or irrelevant
to the decision at hand.

Make or buy (outsourcing) decision

This decision looks at the option of either making a component in-house or buying it
from an external supplier. It is in essence a vertical integration decision. The value chain
is the processes that raw materials go through in order to be transformed into finished
products. Vertical integration in the value chain is where an organisation is involved in
numerous processes within the value chain of its products. Some organisations control all
the processes within the value chain of their products, while others integrate on a smaller
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scale. There are various advantages of vertical integration. Integrated organisations are less
dependent on suppliers, so that they can ensure that production runs smoothly, that is, not
affected by supplier strike action. They can also ensure that their products are of a good
quality. There are two types of make-versus-buy decisions:
● Where the organisation is not working at full capacity, and manufacturing the
component in-house would not displace existing production
● Where the organisation is working at full capacity, and manufacturing the component
in-house would displace existing production.

Relevant costs and revenues for decision making

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Illustrative example 4.7

This example looks at a situation where the manufacturer of the component does not
displace production.

Style Components Ltd produces exclusive ladies’ dresses. They have built up a good
reputation within the trade and are well known for the quality of their clothing. One of
the components for a dress is a 30 cm nylon clothes zipper. Currently the company is
not working at full capacity and is therefore able to manufacture the zippers in-house.
The components that make up the nylon zipper are as follows: a chain (metal teeth
pressed into the woven cotton fabric, the tape), a slider, a bottom stop, and a top
stop. The zippers are then cut into the required size by a specialised machine. The nylon
zippers are non-corrosive and have a durable service life. The specialised machine that is
used to make the zipper has no salvage value and cannot be used to manufacture other
products. During the manufacturing process an expert supervisor checks the quality of
the zippers. The expert supervisor has been hired specifically to check only the processing
of the zippers. Table 4.8 shows the in-house costs related to the manufacturing of the
nylon clothes zipper.
Table 4.8 In-house manufacturing costs
Per unit Rand total
(R) 15 000 zippers per month
Direct material 0.65 9 750
Direct labour 2.00 30 000
Variable overheads 0.35 5 250
Supervisor’s salary 0.50 7 500
Depreciation on special machinery 0.50 7 500
Allocated fixed overheads 1.00 15 000
5.00 75 000

An outside supplier has offered to supply Style Components Ltd with 15 000 zippers
per month for the next 12 months, at a unit cost of R3. If the company buys the zippers
from the outside supplier, the production capacity used at present will be idle.
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Required:
Based on the above information, should Style Components Ltd manufacture the zipper
in-house or buy it from the external supplier? Explain briefly any non-financial factors
that should be considered before a final decision is taken.

Solution:
Steps involved in the make-versus-buy decision:
Step 1: Compare the differential cost to manufacture with the cost to purchase.
Remember the differential costs would be the costs that can be avoided.
Step 2: The decision taken is based on which option has the lowest costs associated
with it.
Step 3: Consider the non-financial factors that could have an impact on the decision.
➤➤

Cost and Management Accounting

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Step 1: Differential cost analysis

Table 4.9 Differential cost analysis
Per unit Relevant costs Differential costs
(180 000 zippers
per annum*)
Make (R) Buy (R) Make (R) Buy (R) Make less buy (R)
Direct material 0.65 – 117 000 – 117 000
Direct labour 2.00 – 360 000 – 360 000
Variable overheads 0.35 – 63 000 – 63 000
Supervisor’s salary 0.50 – 90 000 – 90 000
Depreciation on – – – –
special machinery
Allocated fixed – – – –
overheads
Outside purchase 3.00 540 000 (540 000)
price
Total cost 3.50 3.00 630 000 540 000 90 000

*15 000 zippers per month × 12 months

Which are the differential/avoidable/relevant costs?

● All the variable costs associated with the manufacture of the zipper, that is, direct
material, direct labour and variable overheads, since these costs can be avoided if we
purchase the zippers from the outside supplier.
● Supervisor’s salary can be avoided, since the supervisor has been hired specifically
for the checking of the zippers.
Which are the unavoidable/irrelevant costs?
● Depreciation on special machinery is a sunk cost and therefore cannot be avoided.
● Depreciation is not a cash flow and is therefore irrelevant.
● Allocated fixed costs are common costs associated with all products produced by
the company and cannot be avoided.
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Step 2: Decision
It is cheaper to buy the zipper from the outside supplier than to manufacture it in-house.
The company will save R7 500 per month [(3.50 − 3) × 15 000 zippers] or R90 000 for
the year. The relevant costs for the above decision are the differential costs of the two
alternatives. The differential costs can be isolated by excluding the common costs and
sunk costs, that is, all the costs that cannot be avoided.

Step 3: What are the non-financial indicators that should be considered before a
decision is taken?
● Will the supplier maintain the quality of the component that is required by the
company, since this would impact on the reputation of the company’s main product?
● Will the supplier deliver on time as required to ensure that the production process
continues uninterrupted? ➤➤

Relevant costs and revenues for decision making

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● Will the supplier increase the price of the components after the 12-month period?
Consider the relative permanence of the discount offered.
● What if the supplier is taken over by one of the company’s competitors? This will
definitely restrict the supply of the component.
● Suppliers may breach confidentiality since they have to be informed of any new
improvements or developments regarding the component.
● Consider the effect on employee morale if some employees are to be retrenched.
● What amount of capital will become available, which can be utilised for other
investment opportunities?

Illustrative example 4.8

This example looks at a situation where the manufacturer of the component displaces
existing production.

Assume the same information as in Illustrative example 4.7. The demand for the main
product has increased and Style Components Ltd does not have spare capacity to
manufacture the zipper in-house. This increase in demand for the main product would
result in an increase in contribution by R70 000 per annum. Should the company
manufacture the zipper in-house or buy it from an external supplier? Importantly, if the
manufacture of the product or component displaces (replaces) existing production,
the lost contribution (opportunity cost) resulting from the displacement in production
must be added to the marginal cost of production before comparing it to the buying
in price.

Solution:
Given the above scenario, a differential analysis shows:
Table 4.10 Differential analysis
Make Buy Difference/
differential
(Make less buy)
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Differential cost per unit R3.50 R3.00

× annual requirement 180 000 180 000
Total annual cost R630 000 R540 000 R90 000
Add: Opportunity cost/lost contribution R70 000 – R70 000
Total cost R700 000 R540 000 R160 000

Decision: It is still cheaper to buy the zippers from the outside supplier than to produce
them in-house. Remember to consider all the non-financial indicators before making a
final decision.

Cost and Management Accounting

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111

Test yourself 4.2

A company currently uses three subcomponents in the manufacturing of its only
product. There are surplus machine hours available that could be used to manufacture
the components in-house. The costs per unit of each of the subcomponents are given
in the table.

Subcomponent Subcomponent Subcomponent

A B C
Machine hours per unit 3 hours 6 hours 12 hours
Production requirements 200 units 400 units 100 units
Direct manufacturing costs R30 R36 R24
Buying-in price R21 R48 R42

Required:
Determine how many units of each subcomponent should be purchased from the
outside supplier if only 3 000 machine hours are available in-house.

Closure or deletion of a business segment

A business segment is a division or subdivision of a large organisation which generates
revenue. This decision looks at the option of deleting a non-profitable business segment.
In monetary terms a business segment may be deleted if it fails to render an acceptable
return on capital in the long term. It may also be deleted due to a change in the long-term
goals of the organisation, for example rationalisation, to concentrate activities on a specific
sector rather than on a number of different sectors. The way in which fixed costs have
been allocated can impact on the profitability of a product line or department. Absorption
costing is used for normal reporting within an organisation, resulting in a product line or
department appearing to be unprofitable. This is not necessarily true. By restructuring the
income statement into marginal costing format, you can clearly see whether the product
line or department is profitable or not. Allocated fixed costs may not be avoidable even if the
product line or department is dropped.
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Illustrative example 4.9

Designers Ltd manufacture office furniture and accessories. They were established in
the 1970s and have been providing their customers with high-quality and functional
products. The company’s corporate objective is to offer their customers a complete
office solution. Their product lines consist of desks, seating and office accessories.
The desk line consists of various types of desks: reception desks, boardroom desks,
executive desks, managerial and operators’ desks. The seating line consists of various
types of chairs: operators’, managerial and executive chairs. The office accessories line
consists of file holders and cabinets, as well as desk accessories such document trays,
pen holders and business card holders.
➤➤

Relevant costs and revenues for decision making

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Table 4.11 shows the sales and cost information for the last month for each of the
product lines.
Table 4.11 Sales and information on cost for product lines
Total (R) Desking (R) Seating (R) Accessories (R)
Sales 500 000 250 000 150 000 100 000
Less: Variable costs 210 000 100 000 50 000 60 000
Contribution 290 000 150 000 100 000 40 000
Less: Fixed expenses 250 000 118 000 76 000 56 000
Rent 40 000 20 000 12 000 8 000
Salaries 100 000 59 000 25 000 16 000
Utilities 4 000 1 000 1 000 2 000
Advertising 30 000 2 000 15 000 13 000
Depreciation 10 000 2 000 4 000 4 000
Insurance 6 000 4 000 1 000 1 000
eneral administrative
G 60 000 30 000 18 000 12 000
costs
Net profit or loss 40 000 32 000 24 000 (16 000)

Salaries, insurance and advertising relate specifically to each product line. The office
accessories line appears to be making a loss. Should this product line be dropped?
Explain briefly any non-financial factors that should be considered before a final
decision is taken.

Solution:
Steps involved in dropping a product or department:
Step 1: Analyse the fixed costs being charged to the product line or department, and
identify which of the fixed costs can be avoided if we drop the product line or
department.
Step 2: Compare the total avoidable fixed costs to the contribution generated by the
unprofitable product line or department. If the contribution generated by the
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unprofitable product line is greater than the total avoidable fixed costs, do
not drop the product line, or if the contribution generated by the unprofitable
product line is less than the total avoidable fixed costs, drop the product line.
Step 3: Consider the non-financial factors that could have an impact on the decision.
➤➤

Cost and Management Accounting

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Step 1: Analysis of costs

Table 4.12 Analysis of costs
Total (R) Unavoidable/ Avoidable/
irrelevant costs relevant costs
(R) (R)
Rent 8 000 8 000
Salaries 16 000 – 16 000
Utilities 2 000 2 000
Advertising 13 000 – 13 000
Depreciation: Equipment 4 000 4 000
Insurance 1 000 – 1 000
General administrative costs 12 000 12 000
Total fixed costs 56 000 26 000 30 000

Avoidable costs are salaries, insurance and advertising. They relate specifically to the
office accessories product line and therefore can be avoided if the line is dropped. We
are assuming also that the workers on this line would be laid off and not redeployed
elsewhere in the company.

Unavoidable costs are rent, utilities, depreciation on equipment and general

administration. These costs relate to the company as a whole. A portion has been
allocated using a suitable apportionment basis to the office accessories product line,
but these costs will still continue whether or not the office accessories product line is
dropped or not.

Step 2: Total avoidable fixed costs versus contribution

Table 4.13 Total avoidable fixed costs versus contribution
Lost contribution if accessories line is dropped (R40 000)
Less: Savings in fixed costs (Avoidable fixed costs) R30 000
Decrease in overall net profit (R10 000)
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➤➤

Relevant costs and revenues for decision making

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Table 4.14 The differential analysis

Keep Drop Difference/
accessories line accessories line differential (R)
(R) (R)
Sales 100 000 – (100 000)
Less: Variable costs 60 000 – (60 000)
Contribution 40 000 – (40 000)
Less: Total fixed expenses 56 000 26 000 30 000
Rent 8 000 8 000 –
Salaries 16 000 – 16 000
Utilities 2 000 2 000 –
Advertising 13 000 – 13 000
Depreciation 4 000 4 000 –
Insurance 1 000 – 1 000
General administrative costs 12 000 12 000 –
Net profit or loss (16 000) (26 000) 10 000

Decision: Do not drop the office accessories line, as this will result in an overall decrease
in profit of R10 000.

Step 3: The non-financial factors to consider are as follows:

● Redundancies of workforce and consequences, that is, effect on employee morale
and loss of scarce skills
● Customers’ perceptions
● Competitors’ perceptions
● Is it in the best interest of the organisation both in the short term and long term?
Does the decision impact on the long-term reputation of the organisation? Will
retaining the product line or department be the best way of utilising available
resources, or can the resources be used to manufacture other more profitable
products. Remember, a closure decision has far-reaching consequences and should
only be undertaken as a last option, that is, the organisation has made various
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efforts to improve profitability and has failed.

Test yourself 4.3

Growth Ltd wants to rationalise their existing product lines in order to improve
profitability. The objective is to eliminate or outsource those product lines that have
a low sales volume and use excessive overheads. The budgeted profit statement for the
four product lines for the past six months is given in the following table.
➤➤

Cost and Management Accounting

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Product Product Product Product Total (R)

line A (R) line B (R) line C (R) line D (R)
Sales 2 400 000 3 600 000 1 500 000 6 000 000 13 500 000
Less: Production costs 2 220 000 3 030 000 1 350 000 4 800 000 11 400 000
Direct costs 1 500 000 1 950 000 900 000 3 000 000 7 350 000
F ixed factory 720 000 1 080 000 450 000 1 800 000 4 050 000
overheads
Less: Fixed selling and 960 000 900 000 750 000 1 050 000 3 660 000
administrative
expenses
Profit or loss (780 000) (330 000) (600 000) 150 000 (1 560 000)

The fixed selling and administrative expenses consist of rent, rates, water and electricity,
salaries and advertising for each product line. If a product line is dropped, these costs
become variable.

Required:
(a) Determine which product line/s should be dropped in order to improve profitability.
(b) Assume that 15% of the customers will purchase products from product line A if product
line C is discontinued. Analyse whether or not product line A should be dropped.

Special-order decision
Special orders are once-off orders that are not part of the normal business. These once-off
orders are usually below the normal selling price and generally occur when an organisation
has surplus production capacity. By accepting such orders, the organisation can increase
its contribution and consequently its profits. Special orders can also be undertaken if
the organisation does not have surplus capacity. In this case, the minimum price of the
special order should include the additional costs required to expand the production facility
in order to meet the special-order requirements, as well as the lost contribution from the
regular sales that are displaced by the special order.
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Illustrative example 4.10

Gear Seal Ltd manufactures bearings and seals for both the automotive as well as
industrial sectors. The company operates in two divisions, the rubber division and the
steel division. Their bearings and seals are used in all makes of motor vehicles, as well as
in industrial equipment and machinery, both locally and internationally. The bearings
are manufactured in the steel division, while the seals are manufactured in the rubber
division. The cost to produce a bearing is R4.44 and the cost to produce a seal is R2. The
current selling prices are R7 per bearing and R4 per seal. They are currently producing
60 000 seals and 27 000 bearings for the month, which represent 75% capacity. The
total costs for the steel division are R120 000 of which 70% are variable costs. They have
received an order from Nadasen’s Auto Manufacturers to supply 8 000 bearings for a
vintage-model Supra at a price of R8 per bearing. ➤➤

Relevant costs and revenues for decision making

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Required:
(a) Based on the information, should Gear Seal Ltd accept the special order? Briefly
explain any non-financial factors that should be considered before a final decision
is taken.
(b) Assuming that the special order increased to 10 000 bearings, should Gear Seal Ltd
accept the special order?

Solution:
(a) Steps involved in a special-order decision:
Step 1: Determine if the organisation has surplus capacity to meet the special-order
requirements.
Step 2: Calculate the incremental revenue and incremental costs.
Step 3: If the incremental revenue exceeds the incremental costs, accept the special
order. If the incremental revenue is lower than the incremental costs, do not
accept the order.
Step 4: Consider the non-financial factors that could have an impact on the decision.

Step 1: Determine the organisation’s capacity

Current capacity 27 000 75%
Total capacity 36 000* 100%
Surplus capacity 9 000 25%
100
*27 000 ×  ___
75 5 36 000
he special order is for 8 000 bearings and the surplus capacity is 9 000 bearings.
T
The organisation therefore has sufficient capacity to meet the special-order
requirements.

Step 2: Calculate the incremental revenue and incremental costs

The incremental costs would be the variable costs.
Total fixed costs = Total cost − Total variable costs
Total cost R120 000
− Total variable costs R84 000 (70% × 120 000)
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= Total fixed costs R36 000

Variable cost per unit = Total variable costs ÷ Total number of units
produced
= R84 000 ÷ 27 000
= R3.11
Step 3: Incremental analysis
Table 4.15 Incremental analysis
Incremental revenue (R8 × 8 000) 64 000
Less: Incremental costs (R3.11 × 8 000) 24 880
Increase in profit 39 120 ➤➤

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The incremental revenue exceeds the incremental cost by R39 120. The organisation
should therefore accept the special order since profits would increase by R39 120.

Step 4: Non-financial indicators that could impact on the decision are as follows:
● Will the special order increase fixed costs?
● Is the special order the best possible use of the surplus capacity?
● If the demand for the product increases in the future, will the company be able to
meet this demand, considering that capacity is tied up on the special order?
● What impact would selling the product at a lower price have on the customers’
perceptions as well as the market share?
● Is additional working capital available if required?
● Would downward pressure be placed on normal selling price?

(b) Current capacity 27 000 75%

Total capacity 36 000* 100%
Surplus capacity 9 000 25%
 100
*27 000 × ___ 75 5 36 000

The special order is for 10 000 bearings and the surplus capacity is 9 000 bearings. The
organisation therefore has insufficient capacity to meet the special order requirements.
Since the company has excess capacity of 9 000 units only, it is not enough to fill up the
special order of 10 000 units. Hence, a portion of the regular sales (1 000 units) must
be sacrificed to fill up the entire special order.

The incremental costs would be the variable costs of R3.11 per bearing. The lost contribu-
tion margin (opportunity cost) from the regular sales should be considered. Contribution
margin is equal to sales (at R7 per bearing) minus variable costs (R3.11 per bearing).
Therefore, the lost contribution margin is equal to R3 890 [(R7 − R3.11) × 1 000 units].
Incremental revenue (R8 × 8 000 units) R64 000
Incremental costs (R3.11 × 8 000 units) (R24 880)
Lost contribution margin (opportunity cost) (R3 890)
Increase in profit R35 230
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Even though regular sales will be sacrificed, Gear Seal should still accept the special order
since profits would increase by R35 230. Gear Seal also needs to ensure that this is a
one-time order, and therefore represents a short-run pricing decision. If future orders
from Nadasen’s Auto Manufacturers at R8 per bearing are received, then Gear Seal
must consider the impact this might have on long-run pricing with other customers.
Regular customers may hear of this special price and demand the same price, particularly
customers who have been loyal to Gear Seal for many years. Gear Seal might be forced
to lower prices for regular customers, thereby eroding the company’s profits over time.

The key point is that companies evaluating special orders can drop prices in the short
run to cover differential variable and fixed costs. But in the long run, prices must cover
all variable and fixed costs.

Relevant costs and revenues for decision making

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Test yourself 4.4

Cool Babies Ltd manufactures designer baby diaper bags. Last month they produced
2 000 bags, which utilised 70% capacity. They have recently received an order to supply
150 bags at a price of R80 per bag. The sales managers are reluctant to accept the order
since it is below the normal cost price. It costs the company R96 to produce a bag. The
manufacturing costs per bag are given in the following table.

R
Variable costs 84.00
Direct materials 18.00
Direct labour 36.00
Manufacturing overheads 18.00
Marketing and administration 12.00
Fixed costs 12.00
Manufacturing overheads 6.00
Marketing and administration 6.00
Total unit cost per bag 96.00

The special order will incur marketing and administration costs in the same way that
normal units incur those costs.

Required:
Advise management whether or not the special order should be accepted.

Minimum pricing decision

This pricing decision is particularly useful in situations where there is intensive competition
in the market and the organisation has to price its product or products competitively;
clearance of old stocks; getting special orders and/or improving market share of the product.
It looks at the lowest possible price that the company could sell its products for. The lowest
price is the total relevant costs of producing the product, plus any opportunity cost that
may arise out of the decision. See Chapter 6 on pricing.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Illustrative example 4.11

The minimum price for a one-off decision is the price at which the business would break
even, that is, the total relevant costs for the once-off decision.

A customer has approached JIG Co to manufacture specialised jigs for the machines
used in its production facility. It would be a one-off order which JIG Co would undertake
in addition to its normal budgeted production. The assistant accountant has prepared
the following quotation. Based on relevant costing, determine if the minimum price for
the job as determined by the accountant is correct. ➤➤

Cost and Management Accounting

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119

Table 4.16 Quotation price

Notes Rs
Direct material: – –
Sheet metal (40m² @ R20 per m²) 1 800
Pop rivets (200 @ R2 each) 2 400
Direct labour: –
Skilled (100 hours @ R32 per hour) 3 3 200
Semi-skilled (40 hours @ R20 per hour) 4 800
Overheads 5 200
5 400
Administration overhead @ 10% of production cost 6 540
5 940
Profit 20% of total cost 7 1 188
Selling price 7 128

Additional information:
1. The sheet metal required for the jigs are used regularly on other work within the
business. This metal has an inventory value of R20 per m². However, due to the
current economic circumstances, the purchase price has recently increased to
R24 per m².
2. The pop rivets are currently held in inventory and cost R2 each. The company has
no further use for them. A scrap merchant is willing to purchase them at R1 each.
3. The skilled labourers are paid R32 per hour and are currently working at full capacity.
If the job is undertaken, a maximum of 80 hours of overtime (paid at time and a
half) would need to be worked and any additional hours required would displace
current production of other products which earn a contribution of R40 per hour.
4. The idle semi-skilled labour time available totals 200 hours.
5. Overheads are apportioned to cover the factory fixed cost.
6. The company’s policy is to add 10% to the production cost of each job to cover the
administration cost of orders accepted.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

7. The standard pricing policy requires a profit of 20% of total cost to be added to
each job.
➤➤

Relevant costs and revenues for decision making

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120

Solution
Table 4.17
Direct material: – –
Sheet metal (40m² @ R24 per m²) 1 R960.00
Pop rivets (200 @ R1 each) 2 R200.00
Direct labour: –
Skilled labour 3 R5 280.00
Semi-skilled 4 R0.00
Overheads 5 R0.00
R6 440.00
Administration overhead @ 10% of production cost 6 R644.00
R7 084.00
Profit 20% of total cost 7 R1 416.80
Selling price R8 500.80

Notes
1. The sheet metal is in regular use; and therefore needs to be replaced. The current
purchase price is: Relevant cost = 40 m² × R24 = R960.
2. Pop rivets = Opportunity cost is lost scrap proceeds (200 × R1 = R200).
3. Skilled labour:
It is cheaper to work overtime; however, the job requires 100 hours. Overtime
is limited to 80 hours, the shortfall in hours is 20 hours, which will displace the
regular production
80 hours @ (R32 x 1.5) R3 840
20 hours @ (R32 + R40) R1 440
R5 280
4. Semi-skilled labour: Relevant cost is nil as there is spare capacity available.
5. Overheads: Relevant cost is nil, as overheads will be incurred regardless of this job.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

6. Administration costs will be incurred regardless of whether or not the job is

accepted; therefore, it is not relevant.
7. Profit mark-up is not relevant as the question asks for a minimum price. A minimum
price is one which covers the total of the relevant costs.

Test yourself 4.5

XT Manufacturers Ltd manufactures a single product model XT3. This product is used
as a component in the manufacture of electrical equipment for the industrial sector. The
unit cost of model XT3 is as follows:
➤➤

Cost and Management Accounting

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Direct materials R60

Direct labour 30
Factory overhead (40% variable) 90
Selling expenses (60% variable) 30
Administrative expenses (20% variable) 15
Total per unit R225

The company currently produces 5 000 units of model XT3. Recently, a company
approached XT Manufacturers about buying 1 000 units for R225. Currently, the models
are sold to dealers for R412.50. XT Manufacturers’ capacity is sufficient to produce the extra
1 000 units. No additional selling expenses would be incurred on the special order.
Required:
(a) What is the profit earned by XT Manufacturers on the original 5 000 units?
(b) Should XT Manufacturers accept the special order if its goal is to maximise short-
run profits? By how much will income be affected?
(c) Determine the minimum price XT Manufacturers would want to receive in order to
increase profits by R7 500 on the special order.
(d) When making a special order decision, what non-quantitative aspects of the decision
should XT Manufacturers consider? Explain four non-quantitative aspects.

Joint product and further processing decisions

Organisations that produce a number of products from a common production process
are faced with the problem of how to allocate the costs of the common production
process equitably to all the products produced. Figure 4.4 shows an overview of joint and
by-products.

Further processing
Total cost of the
Split-off point costs for joint
product
products

Direct material 1 Applied joint costs

Joint product 1 Direct labour 1 1 Further processing
Applied overheads costs
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Direct material
1 Direct labour Common Joint product 2 Direct material 1 Applied joint costs
1 Applied production Direct labour 1 1 Further processing
overheads 5 process Applied overheads costs
Joint costs

By-product

Figure 4.4 Overview of joint and by-products

Important terminology related to joint and by-product costing:

● Joint products: These are products that arise out of a common manufacturing process.
They are produced in large quantities and make a substantial contribution to the
organisation’s profits. They are the main products that the organisation produces.

Relevant costs and revenues for decision making

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● By-products: These are products that arise out of a common manufacturing process.
They are produced in smaller quantities in comparison to the joint products and they
contribute a relatively small amount to the overall profits of the organisation. Unlike
the main products, the organisation did not intend to manufacture the by-products.
● Split-off point/separation point: This is the point in the production process where we
can identify the various joint products as well as by-products.
● Joint costs/common costs: These include all direct material and direct labour as well as
manufacturing overhead costs that are incurred up to the split-off point.
● Further processing costs/subsequent costs: This means that often the main products/
joint products produced cannot be sold at split-off point. They need to be processed
further in different processes in order to bring them into a saleable condition. The costs
incurred in these separate processes are known as ‘further processing costs’.

Accounting for joint products

We need to determine the costs of the joint products for both pricing and valuation
purposes. This is calculated as follows:

Total cost of joint product = Allocated joint costs + Related further processing costs

The question is how we allocate joint costs to joint products. We can use one of the
following methods:
● Physical measurement/physical standard method allocates joint costs to each joint product
based on the quantity of the product produced. Obviously, this method allocates more
joint costs to high-volume products than low-volume products.
● Market value at split-off point method allocates joint costs to each joint product based on
the potential market value of the product at split-off point. We can only use this method
if we know or can estimate what the market value is or would be at split-off point.
● Net realisable value/estimated market value at split-off point. With this method we assume
that the market value at split-off point is not known with certainty. It can however be
estimated by using the further processing costs as well as the market value of the final
product. The net realisable value can be calculated as:

(Production × Selling price of final product) − Further processing costs

The various methods used to allocate joint costs are only estimates and the manager should
Copyright © 2021. Juta & Company, Limited. All rights reserved.

be cautioned when using these estimates in a decision-making context. Note that each
method will result in a different valuation of inventory and therefore a different gross profit.

Accounting for by-products

By-products do not constitute part of the main purpose of an organisation’s operations,
therefore the approach regarding by-products should be one that has a minimal effect
on the operating results where by-products are sold. One needs to establish whether a
regular market exists for the by-product or not. If the by-products are sold on a regular
and recurring basis, there is clearly a market for them, and the organisation is assured of
the eventual sale of the by-product at its net realisable value. Where a regular market exists,
the objective is to reflect the sales of the by-product in a way that it yields no profit. This is
achieved by ensuring that the by-products that arise from the common/joint process are
priced at the net realisable value, which is the net proceeds on sales (after subtracting any

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further processing costs and other costs). In this method, the total joint costs for the period
will be reduced by the total net realisable value (NRV) of the production of the by-product.
After this, the net joint costs are allocated to the remaining joint products according to the
methods described in Illustrative example 4.12. If indicated that the organisation can sell as
much of a product as it can produce, it is an indication that a regular market exists.
If there is no market for the by-products, they constitute waste and would generally be
thrown away/discarded. Incidental sales may occur from these waste products and since
such transactions will occur sporadically and in isolation, there should be minimal impact
on the profit. However, these transactions still need to be taken into account. Various
options are available for treatment of the net proceeds of the by-product as a single-line
item in the statement of comprehensive income. These options are the following:
● Additional sales revenue
● Reduction of the cost of goods sold
● Other income.

By-products can either be sold as scrap or be processed further. The decision to process a
by-product further will be based on the following:
● The cost to process the by-product further must be less than the additional revenue
generated by the sale of the by-product.
● The costs incurred up to split-off point are sunk and consequently have no impact on
decisions related to the treatment of the by-product.

Illustrative example 4.12

The following example illustrates the allocation of joint costs to joint products. A
company produces two products, Joint product 1 and Joint product 2, using a common
manufacturing process. The joint costs that arise out of the common process are R3 750.
Table 4.18 Joint costs for Product 1 and Product 2
Joint product 1 Joint product 2
Litres produced 250 750
Litres sold 200 680
Selling price per litre at split-off point R7.50 R3.00
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Required:
Allocate the joint costs to the joint products and determine the estimated gross profit
or loss using the following:
(a) Physical measurement/physical standard method
(b) Market value at split-off point method
(c) Net realisable value method.

Assume that the joint products are processed further before being sold and that the
selling price of each product at split-off point is not known. The further processing costs
of each product amounts to R2 and R3 for Joint products 1 and 2 respectively. These
products can be sold after further processing for R10.50 and R7 respectively.
Round off to two decimal places where necessary. ➤➤

Relevant costs and revenues for decision making

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Solution:
(a) Physical measurement/physical standard method
= Joint costs ÷ litres produced
= R3 750 ÷ 1 000 litres
= R3.75 per litre for both products
Estimated gross profit of each product is given in Table 4.19.

Table 4.19 Estimated gross profit

Total Joint product 1 Joint product 2
Sales (200 × R7.50) (680 × R3) 3 540 1 500 2 040
Less: Joint costs (R3.75 × 200; 680) 3 300 750 2 550
Estimated gross profit/loss R240 R750 (R510)

Not all products produced were sold. The estimated value of the closing stock of
each joint product is as follows:
Joint product 1 50 × R3.75 = R187.50
Joint product 2 70 × R3.75 = R262.50
Note that the high-volume product, Joint product 2, has been allocated a greater
portion of the joint cost, resulting in the product showing a loss. Since both
products arise from a common production process, it is not possible to assess only
the profitability of one product as opposed to the other. The profitability of the
common production process would have to be assessed.
(b) Market value at split-off point method
Allocation of joint costs is given in Table 4.20.
Table 4.20 Allocation of joint costs
Product Market Ratio (R) Joint cost Allocated Cost per
value (R) (R) joint cost litre (R)
(R)
Joint product 1 1 875* 1 875 ÷ 4 125 × 3 750 1 704.55 6.82*
Joint product 2 2 250* 2 250 ÷ 4 125 × 3 750 2 045.45 2.73*
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4 125 R3 750.00

Market value
*250 × R7.50 = R1 875
*750 × R3 = R2 250
Cost per litre
*R1 704.55 ÷ 250 litres = R6.82
*R2 045.45 ÷ 750 litres = R2.73
➤➤

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Estimated gross profit of each product is given in Table 4.21.

Table 4.21 Estimated gross profit
Total (R) Joint product 1 Joint product 2
(R) (R)
Sales (200 × R7.50 ) (680 × R3) 3 540.00 1 500 2 040.00
Less: Joint costs (R6.82 × 200) (R2.73 × 680) 3 220.40 1 364 1 856.40
Estimated gross profit R319.60 R136 R183.60

Not all products produced were sold. The estimated value of the closing stock of
each joint product is as follows:
Joint product 1 50 × R6.82 = R341.00
Joint product 2 70 × R2.73 = R191.10
Note that this method results in a more equitable allocation of joint costs, with
both joint products now reflecting a profit.
(c) Net realisable value method
Allocation of joint costs is given in Table 4.22.

Table 4.22 Allocation of joint costs

Total Joint product 1 Joint product 2
Production in litres 1 000 250 750
Total sales
(250 × R10.50) (750 × R7) R7 875 R2 625.00 R5 250.00
Less: Further processing
costs
(250 × R2) (750 × R3) R2 750 R500.00 R2 250.00
Estimated market value at
split-off point R5 125 R2 125.00 R3 000.00
Allocation of joint cost* R3 750 R1 554.88 R2 195.12
Cost per litre R1 554.88 ÷ 250 5 R6.22 R2 195.12 ÷ 750 5 R2.93
Copyright © 2021. Juta & Company, Limited. All rights reserved.

*Joint cost:
Joint product 1: 2 125 ÷ 5 125 × 3 750
Joint product 2: 3 000 ÷ 5 125 × 750
➤➤

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Estimated gross profit of each product is given in Table 4.23.

Table 4.23 Estimated gross profit

Total (R) Joint product 1 Joint product 2
(R) (R)
Sales (200 × R10.50 ) (680 × R7) 6 860.00 2 100.00 4 760.00
Less: Cost of sales 5 674.14 1 643.90 4 030.24
Opening stock 0 0 0
Add: Cost of goods manufactured 6 500.00 2 054.88 4 445.12
Joint costs 3 750.00 1 554.88 2 195.12
Further processing costs 2 750.00 500.00 2 250.00
Less: Closing stock* 825.86 410.98 414.88
Estimated gross profit 1 185.86 456.10 729.76

*Closing stock:
Joint product 1: 50 ÷ 250 × 2 054.88
Joint product 2: 70 ÷ 750 × 4 445.12

Note: This method results in a more equitable allocation of joint costs, with both joint
products reflecting a profit.

Sell at split-off point or process further

The decision to sell a joint product at split-off point or process it further is based on
whether the incremental revenue from further processing exceeds the incremental cost of
further processing. Joint costs are irrelevant to this decision, since they are past costs and
therefore cannot be changed. The decision is mainly subject to the following:
● Acceptable return on the additional capital required
● Demand for the processed and unprocessed product
● Capacity to accommodate further processing
● Availability of additional working capital.
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Illustrative example 4.13

Refer to Illustrative example 4.12.
Table 4.24 Joint product information
Joint product 1 Joint product 2
(R) (R)
Sales value at split-off point 1 875.00 2 250.00
Sales value after further processing 2 625.00 5 250.00
Allocated joint costs 1 704.55 2 045.45
Cost of further processing 800.00 2 500.00

➤➤

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Required:
Determine whether Joint products 1 and 2 should be sold at split-off point or be further
processed. The net realisable method must be used to allocate joint costs. All units
produced were sold.

Solution:
Using incremental analysis, the increase/decrease in profit can be calculated as shown
in Table 4.25.
Table 4.25 Incremental analysis
Joint product 1 Joint product 2
(R) (R)
Sales value after further processing 2 625 5 250
Sales value at split-off point 1 875 2 250
Incremental revenue from further processing 750 3 000
Less: Cost of further processing 800 2 500
Increase/decrease in profit from further processing (50) 500

Decision: Joint product 1 must be sold at split-off point, since further processing will
result in a decline in profits of R50. Joint product 2 can be processed further, since
profits will increase by R500.

Illustrative example 4.14

Refer to Illustrative example 4.12

The common production process has also resulted in the emergence of 50 litres of a by-
product. This by-product has to be processed further in order to bring it into a saleable
form. The further processing costs of the by-product is R5 per litre and it can be sold
at R10 per litre. The physical standard method is used to allocate joint costs to joint
products and joint products are sold at split-off point.
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Required:
Prepare a statement of comprehensive income indicating the different ways in which the
revenue from the by-product can be treated.
➤➤

Relevant costs and revenues for decision making

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128

Solution:
The revenue from the by-product is R250 [(10 − 5) × 50].
Table 4.26 Statement of comprehensive income: treatment of the by-product revenue
Reduction Reduction Additional Other
in joint in cost of revenue income
costs sales
REGULAR NO NO NO
MARKET REGULAR REGULAR REGULAR
MARKET MARKET MARKET
Sales (200 × R7.50) (680 × R3) 3 540 3 540 3 790 3 540
(3 540 + 250)
Less: Cost of sales 3 050 3 050 3 300 3 300
Opening stock 0 0 0 0
Add: Joint manufacturing costs 3 500 3 750 3 750 3 750
(3 750 − 250)
Less: Closing stock (50 × R3.75) (450) (450) (450) (450)
(70 × R3.75) (250)
Less: By-product income
Gross profit 490 490 440 240
Add: Other income (by- 0 0 0 250
product revenue)
Net profit 490 490 490 490

Note: The joint costs are not allocated to the by-product; however, the by-product is
charged with the further processing cost of R5 per litre. The net profit obtained is the
same, irrespective of which method was used to allocate the by-product revenue.

Test yourself 4.6

ABC Ltd produces three products, A, B and C, in a common production process. The
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cost of the common production process is R26 250. Last month the company produced
1 200 units of A, 3 000 units of B and 1 800 units of C. These products can either be sold
at split-off point or be processed further individually.
A (R) B (R) C (R)
Market value at split-off point 4.50 6.50 5.00
Market value after further processing 7.50 9.00 9.00
Further processing costs (variable) 2.10 1.35 3.50
Further processing costs (fixed) per month – – R1 000

Required:
Determine whether the products should be sold at split-off point or processed further.

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Strategic implications of short-term decisions

The strategic plan of the organisation must integrate both the short-term goals and long-
term objectives of the organisation, that is, the short-term goals must coincide with the
long-term objectives. All short-term and long-term decision making must be aligned to the
overall strategic plan of the organisation. It is therefore imperative for the organisation
to review the long-term effects of every short-term decision taken. As mentioned earlier
in the chapter, despite the fundamental differences between short-term and long-term
decision making, both types of decisions are concerned with maximising the returns of the
organisation. If an organisation focuses solely on short-term profitability, it may not make
the necessary expenditure required to maintain its competitive advantage in the future. On
the other hand, if an organisation focuses solely on investing in its growth in the long term,
it may face shortfalls in the short term.
In addition to the strategic implications of short-term decisions, the organisation needs
to address ethical principles and values within the decision-making process.

Short-term decisions and ethics

The three guiding principles that can assist organisations to make better ethical decisions
are as follows:
1. In the decision-making process, the interests of all the stakeholders should be
taken into account.
The fundamental principle is ‘assist and avoid harm where possible’.
2. Ethical values and principles should always take precedence over unethical ones.
In the decision-making process the organisation should always choose to follow ethical
principles over unethical ones. The choice between ethical and unethical principles is
sometimes a difficult one, as this may result in the organisation giving up profitable
options in order to do no harm.
3. In the decision-making process, it is only appropriate to breach an ethical
principle if the violation of the ethical principle results in the long-term benefit
for all stakeholders.
Some decisions may require the organisation to choose between competing ethical
values and principles. If the only viable option requires the organisation to forego one
ethical principle over another ethical principle, the organisation should act in a way that
creates the greatest amount of good and the least amount of harm to all stakeholders.
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Summary
By improving short-term profitability, long-term profitability is affected as well. The
short-term decisions covered in this chapter looked at special ‘once-off’ situations aimed
at improving the organisation’s profitability by allowing it to respond to changes in its
environment. Both financial and non-financial indicators need to be considered for the
accuracy of the decision at hand.

Relevant costs and revenues for decision making

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130

Key concepts
Arbitrary allocated costs are organisational overheads which are allocated to products
or divisions on an arbitrary basis, for example marketing and administration costs. They
are always irrelevant, as they will be reallocated to the remaining products or divisions
should any one of them be discontinued or shut down.
By-products are products that arise out of a common manufacturing process. They are
produced in smaller quantities in comparison to the joint products, and they contribute
a relatively small amount to the overall profits of the organisation. Unlike the main
products, the organisation did not intend to manufacture the by-products.
Committed costs are costs that will be incurred in the future, but have originated from
a decision made in the past and therefore cannot be changed by any decision made now
or in the future.
Common costs are costs that are present under both options, and consequently they
will not affect the decision at hand.
Constrained resource/limiting factor is something that prevents the organisation from
meeting their sales demand, and consequently has an impact on the profitability of the
organisation. Examples of constraints are limited machine hours, limited labour hours,
limited raw materials, limited floor space, etc.
Depreciation is an irrelevant cost. It does not involve the physical flow of cash and
is merely an accounting adjustment which spreads the cost price of the asset over its
useful life.
Differential or incremental costs and revenues: a differential cost is the difference in
the costs between the alternatives being considered, and the differential revenue is the
difference in revenue between the alternatives being considered.
Discretionary fixed costs are considered relevant since these costs can be managed.
Further processing costs/subsequent costs mean that often the main products/joint
products produced cannot be sold at split-off point. They need to be processed further
in different processes to bring them into a saleable condition. The costs incurred in these
separate processes are known as the further processing costs.
Future costs and revenues are considered relevant because they are cash flows that arise
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out of the decision taken.

Irrelevant costs are costs that do not affect the decision at hand and can consequently
be excluded from the decision-making process.
Joint costs/common costs include all direct material and direct labour as well as
manufacturing overhead costs that are incurred up to the split-off point.
Joint products are products that arise out of a common manufacturing process. They are
produced in large quantities and make a substantial contribution to the organisation’s
profits. They are the main products that the organisation produces.
➤➤

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Non-financial indicators/qualitative factors are the non-quantifiable issues such as

the impact of the decision on the long-term profitability of the organisation, employee
morale, quality of the product produced, customer long-term satisfaction, legal aspects,
ethical aspects, social responsibilities, etc.
Notional costs/speculative costs, such as notional rent and notional interest, are
irrelevant costs. The main purpose of these costs is to make internal decision making
more accurate, since they allow managers to benchmark competitors’ product costs.
Opportunity cost is the possible revenue that is lost as a result of choosing one course
of action above the other.
Outsourcing looks at the option of either making a component in-house or buying it
from an external supplier.
Relevant costs and revenues are costs and revenues that have an impact on the decision
at hand.
Relevant overhead costs are overhead costs that change as a result of the decision taken
and is dependent upon the circumstance.
Split-off point/separation point is the point in the production process where we can
identify the various joint products as well as by-products.
Sunk costs are past costs, and no decision made now or in the future can change them.
They have already been incurred and are consequently irrelevant to the decision at hand.

Test-yourself solutions
Test yourself 4.1
(a) Contribution per litre of raw material
Product X (R) Product T (R)
Selling price 250 300
Less: Variable costs 210 240
Direct materials 45 90
Direct labour 60 30
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Variable overheads 105 120

Contribution per unit 40 60
÷ constrained resource (material in litre) ÷ 5 litres ÷ 10 litres
Contribution per litre of raw material 8 6

Relevant costs and revenues for decision making

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Production mix
Litres
Total litres of raw material available 1 500
Less: Litres used for product X (250 × 5 litres) 1 250
Litres available for production of Product T 250
Litres used for production of Product T (25* × 10) 250*
Litres left 0

*250 ÷ 10 litre = 25 units of T

If raw material is limited, the most profitable production mix would be 250 units of
Product X and 25 units of Product T.
(b) Contribution per labour hour
Product X Product T
Contribution per unit R40 R60

÷ constrained resource (labour hours) ÷ 8 hours ÷ 4 hours

Contribution per labour hour R5 R15

Production mix
Total labour hours available 1 250
Less: Hours used for Product T (250 × 4 hours) 1 000
Hours available for production of Product X 250
Hours used for production of Product X (31* × 8 hours) 248*
Labour hours left 0

*250 ÷ 8 hours = 31 units of Product X rounded

If labour hours are limited, the most profitable production mix would be 250 units of
Product T and 31 units of Product X.

Test yourself 4.2

Differential analysis shows the following:
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Subcomponent Subcomponent Subcomponent

A (R) B (R) C (R)
Buying-in price 21 48 42
Direct manufacturing costs 30 36 24
Difference (9) 12 18

The company will save R9 per unit if subcomponent A is bought in as opposed to being
manufactured in-house. A saving of R12 and R18 respectively will be made if subcomponents B
and C are manufactured in-house. However, the production requirement for subcomponents
B and C cannot be fully met due to the surplus machine hours being limited to 3 000 hours.
The savings per unit of the limiting factor can be calculated in order to determine which of

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the subcomponents has the greatest saving per limiting factor. Attention will then be given
to the production of the subcomponent that yields the greatest savings per limiting factor.
Subcomponent B R12 ÷ 6 hours = R2 per machine hour
Subcomponent C R18 ÷ 12 hours = R1.50 per machine hour

Consequently, the company should manufacture subcomponent B first and then

subcomponent C. The production mix can be determined as shown in the following table:
Surplus machine hours available 3 000
Less: Machine hours used for subcomponent B (400 × 6 hours) 2 400
Machine hours available for production of subcomponent C 600
Machine hours used for the production of subcomponent C (50* × 12) 600*
Machine hours left 0

*600 ÷ 12 hours = 50 units of subcomponent C

Decision:
Subcomponent A: buy in all 200 units.
Subcomponent B: manufacture all 400 units in-house.
Subcomponent C: manufacture 50 units in-house and buy in 50 units.

Test yourself 4.3

(a) The budgeted marginal costing statements for the products are shown in the following
table:
Product Product Product Product Total (R)
line A (R) line B (R) line C (R) line D (R)
Sales 2 400 000 3 600 000 1 500 000 6 000 000 13 500 000
Less: Variable costs 2 460 000 2 850 000 1 650 000 4 050 000 11 010 000
Direct costs 1 500 000 1 950 000 900 000 3 000 000 7 350 000
S elling & admin 960 000 900 000 750 000 1 050 000 3 660 000
expenses
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Contribution (60 000) 750 000 (150 000) 1 950 000 2 490 000
Less: Fixed overheads 4 050 000
Loss for the last six months (1 560 000)

It should be noted that the overall loss remains the same. The budgeted profit statement
has merely been drafted in the marginal costing format to indicate whether or not the
product line generated a positive or negative contribution.
Decision:
Both product line A and C should be dropped, since they have a negative contribution.
By dropping these unprofitable product lines, the contribution would increase to
R2 700 000 (R750 000 + R1 950 000) and the net loss would decrease to R1 350 000
(R2 700 000 − R4 050 000).

Relevant costs and revenues for decision making

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(b) Let us now consider that 15% of the customers will purchase products from product
line A if product line C is discontinued.
Additional sales from product line C
= 225 000 (15% × 1 500 000)
Direct costs as a percentage of sales from product line A
= 62.5% (1 500 000 ÷ 2 400 000 × 100)
Gross profit product line A
= 37.5% (100 − 62.5%)
New contribution = 24 375[(R60 000) + R84 375 (225 000 × 37.5%)]
Product line A should therefore be retained, since the contribution increases from
(R60 000) to R24 375.

Test yourself 4.4

The surplus capacity can be calculated as follows:
Current capacity 2 000 bags 70%
Total capacity 2 857 * 100%
Surplus capacity 857 30%
100
*2 000 ×  ___
70 = 2 857 rounded

The special order is for 150 bags − the company therefore has sufficient capacity to meet the
special order. Using incremental analysis, the increase/decrease in profit can be calculated
as shown below:
Incremental revenue (R80 × 150) 12 000
Less: Incremental costs (R84 × 150) 12 600
Decrease in profit (600)

Decision:
The special order should not be accepted, since profits would decrease by R600.

Test yourself 4.5

(a)
Sales (5 000 x R412.50) R2 062 500
Less: Costs (5 000 x R225) 1 125 000
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Net income R937 500

(b) Yes, profit will increase by R78 000.

Increase in sales (1 000 x R225) R225 000

Less: R147 000
Increase in direct materials (1 000 x R60) (60 000)
Increase in direct labour (1 000 x R30) (30 000)
Increase in variable overheads (1 000 x R30) (36 000)
Increase in variable selling (1 000 x R90 x 0.40) (18 000)
Increase in variable administrative (1 000 x R30 x 0.60) (3 000)
expenses
Increase in profits (1 000 x R15 x 0.20) R78 000

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(c)

R’s
Direct materials 60.00
Direct labour 30.00
Variable overheads (R90 x 0.40) 36.00
Variable selling expenses (R30 x 0.60) 18.00
Variable administrative expenses (R15 x 0.20) 3.00
Relevant costs 147.00
Add required profit (R7 500 ÷ 1 000) 7.50
Minimum price R154.50

(d) What is the impact on regular customers?

Will regular customers demand a similar price?

Do we have the capacity to produce the extra units?
Will we lose some regular customers?
Will we be penetrating new markets?

Test yourself 4.6

Using incremental analysis, the increase/decrease in profit can be calculated as shown below:
A (R) B (R) C (R)
Incremental revenue from 3 600 7 500 7 200
further processing [1 200 × (7.50 − 4.50)] [3 000 × (9 − 6.50)] [1 800 × (9 − 5)]

Less: Cost of further processing 2 520 4 050 7 300

(1 200 × 2.10) (3 000 × 1.35) [(1 800 × 3.50) 11 000]

Increase or decrease in profit

from further processing 1 080 3 450 (100)

Decision:
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Products A and B should be processed further, and product C should be sold at split-off
point.

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Review questions
4.1 Define relevant costs and give examples.
4.2 Define irrelevant costs and give examples.
4.3 What is short-term decision making and how does it differ from long-term
decision making?
4.4 Explain why there are various qualitative factors that have an impact on the
decision at hand.
4.5 In a decision-making context, raw material can be treated in a number of ways.
Discuss this statement.
4.6 What are constrained resources?
4.7 A key factor decision deals with a single binding constraint. Explain.
4.8 When more than one constraint exists, how does a company determine the
optimum production mix?
4.9 What is a vertical integration decision?
4.10 In a make or buy decision, what are the relevant and irrelevant costs?
4.11 There are various non-financial factors to be considered when dropping a
product or department. Discuss this statement.
4.12 Why would a company consider special orders that are below normal selling price?
4.13 Define the terms ‘joint’ and ‘by-products’.
4.14 List and explain the methods used to allocate joint costs to joint products.
4.15 How do we treat the revenue from a by-product?
4.16 On what is a decision to process a product further or to sell it at split-off
point based?

Exercises
4.1 A company’s skilled labour force are fully employed in manufacturing one of
their products. These skilled workers are paid R80 per hour. The data pertaining
to the product is as follows:
R per unit
Selling price 600
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Less: Variable cost 350

Skilled labour 200
Others 150
Contribution 250

The company is evaluating a contract which requires 900 skilled labour hours to
complete. No other sources of skilled labour are available.
Required:
What is the total relevant skilled labour cost of the contract?
Source: ACCA (adapted)

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4.2 A company has three shops, A, B and C. The following budgeted information
relates to these shops:
Shop A Shop B Shop C Total
R'000 R'000 R'000 R'000
Sales 400 500 600 1 500
Contribution 100 60 120 280
Less: Fixed costs (60) (70) (70) (200)
Profit/loss 40 10 50 80

Sixty per cent of the total fixed costs are general company overheads. These are
apportioned to the shops based on sales value. The other fixed costs are specific
to each shop and are avoidable if the shop closes down.
Required:
If shop B closed down and the sales of the other two shops remained unchanged,
what would be the revised budgeted profit for the company?
Source: ACCA (adapted)
4.3 Your client requested assistance in deciding whether the company should
continue to manufacture or should purchase Gigets, a component of their
major product. The annual requirement for Gigets is 10 000 units and the
part is available from an outside supplier in any quantity at R5.00 per unit.
Gigets are currently manufactured in the assembly department. Machinery
used to produce Gigets could be sold for its book value of R15 000 and the
proceeds invested at 6% per year, if the Gigets were purchased. Property taxes
and insurance would decrease by R300 per year, if the machinery were sold. The
machinery has a remaining life of ten years with no estimated salvage value. In
20X2, when 10 000 Gigets were produced, the assembly department costs were
as follows:
Total costs Costs allocated to
(R) Gigets (R)
Materials 95 000 24 200
Direct labour 39 400 12 200
Indirect labour 20 600 7 800
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Heat and light 12 000 3 000

Depreciation 6 000 1 500
Property taxes and insurance 15 000 3 750
Production supplies 4 000 800

In addition, the assembly department’s total costs included R18 300 in payroll
taxes and other benefits assumed to be variable with labour costs. If Gigets
are purchased, the company will incur added expenses of R0.45 per unit
for freight and R3 000 per year for indirect labour (handling and inspecting
the product).

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Required:
(a) Advise whether the company should manufacture or buy the component
Gigets. Show all working to support your answer.
(b) What qualitative factors would have to be considered before the company
makes a final decision?
4.4 Air Limited is a small specialist manufacturer of electronic components and
much of its output is used by the makers of aircraft for both civil and military
purposes. One of the few aircraft manufacturers has offered a contract to Air
Limited for the supply, over the next 12 months, of 400 identical components.
The data relating to the production of each component is as follows:
(i) Material requirements:
3 kg material A1 – see note 1 below
2 kg material B2 – see note 2 below
1 Part No. 715 – see note 3 below
Note 1: Material A1 is in continuous use by the company. 1 000 kg are
currently held in stock at a book value of R4.70 per kg but it is known that
future purchases will cost R5.50 per kg.
Note 2: 1 200 kg of material B2 are held in stock. The original cost of this
material was R4.30 per kg but as the material has not been required for
the last two years it has been written down to R1.50 per kg scrap value.
The only foreseeable alternative use is as a substitute for material B4 (in
current use) but this would involve further processing costs of R1.60 per
kg. The current cost of material B4 is R3.60 per kg.
Note 3: It is estimated that Part No. 715 could be bought for R50 each.
(ii) Labour requirements: Each component would require 5 hours of skilled
labour and 5 hours of semi-skilled labour. An employee possessing
the necessary skills is available and is currently paid R12 per hour. A
replacement would, however, have to be obtained at a rate of R13 per
hour for the work, which would otherwise be done by the skilled employee.
The current rate for semi-skilled work is R10 per hour and an additional
employee could be appointed for this work.
(iii) Overheads: Air Limited absorbs overheads by a machine hour rate, currently
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R20 per hour of which R7 is for variable overheads and R13 for fixed
overheads. If this contract is undertaken it is estimated that fixed costs will
increase by R3 200 for the duration of the contract. Spare machine capacity
is available and each component would require 4 machine hours.
A price of R250 per component has been suggested by a company
manufacturing aircraft .
Required:
(a) State whether or not the contract should be accepted and support your
conclusion with appropriate figures for presentation to management.
(b) Comment briefly on three factors that management ought to consider and
which may influence their decision.
Source: CIMA (adapted)

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4.5 A company is currently manufacturing at only 60% of full practical capacity, in

each of its two production departments, due to a reduction in market share.
The company is seeking to launch a new product which, it is hoped, will recover
some lost sales.
The estimated direct costs of the new product, Product A, are to be established
from the following information:
Direct materials
Every 100 units of the product will require 30 kg net of Material X. Losses of
10% of materials input are to be expected.
Material X costs R5.40 per kilogram before discount. A quantity discount of 5%
is given on all purchases if the monthly purchase quantity exceeds 25 000 kg.
Other materials are expected to cost R1.34 per unit of Product A.
Direct labour (per 100 units):
Department 1: 40 hours at R12.00 per hour
Department 2: 15 hours at R13.00 per hour
Separate overhead absorption rates are established for each production
department. Department 1 overheads are absorbed at 130% of direct wages,
which is based on the expected overhead costs and usage of capacity if Product
A is launched.
The rate in Department 2 is to be established as a rate per direct labour hour
also based on expected usage of capacity. The following annual figures for
Department 2 are based on full practical capacity:
Overheads R5 424 000
Direct labour hours 2 200 000
Variable overheads in Department 1 are assessed at 40% of direct wages and in
Department 2 are R1 980 000 (at full practical capacity).
Non-production overheads are estimated as follows (per unit of Product A):
Variable R0.70
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Fixed R1.95
The selling price for Product A is expected to be R16 per unit, with annual sales
of 2 400 000 units.

Required:
(a) Determine the estimated cost per unit of Product A.
(b) Comment on the viability of Product A.
(c) Market research indicates that an alternative selling price for Product A
could be R15.50 per unit, at which price annual sales would be expected
to be 2 900 000 units. Determine, and comment briefly on, the optimum
selling price.
Source: ACCA (adapted)

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4.6 ABC Ltd manufactures a range of products which are sold to a limited number
of wholesale outlets. Four of these products are manufactured in a particular
department on common equipment. No other facilities are available for the
manufacture of these products.
Owing to greater than expected increases in demand, normal single-shift
working is rapidly becoming insufficient to meet sales requirements. Overtime
and, in the longer term, expansion of facilities are being considered.
Selling prices and product costs, based on single-shift working utilising practical
capacity to the full, are as follows:
Product (R/unit)
A B C D
Selling price 3.650 3.900 2.250 2.950
Product costs
Direct materials 0.805 0.996 0.450 0.647
Direct labour 0.604 0.651 0.405 0.509
Variable manufacturing overheads 0.240 0.217
Fixed manufacturing overheads 0.855 0.950 0.475 0.760
Variable selling and administrative overheads 0.216 0.216 0.216 0.216
Fixed selling and administrative overheads 0.365 0.390 0.225 0.295

Fixed manufacturing overheads are absorbed based on the machine hours,

which, at practical capacity, are 2 250 per period. Total fixed manufacturing
overheads per period are R427 500. Fixed selling and administration overheads,
which totals R190 000 per period, are shared among products at a rate of 10%
of sales. The sales forecast for the following period (in thousands of units) is:
Product A 190
Product B 125
Product C 144
Product D 142
Overtime could be worked to make up any production shortfall in normal time.
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Direct labour would be paid at a premium of 50% above basic rate. Other
variable costs would be expected to remain unchanged per unit of output. Fixed
costs would increase by R24 570 per period.

Required:
(a) If overtime is not worked in the following period, recommend the quantity
of each product that should be manufactured to maximise profits.
(b) Calculate the expected profit in the following period if overtime is worked
as necessary to meet sales requirements.
(c) Consider the factors which should influence the decision whether or not to
work overtime in such a situation.
Source: ACCA (adapted)

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141

4.7 Max Limited manufactures four products using the same machinery. The
following unit cost details relate to its products:
Products
A B C D
Selling price 28 30 45 42
Direct material 5 6 8 6
Direct labour 4 4 8 8
Variable overheads 3 3 6 6
Fixed overheads 8 8 16 16
Profit 8 9 7 6
Labour hours 1 1 2 2
Machine hours 4 3 4 5
Maximum demand per week (units) 200 180 250 100

Fixed overheads are absorbed on budgeted labour hours of 1 000 per week.
There is a maximum of 2 000 machine hours available per week. The marketing
director of Max Limited is concerned about the company’s inability to meet
the quantity demanded by its customers. Two alternative strategies are being
considered to overcome this problem.
Strategy 1
Increase the number of hours worked using existing machinery by working
overtime. Such overtime would be paid at a premium of 50% above normal
labour rates, and variable overhead costs would be expected to increase by the
same percentage as labour costs.
Strategy 2
Buy product B from an overseas supplier at a cost of R19 per unit including
carriage.
This would need to be re-packaged at a cost of R1 per unit before it can be sold.

Required:
(a) Determine the production plan that will maximise the weekly profit of Max
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Ltd, and prepare a profit statement showing the profit your plan will yield
without considering the marketing director’s concerns.
(b) As management accountant, you are required to evaluate each of the two
alternatives and prepare a report for the marketing director, stating your
reasons (quantitative and qualitative) as to which, if either, should be
adopted.
4.8 ABC Ltd manufactures three joint products, A, B and C, from a common
production process and then further processes each of these products before
selling them to customers. They are operating in a highly competitive market,
since there are numerous companies that manufacture and sell the same
products. The current selling prices of these products at split-off point are R8,
R6.75 and R8.25 respectively, which is in line with market prices. The monthly
common costs amount to R113 100. This includes R10 200 allocated to head

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142

office costs. The balances of the common costs are directly linked to the
common production process and can be avoided if the company chooses to
discontinue the production of the joint products. Common costs are allocated
to joint products based on the physical standard method. Output produced
from the common process is product A 6 000 litres, product B 7 500 litres, and
product C 6 750 litres.
Joint products are processed further in three separate processes where they are
converted as follows: product A to Aw; product B to Bw and product C to Cw.
The further processing costs are:
A to Aw R1.88 per litre and an extra R2 775 per month
B to Bw R2.70 per litre and an extra R1 200 per month
C to Cw R2.33 per litre and an extra R3 600 per month.
These further processing costs can be avoided if the company chooses not to
process the products further. After further processing, these products can be
sold for the following prices: product Aw: R10.13, product Bw: R11.25, and
product Cw: R10.80 per litre.

Required:
(a) Advise ABC Ltd whether any of the further processes should be continued,
and whether or not the common process should be continued.
(b) The sister company of ABC Ltd simultaneously produces three products,
X, Y and Z, from a single process. Products X and Y are processed further
before they can be sold. Product Z is a by-product that is sold at split-off
point for R70 per unit after incurring further processing costs of R10 per
unit. A regular market exists for the by-product. The sales prices of products
X and Y after further processing are R494 and R604.50 per unit, respectively.
Data for June 20X1 is as follows:
Description Amount (R)
Joint product costs that produced 3 000 units of X, 4 000 1 400 000
units of Y and 3 000 units of Z
Further processing costs for 3 000 units of X 240 000
Further processing costs for 4 000 units of Y 460 000
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Joint costs are apportioned using the physical standard method. Calculate
the total cost of product Y for June 20X1.
4.9 Dream Vacation Tours operates a number of tours in South Africa. Some of the
tours are not profitable and the company is considering dropping these tours in
order to improve the company’s overall operating performance. One such tour
is a two-day tour conducted in the northern Drakensberg. A profit statement for
a typical two-day tour is given in the following table:

Cost and Management Accounting

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143

R
Ticket sales (300 seats @ 40% occupancy × R112.50 ticket price) 13 500 100%
Less: Variable expenses (R45 per person) 5 400 40%
Contribution 8 100 60%
Less: Tour expenses 8 850
Tour promotions 1 800
Salary of bus driver 1 050
Tour guide fees 2 400
Diesel for bus 375
Depreciation: Bus 1 350
Insurance: Bus 600
Overnight parking fee: Bus 150
Room and meals for the bus driver and tour guide 225
Bus maintenance and preparation 900
Net operating loss (750)

Additional information:
1. Bus drivers are paid a fixed annual salary, while tour guides are paid for
each tour conducted.
2. The bus maintenance and preparation costs are an allocation of the salaries
of the mechanics and other service personnel who are responsible for
keeping the company’s buses in good operating condition.
3. Insurance premiums are based on the number of buses in the company’s
fleet.
4. Dropping the northern Drakensberg bus tour would not allow the company
to reduce the number of buses in its fleet, the number of bus drivers on the
payroll, or the maintenance and preparation of the buses.

Required:
(a) Prepare an analysis showing what the impact will be on the company’s
profits if this tour is discontinued, and advise the company as to whether or
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not the tour should be discontinued.

(b) List and explain the irrelevant costs for the above decision.
4.10 Superb Creation is a business that manufactures and fits various kinds of
wooden furnishings and fittings. They are based in Jacobs, Durban, and have
been in existence since 2005. They have an excellent reputation, with their
work being showcased at the Durban House and Garden Show. They have a
mini factory located in the Jacobs area where they cut and edge material and
assemble cupboards. Their market segment is commercial as well as private
homeowners. The profit generated for last year was R720 000. Profits have been
on the decline due to the economic conditions. The homeowners’ market has
had a sharp decline, with most homeowners not able to do home improvements.
Peter Curtis, the owner and manager, wants to tender for a contract for a local
school, Nlakanipha, in Richards Bay. This contract involves the revamping of

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144

the school, as well as the installation of cupboards and work tops in the school
library and science centre. It also requires the manufacture and fitting of lockers
and desks for students. The contract is estimated to take at least a year.
The types of raw materials that would have to be used for the contract are listed
in the table.
Raw materials A B C D E F
Metres in inventory 15 165 – 15 7 500 150
Required for the contract 150 150 15 30 750 450
Purchase price of inventory R66 R120 – R240 R108 R54
item per metre
Current purchase price per R180 R54 R360 R180 R120 R120
metre
Current resale value per metre R120 R60 – – R150 –

Material A, B and E are in regular use for both commercial and private work.
They can also be sold if they are not used for the contract. Materials D and F
have no other use and the inventories are obsolete.
The labour requirements for the contract are as follows: a bookkeeper/
administrative assistant, a site supervisor, and three highly skilled fitters.
Their salaries for the year are R78 000, R240 000 and R200 000 (per fitter)
respectively. These costs include fixed overheads that are apportioned at a rate
of 15% of the labour costs. Peter has already earmarked certain individuals in
the business that would take on these positions. The only new appointment
would be the bookkeeper/administrative assistant, Xolani Shange, who has
recently graduated from the Durban University of Technology with a diploma in
accounting.
The tools and equipment to be used for the contract were purchased four
years ago at a cost of R500 000. At the end of their useful life, the estimated
residual value will be R3 000. Depreciation is calculated on a straight-line basis
over its useful life. The current replacement value of the tools and equipment
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is estimated to be R750 000 and in one year’s time, this would escalate to
R775 000. In a year’s time, the tools and equipment could possibly be sold for
R4 500. These tools and equipment are only used for infrequent contract work.
Peter’s factory in Jacobs is under lease, and the lease will expire in the next three
years.
The monthly rental paid on the building is R8 000. Half of the factory space
would be used for the assembly of the cupboards for the contract. It has
been estimated that other direct expenses relating to the contract would be
R150 000.
Peter has been offered a one-year contract in New Zealand, manufacturing
designer furniture for children. He would earn $75 000 and incur personal living

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costs of $10 500. The current rand to New Zealand dollar foreign exchange
rate is R6.56 = NZ $1. If he accepts the offer, he will not be able to take on the
contract for the school. He would also have to employ a full-time manager for
his business at an annual cost of R336 000.

Required:
(a) Identify and explain all the relevant costs related to the contract.
(b) Advise Peter on the minimum price that he should charge for the contract,
in order to break even.
Where necessary round off to the nearest whole number.
4.11 WTL manufactures and sells four products, W, X, Y and Z, from a single factory.
Each of the products is manufactured in batches of 100 units using a just-
in-time manufacturing process, and consequently there is no inventory of any
product. This batch size of 100 units cannot be altered without significant cost
implications. Although the products are manufactured in batches of 100 units,
they are sold as single units at the market price. WTL has a significant number of
competitors and is forced to accept the market price for each of its products. It
is currently reviewing the profit it makes from each product and for the business
as a whole, and has produced the following statement for the latest period:

Product W X Y Z Total
Number of units sold 100 000 130 000 80 000 150 000
Machine hours 200 000 195 000 80 000 300 000 775 000
Direct labour hours 50 000 130 000 80 000 75 000 335 000

Rand W X Y Z Total
Sales 1 300 000 2 260 000 2 120 000 1 600 000 7 280 000
Direct materials 300 000 910 000 940 000 500 000 2 650 000
Direct labour 400 000 1 040 000 640 000 600 000 2 680 000
Overhead costs 400 000 390 000 160 000 600 000 1 550 000
Profit/Loss 200 000 (80 000) 380 000 (100 000) 400 000
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WTL is concerned that two of its products are making a loss, and has carried
out an analysis of its products and costs. This analysis shows the following:
● The sales of each product are completely independent of each other.
● The overhead costs have been absorbed into the above product costs using
an absorption rate of R2 per machine hour.
● Further analysis of the overhead costs show that some are caused by the
number of machine hours used, some by the number of batches produced,
and some are product-specific fixed overheads that would be avoided if the
product were discontinued. Other general fixed overhead costs would be
avoided only by the closure of the factory. Details of this analysis are as
follows:

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R’000 R’000

Machine-hour related 310

Batch related 230

Product-specific fixed overhead:

Product W 500

Product X 50

Product Y 100

Product Z 50 700

General fixed overheads 310

1 550

Required:
(a) Prepare a columnar statement that is more useful for decision making than
the profit statement prepared by WTL. Your statement should also show
the current total profit for the business.
(b) Prepare a report to the Board of WTL that:
(i) Explains why your statement is suitable for decision making
(ii) Advises WTL which, if any, of its four products should be discontinued
to maximise its company profits.
(c) Calculate the breakeven volume (in batches) for product W.
(d) Explain how WTL could use value analysis to improve its profits.

Source: CIMA (adapted)

4.12 S Ltd currently publish, print and distribute a range of catalogues and
instruction manuals. The management has now decided to discontinue printing
and distribution and concentrate solely on publishing. L Ltd will print and
distribute the range of catalogues and instruction manuals on behalf of S Ltd,
commencing either on 30 June or 30 November. L Ltd will receive R65 000 per
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month for a contract which will commence either on 30 June or 30 November.

The results of S Ltd for a typical month are as follows:

Publishing Printing Distribution

(R’000) (R’000) (R’000)
Salaries and wages 28 18 4
Materials and supplies 5.5 31 1.1
Occupancy cost 7 8.5 1.2
Depreciation 0.8 4.2 0.7

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Additional information:
1. Two specialist staff from printing will be retained at their present salary of
R1 500 each per month in order to fulfil a link function with L Ltd. One
more staff member will be transferred to publishing to fill a staff vacancy
through staff turnover, anticipated in July. This staff member will be paid
at his present salary of R1 400 per month, which is R100 more than that
of the staff member who is expected to leave. On closure, all other printing
and distribution staff will be made redundant and paid an average of two
months’ redundancy pay.
2. The printing department has a supply of materials (already paid for)
which cost R18 000 and which will be sold to L Ltd for R10 000 if closure
takes place on 30 June. Otherwise, the material will be used as part of the
July printing requirements. The distribution department has a contract
to purchase pallets at a cost of R500 per month of July and August. A
cancellation clause allows for non-delivery of the pallets for July and
August for a one-off payment of R300. Non-delivery for August only will
require a payment of R100. If the pallets are taken from the supplier, L Ltd
has agreed to purchase them at a price of R380 for each month’s supply
that is available. Pallet costs are included in the distribution material and
supplies cost stated for a typical month.
3. Company expenditure on apportioned occupancy costs to printing and
distribution will be reduced by 15% per month if printing and distribution
departments are closed. At present, 30% of printing and 25% of distribution
occupancy costs are directly attributable costs which are avoidable on
closure, while the remainder are apportioned costs.
4. Closure of the printing and distribution departments will make it possible
to sublet part of the building for a monthly fee of R2 500 when space is
available.
5. The printing plant and machinery has an estimated net book value
of R48 000 on 30 June. It is anticipated that it will be sold at a loss of
R21 000 on 30 June. If sold on 30 November, the prospective buyer will
pay R25 000.
6. The net book value of distribution vehicles on 30 June is estimated at
R80 000. They could be sold to the original supplier at R48 000 on 30
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June. The original supplier would purchase the vehicles on 30 November

for a price of R44 000.

Required:
Using the given information, prepare a summary to show whether S Ltd should
close the printing and distribution departments on financial grounds on 30 June
or on 30 November. Show explanatory notes and calculations. Ignore taxation.
Source: ACCA (adapted)

Relevant costs and revenues for decision making

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Reference list
Sedgwick, D. 2012. Production bottleneck? It’s a good thing. Automotive News [serial online]
2012; [cited 2012 Oct 26] Aug 20; 86 (6530): 28. Available from: Proquest Central.
Wait, M. 2012. Toyota plant resumes production after supplier strike. Creamer Media’s
Engineering News [serial online], [cited 2012 Nov 2] Oct 24, 2012. Available: http://
www.engineeringnews.co.za/ar ticle/toyota-plant-resumes-production-after-
supplierstrike-2012-10-24. (Accessed 18 December 2016).
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Cost and Management Accounting

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5 Linear programming

Linear programming

Linear Uses for Limitations

Assumptions and
Constraints programming linear of linear
limitations
methods programming programming

Single Multiple Graphical Simplex

constraint constraint method method

Learning objectives
After studying this chapter, you should be able to:
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● Describe situations where the use of linear programming may be appropriate

● Explain when the graphical method of linear programming can be used
● Explain how graphical linear programming can be used to find optimum output
levels for short-term product mix decisions
● Formulate a linear programming model using the simplex method
● Explain the term ‘shadow prices’ (or ‘opportunity costs’)
● Explain different uses for linear programming
● Explain the assumptions and limitations of linear programming.

Introduction
In management accounting there are always many decisions to be taken. Sometimes,
however, these decisions may have multiple variables that must be taken into account.

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A simple example is the question about what to do when there is more than one constraint
that limits production in an organisation. For that reason, mathematical tools can be very
useful to management accountants. In this chapter, the mathematical principles of linear
programming and its application in management accounting will be discussed.

Constraints
Single resource constraints
In Chapter 4 we covered basic limiting factor analysis to determine the profit-maximising
sales mix whereby a single resource constraint is present. Management accounting
information is useful when it is necessary to determine whether scarce resources are
allocated in the best possible way to ensure the most efficient and profitable manufacturing
plan. In Chapter 4 we saw that if a resource such as labour, time or materials is scarce, the
contribution per unit of scarce resource is calculated to determine which products use the
smallest amount of the scarce resource, while providing the highest profit or the lowest cost.
When faced with one limiting factor, we calculate the contribution per unit of the limiting
factor and then rank the products based on this. We allocate the scarce resource to the best
ranking product, and then the next best ranking product, and so on, until the resource is
fully utilised. For example, a manufacturer of wooden tables has a shortage of labourers
over the December holiday season. Wooden Table 1 gives a contribution of R150 per unit
and requires 6 hours of labour time. Wooden Table 2 gives a contribution of R75 per unit
and requires 2 hours of labour time. Calculating the contribution per limiting resource, we
see that Wooden Table 1 gives a R25 contribution per labour hour, while Wooden Table 2
gives a R37.50 contribution per labour hour. Clearly, it is best to manufacture as many units
of Wooden Table 2 as the number of labour hours and demand allow for.

Multiple resource constraints

When there is more than one scarce resource, it is not quite so easy to establish the optimal
usage plan. The technique mentioned above cannot be applied when there is more than one
limiting factor. In such a situation, linear programming is an effective tool to determine the
most efficient use of scarce resources. Linear programming is a mathematical technique
that is applied in cases where there is more than one constraint. It finds the best possible
way to allocate scarce resources (which can be energy, machinery, materials, funds, workers,
labour hours, etc) in order to obtain the maximum profit or to incur the minimum cost. For
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example, The Juice Man (Pty) Ltd manufactures and sells a variety of juices. The organisation
uses grape juice to sweeten two of its products. In a recent dry year, the availability of grape
juice became a problem while at the same time workers went on strike. This means that
material (grape juice) and labour hours (workers) were scarce resources. In a case such as
this, the best way to establish the optimal manufacturing plan would be to use linear
programming, which would involve construction of a mathematical model to represent the
decision at hand. The optimal manufacturing plan refers to the plan that would result in
the highest possible profit and the lowest possible cost while making the best use of scarce
resources. The linear programming model is then solved by an appropriate method, that is,
either of the following two methods:
● Graphical method, which can only be used with decision problems involving two products
● Simplex method.

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151

Assumptions of linear programming

Linear programming assumes the following:
● The relationships between the variables in a given situation are linear and there is an
optimal solution.
● The contribution per unit for each product and the usage of resources per unit are the
same, regardless of the quantity of the output manufactured and sold.
● The products and resources that are allocated are infinitely divisible, for example an
optimal plan may indicate that the optimal manufacturing plan is 56.589 units,
even though such an answer would be interpreted as 56 units, because one cannot
manufacture 0.589 units, and rounding up to the next full unit would imply another
unit being manufactured, which is untrue for the optimal manufacturing plan.
● There is one clearly defined objective function.
● Single-value estimates are used for the uncertain values.
● The situation remains static in all other respects.

Assuming all of the above holds true, a problem can be solved with the use of linear
programming.

The graphical method

The graphical method of linear programming is ideal where there are no more than two
products being manufactured in an organisation. This method is not practical where more
than two products are manufactured. Where there are more than two products, the simplex
method can be used, which will be explained later in this chapter.
The following example will be used to explain step by step how the graphical method of
linear programming works.

Illustrative example 5.1

Maskia (Pty) Ltd currently manufactures two types of specialised machinery parts. The
standard costs of the products are as follows:
Table 5.1 Information for the Xabex and the Yowek
Xabex (R) Yowek (R)
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Selling price per unit 220 Selling price per unit 236
Variable costs: 192 Variable costs: 204
Material (16 units at R4 per unit) 64 Material (8 units at R4 per unit) 32
Labour (12 hours at R10 per hour) 120 Labour (16 hours at R10 per hour) 160
ariable overhead (8 machine
V 8 Variable overhead (12 hours at 12
hours at R1 per hour) R1 per hour)
Contribution 28 Contribution 32

➤➤

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During the next financial period, the availability of resources is expected to be as follows:
Material 3 360 units
Labour 5 760 labour hours
Machine capacity 2 760 machine hours
The owner of the organisation believes that the maximum sales potential for the Xabex
is 200 units, while there is no expected sales limitation on the Yowek.

Required:
Give advice on the optimal manufacturing plan for Maskia (Pty) Ltd to make best use of
scarce resources, obtain the highest possible profit and incur the lowest cost.

Solution:
Step 1: We use linear programming to find linear relationships between variables or
factors that affect decisions. Using that information, we can establish the optimal
solution for a number of constraints. As a first step we therefore need to identify the
decision variables. In our example it will be the following:
X = number of Xabex units to manufacture
Y = number of Yowek units to manufacture.
Now we can determine the equations that will explain the problem in algebraic terms.
Since this is the graphical method, it is necessary to decide which product will be
denoted on the x-axis and which product on the y-axis. In this example, we can put
Xabex on the x-axis and Yowek on the y-axis. We are also going to denote the products
as such in the algebraic equations.
Step 2: We can assume the goal of Maskia is to maximise its contribution. When we
determine the objective function, we need to take this into account. The Xabex gives a
contribution of R28 per unit and the Yowek a contribution of R32 per unit. If the objective
of the company is to maximise its contribution, the objective function would be stated as:
C ≥ 28X + 32Y.
Step 3: After establishing the objective of the company by means of the objective function,
we can pay attention to possible constraints the company is facing. The constraints are
presented in the form of algebraic equations of the limitations in resources the company
faces and which limits its output. Maskia faces possible resource constraints in the form of
available material, labour hours and machine capacity. The availability of resources is given
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as a maximum of 3 360 units of material, 5 760 labour hours and 2 760 machine hours.
Each Xabex uses 16 units of material and each Yowek uses 8 units of material. Each Xabex
uses 12 labour hours and each Yowek uses 16 labour hours. Each Xabex uses 8 machine
hours and each Yowek uses 12 machine hours. The constraints can be stated as follows:
Material: 16X + 8Y ≤ 3 360
Labour: 12X + 16Y ≤ 5 760
Machine capacity: 8X + 12Y ≤ 2 760
Linear programming as a mathematical tool does not promise that the answer will
necessarily make sense. For example, it may happen that an answer indicates that a negative
number of a certain product should be manufactured. To prevent this from happening, a
non-negativity factor must be included in the algebraic equations to state that one cannot
manufacture and sell less than zero of a product. This will be denoted as 0 ≤ X ≤ 200,
since only 200 units of Xabex can be sold, and Y ≥ 0 because demand for Y is unlimited.

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153

Test yourself 5.1

Baden (Pty) Ltd manufactures two products, an A-Beam and a B-Beam. Details about
the products are as follows:
A-Beam (R) B-Beam (R)
Selling price per unit 270 380
Material (4 kg and 2 kg respectively at R30 per kg) (120) (60)
Labour (5 hours and 9 hours respectively at R12 per labour
hour) (60) (108)
Variable overhead (6 hours and 10 hours respectively at R2.50
per machine hour) (15) (25)
Contribution 75 187

The organisation expects the following constraints on its processes in the current
financial year:
Materials 5 000 kg
Labour hours 13 500 hours
Machine hours 15 000 hours

There is limited demand for both products. Of the A-Beam the company can sell 1 600
units and of the B-Beam 1 200 units.

Required:
Derive the algebraic equations that will be needed to determine the optimal
manufacturing plan for Baden (Pty) Ltd.

The optimal solution

An optimal solution to a linear programming problem is a feasible solution with the largest
objective function value in the case of a maximisation problem. A linear programme may
have multiple optimal solutions, but only one optimal solution value. A linear programme
is unfeasible if it has no feasible solutions, that is, the feasible region is empty. A linear
programme is unbounded if the optimal solution is unbounded, that is, it is either 1 or 21.
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Every linear programme is therefore:

● Unfeasible, or
● Unbounded, or
● A unique optimal solution value.

Finding the optimal solution

The optimal solution can be determined using a graph and supplementing the graph by
solving simultaneous equations.

Linear programming

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Illustrative example 5.1 (cont.)

Step 4: When the algebraic equations are determined, they can be presented on a graph.
All the constraints need to be plotted on a single graph, but for the sake of clarity we are
first going to observe each constraint on its own graph.

Taking the first constraint, which is materials, we need to determine the number of units
of X that can be manufactured from available materials if no units of Y are manufactured,
and also the number of units of Y that can be manufactured from available materials if
no units of X are manufactured. This can be determined by substituting a zero into the
equation for the product of which we assume no units will be manufactured. This will
look as follows:

In the equation 16X + 8Y ≤ 3 360, if Y = 0, then 16X + 8(0) ≤ 3 360.

This means the number of units of X if no units of Y are manufactured would be
3 360 ÷ 16 ≤ 210 units.

In the same equation 16X + 8Y ≤ 3 360, if X = 0, then 16(0) + 8Y ≤ 3 360.

This means the number of units of Y if no units of X are manufactured would be
3 360 ÷ 8 ≤ 420 units.

On a graph, it will be denoted as follows:

500
Quantity of Y manufactured and sold

400

300

200 16X 1 8Y ≤ 3 360

Feasible
100
production
area
0 x
100 200 300 400 500
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Quantity of X manufactured and sold

Figure 5.1 Constraint resulting from limited materials

The same will have to be done for the other constraints. For labour, it means that the
maximum number of units that can be manufactured of each product will be:
12X + 16Y ≤ 5 760
If Y = 0, then 12X + 16(0) ≤ 5 760, therefore making X ≤ 480.
If X = 0, then 12(0) + 16Y ≤ 5 760, therefore making Y ≤ 360.
➤➤

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On the graph, it will be denoted as follows:

500

Quantity of Y manufactured and sold

400

300

200 12X 1 16Y ≤ 5 760

Feasible
100 production
area

0 x
100 200 300 400 500
Quantity of X manufactured and sold
Figure 5.2 Constraint resulting from limited labour hours

For machine capacity, the maximum number of units that can be manufactured of each
product will be:
8X + 12Y ≤ 2 760
If Y = 0, then 8X + 12(0) ≤ 2 760, therefore making X ≤ 345.
If X = 0, then 8(0) + 12Y ≤ 2 760, therefore making Y ≤ 230.
On the graph it will be denoted as follows:
y

500
Quantity of Y manufactured and sold

400

300

200
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8X 1 12Y ≤ 2 760
100 Feasible
production
area
0 x
100 200 300 400 500
Quantity of X manufactured and sold
Figure 5.3 Constraint resulting from limited machine capacity

In addition, we need to show non-negativity constraints. The Y ≥ 0 is shown by not

allowing the graph to go into negative figures (stopping the graph at zero, where the
x-axis and the y-axis meet). The 0 ≤ X ≤ 200 is shown by drawing a line on the x-axis at
200 units to show that production cannot go past that amount.
➤➤

Linear programming

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If all the constraints are drawn on a single graph, it will look as follows:
y

500

Quantity of Y manufactured and sold

0 ≤ X ≤ 200
400

16X
300

18
A

Y≤
12

33
200 X1

60
8X 16
B 1 Y ≤5
100 12 76
C Y≤ 0
27
E D 60
0 x
100 200 300 400 500

Quantity of X manufactured and sold

Figure 5.4 Combination of all the constraints

The shaded area in Figure 5.4 (ABCDE) is the area within which optimal manufacturing
would take place. The contribution-maximising (optimal) manufacturing plan would be
as close as possible to a corner to the right of the shaded area.

Step 5: To find the optimal plan, choose a random contribution value that falls within
the shaded area. We do not know the maximum value of the objective function; however,
we can draw an iso-contribution (or ‘profit’) line that shows all the combinations of
X and Y that provide the same total value for the objective function. You can pick any
total contribution figure, but a multiple of 28 and 32 is easiest. Hence, the best way to
accomplish this is to choose a value that will be divisible by 28 and 32 (the contributions
from the equation C ≥ 28X + 32Y). An easy way to determine a figure to use would be
to take 28 (contribution of X) multiplied by 32 (contribution of Y) and multiplied by
5 (fixed). Let us use 4 480. Substituted into the equation, this means:
If Y = 0, 4 480 ≥ 28X + 32(0), then X ≥ 160, and
If X = 0, 4 480 ≥ 28(0) + 32Y, then Y ≥ 140.
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The fixed ‘5’ we multiply the total with is to make the values of X and Y large enough so
that they can be easily indicated on the graph. If you multiplied with 10, the values for
X and Y would have been larger than the range of values on the graph.

This means that we can draw the iso-contribution line for the equation C ≥ 28X + 32Y
on the graph as shown by the dashed line in Figure 5.5.
➤➤

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500

Quantity of Y manufactured and sold

0 ≤ X ≤ 200
400

16X
300

18
A

Y≤
12

33
200 X1

60
16
C B 8X Y≤
100 ≥2 1
12 57
8X C Y≤ 60
1 27
E 32 60
Y D
0 x
100 200 300 400 500

Quantity of X manufactured and sold

Figure 5.5 All the constraints combined, with the contribution included

The dashed line means that any combination of X and Y on that line will give a contribution
of R4 480. This dashed line can be extended until it touches the last corner of the shaded
area, which in this case would be point B. This is the optimal solution to the problem. At
this point, X is approximately 145, and Y is 135. This gives a total contribution of:
C = 28(145) + 32(135) = R8 380.

Step 6: Since a small drawing error in a graph can provide an inexact solution to the
number of units at the optimal manufacturing plan, a more accurate way would be to
solve the simultaneous equations for the constraints that are applicable at the point of the
optimal manufacturing plan. We can see that the applicable constraints at the point of
the optimal plan are materials and machine capacity. The reason for this is that point
B on the graph is where the materials and machine capacity constraint lines cross. It is
clear that labour hours is not a constraint in the feasible area of this example. Therefore:
8X + 12Y = 2 760 [1]
16X + 8Y = 3 360 [2]
Multiply equation [1] with a figure of 2 to derive equation [3]. The reason we
multiply by 2 is to get one of the variables to have the same value. In this case,
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multiplying by 2 ensures that both equations have a 16X in it, which can be
cancelled out:
16X + 24Y = 5 520 [3]
16X + 8Y = 3 360 [2]
16X cancels each other out. Now subtract equation [2] from equation [3]:
16Y = 2 160
Y = 135
Substitute the answer into equation [3]:
16X + 24(135) = 5 520
16X + 2 280
X + 142.5
This gives an exact contribution of C = 28(142) + 32(135) = R8 296. ➤➤

Linear programming

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Remember that a company cannot produce half a unit, therefore the 142.5 will have to
be rounded down to a full unit. You will not round up, because that means an additional
unit is manufactured, which will not be possible with the limited resources available.

Test yourself 5.2

Use the information from Baden (Pty) Ltd (see Test yourself 5.1) to determine the optimal
manufacturing plan both graphically and by solving the simultaneous equations for the
constraints that are applicable at the point of the optimal manufacturing plan.

Case study: Using linear programming for climate change

Ngyuen, Kojima and Tokai (2019) used linear programming models to investigate the
impact of carbon emissions from different industries on climate change.

Strategies in reducing climate change have an economic impact, often a negative one
as the technologies required to reduce carbon emissions are in many cases still very
expensive. Linear programming can be used to determine the optimal solution between
reducing carbon emissions to its lowest possible level while considering the financial
impact of the effort.

The result of their study indicated that a reduction of 20.3% in total greenhouse gas
intensity is possible and economically feasible.

Note: For quick and easy linear programming solutions, the authors used a linear solver in the
software Lingo 17. However, it is important first to understand the workings of something like linear
programming before using a software solution.
Source: Nguyen, Kojima & Tokai (2019)

Discussion question:
Discuss other areas in daily life, or in an organisation, where linear programming may be
useful to determine optimal input or output levels where there are a scarcity of resources.
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Shadow prices
If it is possible to reduce a constraint or the scarcity of a resource by paying a premium
price, it is important to determine what the maximum additional amount is that can be
paid for the extra resources. In order to answer that question, one must determine how the
optimal solution would change if an additional unit of a scarce resource is added. In the
previous example of Maskia (Pty) Ltd, it was found that the optimal solution is 142 units
of X and 135 units of Y.
If, for example, one additional machine hour is available, the equations would change
as follows:
8X + 12Y = 2 761
16X + 8Y = 3 360

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Using the algebraic method, this would result in an optimal manufacturing plan of
142.4375 units of X and 135.125 units of Y. Therefore, the planned output of X should
be decreased by 0.0625 and the planned output of Y increased by 0.125. This change in
the optimal manufacturing plan is called the marginal rate of substitution. This is the
decrease in the production of one product and the increase in the production of another as
a result of a change in the availability of a scarce resource.
The monetary value of this change in resource usage and the resulting change in the
manufacturing plan can be determined as follows:
Table 5.2 Change in contribution
R
Decrease in contribution from X (R28 × 0.0625) –1.75
Increase in contribution from Y (R32 × 0.125) 4.00
Increase in contribution 2.25

The calculation shows that R2.25 is the maximum extra amount that the organisation
should be willing to pay for an additional machine hour without reducing the current
contribution. This monetary value of an additional unit of a scarce resource is called the
opportunity cost or the shadow price. The shadow price of a resource can be found by
calculating the increase in value (usually extra contribution) which would be created by
having one additional unit of a limiting resource available at its original cost. Essentially,
this is the maximum extra amount that an organisation should be willing to pay for an
additional unit of a scarce resource without reducing the current contribution it can earn.
Non-critical constraints will have zero shadow prices as slack exists already.

Calculating shadow prices

The simplest way to calculate shadow prices for a critical constraint is as follows:
Step 1: Take the equations of the straight lines that intersect at the optimal point. Add one
unit to the constraint concerned, while leaving the other critical constraint
unchanged.
Step 2: Use simultaneous equations to derive a new optimal solution.
Step 3: Calculate the revised optimal contribution. The increase is the shadow price for the
constraint under consideration.
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If, for example, the organisation in our example can obtain extra machine hours at a price
of R3.00 per unit, they should get the extra capacity. The increase in the price of machine
hours is less (R3.00 − R1.00 = R2.00) than the extra contribution that can be earned (R2.25).

Implications of shadow prices

Management can use shadow prices as a measure of the maximum premium that they
would be willing to pay for one more unit of the scarce resource. However, the shadow price
should be considered carefully. For example, the shadow price of material may be calculated
as R100 per kg. However, it may be possible to negotiate a lower shadow price than this.
In addition, if more of the critical constraint is obtained, the constraint line will move
outwards, altering the shape of the feasible region. After a certain point, there will be
little point in buying more of the scarce resource since any non-critical constraints will
become critical.

Linear programming

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Test yourself 5.3

Use the information from Baden (Pty) Ltd once again. Determine the opportunity
cost if the organisation can obtain additional machine hours at a premium price. If
the additional machine hours will cost the organisation R12.80 per hour, should they
obtain it or not?

Slack
Slack is the amount by which a resource is underutilised. It will occur when the optimum
point does not fall on a given resource line. Slack is important because unused resources
can be put to another use, for example hired out to another manufacturer. As illustrated
in the next section, slack variables are added to all the equations in a linear programming
model to compensate for resources that may still be unused at the optimum manufacturing
plan. Slack variables are added to compensate for any constraint that may be unused at the
optimum manufacturing level; therefore, one slack variable is introduced for each constraint.

The simplex method

When more than two products are manufactured from scarce resources, the graphical
method is not useful. An alternative method that solves this problem is called the simplex
method. This method of linear programming is of use when more than one product
makes use of a scarce resource. In addition, it can provide information such as marginal
rates of substitution and opportunity cost, which makes it useful for decision-making
purposes. The simplex method is of particular use because it is able to consider more
complex problems involving more than two output variables. This method is carried out
by a computer which provides the optimal solution and also a sensitivity analysis of the
data. There are spreadsheet packages available that make the simplex method easy to use.
However, as we need to know how the answer is ultimately derived, the entire process will be
explained in the section that follows. The simplex method calculations involve a significant
number of fractions. You can use either fractions or decimal figures, but note that rounding
errors may occur if decimals are rounded off. In the example that follows, fractions are used.

Illustrative example 5.2

The simplex method will be explained using the information from the previous illustrative
example of Maskia (Pty) Ltd.

To apply the simplex method, we must formulate a model that does not allow for any
inequalities. Therefore, we introduce slack variables into similar equations as were
formulated earlier. In the solution that follows, slack variables are added to all the
equations in the linear programming model to compensate for resources that may
still be unused at the optimum manufacturing plan. Therefore, one slack variable is
introduced for each constraint as indicated by S1, S2, S3 and S4.
➤➤

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Solution:
In our example, the equations will be as follows:
C = 28X + 32Y

Subject to:
16X + 8Y + S1 = 3 360 (materials constraint)
12X + 16Y + S2 = 5 760 (labour constraint)
8X + 12Y + S3 = 2 760 (machine capacity constraint)
1X + S4 = 200 (constraint on demand for product X).

In the case of materials, for example, we say with the equation that the optimum
manufacturing level is reached at [(16 x X) + (8 x Y) + (left-over materials)] = 3 360 units
of material.

Now the equations can be expressed in the form of a first matrix as given in Table 5.3.
Table 5.3 The first-level simplex matrix
Quantity X Y Description
S1 = 3 360 −16 −8 Materials constraint
S2 = 5 760 −12 −16 Labour constraint
S3 = 2 760 −8 −12 Machine capacity constraint
S4 = 200 −1 0 Demand constraint
C=0 28 32 Contribution

The matrix can be interpreted as follows: The quantity column indicates the slack that
is available at a manufacturing level of zero. Therefore, there are 3 360 units of material
available when no units are manufactured. Column X indicates what is necessary from
all the resources in order to manufacture one unit of X, which will lead to a contribution
of R28 per unit of X. The same applies to the column for Y. C is zero, because at a
manufacturing level of zero, no contribution will be earned.

Now X and Y need to be eliminated from the matrix in order to determine the optimal
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mix. Let us prepare a second matrix in which we eliminate Y. We eliminate Y first, since
it is the product delivering the highest contribution, and therefore we would like to see
how many units of that product can be manufactured first. Machine capacity limits the
manufacture of Y the most, with only 230 units that can be manufactured with the given
amount of 3 360 units of materials.
Therefore, S3 = 2 760 − 8X − 12Y
becomes 12Y = 2 760 − 8X − S3
2 1
and thus becomes Y = 230 − __  3 X − ___
  12 S3.
➤➤

Linear programming

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This value for Y can now be substituted into the rest of the equations:
 23 X − ___
S1 = 3 360 − 16X − 8(230 − __ 1
  12 S3)
1 2
S1 = 3 360 − 16X − 1 840 + 5 __ __
3 X +   3 S3
2 2
S1 = 1 520 − 10 __ __
3 X +  3 S3
 23 X − ___
S2 = 5 760 − 12X − 16(230 − __ 1
  12 S3)
2 1
S2 = 5 760 − 12X − 3 680 + 10 __ __
3 X + 1  3 S3
1 1
S2 = 2 080 − 1 __ __
3 X + 1  3 S3

 23 X − ___
C = 28X + 32(230 − __ 1
  12 S3)
1 2
C = 28X + 7 360 − 21 __ __
3 X − 2  3 S3
2 2
C = 7 360 + 6 __ __
3 X − 2  3 S3
Now the equations can be expressed in the form of a second matrix as given in Table 5.4.
Table 5.4 The second-level simplex matrix
Quantity X S3 Description
X 5 230 − __23 1
− ___
12
S1 5 1 520 −10 __23 +__  23 Material constraint

S2 5 2 080 −1 13 +1 13 Labour constraint

S4 5 200 −1 0 Demand constraint

C 5 7 360 +6 23 −2 23 Contribution

The same procedure can be followed to eliminate X from the equations. X is next in line,
because it is now the only product that delivers a positive contribution. However, we
first need to establish which resource is putting the biggest constraint on X. This can
be determined by taking the quantity in the first column and dividing it by the negative
values in the column for X. This will show us how many units of X can be manufactured
from each scarce resource. Therefore:
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2
Material: 1 520 ÷ 10 __
3 = 142.5
1
Labour: 2 080 ÷ 1 __
3 = 1 560
 200
Demand for X: ___1 = 200

The constraint that limits the manufacturing of X the most is material. Therefore, we will
use the equation for S1 first.
2 __ 2
S1 = 1 520 − 10 __
3 X +   3 S3
2 2
10 __ __
3 X = 1 520 − S1 +   3 S3
3 1
X = 142.5 − ___
 32 S1 + ___
  16 S3
➤➤

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163

Substitute the value for X into the rest of the equations:

3 1
 23 (142.5 −  ___
Y = 230 − __ ___ ___1
32 S1 +   16 S3) −  12 S3
1 1 1
Y = 230 − 95 + ___
  16 S1 − ___
  24 S3 − ___
  12 S3
1 3
Y = 135 +  ___ ___
16 S1 −   24 S3
1 3 ___ 1 1
S2 = 2 080 − 1 __ ___ __
3 (142.5 −   32 S1 +   16 S3) + 1 3 S3
 18 S1 − ___
S2 = 2 080 − 190 + __ 1
  12 1
S3 + 1 __
3 S3
 18 S1 + 1 __
S2 = 1 890 + __ 1
4 S3
3 1
S4 = 200 − 142.5 +  ___ ___
32 S1 −   16 S3
3 1
S4 = 57.5 +  ___ ___
32 S1 −   16 S3
2 3 ___ 1 2
C = 7 360 + 6 __ ___ __
3 (142.5 −   32 S1 +   16 S3) − 2 3 S3
5
 58 S1 + ___
C = 7 360 + 950 − __ 2
  12 S3 − 2 __
3 S3
 58 S1 − 2 __
C = 8 310 − __ 1
4 S3
Now the equations can be expressed in the form of a final matrix as given in Table 5.5.
Table 5.5 The final simplex matrix
Quantity S1 S3 Description

X 5 142.5 − ___
3 +___
  1
32 16

Y 5 135 + ___
1 −___
  3
16 24

S2 = 1 890 + 1 +1 14 Labour constraint

S4 5 57.5 + ___
3 −___
  1 Demand constraint
32 16

C 5 8 310 − 5 −2 14 Contribution

Since the contribution row only contains negative items, it means that the optimal
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solution has been found. The quantity column shows how many units of each item
should be manufactured in order to reach the optimum contribution of R8 310. This
is the same as the result obtained in the graphical method. If an equation for a slack
variable remains in the matrix, it means that there will be some unused resources at the
optimal manufacturing plan. There will therefore be 1 890 unused labour hours, and
57.5 units of Y will remain unsold. The lack of equations for S1 and S3 indicates that
there will not be anything left of those resources.

Linear programming

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Test yourself 5.4

Use the information from Baden (Pty) Ltd and determine the optimal manufacturing
plan using the simplex method.

Different uses for linear programming

Relevant cost calculations
In Chapter 4 the importance of relevant cost calculations in decision making was explained
and illustrated. When a resource is scarce, there are usually alternative uses for the resource
and therefore an opportunity cost is incurred by using the resource for a certain purpose
instead of another. The relevant cost for a scarce resource is thus the total of the cost of the
resource, and the opportunity cost for using it for one purpose instead of another. We have
seen that linear programming can be used in a case where there is more than one scarce
resource. The opportunity costs can be determined from the calculations of the marginal
rate of substitution and also from the last row in the final matrix when the simplex method
is used.

Selling different products

If an organisation is considering selling a modified version of a product, the question
will surely arise as to whether the product should be modified and manufactured or not.
Normal accounting information does not provide the information that is necessary to
make such a decision. The restrictions to output of other products need to be considered,
and also the opportunity cost for using scarce resources on the new product. In this case,
linear programming can be used to determine a solution while taking all available variables
into account.

Maximum payment for scarce resources

Opportunity cost calculations can indicate the maximum price at which additional
resources should be obtained, if they are available, without causing a negative effect on the
contribution. This has been explained in the section on the marginal rate of substitution.
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Control
Opportunity cost information is useful where cost control needs to be considered. Where
processes are not functioning efficiently, information on opportunity costs can be used
to explain to managers and staff how much the inefficiency is costing the organisation. It
highlights the true cost of inefficient usage of resources, and also focuses attention on the
control of scarce resources.

Capital budgeting
Linear programming can be a useful tool in determining the optimal investment plan where
there is limited capital available for investments.

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Sensitivity analysis
Once the optimum solution to the graphical linear programming problem is found, it is
possible to provide further information from the interpretation of the graph to determine
what would happen if certain values in the scenario were to change. Sensitivity analysis with
linear programming can be carried out by considering the value of each limiting factor.
Constraints are not normally permanent, and therefore opportunity costs can also not be
considered as permanent. A range needs to be determined over which opportunity costs
would apply for each resource. This can be obtained from the final matrix when the simplex
method is used.
For the lower limit by which a resource can be reduced, take all the negative values in
the slack variable column, and for those, divide them into the corresponding value in the
quantity column. If there is more than one, take the highest value to determine the lower
limit. The same applies for the upper limit, except that the positive values in the slack
variable column are divided into the value in the quantity column and the lowest value
chosen to determine the upper limit. For example, we can use the final matrix from our
previous example to determine the upper and lower limits for materials.
3
The lower limit of materials can be determined by X 5 142.5 ÷ (2 __ 32 ) 5 −1 520. There
is only one negative value, so we need only do the one calculation. Since the availability of
materials was given as 3 360 units, the lower limit is therefore 3 360 − 1 520 = 1 840 units.
The upper limit is determined in the same way, by dividing the quantity by the relevant
items in the column for S1. There is more than one positive value, so we need to do the
calculation for all of them and take the lowest one to determine the limit.
  1
Y = 135 ÷ ___
16 = 2 160
1
S2 = 1 890 ÷ __
8  = 15 120
3
S4 = 57.5 ÷ ___
32 = 613.3
The upper limit will therefore be 3 360 + 613.3 = 3 973.3.
The range within which the marginal rate of substitution and opportunity cost applies is
therefore between 1 840 and 3 973.3 units.

Limitations of linear programming

In reality, objective functions and constraints cannot always be expressed in linear form − it
is an assumption that one makes. The following limitations of linear programming have
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been identified:
● In a linear programming problem, fractional values are permitted for the decision
variables. However, many decision problems require that the decision variables be
obtained in non-fractional (integer) values.
● The coefficient of basic variables cannot be determined with certainty, but only with
probability.
● Where a problem consists of multiple objectives, linear programming cannot provide
a solution. Linear programming does not take into account the effect of time and
uncertainty.
● Parameters appearing in a linear programming model are assumed to be constant, but
in real-life situations they are frequently neither known nor constant.
● In case of large, complex and constrained problems, calculating the problems can be a
huge task.

Linear programming

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Summary
In any organisation, decision making is a daily activity of great importance to ensure that
all operations run efficiently. When there is only one scarce resource, it is easy to determine
the optimal number of units of products that need to be manufactured by calculating a
contribution per scarce resource. However, where there is more than one scarce resource,
such a simple calculation will not suffice. In such a case, linear programming is a useful
means of establishing the optimal manufacturing plan. Linear programming establishes
equations for all scarce resources and those are solved by either plotting them on a graph or
by means of matrices in the simplex method.

Key concepts
Graphical method is a method of linear programming that can be used to determine the
optimal manufacturing plan if there are no more than two products being manufactured.
Linear programming is a mathematical technique that is applied in cases where there
is more than one constraint. It finds the best possible way to allocate scarce resources
(which can be energy, machinery, materials, funds, workers, labour hours, etc) in order
to obtain the maximum profit or to incur the minimum cost.
Marginal rate of substitution is the decrease in the production of one product and the
increase in the production of another as the result of a change in the availability of a
scarce resource.
Opportunity cost or shadow price is the maximum extra amount that an organisation
should be ready to pay for an additional unit of a scarce resource without reducing the
current contribution it is able to earn.
Optimal manufacturing plan is the manufacturing plan that would result in the highest
possible profit and the lowest possible cost while making the best use of scarce resources.
Simplex method is a method of linear programming that is used when there is more than
one product using a scarce resource. In addition, it can provide information such as
marginal rates of substitution and opportunity cost, which makes it useful for decision-
making purposes.
Slack variables are variables that are added to all the equations in a linear programming
model to compensate for resources that may still be unused at the optimum man-
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ufacturing plan.

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Test-yourself solutions
Test yourself 5.1
The equations:
Stating the A-Beam = X and the B-Beam = Y,
then:
C ≥ 75X + 187Y
4X + 2Y ≤ 5 000
5X + 9Y ≤ 13 500
6X + 10Y ≤ 15 000
0 ≤ X ≤ 1 600
0 ≤ Y ≤ 1 200

Test yourself 5.2

Drawing the graph:
We first need to establish the maximum number of units of each product that can be
manufactured under each scarce resource.
In equation 4X + 2Y ≤ 5 000 we see that 1 250 units of X or 2 500 units of Y can be
manufactured.
In equation 5X + 9Y ≤ 13 500 we see that 2 700 units of X or 1 500 units of Y can be
manufactured.
In equation 6X + 10Y ≤ 15 000 we see that 2 500 units of X or 1 500 units of Y can be
manufactured.
For the contribution line, first multiply the contribution of each product, and then multiply
by 5: 75 × 187 × 5 = 70 125. This gives a value for X of 935, and a value for Y of 375. On this
basis the contribution line can be drawn.
The linear programming graph for Baden (Pty) Ltd can therefore be drawn as follows:
y
0 ≤ X ≤ 1 600
2 500
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Quantity of Y manufactured and sold

2 000 4X 1 2Y ≤ 5 000

1 500
0 ≤ Y ≤ 1 200
A
B
1 000 C

500 6X 5X 1 9Y ≤ 13 500
1 10Y
C ≥ 75X 1 187Y ≤15
E D 000
0 x
500 1 000 1 500 2 000 2 500
Quantity of X manufactured and sold

Linear programming

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From the graph, we can see that the solution lies at one of the points ABCDE. Spreading the
contribution line, it is clear that the optimal solution lies at point B. At this point, the values
of (X; Y) are (500; 1 200).

We can also solve simultaneous equations to provide an accurate solution to the one derived
from the graph. We need to solve the equations of the lines that cross at point B.
6X + 10Y = 15 000
Y = 1 200

Therefore, substituting Y = 1 200 into the first equation gives:

6X + 10(1 200) = 15 000
6X = 3 000
X = 500

Test yourself 5.3

To solve the marginal rate of substitution and the opportunity cost, simply add 1 to the
equation at the optimal solution. According to the graph, Y = 1 200. Because it is a demand
limitation, obtaining additional resources is not going to help increase the contribution from
this product. However, obtaining additional machine hours can increase the contribution
from product X.
6X + 10Y = 15 001
6X + 10 (1 200) = 15 001
6X = 3 001
X = 500.167

Increase in contribution from X (R75 × 0.167): R12.50.

The opportunity cost of an additional machine hour is thus R12.50.

If the organisation is able to obtain extra machine hours at a rate of R12.80 per hour, they
should buy the extra machine hours, since the increase in the rate of the machine hours is
less (R12.80 − R12.00 = R0.80) than the extra contribution that can be earned (R12.50).

Test yourself 5.4

The equations that we are going to use in the simplex method are the following:
C = 75X + 187Y
For material: 4X + 2Y + S1 = 5 000
For labour hours: 5X + 9Y + S2 = 13 500
For machine hours: 6X + 10Y + S3 = 15 000
For the demand for X: X + S4 = 1 600
For the demand for Y: Y + S5 = 1 200

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The first-level simplex matrix is given in the table below.

Quantity X Y Description
S1 5 5 000 −4 −2 Materials constraint
S2 5 13 500 −5 −9 Labour hours constraint
S3 5 15 000 −6 −10 Machine hours constraint
S4 5 1 600 −1 0 Demand constraint
S5 5 1 200 0 −1 Demand constraint
C50 75 187 Contribution

Y delivers the biggest contribution and is therefore the first product that will be chosen to be
produced (and eliminated from the equations). The biggest limitation on the production of
Y is the demand for it, which is only 1 200 units.

S5 = 1 200 − Y
Therefore, Y = 1 200 − S5

Substitute Y into all the other equations as follows:

S1 = 5 000 − 4X − 2 (1 200 − S5)
S1 = 5 000 − 4X − 2 400 + 2S5
S1 = 2 600 − 4X + 2S5
S2 = 13 500 − 5X − 9 (1 200 − S5)
S2 = 13 500 − 5X − 10 800 + 9S5
S2 = 2 700 − 5X + 9S5
S3 = 15 000 − 6x − 10 (1 200 − S5)
S3 = 15 000 − 6x − 12 000 + 10S5
S3 = 3 000 − 6x + 10S5
S4 = 1 600 − X

C = 75X + 187(1 200 − S5)

C = 75X + 224 400 − 187S5
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C = 224 400 + 75X − 187S5

The second-level simplex matrix is given in the table below.

Quantity X S5 Description
Y = 1 200 0 −1
S1 = 2 600 −4 2 Material constraint
S2 = 2 700 −5 9 Labour hours constraint
S3 = 3 000 −6 10 Machine hours constraint
S4 = 1 600 −1 0 Demand constraint
C = 224 400 75 −187 Contribution

Linear programming

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X is now the only product with a positive contribution. The biggest limitation for X needs to
be determined.
2 600
For material:  _____
4 = 650
2 700
For labour hours:  _____
5 = 540
3 000
For machine hours:  _____
6 = 500
1 600
For demand:  _____
1 = 1 600
Machine hours appear to be the biggest constraint and are therefore our starting point.
S3 = 3 000 − 6x +10S5
6X = 3 000 − S3 +10S5
 16 S3 + 1 __
X = 500 − __ 2
3 S5
Y = 1 200 − S5
 16 S3 + 1 __
S1 = 2 600 − 4 (500 − __ 2
3 S5)
2 2
S1 = 2 600 − 2 000 +  __ __
3 S3 − 6 3 S5
 23 S3 − 6 __
S1 = 600 + __ 2
3 S5
 16 S3 + 1 __
S2 = 2 700 − 5 (500 − __ 2
3 S5)
5 1
S2 = 2 700 − 2 500 +  __ __
6 S3 − 8 3 S5
 56 S3 − 8 __
S2 = 200 + __ 1
3 S5
 16 S3 − 1 __
S4 = 1 600 − 500 + __ 2
3 S5
1 2
S4 = 1 100 +  __ __
6 S3 − 1 3 S5

 16 S3 + 1 __

C = 224 400 + 75 (500 − __ 2
3 S5) − 1 87S5
1
C = 224 400 + 37 500 − 12 __
2 S3 + 1 25S5 − 1 87S5
1
C = 261 900 − 12 __
2 S3 − 62S5

The final-level simplex matrix is given in the table:

Quantity S1 S3 Description
X = 1 200 0 −1
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Y = 500 −  16 +1 23

S1 = 600 +__  23 −6 __23 Material constraint

S2 = 200 +  56 −8 13 Labour hours constraint

S4 = 1 100 +  16 −1 23 Demand constraint

C = 261 900 −12 __12 −62 Contribution

Both contributions are negative, indicating that the optimal solution has been reached.
There will be no unused machine hours and all 1 200 units of Y that demand allows for can
be manufactured and will be sold. For those slack variables with equations, there will be
some unused resources left at the end of the optimal manufacturing plan.

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Review questions
5.1 In which situations will the use of linear programming be appropriate?
5.2 When can the graphical method of linear programming be used?
5.3 How is graphical linear programming used to find optimum output levels for
short-term product-mix decisions?
5.4 What is a shadow price or opportunity cost in the context of linear programming?
5.5 Name the different uses for linear programming.
5.6 Name and discuss the assumptions and limitations of linear programming.
5.7 Explain what the marginal rate of substitution is.
5.8 What is a slack variable in terms of linear programming?

Exercises
5.1 Juicy (Pty) Ltd is a small company that produces two types of fruit juice. After
a long drought, production is limited by scarce resources of apple juice, grape
juice and orange juice. To make Active-C Juice, 5 litres of apple juice, 4 litres
of grape juice and 35 litres of orange juice are required, amongst some other
ingredients. To make Festive Juice, 15 litres of apple juice, 4 litres of grape juice
and 20 litres of orange juice are required, amongst some other flavourants.
Suppose that only 480 litres of apple juice, 160 litres grape juice and 1 190 litres
orange juice are available.
The company makes a contribution of R13 for each litre of Active-C Juice and
R23 for each litre of Festive Juice.

Required:
(a) Determine the algebraic equations to establish how much Active-C and
Festive Juice the company should produce to maximise profit?
(b) Determine the optimal manufacturing plan both graphically and by solving
the simultaneous equations for the constraints that are applicable at the
point of the optimal manufacturing plan.
(c) Determine the opportunity cost if the organisation can obtain additional
apple juice at a premium price of R5.80 per litre. Should they obtain it or
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not? Explain what a shadow price is.

5.2 Part A
CSC Co is a health food company producing and selling three types of high-
energy products (cakes, shakes and cookies) to gyms and health food shops.
Shakes are the newest of the three products and were first launched three
months ago. Each of the three products has two special ingredients, sourced
from a remote part of the world. The first of these, Singa, is a super-energising
rare type of caffeine. The second, Betta, is derived from an unusual plant
believed to have miraculous health benefits.

Linear programming

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CSC Co’s projected manufacture costs and selling prices for the three products
are as follows:
Cakes Cookies Shakes
$ $ $
Per unit 5.40 4.90 6.00
Selling price
Costs:
Ingredients: Singa ($1.20 per gram) 0.30 0.60 1.20
Ingredients: Betta ($1.50 per gram) 0.75 0.30 1.50
Other ingredients 0.25 0.45 0.90
Labour ($10 per hour) 1.00 1.20 0.80
Variable overheads 0.50 0.60 0.40
Contribution 2.60 1.75 1.20

For each of the three products, the expected demand for the next month is 11 200
cakes, 9 800 cookies and 2 500 shakes.
The total fixed costs for the next month are $3 000.
CSC Co has just found out that the supply of Betta is going to be limited to
12 000 grams next month. Prior to this, CSC Co had signed a contract with a
leading chain of gyms, Encompass Health, to supply it with 5 000 shakes each
month, at a discounted price of $5.80 per shake, starting immediately. The
order for the 5 000 shakes is not included in the expected demand levels above.

Required:
(a) Assuming that CSC Co keeps to its agreement with Encompass Health,
calculate the shortage of Betta, the resulting optimum production plan and
the total profit for next month.
Part B
One month later, the supply of Betta is still limited and CSC Co is considering
whether it should breach its contract with Encompass Health so that it can
optimise its profits.
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Required:
(a) Discuss whether CSC Co should breach the agreement with Encompass
Health. No further calculations are required.
Part C
Several months later, the demand for both cakes and cookies has increased
significantly to 20 000 and 15 000 units per month respectively. However, CSC
Co has lost the contract with Encompass Health and, after suffering from further
shortages of supply of Betta, Singa and of its labour force, CSC Co has decided
to stop making shakes at all. CSC Co now needs to use linear programming to
work out the optimum production plan for cakes and cookies for the coming
month. The variable ‘x’ is being used to represent cakes and the variable ‘y’ to
represent cookies.

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The following constraints have been formulated and a graph representing the
new production problem has been drawn:
Singa: 0.25x + 0.5y ≤ 12 000
Betta: 0.5x + 0.2y ≤ 12 500
Labour: 0.1x + 0.12y ≤ 3 000
x ≤ 20 000
y ≤ 15 000
x, y ≥ 0

80 000

70 000
Demand for cakes

60 000
Be
tta

50 000
Cookies

40 000

30 000

20 000 Demand for cookies

A
C= B
10 000 2.6 Lab
x C our Sing
+1 a
.75 D
0 y
0 10 000 20 000 30 000 40 000 50 000 60 000 70 000
Cakes
Required:
(a) Explain what the line labelled ‘C = 2.6x + 1.75y’ on the graph is and what
the area represented by the points 0ABCD means.
(b) Explain how the optimum production plan will be found using the line
labelled ‘C = 2.6x + 1.75y’ and identify the optimum point from the graph.
(c) Explain what a slack value is and identify, from the graph, where slack will
occur as a result of the optimum production plan. No calculations are
needed for part.
Source: ACCA (adapted)
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5.3 Buffro (Pty) Ltd manufactures two types of cooler bags, the Cool and the Ice.
Information about the bags is given in the following table.
Cool Ice
Selling price per unit R200 R210
Variable cost per unit 88 80
Material (R2.50; 8kg and 10 kg respectively) 20 25
Labour (R4.00; 10 hours and 5 hours respectively) 40 20
Variable overhead (R7.00; 4 hours and 5 hours 28 35
respectively)
Contribution per unit 112 130
Maximum demand 350 units 350 units

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Limitations of resources are as follows:

Material 31 000 kg
Labour 20 000 labour hours
Variable overheads 17 500 machine hours
The maximum demand is 1 000 units of the Cool and 3 000 units of the Ice.
Required:
Prepare a linear programming solution for the limited resources of Buffro (Pty)
Ltd using:
(a) The graphical method with simultaneous equations
(b) The simplex method.

5.4 The owner of The Juice Man (Pty) Ltd supplied you with the information given
in the table below about the standard cost per litre of juice.
Orange juice Fruit cocktail juice
Selling price per litre R20 Selling price per litre R25
Standard costs Standard costs
Material: Orange pulp R5 Material: Mixed fruit pulp R8
(500 ml at R10 per litre) (500 ml at R16 per litre)
Material: Diluted grape juice R2 Material: Diluted grape juice R2
(500 ml at R4 per litre) (500 ml at R8 per litre)
Labour R6 Labour R12
(0.5 hour at R12 per hour) (1 hour at R12 per hour)
Variable overheads R1 Variable overheads R2
(0.5 hour at R2 per hour) (1 hour at R2 per hour)
Contribution R6 Contribution R1

Due to a dry season resulting in a limited availability of fruit and a workers’

strike, the limitations of resources are as follows:
Diluted grape juice 12 000 litres
Labour hours 15 000 hours
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There is no limit to the demand for the organisation’s products.

Required:
Prepare a linear programming solution for the limited resources of The Juice
Man (Pty) Ltd, using the graphical method with simultaneous equations.
5.5 The following scenario relates to questions 5.5.1 to 5.5.5.
Cara Co makes two products, the Seebach and the Herdorf. To make a unit of
each product the following resources are required:
Seebach Herdorf
Materials (R100 per kg) 5 kg 7 kg
Labour hours (R45 per hour) 2 hours 3 hours
Machine hours (R60 per hour) 3 hours 2 hours

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175

Fixed overheads are R300 000 each month.

The contribution per unit made on each product is as follows:

Seebach Herdorf
Contribution (R per unit) 250 315

The maximum demand each month is 4 000 units of Seebach and 3 000 units
of Herdorf. The products and materials are perishable and inventories of raw
materials or finished goods cannot be stored.
Cara Co has a legally binding obligation to produce a minimum of 2 000 units of
Herdorf in each of months 1 and 2. There is no minimum production required
in month 3.
The manufacturing manager is planning production volumes and the maximum
availability of resources for months 1, 2 and 3 are as follows:

Month 1 2 3
Materials (kg) 34 000 42 000 35 000
Labour (hours) 18 000 12 000 24 000
Machine (hours) 18 000 19 000 12 000

For month 3 the following linear programming graph has been produced:

10 000
Herdorf (H)

S = 4 000

8 000

6 000
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4 000

H = 3 000
3S
+

2 000
25

5S 2S
+3
0S

+7
=1

H H
+

=3 =2
31

50 40
5H

00
00

00
0
0 2 000 4 000 6 000 8 000 10 000 12 000 14 000
Seebach (S)
Source: ACCA (adapted)

Linear programming

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176

5.5.1 What is/are the limiting factor(s) in month 1?

(a) Materials, labour hours and machine hours
(b) Materials and machine hours only
(c) Materials only
(d) Labour hours only

5.5.2 The production manager has identified that the only limiting factor in month 2
is labour hours. What is the production volume for Herdorf for month 2 (to the
nearest whole unit)?
(a) 0
(b) 1 333
(c) 2 000
(d) 3 000

5.5.3 If the shadow price for month 2 is R125 per labour hour, which of the following
statements is/are correct?
1. The production manager would be willing to pay existing staff a maximum
overtime premium of R125 per hour for the next 2 000 hours.
2. The production manager would be willing to pay a maximum of R170 per
hour for an additional 2 000 hours of temporary staff time.
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

5.5.4 What is the maximum profit which can be earned in month 3?

(a) R1 080 000
(b) R1 380 000
(c) R1 445 000
(d) R1 145 000

5.5.5 Which of the following interpretations of the linear programming graph

produced for month 3 is/are correct?
1. Even if demand for either product increases, labour will be a slack variable
if no other resources change.
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2. If more machine hours were made available in month 3, they would be used
initially to make Herdorfs.
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

5.6 The Pottery Store manufactures two types of artisan mug from clay. The
contribution for Mug 1 is R40 and for Mug 2 R50.
Labour hours are limited to 40 hours per week and clay to 120 units. Mug 1
uses 4 units of clay and 1 hour of labour and Mug 2 uses 3 units of clay and 2
hours of labour. There is unlimited demand for both mugs.

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177

Required:
Use the simplex method to find the optimal production plan.
5.7 A farmer has 800 hectares available for planting soya beans and sunflowers.
He must plant at least 100 hectares of soya and 200 hectares of sunflowers
to meet demand. He prefers to plant more sunflowers than soya, but his work
force and equipment will only allow him to cultivate a maximum of three times
the quantity of sunflowers as soya beans.
The profit on soya is R400 per hectare and on sunflowers R250 per hectare.

Required:
Use linear programming to indicate how many hectares of soya and sunflowers
the farmer should plant to make a maximum profit. Also indicate what this
profit will be.
5.8 GRT (Pty) Ltd manufactures two products, and the raw materials go through
two processes in the production process. The one product is called the Basic,
and the other the Superior. The information available is given in the table below.

Basic Superior
Maximum sales potential 12 000 20 000
Selling price R80 R100
Machine time:
Process 1 0.5 0.3
Process 2 0.4 0.6

Process 1 and Process 2 have maximum available hours of 6 800 and 7 680
respectively. The processes are used for the sole purpose of manufacturing the
two products mentioned above.
The maximum available material is 15 600 kg. Each product requires 1 kg of
material. The material is purchased at R12 per kg. Variable machine overheads
are estimated at R15 per machine hour for Process 1, and R18 per machine
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hour for Process 2.

All units are sold in the year in which they are produced.
There is no limit to the number of units of each product that can be sold.

Required:
(a) Use a linear programming graph and simultaneous equations to determine
the optimal production plan for the two products, the Basic and the
Superior.
(b) Determine the shadow price for one additional kilogram of material.

Linear programming

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178

5.9 YRT Ltd wants to maximise the profits on its products, A and B. The contribution
margin for each product is given in the following table.

Product Contribution
A R2
B R5

The production requirements and departmental capacities, by departments,

are given in the following table.

Department Hourly production Departmental

requirement per product capacity (total
hours)
A B
Assembly 3 4 30 000
Paint 2 3 25 000
Finish 2 4 28 000

Required:
(a) Define and discuss the linear programming technique, including assump-
tions of linear programming and accounting data used.
(b) Solve the linear programming problem above by using the graphical
approach, and present it in a PowerPoint slide show.
5.10 A manufacturer makes two types of engines, X and Y. To make one X model
requires 6 labour hours, while a Y model requires 10 labour hours. The
manufacturer cannot employ more than 15 workers, and each worker can
only work a maximum of 40 hours per week. The materials for the engines cost
R5 000 per engine, and the total weekly amount available for materials is
R400 000. The organisation has a contract to supply at least 30 X-model engines
and 20 Y-model engines per week. The contribution on an X-model engine is
R1 000, and the contribution on a Y-model engine is R3 000.
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Required:
Determine how many engines of each model must be manufactured to deliver
the highest possible contribution. Derive your answer by making use of the
simplex method.

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179

5.11 JRL manufactures two products from different combinations of the same
resources. Unit selling prices and unit cost details for each product are as follows:
Product J (R) L (R)
Unit selling price (R) 115 120
Variable costs per unit:
Direct material A (R10 per kg) 20 10
Direct material B (R6 per kg) 12 24
Skilled labour (R14 per hour) 28 21
Variable overheads (R4 per machine hour) 14 18

Fixed overheads* 28 36

Profit 13 11
* Fixed overheads is absorbed using an absorption rate per machine hour. It is
an unavoidable central overhead cost that is not affected by the mix or volume
of products produced.
The maximum weekly demand for products J and L is 400 units and 450 units
respectively, which is the normal weekly production volume achieved by JRL.
However, for the next four weeks the achievable production level will be reduced
due to a shortage of available resources. The resources that are expected to be
available are as follows:

Direct material A 900 kg

Direct material B 1 750 kg
Skilled labour 1 250 hours
Machine time 2 400 machine hours

Required:
(a) Identify, using graphical linear programming, the weekly production schedule
for products J and L that will maximise the profits of JRL during the next
four weeks.
(b) The optimal solution shows that the shadow prices of skilled labour and
direct material A are as follows:
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Skilled labour R0
Direct material A R11.70
(i) Find the optimal solution using the method of solving simultaneous
equations.
(ii) Explain the relevance of the values of the shadow prices to the
management of JRL.
(iii) Explain, using the graph you have drawn in part (a), how you would
calculate by how much the selling price of product J could increase
before the optimal solution would change.
Source: CIMA (adapted)

Linear programming

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180

5.12 Sencam (Pty) Ltd manufactures two types of chair: ‘Office’ and ‘Standard’. The
data relating to each chair is as follows:

Standard Office
Materials 2 kg 4 kg
Labour 5 hours 6 hours
Contribution R6 R9

There is a maximum of 80 kg of material and 180 labour hours available per

week. The demand for ‘Standard’ chairs is unlimited, and the maximum weekly
demand for ‘Office’ chairs is 10.

Required:
(a) Find the optimal production plan that will maximise contribution and
calculate the contribution that will be generated.
(b) Calculate the slack for each of the constraints.
(c) Calculate the shadow price of each of the constraints.

Source: CIMA (adapted)

Reference list
Nguyen, H.T., Kojima, N. & Tokai, A. 2019. An input–output linear programming model for
assessing climate policy considering economic growth. Environment Systems and Decisions,
39(1), 34–48.
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6 Cost and pricing
management for
competitive advantage

Cost and pricing management

Economic principles of Methods of determining

Pricing issues
pricing and demand prices

Product life-cycle Market-based Cost-based Alternative

pricing pricing pricing pricing strategies

Learning objectives
After studying this chapter, you should be able to:
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● Discuss issues arising in pricing decisions

● Explain how pricing strategies are used to maximise profit
● Discuss market-based approaches to pricing, such as the target costing approach
● Discuss the different methods of cost-plus pricing
● Establish target mark-up percentages
● Explain the advantages and disadvantages of various pricing strategies
● Discuss alternative pricing strategies and their consequences.

Introduction
It seems obvious to say that businesses aim to make profits by selling their products at
prices that are higher than their costs. A price is the monetary amount at which a product is
sold, and is the same as the selling price. This implies two things: that businesses know what

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182

their products cost and what the best selling prices are for their products. Other chapters
deal with the determination of costs using different methods. In this chapter we shall
consider the best ways in which to manage costs and determine selling prices to achieve the
profit and other goals of the business.

Case study: African Sky Rail’s online special

African Sky Rail owns and manages luxurious antique coaches powered by modern
locomotives. The two-day journey between Cape Town and Johannesburg includes
stopovers at historic towns such as Matjiesfontein, and the experience includes nothing
but the finest culinary delights and five-star sleeping cabins. Trip bookings can be made
via the company’s website where they publish their current tariffs. Discount on the
published tariffs are available for corporate clients, travel agents and tour operators
who make block bookings. The advertised price of a standard fare with breakfast, lunch
and dinner is R5 000 per person sharing. Corporate clients can usually obtain tickets
at R3 500 per person sharing and the company lowers its price to as little as R2 300
for the larger tour operators. Needless to say, these offers are not widely publicised.
The variable costs associated with the provision of the cabin and catering are R400
per person.
The company has been approached by a local web-based discount service which
offers substantial discounts on late-booked accommodation and airline flights. They
charge a fixed fee per annum. African Sky Rail would be able to advertise the tickets at
generous discounted prices. The later the booking is made, the greater the discount.
The Board of Directors are about to meet to discuss whether or not to make use of this
discount web service.

Required:
Advise the directors on the main issues that they should consider in their discussion.

Factors influencing pricing

In general, we can say that selling prices are influenced by three major factors: customers,
competitors and costs. For businesses which are not price leaders in their markets, selling
prices are determined by the market, that is, customers and competitors. Where there is a
relatively small number of dominant customers in a market, for example the supermarket
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chains in South Africa’s fast-moving consumer goods market, these customers will be
the major influence on suppliers’ selling prices. If there are a few dominant competitors,
they will tend to be price leaders, and a smaller supplier will set its prices following their
lead. In both these cases, a supplier will be forced to achieve its profit goals through cost
control and cost management. Cost control is the efforts of the business to maintain its
costs at the lowest levels possible while achieving its volume goals. This important topic
is dealt with in the chapters on standard costing and budgeting. Cost management is a
broader concept which includes not only control, but also aspects such as product design,
process engineering, systems design and value analysis. A business that is the price leader
or otherwise dominant in its market has more flexibility in determining its selling prices. In
this case, cost may be a major determinant in setting selling prices. However, the business
must still be aware of the effect of price on its volumes and consequent profits. Even where

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a business has almost complete freedom in setting prices, for example if it is a monopoly,
cost management will still be a necessity to achieve maximum profits. Some of the more
common factors that may influence pricing are described in the next section.

Price sensitivity
Price sensitivity will depend on the purchaser. If the cost can be passed on to a third party,
the purchaser will be less sensitive to the price. For example, the private hospital patient
that is covered by medical aid will be more concerned with the level of care than the cost.
In contrast, a patient who has to buy medicine at a pharmacy and pay for it in cash might
consider generic brands to save money. Price sensitivity is discussed in more detail in the
section that follows.

Compatibility with other products

Some products are used by so many customers that they become the standard. As a result,
there will be a cumulative effect on the demand for products compatible with this standard.
A good example is operating systems for personal computers. The owners of the rights to
the software, which is compatible with the most popular operating systems, have little
competition and may be able to charge a premium.

Competitors
If a product has direct competition, or if substitute products exist, a change in price of one
supplier might initiate a price war, as competitors try to undercut each other. For example,
as high-speed internet and online television channels become more accessible, satellite TV
services will become more competitive.

Price perception
Customers react to price changes based on their perception. For example, one customer
may buy immediately after a drop in the price on an electronic gadget, while another may
delay a purchase in the hope that the price will drop further.

Quality
If no other information is available, customers may judge the quality of a product by its
price. For example, aftermarket automotive components at a discount store may be a
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fraction of the price of the original manufacturer. Customers may perceive this, correctly or
incorrectly, to indicate inferior-quality components.

Incomes
Depending on the disposable income of the customers, marketing (and price) may be
more or less important. For customers with a high disposable income, convenience and
quality may be more important, whereas customers with a low disposable income may be
influenced more by price.

Cost and pricing management for competitive advantage

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Suppliers
Suppliers may demand an increase in price for their goods if they notice a price increase
to end customers. For example, if the shelf price of milk in the grocery store increases, the
farmers may demand more for the milk provided to milk producers.

Inflation
In periods of inflation, prices may have to be increased to keep up with inflationary increases
on input costs. This will keep real (inflation-adjusted) prices constant.

Test yourself 6.1

(a) What factors influence selling prices?
(b) Will a firm that is a price follower have more or less flexibility in setting prices than
a firm that is dominant in its industry?

Review of economic principles of pricing and demand

For any business, profit will be determined by a combination of selling price (P), cost (C)
and volume or quantity of product sold (Q). This may be stated algebraically as:

Profit = Q × P − Q × C = Q × (P − C)

If any or all of P, C and Q change, then profit will also change. However, price, cost and
volume also influence each other. If volume increases, then cost per unit will decrease
within the relevant range because fixed costs are spread over more units. To make the same
total profit with the increased volume, the business can reduce selling prices. As soon as
the volume increases to outside the relevant range, additional capacity must be obtained. If
volumes decrease, then cost per unit increases and the business must increase the price to
maintain a profit. According to economic theory, the law of demand indicates that when
prices increase, demand volumes will decrease, and vice versa. This is called a demand curve,
which is a graphical representation of how quantities sold of a product vary at different
prices. This is illustrated by the graph in Figure 6.1.
Price
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P1 A

P2 B

Q1 Q2 Demand

Figure 6.1 A demand curve

When the price decreases from P1 to P2, an increase in volume from Q1 to Q2 results. The
slope of the line from point A to point B, corresponding to the price and volume changes,

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indicates the rate at which volume changes. This is called the price elasticity of demand.
If the slope is steep, demand is said to be inelastic, because the effect of price changes on
demand is less than when the slope is more gradual, when demand is said to be elastic. The
slope need not be a straight line: if the effect of price on demand proportionately reduces
as prices reduce, then a curved hyperbola will result. For most businesses, the slope of the
curve will always be downwards from left to right. If the slope went up from left to right,
this would indicate demand increasing when prices increased, which might happen very
occasionally with extreme luxury goods.
Price elasticity of demand can be calculated algebraically using the formula:
Percentage change in quantity demanded
Elasticity =  ________________________________
      
Percentage change in price
 

If the demand curve is a straight line, then elasticity will be the same at all points, but if
the curve is a hyperbola, then it will differ at each point on the line. Note that the elasticity
in this formula will normally be a negative number, because demand decreases when price
increases. Because of this, the formula is often multiplied by −1 to make the answer positive.
If elasticity is greater than 1, demand is said to be price elastic, that is, demand is sensitive
to changes in price. If elasticity is less than 1, demand is said to be price inelastic. While
demand elasticity may be a useful concept in economic theory, determining it in practice is
usually difficult. For each of its products, a business would somehow have to obtain data or
estimates of demand at different price levels. As a result, most measures of elasticity are only
approximations. Nevertheless, it is very useful for a business to have some understanding
of whether demand for its products is price elastic or not, as this can have a major effect on
its pricing strategy.
Many factors can affect price elasticity, so that it differs from time to time, and between
regions. For example, in areas where disposable incomes are high, demand for luxury items
may be less elastic than in low-income areas. Necessities and basic items such as food
and clothing will tend to have lower elasticity than luxury items. Products that are highly
differentiated from competitors will be less elastic than those for which there are readily
available substitutes. Advertising and consumer habits may also make certain products less
elastic. The type of market in which it operates can also affect a business’s control over its
prices. The closer the market is to being perfectly competitive, the less control a business
has over its prices. This is due to a number of factors such as customers and competitors
having perfect information, competitors being easily able to enter or leave the market, profit
maximisation strategies and homogeneity of products.
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However, most markets are not perfect. In monopolistic markets, the business has no
competitors and can set prices to maximise profits. In oligopolies there are only a few large
suppliers between whom competition is fierce in price setting and other areas. Most markets
have some form of monopolistic competition in which there are many competitors that are
differentiated from one another and hence are not perfect substitutes. Pricing may often
be a key strategy in these markets to gain short-term benefits, although in the longer term,
prices will tend to be determined by the market as a whole.

The profit maximisation price model

The profit maximisation price model is an economic theory for determining the price
which will generate maximum profit. Economic theory holds that profit for a product is
maximised at the sales volume where marginal cost equals marginal revenue, that is, where the
cost of producing one extra unit equals the revenue gained from selling the unit.

Cost and pricing management for competitive advantage

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An equation has been determined to calculate the price required for a specific quantity of
demand. This is the price/demand equation:

p = a − bx

Where p = price
x = quantity of demand
a = a constant specific to the particular product
b = the slope of the demand curve = change in price divided by change in quantity.

The constants a and b are determined from data obtained for the product being analysed. A
marginal revenue equation has also been determined, using the price/demand equation, by
doubling the value of the demand curve b. This is the marginal revenue equation:

MR = a − 2bx

Illustrative example 6.1

Smart Security produces and sells floodlights that are activated by movement. It has
estimated that its maximum demand is 100 000 units (ie at a selling price of zero, the
maximum number of units that could be sold). It is estimated that sales volumes would
drop by 10 units for every R0.50 increase in the selling price per unit. Based on an analysis
of its cost structure, Smart Security has estimated that it would generate maximum
profits at a sales volume of 75 000 units. Assuming sales at this level, calculate the price
at which it should sell the floodlights to maximise profits.

Solution:
We start off by substituting known values into the price/demand equation, p = a − bx.
At p = 0, x = 100 000 units, therefore:
Equation 1: 0 = a − 100 000b
At p = 0.5, x = (100 000 − 10) = 99 990 units, therefore:
Equation 2: 0.5 = a + 99 990b

Next we subtract equation 1 from equation 2:

0.5 = a 2 99 990b
Less: 0 = a 2 100 000b
Equals: 0.5 = 10b

Thus: b = 0.05
Substitute b = 0.05 into equation 1:
0 = a − 100 000 (0.05)
a = 5 000 units
The demand equation for floodlights is therefore p = 5 000 − 0.05x.
The demand for maximum profit has been determined as 75 000 units.
Therefore, the price to maximise profit is 5 000 − (0.05 × 75 000) = R1 250.

Cost and Management Accounting

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Although the profit maximisation model does satisfy economic theories, applying it in
practice poses some problems − the most significant of which is determining the price/
demand function for products. Businesses often assume that average variable cost is the
same as the economist’s marginal cost. Variable costs may however change at different levels,
for example due to supplier discounts for bulk purchases, bottlenecks in the production
process and price increases as a result of supply constraints. Demand may also be affected
by factors other than price, such as advertising and promotions. The price and volume at
which maximum profits are reached can also be determined in a more practical way by
using a tabular method. In this approach, the quantities that can be sold at certain prices
are estimated, and the costs associated for these quantities determined.

Illustrative example 6.2

Cool Air manufactures and sells aftermarket automotive air-conditioning systems. The
sales manager has estimated that the following quantities of air-conditioning units
could be sold across a range of different prices.
Table 6.1 Demand for air-conditioning units at different selling prices
Price R5 000 R6 250 R8 000 R9 750 R11 500
Units 200 170 150 120 80

The manufacturing plant can produce a maximum of 200 units per annum without
incurring substantial additional fixed cost. Variable cost per unit has been calculated at
R3 500 per unit and fixed costs attributable to the production of air-conditioning units
are R500 000 per annum. Determine the price at which profits would be maximised by
preparing a table showing the profitability at different selling prices.

Solution:
Table 6.2 Profitability of air-conditioning units at different selling prices
R R R R R
Price per unit 5 000 6 250 8 000 9 750 11 500
Variable cost per unit 3 500 3 500 3 500 3 500 3 500
Contribution per unit 1 500 2 750 4 500 6 250 8 000
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Demand in units 200 170 150 120 80

Total contribution 300 000 467 500 675 000 750 000 640 000

The air-conditioning units should be sold at a price of R9 750 per unit to achieve a
maximum contribution of R750 000. Since fixed costs remain unchanged regardless of
the volume, it is not necessary to calculate profit for each selling price. The maximum
profit at a selling price of R9 750 per unit will be R750 000 – R500 000 = R250 000.

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188

Test yourself 6.2

Laser Products Ltd manufactures and sells a product with a variable cost of R4 000 per
unit. Based on an analysis of historic information, the company has established the
following equations:
Price/demand equation: P = 10 000 – 0.6x
Marginal revenue equation: P = 10 000 – 1.2x
Calculate the selling price per unit and the quantity of the product (in units) that will
maximise the profits of Laser Products Ltd.

Product life-cycle pricing

Products, like people, have a lifespan. The length of the lifespan will vary considerably
depending on a number of factors, for example type of product and industry, business
objectives and competitive innovation. During its life a product will pass through several
phases or cycles, namely introductory, growth, maturity and decline. These are called the
product life cycles. It is important for a business to recognise in which cycle a product is and
to adopt appropriate pricing strategies. This practice is called product life-cycle pricing,
which means product pricing is based on the stage in its life cycle. The pattern of sales and
profit for a product during its life is shown in Figure 6.2.

Sales
Rand

Profit

Time

Introductory Growth Maturity Decline

Figure 6.2 Sales and profit trends of a product life cycle

The shape of the life cycle curves will differ from product to product, but will generally
be somewhat similar to those shown in Figure 6.2: rapid growth in sales during the
introductory and growth phases, followed by a flattening out during the maturity phase,
and finally a fall in the decline stage. Profits will also follow a somewhat similar pattern.
Often, but not always, losses will be recorded in the introductory and early growth phases,
then good, consistent profits during the later growth and maturity phases. Finally, during
decline, profits will fall rapidly, sometimes even turning to losses before the product is
discontinued. The duration of each phase will also differ considerably. Most businesses
attempt to extend the maturity phase when greatest profits are achieved. The pricing
strategy in each phase will differ according to several factors, and no one strategy can be
said to be best for each phase.

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Introductory phase
For a product entering a market in which there is a lot of competition, either directly or
through alternative products, a price penetration policy is often adopted on introduction.
The price is kept lower than competitive products so that a critical mass of sales volume may
be achieved at which the product becomes profitable. Once demand has been established,
the price may be increased to improve margins and as a result profitability. Products that
appeal to the fashion conscious or those that are highly innovative may be introduced
at high prices on introduction to take advantage of their novelty value, for example
smartphones and tablets. Once demand has been established, the price may be increased to
improve margins and as a result profitability. During the introductory phase, many costs,
such as advertising, promotion and development, will be higher than later on, to establish
the product in the market. This will also reduce profits during this phase.

Growth phase
As a result of increased sales volumes, unit costs will have decreased because of economies
of scale, resulting in less cost pressure on profits. An established market share may also
enable a firm to increase its prices without reducing volumes significantly, but often there
is still keen price competition to maintain and increase market share. Profits will probably
increase as volumes increase, unit costs fall and there is less price pressure.

Maturity phase
Although demand now levels off, volumes are still high enough to maintain profits,
which may begin to fall towards the end of this phase. Pricing is often not a key factor
in maintaining volumes during this phase, as businesses may use other strategies, such as
product differentiation.

Decline phase
As the product nears the end of its life, sales decline more rapidly. To minimise the decline,
a business may use aggressive price cutting and advertising strategies, which together
with the reduced volume will lead to lower profits and eventually losses. It is important
for a business to recognise when this stage has been reached, so that the product can be
discontinued before losses become too great.
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Test yourself 6.3

Summarise the phases of the product life cycle.

Market-based pricing strategies

Market-based pricing involves setting prices based on customer requirements and
competitors’ prices. The market-based pricing strategy considers what customers want
and also what the competitors’ reaction would be to what the business does. In a very
competitive market, such as the petroleum industry, the market-based approach is suitable.
The products or services produced by one organisation are very similar to those produced
by others, therefore businesses have no influence over what price to charge.

Cost and pricing management for competitive advantage

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Target cost and target price approach

An important form of the market-based approach is the target price, which is the estimated
price that potential customers are willing to pay for the product or service. After a target
price has been established, a target cost is set by deducting a suitable margin. This may
initially result in lower than desired profits being reached, but through improvements, the
firm aims to reach its target cost and profit.
The following steps are involved in target pricing and costing:
● Determine the target price based on customers’ perception of the product and
competitors’ prices. This may involve research on which features customers prefer and
how much they are willing to pay for it.
● Determine the gross profit per unit that the business wants to earn.
● Calculate the target cost per unit: Target price − Target gross profit per unit.
● Estimate the actual cost of the product or service. This may depend on the quality,
quantity and method of delivery.
● If the actual cost is greater than the target cost, find ways of reducing the actual cost.
This can be done through value engineering or Kaizen costing.

Value engineering or value analysis involves rigorously examining and evaluating each
component of the product cost and the value chain business function, and determining
and eliminating those components and activities that do not add value, that is, those whose
elimination will not affect the desirability of the product in the marketplace. In some
cases, this may even lead to a complete product redesign. Kaizen costing is often used in
conjunction with target costing. This is a process of continuously making small incremental
improvements to ultimately reach the target cost. Therefore, Kaizen costing forms part of
the culture of the company, built on the belief that nothing is ever truly perfect and that
there is always room for improvement.

Illustrative example 6.3

Yello Ltd is launching a new product range in a market that faces fierce competition. The
company has determined that it can charge a maximum selling price of R495 per unit. It
is the policy of the company to earn a profit margin of 30% on sales. The total cost per
unit, at the expected level of production, is R400 per unit.
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Required:
Calculate the target cost per unit and suggest ways in which this target cost can be
achieved.

Solution:
Target cost = Target selling price – Profit margin = R495 × (1 − 30%) = R346.50. The
actual cost of R400 is R53.50 higher than the target cost. The company should undertake
a value analysis of its product compared to the competition to identify possible savings
as a result of changes in its quality or specification levels. A marketing campaign might
lead to increased volumes and therefore decreased fixed costs per unit.

Cost and Management Accounting

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Advantages of using target pricing

Apart from being necessary in competitive markets, there are other benefits to using target
pricing, including the following:
● It forces a company to analyse products in detail to find the best way to manufacture
or purchase products at the lowest possible cost. Lowering costs and improving profit
margins are common goals of many companies.
● It is a more systematic way to focus on optimising the cost structure of the company and
involves careful scrutinising of all equipment, processes, labour and materials required
to manufacture or purchase products and get them ready for sale to customers.
● If done right, it ensures greater profitability by taking into account both factors of profit:
selling price and costs. By starting with the price, instead of the cost base, a company
will ensure that each product that is launched has the features customers require at the
right price point.

Disadvantages of target pricing

Some of the disadvantages of target pricing include the following:
● The design team may require a large number of design iterations before it can deliver a
product that meets the target cost and margin criteria. This may delay the development
process considerably.
● Mandatory cost cutting may cause friction between employees in various parts of the
company, especially if a disproportionately large part of the savings is required from one
part of the company.
● It may be difficult to reach consensus on the final design where there is more than one
department involved in the process.

Test yourself 6.4

Outline how a company can achieve its profit objectives using market-based prices and
target costing.

Cost-based pricing strategies

Although economists (and marketing managers) insist that selling prices are set by the
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market, many businesses base their selling prices on product cost, which is called cost-based
pricing. This comes from the irrefutable logic that if its products are sold at prices greater
than their cost, the business will always make a profit. The problem is determining the cost
on which the price is to be based. We have seen that there are many bases on which cost can
be determined, for example marginal, absorption and activity-based, which are dealt with
in Chapter 2. There are also different types of cost: historical, current or actual, standard
and budget. Even if one basis and type is used, it may still be possible to calculate different
costs for the same product. For example, manufacturing overheads may be difficult to trace
to the products and be allocated on the basis of labour hours, or it may be allocated on the
basis of what causes the costs using activity-based costing principles.

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Determining the mark-up to be added to cost

There is also the question of determining the mark-up to be added to the cost: how should
it be determined and how much should it be? It is often assumed that the mark-up will be
a percentage added to cost, that is, if cost is R10, add 25% to get a selling price of R12.50.
There are other ways of determining the mark-up, for example an amount per unit (or some
other measure, such as kilogram or litre), or an amount per labour or machine hour. The
size of the mark-up will depend partly on the cost basis (that is, if using marginal cost, the
mark-up should be higher than if using absorption cost, because with marginal costing, the
mark-up must include an allowance for fixed costs which are already included in absorbed
costs), and partly on profit objective, for example to achieve a target return on investment or
percentage profit to sales ratio. Regardless of how the mark-up is determined, consideration
should be given to capacity utilisation, that is, the volume on which overhead allocation
and return on investment is based.
To illustrate the different methods of determining cost-based prices, let us look at a
simple example.

Illustrative example 6.4

A company makes a single product for which the management accountant has
determined the data given in Table 6.3.
Table 6.3 Cost and production data
Historical Current Budget Standard
Variable cost per unit R37 R40 R45 R43
Fixed manufacturing cost R126 000 R130 000 R150 000 R150 000
Fixed administrative cost R64 000 R70 000 R75 000 R75 000
Capital employed R1 050 000 R1 100 000 R1 200 000 R1 200 000
Units produced and sold 10 500 10 000 12 000 11 000

Because only one product is made, there is no need to consider activity-based costing
as a method, nor the method of absorbing fixed overheads, which are simply calculated
by dividing the relevant cost by the number of units. Total costs are given in Table 6.4.
Table 6.4 Product costs per unit
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Historical (R) Current (R) Budget (R) Standard (R)

Variable cost per unit 37.00 40.00 45.00 43.00
Fixed manufacturing cost/unit 12.00 13.00 12.50 13.64
Total manufactured cost/unit 49.00 53.00 57.50 56.64
Fixed admin cost/unit 6.10 7.00 6.25 6.82
Full cost/unit 55.10 60.00 63.75 63.46

➤➤

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Solution:
We must now determine and apply a mark-up to the different costs. First, let us assume
that the company aims to make 10% return on capital employed or investment, and
to apply the mark-up as a percentage of cost. The mechanics of the calculation will
be the same, no matter which cost basis is used − so let us use budget to illustrate the
calculation:

10% of budget capital employed = 0.10 × R1 200 000 = R120 000 profit

Because there is only one product, we could convert this to profit per unit, R10, and
then calculate this as a percentage of the cost per unit. If there were more products,
we would have to calculate the total cost values of all the products and calculate the
percentage mark-up on each. In this case, total budget variable cost = 12 000 units ×
R45 = R540 000. Add the fixed manufacturing cost of R150 000 to get a total
manufactured cost of R690 000. To this, add the total administrative cost of R75 000
to get the total full cost of R765 000. In calculating mark-up based on anything other
than full cost, we must add the costs not included to the profit target.
Mark-up based on variable cost
(120 000 1 75 000 1 150 000)
= _______________________
 
      
540 000 × 100% = 63.9%
Mark-up based on manufactured cost
(120 000 1 75 000)
_______________
=   
  690 000 × 100% = 28.2%

Mark-up based on full cost  120 000

= _______
765 000 × 100% = 15.7%

Performing the same calculations for all the cost bases gives us the mark-ups in Table 6.5.
Table 6.5 Mark-up for each cost basis
Mark-up based on: Historical Current Budget Standard
Variable cost 75.9% 77.5% 63.9% 72.9%
Manufactured cost 32.8% 34.0% 28.3% 31.3%
Full cost 18.2% 18.3% 15.7% 17.2%
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These mark-ups are then applied to the relevant costs per unit to calculate the required
selling price. Again, we can use budget costs to illustrate this.
Mark-up based on variable cost: Selling price = 45.00 + 63.9% × 45.00 = R73.76
Mark-up based on manufactured cost: Selling price = 57.50 + 28.3% × 57.50
= R73.77
Mark-up based on full cost: Selling price = 63.75 + 15.7% × 63.75 = R73.76

The only difference among the three prices calculated is due to rounding off. This should
be expected, because the same data has been used in all the calculations.

When we use different cost bases, the prices calculated for each cost method will be the
same within a cost basis, but differ between cost bases because different data is used.
➤➤

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Table 6.6 Selling price using mark-up for each cost basis
Historical (R) Current (R) Budget (R) Standard (R)
Variable cost 65.08 71.00 73.76 74.35
Manufactured cost 65.07 71.02 73.77 74.37
Full cost 65.13 70.98 73.76 74.38

As shown, using variable, manufactured or total cost to calculate the price should not
affect the calculations if consistent data is used. The cost basis, however, can affect
the calculation considerably. In this example, there is a 14% spread between highest
and lowest prices. There can be little justification for using historical costs as a basis
for setting future prices, unless the business operates in an extremely cost-stable
environment and has little information on expected costs and volumes. Basing prices
on current or actual costs will probably be difficult for most businesses unless they
produce to order and are able to quote on an actual cost basis. Some firms in industries
with very volatile material costs, and which are able to adjust prices at short notice, may
sometimes set prices using actual material costs and standard labour and overheads.
It may even be possible to use actual labour and variable overhead costs, but fixed
overheads would have to be based on a predetermined rate, because the actual number
of units would only be available after the product has been made and sold. Most firms
using cost-based pricing will base their prices on either budget or standard costs. Usually
the only difference between the two is that standard overhead costs are calculated using
capacity, practical or current volumes, rather than budget.

Where pricing is based on something other than full cost, for example on marginal or
variable cost, a firm can have short-term flexibility in its pricing. In the short term, as long as
the price exceeds variable cost and the price will result in volumes being increased, a selling
price could be set that is lower than that according to the normal formula. This has been
dealt with in Chapter 4 under short-term decision making. Using variable cost as a basis
can have the advantage that a firm is better able to benefit from opportunities to increase or
maintain volumes. In the long term, however, prices on average must exceed costs for a firm
to stay in business. A firm that uses activity-based costing (ABC) as a basis for pricing will
probably find in the short term that its low-volume products are priced higher than those
of competitors who are not using ABC, whereas its high-volume products are priced lower.
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This is consistent with what is normally expected under ABC (see Chapters 2 and 8). In the
longer term, firms that are under-pricing their low-volume products will eventually leave
the market because of low profitability, while those that are over-pricing their high-volume
prices will be forced to reduce prices or lose market share.

Disadvantages of cost-based pricing

The disadvantages of using cost-based pricing should be fairly obvious:
● There is no guarantee that the prices calculated will be accepted by the market, or if they are
accepted, what the effect will be on the volumes that have been used in the calculations.
● The cost basis and overhead absorption method can lead to very different prices being
charged by different businesses for similar products in the same market, possibly making
a firm either uncompetitive or unprofitable.

Cost and Management Accounting

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● Because prices are based on fairly short-term data, for example for the next budget
period, pricing may not take into account the stage in the product’s life cycle, so that
prices that are too high are required in the introductory and growth phases, and prices
that are too low during the maturity phase.
● For some firms, once a price has been established on a cost basis and the firm is able
to do business at that price, the cost becomes accepted as a matter of fact and is no
longer scrutinised. A firm using cost-plus pricing is not motivated to minimise costs,
because these are simply passed on to the customer. Reducing cost may lead to lower
selling prices and, if mark-up is calculated as a percentage of cost, to lower profit. If
new competitors enter the market, they may be able to offer a better price through
new technology and improved processes. A firm should always strive to reduce its costs
to maintain its competitiveness. This may be done using any number of different
techniques which tend to be rather similar to each other, such as target costing, value
engineering and Kaizen costing.

Advantages of cost-based pricing

In spite of its theoretical deficiencies and the problems mentioned, cost-based pricing
remains widely used for many reasons, including the following:
● Once a basis and capacity utilisation has been decided, it is relatively simple to calculate
a selling price, so that the process may be delegated, with senior management only being
concerned with setting and reviewing parameters.
● Price increases can be readily justified to customers and often costly market research is
not required.
● If the expected volumes are attained and costs are as forecast, the required profit will be
achieved.
● Cost-based pricing may help a firm to predict the prices of competitors where the average
mark-up for the industry is known.

Test yourself 6.5

(a) Zees Ltd uses cost-based pricing and aims to make a contribution margin of 25%
on the selling price. The variable cost of a new product is R94.50 per unit. Fixed
manufacturing overheads are absorbed at a rate of R35.00 per unit. Calculate the
selling price for the new product.
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(b) The industry for the new product is highly competitive with a high price elasticity.
The market leader sells a very similar product for R120 per unit. Do you think Zees
Ltd will be successful in selling the new product? Give reasons for your answer.

Alternative pricing strategies

Although many businesses operate successfully using cost-based pricing, there are often
cases where different pricing strategies must be used to suit specific circumstances. In some
cases, these may be used over a long period of time, but often they are only used briefly.

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Penetration pricing
When a business introduces a new product, it usually wants to gain an acceptable market
share as quickly as possible. In this introductory phase of the product life cycle, the aim
is to attract new customers who may not yet be aware of its attributes, and the price is set
lower than its eventual target in the hope of customers switching, based on price. When the
target market share has been reached, the price will be increased. An example is the low-cost
airline industry.

Price skimming
This is the opposite of penetration pricing. When a product is launched, the price is set at
a high level to take advantage of customers who are attracted by novelty and fashion. The
launch is usually preceded by extensive advertising and publicity campaigns to generate
demand for the product. Once the initial wave of excitement over the product has receded,
the price is lowered to attract more conservative and price-conscious customers. Examples
of this strategy are smartphones, tablets and new books by popular authors.

Premium pricing
Unlike price skimming where the higher price is short-lived, premium pricing aims to
maintain higher than normal prices over a long period. This is done by establishing a
popular brand name for a product, which results in customer loyalty and low price elasticity
of demand. The brand name may be established based on the attributes of the product, for
example quality, durability and style. Many car manufacturers employ this pricing strategy
successfully. Almost always, premium pricing requires heavy spending on advertising and
promotion, both initially and through the product life. Often, if advertising is reduced,
the product quickly loses its market share and premium position. The business must
continually assess whether premium price justifies the higher costs, that is, would the
product earn as much or more profit if it was priced lower with less cost.

Price differentiation
Sometimes a business is able to split its market into different parts or segments, in each
of which its customers operate separately from the other segments. Examples of this may
be markets that are divided by region, time of use, and customer or sales outlet type. The
business may then be able to price its product differently in the different segments. In some
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cases, the segmentation may be accompanied by different costs, for example transport
costs to different regions, and profits may not be very different between segments. In other
cases, the price differentiation may lead to higher profits through increased volumes. Price
differentiation is usually a longer-lasting strategy than price penetration and skimming.
Accommodation and conservation fees at game parks are sometimes charged at different
rates for residents and foreigners.

Loss leader pricing

If a business sells a number of products to the same customers, it may price one of the
products, the ‘loss leader’, at a low price, perhaps even at a loss, in the hope of attracting
customers to buy its other products, which are priced much higher. This works especially
well when the other products are required for use in or with the loss leader product. It is
made very difficult to use products other than those specified. An example of this is printers

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which are sold at a low price compared to replacement ink cartridges, which sometimes cost
more than the original printer. While substitute or refilled cartridges may be used, they are
usually not satisfactory.

Product bundling
Product bundling is similar to loss leader pricing in that the aim is to get the customer to
buy a range of the firm’s products, thereby increasing overall volumes and profitability. The
difference is that all the prices in the range are reduced if they are bought at the same time.
For example, travel agents often offer reduced air fares and hotel accommodation if they
are purchased in one package. For bundling to be successful, the reduced prices must be at
least compensated for by increased volumes and potential cost saving resulting from the
bundling, such as reduced packaging and transport costs.

Price discounting
Many firms discount prices from their normal levels on either a permanent or temporary
basis. Trade discounts are permanent and used to differentiate prices between types of
customers, for example wholesale, retail and supermarkets. Sometimes a firm will offer
a product at a more or less permanent discount to make customers think that they are
getting better value. Temporary discounts would be used when a firm needs to increase sales
for a short period without permanently reducing prices. This may happen if sales are poor,
the firm is overstocked, or perishable or damaged goods must be cleared. Cash or settlement
discounts are offered to customers for early settlement of their accounts. These should be
seen as a form of financing rather than pricing strategy.

Controlled prices
Some products have prices that are controlled or regulated by legislation or some other
mechanism external to the business. An example is petrol, for which the price is legislated
monthly. Many other products of large nationalised or recently denationalised industries
are controlled in some way. This price control should force the businesses concerned to
generate profit through cost management, but its effectiveness is often doubtful.

Test yourself 6.6

How does price discounting differ from loss leader pricing?
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Summary
Pricing and cost management in almost any business are keys to its survival and continuing
profitability. For many businesses, prices are determined by their markets, but they have
much greater control over their costs. Economic theory attempts to show how prices may be
determined to satisfy market demands, but has limited applicability in practice. Many firms
use cost-based methods to determine selling prices, but these often have to be adjusted
to suit the market. To meet particular requirements, firms may have to use alternative
pricing strategies.

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Key concepts
Cost-based pricing is a system of determining prices based on product costs.
Cost control is the way in which a business keeps its costs at the lowest levels possible
while achieving its volume goals.
Cost management includes not only cost control, but also aspects such as product
design, process engineering, systems design, and value analysis aimed at ensuring the
lowest possible product cost.
Demand curve is a graphical representation of how quantities sold of a product vary at
different prices.
Market-based pricing involves setting prices based on customer requirements and
competitors’ prices.
Price is the monetary amount at which a product is sold. It is the same as selling price.
Price elasticity of demand involves how the quantity demanded of a product varies in
proportion to its price. It is represented by the slope of the demand curve.
Product life-cycle pricing is where pricing a product is based on the stage in its life cycle.
Profit maximisation price model is an economic theory for determining the price which
will generate maximum profit.
Target price is a selling price based on the estimated price that customers are willing to
pay for a product.

Test-yourself solutions
Test yourself 6.1
(a) Customers, competitors, costs.
(b) It will have less flexibility.

Test yourself 6.2

Variable cost and marginal cost are the same. To maximise profit, marginal revenue must
equal marginal cost.
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10 000 − 1.2x 5 4 000

1.2x 5 10 000 − 4 000
  61.2
x 5 _____000

x 5 5 000 units

When x = 5 000 units, the p = 10 000 − (0.6 × 5 000) = R7 000

Therefore, in order to achieve maximum profits, Laser Products Ltd must sell 5 000 units at
a price of R7 000 per unit.

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Test yourself 6.3

Phases in a product life cycle:
● Introduction: where a product is new and being established in a market
● Growth: where the product has achieved a place in the market and volumes are increasing
● Maturity: where volumes are still relatively high and good profits are earned
● Decline: where volumes decrease rapidly, and the product incurs losses.

Test yourself 6.4

Profit objectives would be achieved following these steps:
● Determine the target price.
● Determine the operating profit per unit that the business wants to earn.
● Calculate the target cost per unit.
● Determine the actual cost of the product or service.
● If the actual cost is greater than the target cost, find ways of reducing the actual cost to
the target cost.

Test yourself 6.5

R94.50
(a) Selling price =  ________
(1 − 0.25) = R126 per unit.
(b) The new product is unlikely to be successful, because the selling price in (a) is R6 (5%)
higher than the market leader. Since demand is sensitive to price, customers will rather
buy from the competitor at a lower price.

Test yourself 6.6

Price discounting may be used in two ways: on a permanent basis to differentiate between
different types of customers, or temporarily to increase sales for a short period, for example
to reduce stocks. Loss leader pricing is used with the aim of attracting customers who buy
the ‘loss leader’ product to buy other products.

Review questions
6.1 What major factors influence selling prices?
6.2 Distinguish between cost control and cost management.
6.3 What are the three determinants of profit?
6.4 What is the economic law of price and demand?
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6.5 At what sales volume is profit maximised?

6.6 Name the product life cycles.
6.7 How is target cost for a product determined?
6.8 Name three cost bases that can be used for determining selling prices.
6.9 Give three reasons why cost-based pricing is often used despite its defects.
6.10 How is price differentiation used as a pricing strategy?

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Exercises
6.1 SeCa (Pty) Ltd has established that the price demand relationship is as follows:

Selling price (R) Demand

16 100
15.5 200
15 300
14.5 400
14 500
13.5 600
13 700

SeCa has also established that the cost per unit for production is as follows:

Quantity Cost per unit (R)

100 14.0
200 13.9
300 13.8
400 13.7
500 13.6
600 13.5
700 13.4
800 13.3
900 13.2

Required:
(a) Complete the table, using the following headings to find the optimal selling
price (profit maximising price).
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Selling Demand Cost per Total Total Total Marginal Marginal

price per unit revenue cost profit revenue cost
unit

(b) Calculate the price elasticity of demand:

(i) If the current selling price is R16 per unit
(ii) If the current selling price is R15 per unit.
(c) SeCa also manufactures an item, Baloo, which has an estimated demand
curve of P = 300 − 0.004Q. The variable cost of each Baloo is R40. Use
this information to find the profit maximising selling price for one unit
of Baloo.

Cost and Management Accounting

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.

6.2 A company is launching a new product and needs to determine a selling price.
The cost price is R450 and a mark-up of 25% is usually applied to all new
products.

Required:
(a) Calculate the selling price using a mark-up of 25%.
(b) Calculate the selling price using a margin of 25%.
6.3 The full cost of a new product is R80 per unit. The company aims to make a
profit margin of 20% on the selling price of all its products. The market for the
new product is highly competitive and similar products are sold for R95 per
unit. The company is unsure whether to use target pricing or cost-based pricing.

Required:
Briefly explain which method is more appropriate, as well as how it will affect
the profit that will be realised on the new product.
6.4 A company is considering launching a new product. After extensive market
research it has been established that maximum demand at a price of R Nil will
be 100 000 units. For every R1 decrease in the selling price, it is expected that
the demand will decrease by 25 units. According to the research, profit will be
the highest if 75 000 units are sold.

Required:
Calculate the price at which the product should be sold to maximise profit.
6.5 The variable and fixed cost per unit of a new product is R5.50 and R8.00
respectively. The company uses cost-plus pricing with a mark-up of 30% on
full cost.

Required:
Calculate the selling price.
6.6 A manufacturing company is considering its pricing policy for next year. It has
already carried out some market research into the expected levels of demand for
one of its products. The company is also launching a new product to the market
next year and is currently considering its pricing strategy for this new product.
The product will be unlike any other product that is currently available and will
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considerably improve the efficiency with which garages service motor vehicles.
This unique position in the marketplace is expected to remain for only six
months before one of the company’s competitors develops a similar product.
The prototype required a substantial amount of time to develop and as a result
the company is keen to recover its considerable research and development costs
as soon as possible. The company has now developed its manufacturing process
for this product and as a result the time taken to produce each unit is much less
than was required for the first few units. This time reduction is expected to
continue for a short period of time once mass production has started, but from
then on a constant time requirement per unit is anticipated.

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Required:
(a) Explain the alternative pricing strategies that may be adopted when
launching a new product.
(b) Recommend a pricing strategy to the company for its new product and
explain how the adoption of your chosen strategy would affect the sales
revenue, costs and profits of this product over its life cycle.
(c) If a contribution of 25% of selling price is required on the new product,
with variable costs of R48 per unit and fixed costs of R8 per unit expected,
what should the selling price be?
Source: CIMA (adapted)
6.7 The cost of a new product is summarised in the following table:

Direct material R25 per unit

Direct labour R60 per unit
Variable overheads R15 per unit
Fixed overheads R8 per unit

A mark-up of 25% on variable cost is used to determine the selling price.

Required:
Calculate the profit per unit.
6.8 A company aims to earn a profit margin of 30% on all sales. After extensive
market research a target price of R1 895 was set for a new product. The
budgeted cost to manufacture the product is R1 500.

Required:
By how much must the cost be reduced?
6.9 ACME Ltd is about to launch a new product. The direct material and direct
labour cost per unit is R35 and R48 respectively. Extensive market research
estimates that the demand for the product will be 100 000 units per annum at
a selling price of R299 per unit. It further suggests that the demand will drop by
5 000 units for every R10 increase in selling price.
Manufacturing overheads at three different activity levels are as follows:
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Number of units Total overheads (R)

80 000 R1 220 000
100 000 R1 520 000
120 000 R1 820 000

Required:
(a) Calculate the total variable cost per unit, the selling price and volume that
will maximise profits from the product, and the profit that will be achieved
at this selling price and volume.
(b) Explain why the company may decide not to use the optimum price
calculated in (a).

Cost and Management Accounting

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(c) Explain two advantages and two disadvantages of total cost-plus pricing.
(d) Explain how target costing and pricing could be of benefit to a company in
a highly competitive market.
(e) Explain briefly how the pricing of a consumer electronics product may vary
during its life cycle.
6.10 A manufacturer of electrical appliances is continually reviewing its product
range and enhancing its existing products by developing new models to satisfy
the demands of its customers. The company intends always to have products at
each stage of the product life cycle to ensure the company’s continued presence
in the market.
Currently the company is reviewing three products:
Product K was introduced to the market some time ago and is now about to
enter the maturity stage of its life cycle. The maturity stage is expected to last
for 10 weeks. Each unit has a variable cost of R38 and takes one standard hour
to produce. The managing director is unsure which of four possible prices the
company should charge during the next 10 weeks. The following table shows
the results of some market research into the level of weekly demand at a range
of different prices:

Selling price per unit R100 R85 R80 R75

Weekly demand (units) 600 800 1 200 1 400

Product L was introduced to the market two months ago using a penetration
pricing policy and is now about to enter its growth stage. This stage is expected
to last for 20 weeks. Each unit has a variable cost of R45 and takes 1.25
standard hours to produce. Market research has indicated that there is a linear
relationship between its selling price and the number of units demanded, which
can be shown as P = a − bx. At a selling price of R100 per unit, demand is
expected to be 1 000 units per week. For every R10 increase in selling price, the
weekly demand will reduce by 200 units, and for every R10 decrease in selling
price, the weekly demand will increase by 200 units.
Product M is currently being tested and is to be launched in 10 weeks’ time.
This is an innovative product which the company believes will change the entire
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market. The company has decided to use a market skimming approach to

pricing this product during its introductory phase.
The company currently has a production facility which has a capacity of 2 000
standard hours per week. This facility is being expanded, but the extra capacity
will not be available for a period of 10 weeks.

Required:
(a) (i) Calculate which of the four selling prices should be charged for
Product K, in order to maximise its contribution during its maturity
phase.
(ii) As a result, in order to utilise all of the spare capacity from your answer
to (i), calculate the selling price of Product L during its growth phase.

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204

(b) Compare and contrast penetration and skimming pricing strategies during
the introductory phase, using Product M to illustrate your answer.
(c) Explain with reasons, for each of the remaining phases of Product M’s life
cycle, the changes that would be expected in the:
(i) Average unit production cost
(ii) Unit selling price.

Source: CIMA (adapted)

6.11 Joneli Associates provides employee selection and evaluation services to
organisations that do not have in-house expertise in these techniques. These
services comprise interviewing and assessing applicants for vacant posts, and
evaluating performance of personnel already employed. Jon heads up the division
which provides selection services, while Elise heads up the division providing
evaluation services. The clients to whom they consult vary considerably in size
and cover a broad spectrum of operations. However, the services they require
are fairly similar, although not all require both selection and evaluation services.
Although they regularly accept new clients, most of Joneli Associates’ clients
deal with them on an ongoing basis, which enables Joneli to become familiar
with the client’s business and offer further services.
Before accepting a new client, either Jon or Elise will meet them to discuss their
requirements and agree to the basis of their fees. New clients tend to be once-
off assignments initially. This requires time and effort to become familiar with
the clients’ requirements and procedures. As a result, Joneli strives to form a
relationship and attract more assignments from each new client.

Required:
Explain how customer life-cycle costing and pricing could be used by Joneli
Associates.
6.12 Rugged Footwear CC has designed and developed a new hiking sandal, Trudgers,
which is ready to be introduced to the market.
The projected standard costs for each pair of Trudgers are as follows:
Standard Standard
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rate (R) cost (R)

Direct materials 120.00
Direct labour 0.25 hours 120.00 30.00
Manufacturing overheads (20% variable) 0.25 hours 160.00 40.00
Total standard manufactured cost per pair 190.00

Additional information:
1. The only variable non-manufacturing costs for Trudgers will be R10 per
pair for distribution. Annual fixed selling, administrative and general costs
allocated to the product are expected to be as follows:

Cost and Management Accounting

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205

R
Advertising and promotions 400 000
Salaries and other costs 160 000
560 000

2. As the firm manufactures a wide range of other products, management

expects that no more than 2 000 direct labour hours per year will be
available for the production of Trudgers.
3. An investment of R900 000 in new equipment and working capital will be
required for the new line. The owners of Rugged Footwear CC require a
return on investment (ROI) of 24% on new products.
4. Manufacturing overhead costs are allocated to products based on direct
labour hours. Non-manufacturing overheads are allocated on a unit basis.

Required:
(a) Assume that the firm uses the absorption approach to cost-plus pricing.
(i) Calculate the mark-up that is needed to achieve 24% ROI.
(ii) Using this mark-up, calculate the selling price for one pair of Trudgers.
(iii) Assuming that all of the sandals that can be produced can be sold at
the price calculated in (ii), prepare an income statement for Trudgers
for the first year of production.
(b) Assume that the company uses the contribution approach to cost-plus
pricing.
(i) Calculate the mark-up that is needed to achieve 24% ROI.
(ii) Using this mark-up, calculate the selling price for one pair of Trudgers.
(iii) Assuming that all of the sandals that can be produced can be sold at
the price calculated in (ii), prepare an income statement for Trudgers
for the first year of production.
(c) After marketing Trudgers for several years, demand has fallen off
considerably due to the economic recession. A large retail chain will make
a bulk purchase of the sandals under its own brand name if an acceptable
price can be agreed on. What is the minimum acceptable price for this
order?
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7 The modern business
environment

The modern business environment

Advanced
Throughput
Total quality manufacturing
Target costing accounting Benchmarking
management technology
(TA)
(AMT)

World-class
Value chain Just-in-time Life-cycle Backflush
Kaizen costing manufacturing
analysis (JIT) costing accounting
(WCM)

Learning objectives
After studying this chapter, you should be able to:
● Describe value chain analysis
● Differentiate between upstream and downstream costs
● Explain the total quality management (TQM) process
● Define the costs of quality and draw up a cost of quality report
● Discuss how total quality management, just-in-time (JIT) and target costing
complement one another
● Discuss why Kaizen costing is suitable to be used in total quality management and
just-in-time
● Define and calculate target costs
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● Define and discuss just-in-time production and purchasing

● Differentiate between push and pull systems
● Define and calculate throughput accounting (TA) ratios
● Define bottlenecks
● Discuss throughput accounting and just-in-time
● Define and discuss throughput accounting and theory of constraints (TOC)
● Discuss life-cycle costing
● Discuss benchmarking
● Discuss backflush accounting
● Discuss advanced manufacturing technology (AMT)
● Discuss world-class manufacturing (WCM).

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208

Introduction
Prior to the 1970s, barriers of communication and geographical distance limited the
extent to which overseas organisations could compete in domestic markets. During the
1970s overseas competitors gained access to domestic markets through global networks.
Competitors were now able, through these networks, to acquire quality raw materials and
distribute high-quality, low-priced goods. To be successful, companies could no longer just
pass on the cost increases to their clients, but had to find innovative ways to manufacture
and supply quality goods and services in a cost-efficient way. New management approaches
such as continuous improvement, employee empowerment and total value chain analysis
were implemented.

Value chain analysis

The Chartered Institute of Management Accountants (CIMA) defines value analysis as
‘the systematic interdisciplinary examination of factors affecting the cost of a product or
service, in order to devise means of achieving the specified purpose most economically as
the required standard of quality and reliability’. Simply put, value analysis is an activity that
helps to design goods or services to meet customer needs at a lower cost, and still maintain
required standards of quality. The purpose of value analysis is to identify unnecessary cost
elements with the components of the organisation’s goods and services, thereby attaining
a competitive advantage. It is more detailed than simple cost reduction, as it examines
the purposes or functions of the product and is also concerned with the means of how
these are achieved. Any cost elements that do not add value to the goods and services are
eliminated. CIMA defines a value chain as ‘the sequence of business activities by which, in
the perspective of the end user, value is added to the products or services produced by an
organisation’.
Understanding an organisation’s value chain enables managers to group the organ-
isation’s activities and obtain a clear picture of how they add value to the organisation.
Managers can then analyse these activities and eliminate or add processes that will enable
the organisation to produce products and services that will give them a competitive edge
over their competitors in the market. In some cases, management may even decide to
outsource some of these processes to enable them to focus on their core activities.
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Cost and Management Accounting

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209

The diagram of the value chain illustrated in Figure 7.1 shows the various processes in an
organisation and how they link into each other.

Research and development

UPSTREAM

Design

Supply
PROCESSES

Production Support Services

PRIMARY

or ✓ Finance
manufacturing ✓ Legal
✓ Human resources
✓ Information systems
✓ Telecommunications
Marketing
DOWNSTREAM

Distribution

Customer service

Value of products and services

Figure 7.1 The value chain

In Table 7.1 the various upstream and downstream processes are explained.
Table 7.1 Various upstream and downstream processes
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Upstream costs Research and All the costs involved in developing new products
development and processes such as:
● building prototypes of new products
● testing new products.
Design costs All the costs involved in:
● designing a product
● designing the processes that will be used in the
production of a new product.
➤➤

The modern business environment

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Supply costs All the costs involved in sourcing and managing

materials:
● procurement costs
● material receiving costs
● stock holding costs.
Downstream costs Marketing All the costs involved in the selling of products and
services:
● advertising
● promotion
● commissions
● sales personnel salaries
● travelling expenses.
Distribution All the costs involved in finished goods:
● storage
● handling
● shipping.
Customer service All the costs involved in:
● after-sales service
● warranty claims
● enquiries.

Once organisations understand all the activities within the organisation that create
competitive advantage, they should manage them in a more effective and efficient way
compared to competitors’ activities. In doing so, the organisation has a competitive
advantage.

Supply chain management

Managing linkages in the value chain is also the central idea of supply chain management
(SCM). The flow of all goods, services and information into and out of the organisation
in a network consisting of customers, suppliers, manufacturers and distributors is known
as a supply chain. SCM considers relationships between the members of the supply
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chain, logistics, identification of end customer benefit and interfirm integration to form
network organisations. Activities in the value chain affect one another. Linkages need to
be coordinated and managed in such a way that all parties involved benefit. The objectives
of SCM are creating net value, building a competitive infrastructure, leveraging worldwide
logistics, synchronising supply with demand, and measuring performance globally.
SCM looks at the supply chain as a whole. All the organisations in the supply chain
collaborate to produce something of value for the end customer. Managers can collaborate
and look for ways of enhancing the profitability of the supply chain as a whole. In doing so,
everyone, including the end customers, will benefit. A view commonly held by management
is that to improve profitability, it is necessary to get the lowest prices from suppliers and to
obtain the best prices from customers next in line down the supply chain.

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Test yourself 7.1

(a) Name the various processes in the value chain.
(b) Categorise the various processes in the value chain into upstream and downstream
processes.

Total quality management

Quality is defined as the extent to which a product or service meets customer expectations
by conforming to the required design or specifications at the price customers are willing
to pay.
The definition and measures of quality come from the market and not from boardrooms.
If organisations are to provide quality products and services, it is not the organisations
themselves that judge whether the quality is acceptable or not. Quality should therefore be
regarded as an external measure of the attributes of products and services. A quality product
or service is distinguished by the degree of excellence with which it is made or performed,
whether it is fit for purpose, and how it compares to the competitors’ products and services.
The management of quality requires the establishment of standards of quality for a
product or service. It requires the establishment of procedures or production methods to
ensure that the required standards of quality are met. Quality has to be monitored and
control action must be taken when quality falls below the standard. Quality management
becomes total when it is applied to everything a business does, and it is then called total
quality management (TQM). CIMA describes TQM as an integrated and comprehensive
system of planning and controlling all business functions, so that products or services that
meet or exceed customer expectations are produced.
TQM is a philosophy of business behaviour, embracing principles like employee
involvement, continuous improvement at all levels, and customer focus. It is a collection
of related techniques aimed at improving quality, such as full documentation of activities,
clear goal setting, and performance measurement from the customers’ perspective.
TQM is the unyielding and continuous effort expended by everyone in the organ-
isation to understand, meet and exceed the expectations of customers. It emphasises
preventative measures. The aim is therefore to design and build quality, rather than
to inspect units in order to assess quality, by focusing on the causes rather than the
symptoms of poor quality. In the quest for TQM, quality-related costs are identified
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and reduced. TQM is a customer-centric approach based on two basic principles:

1. The principle of ‘get it right first time’
2. Continuous improvement.

The first basic principle of TQM is that the cost of preventing mistakes is less than the cost
of correcting them. Every mistake, delay and misinterpretation costs organisations money
through wasted time and effort, as well as the time taken to pacify customers. It also causes
lost potential for future sales. The second principle of TQM is dissatisfaction with the
status quo. The employees should believe that it is always possible to improve and get more
right each time. There are two approaches to continuous improvement that are discussed
later in the chapter, namely Kaizen costing and target costing.

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In a global economic environment, the survival of an organisation depends on their ability

to make quality products or provide quality services. In the global village, there are no
trade barriers, information about competing products and services is readily available, and
potential customers have a wide variety of products and services to choose from. This leads
to customers increasingly demanding their money’s worth from products and services. It
has brought to the fore the need to produce quality products and services, and has resulted
in the application of TQM as a technique. Quality is not a one-dimensional measure of the
degree of acceptability of a product or service. It is a combined measure of a number of
attributes that customers desire and demand in a product or service.
The dimensions of quality can be categorised as follows:
● Performance: how well and consistently a product or service functions
● Fitness of use: the suitability of the product to carry out its advertised functions
● Reliability: the probability of a product performing its intended function for a specified
length of time
● Aesthetics: the appearance of a physical product, that is, how appealing it is in the eyes
of the customer
● Serviceability: how easily a product can be maintained or repaired
● Features: the characteristics of a product that differentiate it from functionally similar
products
● Durability: the length of time that the product functions in the hands of the customer
● Conformance: how well a product meets the specifications set during the development
stage.

The elements aimed at producing and delivering quality products and services to customers
at the lowest cost possible, include the following:
● Encouraging operators to maintain their own equipment, and to detect, record and
solve their own problems
● Streamlining production flow
● Reducing inventories, lead times and defects
● Eliminating or reducing non-value-adding activities such as setting up machines and
ordering materials
● Cooperating with suppliers and synchronising production plans with supplier delivery
schedules increasing flexibility and productivity of the workforce.
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For TQM to be successful, it should be regarded as a culture that permeates every structure,
process and activity performed in the organisation. For organisations to benefit from
TQM, it is necessary to set targets for continuous quality improvement and cost reduction.
Such targets are supposed to be in the context of a well-understood quality improvement
programme, the aim of which is to better the previous period’s quality level. It needs to
be improved all the time if organisations are to sustain their competitive advantage.
Consequently, continuous improvement involves setting new targets that push the
boundaries of quality levels to new heights. Thus organisations that implement TQM
should never be satisfied with the status quo − they should keep in mind that it is always
possible to improve, and should always aim to get it more right the next time.
The implementation of TQM involves every activity of a business. Quality assurance
is not confined to the production process only, but also covers external suppliers, sales,

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distribution and administration departments, and the reaction of external customers.

The successful implementation of TQM requires strict adherence to quality assurance
procedures as illustrated in Table 7.2.
Table 7.2 Quality assurance procedures

Area Procedure
Quality assurance of goods Supplier quality assurance schemes are being used increasingly.
supplied by external suppliers The supplier is responsible for the quality of the goods supplied
and provides a guarantee.
Inspection of goods or Inspection is carried out on goods or services produced to
services produced satisfy management that quality control in production is being
maintained.
Monitoring customer Customer complaints should be monitored. Customer satisfaction
satisfaction surveys should be performed on a regular basis.
Employees and quality Responsibility for quality checking could be given to the workers.
Introduction of interdepartmental competitions to meet and beat
quality standards.

Getting it right the first time means that quality and not faults must be designed into the
organisation’s products and operations from the beginning. Quality control takes place
during the various stages of designing a product or service. Table 7.3 illustrates how quality
can be built into processes and systems.
Table 7.3 How quality can be built into processes and systems

Area Quality improvement

Product design Products must be designed to specifications that provide
a balance between price and quality that will make the
product or service competitive.
Production engineering (the designing During this stage, production methods are designed to
of methods for making the product or make production as efficient as possible and to avoid the
service to the design specifications) manufacture of substandard items.
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Information systems Systems should be designed to get the required

information to the right person at the right time.
Distribution systems Systems should be designed to get the required item to
the right person at the right time.

A distinction should be made between quality control and inspection. Inspection is a

technique of identifying when defective items are being produced at an unacceptable level,
and is usually carried out at three main points:
1. Inspection of raw materials and components purchased from outside suppliers
2. Floor or process inspection for work in progress
3. Final inspection or testing of finished goods before dispatching to the customer.

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The costs of quality

Cost of quality is the sum of the costs that arise from activities associated with prevention,
identification, repair and rectification of poor quality, and opportunity costs from lost
production time and lost sales as a result of poor quality. The costs of quality are generally
classified into costs of conformance and costs of non-conformance.
Costs of conformance are further divided into prevention costs (costs incurred in
preventing mistakes from happening) and appraisal costs (costs incurred in looking for
mistakes before a product is manufactured).
● Prevention costs: These costs arise from initiatives aimed at preventing the production
of defective products. The principle behind initiatives that give rise to these costs is
‘prevention is better than cure’. Prevention costs occur before production in order to
eliminate or reduce the chances of producing defective products. The following are
examples of prevention costs: quality engineering, design and development of quality
control and inspection equipment, administration of quality control, and training in
quality control.
● Appraisal costs: Appraisal costs arise from activities that are performed to
detect, measure and analyse data to ensure that products and services conform to
specifications. These costs occur during production, but before products are delivered
to the customers. Examples of activities undertaken to detect quality problems include
acceptance testing, inspection of goods supplied by external suppliers, inspection costs
of in-house processing, and performance testing. Costs of non-conformance are the
costs of failure to deliver the required standard of quality. They can be further divided
into internal failure costs (costs that occur when the units produced fail to reach the
required standard) and external failure costs (costs that arise when the faulty product is
not detected until after it reaches the customer).
● Internal failure costs: The appraisal function generates useful feedback about the
quality-related problems that exist despite the preventative measures put in place.
Activities aimed at the rectification of defective products and services give rise to
internal failure costs. These costs are called internal failure costs because they occur
before the product leaves the premises of the organisation. Examples of activities that
incur internal failure costs include failure analysis, re-inspection costs, losses from
failure of purchased items, losses due to lower selling prices for sub-quality goods,
costs of reviewing product specifications after failures, and manufacturing and process
engineering required to correct the failed process.
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● External failure costs: The measures put in place to prevent, detect and rectify
defective products and services sometimes fail to eliminate the production and delivery
of unacceptable products and services to end-use customers. When that happens, the
defects in the products and services are detected and experienced by customers. In other
words, in the case of external failure costs, the quality problems are detected outside the
boundaries of the organisation. Examples of external failure costs include the cost of
administering the customer complaints section, costs of the customer service section,
product liability costs, costs of repairing products returned from customers, the cost of
replacing items due to substandard products, and marketing errors and travel costs to
visit sites with faulty products. An expensive (although difficult to quantify in practice)
external failure cost is the opportunity cost of sales lost because of a damaged reputation.

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The cost of conformance is a discretionary cost, which is incurred with the intention
of eliminating the costs of internal and external failure. The cost of non-conformance
can only be reduced by increasing the cost of conformance. The optimal investment in
conformance costs is when total costs of quality reach a minimum (which may be below
100% quality conformance). Figure 7.2 illustrates that to achieve 0% defects, costs of non-
conformance should be nil, but these will increase as the accepted level of defects rises.
There should therefore be an acceptable level of defects at which the total costs of quality
are at a minimum.

Total costs

R Costs of non-conformance

Costs of conformance

0 1 2 3 4

Figure 7.2 Acceptable level of defects at which the total costs of quality are at a minimum

Cost of quality report

A cost of quality report shows the various categories of quality costs expressed as a
percentage of sales or turnover. This is shown as follows:
● Prevention costs: quality engineering, quality training programmes, quality planning,
product design, quality circles or cells, and supplier selection and evaluation
● Appraisal costs: raw materials inspection and testing, work-in-progress inspection,
finished goods inspection, packaging inspection and test equipment (acquisition,
maintenance, salaries and wages)
Internal failure costs: rework, scrap, loss resulting from downgrades, re-inspection,
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retesting, loss due to interruptions and design changes

● External failure costs: cost of recalls, sales returns and allowances due to quality
deficiency, repairs, product liability, warranty costs and contribution lost (from cancelled
orders owing to poor quality and to perceived poor quality).

The cost of quality increases as one moves down the order of prevention, appraisal, internal
failure and external failure costs. The total cost of quality is minimised when more emphasis
is placed on the earlier categories. This implies that more money is spent early on, such
as on designing a quality product and purchasing quality materials. Organisations that
achieve and sustain competitive advantage using TQM therefore focus on prevention and
appraisal in order to eliminate internal and especially external failure. Table 7.4 illustrates
a cost of quality report.

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Table 7.4 Cost of quality report

Types of costs Current % of total
month’s cost in
Rand
Appraisal costs
Materials inspection 22 500 8%
In-process inspection 15 000 5%
Finished goods inspection 15 000 5%
Laboratory testing 30 000 11%
Total appraisal costs 82 500 29%
Prevention costs
Quality training 30 000 11%
Quality planning 7 500 3%
Quality reporting 15 000 5%
Quality systems development 37 500 13%
Total prevention costs 90 000 32%
Internal failure costs
Scrap in production 15 000 5%
Scrapped finished goods 22 500 8%
Rework 15 000 5%
Downtime 7 500 3%
Total internal failure costs 60 000 21%
External failure costs
Warranty costs 5 250 2%
Out-of-warranty repairs and replacement 22 500 8%
Servicing customer complaints 7 500 3%
Transportation losses 15 000 5%
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Total external failure costs 50 250 18%

Total quality costs 282 750 100%

Cost of quality reports give a useful summary of the costs and progress and are a good
indicater of quality. Lower levels of management may also need non-financial quality
measures, including the following:
● Number of customer complaints
● Number of warranty claims
● Number of defective units delivered to customers as a percentage of total units delivered.

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Quality accreditation and ISO 9000

An international guideline for quality standards is the ISO 9000 series. ISO 9000 is a
comprehensive list of quality standards that was developed in 1987 by the International
Organisation for Standardisation, which is based in Geneva, Switzerland. The ISO 9000
series consists of three compliance standards, ISO 9001, 9002 and 9003 and two guidance
standards, ISO 9000 and 9004. These instructions are written in a general manner and
prescribe generic design, material procurement and production, quality control, and
delivery procedures necessary to achieve quality assurance. The standards communicate
what must be done to assure quality, but it is up to management to decide how to meet
the standards.
In recent years a new voluntary ISO standard not linked to the 9000 series has been written
− ISO 14000, that deals with setting guidelines regarding environmental responsibilities.
In South Africa, one of the driving forces behind the growth in quality management has
been the quality accreditation process. This accreditation is only achieved by meeting the
ISO 9000 series of quality standards. Accreditation in South Africa can only be obtained
through approved quality auditors such as the South African Bureau of Standards (SABS).
Although ISO 9000 is not mandatory, it is often used as a guideline to award tenders.

Total quality management and target costing

TQM’s focus is continuous improvement. Target costing aims to reduce costs by con-
centrating on cost management during product development. This makes target costing a
preferred method to use in TQM, as it shares the same focus.

Total quality management and just-in-time systems

Managing inventory and managing quality go hand in hand, and most businesses with
just-in-time (JIT) systems also have TQM programmes. Quality is not only a requirement
of JIT, it is a result thereof. Under JIT, any quality problems become apparent immediately,
because defective outputs are inputted into the next stage of the production process. Under
a conventional approach, the defective units may be hidden in work-in-process inventory
and not discovered for days or even weeks.

Total quality management and Kaizen costing

In addition to target costing, Kaizen costing is also used by Japanese organisations as a tool
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for reducing and managing costs. The word ‘Kaizen’ translates as continuous improvement.
Kaizen costing is applied during the manufacturing stage of the product’s life cycle. With
this method, the emphasis is on the production process, and cost reductions are derived
through the increased efficiency of the production process. After being in production for a
year, the actual cost of the first year becomes the starting point for further cost reduction.
This process of continuous improvement and encouraging constant cost reductions by
tightening the standards makes Kaizen costing the ideal costing system to be used in a
TQM environment.

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Test yourself 7.2

(a) What are the basic principles of TQM?
(b) Categorise the dimensions of quality.

Kaizen costing
Kaizen is a Japanese term for continuous improvement in all aspects of an entity’s
performance at every level. Often associated with total quality management, many
firms limit Kaizen to improving production. Kaizen costing focuses on obtaining small
incremental cost reductions during the production stage of the product life cycle. Kaizen
involves setting standards and then continually improving these standards to achieve long-
term sustainable improvements. The focus is on eliminating waste, improving processes and
systems and improving productivity. It involves all employees and all areas of the business.
Kaizen costing has been used by some Japanese firms for over 20 years and is now widely
used in the electronics and automobile industries, for example.
Functional analysis is applied at the design stage of a new product, and a target cost for
each function is set. The functional target costs are added together, and the total becomes
the product target cost. Once the product has been in production for a year, the actual cost
of the first year becomes the starting point for further cost reduction. It is this process of
continuous improvement, encouraging constant reductions by tightening the standards
that is known as Kaizen costing.

What is continuous improvement?

Continuous improvement is the continual examination and improvement of existing
processes and is very different from approaches such as business process re-engineering
(BPR), which seeks to make radical one-off changes to improve an organisation’s operations
and processes. The following concepts underlie continuous improvement:
● The organisation should always seek perfection. Since perfection is never achieved, there
must always be scope for improving on the current methods.
● The search for perfection should be ingrained into the culture and mindset of all
employees.
● Improvements should be sought all the time.
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● Individual improvements identified by the workforce will be small rather than far-
reaching.

Eliminating waste
Kaizen costing has been developed to support the continued cost reduction of existing
components and products. Cost reduction targets are set on a regular, monthly basis
and variance analysis is carried out at the end of each period to compare the target cost
reduction with the actual cost.

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One of the main ways to reduce costs is through the elimination of the seven main types
of waste:
1. Over-production – producing more than customers have ordered
2. Inventory – holding or purchasing unnecessary inventory
3. Waiting – production delays/idle time when value is not added to the product
4. Defective units – production of a part that is scrapped or requires rework
5. Motion – actions of people/equipment that do not add value
6. Transportation – poor planning or factory layout results in unnecessary transportation
of materials/work-in-progress
7. Over-processing – unnecessary steps that do not add value.

Test yourself 7.3

How are Kaizen goals met?

Target costing
Target costing is the process of determining the maximum allowable cost for a new
product and then developing a prototype that can be profitably made for that maximum
target cost. The target costing approach was developed in recognition of two important
characteristics of markets and costs. The first is that many companies have less control
over price than they would like to think. The market (that is, supply and demand) really
determines the price. A company that attempts to ignore this does so to its detriment.
Target costing is a way of reducing the costs of future products by concentrating on cost
management during product development. In target costing the required profit margin is
subtracted from the target selling price to arrive at the target cost for the product, which,
in the long run, must be met, and is driven by the requirements of the marketplace. Using
the target cost approach, product designers and purchasing and manufacturing specialists
work together to determine the product and process features which will enable the long-
run target costs to be achieved. Hence, the entire product from conception to production
is the joint responsibility of cross-functional teams, including design, engineering, sales,
marketing, material procurement, cost accounting, service and support.
The importance of the target costing approach is that it focuses attention on the product
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at design stage, prior to release to manufacturing. Most costs are committed or locked
in early in the life cycle of the product. Once the product is released to manufacturing,
it becomes much harder to achieve significant cost savings. Most of the opportunities to
reduce cost come from designing the product so that it is simple to make, uses inexpensive
parts, and is robust and reliable. If the company has little control over market price and
little control over cost once the product has gone into production, then it follows that
the major opportunities for affecting profit come in the design stage, where valuable
features that customers are willing to pay for can be added, and where most of the costs
are really determined. That is why the effort is concentrated on designing and developing
the product.

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The target cost for a product is computed by starting with the product’s anticipated selling
price and then deducting the desired profit. Once a competitive market price is determined,
the required profit margin is subtracted from the market price, resulting in the target cost.

Target cost = Anticipated selling price − Desired profit

The product development team is then given the responsibility of designing the product so
that it can be made for no more than the target cost. Cost analysis is guided by the customer
requirements about quality, price and timeliness of the product. The target cost must not
only yield the target profit, but also allow the manufacturer to provide the features customers
expect. This process implies that target costing is customer driven. Cost reduction efforts
are attained by simultaneously designing the product and the manufacturing process,
thus eliminating expensive features and minimising the need for changes once production
has commenced.

Four stages in the target costing process

Stage 1: Product planning – define the product and customer niche.
Stage 2: Concept development and feasibility testing – develop a product concept and
test its feasibility.
Stage 3: Design development – transform the feasible product concept into a detailed
product design.
Stage 4: Production – production can commence once the final design is released.

Conduct
Market
market
price
research

Define
Understand Define
product or Target
customer product
customer cost
requirements features
niche

Conduct
competition Required
analysis profit
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Figure 7.3 Major activities in establishing the target cost

Reasons for using target costing

Target costing is widely used in various industries in different countries, for example Toyota,
Mercedes and Nissan in the car industry, Apple and Toshiba in the computer industry,
and Panasonic and Sharp in the electronics industry. Target costing is a way of reducing
the costs of future products by concentrating on cost management during product
development. Establishing the selling price of the proposed product is done in such a way
that it takes into account expected market conditions at the time of launching the product.

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In addition, the proposed product selling price should take into account certain internal
and external factors. External factors that are considered in setting a target selling price
include the following:
● The organisation’s image in the market
● The level of customer loyalty in the product’s market
● The product’s expected quality level, functionality and price compared to competing
products.

Product inputs Planning Post planning stage

Product marketing Market research

Selling & distribution

Design Decide on product

specific features &
performance

Product development
1. Design
Order of
2. Purchasing
development
3. Manufacture
Operations Scheduling and
production
Achievable cost

Finance
Target selling price No
Yes

Cost comparison Allowable cost

Was the target cost
met?
Target profit
Strategic planning

Figure 7.4 Target costing process diagram

The desired profit margin applied in establishing a product’s target cost is determined by
taking into account, amongst other things, stakeholders’ needs and funding for future
research and development of new products. It is important therefore to remember that not
only is the desired profit margin influenced by the required return on investment (ROI),
but that the organisation’s future financial needs for developing products are also an
influencing factor.

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Illustrative example 7.1

Mokoena & Naidoo Engineering is looking at designing, developing and manufacturing
a new concrete mixer. They want to invest R20 000 000 in this project. The company’s
marketing department researched the market to determine the features and prices of
competing products. Based on their findings, they determined that at a price of R3 000,
they would be able to sell an estimated 40 000 concrete mixers per year. The company
requires a 15% return on investment (ROI).

Required:
Determine the target cost per concrete mixer.

Solution:
The target cost to manufacture, sell, distribute and service one concrete mixer is given
in Table 7.5.
Table 7.5 Target cost to manufacture, sell, distribute and service one concrete mixer
R
Projected sales (40 000 concrete mixers × R3 000 per mixer) 120 000 000
Less: Desired profit (15% × R20 000 000) 3 000 000
Target cost for 40 000 concrete mixers 117 000 000
Target cost per concrete mixer (R117 000 000 ÷ 40 000 concrete mixers) 2 925

This R2 925 target cost per concrete mixer would be broken down into target costs for
the various functions: manufacturing, marketing, distribution, after-sales service, and
so on. Each functional area would be responsible for keeping its actual costs within
target.

Test yourself 7.4

(a) How is the target cost for a product calculated?
(b) What external factors must be considered when setting a target selling price?
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Just-in-time
CIMA defines just-in-time (JIT) as ‘a system whose objective is to produce or procure
products or components as they are required by a customer or for use, rather than for
inventory’. A JIT system is a ‘pull system’ which responds to demand, in contrast to a ‘push
system’ in which inventory acts as a buffer between the different elements of the system,
such as purchasing, production and sales. JIT can be described as a management style that
involves commitment to continuous improvement and seeks excellence in the design and
operation of the production management system. The aim of JIT systems is to streamline
the flow of products through the production process and into the hands of the customers.

Cost and Management Accounting

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It focuses on an organisation’s efforts of performing value-adding activities on demand and

at the same time minimising waste.
JIT has three primary goals:
1. The elimination of any process or operation that does not add value to the product
or service, thus striving for continuous improvement in production, performance and
quality, while meeting customer demand immediately.
2. The reduction of total cost through the elimination of waste, such as waiting time,
transport and inventory, while continuously improving quality.
3. The involvement of staff, because JIT is a cultural issue, and the philosophy must be
embraced by everyone if it is to be implemented and applied successfully.

The elements of the JIT philosophy are as follows:

● Quality is always essential. Work to eliminate defects and waste.
● Employees often have the best knowledge of ways to improve operations. Listen to them.
● Employees generally have more talents than are being used. Train them to be multiskilled
to increase their productivity.
● Ways to improve operations are always possible. Constantly look for them, being certain
to make fundamental changes rather than superficial ones.
● Creative thinking does not cost anything. Use it to find ways to reduce costs before
making expenditures for additional resources.
● Suppliers are essential to operations. Establish and cultivate good relationships with
suppliers and, if possible, use long-term contracts.
● Inventory is an asset that generates no revenue while it is held in stock. Thus it can be
viewed as a liability. Eliminate it as far as possible.
● Storage space is directly related to inventories. Eliminate it in response to the elimination
of inventories.
● Long cycle times cause inventory build-up. Keep cycle times as short as possible by doing
frequent deliveries.

The difference between the traditional ‘push system’ and the just-in-time
‘pull system’
In traditional systems, demand is projected and products are produced accordingly and
kept in stock until they are sold, thus it is a system of ‘pushing’ product units through the
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factory. In push systems, output is increased while idle time is prevented. Inventory units
act as buffers between the different parts of the system, such as procurement, production
and sales.

Supplier → Production → Customer

Figure 7.5 Push system

In contrast, JIT is a pull system, because products are produced only when required by the
customer, and components are not made until required by the next production stage. In
a full JIT system, virtually no inventory is held, that is, no raw material or finished goods
inventory is held. There may be a small amount of work in progress held (approximately
10% of a day’s production). Because non-value-adding items are kept to a minimum,

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inventory, which is regarded as a non-value item, and all the costs related to the keeping
of inventory are eliminated. JIT manufacturing saves money through minimising expenses
and gaining customer goodwill by efficiently ‘pulling’ requested products through the
factory and delivering products on demand, as illustrated in Figure 7.6. Workstations work
on units only when they have received a formal instruction to do so from the next station
in the production line.
Supplier Production Customer
→ →

Figure 7.6 Pull system

The word ‘kanban’ is a Japanese word which means signboard or visual signal. A kanban is
a card attached to a carrier or container of a lot used to match what needs to be produced in
a workstation and what needs to be delivered to the next workstation. A well-timed kanban
system works exactly like a traffic signal in managing the flow of traffic and meeting the
real-time needs of customers by sending clear signals on when to start, slow down, and
stop production.

The benefits of just-in-time

The benefits of JIT extend beyond the obvious savings in inventory carrying costs, such as
reduced storage and handling costs, lower insurance costs, fewer losses due to spoilage,
obsolescence and theft, and decreased opportunity costs associated with having money tied
up in inventory. The aim of JIT is to eliminate all non-value-added activity, not just excessive
inventories. JIT can improve productivity, manufacturing lead times and quality. Under a
successful JIT system, customers’ needs are satisfied more quickly and more effectively. In
theory, the JIT ideal is zero inventories.

Just-in-time production
An important goal of JIT is to simplify the production flow, beginning with the arrival
of materials from suppliers and ending with the delivery of goods to customers. Non-
value-added activities are identified and removed throughout the production process. As
materials are purchased and goods are produced only as required, batch sizes tend to be
small and inventory levels are low. Quick and inexpensive set-ups of production machinery
are used. To produce in small batches, set-up times must be reduced, or the production line
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will be too slow to meet customer delivery requirements. In some companies, set-ups can
take more than an hour, while in other companies, only 10 minutes may be required. Value
analysis and the use of advanced technologies may help to reduce this time. If raw materials,
components and sub-assemblies are to arrive ‘just-in-time’ for production, they must be
‘just right’ for their intended purpose, otherwise the production line will be shut down and
significant non-value-added costs of waiting will result. Quality is not only a requirement
of JIT; it is a result. If goods are to be manufactured ‘just-in-time’ to meet customer orders,
production delays must be avoided, and therefore frequent maintenance of equipment is
essential. To facilitate JIT, many businesses restructure their production processes from
rigid assembly lines into work-based teams. Employees in these teams are multi-skilled
and trained to complete all aspects of the production process. This assists in eliminating
bottlenecks in the production process and non-value-added idle time.

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Just-in-time purchasing
A JIT system involves JIT production as well as JIT purchasing. Some organisations take
a JIT approach only to purchasing, and not to production. The aim of JIT purchasing is
to purchase raw materials from outside suppliers only as they are needed to avoid costly
inventory build-ups. JIT purchasing includes the following key features:
● Under JIT, many companies dramatically reduce the number of suppliers that they deal
with and work on developing close relationships with individual suppliers, who must be
able to deliver high-quality goods on time.
● Long-term contracts are negotiated and entered into with suppliers that include supply
price, quality, design specifications and delivery terms.
● The aim of JIT is to avoid holding costly inventories by having supplies arrive ‘just in
time’ to be placed into production. This results in many small orders delivered more
often. Orders may be received daily, or weekly, or hourly, depending on the company.
● Under JIT, suppliers are selected according to their ability to meet stringent quality
standards and deliver the correct amount of materials on time. Once the quality of
suppliers is proven, the level of quality testing is reduced.
● JIT systems may utilise e-commerce applications, including EDI (electronic data
interchange), often as part of a wider ERP system. This may allow firms to place orders
electronically with suppliers or will provide suppliers with online access to a firm’s
inventory files to determine purchase requirements and to provide orders. Invoices from
suppliers and payments to suppliers will also be managed electronically. These systems
reduce costly paperwork for both supplier and purchaser.
● JIT purchasing is also used in retail, wholesale and service firms to reduce warehouse
inventories and to streamline the purchasing function. JIT purchasing is a critical aspect
of managing suppliers. JIT production and JIT purchasing have implications towards
enhancing customer satisfaction.

The problems of just-in-time

A JIT system often entails a substantial investment in setting up the production facilities to
minimise non-value-added activities, such as material handling and other work associated
with poor quality and excessive inventories. A JIT system can also increase the risk of incurring
inventory shortage costs. This may lead to disrupted production, the costly expediting of
materials, and lost sales. It may be difficult for JIT to deliver benefits to small suppliers.
Although small firms may need to comply with the JIT requests of large customers, they
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may not have the ability to push those same systems onto their own suppliers. It may be
necessary for small suppliers to keep excessive raw materials and finished goods inventory
on hand to meet the JIT requirements of their customers. It is not always easy to predict
patterns of demand. JIT may make an organisation more vulnerable to disruptions in the
supply chain. JIT was designed at a time when all of Toyota’s manufacturing was done within
a 50 km radius of its headquarters. Wide geographical spread makes this difficult. South
African companies wishing to implement a JIT system could be faced with many challenges,
such as the wide geographical spread of suppliers, disruption in the supply chain, such as
labour instability due to strikes and logistical problems, and smaller suppliers may not be
able to afford carrying additional stock.

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Case study: Toyota’s JIT revolution

The JIT production system was one of the most significant production management
approaches of the post-World War II era. Using JIT, Taiichi Ohio revolutionised the
production system at Toyota. In the mid-1990s, many executives and engineers from
major automobile companies visited Toyota’s manufacturing facility in Georgetown
to study the Toyota production system (TPS). The TPS aimed to produce world-class,
quality automobiles at competitive prices. One of the main principles it was built on
was just-in-time (JIT) production. JIT was used not only in manufacturing, but also in
product development, supplier relations and distribution. Analysts remarked that despite
imitating Toyota’s JIT for many years, no other automaker in the world had been able
to make their production systems and processes as efficient as Toyota had done. The
early adoption of JIT principles by Toyota seemed to have helped the company achieve
significant success. It helped the company respond quickly to changing customer needs
and offer high-quality products at low costs, thus increasing customer satisfaction.

Required:
1. Why was it to Toyota’s advantage to implement JIT?
2. What was the effect on the supply chain of Toyota implementing JIT?

Test yourself 7.5

(a) What are the primary goals of JIT?
(b) What is the difference between push and pull systems?

Throughput accounting
Throughput accounting (TA) is a system of performance measurement and costing which
traces costs to throughput time. The name ‘throughput accounting’ was first coined in the
late 1980s by Galloway and Waldron who developed the system in the UK. TA assumes that a
manager has a given set of resources available. These resources consist of existing buildings,
capital equipment and labour force. Using these resources, purchased materials and parts
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must be processed to generate sales revenue. The most appropriate financial objective is
the maximisation of throughput. Throughput accounting is defined as follows: variable
cost accounting presentation based on the definition of throughput (sales minus material
and component costs). It is sometimes known as super variable costing, because only
material costs are treated as variable. TA is different from all other costing systems, because
it emphasises throughput first, then minimisation of inventory, and third cost control.
Throughput is a key performance measure and is the rate at which the system generates
money. Its measurement is in monetary terms and it is linked directly to profitability,
therefore the objective is to maximise throughput values/flow. Throughput is calculated
as follows:

Throughput = Sales revenue − Material and component costs

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Bottlenecks
A bottleneck is an activity that places a restriction on a production line or factory. A typical
bottleneck could be the capacity of a certain key machine. The throughput philosophy
entails the identification and elimination of bottleneck resources. Bottlenecks can be
alleviated by means of rearrangement of existing resources, buying in new resources,
providing additional training for slow workers, changing the product design to reduce
processing time in bottleneck activity, and eliminating idle time at the bottleneck (for
example, machine set-up time). If they cannot be eliminated, production must be limited to
the bottleneck resource to avoid the build-up of work in progress, and the manager should
also consider investing in new equipment. Buffer inventory should also be built up prior
to the bottleneck. Eliminating one bottleneck may lead to the creation of another one.
The management of bottlenecks is thus a primary concern of an organisation seeking to
increase throughput. The CIMA official terminology describes a bottleneck as a ‘facility
that has lower capacity than preceding or subsequent activities, and restricts output based
on current capacity’.

The three concepts of throughput accounting

Concept 1
With the exception of material costs, in the short run most factory costs, including direct
labour, are fixed. These fixed costs can be grouped together and are called total factory costs
(TFC). TA is often compared with marginal costing. In marginal costing, direct labour costs
are assumed to be variable costs. In the past this assumption was true, but employees are
not usually paid a piece rate today and they are not laid off for part of the year when there is
no work, thus labour costs are not truly variable. Marginal costing is generally a short-term
decision-making technique, while TA or theory of constraints (TOC) was conceived with
the aim of changing manufacturing strategy to achieve evenness of flow. It is thus much
more than a short-term decision technique.

Concept 2
In a JIT environment, the ideal inventory is zero. Products are not made unless a customer
is waiting for them. The effect of this is that there will unavoidably be idle capacity in some
operations except for the operation that is experiencing a bottleneck. Working on output
just to increase work in progress or finished goods stock should not be encouraged, because
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it creates no profit. The exception to the zero-inventory policy is that buffer stock should
be kept prior to the bottleneck process. When bottlenecks cause other resources to stand
idle after they have completed the work required, this idle time costs nothing. Thus, profit
is inversely proportional to the level of inventory in the system. This is expressed as follows:

Profit = ∫    ( ____

MRT )
1 where MRT is the manufacturing response time.

Concept 3
Profitability is determined by how quickly goods can be produced to satisfy customer orders.
Producing for stock does not create profits. The goal of any profit organisation is to make
money, thus inventory must be sold for the goal to be achieved. Buffer inventory, work in
progress and finished goods should be valued at material cost only until the output is sold.
No value will be added, and no profit will be earned until the sale takes place. Improving the

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throughput of bottleneck operations will increase the rate at which customer demand can
be met and will improve profitability. The traditional way of calculating contribution is not
a true guide to profitability, because capacity factors and the rate of production are ignored.

Throughput accounting measures

Various performance measures have been devised to measure throughput. Using TA,
product returns should be measured as follows:
Sales price 2 Direct material
Return per factory hour = ____________________________
   
    
 
Product's time on bottleneck resource in factory hours
 

Product costs are then measured:

Total factory cost (TFC)
Cost per factory hour =  ________________________
   
  
Total time available on the bottleneck
The returns and cost per factory hour are combined into the TA ratio:
Return per factory hour (or minute)
TA ratio = _______________________
    
   
Cost per factory hour (or minute)

Products can be ranked according to the TA ratio as follows:

Throughput contribution or value added per time period
TA ratio = _________________________________________

        
Conversion cost per time period
 
(Sales 2 Material costs) per time period
= _____________________________
   
  (Labour
    1 Overheads) per time period
  

The return per factory hour shows how much return is generated by each product at the
bottleneck. Management should strive to maximise this return as it will lead to an increase
in the organisation’s profits. Cost per factory hour includes all other costs that are not used
in the throughput contribution. Management should aim to minimise this cost.
The TA ratio has the advantage of including the costs involved in running the factory.
The higher the ratio, the more profitable the company. If the ratio should be less than 1,
the product will lose money and the organisation should consider withdrawing the product
from the market. When TA is used, value is not created until products are sold. Items made
for stock, produce no return and depress the TA ratio. This should cause managers to
produce only products for which customer demand exists, using their limited bottleneck
resources.

Throughput accounting and just-in-time

JIT operating systems require a particular type of costing system. The TA technique has
been designed to deal with JIT operating systems. TA complements JIT principles and forces
attention to the true determinant of profitability: the rate at which goods can be produced
to satisfy customers’ orders.

Throughput accounting and the theory of constraints

TA is based on the concept of the theory of constraints (TOC), which was formulated by
Goldratt and Cox in the USA in 1986. This is the process of identifying the constraints and
taking steps to remove those constraints that restrict output. The key financial concept of
TOC is to turn materials into sales as quickly as possible, therefore maximising throughput
and the net cash generated from sales.

Cost and Management Accounting

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This process can be done in the following steps:

Step 1: Identify the bottlenecks in the system.
Step 2: Find ways to alleviate the bottlenecks.
Step 3: Subordinate everything to the decision in the previous step.
Step 4: Alleviate all the bottlenecks in the system.

Once a bottleneck has been alleviated, it is generally replaced by a new bottleneck elsewhere
in the system. It then becomes necessary to start again at step 1. A constraint is anything
that confines or limits a person’s or machine’s ability to perform a project or function.
Human constraints can be caused by an inability to understand or perform at some higher
rate of speed. These constraints cannot be totally overcome but can be reduced through
training and the hiring of the right people. The labour component of products is declining
rapidly as automation increases, therefore constraints caused by machines are more of a
concern than human constraints in reducing cycle time. There will always be one process
that acts as a bottleneck. This is known as the binding constraint in TOC terminology. The
important concept behind TOC is that the production rate of the entire factory is set at the
pace of the bottleneck. According to TOC, inventory costs money in terms of storage, space
and interest costs. Therefore, inventory is not desirable.
After identifying the bottleneck, the following steps must be followed in the case of
multi-products when trying to maximise the throughput contribution earned:
Step 1: Calculate the throughput contribution per unit for each product.
Step 2: Calculate the throughput contribution per unit of the bottleneck resource for each
product.
Step 3: Rank the products in order of the throughput contribution per unit of the
bottleneck resource.
Step 4: Allocate resources using this ranking.

Illustrative example 7.2

FANS manufacture two products, Fast and Slow. The following information is given:

Fast Slow
Unit selling price R120 R80
Direct costs per unit R60 R50
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Hours per unit required at the bottleneck 2 1

Maximum demand 18 000 40 000

40% of direct costs relate to direct materials. There are 50 000 hours available at the bottleneck.
Total factory costs for the period are R2 000 000.

Required:
Calculate the throughput accounting ratio for each product, and, taking the constraint
into consideration, advise management if it is wise to continue the production of these
two products.
➤➤

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Solution:
Fast Slow
R120 − R24 R80 − R20
Return per factory hour =  _________
2 =  ________
1
Sales price − Direct material
=  _______________________________________
Product’s time on bottlenect resource in factory hours
   
     = R48 = R60

Cost per factory hour R40 R40

Total factory cost (TFC)
___________________________
=         
Total time available on the bottleneck
R2 000 000
= __________
  50 000 hours
R48 R60
TA ratio =  ____
R40 =  ____
R40
Return per factory hour
_________________ = 1.2 = 1.5
=    
  
Cost per factory hour

Ranking 2 1

Management should continue manufacturing both products as the throughput

accounting ratio is greater than 1, thus the return per hour is greater than the cost per
hour in both cases. If you apply the theory of constraints to the decision, the product
Slow should be manufactured first.

Test yourself 7.6

(a) What is throughput accounting?
(b) How is throughput calculated?
(c) What is a bottleneck?

Life-cycle costing
CIMA defines a product’s life cycle as ‘the period which begins with the initial product
specification and ends with the withdrawal from the market of both the product and
its support’. It is characterised by defined stages, which include research, development,
introduction, maturity, decline and abandonment. Costs are accumulated and managed
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throughout the product’s entire life cycle. The product life-cycle model advocates that each
product and service has the following life cycle:
● Introductory stage: when costs are high and sales grow rapidly
● Maturity stage: when costs and sales are stable, and cash flow is being achieved
● Decline stage: when the market has become saturated, and where eventually a point is
reached when it is no longer viable to produce the product.

From a production perspective, product life cycles cover four stages:

Stage 1: Product planning and initial concept design
Stage 2: Product design and development
Stage 3: Production and distribution
Stage 4: Customer/logistical support.

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In many organisations up to 90% of a product’s life-cycle cost is determined by decisions

made early in the cycle. Management accounting systems that monitor spending and
commitment to spend during the early stages of a product’s life cycle are becoming
increasingly important. Life-cycle costing is therefore the maintenance of cost records
accumulated over the product’s lifespan, which can be divided into the following:
● Preproduction costs are the costs incurred during the research, development and
design stage. The decisions made by the engineers and product designers at this stage
are crucial in saving money during the following two stages. Costs incurred during this
stage also have to be allocated to specific products.
● Production costs start once the product’s feasibility has been established and all
testing has been completed. At this stage, no more design changes can be made, and
the only cost savings that can be achieved are limited to opportunities presented by the
actual production methods. Costs during this stage do not occur evenly. During the
introductory stage, costs are usually high. Costs then stabilise during the maturity stage
when economies of scale and the learning curve and other efficiencies have set in. At the
decline stage, the per unit cost will be considerably lower due to large volumes and the
efficiencies gained through time.
● Most of the marketing, service and support costs are a result of product design
and production in terms of functionality and quality. Marketing costs are the costs
of marketing and advertising the product. Service and support costs include repair,
maintenance and warranty costs.

Test yourself 7.7

What are the stages in a product’s life cycle from a production perspective?

Benchmarking
The practice of benchmarking dates back to 607AD, when Japan sent teams to China to
learn the best practices in business, government and education. Today, most large firms
routinely conduct benchmarking studies to assess current business practices and then
implement them in their own firms. Benchmarking is a technique that is increasingly being
adopted as a mechanism for achieving continuous improvement. It can be described as a
process of continuously comparing and measuring an organisation’s business processes
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against business leaders anywhere in the world to gain information which will help the
organisation take action to improve its performance.
Economic Darwinism predicts that a successful organisation’s practices will be imitated.
Benchmarking is the practice of imitating successful business practices. It is a continuous
process of measuring a firm’s products, services or activities against other best performing
organisations, either internal or external to the organisation. The objective is to ascertain
how the processes and activities can be improved. Ideally, benchmarking should involve an
external focus on the latest developments, best practice and model examples that can be
incorporated within various operations of business organisations. It therefore represents
the ideal way of moving forward and achieving high competitive standards. Different
organisations have adopted different models to benchmarking, and most of these models
generally conform to the same process, comprising five basic steps:

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Step 1: Decide what area of activity to benchmark (for example, customer services,
business’s processes in particular departments, quality of employees and standard
of training).
Step 2: Select a competitor who is reputedly the best in the area of activity to be
benchmarked. Major companies in one country may target an international
competitor rather than a domestic company. In some benchmarking situations,
the competitor benefits from the exchange.
Step 3: Decide on the appropriate measurements to be used in defining performance
levels.
Step 4: Determine the competitor’s strengths and compare these with the company’s own
record.
Step 5: Use the information collected as the basis for an action plan. To be effective, this
action plan must involve all grades of employees working in the area of activity.

Benchmarking practices can be classified according to the nature of the object of study of
benchmarking and the partners against whom comparisons are made. In terms of object of
study, benchmarking can be classified as follows:
● Process benchmarking is used to compare operations, work practices and business
processes
● Product benchmarking is used to compare products and services
● Strategic benchmarking is used to compare organisational structures, management
practices and business strategies. In a sense, it possesses some similarities to process
benchmarking.

The classifications of benchmarking influence the type of partner selected as a basis for
comparison as follows:
● Internal benchmarking, by comparing performance of units or departments within
one organisation. Comparison can also be made of similar products or services of
similar business units.
● Competitive benchmarking, by comparing performance with the direct product
competitor. In this case, comparison can be made of products or services and business
processes. Reverse engineering is a term more appropriate for product benchmarking.
● Functional benchmarking is specific function comparison with best practice. It is an
application of process benchmarking that compares a particular business function in
two or more organisations in the same industry.
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● Generic benchmarking is a search for the best practice, irrespective of industry. It is

similar to functional benchmarking, but the aim is to compare with the best in class
without regard to industry.

Test yourself 7.8

What is benchmarking?

Cost and Management Accounting

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Backflush accounting
Backflush accounting is a simplified costing system used by organisations that use a JIT
production system. No distinction is made between raw material inventory and work-
in-process inventory. In a JIT environment inventories are kept as low as possible and
purchases are placed directly into production. Finished goods inventories are minimal
under JIT because goods are sold as they are produced. The comparison between backflush
and conventional costing is given in Table 7.6.
Table 7.6 Comparison between conventional and backflush costing
Conventional costing system Backflush costing system
Raw material purchases are added to raw Raw material purchases are added directly to
materials inventory account at time of the raw and in-process inventory accounts.
purchase. As materials are drawn to be used in
production, they are moved into the work-in-
process inventory account.
Direct labour and manufacturing overhead Conversion costs are moved directly to the
costs are charged to work-in-process inventory. finished goods inventory.
These costs are moved to the finished goods
inventory only when the goods are completed.
Costs are tracked sequentially through the Works backwards after the manufacturing
physical flow of manufacturing. sequence is complete. Product costs are then
flushed out of the system.
Inventory is an asset. Inventory is not an asset. It is a result of
unsynchronised manufacturing and is a barrier
to making profit.
Costs can be classified as direct and indirect. This classification is no longer useful.
Product profitability can be determined by Profitability is determined by the rate at which
deducting a product cost from the selling price. money is earned.
Profit is a function of costs. Profit is a function of throughput as well as costs.

Backflush accounting is much simpler than and not as expensive as conventional product
costing. It provides much less detailed information than conventional product costing.
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The decision to use backflush accounting must be weighed up against the loss of detailed
information. The use of backflush costing is becoming more popular, but only a small
number of manufacturers use it.

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Illustrative example 7.3

Working backwards from input, see the information given in Table 7.7, which was
extracted from the monthly accounting and production records.
Table 7.7 Extract from monthly accounting and production records
Orders completed and despatched in March 200 units
Orders completed in advance: 1 March 4 units
Orders completed in advance: 31 March 3 units
Scrapped items 6 units
Conversion costs for March R270 000
Material costs for March R525 000
R795 000

Inventory and production can be valued as follows:

B/f (4)
Despatched 200
Scrapped 6
C/f 3
Units produced 205

( R795 000 )
Cost per unit ________
  205   3 878

A single process account can be drawn up as follows:

Dr Cr
R R
Inventory b/fwd (4 × R3 878) 15 512
Materials 525 000
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Conversion costs 270 000

To finished goods (200 × R3 878) 775 610
Losses written off to income statement (6 × R3 878) 23 268
Inventory c/fwd (3 × R3 878) 11 634
810 512 810 512

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Test yourself 7.9

Explain the difference between backflush accounting and conventional accounting
systems concerning the tracking of costs.

Advanced manufacturing technology

The most widely used definition of advanced manufacturing technology (AMT) involves
the use of technology to improve products and/or processes, with the relevant technology
being described as ‘advanced,’ ‘innovative,’ or ‘cutting edge’. Technology-based systems
and processes are integrated in the production of products (fit, for and function) to the
highest level of quality and compliance with industry-specific certification standards. AMT
is the general expression used encompassing computer-aided design (CAD), computer-
aided manufacturing (CAM), flexible manufacturing systems (FMS) and a wide array of
innovative computer equipment. AMT has had a huge impact on manufacturing, causing a
vast reduction in labour costs.

Computer-aided design
The use of computer-aided design (CAD) allows new products as well as the modification
of existing products to be designed on a computer screen. The effects of changing product
specifications can be explored. Designs can be assessed for cost simplicity; a simple design
can produce a product that is more reliable and easier to manufacture. This reduces the
possibility of production errors and quality and cost reduction can be incorporated into a
product at the design stage.

Computer-aided manufacturing
In computer-aided manufacturing (CAM) the physical production processes are
controlled by computers. The following features are used in CAM:
● Robots, typically comprising of computer-controlled arms and attachments, perform
tasks like welding, bolting parts together and moving them about.
● Computer numerically controlled (CNC) machines are used for cutting, machining
and punching holes. Manufacturing configurations and set-up instructions are stored
on computer programs and so can be changed almost immediately via a keyboard. The
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advantages of CAM are flexibility and reduction in set-up times. Computers can repeat
the same operation in an identical manner over and over again, without tiring or error.
This has advantages for both quality and production control.
● Automated guided vehicles (AGVs) are used for material handling. These vehicles
often replace the traditional conveyor-belt approach.
● A flexible manufacturing system (FMS) is a highly automated manufacturing system
that is computer controlled and capable of producing a broad range of parts in a flexible
manner. FMS is characterised by small batch production, the ability to change quickly
from one job to another as well as very fast response times, and output can be produced
quickly in response to specific needs. Although the sophistication of FMS varies
from one system to another, features can include JIT systems, computer-integrated
manufacturing (CIM), which is the integration of many or all of the elements of
AMT into one coherent system or perhaps just islands of automation (IA), which is a

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series of automated subsystems within a factory. FMSs can also include computerised
materials handling systems (MHS) and automated storage and retrieval systems
(ASRS) for raw materials and parts. CIMA defines FMS as an ‘integrated, computer-
controlled production system which is capable of producing a range of parts, and of
switching quietly and economically between them’.

Electronic data interchange

Electronic data interchange (EDI) facilitates communication between an organisation
and its customers and suppliers through the electronic transfer of information without
the need of human intervention. EDI permits multiple companies, possibly in different
countries, to exchange documents electronically. Data can be exchanged through serial
links and peer-to-peer networks, though most exchanges currently rely on the internet for
connectivity.

Advanced manufacturing technology in South Africa

In South Africa, manufacturing contributes more than 18.5% of the national Gross
Domestic Product (GDP), over half of all exports and is the second-largest employer.
The South African government, in recognising the importance of manufacturing in the
economy, recently developed the National Advanced Manufacturing Technology Strategy.
The manufacturing sector remains the engine for growth in the South African economy.
The application of advanced manufacturing technologies is seen as a critical component to
gain competitive advantage in global markets.

Test yourself 7.10

What does AMT encompass?

World-class manufacturing
The term ‘world-class manufacturing’ (WCM) was coined in the mid-1980s and describes
the fundamental changes taking place in manufacturing companies. WCM describes the
manufacturing of high-quality products and reaching customers quickly at a low cost to
provide high performance and customer satisfaction. WCM has four key elements:
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1. A new approach to product quality: Instead of trying to detect defects or poor quality
in production as and when they occur, WCM seeks to identify root causes of poor
quality, eliminate them, and achieve zero defects with 100% quality which incorporates
the principles of TQM.
2. Just-in-time (JIT): As discussed earlier in this chapter.
3. Managing people: WCM aims to utilise the skills and abilities of the work force to the
full. Employees are given training in a variety of skills, to enable them to switch from one
task to another. Employees are also given more responsibility for production scheduling
and quality. A team approach is encouraged, with strong trust between management
and workers.

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4. Flexible approach to customer requirements: The WCM policy is to develop close

relationships with customers in order to know their requirements, supply them on time,
with short delivery lead times and to change the product mix quickly and develop new
products or modify existing products as per customer needs.

Test yourself 7.11

What are the four key elements of WCM?

Business process re-engineering

Business process re-engineering (BPR) involves the radical redesign of existing business
processes to achieve dramatic improvements in productivity, cycle times and quality. In
BPR, companies start with a blank sheet of paper and rethink existing processes to deliver
more value to the customer. They typically adopt a new value system that places increased
emphasis on customer needs. Companies reduce organisational layers and eliminate
unproductive activities in two key areas. First, they redesign functional organisations into
cross-functional teams. Second, they use technology to improve data dissemination and
decision making.
For example, organisations can move from a traditional functional plant layout to a
JIT cellular product layout. BPR can also support TQM because it aims to find innovative
ways of meeting customer needs more effectively. Designing new products to better meet
customer needs may currently involve a sequential flow of ideas from one department to
another. BPR would help to coordinate the work of different departments so their design
ideas are worked on in parallel to achieve dramatically quicker and more cost-effective
product development. In this case, information systems such as CAD can enable more
effective coordination although BPR does not always involve IT.

How business process re-engineering works

BPR is a dramatic change initiative that contains five major steps that managers should take:
Step 1: Refocus company values on customer needs.
Step 2: Redesign core processes, using information technology to enable improvements.
Step 3: Reorganise a business into cross-functional teams with end-to-end responsibility
for a process.
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Step 4: Rethink basic organisational and people issues.

Step 5: Improve business processes across the organisation. For example, organisations
can move from a traditional functional plant layout to a JIT cellular product layout.

How organisations use business process re-engineering

Organisations use BPR to achieve the following goals:
● Reduce costs and cycle times. BPR reduces costs and cycle times by eliminating
unproductive activities and the employees who perform them. Reorganisation by teams
decreases the need for management layers, accelerates information flows and eliminates
the errors and rework caused by multiple handoffs.
● Improve quality. BPR improves quality by reducing the fragmentation of work and
establishing clear ownership of processes. Workers gain responsibility for their output
and can measure their performance based on prompt feedback.

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The five stages of business process re-engineering

Stage 1: Develop business vision and process objectives.
Stage 2: Identify the processes to be redesigned.
Stage 3: Measure existing processes (baseline).
Stage 4: Identify IT levers to be used to apply change.
Stage 5: Design a prototype to show which changes are possible.

Keywords in business process re-engineering

The keywords in BPR are fundamental, radical, dramatic and process. Fundamental and radical
indicate that BPR is somewhat similar to zero-based budgeting. It starts with asking basic
questions such as, ‘Why do we do what we do?’, without making any assumptions or looking
back to what has always been done in the past. Dramatic signifies not incremental but
quantum leaps in performance. Whilst process signifies that the focus should be on process
in addition to the task, job, people and structure.

Test yourself 7.12

How would you as a management account approach BPR at your company?

Summary
In the modern business environment, supply chain management is the management of key
business processes that extend from the original suppliers to the final customer. TQM is a
customer-catered approach that focuses on getting things right the first time and meeting
customer requirements through continuous improvement. In target costing, the required
profit margin is subtracted from the target selling price to arrive at the target cost for the
product. JIT systems produce products as they are required, thus eliminating the need for
inventory. Continuous improvement, or Kaizen, is an integral part of the JIT management
philosophy. Kaizen is a Japanese term meaning to improve processes via small, incremental
amounts rather than through large innovations. Throughput accounting traces costs
to throughput time − the emphasis is on throughput first, then the minimisation of
inventory, and lastly cost control. In life-cycle costing, costs are accumulated and managed
throughout the product’s entire life cycle, which consists of the following stages: research,
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development, introduction, maturity, decline and abandonment. Benchmarking is a

process of continuously comparing and measuring an organisation’s business processes
against leaders globally to gain information which will help the organisation take action
to improve its performance. In backflush accounting, no distinction is made. AMT impacts
manufacturing significantly, causing labour costs to be vastly reduced. WCM insures the
manufacture of high-quality products, which are delivered to the customers speedily at a
low cost to provide high performance and customer satisfaction. BPR involves the radical
redesign of core business processes adopted by organisations to establish a new value system
that places increased emphasis on customer needs.

Cost and Management Accounting

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Key concepts
Advanced manufacturing technology (AMT) involves the use of technology to improve
products and processes.
Automated guided vehicles (AGVs) are used for material handling.
Automated storage and retrieval systems (ASRS) is a subsystem of islands of
automation (IA) for raw material and parts.
Backflush accounting is a simplified method of product costing, where costing is done
after completion of the product, by working backwards to flush costs from the system.
Benchmarking is a process of comparing the products, functions and activities of
an organisation against other external organisations in order to identify areas of
improvement, and to implement a programme of continuous improvement.
Bottlenecks are activities that place restrictions on a production line or factory.
Business process re-engineering (BPR) involves the radical redesign of core business
processes to achieve dramatic improvements in productivity, cycle times and quality.
Computer-aided design (CAD) allows new and existing products to be designed and
modified on a computer screen.
Computer-aided manufacturing (CAM) means that physical production processes are
controlled by computers.
Computer-integrated manufacturing (CIM) is the integration of many or all of the
elements of AMT into one coherent system.
Computer numerically controlled (CNC) machines are used in CAM. These machines
are preprogrammed to perform certain manufacturing tasks such as cutting, machining
and punching holes.
Constraints mean limitations faced by an organisation, including limited productive
resources.
Cost of quality report is a report of the costs incurred in ensuring that the firm maintains
a high level of quality and the costs arising from having poor-quality products.
Electronic data interchange (EDI) facilitates communication between stakeholders
through the electronic transfer of information.
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Flexible manufacturing system (FMS) is a highly automated manufacturing system that

is computer controlled and can produced a wide range of parts.
Islands of automation (IA) are a series of automated subsystems within a factory.
Just-in-time (JIT) inventory and production system is a comprehensive system for
controlling the flow of manufacturing in a multistage production environment.
Kaizen costing is a costing system developed by the Japanese to promote cost reduction
and continuous improvement.
Kanban is the Japanese term for card or visible record, which is used to signal a request
for new production or inventory.
➤➤

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Life-cycle costing is a cost management approach where costs are accumulated and
managed over a product’s life cycle.
Materials handling systems (MHS) is a subsystem of IA.
Pull system is where production and inventory purchases are pulled through the system,
driven by the actual demands of the final customer.
Push system is where goods are produced or purchased to meet inventory requirements,
rather than to meet actual customer demand.
Quality is the degree to which a product or service meets customers’ needs and
expectations.
Reverse engineering (also referred to as backward engineering) is the process by which
an artificial object is deconstructed to reveal its designs or to extract knowledge from
the object.
Supply chain is the flow of all goods, services and information into and out of the
organisation in a network consisting of customers, suppliers, manufacturers and
distributors.
Target costing is a system of profit planning and cost management that determines the
life-cycle cost at which a product must be produced to generate the level of profit, given
the product’s anticipated selling price.
Theory of constraints (TOC) is an approach to managing costs and improving quality
and delivery performance by focusing on identifying and removing bottlenecks.
Throughput accounting (TA) is a method of measuring the effects of bottlenecks and
operational decisions using financial measures of throughput, inventory and operating
expense.
Total quality management (TQM) is a management approach that centres on meeting
customer requirements by achieving continuous improvement in products and services.
Value chain is a set of linked processes or activities that begins with acquiring resources
and ends with providing and supporting products and services that customers value.

Test-yourself solutions
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Test yourself 7.1

(a) Research and development, design, supply, production or manufacturing, marketing,
distribution, customer service.
(b) Upstream processes: research and development, design and supply. Downstream
processes: marketing, distribution, customer service.

Test yourself 7.2

(a) TQM is a customer-centric approach based on the principle of ‘get it right first time’,
and continuous improvement.
(b) Performance, fitness of use, reliability, aesthetics, serviceability, features, durability and
conformance.

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Test yourself 7.3

● Reduction of non-value-added activities and costs
● Elimination of waste
● Improvements in production cycle time

Test yourself 7.4

(a) Target cost = Anticipated selling price – Desired profit
(b) The organisation’s image in the market, the level of customer loyalty in the product’s
market, the product’s expected quality level, functionality, and price compared to
competing products.

Test yourself 7.5

(a) The primary goals of JIT:
● The elimination of processes or operations that do not add value to the product or
service; always striving for continuous improvement in production, performance and
quality, whilst meeting customer demand immediately.
● The reduction of the total costs through the elimination of waste, such as waiting
time, transport and inventory, while continuously improving quality.
● The involvement of staff.
(b) In a push system, demand is projected, and products are produced accordingly and
kept in stock until they are sold, thus it is a system of ‘pushing’ product units through
the factory. In a pull system like JIT, products are produced only when required by the
customer, and components are not made till required by the next production stage. In a
full JIT system, virtually no inventory is held.

Test yourself 7.6

(a) TA is a system of performance measurement and costing which traces costs to throughput
time.
(b) Throughput = Sales revenue − Material and component costs
(c) Bottlenecks are activities that limit production.

Test yourself 7.7

Product planning and initial concept design, product design and development, production
and distribution, and customer/logistical support.
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Test yourself 7.8

Benchmarking is a continuous process of measuring a firm’s products, services or activities
against other best performing organisations, either internal or external to the organisation.

Test yourself 7.9

In a conventional costing system, costs are tracked sequentially through the physical flow
of manufacturing, whereas backflush accounting works backwards after the manufacturing
sequence is complete. Product costs are then flushed out of the system.

Test yourself 7.10

Computer-aided design (CAD), computer-aided manufacturing (CAM), flexible manu-
facturing systems (FMS) and a wide array of innovative computer equipment.

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Test yourself 7.11

A new approach to product quality, JIT, managing people and a flexible approach to
customer requirements.

Test yourself 7.12

The BPR process of re-engineering should be approached in five stages as follows:
Stage 1: Develop business vision and process objectives.
Stage 2: Identify the processes to be re-designed.
Stage 3: Measure existing processes (baseline).
Stage 4: Identify IT levers to be used to apply change.
Stage 5: Design a prototype to show which changes are possible.

Review questions
7.1 Define the value chain.
7.2 Discuss the four categories of quality costs.
7.3 What is TQM and how does it differ from quality accreditation?
7.4 Briefly discuss the Kaizen concept
7.5 Briefly discuss target costing.
7.6 Briefly discuss the JIT philosophy.
7.7 Discuss the concept on which TA is based.
7.8 What is a product’s life cycle?
7.9 What are the basic steps to be followed when benchmarking?
7.10 List the four types of benchmarking.
7.11 Briefly discuss backflush accounting.
7.12 Briefly discuss AMT.
7.13 Briefly discuss WCM.
7.14 Briefly discuss the BPR process.

Exercises
7.1 Sport Shoes Limited designs and manufactures running shoes. Using the value
chain, give two examples of costs in each section.
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7.2 Discuss the sections in the value chain and why information about the costs in
each section of the value chain is useful to management.
7.3 The costs given in the following table were incurred during the month of July by
Thandeka Limited to maintain the quality of the products they manufacture.
R
Cost of faulty goods that are scrapped 12 400
Cost of repairing faulty products discovered during processing 1 800
Cost of sending machine operators on a two-week quality training
9 800
programme
Costs of recalling product 16 000
➤➤

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Costs to confirm a supplier’s quality accreditation 600

Final product inspection into finished goods warehouse 7 400
Inspection to detect faulty products 11 400
Legal fees related to product recall 5 800
Repairs of faulty products returned by customers 10 000

Required:
Prepare a cost of quality report.
7.4 Super Shoes Limited manufactures and sells running shoes. The materials required
to manufacture the shoes are bought in bulk, cut to size, assembled and then
machine sewed. There are several competitors in the running shoe market. Some
of these competitors charge a lower price, but supply a low-quality running
shoe. Others supply higher quality shoes than Super Shoes for a higher price.
Super Shoes is preparing their budgets for the following year and has estimated
that the market demand for running shoes will be 200 000 pairs of shoes, and
its share will be 40 000 pairs, which is equal to 20% of the available market. The
standard cost details for each pair of running shoe is given in the following table:
per unit (R) per unit (R)
Selling price 240
Less: Variable costs 180
Materials 60
Assembly and sewing cost 100
Delivery cost 20
Contribution 60

An analysis of Super Shoes’ recent performance revealed that 4% of the running

shoes supplied to customers were returned to be replaced free of charge due to
faults in the manufacturing. An investigation of the faulty shoes showed that the
damage had occurred during assembly. The faulty shoes could not be repaired
and have no scrap value. If the supply of faulty running shoes can be eliminated,
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there will be an improved customer perception that will lead to Super Shoes
gaining 30% of the market.

Required:
(a) Using Super Shoes as an example, discuss quality conformance costs and
quality non-conformance costs, and the relationship between them.
(b) Assume that Super Shoes continues with its present system, and the
percentage of quality failings remains the same as stated above.
(i) Calculate the total relevant costs of quality for the coming year based
on the budgeted figures and sales returns rate.
(ii) Calculate the maximum saving that could be made by implementing
an inspection process for the running shoes, immediately before the
goods are delivered.

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7.5 JONTY manufactures and sells a range of products. It is not dominant in the
market in which it operates and, as a result, it has to accept the market price for
each of its products. The company is keen to ensure that it continues to compete
and earn satisfactory profit at each stage throughout a product’s life cycle.

Required:
Explain how JONTY could use target costing and Kaizen costing to improve
its future performance. Your answer should include an explanation of the
differences between target costing and Kaizen costing.
7.6 Steel Limited makes two products that both pass through the same production
process. The time available is limited to 6 000 hours, and Steel wants to use
throughput accounting to prioritise which product to produce.
Product details (per unit) are as follows:
Product X Product Y
Selling price R25 R20
Material cost R13 R10
Labour cost R6 R3
Machine time 20 minutes 15 minutes

Total factory costs for the period (excluding materials) are R 228.000.

Required
Calculate to two decimal places the throughput accounting ratios for both
products.
7.7 Corona produces three products, C, O and R. The capacity of Corona’s plant
is restricted by process Covid. Process Covid is expected to be operational for
eight hours per day and can produce 1 200 units of C per hour, 1 500 units of
O per hour, and 600 units of R per hour.
Selling prices and material costs for each product are as follows:
Product Selling price per Material cost per Contribution per
unit (R) unit (R) unit(R)
C 150 70 80
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O 120 40 80
R 300 100 200

Conversion costs are R720 000 per day.

Required:
(a) Calculate the profit per day if daily output achieved is 6 000 units of C,
4 500 units of O, and 1 200 units of R.
(b) Determine the efficiency of the bottleneck process given the output in (a).
(c) Calculate the TA ratio for each product.
(d) In the absence of demand restrictions for the three products, advise
Corona’s management on the optimal production plan.

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245

7.8 Y Co manufactures three products, A, B and C, and has recognised that there is
a bottleneck at one of the machines. The following information is available:

Product A B C
Selling price (R) 40 45 46
Direct material costs per unit (R) 10 18 14
Time in the machine (hours) 2 4 2.5

The firm has 100 000 machine hours each month and total factory costs are
R150 000 per month.

Required:
What is the TA ratio for each product?
Round your answer to two decimal places.
7.9 The selling price of product B is set at R65 each, and sales for the coming year
are expected to be 4 000 units.
The company requires a return of 12% in the coming year on its investment of
R900 000.

Required:
What will the target cost for product B be in the coming year?
7.10 The following information is given for product X.

Product X target selling price per unit R10

Target profit 25% on cost
Current cost R8.40 per unit

Required:
What is the target cost gap for product X?
7.11 A manufacturer of electronic products has designed a new product. The
organisation’s marketing department believes that 200 000 units of the product
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could be sold at a price of R25 each. Development and manufacturing costs of

the product total R16 000. The organisation requires a minimum of 12% return
on any investment.

Required:
Calculate the appropriate target cost for the new product.

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7.12 Pi plc manufactures two products, A and B. The cost cards are as follows:

Product A B

Selling price R25 R28

Materials R8 R20

Labour R5 R2

Other variable costs R7 R2

Fixed costs R3 R2

Profit R2 R2

Machine hours per unit 2 hours 1 hour

Maximum demand 20 000 units 10 000 units

The total hours available are 48 000.

Required:
(a) Calculate the optimum production plan and the maximum profit, on the
assumption that in the short term only material costs are variable. Use a TA
approach.
(b) Calculate and interpret the TA ratio for both products.
(c) Suggest reasons why management might decide not to withdraw an
unprofitable product from sale.
Source: CIMA (adapted)

7.13 Zion manufactures and sells a number of products. All its products have a
life cycle of 12 months or less. Zion uses the four-stage life-cycle model and
measures the profits of its products at each stage of their life cycle. Zion has
developed a new unique product. The product was launched with a market
skimming pricing policy. It is expected that other companies will try to enter
the market very soon. The new product is generating good profits during the
introductory phase of its life cycle. There are concerns that the unit profits may
drop during the other phases of the product’s life cycle.
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Required:
(a) Discuss the likely changes that will occur in the unit selling prices and in the
unit production costs for the growth and maturity phases compared to the
preceding stage of the new product.
(b) What are the four stages of a product’s production life cycle?

7.14 How can management accountants play a role in benchmarking?

7.15 Tornado Limited uses JIT and backflush accounting. There is no raw material
inventory control account. During January 400 units were produced and sold.
The conversion costs amounted to R6 000. The standard unit cost is R60, which
includes material of R30.

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247

Required:
(a) What is the debit balance on the cost of goods sold account at the end of
January?
(b) Explain why a backflush cost accounting system may be considered more
appropriate than a traditional cost accounting system in a company that
operates a JIT production and purchasing system.

Reference list
IBS Center for Management Research. 2003. Toyota’s JIT Revolution. Available: http://
www.icmrindia.org/casestudies/catalogue/Operations/Toyota%20JIT%20Revolution-
Operations%20Case%20Study.htm. (Accessed 1 November 2020).
Scribd. n.d. A Case Study on Toyota’s JIT Revolution. Available: http://www.scribd.com/
doc/43800281/A-Case-Study-on-Toyota-s-Jit-Revolution. (Accessed 1 November 2020).
Copyright © 2021. Juta & Company, Limited. All rights reserved.

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8 Activity-based costing
and management

Activity-based costing (ABC)

Costing using ABC

Product and customer

Activity-based management (ABM)
profitability analysis

Terminology

Uses, benefits and limitations of ABC

Learning objectives
After studying this chapter, you should be able to:
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● Explain why traditional costing approaches are often ineffective and how this can
be overcome by the activity-based costing (ABC) approach
● Describe ABC and how it differs from traditional absorption costing
● Apply ABC in a manufacturing or service organisation to determine the costs of
products and other cost objects
● Determine product and customer profitability using ABC
● Discuss the uses, merits and limitations of activity-based costing (ABC) and
activity-based management (ABM).

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Introduction

History and development of activity-based costing

Historically, cost accounting systems were developed to serve the needs of the manufacturing
industry, particularly for inventory valuation and cost control. Most costs were direct and
fairly easy to relate to manufacturing time and volumes. As manufacturing and marketing
became more complex and competitive, traditional costing systems became less useful
as aids to decision making, especially in service industries, which did not have physical
products and often no direct labour to use for allocating overheads. Activity-based costing
(ABC) was proposed during the 1980s by Kaplan, Johnson and Cooper, amongst others,
as an approach to overcome the problems and limitations of traditional costing systems.
CIMA defines ABC as ‘an approach to the costing and monitoring of activities which
involves tracing resource consumption and costing final outputs. Resources are assigned to
activities, and activities to cost objects based on consumption estimates. The latter utilise
cost drivers to attach activity costs to outputs’ (CIMA, 2005).

Accounting for overheads

Traditional absorption costing systems made little attempt to consider either cost behaviour
(how costs change when volumes change) or cost causation (why the organisation incurs
the cost). Overhead costs were collected in the most convenient way for the accounting
system, usually by functional departments, and allocated to products on a simple basis,
usually labour or machine hours. Marginal costing considers cost behaviour simply: by
differentiating between variable costs which change with volume, and fixed costs, which
are not affected by volume. However, variability is often determined by the length of time
over which costs are examined – as the period becomes longer, more costs will change in
relation to volume. While the distinction between variable and fixed costs is useful for
cost control and in short-term decision making, for longer-term decisions, almost all costs
may be considered variable and the causes of cost are more important. ABC relates costs
to the activities that cause or drive them. The activities, and through them the costs, are
then linked to products and other cost objects by output measures. Its proponents claim
that this provides more accurate costing compared to traditional costing systems, which
usually allocate overheads to products on a basis of volume of product, labour hours or
some arbitrary factor.
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Reasons for ineffectiveness of traditional approaches

Costs are usually analysed on a functional (departmental) basis to suit the accounting
system, which is based on the organisation structure, whereas costs are caused by the business
processes, that is, activities. When indirect costs change, it may be difficult to understand
the reasons, often leading to incorrect decisions being made. For example, product A may
require double the number of quality inspections as product B. If the volume of product
A increases by the same amount as product B decreases, traditional costing would indicate
that inspection costs would remain the same, whereas these would in fact increase. This may
lead to pressure on quality assurance to reduce costs, leading to lower quality and ultimately
lower volumes or profit margins. ABC would indicate that the increase in inspection costs
was to be expected, and reasons for the changes in relative volumes would be investigated,
leading to possible corrective action. Overheads now represent a much greater proportion

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of total cost than when traditional cost management systems were developed. Older systems
focus on direct costs, such as material and labour, rather than indirect costs, and generally
concentrate on production costs, ignoring selling and distribution costs.
Product costs are substantially determined when the product is designed, rather than
when it is produced. Traditional costing systems concentrate on analysing costs after
products are made and sold, when it is often too late to take effective action. By accurately
predetermining full product costs, optimum product decisions can be made before
production starts. Normal variance analysis would still be carried out after production, but
better understanding of causes of the costs will improve cost control. Traditional systems
concentrate on short-term control, whereas in many organisations only a relatively small
proportion of costs are controllable in the short term. Many costs are driven by customers
and/or markets, not by products or production processes. Because traditional systems tend
to allocate most overheads based on labour or machine hours, it is not possible to determine
customer or market profitability accurately, or to make correct decisions when these costs
change. For example, if a supermarket chain requires its suppliers to place products on
its shelves, these costs should only be allocated to products sold to customers purchasing
those specific products, not spread across other products sold to other customers, which
would happen in a traditional system.

Test yourself 8.1

Why are new approaches to the treatment of overhead costs needed in many companies
today?

Overview of the activity-based costing process

Like many significant concepts, the principle of ABC seems simple: resources are consumed
or utilised by activities to produce products and services – this consumption of resources
causes cost. Putting ABC into practice, however, can be extremely complex. The aim of ABC
is not only to calculate the cost of a product (or other cost object), but to determine the
origin and cause of cost, and to relate that cause to a cost object (process, product, unit,
order, customer, etc). ABC does this by recognising that the consumption of resources
by activities causes costs, which can then be assigned or traced to products or other cost
objects. Implementation of ABC requires identification and analysis of activities, grouping
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activities into activity centres, tracing costs to activity centres, determining cost drivers,
and tracing activity costs to cost objects. While ABC has undoubted benefits by providing
more accurate and relevant information for decision making, it also has limitations, such
as being costly and time-consuming to implement and maintain, and its full benefits may
not be achieved unless activity-based management and activity accounting are also used.

Activity-based costing terminology

The following terminology is relevant to ABC:
● Activity: This is an event or transaction that causes costs to be incurred.
● Activity accounting: A system of recording the costs of activities to provide information
to control the cost and performance of activities.

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● Activity-based costing (ABC): This is a costing method for determining the cost of an
activity, which can be used for any purpose for which cost information may be required.
ABC is an attempt to determine the full cost of a product, process, customer or other
cost object.
● Activity-based management (ABM): This is a system which directs attention to ways
of improving how activities are performed. ABM is a continuous improvement process
which eliminates or improves the efficiency of activities that are performed.
● Activity centre: A grouping of several related activities which serve the same purpose,
and all consume resources in the same way.
● Activity cost hierarchy: Activities may be grouped in a hierarchy according to the types
of activity that drive the costs in each level of the hierarchy. As the level in the hierarchy
increases, the cost becomes less directly associated with volume of production or sales.
An ABC system commonly uses a cost hierarchy consisting of four levels: unit-level
activities, batch-level activities, product/service-sustaining activities, and facility/
business-sustaining activities.
1. Unit-level activities are volume-related activities since they are executed every time
a unit is produced or a service is provided. Examples of these expenses include direct
material, direct labour and sales commission. Unit-level activities utilise resources
in relation to production and sales volume. For example, a 20% increase in the
units produced will result in a 20% increase in labour hours and machine hours.
The typical cost drivers for the unit-level activities include machine hours, labour
hours, quantity of material processed, etc. These cost drivers are also used in the
traditional costing system, where the costs of the unit-level activities are assigned
to cost objects.
2. Batch-level activities are activities that occur every time a batch of goods is
produced. Examples of these expenses include machine set-ups, purchase order
processing, etc. The cost of the batch-related activities varies with the number of
batches but is fixed for all the units in the batch. For example, the set-up resources
are utilised when a machine is changed or set up from one product to another.
As more batches are produced, the more set-up resources are utilised. However,
the cost to set up the machine to produce five units or 1 000 units will be the
same. Likewise, every time a purchase order is processed, purchasing resources
are utilised. However, the utilisation of the purchasing resources is not dependent
upon the number of units in the purchase order. Other batch-related costs which
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result from production scheduling include inspection and material movements.

Under the traditional costing system batch-related expenses are regarded as fixed
costs, while under the ABC system batch-related expenses vary with the number of
batches processed.
3. Product/service-sustaining activities are the costs of activities that are undertaken
to support individual products or services. The costs of these activities are not
dependent on the number of units or batches produced. Examples of product-
or service-sustaining activities include design costs, maintaining and updating
product specifications and technical support, product advertising and promotions.
When customers are the cost objects, the product-sustaining activities would be
referred to as customer-sustaining activities. Examples of customer-sustaining
costs would include customer market research and support.

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4. Facility/business-sustaining activities are the costs of activities that support

the organisation as a whole and are common to all products manufactured in the
factory. Hence, these costs cannot be traced to individual products or services.
Examples of these costs include general administration, rent, and building security.

Table 8.1 Activity cost hierarchy

Level Basis Costs primarily dependent on Examples
1 Unit-level activities Volume of production or sales Direct materials, direct
labour, sales commission
2 Batch-level activities Number of batches Machine set-up, inspection
3 Process-level activities Existence of a process Department supervision,
maintenance
4 Product-sustaining Existence of a product group Product advertising and
activities promotions
5 Facility-sustaining Existence of an operating General advertising, audit
activities facility fees

● Bill of activities: A list and description of all the activities involved in taking a cost
object to completion, analogous to a bill of materials.
● Cost behaviour: The manner in which costs change and the reasons why changes occur.
◆ Costs that are consumed in direct proportion to changes in activity output are
variable costs related to that particular activity output.
◆ Costs that are not consumed in proportion to changes in the output of an activity
are fixed costs relative to that activity output.
This definition therefore does not necessarily use time and product volume as
determining factors of variability (although for certain activities they may be), but rather
defines costs in terms of consumption behaviour. In the long term, consumption of
resources (and hence cost) will tend to follow usage of those resources by activities. This
means that ABC treats all costs as variable in the traditional definition of variability.
● Cost objects: Usually products, but may also be customers, services, processes, etc, for
which we want to determine the cost, using ABC.
● Cost pools: Activity centres to which overhead costs have been allocated.
● Drivers can be identified as those factors effecting changes in cost, quality, or capacity,
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or all three, which are referred to as strategic drivers. For ABC purposes, cost drivers,
which are factors that cause changes in the cost of activities, are the most important.
These are identified in two stages:
1. Resource drivers, which are used to trace the cost of resources to activities
2. Activity drivers, which are used to trace the cost of activities to products or other
cost objects.

These drivers consist of the following types:

◆ Transaction drivers, based on the number of transactions of a particular activity, for
example purchase orders placed
◆ Duration drivers, based on the time taken for an activity, for example time spent on
negotiating purchases

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◆ Intensity drivers, based on usage of resources by an activity, for example consumption

of electric power.

A quality driver is a factor which causes changes in the quality of the product, leading
to changes in resource consumption, for example a customer who requires specific
quality levels of otherwise standard products.

A capacity driver is any factor which causes a change in the capacity of an activity, in
other words, in the number of units of that activity that can be carried out.
● Output measure is how cost is conveyed from the activity to the cost object – often the
end result of an activity. It is used in conjunction with a cost driver and in many cases
is the end result of a particular cost driver. Examples are numbers of purchase orders,
hours taken in purchasing activities, and kilowatts used.
● A process is a series of activities that can logically be linked together to produce a
significant and complete output. This implies that all activities in a process must have a
common constraint or limiting factor. Three broad types of processes can be identified:
1. Product-directed processes: those in which activities and hence consumption of
resources are determined by the products of the business: material procurement,
inbound logistics, manufacturing, plant maintenance, quality assurance, storage,
product advertising and promotion, product and process development, plant
depreciation, interest on plant and inventory
2. Customer-directed processes: those in which activities are determined by
customers: sales-related salaries and expenses, outbound logistics, customer-specific
advertising, discounting and rebates, and credit control
3. Support or secondary processes: those where activities cannot be directly traced
to products or customers: general accounting, administration and information
services, corporate advertising, and human resources. The costs of some of these
activities may be traced or assigned to primary activities and then to products or
customers, while others may not be easily traceable and are allocated in an arbitrary
fashion if relatively insignificant.

Traceable costs are accounted for per activity. Resource drivers are used to link traceable
costs to activities, and the related activity drivers and output measures are then used to
assign these costs to the cost objects.
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Test yourself 8.2

Name the levels of activity that can be identified in an organisation.

Cost and Management Accounting

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Case study: Activity-based costing at UNISA

UNISA is the leader in implementing an ABC model at a university in South Africa. The
implementation of this model has resulted in the university’s financial strategy becoming
more intense and directed and the benefits of the system have already become evident.
The university can now determine the cost of any particular activity and plan accordingly.
They have to date costed approximately 10 000 activities. The model reinforces the
university’s strategic and operational plans and links the information available on the
cost of activities to produce performance measures that measure improvements. The
impetus for the introduction of the ABC model was the huge deficit of approximately
R140 million that the university experienced on its budget in the 1990s. The need to
focus on the appropriate financial management of resources became vital to the long-
term sustainability of the university. Professor Lilla Stack, the acting Registrar of Finance
at the time, announced that cost centres would be the only way in which the university
could manage its financial resources effectively. The institutionalisation of cost centres
became imperative, since government subsidies were declining, operating costs were
increasing, and there was pressure to keep student fees in check. Consequently, a project
was launched to develop a costing model. The objective of this model was to help
determine the cost per faculty and per course, by investigating where costs were being
incurred, as well as what it costs to produce the university’s products or services. This
preliminary work proved fruitless, as nothing materialised.
Deloitte and Touche were then appointed in 1997 to investigate UNISA’s financial
position and cited the absence of strategic financial management as the cause. In
2001 the Vice Principal of Finance was instructed to develop cost centres and a cost
management system to monitor the effective utilisation of financial resources and
to keep the Council abreast of financial management information. To ensure that
all the stakeholders of the institution were aware of the ABC project, approximately
63 information sessions were held to explain the details of the costing model to the
stakeholders. The initiative was successful, and the first set of comparative cost data
based on the 2000 financial year was produced. Subsequently, a merger took place
which brought in additional staff and students. This changed the resource profile of the
institution significantly. Because all the groundwork had been done prior to the merger,
the institution had a better understanding of the need for tight financial management.
They also understood the importance of buy-in and support in setting, implementing
and monitoring financial goals.
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At the 2015 institutional strategic management planning meeting, it became apparent

that the institution had to focus on certain core areas to be financially viable in the long
term. The core areas that needed attention were as follows:
● UNISA’s expenditure on salaries was 6% higher than the DoE target and needed to be
reviewed.
● Throughput rates needed improvement. This could be achieved by attracting a better
calibre of student and by providing additional student support.
● UNISA would have to look at the feasibility of some of its offerings to determine their
value, such as expenditure : feasibility ratios.
● The sustainability of non-core functions would have to be investigated, with the
possibility of outsourcing.
➤➤

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There was a general concern at these discussions about the lack of suitable units of
measurement that could be employed by management to determine the cost-efficiency
of an activity, and ultimately its sustainability or feasibility. For example, how would one
determine how many staff members should be employed in a particular department to
ensure the appropriate degree of productivity within the proposed financial targets?
The ABC system is now fully operational. Managers understand the need to limit costs,
but much of the confusion and resentment that might otherwise have existed have been
anticipated by a sound understanding of the necessity to manage down expenditure
over both the short and long term and of the ABC model that offers a sound basis for
measurement.
Source: Adapted from Pityana (2005)

Discussion questions:
1. The focus in the UNISA case study was on the institutional activities. Identify some
of the major activities performed by one of the academic departments and suggest
possible activity drivers for each activity.
2. Are the terms ‘unit level’, ‘batch level’ and ‘product level’ activities relevant to your
answers in question 1? Explain your answer.

Determining costs using activity-based costing

In common with any other costing system, the aims of the costing system must first be
established. Will it be used for inventory valuation, cost control, decision making or a
combination of all three? The major benefit of ABC is to aid decision making, and it is
unlikely that any organisation would only use it for inventory valuation and cost control,
especially considering the costs of implementation. Before beginning the usually onerous
task of analysing activities, the organisation should consider the resources that it will have
for implementation and maintenance of the system, as this will impact on the depth to
which analysis is performed.

The process of determining costs using activity-based costing

The implementation process of an ABC system can be broken down into the following steps
when determining the cost of a cost object:
1. Examine the organisation and identify its processes and activities.
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2. Identify activity centres in which activities that serve the same purpose and have the
same cost drivers are combined. For example, purchasing and inward materials handling
both have the purpose of delivering materials to the factory, and if their costs are largely
driven by the same factor, such as purchase orders, they may be combined into one
activity centre. If this combining of activities is not done, the number of activities may
become unmanageably large.
3. For each activity centre, resource and activity drivers must be identified. Resource drivers
determine how resources and hence costs are traced to activity centres, while activity
drivers determine how costs are traced to cost objects. For example, in an inspection
department the resource driver could be the number of inspectors in the department,
while the activity driver would be the number of inspections made.

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4. Determine the nature of activities and analyse their associated costs into:
● Directly traceable costs (for example, direct materials)
● Activity-traceable costs (that is, those that are linked to activities through drivers)
● Non-traceable (or unallocated) costs.
5. Identify all traceable costs for each activity, distinguishing between primary and
secondary activities. For example, if inspection is identified as an activity, all costs
related to inspection, such as salaries, equipment, materials, etc, should be determined.
6. Trace all secondary activity costs to primary activities so that the combined activity rates
include all support costs.
7. Non-traceable costs can either be traced to other activities on an arbitrary basis or
treated as part of the required profit margin.
8. Bills of activities must now be compiled for each cost object. For direct costs such as
direct materials and direct labour, this is relatively straightforward and will probably
already have been done in a traditional costing system. Other activities are linked to the
cost object through the output measures of the activity drivers. For example, it may be
determined that every hundredth unit of product A is inspected. The bill of activities for
product A will therefore show 0.01 units of inspection activity ( ______________
100 product units )
1 inspection
   .
  
9. A cost basis must be selected, that is, the type of cost to be used, for example standard
costs, budgeted costs, planned costs, historical costs, capacity costs, and so on.
10. A capacity level must be selected to determine how fast the cost of capacity will be
absorbed by total production. Capacity level could be theoretical capacity, practical
capacity, normal volume, budget volume, etc. The cost basis and capacity level must
be applied consistently throughout a cost determination, that is, if budget costs and
volumes are used for the purchasing activity, do not use historical costs and practical
capacity for the inspection activity.
11. The total cost of each activity must then be calculated using the cost basis selected, and
the total number of output measure units using the capacity level selected. For example,
if budget costs and volume for inspection have been selected, the total budgeted cost
may be R1 000 000 for 10 000 inspections. The budget unit cost of the inspection activity
will then be R100 per inspection (_________
  R110000 000
000  ). It should be noted that the unit cost of an
activity is determined according to the total capacity of the activity, which is a function
of resource capacity. The total cost of all activities of an activity centre is determined by
the actual resources consumed by the activities during a selected period, for example a
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budget year. The unit cost of an activity will not change unless factors (drivers) cause
a change in capacity, or if resource costs themselves change (for example, as a result of
inflation). Total activity costs change at different levels of capacity consumption.
12. The cost of the cost object may now be determined by multiplying the activity unit cost by
the quantity of output consumed for each activity as specified in the bill of activities. The
sum of these calculated costs will give the activity-traced cost of the cost object.
13. Direct traceable costs, activity-traced costs and non-traceable costs are then added to
give the full cost of the cost object. The first six steps in the ABC process are normally
the most difficult and time-consuming and are probably done by a multi-disciplinary
team of people from production, engineering, management accounting and any other
necessary experts. Thereafter it is the management accountant’s responsibility to
accurately determine the product costs.

Activity-based costing and management

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Illustrative example 8.1

Components Ltd produces electronic components for the manufacturing industry. Its
product range consists of three similar products, Component 1, Component 2 and
Component 3. The company was first established in 1973 and has been using a single
plant wide rate since then, based on the percentage of direct labour cost to assign
overhead costs to its components.

The company’s profitability has declined over the past few years and its overhead costs
have increased. It has also lost market share for Component 2, one of its major products.
In an attempt to increase profitability Component 3 was recently introduced into the
market and has attracted additional sales. The management accountant believes that
the company’s current costing system is not accurately ascertaining the full product cost
and is consequently impacting negatively on the company’s profitability. He has decided
to implement an ABC system. With the help of the accounting team he collected data
for the different activities for each component. Information on the company’s three
components for the period are provided in Table 8.2.
Table 8.2 Information on the company’s three components
Component 1 Component 2 Component 3
Production in units 9 375 units 15 625 units 5 000 units
Selling price per component R58.75 R100 R85
Direct material cost per component R22.50 R31.25 R20
Direct labour cost per component R5 R10 R8
Number of material movements 50 320 630
Machines hours per component 0.63 0.63 0.25
Number of set-ups 10 60 130
Proportion of engineering work 27% 18% 55%
Number of orders packed 10 90 280

For the period under review there was no difference between the budgeted and actual
direct labour costs. The production overheads have been grouped according to the
different cost pools, which are provided in Table 8.3.
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Table 8.3 Overhead costs linked to activities

Activities Overhead costs (R)
Material receiving and handling 187 500
Machine maintenance and depreciation 425 000
Set-ups 22 500
Engineering 125 000
Packaging 74 860
Total 834 860

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259

Required:
Calculate and compare the component cost per unit under the traditional costing
system and the ABC system.

Round off to two decimal places where applicable.

Solution:
Traditional costing system
Table 8.4 Traditional costing system
Budgeted direct labour cost:
Units Cost p/u (R) Total cost (R)
Component 1 9 375 5.00 46 875
Component 2 15 625 10.00 156 250
Component 3 5 000 8.00 40 000
243 125
Overhead absorption rate
Budgeted manufacturing overheads 100
= __________________________
    
   
Budgeted
___
direct labour cost  ×   1

  R834
= ________ 860 ___ 100
R243 125 ×   1
= 343.39% of direct labour cost
Component 1 Component 2 Component 3
(R) (R) (R)
Direct material cost 22.50 31.25 20.00
Direct labour cost 5.00 10.00 8.00
Applied overheads (343.39% × 5;10; 8) 17.17 34.34 27.47
Production cost per component 44.67 75.59 55.47

Activity-based costing
The following steps must be followed when applying an ABC system.

Step 1: The different activities within the company have been identified in the question
These are material receiving and handling, machine maintenance and depreciation, set-
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ups, engineering, and packaging.

Step 2: Identify the appropriate cost drivers

Table 8.5 List of overhead costs and cost drivers
Overhead cost Cost driver
Material receiving and handling Material movements
Machine maintenance and depreciation Machine hours
Set-ups Number of set-ups
Engineering Proportion of engineering work
Packaging Number of orders packed

➤➤

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_________________Total activity cost

Step 3: Calculate the activity cost driver rate =    
  
Total of the cost driver
Material receiving and handling
_______________________
    
    Total material movements
R187 500
=  ____________________
  
  
*1 000 material movements
= R187.50 per material movement

* Total material movements: 50 + 320 + 630 = 1 000

Machine maintenance and depreciation
 _____________________________
       
Total machine hours
R425 000
= _________________
  *17
      000 machine hours
= R25 per machine hour

* Total machine hours

Component 1: 0.63 × 9 375 5 5 906.25

Component 2: 0.63 × 15 625 5 9 843.75
Component 3: 0.25 × 5 000 5 1 250.00
Set-ups
17 000.00 machine hours
__________________
  Total
     
number of set-ups
R22 500
= __________
  *200 set-ups
= R112.50 per set-up

*Total number of set-ups: 10 + 60 + 130 = 200

An activity cost driver rate will not be calculated for the engineering cost, as this cost will
be allocated to components based on the percentages given.
Packaging
 ___________________
  
  
Number of orders packed
R74 860
=  _______________
  
*380 orders packed
= R197 per order packed
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* Total number of orders packed: 10 + 90 + 280 = 380

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Step 4: Using the activity cost driver rates calculated in Step 3, calculate the overheads
absorbed by each component. This can be done on a total cost basis or a per unit basis.
To calculate the overhead cost per unit, calculate the overhead cost absorbed in total
and thereafter divide it by the number of units:
Table 8.6 Calculation of overheads absorbed by each component
Component 1 Component 2 Component 3 Total
(R) (R) (R) (R)
Material receiving and handling: 9 375 60 000 118 125 187 500
(R187.50 × 50; 320; 630)
Machine maintenance and 147 656.25 246 093.75 31 250 425 000
depreciation
(R25 × 5 906.25; 9 843.75;
1 250)
Set-ups: 1 125 6 750 14 625 22 500
(R112.50 × 10; 60; 130)
Engineering 33 750 22 500 68 750 125 000
(R125 000 × 27%; 18%; 55%)
Packaging 1 970 17 730 55 160 74 860
(R197 × 10; 90; 280)
Total cost 193 876.25 353 073.75 287 910 834 860
Units 9 375 15 625 5 000
Overhead cost per unit 20.68 22.60 57.58

Alternatively, calculate the overhead cost per unit for each activity:
Table 8.7 Overhead cost per unit
Component 1 Component 2 Component 3 Total
(R) (R) (R) (R)
Material receiving and
handling:
Total cost per component: 9 375 60 000 118 125 187 500
(R187.50 × 50; 320; 630)
÷ Units produced 9 375 15 625 5 000
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Unit cost per component 1 3.84 23.63

Machine maintenance and
depreciation:
Total cost per component: 147 656.25 246 093.75 31 250 425 000
(R25 × 5 906.25; 9 843.75;
1 250) ÷ Units produced 9 375 15 625 5 000
Unit cost per component 15.75 15.75 6.25
Set-ups:
Total cost per component: 1 125 6 750 14 625 R22 500
(R112.50 × 10; 60; 130)
÷ Units produced 9 375 15 625 5 000
Unit cost per component 0.12 0.43 2.93
➤➤

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Engineering:
Total cost per component 33 750 22 500 68 750 125 000
(R125 000 × 27%; 18%; 55%)
÷ Units produced 9 375 15 625 5 000
Unit cost per component 3.60 1.44 13.75
Packaging:
Total cost per component: 1 970 17 730 55 160 74 860
(R197 × 10; 90; 280)
÷ Units produced 9 375 15 625 5 000
Unit cost per component 0.21 1.13 11.03

Step 5: Calculate the component cost under the ABC system.

Table 8.8 Component cost under ABC
Component 1 Component 2 Component 3
(R) (R) (R)
Direct material cost 22.50 31.25 20.00
Direct labour cost 5.00 10.00 8.00
Manufacturing overheads: 20.68 22.59 57.59
Material receiving and handling 1.00 3.84 23.63
Machine maintenance and depreciation 15.75 15.75 6.25
Set-ups 0.12 0.43 2.93
Engineering 3.60 1.44 13.75
Packing 0.21 1.13 11.03
Production cost per component 48.18 63.84 85.59

Compare component costs:

Table 8.9 Comparison of component costs under the traditional costing method
Component 1 Component 2 Component 3
(R) (R) (R)
Traditional/Absorption costing 44.67 75.59 55.47
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Activity-based costing 48.18 63.84 85.59

Difference ( 3.51) 11.75 (30.12)
Percentage change* –7.86% 15.54% –54.30%
3.51 11.75 30.12
* _____
  44.67 × 100 _____
 75.59 × 100  _____
55.47 × 100
The negative difference indicates that Component 1 and Component 3 were undercosted
by the traditional/absorption costing method, while Component 2 was overcosted by
the traditional/absorption costing method.
➤➤

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The traditional system relies on volume-based overhead allocation and therefore

overcosts high-volume products and undercosts low-volume products. The ABC system
assigns overhead costs more accurately to products using cost drivers and consequently
provides a fairer valuation of the product cost per unit. This pattern of low-volume
products showing relatively large cost increases, and high-volume products showing
relatively small cost decreases, is fairly typical of ABC and may prompt businesses to
either seek selling price increases for low-volume products, or to eliminate or replace
them if ABC shows them to be unprofitable. Alternatively, a value analysis and cost
reduction programme for the low-volume products could be undertaken to improve
their profitability.

This fairly simple example of a business with a small number of products and processes
shows how complex and challenging implementing ABC can be in real life, where the
number of products and activities will be far greater.

Applying activity-based costing in service organisations

Most of the costs in a service organisation are indirect costs. Service organisations are
therefore ideal candidates for the implementation of an ABC system. Instead of products,
the services provided by the organisation are the cost objects. Because there are no physical
products involved, there will be no direct materials, although in some cases direct labour
may be identified, for example wages paid to a hairdresser in a hairdressing salon. Other
than this, the procedure followed in determining activity-based costs will be the same as for
a manufacturing organisation.

Illustrative example 8.2

Joneli Associates provides employee selection and evaluation services to other
organisations. These services comprise interviewing and assessing applicants for vacant
posts and evaluating performance of personnel already employed. Jon heads up the
division which provides selection services, while Elise heads up the division providing
evaluation services. In addition to the two core functions, there are also various
service departments: selection and evaluation, assessment development, assessment
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measurement, marketing, accounting and administration. The two partners manage

these departments jointly. For some time, the partners effectively determined the costs
of the core functions and charged their services appropriately. They have now decided
to implement an ABC system. Fortunately, the functional make-up of the organisation
already largely reflects its activities, so that historical and budget cost and output data
for the proposed system are easily available. Budgeted costs for the coming year are
shown in Table 8.10.
➤➤

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Table 8.10 Overhead cost budget

Activity Cost
Selection R2 500 000
Evaluation R3 600 000
Assessment development R1 500 000
Assessment measurement R1 600 000
Marketing R2 800 000
Accounting and administration R3 000 000

The budget also reflects fees charged for selection at R8 million and for evaluation at
R10 million. The fee budgets have been established by adding 10% to the previous year’s
actual figures, but the activity cost budgets have been determined by evaluating the staff
involved and resources used by each activity.

Activity analysis has identified cost drivers and output measures for some of the activities,
as well as an estimate of the practical capacities of these activities.
Table 8.11 Activity analysis
Activity Cost driver Output measure Capacity
Selection Applicants interviewed Number of applicants
interviewed 5 000
Evaluation Employees evaluated Number of employees
evaluated 3 000
Assessment development Assessments developed Number of assessments
developed 1 000
Assessment Assessments measured Number of assessments
measurement measured 8 000
Marketing Client base Number of clients 200

No cost driver has been identified for accounting and administration, and it is proposed
that these be apportioned to core functions based on total cost (excluding accounting
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and administration). Approximately the same number of assessments are developed

for both selection and evaluation, while the number of assessments measured is in
proportion to the number of interviews and evaluations. Three quarters of the clients
use selection services and the remainder use evaluation services.

Required:
Calculate activity-based costs for selection and evaluation in total and per unit. If Joneli
Associates wants to achieve a total fee budget of R18 million next year, and requires
that each division makes the same percentage profit of sales, calculate the fee per service
that should be charged.
➤➤

Cost and Management Accounting

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Solution:
The secondary activities must first be apportioned to the primary activities, or core
functions, of selection and evaluation. First calculate cost driver rates for the secondary
activities:
●   R1 1500
Assessment development: _________ 000
000 = R1 500 per assessment developed
R1 600 000
● Assessment measurement:  _________
8 000 = R200 per assessment measured
●   R2 800
Marketing: _________
200
000
= R14 000 per client
R3 000 000
● Accounting and administration: __________
  R12 000 000 = 0.25% of cost
The costs can then be apportioned.
Table 8.12 Apportionment of costs to activities
Activity Selection Evaluation
Assessment
development 500 × R1 500 5 R750 000 500 × R1500 5 R750 000
Assessment
measurement 5 000 × R200 5 R1 000 000 3 000 × R200 5 R600 000
Marketing 150 × R14 000 5 R2 100 000 50 × R14 000 5 R700 000
Accounting and
administration 0.25 × R6 350 000 5 R1 587 500 0.25 × R5 650 000 5 R1 412 500

The costs for the core functions can now be tabulated.

Table 8.13 Activity-based costs of core functions
Costs Selection Evaluation
Direct cost R2 500 000 R3 600 000
Assessment development R750 000 R750 000
Assessment measurement R1 000 000 R600 000
Marketing R2 100 000 R700 000
Accounting and administration R1 587 500 R1 412 500
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Total cost R7 937 500 R7 062 500

Number of services 5 000 3 000
Cost per service R1 587.50 R2 354.17

Total budget cost is R15 million and income is R18 million. Average mark-up on cost
is therefore 20%. The fee for selection should be R1 587.50 + 20% = R1 905.00 per
applicant, and for evaluation R2 825.00 per employee evaluated. Assuming that the
above units are attained, total fee income will be: selection R9 525 000, evaluation
R8 475 000.

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Test yourself 8.3

When ABC is used, why do low-volume products usually receive a higher allocation of
overheads than when traditional absorption costing is used?

Product and customer profitability analysis

Once activity-based costs have been determined, they can be used to perform profitability
analyses for required cost objects. When only direct costs (that is, costs that cannot be
apportioned on an activity basis are excluded) are used in determining profitability, this
is called direct product profitability and direct customer profitability. In a profitability analysis,
the unit costs are multiplied by volumes (usually actual, but could be budget) to obtain
the total cost for each cost object. This is then subtracted from the sales revenue of the
cost object to obtain its profitability. Product profitability analysis can of course be done
using traditional absorption costs, but is more meaningful with the greater accuracy of
activity-based costs. Being able to produce accurate and meaningful customer profitability
analyses is one of the great benefits of ABC. To achieve this, customer-specific costs such
as advertising, discounts, merchandising, transport, etc, are allocated to the relevant
customers. Activity-based production costs are then assigned to the customers based on
sales of the relevant products by each customer. Total customer cost is then determined and
subtracted from total sales revenue for each customer to determine customer profitability.
The process of determining product and customer profitability is illustrated in Illustrative
example 8.3.

Illustrative example 8.3

Better Brands Ltd purchases sauces from its subsidiary Super Sauce Products. These are
then sold and distributed to a number of wholesale and retail customers at differing
selling prices and cost structures. The purchase price of each product is:
● Tomato: R270.00 per unit
● Garlic: R300.00 per unit
● Peri-peri: R280.00 per unit.

Selling prices to each customer type are given in Table 8.14.

Table 8.14 Product selling prices

Customers Tomato Garlic Peri-peri
Wholesalers R360.00 R400.00 R380.00
Supermarkets R380.00 R420.00 R400.00
Small retailers R400.00 R440.00 R420.00

Distribution and merchandising are done by an outside agency, which charges fees per
unit handled that are the same for each product variant but differ by customer type.
➤➤

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Table 8.15 Distribution and merchandising charges

Customers Distribution Merchandising
Wholesalers R10.00 R10.00
Supermarkets R15.00 R20.00
Small retailers R30.00 Nil

Better Brands undertakes cooperative advertising with wholesalers and supermarkets,

and allows settlement discounts for payments within terms. For budget purposes it is
assumed that all discounts are taken. These are expressed as a percentage of the selling
price.
Table 8.16 Co-op advertising and settlement discount rates
Customers Co-op advertising Settlement discounts
Wholesalers 3% 2%
Supermarkets 5% 2%
Small retailers Nil 1%

Annual sales budget in units by product variant and customer type are given in Table 8.17.
Table 8.17 Annual sales budget
Customers Tomato (unit) Garlic (unit) Peri-peri (unit)
Wholesalers 20 000 10 000 3 000
Supermarkets 40 000 20 000 4 000
Small retailers 12 000 2 000 1 000

Required:
Compile a budgeted profitability report by product variant and customer type, and
comment on the results.

Solution:
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In this example, the cost objects are both products and customers. The purchase prices
of the products are direct traceable costs, while the other costs may all be treated as
activity costs. The profitability report may be presented as a matrix with both customers
and products shown, which with a larger number of cost objects could become extremely
complex, or in separate reports for customers and products, which is what we will do.
First, we can compile sales and cost of sales budgets by product.
➤➤

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Table 8.18 Product sales and cost of sales budget

Product Customers Sales value Cost of sales
Tomato Wholesalers 20 000 × R360 = 7 200 000 20 000 × R270 = 5 400 000
Supermarkets 40 000 × R380 = 15 200 000 40 000 × R270 = 10 800 000
Small retailers 12 000 × R400 = 4 800 000 12 000 × R270 = 3 240 000
Total R27 200 000 R19 440 000
Garlic Wholesalers 10 000 × R400 = 4 000 000 10 000 × R300 = 3 000 000
Supermarkets 20 000 × R420 = 8 400 000 20 000 × R300 = 6 000 000
Small retailers 2 000 × R440 = 880 000 2 000 × R300 = 600 000
Total R13 280 000 R9 600 000
Peri-peri Wholesalers 3 000 × R380 = 1 140 000 3 000 × R280 = 840 000
Supermarkets 4 000 × R400 = 1 600 000 4 000 × R280 = 1 120 000
Small retailers 1 000 × R420 = 420 000 1 000 × R280 = 280 000
Total R3 160 000 R2 240 000
Total company R43 640 000 R31 280 000

Activity cost budgets can be compiled by product.

Table 8.19 Activity cost budgets by product
Product Customers Distribution Merchandising
Tomato Wholesalers 20 000 × R10 = 200 000 20 000 × R10 = 200 000
Supermarkets 40 000 × R15 = 600 000 40 000 × R20 = 800 000
Small retailers 12 000 × R30 = 360 000 0
Total R1 160 000 R1 000 000
Garlic Wholesalers 10 000 × R10 = 100 000 10 000 × R10 = 100 000
Supermarkets 20 000 × R15 = 300 000 20 000 × R20 = 400 000
Small retailers 2 000 × R30 = 60 000 0
Total R460 000 R500 000
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Peri-peri Wholesalers 3 000 × R10 = 30 000 3 000 × R10 = 30 000

Supermarkets 4 000 × R15 = 60 000 4 000 × R20 = 80 000
Small retailers 1 000 × R30 = 30 000 0
Total R120 000 R110 000
Total company R1 740 000 R1 610 000

➤➤

Cost and Management Accounting

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Product Customers Co-op advertising Settlement discounts

Tomato Wholesalers R7.2 m × 3% = 216 000 R7.2 m × 2% = 144 000
Supermarkets R15.2 m × 5% = 760 000 R15.2 m × 2% = 304 000
Small retailers 0 R4.8 m × 1% = 48 000
Total R976 000 R496 000
Garlic Wholesalers R4.0 m × 3% = 120 000 R4.0 m × 2% = 80 000
Supermarkets R8.4 m × 5% = 420 000 R8.4 m × 2% = 168 000
Small retailers 0 R0.88 m × 1% = 8 800
Total R540 000 R256 800
Peri-peri Wholesalers R1.4 m × 3% = 34 200 R1.14 m × 2% = 22 800
Supermarkets R1.6 m × 5% = 80 000 R1.6 m × 2% = 32 000
Small retailers 0 R0.42m × 1% = 4 200
Total R114 200 R59 000
Total company R1 630 200 R811 800

We can now compile a budget product profitability report.

Table 8.20 Product profitability report
Tomato Garlic Peri-peri Total
Cost of sales R19 440 000 R9 600 000 R2 240 000 R31 280 000
Distribution 1 160 000 460 000 120 000 1 740 000
Merchandising 1 000 000 500 000 110 000 1 610 000
Co-op advertising 976 000 540 000 114 200 1 630 200
Settlement discounts 496 000 256 800 59 000 811 800
Total cost 23 072 000 11 356 800 2 643 200 37 072 000
Sales 27 200 000 13 280 000 3 160 000 43 640 000
Profit 4 128 000 1 923 200 516 800 6 568 000

Cost per unit R320.44 R354.90 R330.40 R331.00

Average SP per unit R377.78 R415.00 R395.00 R389.64
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Profit per unit R57.34 R60.10 R64.65 R58.64

% Profit to sales 15.2% 14.5% 16.4% 15.1%

Although tomato sauce generates almost double the total profit of the other two
variants combined, both its profit per unit and percentage profit to sales are lower.
Peri-peri sauce has the highest profitability of the three variants, but by far the lowest
volume, making it the logical variant to concentrate on for efforts to increase profits
through volume increases. Although tomato sauce has the lowest cost per unit of the
three variants, because of its much higher volume, cost reduction efforts should be
directed towards this variant, but this could only be achieved by reducing the purchase
price, since all other costs are customer-driven.
➤➤

Activity-based costing and management

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270

Using the same budget data, we can compile sales and cost of sales budgets by customer.
Table 8.21 Customer sales and cost of sales budgets
Customers Products Sales value Cost of sales
Wholesalers Tomato 20 000 × R360 = 7 200 000 20 000 × R270 = 5 400 000
Garlic 10 000 × R400 = 4 000 000 10 000 × R300 = 3 000 000
Peri-peri 3 000 × R380 = 1 140 000 3 000 × R280 = 840 000
Total R12 340 000 R9 240 000
Supermarkets Tomato 40 000 × R380 = 15 200 000 40 000 × R270 = 10 800 000
Garlic 20 000 × R420 = 8 400 000 20 000 × R300 = 6 000 000
Peri-peri 4 000 × R400 = 1 600 000 4 000 × R280 = 1 120 000
Total R25 200 000 R17 920 000
Small retailers Tomato 12 000 × R400 = 4 800 000 12 000 × R270 = 3 240 000
Garlic 2 000 × R440 = 880 000 2 000 × R300 = 600 000
Peri-peri 1 000 × R420 = 420 000 1 000 × R280 = 280 000
Total R6 100 000 R4 120 000
Total company R43 640 000 R31 280 000

Activity cost budgets by customer can be compiled.

Table 8.22 Activity cost budgets by customer
Customers Products Distribution Merchandising
Wholesalers Tomato 20 000 × R10 = 200 000 20 000 × R10 = 200 000
Garlic 10 000 × R10 = 100 000 10 000 × R10 = 100 000
Peri-peri 3 000 × R10 = 30 000 3 000 × R10 = 30 000
Total R330 000 R330 000
Supermarkets Tomato 40 000 × R15 = 600 000 40 000 × R20 = 800 000
Garlic 20 000 × R15 = 300 000 20 000 × R20 = 400 000
Peri-peri 4 000 × R15 = 60 000 4 000 × R20 = 80 000
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Total R960 000 R1 280 000

Small retailers Tomato 12 000 × R30 = 360 000 0
Garlic 2 000 × R30 = 60 000 0
Peri-peri 1 000 × R30 = 30 000 0
Total R450 000 R0
Total company R1 740 000 R1 610 000

➤➤

Cost and Management Accounting

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Co-op advertising Settlement discounts

Wholesalers Tomato R7.2 m × 3% = 216 000 R7.2 m × 2% = 144 000
Garlic R4.0 m × 3% = 120 000 R4.0 m × 2% = 80 000
Peri-peri R1.14 m × 3% = 34 200 R1.14 m × 2% = 22 800
Total R370 200 R246 800
Supermarkets Tomato R15.2 m × 5% = 760 000 R15.2 m × 2% = 304 000
Garlic R8.4 m × 5% = 420 000 R8.4 m × 2% = 168 000
Peri-peri R1.6 m × 5% = 80 000 R1.6 m × 2% = 32 000
Total R1 260 000 R504 000
Small retailers Tomato 0 R4.8 m × 1% = 48 000
Garlic 0 R0.88 m × 1% = 8 800
Peri-peri 0 R0.42 m × 1% = 4 200
Total R0 R61 000
Total company R1 630 200 R811 800

We can now compile a budget customer profitability report.

Table 8.23 Customer profitability report
Wholesalers Supermarkets Small retailers Total
Cost of sales R9 240 000 R17 920 000 R4 120 000 R31 280 000
Distribution 330 000 960 000 450 000 1 740 000
Merchandising 330 000 1 280 000 0 1 610 000
Co-op advertising 370 200 1 260 000 0 1 630 200
Settlement discounts 246 800 504 000 61 000 811 800
Total cost 10 517 000 21 924 000 4 631 000 37 072 000
Sales 12 340 000 25 200 000 6 100 000 43 640 000
Profit 1 823 000 3 276 000 1 469 000 6 568 000
Cost per unit R318.70 R339.44 R312.80 R329.76
Average SP per unit R373.94 R393.75 R406.67 R389.64
Profit per unit R55.24 R54.31 R93.87 R59.88
% Profit to sales 14.8% 13.8% 22.0% 15.4%
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Sales to supermarkets generate the greatest total profit but are the least profitable per
unit and as a percentage of sales. Sales to small retailers are by far the most profitable,
both per unit and as a percentage of sales. This would indicate that efforts to increase
sales should be made to these customers, but market factors must also be considered.
The number of small retailers may be decreasing, while supermarkets are increasing.
It is interesting to note that average selling price to small retailers is far higher, while
average cost is lower (because there are no merchandising and cooperative advertising
costs). Total profitability could be increased by reviewing pricing strategies. If prices
to supermarkets were slightly increased and those to small retailers lowered by a
greater amount, this might cause a beneficial change in sales pattern without affecting
overall volumes.

Activity-based costing and management

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272

Test yourself 8.4

In an ABC system, no cost driver has been identified to link general administration costs
to products.

Required:
Would these costs be used in determining direct product profitability?
Explain your answer.

Activity-based management
Activity-based management (ABM) is defined by CIMA as a ‘system of management
which uses activity-based cost information for a variety of purposes including cost
reduction, cost modelling and customer profitability analysis’. From this definition one
can say that the focus of ABM is on operational decisions such as improving efficiency
and effectiveness, through identifying and improving activities which add value to cost
objects, and eliminating activities that do not add value. However, ABM should also be
used for strategic decision support by identifying products, customers and processes that
should be developed and expanded to improve profitability and competitiveness. Another
strategic use of ABM could be an organisation reorganising itself around processes rather
than functions. The processes are analysed into activities: core activities, which add value;
support activities, which make core activities possible; and diversionary activities, which are
non-value-adding, and should be eliminated. When activities are identified as non-value-
adding, it is important to examine whether or not they have value that is not immediately
apparent and quantifiable. For example, the benefits of pleasant working conditions on
staff morale may be difficult to quantify, but saving cost by making conditions less pleasant
may lead to good staff being lost or having to be paid more to remain. The end result may
be a net increase in cost. Managers should also be careful to understand the effects on other
parts of the organisation of eliminating activities in their areas of responsibility.
Once ABM has been implemented, the system will provide a number of information
outputs:
● Costs of activities and processes
● Cost driver information, which will assist in understanding and managing activities
● Costs of non-value-adding activities
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● Accurate costs of cost objects, that is, products, services and customers
● Activity-based performance measures, which will aid in continuous improvement
efforts.

Using the information provided by ABC/ABM, managers can make the operational and
strategic decisions mentioned. However, it is important to remember that the system alone
will not reduce costs or improve effectiveness, but only provide a better understanding of
costs and activities so that managers are better equipped to perform their tasks.

Cost and Management Accounting

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273

Test yourself 8.5

If an organisation uses ABC, should it concern itself with non-value-adding activities?
Give reasons for your answer.

Uses of activity-based costing/management

The costs incurred in implementing an ABC system are significant, therefore the system
should only be used if there is a cost benefit to the organisation, such as improved decision
making and control. ABC should ideally be used in the context of ABM. ABC information
can be used in an ABM system in assessing strategic decisions such as:
● Whether to continue with a particular activity
● The effect of changes in activities and components on suppliers and the value chain
● How cost structures measure up to those of competitors
● The effect a change in strategy has on cost structures, for example from mass production
to smaller production lots.

Organisations also use ABC systems for the following:

● Cost reduction and improving efficiency by evaluating whether particular activities can
be reduced or eliminated by improving processes
● Planning and managing activities by analysing costs to identify activity cost pools and
activity cost rates. At the end of the period, actual and budgeted costs are compared in
order to provide feedback on how well activities were managed.
● Identifying and evaluating new designs to improve performance by evaluating how
product and process designs affect activities and costs.

Activity-based budgeting
When ABC/ABM has been implemented, the information and systems can be used in other
management activities, such as budgeting. Activity-based budgeting (ABB) refers to
budgeting in terms of identified activities and cost drivers, and utilises cost driver data in the
budget-setting and variance feedback process. The benefits of ABB include the following:
● Activities underlying financial figures of each function/process are defined
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● Resources are allocated to functions/processes, based on the level of each activity

● Performance is measured, based on activity levels (rather than volumes)
● Variances from budget are analysed and explained in terms of activity levels.

Although in principle ABB will use similar procedures to any budgeting system, it is important
to ensure that it is focused on activities rather than functional divisions in the organisation.
The steps to be followed in the ABB process are as follows:
1. Identify activities to which resources may be committed.
2. Determine the value of these activities to business objectives, and rank activities for
allocation of scarce resources, for example finance, skilled labour, etc.

Activity-based costing and management

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3. Assess the levels of service required from these activities.

4. Match the costs resulting from activities with areas of responsibilities.
5. Estimate the cost implications of alterations to activities.

Once these steps have been undertaken, a master budget can be prepared as with any other
budgeting system. However, the underlying sources of the master budget will be organised
based on activities instead of functional responsibilities. A problem with using activity-
based information for budgeting purposes is that budgets typically cover a financial year,
whereas changes in some activities indicated by budget volumes may take much longer. For
example, reductions in volume may indicate that maintenance activity should be reduced,
but this may not be possible in the short term. The financial budget that is prepared may
for this reason not fully match the activity-based budget. The important point is to know
where the differences are, the reasons for them, and the actions that can and are being taken
to address these differences.

Activity-based management accounting

Ultimately, the implementation of all the activity-based systems discussed can result in
an organisation having an activity-based management accounting system, which is an
advanced planning, monitoring and control system, which includes the following:
● Activity-based costing (ABC)
● Activity-based cost management (ABCM)
● Activity-based budgeting (ABB)
● Activity accounting and reporting
● Activity-based performance measurement and benchmarking
● Continuous improvement
● Product/customer/market/sector profitability
● Business process re-engineering (BPR).

Activity-based management accounting examines and utilises drivers in four areas:

1. Cost
2. Quality
3. Time
4. Innovation.
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Test yourself 8.6

What benefits does activity-based budgeting bring to an organisation?

Cost and Management Accounting

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Benefits and criticisms of activity-based costing

Benefits of activity-based costing

These are some benefits of ABC:
● ABC recognises and provides for the increased complexity of modern business.
● Realistic assessment of product profitability is valuable in a competitive environment.
● Indirect overhead costs are of increasing significance in modern business and are better
dealt with in ABC than by traditional costing systems.
● ABC is useful in service industries, and for providing customer profitability assessment.
● Product costs which accurately reflect the use of resources will enable decisions to
be made that contribute to improved performance. If overheads are apportioned to
products on bases that do not match reality, it can cause decisions to be made (for
example, on introduction or elimination of products) that reduce profitability, because
changes in overhead costs are not as indicated by the product costs.
● An ABC system will allow easy validation of expense budgets by explosion of the sales
budget into activity costs and comparison with expense budgets. This comparison
must not be used as a ‘straight-jacket’ for budgets, because the variability of many of
the ABC costs will be longer term than the budgets. However, even if budgets are not
altered because of differences, the comparison will highlight areas of excess capacity
or constraint.
● When the ABC method of allocating overheads is understood by managers, there will be
less likelihood of queries or disagreement about product costs, because the allocation
basis is more logical and ‘fair’ than methods which either tar all products with the same
brush, or allocate on an arbitrary or unrealistic basis.
● Because ABC initially costs activities, and these costs are assigned to cost objects by
way of cost drivers, different cost objects can be selected for costing, using the same
system with relative ease. This means that not only product profitability reports can be
produced, but also customer profitability, divisional profitability, process profitability, etc.

Criticisms of activity-based costing

Below are some criticisms of ABC:
● Implementation costs can be considerable, and there is little empirical evidence of
improved profitability resulting from its use.
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● Certain overhead allocations remain problematic, for example those which relate
to neither volume nor complexity/diversity and which result in some arbitrary cost
apportionment.
● Use of a single cost driver for each activity pool may be questionable.
● Relationships of costs to activities and drivers may be unclear or ambiguous.
● ABC costs all activities in a business regardless of whether they are efficient or not, or
whether they add value to the business or not. Unless ABM is implemented as well,
the full benefits of continuous improvement will not be realised. Improving activity
performance requires a continuous analysis of activities, performance drivers, and
performance measurements.

Activity-based costing and management

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● Implementation of ABC is not a quick, easy job and maintenance will also be more time-
consuming than traditional costing methods.
● The output of ABC may not be as easy to understand as traditional costing methods for
managers used to simple ‘one size fits all’ answers.
● Because of its long-term perspective, ABC is a strategic tool, and some other method
may be more appropriate for tactical problems. This also makes it of comparatively
little use for cost control purposes, unless activity costs are constructed to differentiate
between short- and long-term costs.

ABC makes no attempt to follow generally accepted accounting principles (GAAP), except
where these would result in the correct matching of resource consumption and expenditure,
and in some cases might contradict International Financial Reporting Standards (IFRS), for
example including interest as a cost of inventory-holding activities. However, activity costs
could be constructed in such a way that inventory valuations acceptable to IFRS could be
obtained, although these would only be useful for financial accounting and tax purposes.

Test yourself 8.7

Give two major benefits and limitations of ABC.

Summary
The development of ABC arose in response to the inability of traditional costing methods
to provide accurate costs in environments where overhead costs are more significant and the
use of direct labour as a means of allocation was inappropriate. The basic tenet of ABC is that
production of products and services use activities, which consume resources, causing cost.
Linking products to activities enables accurate determination of product costs, providing
better information for decision making and cost control. Implementing ABC requires analysis
of the activities of an organisation, linking of activities to products and services through
cost drivers and output measures, and collection of costs by activity centre. Once the ABC
system has been implemented, it may be used to provide information in an activity-based
management system for cost reduction profitability improvement through identifying and
improving activities which add value to cost objects, and eliminating activities that do not
add value. Although ABC and management can be extremely costly and time-consuming to
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implement and operate, the benefits to an organisation potentially far outweigh the costs.

Key concepts
Activity is an event or transaction that causes costs to be incurred.
Activity-based budgeting (ABB) is budgeting in terms of identified activities and cost
drivers, utilising cost driver data in the budget setting and variance feedback process.
Activity-based costing (ABC) is a costing method for determining the cost of an activity
which can be used for any purpose for which cost information may be required. ABC is an
attempt to determine the full cost of a product, process, customer or other cost object.
➤➤

Cost and Management Accounting

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Activity-based management (ABM) is a system which directs attention to ways of

improving how activities are performed. ABM is a continuous improvement process
which eliminates or improves the efficiency of activities that are performed.
Capacity drivers are factors which cause a change in the capacity of an activity, in other
words, in the number of units of that activity that can be carried out.
Cost drivers are factors which cause changes in the costs of activities.
Cost objects are products, services, processes, customers, etc − anything for which the
cost must be determined.
Cost pools are activity centres to which costs have been allocated.
Drivers are factors which effect changes in the performance of activities.
Output measure is the means by which cost is conveyed from the activity to the cost
object − often the end result of an activity.
Quality drivers are factors which cause changes in the quality of the product, leading to
changes in resource consumption, for example a customer who requires specific quality
levels of otherwise standard products.

Test-yourself solutions
Test yourself 8.1
Business operations tend to be more complex and the proportion of overheads to direct
costs is greater.

Test yourself 8.2

Unit level, batch level, process level, product sustaining and facility sustaining activities.

Test yourself 8.3

Many overhead costs are driven by activities that are not related to volume.

Test yourself 8.4

No, because only direct costs are used.
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Test yourself 8.5

Yes, because all activities must be examined to identify whether or not they add value. If
identified as non-value adding, an activity must be further examined to see how it can be
eliminated or changed to add value.

Test yourself 8.6

Activities are defined, resources are allocated to processes based on activity levels,
performance measurements are based on activity levels, and variances are analysed in terms
of activity levels.

Activity-based costing and management

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Test yourself 8.7

Major benefits are that ABC recognises the increased complexity and incidence of overheads
in modern businesses, and it provides a more realistic assessment of product and customer
profitability than traditional costing. Major limitations are high implementation
costs and problems with identifying acceptable cost drivers for many overheads.

Review questions
8.1 What is cost behaviour?
8.2 Define activity-based costing.
8.3 Give two reasons why traditional costing systems may be ineffective.
8.4 Define activity-based management.
8.5 Classify activities into a hierarchy.
8.6 What is a bill of activities?
8.7 Differentiate cost drivers from capacity drivers.
8.8 List the steps required to determine the activity-based cost of a product.
8.9 What difference is there between applying activity-based costing in a service
organisation and in a manufacturing organisation?
8.10 List four uses of activity-based management.
8.11 What are the benefits of activity-based budgeting?
8.12 Give five benefits and five limitations of activity-based costing.

Exercises
8.1 Large service organisations such as banks and hospitals used to be noted for their
lack of standard costing systems and their relatively unsophisticated budgeting
and control systems compared with large manufacturing organisations. But this
is changing and many large service organisations are now revising their use of
management accounting techniques.

Required:
(a) Explain which features of large-scale services organisations encourage the
application of activity-based approaches to the analysis of cost information.
(b) Explain which features of service organisations may create problems for the
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application of activity-based costing.

(c) Explain the uses for activity-based cost information in service industries.
(d) Many large service organisations were at one time state owned, but have
now been privatised. Examples in some countries include electricity supply
and telecommunications. They are often regulated. Similar systems of
regulation of prices by an independent authority exist in many countries
and are designed to act as a surrogate for market competition in industries
where it is difficult to ensure a genuinely competitive market.
Explain which aspects of cost information and systems in service organisa-
tions would particularly interest a regulator, and why these features
would be of interest.

Cost and Management Accounting

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(e) The basic ideas justifying the use of activity-based costing and activity-
based budgeting are well publicised, and the number of applications
has increased. However, there are apparently still significant problems in
changing from the existing system.
(i) Explain which characteristics of an organisation, such as its structure,
product range, or environment, may make the use of activity-based
techniques particularly useful.
(ii) Explain the problems that may cause an organisation to decide not to
use, or to abandon use of, activity-based techniques.
Source: CIMA (adapted)
8.2 Boson Ltd manufactures and markets a wide range of components and finished
products for the lighting industry. The company began implementing activity-
based costing in its manufacturing divisions in 2010, using various teams to collect
activity-based data. Each team consisted of a management accountant working
closely with department managers and staff on data collection and developing
spreadsheets for analysis and presentation of results. The implementation
process in the manufacturing divisions is now substantially complete and the
system is operating satisfactorily. Two teams have been set up to collect data
on customer-related costs. One team has looked at order-related costs and the
other at distribution costs. The main objective at this stage is to see whether
activity-based costing can provide a better understanding of customer-driven
costs and customer profitability. Because this phase is regarded as a ‘pilot’
project, only three major customers were included in the analysis, representing
30% of total sales. The company has approximately 200 customers in total.
The teams only considered staff-related costs (salaries, benefits, etc) and direct
costs (transport, computer costs, equipment depreciation, stationery, etc)
for the cost pools. The first objective for each team was to estimate the total
annual overhead cost and annual volume for each cost driver. As the company
only focused on three customers, the data was quickly estimated. The second
objective was to estimate the percentage of each cost driver per customer.
Each team began by identifying activity cost pools and cost drivers for the
activities. They then estimated, from historical and budget data, the total
annual overhead cost for each cost pool and the annual volume for each cost
driver. The main difficulty at this stage was estimating what proportion of cost
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driver activity would be consumed by the three customers. This was based largely
on the experience of departmental staff. The group management accountant
decided that each team should identify between four and eight activities for their
section. Using more activities would take too long to collect and interpret data,
without adding much value to the initial project. Although the departmental
staff assigned to the teams had little experience of collecting data on activities
and cost drivers, the management accountants were able to guide them, using
their experience gained from the manufacturing implementation.

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Activity-based data
Team 1: Order-related overheads
Activity cost pool Cost driver Annual Annual
overhead volume
cost (R)
Pre-sales support Number of hours of pre-sales support 1 520 000 3 800
Post-sales support Number of hours of post-sales support 1 100 000 2 200
Order processing Number of orders 800 000 20 000
Changes to orders Number of order changes 450 000 3 000
Invoicing Number of invoices 540 000 22 500

Team 2: Distribution costs

Activity cost pool Cost driver Annual Annual

overhead volume
cost (R)
Storage expenses Average cartons in stock 125 000 5 000
Order handling Number of orders 990 000 22 500
Standard deliveries Number of standard deliveries 2 640 000 22 000
Special deliveries Number of special deliveries 125 000 500

Customer sales and activity analysis

Customer Electric Home centre Lighting depot
warehouse
Annual sales R19 500 000 R10 700 000 R17 300 000
Cost of sales R17 500 000 R9 700 000 R15 500 000

The percentage of total activity of each cost driver used by these customers was
estimated and is given in the following table.
Cost driver Electric Home centre Lighting
warehouse (%) depot (%)
(%)
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Number of hours of pre-sales support 14 10 16

Number of hours of post-sales support 10 5 10
Number of orders 10 12 12
Number of order changes 20 2 10
Number of invoices 12 15 12
Average cartons in stock 10 15 10
Number of orders 8 12 12
Number of standard deliveries 10 10 15
Number of special deliveries 20 10 10

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Required:
(a) Calculate the profit from each customer based on the activity-based costing
data.
(b) Discuss what steps the company should consider to improve the profitability
of individual customers.
8.3 A company sells a range of products, such as groceries, clothing and home
appliances, through a chain of retail stores. The main administration
functions are provided from the company’s head office. Each retail store has
its own warehouse which receives goods that are delivered from a central
distribution centre.
The company currently measures profitability by product group for each store
using an absorption costing system. All overhead costs are charged to product
groups based on sales revenue. Overhead costs account for approximately one-
third of total costs and the directors are concerned about the arbitrary nature of
the current method used to charge these costs to product groups. A consultant
has been appointed to analyse the activities that are undertaken in the retail
stores and to establish an activity-based costing system.
The consultant has identified the following data for the latest period for each of
the product groups for the Newton store:
Product group
Groceries Clothing Home appliances
Sales revenue R4 400 000 R3 300 000 R1 100 000
Cost of sales R2 800 000 R2 300 000 R600 000
Number of deliveries 104 52 26
Number of pallets per delivery 50 20 10
Number of inventory items 20 000 14 000 6 000
Number of customers 2 100 000 1 050 000 350 000
Number of requisitions 522 243 135

The consultant has also obtained the following information about the support
activities:
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Activity Cost driver Overheads

R’000
Customer service Number of customers 1 100
Warehouse receiving Number of pallets delivered 700
Warehouse issuing Number of requisitions 300
In-store merchandising Number of inventory items 400
Central administration Sales revenue 316

Required:
(a) Calculate the total profit for each of the product groups:
(i) Using the current absorption costing system
(ii) Using the proposed activity-based costing system.

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(b) Explain how the information obtained from the activity-based costing
system might be used by the management of the company.
(c) Explain the circumstances under which an activity-based costing system
would produce similar product costs to those produced using a traditional
absorption costing system.
Source: CIMA (adapted)
8.4 Zee Ltd designs, produces and sells a number of products. Functions are
recognised from design through to the distribution of products. Within each
function, a number of activities may be distinguished and a principal driver
identified for each activity. Each sales order will normally comprise a number of
batches of any one of a range of products. The company is active in promoting,
where possible, a product focus for design, dedicated production lines and
product marketing. It also recognised that a considerable level of expenditure
will relate to supporting the overall business operation.
It is known that many costs may initially be recognised at the unit, batch, and
product-sustaining (order) or business/facility-sustaining (overall) levels. A
list of expenses items relating to Order Number 811 of product Z is shown
below. The methods of calculating the values for Order Number 811 are given
in brackets alongside each expenses item. These methods also indicate whether
the expenses items should be regarded as product unit, batch, and product-
sustaining (order) or business/facility-sustaining (overall) level costs. The
expenses items are not listed in any particular sequence. Each expenses item
should be adjusted to reflect its total cost for Order Number 811.
Order Number 811 comprises 5 000 units of product Z. The order will be
provided in batches of 1 000 product units.

Order Number 811 R

Production scheduling (rate per hour × hours per batch) 60 000
Direct material cost (per unit material specification) 180
Selling – batch expediting (at rate per batch) 60 000
Engineering design and support (rate per hour × hours per order) 350 000
Direct labour cost (rate per hour × hours per unit) 150
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Machines set-up (rate per set-up × number of set-ups per batch) 34 000

Order Number 811 R

Production line maintenance (rate per hour × hours per order) 1 100 000
Business/facility-sustaining cost (30% of all other costs) 1 500 000
Marketing (rate per visit to client × number of visits per order) 200 000
Distribution (tonne miles × rate per tonne mile per batch) 12 000
Power cost (rate per kilowatt hour × kilowatt per unit) 120
Design work (rate per hour × hours per batch) 30 000
Administration − invoicing and accounting (at rate per batch) 24 000

Cost and Management Accounting

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Required:
(a) Prepare a statement of total cost for Order Number 811, which analyses the
expense items into sections for each of four levels, with sub-totals for each
level where appropriate. The four levels are:
(i) Unit-based costs
(ii) Batch-related costs
(iii) Product-sustaining (order level) costs
(iv) Business/facility-sustaining (overall level) costs.
(b) Identify and discuss the appropriateness of the cost driven of any two
expense values in each of levels (i) to (iii) above and one value that relates
to level (iv). In addition, suggest a likely cause of the cost driver for any one
value in each of levels (i) to (iii), and comment on possible benefits from the
identification of the cause of each cost driver.
(c) Discuss the practical problems that may be encountered in the imple-
mentation of an activity-based system of product cost management.
Source: ACCA (adapted)
8.5 Ride Ltd assembles three types of motorcycle at the same factory: the 50cc
Swift, the 250cc Reliable, and the 1 000cc Rocket. It sells the motorcycles
throughout the world. In response to market pressures, Ride Ltd has invested
heavily in new manufacturing technology in recent years and, as a result,
has significantly reduced the size of its workforce. Historically, the company
has allocated all overhead costs using total direct labour hours, but is now
considering introducing activity-based costing (ABC). Ride Ltd’s accountant
has produced the following analysis:
Annual output Annual direct Selling price Raw material cost
(units) labour hours (R per unit) (R per unit)
Swift 2 000 200 000 4 000 400
Reliable 1 600 220 000 6 000 600
Rocket 400 80 000 8 000 900

These are the three cost drivers that generate overheads:

● Deliveries to retailers: the number of deliveries of motorcycles to retail
showrooms
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● Set-ups: the number of times the assembly line process is re-set to

accommodate a production run of a different type of motorcycle
● Purchase orders: the number of purchase orders.
The annual cost driver volumes relating to each activity and for each type of
motorcycle are as follows:
Number of deliveries Number of set-ups Number of purchase
to retailers orders
Swift 100 35 400
Reliable 80 40 300
Rocket 70 25 100

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The annual overhead costs relating to these activities are as follows:

R
Deliveries to retailers 2 400 000
Set-up cost 6 000 000
Purchase orders 3 600 000

All direct labour is paid at R5 per hour. The company holds no stocks. At a
board meeting there was some concern over the introduction of ABC. The
finance director argued: ‘I very much doubt whether selling the Rocket is viable
but I am not convinced that ABC would tell us any more than use of labour
hours in assessing the viability of each product.’ The marketing director argued:
‘I am in the process of negotiating a major new contract with a motorcycle
rental company for the Swift model. For such a big order, they will not pay
our normal prices, but we at least need to cover our incremental costs. I am
not convinced that ABC would achieve this as it merely averages costs for our
entire production.’ The managing director argued: ‘I believe that ABC would be
an improvement, but it still has its problems. For instance, if we carry out an
activity many times, surely we get better at it, and costs fall rather than remain
constant. Similarly, some costs are fixed and do not vary either with labour
hours or any other cost driver.’ The chairman argued: ‘I cannot see the problem.
The overall profit for the company is the same no matter which method of
allocating overheads we use. It seems to make no difference to me.’

Required:
(a) Calculate the total profit on each of Ride Ltd’s three types of product, using
each of the following methods to attribute overheads:
(i) The existing method based on labour hours
(ii) Activity-based costing.
(b) Write a report to the directors of Ride Ltd, as its management accountant.
The report should:
(i) Evaluate the labour hours and the ABC methods in the circumstances
of Ride Ltd
(ii) Examine the implications of ABC for Ride Ltd, and in so doing evaluate
the issues raised by each of the directors.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Refer to your calculations in (a) where appropriate.

Source: ACCA (adapted)
8.6 Crows Accounting Associates (CAA) is a small accounting firm based in
Montclair, Newtown. It provides accountancy services and taxation advice to
close corporations and self-employed individuals. The firm currently charges its
clients a fee calculated by adding a 10% mark-up to total costs attributed to each
client, based on the hours spent on preparing accounts and providing advice.
As the firm has recently been involved in an ABC implementation with one
of its clients, the partners are considering changing CAA to an activity-based
costing system. They have analysed their annual costs by cause as given in the
following table.

Cost and Management Accounting

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Activity Annual cost Cause of cost Annual driver

(R) volume
Accounts preparation 600 000 Hours utilised 2 400
Accounting advice 280 000 Hours utilised 800
Taxation advice 350 000 Hours utilised 1 000
Missing information requests 50 000 Request numbers 250
Travelling to clients 90 000 Kilometres travelled 30 000
Holding client meetings 150 000 Number of meetings 300
Issuing fee payment accounts 28 000 Number of accounts 140
General admin costs 300 000 Undetermined –

Three of their clients are: Montclair Builders CC, for whom they prepare
accounts and give accounting advice; J Smith, who has accounts prepared;
and A Jones, who only receives taxation advice. The following table reveals the
information of the analysis of work done for these three clients.

Activity Montclair Builders CC J Smith A Jones

Acc prep Acc advice Acc prep Tax advice
Accounts preparation hours 200 – 30 –
Accounting advice hours – 60 – –
Taxation advice hours – – – 40
Missing information requests 8 1 2 0
Kilometres travelled to client 500 50 20 10
Client meetings held 3 2 2 1
Fee accounts sent 2 1 1 3

Required:
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Calculate the fees that would currently be charged to each client, and the fees
that would be charged using the activity-based costing system, assuming CAA
wants to make the same overall profit. Compare the two charges, and comment
briefly on the results.
8.7 Reliable Rice imports rice in bulk from Malaysia, repacks it into 500 g bags, and
sells the bags to a variety of retail customers who vary considerably in size. Some
customers order in large quantities but relatively infrequently, whereas others
frequently place small orders.
While Reliable Rice is easily able to determine the cost of the bags of rice when
they have been packed, the manager feels that the firm is losing money on
sales to smaller customers, but does not have any information to support this.

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Consequently, he wants to investigate the use of direct customer profitability

analysis. Before making a decision, he asked his accountant to use the system
to analyse the profitability of one large and one small customer.
The information obtained for the two customers and the company as a whole
is given in the table.

Customer A Customer B Company as

(R) (R) a whole (R)
Sales 7 200 000 2 700 000 49 500 000
Cost of sales after packing 6 000 000 2 250 000 41 250 000
Contribution 1 200 000 450 000 8 250 000
Customer-related overhead costs:
Sales representative costs 600 000
Order processing and invoicing 240 000
Normal delivery costs 2 400 000
Urgent delivery costs 180 000
Activity cost drivers:
Number of packs sold 800 000 300 000 5 500 000
Sales visits to customers 24 12 150
Orders placed 75 40 600
Normal deliveries 120 90 1 200
Urgent deliveries 10 0 60

Required:
(a) For each of the two customers, prepare a direct profitability analysis.
(b) Explain how customer profitability analysis could be used by Reliable Rice
to improve its profits.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

8.8 Southern Salt Company produces three grades of salt for the catering industry:
coarse, fine and herbal. All are packed in similar containers. They currently use
a traditional absorption costing system with overheads allocated to products
based on direct labour hours. They are considering changing to activity-based
costing (ABC) and have undertaken an activity analysis which reveals that the
products use some resources in proportions unrelated to production volumes.
Based on the analysis and other information, the data for a typical month has
been provided in the following table.

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Coarse Fine Herbal

Selling price per unit R220.00 R250.00 R350.00
Units produced 5 000 10 000 500
Direct material:
kg per unit 50 50 50
cost per unit R100.00 R100.00 R150.00
Direct labour:
hours per unit 0.5 0.6 0.7
cost per unit R20.00 R24.00 R30.00
Machine hours per unit 0.10 0.15 0.20
Number of production runs per month 10 10 5
Number of material requisitions per month 20 20 20

The following table gives the overhead costs by activity for a month.

Material stores R120 000

Supervision R531 000
Product handling R232 500
Production batch related R187 500
Machine related R504 000

Required:
(a) Calculate the total cost and profit per unit for each product using the
present costing system.
(b) Identify cost drivers for each activity, and calculate the total cost and profit
per unit for each product using activity-based costing.
(c) Comment on the changes in profitability of each product.
8.9 Duo-tech Ltd manufactures and sells two products, Uno and Duo. Annual
volumes, labour hours and direct cost data for the two products are given in
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the table below.

Uno Duo
Production volume (units) 2 000 10 000
Labour hours per unit 5.0 4.0
Direct material cost per unit R850.00 R770.00
Direct labour cost per unit R300.00 R240.00

Six activity centres have been identified, and cost drivers determined for them
are provided in the following table.

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Activity centre Cost driver Expected activity by product in

cost driver units
Uno Duo
Labour related Direct labour hours 10 000 40 000
Machine set-ups Number of set-ups 3 000 2 000
Product testing Number of tests 5 000 3 000
Production planning Number of orders 100 300
Material receipts Number of receipts 150 600
General factory Machine hours 12 000 28 000

The following table gives the annual overhead costs for each activity.
Labour related R800 000
Machine set-ups R1 500 000
Product testing R1 600 000
Production planning R700 000
Material receipts R900 000
General factory R2 500 000

Required:
(a) Classify the activity in each of Duo-tech’s activity centres according to the
activity-based costing hierarchy of activities.
(b) Assuming that overheads are applied to products based on labour hours,
calculate an overhead absorption rate, and determine the total product
cost per unit of each product, using this overhead rate.
(c) Assuming that activity-based costing is used, calculate cost driver rates
for each activity centre, and determine the overhead cost per unit of each
product, and the total product cost per unit.
(d) Compare the costs calculated in (b) with those calculated in (c).
8.10 WW Ltd produces three models of speedboats for sale to the retail market. The
Copyright © 2021. Juta & Company, Limited. All rights reserved.

company currently operates a standard absorption costing system. Budgeted

information for next year is given below.
Model of speedboat Superior Deluxe Ultra Total

R’000 R’000 R’000 R’000

Sales 54 000 86 400 102 000 242 400
Direct material 17 600 27 400 40 200 85 200
Direct labour 10 700 13 400 16 600 40 700
Production overheads 69 600
Gross profit 46 900

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Superior Deluxe Ultra

Production/sales (number of boats) 1 000 1 200 800
Machine hours per boat 100 200 300

The production overhead cost is absorbed using a machine-hour rate. The

company is considering changing to an activity-based costing system. The
main activities and their associated cost drivers and overhead cost have been
identified as follows:

Activity Cost driver Production overhead cost

R’000
Machining Machine hours 13 920
Set-ups Number of set-ups 23 920
Quality inspection Number of quality
inspections 14 140
Stores receiving Number of component
deliveries 6 840
Number of issues from stores
Stores issue 10 780
69 600

The analysis also revealed the following information:

Superior Deluxe Ultra

Budgeted production (number of boats) 1 000 1 200 800
Boats per production run 5 4 2
Quality inspections per production run 2 6 12
Number of component deliveries 500 600 800
Number of issues from stores 4 000 5 000 7 000

The machines are set up for each production run of each model.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Required:
(a) Calculate the total gross profit for each model of speedboat:
(i) Using the current absorption costing system
(ii) Using the proposed activity-based costing system.
(b) Explain why an activity-based costing system may produce more accurate
product costs than a traditional absorption costing system.
(c) Explain the other benefits to the company of introducing an activity-based
costing system. You should use the figures calculated in part (a) to illustrate
your answer.
Source: CIMA (adapted)

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8.11 A company sells and services photocopy machines. Its sales department sells the
machines and consumables, including ink and paper, and its service department
provides an after-sales service to its customers. The after-sales service includes
planned maintenance of the machine and repairs in the event of a machine
breakdown. Service department customers are charged an amount per copy
that differs depending upon the size of the machine.
The company’s existing costing system uses a single overhead rate, based
on total sales revenue from copy charges, to charge the cost of the service
department support activities to each size of machine. The service manager
has suggested that the copy charge should more accurately reflect the costs
involved. The company accountant has decided to implement an activity-based
costing system and has obtained the following information about the support
activities and service departments:

Activity Cost driver Overheads per

annum
R’000
Customer account handling Number of customers 126
Planned maintenance Number of planned maintenance
scheduling visits 480
Unplanned maintenance Number of unplanned maintenance
scheduling visits 147
Spare-part procurement Number of purchase orders 243
Other overheads Number of machines 600
Total overheads 1 596

The following data has been collected for the machine size:

Small Medium Large

photocopier photocopier photocopier
Charge per copy R0.03 R0.04 R0.05
Average number of copies per year per
machine 60 000 120 000 180 000
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Number of machines 300 800 500

Planned maintenance visits per
machine per year 4 6 12
Unplanned maintenance visits per
machine per year 1 1 2
Total number of purchase orders per 500 1 200 1 000
year R100 R300 R400
Cost of parts per maintenance visit R60 R80 R100
Labour cost per maintenance visit

Each customer has a service contract for two machines on average.

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Required:
(a) Calculate the annual profit per machine for each of the three sizes of
machines, using the current basis for charging the costs of support activities
to machines.
(b) Calculate the annual profit per machine for each of the three sizes of
machine using activity-based costing.
(c) Explain the potential benefits to the company of using an activity-based
costing system.
Source: CIMA (adapted)
8.12 Market Ltd manufactures a product and sells it to two different markets:
Newtown and Oldtown. Each market incurs the same type of marketing, storage,
distribution and packaging costs. For many years, the company has been using
full absorption costing and absorbs overheads based on direct labour hours.
Selling prices are then determined using the cost-plus pricing method. This is
common in this industry, with most competitors applying a standard mark-up.
The selling price for the product is R100 and variable cost per unit is R40. The
budgeted sales for each market are provided below.
Newtown – 9 000 units
Oldtown – 6 000 units
The firm has just employed a new accountant who has analysed the cost
activities of the firm and has decided to conduct an analysis to ascertain the
profitability of each market. In the estimation of the accountant, the current
operational condition demands that the firm moves away from the traditional
costing system and adopts an activity-based costing (ABC) system. It is the belief
of the accountant that the application of ABC will provide an accurate cost
data for each market and better profitability analysis. Management, however,
is not convinced ABC is suitable for Market Ltd. They asked the accountant
to furnish them with the required information that will enable them to apply
ABC. The accountant has identified the following activities and their associated
cost drivers.

Activity Cost driver Number of drivers

Newtown Oldtown
Marketing Number of adverts 200 300
Storage Number of packs stored 6 000 4 000
Distribution Number of deliveries 1 400 1 100
Packaging Number of units sold 9 000 6 000

Activity-based costing and management

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292

The overhead costs of the firm are as follows:

Activity Cost
Marketing R200 000
Storage R300 000
Distribution R250 000
Packaging R90 000
Total cost R840 000

Required:
(a) Prepare a statement showing the profitability of each market.
(b) State what conditions must be present to enable Market Ltd to apply an
ABC system.

Reference list
CIMA. 2005. Activity based costing. Topic Gateway Series No. 1. Available: cimaglobal.com.
(Accessed 8 January 2021).
Pityana, N.B. 2005. Address for the Unisa seminar on activity-based costing for organisations
and higher education institutions, 30–31 August 2005.
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9 Cost estimation and
forecasting techniques

Cost estimation

Least squares The effect of learning Uses of learning

Time series
(regression analysis) in organisations curves

Learning curve Pricing

Correlation Trend
formula decisions

Coefficient of Seasonal Graphical Work

determination (r2) fluctuations method scheduling

Cyclical Mathematical Setting standards

variations method and budgets

The experience
curve

Learning objectives
After studying this chapter, you should be able to:
● Formulate regression equations based on results from high-low, least squares and
scatter graph calculations
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● Explain, calculate and interpret the correlation coefficient and coefficient of deter-
mination
● Describe the learning curve effect
● Calculate the effect that a learning curve will have on the cost of production
● Distinguish between the learning model of cumulative average time and the
learning model of incremental unit time
● Explain an experience curve
● Describe different applications for the learning curve effect.

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294

Introduction
Cost estimation and behaviour was covered in Chapter 1. In this chapter we shall be
expanding on the concept of cost estimation. We shall first discuss the least squares
regression method, which fulfils the same role as the high-low method in forecasting, only
more accurately. Second, we shall look at time series analysis and its role in organisational
planning and forecasting. Last, we will discuss time estimation for labour together with the
effect of the learning curve. Accurate forecasting is important for organisations that uses
any form of budgeting. The forecasting equation derived from a forecasting technique such
as the high-low method or least squares regression can be used for any type of cost to give a
fairly accurate indication of expected future costs.
Learning takes place every day and everywhere. It also happens in organisations.
Sometimes the time it takes a person to finish a task reduces as the person performing the
task gets more adept at it. This is called the learning effect. In organisations, the learning
effect can have a big impact on the estimation of costs. Labour costs can be particularly
affected, since wages are directly linked to the time it takes a worker to finish a task. For that
reason, it is necessary to be able to calculate how labour time will be affected if a learning
effect is present. The effect of learning can be calculated with a mathematical equation that
will be discussed in this chapter. Knowledge of learning curves is relevant for management
accountants, because their effects can be pervasive.

Forecasting techniques
In Chapter 1, forecasting techniques from earlier studies were briefly mentioned. In this
chapter, two additional forecasting techniques are discussed, namely the least squares
regression method and learning curves. Both of these techniques can be used by
organisations to forecast what costs companies can expect to incur in future. Least squares
regression uses past information to predict how costs will be affected by different levels of
production or sales in future. Its aim is similar to that of the high-low method, but it is a
more accurate method. Learning curves also use past information, about labour efficiency,
to predict how labour times (and the resulting labour costs) of an organisation will be
affected in future.
The two techniques are discussed in more detail in the sections that follow.

Least squares method (regression analysis)

The aim of least squares regression is similar to that of the high-low method, because it
prepares a forecasting equation in the form:

Y = a + bX

Where:
Y = total cost (also called the dependent variable)
a = fixed cost and intercept on the y-axis
b = variable cost and the slope of the line
X = the activity level (also called the independent variable)

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In terms of the least squares method, the a and b values have to be calculated mathematically
by solving the following two equations:

∑xy = a∑x + b∑x2

∑y = na + b∑x

Where:
y = dependent variable (total cost)
a = fixed cost and the intercept on the y-axis
b = variable cost per unit and the slope of the line
x = independent variable (activity level)
n = number of observations

This approach will result in the most reliable values for a and b being obtained in comparison
to the high-low method and the scatter diagram method. The high-low method will render
accurate results for a and b if all the points lie on the same straight line which occurs when
there is a perfect correlation.

Illustrative example 9.1

Use the information from Cam Ltd, a manufacturing organisation, to determine the
fixed and variable costs.

The calculation of values required for substitution in the equations are given in Table 9.1.

Table 9.1 Total cost of units produced each month

Month Units produced Total cost
(x) (y) xy x2
R R R
January 35 4 375 153 125 1 225
February 45 5 025 226 125 2 025
March 20 3 400 68 000 400
April 25 3 725 93 125 625
May 40 4 700 188 000 1 600
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June 25 3 725 93 125 625

July 50 5 350 267 500 2 500
August 30 4 050 121 500 900
September 15 3 075 46 125 225
October 30 4 050 121 500 900
November 35 4 375 153 125 1 225
December 37 4 505 166 685 1 369
∑x = 387 ∑y = 50 355 ∑xy = 1 697 935 ∑x2 = 13 619

➤➤

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Solution:
Calculation of the a and b values by substituting in the equations:
∑xy = a∑x + b∑x2 Eq (1)
∑y = na + b∑x Eq (2)
1 697 935 = 387a + 13 619b Eq (1)
50 355 = 12a + 387b Eq (2)
Eq(1) × 12: 20 375 220 = 4 644a + 163 428b Eq (3)
Eq(2) × 387: 19 487 385 = 4 644a + 149 769b Eq (4)
Eq(3) − (4): 887 835 = 13 659b
b = 65
Substitute b = 65 in equation (1):
1 697 935 = 387a + 13 619(65)
1 697 935 = 387a + 885 235
a = 2 100

The straight-line equation:

y 5 R2 100 + R65 (x)

Using this equation, the total costs can be determined for any activity level.

Test yourself 9.1

Your friend is of the opinion that there is a direct relationship between the time spent
studying for the Cost and Management Accounting test and the mark you will get. To
see if this is true, you asked a few friends for information about study time and the
marks they got for the test.

Hours spent studying Mark for the test

6 82
1 88
2 56
4 64
6 77
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7 92
0 23
1 41
8 80
5 59
3 47

Required:
Determine the regression function for the data.

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Tests of reliability
Various tests of reliability can be applied to determine how reliable potential cost drivers
(independent variables) are in predicting the dependent variable.

Correlation analysis
When there is a possibility that a relationship exists between two categories of data, then
the degree of correlation, which is the degree by which change in one variable is related to
change in another variable, that is, the variables, are interdependent. Once an acceptable
correlation has been established, regression analysis can be used as a forecasting model.

Types of correlation
y
Perfect correlation is where all the pairs
of values lie on a straight line. When
there is perfect correlation, that is, r = 1,
then regression analysis can be used as a ●
forecasting model and the forecasts can ●
be made with 100% accuracy. A coefficient ●

of correlation of 0.90 or −0.90 (and closer ●

to 1) indicates a very good correlation, x

although not a perfect one. The linear
relationship between the values is exact as Figure 9.1 Perfect correlation of variables
shown in Figure 9.1.
y
Partial correlation is where there is no
exact relationship between the values, but
there is enough of a correlation that a line
can be drawn through the values, although ● ●
there is not an exact fit as shown by ●
●

Figure 9.2. ●
●
It is generally accepted that if the ● ●
coefficient of correlation is below 0.75 or
−0.75, regression analysis will not provide x

reliable results. However, it is up to man-

Figure 9.2 Partial correlation of variables
agement of the organisation to decide what
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the acceptable range is.

No correlation exists where the values of

the two variables are not correlated with ●
●
each other at all as depicted in Figure 9.3. ● ●
A coefficient of correlation of 0 indicates ● ●
no correlation at all. ● ●

Figure 9.3 No correlation of variables

Cost estimation and forecasting techniques

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298

Measures of correlation
The coefficient of correlation (r)
Coefficient of correlation can be used to measure the degree of correlation between two
variables, where r has a value between 21 for perfect negative correlation and 11 for perfect
positive correlation. If r = 0, then variables are uncorrelated.

The formula for calculating the coefficient of correlation is as follows:

____________
n∑xy 2 ∑x∑y√  [n∑x2 2 (∑x)2] 
____________________
r =   
    
____________
√[n∑y
   2
2 (∑y)2] 

Where:
n = number of observations
x = activity level (independent variable)
y = total cost (dependent variable)

Illustrative example 9.2

Using the data from Cam Ltd in the previous illustrative example, we can calculate the
coefficient of correlation (r) as follows:
n∑xy 2 ∑x∑y
r =  _______________________
   
____________ _____________ 
  
[n∑x 2 (∑x) ] √ [n∑y
√    2 2 2
   2 (∑y) ] 
2

(12)(1 697 935) 2 (387)(50 355)

r =  _________________________________________
    
    
____________________ ___________________________ 
√   
[12(13 619) 2 (387) ] √ [12(216
2
    111 275) 2 (50 355) ] 
2

20 375 220 2 19 487 385

___________________________________________
r =     
    
___________________ _____________________________ 
√ (163
   428 2 149 769) √    
(2 593 335 300 2 2 535 626 025) 
887 835
r = ________________
   
  
√
_______ __________ 
√
13 659  57 709 275 
887 835
r = _______
  887 835 
r=1
The coefficient of correlation of 1 indicates there is perfect correlation between the
dependent variable (units) and the independent variable (cost). The coefficient of
correlation can also be calculated by making use of a financial calculator and Excel.
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Coefficient of determination (r2)

The coefficient of determination is calculated by squaring the coefficient of correlation,
that is, r 2. The coefficient of determination indicates the extent to which a change in the
dependent variable can be explained by the independent variable. For example, if the
coefficient of correlation (r) is 0.80, then the coefficient of determination (r 2) is 0.64. This
can be interpreted as 64% of the change in the dependent variable can be explained by the
independent variable, and the other 36% is caused by other factors.

Cost and Management Accounting

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Test yourself 9.2

Using the data from Test yourself 9.1, calculate the coefficient of correlation and
interpret your answer.

Time series analysis

A time series involves looking at figures (monetary or non-monetary) in an organisation
over time, for example output during a year, sales in a month, and so on. Time series has
four components, namely trend, seasonal fluctuations/variations, cyclical variations and
random variations. Time series data can be interpreted by means of a histogram, as shown
in the following example.

Illustrative example 9.3

The following sales figures were recorded over the last six months.
January R2 000 000
February R1 500 000
March R3 500 000
April R3 000 000
May R7 000 000
June R7 500 000

The graph of the data would look as follows:

y
R
8 000 000
●

7 000 000 ●

6 000 000

5 000 000
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4 000 000
●

3 000 000 ●

2 000 000 ●

1 000 000

0 ● x
January February March April May June
Figure 9.4 Graph of monthly sales
➤➤
Cost estimation and forecasting techniques

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In the graph one can see that there were seasonal fluctuations in sales, but a general
upward trend.

Cyclical variations refer to medium-term changes from events that happen in cycles.
Economies usually operate in cycles, with boom and recession periods happening in
succession.

The components of time series can be summarised in an equation (also called the
additive model):
TS = T + SV + C + R
Where:
TS = time series
T = trend
SV = seasonal component
C = cyclical component
R = random component

It is unlikely you will be asked to consider cyclical variations, therefore the additive
model can be reduced to TS = T + SV + R.

Illustrative example 9.4

To find the trend, let’s look at the figures given in Illustrative example 9.3

It seems as if the organisation is growing. But if the business involves selling heaters, one
can expect that sales will perhaps increase in July, but decrease again in August. A heater
manufacturer in South Africa will always do better in the winter months than at other
times of the year. To establish if the organisation is improving its performance, one can
look at the previous year’s figures, but a number of things can happen in a year’s time
that can also affect sales, for example inflation, new products, etc.

One way to distinguish the trend from seasonal changes is moving averages. A moving
average is an average of results over a fixed period.
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Use the information in Illustrative example 9.3 to get the moving average of monthly
sales.

First, calculate the total for January, February and March (R7 000 000). Divide it by
three to get the average (R2 333 333).

Second, calculate the total for February, March and April (R8 000 000). Divide it by
three to get the average (R2 666 667).

Third, calculate the total for March, April and May (R13 500 000). Divide it by three to
get the average (R4 500 000).
➤➤

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Finally, calculate the total for April, May and June (R17 500 000). Divide this by three to
get the average (R5 833 333).
Table 9.2 Moving averages of monthly sales
Month Sales Moving totals Moving averages
January R2 000 000
February R1 500 000 R7 000 000 R2 333 333
March R3 500 000 R8 000 000 R2 666 667
April R3 000 000 R13 500 000 R4 500 000
May R7 000 000 R17 500 000 R5 833 333
June R7 500 000

These moving averages show that there is an upward trend in sales, regardless of the
seasonal trend present.

If a moving average has to be taken over an even number of periods (as will be seen in
the illustrative example that follows), the mid-point would relate to a single period. For
example:

Summer 2 000
Autumn 1 500
Winter 1 000
Spring 1 500
Average: 1 500

Time series analysis can also be used to forecast future figures. This is also known as
extrapolation. The three steps to do extrapolation are as follows:
1. Find a trend line, using moving averages or linear regression.
2. Use the trend line to forecast future trend line values.
3. Adjust these values for seasonal variations, using the additive model.
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Illustrative example 9.5

The sales of a winter jacket manufacturer over the four quarters of the past four years
are as follows. The moving averages are also provided.
Table 9.3 Quarterly sales data
Year Quarter Actual (R) Trend (R)
Year 1 1
2
3
4 48 000
Year 2 1 16 000
2 60 000 61 000
3 120 000 59 000
4 40 000 65 000
Year 3 1 40 000 75 000
2 100 000 85 000
3 160 000 95 000
4 80 000 105 000
Year 4 1 80 000 110 000
2 120 000
3 180 000
4

Seasonal variations according to the additive model are as follows:

Quarter 1 −R9 250
Quarter 2 +R1 400
Quarter 3 +R14 500
Quarter 4 −R7 200

Predict the sales for the last quarter of Year 4 and the first quarter of Year 5.
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The rise in trend between the first quarter of Year 3 and the first quarter of Year 2 is:
(R110 000 − R75 000) ÷ 4 = R8 750. Since the trend may level out to some extent, let us
assume an increase of R8 000 in future. The forecast for the last quarter of Year 4 and
the first quarter of Year 5 can be established as follows:
Table 9.4 Sales forecast
Year Quarter Trend Seasonal Forecast
variation
Year 4 1 R110 000
Year 4 4 [+ (3 × R8 000)] R134 000 −R7 200 R126 800
Year 5 1 [+ (4 × R8 000)] R166 000 −R9 250 R156 750

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Assumptions of time series analysis

● It is based on past data, assuming what happened in the past will continue into the
future.
● It assumes a linear relationship.
● Seasonal variations are assumed to be constant or proportional to the trend line.

Advantages of time series analysis

● It can be used to predict or forecast the future.
● A review of trend lines can be used to assess the accuracy of forecasts.

Disadvantages of time series analysis and forecasting

● The further one goes into the future, the less reliable forecasts become.
● The less data that is available, the less reliable the forecast.
● The patterns of trends, seasonal and cyclical variations may change over time.
● Random variations can render a forecast worthless.

The effect of learning in organisations

Experience in a manufacturing environment has shown that the more times a task is
performed, the less time is required on each subsequent iteration. The first time a worker
makes a product, it takes them a certain amount of time. However, as they become more
practised in the procedure of manufacturing the product, they will make it faster and
faster as time passes. This is known as the learning curve effect. The learning effect has
the result of fewer labour hours being required to manufacture a product as time passes,
and therefore has an effect on the cost of manufacturing the product. As the operation is
repeated, the worker becomes more familiar with the task, labour efficiency increases and
the labour cost per unit declines. A learning curve effect is expressed as a percentage, and
it is developed over time after observing labourers at work. The learning process begins
from the point when the very first unit comes off the production line. From then on, each
cumulative output is doubled (1 is doubled to 2, 2 is doubled to 4, 4 is doubled to 8, etc),
and the cumulative average time per unit falls to a fixed percentage of its previous level.
For example, let us say that an 80% learning curve applies in the manufacturing process
of a product, and the first product took 500 hours to be manufactured. The cumulative
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labour hours per unit that are required for manufacturing the product will decrease as
follows over time:
Table 9.5 Cumulative labour hours per unit
Product number Cumulative production Cumulative average time per unit
1 1 500 hours (given)
2 2 400 hours (500 hours × 80%)
3 4 320 hours (400 hours × 80%)
4 8 256 hours (320 hours × 80%), etc.

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The 80% learning curve implies that each time cumulative output is doubled, the cumulative
average time per unit falls to 80% of its previous level.
This effect can be plotted on a graph, and is called a learning curve. When this
phenomenon was first researched, it was found that the learning effect takes place according
to a set formula, and that the hours required to manufacture a product or to deliver a
service can be predicted with remarkable accuracy. Calculating the amount of labour hours
that are required for a given level of production is especially useful for predicting future
labour costs and is therefore an important consideration in decision-making processes.
When making use of the learning curve theory, one should take cognisance of the fact that
no learning curve can last forever, which would imply that a task can be completed in zero
time, which is impossible. One needs to consider how long the learning curve is expected to
last. This can be done by determining the absolute minimum time within which a task can
be completed. When no more learning can take place, the cumulative average time per unit
remains constant. The limits of the learning curve can vary between 50%, which implies the
maximum learning effect, and 100%, which implies that there is no learning effect.

The learning curve formulae

As previously explained, the learning curve expresses the cumulative average time per unit
as a percentage of the previous cumulative average time per unit. The following formula can
be used to calculate the learning curve:
Cumulative average time per unit ___
Learning curve = _______________________
  Previous
      
100
cumulative average time per unit × 1

Illustrative example 9.6

You are provided with the following information regarding the manufacturing of a new
type of speedboat:
● Time taken to manufacture the first speedboat: 700 hours
● Time taken to manufacture the second speedboat: 560 hours
● Total time taken to manufacture the first four speedboats: 2 268 hours.

The effect of the learning curve is expected to last for the manufacturing of the first eight
speedboats.
The labour cost amounts to R55 per hour.
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Required:
(a) Calculate the learning curve.
(b) How long will it take to manufacture the first eight speedboats?
(c) How long will it take to manufacture speedboats 9 to 16?
(d) Calculate the labour cost of speedboat 1 and the labour cost of speedboat 8.

➤➤

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305

Solution:
Cumulative average time per unit
(a) Learning curve 5  ______________________________
   
   
Previous cumulative average time per unit
(700 1 560) 4 2
_____________
5    
700

630
5  ___
700
5 0.90

5 90%
(b) Time taken to manufacture speedboats:

Table 9.6 Cumulative labour hours per unit

Cumulative production Cumulative average time Total cumulative hours
per unit
1 700 700
2 (1 260 ÷ 2) 630 (700 + 560) 1 260
4 (90%) 567 (567 × 4) 2 268
8 (90%) 510.3 (510.3 × 8) 4 082.4
16 510.3 (510.3 × 16) 8 164.8

The first eight speedboats will take 4 082.4 hours to manufacture.

(c) Total time required for the manufacturing of speedboats 9 to 16 will be [(16 − 8)
× 510.3], that is, 4 082.4 hours. The average time required per speedboat will also
be 510.3 hours, as the effect of the learning curve is expected to last only for the
manufacturing of the first 8 speedboats. Alternatively, the total time for 16 less the
total time for 8 will be 4 082.4 hours.
(d) The labour cost for the first speedboat would be 700 × R55 = R38 500.

The labour cost for the eighth speedboat would be 510.3 × R55 = R28 067.
This illustrates how the price of the speedboats would decrease over time as fewer
labour hours are required to manufacture a unit. This makes the learning curve an
important tool to use when making decisions about capacity and also for budgeting.
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The graphical method

Table 9.7 shows in a table what an 80% learning curve effect looks like where the first unit
took a total of 500 hours to be manufactured. An 80% learning curve indicates that when
output is doubled, the cumulative average time per unit for the doubled output is 80% of
the cumulative average time per unit for the original unit. Therefore we can see in the table
that when the output is doubled from 5 units to 10 units, the cumulative average labour
hours per unit for the 10 units is 80% of the cumulative average labour hours per unit for
5 units. To determine the total labour hours spent to manufacture all the products, you
multiply the number of units by the cumulative average labour hours per unit.

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Table 9.7 The learning curve effect in table format

Cumulative output in units Average labour time per unit Total labour time in hours
in hours

5 500.0 2 500
10 400.0 4 000
20 320.0 6 400
40 256.0 10 240
80 204.8 16 384

The information in the table can also be displayed on a graph as can be seen in Figure 9.5.
The graph shows that the cumulative average time per unit decreases rapidly at first,
and then slows down until a plateau is reached. This plateau is called the steady-state
production level.
y

500

400
Time (hours)

300

200

100

0 x
10 20 30 40 50 60 70 80

Cumulative quantity (units)

Figure 9.5 An 80% learning curve effect in graphical format

The mathematical method

Research has shown that the learning curve effect can be fairly accurately calculated by
means of a formula.
Yx = tx l
Where:
t is the time it took to manufacture the first unit
x is the number of units of output being considered log%
l is the ratio of the logarithm of the learning curve rate, and is calculated as l 5 ____
  log2 .

This is also known as the ‘learning index’.

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It is important to note that the formula calculates the cumulative average time per unit for the
total number of units being considered in the calculation. Illustrative example 9.7 explains
the concept.

Illustrative example 9.7

Jane owns a restaurant and introduced a new meal to the menu. The recipe is quite
complicated and takes a long time to prepare. It took her head chef six hours to prepare
the dish the first time. She has observed that a 95% learning curve generally applies in
her restaurant. In order to prepare realistic work schedules for the next week, she needs
to know how long it is going to take the head chef to make the dish by the fifth time he
makes it.

Solution:
In order to calculate the time it will take to make the dish the fifth time, the learning
curve formula can be applied.

Calculate l first.
log 0.95
l =  ______
log2 = −0.074
Sometimes, a question will not ask you to calculate the learning index, but it will be
given in the question text.

Now l can be applied to the learning curve formula. In order to determine the time it will
take the chef to make the dish the fifth time, the cumulative average time per unit for the
fifth and the sixth time he makes the dish needs to be calculated.
Y5 = 6 hours × (5)−0.074 = 5.326 hours.
Y6 = 6 hours × (6)−0.074 = 5.255 hours.

To determine the total hours it would take to make the dish either five or six times, the
cumulative average time per unit must be multiplied with the number of units.
Total time to make the dish five times = 5.326 hours × 5 = 26.63 hours.
Total time to make the dish six times = 5.255 hours × 6 = 31.53 hours.

The difference between the two totals gives the time it will take the chef to make the dish
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the fifth time. It is therefore 31.53 − 26.63 = 4.9 hours.

Table 9.8 Alternative solution
Product number Cumulative Cumulative average Total labour
production time per unit (95%) time (hours)
1 1 6 6
2 2 5.7 11.4
3 4 5.415 21.66
4 8 5.14425 41.154
5 16 4.8870375 78.1926

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Test yourself 9.3

Mrs Mdluli decided to knit scarves for the children at the local children’s home. Residents
of an old-age home saw the scarves and asked Mrs Mdluli if she could also knit scarves
for the residents at the home. She realised that the second scarf was quicker to knit than
the first one, which took her 5 hours. Suppose that an 80% learning curve applies.

Required:
Calculate the time it would take Mrs Mdluli to knit the 10th scarf.

The experience curve

The learning curve shows us that a linear relationship between production and labour
costs is unlikely. As the number of units increases, the number of labour hours used in
production will decrease per unit. An extension on the learning curve is what is known as
the experience curve. The experience curve is essentially the learning curve applied to the
whole organisation, rather than being applied to just one task. The experience curve shows
how product costs, including the costs incurred throughout the whole value chain, decrease
as the number of units increases. It is important to realise the relationship between cost
behaviour and learning or experience.

Case study: The learning curve effect

The effect of learning curves has been observed for many years. Hermann Ebbinghaus
first described the learning curve in 1885 in psychology. Theodore Wright also reported
the effect of learning in the aircraft industry in 1936. Hundreds of years later, it is still
used in optimising and forecasting resource use.
We see evidence of a learning curves all around us. Not only do we see it in more traditional
technology such as the development of new motor car models, but also in more modern
technologies such as the ‘internet of things’ as enhancements in electronic equipment. As
soon as we get a new mobile phone or smart TV, a newer model is already being developed.
The learning curve does not only cause products to be designed and manufactured
more quickly, it also results in reductions in total cost. Because this cost reduction effect
can be measured, it is a useful tool for forecasting, planning, production and marketing.
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Learning curve effects can be seen everywhere. If we look at history, the price of memory
cores for computers decreased significantly from 5 cents per unit in 1965 to less than
half a cent in 1973, reducing the costs of computers remarkably. This cost reduction
effect in computer electronics is even more remarkable today. To this day, learning curve
effects are used in many fields, such as construction, engineering and manufacturing,
to determine the optimal use of time and money spent to make a business successful.

Sources: Abdelkhalek et al (2020); Damnianovic & Reinschmidt (2020); Ebbinghaus (1913);

Wright (1936).

Discussion question:
In a group, think of products and/or services in your lifetime that have been manufactured
and/or delivered faster.

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Different uses for the learning curve

Pricing decisions
The application of the learning curve effect in cost calculations makes for more accurate
cost predictions and therefore helps to price products and services better. It is also a more
accurate and fair way to calculate expected labour cost when quotations need to be prepared
for customers.

Work scheduling
Since the learning curve makes it possible to predict the labour hours that are to be expended
for production in the future it can greatly assist in scheduling work plans for staff. This in
turn will lead to better customer service and more satisfied staff.

Setting standards or budgets

If the learning curve is taken into account when setting standards or budgets, a number of
unnecessary variances can be avoided. Also, using the learning curve effect can show staff
how they are improving and therefore motivate them to improve efficiency even more. It can
also be used to set incentives for learning and improving efficiency.

Summary
Forecasting is an essential tool for planning. In this chapter, additional forecasting
techniques, namely least squares regression, time series analysis and learning curves are
discussed. Least squares regression forecasts more accurately than the high-low method
what expected future costs will be. Time series analysis also forecasts what future sales and
expenses will look like based on known trends in seasons and economic cycles. In most
organisations where products are manufactured by means of manual labour, some learning
effect can be observed, which means that the labourers can make a product faster and faster
until a plateau is reached. Research has shown that such a learning effect can be measured
and then the expected time that is likely to be spent on the manufacture of a product or the
delivery of a service calculated. This is useful for setting standards, creating budgets, setting
up work schedules, and pricing products or services accurately.
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Key concepts
Cyclical variations refer to medium-term changes from events that happen in cycles.
Experience curve is similar in concept to a learning curve, but looks at the overall
picture by observing how costs throughout the value chain are affected by experience
and learning.
Extrapolation is an estimation for a value, based on extending a known sequence of
values beyond the area that is known.
Learning curve is the effect that learning has on the amount of labour time used in
manufacturing, as plotted on a graph.
➤➤

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Learning curve effect means the ability of a manual labourer to manufacture a product
or deliver a service faster as they become more familiar with the process and therefore
require fewer labour hours to complete a task as time progresses.
Least squares regression is a statistical technique for estimating changes in a
dependent variable (such as expenditure) which is in linear relationship with one or
more independent variables (such as activity level).
Moving averages are a succession of averages derived from successive segments of a
series of values.
Seasonal fluctuations/variations are short-term variations in data.
Time series is a series of values at successive times, often with equal intervals between
them.
Time series analysis are all the methods that are used to analyse time series data in
order to extract meaningful information from the data.
Trend is the general direction in which values are changing.

Test-yourself solutions
Test yourself 9.1
(Hours
Hours Hours (Hours spent −
spent − Mark −
spent Mark for spent – Average hours
x2 Average Average
studying the test (y) Average spent) * (Mark
hours mark
(x) hours spent − Average mark)
spent)2
6 82 36 1.27 1.62 17.55 22.33
10 88 100 5.27 27.80 23.55 124.15
2 56 4 –2.73 7.44 –8.45 23.06
4 64 16 –0.73 0.53 –0.45 0.33
6 77 36 1.27 1.62 12.55 15.97
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7 92 49 2.27 5.17 27.55 62.60

0 23 0 –4.73 22.35 –41.45 195.97
1 41 1 –3.73 13.89 –23.45 87.42
8 80 64 3.27 10.71 15.55 50.88
5 59 25 0.27 0.07 –5.45 –1.49
3 47 9 –1.73 2.98 –17.45 30.15
52 709 340 94.18 611.36

*Average for hours spent studying: 4.73

Average for test marks: 64.45

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̅ ∑ (x −  x  ) × (y −  y  )

̅
b =   ____________
    
∑ (x −  x  )  2
  611.36
=_ 94.18 = 6.49
̅
∑ xy = a∑ x + b∑ x  2

611.36 = a(52) + 6.49(340)

a = 30.18

Y = 30.18 + 6.49X

Test yourself 9.2

(Hours
spent −
Hours (Hours
Hours Average
Mark for spent − spent − Mark -
spent hours
the test xy x2 y2 Average Average Average
studying spent) *
(y) hours hours mark
(x) (Mark −
spent spent)2
Average
No mark)
1 6 82 492 36 6 724 1.27 1.62 17.55 22.33
2 10 88 880 100 7 744 5.27 27.80 23.55 124.15
3 2 56 112 4 3 136 −2.73 7.44 −8.45 23.06
4 4 64 256 16 4 096 −0.73 0.53 −0.45 0.33
5 6 77 462 36 5 929 1.27 1.62 12.55 15.97
6 7 92 644 49 8 464 2.27 5.17 27.55 62.6
7 0 23 0 0 529 −4.73 22.35 −41.45 195.97
8 1 41 41 1 1 681 −3.73 13.89 −23.45 87.42
9 8 80 640 64 6 400 3.27 10.71 15.55 50.88
10 5 59 295 25 3 481 0.27 0.07 −5.45 −1.49
11 3 47 141 9 2 209 −1.73 2.98 −17.45 30.15
52 709 3 963 340 50 393 94.18 611.36
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n∑xy = 43 593
∑x∑y = 36 868
n∑x2 = 3 740
∑(x)2 = 2 704
n∑y 2
= 554 323
∑(y)2 = 502 681

n∑ xy − ∑ x∑ y
_______________________ 43593 − 36868
r =      ____________ ____________   =   ___________________________
     
   
____________ ________________  = 0.91
√ [n∑
   x  2  − (∑ x)  2 ]  √   
[n∑ x  2  − (∑ x)  2 ]  3740 − 2704]   + √ [  
√ [   554323 − 502681] 

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This indicates there is an almost perfect correlation between the dependent variable, y (test
marks), and the independent variable, x (hours spent studying).
Therefore, regression analysis can be used as a forecasting model to forecast the mark a
student will get based on the hours spent studying.

Test yourself 9.3

To calculate the time it will take Mrs Mdluli to make the 10th scarf, you can apply the
learning curve formula.

Let us calculate l first:

log 0.8
l 5 _____
 
log 2
5 −0.322

Now we can continue with the learning curve formula. We need to calculate the cumulative
average time per unit for the 20th and 21st scarf.
Y11 = 5 hours × (11)−0.322 = 2.310 hours.
Y10 = 5 hours × (10)−0.322 = 2.382 hours.
To determine the total hours it would take to make a 10th or 11th scarf, we need to take the
cumulative average time per unit and multiply it with the number of units.
Total time to make 11 scarves = 2.310 hours × 11 = 25.41 hours.
Total time to make 10 scarves = 2.382 hours × 10 = 23.82 hours.
The 10th scarf will therefore take 1.59 hours to knit.

Review questions
9.1 How does least squares regression differ from the high-low method of cost
estimation?
9.2 What does the different symbols stand for in the equation: Y = a + bX?
9.3 Why is forecasting important for an organisation?
9.4 What are the components of a time series?
9.5 What are the assumptions on which time series analysis is based?
9.6 Explain what is meant by a learning curve effect.
9.7 What is the difference between the learning model of cumulative average time
and the learning model of incremental unit time?
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9.8 What is an experience curve?

9.9 Name the different applications for which the learning curve effect can be used.
9.10 What are the disadvantages of forecasting?

Exercises
9.1 Beatrix Potter manufactures hand-painted teapots. Sibusiso, one of the
craftsmen, recently made a teapot for the celebration of Freedom Day. To date,
eight of these pots have been made and displayed at an international arts and
crafts market. It took Sibusiso 10 hours to make the first teapot and 9.2 hours
for the second teapot. It was found that labour hours reduced as cumulative
output increased. It is expected that this trend will continue until 32 teapots
have been manufactured.

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The following information is available regarding the manufacturing of the first

eight pots:
Direct material R7 200
Direct labour (70.8 hours) R3 800
Variable manufacturing overhead R2 300
The first eight teapots were so popular that Sibusiso has received orders for
eight more teapots. He is unable to quote a price off-hand as he is aware of the
fact that subsequent to the manufacturing of the first eight teapots, the costs of
direct material and labour have increased by 18% and 15% respectively.
Forty per cent (40%) of variable manufacturing overheads is variable to material
cost, and 60% is variable to direct labour cost.
Fixed manufacturing overheads incurred for the manufacturing of the Freedom
Day teapots amount to R5 100. This cost must be allocated to the first 32 teapots.

Required:
Determine the price that should be quoted per teapot if Sibusiso wants to earn
a profit of 40% on quotation price.
Logarithms may not be used. Round all hours to two decimals and all rands to
the nearest rand.
9.2 You are provided with the following information regarding the manufacturing of
a new type of yacht:
Time taken to manufacture the first yacht 70 000 hours
Time taken to manufacture the second yacht 56 000 hours
Total time taken to manufacture the first four yachts 226 800 hours
The effect of the learning curve is expected to last for the manufacturing of the
first eight yachts.
Consider the following statements:
● The learning rate is 0.80.
● The learning curve is 80%.
● According to estimate, the average time per unit required for the manu-
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facturing of the first eight yachts will be 35 840 hours.

● The total expected time required for the manufacturing of the eight yachts
is 286 720 hours.

Required:
(a) Indicate which of the above four statements are true.
(b) Calculate the total estimated time required for the manufacturing of yachts
9 to 16.
9.3 Listen (Pty) Ltd manufactures and sells hearing aids. The technical team
has developed a new model called the ElectroEar. To date, two units of the
ElectroEar have been produced and sold. The company received an order for 14
ElectroEars.

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The direct labour hours taken to manufacture the first two units were:
First unit 25 hours
Second unit 21 hours
The following variable costs relate to the manufacturing of the first two units of
ElectroEar:
R
Direct material 3 180
Direct labour 2 760
Variable overheads 322
6 262

Additional information:
1. Direct material costs have increased by 10% since the first two units were
produced.
2. Variable overheads amount to R7 per direct labour hour.
3. Fixed overheads of R34 000 are incurred exclusively for the manufacturing
of ElectroEar.
4. It is expected that the learning curve will be maintained for the manufacturing
of the first 16 units.

Required:
(a) Calculate the learning rate.
(b) Calculate the minimum selling price per unit that the enterprise can quote
for the government contract, in order to recover the relevant costs and earn
a profit of 25% based on the selling price.
(c) Calculate the expected net profit arising from the new model after all costs
have been accounted for. Assume that all ElectroEar units produced have
been sold at R8 500 per unit.
(d) State the limits between which a learning curve may vary, and briefly explain
the significance of each limit.
Note: You may not use logarithms. Round off all calculations to two decimal
places and all rand values to the nearest rand.
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9.4 Pretty (Pty) Ltd manufactures glass ornaments and housewares. The business
makes use of unskilled labour and provides training to do handcrafting of the
goods. In January they decided to add a fruit bowl to the range. It took 45.60
hours to complete the first two fruit bowls. It was found that labour hours
reduced as cumulative output increased, and it is expected that this trend will
continue until 64 fruit bowls have been manufactured. The total number of
hours to complete the next two fruit bowls was 41.04 hours. The labour and
material costs to manufacture the first four fruit bowls, which have already been
sold, were as follows:
Direct materials R1 360
Direct labour R1 420

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Additional information:
1. A gift shop owner saw these fruit bowls and has asked for a quotation for
12 to add to its range of products.
2. Since the first four fruit bowls were manufactured, the price of material
increased by 8%, and the cost of labour by 15%.
3. Pretty (Pty) Ltd paid the designer of the fruit bowl R1 600. They have
committed to producing and selling only 64 of these fruit bowls, which will
be completed within the next few months.
4. Sundry materials amount to R1.50 per fruit bowl.
5. Other variable manufacturing overheads are allocated at R1.00 per direct
labour hour.
6. Monthly fixed costs of the business amount to R15 200, of which 10%
applies to the above order.

Required:
(a) Calculate the learning curve.
(b) Calculate the quotation price for the 12 fruit bowls if the business requires
a profit margin of 25% on quotation price.
(c) Calculate the total time to manufacture units 17 to 32.

Note: Round off all calculations to two decimal places.

9.5 Due to the COVID-19 pandemic, people tend to opt for comfort whilst confined
to their homes. Zara-Phi is a well-known designer of loungewear in the greater
Durban area. The factory is located in an area where all raw materials can be
purchased from a 100-metre radius.
Zara-Phi has recently taken on two new employees, a qualified tailor, Ms Minnie,
and a general assistant to Ms Minnie, Ms Maxi. Being a second-year fashion
design student, Ms Maxi does not have the qualification or the experience that
Ms Minnie has. Therefore, Ms Maxi takes 10% longer than Ms Minnie to learn
the job.
Ms Minnie has completed her training on company procedures and production;
she has begun working on the production of men’s loungewear. The company
has a large order, from ELS Fusion Wear, which will be produced and procured
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in batches. It took Ms Minnie 200 hours to produce the first batch of men’s
loungewear, and just 120 hours for the second batch.
Ms Maxi was assigned to take on the production of young adults’ loungewear.
An order of the same magnitude and specifications was placed by ELS Fusion
Wear. Ms Minnie supervises Ms Maxi while she works independently. Ms Maxi
takes 160 hours to complete the first batch.
Cumulative production doubles for each subsequent order. In total, 64 batches
were produced. Learning will stop at the first 32 batches.
Ms Minnie is remunerated at R95 per hour and Ms Maxi at R65 per hour. Due
to the recent increase in transport cost, Zara-Phi has also introduced a travel
allowance for all employees of R50 per week. A workweek consists of five days,
based on the assumption of eight hours per workday.

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Once the order for ELS Fusion Wear is complete, Ms Minnie will receive a 2%
production bonus (on total production), which will be based on Zara-Phi’s
total labour cost to produce six batches of men’s or young adults’ loungewear.
Ms Maxi will receive a 0.75% bonus based on the labour costs associated with
the production of her six batches of young adults’ loungewear.
Required:
(a) Based on the information provided above, calculate the following:
(i) The learning curve for both employees
(ii) Total time taken by Ms Minnie to finish all 32 batches
(iii) Total time taken by Ms Maxi to finish all 64 batches
(iv) Number of weeks to complete both orders for ELS Fusion Wear
(v) Amount of travel allowance spent by Zara-Phi on both employees
(vi) The total labour cost for Ms Minnie and Ms Maxi (including the
bonus).
(b) Zara-Phi predicted that the learning rate for production of a new product
would be 80%, however the actual learning rate was 75%. The following
possible reasons were stated for this:
(i) The number of new employees recruited was lower than expected.
(ii) Unexpected problems were encountered with production.
(iii) Unexpected changes to health and safety laws meant that the company
had to increase the number of breaks for employees during production.
Which of the above reasons could have caused the difference between the
expected rate of learning and the actual rate of learning?
A. All of the above
B. (ii) and (iii) only
C. (i) only
D. None of the above
Source: ACCA F5 (June 2015)
9.6 Chair Co has developed a new type of luxury car seat. The estimated labour time
for the first unit is 12 hours but a learning curve of 75% is expected to apply for
the first eight units produced. The cost of labour is $15 per hour. The cost of
materials and other variable overheads is expected to total $230 per unit.
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Chair Co plans on pricing the seat by adding a 50% mark-up to the total variable
cost per seat, with the labour cost being based on the incremental time taken to
produce the eighth unit.
Required:
(a) Calculate the price that Chair Co expects to charge for the new seat. Note:
The learning index for a 75% learning curve is –0·415.
(b) The first phase of production has now been completed for the new car seat.
The first unit actually took 12·5 hours to make and the total time for the
first eight units was 34·3 hours, at which point the learning effect came to
an end. Chair Co is planning on adjusting the price to reflect the actual time
it took to complete the eighth unit.

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(i) Calculate the actual rate of learning and state whether this means that the
labour force actually learnt more quickly or less quickly than expected.
(ii) Briefly explain whether the adjusted price charged by Chair Co will be
higher or lower than the price you calculated in part (a) above. You are
not required to calculate the adjusted price.
Source: ACCA F5 (December 2014)
9.7 A company is preparing its annual budget and is estimating the number of units
of Product W that it will sell in each quarter of year 2. Past experience has shown
that the trend for sales of the product is represented by the following relationship:
y = a + bx
Where:
y = number of sales units in the quarter
a = 15 000
b = 3 000
x = the quarter number where 1 = quarter 1 of year 1
Trend sales for Product W were as follows:
Quarter 1: 18 000 units
Quarter 2: 21 000 units
Quarter 3: 24 000 units
Quarter 4: 27 000 units
Actual sales of Product W in year 1 were affected by seasonal variations and
were as follows:
Quarter 1: 20 250 units
Quarter 2: 19 425 units
Quarter 3: 25 200 units
Quarter 4: 24 300 units
Required:
Calculate the expected unit sales of Product W for each quarter of year 2, after
adjusting for seasonal variations using the multiplicative model.
Source: CIMA P1 (November 2014)
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9.8 A company is developing a new product. During its life it is expected that 8 000
units of the product will be sold for $90 per unit. The direct material and other
non-labour related costs will be $45 per unit throughout the life of the product.
Production will be in batches of 1 000 units throughout the life of the product.
The direct labour cost is expected to reduce due to the effects of learning for
the first four batches produced. Thereafter the labour cost will remain at the
same cost per batch as the fourth batch. The direct labour cost of the first batch
of 1 000 units is expected to be $40 000 and a 90% learning effect is expected
to occur.
There are no fixed costs that are specific to the product.

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318

Required:
(a) (i) Calculate the average direct labour cost per batch of the first four batches.
(ii) Calculate the direct labour cost of the fourth batch.
(iii) Calculate the contribution earned from the product over its lifetime.

Note: The learning index for a 90% learning curve is −0.152.

(b) Due to the low lifetime product volume of 8 000 units, the company now
believes that learning may continue throughout its entire product life.
Calculate the rate of learning required (to the nearest whole percentage)
to achieve a lifetime product contribution target of $150 000, assuming
that a constant rate of learning applies throughout the product’s life.
Source: CIMA P2 (May 2012)
9.9 A company is developing a new product. During its expected life, 2 000 000
units of the product will be sold for R2.50 per unit.
Production will be in batches of 100 000 units throughout the life of the product.
The direct labour cost is expected to reduce due to the effects of learning for
the first 10 batches produced. Thereafter, the direct labour cost will remain
constant at the same cost per batch as the tenth batch.
The direct labour cost of the first batch of 100 000 units is expected to be
R135 000 and a 90% learning effect is expected to occur.
The direct material and other non-labour related variable costs will be R1 per
unit throughout the life of the product.
Required:
(a) Calculate the expected direct labour cost of the tenth batch.
(b) Calculate the expected contribution to be earned from the product over its
lifetime.
9.10 A company has recently launched a new product. The following information is
available for the first month of production:
Budget Actual Variance
Production volume (units) 300 256 44 A
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Direct material cost ($) 11 400 10 500 900 F

Direct labour cost ($) 15 000 4 000 11 000 F
Variable overhead cost ($) 6 000 1 750 4 250 F
Fixed costs ($) 125 000 115 000 10 000 F

The standard labour cost per unit of $50 that was used to calculate the budgeted
labour cost was made up of 2 hours at $25 per hour. However, this ignored the
impact of a learning curve which was expected to apply for the first 300 units
produced. The learning rate was expected to be 90%.
The variable overhead absorption rate is based on direct labour hours.
The actual rate of pay during the month was $25 per labour hour.
Note: The learning index for a 90% learning curve is −0.152.

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319

Required:
(a) (i) Prepare a performance report for the first month of production
taking into account the learning effect.
(ii) Calculate the labour efficiency planning variance for the first month of
production.
(b) Calculate the actual rate of learning that occurred during the first month of
production, assuming that the actual time taken to produce the first unit
was 2 hours.
Source: CIMA P2 (September 2014)
9.11 Retail World (RW) is a major international retail chain, selling groceries,
clothing, electronic items, toiletries and homeware items. It has grown rapidly
across a number of different countries, offering a broad product range to suit
a wide range of customer segments. Growth has been through the expansion of
existing stores, in addition to the opening of new stores.
The new finance director, whose background is in a non-retail environment, is
keen to understand the sales trends of the organisation, as well as the industry,
in order to help develop a strategy that can take advantage of these trends in the
future. A business analyst has provided summarised internal sales data for this
purpose. The company’s IT systems are fully integrated and associated controls
are rigorous, allowing the data to be manipulated in many ways.
The analyst has provided time series analysis (Table 1) and regression analysis
(Tables 2 and 3). He wanted to explore the possibility of identifying different
causal relationships, carrying out least squares regression analysis linking sales
to both time (Table 2) and number of stores in operation (Table 3).
The number of stores has grown annually, and the analyst believes that this is a
better indicator of the expected future revenue than simply the passage of time.
The average number of stores expected to be in operation in 2017 is 3 700,
rising to 4 000 in 2018.
Table 1 – Time series analysis
Year Quarter Sales ($m) Trend (T) Deviation Svar(1) Res Sadj(2)
2013 2 88 116.25
2013 3 110 121.38
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2013 4 134 121.38 12.62 14.6 −1.98 119.4

2014 1 150 122.5 27.50 25.02 2.48 124.98
2014 2 95 123.25 −28.25 −28.25 0.00 123.25
2014 3 112 123.75 −11.75 −11.38 −0.37 123.38
2014 4 138 124.38 13.62 14.6 −0.98 123.4
2015 1 150 126 24.00 25.02 −1.02 124.98
2015 2 100 128.63 −28.63 −28.25 −0.38 128.25
2015 3 120 131.38 −11.38 −11.38 0.00 131.38
2015 4 151 134 17.00 14.6 2.40 136.4
2016 1 159 136 23.00 25.02 −2.02 133.98
2016 2 112 140.25
2016 3 124 135.38

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320

Notes:
1. Svar is the expected seasonal variation, calculated by averaging the varia-
tions of each quarter.
2. Sadj is the sales total, adjusted for average seasonal variation.

Table 2 – Least squares regression analysis (time)

An extract of the values used in the calculation of this is shown below. This
illustrates the basis of the regression analysis. All values were used in the
calculation of the least squares regression formula.

Year Quarter Quarter (x) Revenue (Y)

2016 1 12 159
2016 2 13 112
2016 3 14 124

The least squares regression formula derived from all data was found to be:
Y = 110.93 + 1.81x r = 0.33

Table 3 – Least squares regression analysis (number of stores)

The values used in the calculation of this are shown below:
Year Stores (x) Average quarterly sales (Y)
2013 2 400 111
2014 2 750 124
2015 3 200 130
2016 3 512 132

The least squares regression formula derived from this data was found to be:
Y = 69.50 + 0.02x r = 0.94
The finance director was interested to receive the analysis, saying, ‘We can
use this to estimate what our revenues might be in the future, both quarterly
and annually.’ However, he also stated that it was not quite as useful as he
would have hoped for, commenting, ‘I have been hearing a lot about big data
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at industry meetings I have attended. I think we should investigate the ways in

which we could use this, and the benefits we might hope to obtain from it.’

Required:
Analyse the data given in the time series analysis and least squares regression
analysis (Tables 1, 2 and 3) and evaluate the appropriateness of each technique
in forecasting future sales and developing strategic plans.
Source: ACCA P3 (September/December 2016)

Cost and Management Accounting

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9.12 A company is seeking to establish whether there is a linear relationship between

the level of advertising expenditure and the subsequent sales revenue generated.
Figures for the last eight months are as follows:
Advertising Sales
Month expenditure revenue
£’000 £’000
1 2.65 30.00
2 4.25 45.00
3 1.00 17.50
4 5.25 46.00
5 4.75 44.50
6 1.95 25.00
7 3.50 43.00
8 3.00 38.50
26.35 289.50

Further information is available as follows:

∑(Advertising expenditure × Sales revenue) = £1 055.875
∑(Advertising expenditure)2 = £101.2625
∑(Sales revenue)2 = £11 283.75
All of the above are given in £ million.

Required:
Using the regression formula, calculate the line of best fit.
Source: ACCA Paper 1.2 (December 2002) (adapted)

Reference list
Abdelkhalek, H.A., Refaie, H.S. & Aziz, R.F. 2020. Optimization of time and cost through
Copyright © 2021. Juta & Company, Limited. All rights reserved.

learning curve analysis. Ain Shams Engineering Journal. Dec 2020; 11(4): 1069–1082.
Damnjanovic, I. & Reinschmidt, K. 2020. Forecasting with learning curve models. In Data
Analytics for Engineering and Construction Project Risk Management (pp. 357–371). Cham.,
Switzerland: Springer.
Ebbinghaus, H. 1913. Memory: A contribution to experimental psychology (HA Ruger & CE
Bussenius, Trans.). Annals of Neurosciences, Oct 2013; 20(4): 155–156.
Wright, T.P. 1936. Factors affecting the cost of airplanes, Journal of Aeronautical Sciences, 3(4)
(1936): 122–128.

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10 Budgets

Budgets

Functional budgets and Alternative approaches to

Purpose of budgeting Budgetary control
the master budget budgeting

Rolling budgets
Zero-based budgeting
Flexible budgets
Activity-based budgeting
Incremental budgeting

Learning objectives
After studying this chapter, you should be able to:
● Understand the basic principles of budgetary control
● Identify the various stages in the budget process
● Identify the different purpose of budgeting
● Explain the role of the budget committee
● Understand the behavioural implications of budgeting
● Prepare operational budgets and the master budget
Flex a fixed budget and compile a performance report
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● Describe the alternative approaches to budgeting, such as incremental budgeting,

zero-based budgeting and activity-based budgeting
● Draw up a budget using big data.

Introduction
Budgeting is an activity that most managers identify as being one of the most crucial aspects
in which they are engaged. Management sets goals and objectives for the organisation and
thereafter plans are formulated for achieving these goals and objectives. The financial
impact of these plans are developed and evaluated via the budgeting process. The objective
of this chapter is to consider the role of budgeting and how it fits into the overall general
framework of planning, decision making and control.

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Stages in the budget planning process

It is vital for any organisation to develop plans for the future. It is unlikely that an
organisation will be successful unless its management understands what the future
direction of the organisation is. Hence, the starting point in the budgeting process is to
identify the long-term objectives of the organisation. Once this has been completed, the
various options available to fulfil these objectives should be evaluated. Thereafter, the most
appropriate option should be selected and long-term plans should be developed on the
basis of this selection. The long-term plans would consider the broad directions that top
management intend to follow over the next five or so years. The budget, which is a short-
term plan for the organisation, is prepared within the framework of the long-term plan.
The final stage in the budgeting process is to compare actual outcomes with the planned
outcomes, and to respond to any deviations from the planned outcome.

Purpose of budgeting
Budgeting systems can bring about significant benefits if well organised and thought out.
However, they can also result in dysfunctional behaviour and actions from management
and staff if they are insensitively applied. The purpose and benefits are explained in the
sections below.

Planning
Budgetary planning is the process of converting long-term strategies into short-term
action plans. The preparation of a budget forces managers to spend time planning for
future operations, taking into consideration any anticipated changes that may occur in
the forthcoming year and how they should presently respond to these anticipated changes.

Coordination
All business units in the organisation are to some extent interdependent. The budget
process requires that budgets are developed covering each activity, department or function
in the organisation, interrelating one department’s budget with the others. The budget
process provides for the coordination of activities of the entire organisation by integrating
the plans of the various activities, departments and functions into a common plan.

Control
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For control purposes, it is necessary for the organisation to be divided into areas of authority
with clear guidelines as to the responsibilities of each manager responsible for the budget.
Responsibility accounting is the term used to describe the practice of holding managers
responsible for the performance of their areas. The budget provides the benchmark to allow
a comparison with actual results. A frequent comparison of actual results with the budget
helps to identify any deviations from the budget. This process enables management by
exception to be practised. This means that management’s attention can be focused on
problem areas, that is, any significant deviations from the plan, rather than spending time on
other areas of responsibility that are proceeding according to plan. The budgeting process is
an example of both a feed-forward and feedback control system. Feedback control occurs
where actual outputs are monitored against desired outputs and corrective action is taken
where there is a variance between the two. Feed-forward control occurs when predictions

Cost and Management Accounting

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are made about future outputs and compared to desired outputs and action is taken where
there is a difference between the two.
So, with feed-forward controls any likely errors can be foreseen and actions taken to
avoid them, whereas, with feedback control actual errors are identified and corrective
actions taken to achieve the remainder of the plan.

Communication
The budgetary process involves liaising and discussing a consistent set of plans between
all levels of management. It is via the budget that senior management communicates their
long-term objectives to lower management, who then coordinates their activities laterally
to attain top management’s vision.

Motivation
Budgeting is a managerial activity undertaken by all managers. If the process generates
the right atmosphere, managers will be motivated to support the budget and strive for its
successful accomplishment, especially if they have been involved in the entire process. It is
important for the budget’s performance levels to be set at realistic levels in order for it to
achieve the desired motivational effect.

Performance evaluation
The budget provides a benchmark that can be used to evaluate performance. Many
organisations base their performance reward systems on the achievement of the budget.
Knowledge that a budget will be used for performance evaluation changes managers’
attitudes, encouraging them to perform to the best of their ability, thereby increasing
output and reducing cost.

Authorisation
The approval of the master budget is authorised by the managers of each responsibility
centre to carry out the plans contained in each budget.

Conflicts with the purposes of budgeting

The budget serves a variety of purposes which may also sometimes conflict with one another.
The planning and motivational roles may conflict, as demanding budgets that may not
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be achieved may be appropriate to motivate managers to achieve maximum performance

but are unsuitable for planning purposes. The planning and performance evaluation
purposes may also conflict. For planning purposes, budgets are set in advance of the budget
period, based on an anticipated set of circumstances and/or external environment. If the
circumstances that were anticipated when the budget was prepared have changed, there will
be a planning and performance evaluation conflict.
The performance evaluation and motivation purposes may also conflict with each
other as the budget can cause inefficiency and conflict between managers, particularly if
the budget is imposed from above, in that it may be perceived as a threat rather than a
challenge. Targets that are imposed on managers are unlikely to motivate the managers to
achieve those targets.

Budgets

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Principles of budgeting
An organisational chart forms the basic framework on which to build a coordinated and
efficient system of managerial planning and budgetary control. The budget must be the
joint effort of many people within the organisation and also a working document that
forms the basis for action.

The budget committee

The budgeting process is usually directed by a budget committee who assumes overall
responsibility for the coordination and administration of the budget process. A budget
committee usually consists of representatives from the major sections of the organisation
– sales, production, purchasing, distribution, human resources, etc, with the managing
director as the chairperson and the budget officer who is usually the management
accountant. The functions of the budget committee are as follows:
● Decide on general policies and specify any important guidelines that are to govern the
preparation of the budget
● Receive budget proposals from functional managers and compare them with the
requirements of top management
● Review budgets by comparing them with actual results and suggest revisions on
individual budget estimates after engaging in discussions and negotiations with the
budgeters
● Approve individual budgets
● When all budgets are in harmony with each other, summarise them into a master budget.

The budget period

The length of the budget period varies according to the type of organisation and also with
the nature of the budget. The most frequently used budget period is one year. This approach
to budgeting is known as the periodic budget, where the costs and revenues are shown for
one period of time, for example a year, and are updated on an annual basis. As the year goes
by, the period for which the budget is available will shorten until the budget for the next
year is prepared. The annual budget period is often subdivided into quarters, and the first
quarter is subdivided into months for control purposes. The budgeted data for the year is
frequently revised as the year unfolds. Thereafter, the second quarter is broken down into
monthly budgets, and then the third quarter, etc.
A budget can be continuously updated by adding a further accounting period, that is,
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another month or quarter when the earliest accounting period has expired. For example,
when the budget is prepared for four quarters in the year and the first quarter has ended,
a new quarter is added at the end of the budget period to replace the quarter that has
ended. This type of continuous budgeting is referred to as rolling budgets. The reason for
preparing rolling budgets is to deal with uncertainty in the budget.

Advantages of rolling budgets

The advantages of rolling budgets are the following:
● They encourage managers to constantly look ahead and review future plans.
● They reduce uncertainty in budgeting.
● Actual performance is compared with a more realistic target, because budgets are
constantly reviewed and updated.

Cost and Management Accounting

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Disadvantages of rolling budgets

The disadvantages of rolling budgets include the following:
● They can create uncertainty for managers, as the budget is constantly changed.
● It can be difficult to communicate frequent changes to all affected parties.
● It can be time-consuming to regularly prepare new budgets.

Behavioural considerations
Forecasting future events is not the only problem facing budget officers who are responsible
for carrying out the budget function. Equally important is the problem of human relations.
Human behaviour is unpredictable, and attempts to understand why people act or react as
they do are complex. If budgeting is to be successful, it must have the active cooperation of
the entire organisation. The following issues will be considered in the behavioural effects
of budgets:
● Participation: The process of gaining acceptance of the budget involves much
negotiation and subsequent revision of budget estimates. This process of participative
budgeting allows managers at all levels to submit their estimates to their superiors,
and the stage is set for discussions and negotiations to take place between the affected
parties until an agreement has been reached. It is vital for the success of the budget that
the budgeters participate in arriving at the final budget compilation and no revisions are
made without giving full consideration to the subordinates’ arguments.
● Goal congruence: For budgets to be motivational, employees must accept the budgets
as their own. Goal congruence is a term used to describe the situation in which the
organisation’s goal coincides with an individual’s personal aspiration. The individual is
likely to add more value to the organisation and work in its best interest if the objectives
of the organisation are similar to those of the individual.
● Levels of performance: The budget provides a benchmark against which a manager
is expected to conform. It must be set at a realistically attainable level. If the standards
are too high, the manager will be put under pressure, resulting in low morale and
dysfunctional behaviour.
● Dysfunctional behaviour: When managers are put under pressure to meet targets set
out by the budgets which will affect their performance evaluation, they may seek to
distort the budgetary control system in their favour through dysfunctional behaviour
such as the following:
They may build in slack when the budget is drafted, which is the difference between
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the revenue or cost estimates that the manager provides and a realistic estimate. For
example, a manager may believe that an amount of R150 000 will be incurred for ad-
vertising, but estimates a budget of R200 000. The manager has built R50 000 slack
into the budget.
— There are costs which are under the sole control of managers. When an adverse vari-
ance is shown, managers may attempt to pass responsibility for it onto a colleague.
This will not assist in team building and will have an unfavourable effect on group
dynamics.

Budgets

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Case study: Budgetary slack at a local bank

Mahi Singh is the New Accounts Manager at HFSC Bank in Gauteng. As an initial
task, she has to project the number of new bank accounts she will generate during the
upcoming year. The bank operates in the commercial banking sector within the South
African economy, which has been on an upward growth trajectory in the past decade.
The bank has experienced a 9% increase in its number of bank accounts over each of the
past three years. In the current year, the bank had 8 000 accounts.
Ms Singh’s package includes a salary plus a bonus of R300 for every new account
she generates above the budgeted amount. Thus, if the annual budget calls for 900
new accounts, and 980 new accounts are obtained, Ms Singh’s bonus will be R24 000
(80 × R300).
Ms Singh believes the economy of the country will continue to grow at the same rate
in the upcoming year as it has in recent years due to an increase in GDP and higher
spending. She has decided to send in a budgetary projection of 600 new accounts for
the upcoming year.

Discussion questions:
1. Explain the negative consequences of budgetary slack.
2. Discuss the bank’s bonus system for the New Accounts Manager and how this tends
to encourage budgetary slack.

The budget structure

The structure of a budget depends on an organisation’s operations and its nature. We will
be focusing on a manufacturing organisation, where the budgeting process usually consists
of functional budgets and the master budget. Considerable variation in the number
and content of functional budgets is found in practice. Figure 10.1 illustrates the stages
in budgeting.
Sales budget

Production budget
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Operating budgets

Raw materials Direct labour Manufacturing

budget budget overheads budget

Administration Cost of goods Selling & distribution

expenses budget sold budget expenses budget
Financial budgets

Master budget

Budgeted statement of Budgeted statement of

Cash budget
comprehensive income financial position

Figure 10.1 The budget structure

Cost and Management Accounting

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These budgets cannot be prepared independently. Production is scheduled to meet sales

demand; direct materials, direct labour and manufacturing overheads are all linked to
production; selling and administration expenses are based on sales; and cash receipts and
disbursements can only be estimated after sales revenue and costs are known. We will now
look at a detailed illustration of these budgets.

Comprehensive budgeting illustrated

The following example illustrates the basic concepts or procedures for constructing budgets
in a manufacturing organisation. The level of detail contained in this example is not as
detailed as it would be in practice.

Illustrative example 10.1

The Canning Company, situated in KZN, is involved in the fishing industry and one of
their main activities is the processing and canning of Norwegian salmon. A standard
cost system is used to control its costs. In the assembly department, the fresh salmon
is cleaned, steamed and water and preservatives are added. It is then canned in the
canning department. The two main ingredients which are used in the processing of
the Norwegian salmon are the fresh salmon and preservatives. Management and
department heads have made the following estimates for the coming year ending
31 December 20X1.
1. Sales:
The expected sales demand for the canned salmon is 11 000 tins at a prospective
selling price of R150. The reason for the high price is a confluence of factors,
including an outbreak of sea lice among Norway’s salmon farms. As a result, salmon
production in Norway, which is the world’s largest producer of the fish, is expected
to drop drastically.
2. Materials quantity requirements and unit costs:
Materials requirements per tin of canned salmon includes 35 grams of the fresh
salmon and 10 grams of preservatives. The material cost is expected at R1.20 per
gram of fresh salmon and R0.25 per gram of preservative.
3. Labour requirements per unit and hourly rates:
The production requirements of the canned salmon is 2 hours in the assembly
department and half an hour in the canning department. The hourly rate in the
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assembly department is R10 and R9 in the canning department.

➤➤

Budgets

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4. Budgeted factory overheads:

Table 10.1 Estimates for the year ending 31 December 20X1

Overheads Assembly (R) Canning (R)
Variable overhead rate per direct labour hour:
Indirect materials 1.50 1.20
Indirect labour 1.20 1.00
Power 1.40 1.10
Maintenance 1.10 1.20

Fixed overheads:
Indirect materials 61 980 56 585
Indirect labour 20 000 22 000
Depreciation 5 000 2 000
Maintenance 11 500 10 000
Power 10 000 6 185
Employee fringe benefits 60 000 51 730

5. Inventories:

Table 10.2 Materials

Fresh salmon Preservatives
Beginning inventory 10 000 g 2 000 g
Ending inventory 12 000 g 2 500 g

Work in process: There was no beginning or ending inventory.

Table 10.3 Finished goods

Product Beginning inventory Ending inventory
Units Unit price Units
Canned salmon 400 R95 200

6. Table 10.4 Budgeted non-manufacturing overheads

Overheads R
Salaries (sales) 80 000
Salaries (office) 90 000
Sales commission 70 000
Advertising 50 000
Motor vehicle expenses (sales) 35 000
Miscellaneous (office) 65 000
Stationery (office) 15 000
Depreciation (office) 5 000

➤➤

Cost and Management Accounting

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7. Table 10.5 Budgeted cash flows

Quarter 1 (R) Quarter 2 (R) Quarter 3 (R) Quarter 4 (R)
Receipts from
customers 300 000 350 000 400 000 380 000
Payments:
Materials 100 000 120 000 140 000 110 000
Wages 78 220 78 220 78 220 78 220
Other costs and
expenses 210 050 183 500 116 425 135 900

8. Table 10.6 Budgeted statement of financial position for year end 31 December 20X0
ASSETS (R) (R)
Non-current assets 1 366 910
Property and equipment 1 785 520
Accumulated depreciation 418 610

Current assets 843 870

Inventory
Finished goods 38 000
Raw materials 12 500
Trade receivables 442 310
Cash 351 060
Total assets 2 210 980
EQUITY AND LIABILITIES
Equity 1 522 100
Ordinary share capital 1 000 000
Retained earnings 522 100
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Non-current liabilities 360 780

Loan 360 780

Current liabilities 327 900

Trade payables 327 900
Total equity and liabilities 2 210 780

9. Tax is charged at 28%.

➤➤

Budgets

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Required:
After reading the relevant information, prepare a complete set of budgets consisting of
the following:
(a) Sales budget
(b) Production budget
(c) Materials usage budget
(d) Materials purchases budget
(e) Direct labour budget
(f) Factory overhead budget
(g) Production cost budget
(h) Selling and administration budget
(i) Inventories budget
(j) Cost of goods sold budget
(k) Cash budget
(l) Budgeted statement of comprehensive income
(m) Budgeted statement of financial position.

Sales budget
The sales budget is the foundation on which all other budgets are built and is the keystone
of the budget structure. It shows what products will be sold, in what quantities and at
what prices they will be sold, and sometimes in which regions they should be sold. Prior to
developing a sales budget, it is necessary to do a sales forecast. This forecast is usually based
on past sales and the present market. The task is usually the responsibility of the marketing
manager assisted by sales and market research personnel. Prior to the final acceptance
of the sales budget, it must be determined if the plant has the capacity to produce the
estimated volume.

Illustrative example 10.1 (cont.)

The annual sales budget for The Canning Company reflects that total sales from the
product would be R1 650 000.
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Table 10.7 Sales budget (Schedule 1)

Total
Canned salmon
Units 11 000
Selling price R150
Sales value R1 650 000

Cost and Management Accounting

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Production budget
Once the sales budget is complete, the next step is to prepare the production budget. The
production budget is expressed in units and determines the number of units of the finished
product to be produced. It takes into account the sales forecast and determines inventories
that are sufficient to fulfil periodic sales requirements. This budget provides the basis
for preparing the materials, labour and overhead budgets. It is the responsibility of the
production manager.

Illustrative example 10.1 (cont.)

The annual production budget for The Canning Company reflects production require-
ments for the product adjusted for any inventory changes.
Table 10.8 Production budget (Schedule 2)
Canned salmon
(units)
Units to be sold 11 000
Add: Required closing inventory 200
Total units required 11 200
Less: Opening inventory 400
Production required 10 800

Manufacturing budgets: Direct materials budget

Once the production requirements have been determined, these can be translated into the
manufacturing budgets in order to determine the manufacturing costs and to identify
these costs with products and responsible managers, or responsibility centres in the
case of overheads. The materials usage budget determines the materials requirement for
production, and can be calculated in quantity and in rands.
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Illustrative example 10.1 (cont.)

Table 10.9 Direct material usage budget (Schedule 3)
Fresh salmon Preservatives Total
Canned salmon
Production required 10 800 10 800
× Materials required per unit 35 g 10 g
Materials required for production 378 000 108 000
Purchase price R1.20 R0.25
Cost of materials required for production R453 600 R27 000 R480 600

Budgets

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Purchases of materials depend on inventories and production requirements. The material

purchases budget reflects the amount of materials to be purchased in quantity and in rands,
taking into account the required inventories for materials.

Illustrative example 10.1 (cont.)

Table 10.10 Direct material purchases budget (Schedule 4)
Fresh salmon Preservatives Total
Material required for production 378 000 108 000
Add: Required closing inventory 12 000 2 500
390 000 110 500
Less: Opening inventory 10 000 2 000
Units to be purchased 380 000 108 500
Purchase price R1.20 R0.25
Cost of purchases R456 000 R27 125 R483 125

Manufacturing budgets: Direct labour budget

The direct labour budget takes the production requirements into consideration and is the
principal planning tool for human resources. This budget guides the personnel department
in determining the number and type of labour force required. Indirect labour is included
in the overhead budget and includes employees such as the supervisor, maintenance
workers, etc.

Illustrative example 10.1 (cont.)

The annual direct labour budget for The Canning Company reflects the amount of direct
labour hours required in the two departments, as well as the hourly rates translating
into total direct labour cost.
Table 10.11 Direct labour budget (Schedule 5)
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Assembly Canning Total

Canned salmon
Production required 10 800 10 800
× Hours required per unit 2 0.5
Hours required for production 21 600 5 400
× Hourly rate R10 R9
Direct labour cost R216 000 R48 600 R264 600

Cost and Management Accounting

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Manufacturing budgets: Factory overhead budget

This budget details the various indirect factory costs and expenses allocated to the various
production departments. Once the budget is prepared, including service department cost
allocations, the predetermined overhead rates can be determined. These rates are then used
to estimate the overheads for the products to be manufactured.

Illustrative example 10.1 (cont.)

Table 10.12 Factory overhead budget (Schedule 6)
Assembly Variable Direct labour Variable cost Fixed cost Total cost
overhead rate hours
R R R R
Indirect 1.50 21 600 32 400 61 980 94 380
materials
Indirect 1.20 21 600 25 920 20 000 45 920
labour
Power 1.40 21 600 30 240 10 000 40 240
Maintenance 1.10 21 600 23 760 11 500 35 260
Depreciation 5 000 5 000
Employee fringe benefits 60 000 60 000
Total departmental overhead 280 800
Budgeted overhead allocation base (direct labour hours) 21 600 hours
Budgeted departmental overhead rate (280 800 ÷ 21 600) R13

Canning
Indirect 1.20 5 400 6 480 56 585 63 065
materials
Indirect 1.00 5 400 5 400 22 000 27 400
labour
Power 1.10 5 400 5 940 6 185 12 125
Maintenance 1.20 5 400 6 480 10 000 16 480
Depreciation 2 000 2 000
Employee fringe benefits 51 730 51 730
Total departmental overhead 172 800
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Budgeted overhead allocation base (direct labour hours) 5 400 hours

Budgeted departmental overhead rate (172 800 ÷ 5 400) R32
Total budgeted overhead (280 800 + 172 800) 453 600

Selling and administration budget

Selling and administration expenses are usually separated in practice as separate budgets,
but for the sake of simplification, they are combined into one budget, but reflected
separately. The sales manager is usually responsible for the selling budget, and the chief
administration officer is usually responsible for the administration budget. These expenses
can also be further separated into fixed and variable components.

Budgets

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Illustrative example 10.1 (cont.)

Table 10.13 Selling and administration budget (Schedule 7)
R R
Selling expenses 235 000
Salaries 80 000
Commission 70 000
Advertising 50 000
Motor vehicle expenses 35 000
Administration expenses 175 000
Salaries 90 000
Miscellaneous 65 000
Stationery 15 000
Depreciation 5 000
Total selling and administration expenses 410 000

Beginning and ending inventories budget

Inventory quantities must be determined and costed for raw materials, work in progress and
finished goods, as this leads to the preparation of a budgeted cost of goods manufactured
and sold statement, and ultimately a statement of comprehensive income (income
statement) and a statement of financial position (balance sheet). Prior to calculating
the value of ending finished goods inventory, the budgeted cost per unit for the product
must be calculated. The cost per unit is made up of direct materials, direct labour and
applied overheads.

Illustrative example 10.1 (cont.)

Table 10.14 Budgeted cost per unit (Schedule 8)
Canned salmon
Direct material:
Fresh salmon (R1.20 × 35 g) R42.00
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Preservatives (R0.25 × 10 g) R2.50

Direct labour:
Assembly (R10 × 2 hours) R20.00
Canning (R9 × 0.5 hour) R4.50
Overheads:
Assembly (R13 × 2 hours) R26.00
Canning (R32 × 0.5 hour) R16.00
Cost per unit R111.00
Units produced × 10 800
Cost of production R1 198 800

➤➤

Cost and Management Accounting

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Table 10.15 Beginning and ending inventories budget (Schedule 9)

Beginning inventory Ending inventory
Cost per Cost per
Units unit Total Units unit Total
R R R R
Materials:
Fresh salmon 10 000 g 1.20 12 000 12 000 g 1.20 14 400
Preservatives 2 000 g 0.25 500 2 500 g 0.25 625
12 500 15 025
Work in process: None
Finished goods:
Canned salmon 400 95 38 000 200 111 21 900

Budgeted cost of goods manufactured and sold statement

The direct materials purchases budget, direct labour cost budget and the overhead budget,
together with the inventories budget are required to prepare the budgeted cost of goods
manufactured and sold statement.

Illustrative example 10.1 (cont.)

Table 10.16 Budgeted cost of goods manufactured and sold (Schedule 10)
Materials R
Opening inventory (Schedule 9) 12 500
Add: Purchases (Schedule 4) 483 125
495 625
Less: Closing inventory (Schedule 9) 15 025
Cost of materials consumed (Schedule 3) 480 600
Direct labour (Schedule 5) 264 600
Factory overhead (Schedule 6) 453 600
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Total manufacturing cost 1 198 800

Add: Opening finished goods inventory (Schedule 9) 38 000
Cost of goods available for sale 1 236 800
Less: Closing finished goods inventory (Schedule 9) 21 900
Cost of goods sold 1 214 900

The master budget

The master budget can be summarised as the statement of comprehensive income, the cash
flow forecast for the period reflected in the cash budget, and the statement of financial
position. When all the budgets have been prepared, the master budget provides the overall
picture of the planned performance for the budget period.

Budgets

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Cash budget
A cash budget involves detailed estimates of cash receipts and payments for the budget
period. Cash budgeting is of crucial importance, since it can help organisations to anticipate
their cash needs. Where cash deficits are identified in advance, loans can be sought to meet
any temporary cash deficits. On the other hand, when excessive cash surpluses are identified,
management can invest this surplus cash in short-term investments. When preparing the
cash budget, all cash flows, along with their timings, must be considered. The art of cash
budgeting is getting the timing right. A logical approach to thinking out the sequence of
expenses incurred, credit terms allowed, and payment made, or the time lag between making
a sale and receiving the payment from debtors, is crucial to success. The cash position of
an organisation can reflect any one of the following outcomes with management’s action
dependent on the amount of the deficit or surplus, as well as the length of time it will last:
Table 10.17 Possible management action for different cash positions
Cash position Possible management action
Short-term deficit Apply for a bank overdraft; encourage debtors to pay sooner; keep less
inventory; arrange for longer credit terms with suppliers
Long-term deficit Obtain a long-term loan
Short-term surplus Invest the extra cash; allow debtors to pay later to boost sales; pay suppliers
earlier to get discounts
Long-term surplus Consider expanding the organisation

When you prepare a cash budget, there are certain items that must be specifically excluded,
such as depreciation and allowances for bad and doubtful debt. This is because these two items
do not involve any cash changing hands; in the cash budget, only cash items are considered.

Illustrative example 10.1 (cont.)

Table 10.18 Budgeted cash budget (Schedule 11)
Quarter 1 Quarter 2 Quarter 3 Quarter 4
R R R R
Receipts
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Receipts from customers 300 000 350 000 400 000 380 000

Payments
Materials 100 000 120 000 140 000 110 000
Wages 78 220 78 220 78 220 78 220
Other costs and expenses 210 050 183 500 116 425 135 900
388 270 381 720 334 645 324 120
Net cash flow −88 270 −31 720 65 355 55 880
Balance b/d 351 060 262 790 231 070 296 425
Balance c/d 262 790 231 070 296 425 352 305

Cost and Management Accounting

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Differences between a cash budget and a statement of comprehensive income

It is important to understand that cash receipts and payments are different from sales and
cost of sales used in the income statement, and that profit and the cash balance will not be
the same. The reasons for this are as follows:
● The income statement shows non-cash charges such as depreciation and bad debts,
whereas a cash budget only reflects cash flows.
● The timing of cash receipts and payments does not coincide with the accounting period
in the income statement, that is, income and expenses are recorded in the accounting
period in which the invoice is raised, even though they may not have been paid for.
However, these items are only recorded in the cash budget when they have been paid for.
For example, rent paid in arrears for last year and insurance paid in advance for next year
are cash outflows, but not costs in the income statement this year.
● Not all cash receipts or payments affect the income statement, but may be shown in the
cash budget. These are capital items such as the purchase of plant and equipment, and
the raising of share capital and loans which affect the balance sheet, but not the profit
computation. For example, sale of equipment will be shown as a cash receipt in the cash
budget, but will not affect the income statement.

Purposes of a cash budget

The purposes of a cash budget are as follows:
● Helps management to manage the cash of the firm to attain maximum cash availability
and earn maximum interest on any idle funds
● Indicates the availability of surplus funds for taking advantage of discounts
● Shows the need for taking loans to meet temporary cash deficiencies
● Serves as a basis for evaluating the organisation’s actual cash management performance
● Shows the availability of excess funds that can be utilised for either long- or short-term
investments.

An example of an alternative cash budget

Illustrative example 10.2

Baloo (Pty) Ltd needs to prepare its cash budget for the next three months. The following
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information is available:
Table 10.19 Estimated sales
Estimated sales R
June 25 000
July 27 200
August 34 000
September 33 600

➤➤

Budgets

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Table 10.20 Estimated purchases

Estimated purchases R
June 6 900
July 7 560
August 5 780
September 6 300

Additional information:
1. Direct wages amount to R13 000 per month.
2. Baloo sells 20% of all goods on cash; the remainder of customers have one month
of credit.
3. Suppliers are paid in the month after purchase.
4. Wages are paid in cash as they occur.
5. Overheads are R6 400 per month and Bader is allowed one month’s credit on
overheads. Depreciation of R600 is included in the amount for overheads.
6. Selling, distribution and administrative costs are R3 780 per month and are paid in
cash in the month in which they occur.
7. Baloo wishes to purchase a new vehicle in August with a cash payment of R120 000.
8. The cash balance for the end of June is expected to be R90 500.

Required:
Prepare a cash budget for the months of July to September.

Solution:
The cash budget for the three months will look as follows:
Table 10.21 Cash budget for July to September
July August September
R R R
Opening balance 90 500 86 460 (35 120)

Sales
20% cash 5 440 6 800 6 720
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80% on one month’s credit 20 000 21 760 27 200

Total receipts 25 440 28 560 33 920

Material purchases on one month’s credit 6 900 7 560 5 780

Direct wages 13 000 13 000 13 000
Overheads (excluding depreciation) 5 800 5 800 5 800
Selling, distribution and administrative costs 3 780 3 780 3 780
Vehicle 120 000
Total payments 29 480 150 140 28 360

Net cash inflow (outflow) (4 040) (121 580) 5 560

Closing cash balance 86 460 (35 120) (29 560)

➤➤

Cost and Management Accounting

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Interpretation of the cash budget reveals that the organisation incurs a cash deficit
from August onwards. The main reason for the deficit is the purchase of the vehicle.
Management may have to consider alternative plans, such as purchasing a cheaper
vehicle, purchasing the vehicle at another time, or perhaps purchasing it on credit.
This indicates how useful a cash budget is for planning the future cash position of an
organisation. Because it is a budget, changes can still be made to it to ensure that the
result is positive.

Budgeted statement of comprehensive income

This budget contains summaries of the sales, manufacturing and expense budgets. The
cost of sales may be transferred from the statement of cost of goods sold budget, or may be
calculated by adjusting the production cost, to allow for changes in inventories of finished
goods as shown in The Canning Company’s budget.

Illustrative example 10.3

Table 10.22 Budgeted statement of comprehensive income (Schedule 12)
R R
Sales (Schedule 1) 1 650 000
Cost of sales (Schedule 10) (1 214 900)
Opening inventory 38 000
Production cost (Schedule 8) 1 198 800
1 236 800
Closing inventory (Schedule 9) (21 900)
Gross profit 435 100
Selling and administration expenses (Schedule 7) 410 000
Operating profit for the year 25 100
Tax @ 28% 7 028
Budgeted profit after tax 18 072
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Retained earnings at beginning of year 522 100

Retained earnings at end of year 540 172

Budgeted statement of financial position

The budgeted balance sheet incorporates any changes in assets, liabilities and shareholders’
equity in the budgets submitted by the various departments.

Budgets

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Illustrative example 10.4

Table 10.23 Budgeted statement of financial position (Schedule 13)
ASSETS R R
Non-current assets 1 354 910
Property and equipment 1 785 520
Accumulated depreciation 430 610
Current assets
Inventory 1 051 540
Raw materials (Schedule 9) 15 025
Finished goods (Schedule 9) 21 900
Trade receivables (Note 1) 662 310
Cash (Schedule 11) 352 305
Total assets 2 406 450

EQUITY AND LIABILITIES

Equity 1 540 172
Share capital 1 000 000
Retained earnings (Schedule 12) 540 172

Non-current liabilities 360 780

Long-term loan 360 780

Current liabilities 505 498

Tax liability (Schedule 12) 7 028
Trade payables (Note 2) 498 470
Total equity and liabilities 2 406 450

Notes:
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1. Trade receivables R
Opening balance 442 310
Sales 1 650 000
Cash received (1 430 000)
662 310

2. Trade payables R
Opening balance 327 900
Purchases 483 125
Indirect materials 157 445
Cash paid (470 000)
498 470

Cost and Management Accounting

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Test yourself 10.1

SeCa Com Ltd manufactures two products, Ara and Dara. The financial manager
provides the following information:

Direct material comprises of two materials used in the production process: Material 1
at a price of R1.00 per unit and Material 2 at a price of R1.50 per unit. Direct labour
amounts to R5 per hour. The estimated production overheads are R100 000, including
R12 500 for depreciation. The production overhead is absorbed on the basis of direct
labour hours. The material and labour requirements for the products are as follows:
Dara and Ara material and labour requirements
Ara Dara
Material 1 6 units 6 units
Material 2 3 units 4 units
Direct labour 3.5 hours 5 hours

The sales director is of the opinion that the sales department will sell 2 500 units of the
Ara and 500 units of the Dara. The Ara sells for R91.00 and the Dara for R80.50.

There will be 500 units of Ara and 100 units of Dara in the storeroom at the start of the
year. At the end of the year, a required number of 75 units of Ara and 75 units of Dara
need to be in the storeroom.

The production manager indicates that there will be 1 500 units of Material 1 and 2 000
units of Material 2 in the storeroom at the start of the period. At the end of the year, a
required number of 2 000 units of Material 1 and 1 000 units of Material 2 must be in
the storeroom.

The selling and administration budget is R37 500, including R2 500 for depreciation.

A tax rate of 30% is payable. A cash payment of tax owed from the previous period will
be paid in Quarter 1.

A partial quarterly cash flow statement has been prepared already:

Quarterly cash flow statement

Quarter 1 2 3 4
R R R R
Receipts 55 000 56 000 59 500 84 000
Payments
Materials 5 500 9 250 10 000 15 000
Direct wages 7 500 9 800 6 500 9 700
Overheads 22 500 25 000 35 000 32 500
Taxation 2 500
Machinery purchase 30 000
➤➤

Budgets

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The organisation’s statement of financial position at the start of the period will be as
follows:
Opening statement of financial position
R
ASSETS
Non-current assets 412 500
Land 250 000
Property, plant and equipment 162 500

Current assets 35 000

Raw materials inventory 10 000
Finished goods inventory 7 500
Receivables 12 500
Cash 5 000

TOTAL ASSETS 447 500

EQUITY AND LIABILITIES

Equity 440 500
Share capital 400 000
Retained earnings 40 500

Current liabilities 7 000

Payable 4 500
Taxation 2 500

TOTAL EQUITY AND LIABILITIES 447 500

Required:
Prepare the master budget, including a cash budget and the budgeted financial
statements for the period 1 January to 31 December 20X1.

Budgetary control through flexible budgets

Budgetary control implies the comparison of actual cost incurred to the planned estimates
in the budget. Where the actual level of activity is different to that expected, comparisons of
actual results against a fixed budget can give misleading results. To overcome this difficulty,
the fixed budget (also known as a static budget), which is a budget that contains costs
and revenues for a single, planned level of activity, must be flexed to the actual level of
output achieved. A flexible budget is the only feasible type of budget for control purposes.
It contains the same information as the fixed budget but for several activity levels.

Cost and Management Accounting

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Fixed budgets, flexible budgets and performance reports

A flexible budget adjusts the fixed budget to the level of activity (volume) actually attained.
A flexible budget is geared towards all levels of activity within a relevant range, rather than
towards only one level of activity as is a fixed budget. Flexing the budget requires knowledge
of cost behaviour, that is, we need to know which items are fixed and which are variable to
the volume of output and items that are semi-variable have to be separated. Fixed expenses
remain the same regardless of the activity level. Variable expenses increase as activity levels
increase. For each variable expense, determine the cost per unit. For the semi-variable costs,
use the high-low method, or any other method to separate the cost into fixed and variable.
Once the costs have been separated, the flexible budget is easy to draw up. A performance
report will then be drawn up as reflected in the illustrative example comparing the flexible
budget and the actual results. These variances can either be adverse (A) or favourable (F).

Illustrative example 10.5

A software company has prepared the following budget for May:
Sales R280 000
Less: Expenses R221 000
Direct material R28 000
Direct labour R101 500
Overheads R91 500
Budgeted profit R59 000

Sales are expected to be 70 000 units per month. Material costs vary with sales. Thirty
per cent (30%) of labour costs are variable with sales. The variable portion of overheads
is R0.15 per unit. At the end of the month, the company only managed to sell 60 000
units. The following actual results were obtained for May:
Sales R240 000
Less: Expenses R222 600
Direct material R30 000
Direct labour R105 000
Overheads R87 600
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Actual profit R17 400

Required:
Prepare a performance report for the company.
➤➤

Budgets

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Solution:
The comparison of actual results (60 000 units) with the fixed budget (70 000 units)
does not provide useful control information. A more useful performance report would
include comparison of actual results with a flexible budget. When flexing the budget
to the actual activity level, identify whether the costs are variable, fixed or both. Direct
materials are calculated as 28 000 ÷ 70 000 = R0.40 per unit. When multiplied by the
actual number of units of 60 000, direct materials are R24 000. The variable portion of
direct labour is 30% of R101 500 = R30 450. Direct labour per unit is 30 450 ÷ 70 000 =
R0.435. The fixed portion is R71 050 (R101 500 − R30 450). Therefore, direct labour at
an activity level of 60 000 would be:

Variable portion 5 60 000 units × R0.435 = R26 100

Fixed portion = R71 050
Total direct labour at 60 000 units = R97 150

The variable portion of overheads at the fixed budget level is R0.15 × 70 000 units =
R10 500. Therefore, fixed overheads are R81 000 (R91 500 − R10 500). Overheads at an
activity level of 60 000 would be:
Variable portion 5 60 000 units x R0.15 = R9 000
Fixed portion = R81 000
Total overheads at 60 000 units = R90 000
Table 10.24 Performance report
Original Flexible Actual Variance
budget budget results
Sales volume (units) 70 000 60 000 60 000
Sales revenue R280 000 R240 000 R240 000 0

Direct materials R28 000 R24 000 R30 000 R6 000 (A)
Direct labour R101 500 R97 150 R105 000 R7 850 (A)
Overheads R91 500 R90 000 R87 600 R2 400 (F)
R221 000 R211 150 R222 600 R11 450 (A)
Profit R59 000 R28 850 R17 400 R11 450 (A)
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A performance report is produced to monitor performance and is presented to the relevant

managers who are responsible for implementing the various decisions. In a performance
report focused on cost control, actual costs should be compared to the flexible budget for
the actual level of activity and not the budget for the planned level of activity. A performance
report highlights those costs and revenues that do not conform to plans, so that managers
can focus their time and effort on these areas, thereby supporting a system of management
by exception. Flexible budgets will be addressed in the next chapter on standard costing in
the context of variance analysis.

Cost and Management Accounting

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347

Test yourself 10.2

Caminaysh Ltd, which makes a single product, bases its budgets for manufacturing
overheads on the following data:
Variable overhead cost category Standard cost per unit
Maintenance R0.60
Indirect materials 1.40
Utilities 1.00
Total variable cost R3.00
Fixed overhead cost category Budgeted annual cost
Depreciation R40 000
Supervision 50 000
Insurance 10 000
Total fixed cost R100 000

Caminaysh Ltd originally planned to produce and sell 10 000 units during the year,
but actual activity was only 8 000 units. A report based on the fixed budget from the
beginning of the year follows:
Original
Actual Budget Variance
Units produced and sold 8 000 10 000 2 000 (A)
Variable overhead costs:
Maintenance R4 500 R6 000 R1 500 (F)
Indirect materials 12 000 14 000 2 000 (F)
Utilities 9 500 10 000 500 (F)
Total variable costs 26 000 30 000 4 000 (F)
Fixed overhead costs:
Depreciation 40 000 40 000 —
Supervision 49 000 50 000 1 000 (F)
Insurance 10 000 10 000 —
Total fixed overhead 99 000 100 000 1 000 (F)
Total overhead costs R125 000 R130 000 R5 000 (F)

Required:
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(a) Prepare a flexible budget for manufacturing overheads for three different levels of
activity, ranging from 5 000 to 15 000 units.
(b) Prepare an overhead performance report.

Alternative approaches to budgeting

Incremental budgeting
In this approach the current period’s budget is based on the budget from the previous
period adding on a percentage for inflation. When there is a clear volume-based link with
production/sales, this form of budgeting is more useful in providing accurate budget figures

Budgets

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for variable costs, including direct materials, direct labour and sales commission. However,
when costs are largely fixed and semi-fixed and driven by other factors such as sales orders
and purchase orders, this approach is unlikely to produce accurate figures. In addition,
no consideration is given to the cost of providing existing activities since the focus is on
incremental change. A major disadvantage of this approach is that it allows unnecessary
expenditure and wasteful spending to creep into the budget.

Zero-based budgeting
Zero-based budgeting (ZBB) was developed in the 1960s as an alternative approach to
address the deficiencies of incremental budgeting – in particular, the non-evaluation of
existing activities. Zero-based budgeting splits up the organisation into individual functions
and periodically analyses the operations of each one. ZBB starts from scratch, that is, zero,
first requiring that each unit requesting an appropriation justifies the existence of the cost
item and the benefits the expenditure brings. ZBB is thus a cost–benefit approach.
Managers involved in ZBB must examine their current practices and develop a
questioning attitude. One of the predominant questions should be: ‘Is this expenditure
necessary?’ Other key questions are:
● Should an activity be performed?
● How much of an approved activity should be provided?
● How should the activity be undertaken?
● Should the activity be performed in-house or subcontracted?

Implementation of zero-based budgeting

Implementing ZBB involves the following three stages:
Stage 1: Managers are asked to prepare a decision package for each activity under their
control which should include an analysis of cost and revenues expected from the activity,
the purpose of the activity, alternative courses of action, measures of performance,
consequences of not performing the activity, and benefits.

Stage 2: Each decision package is evaluated and compared with other activities. Based on
the cost–benefit analysis, the decision packages are ranked. Due to the large number of
packages prepared throughout the organisation, the ranking process can become time-
consuming for senior management. In order to alleviate this problem, some organisations
allow lower-level managers to rank the packages for their own departments, and these are
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then consolidated with others at the next level up in the hierarchy.

Stage 3: When the overall budgeted level is decided upon, the resources are allocated to the
various packages in the ranked priority sequence up to the agreed expenditure level.

Advantages of zero-based budgeting

Following are some of the advantages of ZBB:
● The process of drafting a budget from scratch leads to greater management and employee
knowledge of the operations and activities of the organisation, thereby preparing them
for greater responsibility.
● Due to the questioning attitude, it makes it easier to identify inefficiencies in the
operations.

Cost and Management Accounting

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● It results in more efficient allocation of resources, as funds are allocated on a cost–

benefit basis through analysis of existing and planned activities.

Disadvantages of zero-based budgeting

The following are some of the disadvantages of ZBB:
● It is a time-consuming and expensive process.
● Considerable management skills are required in the evaluation of the various decision
packages, and these skills may be scarce in the organisation.
● Computer usage to a large extent is excluded, since decisions are non-repetitive and
human judgement is crucial.

Activity-based budgeting
Activity-based costing principles explained in earlier chapters can also be extended in the
budgeting of future costs. Activity-based budgeting (ABB) uses the costs drivers identified
by ABC to derive budgets for support departments. It involves determining the key budget
factor (sales) for the next budget period, estimating the support activities required for the
budget from cost drivers, and setting the budget for the support activities. ABB is a method
of budgeting for activities or cost pools that utilises cost driver data in the budget-setting
and variance feedback processes. The traditional approach of budgeting for overhead costs
where a percentage is added to the current year’s budget to allow for inflation is not as
effective as using either ZBB or ABB to determine overhead costs. ABB is covered briefly
here, as it is also included in Chapter 8.

Budgeting in a digital age

Big data
Big data is a term used to describe extremely large collections of data that may be analysed
to reveal patterns and trends, especially relating to human behaviour. For example, online
retailers collect large amounts of information on customers, such as what a customer has
bought, what other products they may have looked at on the website but not bought, how
they made payment for purchases, where they live, what items they may have returned, what
products they have ordered more than once, what ratings and/or comments customers may
have posted about specific products, etc. Information of this nature enables the online
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retailer to make recommendations to customers of other items that might appeal to them.
Big data has the following characteristics:
● Volume: The amount of data being stored is enormous in comparison to the amount of
data being stored on a normal PC.
● Velocity: For the data to be useful, the data needs to be analysed and information
provided quickly enough. In the case of online retailers, suggestions need to be presented
to customers immediately when they access the website.
● Variety: The data being stored will come from a large variety of sources and this
information needs special software and algorithms that collate the different data sets
into useful information.
● Veracity: Users must consider data integrity to decide whether it is representative,
authentic and can be trusted.

Budgets

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Big data analytics

Data analytics is increasingly recognised as one of the important means of identifying the
business drivers of the organisation and therefore the major influence on the financial
outcome of the organisation. Big data can be collected, then analysed and used to provide
insights that lead to better decisions based on more informed knowledge.

Using big data for budgets and forecasts

Sale forecasts are often seen as the principle budget factor in many organisations. Big data
can be used to predict buyer behaviour, product popularity and estimate likely sales demand
in the form of detailed forecasts. The data may be misleading and can be misinterpreted –
it can also be overwhelming in some cases but if used correctly can lead to competitive
advantage and intelligent insight into customer preferences. It may enable businesses to
determine why customers are selecting a rival’s product or the reasons behind other subtle
behaviour shifts.

Using big data for stress testing

Stress testing is a form of analysis that can determine which factors are important in a
budget’s success and how they could change and impact the final outcomes. Big data
analytics can play a key role in stress testing, including the identification of these stress
events and then the quantification of the effects of these types of events. Data analytics
can also play a role in the creation and identification of warning signs or triggers for stress
events. For example, in the case of financial institutions, they regularly use big data analytics
to manage and ensure the adequacy of assets used for retirement investments and insurance
funds. Through data modelling and simulation, they can determine their ability to
withstand economic shocks and ensure decisions are resilient enough to withstand changes
in the economy. Big data can be used to inform these models indicating employment shifts,
credit changes, recession factors and other behaviours which can lead to better decisions.

Source: CIMA

Summary
The budget is an important management technique that leads to advantages of planning,
coordination, control and motivation. These advantages can only be realised if the budgetary
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control system is operated with appropriate consideration for the employees whose work is
planned and monitored by the system. The fixed budget is a planning device, but must be
flexed to disclose the planned cost of actual activity if a meaningful comparison with actual
cost is to be made. Variances arising from this comparison focus management’s attention
on those aspects of the organisation which are not performing according to plan, so that
remedial action can be taken. The chapter concludes with an introduction to data analytics,
which is becoming the most important means of identifying the business drivers of the
organisation and therefore a major influence on its financial outcome.

Cost and Management Accounting

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Key concepts
Activity-based budgeting (ABB) is a method of budgeting for activities or cost pools
that utilises cost driver data in the budget-setting and variance feedback processes.
Big data is a term used to describe extremely large collections of data that may be
analysed to reveal patterns and trends, especially relating to human behaviour.
Feedback control occurs where actual outputs are monitored against desired outputs
and corrective action is taken where there is a variance between the two.
Feed-forward control occurs when predictions are made about future outputs and
compared to desired outputs and action is taken where there is a difference between
the two.
Fixed budgets are budgets that contain cost and revenue information for a single activity
level that was originally planned.
Flexible budget is a detailed plan for controlling costs, drawn up for a range of activity
levels.
Management by exception is a system where management’s attention is focused on
problem areas, that is, any significant deviations from the plan, rather than spending
time on other areas of responsibility that are proceeding according to plan.
Performance report is produced to monitor performance where actual costs are
compared to the flexible budget for the actual level of activity, and not the budget for the
planned level of activity.
Periodic budget is prepared where the costs and revenues are shown for one period of
time, for example a year, and is updated on an annual basis. As the year goes by, the
period for which the budget is available will shorten until the budget for the next year is
prepared.
Responsibility accounting is the term used to describe the practice of holding managers
responsible for the performance of their areas.
Rolling budgets is a method of budgeting where a budget can be continuously updated
by adding a further accounting period, that is, another month or quarter, when the
earliest accounting period has expired.
Zero-based budgeting (ZBB) is an alternative approach to budgeting where the budget
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process starts from scratch, that is, zero, first requiring that each unit requesting an
appropriation justifies the existence of the cost item and the benefits the expenditure
brings.

Budgets

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Test-yourself solutions
Test yourself 10.1
The following section provides the step-by-step budget, in the correct order in which it needs
to be prepared. Since everything depends on the number of sales units, sales can be termed
as the key or principal factor and is therefore the first one to be prepared.

Sales budget for the year ended 31 December 20X1

Product Ara Dara Total
Sales volume (units) 2 500 500
Selling price R91.00 R80.50
Sales revenue R227 500 R40 250 R267 750

Production budget (units) for the year ended 31 December 20X1

Ara Dara
Required for sales 2 500 500
Required closing inventory 75 75
2 575 575
Less expected opening inventory 500 100
Production required 2 075 475

The usage of raw materials by the two products is calculated as follows:

Raw material usage for the year ended 31 December 20X1
Material 1 (units) Material 2 (units)
Required for Ara 12 450 6 225
Required for Dara 2 850 1 900
For example: Ara usage of Material 1 = 2 075 units × 6 = 12 450 and Ara usage of
Material 2 = 2 075 units × 3 = 6 225

The cost of raw material purchases will be as follows:

Raw material purchases for the year ended 31 December 20X1
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Material 1 Material 2
(units) (units)
Raw materials required for production 15 300 8 125
(units)
Required closing inventory 2 000 1 000
17 300 9 125
Less expected opening inventory 1 500 2 000
Quantity to be purchased 15 800 7 125
Price per unit R1.00 R1.50
Purchase cost R15 800.00 R10 687.50 R26 487.50

Cost and Management Accounting

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Direct labour budget for the year ended 31 December 20X1

Labour hours Rate per hour Labour cost

Ara (2 075 units) 7 262.5 R5.00 R36 312.50

Dara (475 units) 2 375.0 R5.00 R11 875.00
9 637.5 R48 187.50

To calculate the production cost of the products, we first need to calculate the overhead rate:
Overheads absorbed by Ara = 7 262.5 × R10.3761 = R75 356.43
Overheads absorbed by Dara = 2 375 × R10.3761 = R24 643.24
Production cost budget for the year ended 31 December 20X1
Ara Dara

R R

Direct materials
Material 1 12 450.00 2 850.00
Material 2 9 337.50 2 850.00
Direct labour 36 312.50 11 875.00
Production overheads 75 356.43 24 643.24
Total production cost 133 456.43 42 218.24

Cost per unit R64.32 R88.88

The cash budget will look as follows:

Cash budget for the year ended 31 December 20X1
1 2 3 4
R R R R
Opening balance 5 000 22 000 33 950 11 950

Receipts 55 000 56 000 59 500 84 000

Payments
Materials 5 500 9 250 10 000 15 000
Direct wages 7 500 9 800 6 500 9 700
Overheads 22 500 25 000 35 000 32 500
Taxation 2 500
Machine purchase 30 000
Total payments 38 000 44 050 81 500 57 200

Net cash inflow/(outflow) 17 000 11 950 –22 000 26 800

Closing balance 22 000 33 950 11 950 38 750

Budgets

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The budgeted statement of comprehensive income:

Budgeted statement of comprehensive income for the year ended 31 December 20X1
R
Sales 267 750.00
Cost of sales 177 185.24
Opening inventory of raw materials 10 000.00
Purchases of raw materials 26 487.50
Closing inventory of raw materials 3 500.00
Direct wages 48 187.50
Production overheads 100 000.00
Production cost of goods completed 181 175.00
Opening inventory of finished goods 7 500.00
Closing inventory of finished goods 11 489.76
Gross profit 90 564.76
Selling and administrative expenses 37 500.00
Net profit before tax 53 064.76
Tax 15 919.43
Net profit after tax 37 145.33
Retained earnings b/f 40 500.00
Retained earnings c/f 77 645.33
(1)
Material 1 (2 000 units × R1.00) 2 000.00
Material 2 (1 000 units × R1.50) 1 500.00
3 500.00

(2)
Ara (75 units × R64.32) 4 823.73
Dara (75 units × R88.88) 6 666.04
11 489.76

The budgeted statement of financial position:

Statement of financial position on 31 December 20X1
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R Notes
ASSETS
Non-current assets 427 500.00
Land 250 000.00
Property, plant and equipment 177 500.00 3

Current assets 79 489.76

Raw materials inventory 3 500.00
Finished goods inventory 11 489.76
Receivables 25 750.00 4
Cash 38 750.00

506 989.76

Cost and Management Accounting

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355

EQUITY AND LIABILITIES

Equity 477 645.33
Share capital 400 000.00
Retained earnings 77 645.33

Current liabilities 29 344.43

Payables 13 425.00 5
Taxation 15 919.43

506 989.76

Notes
(3)
Opening balance for PPE 162 500.00
Purchases during the year 30 000.00
Depreciation during the year:
Production related 12 500.00
Selling and administrative related 2 500.00
Closing balance for PPE 177 500.00

(4)
Opening balance for receivables 12 500.00
Sales during the year 267 750.00
Receipts as per the cash budget 254 500.00
25 750.00

(5)
Opening balance for payables 4 500.00
Material purchases 26 487.50
Overheads (excluding depreciation):
Production 87 500.00
Selling and administration 35 000.00
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Wages incurred 48 187.50

201 675.00
Less payments made (from cash budget):
Materials 39 750.00
Overheads 115 000.00
Wages 33 500.00
13 425.00

Budgets

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Test yourself 10.2

(a) Flexible budget for overheads
Cost per unit Units
5 000 10 000 15 000
R R R R
Variable overhead costs:
Maintenance 0.60 3 000 6 000 9 000
Indirect materials 1.40 7 000 14 000 21 000
Utilities 1.00 5 000 10 000 15 000
Total variable costs 3.00 15 000 30 000 45 000
Fixed overhead costs:
Depreciation 40 000 40 000 40 000
Supervision 50 000 50 000 50 000
Insurance 10 000 10 000 10 000
Total fixed overhead costs 100 000 100 000 100 000
Total overhead costs 115 000 130 000 145 000

(b) Overhead performance report

Overhead performance report
Cost per Actual costs Budget Variance
unit 8 000 8 000
units units
R R R R
Variable overhead costs:
Maintenance 0.60 4 500 4 800 300 (F)
Indirect materials 1.40 12 000 11 200 800 (A)
Utilities 1.00 9 500 8 000 1 500 (A)
Total variable costs 3.00 26 000 24 000 2 000 (A)
Fixed overhead costs:
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Depreciation 40 000 40 000 −

Supervision 49 000 50 000 1 000 (F)
Insurance 10 000 10 000 −
Total fixed overhead costs 99 000 100 000 1 000 (F)
Total overhead costs 125 000 124 000 1 000 (A)

Cost and Management Accounting

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Review questions
10.1 Define a budget.
10.2 Describe the purpose of budgeting.
10.3 Explain how a budget can be used for performance evaluation as well as to
provide incentives.
10.4 Describe the functions of the budget committee.
10.5 What do you understand by the term ‘management by exception’?
10.6 Explain what responsibility accounting is.
10.7 Why is participative budgeting regarded as an effective management tool?
10.8 Describe the budget process.
10.9 Why is the sales budget one of the most important budgets?
10.10 What is a master budget?
10.11 What purpose does a cash budget serve?
10.12 How does zero-based budgeting differ from traditional budgeting?
10.13 Describe the different stages in implementing zero-based budgeting.

Exercises
10.1 JS has decided to import T-shirts from India and print them with a logo to
commemorate a major international sporting event. The commemorative
T-shirts will be sold for R10 each and predicted sales are as follows:
July 9 000 T-shirts
August 18 000 T-shirts
September 22 500 T-shirts

One-third of sales will be for cash. The remainder will be on credit with the
customer paying the month after sale. The T-shirts will cost R6 each and will
be purchased in the month prior to sale. It is expected that 10% of the T-shirts
purchased will be damaged during the printing process and will not be suitable
for sale. The supplier has offered two months’ credit. To print the T-shirts with
the logo of the sporting event will require the purchase of a machine costing
R30 000. The machine will be bought at the start of the project and paid
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for in August. The machine will have a five-year useful life, but no expected
residual value. The machine will be used elsewhere in the business at the end of
this project.
Expenses, excluding advertising, of R20 000 per month will be incurred each
month and paid in the month incurred. Advertising costs of R5 000 per month
will be incurred in each of the months of July, August and September, and will
be paid one month in arrears.

Required:
(a) Produce a cash budget for the project for each of the three months: July,
August and September.
(b) Explain why it is important for a business to prepare a cash budget.

Budgets

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(c) State three ways, other than borrowing, of improving the cash flow position
of a business.
Source: CIMA (adapted)
10.2 AB Ltd uses a top–down approach to budgeting. Budgets are imposed by senior
management and budget holders are not given the opportunity to participate
in the budget setting process.
The following table gives the operational and master budget of AB Ltd:

The budgeted statement of financial position as at 1 March 20X1

ASSETS R R
Non-current assets 565 100
Property, plant and equipment 666 000
Accumulated depreciation 100 900
Current assets 39 820
Inventory of raw materials (100 units) 4 500
Inventory of finished goods (110 units) 10 450
Trade receivables (January R7 680, February R10 400) 18 080
Cash and cash equivalents 6 790
Total assets 604 920

EQUITY AND LIABILITIES

Equity 601 020
Share capital 560 180
Retained earnings 40 840
Current liabilities 3 900
Trade and other payables 3 900
Total equity and liabilities 604 920

The estimates for the next four-month period

March April May June
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Sales (units) 80 84 96 94
Closing inventory (units):
Finished goods 100 91 85 81
Raw material 110 115 110 105

Purchases of raw materials (units) 80 80 85 85

Selling and administration R1 200 R1 200 R1 200 R1 200

The current selling price for the product is R209, but the company intends to sell
each unit for R10 more and has estimated that it will have to pay R45 per unit
for raw materials. One unit of raw material is needed for each unit of finished

Cost and Management Accounting

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359

product. Unskilled and casual labourers were employed for this period as many
of the staff will be going for training. They will be remunerated at R15 per hour,
and it has further been determined that 2 hours will be required for each unit
of finished product. Overheads are based on labour hours, and an overhead
rate of R17.50 has been predetermined. (This rate includes cash items only.)
All sales and purchases of raw materials are on credit. Debtors are allowed
two months’ credit, and suppliers of raw materials are paid after one month’s
credit. The wages, manufacturing overheads and selling and administration
costs are paid in the month in which they are incurred. Cash raised from Absa
Bank, using land and buildings as security, amounted to R120 000 at an interest
rate of 7.5%, due to be received on 1 May. Machinery costing R112 000 will be
received in May and paid for in June. The loan interest is payable half-yearly
from September onwards. An interim dividend to 31 March of R12 500 will
be paid in June. Depreciation for the four months is R19 233. Tax is charged
at 28%.

Required:
(a) Prepare the following budgets:
(i) Sales budget per month from March to June
(ii) Production budget per month from March to June
(iii) Materials usage and purchases budget per month from March to June
(iv) Direct labour budget per month from March to June
(v) Finished goods inventory budget
(vi) Cash budget per month from March to June
(vii) Budgeted statement of comprehensive income for the four months
ending 30 June
(viii) Budgeted statement of financial position as at 30 June.
(b) Explain the pros and cons to the company of using this top–down budgeting
approach.
Source: CIMA (adapted)
10.3 A company produces two products, A1 and A2, that are sold to retailers. The
budgeted sales volumes for the next quarter are as follows:
Product Units
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A1 32 000
A2 56 000

The inventory of finished goods is budgeted to increase by 1 000 units of A1

and decrease by 2 000 units of A2 by the end of the quarter. Materials B3 and
B4 are used in the production of both products. The quantities required of each
material to produce one unit of the finished product and the purchase prices
are shown in the following table:

Budgets

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B3 B4
A1 8 kg 4 kg
A2 4 kg 3 kg
Purchase price per kg R1.25 R1.80
Budgeted opening inventory 30 000 kg 20 000 kg

The company plans to hold inventory of raw materials, at the end of the quarter,
of 5% of the quarter’s material usage budget.
Required:
(a) Prepare the following budgets for the quarter:
(i) The production budget (in units)
(ii) The material usage budget (in kg)
(iii) The material purchases budget (in kg and R).
(b) Explain the different purposes of budgeting and how they may conflict with
each other.
Source: CIMA (adapted)
10.4 Shiloh Ltd commenced business on 1 January 20X1 in the Gauteng region to
manufacture and wholesale several lines of luggage. Each luggage line consists
of various pieces and sizes. They also manufacture luggage for large retail
companies according to client specifications. The following transactions are
expected during the first six-month period:
● In order to raise capital, management decided to issue 150 000 ordinary R1
shares for cash on 1 January, as well as take a long-term loan of R50 000 at
12% interest on 1 May.
● Sales volume was expected to be 44 units in January, 33 units in February, 57
units in March, 69 units in April, and increase by 4 units per month thereafter.
Each unit is expected to sell at R2 500. Cash sales were expected to be
R20 000 in January, R40 000 for each of the next three months, and R60 000
per month thereafter. Sixty per cent of credit customers were expected to
pay after one month for a cash discount of 2.5%. The remaining customers
will pay after three months, but 10% of them are expected to be bad debts.
● Purchases of material are planned at R90 000 in January and R64 000 in
Copyright © 2021. Juta & Company, Limited. All rights reserved.

February, increasing at R8 000 per month thereafter, with two months’

credit allowed. The closing stock will be R60 000.
● Wages and salaries will cost R38 000 per month for January, February and
March. Thereafter it will increase to R45 000 per month. Tax deductions
of 15% of labour cost will be paid to SARS one month after the deduction.
● Additional premises that cost R30 000 per annum will be rented and paid
for quarterly in advance.
● Building and equipment insurance is R25 000 for the year, payable in January.
● Rates are R40 000 for the year, paid semi-annually in March and September.
● Administration costs are R8 000 per month, paid one month in arrears.
● The launch advertising will cost R20 000. Selling costs of R5 000 per month
will be incurred, thereafter decreasing to R2 000 per month in May and June.
The launch advertising and selling costs are paid one month in arrears.

Cost and Management Accounting

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● A plant costing R100 000 will be purchased in January in the Limpopo

province and paid for in that month, net of 15% retention which will be
released in May. This plant is to be depreciated over a ten-year lifespan with
no scrap value. Additional premises will be purchased in June for R40 000.
● Overdraft interest will cost 15% per annum on the overdrawn balance at
each month end. There is no interest on cash surpluses.

Required:
(a) Using the above information, prepare the following:
(i) Cash budget for the six months from January until June
(ii) Budgeted income statement for the six months ending 30 June 20X1
(iii) Budgeted balance sheet as at 30 June 20X1
(b) Shiloh Ltd presently operates a top–down budgeting system where senior
managers impose budgets on departmental managers. It is now considering
allowing departmental managers to participate in the setting of their
own budgets. Explain the arguments for and against the participation of
departmental managers in the preparation of their budgets.
Round off all calculations to the nearest whole number.
10.5 A firm of attorneys is using budgetary control during 2010. The senior partner
estimated the demand for the year for each of the firm’s four divisions, that
is, civil, criminal, corporate, and property. A separate partner is responsible
for each division. Each divisional partner prepared a cost budget based on
the senior partner’s demand estimate for the division. These budgets were
then submitted to the senior partner for his approval. He amended them
as he thought appropriate before issuing each divisional partner with the
final budget for the division. He did not discuss these amendments with the
respective divisional partners. Actual performance was then measured against
the final budgets for each month, and each divisional partner’s performance
was appraised by asking the divisional partner to explain the reasons for any
variances that occurred. The corporate partner has been asked to explain why
her staff costs exceeded the budgeted costs for last month, while the chargeable
time was less than budgeted. Her reply: ‘My own original estimate of staff costs
was higher than the final budgeted costs shown on my divisional performance
report. In my own cost budget, I allowed for time to be spent developing new
Copyright © 2021. Juta & Company, Limited. All rights reserved.

services for the firm’s corporate clients and improving the clients’ access to their
own case files. This would improve the quality of our services to clients and
therefore increase client satisfaction. The trouble with our present system is
that it focuses on financial performance and ignores the other performance
indicators found in modern performance management systems.’

Required:
(a) Discuss the present budgeting system and its likely effect on divisional
partner motivation.
(b) Explain two non-financial performance indicators (other than client
satisfaction and service quality) that could be used by the firm.
Source: CIMA (adapted)

Budgets

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10.6 DW, a plastic manufacturing company, operates three divisions. Each division
has a manager who reports directly to the operations director. For many years
the divisional managers have been asked by the operations director to prepare
a budget for their division as part of the company’s annual budgeting process.
A new division manager has been appointed to the southern region and he has
concerns about the validity of these annual budgets. He argues that they soon
become out of date as operational circumstances change. At a recent manager’s
meeting he said, ‘They are restrictive. They do not permit the divisional managers
to make decisions in response to operational changes, or change working
practices for next year until that year’s budget has been approved.’ In one of
the divisions, two products, Ace and Base, are manufactured. The financial
manager of the division provides the following information:
Material prices: Material E R3 per unit
Material O R5 per unit

Direct labour amounts to R10 per hour.

The estimated production overhead is R400 000, including R25 000 for depre-
ciation. Production overhead is absorbed on the basis of direct labour hours.
The material and labour requirements for the products are:
Ace Base
Material E 16 units 15 units
Material O 13 units 14 units
Direct labour 3 hours 5 hours

The sales director is of the opinion that the sales department will sell 12 500
units of Ace and 5 500 units of Base. Ace sells for R190.00 and Base for R160.00.
There will be 1 500 units of Ace and 1 100 units of Base in the storeroom at
the start of the year. At the end of the year a required number of 1 175 units
of Ace and 1 175 units of Base need to be in the storeroom. The production
manager indicates that there will be 11 500 units of Material E and 10 500 units
of Material O in the storeroom at the start of the period. At the end of the year
a required number of 12 000 units of Material E and 11 000 units of Material O
must be in the storeroom. The selling and administration budget is R137 500,
including R12 500 for depreciation. A tax rate of 30% is payable. A cash payment
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of tax owed from the previous period will be paid in Quarter 1.

A partial quarterly cash flow statement has been prepared already:
Quarter 1 2 3 4
R R R R
Receipts 790 000 810 000 825 000 775 000
Payments
Material 450 000 475 000 481 000 528 000
Direct wages 161 000 161 000 161 000 161 000
Overhead 91 000 98 000 101 000 95 000
Taxation 12 500
Machinery purchase 130 000

Cost and Management Accounting

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The organisation’s statement of financial position at the start of the period will
be as follows:
ASSETS
Non-current assets 558 000
Land 400 000
Property, plant and equipment 158 000

Current assets 544 600

Raw material inventory 50 000
Finished goods inventory 450 000
Receivables 26 600
Cash 18 000
1 102 600
EQUITY AND LIABILITIES
Equity 1 074 300
Share capital 400 000
Retained earnings 674 300

Current liabilities 28 300

Payables 15 800
Taxation 12 500
1 102 600

Required:
(a) Prepare the master budget, including a cash budget and the budgeted
financial statements for the period 1 January to 31 December 20X1.
(b) Explain the differences between the above annual budgeting system and a
rolling budget system.
(c) Discuss how the southern region’s division manager could use a rolling
budget system to address his concerns.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

10.7 HFSC Ltd is a retail company that operates five stores. Each store has a manager
and there is also a general manager who reports directly to the board of directors
of the company. For many years the general manager has set the budgets for
each store and the store managers’ performances have been measured against
their respective budgets even though they did not actively participate in the
preparation thereof. If a store manager meets his budgeted target then he is
financially rewarded for his performance. The company has recently appointed
a new finance director who has questioned this previous practice and suggested
that each store manager should be involved in the preparation of their own
budget. The general manager is very concerned about this. She thinks that the
store managers will overstate their costs and resource requirements in order to
make it easier for them to achieve their budget targets.

Budgets

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Zeus Tronics, one of the five stores, used the services of an agency to secure
a contract with Danville High School to be the exclusive supplier of tablets, a
wireless, portable personal computer, to learners in the next academic year,
1 January 20X1 until 31 December 20X1. The school can accommodate 2 000
learners. E-textbooks as well as other learning materials will be provided on
1 November 20X0 to Zeus Tronics, who will pre-load all learning materials for
the following academic year onto the tablet. It will be compulsory for learners
to acquire these tablets and learners must be enrolled at school to qualify
for the purchase of a tablet with the school’s learning content. Tablet sales
transactions will occur directly between learners and Zeus Tronics. All tablets
will, however, be delivered to the school, who will give them to the respective
learners. Learners could pay for the tablets in full in advance during December
20X0, at a discount of 5%. The normal selling price is R9 500 per tablet. Tablets
which are paid for in advance will be delivered to the school in January 20X1.
Based on the information of 2 000 registration forms, 10% of learners will pay
for their tablets in advance by 31 December 20X0. Fifty per cent (50%) would
buy theirs on 15 January 20X1. The rest, namely 40%, would buy theirs on 1
February 20X1. Except for tablets that are paid for in advance by 31 December
20X0, all tablet sales will occur on credit.
Learners who did not pay for their tablets in advance by 31 December 20X0, will
settle their accounts as follows:
– 10% by the end of the month in which the sale occurred
– 60% by the end of the month following the month of sale
– 30% by the end of two months following the month of sale.
Zeus Tronics is required by its supplier to pay for purchases on placement of an
order. The supplier has, however, agreed to accept a 50% deposit when orders
for the tablets are placed, provided that the remaining amount is settled by the
end of the month after the month in which the order was placed.
Additional information:
1. Tablets that were paid for in advance, as well as those that will be sold to
learners on 15 January 20X1, will be purchased by Zeus Tronics during the
course of December 20X0. Tablets anticipated to be sold on 1 February
20X1 will be purchased during the course of January 20X1.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

2. The company’s gross profit margin on the tablets amounts to 40%, based
on the selling price (before any discount).
3. Sales commission of 7.5%, which does not form part of cost of sales, is payable
at the end of the month of sale to the marketing agency who concluded the
deal with the school on behalf of Zeus Tronics. Commission will be based
on the normal selling price of a tablet, irrespective of any discount granted.
Tablets that were paid in advance will be considered sold in January 20X1.
4. Sales to regular customers of Zeus Tronics renders, on average, a gross
profit of R80 000 per month. No inventories are maintained in respect of
these sales and sales transactions occur strictly in cash.
5. Monthly expenses, which are not included in any amount referred to above,
amount to R120 000. Depreciation of R30 000 is included in this amount.

Cost and Management Accounting

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With the exception of depreciation, all expenses are paid for in cash at the
end of each month.
6. The projected positive bank balance of Zeus Tronics at 1 December 20X0
amounts to R8 000. The company does not have other cash reserves or any
credit facilities.
Required:
(a) Calculate the projected cash inflow per month for Zeus Tronics that will
result from tablet sales to learners with regard to the 20X1 academic year –
this would include cash inflow in December 20X0.
(b) Calculate the projected cash outflow per month for Zeus Tronics only
in respect of tablet purchases from its supplier with regard to the 20X1
academic year – this would include cash outflow in December 20X0. (Sales
commission, payable to the marketing agency, must be excluded.)
(c) Compile a cash budget for Zeus Tronics for each month during the period
1 December 20X0 until 30 April 20X1. Transfer the values obtained in (a)
and (b) above to these budgets.
(d) Determine whether Zeus Tronics will be able to meet its financial obligations at
the end of each month during the period 1 December 20X0 to 30 April 20X1.
(e) Briefly comment on the liquidity position of the company.
(f) Explain the problems that could arise, for planning and decision-making
purposes within HFSC Ltd, if the store managers did overstate their
budgeted costs and resource requirements.
(g) Discuss the behavioural issues that could arise if excess costs and resources
are removed from the store managers’ budgets.
Source: CIMA (adapted)
10.8 Cartoon Ltd is preparing its cash budget for the next three quarters. The
following data has been extracted from the operational budgets:

Sales revenue Quarter 1 R500 000

Quarter 2 R450 000
Quarter 3 R480 000
Direct material purchases Quarter 1 R138 000
Quarter 2 R151 200
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Quarter 3 R115 600

Additional information:
1. Cartoon Ltd sells 20% of its goods for cash. Of the remaining sales value,
70% is received within the same quarter as sale, and 30% is received in the
following quarter. It is estimated that trade receivables will be R125 000 at
the beginning of Quarter 1. No bad debts are anticipated.
2. Fifty per cent (50%) of payments for direct material purchases are made in the
quarter of purchase, with the remaining 50% in the quarter following purchase.
It is estimated that the amount owing for direct material purchases will be
R60 000 at the beginning of Quarter 1.
3. Cartoon Ltd pays labour and overhead costs when they are incurred. It has
been estimated that labour and overhead costs in total will be R303 600 per
quarter. This figure includes depreciation of R19 600.

Budgets

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366

4. Cartoon Ltd expects to repay a loan of R100 000 in Quarter 3.

5. The cash balance at the beginning of Quarter 1 is estimated to be R49 400
positive.

Required:
(a) Prepare a cash budget for each of the three quarters.
(b) Cartoon Ltd is preparing the production budget for Product R and the
material purchases budget for Material T for next year. Each unit of Product
R requires 6 kg of Material T. The estimated inventory at the beginning of
next year for Product R is 6 000 units, and the company wants to decrease
the inventory held by 10% by the end of next year.
The estimated inventory at the beginning of next year for Material T is
60 000 kg, and due to problems with the material supplier, the closing
inventory at the end of next year is to be increased to 75 000 kg.
The budgeted sales of Product R for next year are 80 000 units.
(i) Calculate the production budget for Product R for next year.
(ii) Calculate the material purchases budget for Material T for next year.

Source: CIMA (adapted)

10.9 PMB Ltd is planning to purchase a manufacturing business for R315 000 in
the near future. This price will include goodwill (R150 000), equipment and
fittings (R120 000), and stock of raw materials and finished goods (R45 000).
A delivery van will be purchased for R15 000 as soon as the business purchase is
completed. The delivery van will be paid for in the second month of operations.
The following forecasts have been made for the business following purchase:
● Sales (before discounts) of the business’s single product, at a mark-up of
60% on production cost, will be:
Month R
1 96 000
2 96 000
3 92 000
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4 96 000
5 100 000
6 104 000

Twenty-five per cent (25%) of sales will be for cash, the remainder will be on
credit, for settlement in the month following that of sale. A discount of 10% will
be given to selected credit customers, who represent 25% of gross sales.
● Production cost will be R5.00 per unit. The production cost will be made
up of:
Raw materials R2.50
Direct labour R1.50
Fixed overhead R1.00

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367

● Production will be arranged such that closing stock at the end of any month
is sufficient to meet sales requirements in the following month. A value
of R30 000 is placed on the stock of finished goods which was acquired
on purchase of the business. This valuation is based on the forecast of
production cost per unit given above.
● The single raw material will be purchased so that stock at the end of a month
is sufficient to meet half of the following month’s production requirements.
Raw material stock acquired on purchase of the business (R15 000) is valued
at the cost per unit, which is forecast as given above. Raw materials will be
purchased on one month’s credit.
● Costs of direct labour will be met as they are incurred in production.
● The fixed production overhead rate of R1.00 per unit is based on a forecast of
the first year’s production of 150 000 units. This rate includes depreciation
of equipment and fittings on a straight-line basis over the next five years.
● Selling and administration overheads are all fixed and will be R208 000 in
the first year. These overheads include depreciation of the delivery van at
30% per annum on a reducing balance basis. All fixed overheads will be
incurred on a regular basis, with the exception of rent and rates. In month 1
R25 000 is payable for the year ahead for rent and rates.
Required:
(a) Prepare a monthly cash budget. You should include the business purchase
and the first four months of operations following purchase.
(b) Calculate the stock, debtor, and creditor balances at the end of the four-
month period. Comment briefly on the liquidity situation.
10.10 TJ Limited is an industry sector which is recovering from the recent recession.
The directors of the company hope next year to be operating at 85% of capacity,
although currently the company is operating at only 65% of capacity. Sixty-
five per cent (65%) of capacity represents output of 10 000 units of the single
product which is produced and sold. One hundred direct workers are employed
on production for 200 000 hours in the current year. The flexed budgets for the
current year are given in the following table:

Capacity level 55% 65% 75%

R R R
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Direct materials 846 200 1 000 000 1 153 800

Direct wages 1 480 850 1 750 000 2 019 150
Production overhead 596 170 650 000 703 830
Selling and distribution overhead 192 310 200 000 207 690
Administration overhead 120 000 120 000 120 000
Total costs 3 235 530 3 720 000 4 204 470

2
Profit in any year is budgeted to be 16  __
3 % of sales.

Budgets

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368

The following percentage increases in costs are expected for next year:
Direct materials 6%
Direct wages 3%
Variable production overhead 7%
Variable selling and distribution overhead 7%
Fixed production overhead 10%
Fixed selling and distribution overhead 7.5%
Administration overhead 10%
Required:
(a) Prepare a flexible budget statement for next year on the assumption that
the company operates at 85% of capacity. Your statement should show
both contribution and profit.
(b) Discuss briefly three problems which may arise from the change in capacity
level.
(c) State who is likely to serve on a budget committee operated by TJ Limited,
and explain the purpose of such a committee.
Source: CIMA (adapted)
10.11 There is a continuing demand for three sub-assemblies, A, B, and C, made
and sold by MW Limited. Sales are in the ratios of A: 1, B: 2, C: 4, and selling
prices are A: R215, B: R250, C: R300. Each sub-assembly consists of a copper
frame onto which are fixed the same components but in different quantities,
as follows:
Sub-assembly Frame Component Component Component
D E F
A 1 5 1 4
B 1 1 7 5
C 1 3 5 1
Buying in costs per unit R20 R8 R5 R3

Operation times by labour for each sub-assembly are:

Sub-assembly Skilled hours Unskilled hours
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A 2 2
B 1.5 2
C 1.5 3

The skilled labour is paid R6 per hour, and unskilled labour is paid R4.50
per hour. The skilled labour is located in a machining department, and the
unskilled labour in an assembly department. A five-day week of 37.5 hours is
worked, and each accounting period is for four weeks. Variable overhead per
sub-assembly is A: R5, B: R4, and C: R3.50. At the end of the current year,
stocks are expected to be as shown in the following table, but because interest
rates have increased and the company utilises a bank overdraft for working
capital purposes, it is planned to effect a 10% reduction in all finished sub-
assemblies and bought-in stocks during Period 1 of the forthcoming year.

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369

Forecast stocks at current year end are:

Stock Quantity
Sub-assembly A 300
Sub-assembly B 700
Sub-assembly C 1 600
Copper frames 1 000
Component D 4 000
Component E 10 000
Component F 4 000

Work-in-progress stocks are to be ignored.

Overheads for the forthcoming year are budgeted to be as follows:
Production R728 000
Selling and distribution R364 000
Administration R338 000
These costs, all fixed, are expected to be incurred evenly throughout the year
and are treated as period costs.
Within Period 1, it is planned to sell one thirteenth of the annual requirements,
which are to be the sales necessary to achieve the company profit target of
R6.5 million before tax.

Required:
(a) Prepare budgets in respect of Period 1 of the forthcoming year for:
(i) Sales, in quantities and value
(ii) Production, in quantities only
(iii) Materials usage, in quantities
(iv) Materials purchases, in quantities and value
(v) Labour force budget, that is, numbers of people needed in each of the
machining department and the assembly department.
(b) Discuss the factors to be considered if the bought-in stocks were to
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be reduced to one week’s requirements. This has been proposed by the

purchasing officer but resisted by the production director.
Source: CIMA (adapted)
10.12 Wilmslow Ltd makes two products, the Alpha and the Beta. Both products use
the same material and labour, but in different amounts. The company divides
its year into four quarters of 12 weeks each. Each week consists of five days,
and each day comprises seven hours.
You are employed as the management accountant to Wilmslow Ltd, and you
originally prepared a budget for quarter 3, the 12 weeks to 17 September. The
basic data for that budget is reproduced in the following table.

Budgets

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370

Product Alpha Beta

Estimated demand 1 800 units 2 100 units
Material per unit 8 kilograms 12 kilograms
Labour per unit 3 hours 6 hours
Since the budget was prepared, three developments have taken place.
1. The company has begun to use linear regression and seasonal variations to
forecast sales demand. Because of this, the estimated demand for quarter
3 has been revised to 2 000 Alphas and 2 400 Betas.
2. As a result of the revised sales forecasting, you have developed more precise
estimates of sales and closing stock levels.
● The sales volume of both the Alpha and Beta in quarter 4 (the twelve
weeks ending 10 December) will be 20% more than in the revised budget
for quarter 3 as a result of seasonal variations.
● The closing stock of finished Alphas at the end of quarter 3 should
represent 5 days’ sales for quarter 4.
● The closing stock of finished Betas at the end of quarter 3 should
represent 10 days’ sales for quarter 4.
● Production in quarter 4 of both Alpha and Beta is planned to be 20%
more than in the revised budget for quarter 3. The closing stock of
materials at the end of quarter 3 should be sufficient for 20 days’
production in quarter 4.
3. New equipment has been installed. The workforce is not familiar with the
equipment. Because of this, for quarter 3, they will only be working at 80%
of the efficiency assumed in the original budgetary data.
Other data from your original budget, which has not changed, is as follows:
● 50 production employees work a 35-hour week and are each paid R210 per
week
● Overtime is paid at R9 per hour
● The cost of material is R10 per kilogram
● Opening stocks at the beginning of quarter 3 are as follows:
◆ Finished Alphas 500 units
◆ Finished Betas 600 units
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◆ Material 12 000 kilograms

● There will not be any work-in-progress at any time.

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371

Required:
The production director of Wilmslow Ltd wants to schedule production for
quarter 3 (the twelve weeks ending 17 September) and asks you to use the
revised information to prepare the following:
(a) The revised production budget for Alphas and Betas
(b) The material purchases budget in kilograms
(c) A statement showing the cost of the material purchases
(d) The labour budget in hours
(e) A statement showing the cost of labour.

Reference list
Tanaka, T. 1994. Kaizen budgeting: Toyota’s cost-control system under TQC. Journal of Cost
Management for the Manufacturing Industry, Fall: 56–62.
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Budgets

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11 Standard costing

Standard costing

Recording
Types of Setting Variance Variance
in a standard
standards standards analysis investigation
costing system

Material Labour Overhead Sales

variances variances variances variances

Learning objectives
After studying this chapter, you should be able to:
● Explain how standards are set
● Explain the different categories of standards
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● Compute material, labour, overhead and sales variances

● Identify the causes of the variances
● Distinguish between the variances recorded in a marginal costing system and an
absorption costing system
● Prepare a set of accounts in a standard costing system
● Prepare a performance report.

Introduction
As the organisation expands and the economic environment grows more complex, it
becomes increasingly difficult to weigh up the relative value of costs and profits. In practice,
predetermined costs, also referred to as standard costs, are widely used for direct and
indirect costs. Historical costs have no significance for management, especially for internal

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374

reporting. It is only when they have been compared with a norm (benchmark) that they
have any real meaning. Costs become effective tools in decision making and control when
their performance (actual results) is compared with the plan (budget) and deviations have
been explained, thereafter taking the necessary corrective measures. In this chapter we shall
examine the operation of a standard costing system. More specifically, we will be looking at
standard costs: what they are, how they are set, and how they are used as a basis for variance
analysis to monitor and control an organisation’s performance.

Standard costs
A standard is an established measurement that serves as a point of departure in computing
deviations from the norm. Standard cost is a predetermined planned cost of manufacturing
a unit during a specific period in the immediate future under current or anticipated
operating conditions. These predetermined standards provide a basis for planning, a target
for attainment and a benchmark against which actual costs and revenues can be compared.
Standard costs are not the same as budgeted costs. A budget relates to an entire operation,
whereas a standard presents the same information on a per unit basis. The term ‘standard
cost’ has different implications for different people depending on their attitude towards the
tightness with which standards are set. In case of significant deviations from the standard,
managers interrogate the discrepancies to find the problem area, thereafter seeking ways of
eliminating the problem. Management by exception is a process whereby the manager’s
attention is focused on the problem area. The approach of identifying and solving problems
is covered in variance analysis, discussed later in the chapter.

Types of standards
Standards can range all the way from absolute perfection to approximations, reflecting no more
than past experience. Standards can be classified into one of the following four categories:
1. Ideal standards are extremely tight standards which demand perfection. The ideal
standard represents the ultimate goal, but it expects an attainment that is impossible
to achieve over continuous periods. Standards set at ideal levels make no allowance for
inefficiencies such as wasted materials, spoilt units, idle time and inefficient workers.
Ideal standards can have a negative motivational impact when adverse variances arise,
as employees may feel that they have performed poorly. However, some managers
believe that such standards have a motivational value, as such standards are a constant
reminder of the need for ever-increasing efficiency and effort, even though employees
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know that they will rarely meet the standards. Ideal standards usually result in large
variances, which make it difficult to manage by exception.
2. Attainable standards are based on efficient operating conditions, but include allow-
ances for factors such as waste, losses and machine breakdowns. These standards are
viewed as being neither too easy to achieve nor too impossible to achieve. This type of
standard does not have the negative motivational impact that is usually the case in an
ideal standard, as it makes some allowances for unavoidable inefficiencies.
3. Basic standards are standards which remain unchanged over the long term. This
standard is retained as a minimum standard to show trends over time, and is also used
as a basis from which current standards can be set. Basic standards do not represent
current attainable standards, therefore they are seldom used.
4. Current standards are based on current performance levels and are set for use over the
short term. This type of standard does not encourage any attempt to improve on current

Cost and Management Accounting

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375

levels of efficiency. Current standards should be set when there is a temporary problem
to deal with that particular circumstance, for example unexpected price increases.

Case study: Toyota’s ideal standards

Toyota’s notion of the ideal is very pervasive and is essential in understanding the Toyota
production system. When the workers speak of ideal, they have a concrete definition in
mind, one that is consistent throughout the company. For Toyota’s workers, the output
of an ideal person, group of people, or machine is/can be:
● Defect free
● Supplied on demand in the version requested
● Produced without wasting any materials, labour, energy, or other resources
● Produced in a work environment which is physically, emotionally and professionally
safe for every employee.

Toyota’s ideal state shares many features of the popular notion of mass customisation,
which is the ability to create virtually infinite variations of a product as efficiently as
possible and at the lowest possible cost. Toyota’s ideal plant would indeed be one where
a customer could drive up to a shipping dock, ask for a customised product or service,
and get it immediately at the lowest possible price with zero defects.

Discussion questions:
1. What are the different standards that an organisation can set?
2. Which, in your opinion, is the most appropriate standard? Why?
3. Should Toyota change their standard setting? Why?
4. If a Toyota plant or worker falls short of the ideal, what do you think would be the
outcome?

Uses of standard costing

Standard costing is a control technique that compares actual costs and revenues with
predetermined standards and reports on variances. Some of the uses of standard cost or
standard costing systems are as follows:
● Standard costing aids in planning and controlling operations.
Standard costs are used for establishing budgets more speedily and reliably.
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● Standard costs provide a benchmark against which actual performance can be monitored.
● Standard costing facilitates action through management by exception. If variances
are large enough, then managers can focus their attention on those activities where
corrective action is most necessary.
● Standard costs can be used for controlling costs by motivating employees and measuring
efficiencies.
● The use of standard costs to record inventories stabilises the influence of fluctuating
input prices on inventory costs.
● Standards set goals and help develop cost-conscious attitudes.
● They promote possible cost reductions.
● Standards form the basis for establishing tender prices and for setting sales prices.

Standard costing

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376

Appropriateness of standard costing in a modern manufacturing environment

A standard costing system may not be considered appropriate in a modern manufacturing
environment for various reasons. In a just-in-time (JIT) environment, measuring standard
costing variances may encourage dysfunctional behaviour. A JIT production environment
relies on producing small batch sizes economically by reducing set-up times. Performance
measures that benefit from large batch sizes or producing for inventory should therefore be
avoided. In an advanced manufacturing technology (AMT) environment the major costs are
those related to the production facility rather than production volume related costs such
as materials and labour, which standard costing is essentially designed to plan and control.
Fixed overhead variances do not necessarily reflect under- or overspending but may simply
reflect differences in production volume. An activity-based cost management system may be
more appropriate, focusing on the activities that drive the cost. In a total quality environment,
standard costing variance measurement places an emphasis on cost control to the detriment
of quality. Cost control may be achieved at the expense of quality and competitive advantage.
A continuous improvement environment requires a continual effort to do things better rather
than achieve an arbitrary standard based on prescribed or assumed conditions. In today’s
competitive environment cost is market driven and is subject to considerable downward
pressure. Cost management must consist of both cost maintenance and continuous cost
improvement. In a JIT/AMT/TQM environment the workforce is usually organised into
empowered, multiskilled teams controlling operations autonomously.
The feedback they require is real time. Periodic financial reports are neither meaningful
nor timely enough to facilitate appropriate control action.

Source: CIMA (adapted)

Setting standards
The success of a standard costing system depends on the reliability, accuracy and acceptance
of the standards. The most effective standards are set on the basis of careful studies of
the product and operations using appropriate techniques and including participation by
those individuals whose performance is evaluated against the standards. Any manager
who plays an integral part in the operations should participate in the standards setting
process, as they will have greater confidence in their accuracy and be more committed to
meeting standards. Standards must be attainable and neither too easy nor too difficult, as
this will have a negative motivational impact on employees. When standards are too easy,
employees set their goals at this low level, thereby reducing productivity to a level below
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what is attainable. When standards are too high, employees feel that they are impossible to
attain and become frustrated − they will eventually ignore the standards. A standard cost
for a product is recorded on a standard cost card. The standard cost card contains details of
the standard quantity and price of each resource that will be utilised in manufacturing the
product or providing the service. A simple standard cost card is shown in Table 11.1.
Table 11.1 Standard cost card per unit
Materials: 4 metres @ R14 per metre R56.00
Direct labour: 8 hours @ R10 per hour 80.00
Variable overhead: 8 hours @ R8 per hour 64.00
Fixed overhead: 8 hours @ R12 per hour 96.00
Total standard cost per unit R296.00

Cost and Management Accounting

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377

As shown in the standard cost card, each resource to be used has a price and quantity. We
shall now look at some of the sources of information used in setting material, labour and
overhead standards.

Setting material standards

Material requirements of a product are based on technical and engineering specifications
in the form of a bill of materials. The standard quantity to be used includes allowances
to cover the processing losses that are an inevitable part of the manufacturing process.
The standard material price is supplied by the purchasing department after investigating
the sources of supply and selecting a vendor who can provide the required quantity at a
good price. The quality of material to be used and the economical quantities to purchase
in order to obtain quantity discounts must also be considered, as they will affect the price
to be paid. For internally manufactured components, the predetermined standard cost for
the component will be used as the standard price. The standard material cost is found by
multiplying the standard quantities by the standard price.

Setting labour standards

Standard labour time is established after studying each operation and process specifications.
Work study exercises are set up to determine the standard time to perform the required tasks
and the grades of labour to be employed to perform those tasks. Unavoidable delays are included
in the standard time. The effect of the learning curve on labour time must also be considered.
Once the standard time is established, the personnel department determines the wage rates for
the employees based on their grades of labour and skills. Bonus schemes are also considered as
well as any trade union negotiations in progress. The standard labour cost of an operation is
found by multiplying the standard hours allowed by the standard hourly rate for the operation.

Setting overhead standards

The predetermined overhead rates discussed in earlier chapters represent the standard
rates for overheads in each cost centre. The predetermined overhead rate per relevant cost
driver can be calculated, and then the rate is applied to that specific cost driver. In order to
achieve adequate control over overheads, they must be analysed into their fixed and variable
components, and then separate rates must be calculated for fixed production overheads and
variable production overheads.

Variance analysis
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Variance is the difference between predetermined standards and actual costs and revenues.
If the actual cost exceeds the standard cost, then the variance is adverse (unfavourable), as
the excess has an unfavourable effect on income. If the standard cost exceeds the actual
cost, then the variance is favourable, as it has a favourable effect on income. If revenues were
being compared, then the opposite would apply. Variance analysis is identical in principle
to that used in the chapter on budgets, except that the analysis of variances is more detailed.
It involves breaking down the total variance to explain how much of it is caused by the price
of resources and how much of it is caused by the usage of resources, being different from
the predetermined standard. All variances are similar in one respect, that is, each contains
a quantity and a price element. Figure 11.1 shows the breakdown of the operating profit
variance into the costs and revenue variances for an absorption costing system. When a
variable costing system is in use, the fixed overhead volume variance will not be calculated.

Standard costing

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Total sales variance
variances (not variance

Cost and Management Accounting

Accounting: Operations
presented further)

Figure 11.1 The variance structure

Total variable Total fixed
Total direct
Total direct production production Sales price Sales volume
material
labour variance overhead overhead variance variance
variance
variance variance

Variable Variable Fixed Fixed

Direct Direct Direct Sales
production production production production
material material Direct labour labour Sales mix quantity
overhead overhead overhead overhead
price usage rate variance efficiency variance (yield)
expenditure efficiency expenditure volume

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variance variance variance variance
variance variance variance variance

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Direct Direct Direct labour Direct labour Volume Volume
Calendar
material mix material yield idle time efficiency capacity efficiency
variance
variance variance variance variance variance variance

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379

Standards are separated into two categories: price and quantity. The reason being that
different managers are usually responsible for buying or for using inputs and these two
activities occur at different points in time. Figure 11.2 provides a general model for variance
analysis. These variances will be discussed in detail in Illustrative example 11.1.

Variance analysis

Price variance Quantity variance

Difference between Difference between

actual price and actual quantity and
standard price standard quantity

Actual quantity Actual quantity Standard quantity

× × ×
Actual price Standard price Standard price
− −

Price variance Quantity variance

(AQ × AP) − (AQ × SP) (AQ × SP) − (SQ × SP)

AQ = Actual quantity SP = Standard price

AP = Actual price SQ = Standard quantity

Figure 11.2 A general model for variance analysis

An illustration of variance analysis

The following example will illustrate most of the variances shown in Figure 11.1. Later in
the chapter, we shall use this example to illustrate the link between flexible budgets and
standard costing, as well as demonstrate how to record standard costs in the accounts.

Standard costing

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Illustrative example 11.1

Cami’s Beautiful Baskets, a basket manufacturing company, produces a variety of
baskets. One of the products is a wicker basket. The product requires a single operation.
The company uses an absorption costing system for internal profit measurement
purposes and also applies the just-in-time system. The standard cost for this operation
is presented in the following standard cost card:
R
Standard selling price 88.00
Standard cost per unit 77.00
Direct materials:
Wood: 1 m at R15 per metre 15.00
Willow: 2 m at R10 per metre 20.00
Direct labour (3 hours at R8 per hour) 24.00
Variable overhead (3 hours at R2 per hour) 6.00
Fixed overhead (3 hours at R4 per hour) 12.00
Standard profit per unit 11.00

Cami’s Beautiful Baskets plan to produce 8 000 units of the wicker basket for a craft
festival to be held in December when many tourists are expected. The budgeted costs
based on the information contained in the standard cost card are as follows:

Budget based on the above standard costs and an output of 8 000 units:
Sales (8 000 units at R88 per unit) R704 000
Less: Cost of sales R616 000
Direct materials:
Wood R120 000
Willow R160 000
Direct labour R192 000
Variable overhead R48 000
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Fixed overhead R96 000

Budgeted gross profit R88 000

Annual budgeted fixed overheads are R1 152 000 and are assumed to be incurred evenly
throughout the year.

The festival was a huge success and actual production and sales for the period were
9 000 units. Manufacturing overheads are charged to production on the basis of direct
labour hours. The actual results for December are:

➤➤

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Sales (9 000 units at R92) R828 000

Less: Cost of sales R740 100
Direct materials:
Wood: 10 100 m at R16 per metre R161 600
Willow: 19 000 m at R9 per metre R171 000
Direct labour (28 500 hours at R9 per hour) R256 500
Variable overhead R51 000
Fixed overhead R100 000
Actual gross profit R87 900

Required:
Prepare a complete variance analysis after reading the relevant sections below.

Direct material variances

In this section we will cover five variances. The total material variance shows the total
difference in the amount spent on materials − this can be split into a material price variance
and a material usage variance. The usage variance can be split into two further components
– material mix variance and a material yield variance.

Illustrative example 11.1 (cont.)

Table 11.2 Material variances
Material price variance = (SP − AP) × AQ purchased
Wood = (R15 − R16) × 10 100 m R10 100A
Willow = (R10 − R9) × 19 000 m R19 000F
R8 900F
Material usage variance = (SQ − AQ used) X SP
Wood = [(9 000 units × 1 m) − 10 100 m] × R15 R16 500A
Willow = [(9 000 units × 2 m) − 19 000 m] × R10 R10 000A
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R26 500A
Total material variance = SC − AC
= (9 000 × R35) − R332 600 R17 600A

Sub-variances of material usage

Sq
Material mix variance = [(AM × ___
 SM ) − AQ] × SP
1
Wood = [(29 100 ×  __3 ) − 10 100 m] × R15
= (9 700 − 10 100) × R15 R6 000A
2
Willow = [(29 100 ×  __
3 ) − 19 000 m] × R10
R4 000F
= (19 400 − 19 000) R10
R2 000A

➤➤

Standard costing

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Sq
Material yield variance = [SQ − (AM ×  ___
SM )]SP
1
Wood = [(9 000 units × 1 m) − (29 100 ×  __
3 )]R15
= (9 000 − 9 700)R15 10 500A
Willow
 23 )]R10
= [(9 000 units × 2 m) − (29 100 × __
= (18 000 − 19 400)R10 14 000A
24 500A
Material usage variance = Mix + Yield
= 2 000A + 24 500A 26 500A

Where:
AQ = Actual quantities
AP = Actual price paid
SP = Standard price
SQ = Standard quantity allowed (Actual units produced 3 standard quantity
per unit)
AM = Sum of actual quantities (19 000 + 10 100)
Sq = Standard quantity per unit
SM = Sum of the standard quantities per unit (1 + 2)
SC = Standard cost
AC = Actual cost
Table 11.3 Alternative layout: Material variances
Actual Std cost of Actual input in Std cost of actual
cost actual input std ratio @ std output
cost
Sq
AQ × AP >A <F AQ × SP >A <F ( ___
SM × AM)SP >A <F Actual units × SP/u
1
Wood: 10 100A 10 100 × 15 6 000A  __
3 × 29 100 × R15 10 500A 9 000 × 15
161 600 = 151 500 = 145 500 = 135 000
2
Willow: 19 000F 19 000 × 10 4 000F  __
3 × 29 100 × R10 14 000A 9 000 × 20
171 000 = 190 000 = 194 000 = 180 000
8 900F 2 000A 33 9400 24 500A
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Mix Yield
Material price 8 900F Material usage 26 500A

The total material variance is the difference between actual cost of material and the standard
material cost of actual production. Material price variance is the difference between actual
purchase price and the standard purchase price multiplied by the actual quantity of material
purchased or used. The material price variance can be calculated either at the time of purchase
or usage. A material purchase price variance is calculated if stock records are kept at standard
cost. Using actual quantity purchased will ensure that all the variance is eliminated as soon as
purchases are made and the stock will be held at standard cost. A material issue price variance
is calculated using the quantity of materials used in production if stock is valued at actual cost.

Cost and Management Accounting

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383

This will ensure that the variance is calculated and eliminated on each stock item as it is used,
and the remainder of stock will then be held at actual price until it is used and the price variance
is calculated. Material usage variance is the difference between the standard quantity of
material allowed for actual production and the actual quantity used, multiplied by the standard
price of material. The material usage variance measures the overall efficiency of raw material
consumption during a period in terms of the difference between the amount of materials which
should have been used and the actual usage of materials. Where more than one type of raw
material is used in a manufacturing process, these raw materials must be combined in a specific
proportion, thereby resulting in a mix and yield variance. These variances only arise when more
than one type of material is used to manufacture a product and the combination results in
different final output quantities. The fact that more than one material input is required to
produce the final product does not automatically require or imply a mix and yield variance.
Different proportions will inevitably affect the final output quantities and therefore the yield.
This is mostly the case for certain compositions, for example using more milk and fewer eggs
in a dough mixture results in different output quantities of acceptable dough.
Material mix variance shows the cost changes that result from combining quantities
of material in proportions different from standard. This variance is only suitable for
performance measurement and control where the proportion of inputs to the production
process can be altered without reducing the efficiency of the finished product. Therefore, it
may not be used in industries that require a high degree of precision in the input variables
such as in the pharmaceuticals sector. These variances are common in the textile, chemical
and food processing industries. A change in the material mix must also be analysed in the
context of other organisation-wide implications that may follow. Some of the effects of a
change in direct material mix include: a change in the quality, performance and durability
of the final product; the price offered by customers may vary as a result of a change in
perceived quality of the product; the workability of materials may be affected, which may
in turn affect labour efficiency. In Illustrative example 11.1, 10 100 m of the material wood
was placed into production, however, based on a total of 29 100 m input into production in
a standard ratio of 1:3, 9 700 m should have been placed into production. This has resulted
in an adverse mix variance of 6 000 for the material wood. An adverse material mix variance
suggests that a more costly combination of materials has been used than the standard
mix. The material willow has a favourable variance of 4 000 as 19 000 m were placed in
production, however, based on a total of 29 100 m input into production in a standard ratio
of 2:3, 19 400 m should have been placed into production. A favourable mix variance may be
the result of substituting expensive materials with cheaper materials.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Illustrative example 11.1 (cont.)

Material mix variance will be calculated as follows:
Step 1: Calculate the total consumption of raw materials
(10 100 + 19 000) = 29 100 m
Step 2: Calculate the actual usage in standard mix proportions
We need to calculate the quantity of each raw material which would have been consumed
had the total usage of raw materials (29 100 m) been based on the standard mix.
1*
Wood: 29 100 m ×  ___
3  = 9 700 m
2*
Willow: 29 100 m ×  ___
3  = 19 400 m
* Total quantity under Standard usage (1 + 2) = 3 m per basket ➤➤

Standard costing

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Note that the sum of the standard mix of raw materials calculated equals the actual
total consumption of 29 100 m. This is because in material mix variance, we are not
concerned about the efficiency of raw material consumption but rather their relevant
proportions.
Step 3: Calculate the material mix variance
= [Actual usage in standard mix (Step 2) − Actual usage] × Standard price
Wood: (9 700 − 10 100) × R15 = (R6 000) Adverse
Willow: (19 400 − 19 000) × R10 = R4 000 Favourable
Total material mix variance R2 000 Adverse
The material mix variance can be tabulated as follows:
Table 11.4 The material mix variance
Material Actual usage in Actual usage Difference Standard Mix variance
standard mix in actual in usage price (R) (R)
proportions proportions
(sq/sm × AM) (AQ)
1
Wood  __
3 × 29 100 = 9 700 10 100 (400) R15 R6 000A
Willow   23 × 29 100 = 19 400
__ 19 000 400 R10 R4 000F
29 100 R2 000A

Material yield variances arise if losses inherent in the manufacturing process produce a
yield of the finished output different from the material input. Simply put, it is a measure of
the difference in cost between output that should have been produced for the given level of
input and the level of output actually achieved during the period. A material yield variance
also indicates the extent to which raw materials have been used efficiently, after the effect of
the difference in standard mixture has been taken into account. A standard yield is set and
differences between the actual and standard are reported as yield variances. It is also used
in conjunction with the material mix variance to provide additional analysis of the material
usage variance. Material yield variance measures the effect on material cost of a change
in the production yield from the standard, therefore a favourable yield variance indicates
better productivity than the standard yield, resulting in lower material cost. On the other
hand, an adverse yield variance suggests lower production achieved during a period for the
Copyright © 2021. Juta & Company, Limited. All rights reserved.

given level of input, resulting in higher material cost.

The yield variance for wood is unfavourable as it cost R145 500 in terms of the material
placed into production (input), which resulted in an output from the production process
to the standard value of R135 000. The yield variance for willow is unfavourable as it cost
R194 000 in terms of the material placed into production (input), which resulted in an
output from the production process to the standard value of R180 000. The input mixture
used for both materials resulted in more wastage of input material or rejects of final
products, causing an adverse yield variance. An adverse materials yield variance suggests
lower production achieved during a period for the given level of input which may be caused
by the use of inferior quality input materials.

Cost and Management Accounting

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385

Illustrative example 11.1 (cont.)

Material yield variance will be calculated as follows:

Step 1 and 2: As per material mix variance

Step 3: Calculate the actual yield

The actual yield is the input allowed for actual output and this is calculated by multiplying
the actual units produced by the standard quantity per unit.
(Actual units × SQ per unit)
Wood: 9 000 units × 1 m = 9 000 m
Willow: 9 000 units × 2 m = 18 000 m

Step 4: Calculate the material yield variance

= [Actual yield − Actual usage in standard mix (Step 2)] × Standard price
Wood: (9 000 − 9 700 m) × R15 = (R10 500) Adverse
Willow: (18 000 − 19 400) × R10 = (R14 000) Adverse
Total material yield variance (R24 500) Adverse

Table 11.5 The material yield variance

Material Input allowed Actual usage in Difference Standard Yield
for actual output standard mix in yield price variance
(Actual yield) proportions (R) (R)
(Actual units × SQ (Std yield)
sq
per unit) (___
  sm × AM)
1
Wood 9 000 × 1 m = 9 000  __
3 × 29 100 = 9 700 (700) R15 R10 500A
2
Willow 9 000 × 2 m = 18 000  __
3 × 29 100 = 19 400 (1 400) R10 R14 000A
R24 500A

Causes of material price variances

● Paying a higher or lower price than planned due to a change in supplier or an unexpected
price by the current supplier
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● Buying a different quality, either a cheaper or more expensive grade of material than
planned
● Obtaining or losing quantity discounts by purchasing in larger or smaller quantities
● Unexpected buying costs, such as an increase in delivery charges.

Causes of material usage variances

● Using higher or lower quality of material could affect the wastage rate
● The skill of labourers used, for example unskilled workers may be inexperienced and
increase the wastage rate
● Changes in production methods or technology used
● Lack of proper production supervision or improved quality control
● Theft.

Standard costing

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Causes of material mix variances

● Substituting expensive materials with cheaper materials or vice versa.

Causes of material yield variances

● Use of inferior- or better-quality input materials. The input mixture used can result
in more spillage of input material or rejects of final products or better-quality final
products.

Test yourself 11.1

The budgeted statement of comprehensive income for one of the products of Camtec
Limited for January 20X1, a normal production month, is given in the table below.

Camtec Limited
Budgeted statement of comprehensive income for the year ended 31 January 20X1
Budget
Production (units) 10 000
R
Sales (10 000 units @ R50 per unit) 500 000
Less: Cost of sales 400 000
Opening inventory –
Production cost 400 000
Materials: 50 000
Sen (5 000 kg @ R3.00 per kg) 15 000
Cam (5 000 kg @ R7.00 per kg) 35 000
Labour:
Skilled (5 000 h @ R40.00 per hour) 200 000
Overheads: 150 000
Fixed 100 000
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Variable (5 000 × R10.00) 50 000

Less: Closing inventory –

Gross profit 100 000

The normal production capacity for the month, which is used to allocate overheads to
production, is 5 000 labour hours. Sales as well as production exceeded the budget, and
on 31 January 20X1 the following statement of comprehensive income for the month
given in the table was compiled.
➤➤

Cost and Management Accounting

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Camtec Limited
Budgeted statement of comprehensive income for the year ended 31 January 20X1
Budget
Production (units) 12 000
R
Sales (12 000 units @ R45 per unit) 540 000
Less: Cost of sales 480 000
Opening inventory –
Production cost 480 000
Materials: 56 000
Sen (8 000 kg @ R2.00 per kg) 16 000
Cam (5 000 kg @ R8.00 per kg) 40 000
Labour:
Skilled (6 000 h @ R43.15 per hour) 258 900
Overheads: 165 100
Fixed 90 100
Variable (6 000 × R12.50) 75 000

Less: Closing inventory –

Gross profit 60 000

There was no opening or closing inventory of materials at the beginning or end of

January 20X1.

Required:
Calculate all possible material variances.

Direct labour variances

In this section we will cover four variances. The total labour variance shows the impact of
any overall change in the amount spent on labour − it can be split into two variances, labour
rate variance and labour efficiency variance. A labour rate variance shows whether we are
paying more or less per hour than expected for labour. It is calculated as the difference
between the actual rate per hour and the standard rate per hour, multiplied by the actual
hours that were paid for. When there is idle time and it is recorded, an idle time variance
is calculated. A labour efficiency variance indicates whether we are using more or less
hours per unit than expected. It is calculated as the difference between the standard hours
allowed for actual production and the actual hours worked, multiplied by the standard rate
per hour. The labour efficiency variance measures the efficiency of the workforce during
the time that they are actively engaged in production. Situations might arise when there is
idle time, which occurs when labour is available for production, but is not engaged in active
production due to machine breakdowns, shortage of material, etc.

Standard costing

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Illustrative example 11.1 (cont.)

Table 11.6 Labour variances
Labour rate variance = (SR − AR) × AH
= (R8 − R9) 28 500 hours 5 28 500A
Labour efficiency variance = (SH − AH) × SR
= [(9 000 units × 3) − 28 500] R8 5 12 000A
Total labour variance = SC − AC
= (9 000 × R24) − R256 500 5 40 500A

Where:
AH = Actual hours
AR = Actual rate paid per hour
SR = Standard rate
SH = Standard hours allowed (Actual units produced 3 Standard hours per unit)
SC = Standard cost
AC = Actual cost
Table 11.7 Alternative layout: Labour variances
Actual cost Std cost of Std cost of actual
actual input output
AH × AR >A AH × SR >A Actual units × SR/u
28 500 × 9 28 500 × 8 9 000 × 24
= 256 500 28 500A = 228 000 12 000A = 216 000
Labour rate Labour efficiency

An idle time variance is the difference between the standard productive hours and the
actual productive hours, multiplied by the standard work hour rate. It occurs when there is
a difference between the hours paid for and the hours worked and an extra cost is caused
by this idle time. If there is no standard idle time set or if actual idle time is greater than
standard, then this variance will always be adverse as it represents money wasted. By
calculating an idle time variance, the accuracy of the labour efficiency variance is increased.
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At this stage, it is important to differentiate between clock hours and work hours (operating/
production hours). In practice, it is impossible for employees to work productively in the
production line or to deliver services for 100% of the time that they are at work. Time off is
allowed for lunch breaks, having meetings, planned maintenance, etc. Although employees
are remunerated for this time, it is not productive time. Clock hours refer to the time that
the workers are physically present at work and are usually recorded by swiping a personnel
card. Remuneration is based on the clock hours at the standard or actual rate paid per clock
hour. Productive hours refer to the time that the employee is productive which is usually
recorded on job cards.

Cost and Management Accounting

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389

Illustrative example 11.2

The following standards have been set for labour:
Labour rate R18 per clock hour
Required hours per unit 0.08 hours per unit
Idle time provision 20% of clock hours

The actual results were as follows:

Labour cost R14 960 for 880 clock hours
Actual output 10 000 units

Productive hours were 15% less than the hours clocked during the month.

Required:
Calculate all relevant labour variances and provide reasons for these variances.

Solution:
Labour rate variance
= (Standard wage rate per hour − Actual wage rate) × Actual labour hours worked
= [R18 − (R14 960 ÷ 880)] × 880
= (R18 − R17) × 880
= R880F

Idle time variance

= (Actual productive hours – Standard hours(1)) x Standard work hour rate(2)
= (880 − 15%) − (880 − 20%) × R18 ÷ (1 − 0.20)
= (748 − 704) hours × R22.50
= R990 F
(1)
Standard hours are the actual clock hours after allowing for the standard or normal allowed idle time
percentage, that is, clock hours × (1 − standard idle time %).
(2)
Standard work hour rate is the tariff adjusted for the standard (budgeted) idle time allowed.
Standard clock hour rate
Standard work hour rate 5 __________________
   
1 2 standard idle time % 
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The favourable idle time shows that although 20% is allowed for idle time, these workers
were only idle for 15%. They were working more, but not as efficient as expected. Possible
reasons could be unforeseen or unscheduled machine breakdowns/downtime or labour
disputes, such as strikes.

Labour efficiency variance

= (Standard quantity of labour hours for actual production − Actual labour hours) ×
Standard productive hour rate
= [(0,08 × (1 − 0.20) × 10 120) − (880 − 15%)] hours × [R18 ÷ (1 − 0.20)]
= [(0,064 × 10 000) − 748] hours × R22.50
= (640 − 748) hours × R22.50
= R2 430 adverse
➤➤

Standard costing

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Labour was cheaper than expected, but the efficiency variance indicates that the workers
were not as efficient as anticipated. The reason might be that less skilled workers with
less efficient working skills were used at a cheaper rate.

Note: When a question provides information on clock hours, productive hours and
standard hours, you should split the efficiency variance into an idle time variance and
an efficiency variance. The efficiency variance is now computed with the actual work/
productive hours and no longer with the actual clock hours. The standard clock hour
rate (rate paid to workers) should be converted to a standard work hour rate.

A mix and yield variance can also be calculated if different types of labour are used. It would
then be called the labour mix variance and the labour yield variance.

Causes of direct labour rate variances

● Using a single average rate for a department when several different rates exist for
individual workers
● Employing a different level of worker, that is, skilled or unskilled workers, resulting in
different rates than planned
● An unexpected increase in the rates of pay, for example unions have demanded an
increase in the rates.

Causes of direct labour efficiency variances

● Using labour that is more or less experienced than the standard, resulting in efficient or
inefficient labour time
● Lack of proper production supervision
● Improvements in efficiency, due to a learning effect being present amongst the workforce
● An improvement or deterioration in working conditions
● Unexpected time lost, due to production bottlenecks such as machine breakdowns and
shortages in resources
● The quality of materials, for example working with poor-quality materials can cause
time to be wasted
● Change in production methods or technology, for example a new machinery
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● Poor or incorrect production planning or scheduling.

Causes of direct labour idle time variances

● Machine breakdowns
● Shortage of work or materials.

Cost and Management Accounting

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391

Test yourself 11.2

Using the information on Camtec Limited in Test yourself 11.1, calculate all possible
direct labour variances.

Variable production overhead variances

In this section we will cover three variances. The total variable production overhead variance
shows the difference between the variable overhead actually used and the variable overhead
that should be used for actual production. This can be split into two variances: variable
overhead expenditure variances and variable overhead efficiency variances. These variances
can only be calculated in standard product costing. In service costing, only the total variable
overhead variance can be calculated.

Illustrative example 11.1 (cont.)

Table 11.8 Variable overhead variances
Rate/Spending variance = (SR − AR) × AH
51 000
= (R2 −  ______
28 500 ) 28 500 hours = R6 000F
Efficiency variance = (SH − AH) × SR
= [(9 000 units × 3) − 28 500] R2 = R3 000A
Total variable o/h variance = SC − AC
= (9 000 × R6) − R51 000 = R3 000F

Where:
AH = Actual hours
AR = Actual rate paid per hour
SR = Standard rate
SH = Standard hours allowed (Actual units produced 3 standard hours per unit)
SC = Standard cost
AC = Actual cost
Table 11.9 Alternative layout: Variable overhead variances
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Actual cost Std cost of Std cost of actual

actual input output
AH × AR <F AH × SR >A Actual units × SR/u
51 000 28 500 × 2 9 000 × 6
6 000F = 57 000 3 000A = 54 000
Variable overhead rate Variable overhead efficiency

Standard costing

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A total variable production overhead variance is calculated as the difference between

the actual cost of variable overheads and the standard variable overhead cost of actual
production. A variable overhead expenditure variance indicates the actual cost of any
change from the standard rate per hour, and whether we are paying more or less per hour
for variable overheads. It is calculated as the difference between the actual variable overhead
rate per hour and the standard variable overhead rate per hour, multiplied by the actual
hours that were paid for, or it is the difference between the actual variable overhead cost
and the standard variable overhead cost of actual hours worked. The hours refer to either
labour or machine hours, depending on the recovery basis chosen for variable overheads.
A variable overhead efficiency variance indicates whether we are using more or less
variable overheads per unit than expected. It is calculated as the difference between the
standard hours allowed for actual production and the actual hours worked, multiplied by
the standard variable overhead rate per hour.

Causes of variable production overhead rate variances

The causes of this variance are the efficient or inefficient use of the individual factory
overhead items.

Causes of variable production overhead efficiency variances

The causes are similar to a direct labour efficiency variance.

Test yourself 11.3

Using the information on Camtec Limited in Test yourself 11.1, calculate all possible
variable overhead variances.

Fixed production overhead variances

The variances to be calculated in this section depend on whether the organisation is using
an absorption costing system or a marginal costing system.

Marginal costing fixed production overhead variances

In marginal costing, fixed production overheads are not absorbed into the cost of production,
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therefore there is no fixed overhead volume variance. Only a fixed overhead expenditure
variance must be calculated, which is the difference between actual fixed overheads incurred
and the budgeted fixed overheads.

Absorption costing fixed production overhead variances

In an absorption costing system, five fixed overhead variances can be calculated, namely the
total fixed overhead variance, which is split into a fixed overhead expenditure variance
and a fixed overhead volume variance. The fixed overhead volume variance can be split
further into a volume efficiency variance and a volume capacity variance.

Cost and Management Accounting

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393

Illustrative example 11.1 (cont.)

Table 11.10 Fixed overhead variances
Expenditure variance = BFO − AFO
= R96 000 − R100 000 = R4 000A
Volume variance *** = (SH − BH) × SR
(calculate only when absorption = [(9 000 units × 3) − 24 000] R4 = R12 000F
costing used)
Sub-variance of volume variance
Volume capacity variance = (AH − BH) × SR
= (28 500 − 24 000) R4 = R18 000F
Volume efficiency variance = (SH − AH) × SR
= [(9 000 × 3) − 28 500] R4 = R6 000A
Total fixed overhead variance = SC − AC
= (9 000 × R12) − R100 000 = R8 000F

***With variable costing, fixed overheads are not allocated to products. Instead the
total fixed costs are charged as an expense to the period in which they are incurred, that
is, only the expenditure variance is calculated if profit is reconciled. But in absorption
costing, fixed overheads are allocated to products. Therefore, an additional fixed
overhead variance called the volume variance is calculated.
Where:
BFO = Budgeted fixed overhead
AFO = Actual fixed overhead
SH = Standard hours
BH = Budgeted hours
AH = Actual hours
SC = Standard fixed cost
AC = Actual fixed cost
Table 11.11 Alternative layout: Fixed overhead variances
Actual Budget: Budget: Actual input @ Actual output @
cost Normal Specific std cost std. cost
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month month
>A Budgeted <F AH × SR >A Actual units ×
overhead/ SR/u
12 months
100 000   1 152
________
12
000
96 000 96 000
28 500 ×  _____
24 000
1 152 000
9 000 ×  ________
960 000
= 96 000 0 18 000F = 114 000 6 000A =108 000
4 000A Calendar Volume Volume
capacity efficiency
Expenditure variance Volume variance 12 000F

Standard costing

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394

The total fixed production overhead variance is the amount of under-absorbed or

over-absorbed overheads which is the difference between the overheads incurred and the
overheads absorbed. Under-absorbed overheads result in an adverse variance, whereas
over-absorbed overheads result in a favourable variance. It is calculated as the difference
between the actual fixed production overhead incurred and the amount of fixed production
overhead actually absorbed into production, using the standard absorption rate. A fixed
overhead expenditure variance arises when actual expenditure is different from budgeted
expenditure. It is calculated as the difference between actual expenditure and budgeted
expenditure. A fixed overhead volume variance arises when actual production is different
from budgeted production. It represents the amount of fixed production overheads
that has been over- or under-absorbed, due to actual production volume differing from
budgeted production volume. It is calculated as the difference between actual production
volume and budgeted production volume, multiplied by the standard fixed overhead rate
per unit. Remember that this variance does not arise in a marginal costing system. In order
to investigate reasons for the volume variance, ie why the actual production was different
from the budgeted production, this variance can be subdivided into a fixed overhead volume
capacity and a fixed overhead volume efficiency variance. A calendar variance can also be included
as a subdivision of the volume variance. The fixed overhead volume capacity variance
indicates whether the actual production might be different from the budgeted production
and reflects if the planned capacity has been utilised. The volume capacity variance is
the difference between actual hours and the budgeted hours, multiplied by the standard
fixed overhead rate per hour. The volume capacity is favourable, because the actual input
at standard cost is more than what was budgeted for, which means more goods can be
produced than were budgeted for. The fixed overhead volume efficiency variance indicates
whether the labour force worked at a different level of efficiency from that anticipated in
the budget. It is calculated as the difference between the standard hours allowed for actual
production and the actual hours, multiplied by the standard fixed overhead rate per hour.
The volume efficiency variance is unfavourable, because input valued at R114 000 was
placed in production, and output valued at R108 000 resulted from the process. The output
resulted in goods worth less than the initial expectation, based on the input into the process.
A calendar variance is the influence of factors such as public holidays and shorter working
days in some months on the average production for the year. This variance represents the
difference between the budgeted and the average monthly clock hours. Mainly, the effect
of differing number of working days and seasonal sales trends on production is reflected
in this variance. The calendar variance is only an indication of the influence of factors such
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as public holidays, fewer working days in some months, etc on the average production
for the year.

Causes of fixed production overhead expenditure variances

The cause of this variance is fixed overhead expenditure being higher or lower than the
budget, for example an increase in electricity charges or salary increases.

Causes of fixed production overhead volume variances

The causes are similar to a direct labour efficiency variance, as overheads are frequently
absorbed into production by means of labour hours.

Cost and Management Accounting

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Causes of a calendar variance

● Public holidays
● Differences in working days in specific months (for example, February and December
usually have fewer working days than other months)
● Budgeted overtime
● Different production levels as a result of seasonal trends.

Test yourself 11.4

Using the information on Camtec Limited in Test yourself 11.1, calculate all possible
fixed overhead variances.

Sales variances
In this section we will cover five sales variances that help management analyse the
organisation’s sales performance, namely the total sales variance, which is split into the
sales price variance and the sales volume variance; and the sales mix and sales quantity
variances, which are sub-variances of the sales volume variance.
Sales price variance reflects the effect that a change in revenue, caused by the actual
selling price differing from the standard selling price, will have on profit. It is calculated as
the difference between the actual selling price and the standard selling price, multiplied by
the actual number of units sold.
Sales volume variance reflects the effect on contribution or profit of budgeted volume
of sales, rather than sales value or price. In a marginal costing system, the sales volume
variance is calculated as the difference between actual and budgeted sales volumes,
multiplied by the standard contribution margin per unit (selling price less total unit
variable manufacturing cost). In an absorption costing system, the sales volume variance
is calculated as the difference between actual and budgeted sales volumes, multiplied by
the standard gross profit per unit (selling price less total unit manufacturing cost). The
sales volume variance is calculated based on the input quantities and prices in the original
budget. That is the reason why the budget reconciliation will always first take the volume
variance into account in order to flex the budgeted profit to the actual activity level, before
bringing all the cost variances into account. The sales volume variance can be split into
a sales volume mix variance and a sales volume quantity (or yield) variance as shown in
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Illustrative example 11.3.

Standard costing

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Illustrative example 11.1 (cont.)

Table 11.12 Sales variances (absorption costing system)
Sales price variance = (AP − SP) × AV
= (R92 − R88) 9 000 = R36 000F
Sales volume variance = (AV − BV) × SM
= (9 000 − 8 000) × (88 − 77) = R11 000F
Total sales variance = AS − BS
= [9 000 × (R92 − R77)] 2 [8 000 × (R88 − R77)] = R47 000F
Or = Sales price variance + Sales volume variance
= R36 000F + R11 000F = R47 000F

Table 11.13 Sales variances (marginal costing system)

Sales price variance = (AP − SP) × AV
= (R92 − R88) 9 000 = R36 000F
Sales volume variance = (AV − BV) × SM
= (9 000 − 8 000) × (R88 − R65) = R23 000F
Total sales variance = AS − BS
= [9 000 × (R92 − R65)] − [8 000 × (R88 − R65)] = R59 000F
Or = Sales price variance + Sales volume variance
= R36 000F + R23 000F = R59 000F

Where:
AV = Actual sales volume
BV = Budgeted sales volume
AP = Actual selling price
SP = Standard selling price
SM = Standard contribution margin (marginal costing system) or Standard gross
margin (absorption costing)
AS = Actual sales (Actual units × AP − SC)
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BS = Budgeted sales (Budgeted units × SP − SC)

Test yourself 11.5

Using the information on Camtec Limited in Test yourself 11.1, calculate all possible
sales variances.

Cost and Management Accounting

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When the organisation has multiple products with different profit margins, then the sales
volume variance can be divided into a sales mix and sales quantity variance. The sales mix
variance measures the effect of the difference between the actual sales mix and the budgeted
sales mix on profits. The sales mix variance explains how much of sales volume variance is
due to a change in the sales mix and is of significance only when there is an identifiable
relationship (proportions) between the products and these relationships are incorporated
into the planning process. Where relationships between products are not expected, the
mix variance does not provide meaningful information, since it incorrectly suggests that
a possible cause of the sales variance arises from a change in the mix. The variance also
provides insight into market movements between products. The sales quantity variance
measures the effect of changes in volume on profits. These variances can be calculated using
the contribution per unit or the profit per unit.

Illustrative example 11.3

The sales variances for multiple products will be illustrated using the following example.
Table 11.14 Budgeted sales for Sen’s Health Soaps for March
Sales Sales Selling Cost price Contribution Total
units value (R) price (R) (R) margin (R) margin (R)
Sunlight 600 1 800 3 2 1 600
Savlon 300 1 350 4.5 3 1.5 450
Dettol 100 650 6.5 4 2.5 250
1 000 3 800 1 300
and the actual sales were:
Sales Sales Selling Cost price Contribution Total
units value (R) price (R) (R) margin (R) margin (R)
Sunlight 520 1 456 2.8 2 0.8 416
Savlon 290 1 421 4.9 3 1.9 551
Dettol 90 567 6.3 4 2.3 207
900 3 444 1 174
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Required
Calculate sales volume, mix and quantity variances.

Solution:
Sales volume mix variance = (Actual units sold − Actual units sold @ standard mix) ×
Standard margin
6
Sunlight = [520 − (900 × ___
 10 )] × R1.00 = (520 − 540)1.00 = 20A
3
Savlon = [290 − (900 ×  ___
10 )] × R1.50 = (290 − 270)1.50 = 30F
1
Dettol = [90 − (900 ×  ___
10 )] × R2.50
= (90 − 90)2.50 = Nil
Sales volume mix variance = 10F
➤➤

Standard costing

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Sales volume quantity variance = (Actual units sold @ standard mix − Budgeted sales
quantity) × Standard margin
6
Sunlight = [(900 ×  ___
10 ) − 600] × R1.00 = (540 − 600)1.00 = 60A
3
Savlon = [(900 ×  ___
10 ) − 300] × R1.50 = (270 − 300)1.50 = 45A
1
Dettol = [(900 ×  ___
10 ) − 100] × R2.50
= (90 − 100)2.50 = 25A
Sales volume quantity variance = 130A

Sales volume variance = (SQ − AQ used) × SP

Sunlight = (600 − 520)1.00 = 80A
Savlon = (300 − 290)1.50 = 15A
Dettol = (100 − 90)2.50 = 25A
Sales volume variance = 120A

By separating the sales volume variance into sales mix and sales quantity, we can see how
the sales volume variance is affected by a shift in the total volume of sales (sales quantity
variance) and a shift in the relative mix of products (sales mix variance). The sales
quantity variance indicates that, if the original planned sales mix had been maintained,
then for the actual sales volume of 900, profits would have decreased by R120. The
favourable sales mix variance has arisen because of an increase in percentage sold of
Savlon, which has a higher contribution than Sunlight, and a decrease in percentage
sold of Sunlight. An adverse mix variance will occur whenever there is an increase in
percentage sold of units with a lower contribution, or a decrease in percentage of units
sold with a higher contribution.

Causes of sales price variances

● A reduction in price during promotions
● Market conditions forcing a change in price within the industry
● Lower price given, due to bulk buying.

Causes of sales volume variances

● Increase or decrease in sales volume, due to successful or unsuccessful marketing and
selling efforts such as an advertising campaign
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● Unexpected changes in customer demand

● Change in selling price, causing a change in demand
● Losing customers, due to failure to satisfy demand.

Reconciliation
A reconciliation statement represents a summary of the variances for the responsibility
centre. It represents a broader picture to top management that explains the reasons as to
why budgeted profit is not the same as actual profit. A reconciliation can be done using
absorption costing or marginal costing principles.

Cost and Management Accounting

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Illustrative example 11.1 (cont.)

Table 11.15 Reconciliation of budgeted and actual profit for a standard absorption
costing system
Budgeted net profit R88 000
Add: Sales volume variances 11 000F
Standard profit 99 000
Add/(Less): Favourable/adverse variance 11 100A
Sales price variance 36 000F
Material price 8 900F
Material wood 10 100A
Material willow 19 000F
Material usage 26 500A
Material wood 16 500A
Material willow 10 000A
Labour rate 28 500A
Labour efficiency 12 000A
Variable overhead rate 6 000F
Variable overhead efficiency 3 000A
Fixed overhead expenditure 4 000A
Fixed overhead volume 12 000F
Actual profit R87 900

The absorption costing reconciliation statement is similar to the marginal costing

reconciliation statement, except that the absorption costing statement values the sales
volume variance at standard profit per unit instead of at contribution per unit. The other
difference is that the absorption costing statement includes an additional variance, that is,
the fixed overhead volume variance.

Illustrative example 11.1 (cont.)

Table 11.16 Reconciliation of budgeted and actual profit for a standard variable
costing system
R R
Budgeted net profit 88 000
Add: Sales volume variances 23 000F
Standard profit 111 000
Add/(Less): Favourable/adverse variance 23 100A
Sales price variance 36 000F
Material price 8 900F
Material usage 26 500A

➤➤

Standard costing

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Labour rate 28 500A

Labour efficiency 12 000A
Variable overhead rate 6 000F
Variable overhead efficiency 3 000A
Fixed overhead expenditure 4 000A
Actual profit R87 900

Test yourself 11.6

Using the information given on Camtec Limited in Test yourself 11.1, reconcile the
budgeted gross profit with the actual gross profit.

Reporting of variances
Variances should be reported after every control period. If the variance is reported after the
control period, then there might be a chance that the information is out of date. Variance
reports which contain a reconciliation of budgeted and actual profits can be sent to senior
management, or to individual managers, where the report contains information on their
particular aspect of operations. For example, production managers might be sent variance
reports for expenditure items within their control, such as material usage, labour efficiency, etc.

The interrelationship of variances

Favourable variances in one area of the organisation may be interrelated with favourable
variances elsewhere, and vice versa.
● A favourable material price variance that is due to purchasing a cheaper material may
result in an unfavourable material usage variance, as there may be more material wasted.
This may also cause an unfavourable labour efficiency variance, due to an increase in
labour time spent on working with the cheaper quality of materials.
● The sales price and volume may be interrelated as an increase in sales price may result
in a decrease in the units sold. Therefore, a favourable sales price variance may result
in an unfavourable sales volume variance. Alternatively, a reduction in the selling
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pricing (adverse sales price variance) may cause a higher sales demand from customers
(favourable sales volume variance).
● Use of unskilled labour may account for a favourable labour rate variance, which in
effect may result in an unfavourable labour efficiency variance, as there may be an initial
learning effect. On the other hand, using more experienced labour to do the work may
cause the labour rate variance to be adverse, but may increase productivity, resulting in
a favourable labour efficiency variance.
● A favourable/adverse labour efficiency variance also accounts for a favourable/adverse
overhead efficiency variance when overheads are absorbed on a labour-hour basis.
● An adverse material mix variance, due to a more expensive mix of materials, may result
in higher output levels and a favourable yield variance.

Cost and Management Accounting

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401

Investigation of variances
In order for appropriate action to be taken, it is important to identify reasons for the
occurrence of the variance. However, time and effort will be wasted if all variances are
investigated. The following factors can be considered when investigating variances:
● The estimated cost of making the investigation versus the anticipated benefits: If the
costs saved from investigating a variance and taking corrective action exceed the costs
of making the investigation, management should investigate the cause of the variance.
● Large variances, whether favourable or unfavourable, should be investigated. The
problem is to decide how large a variance must be before it is considered abnormal. An
organisation can establish a rule of thumb whereby any variance exceeding x% of its
standard cost may be worthy of investigation. Alternatively, a tolerance limit or a range
can be established, so that if a variance falls outside this limit, it should be investigated.
● Determining the interrelationships between variances is important. For example, a
favourable material price variance, due to purchasing a cheaper material, may be offset
by an unfavourable labour efficiency variance, which is the result of increased labour
time spent on working with the cheaper quality of materials.
● Some variances are uncontrollable, as they are heavily influenced by external factors, so
even if a lengthy investigation is undertaken to determine their causes, not much can be
done to change them.
● The type of standard set, for example an ideal standard, generally results in adverse
variances. Management must decide on what they would view as a normal level of an
adverse variance.
● Is the standard simply outdated, or is the variance due to a non-recurring event, or is the
variance due to a systematic problem that can be corrected? In these cases, there is no
need for investigation.
● A small variance may require investigation if it consistently occurs, as it may indicate an
ongoing problem in production or an outdated standard.

Standard costing’s relationship with budgetary control

Standard costing concerns relate specifically to single cost units, whereas the budgetary
control system will be more concerned with overall company departmental performance.
Both systems incorporate some analysis of variances. While each system can operate
independently, they are best used in conjunction with one another, for example the
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standards being used as a basis for budgeted figures.

Flexible budgets and standard costing

In the previous chapter, we looked at flexing the budget for control purposes and compiling
a performance report where the variances were determined. In this chapter, we looked at
variance analysis, which analyses the variances in more detail. Earlier in the chapter, when we
analysed the variances for direct materials, direct labour, etc, we adjusted the standard cost
benchmark to the actual volume produced, that is, we compared actual costs to standard
costs allowed for actual output produced.
The following table looks at a performance report for Cami’s Beautiful Baskets.

Standard costing

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402

Illustrative example 11.1 (cont.)

Table 11.17 Cami’s Beautiful Baskets performance report
Original budget Flexed budget Actual results Variance
Volume 8 000 9 000 9 000
Sales R704 000 R792 000 R828 000 R36 000* F
Less: Cost of sales R616 000 R681 000 R740 100 R59 100 A
Direct materials R280 000 R315 000 R332 600 R17 600* A
Direct labour R192 000 R216 000 R256 500 R40 500* A
Variable overheads R48 000 R54 000 R51 000 R3 000* F
Fixed overheads R96 000 R96 000 R100 000 R4 000* A
Gross profit R88 000 R111 000 R87 900 R23 100 A

An analysis of the variances indicates the following:

● The sales variance is due to a favourable sales price variance of R36 000.
● The adverse direct material variance of 17 600 is due to an adverse material usage
variance of R26 500 and a favourable material price variance of R8 900.
● The adverse direct labour variance of 40 500 is due to an adverse labour rate variance
of R28 500 and a labour efficiency variance of R12 000.
● The favourable variable overhead variance of R3 000 is due to a favourable variable
overhead rate variance of R6 000 and an adverse variable overhead efficiency
variance of R3 000.
● The adverse fixed overhead variance is due to the adverse fixed overhead expenditure
variance of R4 000.

Recording of standard costs

Standard costs need not be recorded in the accounts for the purpose of planning, decision
making and control. However, recording them in the accounting records saves a considerable
amount of data processing time. Let us consider the example of Cami’s Beautiful Baskets
and the variances that were recorded.
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Cost and Management Accounting

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403

Ledger entries for a standard absorption costing system are given in Table 11.18:

Illustrative example 11.1 (cont.)

Table 11.18 Ledger accounts of Cami’s Beautiful Baskets
Stores ledger control account
1 Creditors (Material: Wood) 3 Material usage variance
AQ × SP 151 500 (Material: Wood) 16 500
2 Creditors (Material: 3 Material usage variance
Willow) AQ × SP 190 000 (Material: Willow) 10 000
4 Work in progress (Material:
Wood) SQ × SP 135 000
4 Work in progress (Material:
Willow) SQ × SP 180 000
341 500 341 500

Creditors control account (Materials)

2 Material price variance 1 Stores ledger control
(Material: Willow) 19 000 (Material: Wood) 151 500
1 Material price variance
(Material: Wood) 10 100
2 Stores ledger control
(Material: Willow) 190 000
Variance accounts
1 Creditors (Material: Wood) 10 100 2 Creditors (Material: Willow) 19 000
3 Stores ledger control 8 Variable production
(Material: Wood) 16 500 overhead control 6 000
4 Stores ledger control 9 Fixed production overhead
(Material: Willow) 10 000 control 12 000
6 Wages control 28 500 15 Costing profit and loss a/c 47 100
6 Wages control 12 000
8 Variable production
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overhead 3 000
9 Fixed production overhead 4 000
84 100 84 100

➤➤

Standard costing

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404

Wages accrued account

5 Wages control account 256 500

Variable production overhead control account

7 Creditors expense 51 000 8 Work in progress 54 000
8 Expenditure variance 6 000 8 Efficiency variance 3 000
57 000 57 000

Fixed production overhead control account

7 Creditors expense 100 000 9 Work in progress 108 000
9 Volume variance 12 000 9 Expenditure variance 4 000
112 000 112 000

Creditors expense
7 Variable production
overhead control 51 000
7 Fixed production overhead
control 100 000
Work in progress control account
3 Stores ledger control 10 Finished goods control
(Material: Wood) 135 000 account 693 000
4 Stores ledger control
(Material: Willow) 180 000
6 Wages control (SH x SR) 216 000
8 Variable production
overhead (SH x SR) 54 000
9 Fixed production overhead
(SH x SR) 108 000
693 000 693 000
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Finished goods control account

10 Work in progress 693 000 11 Cost of sales 693 000

Cost of sales
11 Finished goods control 693 000 12 Costing profit and loss 693 000

➤➤

Cost and Management Accounting

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405

Sales
14 Costing profit and loss 828 000 13 Debtors 828 000

Debtors
13 Sales 828 000

Costing profit and loss account

12 Cost of sales at standard 14 Sales 828 000
cost 693 000
15 Variance account (net
variance) 47 100
Actual profit 87 900
828 000 828 000

The ledger entries have been labelled from 1 to 15 to show the double entries. The references
to the transactions are as follows:
1. The purchase of Material Wood recorded at actual (AQ × AP) and at standard (AQ × SP).
The price variance is also recorded.
Dr Stores ledger control account
Dr Material price variance account
Cr Creditors control account
Recording of actual material cost and variance
2. The purchase of Material Willow recorded at actual (AQ × AP) and at standard (AQ × SP).
The price variance is also recorded.
Dr Stores ledger control account
Dr Material price variance account
Cr Creditors control account
Recording of actual material cost and variance
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3. The usage of Material Wood recorded at actual quantity issued at standard price
(AQ × SP) and standard quantity at standard price (SQ × SP). The usage variance is also
recorded.
Dr Work in progress
Dr Material usage variance account
Cr Stores ledger control account
Recording of material issued and variance

Standard costing

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4. The usage of Material Willow recorded at actual quantity issued at standard price
(AQ × SP) and standard quantity at standard price (SQ × SP). The usage variance is also
recorded.
Dr Work in progress
Dr Material usage variance account
Cr Stores ledger control account
Recording of material issued and variance
5. The actual wages incurred is recorded.
Dr Wages control account
Cr Wages accrued account
Recording of actual labour cost
6. The work in progress is debited and the wages control account is credited with the
standard cost (SH × SR). The labour rate and labour efficiency variance accounts are
debited as they are both adverse variances.
Dr Work in progress
Cr Wages control account
Recording of standard labour cost
Dr Labour rate variance account
Dr Labour efficiency account
Cr Wages control account
Recording of variances
7. The actual fixed and variable production overhead is recorded.
Dr Variable production overhead control account
Dr Fixed production overhead control account
Cr Creditors expense
Recording of actual fixed and variable production overhead
8. Work in progress is debited and variable factory overhead is credited with the standard
variable overhead cost (SH × SR). The adverse efficiency variance and the favourable
expenditure variance are also recorded.
Dr Work in progress
Dr Variable overhead efficiency variance account
Cr Variable production overhead control account
Recording of standard variable overhead and efficiency variance
Dr Variable production overhead control account
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Cr Variable overhead expenditure variance account

Recording of expenditure variance
9. The standard fixed overhead cost is recorded (SH × SR). The adverse expenditure
variance and the favourable volume variance are also recorded.
Dr Work in progress
Dr Fixed overhead expenditure variance account
Cr Fixed production overhead control account
Recording of standard fixed overhead and expenditure variance
Dr Fixed production overhead control account
Cr Fixed overhead volume variance account
Recording of volume variance

Cost and Management Accounting

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10. Transfer of production from work in progress to finished goods.

Dr Finished goods account
Cr Work in progress account
Recording of production transferred from work in progress to finished goods
11. All production is sold, therefore there will not be any closing stock of finished goods.
The standard cost of production is transferred from finished goods to cost of sales.
Dr Cost of sales
Cr Finished goods
Recording of finished goods transferred to cost of sales
12. Cost of sales transferred to the profit and loss account
Dr Costing profit and loss account
Cr Cost of sales
Recording of transfer of cost of sales to profit and loss account
13. Dr Debtors
Cr Sales
Recording of actual sales
14. Dr Sales
Cr Costing profit and loss account
Recording transfer of sales to profit and loss account
15. Dr Costing profit and loss account
Cr Variance account
Recording of net variance

Planning and operational variances

A planning variance would arise from an inability to make exact predictions of costs and
revenues at the budgeting stage. A planning variance simply compares a revised standard
to the original standard, that is, the user has obtained further information following
the setting of budgeted figures. A planning variance is usually uncontrollable, and
operational management cannot be held responsible for them, therefore there is no need
for investigating these variances at the operational level. A planning variance is favourable
when the revised standard cost is lower than the original standard cost, and is adverse when
the revised standard cost is higher than the original standard cost. Planning variances may
arise when there is a change in one of the main materials used, an unexpected change in the
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rates paid to the labour force, an unexpected increase in the price of materials, a change in
working methods that alters the labour time required, etc.
Operational variances are attributable to operating performance, and are the comparison
of the revised budget figures against the actual results, instead of using the plan budget
figures, which have been made redundant, due to further information being obtained to
update the rates and reflect a more accurate budget.
These variances are calculated in the exact same manner as described earlier in the chapter,
except that the revised standard is used. Planning and operational variances are useful, as
they allow for actual results to be compared to realistic updated standards. Operational staff
may also feel motivated, as their performance is judged against realistic standards. However,
these variances can be time-consuming, as a large amount of labour time is involved in
continuously updating standards. These variances can also cause conflict between the
operating and planning staff, whereby each tries to pass the blame onto the other.

Standard costing

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Illustrative example 11.1 (cont.)

Camsen Plastics Manufacturers produce one type of product. Budgeted sales and
output are 1 000 units per month for the current year. The standard unit cost card
included:

Direct material: (5 kg @ R20 per kg) R100

The company has just completed month six of its operations, and extracts from its
records revealed that 1 200 units were produced and sold, and the actual direct
materials purchased and used were 6 300 kg costing R132 300.

The managing director has discovered that a shortage of materials had caused the
market price to rise to R23 per kg.

Required
Calculate for the direct material:
(a) The total material variance
(b) The planning variance
(c) The two operational variances.

Solution:
The important figures are the actual output of 1 200 units and the original and revised
standards (the budget of 1 000 units is totally irrelevant).
(a) The total material variance: This is the difference between the original standard cost
of 1 200 units and the actual cost. This is R12 300 adverse. (1 200 units should cost
R120 000, but they actually cost R132 300.)
(b) The planning variance: This is the difference between the original standard cost of
1 200 units and the revised standard cost of 1 200 units. The cost of the material
has risen by R3 per kg.
The planning variance is therefore 1 200 × 5 × 3 = R18 000 adverse.
(c) The operational variances: These are the operational price and usage variances and
will be calculated using the revised standard cost per unit of 5 kg @ R23 per kg =
R115.
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Price variance = R12 600 favourable (6 300 kg should cost 6 300 × 23 = R144 900, but
they actually cost R132 300).

Usage variance = R6 900 adverse (1 200 units should use 6 000 kg, but instead used
6 300 kg). We are therefore 300 kg adverse, and these are valued @ R23 per kg.

Check: Total variance = Planning variance + Operational variances R12 300 adverse =
R18 000 adverse + R12 600 favourable + R6 900 adverse.

Cost and Management Accounting

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409

Test yourself 11.7

The following data relates to Bratz Angel Ltd on one of their products that uses skilled
labour:

Standard labour (5 hours @ R100 per hour) R500

Actual labour cost (1 450 hours used) R130 500

There were 250 units produced during the month. Due to unforeseen circumstances,
there was a shortage of skilled labour, therefore semi-skilled workers had to be hired.
Consequently, the standard time was revised to six hours per unit.

Required:
Calculate the labour rate and efficiency variances using a planning and operational
approach.

Summary
This chapter has demonstrated how standards are set for materials, labour, overheads and
sales, and how these standards are compared to amounts recorded to determine variances
that can be used by management for cost reduction and control. Incorporating standard
costs in the accounting records were explained and illustrated. Some organisations use
a standard costing system for planning, decision-making and control purposes only and
therefore find it unnecessary to enter standard costs in journals and ledgers.

Key concepts
Attainable standards are based on efficient operating conditions, but include allowances
for factors such as waste, losses and machine breakdowns. These standards are viewed
as being neither too easy to achieve, nor too impossible to achieve.
Basic standards are standards which remain unchanged over the long term. This
standard is retained as a minimum standard to show trends over time, and also used as
a basis from which current standards can be set.
Bill of materials is a document where the required quantity of materials to complete a
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product is recorded.
Current standards are based on current performance levels, are set for use over the
short term and are set when there is a temporary problem to deal with that particular
circumstance, for example unexpected price increase.
Fixed overhead expenditure variance arises when actual expenditure is different from
budgeted expenditure. It is calculated as the difference between actual expenditure and
budgeted expenditure.
Fixed overhead volume capacity variance is the difference between actual hours and the
budgeted hours, multiplied by the standard fixed overhead rate per hour.
➤➤

Standard costing

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Fixed overhead volume efficiency variance is calculated as the difference between the
standard hours allowed for actual production and the actual hours, multiplied by the
standard fixed overhead rate per hour.
Fixed overhead volume variance is calculated as the difference between actual
production volume and budgeted production volume, multiplied by the standard fixed
overhead rate per unit.
Ideal standards are extremely tight standards which demand perfection. The ideal
standard represents the ultimate goal, but it expects an attainment impossible to achieve
over continuous periods.
Labour efficiency variance indicates whether we are using more or less hours per unit
than expected. It is calculated as the difference between the standard hours allowed
for actual production and the actual hours worked, multiplied by the standard rate per
hour.
Labour rate variance shows whether we are paying more or less per hour than expected
for labour. It is calculated as the difference between the actual rate per hour and the
standard rate per hour, multiplied by the actual hours that were paid for.
Management by exception is a system where management’s attention is focused on
problem areas, that is, any significant deviations from the plan, rather than spending
time on other areas of responsibility that are proceeding according to plan.
Material mix variances show the cost changes that result from combining quantities of
material in proportions different from standard.
Material price variance is the difference between actual purchase price and the standard
purchase price, multiplied by the actual quantity of material purchased or used.
Material usage variance is the difference between the standard quantity of material
allowed for actual production and the actual quantity used, multiplied by the standard
price of material.
Material yield variances arise if losses inherent in the manufacturing process produce a
yield of the finished output different from the material input.
Sales mix variance is calculated as the difference between the actual sales quantity and
the actual sales quantity in budgeted proportions, multiplied by the standard margin.
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Sales price variance is calculated as the difference between the actual selling price and
the standard selling price, multiplied by the actual number of units sold.
Sales quantity variance measures the effect of changes in volume on profits and is
calculated as the actual sales quantity in budgeted proportion less the budgeted sales
quantity, multiplied by the standard margin.
Sales volume variance is calculated as the difference between actual and budgeted sales
volumes, multiplied by either the standard contribution margin per unit if a marginal
costing system is used, or standard gross profit per unit if an absorption costing method
is used. It is subdivided into a sales mix and a sales quantity variance.
Standard cost is a predetermined planned cost of manufacturing a unit during a specific
period in the immediate future under current or anticipated operating conditions.
➤➤

Cost and Management Accounting

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Total material variance is the difference between actual cost of material and the
standard material cost of actual production.
Variable overhead efficiency variance is calculated as the difference between the
standard hours allowed for actual production and the actual hours worked, multiplied
by the standard variable overhead rate per hour.
Variable overhead expenditure variance is calculated as the difference between the
actual variable overhead rate per hour and the standard variable overhead rate per hour,
multiplied by the actual hours that were paid for; or it is the difference between the actual
variable overhead cost and the standard variable overhead cost of actual hours worked.
A variance is the difference between predetermined standards and actual costs and revenues.
Variance analysis involves breaking down the total variance to explain how much of it is
caused by the price of resources and how much of it is caused by the usage of resources
being different from the predetermined standard.

Test-yourself solutions
Test yourself 11.1
The following material variances were calculated for Camtec Limited:
Actual cost Std cost of actual Actual input in std Std cost of
input ratio @ std cost actual output
Sq
AQ AP >A AQ × SP >A (___
  SM × AM)SP >A Actual units ×
<F <F <F SP/u
___ 5 15 000
Sen: 16 000 8 000F 8 000 kg × R3.00/ 4 500A   10 × 13 000 × R3 1 500A 12 000 ×  ______
10 000
kg = 24 000 = 19 500 = 18 000
___ 5 35 000
Cam: 40 000 5 000A 5 000 kg × 10 500F   10 × 13 000 × R7 3 500A 12 000 ×  ______
10 000
R7.00/kg = 35 000 = 45 500 = 42 000
3 000F 6 000F 5 000A
Material Material
mix yield
Material price 3 000F Material usage 1 000F
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Test yourself 11.2

The following labour variances were calculated for Camtec Limited:
Actual cost Standard cost of the Standard cost of the
actual input actual output
AH × AR >A AH × SR = Actual units × SR/u
R258 900 6 000 × R40 = R240 000   20
12 000 × ______000
10 000
= R240 000
R18 900(A) Nil
Rate Efficiency

Standard costing

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412

Test yourself 11.3

The following variable overhead variances were calculated for Camtec Limited:
Actual cost Standard cost of the actual Standard cost of the actual
input output
AH × AR >A AH × SR = Actual units × SR/u
75 000 6 000 × R10 = R60 000   50
12 000 × ______000
10 000
= R60 000
R15 000(A) Nil
Rate Efficiency

Test yourself 11.4

The following fixed overhead variances were calculated for Camtec Limited:
Actual Budget: Budget: (Actual input @ (Actual output @
cost Normal month Specific std cost) std. cost)
(budgeted month
overhead/
Actual units × SR/u
12months
<F = <F AH × SR =
100 000
  100
6 000 × _______000
5 000 12 000 ×  _______
10 000
90 100 100 000 0 100 000 20 000F = 120 000 = 120 000
Nil

Calendar Volume Volume

EXPENDITURE 9 900F capacity efficiency

VOLUME VARIANCE 20 000F

Test yourself 11.5

The following sales variances were calculated for Camtec Limited using an absorption
costing system:
Actual sales Standard cost of the actual Standard cost of the actual
input output
Copyright © 2021. Juta & Company, Limited. All rights reserved.

AV × AM >F AV × SM >F BV × SM

<A <A

12 000 × ( _______
12 000 −   10 000 ) ( 10 000 −   10 000 ) 10 000 × (_______
10 000 −   10 000 )
540 000 _______
400 000 500 000 _______
400 000
12 000 ×  _______   500 000 _______
400 000

= 12 000 × (45 − 40) = 12 000 × (50 − 40) = 10 000 × (50 − 40)

= 60 000 = 120 000 = 100 000

R60 000(A) 20 000F
Price Volume

Cost and Management Accounting

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413

Test yourself 11.6

The following statement shows the reconciliation of budgeted and actual profit for a
standard absorption costing system:
Budgeted gross profit R100 000
Add: Sales volume variances 20 000F
Standard profit 120 000
Add/(Less): Favourable/adverse variance 60 000A
Sales price variance 60 000A
Material price 3 000F
Material usage 1 000F
Labour rate 18 900A
Labour efficiency –
Variable overhead rate 15 000A
Variable overhead efficiency –
Fixed overhead expenditure 9 900F
Fixed overhead volume 20 000F
Actual gross profit R60 000

Test yourself 11.7

Conventional approach:
AH × AR AH × SR Actual units × SR/u
130 500 <F 1 450 h × R100 >A 250 × 5 h × R100
14 500F R145 000 20 000A 125 000
Labour rate Labour efficiency

Planning and operational approach:

Planning efficiency variance = (5 hours − 6 hours) × R100 per hour × 250 units
= R250 000A
Operational variances:
AH × AR AH × SR Actual units × SR/u
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130 500 <F 1 450 h × R100 <F 250 × 6 h × R100

14 500F R145 000 5 000F 150 000
Labour rate Labour efficiency

Standard costing

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Review questions
11.1 Describe the different approaches to setting standards.
11.2 Explain what is meant by the term ‘management by exception’.
11.3 Explain how a business can use standard costing for control purposes.
11.4 Distinguish between the different types of standards.
11.5 Explain how material, labour and overhead standards are set.
11.6 What are some causes of material price and material usage variances?
11.7 Under what circumstances will a material mix and material yield variance arise?
11.8 What are some causes of labour rate and labour efficiency variances?
11.9 What additional variances arise with a standard absorption costing system?
11.10 How do sales variances between a standard marginal costing and a standard
absorption costing system differ?
11.11 When should a variance be investigated?
11.12 Explain some of the interrelationships between variances.

Exercises
11.1 Part A
Fer-Hay Limited manufactures and sells several products. Flush, an organic
detoxifier, is one of the products manufactured. You are provided with the
following information regarding the standard cost per unit of Flush:
R
Material Sen 3 kg @ R10 per kg 30
Material Cam 9 kg @ R15 per kg 135
Labour 6 clock hours @ R12 per hour 72
Fixed overheads 58
Variable overheads 30
325

Fer-Hay Limited makes a 10% allowance for idle time.

Following is actual information pertaining to product Flush financial year
ending 30 September 20X1:
Copyright © 2021. Juta & Company, Limited. All rights reserved.

● Number of units produced: 5 000

● Materials:
Purchased Sen: 20 000 kg for R209 000
Cam: 54 000 kg for R756 000
Issued Sen: 18 500 kg
Cam: 45 500 kg
● Labour cost: 30 000 hours clocked at a cost of R294 000 while work hours
amounted to 27 600.

Required:
(a) Material price, mix and yield variance.
(b) Labour rate, idle time and efficiency variance.
Source: CIMA (adapted)

Cost and Management Accounting

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415

Part B
Fer-Hay also produces and sells rooibos tea made from a blend of two direct
raw materials: dried rooibos leaves and dried lemon. The rooibos loose tea is
packed in a box containing 100 grams of the rooibos-lemon loose tea mixture.
The following details, relating to the rooibos-lemon loose tea, have been
extracted from the budget working papers for the financial year ending
30 September 20X1:
● Fer-Hay estimated that it will produce 72 000 boxes of rooibos-lemon loose
tea and sell 70 800 boxes of rooibos-lemon loose tea evenly throughout the
financial year.
● The standard sales price is R40 per box of rooibos-lemon loose tea.
● Direct raw materials required to produce the budgeted 72 000 boxes are:

Price per kg Total cost

Dried rooibos leaves R30 per kg R172 800
Dried lemon R200 per kg R288 000

● Actual information for the month of September 20X1 relating to the rooibos-
lemon loose tea:
◆ 6 500 boxes were produced and 6 100 boxes were sold for a total sales
value of R256 200.
◆ The direct raw materials were purchased and issued to production as
follows:
Purchased Issued
Dried rooibos leaves 600 kg for R21 000 585 kg
Dried lemon 150 kg for R30 000 97.50 kg

Required:
(a) Calculate the following variances for the rooibos-lemon loose tea for
September 20X1:
(i) Sales price variance
(ii) Material mix variance per direct raw material type and in total
(iii) Material yield variance per direct raw material type and in total.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

(b) Briefly discuss two reasons for a possible adverse material yield variance.
11.2 GH manufactures and sells a single product. The company operates a standard
absorption costing system and absorbs overheads on the basis of direct labour hours.
The standard selling price and standard costs for one unit of the product are as
follows:
Per unit (R)
Selling price 300
Direct material 15 metres @ R9 per metre 135
Direct labour 5 hours @ R12 per hour 60
Variable production overheads 5 hours @ R6 per hour 30
Fixed production overheads 5 hours @ R3 per hour 15

Standard costing

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416

The budgeted production and sales for February were 1 000 units. The fixed
overhead absorption rate has been calculated based on budgeted production
for the month.
Actual results for February were as follows:

Production 1 400 units

Sales 1 200 units
Selling price R306 per unit

Direct materials 22 000 metres @ R12 per metre

Direct labour 6 800 hours @ R15 per hour
Variable production overheads R33 000
Fixed production overheads R18 000

No materials inventories are held.

Required:
(a) Prepare a statement that reconciles the budgeted gross profit with the
actual gross profit for February. Your statement should show the variances
in as much detail as possible.
(b) The production director, when questioned about the variances, explained
that, in an attempt to improve the quality of the product, better-quality
material was used and some of the semi-skilled labour was replaced with
skilled labour. The production director believed that the improvement in
the quality of the product would enable the company to increase the price
of the product and would also result in increased sales volumes. Discuss,
using the variances calculated in part (a), the effect on performance of the
decisions taken by the production director.
(c) Explain why a standard costing system may not be considered appropriate
in a modern manufacturing environment.
Source: CIMA (adapted)
11.3 A company manufactures and sells a single product. The company operates a
standard marginal costing system that enables the reporting of planning and
Copyright © 2021. Juta & Company, Limited. All rights reserved.

operational variances.
The original standard contribution per unit of the product for October, which
was used to establish the budgeted contribution for the month, was as follows:
R
Selling price 60
Direct material 1.5 kg @ R10 per kg (15)
Direct labour 2 hours @ R15 per hour (30)
Contribution 15

Cost and Management Accounting

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417

Other information for October:

● Sales and production quantities:
Budgeted sales and production 40 000 units
Actual sales and production 42 000 units
● A change in the product specification was implemented at the start of
October, which required 20% additional material for each unit. The standard
cost shown was not revised to reflect this change.
● Actual direct material purchased and used was 78 000 kg at R9.90 per kg.
● The labour rate shown in the standard cost was overestimated. The correct
standard labour rate for the grade of labour required was R14.60 per hour.
The actual rate paid was R15.20 per hour and actual hours worked were 86
000 hours.
● The actual selling price per unit was R62.
● There was no opening inventory of raw materials or finished goods.

Required:
(a) Prepare a statement for October that reconciles the budgeted contribution
with the actual contribution. Your statement should show the variances
in as much detail as possible. (Planning variances may be ignored for the
purpose of the reconciliation.)
(b) Discuss the performance of the company for October. Your discussion
should give one possible reason for each of the operational variances
calculated in part (a).
(c) Explain why separating variances into their planning and operational
elements should improve performance management.
Source: CIMA (adapted)
11.4 For well over 20 years Haycraft has been on the pioneering edge of office
furnishing design and production. Many other furniture brands have come and
gone, but Haycraft has remained at the forefront, an undisputed brand leader.
The demand for Haycraft furnishings has grown rapidly over the years. The
furniture is stocked in 30 stores across South Africa and recently in Gaborone. A
symbol of the enduring success of the brand can be seen in the daily production
that now exceeds 200 items of furnishings. These are manufactured every day in
the bustling Haycraft factory in Cape Town, and as such, represent the second-
Copyright © 2021. Juta & Company, Limited. All rights reserved.

largest office furniture employer in the Western Cape. The production process
in the factory is perfectly streamlined. The final product is delivered once it has
passed all the stringent quality checks.
The company operates a standard absorption costing system and a just-in-time
purchasing system. Standard production cost details per unit of product X are:

Materials (5 kg at R20 per kg) R100

Labour (4 hours at R10 per hour) R40
Variable overheads (4 hours at R5 per hour) R20
Fixed overheads (4 hours at R12.50 per hour) R50
R210

Standard costing

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418

Fixed and variable overheads are absorbed on the basis of labour hours.
Budget data for product X for July are detailed below:
Production and sales 1 400 units
Selling price R250 per unit
Fixed overheads R70 000

Actual data for product X for July are as follows:

Production and sales 1 600 units
Selling price R240 per unit
Direct materials 7 300 kg costing R153 300
Direct labour 5 080 hours at R9 per hour
Variable overheads R25 400
Fixed overheads R74 000

Required:
(a) Produce a statement that reconciles the budgeted and actual gross profit
for product X for July showing the variances in as much detail as possible.
(b) The details in the table below have been extracted from the company’s
accounting records for August.
Budget Actual
Output of X 800 units 890 units
Materials 4 000 kg 4 375 kg
Cost per kg R20.00 R21.60

It has now been realised that the standard cost per kg of the material should
have been R20.90.
Calculate the following materials variances for August:
(i) Total materials cost variance
(ii) Planning variance for materials price
(iii) Operational variances for materials price and materials usage.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

(c) Discuss three advantages of using a standard costing system that identifies
both planning and operational variances.
11.5 Sencam Designs manufactures exclusive furniture. Results have been disap-
pointing in recent years, and a new managing director, Nayshia Woods,
was appointed to raise production volumes. After an initial assessment, she
considered that budgets had been set at levels which were easy for employees
to achieve. She argued that employees would be better motivated by setting
budgets which challenged them more in terms of higher expected output.

Cost and Management Accounting

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419

Other than changing the overall budgeted output, Ms Woods has not yet altered
any part of the standard cost card which appears below:
R
Materials 25 kg @ R32 per kg 800
Labour 4 hours @ R80 per hour 320
Variable overheads 4 hours @ R40 per hour 160
Fixed overheads 4 hours @ R160 per hour 640
1 920
Selling price 2 200
Standard profit 280

The budgeted output and sales for December 20X1 was 4 000 units. Overheads
are absorbed on the basis of labour hours, and the company uses an absorption
costing system. There are no stocks at the beginning of December 20X1. Stocks
are valued at standard cost.
The actual results for December 20X1 are given in the table below.
R
Sales 3 200 units 7 200 000
Cost of sales 5 712 000
Material 80 000 kg @ R35 2 800 000
Labour 16 000 hours @ R70 1 120 000
Variable overheads 600 000
Fixed overheads 1 960 000
Total production cost 3 600 units 6 480 000
Closing stock 400 units @ R1 920 768 000
Actual profit 1 488 000

The average monthly production and sales for several years prior to December
20X1 had been 3 400 units, and budgets had previously been set at this level.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Very few operating variances had been historically generated by the standard
costs used.
Ms Woods has made some significant changes to the operations of the
company. However, the board of directors thought that Ms Woods had been
too ambitious in raising production standards. Ms Woods also made the
following changes:
● Changed suppliers of raw materials to improve quality
● Increased selling prices
● Introduced unskilled labour
● Significantly reduced fixed overheads.

Standard costing

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420

The finance director suggested that an absorption costing system is misleading

and the company should consider adopting a marginal costing system at some
stage in the future to guide decision making.

Required:
(a) Calculate all possible operating variances.
(b) Reconcile the budgeted and actual profit for the month for Sencam Designs.
(c) Examine the impact of the operational changes made by Ms Woods on the
profitability of the company. In your answer, consider the following:
(i) Motivation and budget setting
(ii) Possible causes of variances.
(d) Reconcile the budgeted and actual profit for the month if the company
were to change to the marginal costing system.
11.6 Part A
Baloo Ltd currently makes use of a standard absorption costing system for
planning and control purposes. This costing system is now under review by the
newly appointed cost accountant. She has started preparing a statement that
reconciles the budgeted and actual profit of Baloo Ltd based on the information
supplied below. She needs your help, however, to obtain the missing figures.
The following budget data relates to the production of Product Baloo for June
20X1. The product gets manufactured by mixing two types of raw materials, So
and Da.
Cost
Raw material input: So (0.4 kg @ R6/kg) R2.40
Raw material input: Da (0.6 kg @ R16/kg) R9.60
Raw material cost per kg input R12.00
Yield 96%
Raw material cost per kg output R12.50
Fixed manufacturing overhead per kg of output R0.40
Total standard cost per kg of output R12.90

Budgeted data for Product Baloo for the period is detailed in the following table:
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Sales 72 000 kg
Production 70 000 kg
Baloo opening inventory (valued at R25 800) 2 000 kg
Selling price per kg R22
Fixed production overheads R28 000

The fixed production overhead absorption rate is based on the budgeted

number of kilograms produced. All inventories are valued at standard cost.

Cost and Management Accounting

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421

Actual data for Product Baloo for the period was as follows:

Sales 71 000 kg
Production 69 000 kg
Selling price per kg R23.00
Fixed production overheads incurred R27 800
Purchase cost per kg of raw material So R6.50
Purchase cost per kg of raw material Da R15.80
Input of raw material So 29 900 kg
Input of raw material Da 40 100 kg

Required:
(a) Complete the statement that reconciles the budgeted and actual profit for
Product Baloo, showing the missing variances as set out in the template.
Reconciliation statement of Baloo Ltd for June 20X1.
R
Budgeted profit: ?
Budgeted sales ?
Budgeted cost of sales:
Budgeted production cost ?
Opening inventory 25 800
Variances: F/A*
Sales margin price variance ? ?
Sales margin volume variance ? ?
Material price variance: 6 930 A
So 14 950 A
Da 8 020 F
Material mix variance: 19 000 ?
So ? ?
Da ? ?
Material yield variance: ? F
Copyright © 2021. Juta & Company, Limited. All rights reserved.

So ? ?
Da ? ?
Fixed overhead expenditure variance ? ?
Fixed overhead volume variance ? ?
Actual profit: ?
Actual sales revenue 1 633 000
So (194 350)
Da ?
Fixed overheads incurred (27 800)
Opening inventory ?
*F/A = Favourable/Adverse

Standard costing

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422

Part B
A subdivision of Baloo Ltd is Lifelab, a chemical processing division that
produces pesticides used by farmers to protect their crops. One of these
pesticides is made by mixing three active ingredients. The standard material
cost details for 1 litre of this pesticide are as follows:

R
0.4 litres of Cyphenothrin @ R30 per litre 12.00
0.3 litres of Imiprothrin @ R30 per litre 9.00
0.5 litres of Propoxur @ R15 per litre 7.50
Standard material cost of 1 litre of pesticide 28.50

During August, Lifelab produced 1 000 litres of this pesticide using the
following active ingredients:
● 600 litres of Cyphenothrin costing R18 000
● 250 litres of Imiprothrin costing R8 000
● 500 litres of Propoxur costing R8 500.
You are the management accountant of Lifelab and the production manager
has sent you the following email:
‘I was advised by our purchasing department that the worldwide price of
Imiprothrin had risen by 50%. As a result, I used an increased proportion
of Cyphenothrin than is prescribed in the standard mix, so that our costs
were less affected by this price change. Management has approved a change
in the standard price of Imiprothrin to be on par with the price hike.’

Required:
(a) Calculate the following operational variances:
(i) Direct material mix
(ii) Direct material yield.
(b) Discuss the decision taken by the production manager.
11.7 A company produces trays of pre-prepared meals that are sold to restaurants
and food retailers. Three varieties of meals are sold: economy, premium and
Copyright © 2021. Juta & Company, Limited. All rights reserved.

deluxe.
Extracts from the budget for last year are given in the table below.
Economy Premium Deluxe
Sales quantity (trays) 180 000 360 000 260 000
Selling price per tray R2.80 R3.20 R4.49
Total sales revenue R504 000 R1 152 000 R1 167 400
Direct material cost per tray R1.00 R1.60 R2.20
Total direct material cost R180 000 R576 000 R572 000
Direct labour cost per tray R0.50 R0.50 R0.50
Total direct labour cost R90 000 R180 000 R130 000

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423

Overhead costs for the budget were estimated using the high-low method,
based on the total overhead costs for three previous years:
Output 720 000 trays 680 000 trays 840 000 trays
Total overheads R1 016 000 R992 000 R1 096 000

Actual results for last year are given in the table below:
Economy Premium Deluxe
Sales quantity (trays) 186 000 396 000 278 000
Selling price per tray R2.82 R3.21 R4.50
Total sales revenue R524 520 R1 271 160 R1 251 000
Direct material cost per tray R1.10 R1.50 R2.10
Total direct material cost R204 600 R594 000 R583 800
Direct labour cost per tray R0.52 R0.54 R0.48
Total direct labour cost R96 720 R213 840 R133 440
Variable overhead per tray R0.64 R0.66 R0.63
Total variable overheads R119 040 R261 360 R175 140
Actual fixed overheads: R546 000

The company operates a just-in-time system for purchasing and production and
does not hold any inventory.
Ignore inflation.

Required:
(a) Calculate, for the original budget, the budgeted fixed overhead costs, the
budgeted variable overhead cost per tray and the budgeted total overhead
costs.
(b) Prepare, for last year, a budget control statement on a marginal cost basis
for the premium product. The statement should show the original budget,
the flexed budget and the total budget variances for sales revenue and each
Copyright © 2021. Juta & Company, Limited. All rights reserved.

cost element.
(c) Discuss the benefits of flexible budgeting for planning and control purposes.
You should use the figures calculated in (b) above to illustrate your answer.
(d) The company has previously calculated only a sales volume variance, but
has now decided that valuable management information will be provided
by further analysis of this variance.
(i) Calculate the sales quantity contribution variance.
(ii) Calculate the sales mix contribution variance.
(e) Explain why the analysis of the sales volume variance into the sales quantity
and sales mix variances will provide valuable management information.
Your answer should refer to the figures calculated in (d) above.
Source: CIMA (adapted)

Standard costing

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424

11.8 Bratz Manufacturing Inc. opened for business in June of 2005 specialising in
service, quality, value and commitment. They have a team of very knowledgeable
people with many years’ experience in customer service, quality control,
engineering and manufacturing. Their location is in the CBD of Durban, giving
them a central location with excellent service times to the surrounding areas.
Bratz Manufacturing makes and sells a single product. The company operates a
standard marginal costing system and a just-in-time purchasing and production
system. No inventory of raw materials or finished goods is held. Details of the
budget and actual data for the previous period are given below.
Budget data:
Standard production costs per unit are given in the table below.
R
Direct material 8 kg @ R10.80 per kg 86.40
Direct labour 1.25 hours @ R18.00 per hour 22.50
Variable overheads 1.25 hours @ R6.00 per direct labour hour 7.50

● Standard selling price: R180 per unit

● Budgeted fixed production overheads: R170 000
● Budgeted production and sales: 10 000 units.
Actual data:
● Direct material: 74 000 kg @ R11.20 per kg
● Direct labour: 10 800 hours @ R19.00 per hour
● Variable overheads: R70 000
● Actual selling price: R184 per unit
● Actual fixed production overheads: R168 000
● Actual production and sales: 9 000 units.

Required:
(a) Prepare a statement using marginal costing principles that reconciles the
budgeted profit and the actual profit. Your statement should show the
variances in as much detail as possible.
(b) (i) Explain why the variances used to reconcile profit in a standard marginal
Copyright © 2021. Juta & Company, Limited. All rights reserved.

costing system are different from those used in a standard absorption

costing system.
(ii) Calculate the variances that would be different, and any additional
variances that would be required if the reconciliation statement was
prepared using standard absorption costing.
(c) Explain the arguments for the use of traditional absorption costing rather
than marginal costing for profit reporting and inventory valuation.

Cost and Management Accounting

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425

11.9 A furniture company manufactures high-quality diningroom furniture that is

sold to major retail stores.
Extracts from the budget for last year are given below:
Tables Chairs Sideboards
Sales quantity (units) 8 000 26 000 6 000
Average selling price R2 200 R320 R2 800
Direct material cost per unit R1 000 R160 R1 200
Direct labour cost per unit R400 R60 R600
Variable overhead cost per unit R40 R6 R60

The budgeted direct labour cost per hour was R20.

Actual results for last year are given in the table below:
Tables Chairs Sideboards
Sales quantity (units) 7 200 31 000 7 800
Average selling price R2 400 R310 R2 500
Direct material cost per unit R1 100 R150 R1 300
Direct labour cost per unit R450 R60 R600
Variable overhead cost per unit R60 R8 R80

The actual direct labour cost per hour was R18.75.

Actual variable overhead cost per direct labour hour was R2.50.
The company operates a just-in-time system for purchasing and production and
does not hold any inventory.

Required:
(a) Calculate the following variances for the furniture company for last year:
(i) Sales mix contribution variance
(ii) Sales quantity contribution variance.
(b) Explain the meaning of the variances calculated in (a) above. You should
refer to the figures calculated to illustrate your answer.
(c) Prepare, for sideboards only, a statement for last year on a marginal cost
Copyright © 2021. Juta & Company, Limited. All rights reserved.

basis that reconciles the budgeted contribution to the actual contribution.

The statement should show the variances in as much detail as possible.
(d) Explain three factors that a company would need to consider before
deciding whether to investigate a variance.
11.10 PQ produces two products, Product B and Product C. The company uses a
standard absorption costing system that absorbs overheads on the basis of
direct labour hours. The company operates a just-in-time purchasing and
production system and no inventory of raw materials or finished goods is held.
Standard selling prices are determined by adding a 100% mark-up to total
production costs per unit.
The following budget and actual data relate to August.

Standard costing

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Budget data:
Product B Product C
Production and sales 2 200 units 1 800 units
Standard production costs per unit: R R
Direct material (R5 per kg) 25.00 35.00
Direct labour (R7 per hour) 14.00 10.50
Variable overhead 3.00 2.25
Fixed overhead 8.00 6.00

Actual data:
Product B Product C
Production and sales 3 000 units 1 500 units
Selling price per unit R110 R105
Production costs:
Direct material R124 800 (25 600 kg)
Direct labour R67 980 (9 140 hours)
Variable overheads R14 300
Fixed overheads R27 000

The company produces a monthly variance analysis report which has pre-
viously included the calculation of the sales volume profit variance. The new
management accountant has decided to extend this analysis and replace the
sales volume profit variance with the sales mix profit margin variance and the
sales quantity profit variance.

Required:
(a) Prepare a statement that reconciles the budgeted gross profit and actual
gross profit for August. The variances should be shown in as much detail
as possible, including the individual sales mix profit margin variances and
the individual sales quantity profit variances.
(b) Explain the benefits to the company of separating the sales volume profit
variance into the sales mix profit margin variance and the sales quantity
profit variance. You should use the figures calculated in (a) to illustrate
your answer.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

(c) Explain two reasons why a standard costing system may not be considered
appropriate in a modern manufacturing environment.
Source: CIMA (adapted)
11.11 XYZ Ltd makes a single product and uses marginal costing. The standard cost
data for the product consists of a selling price of R175; direct material of R16
(8 kg @ R2); direct labour of R20 (4 hours @ R5); variable overheads of R60
(4 hours @ R15).
The average production volume per period is 500 units, but during period 6,
only 450 units were made and sold. At the end of the period the following
variance statement was prepared showing the results for period 6.

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Budget (R) Actual (R) Variances (R)

Sales 87 500 83 250 4 250 A
Less: Marginal cost
Direct materials 8 000 (3 690 kg used) 7 650 350 F
Direct labour 10 000 (1 840 hours worked) 8 100 1 900 F
Variable overheads 30 000 28 350 1 650 F
Contribution 39 500 39 150 350 A
Less: Fixed costs 25 000 24 650 350 F
Profit 14 500 14 500 –

After studying the report, the general manager expressed surprise that all the
cost variances were favourable, as he understood that there had been some
production problems. Furthermore, the sales manager had told him that he
had been able to make some excellent sales during the period, which seemed at
odds with the statement.

Required:
(a) Reconcile budgeted contribution to actual contribution, adjust for fixed
cost, and disclose the actual profit.
(b) Explain briefly why your revised presentation differs from the original statement.
(c) The general manager mentions that he has seen an article stating that
standard costing is becoming less useful in modern factories. He is puzzled
by this, and wonders whether the company should stop using the technique.
You are required to prepare a reply to the general manager explaining
what the article refers to, and giving your opinion whether standard costing
should continue to be used within the company.
Source: CIMA (adapted)
11.12 A newly formed engineering company has just completed its first three months
of trading. The company manufactures only one type of product. The external
accountant for the company has produced the following statement to present
at a meeting to review performance for the first quarter.
The performance report for the quarter ending 31 October 20X2 is given in
the table.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Budget Actual Variance

Sales units 12 000 13 000 1 000
Production units 14 000 13 500 (500)
R R R
Sales 360 000 385 000 25 000
Direct materials 70 000 69 000 1 000
Direct labour 140 000 132 000 8 000
Variable production overhead 42 000 43 000 (1 000)
Fixed production overhead 84 000 85 000 (1 000)
Inventory adjustment (48 000) (12 000) (36 000)
Cost of sales 288 000 317 000 (29 000)
Gross profit 72 000 68 000 (4 000)

Standard costing

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428

The external accountant has stated that she values inventory at the budgeted
total production cost per unit.

Required:
(a) Produce an amended statement for the quarter ending 31 October 20X2
that is based on a flexed budget.
(b) Explain one benefit and one limitation of the statement you have produced.
(c) Explain the links between budgets, standard costs and flexible budgeting.
(d) Discuss the importance of your answer to (c) for management control.

Source: CIMA (adapted)

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12 Dealing with risk and
uncertainty in decision
making

Dealing with risk and uncertainty

Payoff tables
Value of
Decision criteria Measuring risk and expected Decision trees
information
value

Learning objectives
After studying this chapter, you should be able to:
● Distinguish between decision making based on risk and that based on uncertainty
● Explain and apply the maximin, maximax and minimax decision criteria
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● Apply the expected value approach to decision making and outline its limitations
● Calculate and interpret the standard deviation and coefficient of variation as
measures of risk
● Calculate the value of perfect and imperfect information
● Draw and evaluate a decision tree.

Introduction
Decision making involves making decisions now about what will happen in the future.
Decision-making problems such as whether to build a large plant or a small plant, or
whether to launch new products, etc, involve an element of risk and uncertainty. In
this chapter, we will focus on how risk and uncertainty can be built into the decision-
making process.

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Decision making based on risk

Risk is where there are a number of possible outcomes and the probability of each outcome
is known, for example an organisation markets a new product and knows that the
campaign will either be successful or unsuccessful, and the probabilities can be assigned to
these outcomes.
Decision making based on risk refers to situations where the decision-maker is able to
assign probabilities to the possible outcomes of events, based on past experience, market
research, etc. Risk exists where we do not know exactly what will occur in the future, but the
various possibilities are weighted by their probability of occurrence. Risk can be measured,
provided statistical evidence exists.

Case study: British Airways

There are many ways to assess risk and uncertainty in the business environment. British
Airways, in their annual report, outline the risk and uncertainties of their industry. The
operational complexities inherent in the business, together with the highly regulated
and commercially competitive environment of the airline industry, leave the organisation
exposed to a number of risks. Many of these risks – for example, changes in governmental
regulation, acts of terrorism, pandemics, and the availability of funding from the financial
markets – can be mitigated to a certain degree, but remain beyond the organisation’s
control. The Group carries out detailed risk management reviews to ensure that the
risks are mitigated where possible. The directors believe that the risks and uncertainties
described here are the ones that could have the most significant impact on the long-term
value of British Airways.

Brand reputation: The brand is of significant commercial value. Erosion of the brand
could adversely impact on their leadership position with customers and affect future
profitability.

Competition: The markets in which they operate are highly competitive. Some
competitors have cost structures that are lower or have other competitive advantages
such as being supported by government intervention. Fare discounting by competitors
has a negative effect on results, because they are generally required to respond to
competitors’ fares to maintain passenger traffic.
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Consolidation/deregulation: The airline industry is fiercely competitive and will need

to rationalise to meet current market conditions. This will involve further airline failures
and consolidation. As in all consolidations, a merger would introduce integration risks,
such as a failure to realise planned benefits, brand erosion and other execution risks.
Mergers and acquisitions amongst competitors have the potential to adversely affect the
organisation’s market position and revenue.

Debt funding: They carry substantial debt which will need to be repaid or refinanced.
Their ability to finance ongoing operations, committed aircraft orders and future fleet
growth plans may be affected by various factors, including financial market conditions.
➤➤

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Employee relations: They have a large unionised workforce. Collective bargaining takes
place on a regular basis and a breakdown in the bargaining process could disrupt
operations and adversely affect business performance. Continued effort to reduce
employment costs, through increased productivity and competitive wage awards,
increases the risk in this area.

Environment: Failure to adopt an integrated environmental strategy could lead to

deterioration in their reputation and a consequential loss of revenue. An increased focus
on corporate responsibility and a published emissions reduction target will help deliver
the refocused strategy.

Fuel price and currency fluctuation: Volatility in the price of oil and petroleum products can
have a material impact on operating results, which can generate a profit or a loss. The Group
is exposed to currency risk on revenue, purchases and borrowings in foreign currencies.

Global economic slowdown/credit crunch: Their revenue is highly sensitive to economic

conditions in the markets in which they operate. Further deterioration in the global
economy may have a material impact on their financial position. The financial services
sector is one of their key customer segments, and continued difficulties in the banking
industry represent a significant risk to their revenue.

Government intervention: The airline industry is becoming increasingly regulated. The

scope of such regulation ranges from infrastructure issues relating to slot capacity and
route flying rights, through to new environmental and security requirements. Their ability
to both comply with and influence any changes in these regulations is key to maintaining
their operational and financial performance.

Key supplier risk: They are dependent on suppliers for some principal business processes.
In the current economic environment, their suppliers are at increased risk of business
failure. The failure of a key supplier may cause significant disruption to their operation.

Safety/security incident: The safety and security of customers and employees are
fundamental. Failure to prevent or respond to a major safety or security incident could
adversely impact on operations and financial performance.
Source: British Airways (2008/09)
Discussion questions:
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1. Do you think management accountants should spend a lot of time trying to analyse
different risks?
2. What economic factors might reduce business uncertainty?
3. Scores of passengers were left stranded when the low-cost airline, 1Time, announced
on 2 November 2012 that it had applied for liquidation and stopped all operations.
It had about R320 million in short-term debt, and had been in negotiations with
creditors since March. What lessons in risk assessment could they have learnt from
British Airways? Is it possible to assess all business risks?
4. The Star reported that customers who paid cash for their 1Time air tickets might not
get refunded. However, the money paid through a credit card could be recovered.
Could the customers have avoided this loss?
Source: Times Live (2012)

Dealing with risk and uncertainty in decision making

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Payoff tables, probabilities, expected values, and conditional profits

When conditions of uncertainty exist, probabilities can be useful in determining the best
course of action under those circumstances. When the decision-maker is faced with several
courses of action, a payoff table can be constructed to help in choosing the best course of
action. A payoff table shows all the outcomes of the various events for each alternative
action, the conditional value of each outcome, and the expected value of each alternative
based on the probabilities of the outcomes that can occur. The expected value method
is most frequently applied to decision making based on risk. The expected value is the
highest estimated profit or lowest cost. It is calculated by weighing each of the outcomes by
its related probability and summing them into a single value (also referred to as the mean).
When a decision-maker is faced with several decisions and each one has several possible
outcomes, the optimum decision is the one with the highest expected value. The choice of
the option with the highest expected value is known as the Bayes strategy. The formula is
as follows:

EV = ∑px

Where:
x = future outcome
p = probability of occurrence of the event.

The conditional profit relates to the profit that will result if a possible outcome occurs. It
may also be expressed in terms of cost, cash flow or losses. The probability is the likelihood
that an event will occur, and it is usually measured on a scale of 0 to 1 or 0% to 100%. The
sum of probabilities must be equal to 1 or 100%. For example, the probability of passing
the exam is 60% (0.60), and obtaining a supplementary exam is 10% (0.10), therefore, the
probability of failing is 30% (0.30). A probability of 0.3 indicates that the event is expected
to occur three times out of ten. All this information can be presented on a probability
distribution where all possible outcomes for an event and the probability of each outcome
occurring is listed. The probability distribution for the above illustration is as follows:

Outcome Probability
Pass exam 0.6
Obtain a supplementary exam 0.1
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Fail exam 0.3

Total 1.0

Illustrative example 12.1

Trendy Hair Salon is deciding which of two leading brand shampoo and conditioner
ranges to sell in its KwaZulu-Natal salons. Market research has indicated the probabilities
and outcomes given in the following table.
➤➤

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Table 12.1 Probabilities and outcomes for ranges

Bliss range Herbal range
Probability (PX) Outcome (X) Probability (PX) Outcome (X)
0.20 R20 000 0.10 R15 000
0.50 R60 000 0.30 R80 000
0.10 R100 000 0.40 R50 000
0.20 R80 000 0.20 R80 000

Using the expected value approach, determine which range of shampoo and conditioner
should be selected.

Solution:
Trendy Hair should choose the Herbal range, as it will yield a higher expected profit of
R61 500.
Table 12.2 Expected monetary value
Bliss range Herbal range
Probability Outcome (X) Expected Probability Outcome (X) Expected
(PX) (R) value (R) (PX) (R) value (R)
0.20 20 000 4 000 0.10 15 000 1 500
0.50 60 000 30 000 0.30 80 000 24 000
0.10 100 000 10 000 0.40 50 000 20 000
0.20 80 000 16 000 0.20 80 000 16 000
60 000 61 500

Test yourself 12.1

A company is considering the launch of a new product which it estimates has a 75%
chance of success if no marketing is undertaken. The company believes that if it
undertakes a marketing campaign costing R50 000, the probability of success of the
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product will increase to 90%.

If successful, the product will make a profit of R300 000, before marketing costs. However,
if it is unsuccessful, the product will make a loss of R80 000 before marketing costs.

Required:
Calculate whether it is worthwhile for the company to undertake the marketing campaign.
Source: CIMA (adapted)

Standard deviation and coefficient of variation

In addition to determining the expected value, another useful calculation is the standard
deviation which gives management an indication of the degree of uncertainty of the

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expected value. The standard deviation enables the decision-maker to judge the probability
distribution more effectively. It also gives an indication of how the various outcomes are
distributed around the expected value. The standard deviation compares all the actual
values with the mean outcome, and then calculates how far on average the outcomes deviate
from the mean (expected value). The more the outcomes vary from the average (expected
value), the more volatile the returns, resulting in a more risky investment. The standard
deviation is calculated by using the following formula:
____________
σ5√ ¯
  − Px 
∑(X − )
X
Where:
σ = standard deviation
∑ = sum of
X = observation in the data set
__
X
= mean value (expected value)
Px = probability of each outcome.

The coefficient of variation is used to overcome the shortcomings of the standard

deviation, that is, if we have two probability distributions with different expected values,
then their standard deviations are not directly comparable. The coefficient of variation is a
measure which relates the standard deviation of a probability distribution to its expected
value by measuring the relative size of the risk. It is calculated by dividing the standard
deviation by the mean (expected value):
σ(standard deviation)
 __________________
    
X (expected value)
 

Illustrative example 12.2

Use the previous example on Trendy Hair Salon and calculate the standard deviation
and coefficient of variation. Interpret your answer.

Solution:
Table 12.3 Standard deviation and coefficient of variation of Bliss range
Bliss range
Outcome Expected Deviation Standard Probability Weighted
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_
(X) value ( X ) from deviation (P) amount
_ _
expected (X −  X )2 (X − ( X )2 PX
value
_
X −  X
R R R R R
20 000 60 000 −40 000 1600 000 000 0.20 320 000 000
60 000 60 000 0 0 0.50 0
100 000 60 000 40 000 1600 000 000 0.10 160 000 000
80 000 60 000 20 000 400 000 000 0.20 80 000 000
560 000 000
➤➤

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Standard deviation σ 23 664.32

_
Expected value (mean) X

60 000
Coefficient of variation 0.39

Table 12.4 Standard deviation and coefficient of variation of Herbal range

Herbal range
Outcome Expected Deviation Squared Probability Weighted
_
(X) value ( X ) from deviation (PX) amount
expected _ _
  )2
(X − X (X −  X )2 PX
value
_
X −  X
R R R R R
15 000 61 500 −46 500 2 162 250 000 0.10 216 225 000
80 000 61 500 18 500 342 250 000 0.30 102 675 000
50 000 61 500 −11 500 132 250 000 0.40 52 900 000
80 000 61 500 18 500 342 250 000 0.20 68 450 000
440 250 000

Standard deviation σ 20 982.14

_
Expected value (mean) X

61 500
Coefficient of variation 0.34

The Bliss range has a higher standard deviation and will thus be more risky. The Bliss
range has the larger coefficient of variation, which represents the greater uncertainty,
that is, the greater risk that the expected value will not be attained. According to the
coefficient of variation, the herbal range is more favourable. The final selection will be
based on the risk attitude of the organisation.

Test yourself 12.2

Pizza Express sells three sizes of chicken pizza – small, medium and large. On a Sunday,
the expected profits are R3 000, R4 000 and R5 000, respectively. The probability of
occurrence is: 30% of the orders will be for small, 50% for medium, and 20% for large pizzas.

Required:
Calculate the expected value, standard deviation and coefficient of variation.

Perfect and imperfect information

When decision-makers receive forecasts of future outcomes, these may turn out to be
correct or incorrect. Additional information may be useful in selecting the best alternative.
The value of the information can be costly. However, the cost should be weighed against
the increase in expected value that may result by using the additional information. If the

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increase in expected value is greater than the cost of the additional information, then the cost
should be incurred. The value of information could be either perfect or imperfect. Perfect
information is where the forecast of the future outcome is always a correct prediction, that
is, always 100% correct.
Imperfect information is where the forecast is usually correct, but can be incorrect.
Imperfect information usually ties in with decision trees. The value of information is
calculated by subtracting the expected value without perfect information from the expected
value with perfect information. The illustrative example below shows how to determine the
value of information.

Illustrative example 12.3

Senay Shi is a local newspaper dealer who buys newspapers for R2.80 and sells them for
R3.40. Whatever newspapers are unsold by the end of the day are discarded at a total
loss. Senay Shi needs to determine the daily quantity of newspapers to order. Purchasing
insufficient quantities would result in not meeting the demand and forfeiting R0.60 in
profit. On the other hand, ordering too many would result in losing R2.80 for each
unsold newspaper. After studying the sales of the past 50 days, Senay Shi came up with
the probability distribution of demand given in the table below.
Table 12.5 Probability distribution of demand
Sales per day Days Probability
100 5 0.1
200 25 0.5
300 20 0.4
50 1

The daily profits based on a profit of R0.60 per unit at the three levels are given in the
table below.
Table 12.6 Daily profits
Stock Sold Discarded Profit on Loss on Daily profit/
sales discards loss
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R R R
100 100 0 60 0 60
200 100 100 60 280 −220
200 0 120 0 120
300 100 200 60 560 −500
200 100 120 280 −160
300 0 80 0 80

➤➤

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The expected value is calculated at each level by multiplying the daily profit (loss) by the
probabilities. This can be shown in the payoff table.

Table 12.7 Payoff table at 3 levels of sales demand

Sales demand Probability Daily supply
100 units 200 units 300 units
100 units 0.1 R6 −R22 −R50
200 units 0.5 R30 R60 −R80
300 units 0.4 R24 R48 R72
Expected value R60 R86 R58

When the daily supply is 100 newspapers and demand is also 100 newspapers, the
daily profit is R6; if daily supply is 200 newspapers and demand is 100 newspapers,
then a loss of R22 is expected, etc. On the basis of expected values, the best strategy
would be to order 200 newspapers and gain an expected value of R86. Senay Shi wants
to improve profits, but would require more information to make better predictions of
sales demand on a daily basis. Additional information would cost money. How much
would she be justified in paying for this information? The value of the information can
be calculated as given in the table below.

Table 12.8 Expected value of perfect information

Sales demand Daily profit (R) Probability Expected value (R)
100 60 0.1 6
200 120 0.5 60
300 180 0.4 72
Expected value with perfect information 138
Expected value with uncertainty 86
Expected value of perfect information 52

As determined previously, the maximum daily payoff under uncertainty is R86. The
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maximum amount that she should be willing to pay for more reliable information
is R52, which is known as the expected value of perfect information. It is calculated
by subtracting the expected value with uncertainty from the value assuming perfect
knowledge. Perfect information is seldom possible. However, the calculation of perfect
information would give an indication of how much should be expended on obtaining
more valuable information.

Dealing with risk and uncertainty in decision making

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Test yourself 12.3

A retailer wants to introduce a new product with a selling price of R100, R105, R110
or R115. There is a 30% chance that demand could be high, a 50% chance that demand
will be at a medium level and a 20% chance that demand will be low.

A payoff table shows the profits based upon the sales price and the level of demand.

Sales price
Demand R100 R105 R110 R115
High R1 700 000 R1 725 000 R1 700 000 R1 625 000
Medium R700 000 R600 000 R450 000 R250 000
Low R100 000 R60 000 R0 (R80 000)

Using an expected value approach, the retailer decides the sales price should be set at
R100 as this gives the highest expected profit of R880 000. A market research company
has since approached the retailer. They believe that perfect information on the demand
level can be provided to the retailer.

Required:
Determine the maximum amount that should be paid for the information from the
market research company.

Decision trees
When a decision depends on a sequence of linked, risky situations, the problem becomes more
complex. A decision tree is a useful analytical tool that can be used in determining the best
course of action under conditions of uncertainty. It is a pictorial representation of all possible
courses of action (decisions) and the consequent possible outcomes. It is very useful for studying
a decision situation, and can provide assistance in the clarification of complex decisions.

Nodes used in designing a decision tree

A square (□) denotes a decision node, which is the point at which a choice exists between
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alternatives and where a decision must be made, based on estimates and expected returns.
The branches going out from this point indicate the alternative courses of action under
consideration, and a decision must be made between alternatives. A decision node also
indicates that the final decision has not been made, and a choice between alternatives exists.
A circle (○) denotes an event node, which is the point where the outcomes of possible
occurrences are dependent on probabilities. The branches at this point have probabilities
attached to each outcome which must add up to 1 (100%).

Steps in designing a decision tree

1. Identify all the decisions that have to be made.
2. Identify all events/outcomes that can occur.
3. Decide on the chronological order (sequence) of the decisions and events/outcomes.

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4. Draw the decision tree from left to right (known as forward induction, which is where the
tree is drawn), indicating the chronological order and using the correct nodes, that is,
decision and event nodes, linking the nodes with branches.
5. Allocate the probabilities to all outcomes of each event, ensuring that the probabilities
for an event add up to 1 (100%). Do not allocate a probability to a decision.
6. Determine the conditional profit/loss/cash flow/cost for each branch of the tree. This
relates to the profit/loss/cash flow/cost that will occur if that outcome occurs, without
taking into effect the probabilities that are linked to it (this is done in step 7)
7. Calculate the expected monetary values for each node from right to left of the tree
(known as backward induction, where the tree is evaluated). The expected value for a
decision node is the choice between the highest expected value of the event node, that
is, choose the most profitable option where the expected value is based on profit. The
expected value for an event node is calculated by multiplying the probabilities by the
conditional profits, and then adding the expected values for that event node.
8. Make a decision on the course of action to be taken, based on monetary considerations
only. The alternative that is not chosen is indicated by a parallel line crossing the branch.

Illustrative example 12.4

Prima Innovations (Pty) Ltd has a new product called Duel that their design team have
recently developed after spending the past two years on research and development. After
that long battle, the company now faces two courses of action, that is, to test the market
for Duel, or abandon it. It will cost them R100 000 to test the market for the product,
and the market response could be positive or negative, with probabilities of 0.60 and 0.40
respectively. If the response is positive, the company could either abandon the product,
or continue to market it. If the company goes ahead with the market launch, the demand
might be low or high, with probabilities of 0.60 and 0.40 respectively, and the net gain
for a low demand would be R100 000, or R750 000 for a high demand. If the result of
the test marketing is negative and the company goes ahead and markets the product
the estimated losses would be R600 000. The company may at any point abandon the
product, and there would be a net gain of R50 000 from the auction of scrap.

Required:
Advise the company as to the best possible course of action by using a decision tree.
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The time value of money may be ignored.

Solution:
Steps 1 to 3: The starting point for the tree is to establish what decisions have to be made
now. What are the alternative options? In this case, they are to test the market, or abandon
the product. The outcome of the abandon option is known with certainty. There are two
possible outcomes of the option to test the market, that is, positive response and negative
response. Depending on the outcome of the testing of the market, another decision will
then be made − to abandon the product, or to go ahead with the market launch.
➤➤

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Step 4: Draw the tree, starting from left, showing the various decision points and
outcome nodes. Concentrate first on the logic of the problem and do not bother with
the values and probabilities to start with. The decision tree should be illustrated as
shown in Figure 12.1. This is known as the forward pass.
High

O2
Market Low

Positive
Abandon

O1
Test
Negative
D1 Market
D3 Abandon

Abandon

Figure 12.1 Forward pass

Steps 5 and 6: Fill in the outcome values and probabilities as shown in Figure 12.2.
Conditional
profit (R)
High 0.4
+750 000

O2
Market Low 0.6
+100 000
D2

Positive
Abandon
0.6 +50 000
Test
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(100 000) O1
0.4

D1 Negative
Market
–600 000
D3 Abandon
+50 000

Abandon

+50 000

Figure 12.2 Outcome values and probabilities

➤➤

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Step 7: Use the probabilities and outcome values, and calculate the expected values at
various points so that the correct decisions are highlighted. This stage works from right
to left and is known as the backward pass.
Conditional Expected
profit value
High 0.4
+ 750 000 300 000
O2
EV+
360 000
Market Low 0.6
+ 100 000 60 000
D2 360 000
EV+
360 000
Positive
Abandon
0.6 +50 000
O1
Test EV+
(100 000) 236 000
0.4
Negative
D1 Market
D3 –600 000
EV+
50 000 Abandon
+50 000

Abandon

+50 000

Figure 12.3 Backward pass

Figure 12.3 shows the expected values (probability multiplied by conditional profit) in
the event nodes and at D2 and D3, the highest expected values from the subsequent
part of the tree, indicating the best decision.

Step 8: Interpret and recommend. Compare the options at D1:

Test option: Expected value at O1, less the test-marketing cost

= R236 000 − R100 000
= R136 000

Abandon option expected value of R50 000.

Decision: The choice would be to test the market of the product, because it has a higher
expected value of profit of R136 000.

Other factors to consider:

● Time value of money: If the span of time is in excess of one year, the time value of
money should be incorporated into the calculations.
● Risk neutrality: Some decision-makers do not choose the option with the greatest
expected value because they are either risk-seekers or risk averse.
● Sensitivity analysis: The analysis depends on the value of the probabilities in the tree.
These may be subjective estimates assigned by decision-makers and therefore may be
questionable irrespective of the experience of these people.

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Test yourself 12.4

HFSC Ltd has developed a promising new product. The business has three options
available. It can sell the idea of the new product to a company for R20 000, it can hire
a consultant to study the market and then make a decision, or it can arrange financing
for building a factory and then manufacture and market the product. The study will
cost HFSC Ltd R10 000, and its management believes that there is a 50-50 chance that
a favourable market will be found. If the study is unfavourable, management believes
that it can still sell the idea for R12 000. If the study is favourable, it believes that it
can sell the idea for R40 000. But even if a favourable market is found, the chance
of an ultimately successful product is about 40%. A successful product will earn a
profit of R500 000. Even with an unfavourable study, there is only a 10% chance that a
successful product can be expected. If HFSC Ltd’s management decides to manufacture
the product without a study, there is only a 25% chance of being successful. A product
failure costs R100 000.

Required:
Draw a decision tree and determine the course of action that would maximise expected
profits for HFSC Ltd.

Limitations of decision trees

● The time value of money is ignored.
● Decision trees are unsuitable for very complex situations involving too many decisions
and outcomes.
● Decision trees ignore risks, as the decision is based on the highest expected value which
may also have the greatest risks.
● The probabilities of the various outcomes are likely to be estimates which may possibly
be inaccurate or unreliable.

Decision making based on uncertainty

Decision making based on uncertainty refers to situations where the decision-maker has
little or no information enabling probabilities to be assigned, that is, uncertainty exists
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where there is no statistical evidence relating to outcomes. Therefore, the decision-maker

has little or no guidance in predicting them. Furthermore, not all decision-makers have the
same attitude towards risk. There are three types of decision-makers:
1. Risk averse decision-makers: They are likely to consider the strategy with the worst
possible outcome.
2. Risk neutral decision-makers: They will consider all outcomes and select the strategy
with the best possible outcome after taking all relevant information into account.
3. Risk-seekers: They are likely to consider the strategy with the best possible outcome,
regardless of the chance of it occurring.

When one is faced with making choices, there are several ways of making these choices. We
can play it safe and make the decision of choosing the option with the least damaging results;
we could look for the best outcome irrespective of how small the chance of occurrence is;

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look at the opportunity loss when we make a choice but later regret it; balance the expected
value of profit against the risk.
When it is impossible to allocate a probability to the outcome of an event, then the tools
discussed in the sections below can be used to incorporate uncertainty into decision making:

Decision-making criteria
● Maximax decision criterion takes on the highly optimistic view that the best possible
outcome will occur. Therefore, the alternative that will maximise the maximum result is
chosen, that is, ‘the best of the best’. Risk-seekers are likely to apply this criterion.
● Maximin decision criterion takes on a pessimistic view that the worst possible scenario
will occur. Therefore, the alternative with the best minimum result is chosen, that is, ‘the
best of the worst’. Risk averse decision-makers will apply this criterion.
● Minimax decision criterion aims to minimise the maximum possible regret. It is based
on the fact that, should the decision-maker not have selected an alternative that turns
out to be the best, they will regret not having chosen another alternative when they had
the opportunity. This is also referred to as the criterion of regret. Application of this
criterion is where the alternative which provides the minimisation of the maximum regret
(opportunity cost) is selected. The maximum opportunity cost must be determined first,
which is the profit forfeited by not choosing the best alternative. Thereafter, subtract all
other numbers in this row from the largest number. This method is useful for the risk
neutral decision-maker who does not wish to make the wrong decision.

Illustrative example 12.5

Caminaysh (Pty) Ltd, a manufacturer of children’s clothing, is deciding on which of
three new garments to market: fleece jackets, denim jackets, or woollen jackets. Only
one can be marketed, and there is no statistical evidence about the probable success of
the products. Management has provided the following payoff table under three possible
scenarios: customers’ attitudes could be high, neutral or low.
Table 12.9 Payoff table
Profit
Outcome
Fleece jackets Denim jackets Woollen jackets
High R4 000 R16 000 R2 000
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Neutral R8 000 R14 000 R20 000

Low R10 000 (R2 000) R8 000

Required:
Show how you would arrive at a decision on product choice using the maximax, maximin
and minimax decision criteria.
➤➤

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Solution:
Using the maximax criteria, an optimist would consider the best possible outcome for
each product and select the product with the greatest potential, which in this case
would be woollen jackets with the maximum potential profit of R20 000.

Using the maximin criteria, a pessimist would consider the worst possible outcome of
each product and then ensure that the maximum payoff is achieved if the worst were to
happen. Fleece jackets with a minimum payoff of R4 000 would be selected, compared
to R2 000 for denim jackets, or R2 000 for woollen jackets.

Using the minimax criterion, the opportunity cost is calculated for each product and
outcome as shown in the table below.
Table 12.10 Opportunity cost, using the minimax criterion
Outcome Profit
Fleece jackets Denim jackets Woollen jackets
High R12 000 0 R14 000
Neutral R12 000 R6 000 0
Low 0 R12 000 R2 000
Maximum opportunity cost R12 000 R12 000 R14 000

If a high outcome had to occur and we chose denim jackets, we would have maximised
our profit and there is 0 opportunity cost. If we chose fleece jackets, the maximum
opportunity cost is R12 000 (R16 000 − R4 000). If we chose woollen jackets, the
maximum regret is R14 000 (R16 000 − R2 000). The final selection is the product that
minimises the maximum opportunity cost, which in this case would be fleece or denim
jackets. However, denim jackets is a better option, as its next highest opportunity cost is
R6 000, compared to fleece jackets’ next highest opportunity cost of R12 000.

Test yourself 12.5

Apply the maximax, maximin and minimax decision criteria to the following payoff table of
the newspaper dealer introduced earlier. The payoff table was as given in the table below.
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Sales demand Probability Daily supply

100 units 200 units 300 units
100 units 0.1 R6 −R22 −R50
200 units 0.5 R30 R60 −R80
300 units 0.4 R24 R48 R72

Required:
How many newspapers should be ordered, based on the different decision criteria?

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Summary
Decision making is making choices between future, uncertain alternatives. Decision making
based on certainty is seldom possible, because future events cannot be forecasted with
accuracy. Decision making based on uncertainty occurs when the decision-maker does not
have sufficient information at their disposal to assign probabilities to events. The expected
value approach makes it possible to assign probabilities to events. The expected value can be
evaluated as a measure by calculating the standard deviation and the coefficient of variation
regarding the outcome of the event. The expected value of perfect information will give a
good indication of how much can be spent on additional information. A decision tree is a
pictorial representation of all decisions that are to be taken, as well as all events that can
occur if a particular decision should be made. It is presented in chronological order, and
a monetary value is placed on each alternative. This allows the decision-maker to choose
the best alternative. When there are too many alternatives and the use of the payoff tables
and decision tree analysis becomes impractical, the normal distribution becomes a more
practical solution.

Key concepts
Bayes strategy is the choice of the option with the highest expected value.
Coefficient of variation is a measure which relates the standard deviation of a probability
distribution to its expected value by measuring the relative size of the risk.
Conditional profit relates to the profit that will result if a possible outcome occurs. It
may also be expressed in terms of cost, cash flow or losses.
Decision node is the point at which a choice exists between alternatives and where a decision
must be made based on estimates and expected returns. It is represented by a square.
Decision tree is a useful analytical tool that can be used in determining the best course
of action under conditions of uncertainty. It is a pictorial representation of all possible
courses of action (decisions) and the consequent possible outcomes.
Event node is the point where the outcomes of possible occurrences are dependent on
probabilities. It is represented by a circle.
Expected value is the highest estimated profit or lowest cost. It is calculated by weighing
each of the outcomes by its related probability and summed into a single value (also
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referred to as the mean).

Imperfect information is where the forecast is usually correct, but can be incorrect.
Maximax decision criterion is based on the assumption that the best payoff will occur.
Maximin decision criterion is based on the assumption that the worst possible outcome
will occur and the decision-maker should choose the largest payoff when faced with
this criterion.
Minimax decision criterion aims to minimise the maximum possible regret. It is based
on the fact that, should the decision-maker not have selected an alternative that turns
out to be the best, they will regret not having chosen an alternative when they had
the opportunity.
➤➤

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Payoff table shows all the outcomes of the various events for each alternative action, the
conditional value of each outcome, and the expected value of each alternative based on
the probabilities of the outcomes that can occur.
Perfect information is complete and accurate information, where the forecast of the
future prediction is always 100% correct.
Probability is the likelihood that an event will occur, and is usually measured as a decimal
on a scale of 0 to 1. The sum of probabilities must equal 1 or 100%.
Probability distribution is where all possible outcomes for an event are listed, as well as
the probability of each outcome occurring.
Risk is applied to a situation where there are a number of possible outcomes, and
the probability of each outcome is known or can be derived, as there is sufficient past
experience to enable the prediction of these outcomes.
Risk averse decision-makers are likely to consider the strategy with the worst possible
outcome.
Risk neutral decision-makers will consider all outcomes and select the strategy with the
best possible outcome after taking all relevant information into account.
Risk-seekers are likely to consider the strategy with the best possible outcome, regardless
of the chance of it occurring.
Standard deviation is a measure of the dispersion of possible conditional values around
the expected value. The greater the dispersion, the greater the risk the actual value will
differ materially from the expected value.
Uncertainty is where there are a number of possible outcomes, but the probability of
each outcome is unknown as there is little or no evidence to predict the outcome.

Test-yourself solutions
Test yourself 12.1
Expected value of profit with marketing campaign:
(R300 000 × 0.90) + (−R80 000 × 0.1) = R262 000 − R50 000 = R212 000
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Expected value of profit without marketing campaign:

(R300 000 × 0.75) + (−R80 000 × 0.25) = R205 000

It is therefore worthwhile for the company to undertake the marketing campaign as the
increase in the expected value of profit is R7 000.

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Test yourself 12.2

The expected value of the pizzas is shown in the following table:
Pizza Express
Types of pizzas
Probability (Px) Outcome (x) EV
Small 0.30 R3 000 R900
Medium 0.50 R4 000 R2 000
Large 0.20 R5 000 R1 000
R3 900

The standard deviation and coefficient of variation is shown in the table below:
Outcome (X) Expected Deviation Squared Probability Weighted
_
value ( X ) from expected deviation (Px) amount
_
value (X − X
  )2 _
(X − X
  )2 Px
_
X −  X
R3 000 R3 900 −R900 810 000 0.30 243 000
R4 000 R3 900 R100 10 000 0.50 5 000
R5 000 R3 900 R1 100 1 210 000 0.20 242 000
490 000
Standard deviation σ 700
__
Expected value (mean) X
3 900
Coefficient of variation 0.18

Test yourself 12.3

Market condition Sales price Profit(x) Probability(p) px

High R105 R1 725 000 0.30 R517 500
Medium R100 R700 000 0.50 R350 000
Low R100 R100 000 0.20 R20 000
1.00 R887 500
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Expected return with perfect information R887 500

Expected return without perfect information R880 000
Therefore the value of perfect information R7 500

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Test yourself 12.4

The decision tree to determine the course of action that would maximise expected profits for
HFSC Ltd is shown in the following diagram.
Conditional Expected
Profit value

R20 000 R20 000

Sell R30 000 R30 000

Success 0.4
Manufacture R490 000 R196 000
Sell idea EV
EV 130 000
130 000
(R110 000) (R66 000)
Favourable 0.5 Failure 0.6

Study EV
EV 66 000 66 000
Unfavourable
0.5
EV 2 000 Sell
R2 000 R2 000

Manufacture Success 0.1

EV R490 000 R49 000
Manufacture (50 000)
(R110 000) (R99 000)
Failure 0.9
EV Success 0.25
500 000 R125 000
50 000

Failure 0.75
(R100 000) (R75 000)

The initial decision would be to conduct the study, as it yields the greatest expected value
of a profit of R66 000. The subsequent decisions would be, if the study is favourable, to
manufacture the product; and if the study is unfavourable, to sell the product.

Test yourself 12.5

The maximax decision criterion: The manager who uses the maximax decision criterion is
assuming that whatever action is taken, the best outcome will occur, because he is a risk-
taker. The maximum possible payoff is R72. Senay Shi should purchase 300 newspapers.
The maximin decision criterion: If she purchases 100 newspapers, the minimum payoff is
R6. If she purchases 200 newspapers, the minimum payoff is R22. If she purchases 300
newspapers, the minimum payoff is R80. The highest minimum payoff arises from purchasing
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100 newspapers. The minimax decision criterion: If the minimax criterion is to be applied,
we need to calculate the regrets, that is, we need to find the biggest payoff for each demand
row and subtract all other numbers in this row from the largest number. The following table
tabulates the regrets.

Using the minimax decision criteria

Daily demand Daily supply
100 units 200 units 300 units
100 units R0 R28 R56
200 units R30 R0 R140
300 units R48 R24 R0

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If she decides to purchase 100 newspapers, the maximum regret is R48. For 200 newspapers,
the maximum regret is R28, and for 300 newspapers, the maximum regret is R140. If Senay
Shi uses the minimax regret rule, she would want to minimise that maximum regret and
purchase 200 newspapers.

Review questions
12.1 Distinguish between risk and uncertainty.
12.2 Differentiate between the standard deviation and the coefficient of variation.
12.3 What is a decision tree?
12.4 Describe the different nodes used in decision trees.
12.5 Name one disadvantage of the standard deviation as a measure of risk. How
can this risk be overcome?
12.6 Describe the different types of decision-makers.
12.7 How can the expected value of perfect information be calculated?
12.8 Differentiate between maximax, maximin and minimax decision criteria.

Exercises
12.1 The vision of the Department of Health in KwaZulu-Natal is to provide optimal
health for everyone in the province. Their mission is to develop and implement
a sustainable, coordinated, integrated and comprehensive health system at all
levels, based on the primary healthcare approach through the District Health
System, to ensure universal access to health care. In line with this vision and
mission, the department committee is considering the economic benefits of a
programme of preventative flu vaccinations with the option of not implementing
the programme and the other two options as detailed below.
If vaccinations are not introduced, the estimated cost to the government, if there
is an outbreak of flu in the next year, is R7m with a probability of 0.1, R10m
with a probability of 0.3 and R15m with a probability of 0.6. It is estimated that
such a programme will cost R7m and that the probability of a flu outbreak in
the next year is 0.75.
Another alternative open to the committee is to institute an ‘early-warning’
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monitoring scheme (costing R3m), which will enable it to detect an outbreak

of flu early and hence institute an accelerated vaccination programme (costing
R10m because of the need to vaccinate quickly before the outbreak spreads).

Required:
What recommendations should the department committee make to the
national government if their objective is to maximise expected monetary value
(EMV)? Provide a decision tree to support your recommendation.
12.2 A company produces grit for use on public roads during icy conditions. The
grit has to be produced before the winter season. The level of demand depends
on weather conditions. Any excess production has to be disposed of as it will
deteriorate before the following winter. The company has received the following
weather predictions and associated demand for next winter.

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Weather conditions Demand

Severe 72 000 tonnes
Normal 54 000 tonnes
Mild 38 000 tonnes

The company needs to determine the quantity of grit to produce for the next
winter season. It can only produce 40 000, 60 000 or 80 000 tonnes and cannot
change the quantity once production has begun. One tonne of grit has a selling
price of R150 and costs R70 to produce. Any unsold grit will need to be disposed
of at a cost of R20 per tonne.

Required:
(a) Prepare a payoff table showing the profits for production quantities of
40 000 tonnes, 60 000 tonnes and 80 000 tonnes.
(b) It has now been estimated that the probabilities of the weather conditions
are 30%, 50% and 20% for severe, normal and mild weather respectively.
Calculate the profit that would be earned if the decision about the
production quantity was based on the expected value of demand.
(c) Describe the attitude to risk of a decision-maker who makes decisions using
the expected value decision rule.
Source: CIMA (adapted)
12.3 XY has developed two new products, Product X and Product Y, but has insufficient
resources to launch both products. The success of the products will depend on
the extent of competitor reaction. There is a 20% chance that competitors will
take no action, a 50% chance that they will launch a similar product and a 30%
chance that they will launch a better product. The profit/loss that will be earned
by each of the products depending on the extent of competitor reaction is
as follows:

Competitor reaction Product X Product Y

No action R540 000 R620 000
Launch a similar product R320 000 R380 000
Launch a better product (R150 000) (R200 000)
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Another option for XY would be to launch neither product. If it chooses this

course of action there is a 60% chance that competitors will take no action
and there will be no effect on the company’s profit. There is a 40% chance
that competitors will launch a new product and company profits will reduce
by R100 000.

Required:
Demonstrate, using a decision tree and based on expected value, the best course
of action for the company.
Source: CIMA (adapted)

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12.4 Part A
MSS Ltd is a manufacturing company that was formed in 2020 by three cousins,
Mahi, Shakti and Sonali. As an initial decision, they have to decide which of
three new mutually exclusive products to launch. The directors believe that
demand for the products will vary, depending on competitor reaction. There
is a 30% chance that competitor reaction will be strong, a 20% chance that
competitor reaction will be normal, and a 50% chance that competitor reaction
will be weak. The company uses expected value to make this type of decision.
The net present value for each of the possible outcomes is given in the following table:
Competitor Product A Product B Product C
reaction (R) (R) (R)
Strong 200 400 600
Normal 300 600 400
Weak 500 800 500

A market research company believes it can provide perfect information on

potential competitor reaction in this market.

Required:
(a) Calculate the maximum amount that should be paid for the information
from the market research company.
Part B
MSS Ltd expanded their product range and started manufacturing toys for
toddlers with a present factory capacity of 1 200 units per month. The first
product they started manufacturing was wooden puzzles. Each unit costs them
R6 to make and the normal selling price is R11 each. However, the demand per
month is uncertain, and is as follows:
Demand Probability
400 0.2
500 0.3
700 0.4
900 0.1
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They have been approached by a customer who is prepared to contract to a

fixed quantity per month at a price of R9 per unit. The customer is prepared
to sign a contract to purchase 300, 500, 700 or 800 units per month. MSS Ltd
can vary production levels during the month up to the maximum capacity, but
cannot carry forward any unsold units in inventory.
Required:
(a) Calculate all possible profits that could result from the various demand levels.
(b) Determine for what quantity MSS Ltd should sign the contract, under each
of the following criteria:
(i) Expected value
(ii) Maximin regret

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(iii) Maximax regret

(iv) Minimax regret.
(c) What is the most that MSS Ltd would be prepared to pay to obtain perfect
knowledge of the level of demand?
Source: CIMA (adapted)
12.5 Part A
Hayne Ltd uses a third-party delivery service to deliver goods to customers. The
current average cost per delivery is R12.50. The manager is trying to decide
whether to establish an in-house delivery service. A number of factors could
affect the average total cost per delivery for the in-house delivery service. The
following table shows the possible average total costs and the probability of
each one occurring.
Average total cost Probability
(R)
10.50 0.05
10.70 0.10
11.00 0.08
12.10 0.12
12.50 0.14
12.60 0.16
14.20 0.12
15.60 0.18
15.80 0.05

The expected value of the average total cost, based on the probability distribution
above, is R13.
Required:
(a) Explain the decision that the company manager is likely to make, based
on the probability distribution and the current delivery cost of R12.50 per
delivery, if the manager is:
(i) Risk neutral
(ii) Risk averse
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(iii) Risk seeking.

Part B
The marketing manager of Hayne Ltd is deciding which of four potential selling
prices to charge for a new product. The market for the product is uncertain
and reaction from competitors may be strong, medium or weak. The manager
has prepared a payoff table showing the forecast profit for each of the
possible outcomes.
Competitor reaction Selling price
R80 R90 R100 R110
Strong R70 000 R80 000 R70 000 R75 000
Medium R50 000 R60 000 R70 000 R80 000
Weak R90 000 R100 000 R90 000 R80 000

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453

Required:
(a) Identify the selling price that would be chosen if the manager applies the
maximin criterion to make the decision.
(b) Using a regret matrix, identify the selling price that would be chosen if the
manager applies the minimax regret criterion to make the decision.
12.6 SeCa Com, a recently formed communications company, has estimated that
the production volume of a new product for the first year is 2 000 units. The
management accountant has produced the following table, showing the possible
production costs and their associated probabilities at this level of output.
The probabilities of the different levels of fixed production costs and variable
production costs are totally independent.
Total variable Probability Total fixed Probability
production costs (R) production costs (R)
30 000 0.25 80 000 0.40
40 000 0.35 130 000 0.45
50 000 0.40 160 000 0.15

SeCa Com is having problems with one of its offices and has decided that there
are three courses of action available:
● Shut down the office, raising proceeds of R5 million.
● Do an expensive refurbishment of the office at a cost of R4 000 000.
● Do a cheaper refurbishment of the office at a cost of R2 000 000.
If SeCa Com does the expensive refurbishment, a good result will yield a return
of R13 500 000, whereas a poor result will yield a return of only R6 500 000.
Alternatively, for the cheaper refurbishment, a good result will yield a return of
R8 500 000, whereas a poor result will yield R4 000 000.
In either case, the probability of the refurbishment achieving a good result has
been estimated to be two-thirds.
An independent company has offered to undertake market research for them
in order to identify in advance whether the result of refurbishment is likely to be
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good or poor. The research will cost R200 000 and there is a 68% probability
that it will indicate a good result.
Unfortunately, the research cannot be guaranteed to be accurate. However, if
the research indicates a good result, the probability of the actual result being
good is 91%.
If the survey indicates a poor result, the probability of the actual result being
good is 13%.
SeCa Com has already decided that if market research is done, and the research
indicates a poor result, the company will only be prepared to consider the
cheaper refurbishment.

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Required:
(a) Use a decision tree to recommend what actions should be taken with
regards to the problem with one of its offices.
(b) Calculate the expected value of total production costs for the production of
2 000 units.
(c) Calculate the probability of total production costs for 2 000 units being
R180 000 or greater.
12.7 Caminaysh Constructions has tendered for a R13 million contract to complete a
hotel for the Southern Sun Group by 30 June 20X9, but is experiencing delays due
to the complex design. The managers have to now make a decision on whether
to continue as at present, or to employ specialist engineering consultants at a
cost of R2 600 000.
If the company continues as at present, it estimates there is only a 25% chance
of completing the building on time, and that the delay could be one, two or
three months with equal probability. If the building is late, there are penalties
of R1 300 000 for each month’s delay (or part of a month). The managers
believe that if they employ specialist engineering consultants, their chances of
completing the project on time will be trebled. But if the building is still late, it
would be only one or two months late, with equal probability.

Required:
(a) Draw a decision tree to illustrate this decision problem, using squares for
decision points, circles for random outcomes, and including probabilities,
revenues and penalties.
(b) Write a short report for the managers, with reasons and comments,
recommending which decision to make.
(c) Caminaysh Constructions has an opportunity to choose from five mutually
exclusive projects. These projects will last for one year with net cash flows
being determined by the prevailing market conditions. The forecasted
annual cash inflows and their associated probabilities are shown in the table:

Market conditions Poor Good Excellent

Probability 0.20 0.50 0.30
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R R R
Project L 500 000 470 000 550 000
Project M 400 000 550 000 570 000
Project N 450 000 400 000 475 000
Project O 360 000 400 000 420 000
Project V 600 000 500 000 425 000

What would be the value of perfect information about the state of the market?
Source: CIMA (adapted)

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455

12.8 Toyland Ltd has been given the opportunity to market a new toy. The demand
for the product is estimated as given in the table below.

Demand Probability Expected profit (R)

Good 0.30 100 000
Average 0.45 60 000
Poor 0.25 40 000

A major competitor of the company, Toys Galore (Pty) Ltd, will definitely
consider entering the market once it is known what the demand for the product
is. If the demand proves to be good, there will be a 80% chance that Toys Galore
will enter the market. If the demand is average, the chance that Toys Galore
will enter the market will drop by 30% to 50%. A chance of 30% exists that Toys
Galore will enter the market if demand is poor.
Toyland Ltd will obtain 80% of the market should Toys Galore (Pty) Ltd decide
not to enter the market. The market share of Toyland Ltd will drop to 50% if
Toys Galore (Pty) Ltd decides to enter the market.

Required:
(a) Determine by means of a decision tree whether or not Toyland (Pty) Ltd
should market the new product if a profit of at least R50 000 is required.
(b) Toyland Ltd is also considering whether to invest in another project. The
probability distribution of the net present value of the project is given in the
following table.

Net present value (R) Probability

2 800 0.25
3 900 0.40
4 900 0.35

Calculate the expected value of the net present value of the project and its
standard deviation.
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12.9 A university is trying to decide whether or not to advertise a new postgraduate

degree programme. The number of students starting the programme is
dependent on economic conditions. If conditions are poor, it is expected that
the programme will attract 40 students without advertising. There is a 60%
chance that economic conditions will be poor. If economic conditions are
good, it is expected that the programme will attract only 20 students without
advertising. There is a 40% chance that economic conditions will be good.
If the programme is advertised and economic conditions are poor, there is a 65%
chance that the advertising will stimulate further demand and student numbers
will increase to 50. If economic conditions are good, there is a 25% chance
that the advertising will stimulate further demand and numbers will increase to
25 students.

Dealing with risk and uncertainty in decision making

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456

The profit expected, before deducting the cost of advertising at different levels
of student numbers, is given in the table below.
Number of students Profit (R)
15 (10 000)
20 15 000
25 40 000
30 65 000
35 90 000
40 115 000
45 140 000
50 165 000

The cost of advertising the programme will be R15 000.

Required:
(a) Demonstrate, using a decision tree, whether the programme should be
advertised.
(b) ‘Decision rules based on expected values assume that the decision-maker is
risk neutral.’
(i) Explain the above statement.
(ii) Describe two other attitudes towards risk.
12.10 HFSC Premium Brewery produces and sells a classic premium beer throughout
the country and has enjoyed good profits for many years. In recent years,
however, its sales volume has not grown with the general market. This lack of
growth is due to the increasing popularity of light beer and the fact that the
organisation has not entered this market.
HFSC is now developing its own light beer and is considering potential
marketing strategies. Introducing the new light beer nationally would require
a large commitment of resources for a full nationwide introduction, because
HFSC is a late entry into the light beer market. HFSC’s public relations division
has helped to access the market risk and has convinced management that the
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following alternative strategies may be pursued:

● Strategy A: Conduct a nationwide promotion campaign and make the
new light beer available in all nine provinces, without conducting a test
campaign. The nationwide promotion campaign would be allowed to run
for a period of 18 months before any further decision is taken.
● Strategy B: Perform a test promotion campaign in a limited number of
provinces for a six-month period. HFSC would decide whether or not to
introduce the light beer nationally and whether to conduct a nationwide
promotional campaign on the basis of the results of the test campaign.
The management of HFSC Premium Brewery believes that if Strategy A is
selected, there is only a 50% chance of it being successful. The introduction
of light beer nationally will be considered a success if R4 million of revenue
is generated, whilst R3 million of variable cost is being incurred during the

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457

18-month period in which the nationwide promotion campaign is in effect. If

the 18-month campaign is unsuccessful, revenue is expected to be R1.6 million,
and variable cost will be R1.2 million. Fixed costs for this period are expected
to be R600 000, regardless of the result.
The public relations division believe that if Strategy B is selected, there is a
20% chance that the test will indicate that HFSC should conduct a nationwide
promotional campaign when, in fact, a nationwide campaign would be
unsuccessful. The division also believes that there is a 20% chance that the test
will indicate that HFSC should not conduct a nationwide promotion campaign
when, in fact, a nationwide campaign would be successful. The cost of the test
is estimated to be R50 000, and there is a 50% probability of a successful test.

Required:
(a) Demonstrate, by using a decision tree, which strategy is the best to adopt.
(b) Explain the criticism of the expected value approach.
12.11 Master Chef Caterers are considering building a restaurant in a new retail park.
They can build either a small restaurant or a large restaurant. Since there are
strict local planning regulations, once they have committed to the size of the
restaurant, it cannot be extended later.
Past experience suggests that there is a 60% chance that demand will be high,
and a 40% chance that demand will be low. Estimates of the net present values
of the future cash flows for Master Chef Caterers associated with each size of
restaurant are given in the table below.
Demand
Size of restaurant
Low (R) High (R)
Small 800 000 1 200 000
Large (1 000 000) 2 000 000

Required:
(a) Demonstrate, using a decision tree, which course of action Master Chef
Caterers should pursue.
(b) Master Chef Caterers could commission a market research survey that will
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give an accurate prediction of the level of demand. Calculate the maximum

price that they should pay for the market research survey.
(c) Master Chef Caterers can make either of two new products, X or Y, but not
both. The profitability of each product depends on the state of the market,
as shown in the table:

Market state Profit from product Probability of

market state
X Y
Good R20 000 R17 000 0.20
Fair R15 000 R16 000 0.50
Poor R6 000 R7 000 0.30

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458

Calculate the expected value of perfect information about the state of the
market.
Source: CIMA (adapted)
12.12 The Ferhay Hotel Group has 12 hotels and self-catering chalets located
throughout the Drakensberg region in KwaZulu-Natal. They have recently
acquired an additional plot of land adjacent to one of its existing hotels, situated
in the Midlands Meander. The group’s management team are contemplating
the following investment alternatives:
Option 1:
A large dam could be built for an approximate cost of R400 000. It is common
knowledge that guests enjoy fishing as one of the favourite things to do in
this region, therefore the dam would be stocked for fishing. Trout and bass
fingerlings would be purchased from a local supplier at a once-off cost
of R90 000.
In addition, management is considering one of the following options:
purchasing boats and fishing equipment that will be rented to hotel guests and
day visitors on a daily basis, or alternatively, building a small sports bar and
entertainment area with a deck overlooking the dam.
If boats and fishing equipment are purchased for rental, there is a 60% chance
of earning a net income of R300 000 per annum, otherwise R250 000 will
be earned.
If the sports bar is built, there is a 60% chance of earning a net income of
R290 000, otherwise R220 000 will be earned.
The capital outlay for either option is expected to cost R110 000.
Option 2:
The purchase of horses, building stables and developing horse riding trails is
another option. The estimated capital outlay is R600 000. Management plans
to build stables to accommodate 25 horses. Several horse trails will be laid out
for beginner and advanced riders. Hotel guests and day visitors will be charged
an amount of R85 per ride, irrespective of the level of experience of the rider.
Each ride will be 1½ hours long, making it possible for each horse to do a
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maximum number of three rides per day.

Monthly costs involved in keeping the horses are expected to be R28 000.
This includes labour of R10 000, forage of R11 000, and vaccinations and
medication of R7 000. There is a 60% probability that rides would be fully
booked for 120 days per annum, and a 40% probability for 90 days per annum.
(Ignore the days that the rides would not be fully booked.)

Required:
(a) Determine, by using a decision tree, which alternative would render the
highest net income.
(b) The minimum return on capital that management requires is 48% before
taxation. Determine for each alternative whether this requirement would
be met if the investment was made.

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459

12.13 Cam-i-cine (Pty) Ltd, a pharmaceutical company delivering medicine to the

client’s doorstep, has recently decided to adopt good corporate governance
principles by introducing an internal audit department. You have been
appointed as the head of internal audit and need to start the new department.
You are faced with the decision on whether to appoint staff members or to
use specialists from auditing firms to assist you. The following information
is available:
Option 1: In-house department
Operate an in-house internal audit function by appointing specialists such
as information system auditors, internal audit managers and junior internal
auditors to ensure that you can execute the draft audit plan as agreed with
management. The amount needed for the staff compliment at 100% of the
salary range is R9 250 000.
As employer, you are prepared to appoint the permanent staff members at 70%
of the total salary range. Extensive market research has shown that there is a
60% chance to fill all the vacancies with permanent employees on this salary
range. Otherwise you will need to fill the vacancies by appointing contract
workers from a local employment agency at a salary cost of R6 650 000. In
addition to the salary expense, you will need to pay 15% commission of the
salary cost to the agency.
Option 2: Outsourced department
The second option is to outsource the full function to one of the two audit firms
approached to tender for the function. As the head of internal audit, you will be
the only permanently appointed employee of the internal audit department and
will oversee the internal audit function that will be delivered by the audit firm.
You have received two very competitive quotes from highly recommended audit
firms and the following financial information is available from the tenders
received:
Firm A:
Firm A proposed that 3 800 hours will be required at an average rate of R1 750
per hour. The disbursements will be charged in addition to normal costs. The
disbursements are calculated at R4.50 per kilometre travelled. Four cars will
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be utilised per day and the total distance per day is 80 kilometres. Five of the
staff members will travel by Gautrain at a cost of R34 per trip. Assume that 60
working days will be required to execute the audit plan.
Firm B:
Firm B proposed that 3 850 hours will be required at an average rate of R1 800
per hour. The disbursements are absorbed in the average cost per hour.

Required:
Determine by means of a decision tree which option will be the most cost
effective for Cam-i-cine (Pty) Ltd.

Dealing with risk and uncertainty in decision making

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460

Reference list
British Airways Annual Report and Accounts. 2008/09. Available: http://www.britishairways.
com/cms/global/microsites/ba_reports0809/pdfs/Risks.pdf. (Accessed 1 November 2020).
Times Live. 2012. Uncertainty for 1Time cash customers, airline says hands tied. Available:
http://www.timeslive.co.za/local/2012/11/05/uncertainty-for-1timecash-customers-
airline-says-hands-tied. (Accessed 18 December 2016).
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13 Network analysis

Network analysis

Critical path
method Program evaluation
(CPM) and review technique
(PERT)

Network Expected
Critical path Acceleration Slack
diagrams duration

Cost-efficient Time-efficient
manner manner

Learning objectives
After studying this chapter, you should be able to:
● Explain the circumstances under which network analysis can be used as a tool to
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enhance project management

● Distinguish between the different methods used in network analysis
● Understand the different terminology used in network analysis
● Draw a network diagram for a project
● Make an estimate of the expected duration of activities using the PERT method
● Identify the critical path in a project and explain its significance
● Calculate the slack for each activity and explain its significance
● Calculate the cost slope and explain its significance
● Understand how to accelerate a project
● Understand the limitations of network analysis
● Explain the benefits of using network analysis in project management.

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Introduction
In recent years there has been growing acceptance of the use of quantitative techniques as
an aid to managers in planning and control. In Chapter 10, we have seen how budgets can
be applied to coordinate the various activities of an organisation. In many circumstances, a
budget is inadequate for planning and coordinating the physical steps that must be taken
to complete a project. The budget may show the cost of each activity, but does not show
the duration of the activity, or which activities must be completed before other activities
can commence. Network analysis is an effective tool used in project management and is
an extension of budgetary control. It overcomes some of the weaknesses of using budgets
in project management by enabling the planning and controlling of a project in a cost-
and time-efficient manner, thereby contributing to the completion of a project within a set
time and at the least possible cost. By making use of network analysis, project management
finds its application in a variety of fields, for example the construction industry, the civil
engineering industry, and any other industry where diverse people or teams are involved
in the same project. There are various methods of network analysis, but the following two
most common methods will be discussed in this chapter:
● Critical path method (CPM)
● Program evaluation and review technique (PERT).

Initially PERT and the CPM differed in several respects. PERT dealt with time only and the
CPM with both time and cost. But now the cost features of the CPM have been incorporated
into PERT and the differences between these two methods are minimal.

Case study: KwaZulu-Natal – Thombothi River Bridge

The Umfolozi River is one of the major rivers in northern KwaZulu-Natal and has very
large catchments. The river flows continuously, and with even short spells of rainfall in
the catchments area, the volume of flow increases significantly. During these times of
rain, pupils from the surrounding communities attempting to cross the river are unable
to do so to attend school. Over the years many pupils and other community members
have lost their lives while attempting to cross the river. Pupils lose many school days
especially over the rainy season when the river levels are too high to cross. The closest
other school is over 15 km away. As this is a primary school, pupils as young as six years
old are forced to cross this dangerous river without adult supervision. The Thombothi
River Bridge project has been undertaken to create access for vehicles and pedestrians
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across the river. A project steering committee has been established to monitor contract
implementation progress and local labour recruitment. The project is being designed
internally by the South African National Roads Agency Limited (SANRAL), and will be
verified by external engineers. SANRAL is to fund the bridge structure, and the access
road is to be funded by the KwaZulu-Natal Department of Transport. The tender
process will be conducted by SANRAL with input from the KwaZulu-Natal Department
of Transport. The infrastructure will cater for both pedestrians and vehicles. The details
of the contract are as follows:
● Contract duration: two years
● Contract value: approximately R10 000 000.
Source: SANRAL (n.d.)
➤➤

Cost and Management Accounting

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Discussion questions:
1. Determine some of the activities that would be involved in the bridge construction,
considering that the estimated duration of the project is two years.
2. The estimated tender price is R10 million. Use some of your activities identified
above, and estimate costs for each activity.

Procedure for network analysis

The following steps can be followed when doing network analysis:
● Identify the activities to be performed in order to complete the project. For example, in
the construction of a building, some activities are digging the foundation, pouring the
concrete, erecting the roof, etc.
● Identify the sequence in which they should be completed, including parallel activities,
which are activities that occur simultaneously with other activities. For example, the
activity digging the foundation will be followed by pouring the concrete.
● Calculate the time required to complete each activity.
● Construct a network diagram.
● Calculate the duration of the project.

Critical path method

The critical path method (CPM) was developed in 1957 by J.E. Kelly and M.R. Walker to
assist in scheduling maintenance shutdowns of chemical processing plants. The CPM is
used when there is no uncertainty about the duration of the activity.

Network diagrams
All the individual tasks to complete a project must be visualised in a network of activities
and events representing the network diagram for the project. The network diagram is drawn
using the activity on the node method, or activity on the arrow method. We believe that
the activity on the node method is logically easier to follow and it will therefore be used in
this chapter.
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Network analysis

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Illustrative example 13.1

The preconstruction activities and estimated durations for each activity in the following
table have been determined for project Build a Bear by SC Construction’s management
consultant.
Table 13.1 Preconstruction activities and estimated durations for each activity
Activity Normal duration (days)
A−B 12
A−C 14
B−D 10
B−E 12
C−E 14
C−F 12
D−E 0
D−G 15
E−G 16
F−G 14

Required:
Construct a network diagram.

Solution:

10 D

B 15
0
12
12

A 16
E G

14
14
C
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14
12
F

Figure 13.1 Network diagram using activity on node method

An event is a particular point in time which indicates the start or completion of an activity.
It is depicted on the network diagram with a circle labelled with a letter or a number. The
events in Figure 13.1 are:
A B C D E F G

Cost and Management Accounting

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An activity is an identifiable section of a project which takes time to complete and utilises
resources. It is depicted on the network diagram by a solid line with an arrowhead.

Tail of activity → Head of activity

The tail side represents the start of an activity, and the arrowhead represents the completion
of the activity. The duration of the activity is also shown on the line. Some activities are
interacted with others, meaning that they can only commence once the preceding activities
or event have been completed. In Figure 13.1, activities D−G can only commence once the
preceding activities A−B and B−D have been completed. Other activities are independent
of certain activities. They are referred to as parallel activities and can take place
simultaneously. In Figure 13.1, activities A−B and A−C can both commence simultaneously,
that is, they are parallel activities. Other activities that may be used on a network diagram are
dummy activities. They are indicated by a dotted arrow. A dummy activity only indicates
the relationship between two activities. No time is used, and no resources are consumed. In
Figure 13.1, activity D−E is a dummy activity. An example of a dummy activity is as follows.

Illustrative example 13.2

A truck driver goes to the Truck Station to fill up diesel, top up diesel oil, and check
water. The activities are (a) fill diesel, (b) top up diesel oil, and (c) check water.
a
Truck b Truck
arrives leaves Incorrect
c

Figure 13.2 Incorrect diagram for activities

Figure 13.2 is incorrect, as an activity cannot share the same starting and finishing point
as another activity. This problem is solved by creating a dummy activity as in Figure 13.3.

Diesel
filled
a
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Truck b Truck
arrives leaves Correct

Water
filled

Figure 13.3 Creating a dummy activity

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Rules for constructing network diagrams

The following rules apply when constructing a network diagram:
● A network diagram has only one point of entry and one point of exit.
● A network diagram flows from left to right.
● Networks are not drawn to scale, that is, the length of the line does not represent the
duration of the activity.
● Events are progressively numbered from left to right through the network diagram, that
is, the event indicating the conclusion of the preceding activity has a higher number
than the preceding event.
● All activities must be tied into the network, that is, dangling activities are not allowed.
They must either contribute to the progression or be disregarded as irrelevant.

B Incorrect

C D E

Figure 13.4 Activities tied into the network

This can be redrawn correctly by inserting a dummy activity from event B to C.

C D E

● A loop, which is a series of activities that lead back to the same event, is not allowed, as
the network should progress forward.
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Incorrect

A B

D C

This can be redrawn correctly by adding a new activity as follows:

A B C D E

Figure 13.5 Forward progression of activities

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● An event is not reached until all the activities leading to it have been concluded.
● Two or more activities may not have the same activity preceding and succeeding them.
● A dummy activity has to be drawn.

Critical path
There are several routes from the beginning of the project to the end. However, the path with
the longest cumulative activity time determines the duration of the project and the project’s
completion date. This path is known as the critical path. If we refer back to Illustrative
example 13.1, the following different paths for project Build-a-Bear can be identified:
A−B−D−G = 12 + 10 + 15 = 37 days
A−B−E−G = 12 + 12 + 16 = 40 days
A−C−E−G = 14 + 14 + 16 = 44 days ~ critical path
A−C−F−G = 14 + 12 + 14 = 40 days
A−B−D−E–G = 12 + 10 + 0 + 16 = 38 days

Therefore, project Build-a-Bear should take 44 days to complete.

Slack
The slack (also known as float) on an activity is the amount of spare time that is available
on the activity without increasing the duration of the project or the critical path. Activities
on the critical path have a slack of zero, since increasing the duration on any critical activity
will increase the critical path. All non-critical activities have a positive slack. The less slack
on an activity, the more critical the activity, and vice versa. The following terminology is
used in the calculation of slack:
The earliest starting time (EST) is the earliest possible time an activity can commence.
It is calculated by obtaining the longest path from the beginning of the project up to the tail
of the activity, that is, the event which proceeds the predecessor activity.
The latest starting time (LST) is the latest possible time an activity can commence
without delaying the project. It is calculated by subtracting the duration of the critical path
and the longest path from the tail of the activity to the end of the network.
The earliest completion time (ECT) is the earliest possible time an activity can be
completed, giving allowance for preceding activities to be completed. It is calculated by
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computing the longest path from beginning of the network to the head of the activity or by
taking the EST plus the duration of the activity.
The latest completion time (LCT) is the latest possible time at which an activity can
be completed without causing an increase in the duration of the project. It is calculated
by subtracting the duration of the critical path and the longest path from the head of the
activity to the end of the network, or by taking the LST plus the duration of the activity.
Slack can be calculated as follows:
LST − EST or LCT − ECT

Network analysis

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Illustrative example 13.3

If we extend Illustrative example 13.1, the slack for project Build-a-Bear is as follows:
Table 13.2 Slack for project Build-a-Bear
Activity Duration EST LST Slack ECT LCT Slack
A−B 12 0 44 − (12112116)54 4 12 44 −(12116)516 4
A−C* 14 0 44 − (14114116)50 0 14 44 −(14116)514 0
B−D 10 12 44 −(1010116)518 6 12110522 44 −(0116)528 6
B−E 12 12 44 − (12116)516 4 12112524 44 − 16528 4
C−E* 14 14 44 − (14116)514 0 14114528 44 − 16528 0
C−F 12 14 44 − (12114)518 4 14112526 44 − 14530 4
D−E 0 12110522 44 − (0116)528 6 12110522 44 − 16528 6
D−G 15 12110522 44 − 15529 7 12110115537 44 − 0544 7
E−G* 16 14114528 44 − 16528 0 14114116544 44 − 0544 0
F−G 14 14112526 44 − 14530 4 14112114540 44 − 0544 4

*Critical path (There is no slack on the critical path.)

Uses of slack
● It serves as a cushion for non-critical activities, allowing them a measureable amount of
slippage.
● It acts as a reserve against bottlenecks that may occur on the critical path. Resources
such as material and labour can be drawn from this reserve for use on those bottlenecks.
● It serves as a guide for rescheduling workloads so as to advance the project’s completion date.

Test yourself 13.1

Use the information in the following table to answer the questions.
Activity Predecessor activity Expected duration (weeks)
A – 6
B – 10
C – 7
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D C 8
E A 14
F B, D 7.5
G B, D 18
H C 11
I E, F 9
J H 12

Required:
(a) Construct a network diagram.
(b) List all possible paths through the network and indicate the critical path.
➤➤

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(c) Calculate the ECT for each activity.

(d) Calculate the LCT for each activity.
(e) Calculate the slack of each activity.

Network acceleration
The normal duration of the project is based on the duration of its critical path. However,
it is possible to reduce a project’s time by a process called acceleration (crashing). This
process entails reducing the normal duration of the project by incurring additional costs
or by utilising available resources differently. Acceleration will bring in the project ahead of
schedule, but at the same time it will increase the project’s cost. Management must decide
whether the additional cost is justified by the advantage which acceleration of the project
implies. Projects can be accelerated with the aim of either:
● Minimising total project cost: in this case a project will be accelerated as long as it is
cost-effective
● Minimising total project time: in this case the acceleration is focused on minimising
time, regardless of whether the project cost increases.

Prior to commencing with acceleration, the cost per time period, known as the cost slope,
must be determined. The cost slope is the average additional variable cost that must be
incurred to reduce the duration of an activity by one period of time. The following formula
is used to determine the cost slope:
Accelerated cost 2 Normal cost Increase in variable cost
________________________
Cost slope 5   
  Normal
   time 2 Accelerated time
  5  _________________
     
Reduction in time
 

Illustrative example 13.4

The normal cost and accelerated costs, as well as the normal and accelerated durations
for project Build-a-Bear, are displayed in Table 13.3. The cost slope is calculated by
dividing the difference in cost by the difference in duration.
Table 13.3 Normal cost, accelerated cost and normal and accelerated duration
Activity Normal cost Accelerated Normal Accelerated Cost slope
(R) cost duration duration (R)
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(R) (Days) (Days)

A−B 150 000 210 000 12 10 30 000
A−C 180 000 220 000 14 10 10 000
B−D 200 000 245 000 10 9 45 000
B−E 120 000 192 000 12 9 24 000
C−E 150 000 199 000 14 7 7 000
C−F 160 000 200 000 12 7 8 000
D−E 0 0 0 0 0
D−G 240 000 312 000 15 7 9 000
E−G 180 000 222 000 16 9 6 000
F−G 120 000 170 000 14 12 25 000

Network analysis

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Acceleration results in many benefits, such as minimising costs and resulting in a larger
amount of profit earned. It also minimises the project time, allowing the next project to
commence sooner. The organisation has a competitive advantage, as it can tender a lower
price due to minimising costs, and a sooner completion date due to reducing the time on
the project.
The following rules can be applied when accelerating a project:
● Only accelerate activities which are on the critical path. It would be a waste of resources
to accelerate activities that do not lie on the critical path, since it would not alter the
duration of the project.
● Accelerate the activity on the critical path with the lowest cost slope when there is only
one critical path. As acceleration progresses, several critical paths arise.
● After each acceleration, calculate the cost saving by subtracting the additional variable
cost incurred from the saving in discretionary fixed cost. As long as there is a saving,
proceed with acceleration if the aim is to accelerate in a cost-efficient manner. A net
loss would increase the normal cost of the project. If the cost of acceleration equals the
saving in fixed cost, the acceleration can be continued.
● As the project is accelerated, more critical paths will evolve. These critical paths have to
be accelerated simultaneously, that is, if you reduce one of the critical paths by two days,
then the other critical paths must also be reduced by two days.
● When accelerating a number of critical paths, the cost of several options will have to be
compared, and the cheapest option should be selected. Some options are:
◆ The lowest cost slope on each critical path
◆ The common activities on each critical path
◆ A combination of lowest cost slope and common activity on the critical paths.
● When determining the amount of time by which to accelerate the critical path(s), the
amount of time should be the least of:
◆ The maximum amount of time by which the chosen activity on the critical path can
be accelerated, that is, the normal time less the accelerated time
◆ The difference in the duration of the critical path(s) and the duration of the next
longest path.

Illustrative example 13.5

Let us now expand on the illustrative example for SC Construction’s project Build-a-
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Bear to include acceleration. In addition to the variable costs presented in Table 13.3,
discretionary fixed costs amount to R25 000 per day.

Required:
(a) Determine the amount that was tendered for the project, assuming that a mark-up
of 25% on cost was required.
(b) Determine the amount that could have been tendered had the project’s cost been
minimised.
➤➤

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Solution:
(a) Amount tendered for the project:
R
Direct costs (variable cost) 1 500 000
Fixed overhead (R25 000 × 44 days) 1 100 000
Total normal cost 2 600 000
Profit (25% × R2 600 000) 650 000
Tender amount based on normal time 3 250 000

(b) Acceleration schedule:

Table 13.4 Acceleration schedule

Routes Additional Saving in Net
direct costs fixed costs Saving

A-B- A-B-E-G A-C- A-C-F-G A-B-D-

D-G E-G E-G
37 40 44* 40 38
1st acceleration:
E-G by – (4) (4) – (4) R6 000 × 4 R25 000 × 4 R76 000
4 weeks = R24 000 = R100 000
37 36 40* 40* 34
2nd acceleration:
A-C by – – (3) (3) – R10 000 × 3 R25 000 × 3 R45 000
3 weeks = R30 000 = R75 000
37* 36 37* 37* 34
3rd acceleration:

A-C by – – (1) (1) – R10 000 R25 000 R6 000

1 week
D-G by (1) – – – – R9 000
1 week
36* 36* 36* 36* 34
4th acceleration:

D-G by (2) R9 000 × 2 R25 000 × 2 R4 000

1 week
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= R18 000 = R50 000

E-G by (2) (2) (2) R6 000 × 2
1 week = R12 000
C-F by (2) R8 000 × 2
1 week = R16 000
34* 34* 34* 34* 32
5th acceleration:
D-G by (1) R9 000 R25 000 R2 000
1 week
E-G by (1) (1) (1) R6 000
1 week
C-F by (1) R8 000
1 week
33* 33* 33* 33* 31
➤➤

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6th acceleration:
A-B by (1) (1) (1) R30 000 R25 000 (R15 000)
1 week
A-C by (1) (1) R10 000
1 week
32* 32* 32* 32* 30

* Indicates critical path.

Recall the steps for acceleration, and start accelerating on the critical path with the
activity with the lowest cost slope, to the route with the second-highest duration. In this
example, the critical path is 44 days. Activity E−G has the lowest cost slope and can be
accelerated by 7 days (difference between normal and accelerated times: 16 − 9 = 7).
Activity E−G also lies on route A−B−E−G, and it will decrease the duration thereof as
well. The route with the second-highest duration is A−C−F−G (40 days). No time will be
saved by accelerating activity E−G by more than 4 days. Route A−C−F−G will still take
40 days to complete.

Therefore, you accelerate by 4 days. There are now two critical paths, both on 40 days.
Both routes must be accelerated simultaneously, using the option with the lowest
cost slope or a common activity. On A−C−E−G, activity E−G has the lowest cost slope
(R6 000), and on A−C−F−G, C−F is the cheapest (R8 000). The total cost is therefore
R14 000. It will however be cheaper to accelerate activity A−C at a cost of R10 000, as
it lies on both routes. Activity A−C can be accelerated by 4 days, but will be accelerated
to the next highest route, namely 37 days. Therefore, we only accelerate by 3 days
(40−37). Follow the same principle until you start making a loss, that is, when the
additional variable costs exceed the saving in fixed costs. The most cost-effective point
will therefore be the last acceleration before a loss is made, that is, the 5th acceleration.

The amount that could have been tendered:

R
Total direct cost 2 600 000
Less: Net saving (R76 000 + R45 000 + R6 000 + R4 000 + R2 000) (133 000)
2 467 000
Profit (25% × R2 467 000) 616 750
Tender amount based on normal time 3 083 750
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Test yourself 13.2

The management of DnH Ltd uses program evaluation and review technique (PERT)
methods to monitor and control projects. The company wants to tender for a contract.
The table below gives the information regarding the contract.
Activity Estimated duration in days Estimated variable cost Cost slope (R)
Normal Accelerated Normal (R) Accelerated (R)
A→B 4 3 40 000 44 000 4 000
A→C 5 3 54 000 65 000 5 500
A→D 4 2 55 000 59 000 2 000
B→E 6 5 72 000 77 000 5 000
C→F 9 7 93 000 107 000 ?
C→G 9 9 84 000 84 000 0
D→F 11 10 126 000 129 000 3 000
E→G 10 8 150 000 160 000 5 000
F→G 9 7 144 000 152 000 4 000

Additional information:
● Fixed costs amount to R10 000 per week, of which R2 500 is regarded as committed
fixed costs.
● The company applies a profit margin of 25% on tender price.

Required:
(a) Draw the network diagram for the project.
(b) Determine the critical path of the project.
(c) Determine the slack of activity C → F.
(d) Determine the cost slope of activity C → F.
(e) Determine the program to be followed in order to reduce the total project time in a
cost-efficient manner.
(f) Determine the tender amount based on the minimum cost of the project.
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Program evaluation and review technique

Program evaluation and review technique (PERT) was developed by the US Army in 1958
for the Polaris sea to land missile project. The application of PERT made it possible to
complete the project two years earlier than the scheduled date. When a project is undertaken
for the first time, or a considerable amount of time has elapsed since the last similar project,
management is usually uncertain about the duration of the activities in the project. PERT
analysis provides for this uncertainty by determining a weighted average time estimate.

Network analysis

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Estimating the expected duration of activities

PERT is applied when there is uncertainty about activity times. Three time estimates are
determined:
1. The most optimistic duration (to) is the time required to complete an activity under
ideal circumstances.
2. The most likely duration (tm) is the time in which the activity will be completed under
normal circumstances, that is, if everything goes according to plan.
3. The most pessimistic duration (tp) is the time required to complete the activity if
unforeseen delays occur, such as poor weather conditions, employees being ill, etc.

The expected activity time (te) of each activity is a weighted average of these three estimates.
Expressed as a formula:
to 1 4tm 1 tp
te 5  ________
6 

Illustrative example 13.6

Using the preconstruction activities of SC Construction’s project Build-a-Bear and the
estimates of their expected durations, the expected durations in the table below have
been determined, using the PERT formula.
Table 13.5 Expected durations using PERT formula
Activity Most optimistic Most likely Most pessimistic Expected duration
estimate (days) (to) estimate (days) (tm) estimate (days) (days) (te)
(tp)
A−B 12 10 20 12
A−C 10 15 14 14
B−D 5 10 15 10
B−E 12 10 20 12
C−E 10 15 14 14
C−F 12 10 20 12
D−E 0 0 0 0
D−G 10 15 20 15
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E−G 10 15 26 16
F−G 10 15 14 14

Test yourself 13.3

The following estimates of the expected duration were made for the completion of
activity A–C:
● Optimistic estimate: 14 weeks
● Most likely estimate: 15 weeks
● Pessimistic estimate: 10 weeks

In terms of the PERT method, determine the estimated duration of activity A–C.

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Standard deviation
Another aim of PERT analysis is to determine the standard deviation of each activity and
also of the critical path. The standard deviation of each activity indicates the degree of
uncertainty regarding the duration of an activity. The measure of the standard deviation of
activity time is calculated by means of the following formula:
tp 2 t o
σ 5  _____
6  
It is as important to know what variability to expect in the time of the critical path as it
is in the time of an activity. The measure of the standard deviation of the critical path is
calculated by means of the following formula:
____
σc 5 √
∑σ2  
Where: σc = standard deviation of the critical path
∑σ2 = the sum of the standard deviations on the critical path squared.

Illustrative example 13.7

The standard deviation of the activities of project Build a Bear are displayed in Table 13.6,
using the estimated durations from Table 13.5.
Table 13.6 Standard deviation of activities of project Build a Bear
Activity Most optimistic Most pessimistic t p – to
σ = _____
  6
estimate (days) estimate (days)
to tp
A−B 12 20 1.33
A−C 10 14 0.67*
B−D 5 15 1.67
B−E 12 20 1.33
C−E 10 14 0.67*
C−F 12 20 1.33
D−G 10 20 1.67
E−G 10 26 2.67*
F−G 10 14 0.67
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*Indicates activities on the critical path.

Required:
Determine the standard duration of the critical path.

Solution:
The critical path of project Build a Bear was identified as A−C−E−G. The standard
deviation of the critical path, taking into consideration only activities on the critical
path, is: ______________________
σc 5 √    
(0.67)² + (0.67)² + (2.67)² 
5 2.83
The conclusion that can be drawn is that the expected duration of project Build a Bear
is 44 weeks, and a standard deviation of 2.83 weeks can be expected.

Network analysis

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Advantages of network analysis

The advantages of network analysis are as follows:
● It enables the organisation to bid competitively through acceleration, and possibly
increase profit.
● It provides information that makes it possible to deploy personnel optimally.
● It can be used for monitoring – measuring slack and tracking as it helps to keep the
project on schedule.
● It is used as an information generator as it provides continuous feedback to management
as the project progresses.
● It has a variety of uses, such as for budgeting, construction, managing inventories,
scheduling production runs, etc.
● It can be adjusted to changing conditions.

Limitations of network analysis

The limitations of network analysis are as follows:
● It is difficult to obtain reliable data, especially when projects are done infrequently or
for the first time.
● Cost and time estimates tend to be inflated in order to maintain the budgets. The reason
behind this is that when performance is evaluated, it is better to have slack than to miss
a deadline.
● It is very costly and time-consuming to initiate. Even when implemented, it has to be
continuously updated to keep abreast of changing conditions.

Summary
Network analysis is useful for planning and controlling. In this chapter we looked at the
two most common techniques, that is, the critical path method (CPM) and the program
evaluation and review technique (PERT) method. Once the critical path has been identified,
the total time of the project has been calculated, and we know how much slack there is in
the non-critical tasks, we have a structured plan that is logical. The next steps are to assign
resources, put it into action and control the results.

Acceleration (crashing) is the process of reducing the normal duration of the project by
incurring additional costs, or by utilising available resources differently.
Activities are identifiable sections of a project which take time to complete and utilise
resources.
Cost slopes are the average additional variable costs that have to be incurred in order to
reduce the duration of an activity by one period of time.
Critical path The path with the longest cumulative activity time, which determines the
duration of the project and the project’s completion date.
Dummy activities are activities that consume neither time nor resources. They merely
indicate the relationship between two activities. ➤➤

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Earliest completion time (ECT) is the earliest possible time an activity can be completed,
giving allowance for preceding activities to be completed.
Earliest starting time (EST) is the earliest possible time an activity can commence,
allowing all preceding activities to be completed.
Events are particular points in time which indicate the start or completion of an activity.
Latest completion time (LCT) is the latest possible time at which an activity can be
completed without causing an increase in the duration of the project.
Latest starting time (LST) is the latest possible time an activity can commence without
delaying the project.
Parallel activities are activities that can take place simultaneously with another activity.
Slack (also known as float) is the amount of spare time that is available on the activity,
without increasing the duration of the project.

Test-yourself solutions
Test yourself 13.1
(a)
B 6/5

E
4/3 10/8

5/3 9/9
A C G

9/7
4/2 9/7

(b) Critical path:

A−E−I 29 weeks
B−F−I 26.5 weeks
B−G 28 weeks
C−H−J 30 weeks
C−D−G 33 weeks (critical path, ie the shortest time in which a project can be completed)
C−D−F−I 31.5 weeks

Network analysis

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Activity Duration EST LST Slack ECT LCT Slack

A 6 0 33 – (6 + 14 + 9) = 4 4 0+6=6 33 – (14+9) = 10 4
B 10 0 33 – (10 + 18) = 5 5 0 + 10 = 10 33 – (18) = 15 5
C 7 0 33 – (7+ 8 + 18) = 0 0 0+7=7 33 – (8+18) = 7 0
D 8 7 33 – (8 + 18) = 7 0 7 + 8 = 15 33 – (18) = 15 0
E 14 6 33 – (14 + 9) = 10 4 6 + 14 = 20 33 – (9) = 24 4
F 7.5 7 + 8 = 15 33 – (7.5 + 9) = 16.5 1.5 15 + 7.5 = 22.5 33 – (9) = 24 1.5
G 18 7 + 8 = 15 33 – (18) = 15 0 15 + 18 = 33 33 – (0) = 33 0
H 11 7 33 – (11 + 12) = 10 3 7 + 11 = 18 33 – (12) = 21 3
I 9 7 + 8 + 7.5 = 22.5 33 – (9) = 24 1.5 22.5 + 9 = 31.5 33 – (0) = 33 1.5
J 12 7 + 11 = 18 33 – (12) = 21 3 18 + 12 = 30 33 – (0) = 33 3

Earliest start time = The longest path to the tail of the event
Latest start time = Duration of critical path − Longest path from the tail of the event to
the end
Earliest completion time = EST + Duration
Slack / Float = LST − EST or LCT − ECT (Note that there will be no slack on the critical path)
Latest completion time = LST + Duration OR Duration of critical path − Longest path
from the head of the event to end.

Test yourself 13.2

(a)
B 6/5

E
4/3 10/8

5/3 9/9
A C G

9/7
4/2 9/7

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(d) Cost slope of activity C → F:

Increase in variable cost
_________________
Cost slope =      
Reduction time
R107 000 2 R93 000
= ________________
 
   927
  R142000
= _______
= R7 000
(e) Acceleration program:
Activity Routes Saving in Additional Net
A→B→E→G A→C→G A→C→F→G A→D→F→G fixed cost variable saving
cost
(R) (R)
(R)
20 14 23 24
A2D (1) 7 500 2 000 5 500
20 14 23 23
F2G (2) (2) 15 000 8 000 7 000
20 14 21 21
A2C (1) (1) 7 500 5 500

A2D (1) 2 000 0

20 13 20 20 12 500

(f) Tender amount based on total cost of the project:

R
Direct cost 818 000
Fixed cost (24 × R10 000) 240 000
Total normal cost 1 058 000
Less: Net saving 12 500
1 045 500
 25
Profit (R1 045 500 × ___
75 ) 348 500
1 394 000
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Test yourself 13.3

The estimated duration of activity A → C is:
to + 4tm + tp
te =  _________
6 
1 × optimistic + (4 × most likely) + (1 × pessimistic)
= ________________________________________
 
      
6
(1 × 14) + (4 × 15) + (1 × 10)
= ________________________
  
6
= 14

Network analysis

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480

Review questions
13.1 Explain the different methods of network analysis.
13.2 Explain the steps that can be followed when doing network analysis.
13.3 Distinguish between the different types of activities.
13.4 Discuss the rules when constructing network diagrams.
13.5 Define the critical path.
13.6 Explain what slack is and the different ways of calculating slack.
13.7 Explain the process of acceleration.
13.8 What are some of the options when there is more than one critical path to
accelerate?
13.9 Explain how the duration of an activity can be calculated when there is uncertainty.
13.10 Discuss some of the advantages and disadvantages of network analysis.

Exercises
13.1 Consider the following network diagram and table indicating the duration of
the various activities as well as the variable costs of these activities excluding
direct material:

A→B 14 550 12 580

A→C 12 720 10 850
A→D 10 2 100 9 2 300
B→E 5 800 4 1 050
E→F 8 1 350 5 1 670
C→D 7 450 5 750
C→F 13 1 080 9 1 430
D→G 19 2 720 16 3 020
F→G 6 680 4 840
TOTAL 10 450 12 490

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481

In addition to these variable costs, direct material for the project will amount to
R36 000 and fixed costs will amount to R280 per day. These fixed costs are not
regarded as committed fixed costs.
Required:
(a) Complete the network diagram.
(b) Calculate the shortest time in which the project can be completed under
normal circumstances.
(c) Calculate the total normal cost for the project.
(d) Compute the cost slope for activity C → F.
(e) Consider the following network diagram:

18/5
C E

6/5
1/1 9/5

9/9
D
17/9
G

A B
12/9
8/3
5/3
F

Calculate the slack at milestones C and F.

13.2 Balooga Ltd has appointed you as a consultant to assist them in determining an
appropriate tender price for the construction of a clinic for the Department of
Health and Welfare in Ladysmith. The directors of the company have provided
the following information regarding the project:
Variable cost Duration (weeks) Cost slope
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Activity
Normal (R) Accelerated (R) Normal Accelerated (R)
A–B 75 000 105 000 10 8 15 000
A–C 90 000 110 000 12 8 5 000
B–D 100 000 122 500 8 7 ?
B–E 60 000 96 000 11 8 12 000
C–E 75 000 99 500 12 5 3 500
C–F 80 000 100 000 10 5 4 000
D–G 120 000 156 000 13 5 4 500
E–G 90 000 111 000 14 7 3 000
F–G 60 000 85 000 12 10 12 500
Total 750 000 985 000 – – –

Network analysis

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In addition to these variable costs, fixed costs, which are not regarded as
committed costs, amount to R10 000 per week. The tender advertisement
published in the Government Gazette requires the construction of the clinic to be
completed in a period of 30 weeks or less, failing which, a penalty of R7 000 per
week will be levied. Balooga Ltd applies a profit margin of 35% on the tender price.

Required:
(a) Complete the network diagram.
(b) Compute the cost slope for activity B → D and explain the significance of
the cost slope of an activity.
(c) Calculate the latest starting time for activity E → G.
(d) Calculate the shortest time in which the project can be completed in a cost-
efficient manner.
(e) Calculate the tender amount that Balooga Ltd should include in their tender
application.
13.3 SeCa Com is a privately owned company that was established by its present
management in 1990. Years of experience and the efforts of the best experts
in economics, finance and law have helped the company to become one of
the largest finance and management consulting companies in the country.
The company has been operating for 24 years and is well established in the
marketplace. SeCa Com has a client base of approximately 500 clients and
a current revenue of R2 million per annum. They employ over 200 staff. The
business grew steadily in the early years, and about 10 years ago the head office
moved to the upmarket Umhlanga district, with the other two branches in
Sandton and Cape Town. A hybrid organisation structure exists in the company.
Each of the three branches is managed by a general manager who is a member
of the board of directors, and who reports to the managing director. For many
years SeCa Com has sought, with some success, to create a flexible management
team. Management trainees have a wide range of academic backgrounds. Their
training is structured in order to allow them to gain experience across the
whole range of functions and in the various branches. In most cases trainees
decide in which particular function they wish to pursue the next stage of their
management development.
The company is very supportive of studying for professional qualifications and,
Copyright © 2021. Juta & Company, Limited. All rights reserved.

in due course, pursuing an MBA or similar management qualification.

The project
Over the past decade, the company has ensured that they comply with the BEE
codes of good practice, allowing them to tender for government contracts.
They recently tendered for a contract to assist in the management and control
of the ICC T20 Cricket World Cup event due to take place in South Africa in
four years’ time. After much anticipation, they received the news that they
had won the bid. A significant part of the project will be the provision of new
buildings and facilities. Major new works associated with the project include
the construction of a 30 000-seat cricket stadium and a world press and media
centre in the Pietermaritzburg area, which is 90 km from Durban. A further
consideration is the upgrade of the current transport network, with major

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development work required on the local rail system between the main stadium
and the city centre, as well as airport shuttle services. Another consideration is
upgrading the existing Sahara Kingsmead Stadium to accommodate another
10 000 spectators. Success will be measured in terms of trouble-free
performances of the events, the level of customer enthusiasm and satisfaction,
and sustained economic activity generated in the region. Completion of the
project on time is critical, even if cost or quality is adversely affected.
The main software development aspect of the project is the development of
the communications software in the form of an information database. This
will require development of a dedicated website to give public access to event
information. The database will contain information about competitors and
their events, time and location and availability of tickets. The database will
be designed to allow the general public to monitor the events, order tickets
from the website for any event, and purchase merchandise. The website will
also contain links to local hotels and restaurant facilities. The whole package
of communications software and the telecommunications and information
technology hardware has been termed the ‘communications structure’.
After much deliberation between individual specialist project teams led by
project team managers, a list of activities has been identified. It is critical that
these events are coordinated and planned effectively, as timing is critical to the
success of this project.
The list of activities identified by SeCa Com
Activity Activity description Preceding Duration
activity in weeks
A Obtain financial and sponsorship negotiation – 22
B Sporting facilities – 52
C Analysis and design of communications software A 14
D Construct media facilities B, C 16
E Program communication system C 26
F Install communication software and D, E 6
telecommunications hardware
G Update transport network and construct players’ – 40
accommodation
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H Security arrangements and checks G, F 12

I Public relations F 10
J Human resources and volunteers I 12
K Test games, trial events and media systems H, J 6
L Events including opening and closing ceremonies K 2

Required:
(a) You are a trainee management accountant working for SeCa Com and have
been asked by your management team to prepare a report which includes
the following:
(i) An explanation of the importance of undertaking critical path analysis
for a project such as this.

Network analysis

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(ii) A critical path analysis for the project, clearly identifying:

The critical path activities and the critical duration of the project
●

The earliest starting time for each activity

●

● The latest starting time for each activity.

(iii) A calculation of the slack time on activity H (security arrangements
and checks) and an explanation of how this information may assist
decision making during this project.
(iv) How using project management software may benefit this project.
(b) What are the opportunity costs for South Africa of investing in the hosting
of the ICC T20 Cricket World Cup?
(c) Carry out a cost–benefit analysis including qualitative as well as quantitative
factors in order to justify the costs associated with hosting the ICC T20
Cricket World Cup.
13.4 V has just left her job as a website designer for a large systems design company
and is about to start up her own website design business. She will be renting an
office which she needs to prepare for her work. She also has to procure all the
necessary equipment before the business can start operating. She intends to
open her business in 12 weeks’ time. In her previous role, she often encountered
critical path analysis when she was involved in large design projects and she
considers that this technique may help her to plan the setting up of the new
business. V has devised a list of activities shown in the following table that
must be completed before the new business can commence. When drawing up
this list, she was aware that there was a degree of uncertainty in the timescales
for some of the activities. She is concerned that if these uncertainties are not
considered at this stage, she may not meet the deadline of opening her new
business in 12 weeks’ time.
(Note: no slack is shown.)
Activity description Activity Preceding Time
activity (weeks)
Find rental office A – 2
Procure equipment B A 1
Prepare office C A 3
Recruit staff (2 people) D A 4
Delivery and installation of equipment E B, C 2
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Train staff F D, E 2
Design tests on web design system G F 1
Test web design system H G 1

Required:
(a) Using the given information, construct a network diagram for setting up V’s
business, clearly identifying the critical path.
(b) Explain to V the difference between ‘contingency/scenario plans’ and
‘buffering’ in the context of helping V plan for the uncertainties in setting
up the business.
Source: CIMA (adapted)

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13.5 ST is the operations director of F Bakery. He is in the process of putting together

a project plan for the introduction of a new production plant that will enable
the bakery to expand its product range, moving into high-quality cakes and
desserts. ST has identified a number of activities that must be undertaken to set
up the new bakery production plant. He now intends to construct a network
analysis to assist ST in the planning of the project. This will also enable him to
provide an answer for the HR manager who has asked him to provide advice on
when she can start the recruitment campaign to select new employees needed
to work in the new part of the bakery.
The activities can be broken down as given in the following table.
Activity Preceding activities Activity duration (weeks)
A – 12
B – 10
C – 6
D C 26
E A 9
F B 14
G* E, F 10
H D, G 6

* Recruitment campaign

Required:
(a) Construct a network diagram showing the critical path for the introduction
of the new production plant for the bakery and the overall duration of the
project.
(b) Identify the earliest time the recruitment campaign can start.
(c) Identify the activities where there is float/slack time in the project, and
calculate how much float/slack time there is.
13.6 Blue Sky specialises in the installation of large, luxury spa baths. The owner,
Mr Hayne Finch, has approached you to assist him in determining whether
he should accept a special order from the Department of Transport for the
installation of three spa baths in the houses of various diplomats. This order is
Copyright © 2021. Juta & Company, Limited. All rights reserved.

of such urgency that they are prepared to pay an amount of R55 000 per spa
bath. You have been provided with the following details:
1. Fifteen spa baths have been ordered for January 20X1. A 50% deposit for
each has already been received.
2. Selling price per spa bath is R50 175.
3. Labour details:
Number of working days in January 20X1 20
Number of installation teams 3
Hours worked per day (excluding lunch and tea breaks) 8 hours

Network analysis

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4. Project details per spa bath are given in the following table.
Activity Variable cost Duration (hours per Cost
installation team) slope
Normal Accelerated Normal Accelerated
A−B 9 500 9 750 10 8 125
A−D 2 000 2 300 4 3 300
A−C 1 500 1 850 2 1 350
B−D 4 000 4 300 8 6 150
C−D 1 500 1 750 13 12 250
D−E 11 500 12 050 11 10 550
Total 30 000 32 000 – – –

Required:
(a) Calculate the minimum time in which one spa bath can be built in a cost-
efficient manner.
(b) Determine whether Blue Sky has sufficient capacity to complete the spa baths
which have already been ordered, as well as the additional three special order
spa baths, if each spa bath is installed in the minimum time.
(c) Advise Mr Hayne Finch whether the special order should be accepted or
not, by calculating the net profit made:
(i) If the special order is not accepted and each spa bath is built in normal
time
(ii) If the special order is accepted and each spa bath is built in the
minimum time.
13.7 A new project has been approved for construction of the N2 Wild Coast toll road
in South Africa’s Eastern Cape province. The Wild Coast has great potential for
economic development in the form of rural development initiatives and tourism-
based approaches. The creation of this new road will increase accessibility to the
area, and thus increase job creation and improve livelihoods. It will also serve
to increase connectivity and logistics between the Eastern Cape and KwaZulu-
Natal regions. Moreover, the many coastal reserves, whose aims are to educate
people, conserve the natural environment, and serve as tourist attractions, will
become more accessible. Overall, on the positive side, it is anticipated that the
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new N2 road will greatly benefit the surrounding communities in terms of job
creation, infrastructure development and accessibility, which facilitates tourism
and related economic opportunities. The approved contractors called in the
services of DnH CC to assist with the planning of the project. DnH CC developed
the following network diagram indicating all activities (monthly time frame).

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B=4 I=5
1 5 7

L=7
D=5
H=2 G=4
A=9
J=9
2 4 8

C=5 X=0
E=2
K = 10

F=9
3 6

Required:
(a) Calculate the shortest time in which the project can be completed.
(b) Calculate the slack for activity E, using both the starting and completion times.
(c) Currently one skilled labourer is employed to perform activity F. This
employee assembles 16 road rails per hour during an 8-hour shift. To reduce
the total duration of the project, the project manager considers employing
two unskilled labourers with adequate experience to complete activity F.
These two labourers will each be able to assemble 12 road rails per hour,
but according to legislation, they are only allowed to work one shift of 6
hours per day. A work week is from Monday to Friday, each week.
(i) What will the effect be on the duration of activity F if the two unskilled
labourers are employed?
(ii) Will the project manager achieve his goal by employing the two
unskilled labourers? Justify your answer.
13.8 The Sencam Family Trust is converting an abandoned warehouse into a shelter
for the homeless as part of their annual contribution to the community. The
estimated duration of activities was uncertain. However, after using the PERT
method, the expected duration for each activity was calculated. The estimates
in the following table were made on 31 December 20X1.
Activity Predecessor activity Expected duration Number of workers
Copyright © 2021. Juta & Company, Limited. All rights reserved.

(weeks) required
A – 4 1
B – 1 3
C A 3 2
D B 2 1
E A 4 2
F D, E 2 2
G B 5 1
H C, F 2 1
I G, H 3 1

Network analysis

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Once the activity has commenced, the nature of the work requires that all
the relevant workers continue with the activity until it has been completed,
thereafter moving on to other activities. All staff employed on the project are
paid for the duration of the project, whether they work or not, at a rate of
R3 000 per week.

Required:
(a) Construct a network diagram.
(b) List all possible paths through the network and indicate the critical path.
(c) Calculate the slack of each activity.
(d) Using the estimates at 31 December, prepare a work schedule to minimise
labour costs without delaying the completion of the project. What are the
costs associated with this schedule?
13.9 Sencam Ltd was recently inherited by two sisters, Senayshia and Camishka,
from their grandfather. They have been faced with many tribulations, and have
been encountering some tough business decisions in the short time that they
have been there. Senayshia has recently returned from the UK after completing
her CIMA qualification, and Camishka is currently in her final year of study
in the MBA programme at Stellenbosch University. Between the two of them,
they have enough knowledge to run the business successfully. What they do
lack, however, is experience. Their grandfather was working on a tender for a
construction contract, but just as the tender was to be submitted, he became ill
and for health reasons was forced to retire.
The project manager presented the following regarding the contract:
● The network diagram of the project is as follows:

E
B
G
A
D
C

● The durations and costs of the various activities required to complete the
project have been estimated, and are given in the following table.

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489

Activity Preceding Estimated time Estimated total cost

activity (weeks) (Rand)
Normal Crash Normal Crash Cost
slope (R)
A - 1 1 5 000 5 000 –
B A 3 2 12 000 14 000 2 000
C A 7 4 21 000 24 000 ?
D B 5 3 10 000 12 000 1 000
E B 8 6 8 000 12 000 2 000
F C, D 4 2 8 000 10 000 1 000
G E, F 1 1 5 000 5 000 –

If the installation can be completed four weeks earlier than originally planned,
Sencam Ltd can earn a bonus on the contract of R20 000.

Required:
(a) Determine the critical path and the normal cost to complete the project.
(b) Calculate the cost slope, the latest and earliest completion time, as well as
the slack for activity C.
(c) Determine the minimum extra cost that could be incurred to reduce the
time to complete the project by four weeks.
(d) Advise with reasons whether or not Sencam Ltd should reduce the time for
the project by four weeks.
13.10 The board of Hayfer Company has agreed in principle to a project for a
largescale upgrade to its management accounting systems. The finance director
has been asked to provide the detailed requirements for the project. So far, no
one else in the business has been involved in the discussions about the project.
The finance director believes that the project process should proceed in the
following way:
● No details of the functionality should be set. It is important that the system
is allowed to grow in scale during the life of the project.
● Progress should be reported as and when the project manager feels it is
appropriate.
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● Shia Sen, who is a member of the finance department, should be selected as

project manager. The finance director believes it is a good opportunity for
her, as she has not previously managed a project.
The main activities and timescales are given in the table below.
Activity Description Duration (weeks) Preceding activity
A Document requirements 8 –
B Review and select package 6 –
C Demonstration of package 2 A, B
D Training 7 C
E Test programs 5 C
F Changeover 6 D
G Completion 4 E, F

Network analysis

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490

Required:
(a) Construct a critical path analysis (CPA) for the management accounting
system project.
(b) Explain how information from the CPA could help to ensure that the
project is delivered on time.
Source: CIMA (adapted)
13.11 The eThekwini Water and Sanitation division (EWS) provides water to
consumers via a number of different means depending on access and the type
of sanitation system supplied. These include standpipes, ground tanks, semi-
pressure roof tanks, full-pressure systems, or community ablution blocks.
EWS specialises in project management and was recently contracted by the
municipality to develop a new water supply system in the rural areas of KZN.
The water supply system must be in working order within 30 months from the
start of the project, otherwise a penalty of R1 000 000 will be charged and
deducted from the contract fee. The discretionary direct cost saving per month
is R110 000.
You, as the senior project manager of EWS, have the responsibility to plan the
project in order to finish within the 30 months. The following activities with
the corresponding normal times, accelerated times and cost slopes have been
identified.
Activity Normal time Accelerated time Cost slope
(months) (months) (R)
A→B 2 1 400 000
A→C 4 2 200 000
A→D 3 1 100 000
D→F 9 5 110 000
C→E 6 2 500 000
C→D 7 4 9 000
E→G 9 6 110 000
G→H 10 9 50 000
B→H 11 8 30 000
F→G 3 3 0
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Required:
(a) Calculate the duration of all the routes and identify the critical route.
(b) Accelerate the project to the most cost-effective plan.
(c) Calculate the slack of activity A→B.
13.12 Shiloh Ltd is a mining equipment manufacturer and supplier of the largest range
of mining equipment for gemstone, minerals, metal processing and accessories
and a major supplier of earth-moving, construction, and aggregate and waste
recycling machinery and equipment. These machines are produced on special
order according to client specifications. The following table includes activities
that have to be completed in order to manufacture a machine, the relationship
between these activities and the estimated duration of each activity.

Cost and Management Accounting

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491

Activity Description Preceding Most Most Most

activity optimistic likely pessimistic
estimate estimate estimate
(weeks) (weeks) (weeks)
A Design according to – 2 3 4
client specifications
B Ordering and – 14 15 22
procurement of materials
C Preparation of test A 4 4 4
specifications
D Manufacture chassis A, B 18 32 34
components
E Manufacture motor A, B 8 10 12
F Manufacture mechanical A, B 30 39 42
components
G Chassis assembly D 2 5 8
H Machine assembly E, F, G 5 7 15
I Inspection C, H 1 3 5

Required:
(a) Determine the expected time required to complete each activity.
(b) Draw a network diagram.
(c) Determine the EST, LST, ECT, LCT and slack for each activity.
(d) Determine the critical path.
(e) Calculate the standard deviation for each activity and of the critical path.
(f) The customer requires delivery within 60 weeks, failing which a penalty
clause of R7 500 per week of late delivery has been stipulated.
Additional information:
Activity Normal cost (R) Accelerated cost (R) Accelerated time (weeks)
A 1 500 2 300 2
B 80 000 93 000 12
C 2 000 3 000 3
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D 75 000 91 000 25
E 63 500 68 500 8
F 92 000 110 000 32
G 8 000 11 200 4
H 25 000 35 500 5
I 3 000 4 500 2
350 000 419 000

Indirect cost not included in the normal cost is R3 500 per week.
Can the project be completed in 60 weeks? If so, what will be the savings
(if any) made by Shiloh Ltd?

Network analysis

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492

Reference list
South African National Roads Agency (SANRAL). n.d. Thombothi River Bridge, KwaZulu-
Natal. Available: https://www.nra.co.za/socio-economic-development/special-development-
programme/regional-development-plans/eastern-region/kwazulu-natal-thombothi-river-
bridge/. (Accessed 18 December 2016).
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Cost and Management Accounting

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14 Investment appraisal

Investment appraisal

Weighted average cost of

Relevant project cash flows
capital

Capital budgeting techniques Capital rationing Time value of money

Discounted Net present Internal rate of Profitability

Payback period
payback period value return index

Learning objectives
After studying this chapter, you should be able to:
● Describe the capital budgeting process
● Explain the purpose of investment appraisal
● Identify a project’s relevant cash flows
● Calculate a project’s payback period, discounted payback period, net present
value, internal rate of return, profitability index, accounting rate of return and
modified internal rate of return and the weighted average cost of capital
● Apply single period capital rationing for divisible and indivisible projects
● Explain the use of weighted average cost of capital as the discount rate
● Evaluate projects using the various capital budgeting techniques.
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Introduction
The decisions faced by organistions can be categorised into three main areas: operating
decisions, investment decisions and financing decisions. The majority of principles covered
in this book relates to the operating decisions faced by organisations. The focus of this
chapter is on the investment decision. The main aim of any profit-making organisation is
that of maximising shareholder value. In finance theory, the value of anything is the future
cash flows, discounted at the risk-appropriate rate. As a result, when an investment decision
is made, only projects that add value to the organisation by increasing the discounted
future cash flows should be accepted.

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Investment appraisal, also referred to as capital budgeting, entails identifying and analysing
projects that can provide suitable returns. The needs of stakeholders other than the
shareholders, such as suppliers, employees and the general public, should however not be
ignored.

Capital budgeting
Capital budgeting is the process that organisations use to evaluate and appraise
investments or capital expenditure. Since investment decisions are very costly, long term in
nature and often complex, incorrect decisions may be very costly and difficult to reverse. As
a result, it is important to plan the investment decision carefully.

Capital budgeting process

The capital budgeting process involves the following five stages:

Stage 1: Screening stage

Organisations normally set themselves strategic objectives to accomplish. There is therefore
a need for the organisation to screen which types of capital investment projects will be
necessary so that the organisation can achieve its strategic objectives. Line management is
charged with the responsibility of identifying which capital investment projects to invest in,
based on the organisation’s strategies.

Stage 2: Search stage

To make an informed decision regarding the projects in which to invest, the organisation
needs to find out more information regarding the alternative investment projects that are
available. Some of the alternatives that were identified at the screening stage will be rejected
early on at the search stage, after more information about them has been received. Other
alternatives will be evaluated more thoroughly during the next stage.

Stage 3: Information gathering stage

The organisation needs to consider the estimated future cash flows, as well as other
qualitative factors that may have a strategic impact on the organisation for each of the
alternative investments. This is the responsibility of the management accountant.
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Stage 4: Authorisation stage

The best project in terms of the benefits exceeding the costs will be selected. Evaluating
costs and benefits is usually the responsibility of the management accountant. A formal
analysis, which will include the financial outcomes, is used by managers to determine the
best project.

Stage 5: Implementation and monitoring stage

The chosen project will be implemented, and constant monitoring of how the performance
of the project is progressing is vital at this stage. The information generated during the
monitoring exercise is fed into the post-completion audit that will be dealt with later in this
chapter.

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Categories of capital budgeting projects

Organisations normally classify capital budgeting projects into the following categories:
1. Expansion projects: Organisations engage in projects in order to expand their
operations. This might include acquiring additional manufacturing capacity to increase
current market share, or entering new markets by acquiring other businesses.
2. Replacement projects: Organisations operate on a day-to-day basis using fixed assets.
When such fixed assets become old, normally as a result of wear and tear, the frequency
of the asset breaking down increases, thereby affecting the general productivity of the
organisation. The organisation will then be forced to replace the asset with a new, more
efficient asset.
3. Regulatory projects: Some projects have to be undertaken by organisations because
they are required by law to do so in order to improve safety at work or to preserve the
environment. For such projects, the organisation has no choice but to execute the
project, even though the project itself may not generate any shareholder value.
4. New projects: These are projects that the organisation has never undertaken before.
They expose the organisation to even greater uncertainties compared to other categories
of projects. To make decisions on these projects involves a lot more people than usual.

Capital budgeting techniques

There are several techniques that organisations use to rank, screen and evaluate alternative
investments. These techniques include the following:
● Payback (PB)
● Discounted payback (DPB)
● Net present value (NPV)
● Internal rate of return (IRR)
● Profitability index (PI)
● Modified internal rate of return (MIRR)
● Accounting rate of return (ARR).

These techniques are explained in more detail in the sections that follow. First, however,
it is important to understand the difference between independent projects and mutually
exclusive projects.
Independent projects are alternatives where the acceptance of one project does not
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affect the decision to accept any of the other alternatives. An example is the acquisition of
a new business operation. As long as the new acquisition adds value to the organisation it
can be accepted, regardless of whether any of the other investments are also accepted or not.
Mutually exclusive projects are alternatives where one project can be accepted, and the
organisation has to choose the best one. An example of a mutually exclusive investment
might be the replacement of a manufacturing plant at the end of its useful life. The
organisation only requires one manufacturing plant, and therefore has to choose the best
one amongst the alternative investments.

Payback method
The payback period is the length of time that it takes for the cash inflows from an
investment project to pay back the initial cash outflow of the investment. It provides a

Investment appraisal

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measure of liquidity and risk. The sooner the investor can recover the initial investment, the
lower the risk of this particular investment not recouping its initial invested cash. Decision
criteria are as follows:
● Organisations normally set the required payback period as a standard that has to be
adhered to, and if the payback period of an investment project is shorter than this
standard period, the project will be accepted.
● When faced with mutually exclusive projects, the project with the shortest payback
should be selected.

A payback period may not always be exactly in full years. To calculate the payback in years
and months, first determine the number of full years that the investor has to wait before the
project pays back in the following year. Then divide the required cash inflow from the last
year by the cash inflows expected in that particular year. Now multiply this decimal fraction
of a year by 12 to convert it to months. The payback period will then be the initial full years,
plus the number of months during the year in which the project pays back the investment.
Where the cash flows are constant, the payback can be calculated as:
Initial investment
_______________
Payback =    
    
Annual net cash inflow
 

Illustrative example 14.1

A company wants to acquire a new manufacturing machine. There are two alternatives
available and the company needs to decide which one to invest in. Both machines will
cost R1.2 million and the expected annual cash flows are presented below:
Table 14.1 Expected cash inflows from the machines
Year Machine A (R) Machine B (R)
1 400 000 300 000
2 400 000 550 000
3 400 000 400 000
4 400 000 100 000
5 400 000 100 000

The company has a standard payback period of three years.

Determine which machine the company should invest in by calculating the payback
periods.

Solution:
Since the cash flows for Machine A are constant, the payback for Machine A can be
calculated as follows:
Payback = R1 200 000 ÷ R400 000 = 3 years
➤➤

Cost and Management Accounting

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Because the cash flows for Machine B are uneven, the payback is calculated by working
out the cumulative cash flow over the life of the machine:
Table 14.2 Payback of Machine B
Year Cash flows Cumulative cash
(R) flows (R)
0 –1 200 000 –1 200 000
1 300 000 –900 000
2 550 000 –350 000
350 000
_______
3 400 000   400 000  = 0.875
4 100 000
5 100 000

In the first two years the company recovers R300 000 and R550 000 respectively per
annum. Another R350 000 is required from subsequent years. During the third year,
R400 000 cash inflow is expected, hence 0.875 of that year is required to cover the
required cash inflow. The payback period is 2.875 years. This is slightly below the
standard payback period set by the company and lower than the 3 years it takes for
Machine A to pay back. Therefore, since the machines are mutually exclusive, Machine
B should be acquired.

Advantages of the payback method

Below are some advantages of the payback method.
● Managers of organisations find it easy to use and understand.
● It is easy to calculate.
● Much emphasis is placed on cash flows that come in earlier years since they are likely to
be more accurate and more certain than cash flows that come in later years.

Disadvantages of the payback method

The disadvantages of the payback method are as follows:
● The cash flows that come after the payback period are ignored. In Illustrative example
14.1, the R100 000 cash inflows that come in year 4 and year 5 have not been used at all.
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● The time value of money is ignored.

Based on the disadvantages given, it is advisable not to use the payback method on its own
to evaluate capital projects. It is only a measure of payback, but not of profitability. To
try to address some of the disadvantages listed above, a discounted payback period can
be calculated.

Discounted payback method

One of the major criticisms of the payback method is that it ignores the time value of
money. The discounted payback method attempts to overcome this criticism. This method
works in the same way as the payback method, except that before the cumulative cash flows

Investment appraisal

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are calculated, the cash flows have to be discounted to the present. Therefore the discounted
payback can be defined as the number of years required to recover the initial investment
from the discounted net cash flows.

Illustrative example 14.2

Use the cash flows from Table 14.1 in Illustrative example 14.1 to calculate the
discounted payback period for each machine. Assume the discount rate is 10%.

Solution:
The discounted payback periods can be calculated as follows:
Table 14.3 Discounted payback calculation
Machine A
Year Cash flows (R) Discount factor Present value Cumulative
@ 10% (R) cash flows (R)
0 –1 200 000 1 –1 200 000 1 200 000
1 400 000 0.909 363 636 –836 364
2 400 000 0.826 330 579 –505 785
3 400 000 0.751 300 526 –205 259
4 400 000 0.683 273 205   205
_______ 229
273 205  5 0.75
5 400 000 0.621 248 369
Machine B
Year Cash flows (R) Discount factor Present value Cumulative
@ 10% (R) cash flows (R)
0 –1 200 000 1 –1 200 000 1 200 000
1 300 000 0.909 272 727 –927 273
2 550 000 0.826 454 545 –472 727
3 400 000 0.751 300 526 –172 201
4 100 000 0.683 68 301 –103 900
5 100 000 0.621 62 092 –41 808
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Since the discount rate is 10%, we can refer to the present value table at the end of
the textbook to get the present value of R1 each year, or we can apply the formula
discussed later in this chapter, under the heading: Overview of time value of money. In
year 1 the discount factor would be: 1 ÷ 1.1 = 0.909. If we do the same for year 2, we
would get 1 ÷ 1.12 = 0.826.

Now, after getting the discount factor, we multiply it by the cash flows each year to get
the present value of each annual cash flow. Machine A now pays back after 3.75 years
and is rejected due to being longer than the company’s standard payback period. At the
end of five years, Machine B still owes the company R41 808, therefore the machine will
not pay back the initial investment and should also be rejected.

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The discounted payback period method partially addresses the disadvantage of the time
value of money experienced by the payback method, but the method falls short when it
comes to the issue of not taking the cash flows after the payback period into account.

Net present value

The net present value (NPV) represents the net benefit or net loss earned on the project
in present value terms. The NPV of a proposed investment project is calculated by taking
the present value of the future after-tax net cash flows, and then subtracting the initial
investment.
In order to establish the present value of the future cash flows, the project cash flows
should be discounted at the risk-appropriate rate. In the case of operating cash flows (such
as those from a project or other capital asset) the overall risk profile of the company should
be discounted for. The appropriate rate is therefore the weighted average cost of capital
(WACC), which is discussed in more detail later in this chapter. This is theoretically the best
method of investment appraisal, as it calculates the increase or decrease in shareholders’
value. A NPV of zero signifies that the project’s cash flows are exactly sufficient to repay the
invested capital and to provide the required return on the capital. It can also be said that the
project is breaking even from a cash flow perspective. If the NPV is positive, then the project
is generating more cash than is required to service the debt and to provide the required
return to shareholders. A negative NPV signifies that the project is not generating sufficient
cash flows to service the debt and to provide the required return to shareholders.
The decision criteria are:
● Invest in all independent projects that have a positive NPV. (NPV > O)
● Do not invest in a project if the NPV is negative. (NPV < O)
● When faced with mutually exclusive projects, choose the project with the highest NPV.

Illustrative example 14.3

African Tours is a small tour operator that is planning to implement an online booking
system. They are currently considering two potential systems, BookPro and ReserveSys.
Both systems have a useful life of five years. The initial investment and estimated annual
net cash flows of both systems are presented in Table 14.4.
Table 14.4 Cash flows and project information
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BookPro ReserveSys
Initial investment R500 000 R800 000
Project useful life 5 years 5 years
Project net cash flows
Year R R
1 130 000 208 000
2 143 000 225 000
3 157 000 238 000
4 172 000 268 000
5 185 000 312 000
➤➤

Investment appraisal

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500

The company’s weighted average cost of capital (discount rate) is 15%.

Required:
(a) Calculate the net present value (NPV) of the two systems.
(b) Recommend which system should be implemented based only on the NPV calculated
in (a) above.

Solution:
(a) Calculation of NPV:

Table 14.5 Net present value calculations

Net present value: BookPro
Year Cash flows Discount factor @ Present value
(R) 15% (R)
0 –500 000 1.000 –500 000
1 130 000 0.870 113 043
2 143 000 0.756 108 129
3 157 000 0.658 103 230
4 172 000 0.572 98 342
5 185 000 0.497 91 978
Net present value 14 721

Net present value: ReserveSys

Year Cash flows Discount factor @ Present value
(R) 15% (R)
0 –800 000 1.000 –800 000
1 208 000 0.870 180 870
2 225 000 0.756 170 132
3 238 000 0.658 156 489
4 268 000 0.572 153 230
5 312 000 0.497 155 119
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Net present value 15 840

(b) Recommendation:
The decision rule is that any project that generates a positive NPV is acceptable. In
this situation, both projects are acceptable, since both systems have a positive NPV.
ReserveSys, however, has a higher NPV of R15 840 when compared with BookPro
at R14 721. Therefore, based on the NPV only, ReserveSys should be implemented.

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Net present value on a financial calculator

The NPV can easily be calculated on a financial calculator once the annual net cash flows
have been determined. Remember to clear the memory of the calculator before your start.
The following inputs are required to calculate the NPV for the ReserveSys booking system:
− 800 000 [CF0], 208 000 [CF1], 225 000 [CF2], 238 000 [CF3], 268 000 [CF4], 312 000
[CF5], 15 [I/YR], [Shift], [NPV]

Advantages of a net present value method

Listed here are some advantages of a NPV method:
● When using the NPV method, all the cash flows for the project are used.
● This is the best method of appraising investment projects, since the method calculates
the absolute gain or loss in shareholder value.
● The time value of money is taken into consideration.
● The discount rate used for appraising the project can be adjusted to reflect the level of
inherent risk in different projects.
● NPV is based on cash flows and not accounting profits. Using cash flows is more
appropriate for decision making.

Disadvantages of the net present value method

Some disadvantages of the NPV method include the following:
● It is difficult to determine the cost of capital to be used for discounting the cash flows.
● It is not easy to understand NPV analysis figures compared to percentage figures given by
the accounting rate of return and internal rate of return (explained later in this chapter).
● The project that has a higher NPV does not always represent the best investment project
for the organisation, from a strategic point of view.
● It may not be well understood by non-financial managers.

Projects with unequal lives

If we are comparing mutually exclusive proposals and the original or remaining useful lives
of long-term capital projects differ, there is a bias in favour of accepting the asset with the
longer life. For example, assume that you are evaluating two machines, but will only purchase
one of them (that is, they are mutually exclusive). One of the machines has an expected life
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of three years and the other has an expected life of five years before it wears out. Everything
else being the same, the five-year machine will have the higher net present value, as more
interest is earned on the reinvestment of the cash inflows over a longer period of time. The
solution to eliminate the bias is to take the net present value calculation a step further
through the application of the lowest common multiple method or the determination of the
equivalent annual income/cost, whereby a comparative annual income/cost for each project
is calculated. The application of unequal lives is illustrated in Illustrative example 14.4.

Internal rate of return

Internal rate of return (IRR) is the discount rate at which the NPV of a project will be zero.
This means that at an IRR equal to the weighted average cost of capital (WACC), the total
present value of the discounted cash inflows is equal to the total present value of the cash

Investment appraisal

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outflows of the project. The IRR is the exact rate of return that the project is expected to
achieve. The WACC is used to discount project cash flows to calculate NPV. Therefore, if the
IRR exceeds the WACC, the project will have a positive NPV (adding to shareholder value)
and the project will be accepted. Likewise, if the IRR is lower than the WACC, the NPV will
be negative and the project should be rejected. Using linear interpolation, we can determine
the IRR. First, calculate the NPV at two different rates, and then use the following formula
to derive the IRR:
[ 1
NPV
IRR = DR1 + ___________
  NPV 2 NPV
1
× (DR2 − DR1)
2
]
Where:
DR1 = Lower rate
DR2 = Higher rate
NPV1 = NPV at lower discount rate
NPV2 = NPV at higher discount rate

Hint: Do not convert percentages to decimals; instead, use whole numbers and add in a
percentage sign at the end.

The decision criteria are:

● Accept the project if the IRR is greater than the weighted average cost of capital.
(IRR > WACC).
● Reject the project if the IRR is less than its weighted average cost of capital.
(IRR < WACC).

For projects that are mutually exclusive, the project with the highest IRR is the one to
be chosen. The above assumptions will only work well if a project has only one initial
investment, followed by a positive annual after-tax cash flow. In this case, the project will
have only one IRR.

Illustrative example 14.4

This example expands on the previous illustrative example. The table below presents the
present value factors for different discount rates.
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Table 14.6 Present value (PV) factors for different discount rates
Year 0 1 2 3 4 5
12% PV factor 1 0.893 0.797 0.712 0.636 0.567
20% PV factor 1 0.833 0.694 0.579 0.482 0.402

Required:
Calculate the internal rate of return (IRR) for the ReserveSys booking system.
➤➤

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503

Solution:
We first need to calculate two NPVs: one NPV must be positive and the other must
be negative. For illustrative purposes the two discount rates are given. These rates are
usually determined through trial and error.
Table 14.7 NPV at two different discount rates
Year 0 (R) 1 (R) 2 (R) 3 (R) 4 (R) 5 (R)
Net cash flows –800 000 208 000 225 000 238 000 268 000 312 000
12% PV factor 1 0.893 0.797 0.712 0.636 0.567
PV of cash flows –800 000 185 714 179 369 169 404 170 319 177 037

Net present value R81 843

Year 0 (R) 1 (R) 2 (R) 3 (R) 4 (R) 5 (R)

Net cash flows –800 000 208 000 225 000 238 000 268 000 312 000
20% PV factor 1 0.833 0.694 0.579 0.482 0.402
PV of cash flows –800 000 173 333 156 250 137 731 129 244 125 386

Net present value –R78 056

In most questions, the company’s discount rate will be given. By using this discount
rate to calculate the NPV, it will give us a guide as to whether the NPV is positive or
negative. If the NPV at this rate is positive, the next NPV to calculate has to be negative,
and we will have to choose a much higher discount rate than the one we have just used.
Likewise, if the initial NPV is negative, then the next NPV calculated should be positive,
and a much lower discount rate should be used. In this case we chose 20% and 12%. The
IRR can now be calculated as follows:
[
IRR = DR1 + __________
1
  NPV 2 NPV
NPV
1
× (DR2 – DR1)
2
]
Where:
DR1 = 12%
DR2 = 20%
NPV1 = R81 843
NPV2 = –R78 056
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Note: Do not convert percentages to decimals; instead, use whole numbers and add in
a percentage sign at the end.

[ R81 843
IRR = 12 + _______________
  R81
   843 2 (R78 056) × (20 – 12) ]
IRR = 12 + [  ________
R159 898 × 8]
R81 843

IRR = 12 + 4.09
IRR = 16.09% or 16%
The IRR is between the lower discount rate of 12% and the higher one of 20%. If we
discount the cash flows above using the 16% (IRR), the expectation is that we will get
an NPV of R0. In the above example, the IRR is 16%, which is higher than the WACC of
15%, therefore the project should be accepted.

Investment appraisal

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Internal rate of return on a financial calculator

The IRR can easily be calculated on a financial calculator once the NPV has been calculated.
The following inputs are required to calculate the NPV for the ReserveSys booking system:
−800 000 [CF0], 208 000 [CF1], 225 000 [CF2], 238 000 [CF3], 268 000 [CF4], 312 000
[CF5], 15 [I/YR], [Shift], [NPV]

After you have calculated the NPV, simply press [Shift], [IRR] and the IRR will be displayed.
You do not need a discount rate to calculate the IRR, since the return is based on the actual
cash flows and is not influenced by the discount rate.

Calculating internal rate of return when cash flows are perpetuities

A perpetuity is an infinite stream of cash flows. The value of a perpetuity can be determined
by dividing the cash flow by the interest/discount rate. The IRR of a perpetuity can be
determined as follows:
Annual inflows
IRR of a perpetuity = ____________
   
Initial investment
  × 100

Advantages of internal rate of return

The advantages of using the IRR are as follows:
● Its simplicity makes the concept easy to understand.
● IRR is the perfect use of the time value of money theory.
● Equal importance is given to all the cash flows, whether earlier or later.
● IRR calculates breakeven. IRR calculates an alternative cost of capital, including an
appropriate risk premium.

Disadvantages of internal rate of return

The disadvantages of using the IRR include the following:
● IRR is a relative figure, whereas NPV is an absolute figure. Therefore, IRR can give a
different ranking from the ranking proposed by NPV.
● The IRR method assumes that project earnings for the period of the investment will be
reinvested at the IRR, and this usually over-estimates the returns from the project.
● If a project has irregular cash flows, that is, the project generates negative cash flows in
between positive cash inflows, the project can have more than one IRR.
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● IRR cannot accommodate changing interest rates.

Net present value versus internal rate of return

Both the NPV and IRR are discounted cash flow techniques, that is, they are investment
appraisal techniques which discount cash flows. These techniques are superior to the
techniques discussed earlier in the chapter. Only the NPV method can be used to distinguish
between two mutually exclusive projects. The IRR is useful when examining one project.
The NPV tells us the absolute increase in shareholder wealth resulting from accepting the
project at the current rate of return. The IRR simply tells us how far the cost of capital could
increase before the project would not be worthwhile.

Cost and Management Accounting

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505

Illustrative example 14.5

A company is considering investing in one of two mutually exclusive projects, Project
A and Project B. Detailed information on the two alternatives is presented in the table
below:
Table 14.8 Cash flows for two mutually exclusive projects
Year Cash flows
Project A (R) Project B (R)
0 –1 000 000 –100 00
1 1 180 000 135 000

Required:
Determine which project should be invested in on the basis of:
(a) A calculation of the IRR of each project
(b) A calculation of the NPV of each project.

Solution:
Using a financial calculator to determine the IRR and the NPV, these are shown
simultaneously since the steps are very similar.

The inputs for Project A are:

–1 000 000 [CF0], 1 180 000 [CF1], 15 [I/YR], [Shift] [NPV], [Shift] [IRR]

And the inputs for Project B are:

–100 000 [CF0], 135 000 [CF1], 15 [I/YR], [Shift] [NPV], [Shift] [IRR]

The results are as follows:

Project IRR NPV
A 18% R26 087
B 35% R17 391

By looking only at IRR, Project B is clearly the preferred investment with an IRR (35%)
almost double that of Project A (18%). The limitation of IRR is that it does not take
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into account the size of the investment and is not an absolute measure of shareholder
value. The NPV of Project A (R26 087) is much higher than the NPV of Project B
(R17 391) and therefore creates more shareholder value. In conclusion, the company
should choose on the basis of NPV, hence Project A should be invested in.

Profitability index
The profitability index (PI) is the net present value of a project divided by its initial
investment.
When using NPV to make investment decisions, it is assumed that unlimited funds or
capital can be obtained at the weighted average cost of capital. If there is limited capital
available (or capital is rationed), however, the company needs to maximise the NPV earned

Investment appraisal

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506

for each rand invested. In such cases, it becomes very important to rank projects according
to their profitability index, that is, according to their earning power. The profitability index
of a project is calculated as:
NPV of cash flows of the project
Profitability index (PI) = ____________________
 
      
Capital investment

The profitability index is related to the NPV approach. Every time the NPV is positive, the
PI is more than 1, and if the NPV is negative, the PI will be less than 1.
If the capital is not rationed, the decision criteria are:
● Invest in the project if the PI is greater than 1. (PI > 1)
● Do not invest in the project if the PI is less than 1. (PI < 1)

Illustrative example 14.6

Required:
Using the information in Illustrative example 14.3, determine which booking system
should be invested in using the profitability index (PI).

Solution:
514 721
PI for BookPro is  ______
500 000 = 1.03
 815
and for ReserveSys is ______ 840
800 000 = 1.02
If the PI is used, BookPro will be ranked first because of its higher PI, and then ReserveSys
will come next.

The profitability index is an indication of the value that the organisation will receive in
exchange for every rand invested in a capital investment project.

Modified internal rate of return

When there are mutually exclusive investments, the IRR and NPV methods result
in conflicting results due to the reinvestment assumption, that is, the NPV assumes
reinvestment at the project’s cost of capital whereas the IRR method assumes reinvestment
at the project’s IRR. The other problem is that more than one IRR can be found for projects
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with alternating positive and negative cash flows.

The modified internal rate of return (MIRR) is a modification of the IRR and aims to
resolve some problems with the IRR. CIMA defines MIRR as: ‘that rate of return which,
when the initial outlay is compared with the terminal value of the project’s net cash flows
reinvested at the cost of capital, gives an NPV of zero.’ The MIRR can be calculated using
the following formula:
________________

√ PV of positive cash flows

________________
MIRR =   
 PV
      − 1
of negative cash flows

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507

Illustrative example 14.7

An organisation wants to invest in a capital project with the cash flows as given in the
table below.
Table 14.9 Basic data for the illustration of modified internal rate of return
Year Cash flows (R)
0 –10 000
1 4 000
2 4 500
3 –6 000
4 5 000

Assume a discount rate of 15%.

Required:
Calculate the MIRR of this capital investment project.

Solution:
We will need to calculate the present value of the cash outflows as seen in Table 14.9.
This total gives us 13 945. Then we will have to find the terminal values of all the project’s
cash inflows, which gives us 17 035.
Table 14.10 Modified internal rate of return calculation
Year Cash outflows Discount factor Present value of
(R) @ 15% cash outflows
(R)
0 10 000 1 10 000
______ 1
3 6 000   (1.15) 3 3 945
13 945

Year Cash flows Discount factor Terminal value

(R) @ 15% of cash inflows

(R)
1 4 000 (1.15)(4–1) 6 084
2 4 500 (1.15)(4–2) 5 951
4 5 000 (1.15) (4–4)
5 000
17 035

The useful life of the project is four years.

______
√17 035
MIRR 5 ______
  13 945  – 1 = 10.52%

Investment appraisal

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Accounting rate of return

The accounting rate of return (ARR) is the only appraisal method that uses accounting
profits as opposed to cash flows. This method estimates the rate of return from an
investment project without the use of either discounting or compounding. It is also known
as return on investment (ROI) or return on capital employed (ROCE) and has variations in its
formulae. The most common formula is:
Average annual profit
__________________
ARR =   
 Average
   
value of investment

Decision criteria are the following:

● If the ARR is greater than the organisation’s target return, then accept the project.
● If comparing mutually exclusive projects, the project with the highest ARR should be
chosen.

Illustrative example 14.8

Given the following cash flows for a capital investment project for Costa Ltd, calculate
the accounting rate of return (ARR). The required rate of return is 12%. Straight-line
depreciation will be charged on the capital expenditure over the five-year life of this
project. The machine will not have any residual value at the end of its useful life.
Table 14.11 Basic data for the illustration of accounting rate of return
Year Cash flows (R)
0 –150 000
1 80 000
2 80 000
3 65 000
4 40 000
5 20 000

Total profit = Total cash inflows − Depreciation

= R285 000 − R150 000
= R135 000
Average profit = R135 000 ÷ 5 years = R27 000
Initial investment 1 Residual value
Average investment = _________________________
 
      
2
R150 000 1 R0
=  ____________
   2
= R75 000
R27 000
Hence ARR = _______
  R75 000
= 36%

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509

This method is based on profits rather than cash flows, therefore it is affected by accounting
policies. These policies can be different for each organisation, and as such it makes this
measure of accounting rate of return less useful than those methods that are based on
cash flows.

Advantages of the accounting rate of return

The advantages of the ARR are the following:
● The total useful life of the project is considered.
● It is easy to calculate.
● It is expressed in terms that managers of organisations can relate to, that is, profit and
capital.

Disadvantages of the accounting rate of return

Listed here are some disadvantages of the ARR:
● Profits rather than cash flows are used in the calculation.
● The time value of money is ignored.
● Neither tax nor capital allowances are considered.

Test yourself 14.1

Kalorato Corporation is considering an investment of R50 000. The corporation expects
after-tax cash inflows of R16 000 per year for the first five years, and R7 500 for the last
three years of the project. Straight-line depreciation is charged for the entire useful life
of this project. Assume the discount rate for this project to be 8%.

Required:
Make the following calculations for this project:
(a) Payback period
(b) Discounted payback period
(c) Net present value
(d) Internal rate of return
(e) Accounting rate of return.
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Relevant project cash flows

Capital budgeting involves a decision being made and therefore relevant costing principles
should be applied. The project relevant operating cash flows are the inflows and outflows of
cash that result from the investment decision being taken. Interest expenses are excluded,
since it is already included in the WACC, or discount rate; and subtracting interest would
lead to double counting. The most important cash flows are presented in Table 14.12.
Thereafter, each cash flow is briefly discussed under a separate heading.

Investment appraisal

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Table 14.12 Project cash flows

0 (R) 1 (R) 2 (R) 3 (R)
Initial investment –xxx
Proceeds of sale of asset xxx
Working capital –xxx xxx
Net operating cash profit xx xx xx
Opportunity cost –xx –xx –xx
Taxation –xx –xx –xx
Net cash flows –xxx xxx xxx xxx

Initial investment
Most projects have an initial large capital outflow or investment at the start of the first
year (‘year 0’ – refer to the section ‘Overview of the time value of money’ in this chapter).
Remember that an outflow is represented by a negative value.

Proceeds from sale of asset

In many projects the capital outlay may have a residual value at the end of the project and it
can be sold to recover some of the initial investment. It is important to remember that this
positive cash flow in the last year should be the proceeds of the sale and not the accounting
gain or loss.

Working capital
Due to the increased operating level of a new project, an investment in working capital
often takes place. This is due to higher levels of inventory and trade receivables required to
implement the project. The initial investment (year 0) is a cash outflow, which is recovered
at the end of the project life with a positive cash flow. The reason why there is a recovery
of working capital at the end of the project is because inventory will be sold and trade
receivables will be collected once the project ends. Working capital does not qualify for tax
relief and is excluded from the taxable income calculation.

Net operating cash profit

cash flows are shown, therefore items such as depreciation, allocated head office expenses
and impairments are excluded from operating cash profits.

Opportunity cost
If any benefit is foregone as a result of accepting the project, this opportunity cost should
be included as a relevant cash flow. An example is rental income forgone by installing a new
manufacturing machine in an empty warehouse that is currently let out.

Cost and Management Accounting

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Taxation
Different countries have different tax rules, but in most countries, similar principles are
applied in terms of income, expenses and capital allowances on capital assets. Tax can be
included in the project cash flows in two ways: it can either be done on a net basis, showing
each cash flow after tax, where applicable. The preferred method, however, is to calculate
the incremental taxable income as a result of undertaking the project separately, and then
only show the tax payable for each year as a cash outflow (or inflow in case of a saving of
tax payable). An example of the line items that make up the incremental taxable income
calculation for a project is shown in Table 14.13.
Table 14.13 Incremental taxable income
0 (R) 1 (R) 2 (R) 3 (R)
Capital allowance –xxx –xxx –xxx
Recoupment xxx
Net operating cash profit xx xx xx
Opportunity cost –xx –xx –xx
Incremental taxable income xxx xxx xxx

You will notice there are no amounts in year 0 and it only starts in year 1. Tax is not payable
in advance or at the beginning of a project, but at the end of each year.

Capital allowance
Usually depreciation is not an allowable deduction, but taxation rules allow for the
deduction of capital allowances (and wear and tear on some assets). Due to the large values
of capital investments, the taxation benefits may have a significant impact on whether the
project is successful or not. The effect of a capital allowance is a reduction of the taxable
income and a resultant saving in tax payable.

Recoupment
When capital allowances are claimed during the life of an asset, the tax value of the asset
is reduced by the allowance each year. If the asset is disposed of at the end of the project
life and the proceeds exceed the tax value, a taxable recoupment results in the last year of
the project, increasing the incremental taxable income. If, on the other hand, the proceeds
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are less than the tax value and a taxable loss is incurred, the shortfall can be claimed as a
scrapping allowance, thereby reducing the incremental taxable income.

Other items
Most items making up operating cash profit and opportunity cost is taxable and should
be included in the calculation of incremental taxable income. Some items are excluded
from the incremental taxable income calculation: depreciation is not deductible; allocated
expenses from head office are irrelevant and do not have an effect on the incremental taxable
income; and working capital does not have any effect on taxable income.

Investment appraisal

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512

Illustrative example 14.9

Farma Innovations is a market leader in the manufacturing of pharmaceutical drugs and
has been in operation for nearly three decades. One of the manufacturing machines is
giving problems and the company is considering replacing it with a new machine. The
information regarding the machines is available in the table.
Table 14.14 Information regarding machines
Old machine New machine
Initial cost R1 200 000 R2 000 000
Working capital investment R50 000 R400 000
Net operating profit R300 000 R600 000
Remaining useful life 3 years 5 years
Realisable value at end of useful life – R200 000

Additional information:
1. The net operating profit of the new machine includes depreciation of R400 000 per
annum (old machine: R240 000 p.a.).
2. The original useful life of the old machine was also 5 years.
3. The current realisable value of the old machine is R550 000.
4. Taxation: Capital allowances are calculated on the straight-line basis over 4 years
(25% p.a.) and the current tax rate is 28%.
5. The company’s WACC is 15%.
6. Assume all cash flows occur at the end of the year, except the initial capital outlays and
the initial working capital investments, which occur at the beginning of year 1 for the
new asset. The investment in working capital was not done at the start of the useful
life of the old machine, but at the start of year 3 of the useful life of the machine.
Required:
Determine whether the old machine should be replaced with the new machine, using the
net present value (NPV) method. (Refer to the tables in the Appendix.)

Table 14.15 Net present value: new machine

Years
0 (R) 1–4 (R) 5 (R)
Initial cost (2 000 000)
Working capital (400 000) 400 000
Net operating cash profit (R550 000 + R400 000) 1 000 000 1 000 000
Proceeds 200 000
Taxation (140 000) (336 000)
Net cash flows (2 400 000) 860 000 1 264 000
Factor @ 15% (Table B, 4 yrs.); (Table A, 5 yrs.) 1.000 2.855 0.497
(2 400 000) 2 455 281 628 431
➤➤
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Net present value: R683 713

Equivalent annual income* = R683 713 ÷ 3.352 (Table B, 5 years @ 15%)
= R203 962

*The machines have unequal lives and it is therefore necessary to calculate the equivalent
annual income.
Table 14.16 Incremental taxable income: new machine
Years
1–4 (R) 5 (R)
Net operating cash profit 1 000 000 1 000 000
Capital allowance (500 000)
Recoupment (R200 000 – R0 tax value) 200 000
Incremental taxable income 500 000 1 200 000
Taxation @ 28% 140 000 336 000

Capital allowance recouped R

Cost 2 000 000
Less: Capital allowance (R2 000 000 x 25% x 4) (2 000 000) (2 000 000)
Tax value at end of useful life 0
Realisable value 200 000
Recoupment 200 000

The calculations for the old machine are as follows:

Table 14.17 Net present value: old machine
Years
0 (R) 1 (R) 2 (R) 3 (R)
Initial cost – sunk cost –
Working capital (50 000) 50 000
Opportunity cost – proceeds forgone (550 000)
Net operating cash profit 540 000 540 000 540 000
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(R300 000 + R240 000)

Taxation (81 200) (67 200) (151 200)
Net cash flows (600 000) 458 800 472 800 438 800
Factor @ 15% (Table A) 1.000 0.870 0.756 0.658
(600 000) 398 957 357 505 288 518

➤➤

Investment appraisal

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Net present value: R444 979

Equivalent annual income = R444 979 ÷ 2.283 (Table B, 3 years @ 15%)
= R194 891
Table 14.18 Incremental taxable income: old machine
Years
1 (R) 2 (R) 3 (R)
Net operating cash profit 540 000 540 000 540 000
Capital allowance (300 000) (300 000)
Scrapping allowance – forgone 50 000
Incremental taxable income 290 000 240 000 540 000
Taxation @ 28% (81 200) (67 200) (151 200)

Capital allowance recouped R

Cost 1 200 000
Less: Capital allowance (R1 200 000 x 25% x 2) (600 000)#
Tax value at end of useful life 600 000
Realisable value 550 000
Scrapping allowance (tax loss) 50 000

# The original useful life of the machine was five years, and the remaining life is three
years. The machine is therefore two years old at the date of the decision. The capital
allowance would have been claimed for two years.

Conclusion: the company should replace the old machine since the equivalent annual
income of the new machine (R203 962) is higher than that of the old machine (R194 891).
Note: Even though the use of NPV was required, the equivalent annual income had
to be calculated since the two machines did not have equal useful lives on the date of
the decision.

Organisations typically face a situation whereby there are not enough funds available to
undertake all capital investment projects with a positive NPV. This will be a limiting factor
to the capital budgeting cycle which the organisation will have to work around. Capital
rationing is a constraint on an organisation regarding the ability of the organisation to
invest capital funds. It can be imposed by internal factors, such as a budget ceiling on
expenditure that management imposes on the budget. Such capital rationing is known as
soft capital rationing. On the other hand, the constraints might be due to external factors
affecting the organisation, such as the organisation being unable to borrow funds due to
a number of reasons. Such capital rationing is known as hard capital rationing. Capital
rationing can apply to a single period, or to multiple periods.

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Single-period capital rationing

Single-period rationing refers to a situation where there is a shortage of funds in one period
only, while it is assumed that sufficient funds will be available in subsequent periods. When
capital rationing exists, the decision rule, whereby a project with a positive NPV should be
accepted, falls away.

Dealing with single-period capital rationing

Divisible projects
The profitability index will be used to rank projects in a situation where projects are
divisible. Projects are divisible if the organisation is able to invest in a fraction of a project or
the whole project. The projects will have to be ranked according to their profitability index.

Illustrative example 14.10

The divisible projects given in the table below are under consideration by Caminaysh
Ltd.
Table 14.19 Basic data for three divisible projects
Project Initial NPV (R) Profitability Ranking
investment (R) index

X 100 000 550 000 5.5 2

Y 10 000 100 000 10 1
Z 500 000 750 000 1.5 3

Required:
Determine the optimal investment plan if the company only has R250 000 to invest.

1 Y 1 10 000 100 000

2 X 1 100 000 550 000
3 Z 0.28 (2)
140 000 (1)
210 000(3)
250 000 860 000

➤➤

Investment appraisal

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(1)
Investment available R250 000
Less: Utilised by Project Y R10 000
Utilised by Project X R100 000
Available for project Z R140 000
(2)
R140 000 ÷ R500 000 = 0.28
(3)
0.28 x R750 000 = R210 000

If the NPV was used to rank the projects, Project Z would have been chosen first. There
is only enough funds to invest in 50% ( R500 000 )of Project Z. As a result, the total
  R250 000
________

NPV earned would have been R375 000 (50% × R750 000). This is much less than the
maximum of R860 000 that can be earned.

Indivisible projects
Indivisible projects must be selected in their entirety, that is, they must be undertaken completely
or rejected. A fraction of the project cannot be undertaken. Indivisible projects are ranked by
trial and error selection in order to maximise the combined NPV. Funds that are not utilised are
assumed to be invested at the company’s weighted average cost of capital (WACC).

Illustrative example 14.11

Pumba Limited has R200 000 available to invest. There are three alternative projects
that earn positive net present values. The information relating to these projects are
presented in the table.
Table 14.21 Cash flows for alternative projects
Project A Project B Project C
(R) (R) (R)
Initial cost 80 000 90 000 70 000
PV of net cash flows 100 000 120 000 95 000

Prepare the optimum investment plan and calculate the maximum NPV for this plan for
each of the following scenarios:
(a) If the projects are divisible
(b) If the projects are indivisible.
➤➤

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Solution:
Table 14.22 Ranking of alternative projects
Project A Project B Project C
(R) (R) (R)
PV of net cash flows 100 000 120 000 95 000
Initial cost (80 000) (90 000) (70 000)
20 000 30 000 25 000
Profitability index (PI)* 1.25 1.33 1.36
Ranking 3 2 1

* PI = total present value of cash inflows / initial cost of investment

(a) Pumba Limited should invest the R200 000 as follows:
● R70 000 invested in Project C will leave R130 000
● R90 000 invested in Project B will leave R40 000
R40 000
● Only R40 000 invested in 50% ( _______
R80 000 ) of Project A
The resultant combined NPV will be R65 000 (R25 000 + R30 000 + R20 000 ×
50%).
(b) Pumba Limited can only invest in two of the three projects, since any pair of projects
leaves inadequate funds to invest in the last project. Pumba Limited should invest
in Project B and Project C. This will give a combined NPV of R55 000 and leave
R40 000 over. This combination of projects will give the highest NPV. A and B will
give R50 000; and A and C will give R45 000.

Multi-period capital rationing

Multi-period capital rationing is where there will be a shortage of funds in more than one
period. A problem involving multi-period capital rationing cannot be solved using PIs as
this method deals with only one period of shortage. Since a number of periods of shortage
exist, linear programming techniques (dealt with in Chapter 5) must be applied.

Test yourself 14.2

Suppose an organisation has R5 000 that it needs to invest in new projects. The
organisation has four alternative projects for which it can use these funds for investment.

These projects are:

Projects A, B, C and D, which have the following initial costs respectively:
R5 000, R1 500, R2 000, and R3 500.
The future cash flows of the projects are as follows: A = R8 500, B = R4 000,
C = R6 000, and D = R9 000.
➤➤

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518

Required:
Determine the optimum investment plan in each of the following cases:
(a) The projects are divisible
(b) The projects are indivisible
(c) The projects are mutually exclusive.

Source: CIMA (adapted)

Case study: Reduction in Capex

A combination of declining corporate profitability together with significant ongoing
complications in raising external finance exerts downward pressure upon the funds
that organisations have available for investment. There are constantly corporate
announcements regarding an intention to significantly reduce capital expenditure
during the upcoming financial year. In a recent article published in Mining Weekly, Anglo
American announced that they would deliver a cut of nearly $200 million out of the
capital expenditure budget of Anglo American Platinum by year-end and a further $1.5
billion off 2012 group Capex. The CEO stated that at the group level, Anglo would also
be disciplined and would strike the right balance in allocating capital. The group would
sequence investment in line with its funding capacity and focus on the most value-
accretive options. Anglo had invested in the right commodities and the right high-quality
and low-cost assets at the right time, and the company still had ‘the best pipeline of
growth options in the industry’. The company recognised that future cash flows would
be impacted by both economic uncertainty and higher operating and capital costs,
and to maintain its investment rating and dividend to shareholders, it would sequence
investments to take advantage of all stages of development in emerging countries.

Source: Mining Weekly (2012)

Discussion questions:
1. Explain the process of capital rationing.
2. Explain whether the concept of ‘hard’ or ‘soft’ capital rationing applies to the Anglo
American case.
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3. What impact will the decision to cut the Capex budget have on different areas of the
organisation?

The effects of inflation

Inflation affects the cost of capital, future cash flows and the returns that shareholders
require on investment. Two approaches could be used to include inflation into the
NPV analysis:
1. The real approach: When using this approach, there is no need to inflate the cash flows.
The cash flows are used in today’s prices. In order to include the effects of inflation,
when discounting the cash flows, a real discount rate is used. This discount rate is
already adjusted for inflation.

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2. The money approach (nominal rate): When using this approach, the future cash flows
have to be adjusted for the effects of inflation. The cash flows are then discounted using
a money discount rate.

The relationship between the real discount rate and the money rate is shown as follows by
the Fisher formula:
(1 + m) = (1 + r) (1 + i)
Where:
m = Money cost
r = Real cost
i = Inflation rate.

The money rate approach is preferable in all but the simplest scenarios. For most projects,
the different cash flows may not all have the same inflation rates. As a result, the cash flows
need to be adjusted separately by the specific inflation rate for each one. Another reason
why the money rate approach is more appropriate is that some cash flows are not affected
by inflation, for example the tax shield on capital allowances for taxation purposes. The
allowances are usually a fixed percentage of the initial cost, and therefore stay constant. By
using the real approach, these allowances will effectively be overstated.

Overview of the time value of money

One of the characteristics of capital expenditure projects is that cash flows usually occur
over the long term, that is, more than 12 months. In these circumstances, it is necessary
to consider the time value of money. The time value of money implies that money received
today is worth more than the same amount received in the future.

Time value of money concepts

Before we look at the formulae used to calculate the time valve of money and related
examples, it is important to understand the following concepts:
● Annuity: This is a series of repetitive cash flows which occur at fixed intervals for a
specified number of periods.
● Compounding: This refers to the calculation of interest on a principal amount and then
adding that interest to the principal amount in the subsequent period. The investment
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grows in each subsequent period by the amount of interest it would earn over the period.
Compounding calculates the future value of a sum invested today for a number of years.
● Discount rate: This is the rate used when determining the time value of money. The
discount rate should be representative of the risk that is applicable to the cash flows.
Since the cash flows in a capital budget are the operating cash flows of the project, it
represents operating risk and therefore the appropriate discount rate is the weighted
average cost of capital (WACC). WACC is briefly discussed in the next section.
● Discounting: This is the reverse of compounding. It considers the future value and
establishes its equivalent value today. The value in today’s terms is referred to as the
present value.
● Future value (FV): This is the amount to which an investment will grow after one or
several periods through the process of compounding.

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● Present value (PV): This is the value of the future value in today’s terms determined by
the application of the discount rate.
● Perpetuity: This is a periodic cash flow, that is, an annuity that has no terminal date.
● Single cash flow: This is a non-repetitive cash inflow or cash outflow.

Formulae used in time value of money

Certain capital budgeting techniques, like net present value and discounted pay back,
require future cash flows to be discounted to the present. The modified internal rate of
return also requires certain future values to be calculated. The three ways in which the
present value (PV) or future value (FV) can be calculated are: the mathematical formulae,
PV and FV tables, and with the aid of a financial calculator. The use of a financial calculator
will be explained in Illustrative example 14.12.

Present value of a single cash flow

The mathematical formula used for calculating the present value of a single cash flow is:
1
PV = FV ( ______
(1 1 i)n
)
Where:
PV = Present value
FV = Future value
i = Interest rate
n = Number of periods.
1
Appendix A presents the present value factors of a single cash flow. The  ______
(1 1 i)n
in the
mathematical formula can be replaced by the applicable factor from the table, instead of
calculating it mathematically.

Present value of an ordinary annuity

The mathematical formula used for calculating the present value of an ordinary annuity
(annuity received at the end of the period) is:

(
PV = PMT × ________
  i
1
1 2  ______
(1 1 i)n
  )

Table B (see Appendix) presents the present value factors of cash flows invested at the end of
each period. The equation in the brackets in the mathematical formula can be replaced by
the applicable factor from the table, instead of calculating it mathematically.

Illustrative example 14.12

(a) Present value (single cash flow)
Three years from now you want to embark on an over-land expedition from Cape
Town to Cairo. You have estimated that you will require R250 000 for the trip. If you
can earn 10% compound interest per annum, what is the amount that you need to
invest now to reach your goal of R250 000 at the end of the three-year period?
➤➤

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(b) Present value (ordinary annuity)

You plan to take off five years to travel the world and write a guide book. You need
an annual amount of R120 000 at the end of each year to fund the project. How
much do you need to invest now (at a compound interest rate of 10% per annum)
to pay this annuity?

Solution:
(a) Present value (single cash flow)
Using the mathematical approach, the present value can be calculated as follows:

( 1
)
PV = FV ×   _____
1 1 i)n
 
= R250 000 × (   ________
(1 1 0.10) )
1
  3

= R250 000 × 0.751

= R187 829
Using the table approach, the factor can be found in Table A (see Appendix) using
a discount rate of 10% and 3 years as the number of periods:
PV = FV × PVIF10%;3
= R250 000 × 0.751
= R187 750
Using a financial calculator, the following inputs will be used:
250 000 [FV], 10 [I/YR], × [N], [PV] = R187 829
The difference between the table method and the other two is due to the table
factors being rounded off to the nearest three decimals.
(b) The present value of an annuity
Using the mathematical approach, the present value can be calculated as follows:

(
PV = PMT × ________
  i
1 2 ______
 
1
  (1 1 i)n

)
= R120 000 ×   ( 1
1 2  _________
(1 1 0.10)5
___________
0.10

)
 
= R120 000 × 3.791
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= R454 894
Using the table approach, the factor can be found in Table B using a discount rate
of 10% and 5 years as the number of periods:
PV = FV × PVIFA10%;5
= R120 000 × 3.791
= R454 920
Using a financial calculator, the following inputs will be used:
120 000 [PMT], 10 [I/YR], 5 [N], [PV] = R454 894
The difference between the table method and the other two is due to the table
factors being rounded off to the nearest three decimals.

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522

Future value of a single cash flow

The mathematical formula used for calculating the future value of a single cash flow is:
FV = PV(1 + i)n

Table C in the Appendix presents the future value factors of a single cash flow. The (1 + i)n in
the mathematical formula can be replaced by the applicable factor from the table, instead
of calculating it mathematically.

Future value of an ordinary annuity

The mathematical formula used for calculating the future value of an ordinary annuity
(annuity received at the end of the period) is:

( (1 + i) 2 1 )
n
FV = PMT  ________
i  

Table D in the Appendix presents the future value factors of cash flows invested at the end
of each period. The equation in the brackets in the mathematical formula can be replaced
by the applicable factor from the table, instead of calculating it mathematically.

The weighted average cost of capital

The weighted average cost of capital (WACC) of an organisation is the average of all the
costs of financing the organisation. An organisation can be financed in various ways, such
as through equity, debt in terms of debentures or bank loans, and preference shares. To
calculate the WACC, each source of finance is weighted according to the proportion the
source contributes to the makeup of the capital structure of the organisation. The formula
to calculate WACC is:

[   V 1 V ) + Kd × ( ______
Ko = Ke × (______ ] [ V 1 V ) ]
Ve Vd
e d e d

Illustrative example 14.13

Suppose the market value of ordinary shares is R2.5 million, and that debt of unsecured
bonds is R1.5 million of the organisation’s capital structure. The cost of equity is 16%
and that of bonds is 10% after tax.

Required:
Calculate the weighted average cost of capital, using the given information.
➤➤

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Solution:
Since the values given for equity and debt are already in market terms, they will be used
in the formula as they are:
Ko = [16% × (____________________
R2 500 000 1 R1 500 000 )]
   
   R2 500 000
+ [10% × (____________________
   
  
R2 500 000 1 R1 500 000 )]
R1 500 000

= (16% × 62.5%) + (10% × 37.5%)

= 10% + 3.75%
= 13.75%

The organisation’s WACC reflects the returns required by investors and lenders, and
therefore it is used as a discount rate for operating cash flows. The higher the risk involved,
the higher the return required. That is the reason why, in most cases, the cost of equity is
higher than the cost of debt. The capital invested by equity investors is not guaranteed and
they are not obliged to receive a dividend every year. On the other hand, the cash flows to
providers of debt are protected by the contractual agreement and are therefore more certain
and less risky.

When can weighted average cost of capital be used?

It is appropriate to use WACC as a discount rate in the following situations:
● When the capital structure of the organisation is constant. If the capital structure
changes, then it means the proportions of elements that make up the capital structure
will change, leading to a change in the weightings in the WACC.
● The proposed investment must have a similar risk profile to the operations of the
organisation that are in existence. Different factors may have an impact on the risk of
the project. For example, the project may be in a specific industry that is more risky
than the normal operations of the company. Likewise, if the project is in a different
country from the main operations of the company, there might be increased sovereign
risk, necessitating the use of an adjusted discount rate (higher WACC).
● The new investment should not be substantial, since if the investment is large, it will
cause changes to the values of Ke (cost of equity) and Kd (cost of debt).
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Test yourself 14.3

SmartTel has been a provider of WiFi services in Cape Town for the past ten years. They
currently operate only in the major towns in the Western Cape, South Africa. They are
considering an expansion project that involves entering the WiFi market in Angola. The
weighted average cost of capital of SmartTel is 13.5%.

Required:
Briefly discuss the appropriateness of using the WACC of 13.5% as the discount rate for
the capital budgeting process.

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Post completion audit

CIMA defines a post completion audit (PCA) as an ‘objective independent assessment of
the success of a capital project in relation to a plan. It covers the whole life of a project and
provides feedback to managers to aid the implementation and control of future projects.’
An organisation that utilises the post completion audit can benefit as follows:
● The organisation’s decision-making process will be improved, by learning from past
experiences.
● The process can highlight areas of weakness, and control action could be taken to
improve the situation.
● Variances in terms of under-performing or over-performing projects can be identified,
and reasons for such variances can be clarified.
● Experiences of successful projects could be used in future projects for greater benefit.

Summary
Organisations use the process of capital budgeting for making decisions that involve capital
projects. Capital projects are those projects that have a useful life of at least one year.
In this chapter, we have learnt the following:
● Capital budgeting decisions involve the most critical investments for organisations.
● For an organisation to make a sound investment decision, more than one capital
budgeting technique must be used, as no one technique is perfect.
● Financing costs are not included when appraising projects, since the cost of debt is
captured in the discount rate used.

Key concepts
Capital budgeting is the process that organisations normally use for making decisions
about capital projects.
Capital projects are those projects that are for the long term – normally with a life of at
least one year.
Capital rationing is a constraint on an organisation regarding the ability of the
organisation to invest capital funds.
Internal rate of return (IRR) is the discount rate at which the NPV of a project will be
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zero.
Net present value (NPV) is the present value of all after-tax cash flows of the project.
Payback period is the number of years required for a project to recoup the cost of the
original investment.
Profitability index is the net present value of a project divided by its initial investment.

Test-yourself solutions
Test yourself 14.1
(a) Calculation of payback period

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Year Cash flows (R) Cumulative cash flows (R)

0 −50 000 −50 000
1 16 000 −34 000
2 16 000 −18 000
3 16 000 −2 000
4 16 000 14 000
5 16 000 30 000
6 7 500 37 500
7 7 500 45 000
8 7 500 52 500

The payback period is between years 3 and 4. To be more precise, the payback period is
R50 000
_______
R16 000 = 3.125 years.
Therefore, the payback period is 3.125 years or 3 years 1.5 months.
(b) Calculation of the discounted payback period
Year Cash flows DCF @ 8% Present value Cumulative cash flows
(R) (R) (R)
0 −50 000 1 −50 000 −50 000
1 16 000 0.926 14 815 −35 185
2 16 000 0.857 13 717 −21 468
3 16 000 0.794 12 701 −8 766
4 16 000 0.735 11 760 2 994
5 16 000 0.681 10 889 13 883
6 7 500 0.630 4 726 18 610
7 7 500 0.583 4 376 22 986
8 7 500 0.540 4 052 27 038
8 766
When using the discounted payback method, the period is 3 years + ______
 11 760 = 0.7454.
Discounted payback period is 3.745 years.
(c) Calculation of net present value
Year Cash flows DCF @ 8% Present value
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(R) (R)
0 −50 000 1 −50 000
1 16 000 0.926 14 815
2 16 000 0.857 13 717
3 16 000 0.794 12 701
4 16 000 0.735 11 760
5 16 000 0.681 10 889
6 7 500 0.63 4 726
7 7 500 0.583 4 376
8 7 500 0.54 4 052
27 038

The net present value (NPV) when using the discount rate of 8% is R27 038.

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(d) Calculation of internal rate of return

At a discount rate of 8%, the NPV is R27 036. We need to calculate another NPV at a
higher rate to get a negative NPV, since the one at 8% is positive. Let us use 25%.
Year Cash flows DCF @ 8% Present value DCF @ 25% Present value
(R) (R) (R) (R) (R)
0 −50 000 1 −50 000 1 −50 000
1 16 000 0.926 14 815 0.800 12 800
2 16 000 0.857 13 717 0.640 10 240
3 16 000 0.794 12 701 0.512 8 192
4 16 000 0.735 11 760 0.410 6 554
5 16 000 0.681 10 889 0.328 5 243
6 7 500 0.63 4 726 0.262 1 966
7 7 500 0.583 4 376 0.210 1 573
8 7 500 0.54 4 052 0.168 1 258
27 038 −2 174

The IRR = 8% + [_______________

R27 038 2 (R2 174) × (25% − 8%)]
R27 038
    

IRR = 8% + [_______________ × 17%]

R27 038
    
R27 038 2 (R2 174)
IRR = 8% + (0.926% × 17%)
IRR = 8% + 15.7%
IRR = 23.7% or 24%
(e) The total cash inflows for the five years are: R16 000 + R16 000 + R16 000 + R16 000 +
R16 000 + R7 500 + R7 500 + R7 500 = R102 500.
Total profit = Total cash inflows − Depreciation
= R102 500 − R50 000
= R52 500
R52 500
Average profit 5  _______
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R8 years = R6 562.50
Initial investment + Residual value
Average investment = _________________________
 
      
2
  R50 000
= __________
2
+ R0

= R25 000
  R6 562.50
Hence ARR = _________
R25 000
= 26.25%

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Test yourself 14.2

(a) The following table shows the ranking of capital investment projects
Projects A (R) B (R) C (R) D (R)
Future cash flows 8 500 4 000 6 000 9 000
Initial investment cost −5 000 −1 500 −2 000 −3 500
NPV 3 500 2 500 4 000 5 500

NPV/Initial investment cost 0.7 1.67 2 1.57

Ranking 4 2 1 3

 R1
The organisation has to invest in the projects as follows: C, B, and ______000
R3 500 = 43% of D.
(b) If the projects are indivisible, then the organisation can invest the R5 000 as follows:
● Invest in project A (R5 000), and earn a total NPV of R3 500
● Invest in project B (R1 500) and C (R2 000), and earn a total NPV of R6 500
● Invest in project B (R1 500) and D (R3 500), and earn a total NPV of R8 000.
The best option would be to invest the R5 000 in projects B and D.
(c) Project D is the one with the greatest NPV, and therefore it must be chosen if the projects
are mutually exclusive.

Test yourself 14.3

Since the new project will be in a different country than the current operations, the overall
risk of the project may be different from the current operations. There may be country-
specific risk in Angola (sovereign risk) that necessitates adjusting the WACC of 13.5%
upward to compensate for this risk. A WACC higher than 13.5% should therefore be used as
the discount rate for the capital budgeting process.
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Review questions
14.1 Define capital budgeting.
14.2 List the reasons why the payback method is a popular means of investment
appraisal.
14.3 Determine how the internal rate of return (IRR) can be calculated.
14.4 Which method, from the ones covered in this chapter, uses accounting profit
figures when making capital budgeting decisions?
14.5 Identify two assumptions associated with capital budgeting methods.
14.6 What formula is used to find the compound figures of cash flows?
14.7 If NPV and IRR give conflicting conclusions, how should this be resolved?
14.8 Explain what is meant by the time value of money.
14.9 Explain the following terms: capital rationing and discount rate.
14.10 Define the weighted average cost of capital (WACC).

Exercises
14.1 Large Excavation and Drilling (Pty) Ltd (LED) operates in the construction
industry and specialises in excavation and drilling. A large part of LED’s
income comes from horizontal drilling underneath roads and railroads to
install pipes. Major customers include companies that install sewerage pipes
and telecommunication companies that lay cables underground. There are
currently not many companies that own the specialised equipment required to
drill horizontal tunnels and LED services more than half of the market in the
Western Cape, making them the third-largest horizontal drilling company in
South Africa and the largest in the Western Cape.
LED currently owns two drills that they imported from Germany a few years
ago. The current price of a drill at the prevailing exchange rate is in excess of
R4 million. These large machines are extremely heavy, making it very expensive
to move from site to site, especially over long distances. Both drills that LED
currently owns operate solely in the Western Cape.
Expansion plans – second-hand drill
LED has had several queries from potential customers in the Northern Cape, but
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has not been able to quote these customers due to the expense of moving the
drill to the sites. As a result, the management of LED is considering purchasing
a second-hand drill on 1 January 20X1 from a competitor that has recently
filed for liquidation. LED can acquire the three-year-old drill for R800 000 and
it is expected that the drill can be used for another four years if it is carefully
maintained, after which it will be scrapped. SARS allows Section 11e wear and
tear on second-hand equipment.

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The cash revenue that the new drill will earn in the Northern Cape is forecast as
follows:
Year 1 2 3 4
Cash revenue 600 000 1 400 000 1 800 000 2 200 000
(R)

An additional investment in working capital is required to operate the drill and

will amount to 25% of the coming year’s cash revenue. The estimated cash
operating expenses for year 1 amounts to R400 000 and is estimated to increase
by 10% per annum.
Maintenance cost
During year 1 and year 2 maintenance is estimated to amount to R200 000
and R300 000 respectively. When the machine gets older, the maintenance
depends on the conditions under which it is operated. Maintenance in year
3 and year 4 therefore is less certain. LED has asked an expert to estimate the
likely maintenance costs for years 3 and 4, which are presented in the table
below:
Scenario Probability Maintenance expense (R)
Worst case 10% 500 000
Most likely 75% 400 000
Best case 15% 350 000

Transport costs
A large truck is required to transport the drilling equipment between job sites.
LED can either purchase a truck, or outsource the transport to a third party.
LED can purchase a second-hand truck for R450 000. SARS will allow a 20%
wear-and-tear allowance on the second-hand truck each year. The truck is
estimated to have a residual value of R90 000 at the end of year 4. The cash
cost to operate the truck is estimated at R50 000 in year 1, increasing by 10%
per annum.
If LED decides to outsource the transporting of the drill it will cost them
R160 000 in year 1, escalating at 20% per annum.
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Additional information:
LED’s current operations generate taxable income in excess of R1 million per
annum and are expected to do so in the foreseeable future. The corporate tax
rate is 28% and LED’s weighted average cost of capital is 16%.

Required:
(a) Advise whether LED should invest in the second-hand drill. Base your
decision on a calculation of the net present value of the project.
(b) Calculate the discounted payback period and explain what this means for
the investment decision.
(c) Briefly discuss any other factors that need to be considered before investing
in the drilling equipment.

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14.2 An initial investment of R2 million has a useful life of five years and is expected
to generate the following net cash flows:
Year Cash flow
(R)
1 600 000
2 650 000
3 700 000
4 750 000
5 1 000 000

The company’s WACC is 16%.

Required:
Recommend whether the project should be accepted based on a calculation of
the following:
(a) Net present value
(b) Internal rate of return (rounded to the nearest 0.1%).
14.3 Since 1851, the name SecaCom has been synonymous with sewing. The spirit
of practical design and creative innovation that characterised the company at
its beginning continues today as it develops products for every level of sewing.
SecaCom has celebrated many firsts, including the world’s first zig-zag machine,
the first electronic machines and we now proudly produce the world’s most
advanced home sewing and embroidery machines. From home décor and
clothing construction to embroidery and quilting, the company is dedicated
to helping people express themselves through the craft of sewing. SecaCom
has undertaken market research at a cost of R200 000 in order to forecast the
future cash flows of an investment project.
This is an investment in new machinery to produce a recently developed product.
The cost of the machinery, which is payable immediately, is R1.5 million, and
the scrap value of the machinery at the end of four years is expected to be
R100 000. Tax-allowable depreciation can be claimed on this investment on a
25% straight-line basis. Information on future returns from the investment has
been forecast to be as follows:
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Year 1 2 3 4
Sales volume (units/year) 50 000 95 000 140 000 75 000
Selling price (R/unit) 25.00 24.00 23.00 23.00
Variable cost (R/unit) 10.00 11.00 12.00 12.50
Fixed costs (R/year) 105 000 115 000 125 000 125 000

This information must be adjusted to allow for selling price inflation of 4% per
year and variable cost inflation of 2.5% per year. Fixed costs, which are wholly
attributable to the project, have already been adjusted for inflation.
Maintenance costs amount to R250 000 per annum. SecaCom pays profit tax
of 30% per year and weighted average cost of capital of 12%. The management
accountant has a policy of paying back projects within two years.

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Required:
(a) Determine the following:
(i) Operational cash flow
(ii) Net present value
(iii) Payback period
(b) Advise management on the feasibility of the project based on your
calculations as well as the information given.
(c) SecaCom has to choose between two mutually exclusive projects. The
company has a WACC of 15%. The initial investments and the project cash
flows for each of the projects are presented in the following table:

Year Project 1 Project 2

(R) (R)
0 (500 000) (1 000 000)
1 150 000 500 000
2 200 000 500 000
3 220 000 200 000
4 250 000 200 000

Recommend which one of the projects should be accepted based on the

discounted payback period and the net present value method.
14.4 Part A
Camsen Ltd operates in a highly competitive market and is considering
introducing a new product to expand its current range. The new product will
require the purchase of a specialised machine costing R900 000. The machine
has a useful life of four years and is expected to have a scrap value at the end of
year 4 of R50 000. The company uses the straight-line method of depreciation.
The machine would be used exclusively for the new product. The project will
also require an investment of R100 000 in working capital at the beginning of
the project.
Due to a shortage of space in the factory, investment in the new machine would
necessitate the disposal, for R25 000, of an existing machine which has a net
book value of R40 000. This machine, if retained for a further year, would have
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earned a contribution of R90 000 before being scrapped for nil value. The
machine had a zero tax written down value and therefore there will be no effect
on tax depreciation arising from the disposal of the machine.
The company employed the services of HFSC Ltd, a consulting company, at a
cost of R45 000, to determine the demand for the new product. The consultant
estimates that demand in year 1 will be 18 000 units, in year 2, 24 000 units, in
year 3, 26 000 units and in year 4, 22 000 units.
The selling price of the new product will be R40 per unit and the variable cost
per unit will be R10. The selling price and the variable cost per unit are expected
to remain the same throughout the life of the product. Fixed costs of R400 000
per annum, including depreciation of the new machine, will arise as a direct
result of the manufacturing of the new product. Camsen’s financial director has
provided the following taxation information:
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● Wear and tear allowance of 25% per annum is to be provided on a straight-

line basis. The taxation rate is 30% of taxable profits. Tax is payable in the
year in which it arises.
● Camsen has sufficient taxable profits from other parts of its business to
enable the offset of any pre-tax losses on this project.
● A cost of capital of 12% per annum is used to evaluate projects of this type.
Ignore inflation.

Required:
(a) Evaluate whether Camsen should introduce the new product. You should
use net present value (NPV) as the basis of your evaluation.
(b) Identify an irrelevant cost related to the new product. Explain why this cost
is irrelevant.
Part B
A company is deciding which of two alternative machines (Rotatrim and
Waltrim) to purchase. The useful lives for machines Rotatrim and Waltrim are
two years and three years respectively. The cash flows associated with each of
the machines are given in the table below:
Year 0 1 2 3
R R R R
Rotatrim (300 000) 300 000 330 000
Waltrim (340 000) 300 000 330 000 340 000

Each of the machines would be replaced at the end of its useful life by an identical
machine. You should assume that the cash flows for the future replacements of
machines Rotatrim and Waltrim are the same as those in the table above. The
company’s cost of capital is 10% per annum.

Required:
Calculate, using the annualised equivalent method, whether the company
should purchase machine Rotatrim or machine Waltrim.
14.5 A book publishing company is considering investing in equipment to print and
bind their own books. The cost of the equipment is R2.2 million and is expected
to have a scrap value of R630 000 at the end of its useful life of five years. If the
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books are printed in-house, there is a net cash saving of R540 000 each year
and the weighted average cost of capital is 14%. The company only considers
projects with a payback period shorter than three years.

Required:
(a) Determine the following for this project:
(i) Payback period
(ii) Net present value.
(b) Briefly explain which of the two methods in (a) should be used if they are
not in agreement.
14.6 Jumbo (Pty) Ltd is a small private company that manufactures specialised
diagnostics equipment for the medical industry. It is currently considering three

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independent investment opportunities with similar useful lives. The company

has no cash reserves, but has access to R75 million borrowings at the current
cost of debt. Due to its debt-equity ratio being very close to the target capital
structure before taking on any additional debt, if any more funds are required,
the interest rate will be significantly higher.
The initial capital investment and the net present value of each investment
opportunity are presented in the table below:
Investment Initial investment Net present value (NPV)
(R’000) (R’000)
K 32 000 8 100
L 38 500 6 900
M 47 500 9 000

Notes:
1. The projects are not divisible and cannot be postponed.
2. The discount rate considered appropriate for all three investments is 14%.
3. Jumbo (Pty) Ltd pays corporate tax at 28%.
4. Assume that cash flows, other than the initial investment, occur evenly
throughout the duration of the investments.

Required:
(a) Calculate the profitability index for all three projects. Explain the usefulness
of this method of evaluation in these circumstances, and recommend which
project(s) should be undertaken.
(b) Explain the differences between ‘hard’ and ‘soft’ capital rationing, and
which type is evident in this scenario. Discuss, briefly, the advisability of the
directors of Jumbo (Pty) Ltd limiting their capital expenditure in this way.
Source: CIMA (adapted)
14.7 Medicare (Pty) Ltd is a private healthcare group that owns and operates private
hospitals in South Africa. The directors are busy investigating the expansion
into Africa and are planning its first private hospital in Nigeria. The plan is to
build a hospital and get it operational within the next five years, after which it
will be sold to a private healthcare group in West Africa.
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An existing facility will be purchased at a cost of R150 million. To convert the

building into a fully functioning hospital, is estimated to cost an additional
R200 million. The net operating cash profit that is expected to be earned from
the hospital in year 1 is R50 million. A portion of the building is currently let
out and will need to be evacuated. Net rental income in year 1 is expected to be
R2 million.
It is expected that the hospital, including the land and buildings, will be worth
R600 million at the end of five years.
Inflation is 10% and Medicare (Pty) Ltd has a weighted average cost of capital
of 14% in South Africa. Ignore taxation.

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Required:
(a) Advise on the appropriateness of using the WACC of 14% as the discount
rate in the project appraisal.
(b) Advise whether Medicare (Pty) Ltd should go ahead with the project based
on a calculation of the project’s NPV. (Assume a WACC of 16%.)
14.8 MR is a large chain of retail stores operating in South Africa. It sells top-of-
the-range, expensive clothes to a wealthy clientele throughout the country.
Currently, MR only operates in South Africa. Its current market capitalisation is
R760 million, and the current market value of debt is R350 million.
At last month’s management meeting the marketing director explained that
sales volume had increased slightly in the previous year, largely due to heavy
discounting in most of its stores. The finance director expressed concern that
such a strategy might damage the image of the company and reduce profits over
the longer term.
An alternative strategy to increase sales volume has recently been proposed
by the marketing department. This would involve introducing a new range
of clothing, specifically aimed at the middle-income market. The new range
of clothing would be expected to be attractive to consumers in Canada and
Europe, giving the possibility of opening stores in Canada and possibly Europe
in the longer term.
Assume you are a financial manager with MR and have been asked to evaluate
the marketing department’s proposal to introduce a new range of clothing. An
initial investigation into the potential markets has been undertaken by a firm
of consultants at a cost of R100 000, but this amount has not yet been paid.
It is intended that the amount due will be settled in three months’ time. With
the help of a small multi-department team of staff, you have estimated the
following cash flows for the proposed project:
● The initial investment required would be R46 million, payable on 1 January
20X1. This comprises R30 million for non-current assets, and R16 million
for net current assets (working capital).
● For accounting purposes, non-current assets are depreciated on a straight-
line basis over three years after allowing for a residual value of 10%. Tax
depreciation allowances can be assumed to be the same as accounting
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depreciation.
● The value of net current assets at the end of the evaluation period can be
assumed to be the same as at the start of the period.
● Net operating cash flows (before taxation) are forecast to be R14 million in
20X1, R17 million in 20X2 and R22 million in 20X3, and should be assumed
to occur at the end of each year.
The following information is also relevant:
● The proposed project is to be evaluated over a three-year time horizon.
● MR usually evaluates its investments using an after-tax discount rate of 8%.
The proposed project is considered to be riskier than average, and therefore
a risk-adjusted rate of 9% will be used for this project.

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● Corporate tax is payable at 25% in the same year in which the liability arises.
● MR would need to borrow 50% of the initial investment costs.
● Ignore inflation.
MR’s primary financial objectives are:
1. To earn a return on shareholders’ funds (based on market values) of 11%
per annum on average over a three-year period
2. To keep its gearing ratio (debt to debt plus equity, based on market values)
at below 35%.

Required:
(a) Calculate the net present value (NPV), internal rate of return (IRR), and
(approximate) modified internal rate of return (MIRR), as at 1 January
20X1 for the proposed project.
(b) Discuss the advantages and limitations of MIRR in comparison with NPV
and IRR.
Source: CIMA (adapted)
14.9 Sencam Limited is a profitable pharmaceutical company that develops, produces
and markets drugs that are licensed as medication. The pharmaceutical
industry faces challenges in preventing and controlling environmental pollution
due to their rapid growth. Over the past few years there has been growing
pressure on the industry from government and other stakeholders to improve
its environmental management performance. Sencam Ltd has taken a proactive
approach to environmental management and has invested significant resources
in introducing pollution prevention and clean manufacturing practices into
its operation in order to reduce waste and minimise negative environmental
impacts. The company has used marketing and advertising campaigns to
develop an image as a company that is at the cutting edge of ‘green’ technology.
As part of its environmental management programme, Sencam intends to
manufacture a new product, and for this purpose, two mutually exclusive
machines, namely FC105 and HS101 are being evaluated. These new systems
will significantly reduce hazardous emissions and waste.
An initial investment of R1 750 000 is required for FC105, and R900 000 is
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required for HS101, with both machines having an estimated useful life of
four years. The expected residual value at the end of the useful life of FC105 is
R100 000, and R90 000 for HS101.
Initial working capital of R400 000 is required on both machines. Both machines
are expected to have a maximum annual production output of 144 000 units.
The cost and revenue information in the following table is available regarding
machine FC105.

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Machine FCIOS R
Selling price – per unit 35
Annual cost structure
Production:
Direct material per unit 8
Direct labour per unit 13
Total overheads 350 000
Maintenance (year 1) 200 000
(years 2–4) 300 000
Supervisory cost 200 000

An equal amount of R300 000 has been spent by the research department on a
feasibility study for each one of the machines that are being evaluated.
A new marketing manager has recently headed up the department and has
decided to appoint two additional sales personnel at an annual cost of R420 000,
exclusively for the marketing and sales of the new product. The demand for the
new product is expected to be high and positive growth is expected. The sales and
production of the product during the first year is expected to be 130 000 units
and is set to increase by 5 000 units per annum, from the second year onwards.
The before-tax annual operational cash inflow for the HS101, before taking
depreciation into account, is R400 000, R420 000, R440 000 and R485 000 for
years one to four, respectively.
The current rate of normal taxation is 28%. The after-tax cost of capital of 16%
is to be used to evaluate this investment. The depreciation policy, which is in
agreement with the wear and tear policy, stipulates that depreciation be written
off at 25% per annum on the cost price, based on the straight-line method.
Unless stated otherwise, all the estimated cash flows will arise at the end of the
year.

(a) Determine, by using net present values, whether any one of the mutually
exclusive machines should be acquired. (Work to the nearest rand and
round off all your figures to three decimal places.)
(b) Give and explain two factors related to Sencam’s approach to environmental
issues that should be considered before making a final decision about the
projects.
14.10 Tools Ltd has been manufacturing a variety of tools for decades. It started
out as home DIY tools and over the years the product range expanded into
professional and commercial tools used in various industries. Tools Ltd is
continuously looking for new investment opportunities.
The company has R5 million available for investment and has identified three
possible investments, A, B and C, which are set out in the following table:

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A B C
(R) (R) (R)
Initial investment (2 000 000) (2 500 000) (3 000 000)
Net positive cash flows:
Year 1 200 000 350 000 250 000
Year 2 400 000 450 000 250 000
Year 3 2 550 000 3 150 000 1 900 000
Net present value 103 000 154 000 119 000

The projects have equal useful lives, which coincide with Tools Ltd’s investment
plans. The company has a weighted average cost of capital of 16%.

Required:
(a) Assuming that each of the investments is divisible, and that they are
independent and cannot be invested in more than once, state the optimum
investment plan.
(b) How would your answer change if the project were independent and
indivisible?
(c) Calculate the internal rate of return of an investment in project B to the
nearest 0.01%.
14.11 PP is a large architectural partnership. Its client base ranges from large
corporations to an extensive range of smaller companies and individuals.
Much of PP’s marketing and client liaison efforts to date have focused on
the larger corporations, because there tends to be repeat business from such
clients. However, a recent client survey has revealed that 75% of new business
results from referrals from satisfied smaller clients. PP is therefore keen to
improve its marketing efforts within the smaller client market. Improvements
in the information technology (IT) systems currently used by PP are considered
to be essential to such a development, to enable increased visibility of the
company and its achievements across the whole client base and help promote
new business.
PP’s current annual revenue is R10 million.
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Proposed IT project for a new customer relationship management (CRM)

system
PP is considering introducing a new customer relationship management (CRM)
system to help maintain more regular and better targeted communication with
both current and potential new clients. The project is to be appraised over a
four-year time horizon. An initial investment of R600 000 is required on 1 July
20X2, with no residual value at the end of the four-year period. It is estimated
that there would be ongoing system maintenance costs of R50 000 a year,
but no other annual incremental costs attributable to the project. In terms
of savings, it is planned that staff numbers would be reduced by one person
at an annual saving of salary costs of R80 000, and also a saving of other
costs of R20 000 per annum. However, redundancy pay and costs involved

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with redundancy arrangements would be approximately R200 000, payable on

1 July 20X2. Unless stated otherwise, all costs and revenue should be assumed
to be paid or received at the end of the year in which they arise.
The partners of the practice are unsure how much new business would be
generated by the new CRM system. The number of different unknown variables
involved has made it very difficult to arrive at a firm answer. However, it is
anticipated that any new business generated as a result of the CRM system
would give rise to an increase in net cash inflows in each year, equivalent to
52% of the annual cash inflow generated by new business. Assume that the
additional net cash inflow generated by new business is the same in each of
years 1 to 4.
PP evaluates IT projects using a conventional discounted cash flow approach
based on costs and benefits that can be quantified with a degree of confidence.
The partnership’s cost of capital of 12% is to be used as the discount rate.
For the purposes of this question, taxation should be ignored.

Required:
(a) (i) Calculate the net present value (NPV) of the proposed IT project as at
1 July 20X2, ignoring the additional cash flows that might arise from
new business.
(ii) Calculate the additional annual cash inflow from new business that is
required in order to achieve a breakeven result. Use your answer from
part (a) (i) as the starting point for your calculation.
(b) (i) Discuss the appropriateness of using a conventional discounted cash
flow approach to appraise an IT project.
(ii) Advise what other financial and strategic factors should be considered
when deciding whether to proceed with this project.
Source: CIMA (adapted)
14.12 Solar Select (Pty) Ltd (SS) specialises in the installation of solar panel systems.
Most of the products are imported from the US, making it expensive due to the
weakening exchange rate.
SS is considering an investment in a machine that can manufacture solar
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panel systems locally. The machine will be imported from the US at a cost
of $800 000. The manufacturer has machines available in South Africa and
can deliver immediately after payment has been received. The machine will be
delivered and put into use on 1 January 20X1. The best estimate of the top 10
economists is expecting an exchange rate of R18 per US$ on 1 January 20X1
when payment is due.
SARS allows a Section 12C capital allowance (40:20:20:20) on new
manufacturing machines. The machine has a useful life of four years and it is
estimated that the residual value will be R4 million at the end of its useful life.
Depreciation is calculated using the straight-line method to write off the cost
of the asset to the residual value at the end of its useful life.

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The new manufacturing machine will be installed in an empty warehouse that

the company purchased three years ago for R3 million. The building is currently
being let out for R480 000 per annum in year 1 (20X1). The lease agreement
states a 10% annual escalation clause.
The estimated demand for SS’s solar panel systems is as follows:
20X1 20X2 20X3 20X4
Sales demand in units 24 000 25 000 27 000 27 000

Additional information:
1. It is expected that the current demand will be unchanged if the solar panels
are imported. The cash cost per unit will however increase by R350 due to
the increased manufacturing costs, and the current selling price per unit will
be increased by R620 due to better quality and specifications.
2. The policy of the company is to maintain a working capital balance of 10%
of the next year’s sales revenue.
3. Assume that the company’s tax rate is 28% and the weighted average cost
of capital (WACC) is 15%.

Required:
Advise whether SS should go ahead with the investment in the machine, based
on a calculation of the net present value (NPV) of the machine.

Reference list
CFA Program Curriculum. 2012. Corporate and Portfolio Management, Level 1. USA: Pearson,
Volume 4.
CIMA Official Study text. 2011−2012. Financial Strategy. 2011−2012 edition. London: Elsevier
Limited and Kaplan Publishing Limited.
CIMA Study Text. 2001. Management Accounting: Performance Management. 2nd edition.
London: BPP Publishing Limited.
Drury, C. 2012. Management and Cost Accounting. 8th edition. London: Brendan George.
Mining Weekly. 2012. Anglo cuts $1.5 bn group capex, promises $200 m platinum cut by
Copyright © 2021. Juta & Company, Limited. All rights reserved.

year-end. Available: miningweekly.com. (Accessed 17 January 2021).

Seal, W. 2011. Management Accounting for Business Decisions. New York: McGraw-Hill.
Upchurch, A. 1998. Management Accounting – Principles & Practice. London: Pitman Publishing.

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15 Divisional performance
evaluation and transfer
pricing

Divisional performance evaluation and transfer pricing

Decentralisation Incentive schemes

Performance evaluation
Responsibility centres Transfer pricing
measures

Learning objectives
After studying this chapter, you should be able to:
● Explain what responsibility centres are and the differences between cost, revenue,
profit and investment centres
● Explain how responsibility centres may be used in management control and
performance evaluation
● Determine and discuss measures such as return on investment (ROI), residual
interest (RI) and economic value added (EVA) for use in performance evaluation
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● Discuss performance evaluation and the balanced scorecard

● Explain the concept of transfer pricing and its impact on divisional decision making
● Determine transfer prices using different methods
● Discuss the impact of differing tax regimes on international transfer pricing
● Discuss the most important incentive schemes in South Africa.

Introduction
In small organisations it is relatively easy for the owner/manager to control all operations
of the organisation. As organisations become larger, management and control become
more difficult. Most, if not all, large organisations are divisionalised or decentralised to
some extent.

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542

Decentralisation
When authority and responsibility are given to subordinates for certain aspects of the
operations, and they are held accountable for the results of those operations, this is referred
to as decentralisation. In some organisations, the divisionalisation is implemented in a
functional structure, for example production, marketing and accounting departments.
Other organisations may be divided by region (for example Gauteng or Mpumalanga)
or product type (for example Product A and Product B), each of which would likely have
its own functional departments. This is most commonly referred to as decentralisation.
Decentralisation inevitably leads to owners and senior managers relinquishing control
to some extent and the possibility that lower-level managers will make decisions that are
not in the organisation’s best interests. To ensure that congruence is achieved between
organisational goals and the interests of divisional managers, a system of performance
measurement and evaluation is required. Within a decentralised organisation, goods and
services are often transferred between divisions. Performance measurement of the divisions
usually requires that these transfers be valued in some way, which requires a system of
transfer pricing.

Advantages of decentralisation
Decentralisation is usually undertaken for the following reasons:
● Overcome the problems of managing a large organisation
● Increase the motivation and performance of management, and provide training to equip
junior managers to become senior managers
● Reduce head office bureaucracy that is often associated with large functionally divided
organisations, and particularly to improve the speed and quality of decision making
● Achieve congruence between the goals of the organisation as a whole and those of the
individual divisions and managers
● Free top managers from day-to-day operational decisions and enable them to be more
involved in strategic decision making.

Disadvantages of decentralisation
Many successful small businesses have found that decentralising as they grow larger can
come at a cost. Problems that may arise from decentralisation include the following:
● Dysfunctional decision making may occur, in which managers take actions which
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improve the performance of their divisions at the expense of the organisation as a whole.
Cooperation between divisions may be adversely affected when managers are being
measured only on the performance of their own divisions.
● Costs of common activities within divisions may be greater in total than if these
activities were concentrated in a central functional department, for example accounting
and human resources.
● Top management loses some control of operations when they are decentralised and may
become remote from the people and activities, leading to a lack of understanding of the
business.

Overcoming these problems largely depends on instituting an effective performance

measurement and evaluation system.

Cost and Management Accounting

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543

Test yourself 15.1

What is meant by the term ‘decentralisation’?

Case study: Divisional performance at Steel Africa Ltd

Steel Africa Ltd is a local manufacturer of steel products with divisions in Johannesburg,
Durban and Cape Town. The Johannesburg and Durban divisions were established
in 1999, but the Cape Town division was only opened in 2012. Most of the senior
managers at the Cape Town division moved over from one of the other divisions and
a great portion of the customers bought from one of the older established divisions
prior to 2012. Group management is optimistic that the Cape Town division has strong
growth potential and are worried about ageing infrastructure at the other two plants.
Divisional management’s career developments and bonuses are dependent on rankings
of return on capital employed (ROCE) and residual income (RI). Other performance
measures that are also used, and that all managers agreed to, include the following:
● Factory downtime: this is the percentage of practical machine hours that is idle due
to breakdowns and bottlenecks.
● Injuries: steel work is inherently dangerous and injuries are measured by the number
of incidents that require medical treatment per annum.
● Lead time: this is the time from customer order to delivery.
● Performance data: At the end of 2015, the managers at the divisions provided the
information set out in the table below.
Table 15.1 Summary of management accounts for 2015
Cape Town Johannesburg Durban

(R’000) (R’000) (R’000)

Controllable 8 000 14 500 11 000

Non-controllable 6 000 7 000 12 000
Divisional profit 8 000 18 500 5 000
Capital employed:
Total investment 100 000 170 000 150 000
Controllable investment 95 000 130 000 90 000
➤➤

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544

Forecast sales growth – 2016 9.5% 5.2% 6.2%

Forecast sales growth – 2017 10.2% 5.1% 6.2%
Non-financial measures
Downtime – 2014 4.1% 5.5% 4.9%
Downtime – 2015 3.9% 5.9% 5.2%
Injuries – 2014 8 0 3
Injuries – 2015 5 2 1
Lead time – 2014 10 days 7 days 7 days
Lead time – 2015 12 days 7 days 8 days

The weighted average cost of capital for the group is estimated at 15% for 2015.
Discussion questions:
1. Comment on the relative financial performance of the three divisions and discuss
how the ranking of the divisions change if controllable and non-controllable costs
and investments are analysed.
2. Evaluate the choice of performance measures for the three divisions.
3. Identify and discuss the difficulties faced by management when measuring capital
employed for a division.
4. Discuss how using ROI can result in managers making poor investment decisions.

Organisational structure and responsibility accounting

The decision to divisionalise an organisation by delegating authority and responsibility to
subordinates for certain aspects of the organisation requires that a system be implemented
to monitor and control the subordinates’ performance. This is known as responsibility
accounting. The area of responsibility for which each manager is accountable is called a
responsibility centre. A responsibility centre is a division of an organisation for which a
manager has responsibility to a limited extent. The extent of the operations for which each
manager is responsible varies, and this results in different types of responsibility centres:
cost centres, revenue centres, profit centres and investment centres. It should be noted that
these may also be used in highly centralised organisations, where there is little delegation
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of responsibility and authority. In this case the centres are used only for accumulating data
and providing information, not for managerial performance evaluation. If the manager is
only responsible for some or all of the costs incurred in his area, it is called a cost centre.
Costs are accumulated by the accounting system for this centre, and the manager is
periodically called to account for expenditure, for example by comparing against budget
or standard. In addition to the costs recorded in the accounting system, the costing system
may also record other quantitative data, such as production or sales volumes, material usage
and hours worked, for use in performance evaluation. The sizes of cost centres vary from
organisation to organisation, and within an organisation. Some cost centres may have only
one machine, whereas others may include numbers of machines and hundreds of workers.
A large cost centre may include several smaller cost centres within it. For example, the
production department (cost centre) of a sheet metal business may include rolling, cutting,

Cost and Management Accounting

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545

pressing and other operations, each of which is a separate cost centre, with their individual
managers responsible to the production manager, who in turn is responsible to the
general manager.
In a revenue centre the manager is only responsible for the sales revenue generated by
the department. In practice, the manager would very seldom only be responsible for sales
performance. Usually he would also be responsible for some costs as well, such as sales
salaries or commissions and travelling. Both the revenue and costs would be accumulated
by the accounting system in the same centre, which would usually just be called a cost
centre for simplicity. A revenue centre is distinguished from a profit centre because the
manager is only responsible for a limited number of costs, so that a meaningful profit for
the centre cannot be determined.
In a profit centre the manager is responsible for both revenue and costs from which the
profitability of the centre can be determined. This means that both revenue and cost of sales
must be determinable for the centre, as well as other direct costs. Unless transfer pricing
(to be discussed later in this chapter) is used, most production and service departments
could only be cost centres, not profit centres, as they would not have any revenue. A profit
centre might have a number of cost centres and revenue centres within it, which would
be accumulated for the profit centre. The profit centre manager would be responsible
for all operating aspects of the centre, such as sales price and mix, purchasing, staff and
other operating costs. He would not have responsibility for investment decisions, such as
replacement of machinery and inventory holding, and thus should not be responsible for
costs resulting from these decisions, such as depreciation and interest.
In an investment centre the manager has responsibility for investment in the centre as
well as for its profitability, which would be measured not only in rand terms, but also as
some form of return on the investment in the centre. There may be a number of cost and
profit centres making up the investment centre. The investment can be in fixed assets, such
as plant and land, current assets, such as inventory and debtors, and financial investments,
such as shares and bonds.

Test yourself 15.2

(a) Distinguish between a cost centre, a profit centre and an investment centre.
(b) What benefits can an organisation achieve from decentralisation?
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Performance evaluation in responsibility centres

Measuring performance in responsibility centres

In deciding how to measure performance, we can distinguish between personal performance
and economic performance of the centre. For personal performance we concentrate on how
effective the manager is in managing the activities of his centre, for example controlling
costs, generating sales and achieving profit targets. Economic performance would usually
only apply to profit and investment centres and would measure how successful the centre
is according to some economic benchmarks, for example return on investment compared
with average returns in the industry.

Divisional performance evaluation and transfer pricing

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546

The following factors should be taken into account when designing performance measures:
1. Actions which enhance the performance of the centre at the expense of the organisation
as a whole should be avoided. For example, if a production manager’s performance
is measured by the extent to which all his department’s costs are absorbed by units
produced, he may be encouraged to overproduce, resulting in unsaleable stock building
up in the warehouse.
2. As far as possible, the measure of a centre’s performance should be independent of
performance and decisions elsewhere in the organisation. Where goods are transferred
from one centre to another at actual cost or a price based on actual cost, it would be
unfair to expect the receiving manager to be responsible for these costs.
3. All items which are controllable by the centre manager should be included in the
performance measure. Where items are not controllable, they should not be included
in the manager’s performance measure. This is particularly relevant when dealing
with profit or investment centres. If the manager has no control over investment in
equipment, then depreciation of the equipment should be excluded from their profit
measurement, or if included for ‘completeness’, this should be done in such a way that it
is neutral to the measurement of performance. For example, if actual profit is measured
against budget, budgeted depreciation should be used for the profit centre manager’s
performance evaluation, even though the amount of investment or depreciation may
have changed.

Performance measurement in cost and revenue centres

Performance measurement is generally relatively straightforward and usually takes the
form of a statement, comparing actual costs against budget or standard costs. Only
controllable costs should be included, which are usually taken to be all variable costs and
directly attributable fixed costs, that is, those that can be allocated in full to the cost centre.
If non-controllable costs are to be included in the statements for ‘completeness’, these
should be shown in a separate section of the statement. Generally, if a cost is first recorded
by the accounting system in one cost centre and then apportioned on some basis to other
cost centres, this should be regarded as a non-controllable cost in the centres to which it
is apportioned. It should be noted that a cost which is treated as non-controllable in one
department, may be treated as controllable in another department. Although all variable
costs are generally regarded as controllable, some may not be strictly controllable in the
terms which a performance report covers. For example, direct labour is usually treated as
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variable. However, the workers may be paid a fixed amount for a minimum number of hours
per month. In the short term, even if all the labour is not required, the wage bill cannot be
reduced and will show as an unfavourable variance. Some fixed costs, for example salaries
or advertising, may be non-controllable in the short term, but controllable in a longer
term. These are often referred to as committed costs. Other fixed costs, called discretionary fixed
costs, are controllable in the short term, for example a manager’s travel costs. If possible,
non-financial quantitative measures should also be included and related to the financial
performance where relevant.

Cost and Management Accounting

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Illustrative example 15.1

The table below gives simplified examples of performance statements for cost and
revenue centres.
Table 15.2 Production department A: Budget control report for April 20X1
Budget Flexed Actual Variance
(R) budget (R) (R) (R)
Direct materials 100 000 110 000 113 000 −3 000
Direct labour 60 000 66 000 64 000 +2 000
Variable overheads 30 000 33 000 36 000 −3 000
Controllable fixed overheads 20 000 20 000 18 000 +2 000
Total cost 210 000 229 000 231 000 −2 000
Tons produced 1 000 1 100 1 100 +100
Cost per ton 210 208 210 −2

Table 15.3 Finance department: Budget control report for April 20X1
Budget (R) Actual (R) Variance (R)
Salaries 100 000 110 000 −10 000
Printing and stationery 5 000 3 000 +2 000
Communications 10 000 12 000 −2 000
Total cost 115 000 125 000 −10 000

Table 15.4 Sales performance report for April 20X1

Budget (R) Actual (R) Variance (R)
Product A 500 000 600 000 +100 000
Product B 800 000 700 000 −100 000
Total sales 1 300 000 1 300 000 0

Each of these statements should be accompanied by analyses of the performances, and

Performance measurement in profit centres

While in many organisations performance measurement in profit centres is done in a
similar way to cost centres, that is, by comparison against budget, the method of
determining profit is very important. One cannot simply use accounting net profit because
this will include apportionments and other non-controllable costs that should be excluded
in evaluating the manager’s performance. In a pure profit centre, where the manager
has no control over investment in his centre, it might be acceptable to use contribution
margin as a measure, as this excludes any non-controllable fixed overheads. However, the
manager could influence the measure by increasing fixed costs to reduce variable costs, thus
improving his contribution margin, for example additional supervision may reduce direct

Divisional performance evaluation and transfer pricing

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labour, but the total cost may be higher. Controllable or attributable operating profit, in
which controllable fixed expenses are deducted from contribution, is probably a better
performance measure. Once the profit has been determined, it must be measured against
some yardstick. This could be actual profit value compared with budget, actual percentage
profit to sales compared with budget, or a comparison of actual performance with other
profit centre managers.

Illustrative example 15.2

Table 15.5 shows a simplified profit centre performance report.
Table 15.5 Performance report for Hard Candy division: April 20X1
Budget (R) Actual (R) Variance (R)
Sales 1 000 000 1 150 000 +150 000
Cost of sales 700 000 900 000 −200 000
Contribution 300 000 250 000 −50 000
Controllable fixed costs 200 000 180 000 +20 000
Controllable operating profit 100 000 70 000 −30 000
Contribution % of sales 30% 22% −8%
Operating profit % of sales 10% 6% −4%

This should also be accompanied by an analysis of the information. How the report
is used in the manager’s performance evaluation will differ from organisation to
organisation. The manager might be required to provide written or oral feedback to
their superior, or to attend a board meeting at which performance is discussed and
action proposed. In some cases the manager may be paid a bonus dependent on the
profit performance of their division.

This example compares actual performance with budget. Evaluation could also be made
by comparing actual performance against prior periods or years, or with performances
of other divisions in the organisation. Care should be taken in these cases that like
is compared with like. Operating and economic conditions may vary widely from one
period to another. Divisions will probably be of very different sizes, so that comparing
profit values will be of little benefit. Ratios such as percentage of sales will be a better
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comparison.

A deficiency that is sometimes identified with controllable operating profit as a measure

is that the profit centre managers have little concern with other overhead costs, which,
although they may be considerable, are shown only at the total organisation level and may
be affected by demands made by the profit centre managers. For example, the costs of a
centralised human resource division will probably be increased by high staff turnover in the
profit centres without these costs being charged to the profit centres.

Cost and Management Accounting

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549

Illustrative example 15.3

Table 15.6 shows an example of an organisation with three profit centres, as well as
unapportioned central overhead costs.
Table 15.6 Summarised statement of comprehensive income of Choc and Candy Co:
April 20X1
Hard Candy (R) Soft Candy (R) Chocolate (R) Total (R)
Sales 1 150 000 750 000 2 100 000 4 000 000
Cost of sales 900 000 600 000 1 600 000 3 100 000
Contribution 250 000 150 000 500 000 900 000
Controllable fixed costs 180 000 100 000 200 000 480 000
Controllable operating profit 70 000 50 000 300 000 420 000
Central overhead costs 400 000
Net profit 20 000
Contribution % of sales 22% 20% 24% 23%
Operating profit % of sales 6% 7% 14% 11%
Net profit % of sales 0.5%

Although the profit centre managers may feel that they are operating at an acceptable
level, it would require only a small increase in central overhead costs, or a drop in sales,
to push the company into a loss situation. Profit centre managers may argue that the
central cost centre managers are responsible for ensuring that their costs are contained
at the correct level, but as mentioned above, this may be impossible, due to demands
made by the profit centres. Conversely, if central cost centre managers refuse to increase
their costs to satisfy the profit centres, it may have an adverse effect on the overall
performance of the organisation. To make profit centre managers aware of the possible
influence of central overhead costs, some organisations apportion them on an agreed
basis to profit centres. If the central overheads in Table 15.6 were to be apportioned on
the basis of sales value, it would appear as given in Table 15.7.
Table 15.7 Summarised statement of comprehensive income of Choc and Candy Co:
April 20X1
Hard Candy Soft Candy Chocolate Total
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(R) (R) (R) (R)

Sales R1 150 000 R750 000 R2 100 000 R4 000 000
Cost of sales R900 000 R600 000 R1 600 000 R3 100 000
Contribution R250 000 R150 000 R500 000 R900 000
Controllable fixed costs R180 000 R100 000 R200 000 R480 000
Controllable operating profit R70 000 R50 000 R300 000 R420 000
Central overhead costs R115 000 R75 000 R210 000 R400 000
Net profit / (loss) R(45 000) R(25 000) R90 000 R20 000
Contribution % of sales 22% 20% 24% 23%
Operating profit % of sales 6% 7% 14% 11%
Net profit % of sales (4%) (3%) 4% 0.5%

➤➤

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550

While reporting in this manner has the advantage of making profit centre managers
aware of other costs and the need for their profits to cover these costs, if they are made
accountable for them in some way, for example by basing their bonuses on net profit,
they may be more concerned with arguing about methods of apportionment than
improving operating profit. There is also the possibility that a manager whose division
shows a net loss may become demotivated by what they perceive to be unfairness.

Performance measurement in investment centres

In addition to profit performance, managers in investment centres must also be measured
on their utilisation of the investment for which they have responsibility. Three measures
that are widely used are return on capital employed, residual income, and economic value
added. In all cases, it is essential that both the profit used in the calculations, as discussed
in the previous section, and the investment in assets, are the responsibility of and can be
influenced by the manager.

Return on investment
Return on investment (ROI) is the percentage of net profit earned by an investment centre
compared to its capital employed. It is used as a measure by management to appraise the
entire organisation as well as divisional operating performance. The objective of ROI is to
evaluate how well the organisation has performed, based on the assets it has at its disposal.
This widely used ratio is similar to return on capital employed (ROCE), and is calculated
from the following formula:
Attributable profit
_______________
  Capital
ROI =       employed
 × 100%

(Note: Attributable profit, also referred to as controllable profit, is the profit before interest
and tax.)

Because of its wide use, it is readily accepted and understood by managers. Other ratios,
such as percentage profit to sales and asset turnover, can also be derived from ROI and it
is useful in comparing performances between divisions of different sizes. However, using
ROI as a performance measure might cause a manager to reject investments that would
be acceptable to the organisation, but which would reduce the ROI of the division (for
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example, an investment with a positive net present value).

Illustrative example 15.4

The manager of an investment centre has the opportunity to invest in a project that is
expected to earn a return on investment (ROI) of 15%. The average ROI in the specific
division is 16.2%. The investment centre manager is set to receive a bonus if he manages
to increase the division’s ROI. The company’s weighted average cost of capital (WACC)
is 14%.

Required:
Briefly discuss whether the investment should be accepted.
➤➤

Cost and Management Accounting

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Solution:
The manager will be motived to reject the investment, since the investment’s ROI is
lower than the current average ROI of the division (15%, 16.2%). By accepting the
investment, the average ROI of the division will decrease, thereby reducing the chance of
the manager receiving a bonus. From the company’s perspective, the investment should
be accepted, since the return exceeds the WACC (15%, 14%) and will therefore have a
positive net present value, creating additional shareholder value.

Managers may also be encouraged to keep assets beyond their economic life, because
replacing them would increase capital employed and reduce ROI, at least in the short term.
Making comparisons can be misleading where different practices are followed in calculating
profit and valuing assets.

Advantages of return on investment

● Serves as a benchmark in measuring management’s efficiency both for the organisation
as a whole and its divisions.
● Affords comparison of managerial results both internally and externally.
● Aids in detecting weakness with respect to the use and non-use of individual assets,
especially inventories.
● Develops a keener sense of responsibility and team effort amongst divisional managers
by enabling them to measure and evaluate their own activities in the light of results
achieved by other managers.
● Encourages managers to take on projects that will increase ROI and discard those that
decrease ROI.

Disadvantages of return on investment

● Difficulties may be experienced in comparing valuations of assets of different vintages
(nature and age) in different divisions.
● It may not be reasonable to expect the same ROI from each division if the divisions
sell their products in markets that differ widely with, amongst others, competition and
consumer demand.
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● The ROI, as a single measure of performance, may result in a fixation on improving the
components of one measure to the neglect of other necessary activities.
● Profit is affected by accounting policies, some of which are beyond the control of the
divisional manager, for example transfer price policy, depreciation policy and inventory
policy.
● ROI uses accounting profit and not cash flows. Cash flows are used to determine NPV
that drives shareholder value creation, the ultimate aim of the organisation.

Divisional performance evaluation and transfer pricing

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Illustrative example 15.5

The Paint Can division of Metal Pressings Ltd achieved net profit of R1 million before
deducting interest and tax in the last financial year. The manager has authority to invest
in fixed assets up to a total of R5 million without consulting head office, and controls
all inventory levels. Credit terms and debt collection are handled by the central credit
control division at head office. The profit of R1 million has been determined after
deducting discounts allowed of R100 000, bad debts of R50 000, and depreciation
of R250 000. Average net fixed assets in the year were R3 million, average inventory
R500 000 and average debtors R1 million. If a return on capital employed of at least
30% is achieved, the manager will be paid a bonus of 30% × net attributable profit,
otherwise his bonus will be R10 000.

Required:
What bonus will the manager earn? (Round off calculations to the nearest whole
number.)

Solution:
First calculate the attributable profit. The manager has no control over credit extension,
so discounts allowed and bad debts should be excluded, but depreciation is included,
because fixed assets are less than R5 million.

Therefore, attributable net profit = R1 000 000 + 100 000 + 50 000 = R1 150 000.

Debtors will not be included in capital employed, because the manager does not control
them, but fixed assets and inventory will be included.

Capital employed = R3 000 000 + 500 000 = R3 500 000

Attributable profit
______________
  Capital
ROI =       employed × 100%
1 150 000
=  ________
3 500 000 × 100%
= 32.86%

Test yourself 15.3

Suppose, in the example above, that the manager has the possibility of investing in new
equipment at an initial cost of R1 million, which is expected to generate cash profits
of R300 000 per year for the next five years, after which the equipment will have no
economic value. It is not expected that there would be any change in inventory values.
Fixed assets are written off in a straight line over their economic life, and tax effects may
be ignored. The company has a target return on investment of 18%. Without the new
investment, profits for the division are expected to be more or less the same as in the
previous year.
➤➤

Cost and Management Accounting

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Required:
Will the manager be willing to undertake the investment? What would be the effect on
his bonus if the investment was undertaken? How does the manager’s decision meet the
company’s required return? What do you think of the company’s required return target
compared to the manager’s bonus performance target? Show calculations supporting
your answers.

Residual income
Residual income (RI) is net profit earned by an investment centre, less imputed interest on
its capital employed. RI is calculated by deducting an imputed interest charge on capital
employed from attributable net profit. The required rate of return, multiplied by investment,
is called the imputed cost of the investment. The profit and capital employed are determined
in the same way as for ROI.

Residual income = Attributable net profit − (Required rate of return × Investment)

Imputed interest is usually calculated at a rate equal to the organisation’s weighted average
cost of capital (WACC). The imputed cost is not recognised in accounting records because
it is not an incremental cost; instead it represents the return foregone as a result of tying
up cash in various investments of similar risk. The objective of maximising residual income
assumes that, as long as a division earns a rate of return in excess of the required return for
investments, that division should be expanded. If RI is positive, the division has performed
at better than average for the organisation, that is, earnings are in excess of the desired
return; while if it is negative, the division has performed worse than average, that is, the
earnings are less than the desired return.
Because the imputed interest rate is set at the weighted average cost of capital, if this
is also the target for new investments, then undertaking a new project that has positive
net present value will not reduce RI for the division, even though it may reduce its current
ROI. Deducting imputed interest also helps to make managers aware that there is a cost to
financing investments.
However, using RI alone does not allow for easy comparisons between divisions since it
is an absolute value. It also does not relate profits directly to the amount of capital required
to generate the profit, as ROI does.
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Advantages of residual income

● Residual income is consistent with the NPV measure discussed in Chapter 14, which
looks at long-term value creation.
● The imputed interest rate can be adjusted to take different divisional risk levels into
account.
● Divisional managers are made aware of the cost of financing.

Disadvantages of residual income

● Residual income gives an absolute amount, which makes it difficult to make comparative
performance evaluations, that is, RI is affected by size and tends to be larger for
larger units.

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● The amount of RI is not related to the assets employed to generate the profit, except
indirectly through the calculation of imputed interest.
● RI is calculated using accounting information. Managers whose actions are measured
in terms of RI could focus their efforts on improving accounting figures at the expense
of future cash flows.

Illustrative example 15.6

The manager of an investment centre is evaluating a new project. This project will require
investment of R500 000, will have a four-year life, and earn cash profits of R200 000 per
year. Currently his division has net assets of R2 million which are expected to generate
R400 000 of profit before interest and tax in the coming year. Depreciation on existing
assets will be R500 000 for the next year. The group has a WACC of 12% for evaluating
new investments and measuring performance.

Required:
Calculate average ROI and RI with and without the investment for the first year of the
project. Would the manager be prepared to undertake the project, if his performance is
measured by ROI? How would your answer change if the manager is measured by RI?
(Assume the project starts at the beginning of the year, use asset values at this date to
calculate ROI and RI, and calculate depreciation on a straight-line basis.)

Solution:
Depreciation on the investment will be R500 000 ÷ 4 = R125 000, making attributable
profit R200 000 − 125 000 = R75 000. We now calculate ROI and RI for the division
with and without the new investment.
Table 15.8 Performance measures
Without investment (R) With investment (R)
Profit 400 000 (400 000 + 75 000) 475 000
Average capital [(2 000 000 + 1 500 000) ÷ 2)] (1 750 000 + 500 000) 2 250 000
employed 1 750 000
ROCE 23% 21%
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Profit 400 000 475 000

Imputed interest 210 000 (12% × 2 250 000) 270 000
(12% × 1 750 000)
RI 190 000 205 000

If he is measured on ROI, the manager will not undertake the investment, because the
division’s ROI would drop from 23% to 21%. However, RI increases from R190 000 to
R205 000, so he would be prepared to undertake the investment if RI is used to evaluate
his performance.

Cost and Management Accounting

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Economic value added

Economic value added (EVA) is net operating profit after tax, less cost of capital charge.
Net operating profit after tax (NOPAT) adds back accounting charges and non-cash
expenses to net profit, and deducts economic depreciation. Cost of capital charge is a
notional rate applied to economic capital employed. A defect of both ROI and RI as measures
of performance is that they both use accounting profit and asset valuations. As a result,
they are open to manipulation and change from period to period and between companies
because of differences in accounting policies and practices. As its name indicates, economic
value added looks at whether a company or division has added value to the business during
a period, in this way adding to shareholder wealth. In other words, a business must make an
economic profit exceeding its cost of capital to add to its economic value. Determination of
EVA is similar to RI, except that accounting valuations are removed from profit calculations
and asset valuations and replaced by ‘economic’ valuations. Another difference is that EVA
uses after-tax profits, whereas both ROI and RI are usually calculated ignoring tax.
The first step in calculating EVA is to calculate net operating profit after tax (NOPAT).
To accounting profit after tax (PAT), add back non-cash items (such as accounting
depreciation, provision for doubtful debts and goodwill amortised) as they are treated with
suspicion due to the likelihood that they may be used to manipulate the profits rather than
any real costs; interest paid net of tax; development costs; and operating lease charges. We
deduct economic depreciation and any impairment of goodwill. This gives NOPAT in cash
flow terms, which is why we add back non-cash items. Economic depreciation is calculated
by determining the difference in market values of assets at the beginning and end of
the period.
Table 15.9 Net operating profit after tax (NOPAT)
Controllable PAT X
Add back non-cash items such as:
Accounting depreciation X
Non-cash expenses X
Interest paid net of tax X
Add back items that add value such as:
Goodwill amortisation X
Development and advertising costs X
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Operating lease interest cost X

Deduct:
Economic depreciation (X)
Impairment to the value of goodwill (X)
Amortisation of development and advertising costs (X)
= NOPAT X

Next, calculate capital invested in economic terms: adjust the accounting capital employed
to the market value of tangible assets, add the capitalised value of financial and operating
leases, development costs, and intangible assets such as goodwill and brands. The
inconsistency between the treatment of operating leases as an exclusion in the statement of
financial position with finance leases being capitalised implies that firms can use operating

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leases to reduce the reported capital employed. This would in turn increase the calculated
EVA. Therefore, when calculating EVA, operating leases are capitalised and added to
capital employed.

The adjustments to profit and capital employed is summarised in Table 15.10.

Table 15.10 The adjustments to profit and capital employed
Change to profit Change to capital employed
Advertising, research and Increase current year profit Increase capital employed at
development items expensed, Deduct economic depreciation the end of the year
staff training on previous year’s EVA Increase capital employed in
adjustment respect of similar add backs
of previous year’s investments
not treated as such in financial
statements, net of economic
depreciation
Depreciation Add accounting depreciation Adjust value of non-
Deduct economic depreciation current assets (and capital
employed) to reflect economic
depreciation not accounting
depreciation
Operating leases Add back lease payments to Add present value of future
profit lease payments to capital
Deduct depreciation on assets employed
Provisions including allowances Add increases in provision/ Add back the value of
for doubtful debts, deferred tax deduct decreases in provisions provisions to capital employed
provisions and allowances for to/from profits
inventory
Non-cash expenses Add back to profit Add to retained profits at the
end of the year

Multiply economic capital invested by the company’s WACC to obtain the cost of capital
charge.

EVA = NOPAT − Cost of capital charge

Illustrative example 15.7

In their last financial year, Excelsior Products reported a profit after tax of R1.2 million,
with net assets of R8 million. The profit calculation included the items as given in the
following table.
➤➤

Cost and Management Accounting

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Table 15.11 Items included in calculation of Excelsior Products’ profit

R
Depreciation 1 500 000
Provision for doubtful debts 100 000
Operating leases 50 000
Amortisation of goodwill 200 000
Development costs 150 000
Interest paid 300 000

The directors obtained market valuations of tangible assets, including all capitalised
leases, of R10 million at the beginning of the year, and R9 million at the end of the year.
Goodwill on the purchase of a going concern at the beginning of the year had been
brought into the books at a value of R1 million and is to be amortised over 5 years. The
tax rate is 40%. The company’s WACC is 15%.

Required:
Calculate EVA. Comment on the company’s performance.

Solution:
Table 15.12 Calculation of NOPAT and EVA
R
Accounting PAT 1 200 000
Add back:
Accounting depreciation 1 500 000
Provision for doubtful debts 100 000
Operating leases 50 000
Amortisation of goodwill 200 000
Development costs 150 000
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Interest paid net of tax [300 000 × (1 − 0.40)] 180 000

Deduct:
Economic depreciation (10 million – 9 million) (1 000 000)
NOPAT 2 380 000
Less: Cost of capital charge [0.15 × (9 million + 1 million)] (1 500 000)
EVA 880 000

The company has positive EVA of R880 000, which means it has increased shareholders’
wealth by this amount, at the 15% cost of capital. If the cost of capital were 24%, then
EVA would be negative and shareholder wealth would have been destroyed.

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EVA can be considered superior to ROI and RI because it uses economic rather than
accounting values, but determination of these values is often subjective. Also, where
managers’ rewards are based on performances over one year only, all three measures can
encourage managers to make decisions that increase their rewards in the short term, but are
not beneficial to the organisation in the longer term.

Performance evaluation and the balanced scorecard

ROI, RI and EVA are performance measures that only consider financial or economic factors
in evaluating performance. For sustainable long-term profitability an organisation should
also consider various non-financial measures of performance. To address this issue, Robert
Kaplan and David Norton proposed the use of what they called the ‘balanced scorecard’ in
their article in the Harvard Business Review (Kaplan & Norton, 1992).
The balanced scorecard has been shown in many different formats, but it basically requires
the organisation to set goals and evaluate performance from four different perspectives –
financial, customer, internal processes, and learning and growth perspectives. The specific
goals and performance measures set for each perspective will differ from organisation to
organisation, but will usually include some or all of the following perspectives.

Financial perspectives:
● Profitability: ROCE, RI, EVA
● Survival: Cash flow, liquidity and gearing ratios
● Success: Growth in operating income, sales and/or market share.

Customer perspectives:
● Customer retention
● Acquisition of new customers
● Customer satisfaction
● Customer profitability
● Market share
● Lead times and percentage on-time delivery.

Internal processes perspectives:

● Efficiency and effectiveness

● Unit costs
● Capacity utilisation.

Learning and growth perspectives:

● Product and process innovation
● Employee satisfaction and turnover
● Employee productivity.

Many organisations have probably been using most or all of the measures suggested by
the balanced scorecard approach, but in a less structured manner. A problem with the

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approach is that it requires buy-in and commitment from the top down, as the cost and
time implications of setting up and using the scorecard are considerable.

Illustrative example 15.8

Ubuntu Air operates air services carrying both passengers and cargo to smaller regional
centres in South Africa. The company has recently decided to implement a balanced
scorecard approach to performance management and has stated its strategic objectives
according to balanced scorecard perspectives as given below.

Financial perspectives:
● Increase revenue
● Lower costs
● Increase profitability.

Customer perspectives:
● Lowest prices
● On-time flights
● More customers.

Internal processes perspectives:

● Improve flight turnaround time
● Reduce aircraft downtime.

Learning and growth perspectives:

● Air crew goal congruence
● Ground crew goal congruence.

Required:
Compile a balanced scorecard to use for performance measurement, showing for each
strategic objective the performance measures, targets and initiatives required to achieve
targets.

Table 15.13 Balanced scorecard of Ubuntu Air

Strategic objective Performance Targets Initiatives

measures
Financial
Increase revenue Seat revenue 20% increase p.a. Optimise routes
Lower costs Aircraft lease cost 5% per year Standardise aircraft
Increase profitability Company market 10% increase p.a.
value

➤➤

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Customer Customer rating

Lowest prices On-time arrival 98% satisfaction
On-time flights rating First in industry Quality management
More customers No of customers 15% increase p.a. Loyalty programme
Internal For both:
Improve flight On-time departure 95% Cycle time
turnaround time optimisation
Reduce downtime On-ground time < 30 minutes programme
Learning For both: For both:
Air crew goal % air crew Year 1: 50% Share ownership
congruence shareholders Year 4: 75% plan
Ground crew goal Year 6: 100% Training
congruence % ground crew
shareholders

Test yourself 15.4

(a) What is meant by residual income?
(b) What is meant by economic value added?

Transfer pricing
In a decentralised organisation the valuation of movements of goods and services between
responsibility centres becomes a potential problem and area of contention between
managers.
Transfer price may be defined as the price charged by the supplying centre for goods or
services provided to the receiving centre in the same organisation. If there are only cost centres
concerned in the transfers, the issue is usually resolved by valuing transfers at standard or,
occasionally, actual cost. Where transfers occur between profit or investment centres, the
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issue becomes more complex, as the transferring centre wants to make an acceptable profit
on the transfer, while the receiving centre wants to be charged a price that enables it to
make an acceptable profit on its operations. Transfer pricing is important to a decentralised
organisation because it determines the sharing of profit between two divisions, and thus
probably also the individual managers’ incentives and motivation. Where transfer prices are
perceived to be unfair by one of the managers, it would affect that manager’s willingness to
buy from or sell to the other division, possibly adversely affecting the overall performance
of the organisation. It should be a matter of policy in a decentralised organisation that, if
interdivisional transfers occur, both divisions must benefit fairly from the transaction.

Cost and Management Accounting

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We can identify three different methods for determining transfer prices.

1. Cost-based transfer prices. The costs that are included in the transfer price differ
from organisation to organisation and could be either standard or actual costs. Where
the purpose of the transfer price is simply to provide a valuation for the accounting
system, standard variable cost may be used, as this removes the problem of under- or
over-absorption of fixed overheads. In other cases, either full cost, including all fixed
overheads incurred by the centre, or full cost plus a mark-up, may be used. Sometimes
variable cost-plus mark-up is used, where the mark-up is intended to cover both fixed
costs and profit. A problem with cost-based pricing is that the receiving centre has no
control over the price, which may be inflated to cover inefficiencies of the transferring
centre, especially when actual costs are used. To avoid this, cost-based prices may be set
by an independent party, such as the group accounting division.

Illustrative example 15.9

XY Group uses a cost basis for transfers of products between its two divisions. The group
head office has mandated that prices should be set at fully absorbed standard cost of
production plus 20% mark-up to provide the transferring division with an acceptable
return. Division X produces product A at a standard cost of R15.00 per unit, which
includes R4.00 selling costs if sold to outside customers. Product A is also supplied to
division Y for further processing.

The transfer price will be (15 − 4) + (15 − 4) × 20% = R13.20.

2. Market-based transfer prices. To use this method there must obviously be a market
price for the product, or for one similar enough to make a valid comparison. The
price should exclude any costs not incurred by the transferring centre through selling
internally, for example transport, commissions and packaging. This method is often
used where a division has both internal and external customers for its products. Where
significant external buying and selling costs exist, a transfer price may be set lower than
market price to reflect cost savings from internal transfers. These circumstances may
lead to a negotiated market price where the total cost savings are apportioned between
the supplying and receiving divisions. In such circumstances an arbitration procedure
may be required but this could undermine the autonomy of the divisions.
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Illustrative example 15.10

Suppose XY Group changes its transfer pricing policy to use market-based transfer
prices. Division X normally sells product A to external customers for R18 per unit. The
transfer price will now be R14 (R18 − R4).

3. Negotiated prices. Where both centres enjoy substantial autonomy in decision making,
they may negotiate prices between them. The price agreed upon may be based on cost
or market information, but not necessarily. A problem with this method is that if one
manager is a stronger negotiator than the other, their division may achieve a more

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favourable position. Disagreements may require some form of arbitration from central
management, but as mentioned, this may undermine the autonomy of the division and
cause resentment.

Illustrative example 15.11

Arlon Company delegates authority for negotiating transfer prices to divisional managers,
provided divisional and organisational profit targets are achieved. A dispute has arisen
between the Weaving and Trim divisions over the price of carpet rolls. Weaving wants
to transfer the rolls at R100 per metre, which is the price at which it sells to external
customers, less selling costs. Trim is only prepared to pay R90 per metre, which is the
price it would pay a nearby external supplier whose transport costs are significantly less.

Unless the managers of the two divisions can reach a compromise, the dispute would
probably have to be resolved by head office. If Weaving could sell all its production to
external customers at the higher price, it would be beneficial to the group for Trim to
purchase its requirements externally. However, if Weaving cannot sell Trim’s requirements
externally, then it would probably be better to match the external supplier’s price. The
head office decision-maker may, however, decide to set a higher price if this allows both
divisions to achieve acceptable profits.

General guidelines for setting transfer prices

The transfer pricing policy and method should ensure that when they have the option,
divisional managers prefer to buy or sell internally, rather than trade with external suppliers
or customers, unless there is a good commercial reason. The organisation should aim to
ensure that its transfer pricing method achieves a number of objectives.
1. It should enable decisions made by the divisional managers to achieve congruence with
goals of the organisation.
2. The effect on divisional profits should provide a fair measure of each manager’s
performance and encourage managerial effort.
3. Where relevant, it should encourage autonomous decision making within divisions.

decision for the organisation is also the right decision for the division. Divisions should
apply relevant costing principles to decide whether the supplying division should sell their
product internally to another division or externally, as well as the quantities that should be
sold to the various parties.
To the extent that spare capacity exists in the supplying division, the supplying division
would be willing to sell to the receiving division as long as the variable cost of producing
the product is less than the transfer price. To the extent that external demand exists for the
supplying division’s product, the supplying division will base their decision on a comparison
of the transfer price to the external market price for their product. The lowest transfer price
that the supplying division would be willing to accept would be:

Minimum price (supplying division) = Variable cost + Opportunity cost (lost contribution)

Cost and Management Accounting

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The receiving division will only purchase internally as long as the total contribution margin
earned by the receiving division remains positive. This will happen if the selling price of
the receiving division’s product, less the variable costs incurred by the receiving division,
exceeds the transfer price. The selling price of the receiving division, less the receiving
division’s variable costs, is referred to as the net marginal revenue.

Maximum price (receiving division) = Selling price per unit − Variable cost per unit (of receiving
division) = Net marginal revenue

Any transfer price that falls between the minimum and maximum limits above would result
in goal congruence between the organisation and the divisions.

Minimum Maximum
transfer price transfer price

Supplying division: Receiving division: Supplying division: Supplying division:

Transfer price Wants to pay as Wants to charge as Transfer price =
= Variable plus little as possible much as possible Lower of:
opportunity cost 1) Net marginal
revenue
2) Market price

Figure 15.1. The minimum transfer price is set by the supplying division and the
maximum transfer price is set by the receiving division

External markets
In the case where an external market exists, any costs incurred on external sales which is not
incurred when transferring internally, should be adjusted for. There are two possibilities
for the external market, namely a perfectly competitive market and one that is imperfectly
competitive.
1. A perfectly competitive market means that there is only one price for the product, that
all the output of the selling division can be sold in the market, and all the requirements
of the buying division can be met by the market. If the divisions have no selling or buying
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costs, the transfer price would simply be the market price, because any other price would
result in one division benefiting by the difference, while the other division would be
worse off by the difference. The result would be that the disadvantaged division would
prefer to buy or sell in the external market.
Usually the divisions would rather save selling and buying costs in the external market
that would not be incurred if transferring internally. The market price should therefore
be adjusted by these internal cost savings so that the divisions share the benefit.

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Illustrative example 15.12

Alpha Ltd manufactures bicycle wheels in two divisions: Rims and Spokes. The rims
are manufactured in the Rims division, after which it could either be sold externally to
other wheel manufacturers, or it could be transferred to the Spokes division to add the
spokes. The Spokes division could then sell the finished wheels to bicycle shops.

The selling prices, variable costs and selling expenses are presented in the table below:
Table 15.14 Information related to Rims and Spokes
Division Rims Spokes
Selling price per unit 50 95
Variable cost per unit −30 −40
Selling expenses −5 −3

Rims would be satisfied with any transfer price that is greater than or equal to 50 − 5 = R45.
Spokes would be satisfied with any price that is less than or equal to 95 − 40 − 3 = R52.
A transfer price in the range R45 to R52 would therefore satisfy both divisions. The exact
price would be negotiable between the two divisions.

2. Where an intermediate market exists that is imperfectly competitive, the seller has
more capacity than the external market can absorb, or customer knowledge of prices
is defective so that prices may vary. Where the supplying division has surplus capacity,
it would be prepared to supply the receiving division at any price that is greater than
its marginal cost of production, up to the limit of its capacity. If the receiving division
required more than the surplus capacity, a price would have to be negotiated, averaging
between the supplier’s marginal cost and the market price.

Illustrative example 15.13

In the previous example, suppose the Rims division has a capacity of 10 000 units with
a variable cost of R30 per unit, but can only sell 8 000 units externally. The Spokes
division requires 3 000 units. Assume there are no selling expenses. The Rims division
has spare capacity of 2 000 units. Any internal sales up to 2 000 units at a price greater
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than the variable cost of R30 per unit will increase profit. For the additional 1 000 units
required by Spokes, Rims would forgo external sales and incur opportunity cost of R20
per unit (R50 − R30). For the Spokes division, any price less than the net marginal
revenue of R55 (R95 − R40) would increase profit. The minimum transfer price that the
Rims division will accept is therefore the variable cost plus the lost contribution on the
external sales of 1 000 units, which would be: R30 + [(1 000 × R20) ÷ 3 000] = R36.67.
An alternative formula for calculating the transfer price is to average the price of the
spare capacity and the lost external sales. Assuming Rims accepts the minimum price
of R30 for its spare capacity, the average price would be: (2 000 × 30) + (1 000 × 50) ÷
3 000 = R36.67.

Cost and Management Accounting

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Further complexity with setting a transfer price arises when the supplying division has more
than one product using the same production facilities and limited capacity. The supplying
division would not be willing to transfer to the receiving division at a price which gives
it a lower contribution than the lowest of other products using the same facilities. The
contribution that would be lost from the other product is an opportunity cost, sometimes
called a ‘shadow price’.

Illustrative example 15.14

Gamma division produces two products, G1 and G2, using the same production
facilities. G1 is sold both externally and to another division, Delta, while G2 is only sold
externally. The total capacity of Gamma’s production facility is 20 000 units. G1 has a
variable cost of R20 per unit and G2 a variable cost of R30 per unit. On the external
market Gamma can sell 12 000 units of G1 at R45 per unit, and 8 000 units of G2 at
R50 per unit. Delta requires 3 000 units of G1.

If there were no production constraints the minimum transfer price Gamma would
accept for G1 would be its variable cost of R20 per unit. However, because it can sell
its entire capacity for G1 and G2 on the external market, supplying G1 to Delta would
mean losing the contribution made on sales of G2, that is, 50 − 30 = R20 per unit. It
would choose to forgo sales of G2, since the contribution per unit that is lost is R20,
which is less than the contribution per unit of 45 − 20 = R25 for G1. The minimum
transfer price for G1 should therefore be 20 + 20 = R40 per unit.

Supplying
division

Minimum price Maximum price

External market No external Perfect market

and spare market and no spare
capacity capacity TP = Market price
TP = Incremental TP = Variable TP = Market price per unit − Internal
variable cost + cost per unit + per unit − Internal savings per unit
Opportunity cost Negotiated profit savings per unit
per unit

Figure 15.2. The minimum and maximum transfer price of selling division

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Receiving
division

Minimum price Maximum price

TP = Market price
A price that is
per unit + Internal
negotiated
savings per unit

Figure 15.3. The minimum and maximum transfer price of receiving division

The process of determining transfer prices

Determining a ‘fair’ transfer price is essentially a three-step process:
1. Determine how many units must be sold (externally and internally) to maximise profits
of the organisation as a whole.
2. Determine the minimum transfer price that will maximise profits and be acceptable to
the supplying division.
3. Determine the maximum transfer price that will maximise profits and be acceptable to
the receiving division.

The number of units to be sold to maximise profits is an application of cost-volume-profit

principles, taking care to include relevant variable costs of both supplying and receiving
divisions. Steps 2 and 3 will depend on the transfer pricing policy of the organisation.

Illustrative example 15.15

Division A of the Sencam Group makes a product A9, which it sells externally and
to another division in the group, Division B. Product A9 is used by Division B as a
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component in product B26, which it sells externally.

Table 15.5 Division A: Product A9

Variable manufacturing cost R35 per unit
Direct labour R20 per unit
Direct material R20
External selling price R120 per unit
External variable selling cost 2c per unit
Maximum manufacturing capacity 20 000 units per month
Internal transfer to Division B 4 000 units per month
Current capacity and sales 17 000 units per month
➤➤

Cost and Management Accounting

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Required:
Determine the minimum transfer price per unit that Division A will be willing to transfer
to Division B.

Solution
Let us start by establishing the following:
From whose view point? Selling or receiving division?
◆ Selling (Division A)

Minimum or maximum transfer price?

◆ Minimum

Which option is applicable:

● Perfect market and no spare capacity?
● External market and spare capacity?
● No external market?
◆ External market & spare capacity

Which method?
◆ Minimum transfer price of selling division
= Incremental variable cost + Opportunity costs

Total maximum capacity of 20 000 units with 17 000 units for the external market. This
represents a spare capacity of 3 000 units, which is less than the required 4 000 units.
Therefore, 1 000 units need to be sacrificed from the external market.

As a starting point, we can calculate the incremental variable costs:

Incremental costs R
Variable manufacturing costs 35
Direct labour 20
Direct material 20
External variable selling cost (This is not incremental as it 0
applies only to external sales.)
Total variable cost per unit 75
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Total incremental variable costs

= R75 × 4 000
= R300 000

Let us now calculate the opportunity costs. We first need to calculate the lost sales:
Units
Maximum capacity 20 000
External sales 17 000
Spare capacity 3 000
Internal transfer 4 000
Lost sales (4 000 − 3 000) 1 000
➤➤

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The opportunity cost is calculated as follows:

R
Selling price 120
Variable cost 75
External variable selling cost 20
Opportunity cost per unit 25

Total opportunity cost

= R25 × 1 000 units forfeited
= R25 000

Total transfer cost

= Incremental variable cost + Opportunity cost
= R300 000 + R25 000
= R325 000

Minimum transfer price per unit

R325 000
= ______________________________
   
   
4 000 units (total units to be transferred)
= R81.25

Test yourself 15.5

The Gas Company manufactures gas bottles for heaters and other gas appliances.
Division 1 (D1) manufactures the gas bottles, then transfers them to Division 2 (D2),
which adds the valve and regulator, and then sells the gas bottles to end customers.
Standard costs for the production of the two divisions are given in the following table.
Standard costs and selling prices by division
Division D1 D2
(R) (R)
Market price (External selling price) 80.50 168.00
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Variable production costs:

Bottle 42.00 42.00
Regulator and valve – 49.00
Variable selling costs 6.30 7.00

Production capacity (no. of units p.a.) 13 000 12 000

External demand (no. of units p.a.) 5 000 12 000

Required:
Determine the optimum transfer price for The Gas Company.

Cost and Management Accounting

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Resolving transfer pricing problems

No matter what method of determining transfer prices is used, there will almost inevitably
be disagreements between divisions, so that a dispute resolution process should be in place.
A fairly common method of resolving disputes while maintaining divisional autonomy
and target profitability is the ‘dual pricing’ method. In this method the supplier division
records one price (usually higher) in its accounting records, while the receiving division
records a different price (usually lower) in its records. The difference between the two prices,
multiplied by the quantity supplied, is charged to a head office account. While occasionally
disputes may require outside mediation, they are usually settled by head office intervention.
If the dual pricing solution is not used, the mediator will usually decide a ‘fair’ price that
gives both divisions an equitable share of profits from the product, while ensuring that
organisational targets are satisfied.

International transfer pricing

Many organisations have divisions in different countries and transfer prices must be set for
trade that occurs between these divisions. In general, the issues already discussed will apply
to multinational organisations, but there are other issues to be considered as well. One
of the most important of these issues is that of differing tax rates between countries. For
multinational organisations whose divisions trade internationally with each other, transfer
prices should be set to minimise the total tax liabilities of the organisation. This may mean
interfering with the autonomy of divisions to negotiate prices, necessitating adjustments
to divisional performance evaluation. The organisation would try to set its transfer prices
so that profits are lower in high-tax countries and higher in low-tax countries, while being
careful that its transfer pricing practices do not contravene tax laws in any of the countries.

Illustrative example 15.16

Home Company in country A sells a product to its subsidiary, Away Ltd, in country B.
The cost of the product to Home Company landed in country B is R100 per unit. Away
Ltd can sell the product for R200, incurring additional costs of R50 per unit. The tax
rate in country A is 40%, while in country B it is 30%.

Solution:
If Home Company has adequate profits from other products, and it is able to do so
under its tax regime, it should supply the product at no charge. This will reduce its tax
bill by 40% × R100 = R40 per unit. Away Ltd will incur tax of (200 − 50) × 30% = R45
per unit. The net tax liability will be 45 − 40 = R5 per unit.

Compare this with the situation if Home Company sold at its cost of R100. It would
incur zero tax, while Away Ltd would incur tax of (200 − 100 − 50) × 30% = R15. The net
tax liability would then be 0 + 15 = R15 per unit.

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An extreme situation such as that in the example of a company transferring product

at no cost (or even a very low cost) would be very unlikely to occur in practice, as most
countries have anti-dumping legislation, and usually require international transactions to
be conducted ‘at arm’s length’, that is, as if the companies were independent of each other.

Test yourself 15.6

(a) What is meant by the term ‘transfer price’, and why are transfer pricing systems
needed?
(b) Under what circumstances might a negotiated transfer price be more acceptable
than a market price?

Incentive schemes in South Africa

The separation of ownership (shareholding) and control (management) of an organisation
poses an agency problem where self-serving managers put their personal goals above that
of the organisation. These undesirable activities can be limited by establishing appropriate
incentives for the managers. An incentive scheme is a means to motivate employees to
be committed to the organisation, take a long-term view and act in the best interest of
shareholders. Unlike cash compensation, such as salaries and benefits, incentive schemes
may be dependent on the performance of the individuals or the company as a whole.
Incentives are closely related to performance management, but they also have an impact
on the type of people an organisation is able to attract and retain. Incentives schemes
should therefore be an important part of any organisation’s business strategy. Setting a
good incentive scheme is a sensitive exercise, because many factors need to be taken into
account. The goals that the organisation wants the employees to reach must be realistic and
within the control of the employee, otherwise employees would be discouraged, rather than
motivated to perform.
Apart from an annual bonus, which is usually paid in cash within a 12-month period and
represents a short-term incentive, the more important forms of long-term incentives are:
● Share option plans
● Restricted share schemes
● Phantom schemes (share appreciation rights)
Share purchase schemes
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● Deferred bonus schemes.

Share option plans

Share options are instruments granted to employees that carry a right, but not the
obligation, to buy a certain amount of shares in the company at a predetermined price
(termed the ‘strike’ or ‘offer’ price). Employees must typically wait for a specified vesting
period before being allowed to exercise the options, if the performance criteria have been
met. If the performance criteria are not met at a specified date, some or all of the options
might not vest.
If the company’s shares are trading at a price above that of the share option’s strike price
at vesting date, the options are said to be ‘in the money’ and the option holder, or employee,
may decide to exercise the option by buying the company’s shares at the strike price. If the

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employee wishes to cash out the value of the options, the option needs to be exercised and
the underlying share needs to be sold at the market price. The difference is the intrinsic
value of the option. Where the strike price is higher than the market price of the underlying
share, the option is said to be ‘out of the money’.
The actual value received from share options depend on the company’s share price
performance after the grant date, whether the employee remains with the company and the
employee’s risk preference affecting their incentive to exercise the options.

Restricted share schemes

Restricted share schemes (or performance shares) involve granting shares to employees once
performance and/or other criteria have been met. No consideration is generally payable by
the participants. Most share grant programmes in South Africa can be categorised into
two main types, namely forfeitable share plans (FSPs) and conditional share plans (CSPs).
Under a FSP all the rights to the shares are transferred to the employee on the date of
the grant. This means that the employee becomes entitled to vote, attend annual general
meetings and receive dividends. If the performance criteria attached to the shares are not
met or the employee’s employment is terminated by a specified date, the shares revert to the
company (forfeited by the employee).
When conditional shares are granted the employee does not become the owner of the
shares on the grant date and thus does not receive the rights attached to the shares. Some
CSPs, however, do allow the employee rights to receive dividends declared during the period
before the shares vest, but these dividends are only received along with the transfer of the
shares at the end of the performance period, and if the performance targets are reached. Any
dividends received under a FSP are taxed at the dividend tax rate of 15% in South Africa,
whereas dividends received under a CSP are taxed at the employee’s marginal tax rate.

Phantom share schemes (share appreciation rights)

Phantom share schemes (also referred to as share appreciation rights) track the share
price performance over a certain period and pay out the gains on the shares to employees.
The pay-out may be settled in cash or equity (by issuing shares in the company). Many
companies settle phantom shares with equity since it results in the lowest accounting cost
to the company and executives end up holding shares in the company, thereby aligning their
interests with that of the shareholders. The right to receive the gains on shares is normally
subject to the employee’s continued employment and may include certain performance
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requirements.

Share purchase schemes

Under these schemes the company often offers financial assistance to employees to purchase
the shares. The expense to the company is therefore limited to the interest on the loan. If
the share price subsequently drops, the employee still has to repay the full amount of the
loan. Even though this scheme is not that popular, some companies where founding family
members run the company may opt for this scheme since management is expected to take
the risk.

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Deferred bonus schemes

This type of scheme may have different variations, but mainly entails the executive’s bonus
to be declared upfront, tax to be paid and the remainder of the bonus to be converted into
shares that become available after certain performance criteria have been met, or after a
specific time period, or both. It may even become available immediately. If the agreed upon
performance criteria is not met during the specified period, the executive has to pay back all
or some of the bonus. This scheme eliminates the risk to the company and there is no tax
event for the executive after the upfront payment. The executive may therefore be motivated
to keep the shares instead of disposing of it.

Summary
Decentralisation or divisionalisation involves higher level management giving authority and
responsibility for certain aspects of an organisation’s operations to subordinates who are
held accountable for the results of these operations. The degree and type of decentralisation
differs among organisations, with some only using functional divisionalisation into cost
centres, while others have highly autonomous investment centres. Because decentralisation
results in a loss of some direct control by senior managers, an adequate system of
performance measurement and evaluation is required to ensure that the actions of divisional
managers are congruent with organisation goals. Where goods and services are transferred
between divisions, a system of transfer pricing is required that contributes to performance
measurement. Due to the separation of ownership and control in large organisations,
management need to implement incentives in such a way that the interest of management
is aligned with that of the shareholders.

Key concepts
Cost centre is a responsibility centre in which the manager is responsible only for costs.
Decentralisation means an organisation structure in which authority and responsibility
are given to subordinates for certain aspects of the organisation’s operations, and they
are held accountable for the results of these operations.
Economic value added (EVA) is net operating profit after tax, less cost of capital charge.
Net operating profit after tax (NOPAT) adds back accounting charges and non-cash
expenses to net profit and deducts economic depreciation. Cost of capital charge is a
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notional rate applied to economic capital employed.

Incentive scheme is a means to motivate employees to be committed to the organisation,
take a long-term view and act in the best interest of the shareholders.
Investment centre is a responsibility centre in which the manager is responsible for
investment in the centre as well as for its profitability.
Phantom share schemes (also referred to as share appreciation rights) track the
share price performance over a certain period and pays out the gains on the shares to
employees.
Profit centre is a responsibility centre in which the manager is responsible for the profits
earned by the centre. Their responsibility will include all revenue and direct costs of the
centre. ➤➤

Cost and Management Accounting

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Residual income (RI) is net profit earned by an investment centre, less imputed interest
on its capital employed.
Responsibility centre is a division of an organisation for which a manager has respon-
sibility to a limited extent.
Return on investment (ROI) is the percentage of net profit earned by an investment
centre to its capital employed.
Revenue centre is a responsibility centre in which the manager is responsible only for
sales and other revenue.
Share options are instruments granted to employees that carry a right, but not the
obligation, to buy a certain amount of shares in the company at a predetermined price
once vesting criteria have been met.
Transfer price is the price charged by one centre for goods or services provided to
another centre in the same organisation.

Test-yourself solutions
Test yourself 15.1
Decentralisation is a practice in which an organisation gives authority and responsibility to
subordinates for certain aspects of its operations and holds them accountable for the results
of these operations.

Test yourself 15.2

(a) In a cost centre, the manager has authority to incur, and is accountable only for the costs
incurred by the centre. In a profit centre, the manager has authority and is accountable
for revenue, costs and the resulting profits. In an investment centre the manager is
responsible for investment in the centre, as well as for revenue, costs and profit.
(b) Benefits that an organisation would hope to attain through decentralisation are to:
(i) Overcome the problems of managing a large organisation
(ii) Increase the motivation and performance of management, and provide training to
equip junior managers to become senior managers
(iii) Reduce head office bureaucracy that is often associated with large functionally
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divided organisations, and particularly to improve the speed and quality of decision
making
(iv) Achieve congruence between the goals of the organisation as a whole and those of
the individual divisions and managers
(v) Free top managers from day-to-day operational decisions and enable them to be
more involved with strategic decision making.

Test yourself 15.3

The return on capital employed can be determined as follows:
 R15 million
Annual depreciation on new equipment will be ________ years = R200 000
Annual net profit for investment will be R300 000 – R200 000 = R100 000
Total attributable profit = R1 150 000 + R100 000 = R1 250 000

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In the first year of operations, average capital employed will be (R3 000 000 + R3 000 000
− R250 000) ÷ 2 + [R1 000 000 + (R1 000 000 − R200 000)] ÷ 2 + R500 000 = R4 275 000
ROI with investment = 1 250 000 ÷ 4 275 000 x 100% = 29%
ROI without investment = 1 150 000 ÷ 3 375 000 = 34%
The manager would be unwilling to undertake the investment as his bonus in the first year
will only be R10 000 because the division will not achieve the target of 30%.
The ROI on the investment in the first year = 100 000 ÷ 900 000 = 11%
Average ROI over life of the investment = 100 000 ÷ (1 000 000 ÷ 2) = 20%

As the average ROI over the life of the investment exceeds the company’s required ROI, the
company would want the investment to be undertaken. If the company wants the manager
to undertake the investment, it would have to encourage him by revising the target ROI so
that he can earn at least the same bonus with the project as without.

Test yourself 15.4

(a) Residual income is the attributable net profit earned by an investment centre, less
imputed interest on its capital employed.
(b) Economic value added is net operating profit after tax, less a charge for cost of capital,
where net operating profit is determined by adding back accounting charges such as
depreciation, and deducting economic depreciation (opening minus closing market
value of assets).

Test yourself 15.5

Step 1: Calculate the contribution per unit for each division to determine which division will
add the most to the overall contribution of the organisation.

D1 contribution = R80.50 – R42.00 – R6.30 = R32.20 per unit

D2 contribution = R168.00 − R42.00 − R49.00 = R7.00 = R70.00 per unit

Overall contribution (and profit) will therefore be maximised if the gas bottles are transferred
to D2 instead of sold as is from D1. As a result, the organisation would want to set a transfer
that will encourage the transfer of 12 000 units from D1 to D2.

Step 2: Determine the minimum transfer price that will be acceptable to D1. For the first
8 000 units (spare capacity) the minimum transfer price is the variable cost per unit of R42.
For the additional 4 000 units required by D2 (12 000 − 8 000) the minimum transfer price
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is R42 (variable cost per unit) plus the opportunity cost (lost contribution) of R32.20 per
unit, which equals R74.20. An average minimum could be calculated as follows:
(8 000 × 42 + 4 000 × 74.20)
 _____________________
     
12 000
= R52.73

Step 3: Determine the maximum transfer price acceptable to D2. The net marginal revenue is
the selling price of R168 less variable costs specific to D2 (R49 + R7). The maximum transfer
price will therefore be R112 per unit.
A transfer price between R52.73 and R112 would be acceptable to both divisions at the
current sales volumes. The actual price could be settled by negotiation.

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Test yourself 15.6

(a) A transfer price is the price charged by one centre for goods or services provided to
another centre in the same organisation. A transfer pricing system is needed because it
determines the sharing of profit between two divisions and facilitates the valuation of
inventory at group level.
(b) In the absence of a clear market price for the product, a negotiated price would be
better. Both managers would have to have substantial autonomy to negotiate.

Review questions
15.1 How does decentralisation differ from divisionalisation?
15.2 What is a responsibility centre?
15.3 What is the difference between a profit centre and an investment centre?
15.4 Give three advantages of decentralisation.
15.5 Give three disadvantages of decentralisation.
15.6 What factors should be taken into account when implementing performance
measurement in a decentralised organisation?
15.7 Why should non-controllable costs be excluded from performance measurement?
15.8 How do you calculate return on capital employed?
15.9 What advantages does residual income have as a performance measure
compared to return on capital invested?
15.10 List the components of the balanced scorecard.
15.11 What guidelines should be followed in setting transfer prices?
15.12 What steps should be followed in setting transfer prices?
15.13 Explain what a share option plan is.
15.14 What is the difference between a restricted share scheme and a share purchase
scheme?
15.15 What are share appreciation rights?

20.2 20.1

Rm Rm
Revenue 608 520
Pre-tax accounting profit* 134 108
Taxation (46) (37)
Profit after tax 88 71
Dividends (29) (24)
Retained earnings 59 47

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Statement of financial position

20.2 20.1

Rm Rm
Non-current assets 250 192
Current assets 256 208
506 400

Shareholders’ funds 380 312

Medium- and long-term bank loans 126 8
506 400

*After deduction of the economic depreciation of the company’s non-current

assets. This is also the depreciation used for tax purposes.
Other information is as follows:
1. Capital employed at the end of 20X0 amounted to R350m.
2. HFSC had non-capitalised leases valued at R16m in each of the years 20X0
to 20X2. The leases are not subject to amortisation.
3. HFSC’s pre-tax cost of debt was estimated to be 9% in 20X0 and 10% in 20X2.
4. HFSC’s cost of equity was estimated to be 15% in 20X0 and 17% in 20X2.
5. The target capital structure is 70% equity and 30% debt.
6. The rate of taxation is 30% in both 20X0 and 20X2.
7. Economic depreciation amounted to R64m in 20X0 and R72m in 20X2.
These amounts were equal to the depreciation used for tax purposes and
the depreciation charged in the income statements.
8. Interest payable amounted to R6m in 20X0 and R8m in 20X2.
9. Other non-cash expenses amounted to R20m in 20X0 and R15m in 20X2.
10. Research and development expenditure on a new project started in 20X0.
R10 million was written off in 20X1 and R11 million in 20X2.

Source:CIMA (adapted)
15.2 Scooty Ltd manufactures electric scooters in two separate divisions. The motor
division manufactures the electric motor and transfers it to the scooter division.
The scooter division manufactures the rolling chassis and fits the electric
motor from the motor division before selling the complete scooter to the end
customers.
The motor division has an annual capacity to manufacture 5 000 units and the
scooter division can manufacture 4 000 per annum. There is an external demand
for 2 500 electric motors from the motor division and an external demand for
5 000 complete scooters from Scooty Ltd.

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The following information relates to the two divisions:

Motor division Scooter division
R R
External selling price per unit 8 700 21 750
Variable cost per unit: Motor 3 190 3 190
Variable cost per unit: Rolling chassis 12 325
Variable selling costs per unit 1 160 2 175
Contribution per unit 4 350 4 060

The variable selling costs of the motor division will be saved if an electric motor
is transferred to the scooter division.

Required:
(a) Calculate how many motors should be transferred to the scooter division.
(b) Calculate the range of transfer prices that will result in goal congruence
between the divisions and the organisation as a whole.
15.3 The chief executive officer of the company you work for is an engineer by
profession and does not have much financial knowledge. He wants you to
implement an additional incentive scheme for employees and wants to know
more about share option plans.

Required:
Write a one-page document in which you explain in detail to the CEO what a
share option scheme is. Write it in your own words in simple terms so that a
person with little experience in finance can understand it.
15.4 A company manufactures leather couches in two divisions. Division A
manufactures the frame and structure and transfers it to Division B at cost
plus a mark-up of 20%. The cost to Division A is R3 500 per unit. Division B
upholster the couches and sell them externally at a market price of R8 000
per unit after incurring additional variable costs of R2 000 per unit and selling
expenses of R500 per unit.
An extract from the company’s financial records is presented below:
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Division A Division B
R R
Sales 1 875 000 3 000 000
Variable costs 1 050 750 1 800 750
Controllable fixed costs 437 500 525 000
Allocated fixed costs from head office 212 500 345 000

Capital employed 1 650 000 3 457 500

The company has a weighted average cost of capital of 14%.

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Required:
(a) For each of the two divisions, calculate the following:
(i) The controllable operating margins
(ii) The net profit margins
(iii) Return on capital employed
(iv) Residual income.
(b) Calculate the transfer price.
(c) If the group uses market-based transfer pricing, calculate the maximum
transfer price.
15.5 Green Pride is a national chain of vegetarian restaurants, with 35 restaurants
in all major centres. Each restaurant is required to adhere to group standards
of quality, service and decor, but managers otherwise have a large degree of
autonomy. Although some buying, for example of equipment, can be done
nationally to achieve quantity savings, food supplies are almost all sourced
locally by individual restaurants. Restaurant performance is evaluated using
financial measures: gross profit margin, net profit margin and return on capital
employed. The managers are paid incentive bonuses based on their achievement
of targets set by head office for these measures. Many managers are unhappy
with the sole use of financial measures, as they feel there is conflict between
sustained good performance and achieving short-term profits. They are also
unhappy that profits include a share of group head office costs that they cannot
control.

Required:
(a) Explain why non-financial performance measures can be important in a
service industry such as restaurants, and recommend, with reasons, two
non-financial performance measures that could be used to evaluate the
performances of the restaurant managers.
(b) Explain why and how non-controllable costs should be included in the
profit calculations of the restaurants.
15.6 Argeedee Ltd has a number of operating divisions and a group head office. The
operating divisions are each headed up by a general manager who is responsible
for the day-to-day running of the division and can make investment decisions
for projects up to a cost of R1 million. Investments greater than that must
Copyright © 2021. Juta & Company, Limited. All rights reserved.

be authorised by the group chief executive, Dr R.G. Dlamini. All the divisions
trade externally as well as amongst themselves, with transfer prices being set by
head office.
The head office provides services such as human resources, security, IT, and
general accounting to all divisions. Actual head office costs are apportioned
monthly to divisions using bases which head office considers appropriate to
the type of cost. Bases used include sales value, number of employees, hours of
service used, capital invested, etc.
Divisional performance reports are prepared by head office every month, and
include divisional revenue and direct costs, together with apportioned head
office costs. These reports are used to evaluate divisional performance. The
divisional general managers are unhappy with the present reports and how they

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are used for performance appraisal. Dr Dlamini is considering changing the

performance reports to address some of the issues.

Required:
Explain, using examples from the scenario above, three issues that Dr Dlamini
should consider when designing a new divisional performance report.
15.7 Clockwork (Pty) Ltd is a divisionalised company that manufactures instrument
clusters for the automotive industry, which shows the speed, RPM, time, fuel
consumption, odometer and trip data, and more. Two divisions are involved
in manufacturing these instrument clusters: the Electronics division and the
Housing division.
Electronics division
The Electronics division manufactures the electronics that are fitted to the
instrument clusters in the Housing division. The Electronics division has the
capacity to manufacture 33 000 electronic modules per annum. External
demand for these modules is only 9 500 units. Financial information relating to
the production of the electronic modules in the Electronics division is as follows:
Per unit
(R)
Selling price per unit (9 500 units sold externally) 747.50
Variable production costs 299.00
Fixed production costs * 207.00
Net profit per unit 241.50

* Fixed costs per unit is based on total fixed costs of R6 831 000 divided by full
capacity of 33 000 units.
Housing division
The Housing division receives the electronic modules from the Electronics
division. These units are transferred at the full manufacturing cost per unit
(R506). The Housing division builds a stylish housing and installs the electronic
module inside. The complete instrument cluster is then sold to vehicle
manufacturers to attach to the vehicle dashboards. The external selling price
per instrument cluster is R1 196 per unit and annual demand is 27 000 units.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Financial information relating to the production of instrument clusters in the

Housing division is as follows:
Per panel
(R)
Selling price 1 196.00
Variable production costs (excluding transfer price) 437.00
Transfer price 506.00
Fixed production costs ** 41.40
Net profit per unit 211.60

** Fixed costs per unit are based on total fixed costs of R1 117 800 divided by
full capacity of 27 000 panels.

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Required:
(a) Determine the respective number of electronic modules and instrument
clusters that should be sold externally to optimise profits for the company.
Calculate the optimum profit to the company under this plan.
(b) Suggest a suitable transfer price (or range of transfer prices), based on
relevant costing principles, that will result in profit being maximised for the
company.
15.8 Best Brands Ltd is a diversified company in the food industry. It has a number
of production divisions which transfer all their products to the marketing
division for sale to external customers. All products are transferred at the
supplying division’s actual cost, plus a fixed percentage mark-up. Confectionery
is one of the production divisions. One of its products is Glossies, for which it
has determined the current actual cost to be R25 per pack. The mark-up for
confectionery is 20%.

Required:
(a) Explain the performance measurement problem that can arise using a
transfer price based on actual cost. Illustrate your answer with calculations
based on the confectionery example.
(b) Explain how this problem could be solved by using standard rather than
actual cost as the basis for the transfer price.
15.9 National Wholesale Ltd has trading operations in all the major centres of South
Africa. The group uses return on investment (ROI) as its main measure of
divisional performance. Divisional managers’ bonuses are based on the ROI of
their divisions. Bonuses on average make up 30 to 40% of a manager’s annual
earnings.
The managers of the Johannesburg and Durban divisions have earned increasing
bonuses over the past three years, as the ROI of their divisions has increased.
The group accountant has analysed the financial performances of these two
divisions by removing the effects of inflation on sales and costs. The data given
in the table below has been produced showing the inflation adjusted divisional
performances.

20X1 (R'000) 20X2 (R'000) 20X3 (R'000)

Johannesburg division
Sales 4 000 4 000 4 000
Cost of sales 2 400 2 450 2 420
Gross profit 1 600 1 550 1 580
Other operating costs 1 200 1 050 980
Operating profit before tax 400 500 600

Capital invested: Fixed assets 4 000 3 200 2 560

Current assets 400 400 400

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Durban division
Sales 3 000 3 200 3 300
Cost of sales 1 800 1 950 2 050
Gross profit 1 200 1 250 1 250
Other operating costs 1 050 900 776
Operating profit before tax 150 350 474

Capital invested: Fixed assets 3 600 2 880 2 304

Current assets 300 320 330

Other operating costs include depreciation at 20% on reducing balance of the

fixed assets at year-end. There were no additions or disposals in either division
during the period.
The Johannesburg manager is considering investing in a computerised stacking
and packing system in the warehouse. This would replace equipment that would
be disposed of at its net book value of R400 000 at the end of 20X3. The new
equipment would cost R1 million, with an expected life of 5 years, after which it
would be sold at book value. The equipment would be depreciated at 20% per
annum on reducing balance. Using this equipment would significantly reduce
labour costs in the warehouse, to the extent of reducing cost of sales by 8%.
Using projections based on the division’s current operating performance, the
group accountant has determined that the investment would have a positive net
present value of R282 900 at the group cost of capital of 8% and tax rate of 30%.

Required:
(a) Discuss and compare the performances of the Johannesburg and Durban
divisions over the three years.
(b) Discuss, with calculations, whether or not the Johannesburg manager
would be prepared to undertake the investment in new equipment. Ignore
taxation in your calculations.
(c) Show with calculations how the use of residual income instead of ROI
would have led to a goal-congruent decision by the Johannesburg manager.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

15.10 Snazzy Ltd manufactures and sells clothing and related accessories. The
company has seven manufacturing divisions, a retail division and a head office.
Head office is responsible for all financial decisions. Only the most basic
accounting records are kept at the branches while head office is responsible for
most accounting functions, as the branch accountants are not highly skilled.
The seven manufacturing divisions all supply the retail division and have no
other customers. Each manufacturing division is allowed to operate a factory
outlet from their premises. Faulty merchandise and production in excess of
the retail division’s requirements (overruns) are sold through these outlets. If
the manufacturing division has spare capacity, they will increase production
above the level requested by the retail division, and sell the surplus through the
factory shop, in order to keep workers busy and profits up. (Merchandise sold

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through the factory shops is usually sold at less than full cost.) On average,
95% of production is sold to the retail division and the rest through the factory
shops.
Snazzy Ltd’s transfer pricing policy is as follows: All goods are transferred from
the manufacturing divisions to the retail division at actual full cost.
Recently, one of the manufacturing divisions producing yoga pants is refusing
to fill all orders placed by the retail division. The division’s general manager
explained that he will only be able to produce and sell 12 000 pairs of yoga
pants for the retail division (who ordered 19 000 pairs for July). The reason
for this is that it is more profitable for the yoga pants division to sell the pants
through their factory shop (at full cost plus a profit margin of 8%), than to
supply to the retail division at cost.
The yoga pants division warned the retail division that they plan on doing their
own advertising, which should increase the demand at their factory shop. They
may even increase their prices to R210 per pair. Head office does not allow
manufacturing divisions to increase their capacity and as a result the manager
of the yoga pants division cannot help the retail division unless they offer
market prices for the yoga pants, in which case the yoga pants division will sell
to them first.
The following revenue, costs and other financial information regarding the
yoga pants division, are available:
Per yoga pants
Selling price (factory shop) R189
Variable costs R70
Fixed costs R105
Gross profit R14

Investment R28 000 000

8 000 pairs per month

The retail division can sell yoga pants for R420 per pair, once the pants have
been attractively packaged (at a cost of R35 per pair). Transport of pants
from the division’s premises to the retail outlets nationwide is R17.50 per
pair. Investment in assets in the retail division is minimal, as retail outlets are
situated in busy shopping malls and consequently are leased.
Manager’s bonuses are based on the difference between actual net profit and
budgeted net profit.

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Required:
(a) How much profit will Snazzy Ltd forego (lose out on) if the yoga pants
division chooses to sell the pants through their own factory shop, instead
of selling to the retail division?
(b) Based on relevant costing principles, what ranges of prices must the
transfer price fall into, to ensure maximum profit for Snazzy Ltd?
(c) Discuss, with reasons, whether the manufacturing divisions are cost
centres, profit centres or investment centres?
(d) Why do you think head office has a transfer pricing policy of actual full
cost?
15.11 Industrial Containers Ltd manufactures a variety of containers from various
types of metal, mainly aluminium and tinplate. The blanks for the containers
are punched from metal sheets in its Pressings department. Originally the
Pressings department operated as a cost centre within the company, but over
the years, to utilise excess capacity, it has sold products to outside firms as
well as supplying Industrial Containers Ltd’s requirements. As a result, two
years ago the department became an investment centre, the Pressings division,
within the company. The general manager of the division has authority to
incur new investments up to a limit of R10 million per annum, and he and his
senior staff are paid performance bonuses related to the division’s ROI. All new
investments are expected to earn at least 15% return before tax. In its first year of
operating autonomously, the Pressings division recorded ROI of 22% and 20%.
The divisional statement of comprehensive income for the Pressings division for
the most recent financial year is given in the table below.
R
Sales 35 000 000
Cost of goods sold 24 600 000
Gross margin 10 400 000
Administrative expenses 3 900 000
Selling expenses 3 700 000
Net profit before interest and tax 2 800 000
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Net operating assets of the division at the end of the financial year were
R14 million. The management of the Pressings division has recently rejected a
possible new investment requiring capital of R6 million, with an ROI of 18%
in the first year, because they are concerned that a further drop in ROI for the
division will lead to a reduction of their bonuses.

Required:
(a) Calculate the following performance ratios for the Pressings division for
the last financial year:
(i) Return on investment
(ii) Residual income.

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584

(b) If RI were used to measure management performance, explain whether or

not you think the Pressings division would be more likely to accept the
investment opportunity with a ROI of 18%.
(c) The management of Industrial Containers is considering changing the
performance measure for divisional managers to economic value added.
In the Pressings division’s statement of comprehensive income for the last
financial year, depreciation totalled R1 500 000, and there was a provision
for doubtful debts of R200 000. Management estimated that a fair value
of assets at the beginning of the year was R15 500 000, and at the end of
the year R14 400 000. The company would apply a notional capital charge
of 15%, and its tax rate is 30%. Calculate EVA for the last financial year and
comment on the result.
(d) Identify the items that the Pressings division must be free to control as
an investment centre if it is to be fairly evaluated by any of the above
performance measures.
15.12 The Heatwave division of Easy Appliances manufactures electrical heating
elements which it sells externally, as well as supplying other divisions in the
company for use as components in their products. Each division in the company
operates as an autonomous unit, with divisional managers having discretion
over pricing and other decisions. Each division is expected to generate a return
on its assets of at least 12%. Heatwave’s operating assets are given in the table.

Plant and equipment at net book value R1 250 000

Inventories 1 080 000
Accounts receivable 600 000
Cash 70 000
R3 000 000

The elements are sold externally for R40 each. Variable costs are R25 per
element, and fixed costs total R2 340 000 per year. The division’s annual
capacity is 200 000 elements.

each year for the division to obtain the required rate of return on its assets?
What is the net profit margin earned at this sales level? What is the asset
turnover ratio at this sales level?
(b) The Heatwave manager is considering two ways of increasing the ROI figure:
(i) Market research indicates that an increase in price to R42.50 per
element would result in sales of 160 000 units per year. The decrease
in units sold would allow the division to reduce its investment in assets
by R100 000, due to the lower level of inventories and debtors that
would be needed to support sales. Calculate the net margin, asset
turnover, and ROI, if these changes were made.

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(ii) The research also indicates that a reduction in price to R37.50 per
element would result in sales of 200 000 units per year. This would
require an increase in assets of R100 000. Calculate the net margin,
asset turnover, and ROI if these changes were made.
(c) Refer to the original data. Assume that the normal volume of external
sales is 180 000 elements per year at R40 each. The Cookers division of
Easy Appliances currently imports 20 000 elements per year at R32.50 per
element. The Heatwave manager refuses to meet this price on the grounds
that it would result in a loss of R4.20 per element for his division, calculated
as given in the table below.

Selling price R32.50

Total cost price per element 36.70
Variable cost 25.00
Fixed cost (R2 340 000 ÷ 200 000) 11.70
Loss per element (4.20)

If Heatwave sold 20 000 elements per year to Cookers, it would increase

total assets carried by Heatwave by R250 000. Would you recommend that
Heatwave meet the R32.50 price and sell 20 000 elements per period to
Cookers? Support your answer with ROI calculations.

Reference list
Bussin, M. 2011. The Remuneration Handbook for Africa. Randburg, South Africa: Knowres
Publishing.
Crotty, A. & Bonorchis, R. 2006. Executive Pay in South Africa. Who Gets What and Why. Cape
Town, South Africa: Double Storey Books.
Jensen, M.C. & Meckling, W.H. 1976. Theory of the firm: Managerial behavior, agency costs
and ownership structure. Journal of Economics, Vol. 3(4): 305–360.
Kaplan, R.S. & Norton, D.P. 1992. Putting the balanced scorecard to work. Harvard Business
Review. Available: www.hbr.org. (Accessed 20 January 2021).
Copyright © 2021. Juta & Company, Limited. All rights reserved.

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16 Inventory management

Reasons for
holding inventory

Economic
Relevant order quantity Modern Just-in-time
cost (EOQ) techniques (JIT)

Ordering Key
Holding costs Benefits Evaluation
costs elements

Formula Tabulation Graphical Quantity Reorder Safety

method method method discounts level inventory

Materials Enterprise SAP (which stands

Materials Enterprise
requirement resource for systems, Electronic
requirement resource
planning planning applications and commerce
planning II planning II
(MRP) (ERP) products in data (e-commerce)
(MRP II) (ERP II)
systems systems processing)

After studying this chapter, you should be able to:

● Discuss why organisations need to hold inventory
● Justify the costs that are relevant and which should be included to calculate the
economic order quantity (EOQ)
● Use the EOQ formula to calculate ordering cost and determine the optimum order
quantity and reorder point for inventory items
● Calculate the optimum safety inventory when demand is uncertain
● Determine whether an organisation should purchase larger quantities in order to
take advantage of quantity discounts
● Describe the ‘always better control’ (ABC) classification method for inventory
● Describe how e-commerce, SAP, materials requirement planning (MRP) and
enterprise resource planning (ERP) systems can enhance supply chain management
➤➤

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● Recognise the value of close relationships with suppliers

● Use activity-based techniques to analyse supplier costs
● Explain how supplier relationships can be evaluated from the perspective of the
supplier and the organisation
● Discuss the philosophy underlying just-in-time (JIT), as well as the key features of JIT
● Explain JIT purchasing and manufacturing
● Determine the relevant costs and benefits of JIT purchasing and production
● Describe measures to evaluate JIT production performance.

Introduction
All organisations hold some form of goods in store. This is called inventory. Some
organisations have perhaps only stationery in store, while others may hold vast amounts of
raw material for production or finished goods ready for sale. It is important that inventory
levels are managed well, because the organisation will lose money if it runs out of inventory
at a critical time, or if inventory gets damaged or stolen. The list of things that can go
wrong in keeping inventory is endless. This chapter will look at the principles for managing
inventory levels in an organisation, and also introduce various methods that can be applied
to make the process easier.

Why companies hold inventory

Inventory refers to all the products or components of products that an organisation keeps
on hand in order to supply the production department or directly supply customers in a
retail environment. There are three main reasons why companies find it necessary to hold
inventory on hand, namely:
1. Inventory for transactions: Some inventory needs to be kept on hand in order to fulfil
the demand of the production department and customers.
2. Inventory for precaution: An extra amount of inventory may be kept on hand in case
there are future shortages, or in case demand increases unexpectedly. This only applies
when future demand is uncertain.
3. Inventory for speculation: In uncertain economic circumstances, some companies
speculate on the future price of inventory and hold more inventory on hand in case
prices rise.
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Relevant cost of inventory policies

Under circumstances where the demand for a product can be reasonably estimated, the
relevant cost that should be considered when determining the optimal stock levels consists
of holding and ordering costs.
Holding costs are costs that are incurred in the practice of holding inventory on hand
and usually include the following costs:
● Capital costs: the investment in inventory
● Service costs: insurance, physical handling and taxes
● Storage space costs: rented warehouse charges and cost of using own space
● Risk costs: obsolescence, damage, shrinkage and relocation.

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When trying to determine the holding cost of inventory, only those items that will be
affected by changes in inventory levels should be included in the calculation. These costs
can also be referred to as the incremental costs. Those costs that will not be affected by
changes in inventory levels are not relevant. The following example illustrates how holding
costs are calculated.

Illustrative example 16.1

ZZ Ltd needs to determine the cost of holding inventory. The purchasing manager was
able to supply you with the following information about inventory in the previous year:
Table 16.1 Inventory-related costs
R
Storage 800 000
Handling 400 000
Obsolescence 600 000
Damage 800 000
Administrative 600 000
Losses due to pilferage 200 000

The warehouse always holds inventory of an average value of R17 000 000. If the
company has additional money available, it is usually invested in the short term at a
rate of 15%. The company pays an insurance premium equal to 5% of the value of every
item of inventory held. Taxes amount to 8% per unit.

Required:
Calculate the cost of holding inventory.

Storage 800 000

Handling 400 000
Obsolescence 600 000
Damage 800 000
Administrative 600 000
Losses due to pilferage 200 000
Total 3 400 000

➤➤

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Step 2: Divide inventory costs by the average inventory to derive the basic cost to hold
inventory:
R3 400 000
__________
R17 000 000 = 20%
Step 3: Add up:
Table 16.3 Add up
Opportunity cost of capital 15%
Insurance 5%
Taxes 8%
28%

Step 4: Add the percentages:

20% + 28% = 48%

It therefore costs ZZ Ltd 48% of the value of a unit of inventory to keep it in storage for
a year.

Ordering costs refer to the costs of obtaining stock, and include costs incurred from the
time the purchase order is processed until the goods are received and paid for. The following
are examples of ordering costs:
● Clerical costs associated with the purchasing department and goods receiving
department
● Transportation costs
● For internally manufactured goods, the costs include set-up costs, costs of placing the
work order, and costs of placing the purchase order and receiving the stock in order to
produce the required inventory item.

As in the case of holding costs, only those incremental costs of ordering inventory are
relevant in any decision about holding inventory. Ordering costs can be calculated as all
costs related to the inventory item. There are two components of an order cost. The first is
the fixed order cost, which is the amount of money paid when you place an order, regardless
of the number of units ordered. An example is the fee for placing an order, or the shipment
Copyright © 2021. Juta & Company, Limited. All rights reserved.

cost when it does not make any difference whether 1 unit or 100 units are ordered. The
other component is the variable order cost, which is a cost per unit of order. This depends
on the type of item and the costs that are perhaps associated with selling it. For example,
in the case of buying a car, there is the additional cost of registering it. The actual cost
of the inventory itself is not relevant, since it will be incurred regardless of whether the
inventory is being held in storage or used directly upon receipt. The cost of the inventory is
only relevant where quantity discounts on bulk buying of inventory are available. (Quantity
discounts will be discussed in a separate section in the chapter.) In circumstances where
demand cannot be estimated accurately, the relevant cost of an inventory policy should also
include stock-out costs. These are costs associated with running out of stock.

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They include the following:

● Lost contribution through lost sales caused by stock-out
● Future lost orders if customers switch to alternative suppliers
● Loss of customers’ goodwill
● Cost of production stoppages – if business runs out of an item used in manufacturing,
it may cause interruptions in the production process, resulting in idle time, stockpiling
and possibly missed orders
● Costs of placing emergency orders to avoid stock-out.

The economic order quantity

The objective of good inventory management is to determine the optimal reorder level (how
many items left in inventory when the next order is placed) and the optimal reorder quantity
(how many items to order when placing the order). The optimum number of units of a
product or components of a product to order at one time is dependent on the holding cost
of a unit, and the ordering cost of an order. The optimum order quantity can be calculated
using any one of the following methods:
● A formula known as the economic order quantity (EOQ), which is the optimum
quantity of units of a product or components of a product to order at one time that will
result in the organisation incurring the lowest amount of holding and ordering costs
● Tabulating the total relevant costs for various order quantities and choosing the order
quantity with the lowest total relevant costs
● A graphical representation whereby the optimum order quantity is depicted by the
intersection of the ordering cost curve and the holding cost curve.

Formula method
The formula for EOQ is:
____________________________
   √
2 × Annual demand × Cost per order
EOQ = ___________________________
   
Holding cost per unit
_____
√ 2 DO
=  _____
H  

Illustrative example 16.2

Jamison (Pty) Ltd manufactures a single product and purchases one of its raw materials
from an outside supplier. The material costs R18 per unit, and the organisation requires
20 000 units per year. The holding costs of the product amount to R2 per unit and the
ordering cost is R50 per order.
Required:
Calculate the EOQ.

Solution:
______________
√
  2 × 20 000
______________
EOQ = ________
  
   R2
× R50
 
= √________
  2 000
R2
000
 
= 1 000 units ➤➤

Inventory management

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It is therefore most cost beneficial for the organisation to order 1 000 units at a time.
This will result in the lowest possible ordering cost and holding cost being incurred,
while keeping sufficient inventory on hand to satisfy demand.

Test yourself 16.1

Designs For You sells designer wear. The organisation buys 3 000 of a certain type of
shirt per year from its one supplier. The shirts cost the organisation R100 each. The
holding cost amounts to R5 per shirt and it costs R30 to place an order.

Required:
Calculate the EOQ for the shirts.

Sometimes organisations prefer to account also for the fact that inventory in the storeroom
means less cash available for daily transactions. In such a case the organisation will include
in the holding cost per unit an imputed interest charge as shown in the equation below.
This increases the holding cost per unit and thus reduces the number of inventory items
that should be held in storage.
___________________________________ _______

√
EOQ 5     
 
   
    
2 × Annual demand × Cost per order
___________________________________
Holding cost + (Purchase price × Cost of capital)
2DO
  = _______ √
H + (P × i)
 

Illustrative example 16.3

Hayfer (Pty) Ltd is a supplier of powertools. One of its products, the hammer drill is
selling at R5 900. The company sells on average approximately 25 hammer drills per
week. Sales take place evenly throughout the year, which consists of 52 weeks. The
company purchases the hammer drills at a cost of R3 500 each. The cost to place
an order amounts to R310 and orders are executed within 5 weeks. Direct inventory
holding costs are R35 per unit and insurance on the hammer drills amounts to 10%
of the unit cost per year. The company implemented the economic order quantity type
to manage its inventory. The current required after-tax cost return on capital is 4% per
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annum.

Required:
Calculate the EOQ.

Solution:_______________________________
EOQ 5     √
    
   
R35
2 × (25 × 52) × R310
______________________________
+ (R3 500 × 10%) + (R3 500 × 4%)  
_______
√ 806 000
5  _______
R525  
5 39.18
≈ 40 units
➤➤

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The additional R140 (R3 500 × 4%) represents the cost incurred by the company if they
invest in inventory rather than earn interest on the cash in the bank. Insurance on the
hammer drills is part of inventory holding costs and should therefore be included in the
denominator. Also take note that the number of units have been rounded up to ensure that annual
demand will be met.

Test yourself 16.2

Use the same information as provided in Test yourself 16.1, but assume additionally
that the company’s cost of capital is 10%. Use this information to calculate the EOQ.

Tabulation method
In the tabulation method, different order sizes are considered in order to find the most
cost-efficient one. Using the same information from Illustrative example 16.2, the table
below illustrates the tabulation method.
Table 16.4 Illustration of the tabulation method
Order quantity in 1 100 200 400 600 800 1 000 1 200
units
Average inventory 2 50 100 200 300 400 500 600
in units
Number of 3 200 100 50 33 25 20 17
purchase orders
Annual holding 4 R100 R200 R400 R600 R800 R1 000 R1 200
costs
Annual ordering 5 R10 000 R5 000 R2 500 R1 667 R1 250 R1 000 R833
costs
Total relevant cost R10 100 R5 200 R2 900 R2 267 R2 050 R2 000 R2 033
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Notes:
1. This is a random selection of order quantities that can be used.
2. If there is no inventory when an order is received and units are used at a constant rate,
average inventory is half of the quantity ordered.
3. Determined by dividing the total annual demand by the order quantity.
4. Determined by multiplying average inventory by the holding cost per unit.
5. Determined by multiplying the cost per order with the number of purchase orders.

From the table it can be seen that the optimum number of units is 1 000 (where the total
relevant cost is at its lowest), the same as the answer derived from the EOQ formula.

Inventory management

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Graphical method
The information as provided in the example for the tabulation method (Table 16.1) can be
presented in a graph.

R12 000

R10 000
Annual cost (R)

R8 000
Annual holding costs

R6 000 Annual ordering costs

Total relevant cost

R4 000

R2 000

R0
100 200 400 600 800 1 000 1 200
Number of units

Figure 16.1 Illustration of the graphical method to manage inventory

The vertical axis represents the annual cost for investment in inventory, and the horizontal
axis is used to represent the order quantity. The graph gives lines for the total holding costs
and the total ordering costs, as well as the total cost.
The optimum quantity is the place where the total cost is the least and where the two
lines for the holding cost and the ordering cost cross each other. It shows that this optimum
is still 1 000 units, as was the result from the formula and the tabulation methods.

Other calculations and concepts related to the EOQ

In addition to knowing how many units to purchase per order, it is also important to know
when a new order should be placed to ensure that there is no shortage of inventory at any
time and to ensure that the new order is on time. This is called the reorder point and is
determined by means of an equation. The reorder point is calculated as:
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Reorder point = Average usage rate in days/weeks × Lead time in days/weeks

The lead time refers to the time period (days/weeks) it takes for an order to arrive at its
destination.

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Illustrative example 16.4

Using the same information from the example of Jamison (Pty) Ltd in Illustrative
example 16.2, it is determined that the supplier takes five days to deliver an order to the
organisation.

Required:
Calculate the reorder point.

Solution:
The reorder point can be calculated as follows:
Reorder point = Average daily usage rate x Lead time in days
  20365
= ______ 000
× 5 = 273.97 units

This means that the organisation needs to place a new order for inventory when there
are 274 units left in the storeroom. This will ensure that the new inventory is on time and
that the organisation will not run out of inventory.

In some cases, an organisation may feel the need to keep a level of safety inventory on hand.
A safety inventory is a number of extra units that the organisation prefers to keep on hand
over and above the required level as determined by demand. This is in case there is a delay
in delivery, or some other reason which causes the organisation to run out of inventory.
When the inventory level reaches the reorder point, an order is placed. During the lead
time, the remaining inventory in stock will be depleted at a constant demand rate, such
that the order quantity placed will arrive at exactly the same moment as the inventory level
reaches zero. Realistically, demand and lead time are uncertain and it might be such that
the inventory level might be depleted at a slower or faster rate during lead time. A stock-out
occurs when demand exceeds the available inventory in stock. As a hedge against stock-outs
when demand is uncertain, a safety stock of inventory is frequently added to the expected
demand during lead time. Increasing the reorder point with the safety stock will ensure that
the purchasing manager is warned well in advance when a new order needs to be placed.
Including a safety inventory in the equation for the reorder point will change the equation
as follows:
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Reorder point = (Average usage rate in days/weeks × Lead time in days/weeks) + Safety inventory

Illustrative example 16.5

Using the information from the example of Jamison (Pty) Ltd in Illustrative example 16.2,
it is determined that the supplier takes five days to deliver an order to the organisation,
and that the organisation prefers to keep a safety inventory of 50 units on hand.

Required:
Calculate the reorder point.
➤➤

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Solution:
The recorder point can be calculated as follows:
Reorder point = (Average daily usage rate × Lead time in days) + Safety inventory
20 000
Reorder point = ( ______
365 × 5) + 50 = 323.97 units
The calculation shows that the organisation needs to place a new order for inventory
when there are 324 units left in the storeroom. This will ensure that the new inventory is
on time and that the organisation will not run out of inventory.

Test yourself 16.3

Using the same information from the Designs For You exercise in Test yourself 16.1, it
is established that the organisation prefers to keep a safety inventory of five shirts, and
that the supplier takes 15 days to deliver an order.

Required:
Calculate the reorder point for the shirts.

Uncertainty and safety inventory

Inventory decisions are mostly made on the basis of estimations, which in turn are based
on assumptions. As was previously explained, in order to compensate for uncertainty,
organisations sometimes keep a safety inventory on hand. The problem is to find the
optimum amount of safety inventory to keep on hand. The decision whether to hold a
safety inventory rests on the result of an analysis of the cost to hold additional items of
inventory, versus the cost of running out of inventory at a critical time in production.
The cost of running out of inventory is an opportunity cost and is difficult to establish.
Sensitivity analysis can be used to determine estimated costs associated with running out of
inventory. Another way is to determine the lost contribution from a failure to meet demand.
After this opportunity cost has been established, the cost of running out of inventory can be
established at different levels of demand, with probabilities attached to different demand
levels. Probability distributions for future demand can be used to calculate the expected
amounts for various levels of safety inventory.
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The following example will explain the concept.

Illustrative example 16.6

Satey (Pty) Ltd gives the expected usage for an item in its inventory over a week lead
time, with probabilities attached, in the table below.
Table 16.5 Usage for an item over a week lead time, with probabilities
Usage (units) 700 1 000 1 400 1 500 1 700 1 800
Probability 0.1 0.05 0.4 0.25 0.15 0.05

The lead time is known with certainty and currently no safety inventory is held.
➤➤

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Required:
Prepare a probability analysis to determine the most cost-beneficial amount of safety
inventory the organisation should hold.

Solution:
From the expected usage and the probabilities, the expected average usage is 1 400
units as shown in the following table:
Table 16.6 The expected average usage calculation
Usage (units) 700 1 000 1 400 1 500 1 700 1 800
Probability 0.10 0.05 0.40 0.25 0.15 0.05
Probability in units (units x probability) 70 50 560 375 255 90
Expected usage in units (sum of 1 400
probability in units)

Since the lead time is certain, it means the reorder level is also 1 400 units (average
usage during the lead time, as is determined by the reorder level equation). But, should
usage increase to 1 800 units, there will be a shortage of inventory of 400 units. The
probability of this happening is 5%. If the cost of running out of inventory is estimated
at R10 per unit and the cost of holding inventory is R2 per unit, the expected cost of
running out of inventory, holding cost and total cost for various levels of safety inventory
can be established.
Table 16.7 Costs for various levels of safety inventory
Average Reorder Safety Inventory Proba- Proba- Cost of Holding Total cost
usage point inventory shortage bility bility running cost (R2
(units) (units) (units) (units) (units) out of per unit)
inventory
(R10 per
unit)
(B – A) (D × E) (F × R10) (C × R2) (G + H)
1 400 1 800 400 0 0.05 0 R0 R800 R800

1 400 1 700 300 100 0.05 5 R50 R600 R650

1 400 1 500 100 300 0.05 15 R150 R200

200 0.15 30 R300
R450 R650

1 400 1 400 0 400 0.05 20 R200 R0

300 0.15 45 R450
100 0.25 25 R250
R900 R900
A B C D E F G H I

➤➤

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From the table one can see that the total cost is lowest when a safety inventory of 100
or 300 units is held. Therefore, a reorder level of 1 500 or 1 700 units will have to be set.
If demand is expected to change for a period, the exercise will have to be repeated, and
the safety inventory adjusted accordingly.

Some organisations may prefer not to use quantitative measures to determine the level of
safety inventory. In such a case, a maximum probability of running out of inventory can be
established, and a safety inventory held accordingly.

Quantity discounts and other factors

In many cases, suppliers are willing to offer discounts when large numbers are ordered. This
is called a quantity discount and the savings that can arise from it include the following:
● Saving in the purchase price
● Reduction in the ordering cost because fewer orders are placed in bigger batches.

A quantity discount must be considered in conjunction with the fact that holding costs will
increase when more inventory is held. To determine if it is worthwhile to take a quantity
discount, the benefits must outweigh the costs.

Illustrative example 16.7

Brockle (Pty) Ltd purchases materials for production from a supplier at R14 per unit.
Annual demand for the material is 18 000 units per year. The holding cost is R8 per unit
and the ordering cost R100 per order. The supplier offers a quantity discount of 5% if
an order is larger than 2 000 units. Should the organisation order in batches of 2 000
units or rather stay with its EOQ?

5 √  2 × 18 000 × R100

_______________
    R8  

5 670.82

≈ 671 units

Note that one rounds the answer to the higher full number. An organisation will not
manufacture 0.82 units, and rounding up to the next full unit would ensure there is
sufficient to meet the annual demand. Round the answer first before continuing with
the calculation.
➤➤

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Next, the saving that can be made from ordering 2 000 units at a time can be calculated.
Table 16.8 Calculating savings

Saving in the purchase price (18 000 units × R14 x 5%) R12 600
18 000 18 000
Saving in ordering cost [( ______ ______
671 = 27* orders) − ( 2 000 R1 800
= 9 orders)] × R100
[(2 000 − 671) × R8]
Less: Increased holding cost _______________
    2 R5 316
Net savings R9 084

* Number of orders was rounded up as rounding down would imply that there would
be a shortage of annual demand.

Table 16.9 Alternative presentation

EOQ Special offer
(R) (R)
Inventory unit cost
18 000 × R14 252 000
18 000 × R14 × 0.95 239 400
Ordering cost (Number of orders × Cost per order)
  18
______ 000
2 000 = 9 orders × R100 900
  18671
______ 000
= 27 orders × R100 2 700
Holding cost (Average stock × Total stockholding cost per unit)
  2 000
_____
2 × R8 8 000
___ 671
  2 × R8 2 684
Total relevant cost 257 384 248 300
Net savings in favour of the special offer is R9 084

In the example of Brockle (Pty) Ltd, it is clear that the benefit of the saving outweighs
the cost, and therefore the decision should be to take the quantity discount and order
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in batches of 2 000 units.

Test yourself 16.4

Beads R Us orders mixed beads for retail from a single supplier. The beads cost R50 per
kilogram. The annual demand for beads is 50 000 kg. The holding cost is R2 per kg and
the ordering cost R40 per order. The supplier offers a quantity discount of 2% if an order
is larger than 2 500 kg.

Required:
Should the organisation order in batches of 2 500 kg or rather stay with its EOQ?

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Other factors to consider when deciding on ordering quantity

As with all decisions that have to be made in an organisation, there are various qualitative
factors that also need to be taken into account when considering inventory levels. There
may be others, but the most common considerations are listed here:
● Shortage of future supplies: Supplies may not be available because of a strike or a
natural disaster. In anticipation of something like that, an organisation may want to
over-order while the inventory items are readily available.
● Future price increases: If a future increase in price is announced, an organisation may
want to order extra inventory in order to take advantage of the current price.
● Obsolescence: Some types of inventory become obsolete quicker than others, for
example technology. In such a case it is not a good idea to keep too much inventory on
hand, since the inventory may have to be sold at reduced prices or be written off.
● Steps to reduce safety inventory: If a supplier is found that is able to deliver in a
shorter period of time, the amount of safety inventory may be reduced in order to reduce
holding costs.
● Performance reporting: It is important to consider the measures on which managers
are being evaluated. Managers tend to concentrate only on those factors that they are
being measured on. If holding costs are not part of a manager’s performance evaluation,
he may not make sufficient effort to reduce the cost of holding inventory.

Assumptions underlying the economic order quantity

The following assumptions are made when using the EOQ model:
● Ordering cost is constant
● Rate of demand is known and spread evenly throughout the year
● Lead time is fixed
● Purchase price of the item is constant, that is, no discount is available
● Replenishment is made instantaneously and the whole batch is delivered at once
● Only one product is involved.

Classification of inventory to keep control

In order to keep better control of inventory, the ABC inventory classification system
was developed. In some cases, it is also known as selective inventory control. The ABC
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inventory classification system stands for ‘always better control’, as it classifies inventory
according to its impact on the total cost of inventory.
Under the ABC inventory classification system, the items categorised as A-items require
strict control and high-quality record keeping. B-items require less strict control and good
record keeping, while C-items require the least amount of control and minimal record
keeping. Therefore:
● A-items are very important in an organisation and due to their high value, they need to
be analysed frequently. In addition, it may be necessary to consider different production
methods (for example just-in-time – which will be discussed later in the chapter) to
avoid too much of this type of inventory within an organisation.
● B-items are important, but less so than A-items, and more so than C-items.

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● C-items are considered to be only marginally important. It is important to remember

that the ABC inventory classification system has nothing to do with activity-based
costing and should not be confused with or linked with it.

Table 16.10 Example inventory classification list from a computer manufacturer

Item description Classification Remarks
Battery pack B class Normal procedures
Cabinet/Case B class Normal procedures
Disk drives A class Normal storage/Access control required
Hard disk/Storage A class Kept under high value storage/Asset tracking/Access control required
media
Keyboard B class Normal procedures
Memory chips A class Kept under high value storage/Asset tracking/Access control required
Monitor A class Normal storage/Access control required
Mouse B class Normal procedures
Power cord C class Minimal procedures
Processor chips A class Kept under high value storage/Asset tracking/Access control required
Screws & nuts C class Minimal procedures
Software license A class Kept under high value storage/Asset tracking/Access control required
Starter assembly C class Minimal procedures
pack – instructions
Stickers C class Minimal procedures
Training manuals C class Minimal procedures

Planning for materials requirements

There are numerous ways in which an organisation can plan its production schedule and,
through that, its material requirements. These days, such systems are connected over
internal networks or intranets, so that the whole supply chain over many suppliers can be
managed as one. Some of the systems that are used for such planning include the following:
● Materials requirement planning (MRP) systems
● Enterprise resource planning (ERP) systems
● SAP
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● E-commerce.

These systems will be discussed separately in the following sections.

Materials requirement planning systems

The previous methods of inventory management that were discussed are very useful for
small to medium-sized organisations. However, in large and complex organisations
computerised systems are often used to coordinate materials acquisition and production.
The first system to fulfil this task was a computerised system created in the 1960s called
materials requirement planning (MRP). MRP estimates the levels of production
necessary to fulfil demand as well as the timing of production, and thus determines the
requirements for production materials. This means that materials can be ordered as and

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when required. A significant benefit of an MRP system is that, if any change is necessary
to the manufacturing schedule, a new production can be prepared in a very short time,
together with the new purchase and work orders. A benefit of MRP is that it should
reduce inventory levels by avoiding the production of items that are not required in the
foreseeable future.
An MRP system involves the following components:
● A master production schedule as a starting point to specify the demand and the timing
for finished goods
● A bill of materials file that specifies the materials that are needed to produce the goods
as per the master production schedule
● A master parts file that specifies when the materials for production need to be purchased
and/or internally produced
● An inventory file for the items that are kept on hand and that are already scheduled for
production.

The EOQ model can be used together with MRP to determine the optimal order sizes that
will fulfil the demand, while at the same time minimising ordering and holding costs. In
later years, MRP was expanded to include other resources as well. Known as MRP II, it
includes planning for labour and capacity scheduling together with the original system of
materials planning. The original MRP system is now known as MRP I.

Enterprise resource planning systems

Enterprise resource planning (ERP) was developed in the 1990s to integrate both the
internal and the external management functions of an entire organisation, including
finance, manufacturing, sales, service, customer relationships and any other relevant
internal function. ERP facilitates a constant information flow through all parts of an
organisation and also manages connections to external stakeholders.
ERP systems usually make use of computer hardware, software, and internal network
links. A database is usually part of the system to hold all the information in a centralised
and accessible storage space.
ERP systems normally include the following features:
● A system that operates in real time in an integrated way throughout an organisation so
that periodic updates are unnecessary
● A database of information to support all applications
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● A consistent appearance for all parts to create the feel of a single interface
● A single installation without the need to integrate data.

At first, ERP systems focused on those functions that do not affect customers, but later
the so-called ‘front-office functions’ were integrated in order to create a single platform
across the whole organisation. This integration added functions like customer relationship
management and supplier relationship management.
ERP II was developed in the 2000s. It is a basic ERP system with the inclusion of web-
based software to provide employees and external partners (suppliers and customers)
with real-time access to an organisation’s internal systems. ERP II facilitates a constant
information flow to all parts of an organisation and also manages connections to
external stakeholders.

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SAP
SAP (which stands for systems, applications and products in data processing) is a company
that was founded in 1972 in Germany. SAP is a market leader in enterprise application
software. Their best-known products include enterprise resource planning applications,
SAP BusinessObjects software, and more recently also the Sybase mobile products and in
memory computing appliance.
Modern technology developments moved ERP in the direction of software and web-
based business activities. This aims to increase organisations’ adaptability, flexibility,
openness, and efficiency in a global and highly competitive business environment. The
systems developed by SAP help small to medium companies with solutions so that they do
not have to develop them in-house at great expense. Systems can be customised for certain
environments so that they suit the needs of each organisation. The focus of SAP falls mainly
on six types of industries: process (energy and natural resources); discrete; consumer; service;
financial services; and public services. But, in addition, it also offers more than 25 packages
for large organisations and more than 550 packages for small to medium organisations.
Note that there are other software packages available that fulfil the same function.

E-commerce
Electronic commerce (e-commerce) is a changing force in the way organisations do
business. It refers to products and services bought over the internet and other computer-
based networks. Some of the functions that e-commerce fulfils include internet marketing,
automated data collection methods, online transaction processing (OTP), supply chain
management, electronic data interchange (EDI), electronic funds transfer (EFT) and
inventory management. E-commerce has made it possible for an organisation to link with
both suppliers and customers throughout a product’s value chain. This is sometimes
referred to as B2B (business-to-business). For suppliers, this means electronic purchasing
and procurements, supplier management and inventory management. For customers, it
means electronic inquiries, ordering, payments and support. All this is made possible with
electronic data interchange (EDI) across the different networks of suppliers and customers.
All the systems mentioned in this section have the ability to enhance the value of the supply
chain. It makes linkages with suppliers and customers easier and faster, meaning the
possibility of higher volumes of business and better service delivery. As customer value is
enhanced, shareholder value will also improve.
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Managing suppliers
The materials, components and finished goods that an organisation purchases make
up a large proportion of its cost and investment and can therefore make or break an
organisation’s chance of success. It is therefore important to choose suppliers carefully and
also manage the ongoing relationships with suppliers to ensure quality service.

The value of close relationships with suppliers

If relationships with suppliers are managed carefully, it can lead to cost savings, which is
especially important if cost leadership is the focus of an organisation. If there is a good
standing relationship, it may also mean better quality goods and services and better lead
times in production, which is the goal of an organisation with a differentiation focus.
In some cases, organisations go as far as establishing strategic alliances with suppliers.

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This implies that there is a cooperation agreement between the organisation and its
supplier, which involves the sharing of resources and information to benefit all parties.
It can also include joint product development, outsourcing certain functions together,
working together to implement quality programmes in the organisations of suppliers, and
sometimes even joint constructions.

Using activity-based techniques to analyse supplier costs

Selecting the best suppliers is important for any organisation, and the cost considerations
associated with suppliers should form a part of the selection process. Traditional costing
systems do not provide a detailed evaluation of the cost involved in using a supplier. There
are other different types of costs to consider, some of which were already mentioned earlier
in the chapter. The costs of a supplier include:
● Cost of purchasing inventory: costs such as ordering, delivery, receiving and inspection
● Cost of holding inventory: carrying costs such as storage, insurance and obsolescence
● Cost of poor-quality inventory: costs such as rework, scrap, returning defective goods
and downtime
● Cost of inventory delivery failure: costs caused by late or no delivery of goods, as
well as the downtime and lost contribution that result from late delivery or a failure
to deliver.

Some of these costs are hidden in the total cost of inventory and need to be analysed to
determine whether a specific supplier is the best one for the organisation. Activity-based
costing can be used to calculate a more accurate figure for the cost caused by using one supplier
instead of another. Suppliers are dealt with as cost drivers, and the cost of all supplier-related
activities are allocated to suppliers. The following example illustrates the process better.

Illustrative example 16.8

Cooking (Pty) Ltd manufactures stoves and orders the stove knobs from two different
suppliers. Supplier 1 charges R15 per knob, while Supplier 2 charges R17.50. For that
reason, Supplier 1 is used most often, and Supplier 2 is only used when there is a peak
in demand or a problem with delivery from Supplier 1. In the past financial period,
Cooking (Pty) Ltd purchased 15 000 knobs from Supplier 1, and 5 000 from Supplier 2.
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The major activities that drive the costs associated with suppliers are given in the table below.
Table 16.11 Major activities that drive the costs associated with suppliers
Activity Cost per activity driver Number of activities
Supplier 1 Supplier 2
Placing an order R900 per order 16 2
Receiving an order R500 per delivery 25 4
Inspection of the order R200 per delivery 25 4
Storage of inventory R50 per unit per year 1 000 150
Rework and downtime R600 per unit reworked 25 3
due to poor-quality goods
Cost of late deliveries R750 per late delivery 8 2

➤➤

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Required:
Calculate the cost per unit ordered from each supplier, based on the information given.

Solution:
The following table shows the costs associated per supplier, based on activities per-
formed and caused by each supplier.

Table 16.12 Costs associated per supplier, based on activities performed

Supplier 1 Supplier 2
Number of units 15 000 5 000
Purchase cost R225 000 R87 500
R R
Supplier activity costs:
Placing an order 14 400 1 800
Receiving an order 12 500 2 000
Inspection of the order 5 000 800
Storage of inventory 50 000 7 500
Rework and downtime due to poor-quality goods 15 000 1 800
Cost of late deliveries 6 000 1 500
Total cost 327 900 102 900

Cost per unit 21.86 20.58

Even though the difference is small, it is clear that Supplier 2 causes a lower cost per unit
than Supplier 1, even though the cost per unit of Supplier 1 is lower than that of Supplier
2. This proves that it is not sufficient to observe the effect of purchase cost alone; the
other costs that are associated with a supplier must also be considered.

Evaluating supplier relationships from the perspective of the supplier and

the organisation
Using the cost per supplier can be used to evaluate supplier performance, but there is
another way in which suppliers can be evaluated, namely by using the supplier performance
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index. The supplier performance index (SPI) calculates a ratio of supplier cost to the
total purchase price. Therefore:

SPI = Total supplier activity costs ÷ Total purchase price

The lower the value of the SPI, the higher the value of the supplier.

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Illustrative example 16.9

Use the same information from the example of Cooking (Pty) Ltd in Illustrative example
16.8 to calculate the SPI of Supplier 1 and Supplier 2.

Solution:
Table 16.13 SPI for Suppliers 1 and 2
Supplier 1 Supplier 2
R327 900 R102 900
SPISupplier 1 = ________
 R225 000 = 1.46 SPISupplier 2 =  ________
R87 000 = 1.18

This calculation confirms that using Supplier 2 is more cost-beneficial than using
Supplier 1.

However, there are some other criteria that can be used to evaluate suppliers and on which
to base the choice of supplier. They are, amongst others:
● Delivery: on-time delivery and lead time for deliveries
● Quality: number of orders that are rejected and the achievement of quality certification
● Cost: the ability to drive costs down and achieve manufacturing cost reductions
● Organisational change: the ability to adapt to change in the industry
● Relationship: supplier satisfaction surveys, number of disputes and days of downtime
due to industrial action.

Organisations also need to evaluate their own performance with regard to suppliers, and
need to assess, amongst others:
● Number of suppliers that are approved
● Number of new suppliers that are contacted
● Number of new innovations
● Response time to supplier queries
● Information provided to suppliers on time
● Number of orders that are processed electronically
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● Reductions in the number of suppliers

● Number of expedited orders.

Just-in-time systems
Just-in-time systems are dealt with in Chapter 7, but will also be covered from an inventory
management viewpoint. The philosophy behind just-in-time (JIT) systems is simple: cost
of holding inventory does not add value to the organisation, and is therefore considered to
be a waste. A JIT inventory system focuses on the various costs of keeping inventory. It is
unfortunately not a simple solution for organisations to implement, because it involves a
selection of new methods to manage the system. JIT inventory defines inventory and how it
relates to management.

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JIT is a production strategy that aims to improve an organisation’s return on investment by

reducing waste, which mostly refers to inventory and its associated costs. The JIT method is
sometimes also referred to as the Toyota production system, since it was initially developed
and implemented by the Toyota Corporation in Japan. To meet the objectives of JIT, signals
(or kanban) are used between the different steps in the production process. These signals
tell when it is time to manufacture the next part. If it is used correctly, JIT ensures that the
process and products continuously improve and it can improve the return on investment,
quality, and efficiency of an organisation. Continuous improvement relies on improvements
in flow, employee involvement and quality. In JIT, inventory is believed to be pure cost (or
waste) in an organisation, instead of the traditional view of inventory adding value and
being an investment. JIT encourages organisations to attempt to eliminate the holding
of inventory and to constantly improve processes so that it requires fewer inventories. JIT
simply focuses on having the right material, at the right time, at the right place and in the
exact amount without having the safety of inventory.

The elements of just-in-time systems

There are a number of changes to be implemented in an organisation that wishes to benefit
from a JIT inventory system. The elements of implementing a JIT inventory system include
the following:
● Continuous improvement by eliminating everything that is not value adding to a
product or service
● Putting systems in place in order to identify problems
● Striving for systems that are simpler and easier to understand, as well as easier to manage
and less likely to fail
● A product-oriented layout that requires less time that needs to be spent on moving
inventory around
● Quality control at the source so that each worker is responsible for the quality of their
own output
● Tools and methods that are ‘foolproof’ in order to prevent mistakes
● Regular maintenance to ensure that all equipment functions as it should when it is
required
● Eliminating waste, for example from overproduction, waiting time, transportation,
excess processing, inventory, motion and product defects
Cleanliness and proper organisation of the work area
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● Reducing set-up times to increase flexibility and to allow for smaller batches, ideally
only one item
● Employing or training a workforce that is multiskilled and has greater productivity and
flexibility
● Kanbans that ‘pull’ products and components through the process instead of ‘pushing’
them through
● Implementing machinery that has autonomous capability and can use judgement so
that workers can do more important things than just stand around watching machines
work
● So-called ‘trouble lights’ that can signal potential problems to initiate corrective action.

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Case study: Should an organisation implement EOQ or JIT?

This question depends on many factors. A few of those are the type of organisation, the
type of business it conducts, the type of product it sells, its cash position, its risk profile,
etc. Most important is that different policies should apply to different components/
products. As circumstances change, it may be necessary to revise these policies on a
regular basis. But let us look at an example that is more familiar. A family of four will
necessarily implement different ‘inventory’ strategies to different household items.
Maria’s mom may go to a hypermarket once every few months to buy in bulk the cleaning
materials and toiletries for the house. As soon as she sees that the dishwashing liquid
and Danny’s deodorant becomes low, she knows she needs to go to the shops again.
The reason why she can do this is because these items generally have a longer expiration
period and can thus be stored in the cupboard under the bathroom basin for months on
end. In effect, Maria’s mom is applying an EOQ system based on the amount of space
she has, the fact that she can save by buying in bulk, and because the items will not
spoil. Maria’s family insists on drinking only fresh milk from the local dairy – they refuse
to drink long-life milk. Maria’s mom cannot implement an EOQ strategy with fresh milk.
Apart from the apparent difficulty to store 50 litres of milk in the refrigerator, it is most
likely that the milk will spoil before it is finished. Therefore, it is best for Maria’s mom
to buy milk on a JIT basis as soon as she sees it is finished or if she needs it for a recipe.
Different purchasing strategies are therefore needed for different items.

Discussion question:
Think of your own household, whether you stay on your own, in a hostel, with friends
or still with your parents. What products do you use and what inventory system do you
subconsciously apply in your purchasing strategy?

The benefits of just-in-time inventory systems

The financial benefits of JIT include the following:
● Lower investment in inventory
● Reduced carrying cost of inventory
● Reduced risk of obsolescence
● Lower investment in space for inventory and production
Reduced set-up and total manufacturing costs
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● Reduced cost of wastage and spoilage as a result of improved quality

● Higher revenue as a result of being able to respond faster to customer needs
● Reduced paperwork.

Other benefits include the following:

● The flow of supplies improves, as small amounts of inventory reduce delays, which
simplifies the flow of inventory and inventory management
● Multiskilled employees are used more efficiently as they can be moved to where they can
be best applied
● Production scheduling and labour hour usage can be synchronised with demand
● An increased emphasis on supplier relationships to ensure that there are no bottlenecks
due to inventory not being available

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● Supplies are moved to production at regular intervals throughout a day as they are
synchronised with production demand, and the optimal amount of inventory is on hand
at any time. In an ideal situation, material, components or products move directly from
the delivery vehicle to the factory floor, which reduces the need for storage facilities.

Evaluating just-in-time production performance

There are many ways in which the performance of a JIT system can be evaluated. Each
organisation has to design its own performance measurement criteria. However, the
following list gives an idea of measures that can be put into place:
● Personal observation
● Financial performance measures and variances
● Non-financial performance measures, such as time and quality.

Personal observations and the various measurements that can be observed in terms of time
and quality are the most important, because they tend to be the most timely and easy to
understand measures. Quick feedback that can be understood by everyone is the most
meaningful and can be implemented faster to solve problems.

Summary
Because inventory is such an important part of any organisation, it is necessary to manage it
carefully. Over the years a number of inventory management systems have been developed.
Probably the most well-known is the economic order quantity (EOQ), which enables an
organisation to order the correct amount of inventory that will minimise ordering and
holding costs. Together with the EOQ, one can calculate the reorder quantity to establish
when a new order needs to be placed. In organisations that work with large amounts of
inventory, it may be difficult to implement a basic method such as the EOQ. For that
reason, other systems have been developed, including the following:
● Materials requirement planning (MRP) systems
● Materials requirement planning II (MRP II)
● Enterprise resource planning (ERP) systems
● Enterprise resource planning II (ERP II)
● SAP (which stands for systems, applications and products in data processing)
● Electronic commerce (e-commerce).
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Another modern view promotes the practice of not keeping any inventory at all. This is
called just-in-time (JIT), where inventory is ordered and delivered ‘just in time’ for use in a
factory or for sale to customers.

Key concepts
ABC inventory classification system stands for ‘always better control’ and classifies
inventory according to its impact on the total cost of inventory to an organisation (also
known as selective inventory control).
➤➤

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A-items are those inventory items that are very important in an organisation and, due
to their high value, they need to be analysed frequently. In addition, it may be necessary
to consider different production methods (for example just-in-time) to avoid too much
of this type of inventory within an organisation.
B-items are those inventory items that are important, but less so than A-items, and
more so than C-items.
Business-to-business (B2B) means e-commerce is taking place between an organisation
and its suppliers and customers, making use of electronic data interchange (EDI).
C-items are inventory items that are considered to be only marginally important.
Economic order quantity (EOQ) is the optimum quantity of units of a product or
components of a product to order at one time, which will result in an organisation
incurring the lowest amount of holding and ordering costs.
Electronic commerce (e-commerce) are products and services bought over the internet
and other computer-based networks. Some of the functions that e-commerce fulfils
include internet marketing, automated data collection methods, online transaction
processing (OTP), supply chain management, electronic data interchange (EDI),
electronic funds transfer (EFT), and inventory management.
Enterprise resource planning (ERP) is a system that integrates both the internal
and the external management functions of an entire organisation, including finance,
manufacturing, sales, service, customer relationships and any other relevant internal
functions. ERP facilitates a constant information flow through all parts of an
organisation, and also manages connections to external stakeholders.
Enterprise resource planning II (ERP II) is a system that integrates the internal and
the external management functions across an entire organisation, including finance,
manufacturing, sales, service, customer relationships, and any other relevant internal
functions. ERP facilitates a constant information flow to all parts of an organisation,
and also manages connections to external stakeholders. It includes web-based software
that allows both employees and external partners, like suppliers and customers, realtime
access to an organisation’s systems.
Holding costs are those costs that are incurred in the practice of holding inventory on hand.
Inventory is all the products or components of products that an organisation keeps on
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hand in order to service the production department or customers.

Inventory for precaution is an extra amount of inventory that is kept on hand in case
there are future shortages, or if demand should increase unexpectedly.
Inventory for speculation means that in uncertain economic circumstances, some
companies speculate on the future price of inventory and hold more inventory in case
prices rise.
Inventory for transactions means that some inventory needs to be kept on hand to fulfil
the demand from the production department and customers.
Just-in-time (JIT) is a production strategy that aims to improve an organisation’s return on
investment by reducing waste, which mostly refers to inventory and its associated costs.
➤➤

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Materials requirement planning (MRP) is a computerised system that coordinates the

planning that is needed for materials acquisition and production to ensure that demand
is met.
Materials requirement planning II (MRP II) is a computerised system that coordinates
the planning that is needed for materials acquisition and production, as well as labour
and capacity scheduling to ensure that demand is met. This system follows on the
original MRP system, which is now known as MRP I.
Ordering costs refer to those costs that are incurred when a purchase order is processed,
deliveries are received and invoices paid. As in the case of holding costs, only those
incremental costs of ordering inventory are relevant in any decision about holding
inventory.
Quantity discount may be offered by suppliers when large numbers are ordered. This
leads to cost savings in the form of a lower purchase price and a reduction in the ordering
cost, because fewer orders are placed in bigger batches.
Reorder point refers to the number of units left in inventory when a new order needs
to be placed to ensure that the new order is received in time to avoid a situation where
there is a lack of inventory.
Safety inventory refers to a number of extra units that an organisation prefers to keep
on hand over and above the required level as determined by demand. This is in case
there is a delay in delivery, or other reasons for the organisation to run out of inventory.
SAP is the market leader in software applications for organisations. The company’s
best-known products include an enterprise resource planning programme, SAP
BusinessObjects software, and most recently the Sybase mobile product software for
in-memory computing appliance.
Strategic alliance refers to a cooperation agreement between an organisation and its
supplier, which involves the sharing of resources and information to benefit all parties.
It can also include joint product development, outsourcing certain functions together,
working together to implement quality programmes in the organisations of suppliers,
and sometimes even joint constructions.
Supplier performance index (SPI) calculates a ratio of supplier cost to the total purchase
prices.
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Test-yourself solutions
Test yourself 16.1
_____________
√_______
  2  
× 3 000 × R30
EOQ = _____________
R5  

= √ _______
  1805000  
= 189.74
= 190 units

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Test yourself 16.2

________________
  
R5√2 × 3 000 × R30
EOQ = _______________
    
  + (R100 × 0.10)  
_______
√ 180 000
=  _______
R15  
= 109.54
= 110 units

Test yourself 16.3

Reorder point = (Average daily usage rate × Lead time in days) + Safety inventory
3 000
Reorder point = ( _____
365 × 15) + 5 = 128.29 ≈ 129 units
When there are 129 units left on hand, the organisation needs to place a new order.

Test yourself 16.4

First of all, it is necessary to calculate the EOQ for the organisation.
______________
EOQ =   
  √________
  2 × 50 000
______________
R2
× R40
 

= √________
  4 0002 000  
= 1 414.21
= 1 415 kg

Next, we need to calculate the saving that can be made from ordering 2 500 kg at a time:

Saving in the purchase price: (50 000 kg × R50 × 2%) R50 000

( 50 000
Saving in ordering cost:  ______
2 500 )
× R40 – ( ______
  1 415 × R40 )
50 000
R613*

Increased holding cost: (   )  × R2

2 500 2 1 415
___________
  2
(R1 085)

Net savings R49 528

It is clear that the benefit of the saving outweighs the cost, and therefore the decision should
be to take the quantity discount and order in batches of 2 500 kg.

Review questions
16.1 Why do organisations need to hold inventory?
16.2 Which costs are relevant when it comes to inventory management and should
be included to calculate the economic order quantity (EOQ)?
16.3 How does one determine whether an organisation should purchase larger
quantities in order to take advantage of quantity discounts?
16.4 What is meant by an ABC classification method for inventory?

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16.5 How can e-commerce, SAP, materials requirement planning (MRP), and
enterprise resource planning (ERP) systems enhance supply chain management?
16.6 Why is it important to have close relationships with suppliers?
16.7 How can activity-based techniques be applied to analyse supplier costs?
16.8 How can supplier relationships be evaluated from the perspective of the
supplier and the organisation?
16.9 What does just-in-time (JIT) mean?
16.10 What are the key features of JIT?
16.11 What is meant by JIT purchasing and manufacturing?
16.12 What are the relevant costs and benefits of JIT purchasing and production?
16.13 Which measures can be used to evaluate JIT production performance?

Exercises
16.1 Ray’s Ltd is a prosperous wholesaler in sporting equipment. The company
usually has a lead time of six days. On average, 20 tennis rackets are sold per
working day. The management accountant has determined that the cost of
being out of stock amounts to R25.00, and the annual carrying cost per racket
is R2.00. He further determined that actual consumption during the order time
has assumed the following pattern.
Consumption of rackets Number of times
100 5
110 20
120 50
130 15
140 10

Required:
(a) Calculate the optimal safety stock which will minimise the total additional
carrying and ordering cost on an annual basis.
(b) With the rising cost of electricity and the current load shedding in South
Africa, Candle Ltd has diversified into retailing gas lamps. The gas lamps
cost R50 each. The annual demand for these lamps is 50 000 units. The
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holding cost is R2 per unit and the ordering cost R40 per order. Gasprom,
the supplier of the lamps, offers a quantity discount of 2% if an order is
larger than 2 500 units. Should the organisation order in batches of 2 500
units or rather stay with its EOQ?
(c) Explain in your own words what enterprise resource planning (ERP) is, also
mentioning new developments that have improved ERP.
(d) Explain the ABC inventory system, specifically mentioning the difference
between A-, B-, and C-type inventory items. Supplement your answer with
examples of A-, B-, and C-type inventory items from a store or supermarket
with which you are familiar.
16.2 A large furniture manufacturer uses 60 000 boxes of nails per year, which it
orders from a supplier. It costs R3.00 to keep one box of nails in inventory for
one month, and it costs R25.00 to place an order. A box of nails costs R150.00.

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(a) What is the EOQ?

(b) What is the significance of the EOQ?
(c) What is the total annual expense of ordering the EOQ every time?
(d) How many orders will be placed per year?
(e) What is the total annual expense of ordering 600 boxes of nails every time?
How much is saved per year by ordering the EOQ?
16.3 The CEO of Nexti (Pty) Ltd thinks that the company may be holding too much
inventory. You are required to investigate. You were given the information in the
table below.
Inventory item Purchase price Administration Demand in % holding cost
per unit (R) cost per order (R) units per year per year
A 150 25 16 000 10
B 600 80 4 000 20

The company makes use of an EOQ inventory policy.

Required:
(a) Calculate the number of orders that the company would place in a year for
item A.
(b) Calculate the annual holding cost for item B.
(c) Nexti (Pty) Ltd also manufactures genuine leather belts for men and
women. The belt buckles are imported from Spain. The company needs
50 000 buckles per year. The company operates for 260 days per year. The
following information relates to the buckles:
Ordering cost R300
Purchase price R75 per buckle
Required rate of return after tax 10%
Tax rate 28%
Safety inventory 100 buckles
Lead time 25 days

Direct inventory holding costs per buckle amount to R10.

The Spanish company offered Nexti (Pty) Ltd a discount of 10% if they
agree to place 20 orders per year. Nexti (Pty) Ltd has very little storage
space. In order to take the discount and place 20 orders per year, the
company will need to rent additional space at R500 per month.

Required:
Determine whether Nexti (Pty) Ltd should accept the special offer.
16.4 The SeCa Computer Co. Ltd requires 2 400 units per annum of a certain component
for its manufacturing process. Over the past year it was found that while the average
usage of these components was 200 units per month, demand fluctuated between
190 and 220 units. Each component costs SeCa Computer Co. Ltd R10, and the
supplier requires one week from the time of receiving the order to delivering the
goods. The cost of each order is R30, and the holding cost is R2.50 per unit.

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The CEO of the company read about just-in-time (JIT) in a business journal.
He wants to implement an inventory plan that requires less storage space and
wants to know more about JIT.

Required:
(a) Calculate the EOQ.
(b) Calculate the total cost of buying and carrying the components each year.
(c) Assuming a normal level of safety stock is held, what is the reorder point?
(d) Write a one-page document in which you explain in detail to the CEO what
JIT entails. Write it in your own words in simple terms so that a person not
familiar with the terms can understand your information.
16.5 Idnom (Pty) Ltd manufactures pressed wood lengths. The company’s budgeted
production for the year 20X2 requires that 28 000 tonnes of pressed wood be
manufactured.
The production process is as follows:
● Wood is the main material input for the manufacturing of pressed wood.
● The wood is purchased in a stack of wood which is 1.20 metres wide, 1.20
metres high and 2.40 metres long. Its approximate weight is 2.25 tonnes.
This is referred to as a ‘cord’.
● The wood is stripped of its bark and then made into chips, which are used
to manufacture the pressed wood.
Recent cost records for the production of pressed wood showed the information
given in the table below:
Period Wood processed (cords) Pressed wood produced
(tonnes)
Third term 20X0 2.628 5.616
Fourth term 20X0 3.260 6.930
First term 20X1 3.510 7.443
Second term 20X1 3.387 7.218
Third term 20X1 3.374 7.173

and clerical costs to place an order, plus R20.50 to process the supplier’s invoice.
The company estimates its cost of capital at 16% per annum. The estimated
cost to forklift a cord of wood from the supplier’s trucks and to place it into
stock is R55.00 per cord.
The plant is in operation for 260 days per year. The lead time to receive an order
of wood after the order has been placed is 12 days.
It costs R152.00 per cord to take the wood out of stock and to put it into
production.

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Required:
(a) Determine the standard quantity of wood required in order to manufacture
a tonne of pressed wood.
(b) Determine the optimal stock ordering policy for wood, which should be
implemented for the year 20X2 by using the economic order quantity model.
(c) Calculate the total ordering costs as well as the stock carrying costs for the
year 20X2, should the optimal ordering policy be implemented.
16.6 The Clothes Store (Pty) Ltd sells clothing items imported from China and Japan.
The shop is open from Monday to Saturday each week of the year.
The following information relates to ladies’ jackets:
Purchase price R230
Order costs R150
Lead time 14 days
Cost of capital (after tax) 22%
Direct stockholding costs R30
Number of jackets sold per year 1 040
The current rate of inflation is 9% per annum, and the tax rate is 28%.

Required:
(a) Calculate the economic order quantity for the jackets.
(b) Calculate the reorder point for the jackets if 35 are kept as safety stock.
16.7 BB manufactures a range of electronic products. The supplier of component Y
has informed BB that it will offer a quantity discount of 1% if BB places an order
of 10 000 components or more at any one time. Details of component Y are
as follows:
Cost per component before discount R2
Annual purchases 150 000 components
Ordering costs R360 per order
Holding costs R3 per component per annum

component Y, using the economic order quantity and ignoring the quantity
discount.
(b) Calculate whether there is a financial benefit to BB from increasing the order
size to 10 000 components in order to qualify for the 1% quantity discount.
Source: CIMA (adapted)
16.8 PR currently uses a constant flow production system to manufacture components
for the motor industry. The demand from the motor industry is higher in certain
months of the year and lower in others. PR holds inventory so that it can supply
the components as they are demanded. Increasingly, the costs to PR of holding
inventory are having a significant effect on its profits and the management of
PR are considering changing the production system to one that operates on a
just-in-time (JIT) basis.

Cost and Management Accounting

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Required:
(a) Explain the concepts of a JIT production system.
(b) Give two reasons why the profit of PR may not increase as a result of changing
to a JIT production system.
(c) Explain why a backflush cost accounting system may be considered more
appropriate than a traditional cost accounting system in a company that
operates a JIT production and purchasing system.
Source: CIMA (adapted)
16.9 A medium-sized manufacturing company, which operates in the electronics
industry, has employed a firm of consultants to carry out a review of the
company’s planning and control systems. The company presently uses a
traditional incremental budgeting system, and the inventory management
system is based on economic order quantities (EOQ) and reorder levels. The
company’s normal production patterns have changed significantly over the
previous few years as a result of increasing demand for customised products.
This has resulted in shorter production runs and difficulties with production
and resource planning.
The consultants have recommended the implementation of activity-based
budgeting and a manufacturing resource planning system to improve planning
and resource management.
The company uses 50 000 units of material per annum to service a steady
demand for its products. Order costs are R100 per order and holding costs are
R0.40 per order.

Required:
(a) Explain how a manufacturing resource planning system would improve the
planning of purchases and production for the company.
(b) Determine the optimal order quantity.
(c) The supplier now offers a quantity discount of R0.02 per unit if the company
buys in batches of 10 000 units. Should the company take advantage of the
quantity discount?
Source: CIMA (adapted)
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16.10 Emerald (Pty) Ltd is a supplier of kitchen accessories. The organisation is in

the process of reviewing its inventory stockholding policy. Kitchen sinks, one
of the major stock items, are acquired from suppliers at a price of R350 each.
The organisation requires 8% return on capital invested in inventory. Direct
inventory holding costs amount to R24 per sink per year.
Based on the above information, an annual demand of 2 392 sinks, and an
ordering cost of R23 per order, the accountant of the organisation has calculated
the economic order quantity for sinks to be 46 units. Safety stock should amount
to the sales requirement of three working days, assuming that the enterprise
trades for 312 days per year. The lead time for delivery of sinks is six working
days. There is no seasonal fluctuation in the demand for sinks. The organisation
has been approached by another supplier, offering a price of R345 per sink,

Inventory management

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provided that orders are placed in batches of at least 100 units each. In such
a case, however, additional storage space would be required, costing R700 per
month. The lead time for delivery would remain six working days.

Required:
(a) Advise the accountant of Emerald (Pty) Ltd whether the offer to purchase
sinks at R345 each should be accepted.
(b) Determine the reorder point for sinks.
16.11 AZ (Pty) Ltd provides a variety of cricket sporting equipment to the national
cricket team. One of its most popular products, the GM Bat, has a monthly
demand of 7 500 units. The enterprise obtains this product directly from a
factory in China at a price of R100 each. The cost of placing an order for this
product is for the account of the customer and amounts to R60 per order. The
holding cost per unit per annum, excluding the cost of capital, is 10% of the
purchase price.
Cost of capital 16% per annum after taxation
Rate of inflation 12% per annum
Lead time for execution of orders 5 days
Safety stock 1 000 units
Trading days per annum 300 days

The table below gives an estimated probability distribution for the usage of the
raw materials used for the manufacture of GM Bat for the month:
Usage (units) 4 500 4 750 5 000 5 250 5 500 5 750 6 000 6 250
Probability 0.09 0.15 0.1 0.25 0.15 0.12 0.09 0.05

A stock-out will cost the company R25 per unit, and the average monthly
holding cost per unit of the raw material is R2.50.

Required:
(a) Calculate the EOQ and reorder point for the GM Bat.
(b) Calculate the optimum safety inventory for the raw materials.
(c) Determine the probability of the company running out of stock of the raw
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materials.
16.12 Ms Lewis is a wholesaler who buys and sells a wide range of products, one of
which is the Patricia. Ms Lewis sells 240 000 units of the Patricia each year
at a unit price of R220. Sales of the Patricia normally follow an even pattern
throughout the year, but to protect herself against possible deviations,
Ms Lewis keeps a minimum stock of 10 000 units. Further supplies of the
Patricia are ordered whenever stock falls to this minimum level. The delay
between ordering and delivery is small enough to be ignored.
At present, Ms Lewis buys all her supplies of Patricias from May Ltd, and usually
purchases them in batches of 50 000 units. Her most recent invoice from May
Ltd was as given in the following table.

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R
Basic price: 50 000 Patricias at R150 per unit 7 500 000
Delivery charge: Transport at R0.50 per unit 25 000
Fixed shipment charge per order 10 000
7 535 000

In addition, Ms Lewis estimates that each order she places costs her R5 000,
consisting of administrative costs and the cost of sample checks. This cost does
not vary with the size of the order.
Ms Lewis stores Patricias in a warehouse which she rents on a long lease for
R5 per square metre per year. Warehouse space available exceeds current
requirements and, as the lease cannot be cancelled, spare capacity is sublet on
annual contracts at R4 per square metre per year. Each unit of Patricia in stock
requires two square metres of space. Ms Lewis estimates that other holding
costs amount to R100 per Patricia per year.
Ms Lewis has recently learnt that another supplier of Patricias, Van Jaarsveld
Ltd, is willing, unlike May Ltd, to offer discounts on large orders. Van Jaarsveld
Ltd sells Patricias at the prices given in the following table.
Order size Price per unit (R)
1229 999 150.25
30 000249 999 140.50
50 000 and over 140.25

In other respects (that is, delivery charges, and the time between ordering and
delivery), Van Jaarsveld Ltd’s terms are identical to those of May Ltd.

Required:
(a) Calculate the EOQ for Patricias and the associated yearly profit that Ms
Lewis can expect from their purchase and sale (assuming she continues to
buy from May Ltd).
(b) Prepare calculations to show whether Ms Lewis should buy Patricias from
Van Jaarsveld Ltd rather than from May Ltd and, if so, in what batch sizes.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

(c) Explain to Ms Lewis how implementing JIT would impact on the processes
she applies in her business and on the cost of inventory.
(d) Explain to Ms Lewis how implementing TQM would impact on cost in her
organisation.

Inventory management

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17 Environmental
management accounting
and other developments
Corporate Environmental Environmental Greenhouse
Environmental
social management impact of the Social auditing gas (GHG)
costs
responsibility accounting (EMA) supply chain inventory

Sustainability
in South
Africa The quality Environmental
cost activity-based
framework accounting

Financially Physically
Benefits of Implementing The impact The impact
oriented oriented
EMA EMA of suppliers of customers
EMA EMA

Learning objectives
After studying this chapter, you should be able to:
● Explain what corporate social responsibility is and why organisations need to take
cognisance of it
● Explain sustainable accounting and management
● Explain triple bottom line reporting and how it gives a better perspective of
performance than conventional accounting practice
● Explain what integrated reporting is and how it differs from sustainability reporting
● Define and describe environmental management accounting (EMA)
● List and describe the techniques that can be used in EMA
● Explain the benefits that can be derived from measuring and reporting on the
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environmental and social impact of an organisation

● Explain the difficulties in measuring and reporting on the environmental and social
impact of an organisation
● Define environmental costs and list the five parts of environmental costs
● Differentiate between prevention, appraisal, internal failure and external failure
● Analyse costs according to the categories of prevention cost, appraisal cost,
internal failure cost and external failure cost
● Evaluate the effects of environmental and social factors that apply to suppliers and
customers
● Describe and apply measures that can be used to assess social and environmental
performance in organisations
● Define social audit and list the benefits of such audits
● Describe the South African government’s green economic development agenda
● Explain the greenhouse gas (GHG) inventory.

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Introduction
As can be seen from the previous chapters, cost and management accounting is not about
figures and finances alone. It is about running and managing an organisation to the benefit
of all parties (or stakeholders) that have an interest in the organisation. For that reason,
organisations are realising the importance of taking other factors into account when making
important decisions in the organisation. New developments that are going to be discussed
in this chapter include social responsibility, triple bottom line, environmental management
accounting, sustainability and many others. Management accountants have the skills and
are in a position to make a difference, not only within the organisation, but also in the
environment within which the organisation functions. Taking into account broader factors
than monetary alone will benefit not only the organisation and its shareholders, but also
the environment and society.

Corporate social responsibility

Corporate social responsibility refers to the attention that the management of an
organisation gives to the social, environmental and ethical impact that the organisation’s
operations may have in making decisions. These days, many organisations are reporting
not only on their financial performance, but also on social, environmental and ethical
performance. Traditionally, reports only focused on financial performance, but it is
necessary for interested parties to know about organisations’ non-financial performance
as well. The concept of triple bottom line (TBL) reporting was first introduced in 1981.
TBL includes social and environmental performance together with financial results. Social
performance is the impact that the organisation has on the society it operates in, such as
its suppliers, customers and employees. Environmental performance is the impact that the
organisation has on the environment, such as the air, water and living beings. The TBL has
first evolved into sustainability reporting to what is now known as integrated reporting.
The International Integrated Reporting Council (IIRC) makes use of a globally accepted
framework with regard to sustainability accounting. The aim of this framework is to
guide organisations to develop an integrated report (IR), which provides comprehensive
information on the total performance of the organisation and to meet the needs of a more
sustainable, emerging, global economic model. Integrated reporting includes an element of
ethics to the social and environmental impact the TBL reports on.
However, one must note that sustainability accounting and integrated reporting in cost
and management accounting differ from financial accounting. This is because cost and
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management accounting is used for internal decision making. Therefore, sustainability

integrated in cost and management accounting refers to the creation of new policies that will
have an effect on the organisation’s performance at economical, ecological and social level.
Sustainability accounting and integrated reporting can be used as a tool by organisations that
want to be more sustainable. Many organisations make use of triple bottom line reporting.
Especially organisations whose impact on the environment and also society is severe, need to
produce such reports in order to satisfy its shareholders and other stakeholders.
It is important that organisations do not employ TBL or integrated reporting just to
improve its public image. It must be a true reflection of the organisation’s impact on society
and the environment, and deliver honest intentions of improving its impact on both. Issues
of social, environmental and ethical impact should not only be a part of the reporting
process, but must be integrated into all parts and activities of the organisation in order to
produce a real and positive effect.

Cost and Management Accounting

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Test yourself 17.1

Find the annual report of a company of your choice and identify the issues of integrated
reporting in the document, that is, social, environmental and ethical issues.

Corporate social responsibility in South Africa

South Africa is considered to be the world leader in integrated reporting and, ultimately,
integrated thinking in organisations. The initiative started with the introduction of the
first King Report on Corporate Governance. (The fourth version of the King Report (King
IV) is due for publication.) In addition, the Integrated Reporting Committee (IRC) of South
Africa promotes the practice of integrated reporting in South Africa. All companies listed
on the Johannesburg Stock Exchange are compelled to present an integrated report. An
integrated report forms part of the annual report and communicates how an organisation’s
strategy, governance, performance and prospects lead to value creation. Reporting on
issues such as the social, environmental and ethical impact of organisations’ activities
is especially important in South Africa. Not only are investors demanding that such
reporting be produced, but it also has a positive impact on the image of an organisation if
it can be listed on indices such as the JSE SRI Index. With a focus to encourage integrated
thinking and behaviour within organisations, integrated reporting can potentially lead
to better communication of value, and a better relationship between organisations and
stakeholders. A report from the Enhanced Disclosure Task Force of the Financial Stability
Board highlighted a clear link between the investor’s understanding of an organisation and
its value. Transparency over management’s understanding of key risks and likely future
performance can lead to a reduction in the cost of capital.

Ernst & Young conducts a yearly survey of South African companies to assess the level
of compliance with relevant integrated reporting requirements and guidelines. The last
survey was completed in 2015, covering all companies listed on the JSE Stock Exchange.
The 2015 survey reported back, stating an increase in innovation for layout and structure;
improvements in the quality of information; increased use of cross-referencing; better
use of tables and graphs; more organisation-specific information; less repetition of
information; improved business models; a trend towards conciseness and improved
connectedness of information.
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Source: Ernst & Young (2015)

Two other features that are present in South African organisations are transformation and
broad-based black economic empowerment. It is a requirement by law that organisations
fulfil these initiatives. Therefore, an organisation’s compliance to the initiatives needs to
be reported.
Globalisation means that organisations trading in foreign countries have to comply with
the rules and regulations that are present in those countries. Codes and certification relating
to environmental management standards in terms of ISO 14001 also play an important
part in the practices of organisations.

Environmental management accounting and other developments

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Test yourself 17.2

Explain the concept of corporate social responsibility and how it has impacted on the
annual reports of companies.

Environmental management accounting

Should we include the cost of the earth’s natural resources in the price of goods and
services? Or should we continue to ignore the cost until all our resources are gone?
Does our existing accounting model allow for environmental costs? Environmental
management accounting (EMA) is a term that is used in different ways. In our context
it relates to all accounting systems and practices that relate to the environment. Since
EMA is a ‘management accounting’ system, it does not produce reports for external use
as previously described through triple bottom line reporting. It produces information for
internal use in order to assess an organisation’s impact on the environment so that changes
can be made to lessen any negative impact. The International Federation of Accountants
(IFAC) published an international guidance document on EMA in August 2005, defining
it as the management of environmental and economic performance through appropriate
environment-related accounting systems and practices. EMA can involve life-cycle costing,
full cost accounting, benefits assessment, and strategic planning for environmental
management. Some elements of environmental accounting include:
● Measurement and disclosure of environment-related financial information
● Measurement and use of environment-related physical and monetary information
● Estimation of external environmental impact and cost (also known as full cost
accounting (FCA))
● Accounting for inventories and flows of natural resources in both physical and monetary
terms (also known as natural resource accounting (NRA))
● Reporting of organisation-level accounting information, natural resource accounting
information, and other information for national accounting purposes
● Environment-related physical and monetary information in the broader context of
sustainability accounting.

Source: Integrated Reporting SA (nd)

Environmental management accounting techniques

There are two ways in which EMA can be implemented in an organisation; either financially
or physically oriented. Financially oriented EMA supplies financial information to
management regarding the environmental impact of the organisation’s activities. These
costs are already included in traditional management accounting systems. EMA aims
to highlight such costs so that they are visible to management, who can then make
improvements to reduce or eliminate the costs. Different kinds of environmental costs can
come to the fore:
● Environmental costs that are incurred in order to prevent, monitor and report impacts
on the environment, for example legal activities and fines, record keeping, and the cost
of prevention, mitigation and remediation of environmental impacts

Cost and Management Accounting

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● Environmental product costing, which traces direct and indirect costs related to the
environment back to products, for example the cost of waste management, permits and
fees, and recycling
● Environmentally-induced revenue, which is revenue that arises from positive
environmental activities, for example the use of recyclable materials boosting sales and
charging higher prices for so-called ‘green’ products
● Environmentally induced capital expenditure, which is the capital investment that is
made to improve the organisation’s activities and to lessen its impact on the environment.

Physically oriented EMA are techniques that supply information to management that
is not measured in monetary terms. Physical measures include kilograms, litres, kilowatt
hours of electricity, decibels, etc. It therefore provides information to management that
can be used for decisions on how to change activities in order to be more environmentally
responsible.

Benefits of environmental management accounting

Many management accountants may feel that reporting separately on environmental
issues and taking social and environmental issues into consideration place an extra burden
on them. However, taking into account the broader consequences of an organisation’s
activities can even have an impact on the long-term prosperity of the organisation. There are
numerous benefits from taking into account the environmental impact of an organisation’s
activities. Some of the additional benefits that can be derived from EMA are the following:
● Cost reduction: focusing attention on the use of resources and simple improvements in
processes can lead to cost reductions
● Innovation: new innovative ideas may come to the fore to perform processes more
efficiently and at a lower cost
● Cleaner production: because the goal is to reduce waste from production, the whole
process will become cleaner
● Better product pricing: since waste will be removed, prices of products will be more in
line with what the actual cost of production is, and therefore more accurate
● Increased shareholder value: anything that improves the organisation has the ability
to improve the bottom line and ultimately the value attributable to shareholders as well
● Improved reputation: from putting environmentally friendly products on the market
and performing activities with less harmful effects on the environment
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● Improved revenue: producing products or services that meet the environmental needs
or customer concerns can result in increased sales by increasing the demand for the
product, and products can also be sold at a premium price
● Government grants: the costs of complying with legal and regulatory requirements
and any other costs necessary to improve the environmental image of the organisation
can sometimes be offset by government grants.

It is therefore not merely an exercise to complete in order to improve public appearance and
to comply with environmental laws; it can have long-term benefits for any organisation to
integrate environmental management accounting processes into the current management
accounting system.

Environmental management accounting and other developments

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Steps for implementing environmental management accounting

Implementing EMA in an organisation does not happen overnight. It requires a change in
the mindset of all the employees. The following 10 steps give an indication of the process
that needs to be followed when implementing EMA in an organisation:
1. Gain the support of the management team. They are the leaders who must make sure
that the system is accepted by everyone in the organisation, therefore it is imperative
that they buy into the idea.
2. Define the limits of the environmental management system. It is necessary to establish
what is already in place, so that systems are not rebuilt if already available.
3. Ascertain the organisation’s major environmental impacts. This step calls for input
from everyone in the organisation to determine what specific impact the organisation
has on the environment.
4. Determine if and how the environmental impact determined in the previous step is being
accounted for. This is to identify which areas of environmental impact are already taken
into consideration in the current system so as to determine which areas need to be added.
5. Define environmental costs. It is not easy to add a monetary value to the costs borne by
the environment, but it makes it easier to calculate the overall cost that the organisation
causes, therefore making it an important activity.
6. Determine who will be in the ‘review team’. A team must be established to review the
EMA implementation and to make sure that it is complied with at all levels. The team
must be passionate about the idea of EMA to ensure that they take their task seriously.
7. Review existing management accounting systems. This helps to determine if the current
systems are able to handle additional EMA requirements or whether a new system is
necessary.
8. Identify if environmental revenue or cost reduction opportunities are being ignored.
There may already be a number of savings opportunities available to an organisation
that only need to be explored and used.
9. Suggest changes to the existing accounting systems. If the current system is able to
handle additional EMA functionalities, suggestions can be made on how to change the
system to be fully EMA oriented.
10. Trial the system by way of a pilot test. No system is implemented and works perfectly
from the start. A trial period is necessary to iron out possible problems without
disrupting the whole organisation’s operations.
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Why it is difficult to recognise and measure social and

environmental costs
Traditional management accounting systems do not recognise social and environmental
costs separately. They are, however, very real and are hidden, but still included in the costs
of an organisation.
These costs are difficult to recognise and measure for the following reasons:
● The future impacts of activities are not yet known. We make decisions and implement
operations without knowing what the future impact of such operations are going to be.
An example of this is the use of chlorofluorocarbon (CFCs) in aerosol cans.
● Recognising and measuring the external impacts on society and the environment is
difficult. Examples of difficult costs are the long-term cost of dumping waste, damage to
water sources due to pollution and the possible impact on the health of nearby citizens.

Cost and Management Accounting

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● Measuring costs are difficult. To measure in physical terms is in some cases possible, but
the monetary value of any social or environmental impact is difficult to measure.

What are environmental costs?

Environmental costs are those costs that are incurred in efforts to prevent, monitor and
report on the impact of an organisation’s activities on the environment. Organisations
can employ any number of methods to measure these costs, some doing it in much detail,
and others only broadly, or some only recognising internal costs, and others external costs
as well.
The United States Environmental Protection Authority defined the following five types
of environmental costs, calling them ‘tiers’:
1. Conventional (direct) costs – the costs of raw materials, direct labour, supplies and
capital equipment and its depreciation
2. Potentially hidden costs – the initial environmental costs that are incurred when
starting the business, for example building the property and complying with regulations,
the voluntary cost that is incurred in reporting on environmental impact costs, the back-
end environmental costs of decommissioning a business, or cleaning and rehabilitation
3. Contingent costs – costs that may perhaps be incurred in the future, for example the
cost to remedy or compensate for future environmental incidents, fines and penalties
for future infringements on regulations, and the cost of later meeting additional
environmental regulations
4. Relationship and image costs – costs that have resulted from operations and have an
effect on the value of intangible assets such as goodwill and branding − these costs can
be difficult to recognise and measure, and would often not be identified separately in an
accounting system
5. Societal costs (externalities) – these costs represent costs that an organisation causes
others as a result of its activities, but which are ignored by the organisation. Examples
are the environmental damage caused by an organisation, or negative health effects
caused by emissions for which the organisation is not held responsible.

Using the quality cost framework for environmental costs

The quality cost framework classifies costs into the categories of prevention, appraisal,
internal failure and external failure. These costs can be applied to categorise environmental
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costs as follows:
● Prevention costs: these costs relate to preventing environmental problems from
happening in the first place; costs under this category are often investments for future
benefit, for example installing equipment to reduce pollution
● Appraisal costs: these costs relate to monitoring the environmental impact that an
organisation has by inspecting and evaluating processes and products or services for
their environmental impact; an example are the costs incurred for testing equipment
and the accompanying labour
● Internal failure costs: costs that are incurred to correct environmental problems that
have been uncovered through appraisal; these are costs that directly impact on the
statement of comprehensive income of a company, for example the cost of occupational
health and safety issues, waste disposal costs, and regulatory costs such as taxes

Environmental management accounting and other developments

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● External failure costs: these are costs that are imposed on society and are not borne by
the organisation that generates the cost. Governments are becoming increasingly aware
of these costs and are using taxes and regulations to convert these costs to internal costs.
These costs are incurred when the solution for an environmental failure falls outside of
the organisation, for example the cost of cleaning up a chemical spill in a local water
source, healthcare, and social welfare costs.

Prevention costs are considered to be the only costs that are value-adding. The other costs
are non-value-adding, and if the processes and activities of an organisation are properly
planned and executed, it should not be necessary for these costs to be incurred.
Table 17.1 Example of an environmental costs analysis
R
Prevention costs
Training of staff 35 000
Recycling of waste materials 10 000

Appraisal costs
Monitoring water pollution levels 45 000

Internal failure costs

Employee medical cost from chemical spills 105 000
Cleaning up the premises from a chemical spill 16 000

External failure costs

Legal action by the community for water pollution 1 500 000
1 711 000

Test yourself 17.3

Choose an organisation that is well known to you, and make a list of possible prevention,
appraisal, internal failure and external failure costs that the organisation may incur.
Prepare a report in the format that is given in Table 17.1. Include made-up amounts.
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Integrating environmental costs into information for decision making

It is important that the analysis of environmental costs is not just an exercise that is
completed because it is a new concept and for public image. It is very useful if it can be
integrated with the general cost information that is used for decision making. In this way,
managers can determine whether the activities of the organisation have a long-term effect
on the environment and also what the environmental cost is going to be if the organisation
continues with certain activities. Not only will the long-term prosperity of the organisation
be protected, but the environment as well.

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Environmental costing using activity-based costing

In Chapter 8, you learnt how overhead costs can be better allocated to products by means of
an activity-based costing (ABC) system. In this section, we will look at how environmental
costs can be accounted for using ABC principles. Environmental costs are most often part
of overheads. Most organisations do not realise this, nor do they realise the cost savings
that are possible by considering environmental costs separately. When environmental costs
are separated from overheads and allocated to activities appropriately, these costs can be
contained and controlled. In an ABC system, environmental costs become cost drivers and
therefore need to be identified carefully through proper analysis. Environmental costs and
hazards needs to be established by tracking environmental waste. It is furthermore also
important to consider the environmental cost drivers that are active in different stages of a
product’s life cycle. Different environmental costs arise from the design phase through to
decommissioning. In South Africa the best example probably comes from mining activity,
where a lot of environmental waste is created for which a mining company is responsible
long after a mine’s closure. Considering environmental costs through the life stages of a
product ensures that costs are visible and the potential future costs are prevented or reduced
from the start.
Things to consider when allocating environmental costs to activities are the following:
● Volume of waste
● Toxicity of the waste
● The costs of treating different types of waste.

The environmental impact of the supply chain

An organisation does not exist on its own. It is connected with other organisations and
individuals in the form of suppliers and customers. An organisation that is serious about
its impact on the environment needs to assess the impact its suppliers and customers have
on the environment as well. In line with the implementation of EMA in an organisation is
the implementation of EMA in the supply chain. Figure 17.1 illustrates the steps from the
bottom up.

The impact of suppliers

Organisations that are serious about their environmental impact are usually willing to pay
more for materials and services if they are certain that the suppliers of the products and
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services implement measures to reduce any adverse impact on society and the environment.
An organisation can draw up a checklist of requirements that a supplier needs to fulfil
before the supplier will be contracted.

The impact of customers

Organisations can work with their customers to reduce any negative impact on society and
the environment. This relates to the negative impact on the environment while the product
or service is being delivered, as well as when it is disposed of. For example, an organisation
can encourage customers to recycle packaging material and use the product in a way that
does not harm society or the environment. An organisation also has a great measure of
influence on the buying behaviour of customers. If a customer is convinced through proper
marketing that the product is safer to the environment than another product, customers
can be encouraged to buy the ‘friendlier’ product and may even pay more for it.

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Environmental compliance
Green supply chain
implementation Sustainable supply chain efficiencies

Business partner
collaboration

Measurement
Operational
alignment

capabilities
Business
Dimensions of the green
supply chain

Visible leadership
Organisational foundation
Business case
for the green supply chain
Programme governance

Figure 17.1 A model of how the supply chain works in a ‘green’ framework

Source: Adapted from ValueStream (2009)

Measures to assess social and environmental performance

When measuring any type of performance, it is necessary to look at not only quantitative
and financial factors, but also at qualitative and non-financial factors. The qualitative and
non-financial factors in particular have the potential to direct the attention of managers
to areas where problems exist. Therefore, when the social or environmental performance
or impact of an organisation is being measured and evaluated, it is important to look at
all possible factors that can play a role. It can be difficult to measure and evaluate social
and environmental performance, but with careful thought, it is possible to include
such measures into a management accounting system. When deciding on appropriate
environmental performance indicators, relevance is a key factor to consider. Indicators need
to be internationally comparable and must also be useful. Environmental indicators must
fulfil the following requirements:
● Give a true and clear picture of environmental conditions and pressures on the
environment
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● Be simple and easy to understand and interpret

● Be based on international standards to give a basis for international comparison
● Be adequately documented and of high quality
● Be updated regularly.

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The South African Department of Environmental Affairs and Tourism developed a

document called ‘Development of a Core Set of Environmental Performance Indicators:
Final Report and Set of Indicators’. The report was mainly developed for municipalities
and government, and even though the indicators are from the perspective of municipalities
or government, it gives a clear indication of the minimum set of indicators that need to be
considered by organisations. This will assist organisations to determine the effect that they
may have on important environmental factors. Each organisation has to develop its own
relevant set of environmental performance indicators.
Indicators fall into one of five general categories:
1. Input: indicators that are usually related to cost and are most relevant to the daily
operations of an organisation
2. Process: these indicators describe how well resources are used to produce products and/
or services and they cover the activities and operations that change input into output −
the indicators are internal, and therefore must be tailor-made to specific organisations
3. Output: these indicators look at the results from processing inputs
4. Outcome: indicators that measure to what extent goals and objectives are met
5. Impact: these indicators monitor the long-term results of any activity conducted by an
organisation.

Social auditing
Social auditing is the way through which an organisation evaluates its impact economically
as well as on society and the environment. It establishes to what extent an organisation meets
its stated values and objectives. The process of implementing social auditing is illustrated
in Figure 17.2. In a social audit, an organisation’s performance regarding its non-financial
objectives is regularly monitored together with the views offered by stakeholders. A social
audit therefore requires that stakeholders be involved. Stakeholders include, for example,
shareholders, employees, customers, contractors, suppliers and the community. A social
audit is not performed by external auditors, but by the organisation itself. The organisation
itself needs to verify the accuracy and objectivity of the audit. To implement a social
auditing process requires a fixed time commitment by a person within the organisation.
The social auditor needs to be trained in the process and preferably mentored at the start by
an experienced social auditor. The social auditor liaises with all parties in the organisation
to design, coordinate, analyse and document a set of information that is collected during
the audit process. The information for a social audit is collected by means of bookkeeping
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on social issues, surveys and case studies. The objectives of the organisation are the starting
point in establishing indicators to be used and involving stakeholders. Information needs
to be collected at least once every 12 months in order to enable the preparation of an
annual social audit report. Experience has shown that it is important to provide training
to the social auditor as well as mentoring during the first few years if well-facilitated, social
auditors from different organisations can become self-supporting for subsequent years.

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Financial
objectives and
performance

Corporate Environ
Social sustainability mental
objectives and objectives and
performance performance

Designing of social Stakeholder Organisational policy,

auditing process dialogue stategy and operation

Publication of Policy and strategy

statement review

Define audit
External verification
boundaries

Social Auditing Process

Preparation of accounts Stakeholder-based
and external report design

Internet audit and

Defining indicators
document review

Figure 17.2 The process of social auditing

Source: Gao & Shang (2006)

Case study: Biodiversity planning tool

South African civil society groups, government and mining companies came together to
set guidelines with the aim to help mining companies work in a biodiverse environment.
The development of a set of principles lays the foundation for change. In 2011 a large
open-cast coal mine in South Africa hit the national headlines when civil society groups
accused the mining company of damaging the environment near the Mapungubwe
National Park. The mining company argued its operations were in line with the law. The
mine was closed temporarily for non-compliance with environmental regulations but
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reopened after lengthy discussions between the main parties. Controversies such as this
had become familiar in South Africa until now. All parties are now set to find common
ground. South Africa is the third most biodiverse country in the world. But South Africa
is also a mining capital, producing metals ranging from platinum to coal. The mining
industry employs more than 500 000 people, and has been central to the country’s
economic development.
The South African National Biodiversity Institute (SANBI) assisted in setting the
guidelines. Surprisingly, the mining sector initiated the idea rather than government or
environmental interest groups. One of the biggest challenges in drafting the guidelines
was to obtain a common understanding of key terms across all interest groups since the
different parties’ definition of, for example, a wetland are rather different. It is still too
early to gauge the longer-term impact of the Mining and Biodiversity Guidelines. But,
by reframing the risks and opportunities of protecting biodiversity in a language that
businesses can understand, the foundations for more responsible practices have been laid.

Source: IIED (nd)

Discussion question:
Discuss in a group the merits of implementing a biodiversity programme, commenting
specifically on the pros and cons of such a programme and the implementation thereof.

South African government’s green economic development

agenda
The South African government recognises the need for implementing plans, rules,
regulations and laws regarding the country’s ‘green’ status. It is committed to making
environmental issues part of economic growth plans. Currently, the government is working
together with other countries in the Southern African Customs Union (SACU) to develop
and implement programmes to mitigate climate change and to enhance green economic
development. Workshops on the topic were held in the parliaments of the five countries
involved in the project. They are South Africa, Botswana, Lesotho, Namibia and Swaziland.
The workshops resulted in many opportunities and challenges which are to be combined
to establish a code of best practice and frameworks for implementation for the different
countries. South Africa is ahead of the other countries in using policies that were developed
in order to establish relevant legislation. The other four countries are still at the stage of
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developing policies. However, they are not a significant source of greenhouse gas emissions,
but because of delicate eco-systems and the citizens being mostly reliant on agriculture,
climate change needs to be addressed.
The article in the following case study emphasises South Africa’s commitment to address
climate change.

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Case study: Acsa well on its way to reducing its carbon

footprint
Testing vehicle smoke emissions as well as monitoring air quality regularly are just some
of the things Airports Company South Africa [Acsa] are incorporating at Cape Town
International airport to help curb its carbon footprint. Acsa met with the portfolio
committee on environmental affairs and development planning on Tuesday to discuss
its environmental protection plan and air traffic operational improvements following
an increase in arrivals. Acsa spokesperson for Cape Town International Airport, Deidre
Davids, said the airports company had done significant work in monitoring, measuring
and mitigating air emissions. Standing committee chairperson, Rodney Lentit, said he
was satisfied with Acsa’s current initiatives. ‘What is also welcoming is the department
of environmental affairs and development planning’s commitment regarding mitigation
strategies to ensure that the areas surrounding the airport are protected from gases
emitted by aircrafts and other vehicles operating at airports in the Western Cape,’ he said.
Renewable energy sources
‘The briefing revealed that [Cape Town International] has a permanent air quality
monitoring station that has been in place for eight years. The station measures carbon
emissions and it shows that more than 1 800 tons of carbon monoxide are emitted
each year.’ Lentit said renewable energy sources have been introduced at the George
Airport at a cost of R16m for a 1.2 hectare solar plant. ‘An environmental strategy is
also in place and through it, measures are in place to ensure that all vehicles operating
in the airport are tested for carbon emission every two years to ensure vehicles meet
specifications. A limit is also set on the age of vehicles operating in the space.’ Lentit said
he believed Cape Town International was ahead of airports in the rest of the country in
terms of reducing its carbon footprint.
Source: Petersen (2016)

Greenhouse gas inventory

Greenhouse gas (GHG) inventories refer to the accounting of greenhouse gases that are
emitted or that need to be removed from the atmosphere over time. The inventory assists
policy makers to determine a basis in order to track emission trends, to develop strategies
and policies to reduce the effect, and to assess progress. A GHG inventory helps local
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governments to:
● Identify the main sources of emissions
● Understand the trends that relate to emissions
● Give quantitative values to the benefits of reducing emissions
● Create a basis for action plans
● Evaluate the progress made in reducing emissions
● Set targets for future reductions.

Therefore, it makes sense for governments to determine a GHG inventory before creating
and implementing an action plan. A GHG inventory can be established for different spectra:
● Government operations inventories relate to emissions that result from all government-
owned entities, for example government buildings, or streetlights. This is an important

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inventory, because it is the one that needs to be implemented first in order for the
government to illustrate what it expects from the rest of the country.
● Community-level inventories refer to the emissions by community activities, for example
electricity, transport, agriculture and industry.
● Regional inventories refer to the emissions from a combination of communities. This is
helpful in cases where individual communities are too small and have limited resources
to conduct inventories.

The data required to give a value to GHG emissions is a series of data about basic activities
and emission factors over time. For example, the emissions from motor vehicles can be
determined by multiplying litres of fuel used per year by an emissions factor for kilograms
CO2 per litre of fuel. Emission factors can be difficult to calculate and, because they tend to
be similar across similar areas, default values can be calculated and used as the norm.

Summary
In the modern era, it is imperative that organisations take cognisance of the fact that their
operations have an impact on the environment and society. An organisation’s activities are
no longer only with financial aim and for financial gain. One of the new trends is the move
towards triple bottom line reporting, which means that organisations report on financial
performance as usual, and also on environmental and social performance. Internal
to the organisation, new developments can also take into account the environmental
factor of operations. This is called environmental management accounting. This type of
management accounting considers the financial and physical impact that organisations
have on the environment. The South African government, together with countries around
the world, is making an effort to reduce the negative impact that the operations of
organisations have on the environment. In the 21st century, people cannot live only for
their own gain, and organisations cannot look only at financial performance. The era has
come for organisations and individuals also to consider the impact of their activities on the
environment and society.

Key concepts
Corporate social responsibility is the attention that an organisation’s management
gives to the social and environmental impact of its operations when making decisions.
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Environmental costs are those costs that are incurred in efforts to prevent, monitor and
report on the impact of an organisation’s activities on the environment.
Environmental management accounting (EMA) is all the accounting systems and
practices that relate to the environment. It can include systems such as life-cycle costing,
environmental performance, environmental cost accounting and strategic planning for
environmental management.
Financially oriented EMA is a management accounting system that supplies financial
information to management regarding the organisation’s environmental impact through
its activities.
➤➤

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Greenhouse gas inventories refers to the accounting for greenhouse gases (GHGs) that
are emitted or that need to be removed from the atmosphere over time.
Integrated reporting is a means to provide comprehensive, including non-financial, infor-
mation on the total performance of the organisation and includes an element of ethics
to the social and environmental impact of the company
Physically oriented EMA is a technique that supplies information to management which
is not measured in monetary terms.
Quality cost framework is a means to classify costs into the categories of prevention,
appraisal, internal failure, and external failure.
Social auditing is the way in which an organisation evaluates its impact economically,
as well as on society and the environment. It establishes to what extent an organisation
meets its stated values and objectives.
Triple bottom line (TBL) reporting means that an annual report includes financial,
social and environmental performance.

Test-yourself solutions
Solutions to Test yourself 17.1 and 17.3 are open ended and based on the source material
you find.

Test yourself 17.2

Corporate social responsibility is the attention that an organisation’s management gives
to the social and environmental impact of its operations when making decisions. It has an
impact on the annual report, in that the organisation now also has to report on its social
and environmental impact. This is called triple bottom line (TBL) reporting, and it means
that an annual report includes its financial, social and environmental performance.

Review questions
17.1 What is corporate social responsibility?
17.2 Why do organisations need to take cognisance of corporate social responsibility?
17.3 What is meant by sustainable accounting and management?
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17.4 What is triple bottom line (TBL) reporting?

17.5 How does TBL reporting give a better perspective of performance than conven-
tional accounting practice?
17.6 What is environmental management accounting (EMA)?
17.7 Name the techniques that can be used in EMA.
17.8 What are the benefits that can be derived from measuring and reporting on the
environmental and social impact of an organisation?
17.9 Name the difficulties in measuring and reporting on the environmental and
social impact of an organisation.
17.10 Define environmental costs.
17.11 What are the five parts of environmental costs?

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17.12 What is the difference between prevention, appraisal, internal failure and
external failure in terms of environmental management accounting?
17.13 What environmental and social factors apply to suppliers and customers?
17.14 Which measures can be used to assess social and environmental performance
in organisations?
17.15 What is a social audit?
17.16 What are the benefits of social audits?
17.17 Briefly explain the South African government’s green economic development
agenda.
17.18 What is a greenhouse gas (GHG) inventory?

Exercises
17.1 Explain in your own words what social auditing is.
17.2 What are environmental costs? Also name the environmental costs as identified
by the United States Environmental Protection Authority.
17.3 Explain how the quality cost framework can be applied in environmental
management accounting. Supplement your answer with an appropriate example.
17.4 Part A
The owner of Beatter (Pty) Ltd wants to change its operations in order to become
more socially and environmentally aware. He does not know a lot about it, and
asked you to help him. The company operates in the mining industry, doing
research and extracting metals from ore. The activities of the organisation are
currently not environmentally acceptable.
Required:
Explain in detail the steps that are required to implement EMA successfully in
Beatter (Pty) Ltd.

Part B
After the owner of Beatter (Pty) Ltd understood his responsibilities he realised
that he may need some additional funds to implement the correct strategies
and to improve processes to be more environmentally friendly. However, he is
unsure how to convince his investors that this is a necessary exercise that the
organisation has to go through and complete successfully.
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Required:
Prepare a memo that the owner of the organisation can use to convince his
investors of the benefits of EMA.
17.5 An organisation does not exist on its own. It is connected with other organisations
and individuals in the form of suppliers and customers. An organisation that
is serious about its impact on the environment needs to assess the impact its
suppliers and customers have on the environment as well.

Required:
(a) Explain the environmental impact that suppliers and customers may have,
and how an organisation can influence the environmental impact of its
suppliers and customers.

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(b) Describe the requirements for measures and also the categories of measures
that an organisation can implement to measure the environmental per-
formance of its suppliers and customers.
17.6 Seatown is located on the coast. The town’s main industry is tourism with an
emphasis on family holidays, and consequently the cleanliness of the town’s
beaches is a major factor for the town’s success.
The town council, which is the local government authority, has a cleaning
department that is responsible for keeping the beaches clean and tidy. Early
every morning, as soon as the tide has gone out, the beaches are swept, using
equipment that is towed behind tractors. This equipment skims the top layer of
sand and runs it through a filter to remove any litter before returning the cleaned
sand to the beach. Most litter takes the form of paper and plastic packaging,
but it can include glass bottles and aluminium cans.
To try to prevent litter being left on the beach, the town council also places
bins on the beaches above the high-water mark. Litter bins need to be emptied
regularly, otherwise holiday-makers pile their rubbish beside the bins and that
leads to litter being spread by the wind or by seabirds scavenging for food scraps.
The cost of cleaning the beaches is a major expense for the town council. The
management team of the town council has asked the internal audit department
to investigate whether the town is getting good ‘value for money’ from this
expenditure. The head of internal audit has sought clarification from the town
managers on whether the audit should focus on the economy and efficiency of
the cleaning operations, or their effectiveness. Economy and efficiency audits
generally focus on whether cost can be reduced for the same level of service, and
effectiveness audits ask whether better service can be achieved for the same cost.
Required:
(a) Recommend, giving reasons, the matters that the town council’s internal
audit department should study in order to evaluate the economy and
efficiency of the beach cleaning activities. Your answer should include advice
on how to obtain the necessary data and information.
(b) Recommend, giving reasons, the matters that the town council’s internal
audit department should study in order to evaluate the effectiveness of
the beach cleaning activities. Your answer should include advice on how to
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obtain the necessary data and information.

(c) Explain why it is easier to investigate the economy and efficiency, rather
than the effectiveness of the cleaning activities.
Source: CIMA (adapted)
17.7 You have been appointed as a trainee management accountant in a very
old company that is in the construction business. The company is still being
managed by the original owner, Mr Smith, who is turning 80 this year, and he is
very reluctant to accept any form of change.
The company has been in the news over the last couple of months with regard
to its negative attitude towards the damage it does to the environment.
The CFO and other directors are trying very hard to get Mr Smith to embrace
environmental issues.

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Required:
You have been asked to prepare a report in which you explain to Mr Smith
what corporate social responsibility is, and why organisations need to take
cognisance of it. You are to write your report in such a way that Mr Smith
would fully understand and also be enthusiastic about the idea of being socially
responsible.
17.8 Patricia White has been asked by a management accountants’ forum to present
a paper on the subject of social responsibility at the annual conference. She has
been asked to do this because her company has recently won a national award
for its socially responsible initiatives, including its success in recycling methods,
community-based projects and reducing its carbon footprint.
Patricia White has decided that her presentation should start by setting out
what is meant by the concept of social responsibility, as she feels there are often
misconceptions regarding the term. She also wants to emphasise through her
presentation the key benefits that companies can gain from developing strategies
which are socially responsible. Patricia White is aware that there will be some
cynics in the audience who view socially responsible business-driven strategies
as unrealistic, thinking that they conflict with the achievement of healthy profits
and detract from creating shareholder value.

Required:
Discuss the points that Patricia White should include in her presentation on
social responsibility.
Source: CIMA (adapted)
17.9 Environmental costing is an important part of the company’s environmental
management system. Management needs to be aware of the extent of
environmental costs if these ought to be effectively managed.

Required:
Explain three benefits that may arise for a company that uses an environmental
costing system.
Source: CIMA P1 (March 2014)
17.10 (a) What is the relevance of integrated reporting to the broader economy?
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(b) Can organisations use integrated reporting simply as a means to promote

themselves (that is, as a public relations tool)?
17.11 Coca-Cola: A case study in sustainability
How does Coca-Cola integrate sustainability into their operations? For several
years its facility in Brampton, Ontario, one of its largest in North America, has
been transforming its manufacturing and distribution to save energy, reduce
carbon footprint, water usage and material usage. In this case study we look at
the goals, implementation and progress of the programmes put in place by this
$20 billion food and beverage giant. Coca-Cola’s 600 000 square foot facility
in Brampton houses the plant, management team and warehouse. It has three
plastic bottling lines, including a Dasani line, one bag-in-box line producing
syrup for national accounts, one pre-mix line for the restaurant business, and
one canning line. There are 650 plant operators, sales and equipment service

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representatives, truck drivers, warehouse employees, management and staff.

Located within the eco-business zone around Toronto Pearson International
Airport, Coca-Cola in Brampton joins the local community of businesses to
collaborate on green projects. Under the stewardship of Partners in Project
Green, businesses participate in programmes to reduce energy and resource
costs, uncover new business opportunities, and address everyday operational
challenges in a green and cost-effective manner. Other companies in this
programme include Xerox, Unilever, FedEx, Hewlett-Packard, Walmart, Kraft
and LoyaltyOne.
Social and environmental risks are now one of seven business risk categories and
are formally embedded into Coca-Cola’s enterprise risk management process.
This in turn guides the business processes, including annual planning, three-
year business planning and internal audit planning. As a result, sustainability
decisions are becoming an integral part of the business decision making,
commercialisation and capital management processes, the three-year business
planning process, and customer and supplier relationships. Highlighted here
are some of their goals, implementation and progress.
Energy conservation and climate change
The goal is to reduce the overall carbon footprint of business operations by
15% by 2020, as compared to the 2007 baseline. The Brampton operation
converted to an energy-efficient lighting system that uses 50% less energy and
provides 50% more light. These new fixtures also operate on motion sensors for
even greater savings. In the distribution channels, the company has installed
2 000 EMS-55 energy management devices in vending machines. These devices
activate lights and adjust cooling based on use, leading to improved energy
efficiency by up to 35%. In addition, the company installed 1 400 climate-
friendly coolers at the 2010 Olympic Games to reduce greenhouse gas emissions
by approximately 5 600 metric tons, the equivalent of taking about 1 200 cars
off the road for an entire year. Finally, 37 heavy-duty hybrid delivery trucks
and tractors were introduced to the Canadian fleet in 2008 and 2009. These
vehicles improved fuel consumption and reduced emissions by about one-third
and created less noise and emissions when stopped in traffic.
Water usage
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The goal is to establish a water-sustainable operation to minimise water use,

and have a water-neutral impact on the local communities by safely returning
the amount of water used in the beverages to the local communities and
environment. A 20% reduction in water use, accompanied by an efficiency ratio
of 1.62 litres, was achieved between 2005 and 2007. Plant teams focused on
the following two goals:
1. Reducing the water use ratio
2. Recycling the water used in operations (wastewater treatment).
To help reach its water usage goals, the company developed and used a
water conservation toolkit to identify actions that would conserve water. It
implemented recycling and reclaimed water loops through the plant’s membrane
water treatment system. It also installed a new osmotic water recovery system

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designed to reclaim nearly 11 million litres of water for production. In addition,

water-based container rinsers were replaced with ionsed air rinsers, and the
lubrication system on all production lines was retrofitted to discontinue water
use, saving approximately 28 million litres of water annually.
Sustainable packaging and recycling
The goals are to achieve the following:
1. Avoid the use of 100 000 metric tonnes of packaging materials between
2007 and 2010
2. Recycle or recover more than 90% of waste materials at production
facilities by 2010
3. Increase recycled content in plastic (PET) bottles to an average of 10% by
2010.
For the first goal, Dasani PET bottle weight was reduced by 30%, saving 493
metric tonnes of PET. Plastic twist-off closures were designed 24% lighter,
saving 235 metric tonnes of resin. Also, lighter fibreboard was developed for
Minute Maid products, saving 124 metric tonnes of fibreboard annually. The
company also launched the PlantBottle, a 100% recyclable packaging made
with up to 30% plant-based waste materials.
The second goal was achieved in 2009, ahead of schedule. The team also
implemented a centralised recycling initiative that captures broken, damaged
or expired product packaging from satellite facilities to be baled and sold to
an industrial recycler. Investments were made to achieve green innovations in
recycling technologies, renewable packaging materials, vending and cooling
equipment controls and design, and hybrid trucks. Among the tools used was a
proprietary packaging database to identify opportunities for future packaging
material reductions and to benchmark performance against the global Coca-
Cola system. The Coca-Cola operation in Brampton has shown that there are
advantages to thinking ‘outside the box’. By respecting the finite nature of the
earth’s water and resources, the operation is implementing innovative business
practices and contributing to the sustainability of communities while meeting
the expectations of its stakeholders.

Make a list of, and describe, the advantages and disadvantages of each of the
plans that Coca-Cola follows to remain sustainable. Your list must include
financial and non-financial advantages and disadvantages.
Source: Wong (2011)

Environmental management accounting and other developments

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Reference list
Ernst & Young (EY). 2015. A survey of integrated reports of South Africa’s top 100 JSE-listed
companies. Available: http://www.ey.com/ZA/en/Issues/EY-integrated-reporting-2015-
award. (Accessed 18 December 2016).
Gao, S.S. & Shang J.J. 2006. Stakeholder engagement, social auditing and corporate
sustainability. Business Process Management Journal 2006; 12(6): 722−740. Permanent link to
this document: http:// dx.doi.org/10.1108/14637150610710891. (Accessed 19 June 2012).
Integrated Reporting South Africa. n.d. Earth in the balance sheet. Available: http://www.
integratedreportingsa.org/SustainabilityReporting/EnvironmentalAccounting.aspx.
(Accessed 18 December 2016).
International Federation of Accountants (IFAC). 2005. International guidance document:
Environmental management accounting. Available: www.ifac.org. (Accessed 20 January 2021).
International Institute for Environment and Development (IIED). n.d. Mining for common
ground: Putting biodiversity on South African mining companies’ agendas. Available:
http://www.iied.org/mining-for-common-ground-putting-biodiversity-southafrican-
mining-companies-agendas. (Accessed 18 December 2016).
Petersen, T. 2016. Acsa well on its way to reducing its carbon footprint. Available: http://
www.news24.com/SouthAfrica/news/acsa-well-on-its-way-to-reducing-its-carbon-
footprint-20160510. (Accessed 18 December 2016).
ValueStream. 2009. Available: http://valuestream2009.wordpress.com/20/04/02/sustainable-
sourcing-with-a-greensupply-chain-brings-competitive-advantages. (Accessed 20 January 2021).
Wong, D. 2011. Coca-Cola: A case study in sustainability. Environmental Leader. Available:
http://www.environmentalleader.com/2011/08/08/coca-cola-a-case-study-in
sustainability. (Accessed 18 December 2016).
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18 Case studies

Case study 1: Cost-volume-profit analysis

Wood creations
Small businesses have a major role to play in the South African economy. The cost-volume-
profit (CVP) analysis technique can be used to improve the profitability of small businesses
in South Africa.

Background
Government’s objective is twofold, creating employment and fostering a culture of
entrepreneurship. Unemployment in South Africa is on the increase and the focus has shifted
to small businesses, since the corporate sector has not done enough to create employment.
Small businesses have consequently become very important to the South African economy.
According to Nico Jacobs, head of Absa small businesses, in 1998 small businesses employed
around 18% of the population. This has now increased drastically to around 60%. Small
businesses are, however, not creating long-term employment opportunities. According
to the most recent statistics, approximately 63% of small businesses fail in the first two
years of trading. This is due to poor management and the lack of financial expertise. Most
entrepreneurs are people who are unemployed, retired or have been retrenched. They do
not have financial support or knowledge to run a business. Education is the key to assist
small businesses in succeeding in the long term. It is the key to assist them in making the
transition from the informal economy to the formal economy. Adrian Gore from Discovery
Health and Mark Shuttleworth are two examples of successful entrepreneurs in South
Africa. These entrepreneurs were highly skilled and educated individuals. According to the
research done by the Global Entrepreneurship Monitor, approximately only 6% of the South
African population sees entrepreneurship as a career choice. The majority of the population
prefer working in the corporate sector because of the financial stability. Individuals who do
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not have employment should be encouraged to open up their own businesses. Government
must promote a culture of entrepreneurship.

How cost-volume-profit analysis can assist small businesses in becoming more profitable
Price setting for small businesses can be complicated − it requires a great amount of skill
and experience. If the price is set too low, the business can make a loss, and if the price is
set too high, the business can lose market share. Small businesses are more susceptible to
making pricing errors because they have a smaller product range, and these pricing errors
can have a major impact on the profit of the business. Larger companies have a bigger
product range, so the loss from the incorrect pricing of one product range can be spread
over the other product ranges, without having a major impact on the overall profitability
of the company. An understanding of the cost-volume-profit analysis technique can assist

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small businesses in setting the correct price and improving profitability in the long term.
Long-term profitability will ensure that the small business survives into the foreseeable
future and can consequently make a valuable contribution to the South African economy. A
comprehensive investigation that involves answering the following questions can minimise
the risk of setting an incorrect price:
● What is the breakeven point of each product?
● Must we decrease the selling price and sell more products, or must we increase the selling
price and sell fewer products?
● What is the lowest selling price that we can accept on a special order and still make a
profit?
● If we increase our fixed costs and sales volume, what impact would this have on our
contribution and net profit?
● Can the current selling price sustain an increase of, for example, 3% commission to
salespersons?
● If, for example, we spend an extra R15 000 on advertising, how many more products
must we sell in order to recoup this investment?

Sue Singh opened up a small manufacturing business three years ago, located in the
Springfield Park area in KwaZulu-Natal, and called it Wood Creations. They manufacture
children’s wooden puzzles for various retail outlets. Their product range consists of 24-piece,
48-piece, 96-piece and 300-piece puzzles. The pictures used for the puzzles are high-gloss
images which the business orders from a printing company. These puzzle pictures consist of
different types of animals, the alphabet, numbers, famous cartoon characters, etc. Pine wood
is used to make the puzzles, because it is a strong wood which has a smooth finish and it is
inexpensive. The manufacturing process is automated with three machines in the factory:
one for cutting, one for laminating, and one for packaging the finished product. There are
four employees working in the factory, and a receptionist in the general office. There is one
machine operator per machine, and a quality control/supervisor. The production process is
a fairly simple one and consists of four steps:
Step 1: The wood is cut to size on the cutting machine and transferred to the laminate
machine.
Step 2: The chosen picture is laminated onto the wood and transferred back to the cutting
machine.
Step 3: The cutting machine cuts the picture into a 24-, 48-, 96- or 300-piece puzzle.
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Step 4: The packaging machine labels and wraps the puzzles in clear plastic, awaiting
distribution to the retailer. There are two points of inspection: after the picture has been
laminated onto the wood, and then prior to it being packaged for distribution.

Machine 1 Machine 2 Quality control

Cutting Laminating

Quality control
Machine 3
Packaging

Figure 18.1 Production process – Wood Creations

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The cost record of the business revealed the following information relating to the 24-piece
puzzle. The business has the capacity to produce a maximum of 36 000 24-piece puzzles in
a year. Last period the business produced 18 000 24-piece puzzles, and plans on producing
16 500 24-piece puzzles in the next financial period. The cost records for the various
production levels are as follows:
Table 18.1 Cost records for various production levels
18 000: 16 500:
24-piece puzzles 24-piece puzzles
Manufacturing cost R252 270 R237 720
Selling and administration costs R102 180 R97 680

The current selling price of a 24-piece puzzle is R30.

Required:
(a) Using the cost-volume-profit analysis technique, determine the profit that the business
would generate in the next financial period.
(b) The business has received an order for an additional 12 000 24-piece puzzles at a price
of R20.33. The special order would increase fixed costs by R2 500. Determine if the
special order should be accepted, and also determine the lowest price that the business
can charge for the special order and still be profitable.
(c) Besides using the CVP analysis technique to determine if a special order should be
accepted, what other uses can this technique have for a small business?
Sources:
1. The Business Owner. 2012. Case study: Use cost-volume-price analysis to increase
profit. The Business Owner [serial online] 2012; [cited 2012 December 29]: available: http://www.
thebusinessowner.com/businessguidance/business-valuation/2007/09/case-study-use-cost-
volume-price-analysis-to-increaseprofit (Accessed ……). [AQ: Provide correct URL]
2. Fin24 News. 2012. 63% of small businesses fail. Fin24 News [serial online] 20102; [cited 2013
January 4]: available:http://www.fin24.com/Entrepreneurs/63-of-small-businesses-fail-20101111
(Accessed 8 December 2016).
3. Ashton M. 2010. Why are SA’s entrepreneurs reluctant? Fin24 News [serial online] 2010; [cited
2013 January 4]: available: http://m.fin24.com/fin24/entrepreneurs/test-20100727 (Accessed
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8 December 2016).

Case study 2: Divisional performance, transfer pricing

and standard costing
ACDC (Pty) Ltd
ACDC (Pty) Ltd (‘ACDC’) manufactures electric motors and other products for the
automotive industry. The company is based in Gauteng and has three factories. The
products are sold across South Africa. ACDC has a divisional organisational structure
which consists of a head office and four divisions, namely the Valpre division, Solenoid
division, Armature division and Motor division.

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Valpre division
Valpre is the leading distributer of spring water. It produces both still and sparkling water.
The demand for spring water has sky-rocketed during recent years, as South Africa is facing
problems around water shortages and water pollution. The entity is committed to providing
clean, safe and consumable water to a wide range of customers across the country.
Valpre focuses on cost control to ensure that profitability is maintained, and investors
are satisfied with their returns. You were recently appointed as their new cost accountant,
and your first task is to calculate applicable standard costing variances for the year ended
31 December 20X1. The entity applies an absorption costing system, and the following
information is applicable to the financial year under review.

Budgeted information:
Table 18.2 shows the standard cost cards for these products for the year ended 31 December
20X1.
Table 18.2 The standard cost cards for the products for the year ended 31 December
20X1
Description One bottle of still One bottle of
water (1 litre) sparkling water
(1 litre)
Direct material: spring water (@ R1.50 per litre) R1.50 R1.50
Direct labour (@ R2 per hour) R1.00 R0.50
Variable overheads (@ R1 per hour) R0.50 R0.25
Fixed overheads (@ R2 per hour) R1.00 R0.50
Selling price per bottle R10.00 R12.00

Overheads are allocated to the products based on labour hours. It was expected that
500 000 bottles of still water and 350 000 bottles of sparkling water could be sold. The
actual information for the year ended 31 December is shown in Table 18.3.
Table 18.3 Actual information for the year ended 31 December 20X1
Description Rand value
Direct material: spring water (693 000 litres) R1 200 000
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Direct labour (320 000 hours) R630 000

Variable overheads R400 000
Fixed overheads R564 375

During the year, 520 000 bottles of still water and 250 000 bottles of sparkling water were
sold. The actual selling prices were R11 (still water) and R10 (sparkling water).

Solenoid division
The Solenoid division manufactures three types of solenoids at one of the factories. Due to
the large number of competitors in the solenoid manufacturing market, ACDC is a price-
taker and has to charge market-related prices. The results of Solenoid per product and in
total for the year ended 31 December 20X1 are presented in the following table:

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Table 18.4 The results of Solenoid per product and in total for the year ended
31 December 20X1
Product Sol-A1 Sol-B2 Sol-C3
Number of units sold 10 000 13 000 8 000 31 000
(R) (R) (R) (R)

Sales 9 100 000 15 925 000 14 840 000 38 8650 000

Direct materials (3 150 000) (6 370 000) (6 580 000) (16 100 000)
Direct labour (2 800 000) (7 280 000) (4 480 000) (14 560 000)
Overhead costs (2 800 000) (2 730 000) (1 120 000) (6 650 000)
Operating profit / (loss) 350 000 (455 000) 2 660 000 2 550 000
Finance costs (685 300)
Net profit before tax 1 869 700

Total controllable divisional assets 9 790 000

The manager of the Solenoid division is concerned about the loss being made by the Sol-B2
solenoid and has investigated the products and their costs, and found the following:
1. The number of units sold of each product is completely independent of the sales of the
other products.
2. Labour is to be considered a variable cost.
3. A budgeted blanket absorption rate of R20 per machine hour has been applied.
4. No inventory is kept as the Solenoid division employs a just-in-time (JIT) policy to
match supply and demand.

Armature and Motor divisions

The Armature division manufactures only one type of armature (the internal part of
the electric motor which carries alternating current). It sells these armatures to external
electric motor manufacturers and to the Motor division. The Motor division manufactures
the rest of the components and assembles the complete electric motors for sale to vehicle
manufacturers.
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The following statement shows the performance of each division for the year ended
31 December 20X1:
Table 18.5 Statement showing the performance of each division for the year ended
31 December 20X1
Armature Motor
division division
R’000 R’000
Sales 352 800 875 350
Variable costs (245 000) (665 700)
Contribution 107 800 209 650
➤➤

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Fixed manufacturing costs (64 680) (122 500)

Operating profit 43 120 87 150
Finance costs (9 345) (19 460)
Net profit before tax 33 775 67 690

Total controllable divisional net assets 145 500 495 620

During the year ended 31 December 20X1, the Armature division operated at its full capacity
of 140 000 units. The transfer of 70 000 units to the Motor division satisfied that division’s
total demand for armatures. However, the external demand was not satisfied. A further
42 000 armatures could have been sold to external customers by the Armature division at
the current market price of R2 712.50.
The current policy of ACDC is that internal sales should be transferred at their marginal
or variable cost and where appropriate including an opportunity cost. Therefore, during the
year, some armatures were transferred to the Motor division at the market price and some
were transferred at variable cost.
The fixed manufacturing cost of the Armature division includes allocated fixed overhead
cost of R34 300 000, of which R22 442 000 relates to the depreciation of the existing
manufacturing equipment, included in the divisional assets stated above. On 31 December
20X1, this equipment had a book value of R14 427 000, but will only realise a nominal
amount on the sale thereof. The allocated fixed cost of the Processing division amounted to
R29 645 000 for the year ending 31 December 20X1.
A weighted average cost of capital of 12% is used for divisional performance measurement
purposes.

Required:
(a) Based on measurement by residual income (RI) and return on investment (ROI),
determine if Solenoid, Armature or Motor performed best for the year ended 31 December
20X1. List all other information that will assist you in making a more informed decision
regarding their performance.
(b) Prepare an analysis of the sales made by the Armature division that clearly shows, in
units and in rand terms, the internal and external sales made during the year ended
31 December 20X1.
(c) Discuss the fairness of the current transfer pricing policy and the effect of possible
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changes in external demand on the profits of the Armature division, assuming the
current transfer pricing policy continues.
(d) Reconcile the budgeted and actual profits of Valpre for the year ended 31 December
20X1.
(e) Write a memorandum to Valpre in which you provide possible reasons and corrective
measures for the following variances.
● •Sales volume variance
● Material price variance
● Variable overhead rate variance
● Fixed volume variance.

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Use this format to answer the question:

Variance Reason Corrective measure

Case study 3: Linear programming

Linear programming for parking slot optimisation
Transportation plays an important and strategic role in the development of a nation,
particularly in distributing the product of the development to all citizens. A general problem
that occurs in urban transportation is traffic jams. One of the sources of traffic jams is the
decreases of road diameter due to the use of part of the road for on-street parking. This
traffic jam has a massive effect if it is considered comprehensively. One of these effects is, for
instance, the excessive use of fuels which causes a large amount of economic losses. Hence,
it is necessary to make an effort to reduce traffic jams, which includes the management of
the on-street parking problem. A problem that emerges most often with on-street parking
is determining the most effective means of allocating parking slots in limited parking space
for different types of vehicles. In this study, we focus on building a mathematical model
describing the problem, and we try to allocate optimal parking slots proportional to each
type of vehicle by using linear programming.
Peunayong area, located in Banda Aceh, is a centre for business activity in the city. The
problem is that there is a lot of traffic on the road around the area, such as in the road
segment of Jalan T. Panglima Polem. From simple observation, obvious sources of low road
performance in this area are the on-street parking along the road and intersections. The
on-street parking decreases road capacity and increases road-side obstacles. This problem
occurs because of the lack of sufficient parking space available in the area. Parking control
unit (PCU) is the parking space used for a vehicle. This depends on vehicle dimension, plus
additional space needed for a vehicle to manoeuvre itself into and out of a parking space.
PCU of each vehicle can be obtained in the table below.
Table 18.6 PCU per vehicle
No. Jenis Width Width Length Parking length
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Kendaraan (Metre) (Metre) (Metre) (Metre)

1 Becak 1 1.5 2.2 2.7
2 Motorcycle 0.8 1.3 1.9 2.4
3 Passenger car 1.5 2.5 4.1 5.0
4 Medium bus 2.5 3.1 6.0 7.0
5 Big bus 3.5 4.5 9.3 10.3
6 Truck 2.4 3.4 7.2 8.2
7 Small bus 1.6 2.6 4.1 5.1

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The location of this survey is Jalan T. Panglima Polem Peunayong, Banda Aceh, and it
was conducted from 7.00 a.m. to 6.00 p.m. Secondary supporting data and information
for this research is obtained from Dinas Perhubungan Provinsi Aceh. Data sampling for
vehicles entering or leaving the parking site along with their parking duration was obtained
through a field survey walking along the parking site and counting the number of vehicles
and their parking duration.
The problem is how to maximise parking space capacity at Jalan T. Panglima Polem,
subject to available parking land, and how to meet the demand of parking for each type
of vehicle at the same time. The parking demand is based on proportionality of average
parking accumulation and average parking duration.

The focus here is to allocate parking space for all three types of vehicles:
● Parking space for a motorcycle is 3.12 m2
● Parking space for a car is 12.75 m2
● Parking space for a becak is 4.05 m2.

The structure of decision making for maximisation of parking capacity is explained in the
table below.
Table 18.7 Decision-making structure for maximisation of parking capacity
No. Coefficient of objective functions Activity Limitation
x1 x2 x3 factor
c1 c2 c3
1 Motorcycle parking accumulation proportional to all a11 a12 a13 ≥b1
2 Car parking accumulation proportional to all a21 a22 a23 ≥b2
3 Becak parking accumulation proportional to all a31 a32 a33 ≥b3
4 Medium bus parking accumulation proportional to all a41 a42 a43 ≥b4
5 Big bus parking accumulation proportional to all a51 a52 a53 ≥b5
6 Truck parking accumulation proportional to all a61 a62 a63 ≥b6
7 Small bus parking accumulation proportional to all a71 a72 a73 ≥b7

vehicle is calculated from the vehicle average parking accumulation, divided by total average
parking accumulation for all vehicles, and then multiplied by parking space capacity. In a
mathematical model, it is written as: p
1. Proportion of average parking accumulation for motorcycle is _________
  p + p 1+ p (x1 + x2 + x3)
1 2 3
p2
2. Proportion of average parking accumulation for car is  _________
p1 + p2 + p3 (x 1
+ x2
+ x 3)
p
3. Proportion of average parking accumulation for becak is  _________3
(x1 + x2 + x3).
p1 + p2 + p3

Where p1 is the motorcycle average parking accumulation (number of vehicles in 15

minutes), p2 is the car average parking accumulation (number of vehicles in 15 minutes), p3
is the becak average parking accumulation (number of vehicles in 15 minutes), while (x1 +
x2 + x3) is the parking slot capacity to be allocated.

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The proportion of vehicle average parking duration every 15 minutes for each type of vehicle
is calculated from the vehicle average parking duration, divided by total average parking
duration for all vehicles, and then multiplied by parking space capacity. In a mathematical
model, it is written as: t
1. Proportion of average parking duration for motorcycle is ________
  t + t1 + t (x1 + x2 + x3)
1 2 3
t
2. Proportion of average parking duration for car is ________
  t + t2 + t (x1 + x2 + x3)
1 2 3
t
3. Proportion of average parking duration for becak is ________
  t t3 t (x1 + x2 + x3).
1+ 2+ 3

Where t1 is the average parking duration for a motorcycle (minutes), t2 is the average parking
duration for a car (minutes), and t3 is the average parking duration for a becak (minutes).

The problem of parking slot allocation at Jalan T. Panglima Polem uses three parts of linear
programming model, that is:
Objective function: Z = x1 + x2 + x3
Subject to constraints: 3.12x1 + 12.75x2 + 4.05x3 ≤ Parking space area
p
x1 ≥  _________
1
p +p +p (x1 + x2 + x3) × a
1 2 3
p
x2 ≥  _________
2
p1 + p2 + p3 (x1 + x2 + x3) × a
p
x3 ≥  _________
3
p +p +p (x1 + x2 + x3) × a
1 2 3
t1
x1 ≥  ________
t1 + t2 + t3  (x1 + x2 + x3) × a
t2
x2 ≥  ________
t1 + t2 + t3 (x1 + x2 + x3) × a
t3
x3 ≥  ________
t1 + t2 + t3  (x1 + x2 + x3) × a

x1, x2, x3, p1, p2, p3, t1, t2, t3 ≥ 0 and 0 ≤ a ≤ 1

Table 18.8 Non-negativity constraints

Peak of parking accumulation:

Time 14.30–14.45 p.m. 11.30–11.45 p.m. 08.45–09.00
and
09.00–09.15 a.m.
Jumiah Kendaraan (kendaraan) 135 26 10
Parking index (%) 91.84 162.5 111.11
Parking duration:
arking duration of largest number
P 15 15 15
of vehicles (minutes)
ercentage of the number of vehicles
P 68.09 68.60 79.80
parked (%)
➤➤

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Average parking duration (minutes) 46.72 25.69 24.24

Parking exchanges 8.24 26.3 1.23
Parking utilisation (occupation) (%) 67.18 106.875 51.67

After substitution of the values of p1, p2, p3, t1, t2 and t3 from the field survey into the model,
the optimisation problem can be written as:
Maximise:
Z = x1 + x2 + x3
Subject to constraints:
3.12x1 + 12.75x2 + 4.05x3 ≤ 588
x1 ≥ 0.82(x1 + x2 + x3) × a
x2 ≥ 0.14(x1 + x2 + x3) × a
x3 ≥ 0.04(x1 + x2 + x3) × a
x1 ≥ 0.48(x1 + x2 + x3) × a
x2 ≥ 0.27(x1 + x2 + x3) × a
x3 ≥ 0.5(x1 + x2 + x3) × a
Where x1, x2, x3, ≥ 0 and 0 ≤ a ≤ 1.

Considering parking accumulation only

Optimisation considering constraints only of average parking accumulation with values
from 0.75 up to 1 was run with the solution shown in the table below.
Table 18.9 Optimisation considering average parking accumulation
Variable a = 0.75 a = 0.80 a = 0.85 a = 0.90 a = 0.95 a=1
x1 121.6684 119.0373 115.8873 112.8731 109.8823 107.0182
x2 14.769 15.575 16.2817 16.966 17.6289 18.2714
x3 4.2197 4.45 4.6519 4.8474 5.0368 5.2204
Z 140.6571 139.0623 136.8209 134.6505 132.548 130.5101

Considering parking duration only

Optimisation considering constraints only of average parking duration with values from
0.75 up to 1 was run with the solution shown in the table below.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Table 18.10 Optimisation considering average parking duration

Variable a = 0.75 a = 0.80 a = 0.85 a = 0.90 a = 0.95 a=1
x1 68.3923 63.7555 59.3562 55.1768 51.2011 47.4146
x2 22.704 23.5808 24.4126 25.2029 25.9547 26.6707
x3 21.0222 21.8341 22.6403 23.3361 24.0321 24.6951
Z 112.1185 109.1703 106.3732 103.7158 101.1879 98.7804

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Considering both parking accumulation and parking duration

Optimisation considering constraints for both average parking duration and parking
accumulation with values from 0.5 up to 0.7 was run with the solution shown in the table
below.
Table 18.11 Optimisation considering both average parking accumulation and duration
Variable a = 0.5 a = 0.55 a = 0.60 a = 0.65 a = 0.70
x1 95.91958 89.74738 83.93796 78.46021 73.28654
x2 17.49884 18.66595 19.76446 20.80025 21.77855
x3 16.20263 17.28329 18.30043 19.25949 20.16532
Z 129.621 125.6966 122.0028 118.52 115.2304

Required:
Write a report on the linear programming results that came from the linear programming
exercise performed in the case study.
Source: Munzir S, Ikhsan M & Amin Z. 2010. Linear programming for parking slot optimization: A case
study at Jl. T. Panglima Polem Banda Aceh 2010; 6th IMT-GT Conference on Mathematics, Statistics
and its Applications (ICMSA2010), Universiti Tunku Abdul Rahman, Kuala Lumpur, Malaysia.
Available: http://research.utar.edu.my/CMS/ICMSA2010/ICMSA2010_Proceedings/files/statistics/
STMunzir.pdf (Accessed ……..). [AQ: Provide correct URL]

Case study 4: Budgeting

Budgeting at Caminaysh Travel Centre Ltd

Background
Caminaysh Travel Centre Limited is a family-owned and managed business situated in
Morningside, a suburb in KwaZulu-Natal, South Africa. The business was established
some thirty years ago by the current owners’ father, who passed on the business to his two
daughters upon retirement. He saw a huge market in the travel and tourism industry when
he started the business, as he himself was a frequent traveller. Both daughters, Senayshia
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and Camishka, are still deeply involved in the running of the business, even though they
are now close to retirement, and neither of them have children to whom they could pass
on the business. The business was originally run from a small shop in Grey Street in
central Durban, and now the business premises occupies 2 000 square metres of the main
shopping district in Florida Road. The management team of Caminaysh Travel Centre
Limited pride themselves on running a business which retains the standards of service and
customer relationships usually associated with a bygone era. Caminaysh Travel organises
holidays both locally and abroad. The company does a full travel package, from booking
the accommodation and flights to arranging the tours and all land transport. Contracts
have been negotiated with hotels that require them to deal with any local arrangements,
including airport transfers and any local activities. Over the past decade, the company
has acquired units in over 100 resorts in several countries, ranging from Malaysia, India,

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Thailand, United Arab Emirates, etc. All holidays are booked by clients and paid through
South African travel agents.
The company’s management believes that dealing only with airlines, hotels and travel
agents allows them to be administratively streamlined, more efficient and price competitive.
Caminaysh Travel holidays used to offer a variety of packages in the past. They have now
narrowed it down to two packages: summer and winter, charging a flat rate for each holiday.
The summer packages include mainly holidays that have plenty of watersports, buzzing
nightlife and also shopping. For the winter packages, clients prefer destinations that include
plenty of shopping, winter sports and sightseeing. Through intense market research, it was
found that this was the most popular during the season. Caminaysh Travel requires that
full payment be made with the booking. They are able to sustain this policy by being very
price competitive. The management believes that any possible loss of customers through
following this policy is outweighed by the knowledge that bookings, once made, are certain
from the company’s point of view.

Further information about the company and forecasts for next year
Winter packages cost the customer R6 500 each, and summer packages cost R6 100 each.
The company has tried to keep these prices as low as possible, even to the extent of dropping
their margins. Travel agents charge a 10% commission that is included in the full price of
each holiday. They deduct their fee before settling the other 90% to the company at the time
of booking. Once the booking is received from a customer, the company books all flights
and accommodation. After much deliberation with the airlines, the company negotiated
fixed charges of R4 000 per passenger per holiday. Hotel charges are R1 250 for summer
holidays and R1 500 for winter holidays. Both airline and hotel charges must be paid in the
month in which the holiday was originally due to be taken. If a holiday is cancelled by the
time payment is due to the airline and hotels, they accept 60% of these amounts in respect
of the cancelled places. Airline and hotel charges for later cancellations have to be made in
full. Caminaysh Travel Centre does not make any refunds to its clients, irrespective of the
date of cancellation. From past experience, the company knows what percentage of holidays
booked is likely to be cancelled. At 31 December this year, the company has received 660
bookings for winter packages.
The following table shows the estimated bookings and cancellations.
Table 18.12 Estimated bookings and cancellations at Caminaysh Travel Centre
Month Holidays booked Holidays taken Holidays cancelled
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Winter Summer Winter Summer Winter Summer

Jan. 700 150 540 – 40 –
Feb. 740 980 520 – 50 –
Mar. 120 860 790 – 70 –
Apr. 40 660 230 – 20 –
May – 450 200 – 20
June – 100 370 – 30
July – 80 890 – 80
Aug. – 80 1 070 – 90
Sept. 70 50 600 – 60
➤➤

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Oct. 110 – – – –
Nov. 360 – – – –
Dec. 400 – – – –

The ‘Holidays cancelled’ columns of Table 18.12 show the month for which the cancelled
holiday was intended to be taken at the time of booking. From past experience, it is expected
that of the holidays that are cancelled, 50% will be cancelled before payment is due to the
airlines and hotels, and 50% will be cancelled later than this.
The accounts department has prepared the following extract as at 31 December this year:
Freehold land and buildings R3 882 000
Equipment and furniture R 57 000
Cash R 21 700
Share capital and reserves R 99 700
Trade creditors (660 winter sports 3 (6 500 – 10%) R3 861 000

In recent years, Caminaysh Travel Centre has decided to use an online payroll system. This
system takes the hassle out of payroll administration. They have a staff complement of
10, including three managers. Next year, salaries of R150 000 for each month will be paid
during the month in which they are incurred. Due to the rise in Eskom’s tariffs, the amount
budgeted for electricity is expected to increase to R1 500 each month, payable on a quarterly
basis in advance. Depreciation is written off at 20% on the book value of the equipment
and furniture. Depreciation is not charged on land and buildings. The business rates are
also expected to be the same as this year at R3 000 per month. The rates will be paid in two
equal instalments, at the beginning of the fourth month and at the beginning of the tenth
month. The amount budgeted for general and administrative expenditure is expected to be
about R900 each month, payable in cash.
One of the most appealing benefits of working at Caminaysh Travel Centre is that
staff regularly travel abroad on behalf of the company. The company incurs the full cost.
The budget for this cost is projected at the rate of R8 000 per month during the months
when the clients take holidays. The cost is R5 000 during each of the other three months.
The company has various timeshare units throughout the world where the staff can be
accommodated during their travels on company business. Profits on a particular holiday
are realised in the month in which it is taken.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Expansion
Caminaysh Travel Centre has recently won a five-year government contract to provide all
travel arrangements, including accommodation and flights, for government employees.
The company appointed a new director to take responsibility for the government contract
as the existing staff would not cope with the added workload. She has worked in various
positions in other organisations for several years. She put together a team of managers by
recruiting some of her former colleagues and some of the existing managers. The contract
stipulates that the company should prepare detailed budgets for its first year of operations
to show how it intends to meet the various operating targets that are stated in the contract.
The new director is undecided about whether she should prepare the budgets herself or
whether she should involve her management team, including the newly recruited managers,
in the process.

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Required:
(a) Prepare a monthly cash budget, a budgeted income statement, and a budgeted balance
sheet as at the end of next year.
(b) Comment on the company’s plans and on the policy of waiting until holidays have been
taken, or were due to be taken, before realising the profit on them.
(c) Produce a report, addressed to the new director, that discusses participative budgeting.
Your report must explain potential benefits and disadvantages of involving the new and
existing managers in the budget setting process, and provide a recommendation to the
new director.

Case study 5: Budgeting, financial and non-financial

information
The Edcon Group
The Edcon Group, one of the largest non-food retailers in southern Africa and true to
its 90-year history, continues to lead the way in retail with a number of ground-breaking
initiatives aimed at supporting and investing in the communities it serves. It is a Proudly
South African Group in the retail sector creating a culture of sustainability. The company’s
operations are divided into two divisions managed by two independent management teams.
The divisions are Jungle Co and Bags4All. Jungle Co operates internationally while Bags4All
targets the local markets.

Jungle Co division
Jungle Co is a very successful multinational retail division. It has been selling a large range of
household and electronic goods for some years. One year ago, it began using new suppliers
from the country of Slabak, where labour is very cheap, for many of its household goods.
In 20X4, Jungle Co also became a major provider of ‘cloud computing’ services, investing
heavily in cloud technology. These services provide customers with a way of storing and
accessing data and programs over the internet rather than on their computers’ hard drives.
All Jungle Co customers have the option to sign up for the company’s ‘Gold’ membership
service, which provides next-day delivery on all orders, in return for an annual service fee
of $40. In September 20X5, Jungle Co formed its own logistics company and took over the
delivery of all of its parcels, instead of using the services of international delivery companies.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Over the last year, there has been worldwide growth in the electronic goods market of
20%. Average growth rates and gross profit margins for cloud computing service providers
have been 50% and 80% respectively in the last year. Jungle Co’s prices have remained stable
year on year for all sectors of its business, with price competitiveness being crucial to its
continuing success as the leading global electronic retailer. The following information is
available for the last two financial years:

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Table 18.13 Information available for Jungle Co for 20X5 and 20X6
Notes 31 December 20X6 31 December 20X5
$’000 $’000
Revenue 1 94 660 82 320
Cost of sales 2 –54 531 –51 708
Gross profit 40 129 30 612
Administration expenses 3 –2 760 –1 720
Distribution expenses –13 420 –13 180
Other operating expenses –140 –110
Net profit 23 809 15 602

Notes:
1. The breakdown of revenue is shown in the table below.

Table 18.14 Breakdown of revenue for 31 December 20X5 and 20X6

31 December 20X6 31 December 20X5

$’000 $’000
Household goods 38 990 41 160
Electronic goods 41 870 32 640
Cloud computing services 12 400 6 520
Gold membership fees 1 400 2 000
94 660 82 320

2. The breakdown of cost of sales is shown in Table 18.15.

Table 18.15 Breakdown of cost of sales for 31 December 20X5 and 20X6

31 December 20X6 31 December 20X5

Electronic goods 26 797 21 216

Cloud computing services 4 240 1 580
Gold membership fees 100 100
54 531 51 708

3. Administration expenses:
Included in these costs are the costs of running the customer service department
($860 000 in 20X5; $1 900 000 in 20X6). This department deals with customer complaints.
4. Non-financial data is given in the Table 18.16.

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Table 18.16 Non-financial data for 31 December 20X5 and 20X6

31 December 20X6 31 December 20X5

Percentage of orders delivered on time 74% 92%
Number of customer complaints 1 400 000 3 200 000
Number of customers 7 100 000 6 500 000
Percentage of late ‘Gold’ member deliveries 14% 2%

Bags4All division
Bags4All produces and sells high-quality leather bags. Under current conditions, they
produce two different products: a handbag and a satchel bag (ie a sling bag used to carry
books). Locally, Bags4All has had great success and it is the main supplier of leather
handbags to several chain stores.
Although profitability and share price growth has proven to be consistent, the financial
manager, Mrs Joe Baggage, is always searching for new ways through which the business can
be expanded and competitive advantage obtained. Her suggestion is that Bags4All should
expand its business sphere to the international market and establish its brand in other
countries. She argues that the South African rand is trading poorly against other currencies,
and that this can pay off generously if products are exported.
The production manager, Mr Lucky Carrier, is not keen on this idea. He is eager to expand
the production line and was approached by the directors of PinkWorths Ltd, a well-known
retailer of fashionable clothing and accessories for women. PinkWorths Ltd is searching for
a manufacturer that is willing to produce a custom-designed handbag that will be marketed
and sold exclusively as the ‘PinkWorths bag’. This quality handbag will be mainly produced
from black leather and quartz crystals. Bags4All will sign a contract of restriction, since
these handbags may not be produced for any other retailer.
Mrs Baggage and Mr Carrier had an argument recently, because Bags4All cannot fund
exportation, as well as a new product line. Decisions need to be made as to which suggestion
is best.

Note 1: Budget to produce the PinkWorths bag

Before further negotiations are entered into with the directors of PinkWorths Ltd, a master
budget must be set in order to estimate the costs associated with this business venture.
PinkWorths Ltd indicated that it will buy approximately 5 000 of the PinkWorths bags
Copyright © 2021. Juta & Company, Limited. All rights reserved.

from Bags4All on an annual basis. The monthly sales distribution is expected to be as

shown in Table 18.17.
Table 18.17 The expected monthly sales distribution
Month Jan 20X6 Feb 20X6 Mar 20X6 Apr 20X6 May 20X6 Jun 20X6
Sales units 300 400 420 420 250 400
Month Jul 20X6 Aug 20X6 Sep 20X6 Oct 20X6 Nov 20X6 Dec 20X6
Sale units 400 420 300 300 700 270

PinkWorths Ltd is willing to pay R600 per bag. It is policy for Bags4All to maintain closing
finished goods at a level that is equal to 40% of the next month’s demand. The material
required per handbag is shown in the following table.

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Table 18.18 Material required per handbag

Leather Crystals
Input per PinkWorths bag 1.5 metres per bag 25 crystals per bag
Cost R180 per metre R3 per crystal

It takes 30 minutes to produce a handbag. Material is purchased on a just-in-time (JIT)

basis and no such inventories are kept readily on hand.
The crystals are sewn to the handbags by hand with the upmost care. Direct labourers
earn R200 per hour. Variable overheads are allocated on the basis of direct labour hours.
Variable overheads are shown in the following table.
Table 18.19 Variable overheads based on direct labour hours
Cost per direct labour hour
Electricity R25
Indirect material R40
Indirect labour R45

No additional rental expenses will be incurred as a fixed cost, however additional insurance
will be needed to protect Bags4All Ltd against potential theft and loss. The increase in the
insurance expense is yet to be determined.

Note 2: Exporting handbags and satchel bags

Mrs Baggage did her own research and concluded that it will be best to export leather bags
to the Netherlands. The Netherlands’ economy has been performing well during the last
few years and the demand for leather bags is expected to be based on different economic
probabilities, as shown in the following table.
Table 18.20 Demand based on economic probabilities for the year ended 31 December
20X6
State of Netherlands’ Probability of Demand for leather Demand for leather
economy economic state handbags satchel bags
Economic boom 0.50 5 000 bags 7 000 bags
Recession 0.10 100 bags 140 bags
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Depression 0.05 25 bags 30 bags

Economic rise 0.35 4 000 bags 5 500 bags

Exportation will require the necessary cash flow to be available, and thorough planning in
this regard is of utmost importance.

Note 3: Cash flow required to export products

If products are exported, it is probable that a leather handbag can be sold for €45 and a
satchel bag for €52. On average, the euro trades at €1 = R16.10. All sales will be done to
foreign suppliers on credit. It is expected that 50% of foreign suppliers will pay within the
same month, 30% in the month after sale, and 15% will pay two months after the sale. A
total of 5% represents bad debts. Sales are distributed evenly throughout the year. (Refer to
note 2.)

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Information relating to costs are as follows:

● Direct labour costs are R50 000 per month and are expected to increase with 9% as from
1 June 20X6.
● Variable overheads are approximately R25 000 per month, with an expected increase of
6% as from 1 August 20X6.
● Fixed costs are R100 000 per month with no expected changes in the near future.
● Direct material purchases are summarised in Table 18.21.

Table 18.21 Direct material purchases for 20X6

Month Jan 20X6 Feb 20X6 Mar 20X6 Apr 20X6 May 20X6 Jun 20X6
Direct R120 000 R160 000 R170 000 R175 000 R175 000 R180 000
material
purchase
Month Jul 20X6 Aug 20X6 Sept 20X6 Oct 20X6 Nov 20X6 Dec 20X6
Direct R135 000 R170 000 R165 000 R170 000 R220 000 R190 000
material
purchase

● A total of 40% of the direct materials are paid for in cash. The remainder is purchased
on credit. Credit purchases are paid for in full in the month that follows the month of
purchase.
● The opening bank balance on 1 May 20X6 is R300 000.

No final decision has been taken regarding exportation or extension of the production line.
You were approached to provide advice on the preceding notes.

Required:
(a) Discuss the financial and non-financial performance of Jungle Co for the year ending
31 December 20X6.
(b) Draft the following budgets of Bags4All for the months June, July and August 20X6, as
per Note 1:
(i) Production budget
(ii) Material purchase budget
(iii) Variable overhead budget.
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(c) Refer to Note 2 and calculate the probable demand for leather handbags and leather
satchel bags.
(d) From the case study it is clear that Mrs Baggage is of the opinion that a poorer rand-
to-euro relation can benefit local exports. Explain three possible ways in which local
financial prosperity can be stimulated under such circumstances.
(e) Refer to Note 3 and compile the cash budget for exported products, for the months
May, June and July 20X6.
(f) Discuss three reasons why management of Bags4All should set a cash budget.
(g) Discuss any four non-monetary considerations that Bags4All should take into account
before exporting its products.
Source: ACCA (adapted)

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Case study 6: Relevant costs, divisional performance,

breakeven analysis and direct costing
Solarpower Ltd
Solarpower Ltd has two divisions, the Solar Panel division, which manufactures solar
panels, and the Turbines division, which manufactures wind turbines. The company makes
use of the absorption costing system and all its inventory items are valued using the first-
in-first-out (FIFO) method.

Solar Panel division

The Solar Panel division manufactures three types of solar panels which are sold to retailers
across the country. During the budget presentation meeting, concerns were raised about
the division’s allocation of the fixed manufacturing overheads and the impact thereof on
the budgeted gross profit percentages. An immediate investigation into the activities that
drive the allocation of these fixed manufacturing overheads was ordered.
1. Budgeted information for the month ending 31 December 20X1 is given in Table 18.22.

Table 18.22 Budgeted information for the month ending 31 December 20X1
Product STANDARD SUPER R2R TOTAL
Production and sales units 5 000 3 000 2 000 10 000
R’ 000 R’ 000 R’000 R’000
Revenue 80 000 55 500 48 000 183 500
Less: Costs of sales 75 200 53 700 49 400 178 300
Direct raw materials 29 000 19 500 20 000 68 500
Direct labour 24 700 20 700 18 400 63 800
Variable manufacturing overheads 16 500 10 500 9 000 36 000
Fixed manufacturing overheads 5 000 3 000 2 000 10 000
Gross profit/(loss) 4 800 1 800 (1 400) 5 200
Less: Non-manufacturing overheads
Variable selling costs 60
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Fixed head-office allocated costs 125

Fixed salary costs 261
Net profit 4 754
Gross profit percentage 6.00% 3.24% (2.92%) 2.83%

Additional budgeted information relating to the month ending 31 December 20X1:

1.1 The total budgeted units of panels are equivalent to 100% monthly manufacturing
capacity. All losses in the manufacturing process may be regarded as immaterial.
1.2 The budget assumes that all panels manufactured during the month will be sold. The
division had no budgeted work in progress, and opening and closing inventory for all
three types of panels.

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1.3 The direct raw materials used in the panel manufacturing process are mainly steel and
other parts. The division currently makes use of the just-in-time (JIT) procurement
technique for the acquisition of the direct raw materials.
1.4 The fixed manufacturing overheads are expected to be absorbed by the three panels on
the basis of a pre-determined fixed manufacturing overheads absorption rate.
1.5 The variable selling costs are budgeted at R6 per unit for each type of panel.
1.6 The fixed head-office allocated costs represent corporate sponsorship to the Nu-West
Secondary’s fundraising weekend event. This amount is allocated monthly to all the
companies in the group on an arbitrary basis.
1.7 The fixed salary cost represents monthly salaries for five administrative employees of
the Solar Panel division.
2. Investigation results of the allocation of the fixed manufacturing overheads are given
below.
The investigation established that the current blanket allocation of the fixed
manufacturing overheads is not appropriate and should be revised. The proposal is
to allocate these overheads on the basis of the activities that drive these overheads, as
shown in Table 18.23.
Table 18.23 Overheads allocated on basis of activities that drive these overheads
Fixed manufacturing
overheads
Activity driver Notes
R
Number of production runs 2.1 1 485 000
Machine hours 2.2 1 599 600
Number of purchase orders 2.3 828 900
Number of quality inspections 2.4 6 086 500
R10 000 000

2.1 Panels are manufactured in production runs. Standard’s production run contains
250 panels, Super’s production run contains 200 panels, and R2R’s production run
contains 200 panels.
2.2 The division’s manufacturing process is predominantly performed by specialised
machines. The machine time to manufacture each panel is 15 minutes for Standard,
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30 minutes for Super, and 57 minutes for R2R.

2.3 The budget assumes a total of 20 working days for the month. Direct raw material
purchase orders as per the JIT manufacturing schedule will be placed every 3rd working
day for the Standard panels, every 5th working day for the Super panels and every 8th
working day for the R2R panels.
2.4 Quality inspections occur as follows: every 500th Standard panel is inspected, every
100th Super panel is inspected, and every 20th R2R panel is inspected.
3. The following is an extract of the actual results for the month ended 31 December 20X1
for product R2R only:
3.1 The actual production schedule is given in Table 18.24.

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Table 18.24 Production schedule

R2R panels Number of panels R
Opening inventory: 1 December 20X1 70 R1 715 000
Production 2 200 ?
Sales 2 150 ?
Closing inventory: 31 December 20X1 ? ?

3.2 The opening inventory value of R1 715 000 included fixed manufacturing overheads
absorbed at a rate of R800 per unit and the related variable manufacturing costs per
unit is equivalent to the December 20X1 budget.
3.3 An end-of-range sale was held in December 20X1 whereby the R2R panels were sold at
2% less than the budgeted selling price.
3.4 The actual direct raw materials and direct labour actual price/rate were 5% higher than
the budgeted price/rate.
3.5 The actual variable manufacturing overheads per unit and variable selling costs per
unit rates were the same as the related budgeted unit prices.
3.6 The actual total fixed manufacturing overheads and the actual fixed salary costs were
R1 950 000 and R55 500 respectively.

Turbine division
The Turbine division has a monthly manufacturing capacity of 50 turbines, 35 of which
represent the current monthly existing external market. The selling price in the existing
external market is R3 800 per turbine and the related total variable costs are R2 600
per turbine.
The division was approached by SeCa SA to prepare a quotation for a tender of 25 high-
tech wind turbines.

Additional information:
1. The manufacturing of the proposed 25 turbines will require the installation of one Part
A per turbine. Part A is regularly used by the division. The required parts are all available
in inventory and were purchased at R1 500 per part. Each part has a resale value of
R1 550 and a current replacement cost of R1 700.
2. In addition to Part A, each of the proposed 25 turbines will require three high-tech parts
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(Part Z). Part Zs can only be bought in batches of 50 high-tech parts per batch. The total
cost per batch is R20 000. Although Part Zs are in regular use, the division does not
currently have them in inventory.
3. The machine time to manufacture each turbine is 40 minutes and the cost is R300 per
machine hour. The machine was purchased two years ago with an R8 000 000 loan at
10.50% interest per annum. The machine is depreciated over its intended economic
useful life of eight years.
4. The normal direct labour time to manufacture each high-tech turbine is 16 minutes.
Due to the specialised nature of these high-tech turbines, overtime will be worked on
only 12 of the 25 turbines. The normal direct labour rate is R180 per hour, and the
overtime rate is 1.5 times the normal rate. The direct labour is variable in nature.

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5. The divisional manager attended the initial tender briefing at SeCa SA’s offices and had
subsequently visited their offices three times at a cost of R1 200 per return trip.
6. The fixed manufacturing overheads are allocated to the turbines on the basis of a pre-
determined fixed manufacturing overheads absorption rate of R1 500 per turbine. No
additional fixed manufacturing overheads will be incurred due to the manufacturing of
these high-tech turbines.
7. The division’s pricing policy is to add 20% mark-up on the total relevant costs for such
quotations.

Required:
(a) Determine the total budgeted number of each type of panel required by the Solar Panel
division for the month of December 20X1 to break even.
(b) Briefly discuss two benefits to the Solar Panel division of using the JIT direct raw
materials procurement technique.
(c) Assume a budgeted controllable investment of R250 000 000 for December 20X1.
Calculate the Solar Panel division’s annualised budgeted return on investment for
December 20X1.
(d) Assume that the Solar Panel division implements the proposal to revise the allocation
of the fixed manufacturing overheads. Calculate the revised budgeted gross profit
percentage of each type of panel.
(e) The direct costing system could provide meaningful information for assessing the
economic performance of the Solar Panel division. Prepare the December 20X1 actual
income statement for product R2R, based only on the direct costing system.
(f) Determine the total price to be quoted by the Turbines division for the 25 high-tech
wind turbines as per SeCa SA’s request. Give a reason for inclusion or exclusion of all
items. Show all your calculations. Briefly discuss qualitative factors which the Turbines
division should consider before quoting the tender price to SeCa SA.

Case study 7: Relevant costs and expected values

and has approached the VBJ holiday company (‘VBJ’) to obtain a quotation. VBJ has been
trying to win the business of the CS group for some time and is keen to provide a quotation
that the CS group will find acceptable in the hope that this will lead to future contracts.
The manager of VBJ has produced the cost estimate for the conference as shown in the
following table.

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Table 18.25 Cost estimate for conference

R
Coach running costs 2 000
Driver costs 3 000
Hotel costs 5 000
General overheads 2 000
Subtotal 12 000
Profit @ 30% 3 600
Total 15 600

You have considered this cost estimate, but you believe that it would be more appropriate
to base the quotation on relevant costs. You have therefore obtained the following further
information: Coach running costs represent the fuel costs of R1 500 plus an apportionment
of the annual fixed costs of operating the coach. No specific fixed costs would be incurred if
the coach was used on this contract. If the contract did not go ahead, the coach would not
be in use for eight out of the 10 days of the conference. For the other two days, a contract has
already been accepted which contains a significant financial penalty clause. This contract
earns a contribution of R250 per day. A replacement coach could be hired for R180 per day.
Driver costs represent the salary and related employment costs of one driver for 10 days.
If the driver is used on this contract, the company will need to replace the driver, so that VBJ
can complete its existing work. The replacement driver would be hired from a recruitment
agency that charges R400 per day for a suitably qualified driver. Hotel costs are the expected
costs of hiring the hotel for the conference. General overheads are based on the overhead
absorption rate of VBJ, and are set annually when the company prepares its budgets. The
only general overhead cost that can be specifically identified with the conference is the time
that has been spent in considering the costs of the conference and preparing the quotation.
This amounted to R250.

Required:
(a) Prepare a statement showing the total relevant cost of the contract. Explain clearly the
reasons for each of the values in your quotation, and for excluding any of the costs (if
appropriate).
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Part 2: Now that the quotation has been prepared, there seems to be some uncertainty
about the hotel cost and the fuel cost. Further investigation has shown that these costs
may be higher or lower than the original estimates. Estimated costs with their associated
probabilities are given in the table below.
Table 18.26 Estimated cost and probabilities
Estimated hotel cost Probability Estimated fuel cost Probability
R % R %
4 000 20 1 200 10
5 000 50 1 500 50
6 000 30 2 000 40

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The two-way data table below shows the effect of these alternative values on the total
relevant cost. All figures are in rand.
Table 18.27 Two-way data table
Hotel
R R R R
4 000 5 000 6 000
1 200 –1 300 –300 700
Fuel
1 500 –1 000 0 1 000
2 000 –500 500 1 500

Required:
(a) Explain the meaning of the above two-way data table.
(b) Produce and interpret a table that shows how the two-way data table may be used in
conjunction with the probabilities to improve the information available to the manager
of VBJ.
Source: CIMA (adapted)

Case study 8: Integrated case study on inventory

management
Geoffrey’s Ltd manufactures a range of valves that are used in the manufacture of tractors.
Geoffrey’s sells its components internationally to several major tractor manufacturers.
The company uses 3 tonnes of steel per year to manufacture the valves. Orders for steel
are placed with a local steel producer at R300 per order. The supplier requires a working
week for delivery. The steel costs R5 per kg. The company prefers to hold at least 200 kg of
steel on hand in case of emergencies. Storage space for a tonne of steel amounts to R1 000
per year. It is difficult to manufacture a perfectly serviceable valve every time because the
manufacturing process is complicated and involves several steps. After each step has been
completed, the company runs a series of quality checks and valves that fail are discarded
before they go on to the next stage or are accepted into inventory. The rejection rates vary
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from step to step, but can be as high as 5% in some stages of the production process. Overall,
Geoffrey’s budgets for a 20% rejection rate when estimating the size of production runs.
There are substantial costs associated with quality checks and rejections. Approximately
20% of staff time is devoted to quality control. The rejected components have no scrap value
and so Geoffrey’s has to pay to dispose of them in an environmentally acceptable manner.
Staff morale appears to play a role in the determination of quality. Failure rates are higher
on Friday afternoons and Monday mornings when employees are distracted by looking
forward to the weekend or demotivated by the start of the working week. Also, major
televised sporting events broadcast late at night can lead to deterioration in the quality
of the following day’s output because staff have stayed up to watch the event. The failure
rate depends largely upon the care with which the manufacturing machinery has been set
up and calibrated before a batch of parts is processed, although that is not the only factor.
For example, a defective part may have passed through earlier quality checks unnoticed and

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could cause a failure at a later stage. In addition to the quality issues, sales have been falling
at a constant rate as new companies have entered the market, providing more reliable valves
than Geoffrey’s.
Geoffrey’s board is keen to address its problems and enjoys the benefits associated with
total quality management (TQM), but has not committed itself to a full implementation
of TQM. As an initial step the board asked production supervisors to come into work an
hour early once a week for a quality circle meeting. The board had intended to devote more
time and effort to TQM if this initial step had proved successful, but the directors have been
disappointed by the initial feedback, which can be summarised as follows:
● The supervisors have proposed that the working week be reorganised so that staff can
leave early on a Friday afternoon and have longer breaks on a Monday. This proposal
is supported by a revised schedule that would make up for this time by having staff
work longer hours in the middle of the week. Geoffrey’s board has rejected this proposal
because there would be some additional administrative costs associated with the
proposed new working arrangements.
● The supervisors wish to reallocate some of the present quality control staff to production
so that more staff time would be available to permit production processes to be set up
properly. The supervisors believe that production staff have to work at close to 100%
of their capacity and that such effort is not consistent with producing high-quality
work. Reducing the pressure would lead to a dramatic reduction in failed parts and so
the company would need fewer quality inspectors. Geoffrey’s board has rejected this
proposal because it believes that staff should be encouraged to work harder and not to
slow down. Also, the board would expect any reduction in the quality-control staff to
offer the opportunity to reduce staffing and save costs.

The company’s cost of capital is 12%.

Required:
(a) Calculate the economic order quantity (EOQ) and reorder point for Geoffrey’s and
interpret the figures.
(b) Explain two concepts of Kaizen costing.
(c) Explain three conditions that must exist for TQM to be successfully implemented at
Geoffrey’s.
(d) Advise Geoffrey’s board on the shortcomings of the approach that it has taken to TQM.
(e) Recommend, stating reasons, the actions that Geoffrey’s board should have taken in
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order to introduce TQM within Geoffrey’s successfully.

(f) Advise Geoffrey’s board on the risks associated with reducing the number of quality
control staff in the factory.
Source: CIMA (adapted)

Case study 9: Relevant costing, standard costing,

transfer pricing
Since the inception of Moor-wood Bikes in Pietermaritzburg almost a decade ago, their
craft of designing and manufacturing the highest quality mountain bike frames has
certainly progressed. The machines have evolved, the graphics and corporate identity have

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changed. Moor-wood Bikes is a manufacturer of mountain bike tyres and fully assembled
mountain bikes which it distributes to wholesalers around the country. The Tube
department manufactures the tyres, and the Assembly department assembles the complete
bike. Currently, the Assembly department purchases the tyres from an outside supplier.
The Tube department currently manufactures 10 000 tyres per month. Moor-wood Bikes is
currently considering buying the tyres from an outside supplier. The total budgeted costs
per month to manufacture 10 000 tyres are as follows:
Table 18.28 Total budgeted costs per month
R
Direct raw material 800 000
Direct labour 500 000
Variable manufacturing overheads 200 000
Fixed manufacturing overheads 100 000
Allocated corporate expenses 100 000

An outside supplier has offered to supply Moor-wood Bikes with 10 000 tyres at a price of
R165 per tyre. Direct raw material of R800 000 are avoidable if the offer is accepted, whereas
the direct labour employed in the Tube department will become redundant if the offer is
accepted and redundancy costs of R50 000 will be incurred before they close down. Variable
manufacturing overheads are avoidable if the offer is accepted. Fixed manufacturing
overheads will be reduced by R50 000 in total in the month of acceptance of the offer.
Allocated corporate expenses per month for the Tube department will reduce by 20% if the
offer is accepted. The total expenses for the company will, however, remain the same. The
Tube department currently sells all 10 000 tyres to the outside market at a selling price of
R200 per tyre. The Assembly department assembles the complete mountain bikes using the
tyres and other direct raw material. The department uses a standard absorption costing
system for planning and control purposes. The standard cost per unit is as follows:
Table 18.29 Standard cost per unit
R
Selling price 450
Direct material – Tyres (1 kg) 160
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Direct material – Other (2 kg) 50

Direct labour 80
Variable manufacturing overheads 40
Fixed manufacturing overheads 50

The budgeted allocated corporate expenses for the month of August were R300 000. The
budgeted monthly sales units for the department are 10 000 mountain bikes.

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The actual results for August 2016 were as follows:

Table 18.30 Actual results for August 2016
Actual production and sales units 8 000
Selling price (per unit) R460
Direct material – Tyres per unit (1 kg) R180
Direct material – Other per unit (2.5 kg) R40
Direct labour per unit R65
Variable manufacturing overheads per unit R45

The total fixed manufacturing overheads for the month of August 2016 were R490 000.
Allocated corporate expenses were R320 000. There was no opening or closing
inventories of direct raw material and finished scanners. Moor-wood Bikes is considering
the possibility of transferring all the tyres manufactured by the Tube department to the
Assembly department. The Assembly department currently buys all the required tyres from
an outside supplier at a cost of R155 per unit, plus delivery cost per unit of R5. The Tube
department sells all the tyres it manufactures to external customers. The two departments
are managed by independent management teams, and the performances of these teams are
evaluated independently.

Required:
(a) Determine if the Tube department should continue to manufacture the scanner
screens or whether they should purchase them. Your analysis should be from a purely
quantitative viewpoint.
(b) Briefly discuss five non-financial factors that Moor-wood Bikes should consider before
deciding to purchase the tyres from the outside supplier.
(c) Calculate the possible variances for the Assembly department for the month of August
2016 and provide any possible reasons for the variances. Ignore the possibility of
transfer pricing.
(d) Determine the minimum transfer price at which the Tube department will be willing to
sell the scanner screens to the Assembly department.
(e) Determine if Moor-wood Bikes should introduce the transfer pricing system.

per unit.

Case study 10: Short-term decision making

Motorcycling – is the risk worth the reward?
Make-it Ltd was established 18 months ago. They produce motorcycle engines which
they supply to three other motorcycle manufacturers. The cylinder head and crankshafts
for the motorcycles are sourced from a local foundry on a just-in-time basis. The other
components required for the engines are purchased from various other suppliers in the
surrounding areas. The current market for motorcycles has declined, due to consumers’

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negative perceptions related to the risks involved with riding motorcycles. The company
operates three main production departments, machining, assembly and quality control,
and has five service departments which include the purchasing department, goods receiving
department, tool store, factory office and research and development department.
Due to the decline in market share, the company only has sufficient work for the month
of July, as well as a once-off order for 6 000 engines. No other orders are expected until
November. Market research has indicated that the demand for motorcycles is expected to
increase after November. The factory is currently operating at 75% capacity and the order
for 6 000 engines equates to one month’s production at the current level. Management is
faced with two options:
Option 1: Complete the order for 6 000 engines in August and close down the factory in
September and October.
Option 2: Operate at 25% capacity for the three months, August, September and October.
The estimated direct labour cost per month in the three production departments is as
follows:
Table 18.31 Estimated direct labour cost per month in the three production departments
75% capacity 25% capacity
(R) (R)
Machining department 37 800 13 500
Assembly department 120 600 39 000
Quality control department 63 000 21 000

If the factory is closed down, the direct labour workers will be put off in the interim.
Consequently, no direct labour cost would be incurred during the months of closure. Since
the company was recently established, no trade unions would be involved. Other costs are
provided below at 75%, 25% and idle capacity.
Table 18.32 Other cost data
75% 25% Idle
capacity capacity capacity

(R) (R) (R)

Depreciation on plant and machinery 525 000 285 000 150 000
Power 12 000 4 200 900
Supervisory salaries 10 500 10 500 10 500
Indirect labour for:
Machining department 12 000 6 000 3 000
Assembly department 6 000 3 000 0
Quality control department 3 600 1 800 0
Research and development 7 500 7 500 7 500
Receiving department and tool store 14 400 7 200 3 600
Factory office staff salaries 25 500 25 500 25 500
➤➤

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Consumable supplies:
Machining department 1 200 300 0
Assembly department 600 150 0
Quality control department 900 300 150
Research and development, purchasing & receiving 1 500 1 500 1 500
departments
Factory office 2 100 600 600
Salaries and wage-related costs 38 100 16 500 3 450
Lighting and heating 6 000 4 500 1 500
Insurance 3 000 3 000 3 000
Repairs and maintenance 12 000 12 000 3 000
Totals 746 400 454 050 278 700

Required:
(a) As the management accountant, prepare a report for the production manager
recommending which course of action should be taken. Your report must include a
cost statement comparing both options available to the company.
(b) Identify and explain three other relevant costs associated with the decision taken in (a)
above.
(c) Explain how cost-volume-profit analysis can be used by the company for short-term
decision making.
(d) Comment on whether or not the company should adopt a diversification strategy in
order to improve its long-term profitability.

Case study 11: Capital investments; pricing

Super Shine (Pty) Ltd is a manufacturer of dog shampoos for the upper end of the market.
One of their current product lines aimed specifically at large breeds, is coming to an end
of its production life in four years’ time when the patent expires on 31 December 20X4.
After spending R250 000 on market research, the directors of Super Shine (Pty) Ltd are
considering entering the human shampoo market with a new product (‘NewWave’) that
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has been derived from the dog shampoo. They will need to replace the current machine
manufacturing the dog shampoo with a new machine, as the process is slightly different
from the existing process.

Manufacturing machines
The new manufacturing machine will cost US$1.75 million and will be imported from
an unknown Chinese company (www.cheapmachines.com) found on the internet at an
estimated exchange rate of R15 per US$ on 1 January 20X1. The machine will be put to
use immediately and has an estimated useful life of four years. The South African Revenue
Service (SARS) will allow a section 12C capital allowance of 40% on the initial cost in the
first year, and 20% on the cost in each subsequent year. The new machine will only be able
to manufacture the new product and will have an estimated residual value of R1 million

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at the end of its useful life. The capacity of the new machine is 150 000 units of shampoo.
Additional raw material inventory of R1.1 million is required in the production of the
human shampoo.
The existing machine will have a market value of R1 350 000 and a tax value (cost less
capital allowances) of R500 000 on 1 January 20X1. This old machine was bought new
three years ago and qualified for the same section 12C allowance of 40% in the first year and
20% in each subsequent year. The old machine would have been scrapped at the end of its
original useful life of seven years.

Operating cash profits

The net cash profits from the dog shampoo amounts to R1 200 000 per annum. The
following table shows the estimated sales of the ‘NewWave’ human shampoo for the four-
year life cycle of the product:
Table 18.33 Estimated sales
20X1 20X2 20X3 20X4
Sales (in units) 100 000 150 000 170 000 200 000

The new shampoo will be sold for R80 per unit and the estimated variable cost per unit
is R35. The new machine is too large for the current warehouse (where the dog shampoo
machine is located). The current warehouse was purchased by Super Shine (Pty) Ltd eight
years ago at a cost of R3 million and can be let out at R240 000 (in 20X1 money) per annum.
If the new machine is bought, a bigger warehouse will have to be rented at R300 000 (in
20X1 money) per annum. It is common for rental in the area to escalate at a rate of 10%
per annum.

Additional information:
Super Shine (Pty) Ltd has a weighted average cost of capital of 15%. The directors have
heard that the cost of capital should be adjusted for any additional risk due to the specific
nature of new projects. Since the product ‘NewWave’ has not been tested on humans, the
directors felt is necessary to add two percentage points to the cost of capital and thus make
use of 17% as a project-specific discount rate. The directors are also concerned as to the
time it will take to recover the initial capital outlay, as the existing product lines have been
experiencing cash flow problems recently. The company has enough taxable income from
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existing product lines against which any tax losses from this project can be utilised. Assume
a corporate tax rate of 28% applies and ignore any VAT implications.

Required:
(a) Recommend whether Super Shine (Pty) Ltd should go ahead with the ‘NewWave’
shampoo. Base your recommendation on a calculation of the following:
(i) Net present value (NPV)
(ii) Internal rate of return (IRR) of the replacement decision.
(b) Discuss the qualitative risk factors that should be taken into account before replacing
the machine.
(c) Taking your discussion in (b) above into consideration, briefly discuss the consequences
and the appropriateness of using 17% as the discount rate.

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(d) Calculate the discounted payback (DPB) period and discuss what this means for Super
Shine (Pty) Ltd.
(e) Briefly discuss the various pricing strategies available to Super Shine (Pty) Ltd and
recommend the most appropriate one.

Case study 12: Transfer pricing, divisional performance,

breakeven analysis and learning curves
Introduction
P Ltd is based in the UK. It is one of the world’s leading distributors of plumbing, heating
and building materials, employing over 35 000 people. It operates its own retail outlets,
some of which share a common trading name and are organised as separate business units.
P Ltd also sells directly to building and plumbing contractors and merchants through
its external direct sales units. P Ltd was founded in the early 20th century as a plumbing
and building materials manufacturing business and enjoyed very rapid growth in the
1970s and 1980s. In 1985, P Ltd was listed on the UK stock exchange and at this time first
ventured into the USA by acquiring a building materials distribution company based in
New Jersey. In 1990, P Ltd acquired a building supplies business in the UK and, later in
that decade, made acquisitions of other European-based plumbing, heating and building
materials distribution companies. In the early years of the 21st century, P Ltd sold off all its
manufacturing business units and concentrated solely on being a distributor and retailer of
plumbing, heating and building materials.

Business operations
P Ltd’s head office is in the UK, which also contains its centralised treasury. It has three
operating divisions:
1. Plumbing: Baths, showers, toilets, sinks, geyser components, general plumbing parts
such as water taps, pipes and drainage systems
2. Heating: Heating pumps and other heating systems
3. Building materials: Concrete building blocks, bricks, tiles, flooring products, roofing
materials, wooden roof beams and other timber, as well as other products, such as doors
and window frames.
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Each division’s operating arrangements are similar. Each division has two distribution
warehouses, one each in Europe and the USA. Each division uses these warehouses to fulfil
sales orders placed by its external direct sales units and retail outlets. The external direct
sales units sell to building contractors, plumbing contractors and merchants who supply
small building and plumbing companies with materials and parts. P Ltd’s retail outlets sell
directly to the public and to the building and plumbing trades. Some of these retail sales
outlets were set up or acquired as chains of retail outlets, each with a common trading
name and these have been retained as separate business units. The retail outlets that have
been acquired continue to operate under their own trading names so that P Ltd can retain
the benefit of the goodwill the retail outlets developed. Each has a specific line of business,
such as the sale of complete bathrooms and kitchens through chains of showrooms. The
plumbing and heating divisions carry out retail operations through established chains of

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showrooms. These showrooms sell products to local tradespeople and also directly to the
public. The building materials division’s retail activities are carried out through small-
scale retail outlets which are usually located on industrial estates and those that have been
acquired retain their local building supply trading names. Overall, P Ltd has well over
90 000 suppliers and sells to over 1.2 million customers across the world. Each of the two
divisions operates its own large logistics and distribution network. They operate their own
fleet of road transport vehicles to distribute products in Europe and the USA, and use rail,
sea and air networks for distribution to their external direct sales units and retail outlets in
other parts of the world.

Financial structure, operations and performance

The divisional managers will receive performance bonuses when a divisional return on
investment of 20% or more is generated by the respective divisions in 2014. The shareholders
are upset that some of the divisional managers have received performance bonuses, as
the company as a whole suffered a loss in 2014. The performance of the divisions for the
financial year 20X1 and the assets they employed as at 31 December 20X1 are as follows:

Plumbing division
The divisionalised variable (direct) statement of profit/loss for 20X1 for the Plumbing
division is given below:
Table 18.34 Profit and loss statement
R
Sales (42 500 units) 850 000
Less: Variable cost of sales (R6 per unit) (255 000)
Less: Variable sales and administrative costs (R1.50 per unit) ( 63 750)
Contribution 531 250
Less: Fixed production cost (300 000)
Less: Fixed sales and administrative cost ( 31 250)
Divisional profit 200 000

Heating division
The Heating division currently purchases components from an outside supplier at a
cost of R15 per unit and uses them to manufacture their heating systems. The manager
of the Heating division is convinced that they can use the component manufactured by
the Plumbing division in the manufacture of their heating system. This would enable the
Heating division to increase its profits. The managers of the Plumbing division and the
Heating division have to negotiate the transfer price of these components. An internal
transfer of components between these divisions would lead to a saving in the variable sales
cost of 50 cents per component for the Plumbing division, based on the assumption that all
costs would be in line with 2014.

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Heating division: proposed new product range

The manager of the Heating division recently invested R500 000 in the expansion of their
factory to manufacture a new range of heating systems. The full cost price per unit of
this type of system at the expected level of demand amounts to R15. The expected annual
demand for these systems will be as follows:
Table 18.35 Expected annual demand
Probability Number of units
15% 18 000
35% 24 000
40% 27 500
10% 29 000

The target rate of return on capital invested for the proposed heating system range is 20%
per annum.

Building materials division

The Building materials division has hired a carpenter to create 32 handcrafted identical
sets of doors, made from wood. The target market for these doors is builders’ warehouses
and house and garden shows. The carpenter charges R300 per hour. The first set of doors
took the carpenter 8 hours to create. The total time spent on the first two sets of doors was
15.36 hours. The learning curve is expected to continue throughout the production of the
32 sets of doors.
The divisional residual income of the Building materials division for 2014 was R80 000.
The cost of capital of controllable investments was R160 000 for the year.

Required:
(a) Determine whether the manager of the Plumbing division received a performance
bonus based on the 20X1 results.
(b) Calculate the breakeven quantity as well as the breakeven sales value of the Plumbing
division (at a divisional level) for 20X1.
(c) Calculate the minimum percentage increase in sales volume required if the current
selling price is decreased by 5%, to ensure that the 20X1 total contribution for the
Plumbing division remains unchanged.
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(d) Calculate how many units the Plumbing division should sell if this division’s manager
wants to earn a target profit of 25% on total sales. Base your calculations on the current
information and ignore the effect of (c) above.
(e) What is the minimum transfer price per component that the manager of the Plumbing
division would be willing to accept if the division has sufficient spare capacity and the
manager is more concerned about the company’s profit than his bonus?
(f) What is the maximum transfer price per door that the manager of the Heating division
would be willing to pay?
(g) Determine the target mark-up per door for the proposed new range of doors.
(h) Determine the target price per door for the proposed new range of doors.
(i) Calculate the amount to be paid by the Building materials division to the carpenter in
the production of the 32 sets of doors.

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(j) Determine the maximum controllable investment which would have ensured the
manager of the Building materials division of receiving a performance bonus.
Source: CIMA (adapted)

Case study 13: Relevant costing and pricing

RDP builds affordable environmentally friendly housing. High-quality materials are used
and the company uses their own patented energy saving technology. RDP is planning to
expand to a neighbouring country and has been asked by the president of that country
for a quotation to build a house. The directors of RDP believe that if their quotation is
successful, this could help them to launch their houses in that country and have come to an
agreement to quote a price that will cover its relevant cost.
The following information has been obtained with regards to the contract:
1. The CEO (Chief Executive Officer) and marketing manager recently met with the
potential client to discuss the house. The meeting was held at a restaurant and RDP
provided food and drinks at a cost of R375.
2. 1 200 kg of Material B will be required for the house. RDP currently has 550 kg of
Material B in its inventory purchased at a price of R58 per kg. Material X is regularly
used by RDP in its houses and has a current replacement cost of R65 per kg. The resale
value of Material B in inventory is R35 per kg.
3. 400 hours of construction worker time are required to build the house.
4. The house will require 90 hours of engineer time. RDP engineers are paid a monthly
salary of R4 750 each and do not have any spare capacity. In order to meet the engineering
requirement for the house, RDP can choose one of two options:
(a) Pay the engineers an overtime rate of R52 per hour to perform the additional work.
(b) Reduce the number of engineers’ hours available for their existing job, the building
of Product A. This would result in lost sales of Product A. Details of the existing job
the engineers are working on are as follows:

Table 18.36 Summary details at existing job

Variable costs R3 365

Engineers’ time required per unit 30 h

5. A specialist machine would be required for 7 weeks to build the house. RDP have 4
weeks remaining on the 15-week specialist machine rental contract that cost R15 000.
The machine is currently not in use. The machine can be rented for an additional 15
weeks at a cost of R15 250. The specialist machine can only be rented in blocks of 15
weeks. Alternatively, a machine can be purchased for R160 000 and sold after the work
on the house has been completed for R140 000.
6. The windows required for the house have recently been developed by RDP and use the
latest environmentally friendly insulating material. RDP were planning to exhibit the
windows at a house-building conference. The windows would only be used for display

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purposes at the conference and would not be for sale to prospective clients. RDP has had
assurances from three separate clients that they would place an order for 25 windows
each if they saw the technology demonstrated at the conference. The contribution from
each window is R10 450. If the windows are used for the contract, RDP would not be
able to attend the conference. The conference organisers will charge a penalty fee of
R1 500 for non-attendance by RDP. The CEO of RDP can meet the clients directly and
still secure the orders for the windows. The meetings would require two days of the
CEO’s time. The CEO is paid an annual salary of R414 000 and contracted to work 260
days per year.
7. The building of the house requires 400 kg of other materials. RDP currently has none
of these materials in its inventory. The total current purchase price for these other
materials is R6 000.
8. RDP’s fixed absorption rate is R37 per construction worker hour.
9. RDP’s normal policy is to add a 12% mark-up to the cost of each house.

Required:
(a) Produce a schedule that shows the minimum price that could be quoted for the contract
to build the house.
(b) Your schedule should show the relevant cost of each of the nine items identified above.
You should also explain each relevant cost value you have included in your schedule,
and why any values you have excluded are not relevant.
(c) Explain the reasons why relevant costing may not be a suitable approach to pricing
houses in the longer term for RDP.
(d) Recommend, with justifications, a pricing strategy for RDP to use to price the innovative,
environmentally friendly houses when they are launched in the new country.
Source: CIMA (adapted)

Case study 14: Relevant costing and cost-volume-profit

the business is one of the principle sources of its competitive advantage and brand
differentiation. It is committed to conduct its business in an ethical manner based on its
core values and acceptable principles.

External service promise

Customer first – Our job is to help you create the future you desire. Through simple, intuitive
and responsive service, we aim to connect your business, your world, and opportunity.
Understanding your needs – Only by truly understanding your needs and circumstances
can we deliver what you need to thrive. We listen, understand, then act to deliver an enabling
experience.
We never stop working to get it right – Whether it is our service or our products, we
take ownership and strive to get it right for you.

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Internal customer service commitment

We exist to serve the customer – Our job is to enable people with connectivity, empowering
them to live more richly. Even if we do not serve customers directly, we work to enable
the person who does. Through simple, intuitive, responsive service, we aim to change their
world.
Interaction is opportunity – We are always seeking new ways to connect with, share
with and discover more about our customers, so we can deliver the right solutions to make
their worlds easier, simpler and better.
We are relentless in getting it right – It is our responsibility to provide our customers
with fit-for-purpose solutions and processes that work. We strive for zero defect, zero faults
and zero downtime. We never stop working to get it right.

Product details
The company specialises in the provision of telephone systems for commercial clients.
There are two parts to the business: installing telephone systems in businesses, either first-
time installations or replacement installations, and supporting the telephone systems with
annually renewable maintenance contracts. Their commercial telephone systems support a
wide variety of features, including caller ID (name and number), distinctive ringing, send-all
calls, speed dialling, and five-party conferencing, each helping employees to be more efficient
and productive. Cellphone Connect via the T1 module enables customers to answer calls,
even if they are out of the office, by simultaneously allowing calls to ring at their desk phone
and to their cellphone. Enhanced accessibility is also achieved through the remote-call
forwarding feature, which enables a call to be directed to any external number immediately.

Current situation
A potential customer, Connect Ltd, who wants to install a telephone system in the new
offices it is opening, has approached C Ltd. While the job is not a particularly large one,
C Ltd is not hopeful of future business in the form of replacement systems and support
contracts for Connect Ltd. C Ltd is therefore keen to quote a competitive price for the job.
The following information should be considered:
1. One of the company’s salespersons has already visited Connect Ltd to give them a
demonstration of the new system, together with a complementary lunch, the costs of
which totalled R400.
2. The installation is expected to take one week to complete and would require three
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engineers, each of whom is paid a monthly salary of R15 000. The engineers have just
had their annual contracts renewed with C Ltd. One of the three engineers has spare
capacity to complete the work, but the other two would have to be moved from Contract
A to complete the Connect Ltd contract. Contract A generates a contribution of R5
per engineer hour. There are no other engineers available to continue with Contract A
if these two engineers are taken off the job. It would mean that C Ltd would miss its
contractual completion deadline on Contract A by one week. As a result, C Ltd would
have to pay a one-off penalty of R1 000. Since there is no other work scheduled for their
engineers in one week’s time, it will not be a problem for them to complete Contract A
at this point.
3. C Ltd’s technical advisor would also need to dedicate 8 hours of his time to the job. He
is working at full capacity, so he would have to work overtime . He is paid an hourly rate
of R240 and for all overtime at a premium of 50 per cent above his usual hourly rate.

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4. Two visits would need to be made by the site inspector to approve the completed work.
He is an independent contractor who is not employed by C Ltd, and charges Connect
Ltd directly for the work. His cost is R2 000 for each visit.
5. C Ltd’s system trainer would need to spend one day at Connect Ltd, delivering training.
He is paid a monthly salary of R5 000 and also receives commission of R1 250 for each
day spent delivering training at a client’s site.
6. 120 telephone handsets would need to be supplied to Connect Ltd. The current cost
of these is R18.20 each, although C Ltd already has 80 handsets in inventory. These
were bought at a price of R16.80 each. The handsets are the most popular model on the
market and frequently requested by C Ltd’s customers.
7. Connect Ltd would also need a computerised control system called ‘Swipe 2’. The
current market price of Swipe 2 is R10 800, although C Ltd has an older version of the
system, Swipe 1, in inventory, which could be modified at a cost of R4 600. C Ltd paid
R5 400 for Swipe 1 when it ordered it in error two months ago and has no other use for
it. The current market price of Swipe 1 is R5 450, although, if C Ltd tried to sell the one
they have, it would be deemed to be ‘used’ and therefore worth only R3 000.
8. 1 000 metres of cable would be required to wire up the system. The cable is used
frequently by C Ltd, and it has 200 metres in inventory, which cost R1.20 per metre. The
current market price for the cable is R1.30 per metre.
9. Assume that there are four weeks in each month and that the standard working week is
40 hours long.

Required:
(a) Prepare a cost statement, using relevant costing principles, showing the minimum cost
that C Ltd should charge for the contract. Make detailed notes showing how each cost
has been arrived at and explaining why each of the costs above has been included or
excluded from your cost statement.
(b) Explain the relevant costing principles used in question (a) and explain the implications
of the minimum price that has been calculated in relation to the final price agreed with
Connect Ltd.
(c) Explain how the company can use cost-volume-profit analysis for short-term decision
making, highlighting the assumption of this technique.
(d) Discuss the strategic implications of short-term decision making.

Source: ACCA (adapted)

Case study 15: Short-term decision making

Superb Creations is a small, exclusive producer of bedroom furniture. Turnover last year
was just over R1 million and the business continues to provide a steady profit margin. It
is a private limited company owned by Peter Carpenter and his wife Cassandra and it has
been trading for 25 years. Peter, who is a fully qualified cabinetmaker, started in the trade
immediately after leaving school. He has little formal training in management, but has
much hands-on experience gained from running his business.

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Background of the company

The company originally operated from small, cold and draughty premises in the back
streets of Umbilo and in the early years, its only employee was Chad. The business grew
steadily in the early years and about 10 years ago Peter was able to move from the original
site to a highstreet location in Mount Edgecombe, which provides a small showroom area, a
workshop, staff room and storage. However, the product range has remained constant and
consists of three pieces of bedroom furniture: a wardrobe, a chest of drawers and a dressing
table. These are sold directly to customers either as separate items or as a bedroom suite.
The furniture is handmade to a very high standard, authentically reproducing the
Baxendale style, which was popular in the late nineteenth century. This requires a high
degree of skill in the construction and finishing stages of the production process. Although
most of Peter’s time these days is spent on managing the business, he still keeps a watchful
eye on activities and likes to help if the workers are over-stretched. The furniture is made
from mahogany supplied by Timber Company, which imports high-quality seasoned timber
from Indonesia. Although Peter could buy mahogany more cheaply elsewhere, he has dealt
with this company for a long time and has confidence that the quality will be consistently
good. The grain and colour of the wood is extremely important, and because the fronts
of the furniture must match in grain and colour for each piece or suite of furniture, the
company expects to have a high level of off-cuts and waste.
The unique finish to the furniture is produced through a highly skilled hand-staining
process, using wood stain mixed to a special recipe created especially for Superb Creations
by CT Stain Specialists, who make and supply this recipe exclusively to the company.
Mahogany and wood stain are the two main materials used to make the finished products.
Twelve people are now employed full time in the production process: ten are highly skilled
cabinetmakers and two are young apprentices. All the cabinetmakers have been with the
company for a long time and Chad is now the workshop supervisor. Chad is a bit set in his ways,
but, according to Peter, ‘He does a damned good job and he is a very good craftsman’.
Careful delivery of the furniture to the customer is very important and Peter is proud
of the fact that the company receives very few complaints of furniture damaged in transit.
The company sub-contracts this part of its activities to a well-established company in the
city of Durban. This company has always been reliable and has provided a high-class service
to customers, carefully protecting the furniture in transit, setting the piece in its position
for the customer and asking them to check it over. If the customer is not satisfied with the
furniture, it is returned to the workshop immediately. Of course, Superb Creations pay a
premium price for this service, but it has proved of benefit to both the company and the
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customer, since problems can be resolved immediately.

The specialised nature of the production process and the specialised delivery service
results in high product costs. However, Peter has found that the company’s products attract
the type of customer who is willing to pay a premium price. In the past year the company has
invested R100 000 in the refurbishment of the offices and showroom and in the extension
of the workshop and storage area to meet increasing demand for the company’s products.
Peter also launched a national advertising campaign. However, the increased demand
is putting pressure on the workforce and the lead-time (the time between the customer
ordering the furniture and the expected delivery date) is increasing.
Kirsten has been responsible for the paperwork ever since Peter started the business. Initially
she worked part time while her children were young but has worked full time for the last five
years. She has had the help of Denzil, who is a qualified accountant, for the last 12 months. Denzil
spends two days each month on the company premises, assisting with costings and accounts.

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Although, according to Peter, ‘Kirsten has always done a great job of sorting us out’, Peter
feels that the company is getting too busy for her to cope on her own. He has asked Denzil’s
advice, who has suggested that it is probably time to employ a full-time management
accountant, even though this will mean a reduction in his own services for the company.
Peter took Denzil’s advice and contacted the Durban University of Technology to
advertise the post on the undergraduate careers board. He felt that the post would suit a
new graduate and that he could offer a fair salary while not placing too large a burden on
the company’s overheads. A number of students expressed an interest and Peter interviewed
three of them. He selected Nicole, who is due to start working for the company as soon as
her final exams are completed.

Recent developments
Nicole arrived at Superb Creations and settled in nicely. Wisely, Peter involved Kirsten in the
selection process and the two seem to be getting on well. Peter received a profit statement
from Denzil for the previous six months’ trading, which itemised the performance of the
company’s three products. This is attached as Exhibit 1. Peter was appalled to see that the
dressing tables had made a loss. He has called a meeting for next week with Nicole, Kirsten
and Chad to discuss the situation. It could not be before then, as Peter had important
appointments for the rest of the week. First, he had to visit the wood-stain suppliers, in order
to renegotiate a contract for wood stain for the coming year; next, Timber Company had
telephoned and asked for an urgent meeting. Peter informed Nicole, Kirsten and Chad that
at next week’s meeting he also wishes to discuss another matter with them. This concerns
a potential new venture for the company. One particular company has approached Peter
with an enquiry for 50 chests for export to Dubai. Superb Creations has never supplied
bulk orders before and this customer is only willing to pay 70% of the normal selling price.
He has briefly discussed the problems with Nicole who, being keen and enthusiastic in her
first job, wishes to anticipate Peter’s information needs before the meeting takes place. She
has been working overtime (after Kirsten has left for the day) to produce the information,
which is attached in Exhibit 2. She hopes to impress Peter at the meeting by being well
prepared, but has only managed to obtain the raw data by the date of the meeting.

tables drawers
(R’000) (R’000) (R’000)
Sales revenue 340 200 300 840
Direct materials 100 96 90 286
Direct labour 63 48 53 164
Variable workshop overheads 17 16 15 48
Apportioned fixed workshop overheads 60 70 68 198
Total manufacturing costs 240 230 226 696
Gross profit (loss) 100 (30) 74 144
Selling & distribution costs 80
Net profit 64

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Exhibit 2
Nicole’s initial information gathering
Profit statement:
Numbers of each product sold in the period are as shown in the following table.
Table 18.38 Numbers of each product sold
Wardrobes 200
Dressing tables 160
Chests of drawers 200

Selling and distribution costs includes delivery costs to the customer.

Amount paid to delivery contractor for last six months totalled R19 600; average delivery
cost per product was R35 each.

Dressing tables:
Six months ago, Peter made the decision to buy in the mirror section of the dressing tables
from a local firm at a cost of R200 each. Nicole has found the original estimate of the cost
if the company were to continue making the mirror section in-house, which was used for
comparison with the sub-contract price. This is shown in Table 18.39.
Table 18.39 Cost estimate for in-house manufacturing of mirror section
(R)

Direct materials 120

Direct labour 40
Variable overheads 20
Fixed overheads 40
Total 220

In order to ensure that the timber used to frame the mirror section matched the main body
of the dressing table, it was agreed that the supplying firm would buy their timber from
the same supplier, that is, Timber Company. The mirror sections were delivered to Superb
Creations in an unfinished state and were hand-stained by the company’s own craftsmen.
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Control over the quality of the mirror sections has been problematic.

The Dubai enquiry:

Nicole has obtained the following information:
Delivery charges:
(50 chests to the dockside) 3 vans @ R300 each
Average lead time:
for the last six months – 12 weeks
for the six months prior to that – 8 weeks
Average overtime:
last week – 6 hours per man
for the last six months – 1 hour per man per week

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Stocks of mahogany – 3 250 m2

Average usage of mahogany per product:
Wardrobes – 10 m2
Dressing tables (excluding mirror) – 4 m2
Mirror section – 1 m2
Chests of drawers – 5 m2

The meeting
The first item on the agenda is the loss-making situation of the dressing tables. Peter
comments, ‘I am appalled to find that the dressing tables are making a loss of R30 000. I
cannot understand it as it has never happened before. It looks as though we shall have to
stop making them and concentrate on the other products, unless any of you can offer an
alternative solution.’
Kirsten says, given Denzil’s figures, she has to agree with Peter about the dressing tables.
Chad comments that he has not had time to look at the figures as he has been ‘snowed
under’ with work. Nicole decides to keep her data to herself at this stage and offers to go
away and ‘work on some numbers’. The second item is the potential new venture. Peter
passes copies of the Dubai enquiry to all those present, and asks, ‘Do you have any views on
whether we should accept it or not?’
Kirsten and Chad have discussed this item before the meeting. Chad tells Peter that the
order is totally impossible, given that the workshop is getting very overstretched, and Kirsten
agrees with him, adding, ‘How on earth do they expect us to make a profit at only 70% of the
normal selling price?’ Nicole interrupts at this stage, having gained a little more confidence,
and suggests to Peter that the enquiry might be worth looking into. She promises to provide
further information by the end of the week. Peter decides that they should meet again on Friday,
when Nicole will have more information for them and hopefully Chad will have had time to
give the issues greater consideration. As they leave the meeting, Chad comments to Kirsten,
‘There’s something else worrying him besides what he’s telling us. I wonder what it can be.’
Nicole has decided to restate Denzil’s original profit statement by using the additional
information she has collected and by employing a marginal costing approach.

Required:
(a) Prepare a new profit statement for Nicole, which clearly identifies both the contribution
made by each product over the last six months and the overall profit.
(b) Prepare a profit statement, which shows the potential situation if Peter stops production
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of the dressing tables and demand for the other products remains the same as that of
the past six months. Assume that supplies of mahogany are unlimited.
(c) Suggest four other issues that Peter should consider before making the decision to stop
producing dressing tables.
(d) Prepare a statement that identifies the contribution the dressing tables would have made
in the last six months, had the mirror section not been sub-contracted out. Suggest
three other issues which might affect Peter’s decision to make the mirror sections in-
house once again.
(e) Discuss the decision situation regarding the Dubai enquiry. Your discussion should
also be supported by financial information Nicole would be likely to produce. Suggest
five other issues that may affect the decision regarding the Dubai enquiry.

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(f) Nicole has suggested to Peter that the company would benefit from a management
information system to aid him in planning and controlling the activities of the business
and to assist in organisational decision making. Peter is not sure what Nicole means.
Illustrate the types of planning and controlling activities that are likely to take place at
Superb Creations:
(i) Describe the types of information which might be useful.
(ii) Suggest the likely sources of this information.
(g) At the urgent meeting last week, the Timber Company informed Peter that supplies
of mahogany from South Dubai were in jeopardy. There had been a serious forest fire
and much of the seasoned stock ready for export at the premises of the South Dubai
exporter had been wiped out. Timber Company envisaged that there would be no more
supplies of the type used by Superb Creations for the next six months. After that date,
it seems that supplies can be restored to normal.
(i) Provide a production schedule that would maximise profits on the stocks of
mahogany held by Superb Creations and identify the forecast profit figure based
on this production schedule. Assume that forecast demand from the normal
customer base will be 10% higher than the last six months’ figures and that the
Dubai enquiry must be considered as well. Also assume that the mirror section of
the dressing table will have to be produced by Superb Creations, since the current
supplier does not hold any stock of the mahogany.
(ii) Identify four other issues that Peter would need to take account of if this production
schedule is undertaken.
(iii) Compare the predicted profit in (i) above with the profit that Peter might have
expected in the second half of the year, if the predicted demand for all three
products had been met, the Dubai contract had not been taken on and the mirror
section of the dressing table had been produced by Superb Creations. Comment
on your findings.
Source: CIMA (adapted)
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Cost and Management Accounting

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 684 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:50 PM
Created from durbanut-ebooks on 2022-08-08 14:00:08.
Copyright © 2021. Juta & Company, Limited. All rights reserved.

Marimuthi,
CMA Management
Table A

F. (2021).and
Cost
Present value interest factor of R1 per period at i% for n periods, PVIF(i, n)
Period Interest rate (i)

operations
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833

and management
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579

3e_Book.indb
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482

accounting
Created from durbanut-ebooks on 2022-08-08 13:59:33.
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
Appendices

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092 0.074 0.059 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.010
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057 0.044 0.033 0.026 0.020 0.015 0.012 0.009 0.007 0.005 0.004
35 0.706 0.500 0.355 0.253 0.181 0.130 0.094 0.068 0.049 0.036 0.026 0.019 0.014 0.010 0.008 0.006 0.004 0.003 0.002 0.002
40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022 0.015 0.011 0.008 0.005 0.004 0.003 0.002 0.001 0.001 0.001
50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009 0.005 0.003 0.002 0.001 0.001 0.001 0.000 0.000 0.000 0.000

Marimuthi,
Table B
686

CMA Management
F. (2021).and
Cost
Present value interest factor of an (ordinary) annuity of R1 per period at i% for n periods, PVIFA(i, n)
Period Interest rate (i)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

operations
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528

and management
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589

3e_Book.indb
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326

accounting
Created from durbanut-ebooks on 2022-08-08 13:59:33.
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077 8.422 7.843 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427 8.694 8.055 7.496 7.003 6.566 6.177 5.829 5.517 5.235 4.979
35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.644 8.855 8.176 7.586 7.070 6.617 6.215 5.858 5.539 5.251 4.992
40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.779 8.951 8.244 7.634 7.105 6.642 6.233 5.871 5.548 5.258 4.997
50 39.196 31.424 25.730 21.482 18.256 15.762 13.801 12.233 10.962 9.915 9.042 8.304 7.675 7.133 6.661 6.246 5.880 5.554 5.262 4.999

Marimuthi,
CMA Management
Table C

F. (2021).and
Cost
Future value interest factor of R1 per period at i% for n periods, FVIF(i, n)
Period Interest rate (i)

operations
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100 1.110 1.120 1.130 1.140 1.150 1.160 1.170 1.180 1.190 1.200

and management
2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.188 1.210 1.232 1.254 1.277 1.300 1.323 1.346 1.369 1.392 1.416 1.440
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331 1.368 1.405 1.443 1.482 1.521 1.561 1.602 1.643 1.685 1.728

3e_Book.indb
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464 1.518 1.574 1.630 1.689 1.749 1.811 1.874 1.939 2.005 2.074

accounting
Created from durbanut-ebooks on 2022-08-08 13:59:33.
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611 1.685 1.762 1.842 1.925 2.011 2.100 2.192 2.288 2.386 2.488
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772 1.870 1.974 2.082 2.195 2.313 2.436 2.565 2.700 2.840 2.986
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949 2.076 2.211 2.353 2.502 2.660 2.826 3.001 3.185 3.379 3.583
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144 2.305 2.476 2.658 2.853 3.059 3.278 3.511 3.759 4.021 4.300
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358 2.558 2.773 3.004 3.252 3.518 3.803 4.108 4.435 4.785 5.160
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594 2.839 3.106 3.395 3.707 4.046 4.411 4.807 5.234 5.695 6.192
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853 3.152 3.479 3.836 4.226 4.652 5.117 5.624 6.176 6.777 7.430
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138 3.498 3.896 4.335 4.818 5.350 5.936 6.580 7.288 8.064 8.916
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452 3.883 4.363 4.898 5.492 6.153 6.886 7.699 8.599 9.596 10.699
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797 4.310 4.887 5.535 6.261 7.076 7.988 9.007 10.147 11.420 12.839
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177 4.785 5.474 6.254 7.138 8.137 9.266 10.539 11.974 13.590 15.407
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595 5.311 6.130 7.067 8.137 9.358 10.748 12.330 14.129 16.172 18.488
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054 5.895 6.866 7.986 9.276 10.761 12.468 14.426 16.672 19.244 22.186
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560 6.544 7.690 9.024 10.575 12.375 14.463 16.879 19.673 22.901 26.623
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 6.116 7.263 8.613 10.197 12.056 14.232 16.777 19.748 23.214 27.252 31.948
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.727 8.062 9.646 11.523 13.743 16.367 19.461 23.106 27.393 32.429 38.338
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.623 10.835 13.585 17.000 21.231 26.462 32.919 40.874 50.658 62.669 77.388 95.396
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063 13.268 17.449 22.892 29.960 39.116 50.950 66.212 85.850 111.065 143.371 184.675 237.376
35 1.417 2.000 2.814 3.946 5.516 7.686 10.677 14.785 20.414 28.102 38.575 52.800 72.069 98.100 133.176 180.314 243.503 327.997 440.701 590.668
40 1.489 2.208 3.262 4.801 7.040 10.286 14.974 21.725 31.409 45.259 65.001 93.051 132.782 188.884 267.864 378.721 533.869 750.378 1,051.668 1,469.772
50 1.645 2.692 4.384 7.107 11.467 18.420 29.457 46.902 74.358 117.391 184.565 289.002 450.736 700.233 1,083.657 1,670.704 2,566.215 3,927.357 5,988.914 9,100.438

687 : Operations and management : a southern african approach. Juta & Company, Limited.
687

Marimuthi,
Table D
688

CMA Management
F. (2021).and
Cost
Future value interest factor of an ordinary annuity of R1 per period at i% for n periods, FVIFA(i, n)
Period Interest rate (i)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

operations
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100 2.110 2.120 2.130 2.140 2.150 2.160 2.170 2.180 2.190 2.200

and management
3 3.030 3.060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310 3.342 3.374 3.407 3.440 3.472 3.506 3.539 3.572 3.606 3.640
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641 4.710 4.779 4.850 4.921 4.993 5.066 5.141 5.215 5.291 5.368

3e_Book.indb
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105 6.228 6.353 6.480 6.610 6.742 6.877 7.014 7.154 7.297 7.442
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716 7.913 8.115 8.323 8.536 8.754 8.977 9.207 9.442 9.683 9.930

accounting
Created from durbanut-ebooks on 2022-08-08 13:59:33.
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487 9.783 10.089 10.405 10.730 11.067 11.414 11.772 12.142 12.523 12.916
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436 11.859 12.300 12.757 13.233 13.727 14.240 14.773 15.327 15.902 16.499
9 9.369 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579 14.164 14.776 15.416 16.085 16.786 17.519 18.285 19.086 19.923 20.799
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937 16.722 17.549 18.420 19.337 20.304 21.321 22.393 23.521 24.709 25.959
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531 19.561 20.655 21.814 23.045 24.349 25.733 27.200 28.755 30.404 32.150
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384 22.713 24.133 25.650 27.271 29.002 30.850 32.824 34.931 37.180 39.581
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523 26.212 28.029 29.985 32.089 34.352 36.786 39.404 42.219 45.244 48.497
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975 30.095 32.393 34.883 37.581 40.505 43.672 47.103 50.818 54.841 59.196
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772 34.405 37.280 40.417 43.842 47.580 51.660 56.110 60.965 66.261 72.035
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950 39.190 42.753 46.672 50.980 55.717 60.925 66.649 72.939 79.850 87.442
17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545 44.501 48.884 53.739 59.118 65.075 71.673 78.979 87.068 96.022 105.93
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 45.599 50.396 55.750 61.725 68.394 75.836 84.141 93.406 103.74 115.27 128.12
19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159 56.939 63.440 70.749 78.969 88.212 98.603 110.28 123.41 138.17 154.74
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275 64.203 72.052 80.947 91.025 102.44 115.38 130.03 146.63 165.42 186.69
25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347 114.41 133.33 155.62 181.87 212.79 249.21 292.10 342.60 402.04 471.98
30 34.785 40.568 47.575 56.085 66.439 79.058 94.461 113.28 136.31 164.49 199.02 241.33 293.20 356.79 434.75 530.31 647.44 790.95 966.71 1,181.9
35 41.660 49.994 60.462 73.652 90.320 111.43 138.24 172.32 215.71 271.02 341.59 431.66 546.68 693.57 881.17 1,120.7 1,426.5 1,816.7 2,314.2 2,948.3
40 48.886 60.402 75.401 95.026 120.80 154.76 199.64 259.06 337.88 442.59 581.83 767.09 1,013.7 1,342.0 1,779.1 2,360.8 3,134.5 4,163.2 5,529.8 7,343.9
50 64.463 84.579 112.80 152.67 209.35 290.34 406.53 573.77 815.08 1,163.9 1,668.8 2,400.0 3,459.5 4,994.5 7,217.7 10,436 15,090 21,813 31,515 45,497

688 : Operations and management : a southern african approach. Juta & Company, Limited.
2021/02/05 2:44:51 PM
Index

Page numbers in italics refer to tables, figures, graphs and illustrative examples.

A CIMA definition of 38, 250

compared to traditional costing 39, 39
ABC inventory classification system 600–601,
cost hierarchy in 252–253, 253
601, 609
criticisms of 275–276
absorption cost card 29, 30
and customer profitability analysis 266
absorption costing
definition/description of 38, 40, 252, 276
aim of 29
development of 250
and banks 24
and environmental costing 629
and conversion of financial statements
example of 258–263
33–36, 33–34, 34–36
implementation process of 256–257
definition of 29, 40
introduction of 38
effect on profits 31, 31–32, 33
as basis for pricing 194
principles of 30–31, 30–31
principles of 251
reconciliation statement 399, 399
in service organisations 263–265
system 29, 250, 392, 395, 396, 399, 403
terminology relevant to 251–254
acceleration
uses of 273
benefits of 470
see also activity-based budgeting; activity-
definition/description of 469, 476
based management
rules for 470
activity-based management (ABM)
schedule 470, 471
accounting system 274
accountant’s graph 69
CIMA definition of 272
accounting rate of return (ARR) 508, 508
definition of 252, 277
advantages of 509
information 272, 273
disadvantages of 509
outputs of 272
activities (in network analysis)
uses of 272, 273
definition of 465, 476
activity-based performance measurement 274
and duration estimates 474
advanced manufacturing technology (AMT)
and network acceleration 470, 472
and activity-based costing 38
in network diagrams 464, 465, 465, 466, 466
Copyright © 2021. Juta & Company, Limited. All rights reserved.

definition of 235, 239

and slack 467, 468
in South Africa 236
standard deviation of 475, 475
and standard costing 376
activity
aesthetics 212 (dimension of quality) 212
accounting 251
A-items 600, 610
centre 252
annuity 519, 520, 521, 522
cost hierarchy 252–253, 253
appraisal costs 214, 215, 216, 627, 628
definition of 251, 276
arbitrary allocated costs 100, 130
drivers 253–254
attainable standards 374, 409
time 467, 474, 474, 475
automated guided vehicles (AGVs) 235, 239
activity-based budgeting (ABB)
automated storage and retrieval systems (ASRS)
benefits of 273
236, 239
definition/description of 276, 349, 351
process 273–274
activity-based costing (ABC)
B
and banks 24 B2B (business-to-business) 603, 610
benefits of 275 backflush accounting 233, 233, 238, 239

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 689 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:51 PM
Created from durbanut-ebooks on 2022-08-08 13:59:12.
690

balance sheet 25, 26, 339, 341 budgets

see also statement of financial position behavioural effects of 327
balanced scorecard 558–560, 559 procedures for constructing 329–338
banks, costing systems in South African (case buffer inventory/stock 222, 223, 227
study) 24 business process re-engineering (BPR)
basic standards 374, 409 definition/description of 237, 238, 239
batch-level activities 252, 253 and Kaizen costing 218
Bayes strategy 432, 445 keywords in 238
beginning and ending inventories budget 336, 337 and short-term decision making 106
benchmarking stages of 238
classification of 232 business segment, closure of non-profitable 111
definition/description of 231, 238, 239 business to business (B2B) 603, 610
process 321–232 by-products 122, 130
big data accounting for 122–123
characteristics 349 overview of 121
definition of 351 processing of 123, 126
uses of 350 revenue from 127–128
bill
of activities 253 C
of materials 377, 409, 602 calendar variance, causes of 395
biodiversity planning tool (case study) 632–633 capacity driver 254, 277
B-items 600, 610 Capex, reduction in (case study) 518
bottleneck capital budgeting
case study on production 101–102 categories of 495
CIMA definition of 227 definition of 494, 524
controlling of 104, 106 stages of 494
definition of 227, 239 techniques 495–509
eliminating of 224, 227, 228 capital investments; pricing (case study) 671–673
and slack 468 capital
and throughput accounting 229 projects 497, 501, 524
breakeven analysis rationing 514–518, 515, 516, 524
case studies on 661–664, 673–676 cash budget 328, 338–341, 338
for multiple products 69–75, 73, 75 example of alternative 339–341, 339, 340
see also cost-volume-profit analysis purposes of 339
breakeven graph 64–67, 64, 65, 66, 69, 69 vs statement of comprehensive income 338
breakeven point cash positions, possible management action for
definition of 52, 79 338, 338
equation to determine 57 cash, availability of (in decision making) 102
in graph 66, 66 changeover point
and margin of safety 53 calculation of 76, 77, 78
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and marginal costing statement 55 definition of 76, 79

in rands 54, 67 Chartered Institute of Management
in units 54, 57, 67 Accountants (CIMA) xvi
and what-if analysis 58 definitions 38, 208, 211, 222, 227, 230, 236,
British Airways (case study), decision making 250, 272
based on risk 430–431 C-items 601, 610
budget committee, functions of 326 climate change, linear programming for (case
budgetary slack (case study) 328 study) 158
budgeted coefficient
cash budget 338, 338 of correlation 297, 298
statement of comprehensive income 328, of determination 298
341, 341, 345 of variation 434, 434, 435, 445
statement of financial position 328, 331, 342 committed costs 100, 130, 546
budgeting (case studies) 653–656, 656–660 common costs 99, 109, 122, 130
see also joint costs

Cost and Management Accounting

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 690 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:51 PM
Created from durbanut-ebooks on 2022-08-08 13:59:12.
691

competitive advantage controllability, principle of 3

and quality management 212, 215 conversion
and value chain 208, 210 costs of 4, 29, 233, 234
competitive benchmarking 232 of financial statements 33–36, 33–34, 34–36
competitors (in decision making) 103 corporate social responsibility 622, 623, 635
compounding 519 correlation
computer numerically controlled (CNC) analysis 297
machines 235, 239 coefficient of 297, 298
computer-aided types of 297
design (CAD) 235, 239 cost
manufacturing (CAM) 235–236, 239 cards 25, 25, 30, 30, 376, 376, 377, 380, 646, 646
computer-integrated manufacturing (CIM) 235, centres 3, 13, 544, 545, 546, 572
239 definition of 2, 13
conditional drivers 277
profit 432, 439, 445 of inventories 29
share plans (CSPs) 571 object 2, 4, 13, 253, 277
conformance (dimension of quality) 212, 214, pools 253, 277
215, 215, 216 of quality report 215, 216, 216, 239
constrained resource 104, 105, 130 slopes 469, 469, 470, 472, 476
see also limiting factor cost accounting 2
constraint basic principles of 24
definition of 104 definition of 13
resulting from limited labour hours 155 systems, categories of 24
resulting from limited machine capacity 155 cost-based
resulting from limited materials 154 prices, determining of 192–194
theory of (TOC) 227, 228, 229, 240 transfer prices 561
see also scarcity cost-based pricing 191–195
contemporary costing systems, description of 24 advantages of 195
continuous improvement 211, 212, 217 definition of 191, 198
and activity-based management 252, 272, 275 disadvantages of 194–195
concepts underlying 218 and transfer pricing 561
and JIT 222, 223, 238, 607 cost behaviour 4–7, 5, 6, 7
see also Kaizen costing; target costing; total and activity-based costing 253
quality management definition of 5, 253
continuous quality improvement 212 and marginal costing 250
see also Kaizen costing; target costing; total patterns 5, 10
quality management cost control
contribution and activity-based costing 250, 256
and cost-volume-profit analysis 52, 53, 60, 61 definition of 182, 198
and decision making 100, 103, 105, 105, 106 and standard costing 376
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definition of 52, 79 systems xvii

graph 67, 67, 68 and throughput accounting 226, 238
and linear programming 150, 152, 156, 157, cost management
157, 161, 162 activity-based 274, 376
and marginal costing 25, 26, 52, 53 and banking sector 24
margin ratio 54, 56, 71, 74 definition/description of 182, 198
and performance measurement 447, 548, 549 and pricing 197
and shadow prices 159, 159 and standard costing 376
and standard costing 395, 397 cost reduction 212, 217, 218
and throughput accounting 228, 229 and activity-based costing 272, 273
and transfer pricing 563, 564, 565 and effect of learning 308
as percentage of sales 54 and environmental management accounting
per unit 54, 55, 59, 59, 67, 71, 106 625, 626
vs total avoidable fixed costs 113 and standard costing 375
contribution to sales graph see profit-volume graph

Index

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 691 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:51 PM
Created from durbanut-ebooks on 2022-08-08 13:59:12.
692

cost structure decision-makers, types of 442

and changeover point 76–78 decision-making model
and operating leverage 76 for direct labour costs 97
types of 75 for material costs 95, 95
costing principles, and banks 24 for overhead costs 99
costing systems decision tree
definition of 40 definition of 438, 445
evolution of 39–40 designing a 438–439
types of 24 illustrative example of 439–441, 440, 441
costs limitations of 442
classification of 3–7 defective products/units 106, 214, 216, 217, 219
of conformance 214, 215, 215, 216 degree of operating leverage 76, 77, 77, 79
of conversion 29, 233, 234 demand
estimation of 8–12 curve 184, 184, 185, 186
of failure 214, 215, 216, 627, 628, 628 law of 184
of non-conformance 214, 215, 215, 216 price elasticity of 185, 196, 198
cost-volume-profit (CVP) analysis Department of Environmental Affairs and
assumptions of 78–79 Tourism, categories of environmental
case study 643–645 indicators 631
definition/description of 52 depreciation 92, 93, 100, 109, 109, 113, 130
and relevant costing (case study) 677–679 determination, coefficient of 298
see also breakeven analysis differential analysis 93, 110, 114
crashing see acceleration differential cost 93, 93, 108, 109, 110, 130
criterion of regret 443 analysis 109, 110, 114
critical path see also incremental cost
definition of 467, 476 direct costing 25, 661–664
and network acceleration 469, 470, 471–472, see also marginal costing; variable costing
472 direct
and slack 467, 468 costs 4, 13
standard deviation of 475, 475 customer profitability 266
critical path method (CPM) marketing vs internet marketing 93
and critical paths 467 material costs 94–95, 95
development of 463 materials budget 333, 333, 334, 334
and network acceleration 469–470, 469, product profitability 266
471–472 direct labour 4
and network diagrams 464, 465, 465, 466, 466 budget 334, 334
and slack 467, 468 cost 97, 97
CS group (case study) 664–666 efficiency variances, causes of 390
cumulative average time per unit 307 idle time variances, causes of 390
current standards 374–375, 409 rate variances, causes of 390
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customer profitability discount rate 498

analysis 266–271 and investment appraisal 501, 502
report 271 NPV at 503, 503
customer-directed processes 254 and time value of money 519
cyclical variations 300, 309 and WACC 523
discounted payback
D calculation of 498
decentralisation method 497–499, 498
definition of 542, 572 period 498, 498, 499
problems arising from 542 discounting 508, 518, 519
reasons for 542 discretionary fixed costs 92, 130, 546
decision displacement of current production 97
making (case study) 669–671 divisible projects 515, 515
node 438, 439, 445 divisional performance
types of short-term 103 case studies on 543, 645, 648, 661, 673

Cost and Management Accounting

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 692 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:51 PM
Created from durbanut-ebooks on 2022-08-08 13:59:12.
693

evaluation 569 experience curve 299, 308, 309

reports 578 external
divisionalisation 542, 572 failure costs 214, 215, 216, 628, 628
see also decentralisation non-financial factors (in decision making)
drivers 253–254, 277 103
dual pricing 569 extrapolation 301, 309
dummy activities 465, 465, 466, 467, 476
durability (dimension of quality) 212 F
duration drivers 253 facility/business-sustaining activities 253, 253
factory overhead budget 335, 335
E feasibility (in decision making) 103
earliest feedback control 324, 325, 351
completion time (ECT) 467, 477 feed-forward control 324–325, 351
starting time (EST) 467, 477 financial
Economic Darwinism 231 accounting 2, 13
economic indicators (in short-term decision making)
order quantity (EOQ) 591–594, 608, 610 102
value added (EVA) 555–558, 556, 557, 572 financial statements
economist’s graph 69, 69 conversion from absorption to marginal
Edcon Group (case study) 656–660 costing 34, 34–36
electronic conversion from marginal to absorption
commerce (e-commerce) 603, 609, 610 costing 33, 33–34
data interchange (EDI) 236, 239 financially oriented EMA 624, 635, 636
employee fitness of use (dimension of quality) 212
in decision making 102 fixed
empowerment 208 budget 344, 345, 346, 347, 351
relations 431 costs 5, 6, 6, 7, 14
enterprise resource planning (ERP) 602, 610 manufacturing overheads 29
enterprise resource planning ll (ERP ll) 602, 610 fixed overhead
environmental costs 627, 635 expenditure variance 392, 394, 409
analysis 628 variances 393
indicators 630–631 volume capacity variance 394, 409
kinds of 624–625 volume efficiency variance 394, 410
performance 622, 630, 631, 635, 636 volume variance 392, 394, 410
and waste 629 fixed production overhead
environmental management accounting (EMA) expenditure variances, causes of 394
624–626, 629, 635 volume variances, causes of 394
Ernst & Young annual survey 623 flexibility (in decision making) 103
ERP see enterprise resource planning flexible
ethical budget 344, 345, 346, 351
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constraints (and decision making) 103 manufacturing systems (FMS) 235–236, 239
decisions, guiding principles 129 float 467, 477
event (in network analysis) see also slack
definition of 464, 464, 477 forecasting
in network diagrams 466, 466 disadvantages of 303
node 438, 439, 445 equation 294, 295
see also activities importance of 294
expansion projects 495 model 297
expected value 432 techniques 294–299
and coefficient of variation 433, 434, 434, 435 forfeitable share plans (FSPs) 571
and decision tree 439, 441 full absorption costing, and banks 24
definition of 432, 445 functional benchmarking 232
of perfect information 436, 437, 437 further processing costs 121, 122, 125, 126, 130
and relevant costs (case study) 664–666 future costs and revenues 92, 130
expense, definition of 2, 13 future value (FV) 519, 520, 521, 522

Index

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 693 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:51 PM
Created from durbanut-ebooks on 2022-08-08 13:59:12.
694

G non-financial factors (in decision making)

102–103
generic benchmarking 232
internal rate of return (IRR)
globalisation 623
advantages of 504
graphical method
calculation of 502, 503, 505
of cost estimation 8
definition/description of 501–502, 524
and the effect of learning 305–306, 306
disadvantages of 504
of linear programming 150, 151–153, 166
on financial calculator 504
to manage inventory 594, 594
vs net present value 504
graphs
of perpetuity 504
limitations of 68–69
see also modified internal rate of return
and cost-volume-profit analysis 63–69
International Accounting Standards 29
and multiple-product breakeven analysis
International Federation of Accountants (IFAC) 624
73, 73, 75, 75
International Integrated Reporting Council
green framework supply chain, model of 630
(IIRC) 622
greenhouse gas (GHG) inventories 634, 636
International Organisation for Standardisation
H (ISO) 217, 623
internet marketing vs direct marketing 93
hard capital rationing 514 inventories
high-low method 8, 10–11, 11, 294, 295 budget 336, 337, 337
holding costs 588, 610 cost of 29
hospital, managing costs at a (case study) 13 and greenhouse gas 634, 635, 636
and JIT 224, 225, 233, 607
I inventory
ideal standards 374, 410 cost of delivery failure 604
idle time 97, 219, 223, 224, 227, 387 cost of holding 604
variance 388, 389, 390 cost of poor quality 604
imperfect information 436, 445 cost of purchasing 604
incentive scheme 570, 572 management (integrated case study on)
income statement 25, 26, 339 666–667
incremental analysis 59, 116, 116, 127, 127 for precaution 588, 610
incremental costs 116, 117, 126 and quality management 217
see also differential costs reasons for 588
incremental taxable income 511, 511, 513, 514 for speculation 588, 610
independent projects 495 for transactions 588, 610
indirect costs 4 and waste elimination 219
and activity-based costing 250, 263 investment centre 3, 14, 545, 550–554, 572
definition of 14 irrelevant costs, types of 99–100, 130
and environmental management 625 islands of automation (IA) 235, 239
indirect labour costs 97 ISO 9000 series 217
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indivisible projects 516 ISO see International Organisation for

inflation Standardisation
and activity-based budgeting 349 iso-contribution line 156
and decision making 103 see also profit line
and investment appraisal 518–519
and NVP analysis 518 J
and pricing 184 JIT see just-in-time
information technology (IT) 237, 238 Johannesburg Stock Exchange (JSE) 623
integrated reporting (IR) 622, 636 joint costs 122, 130
Integrated Reporting Committee (IRC) 622, 623 allocation to joint products 122–126, 124, 125
intensity drivers 253 see also common costs
internal joint products 121, 130
benchmarking 232 accounting for 122
control (in decision making) 103 methods of allocating joint costs to
failure costs 214, 215, 216, 627, 628 122–126, 124, 125

Cost and Management Accounting

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 694 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:51 PM
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695

overview of 121 learning index 306

selling/processing of 126–127 least squares
and split-off point 122, 123, 124, 126–127 method 8, 11–12, 12, 294, 295
just-in-time (JIT) regression 294, 309, 310
benefits of 224, 608 see also regression analysis
and cases studies 647, 659, 662 ledger accounts 403–405, 405–406
CIMA definition of 222 legal constraints (and decision making) 103
definition/description of 222, 239, 610 life cycle see product life cycle
elements of implementing 607 life-cycle costing
environment 376 and environmental management accounting
or EOQ (case study) 608 624
goals of 223, 224 definition/description of 40, 231, 240
inventory 606, 608 stages of 230, 238
origin of 39 types of 231
philosophy behind 223, 606 limiting factor 132, 133, 150, 165
problems of 225 see also constrained resource
production 224 linear programming
purchasing 225 case study 649–653
vs push system 223 for climate change (case study) 158
and standard costing 376, 380 definition/description of 150, 166
and throughput accounting 228 long-term decision making, vs short-term
and Toyota 226 decision making 92
and TQM 217 loss leader pricing 196
and world-class manufacturing 236
M
K make-versus-buy decisions 107–108
Kaizen management accounting
costing 190, 217, 218–219, 239 definition\description of 2, 14
and eliminating waste 218 information provided by 2
philosophy xvi management by exception 324, 346, 351, 374, 410
kanban 224, 607 management, three main tasks of 1
King Report on Corporate Governance 623 manufacturing
costs 3
L importance in SA economy (GDP) 236
labour 3, 4 overheads 4
costs 97, 97, 305, 305 systems 235, 236, 239
efficiency variance 387, 389, 390, 410 technology 38, 235, 236, 238, 239, 376
mix variance 390 margin of safety
rate variance 387, 398, 410 and breakeven graph 66
definition of 53, 79
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variances 387–390, 388

yield variance 390 as percentage 56, 72
latest in rands 56, 72
completion time (LCT) 467, 477 ratio 56
starting time (LST) 467, 477 in units 56
learning curve 294 marginal
calculation of 304, 305, 305, 306, 306 rate of substitution 159, 164, 165, 166
case study on 673–676 revenue 185, 186, 563, 564
definition of 309 marginal cost
learning curve effect 303, 303 card 25, 25
calculation of 306 and pricing management 185, 187, 192
case study on 308 marginal costing
definition of 310 and conversion of financial statements
in graphical format 305–306, 306 33–36, 33–34, 34–36
mathematical method 306–307 definition of 25, 40
in table format 306, 306
uses for 309
Index

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 695 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:52 PM
Created from durbanut-ebooks on 2022-08-08 13:59:12.
696

effect on profits 31, 31–32, 33 net present value (NPV)

external uses of 26–29, 27 advantages of 501
internal uses of 26 analysis 518
principles of 25 calculation of 500, 501–503, 503, 512, 513
reconciliation statement 399 definition of 499, 524
strengths and weaknesses of 36, 36–37 disadvantages of 501
system 392, 394, 395, 396 and inflation 518
see also direct costing; variable costing vs internal rate of return 504
marginal costing statement 36, 36 vs modified internal rate of return 506
and cost-volume-profit analysis 53, 53, 55, and profitability index 505, 506
58, 59, 76, 78 network
and decision making 92 acceleration 469–470, 469, 471–472
format of 52, 52 diagrams 464, 465, 465, 466, 466
market-based non-conformance, costs of 214, 215, 215, 216
pricing, definition of 189, 198 non-financial indicators/factors (in short-term
transfer prices 561 decision making) 102–103, 109, 112, 114, 131
marketing costs 231 non-manufacturing costs 3
master budget 274, 328, 328, 337 non-negativity factor 152
material mix variance non-production overheads 12, 14
calculation of 383–384, 384 non-value-added activity 224, 225
causes of 386 notional costs 100, 131
definition of 383, 410
material price variance O
causes of 385 objective function (in linear programming) 152,
definition of 382, 410 156, 166, 650, 651
material usage variance operating leverage, degree of 76, 77, 77, 79
causes of 385 operational variances 407, 408
definition of 383, 410 opportunity cost 94, 117, 131
material variances 381, 381–382, 382 and decision making 103
material yield variances and decision-making criteria 443, 444, 444
calculation of 385, 385 and inventory management 596
causes of 386 and JIT 224
definition of 384, 410 and linear programming 159, 160, 164,
materials 165, 166
handling systems (MHS) 236, 240 and project cash flow 510, 510
requirement planning (MRP) 601, 602, 611 and taxable income 511, 511, 513
requirement planning I (MRP l) 602 and transfer pricing 562, 563, 565, 565, 567, 568
requirement planning II (MRP ll) 602, 611 optimal manufacturing plan 151, 156, 157, 159
maximax decision criterion 443, 445 definition/description of 150, 166
maximin decision criterion 443, 445 optimal solution (in linear programming)
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maximum transfer prices 563, 565, 566 153–158, 154, 155, 156, 157, 158
metric conversion chart xx ordering costs 590, 611
minimax decision criterion 443, 445 output measure 254, 277
minimum transfer prices 563, 565, 566, 568 outsourcing 107
mixed costs 5, 6–7, 7, 14 overhead costs, and decision making 99, 99
see also semi-variable costs over-processing 219
modified internal rate of return (MIRR) 506, 507 over-production 37, 219
moving averages 300, 301, 302, 310
MRP see materials requirement planning P
mutually exclusive projects 495
parallel activities 463, 465, 477
partial correlation 297, 297
N payback method
negotiated prices 561–562 advantages of 497
net operating profit after tax (NOPAT) 555, disadvantages of 497
555, 557, 572 see also discounted payback method

Cost and Management Accounting

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 696 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:52 PM
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697

payback period 496, 497 pricing and relevant costing (case study)
definition of 495, 524 676–677
see also discounted payback period prime costs 4, 12, 14
payoff table 432, 437, 438, 443, 444, 446 probability 430
penetration pricing 196 coefficient of variation 434, 434
perfect definition of 432, 446
correlation 11, 295, 297, 297, 298 and distribution 432, 434, 436, 436, 437, 437
information 436, 437, 437, 446 and outcomes for ranges 433
performance process
and activity-based costing 273, 274, 275 benchmarking 232
and balanced scorecard 558–560, 559–560 definition of 254
and benchmarking 232 types of 254
and corporate social responsibility 622, 623 processing costs 121, 122, 125, 126, 130
in cost and revenue centres 546–547, 547 product
data 543 benchmarking 232
as dimension of quality 212 bundling 197
drivers 275, 277 costs 4, 14
and environmental indicators 630–631 features 190, 191, 212, 219, 220
evaluation 325, 327, 544, 548, 558–560 mix 52, 79, 104
in investment centres 550–554, 554 profitability 266, 266–271
of JIT system 609 profitability report 269, 275
levels of 327 return 228
measurement/measures 211, 226, 228, 232, product-directed processes 254
275, 542, 543, 545, 546, 554, 558, 630 product life-cycle
in profit centres 547–550, 548, 549 costing 40, 230–231, 238, 240
reporting 600 model 230
reports 345–346, 346, 351, 402, 547, 548 pricing 188, 188–189, 198
and responsibility centres 3, 545–546 stages 195, 230
reward system 325 see also life-cycle costing
shares 571 product life cycle 219, 231, 238, 629
statements 547, 547 CIMA definition of 230
and supplier relationships 605, 606 phases/stages of 40, 188, 189, 196, 218, 230
see also divisional performance; sales and profit trends of 188, 188
environmental performance see also life-cycle costing; product life-cycle
period costs 4, 14, 25, 36, 37, 40 product/service-sustaining activities 252, 253
periodic budget 326, 351 production
perpetuity 504, 520 bottlenecks (case study) 101–102
PERT see program evaluation and review budget 333, 333
technique costs 12, 14, 231
phantom share schemes 571, 572 delays 219, 224
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physically oriented EMA 625 mix 105, 105, 132, 132, 133
planning variance 407, 408 overheads 4, 12, 14, 27
political pressure (and decision making) 103 productive hours 388
post completion audit (PCA) 524 profit
premium pricing 196 after tax (PAT) 555, 557
preproduction costs 231 calculation of 184
present value (PV) 498, 499, 520, 521 centre 3, 14, 545, 546–550, 572
see also net present value line 68, 73, 74
prevention costs 214, 215, 216, 627, 628, 628 maximisation price model 185–187, 198
price measurement 40, 380
differentiation 196 profit margin 70
discounting 197 case studies on 656, 679
elasticity of demand 185, 196, 198 and market-based pricing 190, 191
price/demand equation 186 and sales variance 397
skimming 196 and target costing 219, 220, 221, 238

Index

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 697 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:52 PM
Created from durbanut-ebooks on 2022-08-08 13:59:12.
698

profitability and expected values (case study) 664–666

index (PI) 505, 506, 517, 524 and pricing (case study) 676–677
report 267, 269, 271, 275 and standard costing (case study) 667–669
profit-maximising sales mix 150 relevant range (of activity level) 4, 5, 6, 78, 184, 345
profit-volume graph 68, 68, 73, 74–75, 75 definition of 68–69, 79
program evaluation and review technique reliability, as dimension of quality 208, 212, 297
(PERT) remuneration 388
vs critical path method 462 reorder point 594, 611
development of 473 replacement projects 495
formula 474, 474 required profit see target profit
and standard deviation 475, 475 residual income 553–554, 573
and time estimates 474, 474 resource drivers 253
project cash flows 509–514, 510, 511, 512 responsibility
pull system 39, 222, 223, 224 accounting 324, 351
push system 222, 223, 223 centres 3, 14, 544, 545–546, 572, 573
return
Q on capital employed (ROCE) 508, 550
quality on investment (ROI) 508, 550, 551, 573
accreditation 217 revenue centre 3, 14, 545, 546, 573
and activity-based costing 250, 254 revenues and relevant costs 92, 100, 131
assurance 213, 213, 217 reverse engineering 232, 240
control 213, 214, 217, 607, 644, 666, 667 risk
cost framework 627–628, 636 averse decision-makers 442, 443, 446
cost of 214–215, 215, 216 definition of 430, 446
definition of 211, 240 neutral decision-makers 442, 443, 446
dimensions of 212 neutrality 441
drivers 254, 277 risk-seekers 441, 442, 443, 446
improvement 212, 213, 213 rolling budgets 326, 327, 351
inspection 213, 250 running out of stock costs 591
and JIT 223, 224, 225, 607
of materials 383, 385, 386 S
measures 216 safety inventory 595, 611
report 215, 216, 216, 239 sales
standards of 208, 211, 216 budget 332, 332
and supplier relationships 606 mix 70, 72, 79
see also continuous improvement; total mix variance 397, 398, 410
quality management price variance 395, 396, 398, 399, 410
quantity discounts 598, 611 quantity variance 397, 398, 410
sales variances 396, 397–398, 397
R volume variance 395, 396, 397, 398, 399,
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random variations 299, 303 400, 410

reconciliation statement 398, 399, 399–400 SAP (enterprise application software company)
regression analysis 295–296, 296 603, 611
in cost estimation 8 scarce resource, and linear programming 150,
as forecasting model 297, 312, 319, 320, 320 159, 160, 164, 166
see also least squares method scarcity (of resource) 158
regulatory projects 495 see also constraint
relevant scatter graph method, of cost estimation 8, 9,
costs and revenues 92, 100, 131 9–10, 11
direct labour cost 97, 97 seasonal fluctuations/variations 299, 310
overhead costs 99, 99, 131 selective inventory control 6
relevant costing selling and administration budget 335, 336
and cost-volume-profit analysis (case study) semi-variable costs 345
677–679 see also mixed costs

Cost and Management Accounting

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 698 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:52 PM
Created from durbanut-ebooks on 2022-08-08 13:59:12.
699

sensitivity analysis 68, 160, 165, 441, 596 step costs 5, 7, 7, 14

see also what-if analysis strategic
separation point see split-off point alliance 603, 611
service and support costs 231 benchmarking 232
serviceability (dimension of quality) 212 subsequent costs see further processing costs
shadow price 158–159, 159, 166, 565 substitution, marginal rate of 159, 164, 165, 166
see also opportunity cost sunk costs 99, 131
share options 570, 573 supplier performance index (SPI) 605–606, 611
short-term decision making supply chain
case study 669–671 definition of 210, 240
vs long-term decision making 92 and e-commerce 603, 610
short-term decision 103, 129 environmental impact of 629, 630
Shuttleworth, Mark, entrepreneur 643 and JIT 225
simple regression analysis (in cost estimation) 8 management 210, 238
simplex method, of linear programming 150, surplus capacity 97
160–163, 161, 162, 163, 166
single cash flow 520, 521, 522 T
single-period capital rationing 515 target
slack price 190–191, 198
and activities 467, 468 pricing 190, 191
and budgets 327, 328 profit 55, 55, 56, 58, 72, 79
on critical path 467, 468 target costing
definition of 477 definition/description of 40, 219, 240
and linear programming 160, 161 process diagram 221
and network analysis 467–468, 468 reasons for using 220–221
uses of 468, 476 stages in 220, 220
variables 160, 165, 166 and total quality management 217
small business development, government technology 38, 235, 137, 238, 239, 376, 603
objectives 643 theory of constraints (TOC) 227, 228, 229, 240
social auditing 631, 632, 636 throughput
soft capital rationing 514 and bottlenecks 227, 228, 229
South African Bureau of Standards (SABS) 217 calculation of 226
Southern African Customs Union (SACU) 633 concepts of 227–228
special contribution 228, 229
material 95 definition of 226
orders 115, 116, 117 measuring of 228
speculative costs 100, 131 philosophy 227
split-off point 121, 122, 123, 124, 126–127, 130 see also throughput accounting
standard cost 374 throughput accounting (TA) 40
card 376 definition/description of 226, 238, 240
Copyright © 2021. Juta & Company, Limited. All rights reserved.

uses of 375, 410 and JIT 228

standard costing ratio 228, 230
and banks 24 and theory of constraints 228–229
divisional performance and transfer pricing time estimates, and PERT 474, 474
(case study) 645–649 time series
transfer pricing and relevant costing (case analysis 301, 303, 310
study) 667–669 components of 300
standard deviation 433, 434, 434, 435, 446, 475, 475 cyclical variations 299
standards, categories of 374–375 data 299, 299–302
statement of comprehensive income 30–31,123, trend 299
128, 328, 336, 337, 339, 341, 345, 349, 549 time value of money 441
see also income statement timing (in decision making) 103
statement of financial position 328, 331, 336, total
341–342, 342, 555 contribution 40, 41, 59, 60, 61, 106, 157, 187
see also balance sheet cost 5, 9, 10, 11, 11, 12, 12, 14

Index

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 699 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:52 PM
Created from durbanut-ebooks on 2022-08-08 13:59:12.
700

factory costs (TFC) 227, 228, 229, 230 V

fixed overhead variance 392
value chain 107, 190
fixed production overhead variance 394
analysis 208–210
material variance 381, 382, 408, 411
CIMA definition of 208
value chain analysis 208–210, 209
definition of 208, 240
variable production overhead variance 392
processes in 209
total quality management (TQM)
purpose of 208
CIMA definition of 211
upstream and downstream processes in 209,
and business process re-engineering 237
209–210
definition/description of 211, 238, 240
value engineering/analysis 190, 195, 198
implementation of 212–213, 213, 667
variable costing 25, 226, 377, 393, 399
and JIT 217
see also direct costing; marginal costing
principles of 211
variable costs 5–6, 6, 7, 14
and target costing 217
variable overhead
and world-class manufacturing 236
efficiency variance 391, 392, 402, 411
see also continuous improvement; Kaizen
expenditure variance 391, 392, 411
costing; quality
variances, 391, 391, 411
toxic material 95
variable production
Toyota’s ideal standards (case study) 375
overhead efficiency variances, causes of 392
Toyota’s JIT revolution (case study) 226
overhead rate variances, causes of 392
trade unions (in decision making) 102
variance
traditional costing systems, description of 24
definition of 377, 411
transaction drivers 253
investigating of 401
transfer price
structure 377, 378
definition of 560, 573
variance analysis 251, 374
determining fair 566, 567, 568
definition of 377, 411
and external markets 563, 564, 565, 565, 566
illustrative example of 380–385, 381, 382,
guidelines for setting 562–563, 563
384, 385
methods for determining 561
model for 379, 379
transfer pricing (case studies) 645–649,
vertical integration 107
667–669, 673–676
volume
transportation 216, 219, 590, 649
capacity variance 392
trend, and forecasting techniques 299, 300,
efficiency variance 392
302, 303, 310
triple bottom line (TBL) 622, 636 W
U waste
elimination/minimisation of 39, 218– 219, 223
uncertainty
and environmental costing 629
in budgeting 326, 327
and environmental management accounting 625
in decision making 429
Copyright © 2021. Juta & Company, Limited. All rights reserved.

and JIT 607

and decision-making criteria 443
management 625
definition of 446
types of 219
and expected value 437, 437
weighted average cost of capital (WACC) 499,
and probabilities 432
501, 502
and types of decision-makers 442
appropriate use of 523
unequal lives, projects with 501
calculation of 522, 523
Unilever (case study) 56–57
what-if analysis 58–62, 79
UNISA, activity-based costing at (case study)
see also sensitivity analysis
255–256
world-class manufacturing (WCM) 236–237, 238,
United States Environmental Protection
240
Authority, types of environmental
costs 627 Z
unit-level activities 252, 253
unquantified opportunity costs (in decision zero-based budgeting (ZBB) 238, 348, 349, 351
making) 103 zero-inventory policy 227

Cost and Management Accounting

CMA Management
Marimuthi, F. (2021).and operations
Cost 3e_Book.indb
and management 700 : Operations and management : a southern african approach. Juta & Company, Limited.
accounting 2021/02/05 2:44:52 PM
Created from durbanut-ebooks on 2022-08-08 13:59:12.

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Cost and Management Accounting Textbook Softcopy.

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Cost and Management Accounting Textbook Softcopy.

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34mm

Cost and Management Accounting

Operations and Management – A southern African approach

Cost and Management Accounting

About the editor

Copyright © 2021. Juta & Company, Limited. All rights reserved.

General editor: Ferina Marimuthu

General editor: Ferina Marimuthu

Juta and Company (Pty) Ltd

© 2021 Juta & Company (Pty) Ltd

ISBN (Print): 978 1 48513 122 9

ISBN (WebPDF): 978 1 48513 123 6

Print production specialist: Seshni Kazadi

Typeset in 10 pt on 12 pt ITC Legacy Serif Std

Make or buy (outsourcing) decision.................................................................................................. 107

Cost and Management Accounting

The profit maximisation price model............................................................................................... 185

Loss leader pricing.................................................................................................................................. 196

Backflush accounting................................................................................................................................... 233

Cost and Management Accounting

Review questions........................................................................................................................................... 242

Pricing decisions..................................................................................................................................... 309

Cost and Management Accounting

Fixed production overhead variances................................................................................................ 392

Critical path............................................................................................................................................. 467

Cost and Management Accounting

Performance measurement in investment centres......................................................................... 550

Managing suppliers...................................................................................................................................... 603

17 Environmental management accounting and other developments������������������������ 621

Case study 14: Relevant costing and cost-volume-profit analysis.................................................... 677

Cost and Management Accounting

Elda du Toit is an associate professor in the Department of Financial Management at the

Ferina Marimuthu is a senior lecturer in the Department of Management Accounting at

understanding of the main topics and issues covered in each chapter.

How to use this book

Rona Louwrens CA(SA), ACMA

Case study: British Airways on pages 391–393. Public Domain: www.britishairways.com/

Text from Environmental Management Accounting (EMA) on page 624. ‘Integrated

METRIC AREA CONVERSIONS

METRIC VOLUME CONVERSIONS

METRIC WEIGHT CONVERSIONS

1 decagram = 10 grams 1 dag = 10 g

METRIC LIQUID VOLUME (CAPACITY) CONVERSIONS

Basic cost accounting Cost classification Cost estimation

Definitions Element Behaviour Scatter graph Least squares

Assignment Timing High-low

Why do we care about costs?

Fundamental aspects of cost accounting

Cost and Management Accounting

Basic cost accounting, cost classification, behaviour and estimation

Direct and indirect costs

Direct material + Direct labour = Prime cost

Direct labour + Manufacturing overheads = Conversion costs

Product and period costs

Cost and Management Accounting

Illustrative example 1.1

Total variable costs 19 500 48 750 58 500

Basic cost accounting, cost classification, behaviour and estimation

Therefore, variable costs could be represented in a graph as shown in Figure 1.1.

Total cost (R)

Figure 1.1 Variable costs

Figure 1.2 Fixed costs

Cost and Management Accounting

Mixed cost = Fixed cost + Variable cost

Figure 1.3 Mixed costs

Basic cost accounting, cost classification, behaviour and estimation

Test yourself 1.1

Cost items (cost object):

Cost and Management Accounting

Illustrative example 1.2

Scatter graph method

and the activity cannot be used to estimate the cost.

Basic cost accounting, cost classification, behaviour and estimation

Illustrative example 1.2 (cont.)

Figure 1.5 Scatter graph of Cam Ltd

The variable cost can be calculated as:

17 Environmental management accounting and other developments�� 621

Less: Selling, distribution and