f5 performance management kaplan 2013

3Opportunity cost

Opportunitycostisanimportantconceptfordecisionmakingpurposes.Itisthevalueofthebestalternativethatisforegonewhenaparticularcourseofactionisundertaken.Itemphasisesthatdecisionsareconcernedwithchoicesandthatbychoosingoneplan,theremaywellbesacrificeselsewhereinthebusiness.

Acompanywhichmanufacturesandsellsonesingleproductiscurrentlyoperatingat85%offullcapacity,producing102,000unitspermonth.Thecurrenttotalmonthlycostsofproductionamountto330,000,ofwhich75,000arefixedandareexpectedtoremainunchangedforalllevelsofactivityuptofullcapacity.

Anewpotentialcustomerhasexpressedinterestintakingregularmonthlydeliveryof12,000unitsatapriceof2.80perunit.

Allexistingproductionissoldeachmonthatapriceof3.25perunit.Ifthenewbusinessisaccepted,existingsalesareexpectedtofallby2unitsforevery15unitssoldtothenewcustomer.

What is the overall increase in monthly profit which would result from accepting the new business?

4The relevant cost of materials

Make or buy and other short-term decisions

166 KAPLAN PUBLISHING

Test your understanding 1 Opportunity cost

Anyhistoriccostgivenformaterialsisalways a sunk costandnever relevantunlessithappenstobethesameasthecurrentpurchaseprice.

5The relevant cost of labour

6Make versus buy Making the decision on financial grounds

Aproductshouldbemadeinhouseiftherelevantcostofmakingtheproductinhouseislessthanthecostofbuyingtheproductexternally.

Spare capacity exists

Unlessstatedotherwiseinthequestion,itshouldbeassumedthatthereissparecapacity.

No spare capacity exists

Therelevantcostofmakingtheproductinhouse=thevariablecostofinternalmanufactureplusanyfixedcostsdirectlyrelatedtothatproduct.

Therelevantcostofmakingtheproductinhouse=thevariablecostofinternalmanufactureplusanyfixedcostsdirectlyrelatedtothatproductplustheopportunitycostofinternalmanufacture(e.g.lostcontributionfromanotherproduct).

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KAPLAN PUBLISHING 167

Afactorysentiremachinecapacityisusedtoproduceessentialcomponents.Theproductioncostsofusingthemachinesareasfollows.

Ifallcomponentproductionwasoutsourced,thenthemachinescouldbeusedtoproduceotheritemsthatwouldgenerateadditionalcontributionof$50,000. Assumethefixedcostswillstillbeincurredifproductionisoutsourced.

Whatisthemaximumpricethatthecompanyshouldbewillingtopaytotheoutsidesupplierforthecomponents?

$ Variable 30,000Fixed 50,000

Total 80,000

RobustLtdmakesfourcomponentsA,B,CandDandtheassociatedannualcostsareasfollows:

A B C DProductionvolume(units) 1,500 3,000 5,0007,000Unitvariablecosts $ $ $ $Directmaterials 4 4 5 5Directlabour 8 8 6 6Variableproductionoverheads 2 1 4 5

Total 14 13 15 16Fixedcostsdirectlyattributableare: 3,000 6,00010,0007,000Theunitpricesofanexternalsupplierare: 12 16 20 24

Determine whether any of the components should be bought in from the external supplier.



Test your understanding 2

Illustration 1 Make or buy

Solution

Other issues to consider

Inadditiontotherelativecostofbuyingexternallycomparedtomakinginhouse,managementmustconsideranumberofotherissuesbeforeafinaldecisionismade.

Reliability of external supplier: cantheoutsidecompanybereliedupontomeettherequirementsintermsof: quantityrequired

qualityrequired

deliveringontime

pricestability

Specialist skills:theexternalsuppliermaypossesssomespecialistskillsthatarenotavailableinhouse.

Alternative use of resource: outsourcingwillfreeupresourceswhichmaybeusedinanotherpartofthebusiness.

Social: willoutsourcingresultinareductionoftheworkforce?Redundancycostsshouldbeconsidered.

Legal: willoutsourcingaffectcontractualobligationswithsuppliersoremployees?

Confidentiality: isthereariskoflossofconfidentiality,especiallyiftheexternalsupplierperformssimilarworkforrivalcompanies.

Customer reaction: docustomersattachimportancetotheproductsbeingmadeinhouse?

KRSLtdisconsideringwhethertoadministeritsownpurchaseledgerortouseanexternalaccountingservice.Ithasobtainedthefollowingcostestimatesforeachoption:

Internal service department

Cost VolumePurchasehardware/software $320paHardware/softwaremaintenance $750paAccountingstationery $500paParttimeaccountclerk $6,000paExternal servicesProcessingofinvoices/creditnotes $0.50perdocument 5,000paProcessingofchequepayments $0.50percheque 4,000paReconcilingsupplieraccounts $2.00persupplier

permonth 150suppliers

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Test your understanding 3 Additional question on make vs buy

Determine the cost effectiveness of outsourcing the accounting activities and identify the qualitative factors involved.

7Shutdown decisions

Partofabusiness,forexampleadepartmentoraproduct,mayappeartobeunprofitable.Thebusinessmayhavetomakeadecisionastowhetherornotthisareashouldbeshutdown.

The quantifiable cost or benefit of closure

Therelevantcashflowsassociatedwithclosureshouldbeconsidered. Forexample:

Iftherelevantbenefitsaregreaterthantherelevantcostsofclosurethenclosuremayoccur. However,beforeafinaldecisionismadethebusinessshouldalsoconsiderthenonquantifiablefactorsdiscussedbelow.

Nonquantifiable costs and benefits of closure

thelostcontributionfromtheareathatisbeingclosed(=relevantcostofclosure)

savingsinspecificfixedcostsfromclosure(=relevantbenefitofclosure) knownpenaltiesandothercostsresultingfromtheclosure,e.g.

redundancy,compensationtocustomers(=relevantcostofclosure)

anyknownreorganisationcosts(=relevantcostofclosure) anyknownadditionalcontributionfromthealternativeuseforresources

released(=relevantbenefitofclosure).

Someofthecostsandbenefitsdiscussedabovemaybenonquantifiableatthepointofmakingtheshutdowndecision: penaltiesandothercostsresultingfromtheclosure(e.g.

redundancy,compensationtocustomers)maynotbeknownwithcertainty.

reorganisationcostsmaynotbeknownwithcertainty.

additionalcontributionfromthealternativeuseforresourcesreleasedmaynotbeknownwithcertainty

Knockonimpactoftheshutdowndecision. Forexample,supermarketsoftenstocksomegoodswhichtheysellataloss.Thisistogetcustomersthroughthedoor,whotheythenhopewillpurchaseotherproductswhichhavehigherprofitmarginsforthem. Ifthedecisionistakentostopsellingtheseproducts,thenthecustomersmaynolongercometothestore.



ThemanagementofFionaCoisconsideringtheclosureofoneofitsoperations,department3,andthefinancialaccountanthassubmittedthefollowingreport.

Additionalinformation:

Asmanagementaccountant,youfurtherascertainthat,onacostdriverbasis:

Department 1 2 3 TotalSales(units) 5,000 6,000 2,000 13,000

Sales($) 150,000 240,000 24,000 414,000Costofsales($)Directmaterial 75,000 150,000 10,000 235,000Directlabour 25,000 30,000 8,000 63,000Productionoverhead 5,769 6,923 2,308 15,000

Grossprofit($) 44,231 53,077 3,692 101,000Expenses($) 15,384 18,461 6,155 40,000

Netprofit($) 28,847 34,616 (2,463) 61,000

productionoverheadsof$15,000havebeenapportionedtothethreedepartmentsonthebasisofunitsalesvolume

expensesareheadofficeoverheads,againapportionedtodepartmentsonsalesvolume.

50%oftheproductionoverheadscanbedirectlytracedtodepartmentsandsocouldbeallocatedonthebasis2:2:1.

Similarly60%oftheexpensescanbeallocated3:3:2,withtheremaindernotbeingpossibletoallocate.

80%ofthesocalleddirectlabourisfixedandcannotbereadilyallocated. Theremaining20%isvariableandcanbebetterallocatedonthebasisofsalesvolume.

(a) Restatethefinancialpositionintermsofthecontributionmadebyeachdepartmentand,basedonthesefigures,makeaclearrecommendation.

(b) Discussanyotherfactorsthatshouldbeconsideredbeforeafinaldecisionismade.

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8Oneoff contracts

Whenabusinessispresentedwithaoneoffcontract,itshouldapplyrelevantcostingprinciplestoestablishthecashflowsassociatedwiththeproject.

Theminimumcontractprice=thetotaloftherelevantcashflowsassociatedwiththecontract.

Ifthecontractpricedoesnotcoverthesecashflowsthenitshouldberejected.

MrSmithhasbeenaskedtoquoteapriceforaspecialcontract.Hehasalreadypreparedhistenderbuthasaskedyoutoreviewitforhim.

Hehaspointedouttoyouthathewantstoquotetheminimumpriceashebelievesthiswillleadtomorelucrativeworkinthefuture.

Mr Smiths tender

$Material: A2,000kgs@$10perkg 20,000

B1,000kgs@$15perkg 15,000C500kgs@$40perkg 20,000D50litres@$12perlitre 600

Labour: Skilled1,000hrs@$25perhr 25,000Semiskilled2,000hrs@$15perhr

30,000

Unskilled,500hrs@$10perhr 5,000Fixedoverheads3,500hrs@$12perhr 42,000Costsofpreparingthetender:MrSmith'stime 1,000otherexpenses 500Minimumprofit(5%oftotalcosts)

7,725

Minimumtenderprice 166,825




Additional example on shutdown decisions

Other information

MaterialA

MaterialB

MaterialC

MaterialD

Skilledlabour

1,000kgsofthismaterialisinstockatacostof$5perkg. MrSmithhasnoalternativeuseforhismaterialandintendssellingit

for$2perkg.

However,ifhesoldanyhewouldhavetopayafixedsumof$300tocoverdeliverycosts.

Thecurrentpurchasepriceis$10perkg.

ThereisplentyofMaterialBinstockanditcost$18perkg. Thecurrentpurchasepriceis$15perkg. ThematerialisconstantlyusedbyMrSmithinhisbusiness.

Thetotalamountinstockof500kgswasboughtfor$10,000sometimeagoforanotheroneoffcontractthatneverhappened.

MrSmithisconsideringsellingitfor$6,000intotalorusingitasasubstituteforanothermaterial,constantlyusedinnormalproduction.

Ifusedinthislattermanneritwouldsave$8,000oftheothermaterial.

Currentpurchasepriceis$40perkg.

Thereare100litresofthismaterialinstock. Itisdangerousandifnotusedinthiscontractwillhavetobe

disposedofatacosttoMrSmithof$50perlitre.

Thecurrentpurchasepriceis$12perlitre.

MrSmithonlyhiresskilledlabourwhenheneedsit. $25perhouristhecurrenthourlyrate.

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Semiskilledlabour

Unskilledlabour

Fixedoverheads

Costsofpreparingthetender

Profit

Required:

CalculateandexplainforMrSmithwhatyoubelievetheminimumtenderpriceshouldbe.

MrSmithhasaworkforceof50semiskilledlabourerswhoarecurrentlynotfullyutilised.

Theyareonannualcontractsandthenumberofsparehourscurrentlyavailableforthisprojectare1,500.Anyhoursinexcessofthiswillhavetobepaidforattimeandahalf.

Thenormalhourlyrateis$15perhour.

ThesearecurrentlyfullyemployedbyMrSmithonjobswheretheyproduceacontributionof$2perunskilledlabourhour.

Theircurrentrateis$10perhour,althoughextracouldbehiredat$20anhourifnecessary.

ThisisconsideredbyMrSmithtobeanaccurateestimateofthehourlyratebasedonhisexistingproduction.

MrSmithhasspent10hoursworkingonthisprojectat$100perhour,whichhebelievesishischargeoutrate.

OtherexpensesincludethecostoftravelandresearchspentbyMrSmithontheproject.

ThisisMrSmithsminimumprofitmarginwhichhebelievesisnecessarytocover'generaldaytodayexpensesofrunningabusiness'.



Additional example on oneoff contracts

9Further processing decisions

Afurtherprocessingdecisionwillbetestedinthecontextofjointproductsintheexam.

Revision of joint product costing

JointproductcostingwasintroducedinpaperF2:

Thebasisofapportionmentofjointcoststoproductsisusuallyoneofthefollowing:

Jointproductsarisewherethemanufactureofoneproductinevitablyresultsinthemanufactureofotherproducts.

Thespecificpointatwhichindividualproductsbecomeidentifiableisknownasthesplitoffpoint.

Costsincurredbeforethesplitoffpointarecalledjointcostsandmustbesharedbetweenjointproductsproduced.

Afterseparationproductsmaybesoldimmediatelyormaybeprocessedfurther.Anyfurtherprocessingcostsareallocateddirectlytotheproductonwhichtheyareincurred.

(i) Salesvalueofproduction(alsoknownas'marketvalue')

(ii) Productionunits

(iii) Netrealisablevalue.

ProductsAandBaretwojointproductswithinformationasfollows:

(a)Apportionment by production units

Kgsproduced Kgssold SellingPriceperkg JointcostProductA 100 80 $5

$750ProductB 200 150 $2

Jointcost $750 = = $2.50perkgforAandBKgsproduced 300

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Illustration 2 Valuation of joint products

Trading results are as follows:

Theproductionratiois100:200whichmeansthatinordertoobtain1kgofA,itisnecessarytoproduce2kgsofB.Forexampurposes,youshouldassumethattheratioofoutputisfixed.

(b)Apportionment by market value at point of separation

Trading results:

NotethattheapportionmentisonthebasisofproportionatesalesvalueofproductionProfitperunitwillbethesame(withasmallroundingdifference.)

ProductA ProductB TotalSales 80x$5.00 $400 150x$2.00 $300 $700CostofSales 80x$2.50 ($200) 150x$2.50 ($375) ($575)

Profit/(loss) $200 ($75) $125

Valueofclosingstock 20x$2.50 $50 50x$2.50 $125

SalesValueofproduction

Proportion Jointcostapportionment

Perkg

A:100x$5

$500 5/9 $417 $4.17

B:200x$2

$400 4/9 $333 $1.67

750

A B TotalSales 400 300 700Costofsales 333.6 250.5 585.1Profit 66.4 49.5 114.9Profit/Salesratio 16.6% 16.5%Closinginventory (20x4.17)=$83 (50x$1.67)=$83



(c)Apportionment by Net Realisable Value

Thisapproachshouldbeusedinsituationswherethesalesvalueatthesplitoffpointisnotknowneitherbecausetheproductisnotsaleable,oriftheexaminerdoesnottellus.

Furtherinformationisneeded:

Apportionmentofjointcosts:

Furtherprocessingcosts

Sellingpriceafterfurtherprocessing

ProductA $280+$2.00perkg $8.40ProductB $160+$1.40perkg $4.50

ProductA

ProductB

FinalSalesValueofProduction(100x$8.40200x$4.50)

$840 $900

FurtherProcessingCost(280+100x$2160+200x$1.40)

$480 $440

NetRealisablevalue $360 $460

Jointcostapportionment(360460) 329 421Jointcostperkg $3.29 $2.10

Tradingresults(forcommonprocessonly)Sales $700JointCosts $750lessclosinginventoryA:20x$3.29 $66B:50x$2.10 $105

171

Costofsales $579

Profit $121

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ThefollowingisrelevantforaproductionprocessforPeriod1:

TheprocessproducesjointproductsAandB,whicharethensoldatthepricesgivenbelow.Theoutputfigurerepresentsalloftheoutputfromtheprocess:

Required:

Calculatethecostofsales,andgrossprofitforproductsAandBassuming:

DirectmaterialCost $10,000DirectLabourCost $5,000Overheads $3,000Totalcosts $18,000

ProductA ProductBUnitsofOutput 2,000 8,000PriceperUnit $5 $2.50

(i) jointcostsareapportionedbymarketvalue

(ii) jointcostsareapportionedbyproductionunits.

Further processing decision

Whendecidingwhethertoprocessaproductfurtherortosellaftersplitoffonlyfutureincrementalcashflowsshouldbeconsidered:

Anydifferenceinrevenueandanyextracosts. Jointcostsaresunkatthisstageandthusnotrelevanttothedecision.




Afirmmakesthreejointproducts,X,YandZ,atajointcostof$400,000.Jointcostsareapportionedonthebasisofweight.ProductsXandZarecurrentlyprocessedfurther.

Anopportunityhasarisentosellallthreeproductsatthesplitoffpointforthefollowingprices.

Which of the products, if any, should the firm process further?

Product Weight at Furtherprocessingcosts Salessplitoff (variable)(tonnes) $000 $000

XYZ

600200200

800

400

980120600

XYZ

$200,000$120,000$160,000

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10Chapter summary



Test your understanding answers

(a) Thesalaryisarelevantcostof12,000.Donotbefooledbythementionofthefactthatitisafixedcost,itisacostthatisrelevanttothedecisiontoproceedwiththefuturedevelopmentofthenewproduct.Thisisanexampleofadirectlyattributablefixedcost.Adirectlyattributablefixedcostmayalsobecalledaproductspecificfixedcost.

(b) The2,500additionalrunningcostsarerelevanttothedecisiontopurchasethenewmachine.Thesavinginoverheadabsorptionisnotrelevantsincewearenottoldthatthetotaloverheadexpenditurewillbealtered.Thesavinginlabourcostwouldberelevantbutweshallassumethatthishasbeenaccountedforindeterminingtheadditionalmonthlyrunningcosts.

(c) Thisisnotarelevantcostfornextmonthsinceitwillbeincurredevenifthecontractiscancelledtoday.Ifadecisionisbeingmadetoclosetheoffice,thiscostcannotbeincludedasasavingtobemadenextmonth.However,itwillbesavedinthemonthsafterthatsoitwillbecomearelevantcostsavingfrommonth2onwards.

(d) Thisisnotarelevantcostofthedecisiontocontinuewiththecontract.The75issunkandcannotberecoveredevenifthecompanydoesnotproceedwiththenegotiations.

chapter 6


Relevant costs

100%capacity = 102,0000.85 = 120,000units

Sparecapacityamountsto18,000units.Sothereissufficientslacktomeettheneworder.

Variablecosts = 330,000less75,000

= 255,000

Variablecostperunit

= 255,000102,000 = 2.50

Contributionperunitfromexistingproduct = 3.252.50=0.75

Contributionperunitfromnewproduct = 2.802.50=0.30

Increaseincontributionfromnewproduct:

0.3012,000units 3,600Fallincontributionfromexistingproduct:

0.75(12,00015)2 0.751,600 (1,200)

NetGainincontribution 2,400

A B C D$ $ $ $

Buyexternally unitprice 12 16 20 24

Makeinhouseunitvariablecost 14 13 15 16unitfixedcost 2 2 2 1

total 16 15 17 17

Saving/(loss)throughmakinginhouse 4 1 3 7

RobustLtdshouldbuyincomponentAsinceitwouldachievesavingsof$4perunitor$6,000pa.Buyinginanyoftheothercomponentswouldincreaseitscosts.



Test your understanding 1 Opportunity cost


Annualinternalprocessingcosts

Hardwareandsoftware $320Hardware/softwareannualmaintenance $750Accountingstationery $500Parttimeaccountsclerk $6,000

Total $7,570

AnnualoutsourcingcostsProcessingofinvoices/creditnotes $2,500 5,000$0.50Processingofchequepayments $2,000 4,000$0.50Reconcilingsupplieraccounts $3,600 150$212

Total $8,100

Itwouldnotbecosteffectivetooutsourcetheaccountingactivities.Thepresentcostsof$7,570wouldriseto$8,100pa

Qualitativefactorsinclude:

predictedvolumeshighervolumeswillmakeoutsourcingmoreexpensive

thequalityofsupplywilltheexternalsuppliermakemoreerrors? securityofinformation.

chapter 6


Test your understanding 3 Additional question on make vs buy

(a) Firstofallwemustrestatethefiguressothattheypresentthesituationinitstruelight.Onlyrelevantcashflowsshouldbeconsidered.Thiswillenableeachdepartmenttobereadilyevaluatedonitslocallycontrollableperformance.

Notes

Department 1 2 3 TotalSalesvolume(units) 5,000 6,000 2,000 13,000Salesvalue($) 150,000240,000 24,000414,000Costofsales:($)Directmaterial 75,000150,000 10,000235,000Directlabour(note1) 4,846 5,815 1,939 12,600Prodnoverhead(note2) 3,000 3,000 1,500 7,500Expenses(note3) 9,000 9,000 6,000 24,000

Contribution($) 58,154 72,185 4,561134,900Othercosts($):Labour (note4) (50,400)Overhead (note5) (7,500)Expenses(note6) (16,000)

Netprofit 61,000

(1) 80%ofthelabourcostisfixedandisthereforeexcludedfromthecontributioncalculation. Theremaining20%hasbeenallocatedonthebasisofsalesvolume.

(2) Only50%oftheproductionoverheadscanbedirectlyallocatedtothedepartments. Thishasbeenallocatedintheratio2:2:1.

(3) Only60%oftheexpensescanbedirectlytracedtothedepartments. Thishasbeenallocatedintheratio3:3:2.

(4) Fixedcostoflabouris80%.

(5) Thisistheremaining50%ofoverheadsthatcan'tbeallocatedtodepartments.

(6) Thisistheremaining40%ofexpensesthatcan'tbeallocatedtodepartments.




Conclusion

Fromtherestatedfiguresdepartment3shouldbekeptopensince:

Thedepartmentismakingacontributionof$4,561totheoverallprofitofthebusiness.

Theapparentlossarisespurelyfrominappropriateapportionmentofoverheadsandexpenses.

Ifthedepartmentwereclosed: therewouldbealossof$4,561contributiontothebusiness

and

ontheassumptiontherewouldbenofurthersavingonfixedcosts,theprofitwouldbereducedto$56,439.

(b) Considerationmustbegiventothefollowingfactorswhichmaybenonquantifiableatpresent:

Redundancycostsorcostsrelatingtothedisposalofequipmentifdepartment3isclosed.

Thepossiblelossofbusinessduetoproductsfromdepartment3beingunavailabletocustomerswhobuyfromotherdepartmentsatthesametime.

Thereorganisationcoststhatmayarisefromtheclosureofdepartment3.

Additionalbenefitsofclosureofdepartment3suchaslabourandmachinerybeingusedtogeneratecontributionelsewhereinthebusiness.

chapter 6


$ $MaterialA 1,000kgs@$2$300 1,700(note1) 1,000kgs@$10 10,000

11,700

MaterialB(note2) 1,000kgs@$15 15,000MaterialC(note3) 500kgsopportunitycost 8,000MaterialD(note4) 50litres@$50 (2,500)Skilledlabour(note5) 1,000hrs@$25 25,000Semiskilledlabour(note6)

500hrs@$22.50 11,250

Unskilledlabour(note7) 500hrs@$12(opportunitycost)

6,000

Minimumtenderprice=totalofrelevantcashflows 74,450

Notes

Option1Sellitfor$6,000.

Option2Useitasasubstituteandsave$8,000.

Option2ispreferable.Thisisthereforetheopportunitycostofusingitinthecontract.

(1) Thereare1,000kgsinstockandthesewillnotbereplaced. Thesewouldotherwisebesoldatanetgainof$1,700.Thisgainisthereforeforegoneasaresultofusingthismaterialinthecontract.Theother1,000kgsareoutofstockandthereforetherelevantcostisthecurrentpurchasepriceof$10perkg.

(2) Thematerialisinstockbutwillbereplacedandthereforetherelevantcostisthecurrentpurchasepriceof$15perkg.

(3) Thematerialisinstockandtherearetwooptionsifthismaterialisnotusedforthecontract:




(4) Thematerialisinstockandwillnotbereplaced.Thecostofdisposingof50litreswillbesaved(@$50/litre,i.e.$2,500).Savingthiscostisarelevantbenefit.

(5) Theincrementalcostofpayingforthelabourneeded.

(6) 1,500sparehourshavealreadybeenpaidforastheworkforceareonannualcontracts.Theadditionalcashflowisthereforetheextra500hoursthatareneededattimeandahalf.

(7) Foreachhourdivertedfromtheirnormaljobscontributionof$2willbeforegone.Thistogetherwiththecostofpayingtheworkerstodotheprojectamountstoarelevantcostof$12perkg.Theywouldnotbehiredat$20perhourasthisismoreexpensive.

(8) Fixedoverheadscanbeignoredastheyarenotincremental.

(9) Costsofpreparingthetenderareallsunkcostsandhencemustbeignored.

(10)Profitelementshouldbeignoredsinceaminimumcontractpriceisbeingcalculated.

(a) Market value basis

Working:

(b) Production units basis

Product A Product B TotalSalesvalue $10,000 $20,000 $30,000Jointcostsapportioned(W1) $6,000 $12,000 $18,000GrossProfit $4,000 $8,000 $12,000

10,000JointcostsallocatedtoProductA =$18,000 =$6,000

30,000

20,000JointcostsallocatedtoProductB =$18,000 =$12,000

30,000

Product A Product B TotalSalesvalue $10,000 $20,000 $30,000Jointcostsapportioned(W1) $3,600 $14,400 $18,000GrossProfit $6,400 $5,600 $12,000

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Working:

Totaloutputunits=2,000+8,000=10,000

2,000JointcostsallocatedtoProductA =$18,000 =$3,600

10,000

8,000JointcostsallocatedtoProductB = $18,000 =$14,400

10,000

Thepreseparation(i.e.joint)costsarenotincrementalandsocanbeignored.Theonlyincrementalcashflowsareasfollows:

ThusonlyZshouldbeprocessedfurther.

Product X Y Z$000 $000 $000

Additionalrevenuefromfurtherprocessing 780 n/a 440Additionalcostsfromfurtherprocessing 800 n/a 400

Benefit/(cost)offurtherprocessing (20) 40




RiskanduncertaintyChapter learning objectives

Uponcompletionofthischapteryouwillbeableto:

describegenerallyavailableresearchtechniquestoreduceuncertainty,e.g.focusgroups,marketresearch

suggestforagivensituation,suitableresearchtechniquesforreducinguncertainty

explain,usingasimpleexample,theuseofsimulation explain,calculateanddemonstratetheuseofexpectedvalues

andsensitivityanalysisinsimpledecisionmakingsituations

forgivendata,applythetechniquesofmaximax,maximinandminimaxregrettodecisionmakingproblemsincludingtheproductionofprofittables

calculatethevalueofperfectinformation calculatethevalueofimperfectinformation.

189

chapter

7

1Introduction Risk and uncertainty

Allbusinessesfacerisk.

Riskisthevariabilityofpossiblereturns.

Riskmanagementisimportantinabusiness. Itistheprocessofunderstandingandmanagingtherisksthatanorganisationisinevitablysubjectto.

Distinction between risk and uncertainty

Risk: thereareanumberofpossibleoutcomesandtheprobabilityofeachoutcomeisknown.

Forexample,basedonpastexperienceofdiggingforoilinaparticulararea,anoilcompanymayestimatethattheyhavea60%chanceoffindingoilanda40%chanceofnotfindingoil.

Uncertainty: thereareanumberofpossibleoutcomesbuttheprobabilityofeachoutcomeisnotknown.

Forexample,thesameoilcompanymaydigforoilinapreviouslyunexploredarea. Thecompanyknowsthatitispossibleforthemtoeitherfindornotfindoilbutitdoesnotknowtheprobabilitiesofeachoftheseoutcomes.

Risk and uncertainty

190 KAPLAN PUBLISHING190 KAPLAN PUBLISHING

2Other methods of dealing with risk and uncertainty

Inadditiontotheresearchtechniquesdiscussed,thefollowingmethodscanbeusedtoaddressriskoruncertainty.

Eachmethodwillbereviewedinturn.

Sensitivityanalysis Simulation Expectedvalues Maximax,maximinandminimaxregret DecisionTrees

3Sensitivity analysis

Sensitivityanalysistakeseachuncertainfactorinturn,andcalculatesthechangethatwouldbenecessaryinthatfactorbeforetheoriginaldecisionisreversed.Typically,itinvolvesposing'whatif'questions.

Byusingthistechniqueitispossibletoestablishwhichestimates(variables)aremorecriticalthanothersinaffectingadecision.

Theprocessisasfollows:

Bestestimatesforvariablesaremadeandadecisionarrivedat. Eachofthevariablesisanalysedinturntoseehowmuchtheoriginal

estimatecanchangebeforetheoriginaldecisionisreversed.Forexample,itmaybethattheestimatedsellingpricecanfallby5%beforetheoriginaldecisiontoacceptaprojectisreversed.

Estimatesforeachvariablecanthenbereconsideredtoassessthelikelihoodoftheestimatebeingwrong.Forexample,whatisthechanceofthesellingpricefallingbymorethan5%?

Themaximumpossiblechangeisoftenexpressedasapercentage.Thisformulaonlyworksfortotalcashflows.Itcannotbeusedforindividualunits,sellingprices,variablecostperunit,etc.

chapter 7


The use of research techniques to reduce uncertainty

Motivational research techniques

Types of measurement research

Amanagerisconsideringamakevbuydecisionbasedonthefollowingestimates:

Youarerequiredtoassessthesensitivityofthedecisiontotheexternalpurchaseprice.

Solution

Step 1: Whatistheoriginaldecision?

Comparingcontributionfigures,theproductshouldbeboughtinandrebadged:

Step 2: Calculatethesensitivity(totheexternalpurchaseprice)

Forindifference,thecontributionfromoutsourcingneedstofallto$5perunit.Thustheexternalpurchasepriceonlyneedstoincreaseby$1perunit(or$1/$6=17%).Iftheexternalpurchasepricerosebymorethan17%theoriginaldecisionwouldbereversed.

If made inhouse If buy in and rebadge$ $

Variableproductioncosts 10 2Externalpurchasecosts 6Ultimatesellingprice 15 14

If made inhouse If buy in and rebadge$ $

Contribution 5 6

Strengths of sensitivity analysis

Thereisnocomplicatedtheorytounderstand. Informationwillbepresentedtomanagementinaformwhichfacilitates

subjectivejudgementtodecidethelikelihoodofthevariouspossibleoutcomesconsidered.

Itidentifiesareaswhicharecrucialtothesuccessoftheproject.Iftheprojectischosen,thoseareascanbecarefullymonitored.



Illustration 1 Sensitivity analysis

4Weaknesses of sensitivity analysis

Itassumesthatchangestovariablescanbemadeindependently,e.g.materialpriceswillchangeindependentlyofothervariables.Simulationallowsustochangemorethanonevariableatatime.

Itonlyidentifieshowfaravariableneedstochangeitdoesnotlookattheprobabilityofsuchachange.

Itprovidesinformationonthebasisofwhichdecisionscanbemadebutitdoesnotpointtothecorrectdecisiondirectly.

5Simulation

Simulationisamodellingtechniquethatshowstheeffectofmorethanonevariablechangingatthesametime.

Itisoftenusedincapitalinvestmentappraisal.

TheMonteCarlosimulationmethodusesrandomnumbersandprobabilitystatistics.Itcanincludeallrandomeventsthatmightaffectthesuccessorfailureofaproposedprojectforexample,changesinmaterialprices,labourrates,marketsize,sellingprice,investmentcostsorinflation.

Themodelidentifieskeyvariablesinadecision:costsandrevenues,say.Randomnumbersarethenassignedtoeachvariableinaproportioninaccordancewiththeunderlyingprobabilitydistribution.Forexample,ifthemostlikelyoutcomesarethoughttohavea50%probability,optimisticoutcomesa30%probabilityandpessimisticoutcomesa20%probability,randomnumbers,representingthoseattributes,canbeassignedtocostsandrevenuesinthoseproportions.

Apowerfulcomputeristhenusedtorepeatthedecisionmanytimesandgivemanagementaviewofthelikelyrangeandlevelofoutcomes.Dependingonthemanagement'sattitudetorisk,amoreinformeddecisioncanbetaken.

Thishelpstomodelwhatisessentiallyaoneoffdecisionusingmanypossiblerepetitions.Itisonlyofanyrealvalue,however,iftheunderlyingprobabilitydistributioncanbeestimatedwithsomedegreeofconfidence.

TheMPOrganisationisanindependentfilmproductioncompany.Ithasanumberofpotentialfilmsthatitisconsideringproducing,oneofwhichisthesubjectofamanagementmeetingnextweek.ThefilmwhichhasbeencodenamedCA45isathrillerbasedonanovelbyawellrespectedauthor.

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Illustration 2 The MP Organisation

Theexpectedrevenuesfromthefilmhavebeenestimatedasfollows:thereisa30%chanceitmaygeneratetotalsalesof$254,00050%chancesalesmayreach$318,000and20%chancetheymayreach$382,000.

Expectedcosts(advertising,promotionandmarketing)havealsobeenestimatedasfollows:thereisa20%chancetheywillreachapproximately$248,00060%chancetheymaygetto$260,000and20%chanceoftotalling$272,000.

InaMonteCarlosimulation,theserevenuesandcostscouldhaverandomnumbersassignedtothem:

Acomputercouldgenerate20digitrandomnumberssuchas98125602386617556398.Thesewouldthenbematchedtotherandomnumbersassignedtoeachprobabilityandvaluesassignedto'SalesRevenues'and'Costs'basedonthis.Therandomnumbersgeneratedgive5possibleoutcomesinourexample:

Sales Revenue

Probability

Assign Random Numbers (assume integers)

$254,000 0.30 0029$318,000 0.50 3079$382,000 0.20 8099

Costs$248,000 0.20 0019$260,000 0.60 2079$272,000 0.20 8099

Random number

Sales revenue in $000

Random Number

Costs in $000

Profit

98 382 12 248 13456 318 02 248 7038 318 66 260 5817 254 55 260 (6)63 318 98 272 46



Abusinessischoosingbetweentwoprojects,projectAandprojectB. Itusessimulationtogenerateadistributionofprofitsforeachproject.

Required:

Whichprojectshouldthebusinessinvestin?

Solution

ProjectAhasaloweraverageprofitbutisalsolessrisky(lessvariabilityofpossibleprofits).

ProjectBhasahigheraverageprofitbutisalsomorerisky(morevariabilityofpossibleprofits).

Thereisnocorrectanswer. Allsimulationwilldoisgivethebusinesstheaboveresults. Itwillnottellthebusinesswhichisthebetterproject.

Ifthebusinessiswillingtotakeonrisk,theymaypreferprojectBsinceithasthehigheraveragereturn.

However,ifthebusinesswouldprefertominimiseitsexposuretorisk,itwouldtakeonprojectA. Thishasalowerriskbutalsoaloweraveragereturn.

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Illustration 3 Simulation

Drawbacks of simulation

Therearemajordrawbacksofsimulation:

Itisnotatechniqueformakingadecision,onlyforobtainingmoreinformationaboutthepossibleoutcomes.

Modelscanbecomeextremelycomplex. Thetimeandcostsinvolvedintheirconstructioncanbemorethanis

gainedfromtheimproveddecisions.

Probabilitydistributionsmaybedifficulttoformulate.

Assess the use of simulation for a chain of betting shops.

6Expected values (EVs)

Anexpectedvalueisaweightedaverageofallpossibleoutcomes.Itcalculatestheaveragereturnthatwillbemadeifadecisionisrepeatedagainandagain.Inotherwords,itisobtainedbymultiplyingthevalueofeachpossibleoutcome(x),bytheprobabilityofthatoutcome(p),andsummingtheresults.

TheformulafortheexpectedvalueisEV = px

Returnsfromanewrestaurantventuredependonwhetheracompetitordecidestoopenupinthesamearea.Thefollowingestimatesaremade:

Competitor opens up Probability (p) Project NPV (x) px$ $

Yes 0.3 (10,000) (3,000)No 0.7 20,000 14,000 EV= 11,000

Sincetheexpectedvalueshowsthelongrunaverageoutcomeofadecisionwhichisrepeatedtimeandtimeagain,itisausefuldecisionruleforarisk neutral decision maker.Thisisbecauseariskneutralinvestorneitherseeksriskoravoidsitheishappytoacceptanaverageoutcome.

Advantages and disadvantages of EVs



Illustration 4 Calculating EVs


Advantages:

Disadvantages:

Takesuncertaintyintoaccountbyconsideringtheprobabilityofeachpossibleoutcomeandusingthisinformationtocalculateanexpectedvalue.

Theinformationisreducedtoasinglenumberresultingineasierdecisions.

Calculationsarerelativelysimple.

Theprobabilitiesusedareusuallyverysubjective. TheEVismerelyaweightedaverageandthereforehaslittlemeaning

foraoneoffproject.

TheEVgivesnoindicationofthedispersionofpossibleoutcomesabouttheEV,i.e.therisk.

TheEVmaynotcorrespondtoanyoftheactualpossibleoutcomes.

Payoff tables

Aprofittable(payofftable)canbeausefulwaytorepresentandanalyseascenariowherethereisarangeofpossibleoutcomesandavarietyofpossibleresponses.Apayofftablesimplyillustratesallpossibleprofits/losses.

GeoffreyRamsbottomrunsakitchenthatprovidesfoodforvariouscanteensthroughoutalargeorganisation.Aparticularsaladissoldtothecanteenfor$10andcosts$8toprepare.Therefore,thecontributionpersaladis$2.

Baseduponpastdemands,itisexpectedthat,duringthe250dayworkingyear,thecanteenswillrequirethefollowingdailyquantities:

Thekitchenmustpreparethesaladinbatchesof10meals.Itsstaffhasaskedyoutohelpthemdecidehowmanysaladsitshouldsupplyforeachdayoftheforthcomingyear.

On25daysoftheyear 40saladsOn50daysoftheyear 50saladsOn100daysoftheyear 60saladsOn75days 70saladsTotal 250 days

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Illustration 5 Geoffrey Ramsbottom

7Maximax, maximin and minimax regret

Whenprobabilitiesarenotavailable,therearestilltoolsavailableforincorporatinguncertaintyintodecisionmaking.

Maximax

Themaximaxruleinvolvesselectingthealternativethatmaximisesthemaximumpayoffachievable.

Thisapproachwouldbesuitableforanoptimist,or'riskseeking'investor,whoseekstoachievethebestresultsifthebesthappens.

Followingupfromthepayofftableexample,GeoffreyRamsbottom'stablelooksasfollows:

Themanagerwhoemploysthemaximaxcriterionisassumingthatwhateveractionistaken,thebestwillhappenhe/sheisarisktaker.Howmanysaladswillhedecidetosupply?

Daily demand

Daily SupplyProbability 40

salads50

salads60

salads70

salads40

salads0.10 $80 $0 ($80) ($160)

50salads

0.20 $80 $100 $20 ($60)

60salads

0.40 $80 $100 $120 $40

70salads

0.30 $80 $100 $120 $140



Answer

Illustration 6 The Maximax rule

Solution Geoffrey Ramsbottom

Acompanyischoosingwhichofthreenewproductstomake(A,BorC)andhascalculatedlikelypayoffsunderthreepossiblescenarios(I,IIorIII),givingthefollowingpayofftable.

Required:

Usingmaximax,whichproductwouldbechosen?

Profit (loss) Product chosenScenario A B C

IIIIII

204050

8070(10)

1010040

Maximin

Themaximinruleinvolvesselectingthealternativethatmaximisestheminimumpayoffachievable.Theinvestorwouldlookattheworstpossibleoutcomeateachsupplylevel,thenselectsthehighestoneofthese. Thedecisionmakerthereforechoosestheoutcomewhichisguaranteedtominimisehislosses.Intheprocess,helosesoutontheopportunityofmakingbigprofits.

Thisapproachwouldbeappropriateforapessimistwhoseekstoachievethebestresultsiftheworsthappens.

Required:

UsingtheinformationfromthepreviousTYUapplythemaximinruletodecidewhichproductshouldbemade.

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Test your understanding 3 Applying maximin

Test your understanding 2 Applying maximax


Howmanysaladsshouldwesupply,usingtheMaximinrule?

Daily demand


salads50

salads60

salads70

salads40

salads0.10 $80 $0 ($80) ($160)

50salads

0.20 $80 $100 $20 ($60)

60salads

0.40 $80 $100 $120 $40

70salads

0.30 $80 $100 $120 $140

The minimax regret rule

Theminimaxregretstrategyistheonethatminimisesthemaximumregret.Itisusefulforariskneutraldecisionmaker.Essentially,thisisthetechniqueforasoreloserwhodoesnotwishtomakethewrongdecision.

Regretinthiscontextisdefinedastheopportunitylossthroughhavingmadethewrongdecision.



Answer

Illustration 7 The 'Maximin' rule


Howmanysaladsshouldwedecidetosupplyiftheminimaxregretruleisapplied?

Daily demand


salads50

salads60

salads70

salads40

salads0.10 $80 $0 ($80) ($160)

50salads

0.20 $80 $100 $20 ($60)

60salads

0.40 $80 $100 $120 $40

70salads

0.30 $80 $100 $120 $140

8Decision trees

Adecisiontreeisadiagrammaticrepresentationofamultidecisionproblem,whereallpossiblecoursesofactionarerepresented,andeverypossibleoutcomeofeachcourseofactionisshown.

Decisiontreesshouldbeusedwhereaprobleminvolvesaseriesofdecisionsbeingmadeandseveraloutcomesariseduringthedecisionmakingprocess.Decisiontreesforcethedecisionmakertoconsiderthelogicalsequenceofevents.Acomplexproblemisbrokendownintosmaller,easiertohandlesections.

Thefinancialoutcomesandprobabilitiesareshownseparately,andthedecisiontreeisrolledbackbycalculatingexpectedvaluesandmakingdecisions.

Three step method

Step 1:Drawthetreefromlefttoright,showingappropriatedecisionsandevents/outcomes.

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Illustration 8 The 'Minimax Regret' rule

Answer

Somecommonsymbolscanbeused:asquareisusedtorepresentadecisionpoint(i.e.whereachoicebetweendifferentcoursesofactionmustbetaken.Acircleisusedtorepresentachancepoint.Thebranchescomingawayfromacirclewithhaveprobabilitiesattachedtothem.Allprobabilitiesshouldaddupto'1'.

Labelthetreeandrelevantcashinflows/outflowsandprobabilitiesassociatedwithoutcomes.

Step2:Evaluatethetreefromrighttoleftcarryingoutthesetwoactions:

Step 3:Recommendacourseofactiontomanagement.

(a) CalculateanEVateachoutcomepoint.

(b) Choosethebestoptionateachdecisionpoint.

Auniversityistryingtodecidewhetherornottoadvertiseanewpostgraduatedegreeprogramme.

Thenumberofstudentsstartingtheprogrammeisdependentoneconomicconditions:

Iftheprogrammeisadvertisedandeconomicconditionsarepoor,thereisa65%chancethattheadvertisingwillstimulatefurtherdemandandstudentnumberswillincreaseto50.Ifeconomicconditionsaregoodthereisa25%chancetheadvertisingwillstimulatefurtherdemandandnumberswillincreaseto25students.

Ifconditionsarepooritisexpectedthattheprogrammewillattract40studentswithoutadvertising.Thereisa60%chancethateconomicconditionswillbepoor.

Ifeconomicconditionsaregooditisexpectedthattheprogrammewillattractonly20studentswithoutadvertising.Thereisa40%chancethateconomicconditionswillbegood.



Decision trees

Theprofitexpected,beforedeductingthecostofadvertising,atdifferentlevelsofstudentnumbersareasfollows:

Required:

Demonstrate,usingadecisiontree,whethertheprogrammeshouldbeadvertised.

Number of students Profit in $15 (10,000)20 15,00025 40,00030 65,00035 90,00040 115,00045 140,00050 165,000

9The value of perfect information

Inmanyquestionsthedecisionmakersreceiveaforecastofafutureoutcome(forexampleamarketresearchgroupmaypredicttheforthcomingdemandforaproduct).Thisforecastmayturnouttobecorrectorincorrect.Thequestionoftenrequiresthecandidatetocalculatethevalueoftheforecast.

Perfect information Theforecastofthefutureoutcomeisalwaysacorrectprediction.Ifafirmcanobtaina100%accuratepredictiontheywillalwaysbeabletoundertakethemostbeneficialcourseofactionforthatprediction.

Imperfect information Theforecastisusuallycorrect,butcanbeincorrect.Imperfectinformationisnotasvaluableasperfectinformation.

Thevalueofinformation(eitherperfectorimperfect)maybecalculatedasfollows:Expected Profit (Outcome) WITH the information LESS Expected Profit (Outcome) WITHOUT the information

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Answer University advertising decision tree

Aneworderingsystemisbeingconsidered,wherebycustomersmustordertheirsaladonlinethedaybefore.WiththisnewsystemMrRamsbottomwillknowforcertainthedailydemand24hoursinadvance.Hecanadjustproductionlevelsonadailybasis.

How much is this new system worth to Mr Ramsbottom?

10The value of imperfect information

Perfectinformationisonlyrarelyaccessible.Infact,informationsourcessuchasmarketresearchorindustryexpertsareusuallysubjecttoerror.Marketresearchfindings,forexample,arelikelytobereasonablyaccuratebuttheycanstillbewrong.

Therefore,ouranalysismustextendtodealwithimperfectinformation.Thequestionisasfollows:how much would it be worth paying for such imperfect information,giventhatweareawareofhowrightorwrongitislikelytobe?

(a) Youhavethemineralrightstoapieceoflandthatyoubelievemayhaveoilunderground.Thereisonlya10%chancethatyouwillstrikeoilifyoudrill,buttheprofitis$200,000.

Itcosts$10,000todrill.Thealternativeisnottodrillatall,inwhichcaseyourprofitiszero.

Shouldyoudrill?Drawadecisiontreetorepresentyourproblem.

Drawadecisiontreeandcalculatethevalueofimperfectinformationforthisgeologist.Ifthegeologistcharges$7,000,wouldyouuseherservices?

(b) Beforeyoudrill,youmayconsultageologistwhocanassessthepromiseofthepieceofland.Shecantellyouwhethertheprospectsaregoodorpoor,butsheisnotaperfectpredictor.Ifthereisoil,theprobabilitythatshewillsaytherearegoodprospectsis95%.Ifthereisnooil,theprobabilitythatshewillsayprospectsarepooris85%.



Test your understanding 4 Geoffrey Ramsbottom

Solution

The Value of Imperfect Information

11Chapter summary

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Simulationwouldbeparticularlyusefulonanoperationallevelforanalysingthepossibleimplicationsofasingleevent,suchasamajorhorseraceorfootballmatch:

Simulationcouldalsobeusedforwiderstrategicanalysissuchasforassessingthepossibilityandimplicationsofstricterantigamblinglegislation.

Possibleoutcomesareeasytoidentify(e.g.win,lose,draw,21,30,etc)

Quotedoddscanhelpestimateprobabilities Theoutcomesofthesimulationcouldbeusedtoassessimpacton

cashflow,whetherbetsshouldbelaidoffwithotherbettingagentstoreducesrisk,etc

Usingmaximax,anoptimistwouldconsiderthebestpossibleoutcomeforeachproductandpicktheproductwiththegreatestpotential.

HereCwouldbechosenwithamaximumpossiblegainof100.

Usingmaximin,apessimistwouldconsiderthepoorestpossibleoutcomeforeachproductandwouldensurethatthemaximumpayoffisachievediftheworstresultweretohappen.

Therefore,productAwouldbechosenresultinginaminimumpayoffof20comparedtoaminimumpayoffof10forproductsBandC.



Test your understanding 2 Applying maximax

Test your understanding 3 Applying maximin


X PSupply=demand Payoff Probability px

40 $80 0.1 850 $100 0.2 2060 $120 0.4 4870 $140 0.3 42

118

E.V.withperfectinformation =$118E.V.withoutperfectinformation(Working1) =$90

Valueofperfectinformation $28perday

Working 1:

AccordingtothepayofftablefromIllustration5,theExpectedValueofProfitsif40 saladsaresuppliedcanbecalculatedas(0.10x$80)+(0.20x$80)+(0.40x$80)+(0.30x$80)=$80.

Likewise:

Profitsarethereforemaximisedat50saladsandamountto$90.

EV('50 saladsdailysupply')= ($0x10%)= $0+($100x20%)= $20+($100x40%)= $40+($100x30%)= $30 $90

EV('60 saladsdailysupply')= ($80x10%)= ($8)+($20x20%)= $4+($120x40%)= $48+($120x30%)= $36 $80

EV('70 saladsdailysupply')= ($160x10%)= ($16)+($60x20%)= ($12)+($40x40%)= $16+($140x30%)= $42 $30

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Test your understanding 4 Geoffrey Ramsbottom

BudgetingChapter learning objectives


explainwhyorganisationsusebudgeting explainhowbudgetarysystemsfitwithintheperformance

hierarchy

describethefactorswhichinfluencebehaviouratwork discusstheissuessurroundingsettingthedifficultylevelfora

budget

explainthebenefitsanddifficultiesoftheparticipationofemployeesinthenegotiationoftargets

explainandevaluatetopdownandbottomupbudgetarysystemsrolling,activitybased,'incremental'and'zerobased'budgetarysystems.

explainandevaluatefeedforwardbudgetarycontrol selectandjustifyanappropriatebudgetarysystemforagiven

organisation

describetheinformationusedinvariousbudgetarysystemsandthesourcesoftheinformationneeded

explainthedifficultiesofchangingabudgetarysystemandtypeofbudgetused

explainhowbudgetsystemscandealwithuncertaintyintheenvironment

explainthemajorbenefitsanddangersinusingspreadsheetsinbudgeting.

209

chapter

8

1Purpose of budgets

Abudgetisaquantitativeplanpreparedforaspecifictimeperiod.Itisnormallyexpressedinfinancialtermsandpreparedforoneyear.

Budgetingservesanumberofpurposes:

Abudgetingprocessforcesabusinesstolooktothefuture.Thisisessentialforsurvivalsinceitstopsmanagementfromrelyingonadhocorpoorlycoordinatedplanning.

Actualresultsarecomparedagainstthebudgetandactionistakenasappropriate.

Thebudgetisaformalcommunicationchannelthatallowsjuniorandseniormanagerstoconverse.

Thebudgetallowscoordinationofallpartsofthebusinesstowardsacommoncorporategoal.

Planning

Control

Communication

Coordination

Budgeting


Responsibilityaccountingdividestheorganisationintobudgetcentres,eachofwhichhasamanagerwhoisresponsibleforitsperformance.Thebudgetmaybeusedtoevaluatetheactionsofamanagerwithinthebusinessintermsofthecostsandrevenuesoverwhichtheyhavecontrol.

Thebudgetmaybeusedasatargetformanagerstoaimfor.Rewardshouldbegivenforoperatingwithinorunderbudgetedlevelsofexpenditure. Thisactsasamotivatorformanagers.

Thebudgetactsasaformalmethodofauthorisationtoamanagerforexpenditure,hiringstaffandthepursuitofplanscontainedwithinthebudget.

Managersmaybeinvolvedinsettingthebudget. Extraresponsibilitymaymotivatethemanagers. Managementinvolvementmayalsoresultinmorerealistictargets.

Evaluation

Motivation

Authorisation

Delegation

2Budgets and performance management

Budgetscontributetoperformancemanagementbyprovidingbenchmarksagainstwhichtocompareactualresults(throughvarianceanalysis),anddevelopcorrectivemeasures.Theytakemanyformsandservemanyfunctions,butmostprovidethebasisfor:

Budgetsgivemanagers"preapproval"forexecutionofspendingplans,andallowthemtoprovideforwardlookingguidancetoinvestorsandcreditors.Forexample,budgetsarenecessarytoconvincebanksandotherlenderstoextendcredit.

detailedsalestargets staffingplans production cashinvestmentandborrowing capitalexpenditure

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Eveninasmallbusiness,anrobustbusinessplan/budgetcanoftenresultinanticipatingandavoidingdisastrousoutcomes.Mediumandlargerorganisationsinvariablyrelyonbudgets. Thisisequallytrueinbusinesses,government,andnotforprofitorganizations. Thebudgetprovidesaformalquantitativeexpressionofexpectations. Itisanessentialfacetoftheplanningandcontrolprocess. Withoutabudget,anorganisationwillbehighlyinefficientandineffective.

Awageawardforproductionstaffisagreedwhichexceedstheallowanceincorporatedinthebudget.Discusswhethertheperformanceoftheproductionmanagershouldbelinkedtothewagecost.

3The performance hierarchy

AsyoumayrecallfrompaperF1,firmshaveaplanninghierarchy:

Theaimisthatifamanagerachievesshorttermbudgetarytargets(operationalplans)thenthereismorechanceofmeetingtacticalgoalsandultimatelysuccessforstrategicplans.

Theachievementofbudgetaryplanswillimpactontheeventualachievementofthetacticalandstrategicplans.However,budgetsshouldalsobeflexibleinordertomeetthechangingneedsofthebusiness.

Strategicplanningislongterm,looksatthewholeorganisationanddefinesresourcerequirements.Forexample,todevelopnewproductsinresponsetochangingcustomerneeds.

Tacticalplanningismediumterm,looksatthedepartment/divisionallevelandspecifieshowtouseresources.Forexample,totrainstafftodealwiththechallengesthatthisnewproductpresents.

Operationalplanningisveryshortterm,verydetailedandismainlyconcernedwithcontrol.Mostbudgetingactivitiesfallwithinoperationalplanningandcontrol. Forexample,abudgetissetforthenewproducttoincludeadvertisingexpenditure,salesforecasts,labourandmaterialexpenditureetc.

Budgeting


Test your understanding 1 Evaluation of managers

4Behavioural aspects of budgeting

Individualsreacttothedemandsofbudgetingandbudgetarycontrolindifferentwaysandtheirbehaviourcandamagethebudgetingprocess.

Behaviouralproblemsareoftenlinkedtomanagementstyles,andincludedysfunctionalbehaviourandbudgetslack.

Management styles (Hopwood)

ResearchwascarriedoutbyHopwood(1973)intothemanufacturingdivisionofaUSsteelworks,involvingasampleofmorethan200managerswithcostcentreresponsibility.Hopwoodidentifiedthreedistinctstylesofusingbudgetaryinformationtoevaluatemanagementperformance.

Management style

Performance evaluation

Behavioural aspects

(1) Budgetconstrainedstyle

Managerevaluatedonabilitytoachievebudgetintheshortterm.

Jobrelatedpressure Mayresultinshortterm

decisionmakingattheexpenseoflongtermgoals.

Managerwillbecriticisedforpoorresults.Forexample,ifspendingexceedsthelimitset.

Canresultinpoorworkingrelationswithcolleagues

Canresultinmanipulationofdata

(2) Profitconsciousstyle

Managerevaluatedonabilitytoreducecostsandincreaseprofitinthelongterm.

Lessjobrelatedpressure

Forexample,amanagerwillbepreparedtoexceedthebudgetarylimitintheshorttermifthiswillresultinanincreaseinlongtermprofit.

Betterworkingrelationswithcolleagues

Lessmanipulationofdata

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(3) Nonaccountingstyle

Managerevaluatedmainlyonnonaccountingperformanceindicatorssuchasqualityandcustomersatisfaction.

Similartoprofitconsciousstylebutthereislessconcernforaccountinginformation.

Requiressignificantandstringentmonitoringofperformanceagainstbudget

5Setting the difficulty level of a budget

Budgetarytargetswillassistmotivationandappraisaliftheyareattherightlevel.

Anexpectationsbudgetisabudgetsetatcurrentachievablelevels.Thisisunlikelytomotivatemanagerstoimprovebutmaygivemoreaccurateforecastsforresourceplanning,controlandperformanceevaluation.

Anaspirationsbudgetisabudgetsetatalevelwhichexceedsthelevelcurrentlyachieved.Thismaymotivatemanagerstoimproveifitisseenasattainablebutmayalsoresultinanadversevarianceifitistoodifficulttoachieve.Thismustbemanagedcarefully.

Amanagerisawardedabonusforachievingmonthlybudgetarytargets.Statethreepossiblebehaviouralimplicationsofthispolicy.Whatshouldbedonetotrytoimprovetheprocess?

Asalesmanagerhasachieved$550,000ofsalesinthecurrentyear.Businessisexpectedtogrowby10%andpriceinflationisexpectedtobe3%.

Suggest a suitable budget target for the forthcoming year.

6Conflicting objectives

Therearemanyexamplesofconflictingobjectivesthatoccurinbudgeting.Theillustrationbelowidentifiessomecommonconflictsandexplainshowtheycanberesolved.

Budgeting




Type of conflict

Examples Resolution

Companyversusdivision.

Thecompanywishestoincreaseshareholderwealth.ThisshouldinvolvetheuseofNPVbutdivisionsareassessedonaccountingtargetssuchasprofit.

Similarlyshareholderwealthisdeterminedbythelongtermbutdivisionsaresetshorttermtargets(seebelow).

Managersrejectprojectsthatdilutedivisionalperformance,eventhoughtheybeatcompanytargets.

SomecompaniestrytoinsistthatprojectsareassessedusingNPVbutthenstillimposeaccountingtargets.

Givemanagersshareoptionssotheyfocusonshareholderwealth.

Useperformancemeasuresthatencouragethedivisiontoacceptprojectswhichmeetorexceedcompanytarget. Forexample,residualincome(reviewedinchapter12)

Divisionversusdivision.

Divisionsmaycompeteforlimitedfinancialresourceswhensettingbudgets.

1 Prioritisation(e.g.usingzerobasedbudgetingcoveredinchapter7).

2 Negotiationandcompromise.

Shorttermism.

ManagerscutR&Dtohitshorttermtargetsbuterodelongtermcompetences.

ManagersrejectprojectsthatareslowstarterseventhoughtheyhavepositiveNPV.

1 Usemorenonfinancialindicatorsthatfocusonkeylongtermissuessuchasquality,productivity,etc.(Thesearediscussedinmoredetailinchapter11).

2 Linkbonusestolongertimeperiods.

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Illustration 1 Conflicting objects

Individualism. Theriskofbudgetaryslack.Thisiswhenmanagersparticipateintargetsettingand,asaresult,makethebudgettooeasytoachieve.

Greaterscrutinyofbudgets.

Bettertrainingofmanagers.

Amanagerisplanningtoretireattheendofthecurrentperiod.Hisfinalbonusisbasedontheperformanceofhisdivisionfortheperiod.

Required:

Suggestsomeperformancemanagementissuesthisraisesandhowtheycanberesolved.

7Approaches to budgeting Introduction

Thereareanumberofdifferentbudgetarysystems:

Eachsystemwillbereviewedinturn.

Topdownvsbottomupbudgeting Incrementalbudgeting Zerobasedbudgeting(ZBB) Rollingbudgets Activitybasedbudgeting Feedforwardcontrol

Top down and bottom up budgeting

Atopdownbudgetisabudgetthatissetwithoutallowingtheultimatebudgetholdertohavetheopportunitytoparticipateinthebudgetingprocess.

Abottomupbudgetisasystemofbudgetinginwhichbudgetholdershavetheopportunitytoparticipateinsettingtheirownbudgets.Alsocalledparticipativebudgeting.

Budgeting



Advantages of bottom up budgets

Disadvantages of bottom up budgets

(1) Increasedmotivationduetoownershipofthebudget

(1) Seniormanagersmayresentlossofcontrol

(2) Shouldcontainbetterinformationsinceemployeesmostfamiliarwiththedepartmentsetthebudget

(2) Dysfunctionalbehaviour:budgetsmaynotbeinlinewithcorporateobjectivesasmanagerslackastrategicperspectiveandwillfocusondivisionalconcerns

(3) Increasesmanager'sunderstandingandcommitment

(3) Baddecisionsfrominexperiencedmanagers

(4) Bettercommunicationbetweendepartments

(4) Budgetpreparationisslowanddisputescanarise

(5) Seniormanagerscanconcentrateonstrategy

(5) Budgetaryslack: managerssettargetsthataretooeasytoachieve.

Bottomupbudgetingisgenerallyseenaspreferablebecauseitleadstoimprovedmanagerialmotivationandperformance.However,therearesituationsforwhichtopdownbudgetingispreferable.

Describe three situations where top down budgeting would be more applicable.

Incremental budgets

Anincrementalbudgetstartswiththepreviousperiodsbudgetoractualresultsandadds(orsubtracts)anincrementalamounttocoverinflationandotherknownchanges.

Itissuitableforstablebusinesses,wherecostsarenotexpectedtochangesignificantly.Thereshouldbegoodcostcontrolandlimiteddiscretionarycosts.

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Advantages of incremental budgets

Disadvantages of incremental budgets

(1) Quickestandeasiestmethod (1) Buildsinpreviousproblemsandinefficiencies

(2) Suitableiftheorganisationisstableandhistoricfiguresareacceptablesinceonlytheincrementneedstobejustified

(2) Uneconomicactivitiesmaybecontinued.E.g.thefirmmaycontinuetomakeacomponentinhousewhenitmightbecheapertooutsource.

(3) Managersmayspendunnecessarilytouseuptheirbudgetedexpenditureallowancethisyear,thusensuringtheygetthesame(oralarger)budgetnextyear.

AWIncproducestwoproducts,AandC.Inthelastyear(20X4)itproduced640unitsofAand350unitsofCincurringcostsof$672,000.Analysisofthecostshasshownthat75%ofthetotalcostsarevariable.60%ofthesevariablecostsvaryinlinewiththenumberofAproducedandtheremainderwiththenumberofC.

Thebudgetfortheyear20X5isnowbeingpreparedusinganincrementalbudgetingapproach.Thefollowingadditionalinformationisavailablefor20X5:

What is the budgeted total variable cost of products A and C for the full year 20X5?

Allcostswillbe4%higherthantheaveragepaidin20X4. Efficiencylevelswillremainunchanged. ExpectedoutputofAis750unitsandofCis340units.

Budgeting



Zerobased budgeting

Amethodofbudgetingthatrequireseachcostelementtobespecificallyjustified,asthoughtheactivitiestowhichthebudgetrelateswerebeingundertakenforthefirsttime.Withoutapproval,thebudgetallowanceiszero

Itissuitablefor:

TherearefourdistinctstagesintheimplementationofZBB:

allocatingresourcesinareaswerespendisdiscretionary,i.e.nonessential. Forexample,researchanddevelopment,advertisingandtraining.

publicsectororganisationssuchaslocalauthorities.

(1) Managersshouldspecify,fortheirresponsibilitycentres,thoseactivitiesthatcanbeindividuallyevaluated.

(2) Eachoftheindividualactivitiesisthendescribedinadecisionpackage.Thedecisionpackageshouldstatethecostsandrevenuesexpectedfromthegivenactivity.Itshouldbedrawnupinsuchawaythatthepackagecanbeevaluatedandrankedagainstotherpackages.

(3) Eachdecisionpackageisevaluatedandrankedusuallyusingcost/benefitanalysis.

(4) Theresourcesarethenallocatedtothevariouspackages.

Advantages of ZBB Disadvantages of ZBB(1) Inefficientorobsoleteoperations

canbeidentifiedanddiscontinued

(1) Itemphasisesshorttermbenefitstothedetrimentoflongtermgoals.

(2) ZBBleadstoincreasedstaffinvolvementatalllevelssincealotmoreinformationandworkisrequiredtocompletethebudget

(2) Thebudgetingprocessmaybecometoorigidandtheorganisationmaynotbeabletoreacttounforeseenopportunitiesorthreats

(3) Itrespondstochangesinthebusinessenvironment

(3) Themanagementskillsrequiredmaynotbepresent

(4) Knowledgeandunderstandingofthecostbehaviourpatternsoftheorganisationwillbeenhanced

(4) Managersmayfeeldemotivatedduetothelargeamountoftimespentonthebudgetingprocess

(5) Resourcesshouldbeallocatedefficientlyandeconomically

(5) Rankingcanbedifficultfordifferenttypesofactivitiesorwherethebenefitsarequalitativeinnature

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Foranumberofyears,theresearchdivisionofZInchasproduceditsannualbudget(fornewandcontinuingprojects)usingincrementalbudgetingtechniques.Thecompanyisnowundernewmanagementandtheannualbudgetfor20X4istobepreparedusingZBBtechniques.

Explain how Z Inc could operate a ZBB system for its research projects.

Rolling budgets

Abudget(usuallyannual)keptcontinuouslyuptodatebyaddinganotheraccountingperiod(e.g.monthorquarter)whentheearliestaccountingperiodhasexpired.

Suitableif:

accurateforecastscannotbemade. Forexample,inafastmovingenvironment.

orforanyareaofbusinessthatneedstightcontrol.

Atypicalrollingbudgetmightbepreparedasfollows:

(1) Abudgetispreparedforthecomingyear(sayJanuaryDecember)brokendownintosuitable,sayquarterly,controlperiods.

(2) Attheendofthefirstcontrolperiod(31March)acomparisonismadeofthatperiodsresultsagainstthebudget.Theconclusionsdrawnfromthisanalysisareusedtoupdatethebudgetsfortheremainingcontrolperiodsandtoaddabudgetforafurtherthreemonths,sothatthecompanyonceagainhasbudgetsavailableforthecomingyear(thistimeAprilMarch).

(3) Theplanningprocessisrepeatedattheendofeachthreemonthcontrolperiod.

Budgeting



Illustration 2 Rolling budgets

Additional information on decision packages

Advantages of rolling budgets Disadvantages of rolling budgets

(1) Planningandcontrolwillbebasedonamoreaccuratebudget.

(1) Rollingbudgetsaremorecostlyandtimeconsumingthanincrementalbudgets

(2) Rollingbudgetsreducetheelementofuncertaintyinbudgetingsincetheyconcentrateontheshorttermwhenthedegreeofuncertaintyismuchsmaller.

(2) Maydemotivateemployeesiftheyfeelthattheyspendalargeproportionoftheirtimebudgetingoriftheyfeelthatthebudgetarytargetsareconstantlychanging

(3) Thereisalwaysabudgetthatextendsintothefuture(normally12months)

(3) Thereisadangerthatthebudgetmaybecomethelastbudget'plusorminusabit'

(4) Itforcesmanagementtoreassessthebudgetregularlyandtoproducebudgetswhicharemoreuptodate.

(4) Anincreaseinbudgetingworkmayleadtolesscontroloftheactualresults

(5) Issueswithversioncontrol,aseachmonththefullyearnumberswillchange

(6) Confusioninmeetingsastoeachnumbersthebusinessisworkingtowardsthiscandistractfromthekeyissues.asmanagersdiscusswhichnumberstoachieve

Acompanyusesrollingbudgetingandhasasalesbudgetasfollows

ActualsalesforQuarter1were$123,450.Theadversevarianceisfullyexplainedbycompetitionbeingmoreintensethanexpectedandgrowthbeinglowerthananticipated.Thebudgetcommitteehasproposedthattherevisedassumptionforsalesgrowthshouldbe3%perquarter.

Update the budget as appropriate.

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total$ $ $ $ $

Sales 125,750 132,038 138,640 145,572 542,000

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Activity Based Budgeting

ABBisdefinedas:amethodofbudgetingbasedonanactivityframeworkandutilisingcostdriverdatainthebudgetsettingandvariancefeedbackprocesses.

Or,putmoresimply,preparingbudgetsusingoverheadcostsfromactivitybasedcostingmethodology.

TheoperatingdivisionsofZplchaveinthepastalwaysusedatraditionalapproachtoanalysingcostsintotheirfixedandvariablecomponents.Asinglemeasureofactivitywasusedwhich,forsimplicity,wasthenumberofunitsproduced.Thenewmanagementdoesnotacceptthatsuchasimplisticapproachisappropriateforbudgetinginthemodernenvironmentandhasrequestedthatthemanagersadoptanactivitybasedapproachinfuture.

Required:

ExplainhowABBwouldbeimplementedbytheoperatingdivisionsofZplc.

TheadvantagesofABBaresimilartothoseprovidedbyactivitybasedcosting(ABC).

DisadvantagesofABB

Itdrawsattentiontothecostsofoverheadactivitieswhichcanbealargeproportionoftotaloperatingcosts.

Itrecognisesthatitisactivitieswhichdrivecosts. Ifwecancontrolthecauses(drivers)ofcosts,thencostsshouldbebettermanagedandunderstood.

ABBcanprovideusefulinformationinatotalqualitymanagement(TQM)environment,byrelatingthecostofanactivitytothelevelofserviceprovided.

Aconsiderableamountoftimeandeffortmightbeneededtoestablishthekeyactivitiesandtheircostdrivers.

Itmaybedifficulttoidentifyclearindividualresponsibilitiesforactivities. Itcouldbearguedthatintheshorttermmanyoverheadcostsarenot

controllableanddonotvarydirectlywithchangesinthevolumeofactivityforthecostdriver.Theonlycostvariancestoreportwouldbefixedoverheadexpenditurevariancesforeachactivity.

Budgeting


Test your understanding 9 Preparing an ABB

Which statement is correct regarding the benefits to be gained from using ABB?

A IfthereismuchinefficiencywithintheoperationsofabusinessthenABBwillidentifyandremovetheseareasofinefficiency.

B Inahighlydirectlabourintensivemanufacturingprocess,anABBapproachwillassistmanagementinbudgetingforthemajorityoftheproductioncosts.

C Inanorganisationcurrentlyoperatingefficiently,wherethenextperiodwillberelativelyunchangedfromthecurrentone,thenABBwillmakethebudgetingprocesssimplerandquicker.

D IfanorganisationproducesmanydifferenttypesofoutputusingdifferentcombinationsofactivitiesthenABBcanprovidemoremeaningfulinformationforbudgetarycontrol.

Feedforward control

Afeedforwardcontrolsystemoperatesbycomparingbudgetedresultsagainstaforecast. Controlactionistriggeredbydifferencesbetweenbudgetedandforecastedresults.

Incontrast,afeedbacksystemwouldsimplycomparetheactualhistoricalresultswiththebudgetedresults.

Forexample,thegraphbelowshowsthefeedbackandfeedforwardsystemforsales:

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Activity matrix

Advantages of feedforward control

Disadvantages of feedforward control

(1) Itencouragesmanagerstobeproactiveanddealwithproblemsbeforetheyoccur

(1) Itmaybetimeconsumingascontrolreportsmustbeproducedregularlyandlabourandtimeintensive

(2) Reforecastingonamonthlyorcontinuousbasiscansavetimewhenitcomestocompletingaquarterlyorannualbudget

(2) Itmayrequireasophisticatedforecastingsystem,whichcouldbeexpensive.

(3) Takesthefocusoffthedaytodayorganisation

Asalesmanagerreceivesmonthlycontrolreportsaboutsalesvalues.Thebudgetedsalesfortheyearto31Decemberare$600,000intotal.AttheendofAprilthemanagermightreceivethefollowingfeedbackcontrolreport.

Alternatively,thesalesmanagermightbepresentedwithafeedforward controlreport,asfollows:

Sales report for AprilMonth Cumulative

Budget Actual Variance Budget Actual VarianceProduct $000 $000 $000 $000 $000 $000P1 35 38 3(F) 90 94 4(F)P2 20 14 6(A) 50 39 11(A)P3 25 23 2(A) 50 45 5(A)

Total 80 75 5(A) 190 178 12(A)

Sales report, AprilBudget Latest forecast

for the yearExpected variance

Product $000 $000 $000P1 240 250 10(F)P2 150 120 30(A)P3 210 194 16(A)

Total 600 564 36(A)

Budgeting


Illustration 3 Feedforward control

Theuseofafeedforwardcontrolsystemmeansthatcorrectiveactioncanbetakentoavoidexpectedadversevariances.

Explain why feedforward control may be particularly appropriate for the capital expenditure budget.

8Selecting a suitable budgetary system Introduction

Asseen,therearemanyapproachestobudgetingandanorganisationwillwishtoselectasystemwhichismostappropriate.

Factors,whichwilldeterminesuitabilityinclude:

typeandsizeoforganisation typeofindustry typeofproductandproductrange cultureoftheorganisation.

Ahospitaloperatesinarelativelystablefinancialenvironment,hasaveryhighproportionoffixedcostsandadiverserangeofactivities.Factorstoconsiderwhenselectingasuitablebudgetarysystemmaybe:

Anincrementalapproachmaybesuitableforallroutineactivities.Newventuresmayuseazerobasedapproach.

ThefixedcostsmayneedclosecontrolandthereforesomeformofABBmaybeappropriate.

Thecultureoftheorganisationmaydictatewhetheraparticipativeorimposedbudgetingstyleismoreeffective.Iftherearemanagerswhoaretrainedinbudgetingandcostsaremainlycontrollablethenitmaybepreferabletoadoptaparticipativeapproachtoempowerandmotivatestaff.Ifcostsaremainlyuncontrollableitmaybepreferabletouseacentrallycontrolled,imposedbudget.

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Illustration 4 Selecting a suitable budgetary system

Select and justify a suitable budgeting system for a company operating in the mobile phone market.

Information for budgeting

Budgetingrequiresagreatdealofinformationthatcanbedrawnfrommanysources.

Themainsourcesofinformationforbudgetingpurposesare:

previousyearsactualresults otherinternalsourceswhichmayincludemanagersknowledge

concerningthestateofrepairoffixedassets,trainingneedsofstaff,longtermrequirementsofindividualcustomers,etc.

estimatesofcostsofnewproductsusingmethodssuchasworkstudytechniquesandtechnicalestimates.

statisticaltechniquessuchaslinearregression(chapter8)mayhelptoforecastsales.

models,suchastheEOQmodel,maybeusedtoforecastoptimalinventorylevels.

externalsourcesofinformationmayincludesuppliers'pricelists,estimatesofinflationandexchangeratemovements,strategicanalysisoftheeconomicenvironment.

Describe the sources of information required for a companys cash budget.

Budgeting



Change factors impacting budgeting


Changing a budgetary system

Achangeinthebudgetarysystemcouldbringaboutimprovedplanning,controlanddecisionmaking.

However,beforeachangeismadethefollowingissuesshouldbeconsidered:

Aresuitablytrainedstaffavailabletoimplementthechangesuccessfully?

Willchangingthesystemtakeupmanagementtimewhichshouldbeusedtofocusonstrategy?

Allstaffinvolvedinthebudgetaryprocesswillneedtobetrainedinthenewsystemandunderstandtheproceduretobefollowedinchangingtothenewapproach.Alackofparticipationandunderstandingbuildsresistancetochange.

Allcostsofthesystemschange,e.g.newsystemcosts,trainingcosts,shouldbeevaluatedagainsttheperceivedbenefits. Benefitsmaybedifficulttoquantifyandthereforearigorousinvestmentappraisaloftheprojectmaybedifficulttoprepare.

Alargeholidaycomplexcurrentlyusesincrementalbudgetingbutisconcernedaboutitsveryhighproportionofoverheadcostsandisconsideringchangingtoanactivitybasedbudgetingsystem.Demandfollowsafairlypredictableseasonalpattern.

Discuss the issues that should be considered before changing to a new budgetary system.

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Dealing with uncertainty in budgeting

Budgetsareopentouncertainty. Forexample,noncontrollablefactorssuchasarecessionorachangeinpriceschargedbysupplierswillcontributetouncertaintyinthebudgetsettingprocess.

Thereareseveraltechniquesavailabletohelpdealwithuncertainty. Thesehavebeendiscussedbeforeandinclude:

Flexiblebudgets: thesearebudgetswhich,byrecognisingdifferentcostbehaviourpatterns,aredesignedtochangeasthevolumeofactivitychanges.Flexiblebudgetsarepreparedundermarginalcostingprinciples,andsomixedcostsaresplitintotheirfixedandvariablecomponents.Thisisusefulatthecontrolstage:itisnecessarytocompareactualresultstotheactuallevelofactivityachievedagainsttheresultsthatshouldhavebeenexpectedatthislevelofactivitywhichareshownbytheflexiblebudget(moreonnextchapter).

Rollingbudgets: thebudgetisupdatedregularlyand,asaresult,uncertaintyisreduced.

Sensitivityanalysis: variablescanbechangedoneatatimeandalargenumberofbudgetsproduced. Forexample,whatwouldhappeniftheactualsalesvolumewasonly75%ofthebudgetedamount?

Simulation: similartosensitivityanalysisbutitispossibletochangemorethanonevariableatatime.

Spreadsheets

Aspreadsheetisacomputerpackagewhichstoresdatainamatrixformatwheretheintersectionofeachrowandcolumnisreferredtoasacell. Theyarecommonlyusedtoassistinthebudgetingprocess.

Advantages of spreadsheets

Closing cash balances

Largeenoughtoincludealargevolumeofinformation Formulaeandlookuptablescanbeusedsothatifanyfigureis

amended,allthefigureswillbeimmediatelyrecalculated.Thisisveryusefulforcarryingoutsensitivityanalysis.

Theresultscanbeprintedoutordistributedtootheruserselectronicallyquicklyandeasily.

Mostprogramscanalsorepresenttheresultsgraphicallye.g.balancescanbeshowninabarchart:

Budgeting


Disadvantages of spreadsheets:

Spreadsheetsforaparticularbudgetingapplicationwilltaketimetodevelop.Thebenefitofthespreadsheetmustbegreaterthanthecostofdevelopingandmaintainingit.

Datacanbeaccidentallychanged(ordeleted)withouttheuserbeingawareofthisoccurring.

Errorsindesign,particularlyintheuseofformulae,canproduceinvalidoutput.Duetothecomplexityofthemodel,thesedesignerrorsmaybedifficulttolocate.

Datausedwillbesubjecttoahighdegreeofuncertainty. Thismaybeforgottenandthedatausedtoproduce,whatisconsideredtobe,an'accurate'report.

Securityissues,suchastheriskunauthorisedaccess(e.g.hacking)oralossofdata(e.g.duetofireortheft).

Versioncontrolissuescanarise. Educatingstafftousespreadsheets/modelsandwhichareas/cellsto

useasinputscanbetimeconsuming.

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Whenproducingamasterbudgetmanuallythemajorproblemisensuringthatanyinitialentryinthebudgetoranyadjustmenttoabudgetitemisdealtwithineverybudgetthatisrelevantineffect,budgetsneedtocomplywithnormaldoubleentryprinciplestobeconsistent.

Suppose, for instance, that sales in the last month were expected to rise by $10,000, what adjustments would be necessary?

Usingspreadsheetsalloftheaboveadjustmentscouldbeprocessedautomaticallyiftherelevantformulaeweresetupproperly.Receivables,costofsales,purchases,payables,cash,inventoryandprofitcouldchangeinstantlyonadjustingsalesofmonth12.

Budgeting


Illustration 5 Using spreadsheets in budgeting

9Chapter summary

chapter 8



Thekeypointhereisthattheanswerdependsonwhoawardedthepayincrease.

Ifthiswastheproductionmanagersdecision,thenthecostwouldbecontrollable.Dependingonthecultureofthefirm,themanagerwouldthenbeunderpressuretoexplainwhytheydepartedfromthebudgetinthisinstance.

Ifawardedby,say,theboardofdirectors,thenthecostincreasewasnotcontrollablebythemanagerandshouldnotfeatureintheirappraisal.

Note: Theconceptofcontrollabilityisimportantfortheexam.

Themanagermaytryto:

Theprocesscanbeimprovedbymeasuringperformanceagainstavarietyoftargets,includingnonfinancialtargets,andlinkingperformancetolongtermobjectives.

delaydiscretionaryshorttermexpenditure,e.g.maintenance,attheexpenseoflongtermperformancetoimproveresults.

manipulateresultstomakesuretherelevanttargetsareachieved. incorporatebudgetaryslackintothetargetstomakethemeasierto

achieve.

Salesareexpectedtobe$550,000110%103%=$623,150.Themanagermayacceptthisasafairtargetforperformanceappraisal,planningandcontrolpurposes.Toencouragethemanagertoimprovefurtheranaspirationstargetincorporatingafurtherimprovement,sayto$650,000,couldbeusedandlinkedtotherewardsystem.

Budgeting


Test your understanding 1 Evaluation of managers



Thekeyissueisshorttermismthemanagermayacttoincreaseprofitforthisperiod(thusincreasinghisfinalbonus)withoutanyconsiderationoflongertermimplications.Thesecouldinclude:

Itwillbedifficulttolinkthebonustoalongertimescaleasthemanagerwillhaveretired.Insteadanonaccountingstylefocussingonquality,productivity,brandawareness,marketshare,etccouldbeadopted,ifnotalreadyinplace.

cuttingR&D cuttingmarketingexpenditure cuttingbackontraining rejectingprojectsthatdonothavehighreturnsinyear1 sackingnoncorestaff.

(1) Operationalmanagersmaynothavetheknowledgeandexperiencetosetabudget.Forexample,inasmallbusinessonlytheownermaybeinvolvedinallaspectsofthebusinessandmaythereforesetthebudget.

(2) Intimesofcrisistheremaybeinsufficienttimetosetaparticipativebudgetandtargetsmayhavetobeimposedtoensuresurvival.

(3) Participationhastobegenuineforittoresultinimprovedmotivation.Pseudoparticipation,whereseniormanagersseektheopinionsoftheultimatebudgetholdersbutdonotactontheseviews,mayleadtodemotivation.

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Total variable cost Variable cost per unit20X4:ProductA

$672,00075%60%=$302,400

$302,000640units=$472.50

ProductC

$672,00075%40%=$201,600

$201,600350units=$576

20X5:ProductA

$472.501.04750units=$368,550

n/a

ProductC

$5761.04340units=$203,674

n/a

Stage 1: Managersshouldspecifytheactivitiesthatcanbeevaluated

Themanagers/researchersresponsibleforeachprojectshoulddecidewhichprojectstheywishtoundertakeintheforthcomingperiod.Theseprojectswillbeamixtureofcontinuedprojectsandnewprojects.

Stage 2: Eachactivityisdescribedinadecisionpackage

Fortheprojectswhichhavealreadybeenstartedandwhichthemanagerswanttocontinueinthenextperiod,weshouldignoreanycashflowsalreadyincurred(theyaresunkcosts),andweshouldonlylookatfuturecostsandbenefits.Similarly,forthenewprojectsweshouldonlylookatthefuturecostsandbenefits.

Stage 3: Eachdecisionpackageisevaluatedandranked

Differentwaysofachievingthesameresearchgoalsshouldalsobeinvestigatedandtheprojectsshouldonlygoaheadifthebenefitexceedsthecost.

Budgeting




Stage 4: Resourcesareallocatedtothevariouspackages

Onceallthepotentialprojectshavebeenevaluatedifthereareinsufficientfundstoundertakealltheworthwhileprojects,thenthefundsshouldbeallocatedtothebestprojectsonthebasisofacostbenefitanalysis.

ZBBisusuallyofahighlysubjectivenature.(Thecostsareoftenreasonablycertain,butusuallyalotofuncertaintyisattachedtotheestimatedbenefits.)Thiscanbeshownbytheexampleofaresearchdivisionwheretheresearchersmayhavetheirownpetprojects,whichtheyareunabletoviewinanobjectivelight.

Therevisedbudgetshouldincorporate3%growthstartingfromtheactualsalesfigureofQuarter1andshouldincludeafigureforQuarter1ofthefollowingyear.

Quarter 2 Quarter3 Quarter 4 Quarter 1 Total$ $ $ $ $

Sales 127,154 130,969 134,898 138,945 531,966

Step 1 IdentifycostpoolsandcostdriversStep 2 Calculateabudgetedcostdriverratebasedonbudgeted

costandbudgetedactivityStep 3 Produceabudgetforeachdepartmentorproductby

multiplyingthebudgetedcostdriverratebytheexpectedusage.

Disthecorrectanswer.

SituationAwouldbebestsuitedbyimplementingZeroBaseBudgeting.SituationBdoesnotrequireABBsinceithasrelativelylowoverheads.SituationCwouldbesuitableforincrementalbudgeting.ABBwillcertainlynotbequicker.

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Test your understanding 9 Preparing an ABB

Capitalexpenditureisoftenlongterminnature.Itismoreusefultocompareactualcoststoforecastcompletioncostssothatactioncanbetakenwhenaprojectisinprogressratherthanwaitingforcompletion.

Themobilephonemarketisintenselycompetitivesoacompanywillneedsophisticatedsystemstogatherinformationaboutthemarketandcompetitors.Themarketisalsofastchangingsoarollingbudgetapproachmaybesuitabletokeepbudgettargetsuptodate.Itwillbeveryimportanttoincorporatethelatestinformationintobudgetsandaparticipativeapproachwillbeimportantasproductionmanagersandsalesmanagersmayhavelocalknowledgewhichwouldimprovethebudgetingprocess.

Internalinformationwillberequiredfromthe:

Externalinformationmayberequiredrelatingtoforecastinterestrates,taxrates,paymenttermsfortax,exchangerates,inflation,etc.

salesdepartmentrelatingtovolumeandestimatedcollectionperiods

theproductionmanagerwillestimatematerial,labourandoverheadusage

thepurchasingmanagerwillestimatematerialpricesandpaymentterms

humanresourceswillforecastpayrates,bonuspaymentsandovertimerequirements

thefinanceofficemayforecastpaymentsofinterest,dividendsandgeneralofficecosts.

Budgeting





Ananalysisofoverheadsshouldbecarriedouttodeterminetheproportionthathaveidentifiablecostdriverswhichdifferfromthenormalvolumerelatedcostdriverswhichmaybeusedwhencarryingoutincrementalbudgeting.IfasubstantialvolumeofoverheadisnonvolumerelatedthenimplementingABBmayleadtomoreaccurateplanningandcontrol.

Issues,whichshouldthenbeconsideredinclude:

thedevelopmentorpurchaseofasuitablecomputersystemtosupportanABBprocess

trainingofstafftooperateandinterprettheinformationproduced developmentofanimplementationplanandwhetherthisshouldrun

intandemwiththeexistingprocessforatrialperiod.

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Budgeting


QuantitativeanalysisChapter learning objectives


explainandevaluatetheuseofhigh/lowanalysistoseparatethefixedandvariableelementsoftotalcost

explainandevaluatetheuseofregressionanalysistoseparatethefixedandvariableelementsoftotalcost

explaintheuseofjudgementandexperienceinforecasting explainthelearningcurveeffect estimatethelearningeffectandapplythistoabudgetary

problem

calculateproductiontimeswhenthelearningcurvehasreachedasteadystate

explainthelimitationsofthelearningcurvemodel.

239

chapter

9

1High/low analysis

Amethodofanalysingasemivariablecostintoitsfixedandvariableelementsbasedonananalysisofhistoricalinformationaboutcostsatdifferentactivitylevels.

Thefixedandvariablecostscanthenbeusedtoforecastthetotalcostatanylevelofactivity.

Theapproachisasfollows:

Step 1

Selectthehighestandlowestactivitylevels,andtheircosts.

Step 2

Findthevariablecost/unit.

Variablecost/unit=(CostathighlevelofactivityCostatlowlevelactivity)/(HighlevelactivityLowlevelactivity)

Step 3

Findthefixedcost,usingeitherthehighorlowactivitylevel.

Fixedcost=TotalcostatactivitylevelTotalvariablecost

Step 4

Usethevariableandfixedcosttoforecastthetotalcostforaspecifiedlevelofactivity.

Quantitative analysis


Advantages of high/ low analysis

Disadvantages of high/ low analysis

Thehighlowmethodhastheenormousadvantageofsimplicity. Itiseasytounderstandandeasytouse.

Itassumesthatactivityistheonlyfactoraffectingcosts. Itassumesthathistoricalcostsreliablypredictfuturecosts. Itusesonlytwovalues,thehighestandthelowest,sotheresultsmaybe

distortedduetorandomvariationsinthesevalues.

Costdataforthesixmonthsto31December20X8isasfollows:

Required:

Usehigh/lowanalysistofindthevariablecostperunitandthetotalfixedcost. Forecastthetotalcostwhen500unitsareproduced.

Month Units Inspection costs $July 340 2,240August 300 2,160September 380 2,320October 420 2,400November 400 2,360December 360 2,280

2Regression analysis

Introduction

Regressionisanothermethodofforecasting. Itinvolvesusinghistoricaldatatofindthelineofbestfitbetweentwovariables(onedependentontheother),andusesthisstraightlinetopredictfuturevalues.

Ascatterdiagramcanbedrawn:

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Additional example on high/low

Thedependentvariableisyandmustalwaysbeontheverticalaxis,e.g.sales.

Theindependentvariableisxandalwaysgoesonthehorizontalaxis,e.g.advertisingspend.

Scatter diagram

Theaimistofindthebestline(thelineofbestfit)throughthecentreofthisdiagram.

Thisstraightlinecanthenbeusedforforecasting,e.g.toforecastsalesforanylevelofadvertisingspend.

Equation of a straight line

Theequationofastraightlineis y=a+bx

Itcanbetimeconsumingtofindthevaluesof'a'and'b'bydrawingthescatterdiagram. Instead,thefollowingformulaecanbeusedtofindthesevalues.

wheren=samplesize

(a) istheinterceptwiththeyaxis (b) isthegradientorslope

b=[nxyxy]/[nx2(x)2]

a=(y/n)(bx/n)

Bothoftheseformulaearegivenintheexamination.



Acompanyhasrecordedexpenditureonadvertisingandresultingsalesforsixmonthsasfollows:

Required:

Month Advertising expenditure Salesx y

$000 $000March 20 170April 40 240May 50 260June 60 300July 30 220August 40 250

(a) Plotthedataonascatterdiagramandcomment.

(b) Calculatethevaluesof'a'and'b'andcomment.

(c) Whatistheequationofthelineofbestfit?

(d) Forecastsaleswhenadvertisingexpenditureis:

andcommentonyouranswers.

(i) $50,000

(ii) $100,000

Correlation coefficient

Thestrengthofthelinearrelationshipbetweenthetwovariables(andhencetheusefulnessoftheregressionlineequation)canbeassessedbycalculatingthecorrelationcoefficient(r):

Thecorrelationcoefficientwillbebetween1and+1.

riscloseto+1: thereisastrongpositivecorrelationbetweenthetwovariables

chapter 9


Additional example on regression analysis


Thecloserthecoefficientisto+1or1,thebetterregressionanalysiswillbeasamethodofforecasting.

Usingthedatafromtheprevioustestyourunderstanding:

Coefficient of determination

Thecoefficientofdetermination=r2

Itshowsthepercentagechangeinthedependentvariable,e.g.sales,thatcanbeexplainedbyachangeintheindependentvariable,e.g.advertisingspend.

Usingthedatafromtheprevioustestyourunderstanding:

r2=0.957

Thus95.7%oftheobservedvariationinsalescanbeexplainedasbeingduetochangesintheadvertisingspend.Thiswouldgivestrongassurancesthattheforecastsmadeusingtheregressionequationarevalid.

riscloseto1:thereisastrongnegativecorrelationbetweenthetwovariables

riscloseto0:thereislittlerelationshipbetweenthetwovariables

3Learning curves Introduction

Asworkersbecomemorefamiliarwiththeproductionofanewproduct,averagetime(andaveragecost)perunitwilldecline.

Wrights Law:ascumulativeoutputdoubles,thecumulativeaveragetimeperunitfallstoafixedpercentage(referredtoasthelearningrate)ofthepreviousaveragetime.



Ascanbeseenonthegraph,eventuallythecurvebecomesalmosthorizontalwhenmanyunitshavebeenproduced,asthelearningeffectislostandproductiontimeperunitbecomesaconstant.

Learning curve calculations

Thelearningcurveeffectcanbecalculatedby:

Bothmethodswillgivethesameanswer. However,theformulaisquickerandeasiertouseintheexam.

Method 1: setupatableandreducetheaveragetimebythelearningrateeachtimetheoutputdoubles.

Method 2:usingtheformulay=axby= cumulativeaveragetime(oraveragecost)perunitorperbatcha= time(orcost)forfirstunitorbatchb= logr/log2(r=rateoflearning,expressedasadecimal)x= cumulativeoutputinunitsorinbatches

Assumethatithastaken400directlabourhourstomanufacturethefirstunitofanewproduct.Asinthepastforthisbusinessitisanticipatedthata75%learningcurvewilloccur.

Required:

Setupatableshowing:

Theaveragetimetakenforthe2ndandthe4thunit. Thetotaltimetakenfor2unitsandfor4units.

chapter 9


Test your understanding 3 Method 1

Using the information from the

f5 performance management kaplan 2013

Documents

relevant cost of labour

relevant cost of materials

w variable

overall increase

buysolutionother issues

monthly profit

new business