97_management_accounting_complete KİTAP

Management accountingT. Ahrens2790097

2005

Undergraduate study in Economics, Management, Finance and the Social Sciences

This guide was prepared for the University of London External Programme by:

T. Ahrens, BA, MSc, PhD, Professor of Accounting, Warwick Business School, Universityof Warwick.

This is one of a series of subject guides published by the University. We regret that dueto pressure of work the author is unable to enter into any correspondence relating to,or arising from, the guide. If you have any comments on this subject guide, favourableor unfavourable, please use the form at the back of this guide.

This subject guide is for the use of University of London External students registered forprogrammes in the fields of Economics, Management, Finance and the Social Sciences(as applicable). The programmes currently available in these subject areas are:

Access route

Diploma in Economics

BSc Accounting and Finance

BSc Accounting with Law/Law with Accounting

BSc Banking and Finance

BSc Business

BSc Development and Economics

BSc Economics

BSc (Economics) in Geography, Politics and International Relations, and Sociology

BSc Economics and Management

BSc Information Systems and Management

BSc Management

BSc Management with Law/Law with Management

BSc Mathematics and Economics

BSc Politics and International Relations

BSc Sociology.

The External ProgrammePublications OfficeUniversity of London34 Tavistock SquareLondon WC1H 9EZUnited Kingdom

Web site: www.londonexternal.ac.uk

Published by: University of London Press

© University of London 2005

Printed by: Central Printing Service, University of London, England

Contents

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ContentsIntroduction 1

Aims 1Learning outcomes 1Why study management accounting? 1Organising your studies 2Essential reading 4Further reading 4Examination advice 5Abbreviations 6

Chapter 1: Modern management accounting 7Essential reading 7Further reading 7Aims 7Learning outcomes 7Introduction 7Management accounting, cost accounting and financial accounting – routine and non-routine information provision 8From record keeping to problem solving? The strategic turn in management accounting 9‘Price leadership’ and ‘differentiation’ 10Calculating success 10Strategic management accounting 11Information technology 11Enterprise Resource Planning Systems (ERP) 12Planning, controlling and ‘experience’ 13The budgeting process and ‘beyond’ budgeting 14Decision-making and organisational goals 15Stakeholders 15Sample examination question 16Suggestions for answering the sample examination question 16

Chapter 2: Decision-making 17Essential reading 17Further reading 17Aims 17Learning outcomes 17Levels of decision-making 17The importance of cash flows 18Opportunity costs 19The concept of relevant costs and revenues 20Identifying relevant costs and revenues 21Purchased resources 21Resources already under the organisation’s control 22Decision-making and current replacement cost 22Comparing cash flows in the long run 23Discounting 24The net present value decision rule 24Making estimates for project appraisals 25Problems with the opportunity cost concept 27Uncertainty and relevant information 28Characteristics of useful information 28

Objective and subjective probabilities 29Expected value 30The value of information 30Sample examination question 30Suggestions for answering the sample examination question 31

Chapter 3: Cost behaviour 33Essential reading 33Aims 33Learning outcomes 33Introduction 33The elements of total costs and their behaviour 33Direct and indirect costs 34Fixed and variable costs 34Costs in-between 35The identification of cost drivers 36Allocation 37Cost estimation 37Linear regression 39Error terms and outliers 39Cost-volume-profit and break-even analysis 40Sample examination question 41Suggestions for answering the sample examination question 41

Chapter 4: Costing and pricing 43Essential reading 43Aims 43Learning outcomes 43Costs and pricing 43Contribution margin pricing 44Short-term decisions with one scarce resource 45Contribution per bottleneck resource 46More than one scarce resource: linear programming (LP) 46Dual prices (shadow prices) and opportunity costs 48Dual (shadow) prices 49Opportunity costs 49Sample examination question 50Suggestions for answering the sample examination question 50

Chapter 5: Budgeting and control 51Essential reading 51Further reading 51Aims 51Learning outcomes 51The purposes of budgets 52Budget organisation 53Budget frequency 53Types of budgets 54Budgeting and control 55Variance analysis 57The interpretation of variances 59Sample examination question 60Suggestions for answering the sample examination question 60

Chapter 6: Traditional cost systems 61Essential reading 61Aims 61

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Learning outcomes 61The nature of costing systems and their integration into financial accounting systems 61Cost centres and control 62Process costing 63Example of process costing 63Job costing 65Batch and contract costing 66Allocation of fixed overheads 66Example of an absorption costing system 67Variable costing 68Sample examination question 69Suggestions for answering the sample examination question 69

Chapter 7: Activity-based costing (ABC) 71Essential reading 71Further reading 71Aims 71Learning outcomes 71‘Overhead creep’ in multi-product firms 71Instruments Inc. 72Over- and undercosting 72Cost drivers 72Cost pools 73Cross-subsidisation 74Towards activity-based management 74Products and processes 75Customer focus 75Service industries 75ABC adoption 75The costs of ABC 76Some problems with ABC 76Homogeneity of cost pools 76Homogeneity of cost drivers 77Outlook 77Sample examination question 78Suggestions for answering the sample examination question 78

Chapter 8: Inventory costing 79Essential reading 79Further reading 79Aims 79Learning objectives 79Introduction 79The purposes of standard costing 80How to develop standards 80When is standard costing recommended? 80Actual costing 81Inventory accounting and income measurement 82Marginal (or direct or variable) costing 83Absorption (or full) costing 83Production volume variance 84Profit impact of different methods 85The key lies in the inventory 87How to cheat with inventory accounting 88Sample examination question 88Suggestions for answering the sample examination question 88

Contents

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Chapter 9: Performance measurement systems 89Essential reading 89Further reading 89Aims 89Learning outcomes 89Introduction 89Main components of performance measurement systems 90Financial records 90Responsibility structures 90The three most common responsibility centres: cost centres, profit centres and investment centres 91Transfer prices 91Transfer-pricing methods 91Gasoil & Co. 92Divisional and corporate profit calculations 93How a transfer price may lead to sub-optimal decisions 94Financial measures 95Divisional performance 97Sample examination question 98Suggestions for answering the sample examination question 98

Chapter 10: Strategic management accounting 99Essential reading 99Further reading 99Aims 99Learning outcomes 99Target costing 100Life cycle costing 101Quality costs and the theory of constraints (TOC) 101Costs of quality 102Techniques used to identify quality problems 103Theory of constraints (TOC) 104Bottlenecks 104The balanced scorecard 104‘Lead’ and ‘lag’ indicators 105Evidence 106Outlook 106Enabling management control systems 107Sample examination question 107Suggestions for answering the sample examination question 108

Appendix: Sample examination paper 109


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Introduction

AimsThis unit is designed to give students a grounding in the key concepts andtechniques of management accounting, and to prepare them for the use ofrecent innovations in the management accounting function. Traditionallyconcerned with the recording and measurement of costs, managementaccountants have increasingly become concerned with supporting themanagement of organisational strategy. This has entailed the inclusion ofnon-financial information in management accounting reports that arebecoming increasingly tailored to organisational circumstances. Underlyingthis work of providing information is a core of economic principles, to whichI will make reference throughout this subject guide.

Your subject guide is arranged in three main sections. The first sectionintroduces traditional and contemporary functions of managementaccounting and some of the key economic concepts underlying managementaccounting. The second section covers costing principles and costing systems,with some recent managerial applications, such as activity-basedmanagement. The third section puts costing principles and systems intocontext by explaining what roles they would play as part of an organisation’sperformance measurement and strategic management accounting systems.

Learning outcomesSpecifically, for this unit you should be able to:

• assess the possible uses of information for different types of decision-making

• calculate and distinguish between different types of costs and explain therole of costs for pricing and other business decisions

• prepare budgets and explain the significance of budgets for planning andcontrol

• explain the functioning of costing systems and analyse, calculate andinterpret variances

• discuss the problems of performance measurement and control in divisionalised organisations and calculate simple measures of performance

• explain the changing role of management accounting.

Why study management accounting?After completing your degree you may want to work in government, for afirm, or for a non-profit-making organisation. Whatever you do, you willmeet people who are concerned with the resources which you consume to doyour work, and who will ask what the benefits of your activities are. Theywill very often want to measure your department’s inputs and outputs inmoney. Theirs is the language of cost, revenue and return on investment.They rely on some form of accounting to evaluate the internal functioning ofyour organisation. This is what is called management accounting ormanagerial accounting. Whether or not you want to be a specialist in this

Introduction

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field, you will become involved in discussions of the uses of resources. Thissubject is intended to help you understand the thinking behind managementaccounting calculations, devise alternative ways of accounting fororganisational activities and put accounting into perspective relative to otherways of describing the organisation.

Think back to Elements of accounting and finance (or Principles ofaccounting). How would you describe the nature of the accountingknowledge with which you are now acquainted? Is it a science? Is it an art? Is it a more or less coherent set of rules for practice? There seem to beelements of all of those three labels in accounting. You can find theory, forinstance, on the notions of wealth, income and profit. To calculate the profitof an accounting period you need to rely on experience to carefully balancesomewhat contradictory principles, such as the matching and the prudenceprinciple. Finally, accounting also contains certain rules, relating, forexample, to depreciation or to the arrangement of financial statements.Often, those rules are laid down in accounting standards, the law,government regulation, audit practice statements, etc. You can see thataccountants need to draw on theory and their experience to arrive atjudgements that can be justified within the existing rules of practice.

Organising your studiesIf you are following regular instructions at a teaching institution you ought toread through each chapter of the subject guide once before you attend anyrelevant teaching sessions to get the flavour of the topic. Take it as anopportunity to learn to read faster. Read the introduction of each chaptercompletely, then read only the first and the last sentence of each paragraph.‘Scan’ the lines in between. If you do not get a sense of the argument, readparagraphs completely. This should not take you longer than 10 or 15minutes per chapter. After attending the lecture, you should then read thechapter more slowly. With your newly-gained overview of the topic, you canprobably do that in 30–40 minutes. It is important to take your time to thinkabout the activities in the chapter. Often things seem clear to you so long asyou just follow my writing. When you are asked to do the activities you havea chance to express things in your own words and explain things to yourself.Teaching is the best way of learning!

How should you use the textbook? The reading relevant to each chapter islisted at the beginning of each chapter. The essential reading consists of oneor more textbook chapters and specified journal articles that are mostlyavailable online through the University of London online library (see below‘Reading’). In working with the textbook it is important to remember thatthe subject guide is not meant to replace the textbook. The subject guideprovides a framework for your study, contains aims and learning objectivesfor each topic, and references to the essential and further reading, acts as a pointer to the most important issues in each topic, provides additionalexplanations where appropriate, and contains additional worked examples,activities to involve you in the topic and clarify its relevance, and sampleexam questions. Your use of the textbook depends very much on whetheryou receive instruction from a teaching institution or whether you study by yourself.

If you receive instruction, the main role of the textbook is to support whatyou have learned at your teaching institution. It can confirm what you havelearned already and present topics in a slightly different light. As you readthe textbook, ask yourself, how do the chapters relate to the subject guide?Which are useful examples, where does the textbook chapter elaborate


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a concept in more depth, and where does it simplify the argument made inthe subject guide. The many examples in the textbook allow you to becomemore secure in your understanding of specific techniques. Depending on howfamiliar you are with the topic when you start reading the assigned material,it might take you between 45 and 90 minutes. I would recommend that youread the textbook after your instruction – most students prefer this and findit saves them time. However, some students find that they are not able tofollow the instruction as well as they would like to if they leave the essentialreading until after the instruction. In this case you should read the relevantsections in the textbook beforehand. But be sure to return to the essentialreading after the relevant teaching session because the instruction oftenhighlights important aspects of a topic that you did not notice upon first reading.

If you study by yourself, the textbook and the other readings are your mainsource of knowledge. This means you will need more time on each topic,typically between one and a half and two hours. Start always with thetextbook before moving on to journal articles. Make sure you understand thelogic of the learning objectives at the beginning of each chapter. Readcarefully through the assigned material, making sure you understand howthe various exhibits and the summaries in the margins relate to the maintext. As you read, try to relate the text to the learning objectives for thischapter. After completing a chapter, go over the summaries in the marginsagain and make sure they still make sense! In my experience, for checkingthat you really understand a chapter, it is useful to wait for a day or twobefore attempting the problem for self-study at the end of each chapter. Theyhave detailed solutions for your guidance. After completing the work for eachtopic you should have a sense of how the material integrates with theprevious topics. This subject guide is written in order to support you in this.

Especially if you study by yourself you should benefit from the fact that thetextbook takes a holistic approach to the subject of management accounting.It does not make artificial distinctions between the main topics of theindividual chapters, but makes reference to relevant issues at different pointin the book. For example, activity-based costing (ABC) has its own chapter(Chapter 5) but reference to ABC is also made on page 337 because ABC isrelevant to the question of cost behaviour. The advantage of this holisticapproach is that it explains the relevance of certain techniques in relation todifferent ideas within management accounting. Therefore, if you seek to findout more about a particular topic or technique, consult firstly the glossaryand then the index. Follow up the references from the index to find out aboutthe different ideas in relation to which a topic or technique is explained.Management accounting is a practice that has developed over a long timeand in response to different demands. As a consequence, it does not alwaysappear logical at first!

When you have finished your textbook reading, and made such notes as youconsider useful, you should test your understanding of the topics covered byattempting the sample questions that appear at the end the relevant chapterof this subject guide or the exercises that appear at the end the relevantchapter of the textbook.

It is helpful to look back regularly to the earlier chapters of the subject guide,in order to refresh and reinforce your understanding of the earlier topics.Also, it is a good idea to follow up some of the references provided in thetextbook together with the suggestions for further reading which I give youin the subject guide. Even though I have indicated how much time I think isappropriate for working through the guide and the readings, it is difficult topredict how much time different students need to spend on this topic. Overall,you will probably need to devote between three and four and a half hours per

Introduction

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week in addition to any time you may have spent in lectures. That shouldcover lecture preparation, organisation of lecture notes after the lecture,reading in the guide, essential reading, further reading and exercises.

Essential readingHorngren, Charles T., Srikant M. Datar and George Foster Cost accounting: a

managerial emphasis. (Prentice Hall Publishing, 2003) eleventh edition(international) [ISBN 0-13-099619-X].

This subject guide is largely a commentary on that book and I recommendthat you purchase it. If you find a tenth edition second hand (at a goodprice!) it would be equally suitable.

Further readingIt is essential that you support your learning by reading as widely as possibleand by thinking about how those principles apply in the real worlds. To helpyou read extensively, all external students have free access to the Universityof London online library where you will find either the full text of or anabstract of many of the journal articles listed in this subject guide. You willneed to have a username and password to access this resource. Details can befound in your handbook or online at:

www.external.ull.ac.uk/index.asp?id=lse

Ahrens, T. and C.S. Chapman ‘Accounting for flexibility and efficiency: A fieldstudy of management control systems in a restaurant chain’, ContemporaryAccounting Research (2004) 21(2): 271–301.

Ahrens, T. and C.S. Chapman ‘Occupational identity of managementaccountants in Britain and Germany’. European Accounting Review (2000)9(4): 477–498.

Balakrishnan, R. and G.B. Sprinkle ‘Integrating Profit Variance Analysis andCapacity Costing to Provide Better Managerial Information’, Issues inAccounting Education (May 2002) Vol. 17 Issue 2: 149–162 [concentrate onthe case study in this paper].

Chapman, C.S. and W.F. Chua ‘Technology-driven integration, automation andstandardisation of business processes: implications for accounting’. In A.Bhimani (ed.) Management Accounting in the Digital Economy. (Oxford:Oxford University Press, 2003) pp. 74–94.

Cooper, R. and R.S. Kaplan ‘Measure Costs Right: Make the Right Decisions’,Harvard Business Review (September–October 1988): 96–103.

Cooper, R. and W.B. Chew ‘Control Tomorrow’s Cost Through “Today’s Design’’,Harvard Business Review (January–February 1996): 80–97.

Covaleski, M.A., J.H. Evans III, J.L. Luft and M.D. Shields ‘Budgeting Research:Three Theoretical Perspectives and Criteria for Selective Integration’,Journal of Management Accounting Research (2003) Vol. 15: 3–51.

Friedman, A.L. and S.R. Lyne ‘Activity-based techniques and the death of thebeancounter’, European Accounting Review (1997) 6(1): 19–44.

Goldratt, E. and J. Cox The Goal. (North River Press, 1992) second edition.Hayes, R.H. and W.J. Abernathy ‘Managing our way to economic decline’,

Harvard Business Review (1980) 58(4): 67–77.Hopper, T., T. Koga and J. Goto ‘Cost accounting in small and medium sized

Japanese companies: an exploratory study’, Accounting & Business Research,(Winter 1999) Vol. 30 Issue 1: 73–87.

Ittner, C. and D. Larcker ‘Moving From Strategic Measurement to Strategic DataAnalysis’, C.S. Chapman (ed.) Controlling Strategy: Management, Accountingand Performance Measurement. (Oxford: Oxford University Press, 2005).

Ittner, C. and D. Larcker (2003) ‘Coming up Short on Nonfinancial PerformanceMeasurement’, Harvard Business School Press, 81/11: 88–95.


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Johnson, H. and R. Kaplan Relevance lost: The rise and fall of managementaccounting. (Boston: Harvard Business School Press, 1987) [ISBN0875841384].

Kaplan, R.S. and S.R. Anderson ‘Time-Driven Activity-Based Costing’, HarvardBusiness Review (November 2004) Vol. 82 (Issue 11): 131–140.

Kaplan, R.S. and D.P. Norton ‘Transforming the Balanced Scorecard fromPerformance Measurement to Strategic Management: Part I’, AccountingHorizons (2001a) 15(1): 87–105.

Kaplan, R.S. and D.P. Norton ‘Transforming the Balanced Scorecard fromPerformance Measurement to Strategic Management: Part II’, AccountingHorizons (2001b) 15(2): 147–161.

Mouritsen, J. ‘Five aspects of accounting departments’ work’, ManagementAccounting Research (1996) 7(3): 283–303.

Narayanan, V.G. and R.G. Sarkar ‘The Impact of Activity-Based Costing onManagerial Decisions at Insteel Industries – A Field Study’, Journal ofEconomics & Management Strategy (Summer 2002) Vol. 11, number 2:257–288.

Roslender, R. and S.J. Hart ‘In search of strategic management accounting:theoretical and field study perspectives’, Management Accounting Research(2003) 14(3): 255–279.

Sahay, S.A. ‘Transfer Pricing Based on Actual Cost’, Journal of ManagementAccounting Research (2003) Vol. 15: 177–193.

Simmonds, K. ‘Strategic Management Accounting’, Management Accounting(1981) 59(4): 26–29.

Simon, H.A. Centralisation Vs Decentralisation in Organizing the Controller’sDepartment. (Houston: Scholars Books Co., 1954) third edition.

Spiller Jr., E.A. ‘Return on Investment: A Need for Special Purpose Information’,Accounting Horizons (June 1988) Vol. 2, Issue 2: 1–10.

Verdaasdonk, P. and M. Wouters ‘A generic accounting model to supportoperations management decisions’, Production Planning & Control,(September 2001) Vol. 12 Issue 6: 605–21.

Examination adviceImportant: the information and advice given in the following section arebased on the examination structure used at the time this guide was written.Please note that subject guides may be used for several years. Because of thiswe strongly advise you to always check both the current Regulations forrelevant information about the examination, and the current Examiners’reports where you should be advised of any forthcoming changes. You shouldalso carefully check the rubric/instructions on the paper you actually sit andfollow those instructions.

The subject is examined in a written unseen examination which lasts forthree hours. There are two sections. Section A contains four questions whichrequire the use of calculations to answer the question. Section B has essayquestions. There are four questions in each section. You must answer fourquestions in total and at least one from each section. All questions carryequal marks, 25 in total. Where the questions require you to answer differentparts, the relative weighting of marks is given. Typically, those questionswhich ask you to perform calculations also ask you to interpret your results ina later part. Some of the essay questions may give you a further choice of twoquestions. At the end of each chapter in the subject guide I will be showingyou one or two sample questions. Note that the questions cannot usually beanswered with reference to only one chapter in the subject guide, but requireyou to integrate the material with other chapters, textbook and journalarticle reading, and also with other subjects, such as Elements ofaccounting and finance (or Principles of accounting).

Introduction

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Before you are examined, you will be sent past examination papers andassociated Examiners’ reports for this unit. The Examiners’ reports containvaluable information about how to approach the examination and so you arestrongly advised to read them carefully. Past examination papers and theassociated reports are valuable resources when preparing for the examination.

Both question papers and reports for the last three years are available onlinebut you should be aware that the syllabus and subject guide were revised for2005 and bear this in mind as you look at past examination papers. Youshould also consult the Examination section of your Student Handbook.

AbbreviationsFollowing is a list of abbreviations used in this subject guide.

ABC activity-based costing

ABM activity-based management

CVP cost-volume-profit analysis

ERP enterprise resource planning system

JIT just-in-time inventory system

LP linear programming

NPV net present value

OWM owners’ wealth maximisation

R&D research and development

RI residual income

RoI return on investment

SMA strategic management accounting

TOC theory of constraints

WACC weighted average cost of capital


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Chapter 1: Modern management accounting


managerial emphasis. (Prentice Hall Publishing, 2003) eleventh edition(international) [ISBN 013099619X] Chapter 1.

Mouritsen, J. ‘Five aspects of accounting departments’ work’, ManagementAccounting Research (1996) 7(3): 283–303.

Further readingAhrens, T. and C.S. Chapman ‘Occupational identity of management

accountants in Britain and Germany’, European Accounting Review (2000)9(4): 477–498.

Chapman, C.S. and W.F. Chua ‘Technology-driven integration, automation andstandardisation of business processes: implications for accounting’, A.Bhimani (ed.) Management Accounting in the Digital Economy. (Oxford:Oxford University Press, 2003) pp. 74–94.

Friedman, A.L. and S.R. Lyne ‘Activity-based techniques and the death of thebeancounter’, European Accounting Review (1997) 6(1): 19–44.

Johnson, H. and R. Kaplan Relevance lost: The rise and fall of managementaccounting. (Boston: Harvard Business School Press, 1987).

Roslender, R. and S.J. Hart ‘In search of strategic management accounting:theoretical and field study perspectives’. Management Accounting Research,(2003) 14(3): 255–279.

Simmonds, K. ‘Strategic Management Accounting’, Management Accounting(1981) 59(4): 26–29.

Simon, H.A. Centralisation Vs Decentralisation in Organizing the Controller’sDepartment. (Houston: Scholars Books Co., 1954) third edition.

AimsThe aim of this chapter is to clarify what the term ‘modern managementaccounting’ means and why it has gained currency. It also outlines howrecent changes in the management accounting function have affected therole of the management accountant in organisational practice.

Learning outcomes After reading this chapter and the essential reading, you should be able to:

• define the terms ‘modern management accounting’ and ‘strategicmanagement accounting’

• explain why organisations have become concerned with modernmanagement accounting

• evaluate the extent to which modern management accounting haschanged the role of the management accountant.

IntroductionModern management accounting is a term that has become more popularover the last decade or so. It implies a changing set of preoccupations amongmanagement accountants. In the past the vast majority of managementaccountants have been regarded as technical specialists whose expertise lay


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in the operation of accounting and other information systems. This includedthe preparation of reports to support management decision-making. Recently,more emphasis has been put on giving commercial advice to management.

Management accounting, cost accounting and financialaccounting – routine and non-routine information provision

In contrast with financial accounting, which is concerned with accountingreports for the external constituents of an organisation, such as banks,investors, trade unions, suppliers, customers and the government, managementaccounting produces the reporting for a key internal constituent, namelymanagement. The idea is to produce and communicate information that isrelevant to managerial decision-making.

Management accounting is therefore much more detailed and potentiallymuch more varied than financial accounting because it ought to respond tospecific information requests rather than follow general reporting standardsthat are valid for very different types of organisations. This is not to say thatall management accounting reporting is ad hoc. An important distinctionwith respect to management accounting work is that between routine andnon-routine reporting.

Routine reports regularly cover defined aspects of organisations, such asefficiency variances of certain input factors, which allow the charting oftrends over time and structured comparisons between different entitieswithin the organisation. They can be prepared according to widely-usedprinciples of calculation or be tailor made for the organisation. Non-routinereports analyse one-off events or decisions that can benefit from in-depthstudies of their different aspects. It is often said that routine reports concernongoing operations and non-routine reports tend to be concerned withinvestment decisions. Often this is the case but it is also possible that non-routine reports are prepared to address specific aspects of operations,such as the further analysis of unusual production variances. Likewise,certain kinds of investment decisions may, especially in large organisationswith great investment volumes, be highly routinised.

A typical textbook definition of management accounting is that ‘it measuresand reports financial and non-financial information that helps managersmake decisions to fulfil the goals of an organization’ (Horngren et al., 2003),which covers routine and non-routine decisions. Management accountingbuilds on financial accounting information because it requires measurementsand records of business transactions from diverse systems such as creditorsand debtors records, the payroll, the fixed asset inventory, etc. It also builds on cost accounting, defined as the provision and communication of cost information.

In addition, management accountants can create additional ‘fictitious’ or‘notional’ accounting information, for example, by charging opportunitycosts for uses of capital. Imagine, for example, two manufacturing divisionsengaged in similar activities and producing similar output levels. Imaginefurther that one division uses twice as much working capital (debtors,inventory, cash) as the other. In terms of reported profit, based on financialaccounting records, those two divisions are very similar. But the division thatproduces its results with less working capital achieves a preferable resultbecause it leaves a lot of working capital unused. Thereby, it allows theorganisation to expand activities with the unused working capital, thuspotentially enhancing profitability. Management accountants may thereforedecide to include a notional interest charge on working capital when


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calculating the financial contribution of the divisions. This incentivisesdivisional managers to be economic with working capital by, for example,seeking to minimise inventory or asking debtors to pay earlier. The overallfinancing costs of the organisation would be lower as there would be lowerinterest payments on bank overdrafts, loans, bonds, etc.

Cost accounting is more technically oriented than management accounting.It ‘measures and reports financial and non-financial information relating tothe cost of acquiring or consuming resources in an organisation’ (Horngrenet al., 2003, p.836). Cost management, by contrast, is defined by Horngren etal. (2003) as ‘the approaches and activities of managers in short-run andlong-run planning and control of decisions that increase value for customersand lower costs of products and services.’ (p.837). This makes costmanagement a key part of the organisation’s general management strategiesand their implementation.

How important is cost reduction for organisations? Is it a relevant strategy forall organisations? This is probably not the case. Some organisations focustheir management attention on, say, market differentiation strategies,thereby avoiding price competition. They may not possess the managementcapacity to also pursue an elaborate cost reduction strategy (although inprinciple price competition and market differentiation strategies do notpreclude each other).

Activity

Fill in the following table based on your understanding of the previous section. Rereadthe section if necessary.

Table 1.1: A comparison of financial accounting and management accounting

Characteristics of Characteristics of financial accounting management accounting

Users of information

Extent of formal regulation

Degree of uniformity across different organisations

Degree of detail

Likelihood of including non-financial information

Relevance for managerial decision-making

From record keeping to problem solving? The strategic turnin management accounting

The relationship between management accounting and strategicmanagement has over the last decade or so been undergoing some changes.By ‘strategic’ management, I mean those aspects of management that areconcerned with the core competencies of the organisation. Typically, thosecore competencies are defined with respect to an organisation’s relationshipswith customers, suppliers, competitors, and the markets for labour andcapital. The core competencies describe what the organisation can(uniquely) offer its customers in ways that are superior to the competition,using its own process capabilities as well as its relationships to suppliers andits own specific access to labour and capital markets.


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‘Price leadership’ and ‘differentiation’Two ‘generic’ strategies that are frequently distinguished are ‘priceleadership’ and ‘differentiation’. ‘Price leadership’ implies low pricescombined with a standardised offering. The strategic effort goes intodeveloping a customer proposition that appeals to large numbers ofcustomers and can be provided at low cost. Product variation or eventailoring products to individual customers’ wishes is then not usually part ofthe product offering. Budget airlines are a recent and fairly extreme exampleof this strategy.

By contrast, ‘differentiation’ emphasises the satisfaction of individualcustomers’ wishes as closely as possible, be it with respect to quality ofmanufacture, ease of use, flexibility of application or delivery, productvariety, reliability or any combination of these. An example would be luxurymotor vehicle manufacturers. Product cost is also a concern for organisationsthat pursue this strategy but not to the same extent as for those that pursueprice leadership.

Even though the strategy literature often portrays price leadership anddifferentiation as strategic opposites, in practice one usually finds combinationsof the two, for example, in the various markets for electronic consumer goods.There are different reasons for this. In large organisations some divisionsmay tend towards one strategy and some towards the other. During their life cycle, certain products may start out as differentiated products that aretailored towards the high price segment (perhaps because they are innovative),and later they may be marketed to compete mainly on price (perhaps becausemany competitors have entered this market, production volumes haveincreased and high quality is no longer a differentiating factor).

The strategic relevance of management accounting would depend on theextent to which it supports management in finding out which strategy is most promising for an organisation. Here one would expect managementaccountants to prepare alternative scenarios together with marketing, product,and production managers who assess the long-term profitability of operatingin different markets, offering different price–value combinations to differentcustomer segments. In target costing, value engineering and life cycle costing,for example, which are explained in later chapters, and which you shouldlook up in your textbook’s glossary, the experience has been that such effortsare best placed in the development and design stages of a new product becausehere a large percentage of a product’s cost is built into its design. The role ofmanagement accountants can be to advise on the cost implications of certaindesign choices and calculate the added revenue that can be expected fromadditional product attributes (e.g. reliability, functionality, appearance, etc).

Calculating successStrategic management is, however, also concerned with finding out if certainstrategies have been pursued successfully. Here management accountantscan prepare cost and revenue information by product, product group andmarket segment, calculating variances in sales volumes, sales mix and marketshares, and their implications for profitability. Ideally one would want tocalculate the profit impact of pursuing certain strategies. A common problemin this respect is the isolation of causal factors because the environments oforganisations tend to change in many respects at the same time from onereporting period to the next.


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At a more elementary level, strategic cost accounting might calculate thecosts of providing certain product attributes that are important for anorganisation’s strategy. For example, a fast food chain might want to calculatethe cost of providing high levels of cleanliness through its estate, or a vehiclemanufacturer the cost of being able to offer engines with lower emissionsthan the competition.

Strategic management accounting In the 1980s management accounting and accountants were criticised fortheir failure to recognise organisations’ new strategic priorities (Johnson andKaplan, 1987), and from this decade stem many of the initiatives to makemanagement accounting more strategically relevant. The reproach was that management accounting was in fact dominated by financial reportingrequirements and took no account of what decision-makers wanted to know.For example, standard costing systems allocated overhead costs to productsthat were not causing them, and standard costs were updated so infrequentlythat changes in the design and manufacture of products quickly made themobsolete.

One of the attempts to correct the shortcomings of traditional standardcosting systems was Activity-based costing (ABC), which sought to allocatemanufacturing overheads depending on the manufacturing activities thatwere caused by a product, and which is the subject of Chapter 7. A moregeneral suggestion to enhance the managerial relevance of managementaccounting was Simmonds’ (1981) concept of Strategic ManagementAccounting. It focused on the incorporation of marketing knowledge intomanagement accountants’ roles. A recent study by Roslender and Hart(2003) suggested that even though the term ‘strategic managementaccounting’ itself was not common in practice, on the whole, the managementaccountants whom they studied could be said to possess more strategic rolesnow than they had in the past.

Studies of the role of the management accountant in organisationalmanagement in different countries have found that commercially aware andactive management accountants distinguish commercial involvement fromthe ‘bean counter’ mentality of old (e.g. Friedman and Lyne, 1997). By ‘beancounting’ they meant an overriding concern with administration, recordkeeping, and elementary financial reporting work. In terms of Simon’s(1954) old distinction between the roles of the management accountant –namely, record keeping, attention directing and problem solving – thisimplies a shift in emphasis from the first to the last two.

Information technologyIf the calls for greater strategic relevance have been an important criticismthat led to conceptual changes within management accounting, an importantenabler of those changes has been the technical advances in informationtechnology. Contemporary accounting and information systems are significantlymore powerful and easier to operate than they were only a few years ago.Generally speaking, it is now easier to extract information from the systemsthat are used in organisations. Management accountants can offerinformation that is better tailored to answer the questions of managers. Insome cases, managers can now directly access information. As a consequence,less effort is needed on the part of management accountants to administerinformation systems and serve simply as mediators between an


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organisation’s management and its information systems. There is now thepotential for management accountants to become much more activelyinvolved in management decision-making.

That said, a questionnaire survey by Mouritsen (1996) about the accountingfunction in the 800 largest Danish firms suggested that reports of the‘disappearance of the bean counters’ are premature. This was one of thelargest surveys of accountants in industry with a response rate of almost 50per cent, yielding 370 usable responses. While it is true that many traditionalrecord keeping and administrative tasks can now be automated and consumeless working time of the management accountants, 50 per cent of respondentsranked general ledger work and internal controls as ‘important’ or ‘veryimportant’ aspects of accounting departments’ work. 56 per cent said thesame for record keeping, 63 per cent for work on financial accounts, and 54per cent for the layout of reports. Thus it would seem that the tasks ofinformation systems design, the structuring of data capture, watching overdata integrity, etc. are still regarded as central to the tasks of accountingdepartments. However, commercial awareness and involvement were alsorated highly. 46 per cent said that internal consulting was an important task,and about 75 per cent of respondents mentioned the importance ofbudgeting and variance analysis. In practice it would appear that goodcommercial advice depends on reliably and sensibly structured data. Bothdata and advice need to be regarded as priorities.

Activity

Read Mouritsen’s (1996) paper and list the five aspects of the work of the accountingdepartment that he found in his study. Then write one paragraph explaining if and howSimon’s three roles can be mapped on Mouritsen’s five aspects.

Enterprise Resource Planning Systems (ERP)In the discussion on the changing roles of management accountants oneneeds to keep in mind that new technology does not automatically mean less administrative work for management accountants. An interesting case inpoint are the implications for record keeping of Enterprise Resource PlanningSystems, also known as ERP. Your textbook discusses them on pages 688–9.ERP has been a key technological innovation of the past decade and manylarge companies have spent very large sums on buying ERP systems fromcompanies such as SAP, Oracle, PeopleSoft, and many others that aredescribed on websites such as: http://www.olcsoft.com/top%20ERP%20vendors.htm.

The basic idea of ERP was to replace the multiple stand-alone informationand accounting systems that had historically evolved in organisations withone all-encompassing information system that would minimise dataduplication and avoid the need for comparisons of the data between systems.With ERP, all the reports which needed to draw on, for example, the numberof units in inventory of a certain finished good, would find that informationin just one file, such that the information would not be held in any other file.So, for example, the material requirement planning systems, the productionplanning systems, the sales forecast systems, the customer order andshipping systems, and the various accounting reports that would use thisinventory number would all be fed the same number from the same file. Thismeans there would be no need for updating other systems when this numberchanged and there could consequently be no confusion due to time lagsbetween updates of different systems – a common problem within traditionalinformation technology environments.


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On the face of it ERP looked like a great example of how unrewardingmanual record keeping and administrative work could be reduced, freeing upthe time of management accountants to concentrate on giving commercialadvice to managers – sometimes referred to as ‘adding value’. While some ofthose expectations were met by ERP systems, they did, however, alsogenerate novel requirements for record keeping and data integrity work.Because they sought to represent all organisational processes in one systemin real time, ERP systems required many organisational members who usedto provide information on paper or on subsidiary electronic systems to enterinformation straight into the ERP system. Often this happened through theautomatic capture of their day-to-day work. However, that day-to-day workusually contains data errors, which can now enter the new ERP systemsunchecked. So, for example, a mistakenly-entered invoice amount may be feddirectly and immediately into budgets, material ordering systems, creditormanagement reports, etc. (Chapman and Chua, 2003). Data entry mistakescan have greater and more immediate impact in ERP systems. This hascreated new threats to organisational data integrity and new record keepingwork for management accountants.

Another important point to bear in mind in the discussion of themodernisation of management accounting is that traditional record keepingand modern business advice exist in parallel, and that there are potentialadvantages to this. A study by Ahrens and Chapman (2000) suggested thatrecord keeping work served as an important entry level task for juniormanagement accountants. Through such work they gained experience ofspecific organisational processes and the different ways in which they arerelated to accounting and organisational information systems moregenerally. Record keeping work can thus be useful experience on the basis ofwhich management accountants can, later in their career, adopt a moreadvisory role that is of greater commercial and strategic relevance. Givingcommercial and strategic advice sounds great as a task for juniormanagement accountants but in reality it is something that newcomers needto grow into over time. Entry level work lays the foundation for a moreimportant role later in the career.

Planning, controlling and ‘experience’The headings most commonly used to describe management accountants’work are planning, control and performance evaluation. The more senior themanagement accountants who are involved in any of those three roles themore experience of the detailed workings of the organisation they need. This is because they are interacting with senior line managers who areresponsible for large arrays of organisational activity and who tend to havethemselves complex insights into the workings of the organisation that theybuilt up over time. If, as a management accountant, you want to discusscommercial opportunities and strategic priorities with those managers, and be in a position to effectively contest their views of what is and is notrealistically possible for the organisation to achieve, you cannot do withoutexperience – gained either in your organisation or with a competitor, or,sometimes, in a different industry with similar characteristics.

Planning and control are sequential. Control (defined on page 836 of yourtextbook) only makes sense if actual results can be compared against abenchmark – the plan. In some organisations it makes sense to develop theplan largely as a continuation of historical performance. Other organisations


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prefer to question their planning assumptions more rigorously every timethey make a new plan, often because their operations and competitiveenvironment are subject to greater change.

The budgeting process and ‘beyond’ budgetingCentral to planning is the budgeting process, which is discussed in greaterdetail in Chapter 5. The budget is a financial plan of the organisationalfuture. It typically comprises a budget profit and loss account, a budgetbalance sheet, and a budget cash flow statement for the organisation as awhole as well as for its key sub-units, be they divisions, research laboratories,factories, sales organisations, etc. Organisations determine on a need-to-knowbasis how far down in the organisational hierarchy they want to draw upcomplete budget profit and loss statements for organisational sub-units.Sometimes a factory only budgets costs (especially when it is not involved inthe process of selling and has little influence over revenues), and a salesoffice only budgets revenues and the costs of running the office. It wouldoften not budget the costs of goods sold for the products that it sells, becausethose would be controlled by the factories that supply its products. In thiscase it would make sense for a larger entity, for example, a division thatcontrols both the sales office and the supplying factories, to budget profitsbecause this division is responsible for revenues and costs (and, by implication,profit and loss).

In the debate around strategic management accounting, budgeting has beencriticised for being too administratively oriented, not producing enoughcommercially-relevant information, and being too time consuming. In practice,budgeting processes that take up nine months prior to the financial year forwhich they are meant are not unusual. Typically, it takes a long time to collectcost and revenue estimates from numerous budget holders, co-ordinate them,and, finally, communicate a coherent plan.

Budgeting has also been criticised for inducing a culture of complacency withrespect to performance targets. Managers whose departments perform wellagainst budget may not be willing to push their subordinates to achievebetter than budgeted results because, firstly, budgets tend to rewardfulfilment of expectations, not overfulfilment, and, secondly, overfulfilmentmay lead to heightened expectations in subsequent budgeting rounds.Managers may thus be tempted to initially hide the effects of processimprovements and other cost savings and only use them to improve thefinancial results of their units gradually – as and when future budgetsdemand such improvements.

At the heart of the detection of organisational slack and similar problems lie the ways in which budgets are used and the kinds of expectationsorganisational members have of them. A diverse group of organisations thathave since 1972 come together in the Consortium for Advanced ManufacturingInternational (CAM-I, see web site http://www.cam-i.org/) has formed asub-committee, known as the Beyond Budgeting Round Table (www.bbrt.org/),which is specifically concerned with improving the budgeting process. TheRound Table is exploring ways of using budgets more flexibly in ways thatalleviate budgets’ performance reducing effects, for example, by introducing‘stretch targets’, and finding ways of overcoming the gaming and creation ofslack that often occurs in the process of agreeing performance targets. A commentary in the British newspaper The Observer provides an easily-understandable overview over some other key problems with budgets andmakes reference to the Beyond Budgeting Round Table.(http://observer.guardian.co.uk/business/story/0,6903,1174315,00.html).


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Activity

Visit www.bbrt.org and have a good look around the web site, then rank what youregard as the 10 most important criticisms of traditional budgeting practice. Whichcriticisms would you regard as unimportant?

Decision-making and organisational goalsUnderlying the difficulties of detecting organisational slack, or even decidingwhat counts as organisational slack, is the definition of organisational goals.Especially when you deal with matters of organisational strategy, onemanager’s slack can be another manager’s strategic resource. How muchmoney should be budgeted for activities of strategic relevance, such asresearch and development (R&D), advertising, sales promotion, processimprovement, the speed of logistics, etc.? The key task in managementaccounting is to relate budgets to organisational tasks in ways that enhancethe likelihood that the organisation meets its strategic objectives.

From an economics point of view, those objectives are easily defined. Theorganisation should maximise its cash flows over its lifetime. Discountingthose cash flows to the present gives the economic value of the organisation,or the price that the organisation’s owners can demand when they sell it.From an economic point of view, therefore, management accounting isconcerned with owners’ wealth maximisation or OWM, which we will discussin more detail in the next chapter.

StakeholdersHowever, owners are not the only organisational stakeholders. The socialenvironment of an organisation typically includes employees, customers,neighbours, and suppliers, to name but a few. Not-for-profit organisationsmay, moreover, need to consider much wider concerns. For example,universities can be held accountable by students, parents and the widerscientific community. Hospitals are subject to the concerns of patients, theirrelatives, the professional associations of doctors, the government’s drugregulators, etc.

Even when the number of stakeholders is small and there is agreement thatfinancial success is an important criterion for organisational performance,there may exist significant differences of opinion as to what concrete actionsto take to achieve financial success. Production engineers tend to havedifferent solutions to organisational problems from marketing managers.Both groups have incentives to depict particular organisational problems inways that suggest a solution that is designed and implemented by them, thusincreasing their own influence in the organisation.

A behavioural perspective on the organisational uses of managementaccounting would take such possibilities into account. An important pointfrom a behavioural standpoint is that, strictly speaking, organisations haveno goals at all – only individuals have. The expression ‘organisational goal’could then be taken as a shorthand for some sort of aggregate of the goals ofindividual organisational members. Economists would regard OWM as themeasure of aggregate organisational goals. Behaviourists, by contrast, allowconflicting goals within the organisation. What gets talked about or writtendown as ‘the goals of the organisation’ or the ‘organisational missionstatement’ would then appear as a temporary settlement of ongoing disputethat depends on the shifting powers of organisational sub-groups withconflicting (and presumably changing) interests.


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The implications for the role of management accounting in decision-makingare profound. There would be no a priori normatively ‘correct’ answerbecause different coalitions within the organisation would prefer differenttypes of outcomes that cannot be clearly ranked on a scale of payoffs. Theresolution of potential conflict becomes a key task of management.Management accounting often carries great weight in the formulation oforganisational objectives and the weighing of alternative courses of action.One can therefore expect senior management as well as the differentorganisational coalitions to attempt to use information selectively to presentthe management accounting information most suitable for their causes.

Sample examination questionTo what extent do you regard the current concerns with the strategicrelevance of management accounting as technologically driven?

Suggestions for answering the sample examinationquestion

This question can be answered in many different ways. One possibility is tostart by making a list of technological reasons for the emergence of strategicmanagement accounting. Looking at those reasons more closely, are you surethat all of them are purely technological? Why were the technologiesintroduced? Now you could move on to explaining what other influencescontributed to the emergence of, and demand for, strategic managementaccounting.

A different way of answering the question would be to distinguish betweenenablers of strategic management accounting and demand factors. Some ofthe enablers could be broadly labelled as ‘technological’, but were thereperhaps other enablers, too? And was the demand for strategic managementaccounting purely driven by considerations of strategy making?


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Chapter 2: Decision-making

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Essential readingHorngren, Charles T., Srikant M. Datar and George Foster Cost accounting:

a managerial emphasis. (Prentice Hall Publishing, 2003) eleventh edition(international) [ISBN 013099619X] Chapter 11 (without appendix on linearprogramming) and Chapter 21.

Further readingHopper, T., T. Koga and J. Goto ‘Cost accounting in small and medium sized

Japanese companies: an exploratory study’, Accounting & Business Research(Winter 1999) Vol. 30, Issue 1: 73–87.

Verdaasdonk, P. and M. Wouters ‘A generic accounting model to supportoperations management decisions’, Production Planning & Control(September 2001) Vol. 12 Issue 6: 605–21.

AimsThis chapter covers the economic foundations of management accountingtheory and practice. Specifically, it suggests that management accountingought to help in decision-making; indeed, that the support of decision-makingprocesses is its main purpose. To highlight some of the most importantaspects of decision-making, this chapter introduces you to different levelsand stages of decision-making. The chapter also explains the uses of theconcept of uncertainty and derives from this the concept of the value ofinformation and how it can be calculated. Throughout, the chapteremphasises the centrality of the concepts of relevant information andrelevant costs for the unit as a whole and for the examination.

Learning outcomesAfter reading this chapter and the essential reading, you should be able to:

• distinguish different types of decision-making

• define the terms ‘opportunity cost’ and ‘relevant information’

• conduct long-term project appraisals using relevant information

• calculate the value of information under uncertainty.

Levels of decision-makingThe American Accounting Association defined accounting as:

‘[...] the process of identifying, measuring, and communicatingeconomic information to permit informed judgements anddecision by users of information.’

This means that accounting plays a role at several levels and in several stagesof organisational processes:

1. Setting the objectives of the organisation.

2. Determining the strategy for achieving the organisation’s objectives,given the resources available to the organisation, and the environmentin which it operates.

3. Determining plans, both long-range and short-range (such as theannual budget), aimed at achieving the organisation’s strategic goals.

4. Controlling the organisation by comparing actual performance againstthat planned, and by reviewing and modifying the organisation’s plansin the light of experience.

5. Communicating the organisation’s plans and their outcome.Communication is maybe the most important process in whichmanagement accounting is involved because it is not only related tospreading the objectives of new plans; more significantly, the languagewhich is used to deal with processes can have wide-ranging effects ontheir outcomes. For example, if you set objectives and strategies withfinancial performance measures in mind, you signal differentpriorities from someone who plans with reference to, say, newtechnologies and market share.

Management accounting’s main role in these processes is the provision ofinformation to assist in decision-making. Decisions arise at three levels:strategic planning, management control and operational control. The level of strategic planning has perhaps the greatest long-term significance for theorganisation, and decisions at this level are likely to be crucial for theorganisation’s survival and growth. Such decisions will relate to theorganisation’s overall goals and the long-term strategy for achieving thesegoals. Strategic decisions will be made relatively rarely and after extensiveconsideration. Management control is a more frequent and regular process,and may well follow a weekly, monthly, quarterly or, at most, annual cycle. It isconcerned with the implementation of the organisation’s strategic plan, byensuring that the necessary resources have been obtained and are being usedefficiently and effectively. Operational control focuses on specific tasks as theyare carried out, trying to ensure that this happens efficiently and effectively.

As an example of the different levels, consider an organisation’smanufacturing operations.

At the strategic level, the organisation will determine matters such as:

a. whether to adopt a high technology or a low technology productionmethod

b. whether to manufacture large volumes of a small range of products orsmaller volumes of a larger product range

c. whether to concentrate production geographically or to disperse it.

The decisions taken at the strategic level will imply certain detailed plans forthe organisation’s manufacturing. Therefore, at the management controllevel, decisions will need to be made as to the resources required to put thestrategic manufacturing plan into operation, for example, how much ofwhich materials to use, and the usage of such materials will need to bemonitored and controlled periodically to ensure that they are being usedefficiently. This might involve the setting of quality criteria for decidingwhether products have been satisfactorily manufactured.

At the level of operational control, decisions will be made about particularbatches of goods produced, for example, whether they meet the criteria ofquality set at the management control level.

The importance of cash flowsIn decision-making we distinguish typically between the short and the longterm. In short-term decision-making, we can usually ignore the time value ofmoney, and therefore avoid the need to discount cash flows. Nonetheless,


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in making short-term decisions, we still need to focus on the cash flowsinvolved in our decisions, and we use the goal of owners’ wealthmaximisation to argue that we should assess alternative actions in terms ofthe amount by which they are expected to change the future net cash flowsof the organisation.

When we consider any action, we should therefore attempt to identify how,and by how much, the organisation’s cash balances will change as a result oftaking the action. Cash inflows will arise from revenues generated by sellinggoods and providing services, from interest and dividends received, from taxrefunds and subsidies, and from the sale of assets. Cash outflows will arisefrom purchasing the resources (goods and services, people and machines)needed to undertake the course of action. For short-term decision-making,we need some baseline against which we can identify the cash flows thatchange as the result of taking a particular course of action. The baseline canbe defined as the consequence of taking an alternative decision. Given thebaseline, we may then attempt to estimate the changes in cash flow (theincremental cash flows) that arise from the course of action beingconsidered. The baseline we normally assume is the total net cash flowsassociated with the best available alternative to the action underconsideration. This baseline is chosen because we assume that the actions ofthe organisation are determined ‘rationally’, and this implies that theorganisation will always select the best available alternative if the particularaction under consideration is unavailable.

Activity

Read pages 379 (bottom of page)–380 and the ‘concepts in action’ box on page 381 ofyour textbook, and write a definition of the term ‘opportunity cost’ in one sentence.

Opportunity costsWithin this framework, we may define cost as any decrease in wealth(measured in cash terms) brought about by a decision to use a particularresource or set of resources. By measuring the decrease in wealth byreference to the next best alternative, we are effectively using the economicconcept of opportunity cost. Economists define opportunity cost as thebenefits foregone by not adopting the next best alternative, where ‘benefits’can relate to any economic benefit, not only cash.

Examples of opportunity cost are more easily presented as situations ofchoice under resource constraint. Suppose you have an amount of moneyfree to spend at the end of the month. You have been looking forward to aholiday trip for a long time, but now realise that your house needs somerepair work fairly urgently. The opportunity cost of going on holiday wouldbe to delay the house repair with all the problems to which this course ofaction may give rise. The opportunity cost of having the repairs carried outwould be to forego the enjoyment of the holiday. The example shows thatyour personal opportunity costs can be very subjective, depending on theutility of the benefits which you forego. However, for short-term decision-making purposes, the most relevant economic benefits are likely to beexpressible in terms of cash.

Activity

What opportunity costs did you incur by enrolling on the University of London’s ExternalProgramme?


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The concept of relevant costs and revenuesDecision-relevant costs (and benefits) have three essential characteristics.Although what follows concentrates on costs, analogous arguments apply for revenues.

1. Only cash costs are relevant. From an economic point of view, anythingthat does not bring about a cash change to the organisation (immediateor future) is irrelevant to the decision. It is important to emphasise thecash basis for decision-making, as several items are treated as costs for financial accounting purposes (and, indeed, in certain aspects ofmanagement accounting) that are not directly associated with present or future cash changes. The classic example is depreciation. This is anallocation of the cost of a fixed asset (such as a machine) over the periodsduring which the asset is used or on some other basis associated with theusage of the asset. Depreciation is not itself a cash outflow (the cashoutflow was the original cost of the asset) and hence is ignored in cash-based decision-making. Note that, while only cash costs are relevant, we must take into account all cash costs, both direct and indirect. It issometimes difficult to identify and quantify all the indirect cash costs. For example, if the organisation chooses a particular action, perhaps tosell a certain type of product, this might make customers more likely to dobusiness with the organisation in the future; but how is the cash impact ofthis to be estimated? Nonetheless, all cash impacts should be includedwhere possible in the decision-making process.

2. Only differential cash costs are relevant. This flows from our baselineof the next best alternative: any cash costs that would be incurredwhether or not the course of action is taken should be ignored, as theywould be incurred under the next best alternative and are thus alreadyreflected in the baseline. Some care is needed in identifying the costs thatare genuinely differential in the context of a particular decision, especiallywhere following a particular course of action would use resources thatwould otherwise be allocated to the next best alternative. Where theaction under consideration and the next best alternative are mutuallyexclusive, and resources already contracted for would be used either forthe action under consideration or for the next best alternative action,then the cost of those resources cannot be regarded as differential andshould be ignored. An example of this would be an airline’s decision toprovide passenger services from Hong Kong to one of two possible newlocations where ground staff handling additional check-ins and baggagehave already been contracted.

3. Only future cash costs are relevant. The decision can only change futurecash flows, it cannot act retrospectively to change cash flows alreadyincurred. This could either have been the actual spending of cash (past costs) or the incurring of an obligation to spend cash that cannot be avoided (committed costs).

The rule is therefore: for making decisions, only differential future cashflows should be considered. This principle implies that the costs taken intoconsideration for decision-making purposes, and the amounts at which thosecosts are measured, will often be quite different from the costs and amountsused in financial accounting statements. By including only differential costs,we ignore those costs not changed by the decision. The costs actually affectedby the decision will very much depend on the scope of the decision itself. For very short-term decisions, most resources to be used will already be


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contracted for, so that the costs that will change as a result of the decisionwill relate to relatively few items. For example, it may be impossible in thevery short term for a business to increase (or decrease) its workforce and itsequipment. If the cost of labour and machinery is effectively fixed, so that theonly cost that could change is that relating to materials, it may well be rationalto accept a contract to manufacture and sell goods whose selling priceexceeds the cost of materials alone. This may be advantageous even thoughthe selling price is significantly less than the accounting cost including wagesand depreciation of equipment, if the next best alternative leaves theresources idle that would otherwise be used to fulfil this contract. As thedecision horizon lengthens, fewer costs become unavoidable, and morebecome relevant. At the extreme, all future costs become relevant, but pastcosts will always remain irrelevant.

Activity

A customer offers to buy from your company 100 electrical engines of a standard designbut with a slight modification to its electricity intake. Both the workers and thesupervisors of your factory are paid fixed monthly salaries. You expect to have somespare production capacity over the coming weeks. The material cost of one engine isestimated to be $500. To manufacture the altered design specified in the order, youwould have to modify some of your production machinery. An engineer would have towork on it for eight hours and use materials worth $3,000. The customer offers to pay$650 per engine. Your company’s list price for the standard design is $880. What furtherinformation do you require to decide whether you should accept the offer?

Identifying relevant costs and revenuesWhat general factors are involved in applying the opportunity cost concept toa concrete decision? The first stage is to identify the resources required forthe action under consideration and incorporate them in alternative budgets.The resources will typically include materials, labour, machines and otherservices. We shall see in Chapter 4 that these are the basic elements of overallcost. Having identified the resources required, it is then necessary to find outwhether or not the organisation already has each resource in its control. Forexample, materials to be used might already form part of the organisation’sinventory, labour needed to carry out the action under consideration mightalready be employed, and so on.

Purchased resources If the resource is not already controlled by the organisation, then it must bepurchased, and the measure of the cost to the organisation is the currentpurchase price of the resource. For many resources, this current price providesa suitable measure with no need to make adjustments. Problems arise,however, when it is considered appropriate to acquire some resource to undertake a particular action, and the resource in question will provideservices over and above those needed for the action under consideration. For example, in order to accept a contract to manufacture a particularproduct, it might be necessary to acquire the services of a special machine.The organisation might simply hire the machine for the contract, in whichcase the cost of the machine is the hire charge. But what if it is decided thatthe machine should be bought outright, and the organisation intends to usethe machine on other contracts, as well as the one under consideration? Inthese circumstances, to assign the whole cost of the machine to the particularcontract currently under consideration would be misleading, as we wouldeffectively be ‘overcharging’ this contract for the machine and ‘undercharging’


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other contracts. It is necessary in such circumstances to somehow allocatethe cost of the machine to the contracts that will benefit from its use. Varioustechniques for performing such an allocation have developed, but the methodsthat are considered to come closest to a rational economic allocation of costare too advanced to address in this subject guide. It is important to realisethat the problem exists, and that the current replacement price for a resourcethat must be acquired for an action is not always the straightforwardmeasure of opportunity cost.

Resources already under the organisation’s controlWhat if the organisation already controls the resource? In this case, we mustconsider how the resource would be used if the organisation were to rejectthe action under consideration and were to adopt the next best use for theresource. By undertaking the action, the next best use cannot be undertakenwith that particular resource. If there is in fact no next best use for theresource, then the organisation bears no economic cost in using the resourcefor the action under consideration. This might be the case where the actionunder consideration makes use of the labour services of employees whowould otherwise be paid for doing nothing. However, for most resources,there will be an alternative use. Bear in mind that the next best use for theresource could be to sell it immediately. If the resource is used for the actionunder consideration, the sales revenue that would otherwise be received willhave to be sacrificed. In these circumstances, the opportunity cost of theresource is the net realisable value foregone of the resource.

If there is an alternative use for the resource, then it will be necessary, if the resource is assigned to the action under consideration, to replace theresource to enable the next best alternative to be carried out. Materials thatwould otherwise be used elsewhere will have to be replaced, and theopportunity cost is therefore the replacement cost of the materials. If labouris transferred from other jobs, it will be necessary to employ replacementlabour, so the opportunity cost is the pay due to the replacement workers. So for resources that would have to be replaced, the measure of opportunitycost is current replacement cost.

Activity

Read the section ‘Insourcing-versus-outsourcing and make-versus-buy decisions’ in yourtextbook (pages 375–377) and work through example 2.

Decision-making and current replacement costYou should note carefully that, for decision-making purposes, the originalhistorical cost of the resources is not relevant, only current replacement costand net realisable value. This reflects the forward-looking nature of decision-making. What has already happened is no longer relevant for decisions. Forfinancial accounting purposes, however, historical costs are still important inpractice, because most financial statements are drawn up using the HistoricalCost Convention (i.e. using the actual costs at the time they were incurred).A common criticism of this accounting convention is that the costs it reportsare not relevant for decision-making. You should also note that costs allocated to a particular resource or overall opportunity because of a financial accountingconvention or a management decision are normally irrelevant within thecontext of opportunity costs. Thus depreciation (as a financial accountingallocation) and apportioned general overheads (as a management accountingallocation – see Chapter 4 of this subject guide) are not relevant. However,specific changes in cash flows, such as an incremental expenditure onoverhead services, are relevant.


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Activity

A department store considers closing one of its branches. Which of the following list isrelevant information?

Information on… Yes No

Hourly wages for sales assistants

Rent of property

Premium for fire insurance(one policy for the whole company)

Local authority taxes

Sales revenue

Bulk buy discount which the company negotiates with suppliers

Renovations of premises which were carried out last year

Head office overheads which are allocated to branches based on sales revenue

Salary of branch manager

Trade union relationships

Comparing cash flows in the long runFuture differential cash flows are relevant in the short and the long run. Inthe long run you need, however, to be aware of what is known as the timevalue of money. The time value of money is the result of the existence ofinvestment, lending and borrowing opportunities and of people’s preferencefor immediate rather than future uses of money. The time value of moneyconcept recognises that holding on to money, rather than using it nowpresents an opportunity cost in itself. By holding on to money you foregoprofitable investment opportunities. At a minimum, you could, for example,deposit money in a savings account and receive interest (or, if receivinginterest is forbidden, lend the money for a fee or for a profit share). Theinterest rate on the capital markets therefore determines the opportunitycost, also known as the cost of capital.

Management accounting uses the cost of capital (or ‘i’ for rate of interest) to express future cash receipts and payments in terms of their present value.This is necessary because the receipt of $100 in a year’s time is worth less toyou than the receipt of £100 now.

Activity

Before showing you the relevant equations, see if you can understand the principle ofcomparing cash flows at different points in time intuitively, through an example. Supposeyou are selling a piece of land today. The selling price is $1,000. As you sign the contract, thebuyer offers you to pay you $1,100 in a year’s time instead of $1,000 now. Assume thati, the cost of lending and borrowing (you can also think about it as the cost of capital) is9 per cent per year (also often expressed as ‘p.a.’ = per annum). Would you rather bepaid now or in one year? Hint: compare the difference between the cash flow now andin one year with the opportunity cost of delaying payment (i.e. how much do you ‘lose’by accepting payment in one year’s time?)


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An individual will be indifferent between receiving an amount of capital Cnow and C(1+i)n in n years’ time because he or she could lend C (the $1,000for which the land is sold) at the market rate of interest i (which would be$1,000 x 9 per cent for the year). For this to hold, we need to assume perfectcapital markets with identical lending and borrowing rates, no transactioncosts and no single individual able to affect the equilibrium interest rate bythe amounts he or she chooses to lend or borrow.

Note that the reason why an individual is indifferent to an amount paid nowand a greater amount paid in the future is not the inflation rate. Theexamples that we use in this subject guide ignore inflation. The reason is thatan amount paid now contains opportunities for investment. That makes itmore valuable than the same amount paid in the future. The difference, C x i,is the opportunity cost of deferring receipt of C by one year.

DiscountingCalculating the present value of a future cash flow is usually called discounting.The present value approach allows us to reduce all the various cash flowsassociated with a project to one figure, the net present value (NPV). Wecalculate the discounted present values of the various cash flows associatedwith the project, and add them up (remembering that cash inflows areusually taken to be positive and cash outflows negative). The total we arriveat is the NPV of the project. For example, assume a project that involves anoutflow of £5,000 immediately, and that will produce inflows of £1,000 atthe end of the first year, £2,000 at the end of the second year and £4,000 atthe end of the third year. The NPV of the project, assuming an interest rate of10 per cent (i=0.1) is:

−Cash outflow + [cash inflow year 1/(1+i)1] + [CF year 2/(1+i)2] + [CFyear 3/(1+i)3]

= −5000 + 1000/1.1 + 2000/1.21 + 4000/1.33

= −5000 + 909 + 1653 + 3005

= 567.

The actual calculation of NPVs is often made more straightforward by the useof discounting tables, which is explained in your textbook.

The net present value decision rule The NPV rule simply states that a business should accept any project thatyields an NPV that is positive, as acceptance of such projects will increase (or, in the case of a zero NPV project, not decrease) the value of the business.The NPV of a project is effectively its value in cash terms at the time ofdecision, that is, the NPV is the amount of cash that the business would beindifferent between accepting immediately and undertaking the project, withits associated cash flows. The business could in principle borrow not only thecash needed to invest in the project but also the NPV of the project; it couldthen pay the NPV to the owners of the business, and be able (just!) to repayits loan and the related interest out of the cash inflows from the project, solong as the interest rate of the loan is equal to the rate of discount used todetermine the NPV.

In practice, there are three stages in a project appraisal:

1. estimate the date and amount of the relevant cash inflows and outflowsassociated with the project

2. discount the cash flows at an appropriate discount rate


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3. assess the project using the NPV rule.

The relevant cash flows are those that would change as a result of acceptingthe project. Some care is needed here, as it is necessary to include not onlythe initial cost of the project and any ultimate realisable value but also anyrelevant operating cash receipts and payments and any indirect benefits andcosts such as capital investment grants, tax allowances and tax payments onoperating profits that would arise from accepting the project. If theacceptance of the project would involve the commitment of working capital,which will require cash to fund it, then this should also be taken into accountin the appraisal. Conversely, it is important not to confuse the appraisal ofthe investment decision by including cash flows relating to the way in whichthe project is to be financed (such as interest charges). One important pointto note is that, because we are interested in cash flows, accountingallocations such as depreciation, which do not represent cash flows, shouldnot be taken into account in calculating NPV. Thus the NPV should reflect thenet cash flow from year to year associated with the project and not theaccounting profit.

Activity

Now read the section ‘Discounted cash flow’ (pages 720–722) in your textbook, payingparticular attention to exhibit 21-2.

Making estimates for project appraisals If we are appraising a project whose associated cash flows are known andcertain, the calculation of NPV is a fairly mechanical exercise in identifyingthe dates and amounts of the various relevant cash flows and performing theappropriate discounting exercise. However, where the cash flows areuncertain, they must be estimated, and this is reflected in appraisals inpractice either by calculating a range of NPVs, usually for the worst likelycash flows, the best likely cash flows, and some average value of cash flows,or by calculating expected cash flows using probability estimates (sometimescalled certainty equivalents) and discounting these. There are problems withthe latter approach, as it is strictly only valid where the cash flows forecast inany one year are independent of those forecast in any other year. For manyprojects, however, there is likely to be a strong association between the levelsof cash flow achieved from one year to another. Calculation of a range ofNPVs (and perhaps using these together with overall probability estimates tocalculate an expected NPV for the project) overcomes this problem.

The second stage of the appraisal involves the choice of an appropriatediscount rate. In a certain world, given perfect capital markets, this willsimply be the equilibrium market rate of interest. In an uncertain world,however, matters are more complicated, and it is usual for a business to useits cost of capital – the rate of interest it has to pay for its long-term finance –for discounting purposes. Calculating the cost of capital is a difficultprocedure in practice. First of all, it is necessary to determine what should beincluded as ‘capital’. This is usually taken as the long-term finance of thebusiness, and is classified into debt capital (long-term loans) and equitycapital (shares or other ownership interests). It is then necessary to identifythe cost (usually measured as the rate of return) of the various componentsof capital. Here it is important to note that the true rate of return must beused, not the nominal rate of return offered by a component of capital. Forexample, the dividend paid on an equity share might be expressed as 10 per


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cent of the nominal value of the share, but the true return is given byexpressing the monetary amount of the dividend as a percentage of thecurrent market value of the share.

Appreciations in share price are another source of returns to the shareholder,but they are more difficult to incorporate in the cost of capital. They are notpaid in cash by the company, but they can be seen as an opportunity cost. Ifthe company had not already issued a share in the past, it could issue it now(after its share price went up) and obtain more money from the buyer of thenewly-issued share. Share price appreciations for all shares should beexpressed as a percentage of the market value of the company because theyconstitute an opportunity cost of having used shares to finance the companyin the past and not, say, bonds.

Another problem in estimating the cost of a component of capital is decidingwhether to use a pre-tax or post-tax rate of return. Certain types of capitalare often taxed differently from other types, and the tax treatment dependson the tax laws of the country in which the business operates. Usually,however, interest on debt capital is deductible from the profits of the businessbefore they are assessed to whatever tax is levied on profits, while dividendsand other payments to owners are not deductible. If after-tax rates of returnare used in calculating the NPV of a project, the after-tax cash flows shouldbe discounted.

The final problem comes in combining the rates of return for the variouscomponents of capital into one overall cost of capital (the weighted averagecost of capital – WACC). The rates of return for the various componentsshould be weighted by the market values of the components (not their bookvalues), in the same way that the rates of return are themselves based onmarket values. One important point to note is that care must be taken inappraising projects which it is intended will be financed out of a new issue of a particular type of capital. It is sometimes suggested that, in thesecircumstances, the appropriate cost of capital to use is the cost of the newspecific finance, the marginal cost of capital. This would indeed be correct ifthe new issue of capital had no impact on the overall capital structure of thebusiness, but this is seldom the case. For example, if the business were tochoose to finance the project by debt capital (the cost of which is usually lessthan WACC), this would increase the ‘gearing’ (i.e. the relative importance ofloans in the overall capital structure; this is sometimes called the ‘leverage’)of the business as a whole. The greater the gearing of a company, the morerisky becomes its equity capital, and holders of equity capital would require a greater return than before to compensate them for the additional risk thatthey are forced to bear. The true marginal cost of capital should incorporatenot only the direct cost of the incremental capital issued to finance the newproject but also any indirect costs arising in respect of other components ofcapital. I include the ideas mentioned in this paragraph because you will findthem useful for making connections for your study of Finance. They are notexamined as part of Management accounting.

Activity

You receive a proposal to invest in energy-saving light bulbs in your factory. How do youdetermine the relevant costs? Outline the decision-making process.


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Problems with the opportunity cost conceptCentral to the decision-making concept is the notion of opportunity costs.You should understand several problems of the opportunity cost approach.

1. The approach assumes that decision-makers are able to identify the nextbest action in any given circumstances. But this might imply an evaluationand ranking of all conceivable alternatives. In practice, the examinationof alternative actions is likely to be limited to those immediately obviousto the decision-maker. For example, it might be assumed by the decision-maker that materials already in inventory will be replaced, even thoughthe actual next best use of the materials is left unspecified.

2. The determination of opportunity cost in a complex organisation becomescomplicated, as it is not always obvious at which level the cash changescaused by the decision should be analysed. For example, the decisionmight be analysed at the level of an operating division of the organisation,so that only those cash changes that may be observed at divisional levelare identified. The problem with this from the perspective of theorganisation as a whole is that, first, indirect cash changes elsewhere inthe organisation might be omitted and, secondly, many of the cashchanges identified at divisional level will reflect cash transfers with otherdivisions of the organisation, so that the net cash flow for theorganisation as a whole is zero. This might lead to the taking of decisionsthat are optimal for the division in isolation but sub-optimal for theorganisation as a whole. (We return to this problem in Chapter 9.)

3. Opportunity costs are forward looking, but in practice they are oftenestimated on the basis of past experience of costs and revenues associatedwith similar actions; however, it is not always straightforward to estimatefuture cash flows from past data.

4. Traditional accountants often have difficulty in understanding andaccepting the basis of opportunity costs, particularly the treatment of pastcosts. To the traditional accountant, past costs are actual costs that havebeen incurred, so how can they be irrelevant? Moreover, much traditionalmanagement accounting has emphasised the need to ‘recover’ costs thathave been incurred, through the earning of sales revenues. These attitudeshave some validity, in that the costs that have already been incurred arelikely to determine the range of possible future actions for the organisation,allowing some options and ruling out others. Also, for the organisation tosurvive in the long run, it is necessary for revenues to cover costs. In theshort term, however, the relevant costs to be covered by revenues are notthose that the traditional management accountant calculates but ratherthe opportunity costs.

5. The opportunity cost concept implies a model of rational decision-making,yet it is not obvious that this model is an appropriate description of realitywithin organisations. People working in organisations have many otherconcerns besides rational decision-making.

Activity

What might those other concerns be?


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Uncertainty and relevant informationThose other concerns notwithstanding, the assumption of rational decision-making enables us to calculate the value of information under uncertainty.Take Yassin, for example, who sells cheap umbrellas outside an undergroundtrain station on Singapore’s Orchard Road. On rainy days, he sells manyumbrellas to people who have forgotten theirs and do not want to get wet.On sunny days, no one buys umbrellas, and Yassin would prefer to stay athome and work in his garden. Every day, Yassin must decide whether to go towork or stay at home. If he stays at home and the day is rainy, Yassin loses aday’s sales, but if the day is fine, he can enjoy his garden. If he goes to workand the day is rainy, Yassin can sell his umbrellas, but if the day is fine, hemakes no sales, has to pay his fares to central Singapore, and wastes the day.

Activity

What is Yassin’s opportunity cost of travelling from his house in the suburbs to the centreof Singapore to sell umbrellas?

We may express the possibilities for Yassin in terms of the ‘satisfaction’ thathe gains from the various outcomes. (These ‘satisfaction’ values are arbitrary,for the purposes of illustration, and the units are unspecified.) Have a look atthe following table.

Table 2.1: Example of outcomes from decision under uncertainty

State of weather

Fine Rainy

Yassin’s Stay at home +10 0action Go to work −10 +30

From the table, you can see that, if it is going to rain, Yassin would prefer togo to work. If it is going to be fine, Yassin would prefer to stay at home.Information about the likely state of the weather would help Yassin indeciding what action he should take at the start of the day. Can you imaginehow valuable that information would be for Yassin? What is at stake? Whatdoes he stand to gain or lose from not knowing whether it will rain or not?

Characteristics of useful informationLet us now examine the characteristics of the information that Yassin needs.

1. Relevance. The crucial factor for Yassin’s decision is the state of theweather, so only information about the weather will be relevant. Factssuch as yesterday’s football scores will be irrelevant, and would notconstitute relevant information for Yassin’s decision.

2. Significance. Yassin wants information about today’s weather inSingapore. Information about today’s weather in New York or yesterday’sweather in Singapore are unlikely to be significant. (They might besignificant if they are related in some way to today’s weather, so in certaincircumstances information about yesterday’s weather will be significant ifit is a good predictor of today’s weather.)

3. Reliability. Yassin will place greater value on weather forecasts that givegood predictions than on those that do not. A weather forecaster who isbiased in some way (perhaps he or she is an optimist, and tends to predictbetter weather on average than actually occurs) will be less reliable than


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one who is free from bias. Weather forecasts based on forecastingprocedures that can be verified are likely to be more reliable than thosebased on unverifiable procedures.

4. Understandability. Yassin simply wants a forecast of whether the day willbe rainy or fine. A complicated forecast, complete with obscure charts anddiagrams, might not be of much use to Yassin, particularly if he needs tospend a lot of time trying to understand what the complicated forecast is saying.

5. Sufficiency. Yassin wants a forecast covering all the day, so a forecastrelating only to the morning would be insufficient. Similarly, Yassin wantsa clear-cut forecast implying either that it will be rainy or that it will befine: sometimes weather forecasters try to cover both alternatives in a vague statement, but this would not tell Yassin anything.

6. Practicality. Yassin wants the forecast at the time he has to make thedecision, so a ‘forecast’ available to Yassin only at the end of the daywould be too late. It would have no value for Yassin.

In Singapore, weather forecasts are usually ‘free’: they are obtained fromradio, television or newspapers and not paid for separately. If Yassin wasprepared to pay for a weather forecast, how much do you think he would beprepared to pay for it? In general terms, it would have to be no more than thevalue which the information has for him. From this example, we can see thatnot every fact represents information for a particular decision. Facts or dataare usually regarded as information only if they are likely to change theexpectations of the person receiving them. Moreover, information will besignificant only if it is likely to change the outcome of the decision underconsideration. In some circumstances, the outcome of a particular choice ofaction might be such as to dominate all other alternative choices, whatevermight be the true data about unknown matters. (For example, if Yassin wereable to sell his umbrellas regardless of the weather, he would decide to go towork every day.) In such cases, data about the unknown matters will notchange the dominant action implied by the decision. But where facts willmake a difference to the action chosen, we will call those facts ‘information’,and the information has value. We can often quantify the value ofinformation, as we do in the section below. Conversely, information will oftenhave a cost, and it is not sensible to pay more for information than it is worth.

Activity

Read the Appendix to Chapter 3 ‘Decision models and uncertainty’ on pages 80–82 ofyour textbook and solve problem 3-47 on page 92.

Objective and subjective probabilitiesOn the assumption that the weather in the future will be similar to that in thepast, historic frequencies of rain and sunshine may be used to estimate theprobabilities of the weather in the future. Our records might show rain on sixdays out of every 10. We could use this frequency to estimate the probabilityof rain as 0.6 or 60 per cent or 3/5. Where probabilities are derived fromfrequencies, we often describe them as objective probabilities. While manymanagement decisions arise in circumstances where the past is a good guideto the future, it is often necessary to take decisions where the future isuncertain but there is no past data on which to base estimates of futureprobabilities. In such cases, involving ‘one off’ decisions, it is impossible to laydown rules for estimating future probabilities, and we often talk of thedecision-maker using subjective probabilities in his or her decision-makingprocess.


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Expected valueThe expected value of an outcome is found by adding together the value ofeach possible outcome multiplied by the probability that the outcome willoccur. For example, suppose that we estimate that a project will earn a profitof £1,000 with probability 0.3, £2,000 with probability 0.5, and £3,000 withprobability 0.2. Then the expected value of the profit is:

(£1,000 x 0.3) + (£2,000 x 0.5) + (£3,000 x 0.2) = £1,900.

You should note that the expected value is not necessarily equal to one of thepossible outcomes. It measures the average profit that would be expected ifthe project were to be repeated many times under the same conditions.

Returning to the example of Yassin, there are two possible states of theworld: ‘fine’ and ‘rainy’. Suppose that our decision-maker, Yassin, believesthat the probability that it will be fine is 0.4 and that it will be rainy is 0.6.(Note that these probabilities add up to 1.0, as it is certain that one of thetwo states will occur.) We can work out the expected value of each of Yassin’spossible actions in terms of units of ‘satisfaction’:

stay at home (+10 x 0.4) + (0 x 0.6) = 4

go to work (−10 x 0.4) + (+30 x 0.6) = 14.

Yassin maximises the expected value of his satisfaction by going to workevery day.

The value of informationGiven an uncertain world, the expected value rule enables us to choosebetween alternative actions, so long as we are able to assign probabilities tothe various possible states of the world. Are there circumstances in whichdecision makers can improve the expected outcome? Can they refine thedecision making process? If Yassin knew at the start of the day what theweather was going to be, he could choose to stay at home if it was going tobe fine (achieving 10 units of satisfaction) or go to work if it was going to rain(achieving 30 units). What, however, is his best choice without thisinformation? At present, given the uncertainty about the weather, his bestchoice is to go to work every day. How would certain information about theweather change his choices? Assume that the probability of a fine day is still0.4 and of a rainy day 0.6. If Yassin has perfect knowledge of the weather, hewill stay at home on average four days out of 10 and go to work on averagesix days out of 10. The expected value of his satisfaction will therefore be:

(10 x 0.4) + (30 x 0.6) = 22

This is greater than Yassin’s expected satisfaction if he always goes to work,regardless of the weather. That means that perfect knowledge of the weatherimproves Yassin’s decision making by 22 – 14 = 8. If Yassin were able toacquire a weather forecast that was correct every time he could pay up toeight units for the forecast and still be no worse off than if he did not use theforecast at all.

Sample examination question‘The notion of relevant costs is impractical for management practice becauseit ignores past cash flows.’ Critically discuss this statement.


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It might be worth pointing out that the relevant cost definition seeks toestablish a theoretical yardstick for identifying how organisations canidentify the most profitable courses of action. Insofar as this theoreticalyardstick presents problems in practice it is useful to explain in what wayspractice differs from the assumptions on which theoretical concepts arefounded. In practice accountants may be uncomfortable with the idea thatpast cash flows are irrelevant. They often suggest that investments made inthe past should be utilised. For theoretical economists, by contrast, ‘bygonesare bygone.’ Just because money was spent on a certain project does notmean for them that more money should be spent on it, for example, tocomplete it.

One of the reasons why they think like this is that they assume perfect capitalmarkets. If another, more promising project can be identified, they assumethat capital can be raised for it. In reality, organisations face credit limits andmay not possess the option of raising large amounts of fresh capital.Accountants realise that past cash flows produce dependencies as well asexpectations that often make it attractive to stay with an ongoing project,even if new opportunities open up.


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Notes


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Chapter 3: Cost behaviour


managerial emphasis. (Prentice Hall Publishing, 2003) eleventh edition(international) [ISBN 0-13-099619-X] Chapters 2, 10 and 3.

AimsThis chapter introduces the cost terminology used in this guide. It explainscost behaviour as fundamental to costing systems and shows how to chartfixed and variable costs. Cost-volume-profit analysis (CVP) is introduced as a key management accounting technique for diverse decision-makingsituations. Cost estimation is mentioned as an important topic formanagement accounting practice even though it is of minor theoreticalrelevance for the unit.


• distinguish different types of costs

• structure problems in ways that lend themselves to the application of CVP

• explain the differences between cost estimation techniques.

IntroductionThe basic framework of the decision-making approach to managementaccounting may still seem somewhat abstract, but you will find that it is animportant basis for approaching the remainder of this subject. It will alsohelp you structure your thinking when you come into contact withmanagement accounting in your future career.

You have by now spent some time thinking about how to approach ‘what if’questions; what will be the effect on resources if we do X? This chapter stayswith the ‘what if’ question but focuses in more detail on the daily work ofmanagement accountants. It looks at costs, specifically, at what happens tocosts if organisational activity varies. This is called ‘cost behaviour’. Costbehaviour depends on activities which cause costs to occur. Those activitiesare called ‘cost drivers’. The chapter also considers how costs can beestimated. Also, you will learn about cost-volume-profit (CVP) analysiswhich is a technique linking organisational activity to cost and profit thatallows us to determine the minimum level of activity for profitability: the so-called ‘break-even point’.

The elements of total costs and their behaviour Probably the biggest part of management accounting in practice is costaccounting. It measures and reports financial and non-financial informationthat helps managers make decisions to fulfil the goals of an organisation. Thecomponent elements of total cost may be presented as follows (sums in bold):


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Direct material cost X

Direct labour cost X

Direct expenses X

Prime cost X

Production (or factory) overhead X

Production (or factory) cost X

Administrative overhead X

Selling and distribution overhead X

Total cost X

It should be noted that this analysis of total cost is similar to the overallanalysis that might appear in a profit and loss account: the difference is thatthe profit and loss account reflects all the costs attributable to a particularperiod while the cost statement above relates to a particular product orservice. Also management accounts tend not to include the detailed expensesfor financing and taxation.

Direct and indirect costsCosts are traditionally classified in a number of different ways. The firstimportant distinction is that between direct and indirect costs. Direct costsare those that can be directly related to a cost object. A cost object can be anyproduct or service. Direct costs include, for example, the cost of materialsspecifically used in manufacturing a product or providing a service, specificlabour costs that can be identified with the work involved in manufacturing a product or providing a service and other expenses that can be specificallyidentified with a product or service. Indirect costs are those costs that cannotbe specifically attributed to a good or service. Indirect costs are also knownas ‘overheads’. They are often classified into:

1. production overhead: all indirect material cost, indirect labour andindirect expenses incurred in the factory from receipt of an order forgoods to be produced until completion of production

2. administration overhead: all indirect material, labour and expense costsincurred in the direction, control and administration of the organisation

3. selling overhead: all indirect materials, labour and expenses involved inpromoting sales

4. distribution overhead: all indirect materials, labour and expensesincurred in preparing the finished product for despatch and indistributing the product to its destination.

Fixed and variable costsThe second important way of classifying costs is as fixed or variable costs.Fixed costs are those that arise in relation to the passage of time and which,within certain output and turnover limits, tend to be unaffected byfluctuations in the level of output or turnover. Fixed costs tend to beoverheads such as rent, insurance and the cost of managerial staff. It isimportant to remember that costs are, strictly speaking, only fixed in relationto a particular time horizon: in the very long run, no costs are truly fixed, inthe sense that they cannot be altered. They will vary with large variations inproduction output, for example, when a second factory is built next to theoriginal one. It is also important to note that costs may be fixed over aparticular range of output levels but start to vary outside that range.


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The converse of a fixed cost is a variable cost, which is a cost that tends tofollow (in the short term) the level of activity of the organisation.Traditionally, examples of variable costs have been taken as materials used,labour directly employed on production, and selected overheads such aspower used to drive machines. However, with the exception of materialsused, many costs are in practice (at least in the short term) effectively fixed:for example, if production workers are paid wages independent of thevolume of production, and it is difficult to increase or decrease the size of theworkforce, labour costs behave as if they are fixed in the short term. Variablecosts are usually taken as varying linearly with the level of activity (that is, a graph of cost against activity level is an upward-sloping straight line, likeexhibit 2–3 in your textbook), and this implies that the variable cost per unitof output is constant at all levels of output. However, in practice variablecosts might not be linearly related: for example, unit variable costs mightgradually decrease relative to the level of output (as would be the case wherethere are economies of scale available from production), gradually increase(if there are diseconomies of scale) or exhibit a more complex relationship.However, it may be possible to regard variable costs as approximately linearover a relevant range of output.

Costs in-betweenSome costs do not fit neatly into either the fixed or variable categories. Oneimportant type of cost is the step fixed cost. This is a cost that is fixed overrelatively short activity ranges, but which increases dramatically as the levelof activity moves from one range to another. For example, for a particularrange of outputs, a business may need to employ only one productionsupervisor on a fixed salary. However, to increase production beyond thisrange will require the employment of a second supervisor. The fixed cost ofsupervisory salaries increases suddenly and then continues at the new leveluntil output is such that a third supervisor needs to be employed. This isgraphically illustrated in exhibit 2-4 of your textbook.

Another important cost category is that of semi-variable costs. These arecosts that reflect both a fixed and a variable component. An example of asemi-variable cost would be a charge for electricity based on a fixed monthlycharge (paid whatever quantity of electricity is consumed) and a charge perunit of electricity actually consumed (which will therefore vary with the levelof activity). There are other, more complicated, relationships that might existbetween activity levels and costs, but for many purposes we can assume that(at least over the range of output that interests us) total cost may be dividedinto a fixed element, which does not vary over the range of output, and avariable element, related linearly to output. Expressed algebraically, we candefine total cost using the following equation:

y = a + bx

where y = total cost, a = fixed cost

b = unit variable cost, x = units of output.

An example of a total cost curve is represented by line AB in exhibit 3-2 ofyour textbook.


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Activity

From your own experience, think of three examples of each of the costs discussed above.Don’t forget to specify with regard to which cost object you define direct and indirect costs.

1 2 3

Direct

Indirect

Fixed

Variable

Step-fixed

Semi-variable

Some students mistakenly equate variable costs with direct costs and fixed costs withindirect costs (overheads). Often variable costs are direct (e.g. direct material costs) andfixed costs are indirect (e.g. rent), but this is not always the case. Importantly, what isclassified as direct and indirect depends on the cost object!

Activity

Carefully study exhibit 2-5 in your textbook and explain all four combinations given inthe diagram.

The identification of cost driversMuch of the work of the cost accountant is involved in dividing up overallcosts for particular expense items and assigning these to particular productsor services, so that the total cost of each product or service may beascertained. Sometimes, it is possible to identify whole items of cost that arespecifically attributable to a particular product, in which case we are said to‘allocate’ the cost to the product. In other cases, a cost may be incurred onbehalf of two or more products, and we must therefore apportion the totalcost to the relevant products. We often speak in more general terms ofallocation or apportionment of costs to cost objects. Those cost objects areanything for which we wish to ascertain a cost. Typically, we are interested inknowing the costs of two types of cost objects: cost units and cost centres.What do we mean by these terms?

A cost unit is an arbitrary unit of production, service or time in relation towhich costs may be ascertained or expressed. The unit selected must beappropriate to the organisation, be it a business or a not-for-profit-organisation, and one with which expenditure may be readily associated.Typical cost units might be physical units of production, such as a can ofbaked beans or a motor car, or some unit of quantity or volume, such as akilogram of sugar or a tonne of steel. In some cases, the cost unit might be aunit of time, for example, an hour of time charged to a client by aprofessional (so your lawyer knows how much to bill you), or a unit ofservice, for example, a share purchase made by a stockbroker.

A cost centre is a location, person, or item of equipment (or group of these)for which costs may be ascertained. In a factory, cost centres might bedepartments such as stores, maintenance, personnel or design; operationalcost centres such as the machines or operators performing a particularoperation; particular salespeople, departmental supervisors or managers; or particular contracts or customers.

Activity

Think of five further examples of cost centres.


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AllocationTo calculate total costs for particular cost objects, it is necessary to allocate orapportion costs first to cost centres and cost units. The overall criterion usedfor this is cost causation. If you are to calculate the economic resourceconsumption of cost objects it is advisable to follow the lines of causality fromthe cost object to the consumed resource and then to ascertain its value. Thelink between the two is called cost driver. Cost drivers are variables theoccurrence of which ‘drives’ or causes costs.

Activity

Study exhibits 2-1 and 2-2 in your textbook and read pages 30–31.

In practice this is usually not as straightforward as it sounds, particularly in a large complex operation with hundreds and thousands of machines,people, and products. Often, management accountants therefore employ atwo-stage process of allocating and apportioning costs to cost objects. Firstly,costs might be assigned to cost centres on a particular basis and, secondly,the cost per cost centre further assigned to individual cost units. Severaldifferent cost drivers (they are sometimes called ‘bases’ of apportionment orallocation) are used in practice, and cost accountants often attempt to selecta ‘suitable’ driver in the light of the cost being apportioned. Some drivers,with examples of costs for which they could be used, are:

1. capital values for insurance and depreciation of plant and machinery

2. relative area of floor space for rent, cleaning expenses, light and heat,depreciation of buildings

3. number of employees for personnel office, canteen, safety and first aid

4. number of set-ups for machines or production lines for engineeringoverheads, production planning overheads

5. number of purchase orders for purchase department overheads

6. number of warehouse orders for overheads for the organisation’s internallogistics

7. number of orders to change product design for design engineeringoverheads.

You can see that there are different drivers available for the same costs, and the cost accountant must, in the end, select an arbitrary basis of apportionment.

Activity

Consider an organisation which you know well. (Take the institution where you arestudying if you have little work experience.) What are its most significant costcomponents? Labour? Materials? Process improvement? Different forms of administration?What causes those costs? What are their drivers? How could you allocate cost to thosemanagers or administrators who should be held responsible for them?

Cost estimationComplete allocation and apportionment of costs may be carried out only atthe end of a period, when the total costs to be assigned have been determined.If the purpose of cost attribution is simply to achieve an ex post measure ofthe cost of the organisation’s products, for the purposes of control orotherwise, then this retrospective cost attribution will be acceptable. For


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many purposes, however, the end of the period is too late: estimates of costwill be needed for planning, pricing and control purposes at the time whengoods are produced and services provided, and indeed before such a time.Different techniques exist for estimating costs, some of which rely on theclassification of costs into fixed and variable categories to estimate a costfunction of the form y = a + bx, as discussed in the previous section. In sucha function, the independent variable x is sometimes units of output, butcould be a measure of input such as machine hours or labour hours.Sometimes there might be circumstances in practice where total cost isbetter expressed as a function of two or more variables rather than one, butfor expository purposes, textbooks usually assume that total cost is a linearfunction of a single variable, normally output.

Cost estimation usually involves two aspects: estimation of the usage offactors of production such as materials, labour and overheads, andestimation of the cost of such factors. The first method of cost estimation isthe engineering method, which gets its name from estimates determined byengineers of the materials, labour and overheads required to manufacture a product or provide a service. Materials needed will be estimated from thespecification of the product, labour from time and motion studies andestimates of the operations needed to make the product, and overheads fromestimates of capital equipment needed and other costs to be incurred. Theengineering method is particularly relevant where there is little pastinformation on which to base a cost function, but it is costly to operate, andnot always easy to carry out. However, the use of the engineering method isoften associated with a standard costing system (described in more detail inChapter 8), which helps to integrate the cost estimates into the overallcontrol system of the organisation. Where past data exist relating to theproduct in question, these may be used to estimate a cost function. Past datamay be used to obtain directly a cost function expressed in monetary termsor indirectly to estimate how production inputs are related to productionoutputs. To estimate a cost function, it is necessary for us to be satisfied thatthe relationship between costs and output shown in the past will give usreliable information about the relationship at present and in the future.There are three important factors to take into account when using historicaldata.

1. Choice of independent variable: we usually select output level, althoughthe total cost for an item may depend on many factors, such as level ofoutput, total machine hours, total labour hours, volume and quality ofmaterials and so on. While cost estimates might be more accurate if amultivariate cost function were used, it is likely that the various variablesselected will themselves depend to a great extent on the level of output. Ifthe ‘independent’ variables are not truly independent, there is little extrabenefit from a multivariate function in comparison with a univariate one,where the independent variable is level of output.

2. Selection of time period: the period covered by past data should bereasonably long, so as to allow for a large number of observations, butcircumstances during the period should be comparable to the current andfuture environment, so that it is reasonable to use cost functions based onpast data for future cost estimations. In this context the learning curveeffect may assist in the estimation. This effect arises becauseorganisations tend to become more efficient at the production of an itemas time passes. Initially, the product is new, the workforce has to learnhow to make it, the specification of the product may need to be modifiedin the light of manufacturing experience, and, overall, unit costs will berelatively high. As time passes, the organisation becomes more


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experienced and efficient at manufacturing the product, and unit costsfall. The graph of unit costs over time shows a curve which falls rapidly tobegin with and then starts to level off. This is called the learning curve. Inorder to estimate future costs, it is necessary either to exclude or to adjustobservations where the learning curve effect is likely to be significant.

3. Examination of accounting data: it is important to make sure that anybiases, which might be induced in the data by the methods by which thedata are compiled, are identified and adjusted for. Where data cover along time period, allowance must be made for inflation so that the costfunction reflects current prices. When the data have been collected and,where necessary, adjusted to reflect inflation and accounting biases, theymay be used to estimate a cost function. This estimation may be carriedout using approximate methods, such as basing the function on thehighest and lowest values of total cost or plotting the observations on agraph of output against total cost and fitting a line to the observationsvisually.

Linear regressionA different approach uses the statistical technique of linear regression. Thisapproach determines a line of best fit using the ‘method of least squares’.Your textbook describes the mechanics of calculating the least squares line ofbest fit (see exhibits 10-6 and 10-8), but it is worth pointing out that theactual calculations would usually be carried out in practice using appropriatecomputer programs. The linear regression approach has two importantadvantages over less sophisticated methods. First, we can estimate how goodis our line of best fit, using the correlation coefficient. The closer r2

approaches 1, the closer our line of best fit explains the variation in total cost(or other dependent variable) in terms of output (or whatever otherindependent variable we use). Second, the linear regression method can beeasily extended to cope with several independent variables, using multipleregression analysis (although this makes a computer almost essential). Thecomputer programs used for multiple regression analysis are sophisticated,and are capable of identifying situations of multicollinearity, where the‘independent’ variables are in fact interdependent, so that a cost functionbased on the smallest number of significant variables may be derived.Although regression analysis is a valuable tool in cost estimation, it must beremembered that, as a statistical method, it makes various assumptionsabout the data that might not be true in practice. For example, it may classifydata in one category despite underlying differences.

Error terms and outliersBefore discussing these, it is necessary to introduce the expression errorterm. The regression equation derived from the method of least squaresallows us to calculate an estimated value of our dependent variable (such astotal cost) for any value of the independent variable (such as total output). If we compare the estimated value with the observed value y for that level ofactivity x, the error term is simply the difference in y. Now, the method ofleast squares mathematically forces the mean of the error terms for all theobservations to equal zero. This means that the regression equation derivedis very sensitive to isolated observations lying far from the line of best fit,which are called outliers. If outliers were not included, the regressionequation could be quite different (and the value of r2, measuring goodness offit, would almost certainly be higher). It is often the case that there arespecial factors explaining the occurrence of specific outliers, which can be


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adjusted for, and it is useful to try to identify potential outliers visually beforethe regression calculations are performed. There are two further technicalproblems.

1. The method of least squares assumes that the error terms areindependent of each other, but in some cases they are not: this is referredto as autocorrelation. An example arises where the observations areaffected by seasonal factors, which should have been adjusted for beforeperforming the regression. The seasonal factors will leave theobservations subject to a particular underlying pattern in addition to anyfundamental trend.

2. The method of least squares assumes that the likely size of the error termsis independent of the value of the independent variable: that is, the errorterm does not grow larger as the level of output increases. Where the sizeof the error term does increase (referred to as heteroscedasticity), theregression equation becomes less reliable. The existence ofheteroscedasticity is often an indication that there is an underlyinggrowth or inflation factor that has not properly been adjusted for.Standard statistical regression computer programs often determinewhether autocorrelation and heteroscedasticity are significant problems.

The use of regression analysis to estimate a cost function is a usefultechnique, but it is more of a blunt instrument than the engineering method,as it breaks total cost down only into fixed and variable elements. For manypurposes, this is enough, but where detailed estimates of all the elements oftotal cost are needed, something like the engineering method must be used.As already mentioned, standard costing is likely to be based on engineeringcost estimates, but any other detailed costing will also need such anapproach.

Activity

Define the following:

• autocorrelation

• error term

• heteroscedasticity

• the learning curve effect

• linear regression

• multicollinearity

• outliers.

Check that you know how to use these terms appropriately before continuing.

Cost-volume-profit and break-even analysisThe division of total costs into fixed and variable components lies at the heartof cost-volume-profit analysis (CVP), which focuses on four key businessvariables: costs, revenues, volume of output and profits.

CVP looks at changes in total costs and in profits arising through changes inthe volume of output, and may be used in decisions about pricing, the bestbalance (or ‘mix’) of sales from several products, and many other short-termdecisions.

An important concept in CVP analysis is that of the contribution margin(sometimes referred to simply as contribution). If we are able to divide totalcosts into a component which is fixed and independent of output over aparticular range and a component which is variable and proportionate to


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output over that range, then the contribution margin is calculated bydeducting variable costs from revenue. Over the output range, thecontribution margin will itself be proportionate to the volume of output(assuming that the unit selling price of output is independent of volume). Wemay compare the contribution margin at a particular output level with thefixed costs to see whether a net profit or loss will be made at that level:where the contribution margin exceeds the fixed costs, a net profit arises,and vice versa. The point at which contribution margin is equal to fixed costsis called the break-even point at this level of output, the net profit is zero, andtotal costs equal total revenues.

Calculating the break-even point indicates the minimum output level neededfor sales of a product to be profitable. Remember that several assumptionsunderlie the determination of the break-even point:

1. fixed costs are constant

2. variable costs vary linearly with output

3. sales revenues per unit of output are constant

4. volume of output is the only factor affecting total cost.

These assumptions are often unrealistic in practice, so break-even analysismust be regarded as a rough guide rather than a precise one. The break-evenchart is the most common way of presenting the relationship between totalcosts and total revenues at different output levels, and finding the break-evenpoint. The break-even point occurs where the profit line (the linerepresenting profit as a function of output) cuts the output axis: at this point,profit is zero.

If you look closely at the break-even chart you notice that it fails to show netprofit or loss clearly at different output levels. To remedy this, the profitvolume chart has been developed. This is a graph of volume against profit (orloss) at each level of output. Profit volume charts and break-even charts maybe used to illustrate what happens when changes occur in key variables, suchas fixed costs, variable costs and selling price.

Activity

Compare the CVP chart in exhibit 3-2 with the profit-volume graph in exhibit 3-3 andexplain how the latter is derived from the former.

Sample examination questionWhat are the principle ideas underlying cost-volume-profit analysis, what arepossible applications, and what are its limitations?


This question can be answered by rereading this chapter and the textbook.


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Notes


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Chapter 4: Costing and pricing


managerial emphasis. (Prentice Hall Publishing, 2003) eleventh edition(international) [ISBN 0-13-099619-X] Chapter 12, appendix to Chapter 11on linear programming.

Cooper, R. and W.B. Chew ‘Control Tomorrow’s Cost Through Today’s Design’,Harvard Business Review (January–February 1996) 80–97.

AimsOnce you have calculated product cost, what price should you charge? Thelink between costs and prices depends on the kind of product market inwhich your organisation operates and the marketing strategy which itpursues. Given those contexts, management accounting can attempt toprovide information on optimal prices as well as bounds for the lowest price.Typical methods that are used include cost-plus and contribution marginpricing. This chapter also deals with the question of the optimal allocation ofscarce resources. It shows how linear programming can be used forallocation decisions, and how linear programming techniques can producedual or ‘shadow’ prices which simulate for decision-makers an internalmarket for the organisation’s resources.


• outline the distinction between different types of pricing and explainunder what circumstances they might be appropriate

• conduct Linear Programming Analysis

• explain the how the consideration of scarce resources affects the notion ofopportunity costs.

Costs and pricingOne of the justifications for costing is that it assists in setting selling prices. In some situations, producers are faced with a selling price determined bythe market, and any individual producer cannot materially affect the marketprice. Even so, a producer will wish to know whether to enter or remain inthe market for a particular product, and this will require a comparison of unitcosts and selling prices. In other situations, market prices are not available(for example, for a new product) or an individual producer might have asignificant effect on the determination of price. Many businesses operate inan environment where the quantities of products demanded by customersdepend in some way on selling price. Economists refer to such markets asexhibiting high elasticity of demand. Demand responds to price changes. In such a case, given the desire to maximise net cash flows accruing to thebusiness, it will be necessary to determine the optimal price and level ofproduction so as to maximise net cash flow. In these circumstances, the profitvolume chart may be used to help determine maximum profit.


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Such use of the profit volume chart hinges on your ability to estimate theprice elasticity of demand (i.e. the sensitivity of demand to changes in price).Where it is difficult to estimate demand at various prices, many businessesuse a cost-plus approach to pricing, either as the sole basis for price setting oras an indication of the minimum acceptable price (the actual price thenbeing determined by taking into account marketing considerations). Todetermine a cost-plus price, the total cost, including allocated fixed overheads,of a cost unit is determined, and a pre-set profit percentage (the ‘mark-up’) isadded to arrive at the selling price. For example, if total direct costs per unitare £12, allocated fixed overheads are £8, and the required mark-up is 50 percent, the cost-plus price is:

(12 + 8) x 150 per cent = £30.

Activity

Recall Elements of accounting and finance (or Principles of accounting): Howmuch is the margin in this example?

Cost-plus pricing is simple to operate, but the prices obtained depend on thebasis of allocating fixed costs, and on the profit percentage applied. Both ofthese are ultimately arbitrary, so the use of cost-plus pricing could lead tosub-optimal pricing decisions.

For instance, assume that an organisation sells one kind of product for $10.Variable costs are $2 per unit, period fixed costs are $500. The per unit fixedcost would depend on volume. If volume was 100 units, it would be $500/100 = $5.

Table 4.1: Contribution margin per unit and for the organisation

Per unit in $ For the organisation in $

price 10 1000

− variable costs 2 200

= contribution 8 800

− fixed costs varies with volume, 500therefore of limited usefulness

= net profit often not calculated 300

Contribution margin pricingContribution margin pricing does not insist on covering long-term fixedcosts. (Remember that their allocation to particular product lines isproblematic.) Instead it is based on the difference between sales price andvariable costs. If variable cost measures resource consumption accurately,then any sales price greater than variable costs gives the business acontribution towards its fixed costs and profit requirements. In that sense,variable costs are the minimum price in the short run. Why in the short run?Because in the long run you need to be profitable. What should you considerbefore accepting an order which would cover variable but not fixed costs?You need to be cautious about a general deterioration of sales prices for yourproduct. (Will other customers also demand lower prices?) A point ofcaution: most students think that it is okay to accept an order which coversonly variable costs (because this would generate a positive contribution), but only if you have already covered your fixed costs. To connect the issues of contribution and the covering of fixed cost in this manner is nonsense.Whether or not you have covered your fixed costs for the current period,


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such an order would help you cover them. So, as long as you have idlecapacity and the market price for your product will not generally deteriorate,you should accept the order which gives a contribution.

How then do you find out about, and manage, scarce resources? Suppose a soft drinks producer obtains an order from overseas offering £10 per case.If the producer has idle capacity and the overseas market has no knock-oneffects on its core markets, the producer should accept the offer so long asthe variable cost per case including transport is less than £10. Whether fixedperiod costs have already been covered at the time of the order is irrelevant.Any contribution earned from this and other orders will be used to help coverfixed costs and profits. Once fixed costs are covered, the remainingcontribution adds to profits.

Short-term decisions with one scarce resourceMany decisions will need to be taken in circumstances where resources are in short supply. It may be that resources are externally rationed, so that a business is restricted in the amount of a resource that can be acquired.Alternatively, it may be impossible for the amount of resource to be increasedover the time horizon relevant to a decision. For example, workers mighttake time to recruit and train, so that they are available for production onlyafter a certain period. If an order comes in that needs immediate attention,then the labour required must be transferred from that already employedelsewhere in the business. Thus acceptance of a new order might mean thatexisting products must be curtailed or dropped altogether. When a decision is assessed using incremental costs, and resources are scarce, then it isnecessary to take into account not only the incremental cash outflowsarising, but also any contribution sacrificed by transferring scarce resourcesfrom other productive uses.

Some decisions will not be of an incremental nature. They concern ‘lumpy’items. These are items which cannot be divided. For example, productioncapacity may need to be dedicated to one product and not be halved. Themost important of lumpy items are encountered in resource allocationdecisions, where the business must decide how to allocate a scarce resourceto the various available products, so as to achieve the best overall outcome.Various assumptions are normally made about the business and itsproduction processes:

1. the business seeks to maximise its cash contribution

2. costs are linearly related to output

3. all the products of the business may be produced and sold independentlyof each other

4. all production processes are perfectly divisible, as regards both inputs andoutputs

5. there are no hidden costs associated with non-production such as loss of reputation

6. all inputs and all production processes are known with certainty.

For many businesses, these assumptions (except perhaps assumption 6.) arereasonably good approximations to reality. However, the assumption ofperfect divisibility is questionable where the business manufactures largeindividually identifiable items, and caution must be used in such cases inapplying the techniques of this chapter.


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Contribution per bottleneck resourceLet us further suppose that one resource is scarce. It might be material thatcannot be easily replaced or whose supply is rationed, or labour hours, forexample, where the workforce and the time worked by each employee islimited and cannot be easily expanded, or some other constraining factor. In the absence of the constraint, the business would produce all goodsgenerating a positive incremental contribution, but given the scarce resource,this must be utilised in the most efficient way. We can achieve efficientutilisation of the scarce resource by calculating the contribution per unit ofthe scarce resource for each product, and producing the product that yieldsthe maximum contribution per unit of scarce resource. Where the demandfor products is limited, the various products should be ranked in order ofcontribution per unit of scarce resource.

The product yielding the greatest contribution per unit of scarce resourceshould be produced up to the maximum output demanded, then the productyielding the next highest level of contribution per unit of scarce resource, and so on until the scarce resource is fully utilised. You should note that theranking of products by contribution per unit of scarce resource will notnecessarily correspond to the ranking of contribution per unit of product, as products yielding high unit contributions might use the scarce resource toa greater relative extent than products yielding low unit contributions. Inother words, you work out how much of a bottleneck resource each productwould consume and decide to make those that give you the highest benefit(contribution) per ‘bottleneck unit’ (e.g. time spent in a final spraying boothor a drying oven).

More than one scarce resource: linear programming (LP)Where the business faces more than one scarce resource, the techniqueoutlined above does not always work. If the products are ranked bycontribution per unit of each scarce resource, it is likely that the rankings willdiffer, as a product that uses one scarce resource relatively extensively mightnot use another scarce resource to the same relative extent. Where therankings differ, there is no clear-cut answer to the problem of whatcombination of goods should be produced to maximise total contribution,unless a more sophisticated technique is used. One such technique is linearprogramming (LP). This is a mathematical technique that, given theassumptions stated above, gives the theoretically-optimal solution to theproblem of allocating scarce resources to maximise contribution.

Although the LP technique is conceptually simple, it is difficult to apply inpractice, and many real world LP problems require a computer to obtain asolution quickly (there is a method of solving LP problems manually calledthe ‘Simplex Algorithm’, but this is time-consuming to apply). Where thereare only two products, however, it is possible to solve the LP problem using a graph (because the problem is two dimensional and a graph exists in twodimensions), and two product problems are usually to be found inmanagement accounting textbooks.

Now take a look at the appendix on LP in Chapter 11 of your textbook.Exhibit 11-14 is a graphic solution to an LP problem. Keep the graph by youwhile you read the following. Here are various stages in applying the LPtechnique to a problem.

1. Identify the objective function. This is an expression that shows inalgebraic terms what is to be maximised (or minimised). For example,


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where the LP problem involves maximisation of total contribution, theobjective function will be an expression defining the contribution andshowing how it would be made up of the contributions from each unit ofthe various products that could be produced. (The LP technique may alsobe used where we wish to minimise rather than maximise, for example to calculate the minimum cost to produce certain given combinations of output.)

2. Identify the constraints. For each scarce resource, there will be a constraint,which is an algebraic expression in the form of an inequality. This impliesthat the total of the scarce resource used in production cannot be exceeded,but that it is possible for some of the scarce resource not to be used.Additionally, there will be non-negativity constraints, which state that theproduction of each good must be greater than or equal to zero, as wecannot produce negative quantities of any good. There could also bedemand constraints, where there is a maximum demand for any good.Alternatively, powerful customers who buy large portions of your outputmay require you to keep output of certain products over a specified level.This would be a minimum demand constraint.

3. Plot the constraints on a graph and determine the feasible region. This isthe area of the graph such that all points within the feasible region satisfyall the inequalities. (On a two-axis graph, any point within the feasibleregion would indicate a production combination of your two products.)Any point outside the feasible region must break at least one of theconstraints, and cannot be a possible solution. Note that the feasibleregion normally includes points lying on the boundary of the feasibleregion, as the constraints are normally of the form ‘less than or equal to’or ‘greater than or equal to’ rather than strict inequalities.

4. Identify on the graph the optimal solution. This is given by the point lying‘furthest away’ from the origin of the graph. The ‘furthest away’ point inthis context depends on the objective function (i.e. in exactly whichdirection – a bit more to the top, or a bit more to the right – do you aim tomove away from the origin of the graph?). The solution to a maximisationproblem is achieved when the objective function takes its highest valuewithin the feasible region. We can draw on our graph various parallellines representing the graph of the objective function for various values ofthe objective function. As these lines (sometimes called iso-profit or iso-contribution lines, because they join all combinations of output of thegoods that yield the same profit or contribution) move out from theorigin, the value of the objective function increases, and the highest valuewill be reached at the last line to just touch the feasible region. In LP, theoptimal solution will lie on the boundary of the feasible region, and willbe either a point where two constraints intersect (the more typicaloutcome, giving a unique solution) or, where the objective function hasthe same slope as one of the constraints, a segment of that constraintbetween the points where it intersects with two other constraints (inwhich case there is no unique solution). Given a unique solution, the co-ordinates of the point represented by the solution may be determinedeither directly from the graph or alternatively by solving the two constraintsdefining the point of intersection as simultaneous equations.

The LP approach is useful when we can be sure that our underlyingassumptions represent reasonable approximations of the reality of thesituation. Even where some of the assumptions do not hold, it might bepossible to employ non-linear techniques to overcome the problems


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(although these almost inevitably require computers even in simple settings).For example, LP assumes perfect divisibility of inputs and outputs, and it isnot unlikely that the solution obtained will involve fractions of units.

If, however, the products are such that fractional units are not sensible, thena solution in terms of integers is required. This could be approximated byrounding down the precise solution to the nearest whole number, but incertain situations the more advanced technique of integer programming isneeded to deal with a requirement for an integer solution. Similarly, wherecertain constraints are non-linear, and where there are interdependenciesbetween inputs or outputs (for example, certain products can be producedonly jointly), the LP formulation needs extra constraints and it may benecessary to utilise a non-linear approach such as quadratic programming.Note that non-linear techniques are beyond the scope of this unit.

Activity

Work through the example in the LP appendix of Chapter 11 in your textbook and writea brief paragraph on the limitations of LR.

Dual prices (shadow prices) and opportunity costsOne of the most important assumptions of LP is that the constraints are givenexternally and cannot be affected by the decision-maker. However, thisassumption might be incorrect in two ways.

1. There might be some uncertainty about a particular constraint. Forexample the total quantity of a particular scarce resource might beuncertain, although estimates may be made in formulating the LPproblem. To overcome this, it is possible to perform a sensitivity analysisby reformulating the LP problem with different quantities of the scarceresource in the relevant constraint, and finding the new solution. Manycomputer programs for LP do this automatically. One important situationarises when a constraint is non-binding, that is, it is not one of theconstraints that define the optimal solution. Graphically, this means thatthe constraint line does not touch the point which represents the optimalsolution on the edge of your feasible region. In this case, the constraint isnot actually effective in limiting production (this is achieved by otherconstraints), and it is irrelevant to the solution. Where a constraint is non-binding, the optimal solution implies that there are unused quantitiesof the resource involved, so that small changes in the quantity availablewill not change the optimal solution. We say that there is ‘slack’ in respectof this resource. The resource becomes significant only if the quantityavailable changes so much that the constraint becomes a binding one, in which case it starts to define the optimal solution.

2. The second way in which the assumption that constraints are givenexternally might be incorrect is where the quantity of a scarce resourcecould be changed, by increasing or decreasing it. Although this mightseem inconsistent with the assumption that the resource is scarce, insome cases it is possible to increase resources at a price. For example,labour hours might be limited, but it might be possible to increase themby paying higher overtime rates. Machine hours might be increased byhiring time elsewhere, even if this is relatively expensive. Emergencysupplies of materials could be purchased at a higher price than usual. Thedecision-maker will want to know when it is worthwhile to pay over thenormal price to overcome a resource scarcity, and the maximum that canbe paid while still increasing the net contribution to the business. Ratherthan a strictly optimal solution, LP would give management a tool forthinking about its options!


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Dual (shadow) pricesIn order to provide such information, the technique of calculating the dualprice (sometimes called the shadow price) of a scarce resource is used. Thedual price represents the additional contribution that will be obtained fromone more unit of scarce resource, or the contribution loss that will beincurred if one unit of scarce resource is removed. We calculate (or a suitablecomputer programme gives) the dual price of a scarce resource by:

1. adding one unit to the constraint corresponding to the scarce resource

2. solving a new LP problem with the revised constraint in place of theprevious constraint

3. calculating the value of the objective function at the solution to the newLP problem

4. finding how much this new value exceeds the value of the objectivefunction at the optimal solution to the old LP problem: this is the dualprice of the scarce resource.

The dual price of a scarce resource, then, is the incremental contribution,after taking into account changes in the quantities of each good producedand consequent changes in the usage of slack resources, from an incrementalunit of the scarce resource. The dual price therefore represents the maximumextra amount that the business will be prepared to pay (in excess of thenormal unit price) to acquire an extra unit of the scarce resource.

Activity

For example, if a unit of a scarce resource normally costs £10, but buying an extra unitwill increase total contribution by £4 (remember that the objective function reflectscontribution figures that already take account of the normal price of the scarce resource),then how much would the business be willing to pay for it?

Up to £14 for an extra unit is correct, as any amount less than that would stillgenerate a positive incremental contribution, after paying for the scarceresource and amending the optimal business plan to allow for the availabilityof the extra unit of the scarce resource.

Opportunity costsWhere a resource is scarce, its use in producing one good means that it is notavailable for other goods. In many situations with scarce resources, it may beassumed that the business has already determined its optimal productionplan. Suppose that an alternative arises, and the business wishes to considerwhether it should be accepted. In Chapter 2, we saw that such anincremental opportunity should be assessed by calculating the netincremental cash contribution that the business would earn if this newopportunity is accepted. The basis for calculating this is the opportunity costsof the resources used. Where resources are not scarce, acceptance of anopportunity does not imply a rearrangement of the other activities of thebusiness: these may be carried on in any event. The opportunity cost of aresource is in general its current replacement cost, which we can refer to asits external opportunity cost.

Where a resource is scarce, however, its use for a new alternative actionmeans that it must be transferred from existing activities, so that these mustbe rearranged. Contribution will be foregone through this, and the foregonecontribution is just as much an incremental cost for the new activity as the


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replacement price of the resource. We call such a cost the internalopportunity cost, and measure it by the dual price of the resource. In ourdecision-making process, then, the total opportunity cost of a scarce resourcewill be the sum of the external and internal opportunity costs. Thus the dualprice of a scarce resource represents part of the economic cost that must beborne if the resource is allocated to another use.

What happens with slack resources? These correspond to non-bindingconstraints, which do not enter into the solution to the LP problem. Thusadding or subtracting extra units of a slack resource will not change thesolution (at least for small additions or subtractions). Therefore the value ofthe objective function remains unchanged. The dual price of a slack resourceis therefore zero. You should note that constraints are likely to remainbinding or non-binding only over certain ranges of resource supply, and thedual price is valid only so long as the binding constraints remain effective.

A final point relating to dual prices arises when one of the bindingconstraints is a demand constraint (specifying the maximum number of unitsof a particular good that will be demanded). In this situation, the good inquestion will have a dual price, in that an extra unit of demand for the goodwill increase the total contribution (this occurs because a binding demandconstraint can arise only in respect of the good with the highest unitcontribution, unless several demand constraints bind simultaneously). Whatis the interpretation of this dual price? Just as the dual price for a scarceresource represents the maximum extra amount over normal price that it isrational to pay for an extra unit of the resource, so the dual price for a unit ofoutput represents the maximum amount that the business will be willing topay (in the form of a reduction of the normal selling price or through agreater marketing effort) in order to achieve an extra unit of demand. Notethat the extra payment or discount applies only to incremental units, not tothe total units bought or sold.

Activity

What is the opportunity cost of your current management accounting studies? How canyou measure it? In what way would it make sense to distinguish between internal andexternal opportunity costs in your case?

Sample examination questionHow does the introduction of scarce resources affect the notion ofopportunity costs?


The main point for this question is that with scarce resources managementstops considering opportunity costs in the abstract and begins to relate thecontributions to be earned from different activities to the resources used forpursuing those activities. This means that contribution is calculated ascontribution per unit of scarce resource, thus changing the relative rankingof possible actions, depending on their projected resource consumption.


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