Revision

Performance Management-P2KAPP EDGE SOLUTIONS

2

Syllabus structure

A: Pricing and Product Decisions (30%)

B. Cost Planning and Analysis for Competitive Advantage (30%)

C: Budgeting and Management Control (20%)

D: Control and Performance Measurement of

Responsibility Centres (20%)

Pricing and Decision Mak-ingBudgeting and Management Control

Responsibility Centres

Important TopicsTransfer pricing

Pricing decision

Linear Programming

Budgeting

ROCE and RI

Learning Curve

PERFORMANCEManagementLINEAR PROGRAMMING

Topics Covered

Meaning

Use

Slack and surplus

Sensitivity Analysis and Shadow price

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Linear ProgrammingMathematical programming is used to find the best or optimal solution to a problem that requires a decision or set of decisions about how best to use a set of limited resources to achieve a state goal of objectives.

Linear programming requires that all the mathematical functions in the model be linear functions.

Linear Programming is used where more than one limiting factor is involved.

Two main methods:

Graphical method

Simplex solution

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Example of LP ProblemProduct Mix Problem

A manufacturer has fixed amounts of different resources such as raw material, labor, and equipment.

These resources can be combined to produce any one of several different products.

The quantity of the ith resource required to produce one unit of the jth product is known.

The decision maker wishes to produce the combination of products that will maximize total income.

Example of LP Problem A Blending Problem

Blending problems refer to situations in which a number of components (or commodities) are mixed together to yield one or more products.

Typically, different commodities are to be purchased. Each commodity has known characteristics and costs.

The problem is to determine how much of each commodity should be purchased and blended with the rest so that the characteristics of the mixture lie within specified bounds and the total cost is minimized.

Steps ◦ Determine the objective of the problem and describe it by a criterion function in

terms of the decision variables.

◦ Find out the constraints.

◦ Do the analysis which should lead to the selection of values for the decision variables that optimize the criterion function while satisfying all the constraints imposed on the problem.

Example The N. D. Company produces two products: I and II. The total amount of raw material available per day for both products is 15751b. The total storage space for all products is 1500 ft2, and a maximum of 7 hours per day can be used for production.

All products manufactured are shipped out of the storage area at the end of the day. Therefore, the two products must share the total raw material, storage space, and production time. The company wants to determine how many units of each product to produce per day to maximize its total income.

Solution • The object is to maximize the equation:

Z = 13x1 + 11x2

subject to the constraints on storage space, raw materials, and production time.• Each unit of product I requires 4 ft2 of storage space and each unit of product II requires 5

ft2. Thus a total of 4x1 + 5x2 ft2 of storage space is needed each day. This space must be less than or equal to the available storage space, which is 1500 ft2. Therefore,

4X1 + 5X2 1500

• Similarly, each unit of product I and II produced requires 5 and 3 1bs, respectively, of raw material. Hence a total of 5xl + 3x2 Ib of raw material is used.

Solution contd.• This must be less than or equal to the total amount of raw material available, which is 1575 Ib.

Therefore,

5x1 + 3x2 1575

• Prouct I can be produced at the rate of 60 units per hour. Therefore, it must take I minute or 1/60 of an hour to produce I unit. Similarly, it requires 1/30 of an hour to produce 1 unit of product II. Hence a total of x1/60 + x2/30 hours is required for the daily production. This quantity must be less than or equal to the total production time available each day. Therefore,

x1 / 60 + x2 / 30 7

or x1 + 2x2 420

• Finally, the company cannot produce a negative quantity of any product, therefore x1 and x2 must each be greater than or equal to zero.

Solution Contd.• The linear programming model for this example can be summarized

as:

Solution Contd.

Solution contd.•The shaded area of the figure comprises the area common to all the regions defined by the constraints and contains all pairs of xI and x2 that are feasible solutions to the problem.

•This area is known as the feasible region or feasible solution space. The optimal solution must lie within this region.

•There are various pairs of x1 and x2 that satisfy the constraints such as:

•Trying different solutions, the optimal solution will be:

X1 = 270

X2 = 75

•This indicates that maximum income of $4335 is obtained by producing 270 units of product I and 75 units of product II.•In this solution, all the raw material and available time are used, because the optimal point lies on the two constraint lines for these resources.

Slack Slack- this is the amount of resource which is under utilized when the optimum plan is implemented.

It occurs when the optimum point does not fall on a given resource line.

It is concerned with “less than or equal to” constraints.

However, 1500- [4(270) + 5(75)], or 45 ft2 of storage space, is not used. Thus the storage space is not a constraint on the optimal solution; that is, more products could be produced before the company ran out of storage space. Thus this constraint is said to be slack.

Surplus Surplus- this is utilization of resources over and above minimum.

It is concerned with “greater than or equal to” constraints.

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Simplex MethodWhen decision variables are more than 2, it is always advisable to use Simplex Method to avoid lengthy graphical procedure.

The simplex method is not used to examine all the feasible solutions.

It deals only with a small and unique set of feasible solutions, the set of vertex points (i.e., extreme points) of the convex feasible space that contains the optimal solution.

Sensitivity Analysis and Shadow price

Sensitivity Analysis- by considering the value of each limiting factor.

Shadow price- the extra contribution that would arise if one more unit of that scarce resource became available.

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Performance ManagementPRICING DECISION

Topics Covered

Factors affecting profit

Price Elasticity of demand

Price Elasticity Graph

Factors affecting price elasticity

Perfectly Competitive Market

Imperfect Competition

Product Life Cycle

Pricing strategies

Factors affecting profit Profit is the factor of three components:

Cost - volume -price

Cost• Higher

volume reduces the cost per unit

• Lower cost helps in lower prices

Volume• Volume

increase- per unit cost decreases

Price• Lower cost

helps in setting lower price


The relative response of a change in quantity demanded to a change in price.

Price elasticity

An elastic demand means that the quantity demanded is relatively responsive to changes in price.

An inelastic demand means that the quantity demanded is not very responsive to changes in price.

Price Quantity

Price Elasticity of demandFormula:


=Percentage change in quantity demanded

Percentage change in price

Price Elasticity Graph Inelastic Demand

Price Elasticity GraphElastic demand

Factors affecting price elasticity

1. Scope of the market

2. Information within the market

3. Availability of substitutes

4. Complementary products

5. Disposable Income

6. Necessities

7. Habit

Perfectly Competitive Market All the firms and consumers are price takers.

They cannot affect the market price.

Assumptions

Many small firms,

Many individual buyers,

Perfect freedom of entry and exit from the industry.

Homogeneous products

Perfect knowledge

No externalities

Imperfect Competition

Monopoly

Oligopoly

Monopolistic Competition

Product Life CycleIntroductory phase

Growth

Maturity

Decline

Marginal cost and Marginal Revenue 'Marginal Revenue - MR‘-The increase in revenue that results from the sale of one additional unit of output.

'Marginal Cost- MC- variable cost of production

Profit maximized MR=MC

Price equation =p=a- bx P= price

X=quantity

A and b are constants

MR=a-2bx

Pricing strategies

Total cost plus

Marginal cost plus

Premium pricing

Market Skimming

Penetration Pricing

Loss leader pricing

Controlled Pricing

Performance ManagementTRANSFER PRICING

Topics CoveredMeaning of Decentralization

Meaning of transfer pricing

Purpose

Basis of Transfer Pricing

Objective of Transfer Pricing

A Perfect Intermediate Market

Imperfect Intermediate Market

Decision –making

TP and International Taxation

Meaning of Decentralization

Delegation of decision-making to the subunits of an organization.

It is a matter of degree.

The lower the level where decisions are made, the greater is the decentralization.

Decentralization is most effective in organizations where subunits are autonomous and costs and profits can be independently measured.

The benefits of decentralization include:

(1) decisions are made by those who have the most knowledge about local conditions;

(2) greater managerial input in decision- making has a desirable motivational effect; and

(3) managers have more control over results.

Meaning of Transfer Pricing

A “transfer price” is the price at which one company buys and sells goods or services or shares resources with a related affiliate in its supply chain.

A transfer price is what one part of a company charges another part of the same company for goods or services.

PurposeGenerate separate profit figures for each division and thereby evaluate

the performance of each division separately.

Help coordinate production, sales and pricing decisions of the different

divisions (via an appropriate choice of transfer prices).

Transfer prices make managers aware of the value that goods and services have for other segments of the firm.

Transfer pricing allows the company to generate profit (or cost) figures

for each division separately.

The transfer price will affect not only the reported profit of each centre,

but will also affect the allocation of an organization’s resources.

Guidelines for transfer pricing The Price Must be Similar to That Sold to Arm's-length Customers

An arm's-length transaction is one between two unrelated entities. If one division of a company normally sells products to companies that are unrelated to them, then that price should be used for a division that is related to them. "Related" means two companies that are legally part of the same corporation, LLC or other recognized business organization.

The Price Must be Similar to Prices Other Companies Charge Each Other

Examine the prices other companies charge each other for similar products. This is a good guideline for setting prices between divisions of your own company. Set the price near what the company-to-company market dictates.

Set Prices According to What You Have Paid Other Companies

The division acquiring the product may have purchased from outside sources in the past. Use the prices established in those transactions as a guide. Allow for inflation or other market changes, and set the price accordingly.

Basis of Transfer PricingThere are three general methods for establishing transfer prices.

Market-based transfer price: In the presence of competitive and stable external markets for the transferred product, many firms use the external market price as the transfer price.

Cost-based transfer price: The transfer price is based on the production cost of the upstream division. A cost-based transfer price requires that the following criteria be specified: Actual cost or budgeted (standard) cost. Full cost or variable cost. The amount of markup, if any, to allow the upstream division to earn a profit on the transferred product.

Negotiated transfer price: Senior management does not specify the transfer price. Rather, divisional managers negotiate a mutually-agreeable price.

Decision -making Perfectly competitive market

Optimum TP

=Market price + Any small Adjustments

Where there is surplus capacity

Optimum TP=Marginal Cost

Where there is production constraint

Optimum TP=Marginal Cost + shadow price (opportunity cost)

TP and International TaxationIn order to minimize the tax liability:

1. reduce the profitability of its subsidiaries in high tax countries.

2. Increase the profitability of its subsidiaries in low tax countries.

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Performance ManagementRESPONSIBILITY CENTERS

Topics Covered

Cost , profit and Investment Centers

Responsibility accounting

ROCE

Residual Income

Economic Value Added

Cost Centre

A cost centre is a business unit that is only responsible for the costs that it incurs. The manager of a cost centre is not responsible for revenue generation or asset

Assigning costs to cost centres lets you determine where costs are incurred within the organization.

If you plan costs at cost centre level, you can check cost efficiency at the point where costs are incurred.

Profit center

A business unit or department which is treated as a distinct entity enabling revenues and expenses to be determined so that profitability can be measured.

A large corporation with diversified interests in paper manufacturing, trucking, and fast food may regard each of these three businesses as a profit centre.

Investment CentreDepartment or an area of responsibility, where a manager controls revenues and associated costs, assets, and liabilities. His or her performance is assessed largely on the basis of return on investment (ROI) achieved.

The corporate headquarters or division in a large decentralized organization would be an example of an investment centre.

Return on investment and residual income are two key performance measures of an investment centre.

Responsibility accounting

Responsibility accounting is an underlying concept of accounting performance measurement systems.

The basic idea is that large diversified organizations are difficult, if not impossible to manage as a single segment, thus they must be decentralized or separated into manageable parts.

These parts, or segments are referred to as responsibility centres that include: 1) cost centres, 2) profit centres and 3) investment centres.

These elements include costs for a cost centre, a measure of profitability for a profit centre and return on investment (ROI) for an investment centre.

ROCEReturn on capital employed establishes the relationship between the profit and the capital employed.

It indicates the percentage of return on capital employed in the business and it can be used to show the overall profitability and efficiency of the business.

Return on Capital Employed=(Adjusted net profits*/Capital employed)×100

*Net profit before interest and tax minus income from investments.

Residual Income

ROI Residual income

Average operating assets

(a) Net operating income (b) ROI,

Minimum required return (15% $100,000)

Residual income

$100,000=======$20,000

20%

$100,000=======$20,000

15,000----------$5,000

=======

Net income that an investment can earn over the minimum rate of return (time-deposit interest rate).

Residual income, unlike ROI, is an absolute amount of income rather than a rate of return.

Economic Value AddedThe fundamental concept of EVA is not whether the business or venture is profitable, but whether that profit is sufficient to compensate the equity capital invested in the firm at its opportunity cost and have any revenue remaining after compensating the cost of all resources.

Economic value added asserts that businesses should create returns at a rate above their cost of capital.

The formula for calculating EVA is as follows:

EVA = Net Operating Profit After Tax - (Capital Invested x WACC)

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PERFORMANCE MANAGEMENT

LEARNING CURVE

Topics Covered

Meaning

Formula

Application

KAPP Edge Solutions

Learning curve- Meaning

It is a mathematical expression.

It is based on the observation that as complex and labor intensive procedures are repeated , unit labor times tend to decrease.

Learning rate:

When cumulative output doubles, the cumulative average time per unit falls to a fixed percentage of the previous average time.

This is called learning rate.

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Example

57

Consider a product with the following data about the hours of labor required to produce a unit:

Hours required to produce 1-st unit: 100

Hours required to produce 10-th unit: 48




As more and more units are produced, the hours of labor required to produce the most recent unit is lower and lower.

Graph for Example

58

1 10010 4825 3575 25200 18

Hours Required to Produce

Most Recent UnitCumulative Production

Learning Curve

0102030405060708090100110

0 25 50 75 100 125 150 175 200 225

Cumulative Production

Hour

s Re

quire

d

to P

rodu

ce

Mos

t Rec

ent U

nit

What happens when cumulative production doubles?

59

The concept of a Learning Curve is motivated by the observation (in many diverse production environments) that, each time the cumulative production doubles, the hours required to produce the most recent unit decreases by approximately the same percentage.

For example, for an 80% learning curve,If cumulative production doubles from 50 to 100, then the hours required to produce the 100-th unit is 80% of that for the 50-th unit.If cumulative production doubles from 100 to 200, then the hours required to produce the 200-th unit is 80% of that for the 100-th unit.

Learning curve-ExampleIncremental Qty. Cumulative

Qty.Avg. time per

unitCumulative Time taken

1 1 100 100

1 2 80 160

2 4 64 256

4 8 51 408

8 16 41 656

The time taken for 2nd unit is 80% of time taken for 1st unit as 80% learning rate is applicable.

Learning Ratio Learning curve ratio

= Average labour cost of first 2N units

Average labour cost of first N units

If the average labour cost for the first 500 units is $25 and first 1000 units is $20, the ratio is:

$20 x 100

$25

=80%

Every time output doubles, the average cost declines to 80% of the previous amount.

Calculation Of Learning Rate Example 1P Co operates a standard costing system. The standard labour time per batch for its newest product was estimated to be 200 hours, and resource allocation and cost data were prepared on this basis. The actual number of batches produced during the first six months and the actual time taken to produce them is shown below

Month Incremental number of batches produced

each month

Incremental labour hours taken to

produce the batches

June 1 200 July 1 152

August 2 267.52 September 4 470.8

October 8 1,090.32 November 16 2,180.64

Solution - Monthly rates of learningMonth

Incremental number of

batches

Incremental total hours

Cumulative number of

batches

Cumulative total hours

Cumulative average

hours per batch

June 1 200 1 200 200July 1 152 2 352 176

August 2 267.52 4 619.52 154.88Septembe

r 4 470.8 8 1090.32 136.29

October 8 1090.32 16 2180.64 136.29Novembe

r 16 2180.64 32 4361.28

Learning rate:176/200 = 88%154.88/176 = 88%136.29/154.88 = 88% Therefore the monthly rate of learning was 88%

Functional Form of a Learning Curve

64

To model the behavior described in the previous slides, we proceed as follows:

Let x = cumulative production

y = hours required to produce the x-th unit

Then, y = ax-b

where a and b are parameters defined as follows:

a = hours required to produce the 1-st unit

b = a value related to the percentage associated with the Learning Curve

b= log learning curve rate

log 2

An 80% Learning Curve

65

Assume that production of the first unit required 100 hours and that there is an 80% Learning Curve.

Again, let

x = cumulative production

y = hours required to produce the x-th unit

Then, mathematicians can show that the Learning Curve is

y = 100x-0.322

An 80% Learning Curve(continued)

66

Hours RequiredCumulative to ProduceProduction Most Recent Unit

x y = 100x -0.322

1 100.0002 80.000

--- --- 4 64.000

--- --- 8 51.200

--- --- 16 40.960 --- --- 25 35.478 --- --- 32 32.768 --- --- 50 28.383 --- --- 64 26.214 --- --- 100 22.706 --- --- 128 20.972 --- --- 200 18.165

Application 1. Budgeting and standard costing

2. Pricing

3. Work scheduling

4. Steady rate

5. Experience curves

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Study TipsBe regular in studies. Study at least 11 hours per week.

Attempt at least two mock papers to timed conditions before the exam including reading time of 20 minutes (Total 3 hrs and 20 minutes to complete).

Students have performed worse in calculating and explaining variances. Try to concentrate on this topic specifically.

Timed conditions it is 1.8 minutes per mark (18 minutes for 10 mark, 45 minutes for 25 marks).

Don’t forget to carry your scientific calculator in exam.

KAPP Edge Team wishes you all the best.

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ThanksKAPP Edge Solutions Pvt. Ltd.E mail-info@onlineglobalcareer.comWebsite-www.onlineglobalcareer.com9871434852

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