Principles of Management Accounting A SA Perspective 3e (2020)

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Preface
Foreword
Acknowledgements
List of contributors
Chapter 1 Introduction to management accounting

Chapter 2 Cost classi cation
Chapter 3 Cost estimation
Chapter 4 Cost-volume-pro t relationships
Chapter 5 Absorption versus variable costing
Chapter 6 Overhead allocation
Chapter 7 Job costing
Chapter 8 Process costing
Chapter 9 Joint and by-product costing
Chapter 10 Relevant information for decision-making
Chapter 11 Decision-making under operational constraints
Chapter 12 Budgets, planning and control
Chapter 13 Standard costing
Chapter 14 Performance management
Chapter 15 Transfer pricing
Chapter 16 Contemporary management accounting concepts
Chapter 17 Competitive advantage
Glossary
Index

Contents
Preface
Foreword
Acknowledgements
CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING
Shelley-Anne Roos (updated by John Williams)

1.1 Introduction
1.2 Management accounting
1.3 Financial reporting versus management accounting
1.4 Levels of management information
1.5 Modern management accounting
CHAPTER 2 COST CLASSIFICATION
Carol Cairney
2.1 Introduction
2.2 Cost behaviour
2.3 Assignment
2.4 Relevance
2.5 Function
2.6 Timing
2.7 Summary
Conclusion: Cost classi cation and other topics in this book
Basic questions
Long questions
CHAPTER 3 COST ESTIMATION

Carol Cairney
3.1 Introduction
3.2 Cost drivers
3.3 Scatter graph
3.4 High-low method
3.5 Least squares regression
3.6 Factors affecting the accuracy of cost estimation
3.7 Other means of estimating costs and predicting cost behaviour
3.8 Summary
Conclusion: Cost estimation and other topics in this book
Appendix 3.1 Learning curves
Basic questions
Long questions
CHAPTER 4 COST-VOLUME-PROFIT RELATIONSHIPS
John Williams
4.1 Introduction
4.2 CVP analysis – the accountant’s and economist’s models
4.3 Break-even analysis
4.4 Sensitivity analysis
4.5 Break-even analysis with multiple products
4.6 CVP analysis assumptions and limitations
4.7 Summary
Conclusion: Cost-volume-pro t relationships and other topics in this
book
Basic questions
Long questions
CHAPTER 5 ABSORPTION VERSUS VARIABLE COSTING
Dewald Joubert

5.1 Introduction
5.2 Cost accounting concepts
5.3 The impact of changes in inventory on pro t
5.4 Strengths and weaknesses of absorption and variable costing
5.5 Summary
Conclusion: Absorption versus variable costing and other topics in
this book
Basic questions
Long questions
ADVANCED READING INTEGRATION SECTION: CHAPTERS 1 TO 5
Shelley-Anne Roos (updated by John Williams)
CHAPTER 6 OVERHEAD ALLOCATION
Carol Cairney
6.1 Introduction
6.2 Volume- and value-based techniques
6.3 Allocation of support service department costs
6.4 Activity-based costing
6.5 Activity-based management and activity-based budgeting
6.6 Digital technologies
6.7 Summary
Conclusion: Overhead allocation and other topics in this book
Basic questions
Long questions
CHAPTER 7 JOB COSTING
John Williams
7.1 Introduction
7.2 Job costing objectives

7.3 The elements of cost in a job costing system
7.4 Integrating the costing and nancial accounting systems
7.5 Summary
Conclusion: Job costing and other topics in this book
Basic questions
Long questions
CHAPTER 8 PROCESS COSTING
John Williams
8.1 Introduction
8.2 Calculations in a process costing system
8.3 Consecutive processes
8.4 Decision-making
8.5 Summary
Conclusion: Process costing and other topics in this book
Basic questions
Long questions
Appendix 8.1 Normal losses revisited – the ‘short cut’ method of
accounting for normal losses
CHAPTER 9 JOINT AND BY-PRODUCT COSTING
John Williams
9.1 Introduction
9.2 Cost accounting treatment of joint costs
9.3 Joint costs and nancial reporting
9.4 Joint costs in relation to decision-making
9.5 Summary
Conclusion: Joint and by-product costing and other topics in this
book
Basic questions

Long questions
John Williams and Shelley-Anne Roos
CHAPTER 10 RELEVANT INFORMATION FOR DECISION-MAKING
Dewald Joubert
10.1 Introduction
10.2 Understanding the concept of relevance
10.3 Decisions under conditions of certainty
10.4 Applying the concept of relevance to basic cost elements
10.5 Decisions under conditions of uncertainty
10.6 The pricing decision
10.7 Summary
Conclusion: Relevant costs for decision-making and other topics in
this book
Basic questions
Long questions
CHAPTER 11 DECISION-MAKING UNDER OPERATIONAL CONSTRAINTS
Appie Pienaar & Dewald Joubert

11.1 Introduction
11.2 The importance of contribution
11.3 Limiting factors
11.4 Make-or-buy decisions and scarce resources
11.5 Limiting factors and shadow prices
11.6 Linear programming: the graphical method
11.7 Shadow prices and linear programming
11.8 Linear programming: the simplex method
11.9 Concluding on operational constraints scenarios

11.10 Linear programming in practice
11.11 Summary
Conclusion: Decision-making under operational constraints and
other topics in this book
Basic questions
Long questions
CHAPTER 12 BUDGETS, PLANNING AND CONTROL
Appie Pienaar and Elton Pullen

12.1 Introduction
12.2 Objectives of budgets
12.3 Strategic, tactical and operational budgets
12.4 Responsibility for the budget
12.5 Determining the principal budgeting factor
12.6 The sequence in budget preparation
12.7 Production and related budgets
12.8 Cash budgets
12.9 The master budget
12.10 The role of ratio analysis and key performance indicators in the
budgeting process
12.11 Alternative approaches to budgeting
12.12 Budgeting and probability theory
12.13 Preparing projections using historical data
12.14 Projecting sales
12.15 Budgetary control
12.16 Fixed and exed budgets
12.17 Preparing a exed budget
12.18 Impact of budgeting on the motivation of managers
12.19 Participation and performance evaluation
12.20 Negotiated style of budgeting

12.21 Continuous feedback on performance
12.22 The role of the management accountant in the budget process
12.23 Beyond Budgeting®
12.24 Summary
Conclusion: Budgets, planning and control and other topics in this
book
Basic questions
Long questions
CHAPTER 13 STANDARD COSTING
Jonathan Streng and Elton Pullen

13.1 Introduction
13.2 Standards and the interrelationship between standards and
budgets
13.3 Standard costing and inventory valuation
13.4 Determination of cost standards
13.5 Calculation of variances
13.6 Reconciliation of actual pro t to standard pro t
13.7 Investigation of variances
13.8 Interpretation of variances
13.9 Possible causes of variances
13.10 Planning and operating variances
13.11 Revision of standards
13.12 Accounting entries
13.13 Balances in the variance accounts
13.14 Criticisms of standard costing
13.15 Variance analysis in modern mechanised environments
13.16 Standard costing in service organisations
13.17 Standard costing and benchmarking
13.18 Summary

Conclusion: Standard costing and other topics in this book
Appendix 13.1 Advanced standard costing concepts
Basic questions
Long questions
John Williams and Shelley-Anne Roos
CHAPTER 14 PERFORMANCE MANAGEMENT
Shelley-Anne Roos
14.1 Introduction
14.2 Responsibility accounting
14.3 Centralised and decentralised organisational structures
14.4 Financial performance measures
14.5 Multidimensional performance measures
14.6 Agreeing on targets and rewarding performance
14.7 Not-for-pro t and public sector organisations
14.8 Summary
Conclusion: Performance management and other topics in this book
Basic questions
Long questions
CHAPTER 15 TRANSFER PRICING
Shelley-Anne Roos and Elton Pullen

15.1 Introduction
15.2 Decentralisation and transfer pricing
15.3 Principles of transfer pricing
15.4 Market price-based transfer prices
15.5 Cost-based transfer prices
15.6 Negotiated transfer prices

15.7 Resolving transfer pricing problems
15.8 Transfer of self-constructed assets
15.9 International transfers
15.10 Strategic and ethical considerations
15.11 Summary
Conclusion: Transfer pricing and other chapters in this book
Appendix 15.1 Determining transfer prices in perfect and imperfect
markets
Basic questions
Long questions
CHAPTER 16 CONTEMPORARY MANAGEMENT ACCOUNTING CONCEPTS
Richard Chivaka and Shelley-Anne Roos

16.1 Introduction
16.2 Theory of constraints
16.3 Business process re-engineering (BPR)
16.4 Just-in-time systems
16.5 Benchmarking
16.6 Summary
Conclusion: Contemporary management accounting concepts and
Basic questions
Long questions
CHAPTER 17 COMPETITIVE ADVANTAGE
Richard Chivaka and Shelley-Anne Roos

17.1 Introduction
17.2 Porter’s generic strategies
17.3 Activity-based management
17.4 Total quality management

17.5 Target costing
17.6 Life-cycle costing
17.7 Supply chain management
17.8 Value chain analysis
17.9 Summary
Conclusion: Competitive advantage and other chapters in this book
Basic questions
Long questions
Shelley-Anne Roos
INTEGRATION SECTION SOLUTIONS
Glossary
Index

Preface
This third edition of Principles of Management Accounting: A South

African Perspective is the result of the collaborative effort of authors
from several leading South African universities to produce an
understandable yet comprehensive, principles-based management
accounting textbook.
The book is unique in a number of ways. Firstly, the involvement
of experienced lecturers from several different universities means the
text is representative of the way in which management accounting is
currently taught at South African universities. Secondly, it covers the
topics that form the basis of almost any management accounting
course (such as those followed by MBA students, or students
studying towards a general business quali cation who choose to
include management accounting in their studies); yet it also very
speci cally aims to cover the management accounting syllabus of the
South African Institute of Chartered Accountants (SAICA). In doing
so, most aspects of the relevant papers’ syllabi of the Chartered
Institute of Management Accountants’ (CIMA), as well as those of
the Association for Certi ed Chartered Accountants (ACCA) are
dealt with as well. Thirdly, the book was written by South Africans
for South Africans, and gives preference to local examples, scenarios
and business issues rather than international ones. Fourthly, the
book aims to encourage students to integrate their knowledge of
different management accounting topics, rather than to ‘box’ pieces
of information inappropriately in their memories by viewing each
topic in isolation.
The book has been structured in a manner that we hope will be
most useful to its target readership. Every chapter lists the relevant

learning outcomes to be achieved, followed by a brief introductory
tutorial case study to illustrate the real-life need for the management
accounting techniques that are to be discussed in the chapter.
Numerous worked examples are integrated into the text of chapters
throughout, and are used to explain the principles and provoke
thinking about the topic, rather than merely to illustrate the
calculations required. Each chapter ends with a brief summary and
an explanation of how the topics in that particular chapter link with
those in other chapters in the book (to facilitate integration of
knowledge). At the end of the text, a real-life tutorial case study with
questions for class discussion is presented.
Finally, the integration sections, which tie together the
knowledge gained in a number of chapters, are speci cally aimed at
more advanced students preparing for higher-level exams.
Assessment opportunities provided include ten basic questions
as well as ve long questions at the end of each chapter. Answers to
the basic questions, and suggested solutions to the long questions,
are contained in the Instructor’s Manual, which is in the Learning
Zone made available to lecturers who prescribe this book. The third
edition of the separate question book, Principles of Management
Accounting: The Question Book, which includes questions based on all
the topics covered in the various chapters in this book, is also
available for purchase to accompany and support this textbook.
Our hope is that this book will play a part in shaping competent,
well-educated and well-informed management accountants. We
hope that these management accountants will nd themselves in
in uential business positions where they deliver quality
information, resulting in optimal decision-making in the
organisations that drive South Africa’s economy forward.
John Williams

March 2020

Foreword
This foreword to the Principles of Management Accounting: A South

African Perspective 3rd edition is being written in the midst of the
Covid-19 global pandemic. This singular event has demonstrated
that despite us knowing more than ever before about the natural
order of things, we have had to deal with something that very few
saw coming. What it has con rmed is that we cannot ever plan a
future with certainty. However, it has also shown that access to
relevant data and information, considering the nancial and
qualitative impacts of its transmission, and implementing key
control and performance measurements are essential in enabling
effective decision making to combat it. It is no coincidence that these
are also core to management accounting. Managers are having to
assess, plan, implement and control in an environment where little
can be taken for granted. Management accounting is a dynamic
discipline and even though it is founded on principles that are
timeless, it too has to maintain relevance to remain at the forefront of
enabling managers to make the right decisions. The update to this
book consequently comes at just the right time.
Management accounting is a ‘doing’ subject. It requires actively
applying the theory, considering the options and then working out
the answer. This book does just that. Each chapter exposes the
scholar to the core principles and concepts of the topic and then
through appropriate scaffolding ensures the progression of learning
in an accessible way. Pertinent and contemporary examples that
show the application of theory give an important background as to
why management accounting is such an important discipline,

regardless of the organisational context in which practitioners nd
themselves.
This updated edition has introduced, made more explicit and
provided a richer context to what is essential to management
accounting today. For example, the King IV Code of Corporate
Governanceª requires an ethical culture to permeate the
organisation. Ethical dilemmas have been introduced. Some state-
owned enterprises (SOEs) in South Africa have struggled to
maintain nancial sustainability. Some insights as to how this might
have been addressed are provided. The advent of the fourth
industrial revolution sees the importance of focusing on digital
developments in management accounting such as predictive
analysis in costing and other strategic applications. Sustainability
and the impact of climate change will ever increasingly be part of the
vocabulary of the management accountant.
Having been updated in accordance with the ACCA and CIMA
syllabi, this volume will ensure that students are adequately
prepared for whichever professional association they wish to pursue.
Furthermore, with Covid-19 requiring a sudden change over to
remote learning, the content and style of the book will give the
teacher the con dence that this will be an important resource
regardless of the mode of delivery.
Associate Professor Owen Skae

Director
Rhodes Business School
Rhodes University

Acknowledgements
The authors and publisher gratefully acknowledge permission to

reproduce copyright material in this book. Every effort has been
made to trace copyright holders, but if any copyright infringements
have been made, the publisher would be grateful for information
that would enable any omissions or errors to be corrected in
subsequent impressions.
We are grateful to the Association of Chartered Certi ed

Accountants (ACCA) for permission to reproduce past examination
questions. These questions are the copyright of ACCA and are
reprinted with the permission of ACCA. The suggested solutions in
the solutions bank have been prepared by the authors unless
otherwise stated.
We are grateful to the Chartered Institute of Management

Accountants (CIMA) for permission to reproduce past examination
questions. These questions are the copyright of CIMA and are
reprinted with the permission of CIMA.
We are grateful to the South African Institute of Chartered

Accountants (SAICA) for permission to reproduce past examination
questions. These questions are the copyright of SAICA and are
reprinted with the permission of SAICA.
Chapter 2 Long questions 1 and 2, Chapter 3 Basic questions 7 and 8,

Chapter 6 Long questions 1, 2, 4 and 5 and Chapter 13 Long question
4 are based on examination questions and solutions from the

University of Cape Town. The examination questions and solutions
in their original examination form are the sole copyright of the
University of Cape Town. Adapted questions and solutions are
copyright of the authors and Oxford University Press.
Information and text on page 128 taken from the article: Davie, L.
Chappies, a Joburg creation. Available online:
https://www.lucilledavie.co.za/post/2003/03/10/chappies-a-
joburg-creation [accessed 08 September 2020]. Reprinted by
permission of Lucille Davie.
Figure 17.1 Critical Total Quality Management Factors Source:

Blocher, EJ, Chen, KH, Cokins, G & Lin, TW. 2005. Cost management: a
strategic emphasis, 3rd edition (international edition), Exhibit 16.2, p.
682, New York: McGraw-Hill/Irwin. Reprinted with permission by
McGraw-Hill LLC through Copyright Clearance Centre.
Figure 17.2 Product-level target costing processes Source: Cooper, R

& Slagmulder, R. 1999. Develop pro table new products with target
costing. Sloan Management Review, 40(4):23–33, summer, Figure 5.
Reprinted by permission of MIT Sloan Review through Tribune
Content Agency.
Figure 17.5 Porter's Value Chain Source: Porter, Michael E.

Competitive Advantage: Creating and Sustaining Superior Performance,
Figure 2.2 The Generic Value Chain ©1985, 1998, Free Press, an
imprint of Simon & Schuster Inc.
The authors and the publisher would like to thank the following
authors for their contributions to previous editions of Principles of

management accounting: Hendrik Fourie, Prof. Ahmed Mohammadali
Haji, Prof. Lilla Stack, and Prof. Gary Swartz.

Editors
John Williams (Chapters 4, 7, 8, 9 and integration sections)
CA(SA), MCom, BSc (Inf Sys)
John is the General Manager: Finance at GBS Mutual Bank. He

was an associate professor and head of management
accounting at Rhodes University for many years. John has
extensive experience with setting and marking SAICA
qualifying examinations and was a panel member on a number
of SAICA university monitoring visits.
Shelley-Anne Roos (Chapters 1, 14, 15, 16, 17, and integration

sections)
BAcc (Stell), BAcc Hons (Stell), MPhil (Futures Studies) (Stell),
CA(SA), ACMA
Shelley-Anne Roos lectured at Stellenbosch University for over

a decade, primarily preparing post-graduate students for the
examinations of the South African Institute of Chartered
Accountants (SAICA) and the Chartered Institute of
Management Accountants (CIMA). Her research focused
mainly on performance management, and on the instruction of
management accounting at tertiary level.
Authors
Carol Cairney (Chapters 2, 3 and 6)
BCom (UCT), PGDA (UCT), CA(SA)

Carol Cairney lectured in management accounting and nance
in the Department of Accountancy at the University of Cape
Town and at the University of the Western Cape. She has
lectured nal year post-graduate students preparing for the
examinations of the South African Institute of Chartered
Accountants (SAICA), on the MBA programme offered by the
University of Cape Town Graduate School of Business, as well
as on various other executive courses. Her research is in the
area of cost allocation.
Richard Chivaka (Chapters 16 and 17)

PhD (UCT), MSc (Acc & Fin) (Manchester), BCom Hons
(NUST)
Richard Chivaka is the Chief Executive Of cer and Founder of

Spark Health Africa. He is an associate professor of Business
Strategy & Supply Chain Management at the University of
Cape Town, Graduate School of Business. Dr Chivaka has led
the health systems strengthening work of Spark Health Africa
in Lesotho, South Africa, Malawi, Nigeria, Kenya, Uganda and
Zimbabwe. He is the inaugural Research Scholar and a visiting
professor of the Stanford Institute for Innovation in
Developing Economies (SEED), Stanford University, USA.
Dewald Joubert (Chapters 5, 10 and 11)

CA(SA), MCom (Financial Management)
Dewald Joubert is a senior lecturer and subject head in

managerial accounting and nance in the Department of
Accountancy at the University of Johannesburg. He is a
chartered accountant and lectures managerial accounting and
nance to prospective chartered accountants in their nal year

of studies. He is also a presenter on the Gauteng Board Course
and APT programs which prepares candidates in writing the
SAICA ITC and SAICA APC respectively.
Appie Pienaar (Chapters 11 and 12)

CA(SA), ACMA, MCom (Acc), BA (cum laude), BA Hons
(Classical Greek), BD (cum laude).
Appie Pienaar was formerly an associate professor in

management accounting at the University of South Africa
(UNISA). He is currently the Chief Financial Of cer of the
Solidarity Movement. He has a wide range of lecturing
experience at various institutions, including the University of
Pretoria, the University of Johannesburg, UNISA, Bond
University and CIMA.
Appie is a quali ed FCMA (in one of the papers, nancial

strategy, he obtained the highest mark worldwide).
Jonathan Streng (Chapter 13)

BCom (Acc) (cum laude), BCom Hons (Acc) (RAU), CA(SA)
Jonathan Streng is a chartered accountant with specialised

knowledge of technical IFRS, nancial and integrated
reporting. He is currently Director, Accounting Technical, at
Deloitte Australia, specialising in leasing (IFRS 16), revenue
(IFRS 15) and nancial instruments (IFRS 9). Jonathan is a
facilitator for the CA ANZ Capstone programme. Previously
he was a senior lecturer at the University of Johannesburg, and
was a senior reviewer to the Johannesburg Stock Exchange
proactive monitoring programme during his time at this
university.

Elton Pullen (Chapters 12, 13 and 15)
CA(SA), MCom (Finance)(UCT), BCom (Hons)(Acc), BCom
(Acc)(UWC)
Elton Pullen is a senior lecturer and section head of managerial

accounting and nance (MAF) in the Department of
Accounting at the University of the Western Cape. He was a
nalist in the South African Institute of Chartered
Accountants’ (SAICA) Top 35 CAs under 35 competition in
2017. He is part of SAICA’s competency framework mapping
task team for MAF and has also been the ITC reviewer for
MAF for two years. Elton also has over ve years’ experience
in marking both the SAICA ITC and APC exams, and he
currently acts at the level of assistant umpire for both exams.
He has also served as a MAF reviewer on multiple occasions
on SAICA’s academic review team visits of universities.

LEARNING OBJECTIVES
By the end of this chapter, you should be able to:
• de ne management accounting
• discuss the key elements of the de nition of management
accounting
• distinguish between nancial reporting and management
accounting
• explain the different levels in an organisation at which
management accounting information is required
• explain how nancial reporting differs from reporting for
management accounting purposes.
1.1 Introduction
When students register for business courses at South African
universities and colleges, one of the subjects on offer is called either
‘management accounting’ or ‘cost accounting’. Even in postgraduate
MBA courses in South Africa, one of these terms makes its way into
the syllabus. The South African Institute of Chartered Accountants
(SAICA) includes ‘management accounting’ as one of the key
elements in its syllabus and professional examinations. Many South
African students study management accounting in order to obtain
membership of the London-based organisation, the Chartered

Institute of Management Accountants (CIMA), which focuses
exclusively on professional management accountants. Management
accounting principles also feature strongly in the syllabus of the
Association of Chartered Certi ed Accountants (ACCA), another
UK-based organisation that some South African students aspire to
join.
What is management accounting, and why is it so important for
business and accounting students to have a high-level
understanding of it? This chapter introduces management
accounting and provides an initial perspective on which the other
chapters in the book build.

CIMA formally de nes management accounting as follows:
The application of the principles of accounting and nancial

management to create, protect, preserve and increase value for
the stakeholders of for-pro t and not-for-pro t enterprises in
the public and private sectors. Management accounting is an
integral part of management. It requires the identi cation,
generation, presentation, interpretation and use of information
relevant to:
• inform strategic decisions and formulate business strategy
• plan long-, medium- and short-term operations
• determine capital structure and fund that structure
• design reward strategies for executives and shareholders
• inform operational decisions
• control operations and ensure the ef cient use of resources
• measure and report nancial and non- nancial performances
to management and other stakeholders

• safeguard tangible and intangible assets
• implement corporate governance procedures, risk
management and internal controls.
To understand this lengthy de nition of management accounting,

we need to focus on its individual parts. The subsections below
discuss these parts in turn.
‘The application of the principles of

1.2.1
accounting and financial management …’

As the term suggests, management accounting is a form of
accounting. Accounting entails the communication of historical
economic information to interested parties. However, because the
word ‘accounting’ is often immediately associated with the routine
recording of debit and credit entries and the preparation of annual
nancial statements, care has to be taken to make a distinction
between the disciplines of management accounting and nancial
reporting.1 This distinction is dealt with in section 1.5 below and is
fundamental to understanding the principles described in this book.
The de nition also refers to the principles of ‘ nancial
management’. In most tertiary institutions in South Africa, the
subject area of ‘management accounting’ is divided into two parts.
One may have a name such as ‘cost accounting’ or ‘cost
management’, or may even go by the straightforward name of
‘management accounting’; while the other is likely to be called
‘ nancial management’, ‘ nance’ or something similar. SAICA uses
the terms ‘management decision-making and control’ and ‘ nancial
management’ to describe the two parts.

This book does not deal with nancial management as such,
which is the part of the discipline that focuses speci cally on how
nancial resources are best acquired and deployed. Instead, this
book focuses on the pure ‘management accounting’ aspects, also
often referred to as ‘cost accounting’, ‘cost management’, or even
‘costing’. Because the aforementioned terms employing the word
‘cost’ do not embrace the full scope of the subject matter, we prefer
the broader and more descriptive term ‘management accounting’
and have therefore used it in the title of this book.
‘… to create, protect, preserve and

1.2.2
increase value for the stakeholders …’

Although most people would expect accountants to play some role
in protecting and preserving value in an organisation, the fact that
management accountants ‘create’ and ‘increase’ value may surprise
some. Increasingly, management accountants are moving away from
the stereotypical ‘number crunching’, ‘back of ce’ roles, and playing
a crucial part in strategic decision-making within the organisation.
Part of this change in focus may be due to advances in information
technology that have resulted in tedious, repetitive tasks being
automated, but much of it also has to do with the manner in which
management accountants are educated and how they see their own
roles in practice.
It is important to note that the de nition refers to the delivery of
value to ‘stakeholders’, not ‘shareholders’. Stakeholders are any
parties that have an interest in the organisation. The term is therefore
much broader than ‘shareholders’, which refers only to those with an
equity stake in a company. While shareholders are indeed one of the
primary user groups of nancial reporting information, managers

inside the organisation (who are included under the term
‘stakeholders’) are usually the primary (although not necessarily the
only) users of management accounting information. Furthermore, it
is a modern trend for businesses to focus their attention broadly on
all stakeholders (which include, among many others, customers,
suppliers, employees, the community, suppliers of capital, and even
the natural environment), as it is increasingly believed that the long-
term sustainability of organisations depends on this broader focus.
‘… of for-profit and not-for-profit

1.2.3
enterprises in the public and private

sectors’
Although many of the techniques described in this book have their
origins in a manufacturing environment, companies in the retail and
services sectors have customised and employed them with great
success. Management accounting techniques are even applicable
beyond these pro t-driven private sector companies. Some of the
most welcome applications of the techniques are being experienced
nowadays by not-for-pro t and public sector organisations, where
the need for quality management information is high and
management information systems have traditionally been unre ned
and ineffective. The CIMA syllabus speci cally emphasises
application of the techniques in all types of environment.
1.2.4 The remaining part of the definition

In the last sentence of its de nition of management accounting,
CIMA calls it an ‘integral part of management’ and lists the different
areas to which the information in a management accounting system

is relevant. A shorter and more frequently encountered classi cation
of the areas to which the information relates divides management
activities into the three categories of planning, control and decision-
making. Although these three are valid categories to keep in mind
when studying management accounting (as are the categories in the
CIMA de nition), management functions are very much intertwined
and often almost indistinguishable in practice. In this book, we have
therefore not attempted to classify chapters or techniques according
to categories, but have rather aimed to provide students with the
principles that will enable them to ful l these functions and/or to
supply management accounting information for these functions.
Notice that the de nition of management accounting does not
limit it to either nancial or quantitative information. This is because
a well-designed, balanced management information system provides
not only nancial information (that which is measured in rands,
such as the cost of a new production machine), but also non- nancial
information (that which is not measured in rands, such as the
speci cations of a new production machine). It also does not provide
only quantitative information (that which is measured using
numbers, such as how many units a machine can produce per hour),
but also qualitative information (that which is not measured using
numbers, such as the likely impact of automated production on staff
morale).
Financial reporting versus management

1.3
accounting
[Section 1.3 is based on material written by Ahmed Mohammadali Haji.]
Financial reporting involves the preparation of nancial statements

in line with prescribed standards to satisfy the needs of various

external stakeholders of the organisation. Financial statement
reporting originates from governance and stewardship principles:
management is entrusted with shareholder funds and consequently
has to prepare a statement of account to shareholders on how those
funds have been managed during a speci ed period in the past.
Such statement of account is made publicly in the form of the
company’s published nancial statements. In South Africa,
companies issue nancial statements once a year to comply with
legal requirements and listed companies report twice a year to
comply with JSE regulations. Financial statements have to comply
with International Financial Reporting Standards (IFRS), which aim
to obtain consistency in the manner in which organisations across
the world report the nancial consequences of past transactions and
events.
Management accounting primarily deals with information for
internal reporting purposes. It involves a combination of past
information, together with future-orientated information, such as
forecasts and budgets, to enable managers to perform their duties.
This form of reporting is not governed by laws or reporting
standards. Information is supplied according to the needs of the
particular organisation, without having to comply with general
standards for the sake of comparability with other reporting entities.
The real nature of the transaction or event is therefore more likely to
be retained and reported.
The aim of management accounting is simply to supply
managers with relevant, quality information in a timely manner in
order to enable them to take the best possible decisions.
Table 1.1 summarises the main differences between nancial
reporting and management accounting.
Table 1.1 The main differences between nancial reporting and management accounting

Financial reporting Management accounting
Information primarily prepared for
Target Information primarily prepared for internal users
external users
Includes past events, but focuses on information that
Time frame Reports on past events
enables decisions about the future
Framework Complies with IFRS Is not governed by laws or reporting standards
Depth General purpose reporting Speci c purpose reporting
Organisation as a whole or speci c parts thereof (e.g.
Focus Organisation as a whole
products, clients, and so on)
Annually (semi-annually for
Frequency Determined by management needs
companies listed on the JSE)

Management accounting is about supplying relevant accounting and
related information to managers. Therefore, the ‘correct’
management accounting information in terms of content, scope,
presentation and timing depends on the purpose for which the
information is required.
An organisation can be divided into three layers of management
and decision-making. The lowest is the ‘operational level’, where
day-to-day operations are executed and controlled. In a factory, for
example, nished goods may be produced and accounted for daily.
The process is controlled by the factory oor manager. In a bank,
cheques are received from clients and accounted for every day, a
process controlled by the head teller.
The middle level of an organisation is often called the ‘tactical
level’, where mid-level managers control operations. For example,
the Epping factory manager is in control of the whole Epping
factory. The factory oor manager reports to him and he in turn
reports to the company’s head of ce. Similarly, the branch manager
is in charge of the East London city centre branch of the bank. The

head teller reports to her and she in turn reports to the bank’s head
of ce in Johannesburg.
The highest level of management and decision-making in an
organisation is called the ‘strategic level’. Executive directors and
high-level managers take decisions and control operations at this
level. This overall strategic function is usually performed at the
headquarters of an organisation.
The characteristics of management accounting information differ
at each level. Information that is required at operational level is
typically speci c, detailed, of limited scope, short-term orientated,
frequently required and of a repetitive nature. At the tactical level,
management accounting information needs are likely to be less
speci c and detailed than at the operational level, of broader scope,
medium-term orientated, less frequently required (for example,
weekly or monthly reports instead of daily ones) and of both a
repetitive as well as an ad hoc nature. At strategic level, the
information needs are likely to be broader; summarised rather than
detailed, dealing with the organisation as a whole; long-term
orientated; and of even lower frequency, with information needs of
an ad hoc nature arising more regularly.
It is therefore imperative that students of management
accounting are skilled in analysing the purpose for which
information is required in a given scenario and that they understand
the importance of delivering the best information for the speci c
circumstance.

In the 1980s, management accounting received much criticism from
scholars and practitioners who believed that the discipline had lost

its relevance. This was put on record in a book by Johnson and
Kaplan, Relevance lost – the rise and fall of management accounting. The
authors expressed their concern that management accounting
information was simply extracted from the organisation’s nancial
reporting system (instead of being generated by an independent,
purpose-made system) and that a lack of innovation had prevented
management accounting from keeping up with changes in the
environment. Because the book was highly regarded and received
much publicity, many experts reacted to the criticism and have since
made vast improvements to the discipline. The challenge, however,
remains, in that management accountants should free themselves
from the constraints of nancial reporting systems and continue to
keep their work relevant to an ever-changing environment.
The rising global pro le of environmental issues has led to the
questioning of business practice and calls for increased
accountability. Businesses have been forced to become increasingly
aware of the environmental impact of their operations, products and
services. Traditional management accounting techniques often dis-
torted and misrepresented environmental issues. For example, only
direct costs relating to polluting the environment (such as nes) were
accounted for while indirect costs (such as increased sickness among
residents in the area) were ignored.
The greater focus on environmental issues has resulted in a
change in the type of information that management accountants
need to provide and resulted in a new, specialised area of
management accounting referred to as environmental management
accounting. Environmental management accounting involves
generating and analysing both nancial and non- nancial
information to support internal environmental management
processes.

In recent years, there has been an exponential increase in the
amount of data that has become available to organisations. As an
example, businesses that operate via the internet are able to obtain
information such as the number of new visitors to their website as
well as their location, language, age and gender etc. Data can also be
obtained about how they accessed the website (for example, via a
search engine or a link from another website), the amount of time
they spent on the website, and how many actually transacted on the
website in comparison with those who just visited. These large
amounts of data are commonly referred to as ‘big data’.
Traditionally, management accountants mainly analysed and
interpreted nancial data, which is very structured in its nature.
However, with the increase in big data, management accountants
increasingly need to be able to analyse big data to reveal patterns,
trends and associations (‘data analytics’). The acquisition of data
analytics skills will help ensure that management accountants
remain relevant despite the fourth industrial revolution resulting in
much of the routine transaction work currently performed by
management accountants being automated by robotic processes. In
the modern, highly competitive business environment, managers are
increasingly aware of the quality and timeliness with which
products and services should be delivered to clients. Similarly,
management accountants are increasingly aware of the quality and
timeliness with which information should be delivered to their
‘clients’ – the managers. Although management accounting is still
primarily supplied to managers inside the organisation, there is also
increasingly a tendency to disclose some of the information
voluntarily to other stakeholders through the organisation’s
integrated report.

An effective management accounting system provides high-
quality, timely information to the relevant persons. However, some
consideration needs to be given to the cost of the system. Although
advances in information technology have made the provision of
information cheaper than ever, the cost of further re ning an
information system still needs to be weighed against the bene ts
that are likely to result from such re nement.
Tutorial case study
Thabo, who is in Grade 12, would like to become an ‘accountant’ and is thinking
about registering for a BCom degree next year. He has noted that two of the
subjects included in the curriculum are nancial reporting and management
accounting. He is unsure about what these subjects entail and what the differences
between the two subjects are. Knowing that you are currently registered for a BCom
degree, he has approached you for some advice.
1 Explain, in simple terms, what management accounting is.

2 Discuss how management accounting is different from nancial reporting.
3 Brie y outline the tasks for which you think a management accountant may be
responsible. Use the different levels at which information is required in an
organisation as a guide.
References
ACCA. N.d. Data analytics and the role of the management accountant. [Online]. Available:
https://www.accaglobal.com/in/en/student/exam-support-resources/professional-
exams-study-resources/p5/technical-articles/data-analytics.html [11 January 2020].
ACCA. N.d. Environmental management accounting. [Online]. Available:
https://www.accaglobal.com/in/en/student/exam-support-resources/professional-
exams-study-resources/p5/technical-articles/environmental-management.html [11
January 2020].
Eaton, G. 2005. Management accounting: of cial terminology. London: CIMA.
Financial Times. N.d. Data analytics and digital business to form part of accountancy courses.
[Online]. Available: https://www.ft.com/content/acf60394-70e1-11e9-bf5c-6eeb837566c5
[11 January 2020].

Johnson, HT & Kaplan, RS. 1987. Relevance lost – the rise and fall of management accounting.
Boston, MA: Harvard Business School.
1 The terms ‘financial reporting’ and ‘financial accounting’ are used interchangeably. For consistency,
in this textbook we have chosen to use the term ‘financial reporting’.

LEARNING OBJECTIVES
• understand the reasons for classifying costs according to each of
the various cost attributes
• classify costs according to the criteria set out in each of the cost
categories
• identify whether a cost is xed, variable, mixed or step in nature
• determine the total cost of an expense, for a given level of activity
• identify which costs are to be allocated to the cost of inventory
produced and which costs are expensed through the income
statement
• distinguish between direct and indirect costs and be aware of
how these two types of costs are traced or assigned to cost objects
• identify the kinds of costs that are relevant and not relevant to
decision-making.
SAPPI and cost classi cation
The following is an extract taken from the group statement of comprehensive

income included in SAPPI’s 2018 integrated report:

SOURCE: SAPPI INTEGRATED REPORT (2018)
Notice that most of the group’s operating expenses have been split into two
categories and classi ed as costs that are either ‘variable’ or ‘ xed’. This is a less
common way of presenting cost information in a statement of comprehensive
income. What do the classi cations ‘ xed’ and ‘variable’ mean, and why does
SAPPI regard this distinction as so important to understanding its nancial results
that it chooses this less common format of presentation?
The answers to these questions lie in understanding the kind of cost information
that the management of any organisation uses to take decisions and control its
operations. While SAPPI’s classi cation of operating costs as ‘ xed’ or ‘variable’ is a
less common approach in presenting integrated reports, this distinction lies at the
heart of all management accounting information used in decision-making for
generating more value, and this is not the only way in which costs are analysed and
classi ed internally by an organisation.
This chapter examines the fundamental questions of how costs

behave and are classi ed, for the purposes of management decision-
making and control.
2.1 Introduction
Key terms: assignment, cost behaviour, function, relevance,

timing

This chapter introduces concepts that form the foundation of all of
the management accounting tools and techniques that are discussed
in this book. The title of this chapter, Cost classi cation, refers to the
categorisation of nancial information (with a focus on cost
information) according to a number of different attributes that are of
interest from a managerial perspective. The logical question that
should arise at this point is: why would we want to classify
accounting information in a number of different ways? We already
have the nancial accounting classi cation – revenue or expense,
asset, liability or equity – surely this is suf cient for management?
The answer is: no, it’s not. Not by a long shot. But why not?
In order to understand why, for managerial purposes, viewing
nancial information from a nancial accounting perspective is
unhelpful, and why nancial information actually needs to be
considered from a number of different angles, we need to start by
understanding what the management of an organisation is there to
achieve. (The term ‘management’ in this context refers to all levels of
management, but with particular emphasis on senior management,
including an organisation’s directors.)
The objective of a pro t-seeking organisation’s management is to
create and enhance shareholder value. In order to achieve this,
management needs to focus on maximising the value of the
organisation itself. They do this by making decisions that increase the
value of the organisation (such as which product and service ranges
to introduce or discontinue, which departments and divisions to
expand or close, which contracts and projects to accept or decline,
and similar issues) and by controlling the actions of the organisation’s
employees through nancial mechanisms (such as performance
evaluation and incentives).

Managers should seek to make decisions and control the
organisation in such a way as to increase the future cash ow that the
organisation is likely to generate. Managers view nancial
information from a number of perspectives that provide insight into
the relationship between management’s actions, and the value of the
rm. These perspectives are based on the various attributes
(characteristics) that cost information has, and comprise the
following:
• Cost behaviour
• Assignment
• Relevance
• Function
• Timing
These various perspectives are laid out below in section 2.1.1, and
explained more fully in the remainder of this chapter. You will notice
as we work through the explanations and examples that follow that
many of these attributes are related, and an understanding of all of
these aspects is required in order to determine how costs and
revenues can be altered and managed.
2.1.1 Cost classification

As mentioned above, for management accounting purposes, the
perspectives from which cost information is viewed are based on the
following characteristics:
• Cost behaviour: This deals with how a cost reacts to a change in
sales volume, production volume or any other activity level (for
example, the number of machine set-ups). This chapter
introduces four basic cost types: variable, xed, step and mixed
costs.

• Assignment: This is the tracing of costs to cost objects, such as
products, services, projects, customers, departments and
divisions. Assignment is concerned with identifying the
relationship between the cost and the object for which the total
cost is calculated. Does the cost arise directly from producing and
selling the product concerned, or does the cost represent some
resource that is drawn on by many aspects of the business? If the
latter is the case, then the relationship between the cost object
(the product, service, or business unit, or any other relevant
aspect) and the cost is less direct and more dif cult to determine
and trace. This chapter focuses on distinguishing between costs
that are direct and costs that are indirect to the cost object.
Chapter 6, Overhead allocation addresses in depth the problem of
how to attach indirect (‘overhead’) costs to products.
• Relevance: It is important to identify costs and revenues that are
affected or altered by a decision, as well as costs that are not
altered by a decision. Costs and revenues should be taken into
account in decision-making only to the extent that they are
incremental (that is, to the extent that they will be changed by the
decision). The basic principles of decision relevance are
introduced in this chapter. Chapter 10, Relevant costs for decision-
making explores these concepts more fully.
• Function: The presentation of cost information is done in
accordance with the function of the cost within the entity. This
aspect distinguishes, for example, between costs that are incurred
in order to bring a product into a saleable location and condition,
and costs that are incurred in order to support, but that are not
directly related to, this function.
• Timing: This relates to the date and time period when a cost is
recognised in the income statement.

In our discussion so far we have explained the need for classifying
costs and analysing their behaviour from the perspective of the
management team of a pro t-seeking organisation operating in the
private sector (in other words, an organisation that aims to make a
pro t from its operations). However, an understanding of cost
classi cation and behaviour is just as important in public sector
organisations (such as government departments) and in not-for-
pro t organisations (such as professional institutes or charities). In
these cases, there is usually an almost unlimited demand for the
services of the organisation, but limited resources to supply the
services. A thorough understanding of the organisation’s costs helps
managers to run the organisation ef ciently.
2.2 Cost behaviour
Key terms: xed costs, mixed costs, step costs, variable costs
Cost behaviour refers to how costs are affected by a change in sales

volumes, production volumes or other activity level (for example,
the number of machine setups). This information is necessary in
order to establish how changing production and sales levels will
affect the organisation’s pro tability. Costs can be divided into four
broad categories based on their relationship to changing activity
levels: variable costs, xed costs, step costs and mixed costs.
2.2.1 Variable costs

Variable cost increases (or decreases) in proportion with increases (or
decreases) in the level of activity. Where the cost is related to
production activities (for example, materials costs), the total cost

changes as production volumes change, while if the cost is related to
sales (such as sales commission), the total cost changes as sales
volumes change. Some costs may change in relation to another
activity, for example set-up costs are likely to change in relation to
the number of machine set-ups.
Example 2.1
Suppose one of the large South African universities decided to introduce a new
course: a master’s degree in management accounting. The number of students
accepted on to the course each year is expected to vary from 15 to 20. The master’s
degree will require students to complete one year of course work, which includes
writing and passing three term tests and one nal exam. The university will supply
each student with course notes and lecture notes. The cost of stationery (the cost of
providing students with course and lecture notes, test and exam papers, and exam
books) is R400 per student. In addition to writing tests and exams, students must also
submit a thesis. Each student writing a thesis is supervised by a university lecturer,
who is paid a supervisor’s fee of R5 000 for each student supervised. Each thesis is
marked by two markers. Each marker is paid R1 000 per thesis marked.
Required:
Calculate and discuss the variable and xed cost components of the new master’s
degree.
All the costs described above are variable costs in respect of the
number of students on the course. The variable cost per student is R7
400 (R400 + R5 000 + R1 000 × 2). These costs will increase directly
with the number of students accepted onto the course. If only one
student is accepted onto the course, then the total variable cost is R7
400, but if two students are accepted, the total variable cost increases
to R14 800 (R7 400 × 2). The relationship between the total variable
cost and the number of students can be plotted on a graph. Figure
2.1 shows the relationship between the total variable cost and the
number of students accepted on the course, while Figure 2.2 shows

the variable cost per student relative to the number of students on
the course. Notice that while the variable cost varies in aggregate,
the variable cost is constant per unit of the activity level (in this case,
the number of students).
Figure 2.1 Variable cost graph: total cost
Figure 2.2 Variable cost graph: per student

Economic considerations
Figure 2.3 Variable cost graph: activity level

A perfectly linear relationship between the total variable cost and
activity level existed in example 2.1, as shown in Figure 2.1. In many
circumstances, such a perfectly linear relationship may not exist.
Consider Figure 2.3. At low levels of activity (point A), an
organisation may not bene t from economies of scale such as
volume discounts and ef cient use of resources, causing the variable
cost per unit of activity to decrease initially with increasing activity
levels (from A to B). Likewise, at high activity levels (C to D), where
maximum capacity is approached, dis-economies may result from
inef ciencies arising as a result of tired staff, overworked machinery,
less exibility owing to increased size, and other similar factors. For
this reason, variable cost per unit increases in the C to D range as
activity levels increase. However, a linear relationship between the
activity level and total cost may well exist between these two
extremes. This (B to C) is referred to as the relevant range – the range
for which the linear relationship assumption is true.
2.2.2 Fixed costs

A xed cost is a cost that in total is unresponsive to a change in
activity. As a result, the cost per unit of activity would decrease as
the activity level increased, and vice versa. The following example
illustrates this.
Example 2.2
Other than the variable costs of running the course described in example 2.1, certain
other costs must also be incurred in order for the course to be run. The class will be
lectured by a retired professor who is no longer otherwise involved with the university
and who will be paid R200 000 for the year to lecture up to 20 students exclusively.
There will also be a number of guest lecturers, who will collectively be paid R10 000
for the year.

Required:
Calculate and discuss the variable and xed cost components of the new master’s
degree.
All the costs in example 2.1 were variable in relation to the number
of students, and the total variable cost was calculated to be R7 400
per student. The costs introduced to the scenario in example 2.2 are
xed costs, as these amounts will be incurred regardless of the
number of students in the course (within a range of 0 to 20 students).
Whether there are 15 students or 20 students in the class, the salary
paid to the professor and guest lecturers remains at R210 000.
Figure 2.4 Fixed cost graph: total cost
Figure 2.5 Fixed cost graph: per student

Notice that while the total xed cost remains constant regardless of
the number of students on the course, the xed cost per unit of
activity level (in this case the number of students) decreases as the
number of students increases.
Economic considerations
The assumption that xed costs remain unaltered regardless of the
activity level is true only within the relevant range. Should the xed
costs relate to a machine or a factory building with a maximum
capacity and if production volumes were to be increased beyond that
capacity, then a second machine or building would have to be
acquired, which would result in an increase of xed costs. Referring
again to the master’s course example, if the course were to be
expanded to more than 20 students, the professor would be paid
more in terms of his contract, thereby increasing the total xed costs.
Likewise, so-called xed costs are xed only for a speci c period
of time. The professor in the example above would probably not be
paid R200 000 per year for as long as he is willing to lecture the class.
Instead, it is likely that his fee would increase every year, perhaps in
line with the university’s general salary increase granted to staff. The
professor ’s fee is ‘ xed’ only for the period under consideration,

which is one year in this example. Although most management
accountants make a habit of simply referring to a cost as ‘ xed’,
strictly speaking we should phrase it more speci cally by saying a
cost is ‘ xed for the period of (say) one year ’. It follows that, in the
long run, all costs are in fact variable in nature.
2.2.3 Step costs

A step cost is a cost that is available only in xed allotments. It varies
with the activity level, but in a stepwise rather than linear manner.
Example 2.3
In addition to the xed and variable costs for the new master’s course described in
examples 2.1 and 2.2, the master’s course will include a groupwork component
whereby students will be required to submit projects in groups of no more than ve
students each. As a result, for every ve students or part thereof accepted on to the
course, marking costs will increase by R600.
Required:
Discuss the nature of the additional marking cost.
The additional R600 marking cost per ve students (or part thereof) is
a step cost. This can be plotted on a graph, as shown in gures 2.6
and 2.7. As shown in Figure 2.6, marking costs for three students
would be the same as marking costs for ve students (R600). Any
number of students from six to 10 would increase the marking costs
to R1 200, and so on.
Figure 2.6 Step cost graph: total cost

Figure 2.7 Step cost graph: per student
2.2.4 Mixed costs

A mixed cost is a cost that consists of two components, usually a
variable and a xed component. A typical example of a mixed cost is
your monthly telephone account for a landline, or for a cellphone on

contract. The telephone account is made up of a xed component
(the monthly line rental charge for a landline, or monthly contract
fee in the case of a cellphone) as well as a variable component (call
charges, which vary with the number and length of calls made).
Another example of a mixed cost can be found in commercial
property rental agreements. The rental charge paid by shopping
centre tenants frequently consists of a xed rental amount (usually
based on oor area) as well as a variable portion calculated as a
percentage of the tenant’s monthly revenue.
In order to determine how a mixed cost will respond to a change
in activity level, the mixed cost must be split into its xed and
variable components. There are a number of approaches to splitting
mixed costs, as discussed in Chapter 3, Cost estimation.
Example 2.4
Consider the same university master’s degree as in examples 2.1 to 2.3. In addition to
the teaching and evaluation costs already discussed, there is one nal cost with which
the master’s course will be charged: university administration fees. All courses offered
by the university are expected to contribute towards the administrative costs of the
university, which are signi cant. A few examples of administrative costs that the
university bears on behalf of all faculties, departments and courses are maintenance of
facilities, cleaning, graduation ceremonies, student records, technological
infrastructure, research and the nance function. These costs are not traced directly to
courses, as this would be an incredibly expensive task which, in the view of the
university, would have little bene t. Instead, all courses are charged a general fee that
is calculated at R2 000 per course plus R500 per student.
Required:
Discuss whether the university administration charges allocated to the new master’s
degree can be described as a mixed cost.
The university administration charge is a mixed cost, as it has both

xed (course fee) and variable (charge per student) components. The

mixed cost is plotted on a graph, as shown in gures 2.8 and 2.9
below. Notice that the mixed cost graph (Figure 2.8) has the same
shape as the variable cost graph (Figure 2.1), except that the
intersection with the Y axis is not at zero as with the variable cost,
but instead the line intersects the Y axis at R2 000, the amount of the
xed cost, just as a xed cost graph does.
Figure 2.8 Mixed cost graph: total cost
Figure 2.9 Mixed cost graph: per student

Example 2.5
Consider the same university master’s degree as in the previous examples. In the rst
year that the course is run, 19 students are accepted onto the programme. Each
student is charged a R20 000 course fee for the year.
Required:
Given all the cost information supplied in examples 2.1 to 2.4, draft an income
statement for management accounting purposes for the course for the rst year.
Taking all the available information into account, the income

statement for management accounting purposes can be drawn up as
follows:
Income statement for the master’s course
Revenue1 R380 000

Variable costs
Stationery (R7 600)2
Supervision (R95 000)3
Thesis marking (R38 000)4
Fixed costs
Salary (R200 000)
Guest lecturer fees (R10 000)
Step cost
Project marking fees (R2 400)5
Mixed cost
Administrative charges (R11 500)6
Pro t R15 500
Notes:
1 R20 000 × 19 students

2 R400 × 19 students
3 R5 000 × 19 students
4 R1 000 × 2 markers × 19 students
5 R600 × 4 (that is, 19 students/5, and rounded up)
6 R2 000 + (500 × 19 students)
Application of cost behaviour

2.2.5
principles
Key term: analytical review
Earlier in this chapter, it was noted that an understanding of cost

behaviour is necessary for the majority of management accounting
tools and techniques that are discussed in this text. In addition to
this, cost behaviour principles are regularly used in certain audit
procedures. Many students reading this text may nd themselves in
a position where they need to apply these principles in the context of
an audit assignment.
Auditors carry out audit procedures in order to gain assurance
that the nancial statements of an organisation are free of material
misstatement. Many types of procedures exist, one of which is
analytical review. Auditors assess the reasonableness of the current
year’s gures by, among other things, comparing the current year’s
gures to the prior year’s gures, after adjusting for expected
changes. In adjusting prior year gures, some of the prior year’s
production costs may have to be adjusted for comparison if current
year production volumes differ, while others may not. Other costs
may be adjusted for changes in sales levels. Some costs may be
changed for uctuations in other activity levels, not just increases or
decreases in production or sales volumes. In order to carry out this

analytical review procedure, auditors need an understanding of the
way that costs behave – are costs variable, xed, step or mixed?
They also need to understand what causes costs to change. What
activities cause costs to vary? What causes these costs to be incurred
in the rst place? What underlying reason is there for these costs
being expended? Similarly, managers frequently compare nancial
results line by line to the budget and to the prior year’s gures, and
therefore also need a thorough understanding of cost behaviour.
2.3 Assignment
Key terms: cost object, direct cost, indirect cost, tracing or

allocating costs
Cost assignment refers to tracing or allocating costs to cost objects.

A cost object is the item to which the cost is to be traced or allocated.
Should an organisation intend to establish the cost of a service that it
offers, then this service is the cost object. Likewise, if an organisation
wishes to establish the cost of operating its human resources
department, then the human resources department is the cost object.
In general terms, a cost object could be a product, service, customer,
project, job or activity that is carried out within the organisation (or
within a division, department or other organisational unit). Costs
can be traced to cost objects with varying degrees of effort. The
extent to which a cost can be feasibly traced to the cost object is what
determines whether that cost is classi ed as a direct cost (when it is
economically feasible to trace to the cost object) or an indirect cost
(when it is impossible or not economically feasible to trace to the
cost object).

For example, suppose SAA wanted to determine the cost of a
ight from Cape Town to London’s Heathrow airport. The cost of
the food served to passengers on that ight and the cost of the jet
fuel used on the ight would be considered direct costs as these costs
are easily traced to the ight. However, other costs associated with
the ight may not be as easily traceable to the ight itself, such as the
cost of maintaining the plane and expenses related to operating
SAA’s head of ce. These costs would be considered to be indirect
costs should the organisation decide that accurately tracing these
costs directly to this speci c ight is either not possible or not
economically feasible.
Does this imply that indirect costs are then not assigned to cost
objects? Not necessarily. Where it is not economically feasible to trace
actual costs to cost objects, these indirect costs can be allocated to cost
objects on some reasonable basis. A synonym for the word
‘allocated’ in this context is ‘apportioned’. For instance, the monthly
salary costs of the pilots and aircrew could be allocated to the ight
based on the number of hours of ying time of the ight, relative to
the number of hours the crew would normally y in a month.
Provided that there is some cause-and-effect relationship between
the basis on which costs are incurred and the basis on which costs
are allocated, the indirect costs assigned to the cost object will be a
reasonably accurate re ection of the actual costs incurred.
A synonym for indirect cost is overhead cost.
Example 2.6
Look at all the costs incurred to run the master’s course, detailed in examples 2.1 to
2.4 above.

Required:
For costs appearing in the income statement, classify each cost as either a direct or
indirect cost of the course.
The variable costs in this example, namely stationery, supervision

and thesis marking, can all be classi ed as direct costs. The nature of
these costs is such that they are all easily and readily traceable to the
cost object (the master’s course). The same holds true for the
professor’s salary and the guest lecturer fees (both xed costs), as
well as the project marking fees (a step cost). For all of these costs, it
is easy to determine how much will be spent solely as a result of
offering the master’s course.
Table 2.1 Summary of direct and indirect costs in example 2.6
Variable costs
Stationery Direct
Supervision Direct
Thesis marking Direct
Fixed costs
Salary Direct
Guest lecturer fees Direct
Step cost
Project marking fees Direct
Mixed cost
Administrative charges Indirect
The administrative charges, however, constitute an indirect cost.

This is because it is not easy to determine the extent of the resources
relating to maintenance of facilities, graduation, student records and
similar matters that will be utilised by the course, as these resources
are used only indirectly by the course and as a result are dif cult to
trace. Since tracing the costs to the cost object is not economically

feasible, the university allocates a portion of these administrative
costs to the course, based on a general formula that is used
throughout the university.
How was this general formula determined? At some point the
nance director for the university most probably added up the total
administrative costs that could not be easily traced to speci c
courses. He then possibly considered what the kinds of tasks were
that the various administrative departments carry out on behalf of
the numerous courses that the university offers and noticed that
some administrative costs would be the same regardless of the
number of students on a course, while other costs would be driven
by the number of students.
The nance director would then have divided the costs that did
not uctuate according to the number of students by the number of
courses the university offered, to arrive at a cost of R2 000 per
course. The costs that did indeed uctuate according to the number
of students would then have been divided by the total number of
students at the university, in order to determine an average cost per
student of R500. While this may not be 100% accurate, clearly the
university feels that the allocation is reasonable enough to provide a
pro t gure per course that is suf ciently reliable for their needs.
Note that it would be a mistake to assume that variable costs are
always direct costs or that xed costs are always indirect. In fact,
example 2.6 illustrates that xed costs can indeed be direct costs.
Similarly, it illustrates that variable costs can sometimes be indirect,
like the variable position of administrative charges allocated.
Note that the classi cation of costs as variable, xed, step or
mixed can be accurate only:
1 within the relevant range
2 within a speci ed time period

3 in relation to a speci c cost driver.
Requirements (1) and (2) above should be clear from section 2.2,
while requirement (3) is discussed further in Chapter 6, Overhead
allocation. The classi cation of costs as direct or indirect depends,
however, on the cost object, as discussed above.
2.4 Relevance
Key term: relevant cost
Relevant costing refers to determining the nancial effect of a

decision on the organisation. The nancial effect is the overall
increase or decrease in costs and revenues that will result from a
decision to take a certain action. The key question that this topic
addresses is: what costs and revenues should be taken into account
in order to determine the nancial impact on the organisation of a
decision that is under consideration?
The objective of a pro t-seeking organisation’s management
team is to maximise shareholder value by making decisions that will
increase the future cash ows of the organisation.
An organisation’s value is the present value of all the future cash
ows that the organisation is likely to generate. Management’s
decisions should be focused on increasing these future cash ows.
Consequently, when we wish to determine the nancial impact of a
decision, what we wish to determine is the amount by which the
decision is likely to change the value of the organisation.
In order to determine the nancial impact of a decision, only
differential, future cash ows should be taken into account.

In other words, a cost (or revenue) that is relevant and should be
taken into account for decision-making purposes has three
attributes. A relevant cost or revenue is as follows:
• A future cost (or revenue): Since the value of the rm is determined
by the future cash ows it will generate, only future costs and
revenues have any effect on value. Besides, costs or revenues that
have already been incurred cannot be changed by a decision, as
they have already happened (such costs are referred to as ‘sunk
costs’).
• A differential cost (or revenue): If a cost or revenue item will not be
changed by the decision under consideration, then that cost is
irrelevant from a decision-making perspective.
• A cash ow: A basic nance principle is that the value of an asset
is the present value of the cash ows that the asset is likely to
generate. Non-cash items (such as depreciation) that are created
by accounting statements are irrelevant for establishing the
nancial effect of a decision on an organisation. (Depreciation
refers to writing off the cost of an asset that has already been
purchased. Regardless of the decision that is made, the asset has
been purchased and the cash ow has already happened.)
Relevant costing is an extremely important principle. To ignore this

principle and apply any other criteria to determine what costs and
revenues should be considered or ignored for a decision, can result
in a decision being made that appears to be pro table, but which
will actually reduce the value of the rm. The nancial accounting
pro t for a decision, and the relevant cost (or real nancial impact)
of the same decision, could be very different.
In order to understand the difference between accounting pro t
and the nancial impact of a decision on an organisation (relevant
cost to the organisation), consider example 2.7 below.

2.4.1 Relevant cost
Example 2.7
Refer again to the income statement that we drew up in example 2.5 for year one of
the master’s course. Assume that the following circumstances existed at the time that
the decision needed to be made as to whether to launch the management accounting
master’s degree:
• Five of the 19 students would have taken the master’s course in nancial
management, for which the course fee is R24 000 per student, if they had not been
accepted onto the master’s course in management accounting. The nancial
management master’s course has been unable to ll these ve positions with other
students. The stationery, supervision and thesis costs per student are the same on
both courses. No project-marking fees are incurred in the nancial management
course.
• 40% of the stationery costs have already been incurred, as certain stationery had
to be ordered months before the start of the nancial year. The stationery was
customised with the course name and year and cannot be used by the university
for other purposes. The stationery on the nancial management course has not yet
been ordered.
• 95% of the administrative charges allocated to the new master’s course will be
incurred by the university regardless of whether the new master’s course is run.
Required:
Discuss whether the master’s course should be run or not, and what the nancial
impact on the university would be if the course were to be offered in the upcoming
academic year.
If the decision is based on the pro t gure on the income statement

that was drawn up in example 2.5, we will come to the wrong
answer, which would be: yes, the course should be offered, as the
university will make a pro t of R15 500. This answer is incorrect,
because it has not been made with reference to the amount by which
the future cash ows of the university would change if the new
master’s course were to be introduced.

Working through the income statement (to identify the cash ows
that would arise directly out of offering the course) and the
additional information above (in order to identify any other reasons
for the university’s cash ows to change or remain unchanged), we
are able to determine correctly the change in cash ow (that is, the
nancial impact of the decision to introduce the course). This correct
answer is set out below.
The nancial impact on the university as a whole of offering the
management accounting master’s course in the upcoming nancial
year is as follows:
Additional fee revenue received

Fee revenue for the management accounting course R380 000
Less: Fee revenue lost on the nancial management course (5 × R24 000) R120 000
Variable costs
Stationery – 60% not yet incurred (R7 600 × 60%) R4 560
Less: Cost saving on nancial management course (5 students × R400 each) R2 000
Supervision (14 extra students × R5 000 each) R70 000
Thesis marking (14 extra students × R1 000 × 2 markers each) R28 000
Fixed costs
Salary R200 000
Guest lecturer fees R10 000
Step cost
Project marking fees (assuming none on the nancial management course) R2 400
Mixed cost
Administrative charges (5% × R11 500) R575
Financial loss (R53 535)
This is a very different picture. The course will have a negative

nancial impact on the university, despite the fact that the income
statement for the course shows a pro t.

The principle that we have applied in order to calculate the actual
nancial impact on the university gives rise to cost classi cation
based on the relevance of the cost to the decision. They are discussed
below.
2.4.2 Opportunity cost

Key terms: opportunity cost
An opportunity cost is the best bene t forgone by taking the proposed

course of action. The best bene t is de ned as the greatest pro t
option or the least cost option. In this case, the opportunity cost was
the revenue that would be lost on the nancial management course
of R24 000 per student, if the new course were launched.
In this situation, we also had a saving on opportunity cost – the
saving on stationery costs on the nancial management course for
the ve students accepted onto the management accounting course
instead.
2.4.3 Differential cost

Key term: differential cost
A differential cost is a cost that differs between two alternatives.

Notice that in the case of supervision and thesis costs, we took only
the increase in thesis and supervision costs into account, as the other
ve students would have to be supervised regardless of which
course they were on. The salary cost, guest lecturer fees and project
marking fees, as well as the 5% of administrative charges which

represents variable costs, are also differential costs, as they would be
incurred only if the new master’s course were to be introduced.
2.4.4 Sunk cost

Key term: sunk cost
A sunk cost is a cost that has already been incurred and

consequently cannot be altered by, and is therefore not relevant to,
the decision. An example of a sunk cost is the 40% stationery costs
which have already been incurred and which could not be saved if
the course were not offered.
Relevant costing is discussed in more detail in Chapter 10,
Relevant information for decision-making.
2.5 Function
Key terms: inventoriable costs, non-inventoriable costs
Function refers to the classi cation of costs in the nancial

statements in accordance with the function of the cost – or the
purpose which the cost serves – within the organisation. Note that,
unlike the other cost classi cations we have made in this chapter, the
‘function’ classi cation focuses on nancial accounting requirements
(the requirements contained in international accounting standards)
as opposed to focusing on management accounting principles. This
is a matter of presentation, rather than an aid to management
decision-making.
International Accounting Standard 1 (IAS 1) requires an entity to
‘present an analysis of expenses using a classi cation based on either

the nature of the expense, or their function within the entity,
whichever provides information that is reliable and more relevant’
(IAS 1 para 99). When costs are classi ed by function, they are
divided, at a minimum, into inventoriable costs or non-
inventoriable costs. Inventoriable costs are those that are included
in inventory for nancial accounting purposes, in other words, all
costs required to be incurred in order to bring inventory into its
present location and condition (IAS 2 para 10). Non-inventoriable
costs are other operating costs and are often subdivided into selling
costs (for example, sales commission) and administrative costs (for
example, salary costs of accounting and bookkeeping staff).
In a manufacturing environment, manufacturing costs are
inventoriable and these can be subdivided into three categories:
direct materials, direct labour and manufacturing overheads.
2.5.1 Direct materials

Direct materials are the physical inputs that can be traced in an
economically feasible manner to the product that is manufactured.
Materials that are considered to be indirect (that is, materials that
cannot be traced to the product in an economically feasible manner
such as, for example, the detergent used to clean production
machinery) are classi ed as manufacturing overheads and allocated
to the product on some basis (refer to manufacturing overheads
below in section 2.5.3).
2.5.2 Direct labour

Where it is economically feasible to trace the amount of labour that is
physically expended on a product, such labour costs are considered
to be direct labour costs. An example would be factory employees

who work on only one product line, and where the amount of time
that the workers spend working on each unit of that product is
known. In contrast, it is usually not feasible to trace the amount of
time spent on one unit of a product by the factory supervisors who
do not work directly on the product, and may even supervise the
manufacture of a number of product lines manufactured in the
factory. The salary cost of the supervisors would typically be
considered to be indirect labour costs and classi ed as
manufacturing overheads, again to be allocated to the product on
some reasonable basis.
2.5.3 Manufacturing overheads

Key terms: xed manufacturing overheads, variable
manufacturing overheads
Manufacturing overheads comprise all manufacturing costs that are

classi ed as indirect when the product is the cost object. These
include indirect materials and indirect labour. Other examples of
manufacturing overheads are water, electricity, rent, maintenance
and depreciation, to the extent that these costs relate to the
manufacturing process. Manufacturing overheads can be further
subdivided into variable manufacturing overheads and xed
manufacturing overheads. Maintenance may be a variable overhead
if it varies in proportion to production volume changes. Depreciation
and factory rental are examples of xed overheads over relevant
ranges of production volume.
Example 2.8

The detailed income statement of a South African manufacturer is presented below.
R’000
Revenue 500 000
Salaries
Factory (workers)1 61 000
Factory (management)2 55 000
Sales3 42 500
Human resources and payroll4 5 000

Accounting 10 000
Internal audit5 8 000
Directors 40 000
Security6 6 500
Engineers7 2 500
Depreciation8
Factory equipment 10 000
Warehouse xtures 2 500
Of ce xtures and ttings 2 200
Forklifts 1 500
Delivery vehicles 1 600
Buildings 3 500
Purchases from creditors
Raw materials 95 000
Spare parts for factory equipment9 7 000
Grease and lubricants for factory machinery9 2 900

Stationery for administrative use 2 100
Water and electricity10
Factory 22 000
Warehouse 3 000
Of ce 4 000
Other

Royalty11 10 000
Telephone (of ce) ( xed charges of R0,6m included) 3 500
Cleaning (of ce) (‘ at rate’ as per contract) 1 800
Entertainment (this amount is spent in every period) 600
Speeding nes (delivery) 180
Repairs (delivery)12 400
Repairs (factory equipment)12 6 500

External audit fee (as agreed per contract) 1 500
Advertising and marketing (this amount is spent in every period) 32 000
Pro t 55 720
Notes:
1 Factory workers are paid on the basis of hours worked, in order to match labour
hours to production requirements.
2 Factory managers are permanent employees who are paid xed salaries regardless
of hours worked.
3 Sales staff remuneration includes commission of 5% of revenue.
4 60% of human resources and payroll time is spent on factory staff salaries and
labour issues.
5 30% of internal audit time is spent on factory controls and procedures.
6 Security guards are on the premises 24 hours a day, 7 days a week. Part of their
responsibilities includes checking all goods that leave the premises are
accompanied by an authorised despatch note.
7 An engineering team is permanently employed to monitor the factory equipment
and perform routine maintenance on a regular basis.
8 All assets are depreciated on a straight-line basis over their useful lives expressed
in years, except for delivery vehicles, which are depreciated based on the number
of kilometres travelled. The number of kilometres travelled is roughly proportional
to production volumes. Three buildings exist on the premises – the factory building
(depreciation of R1 400), the warehouse, in which raw materials are stored (R1 050)
and the administrative building (R1 050).
9 The amount of part replacements and lubrication that machines require is directly
proportional to the number of operating hours. Operating hours are dependent on
production volumes.
10 The water and electricity costs for the warehouse and of ce remain constant from
month to month, regardless of sales and production volume changes. R3 million of
the water and electricity requirements of the factory are unaffected by production

requirements. The remaining amount and majority of the cost is directly affected by
production volumes.
11 A royalty of 2% of revenue is payable to the manufacturer’s parent organisation for
the use of patents and other copyright or protected material.
12 Repair costs vary directly with production quantities.
Required:
Analyse each of the costs in the income statement using the following categories:
• Manufacturing (state whether it constitutes direct materials, direct labour or
overheads) or non-manufacturing
• Fixed or variable, with regard to production sales volume
Below is a summary detailing the classi cation of each line item:
Table 2.2 Classi cation of income statement costs

2.6 Timing

Key terms: absorption costing, period cost, product cost,
variable costing
Timing refers to when a cost is recognised as an expense in the

income statement. A distinction is drawn between a period cost and
a product cost. A period cost is a cost that is recognised as an
expense immediately on being incurred, while product costs in an
absorption costing system are absorbed in inventory and expensed
only when the inventory is sold.
Under an absorption inventory costing system, manufacturing
costs (in a manufacturing environment) are product costs, while
non-manufacturing costs are period costs. Absorption costing is
required by the international nancial reporting standards (standard
IAS 2).
IAS 2 requires that all costs incurred to get inventory into a
saleable location and condition are included in inventory until that
inventory is sold, at which point the costs are expensed as part of
cost of sales. Examples of costs that would be regarded as necessary
to get inventory into a saleable condition would be the following:
• Manufacturing costs (raw materials, all labour involved in the
manufacturing process in any way, even the employees who
work in the raw materials warehouse)
• Overheads (both xed and variable, including typical expenses
such as depreciation of factory and raw materials store
equipment, electricity, water, rent of the buildings, and similar
expenses)
• Delivery costs that were incurred to get the product to the location
from where it is sold
• Packaging costs, if packaging was either necessary to get the
product to the location from which it will be sold (for example,

protective packaging) or if the product is sold in special
packaging (for example, an attractive box).
Packaging and delivery costs incurred in getting the product from

the location from which it was sold (for example, a sales branch) to
the customer who purchased the product would not be included in
the cost of inventory, as these were not incurred to get the product
into a saleable condition and location. These costs were incurred
after the sale of the product, in order to deliver the product to the
customer.
An alternative inventory costing system that can be used instead
of absorption costing, which is more useful for internal reporting
and decision-making purposes, is variable costing. A variable
costing system requires all xed costs to be recognised as an expense
in the period in which they are incurred.
Chapter 5, Absorption versus variable costing discusses these
costing systems in detail.
2.7 Summary
This chapter introduced the numerous perspectives from which
nancial information is classi ed for the purposes of management
decision-making and control.
Certain aspects of costs – such as behaviour, assignment,
relevance, function and timing – are key considerations when
analysing and interpreting accounting information for management
purposes. An undiscerning use of nancial accounting information
may result in sub-optimal and counterproductive decisions being
implemented. Management’s primary mandate is to enhance
shareholder value. It is for this reason that nancial accounting rules

are largely ignored for managerial purposes as they are of only
limited relevance when it comes to analysing the feasibility of a
decision, or the effectiveness of the controls that are put in place in
order to encourage non-executive staff and managers alike to behave
in the best interests of the organisation and its stakeholders.
Conclusion: Cost classification and other

topics in this book
This chapter introduced several different perspectives from which
cost and revenue information need to be considered in order for
accounting information to be correctly interpreted and used for
managerial purposes.
These concepts will be more fully developed and applied in the
subsequent chapters in this text. The principles underlying decision-
making are of central importance in managerial accounting, and
these are examined more thoroughly in Chapter 10, Relevant
information for decision-making and Chapter 11, Decision-making under
operational constraints. The issue of how to measure, trace and
allocate indirect costs is explored in Chapter 6, Overhead allocation,
while Chapter 5, Absorption versus variable costing analyses the issue
of timing of measuring and recognising xed costs (period or
product cost) and answers the question of how absorption costing
can distort decision-making and performance evaluation. Chapter 3,
Cost estimation addresses the issue of how to generate the cost
information if it is not readily available from existing sources inside
the organisation.
Tutorial case study: Shoprite Holdings

Shoprite Holdings Ltd has a number of brands, one of which is the Shoprite chain of
supermarkets. The Shoprite brand is one of the leaders in the South African food
retailing sector. It is the mainstay of the group’s operations and its biggest business
by far.
SOURCE: SHOPRITE HOLDINGS LTD (2018)
Consider the following revision questions using your existing knowledge of the
Shoprite retail brand. Identify what you would view as an example of an appropriate
cost object in Shoprite and answer the following questions in relation to the cost
object you have identi ed.
1 Name one good example of a variable cost.
2 Name one good example of a xed cost.
3 Discuss what factor is likely to determine the relevant range over which the xed
cost you named remains xed.
4 Estimate the period over which the xed cost you named is likely to remain xed.
5 Name one good example of a step cost.
6 Name one good example of a mixed cost.
7 Name one good example of a direct cost.
8 Name one good example of an indirect cost.
9 Suggest a cost that is likely to be both variable and indirect, and one that is likely
to be both xed and direct.
Basic questions
BQ 1
If sales volume increases by 20%, selling expenses increase by 15%.
What proportion of selling expenses was xed at the initial sales
volume, and at the nal sales volume?
BQ 2
At a sales level of 10 000 units per month, the manufacturing
overhead per unit is R3,30 per unit. If the sales level increases by 4
000 units, the manufacturing overhead per unit falls to R2,70. What
is the variable manufacturing overhead per unit?

BQ 3
overhead is R4,00 per unit. The next month the price of all
manufacturing costs increases by 5%. If the sales level increases by 4
000 units, the manufacturing overhead per unit falls to R3,48. What
is the variable manufacturing overhead per unit?
BQ 4
The total manufacturing cost incurred during a year was R460 000,
which comprises both variable and xed costs in a ratio of 3:2
respectively, at a production level of 80 000 units. If a production
level of 100 000 units is reached, a discount of 5% is available on all
variable costs. What will the total manufacturing costs be at a
production level of 120 000 units?
BQ 5
overhead per unit of company A is R6,00/unit. The next month the
price of all manufacturing costs increase by 25%. If the sales level
increases by 12 000 units, the manufacturing overhead per unit falls
to R5,50. Determine the total monthly xed manufacturing overhead
for company A.
BQ
The total manufacturing cost per unit was R10 at a production level
of 90 000 units. If the production level increases to 111 000, total
manufacturing costs will increase by 7%. What is the variable
manufacturing cost per unit?
BQ 7

Full capacity is 200 000 units. The direct labour cost is R10 per hour.
4 hours of labour time is required per unit. The current production
level is 185 000 units. A large order for 40 000 units has been
received. Staff will work overtime (at time and half) in order to
create the additional capacity required to ll the order. What will the
labour cost be for this order?
BQ 8
An organisation has 345 600 labour hours available to it each year
(180 employees working 1 920 hours a year, who earn a salary of R60
000 per annum each). The organisation manufactures two kinds of
units, type 1 and type 2. A type 1 unit requires 3 labour hours to
manufacture, while type 2 requires 5 hours of labour time per unit.
Both units incur other variable expenses at a rate of R25 per unit. The
organisation already has orders for 44 000 and 39 000 type 1 and type
2 units respectively.
A large order for 6 000 type 1 units and 4 000 type 2 units has
been received. The organisation is very excited, as the customer has
a high pro le in the industry and an association with this customer
will enhance the organisation’s image. As a result, staff will work
overtime (at time-and-a-half) in order to create any additional
capacity required to ll the order, if necessary. If the organisation
accepts this order, by what amount will total manufacturing costs
increase?
BQ 9
An organisation has the following total costs at two activity levels:
Activity level (units) 15 000 24 000

Total costs R380 000 R470 000

Variable cost per unit is constant in this activity range, but there is a
step-up of R18 000 in the total xed costs when the activity exceeds
20 000 units. What are the total costs at an activity level of 18 000
units?
a) R404 000
b) R410 000
c) R422 000
d) R428 000
BQ 10
Which of the following should be classi ed as indirect labour?
a) Machine operators in a factory producing furniture
b) Lawyers in a legal rm
c) Maintenance workers in a power generation organisation
d) Lorry drivers in a road haulage company
BQ 11
Equipment owned by an organisation has a net carrying amount of
R1 800 and has been idle for some months. It could now be used on a
six-month contract which is being considered. If not used on this
contract, the equipment would be sold for a net amount of R2 000.
After use on the contract, the equipment would have no saleable
value and would be dismantled. The cost of dismantling and
disposing of it would be R800. No dismantling cost will be incurred
should the equipment be sold. What is the total equipment cost
relevant to the contract?
a) R1 200
b) R1 800
c) R2 000
d) R2 800

Long questions
LQ 1 – Intermediate (11 marks; 20 minutes)

SOURCE: ADAPTED FROM UCT (CAROL CAIRNEY)
There are numerous types of operational decisions that need to be
made on a regular basis within any organisation. Below are three
scenarios that illustrate some of the most basic and typical decisions
that are faced by organisations: introducing a new product, altering
sales volumes and considering new markets. These three scenarios
are described in the context that most students would be familiar
with: a large South African university.
Scenario 1
The accounting department of this university offers a number of
highly successful postgraduate degrees in accounting and nancial
management. The accounting department is considering introducing
a new degree in this area, which is also expected to be highly
successful. In order to prove to the university board that this course
will be nancially viable and will contribute towards the nancial
position of the university, a projected income statement has been
drawn up for the course.
The projected income statement shows that after deducting all
the costs that would be attributable to the course (including
everything from lecturers’ fees and stationery to more general
university resources such as electricity, maintenance, administration
and student records) from the anticipated revenue, the course is
expected to make a pro t of R150 000.
Scenario 2
The manager of a breakfast and brunch bar on campus thinks that
because of a larger student intake, there is a strong possibility that

sales will double in volume in the next year. If sales volume doubles
(assuming the mix of products sold stays the same), what is the most
likely effect on the breakfast bar’s pro ts?
a) As sales volume is expected to double, pro t should double
(approximately).
b) Pro t should increase by more than 100% (that is, pro t should
more than double).
c) Pro t would increase by less than the increase in sales volume.
d) It is impossible to make any reasonable prediction without the
numbers.
Scenario 3
All of cial university track tops and tog bags are made by an
organisation called Of cial University Merchandise (Pty) Ltd
(OUM). The student union has approached OUM on behalf of a
group of students on nancial aid with respect to purchasing 100
track tops at a discounted price. The student union is able to pay
R110 per track top. OUM understands that there is no other way that
these students could ever hope to own a track top, as they cannot
afford to buy them at the normal market price. OUM also
understands that owning of cial university track tops will boost
morale among these students, but has refused to sell these track tops
at R110 as this would result in OUM making a loss and suffering a
loss of pro ts overall. OUM has calculated a loss per top as follows:
Selling price R110
Total manufacturing costs per top (R130)
Loss per top (R20)
REQUIRED Marks
Based on the very limited information available, discuss the most likely nancial consequence of
each scenario. Ignore strategic and qualitative issues (they are important in decision-making, but
you are not required to take them into account here). 11

TOTAL MARKS 11

SOURCE: ADAPTED FROM UCT (CAROL CAIRNEY)
You are a university student doing vacation work at an audit rm
and you have been assigned to the audit of GreyLine Carriers Ltd.
GreyLine is a transport company specialising in the freighting of
chemicals and commercial goods (for example, fresh chickens). The
company’s head of ce is situated in Cape Town, while operations
are carried out from the 11 branches (four in Gauteng, two in the
Western Cape, two in the Eastern Cape, one in Durban and another
two in the Northern Cape and Mpumalanga respectively). The
company owns a eet of approximately 300 trucks (2XX6 and 2XX7
models), and performs all its own maintenance and repairs from
their purpose-built workshop in Durban.
Your task on the audit is to perform an analytical review of the
income statement. The rst-year clerk has given you the following
instructions: ‘Here’s a copy of the 2XX6 and 2XX7 income
statements. Go and chat to the nancial director (FD) about the
operations of the company for 2XX7. For each line item on the
income statement, obtain reasons why that line item has changed
from year to year. Then, for each line item, based on those reasons,
recalculate the 2XX7 gure and see if the actual 2XX7 gures make
sense and appear reasonable.’
You duly discuss the income statement with the FD and obtain
the following information:
• Revenue: In 2XX6, the total number of kilometres travelled and
billed was 18 301 000 kilometres. This distance could be divided
almost equally between chemical and commercial haulage. In
2XX7, the total number of kilometres travelled increased by 9%.

However, chemical haulage accounted for almost two-thirds of
the total number of kilometres travelled, as two large chemical
contracts were won at the beginning of the year. The price per
kilometre charged by GreyLine is 15% higher for chemical
haulage than for commercial work, owing to the hazardous
nature of the cargo.
• Salaries (drivers): New safety regulations were promulgated at the
beginning of 2XX7, whereby the number of hours drivers are
allowed to drive continuously has been decreased signi cantly
and the length of breaks has been increased. In order to prevent
journey times from increasing (which would result in a loss of
revenue), GreyLine hired 32 additional drivers at the beginning
of 2XX7, and the average number of drivers employed for the
2XX7 year was 218. Drivers received salary increases of 7% in
that year.
• Salaries (head of ce): Head of ce staff received increases of 8,5% in
2XX7. The number of staff at head of ce has remained constant
for the last 3 years.
• Salaries (maintenance): Maintenance staff had to work overtime (at
time-and-a-half) this year, owing to more maintenance being
required as a result of the increased proportion of chemical
haulage (safety requirements require more frequent inspections
and greater preventative maintenance on chemical haulage
because of the increased cost of accidents, environmental damage
and similar issues). On average, staff worked 15 hours’ overtime
a month. No overtime was worked in 2XX6. Normal hours per
month are 160 hours. Staff received 9% salary increases in 2XX7
in recognition of their hard work.
• Rental expense: The rental expense is stipulated as follows in the
rent agreement: a xed lump sum (which will be increased by

10% per annum), plus 1% of revenue.
• Depreciation: The company replaced 30% of the vehicles in 2XX7.
• Other expenses: Two-thirds of ‘other expenses’ are xed.
REQUIRED Marks
Recalculate the 2XX7 amount for each line item above and comment on any large deviations 23
noticed. Assume a threshold of R653 100. You may also assume an annual average in ation rate

of 6,5%, applicable to all expenses and income, except salaries.
TOTAL MARKS 23

SOURCE: ADAPTED FROM ACCA PAPER 1.2
Pointdextre Ltd, which manufactures and sells a single product, is
currently producing and selling 102 000 units per month, which
represents 85% of its full capacity. Total monthly costs are R619 000,
but at full capacity these would be R700 000. Total xed costs would
remain unchanged at all activity levels up to full capacity. The
normal selling price of the product results in a contribution to sales
ratio of 40%.
A new customer has offered to take a monthly delivery of 15 000
units at a price per unit 20% below the normal selling price. If this
new business is accepted, existing sales are expected to fall by one
unit for every six units sold to this new customer.
REQUIRED Marks
(a) For the current production and sales level, calculate:

(i) the variable cost per unit
(ii) the total monthly xed costs
(iii) the selling price per unit. 5
Calculate the net increase or decrease in monthly pro t which would result from acceptance
(b)
of the new business. 4
TOTAL MARKS 9
LQ 4 – Advanced (9 marks; 16 minutes)

SOURCE: ADAPTED FROM CIMA FOUNDATION LEVEL PAPER 2
The management accountant of J Ltd, a supplier of farm machinery
components, is compiling the budget for next year. Forecast sales for
the rst seven months of 2XX4 are as follows:

Month Sales (units)
January 5 500
February 5 800
March 5 600
April 4 900
May 4 400
June 5 200
July 5 500
Other relevant information:

• Units held in inventory at the end of the month are maintained at
25% of the following month’s sales.
• Suppliers are paid two months after the inventory has been
received.
• The purchase cost per unit is R7,20, increasing to R8,40 from
April 2XX4.
• The warehouse section consists of 4 employees who each earn
R950,00 per month, and a supervisor who earns R1 200,00 per
month.
• A monthly bonus equivalent to 15% of normal earnings is paid to
everyone in the warehouse section if sales exceed 5 500 units per
month.
• Normal wages are paid in the month in which they arise. Any
bonus is paid one month after it is earned.
REQUIRED Marks
(a) Calculate the number of units the purchases in May will amount to. 3
(b) Determine the amount that will be paid to suppliers in June. 3
(c) Calculate the total cash paid for wages in April. 3

TOTAL MARKS 9

SOURCE: ADAPTED FROM RHODES UNIVERSITY (JOHN WILLIAMS)
The following scenario and questions relate to the classi cation and
behaviour of costs.
Barcon (Pty) Ltd has been manufacturing and selling Acron for
many years. As at 31 December 2XX8, the organisation had 20 000
units of Acron in inventory, valued at the cost to manufacture these
units, amounting to R200 000. One kilogram of materials costing
R5/kg is used in the manufacture of each unit of Acron and the
direct labour time required to manufacture one unit is 15 minutes,
the labour cost being R4 per hour. The balance of the cost is made up
of a variable cost element (30%) and a xed cost element.
REQUIRED Marks
(a) Calculate and discuss the elements of cost in one unit of Acron. 3
Discuss the behaviour of these elements of cost, in relation to increases (or decreases) in the
(b)
volume of production. 6
(c) During January 2XX9, a competitor placed a product on the market which is identical to Acron
and which sells for R8 a unit, far less than the selling price of Acron (R14 a unit). The directors
of Barcon (Pty) Ltd will discontinue the production of Acron and are considering two
alternatives in relation to existing inventories of Acron:
(i) To sell all the inventory on hand for R7,50 a unit, the distribution costs amounting to 20c a
unit
(ii) To convert Acron units into another product manufactured and sold by the organisation,
Lacron. There are no competing products for Lacron, which has an unlimited market,
costs R11 a unit to manufacture and 20c a unit to distribute, and sells at R16 a unit.
Variable costs amounting to R8 a unit will be incurred in the conversion of Acron to
Lacron.
Advise the directors which of the two alternative courses of action to adopt in relation to the
existing inventory of Acron, assuming that adequate facilities are available to convert Acron to
Lacron. 16
TOTAL MARKS 25

References
SAICA (South African Institute of Chartered Accountants). 2010a. Statements of
Generally Accepted Accounting Practice: IAS 1 (AC 101), Presentation of nancial
statements (revised January 2010). Johannesburg: SAICA.
SAICA. 2010b. Statements of Generally Accepted Accounting Practice: IAS 2 (AC 108),
Inventories (revised January 2010). Johannesburg: SAICA.
SAPPI Limited. 2018. Sappi Annual Integrated Report 2018. [Online]. Available: https://cdn-
s3.sappi.com/s3fs-public/2018-Sappi-Annual-Integrated-Report.pdf
Shoprite Holdings Ltd. 2018. Integrated Report 2018. [Online].
https://www.shopriteholdings.co.za/content/dam/MediaPortal/documents/shoprite-
holdings/integrated-report/2018/Shoprite_IR_2018E_Full.pdf

LEARNING OBJECTIVES
• split mixed costs into xed and variable components using both
the high-low method and least squares regression
• formulate a cost estimation equation based on the results of the
high-low method and least squares regression calculations, and
use the cost estimation equation to predict costs at various
activity levels
• interpret the r2 statistic and be able to determine the extent to
which a cause and effect relationship exists between the cost and
the cost driver
• indicate factors other than the extent of the relationship between
the cost and the cost driver that affect the accuracy with which
costs can be predicted
• apply learning curves to estimate costs.
SAPPI and cost estimation
The following is an extract from the chairman’s review in the 2018 annual integrated
report of SAPPI Ltd, in explaining the changes in the group’s xed and variable
costs that occurred from the 2017 to 2018 nancial years, as presented in their
statement of comprehensive income (which is found at the start of Chapter 2, Cost
classi cation in this book).

Variable and delivery costs
Variable and delivery costs increased by US$374 million, or 12%, from 2018. Higher
sales volumes and an increase in purchased pulp, energy, delivery and chemical
prices contributed to the increase in costs
Fixed costs
Fixed costs increased by US$166 million, or 10%, from scal 2017. This increase
was mainly due to a higher depreciation charge (US$19 million) as a result of the
increased capital spend, the acquisition of the Cham Paper Group business (US$26
million) and the stronger Rand and Euro resulting in an increase in US Dollar costs
(US$28 million). Excluding the currency impact xed cost increased by US$138
million.
Southern Africa: Fixed costs were mainly in uenced by wage in ationary increases
at 7% for the year.“
SOURCE: SAPPI (2018)
SAPPI’s xed and variable costs are affected by very different factors. Notice that
variable costs are related to sales volumes and affected by unit prices, while xed
costs bear a relationship to capital investment and capacity.
SAPPI operates in a highly competitive industry and must manage margins (the
relationship between sales revenue and variable costs) and investment in production
capacity (which gives rise to xed cost commitments) very carefully to generate its
targeted pro tability and returns. Consequently, SAPPI would consider cost
estimation (predicting how cost will respond) as of importance in its decision-
making process.
This chapter examines the issues related to cost estimation and helps
us to realise how companies like SAPPI can optimise their
management team’s decision-making if costs are properly
understood.
3.1 Introduction
The previous chapter introduced the concept of cost behaviour and
described the manner in which four types of costs (variable, xed,
step and mixed costs) would react to changes in sales or production

volumes or other activity levels. The previous chapter also indicated
that an understanding of how a cost would behave given a change in
activity level is necessary in order to predict the magnitude of costs
in the future. Being able to predict costs with a reasonable degree of
accuracy is necessary for decision-making and control purposes.
In this chapter, we discuss some of the methods, with particular
emphasis on mathematical and statistical tools, which can be used to
determine how a cost behaves. This provides information about the
accuracy and predictability of the cause-and-effect relationship that
exists between the cost and the variable that it is related to, and
allows us to split composite (mixed) costs into their xed and
variable components.
The following cost estimation methods will be discussed:
• Scatter graph (a graphical approach)
• High-low method (a mathematical approach)
• Least squares regression (a statistical approach), also referred to
as linear regression
Most management accounting students would have completed

at least a basic course in statistics. Parts of this chapter build
on some of your knowledge of statistics, but the detailed theory
is not repeated here. Your statistics textbooks and notes may be
useful if you need to revise some of the technical terms and
concepts.
3.2 Cost drivers
Key term: cost driver

When we refer to measuring costs, what we really mean is
measuring how a cost will change in response to a change in some
activity. For each cost, an activity needs to be identi ed that can be
regarded as the cost driver of that particular cost. To what activity
are we referring? The number of units sold? The number of units
produced? We could use these as cost drivers, or we could dig down
to a lower level and use more speci c activities that are carried out in
the sales or production process. For instance, suppose an
organisation carried out quality testing on a random selection of the
items it produced. The cost of testing each unit could be calculated
with reference to the total number of items produced by the factory
(that is, the production of units is seen as the cost driver and the
variable cost is expressed per unit produced). It could also be
calculated with respect to the number of items tested (that is, the
number of items tested is seen as the cost driver and the variable cost
is expressed per item tested). In addition, if the items that the
organisation produced are not all identical and different items
require different amounts of inspection time, then the cost of testing
could be determined in respect of the number of testing hours
(rather than the number of items produced or tested).
What would you choose as your cost driver to measure the
quality testing costs against? Would you calculate the cost per item
produced, or per item tested, or per testing hour? You should be
inclined to choose whichever cost driver you believe to be the most
closely related to the cost itself. To put that another way, you should
choose the cost driver that caused the costs to be incurred. You may
argue that producing units does not cause the testing costs to be
incurred, unless a xed percentage of units is tested. Quality testing
costs are caused by the number of units tested, so you can make a
good case for calculating the cost per unit tested, not per unit

produced. However, if different items used different amounts of
testing time, and if many of the costs are related to hours of use
(such as labour costs), you would choose to calculate the testing cost
per hour. In order to determine by how much the testing cost would
increase in the next period, the organisation would have to estimate
how many additional testing hours would be worked as a result of
the additional production volumes that the organisation anticipates.
The additional hours that are expected would then be multiplied by
the testing cost per hour, in order to calculate the increase in testing
costs in the next period.
Before mathematical or statistical techniques can be applied to a
cost in order to calculate the variable and xed components of that
cost, consideration must be given to whether it is plausible (makes
sense) that there is a relationship between the cost and the cost
driver (in other words, that a change in the cost driver would cause
the cost to change). Likewise, the extent to which this cost driver is
able to in uence the cost, and whether there are other factors that
in uence this cost, should also be considered. These two
considerations are discussed in more detail below.
3.2.1 Plausibility of the cost driver

When we ask whether the selected activity represents a ‘plausible
cost driver’ for a speci c cost, we mean does it make sense that the
cost would be signi cantly affected by changes in the selected
activity? For example, suppose an airline wanted to investigate the
cost implications of providing passengers with a complimentary
newspaper on board each ight. The airline needs to establish the
cost driver in order to predict the cost accurately. It is possible to
calculate the cost of complimentary newspapers per kilometre
travelled, but this would be meaningless as the number of

kilometres travelled does not cause the cost to be incurred.
Calculating the complimentary newspaper cost per passenger would
be more meaningful. A plausible relationship exists between the
number of passengers and the cost of providing them with
newspapers. It is reasonable to expect the cost to increase as the
number of passengers increases.
Extent to which the cost driver

3.2.2
determines total cost

Certain costs may be driven by more than one cost driver. Staying
with the airline scenario, what is the cost driver of fuel costs? Jet fuel
costs are affected by numerous factors, including the following:
• The distance that the aircraft ies
• The atmospheric pressure at take-off (less fuel is required for
take-off in Cape
• Town than in Johannesburg, owing to Cape Town’s lower
altitude)
• The weight of the passengers and their luggage
• Wind speed and direction
While all of these factors play a role, the distance that the aircraft
ies probably would have the most signi cant effect on the amount
of jet fuel required for the ight. However, does the distance
travelled determine such a great portion of the fuel cost that we can
base our estimate of fuel costs on just this one variable, or do we also
have to take into account the effect of a second cost driver (perhaps
wind speed and direction) in order to build a reasonably accurate
and reliable nancial model?

Fortunately there are a number of methods available to help us to
understand the relationship between costs and cost drivers.
3.3 Scatter graph
Key term: scatter graph
The scatter graph is a graphical method of cost estimation that plots

various observations of costs against the activity level: cost is plotted
in point form on the vertical (y) axis against the activity level on the
horizontal (x) axis. The ‘best guess’ approach is then followed to t a
line to the points and the line is extended to intercept the y-axis. In
the scatter graph approach, the line is drawn onto the graph entirely
according to one’s own visual judgement. The intercept indicates the
xed cost portion (on the assumption that the intercept falls within
the relevant range).
In reality, we cannot draw the conclusion that the intercept
represents the xed cost, as the observations on which the ‘best
guess’ line is based are only for the activity levels falling within the
relevant range of operations. If the level of operating activity
increases above, or falls below, the relevant range, the new total cost
gures at these points may not continue with the same linear
relationship.
To predict a cost at a speci c level of activity, a point is plotted
(on the line drawn) at the relevant activity level (the x-value), and
the predicted cost is read as the corresponding y-value. The scatter
graph method is not very accurate, but it is useful to establish
whether a linear relationship exists between cost and activity. What
is the signi cance of the existence (or lack thereof) of a linear
relationship? Simply put: the more linear the relationship between

total cost and the activity level, the more reliable the cost estimate
that is obtained when linearity is assumed.
The example below deals with telephone costs. The total cost of a
monthly telephone account is driven by a number of factors,
including the number of telephone calls made in that month and the
length of each call. Which of these do you think determines the
telephone expense for the month to a greater extent? If we wanted to
predict next month’s telephone account, on which cost driver would
we rely more heavily?
Example 3.1
The total cost per month, total number of calls and total amount of talk time (in
minutes) for a landline for 12 consecutive months is summarised below:
Required:

Use scatter graphs to determine which of the number of calls per month or the
minutes talked per month has a stronger linear relationship with the total monthly
telephone cost.
In order to answer this question we can draw two scatter graphs.

Both graphs re ect the total monthly cost on the y-axis, but the rst
graph (Figure 3.1) re ects on the x-axis the total number of telephone
calls per month as the cost driver, while the second graph (Figure
3.2) re ects the total number of minutes per month as the cost driver.
Figure 3.1 Total cost relative to number of calls per month
Figure 3.2 Total cost relative to number of minutes per month

Notice that in both Figure 3.1 and Figure 3.2, the total telephone bill
increases as the number of calls and talk time increases, although the
relationship between the total telephone cost per month and number
of minutes is signi cantly more linear than the relationship between
the total monthly telephone cost relative to number of calls made per
month. From the graphs it appears that the telephone expense is
determined to a greater extent by the total duration of calls (number
of minutes) than by the number of calls made.
The scatter graph can be used both to predict the total cost for a
given level of activity, and to estimate the xed and variable
elements that make up the total cost. In order to do these two things,
a line is tted by inspection to the points that have already been
plotted. This line is extended to intercept the y-axis (see Figure 3.3).
The total cost at the y-intercept comprises only the xed cost
component of the telephone cost, as the activity level at the y-
intercept is nil, which means that the variable cost at this point is
also nil. Reading off the graph, the xed cost component of the
monthly telephone expense is approximately R70. Compare this
amount to the telephone account received from the service provider,
which re ects the xed cost at R87. The scatter graph method has
not resulted in a perfectly accurate estimate of xed costs, but this is
not surprising as the scatter graph method is a rough approach to
cost estimation.
Figure 3.3 Total cost relative to number of minutes

Given that a telephone account has an easily determinable xed and
a variable component, you may wonder why the points on the graph
do not form a neat, straight line that intercepts the y-axis precisely at
the xed cost amount and slopes steadily upwards in relation to the
variable cost. We will rst turn our attention to two further cost
estimation techniques, and then discuss the reasons for these
deviations in section 3.6.
3.4 High-low method
Key terms: high-low method, linear relationship
The high-low method is the mathematical approach which involves

calculating the equation of a line to split a mixed cost into its
variable and xed components. Note that we are addressing the
same linear relationship between cost and cost driver that we
discussed under the scatter graph method, but the high-low method
is an alternative method of estimating the line. The equation for a
linear relationship is as follows:

y = mx + c
where:
y is the total (aggregate) cost
m is the gradient or slope of the line (and the variable cost per unit of
the cost driver) x is the cost driver level
c is where the line intercepts the y-axis (and therefore the xed cost).
The above equation is referred to as a regression equation, in which y

is called the dependent variable (because y is dependent on the value
of x) and x is the independent variable.
Example 3.2
The same information regarding a monthly telephone account as in example 3.1
applies.
Required:
Use the high-low method to determine the variable and xed cost portion of the
monthly telephone account and to derive an equation that explains the relationship
between the two.
Table 3.1 Breakdown of annual cost and number of minutes
Total cost (R) Total talk time in minutes

January 260,00 762,3
February (the most talk-time minutes) 428,54 1 338,0
March 338,58 956,4
April 310,00 900,0
May (the least talk-time minutes) 260,76 485,3
June 387,09 1 255,0
July 354,83 1 110,1

Total cost (R) Total talk time in minutes
August 208,92 555,8
September 400,44 1 269,6
October 201,32 612,0
November 297,71 861,0
December 329,62 997,0
We have already established that talk time, rather than the number
of calls made, should be used as the cost driver, as a signi cantly
more linear relationship exists in the case of the former. In order to
employ the high-low method, we select the two points with the
highest and lowest cost driver levels (all other points are disregarded
at this stage). In this example, it means we have to select the month
with the most minutes of talk time, and the month with the least
minutes of talk time. From Table 3.1, we see that these months are
February and May respectively.
Simultaneous equations can be used to determine the equation of
the total cost line, which can then be used to predict the total cost at
any activity level within the relevant range.
The following mathematical shortcut can be used to calculate the
variable cost per unit (the gradient or slope), eliminating the need
for simultaneous equations:
This means that the variable cost (m in the equation) is R0,19676 per
minute of talk time.

The xed cost portion of the telephone expense can be calculated by
replacing m in the formula with the variable cost per minute as
calculated above, and then substituting the x and y co-ordinates of
the highest or lowest data point. In the calculation of the xed cost
below, we have chosen to use the data for February:
y = mx + c
c = y – mx
= R428,54 – (R0,19676 × 1 338)
= R165,28
The xed cost is approximately R165 per month and the complete
equation is as follows:
y = 0,19676x + 165
Figure 3.4 Shortcomings of using the high-low method
The line is tted to the data using the data points at the highest and
lowest activity levels. Disturbingly, the xed cost that results is even
further from reality (R165 as calculated, compared to R87 per the
telephone account) than the rough scatter graph method employed
earlier. This is a result of two major aws that are inherent in this
approach:

1 Only two points are selected (no coverage of the population).
2 These points are the extremes and may not be representative of
the population, or they may lie outside the relevant range.
Note that the high-low method is often used to split a mixed cost
into its variable and xed components. Where the relationship
between the cost and the cost driver is perfectly linear (in other
words, where the line is not merely an estimate as in example 3.2
above, but all the data points are genuinely on the line), the method
results in a 100% accurate split between the variable and xed
components. In such a situation, any two observations in the data
set, not only the points with the highest or lowest cost driver value,
can be used in order to calculate the variable and xed cost
components and all will yield the same result.
Key terms: best t line, least squares regression, regression

error
Least squares regression is a statistical approach to establishing the

equation of the line that best ts all of the data points provided. A
best t line is de ned as the line that reduces the sum of the squares
of the regression errors. (A regression error is the distance between
the line and the point/observation. Refer to Figure 3.5.) This is the
most accurate of the three approaches, but the most tedious if the
calculation is performed manually, as described in this section. The
use of a computer software package greatly speeds up the process.
This is described in the following section. In both instances, the
equation for the linear relationship is again as follows:

y = mx + c
where:
the cost driver)
x is the cost driver level
Figure 3.5 Regression error
Manual approach to determining the

3.5.1
equation of the line

The gradient (slope) and intercept (the variable and xed cost
components of the formula respectively) can be found with the

following two formulae:
n represents the number of observations.
Example 3.3
The same information regarding a monthly telephone account as in example 3.1
applies.
Required:
Manually apply least squares regression to determine the variable and xed cost
portion of the monthly telephone account, and derive an equation that explains the
relationship between the two.
Again talk time, rather than the number of calls made, is used as the
cost driver, as a signi cantly more linear relationship exists in the
case of the former.
The total cost and cost driver can be tabulated as follows in order
to facilitate working with the equations:

The above information can now be substituted into the regression
formula. Solve for the slope, m (that is, the variable cost per minute):
The variable cost (m in the equation) is R0,24298 per minute.
Solve for y-intercept, c (that is, the xed cost per month):

The linear equation that represents the relationship between the
monthly telephone cost (y) and the number of minutes of talk time
per month (x) is as follows:
y = r0,24298x +
r90,01
Notice that the xed line rental cost per month as calculated using
least squares regression is much closer to the actual xed cost than
the estimates we determined using the scatter graph and high-low
methods. However, a difference between the actual (R87) and
estimated (R90) xed cost still exists. The reasons for this are
discussed in section 3.6 below.
Most students use a calculator to perform least squares

regression calculations under exam conditions – it is unlikely
that time restrictions will allow you to do the calculations
manually. If the calculator that you are permitted to take into the
exam room has statistical functions, please refer to the
‘statistical calculations’ or similarly named section of your
calculator manual.

Computerised approach to calculating
3.5.2
the equation of the line using Microsoft

Excel®
Key terms: coef cient of determination, correlation coef cient,
normal distribution table, regression analysis,
standard error
The section explains how to perform least squares regression with

the use of Excel®, and also discusses two key pieces of statistical
information that the Excel® analysis provides.
The syllabi of professional accounting bodies require students

to be capable of integrating IT skills with management
accounting skills. The following example provides an
opportunity for such integration.
Example 3.4
The same information as in example 3.1 regarding a monthly telephone account
applies.
Required:
Apply the least squares regression technique using Microsoft’s Excel® software to
determine the variable and xed cost portion of the monthly telephone account, and to
derive an equation that explains the relationship between the two.
The data set (total cost and total talk time per month, for each month
for which information is available) is set out in Excel®, as shown in
Figure 3.6 below.

Figure 3.6 Setting out the data
• Select the ‘Data Analysis’ tool from the ‘Tools’ menu option, as
illustrated in Figure 3.6. If the Data Analysis tool is not available,
follow the Microsoft Of ce® help options to install the menu
item.
• The dialog box in Figure 3.7 appears. Select the ‘Regression’
option. A second dialog box appears into which you are required

to input the data set (as in Figure 3.8). Click ‘OK’ once you have
done this.
• The regression output appears in another sheet, as shown in
Figure 3.9. You will notice that Excel® returns a fair amount of
regression information. We will focus on just a few key statistics.
Figure 3.7 Selecting the regression data analysis tool
Figure 3.8 Inputting the data set

Figure 3.9 Telephone expense calculated in Excel®

The coef cient that is returned by the regression analysis (0,24298288
in the example above) is the best estimate possible of the variable
cost, using the data available. In other words, the coef cient that is
returned by the regression analysis is the best t to the data that was
used. Refer to the scatter graph that was originally plotted (Figure
3.2), which re ects the relationship between y (the total cost) and x
(the total number of minutes (the cost driver)). Notice that the
relationship between these two is not perfectly linear and that
regression errors exist. Because the relationship between cost and
cost driver is not perfectly linear, it is impossible to say with 100%
certainty that the true value of the coef cient (the true variable cost
per minute) is exactly 0,24298288.
While it is not possible to be 100% con dent that the true value of
the coef cient is one speci c number, it is possible to be con dent, up
to a certain level, of the true value of the coef cient, if the value of
the coef cient is expressed as a range, instead of a discrete number.
The standard error can be used to determine what the range needs to
be, depending on the level of con dence that is required. The higher
the required level of con dence that the true coef cient lies in the range of
numbers speci ed, the wider the range needs to be.
This range is calculated by adding to and deducting from the
coef cient determined by the regression analysis a certain number of
standard errors of the coef cient. The more con dent we want to be
that the true value of the coef cient lies within the range, the wider
the range needs to be, and the greater the number of standard errors
that need to be added to and subtracted from the estimated

coef cient. How many standard errors need to be added or
subtracted for a certain probability level? This has been statistically
determined and for normal distributions, the normal distribution
table is used. The normal distribution table can be found in statistics
textbooks.
For the purposes of illustration, assume that we wish to
determine a range within which we can be 95% con dent that the
true value of the coef cient lies. We can see from a normal
distribution table that to obtain a 95% con dence level, 1,96 standard
errors need to be added to and subtracted from the coef cient.
We are therefore 95% con dent that the true variable cost per minute
lies between R0,19569 per minute and R0,29027 per minute.
T-stat
Key term: t-stat
The t-statistic (t-stat) compares the size of the standard error of the
coef cient to the size of the coef cient itself, in order to provide an
understanding of the relative size of the standard error. It is
calculated by dividing the coef cient by the standard error of the
coef cient. In the example above, the t-stat of 10,07048601 (see
Figure 3.9) is calculated as follows 0,24298288/0,024128217.
The t-stat therefore provides a relative measure of the standard
error of the coef cient. This is useful, as the t-stat provides an
indication of whether there is a statistically signi cant relationship
between the dependent and independent variables. The larger the
standard error of the coef cient relative to the coef cient itself, the

smaller the t-stat, and the less meaningful the relationship between
the dependent and independent variables. In the example above, the
t-stat is in excess of 10, indicating that the standard error of the
coef cient is quite small relative to the size of the coef cient and that
a statistically signi cant relationship exists between the number of
minutes of talk time and the total cost of the telephone account.
3.6Factors affecting the accuracy of cost

estimation
Key terms: duration driver, intensity driver, multiple regression,

transaction driver
A number of factors affect the accuracy with which costs can be

estimated and predicted.
The rst factor has already been raised. A cost may have multiple
cost drivers. As an example, consider a monthly telephone account
again: the number of telephone calls made; the amount of time spent
on the phone; whether the telephone call is local, national,
international or to a cellphone. The number of telephone calls is a
speci c kind of cost driver, known as a transaction driver.
Transaction drivers measure the number of times an activity is
performed. The amount of time spent on the phone is a type of cost
driver referred to as a duration driver. Duration drivers recognise
that the time spent performing an action may be in uential in terms
of driving costs. The third driver – the kind of call that is made –
recognises that some types of calls make use of network resources
more intensively than other types of calls. Local calls would place
the least amount of demand on network resources, while national
calls utilise greater quantities of bandwidth. This type of cost driver

is referred to as an intensity driver. Costs with multiple cost drivers
can be analysed using multiple regression, the detailed calculation
of which falls outside the scope of this text.
A second factor is that a change in price or pricing structures of
the cost may have occurred during the period. Suppose that, in an
effort to reduce costs, the owner of the telephone decided to move to
a structured billing plan, which would result in all calls made in off-
peak time being free. There would be a change in the telephone
account that is purely price related and has nothing to do with a
change in the cost driver. This would result in a distortion of the
variable and xed-cost components calculated under any of the
above methods. In such an instance, only telephone accounts after
the pricing change should be considered in order to understand how
costs will behave in future.
A third problem is that a linear relationship may not exist. The
relationship may have step aspects to it, or the existence of
ef ciencies and inef ciencies at certain points may result in a
curvilinear relationship between cost and cost driver (refer to the
economists’ curve described in Chapter 2, Cost classi cation). Direct
labour cost, speci cally, often has a non-linear relationship with
production volumes, because labour ef ciency may improve over
time. ‘Learning curves’ are then used (these are discussed in
Appendix 3.1).
Changes in technology, such as a switch from landline to
cellphone, or switching from using a standard telephone line to
using broadband for internet access, is the fourth factor that can
affect costs. A broadband line is often charged as a xed amount
each month with no variable cost component, where internet usage
over the dial-up telephone system may to a large extent have been a
variable cost. (Internet usage would have been billed based on time

spent on the telephone line.) In such a case, the cost structure has
changed from partially xed, with a large variable cost component,
to exclusively xed.
Lastly, cut-off problems could exist between the periods over
which the cost and activity respectively are recorded. A cut-off
problem refers to the situation where the cost is for one particular
period (for example, 1 January to 31 January), but the activity is
reported for a slightly different period (for example, 3 January to 2
February). This often happens in organisations where cost
information is generated by one system and activity information is
gathered from a different source. In our telephone example, a
different kind of cut-off problem (or mismatch between billing and
usage periods) could have arisen. If the telephone user had decided
to switch from the old system of being billed – monthly in arrears –
to another type of billing plan which is perhaps billed monthly in
advance, this might result in an unusually large bill in the month of
switching. Effectively, the switch-over month would represent a
double bill. The increase in cost is a timing or cut-off issue, and has
nothing to do with a change in usage.
3.7Other means of estimating costs and

predicting cost behaviour
Key term: historic cost data
In addition to the cost estimation methods discussed above, various

other methods of cost estimation and prediction exist which may be
useful in various circumstances. In situations where no historic cost
data exists, the cost estimation could be carried out by means of an
experimental approach. This is often referred to as a scienti c or

engineering approach, whereby a sample of activities is carried out,
and the results are recorded and extrapolated over the full extent of
the anticipated activities.
Alternatively, where historic cost information with which
management is quite familiar is readily available, management may
not feel it necessary to carry out graphical, mathematical or
statistical analysis. Rather, a perusal of the accounting records, given
a high level of familiarity with the detail of the accounts, may be
suf cient to distinguish between the xed and variable cost
components of the total cost that is under analysis.
3.8 Summary
This chapter provides an introduction to some measurement
techniques that can be used to calculate the variable and xed
components of a mixed cost, when these amounts are not already
known. These techniques require an activity to be identi ed against
which the cost can be measured, and the following linear equation is
developed in order to assist the organisation with predicting future
costs:
y = mx + c
where:
the cost driver)
x is the cost driver level

This formula is valid only within the relevant range.
The relationship between costs and units can also be non-linear,
as discussed in Appendix 3.1.
The most important criterion in selecting an appropriate cost
driver is that there should be a plausible relationship between the
cost and the cost driver. Furthermore, the relationship between the
cost and the cost driver needs to be reasonably linear in order for the
measurement techniques discussed in this chapter to be of use. In
order to obtain a visual perspective as to whether a linear
relationship exists between a cost and a selected activity, a scatter
graph can be used. The observations of costs versus activity level can
be plotted on a pair of axes in order to determine whether or not the
points are linear.
The high-low method can be used to calculate the xed and
variable components of the total cost for a set of observations. The
observations at the highest and lowest activity levels are used. High-
low analysis is based on the assumption that any increase in total
cost from one activity level to the other is due to the change in
activity level, and by dividing the change in cost by the change in
the activity level, the variable cost per activity can be determined.
The shortcoming of this method is that only two observations are
taken into account.
The least squares statistical method (whether performed
manually, on a calculator or in Excel®) is able to take all observation
points into account. Further statistics can be computed to provide
information on the reliability of the equation determined in this
manner.
Potential shortcomings of all methods of analysis is that there
may be more than one cost driver; price changes may have occurred
in the cost; a linear relationship between cost and cost driver may

not exist; changes in technology may have affected the cost or cost
driver; or cut-off problems may have occurred.
Conclusion: Cost estimation and other

topics in this book
Chapter 2, Cost classi cation introduced a number of different ways
in which costs were classi ed for management accounting purposes.
One of these classi cations related to cost behaviour, with four types
of costs being highlighted: variable, xed, step and mixed costs.
This chapter focuses on quantitative methods of identifying and
calculating the variable and xed cost components of a mixed cost.
Such quantitative techniques are useful in budgeting, as discussed in
Chapter 12, Budgets, planning and control. Management will nd it
necessary to apply some cost estimation technique when the
relationship between the cost and activity to which it relates is not
clear. The starting point for applying any quantitative technique is to
identify the cost driver (or activity) that drives the cost under
examination. The concept of cost drivers is further explored in
Chapter 6, Overhead allocation. Appendix 3.1 deals with a nonlinear
relationship between cost and cost-driver. It examines the learning
curve effect often encountered in direct labour costs.
Tutorial case study: SAPPI
Consider again the example of SAPPI LTD introduced at the start of the chapter and
the extract from the Chairman’s review relating to costs.
1 Identify an appropriate cost driver for delivery costs and discuss whether the
same cost driver for energy costs.
2 Although delivery costs are discussed together with variable costs, explain under
what circumstances delivery costs would be a mixed cost.

3 Comment on whether SAPPI’s management accounting team could possibly
make use of scatter graphs, the high-low method or least squares regression to
determine cost equations. Discuss what the relative advantages and
disadvantages of the techniques would be.
4 If the management accountants did employ least squares regression, suggest a
way around the tedious mathematical calculations that underlie this technique.
5 Determine what you think would be a possible example of a transaction cost
driver, a duration cost driver and an intensity cost driver respectively, SAPPI.
6 Discuss what factors could affect the accuracy of estimations where cost
estimation techniques have been employed by SAPPI.
Appendix 3.1 Learning curves1
Key terms: cumulative average–time learning model,

cumulative doubling approach, experience curve,
graph/schedule approach, incremental unit–time
learning model, learning curve, learning curve index,
learning rate, learning tempo, mathematical
approach
Introduction
In the cost estimation methods and examples earlier in this chapter,
we assumed a linear relationship between cost and cost driver.
Sometimes this may not be true, particularly if we have (1) a new
production process, (2) which is repeated, and (3) which has large
labour inputs – these are the three requirements that need to be present
before a learning process can take place. In such a situation, as workers
repeat the job, they become better at it and ‘learn’ to perform it more
quickly. In other words, the labour ef ciency increases. The time
taken to produce each additional unit is therefore less than for the
previous one, and the total labour costs (and related variable costs,

where labour is the cost driver) increase at a relatively slower rate
than the number of units produced. This relationship can be
presented graphically as a curve, known as the learning curve.
The learning curve is a function that indicates how the number
of labour hours per unit decreases as the number of units produced
increases. Learning normally has the greatest impact on the rst few
units, and then the effect of the learning process decreases until,
eventually, a point is reached where all possible learning has
occurred and the curve attens. This relationship is shown in exhibit
3.1.
Exhibit 3.1 Cumulative average time per unit
Exhibit 3.2 shows the impact on total production time. For each
additional unit produced, the total time taken to produce all units
increases by a smaller amount, resulting in a curve that attens, but
never becomes a line parallel to the x-axis (as each additional unit
still takes some time to produce).
Exhibit 3.2 Cumulative total labour hours

The learning tempo is de ned as the percentage by which the labour
time decreases each time the number of units doubles. The de nition
implies that, as time passes and workers’ skills increase, more units
have to be produced (for example, four units instead of two units) to
achieve the same percentage decrease in labour time. Furthermore,
the reduction in labour time becomes increasingly smaller in
absolute terms, as the constant percentage is applied to an
increasingly smaller amount. Appendix example 3.1 illustrates this.
Appendix example 3.1

ShadeConcepts manufactures umbrellas that are used outdoors by businesses such
as restaurants to protect their customers from the harsh South African sun. It recently
started manufacturing a new type of umbrella, the ‘KerbCover’, which provides shade
for several tables at a time. It estimates that a learning tempo of 20% will apply in the
manufacturing process. The rst unit took 10 hours to manufacture.
Required:
Calculate how long it is likely to take to manufacture the second and fourth units of the
KerbCover.
If the rst unit took 10 hours to produce, the second one will take 10
hours – (10 hours × 20%) = 8 hours. The fourth unit will take 8 hours

– (8 hours × 20%) = 6,4 hours. If we calculate the absolute decrease in
hours, it is 2 hours (10 hours – 8 hours) from the rst to the second
unit and only 1,6 hours (8 hours – 6,4 hours) from the second to the
fourth unit. The way the learning tempo is de ned therefore
automatically captures the decreasing tempo of learning. This makes
sense, as the more workers have learnt about manufacturing the new
product, the less remains to be learnt. Eventually they will reach a
point where they are manufacturing the umbrellas as quickly as they
can and very little further ‘learning’ will be possible.
It is generally assumed that learning occurs at a steady rate – the
learning rate. This rate is de ned as 100% less the learning tempo,
which was discussed above. Using the information in appendix
example 3.1, the learning rate would be 80% (100% – 20%). Most
exam questions give the learning rate rather than the learning
tempo. Synonyms for the learning rate are rate of learning, learning
curve and learning curve rate.
It is important to note that a unit can refer to more than one
product unit. If it refers to batches, the labour time per unit is
obtained by dividing the total time needed to complete a certain
number of batches by the number of units in the batch. Note that in
such a case, the situation must speci cally be one where learning
occurs according to batches of units (and not individual units) –
calculations will be incorrect if batches are randomly created just to
facilitate doubling and therefore calculation.
To illustrate a situation where learning occurs in batches, assume
that ShadeConcepts, the organisation in appendix example 3.1, also
manufactures smaller umbrellas for children’s tables. These are
manufactured in batches, with each batch containing six different
animal-shaped umbrellas. Because the shape of each of the six
umbrellas in a batch is unique, the effect of learning is felt only once

an entire batch is complete. If it takes 10 hours to manufacture the
rst batch and the learning tempo is 20%, it will take 8 hours (10
hours – 20%) to manufacture the next batch and 6,4 hours (8 hours –
20%) to manufacture the fourth batch. The labour hours per unit can
now be calculated as 1,67 hours (10 hours per batch/ 6 units per
batch) for the rst batch and 1,5 hours (18 hours/12 units) for the
total production of the rst two batches.
The learning curve can apply to both direct labour cost and
variable overhead cost, if the cost driver for overheads is direct
labour hours (or a related measure such as labour costs).
Learning curves are not applicable only to the time taken to
manufacture units in a factory setting. They can also be applied to
white-collar work, such as the time it takes to make price and
investment decisions, to schedule work and to prepare budgets.
They are also applied in the determination of standards, and in
recent years have been applied to areas such as marketing,
distribution and client services. In these settings, the term
‘experience curve’ is often used instead of ‘learning curve’.
Incremental unit–time learning model and cumulative

average–time learning model
The applicable learning rate can be modelled in one of two ways: the
incremental unit–time learning model or the cumulative average–
time learning model. The incremental unit–time learning model
expresses the effect on the additional time taken to produce the last unit
if the cumulative quantity of units doubles. The cumulative
average–time learning model expresses the effect on the cumulative
average time per unit when the cumulative quantity of units doubles.
The difference is best illustrated with an example.

ShadeConcepts’ ‘KerbCover’ umbrella is being manufactured. It is estimated that a
learning rate of 80% is applicable. The rst unit took 10 hours to complete.
Required:
Indicate the impact on the cumulative average time per unit, the total time taken to
produce all units and the incremental time taken to produce the last unit, if the
applicable model is:
• an incremental unit–time learning model
• a cumulative average–time learning model
and the total number of units produced is two KerbCovers.
Under an incremental unit–time learning model, the additional time

to produce the second unit is 8 hours (10 hours × 80%). You will
recognise this model as the one that was applied in appendix
example 3.1. The total time it takes to produce both units is 18 hours
(10 hours + 8 hours). To calculate the cumulative average time per
unit, we must divide the total time it took to produce the units by
the cumulative number of units produced: 18 hours/2 units = 9
hours per unit.
Under a cumulative average–time learning model, the
cumulative average time for each unit produced would be 8 hours (10
hours × 80%). The total time taken to produce both units would
therefore be 8 hours × 2 = 16 hours. Since we know that the rst unit
took 10 hours to produce, it will take 16 hours – 10 hours = 6 hours
to produce the second unit.
From the above, it is clear that the time it takes to produce a
given unit can differ signi cantly depending on whether an
incremental unit–time or a cumulative average–time learning model
applies.

The incremental unit–time learning model usually predicts a
higher cumulative average time per unit than the cumulative
average–time learning model (when the same learning rate is used in
both models). The nature of the actual learning process that takes
place in a given scenario determines which model is applicable.
As mentioned earlier in the chapter, correct costing information is
necessary to facilitate decision-making. It is therefore important to
determine whether a learning process does take place and which rate
and model best approximate it. The enhanced information is useful
in pricing and production decisions as well as in performance
evaluation.
If a question does not state which learning curve model is

applicable and does not give data from which this can be
deduced, it is usually safer to assume that the cumulative
average–time learning model applies. Be sure, however, to look
thoroughly for clues in the question before you make this
assumption.
Approaches
Now that the theory of learning curves has been explained, we turn
our attention to the practical approaches to calculating learning
curves. The following approaches have been developed to calculate
the time needed to produce units (an additional unit, the average
time per unit produced or the total time needed to produce all units)
or the learning rate:
• The cumulative doubling approach
• The graph/schedule approach
• The mathematical approach

The cumulative doubling approach
The cumulative doubling approach can be used only if the problem
involves the doubling of units or batches, as has been the case in our
examples so far. It can therefore be applied, for example, if eight
units are produced (as it involves the doubling from 1 to 2 to 4 to 8),
but not to determine the effect if seven units are produced.
Appendix example 3.2 showed how this approach is used in
calculating the following:
• The time needed to produce the last unit
• The average time per unit produced
• The total time needed to produce all units
The same principles apply when more than two units are produced.
Appendix example 3.3 illustrates this.

Assume the same information as for appendix example 3.2.
Required:
Calculate the time needed to produce the last unit, the average time per unit produced
and the total time needed to produce all units if eight KerbCover umbrellas are to be
manufactured and:
• an incremental unit–-time learning model applies
• cumulative average–time learning model applies.
If the model is an incremental unit–time learning model, we can

calculate the additional time it takes to produce the eighth unit. The
calculation would be:
10 hours × (0,8)3 = 5,12 hours

As it is impossible to calculate the incremental time of the third, fth,
sixth and seventh units under the cumulative doubling approach, we
cannot calculate the total time it takes to produce eight units or the
cumulative average time per unit.
Let us now apply the cumulative average–time learning model.
As the number of units produced doubles three times, the
cumulative average time per unit produced would be: 10 hours ×
(0,8)3 = 5,12 hours. The total time it takes to produce eight units
therefore amounts to 5,12 hours × 8 = 40,96 hours. It is not possible
to calculate the additional time taken to produce the last unit. The
reason is that we do not know how long it took to produce seven
units. We cannot calculate it using the cumulative doubling
approach, as seven is not a doubling of units. We can merely state
that it took an additional 30,96 hours (40,96 hours – 10 hours) to
produce the last seven units, or an additional 15 to 36 hours (40,96
hours – (10 × 0,82 × 4 hours)) to produce the last four units.
The learning rate can be calculated using the cumulative
doubling approach, if the cumulative average (or incremental
average) times for the rst and subsequent doubled units are given.
Appendix example 3.4 shows the necessary calculations.

Assume that the following independent sets of information about ShadeConcepts’
KerbCover umbrellas are available:
• Scenario A: It takes 10 hours to produce the rst unit and 6,4 hours to produce the
fourth unit. An incremental unit–time learning model is applicable.
• Scenario B: It takes 10 hours to produce the rst unit and a cumulative average of
6,4 hours per unit to produce four units. A cumulative average–time learning model
is applicable.
Required:
Calculate the learning rate for each of the independent scenarios A and B above.

First of all, we need to determine how many times the number of
units produced doubles. Here it doubles twice, and the following
formula is therefore applicable:
10 hours × (y)2 = 6,4 hours, where y is the learning rate
Solving for y, we obtain the following: The

learning rate is therefore 80% (notice that this corresponds with the
learning rate given in appendix example 3.2). The same calculation
applies to both scenarios A and B. This implies that, if an
incremental unit–time learning model applies, a learning rate of 80%
means it would take 6,4 hours to produce the fourth unit. However,
if a cumulative average–time learning model applies, a learning rate
of 80% means it would take on average 6,4 hours to produce each of
the four units, and a total of 25,6 hours.
Let us now assume that we are given the information that it took
eight hours to produce the second KerbCover unit. For the second
unit, the units produced doubled only once. If an incremental unit–
time learning model applies, the learning rate can be calculated as
follows:
10 hours × (y)1 = 8, where y is the learning rate
Solving for y, we nd that the learning rate is 8 hours/10 hours =

80%. Notice that this corresponds with the learning rate given in
appendix example 3.2, where we used the 80% learning rate to
calculate that the second unit would take 8 hours to produce.
If a cumulative average–time learning model applies, the
learning rate would be calculated as follows. First, we would need to
calculate the cumulative average time per unit it takes to
manufacture the two units: (10 hours + 8 hours)/2 = 9 hours. The
learning rate is as follows:

10 hours × (y)1 = 9 hours
Solving for y, we nd that the learning rate is 9 hours/10 hours =

90%.
This (90%) differs from the 80% learning rate given in appendix
example 3.2 because in that example, it was shown that the second
unit would take 6 hours (not 8 hours) to produce if a cumulative
average–time learning model with a learning rate of 80% applied.
The information we were given in appendix example 3.2 was not
that the second unit took 8 hours to produce, but rather that the
learning rate was 80%.
The graph/schedule approach

The graph/schedule approach is best illustrated by an example.
Once again, we can either determine the time needed to produce
units (appendix example 3.5) or we can estimate the learning rate
(appendix example 3.6).

As we know, ShadeConcepts also manufactures smaller umbrellas for children’s
tables. These are manufactured in batches, with each batch containing six different
animal-shaped umbrellas. Because the shape of every one of the six umbrellas in a
batch is unique, the effect of learning is felt only once an entire batch is complete. It
took 10 hours to complete the rst batch.
A learning curve of 80% is applicable and the organisation nds that a cumulative
average–time learning model best describes the learning process.
Required:

Calculate the cumulative average time it takes to produce 15 children’s umbrellas and
determine the necessary time to produce an additional three umbrellas once 15
umbrellas have already been produced.
The rst step is to convert the required umbrellas into batches, as the
model described above relates to batches (and not individual units):
15 umbrellas/6 umbrellas per batch
= 2,5 batches
Next we obtain the relevant cumulative average time percentage

from the table and calculate the total time it takes to produce 15
umbrellas:
10 hours for the rst batch × 74,46% (read off the table) × 2,5
batches
= 18,62 hours
The last step is simply to divide the total time by the number of
umbrellas produced:
18,62 hours/15 umbrellas
= 1,24 hours per umbrella
The time taken to produce an additional three umbrellas can be

determined by calculating the time it takes to produce 18 umbrellas
and then deducting the time it takes to produce 15 umbrellas. 18
umbrellas are produced in three batches; therefore the total time it
takes to produce them is as follows:
10 hours for the rst batch × 70,21% × 3 batches
= 21,06 hours
We calculated above that it takes 18,62 hours to produce 15

umbrellas and therefore the extra time to produce another 3
umbrellas is as follows:

21,06 hours – 18,62 hours
= 2,44 hours
To estimate times when an incremental unit–time learning model is

used, the table (or graph, if one has been given) needs to display the
incremental time for the last unit at different numbers of cumulative
units. To calculate information other than the additional time it takes
to produce the last unit, the incremental times for all successive
times must be provided (for 1, 2, 3,...). The reason is that these times
must be added to obtain a total time and to be able to calculate a
cumulative average time per unit.

ShadeConcepts is looking to launch a new type of umbrella, the StreetCafé. Each
batch consists of 50 units. It takes 250 hours to manufacture the rst batch and 195
hours to manufacture the third batch. The learning process is best approximated by an
incremental unit–time learning model.
The management of ShadeConcepts suspects that the learning rate applicable to
the manufacture of StreetCafé is somewhere between 80% and 90%. They have
therefore determined the time it would take to produce the last batch for different
numbers of cumulative batches at learning rates of 80% and 90% respectively, and
summarised it in the table below.
Required:
Use the tables given to determine the applicable learning curve based on the
information you have about the StreetCafé product line.

First, we need to express the time it takes to manufacture the third
unit as a percentage of the time it takes to manufacture the rst unit:
195 hours/250 hours × 100
= 78%
The time taken to produce the third batch, expressed as a percentage

of the time taken for the rst batch, is 70,21 hours for an 80% curve
and 84,62 hours for a 90% curve. The appropriate learning curve will
therefore be as follows:
[(78 hours – 70,21 hours)/(84,62 hours – 70,21 hours) × (90% −
80%)] + 80%
= 85,4%
If the cumulative average–time learning model is used, the relevant

table provided and the cumulative average time for three units
given, we would proceed in the same way. If the total time to
manufacture three units is given, we would rst need to calculate the
cumulative average time and then continue as above.
The mathematical approach

In the mathematical approach, the following mathematical formula
is used:
y = axb
where:
y = cumulative average time per unit (cumulative average–time
learning model) OR time taken to produce the last unit (incremental
unit–time learning model)

x = cumulative number of units produced
a = time taken to produce the rst unit
As this approach can always be used (provided that the values for all
but one variable are given or that the information for two formulas
for all but two variables is given), it is the one most commonly used.
Its main advantage is that its application is not limited to a doubling
of units or to the cumulative units given in a table. Although you
may often need to use this approach to solve problems, it may
sometimes be quicker to use one of the rst two approaches, if
possible.
The formula can appear quite intimidating, especially because of
its use of logarithms (‘logs’). In appendix example 3.7 below, we
show the log calculations to determine variable ‘b’ in the equation
for the sake of completeness. However, in exam questions, the value
of ‘b’, which is also known as the learning curve index, will often be
given.
Appendix example 3.7 shows how to estimate the various times
given a cumulative average–time learning model and an incremental
unit–time learning model.

ShadeConcepts’ original umbrella was known as the ShadeMaster. Five years ago,
when it was launched, it took 300 minutes to produce the rst ShadeMaster and the
applicable learning rate was 85%. The organisation did not keep detailed records of
how long it took to produce any subsequent units, or of the type of learning model
applicable.
Required:

Calculate the additional time it probably took to produce the xth ShadeMaster, the
cumulative total time to produce all ShadeMasters and the cumulative average time
per ShadeMaster, if the:
• incremental unit–time learning model applied
• cumulative average–time learning model applied.
Perform this calculation when a total of 1 to 16 ShadeMasters is produced (and

therefore for the cumulative number of ShadeMasters of 1,2,3,...,16).
Exhibit 3.3 summarises the results if an incremental unit–time

learning model was applicable. The time for the xth unit is obtained
by using the formula. For example, for the second unit it would be as
follows:
y = 300 minutes × 2[log(0,85)/log(2)]
= 255 minutes
Note that this answer can also be obtained by multiplying 300

minutes by 85%. This is possible only because two is a doubling of
units. The same would be applicable for the fourth unit (255 minutes
× 85% or 300 minutes × (0,85)2 ), but for the third unit we need to
use the formula (y = 300 minutes × 3[log(0,85)/log(2)] ).
Once this value is calculated for each of the cumulative number
of units (x-values), it is easy to calculate the cumulative total time it
takes to produce x units. The individual time for each of the units is
added. It would therefore take 786,87 minutes (300 minutes + 255
minutes + 231,87 minutes) to produce three units.
Lastly, we can calculate the cumulative average time per unit,
when x units were produced. The cumulative total time for x units
(column 3) is divided by the cumulative number of units (x) (column
1). For example, it would have taken an average of 206,11 minutes (2
473,33 minutes/12) to produce each unit if a total of 12 units had
been produced.

Exhibit 3.3 Incremental unit–time learning model
Exhibit 3.4 summarises the results when the cumulative average–

time model is applicable. The cumulative average time per unit is
obtained by using the formula. For example, for two ShadeMasters it
would be as follows:
y = 300 minutes × 2[log(0,85)/log(2)]
= 255 minutes

Note that this answer can also be obtained by multiplying 300
minutes by 85%. This is possible only because two is a doubling of
units. The same would be applicable for four units (255 minutes ×
85% or 300 minutes × (0,85)2), but for three units we need to use the
formula (y = 300 minutes × 3[log(0,85)/log(2)]).
Once this value is calculated for each of the cumulative number
of units (x-values), it is easy to calculate the cumulative total time it
takes to produce x units. The cumulative average time (column 2) is
simply multiplied by the cumulative number of units (column 1).
For example, for 5 units it would be as follows:
205,7 minutes × 5 units
= 1 028,5 minutes
Lastly, we can calculate the additional time it takes to produce the

xth unit. The cumulative total time for x – 1 units is subtracted from
the cumulative total time for x units. To ascertain the time it would
take to produce the 16th unit, we need to subtract 2 384,84 minutes
(for 15 units) from 2 505,63 minutes (for 16 units) = 120,79 minutes.
Exhibit 3.4 Cumulative average–time learning model

In appendix example 3.7, the learning curve index could have been
given. In other words, the value of log [0,85]/log [2], which is –
0,2345, could have been supplied as part of the question.
The mathematical approach can also be used to calculate the
learning rate, the time taken to produce the rst unit or the
cumulative number of units produced. The formula is simply solved
for the required variable. Calculating the learning rate by using the
mathematical approach is demonstrated in appendix example 3.8.

It takes 15 hours to produce the rst unit and a total of 1 965,81 minutes to produce
ve units. It was found that a cumulative average–time learning model best describes
the learning process.
Required:
Calculate the learning rate.
First of all, we need to ensure that we have all the necessary inputs
for the formula. x is 5 units and a equals 15 hours. y needs to be
calculated, by dividing 1 965,81 by 5 units. The resulting cumulative
average time per unit is given in minutes and must therefore be
converted to hours by dividing by 60:
393,16 minutes/60 minutes per hour
= 6,55 hours
The formula must now be solved for b. By dividing by a, then taking

the logarithm and nally dividing by log(x), we obtain the following
formula:
For our example, the values are:
= –0,514829 (or –0,514573 if 6,55 hours is not rounded)
We now know b, which is:

So:
log (learning rate) = b × log(2)
To nd the learning rate we now need to perform the reverse

operation of using the logarithm, which is to raise the term to the
base 10. The base 10 and the logarithm on the left-hand side of the
equals sign in the equation directly above this paragraph will cancel
each other out.
Therefore the learning rate: = 10b × log(2)
= 10 (–0,514829) × log(2)
= 0,6999
≈ 0,70
The applicable learning rate is therefore 70%. It is important to note

that it is necessary to keep as many decimal places as possible to
ensure an accurate result.
Note:
Management accounting students may sometimes use nancial
calculators that do not have the ‘log’ function. However, most
will have the ‘ln’ function and you can use ‘ln’ instead of ‘log’ if
necessary. The mathematical equation y = axb that is used in
this chapter can be restated as ln y = ln a + b × ln x.
If you were to use this restated formula in appendix example
3.8, you would end up with the equation:

b = ln learning
rate/ln 2
Therefore:
–0,514829 = ln learning rate/ln 2 and
0,356852 = ln learning rate
Now look for the calculator function ex and apply it to 0,356852.

The answer is 0,6999, which again indicates a learning rate of
70%.
Basic questions
BQ 1
The following statements relate to the calculation of the regression
line y = a + bx.
Using the information in the formula below:
i) sum(xy) is calculated by multiplying the sum of x by the sum of y

ii) (sum(x2)) is not the same as (sum(x))2
iii) n represents the number of pairs of data items used.
Which statements are correct?

a) (i) and (ii) only

b) (i) and (iii) only
c) (ii) and (iii) only
d) (i), (ii) and (iii)
BQ 2
Which of the following correlation coef cients indicates the weakest
relationship between two variables?
a) +0,9
b) –0,6
c) –0,8
d) –1,0
BQ 3
Regression analysis is being used to nd the line of best t (y = a +
bx) from ve pairs of data. The calculations have produced the
following information:
sum(x) = 129
sum(y) = 890
sum(xy) = 23,091
sum(x2) = 3,433
sum(y2) = 29,929
What is the value of a in the equation for the line of best t (to the
nearest whole number)?
a) 146
b) 152
c) 210
d) 245

BQ 4
Which of the following is a feasible value for a correlation
coef cient?
a) +1,2
b) 0
c) –1,2
d) –2,0
BQ 5
The following statements relate to the calculation of the regression
line y = a + bx, using the information in the formulae below:
(i) n represents the number of pairs of data items used
(ii) (∑x)2 is calculated by multiplying ∑x by ∑x
(iii) ∑xy is calculated by multiplying ∑x by ∑y
Formulae:
Which statements are correct?

a) (i) and (ii) only
b) (i) and (iii) only
c) (ii) and (iii) only
d) (i), (ii) and (iii)

BQ 6
The correlation coef cient (r) for measuring the connection between
two variables (x and y) has been calculated as 0,6.
How much of the variation in the dependent variable (y) is
explained by the variation in the independent variable (x)?
a) 36%
b) 40%
c) 60%
d) 64%
BQ 7
SOURCE: UCT (CAROL CAIRNEY)
For what purpose is the so-called ‘high-low method’ commonly
used?
BQ 8
What does the r-squared (r2) value mean in the context of a
regression model?
BQ 9
SOURCE: ADAPTED FROM CIMA P2
PT has discovered that when it employs a new test engineer, there is
a learning curve with a 75% learning rate that exists for the rst 12
customer assignments. A new test engineer completed her rst
customer assignment in 6 hours. A cumulative average–time
learning curve model applies. How long should she take for her
seventh assignment, to the nearest 0,01 hours?
Note: The index for a 75% learning curve is –0,415.

BQ 10
FH is an electronics company that has developed a new product for
the video conferencing market. The product has successfully
completed its testing phase and FH has now produced the rst four
production units. The rst unit took 3 hours of labour time and the
total time for the rst four units was 8,3667 hours. A cumulative
average–time learning curve model applies. What is the learning
curve improvement rate (learning rate), to the nearest 0,1%?
Long questions

SOURCE: ADAPTED FROM CIMA PAPER 3C
Each year, a large organisation which manufactures domestic
electrical appliances pays its employees an annual bonus. The head
accountant wishes to assess the effect of the previous year’s bonus
on the organisation’s output for the following year.
Data relating to bonus paid (as a percentage of annual salary) and
total output (tens of thousands of units sold) over an 8-year period are
given in the following table:

An organisation is seeking to establish whether there is a linear
relationship between the level of advertising expenditure and the
subsequent sales revenue generated.
Figures for the last eight months are as follows:
Month Advertising expenditure Sales revenue

R’000 R’000
1 2,65 30,0
2 4,25 45,0

Month Advertising expenditure Sales revenue
3 1,00 17,5
4 5,25 46,0
5 4,75 44,5
6 1,95 25,0
7 3,50 43,0
8 3,00 38,5
Total 26,35 289,5
The following further information is available:

∑ (advertising expenditure × sales revenue) = R1 055,875
∑ (advertising expenditure)2 = R101,2625
∑ (sales revenue)2 = R11 283,75
All of the above are given in R’million.
REQUIRED Marks
On a suitable graph, plot advertising expenditure against sales revenue or vice versa, as
(a)
appropriate. Explain your choice of axes. 5
(b) Using regression analysis, calculate a line of best t. Plot this on your graph from (a). 5
TOTAL MARKS 10

The management accountant at Josephine Ltd is trying to predict the
quarterly total maintenance cost for a group of similar machines. She
has extracted the following information for the last eight quarters:

The effects of in ation have been eliminated from the above costs.
The management accountant is using linear regression to
establish an equation of the form y = a + bx and has produced the
following preliminary calculations:
∑ (total maintenance cost × production units) = R61 250m

∑ (total maintenance cost)2 = R809 598m
∑ (production units)2 = 4 640m
REQUIRED Marks
Establish the equation which will allow the management accountant to predict quarterly total
(a) maintenance costs for a given level of production. Interpret your answer in terms of xed and
variable maintenance costs. 7
Using the equation established in (a), predict the total maintenance cost for the next quarter
(b) when planned production is 44 000 units. Suggest a major reservation, other than the effect
of in ation, that you would have about this prediction. 3
TOTAL MARKS 10

AVX CC assembles circuit boards for use by high technology audio
video companies. Because of the rapidly advancing technology in
this eld, AVX CC is constantly being challenged to learn new
techniques.
AVX CC uses standard costing to control its costs against targets
set by senior managers. The standard labour cost per batch of one
particular type of circuit board (CB45) is set out below:
Direct labour – 50 hours @ R10/hour = R500
The following labour ef ciency variances arose during the rst six
months of the assembly of CB45:

Month Number of batches assembled and sold Labour efficiency variance (R)
November 1 Nil
December 1 170,00 Favourable
January 2 452,20 Favourable
February 4 1 090,65 Favourable
March 8 1 712,85 Favourable
April 16 3 425,70 Favourable
An investigation has con rmed that all of the costs were as expected
except that there was a learning effect in respect of the direct labour
that had not been anticipated when the standard cost was set.
REQUIRED Marks
(a) Calculate the monthly learning rates that applied during the six months. 6
Identify when the learning period ended and brie y discuss the implications of your ndings
(b)
for AVX CC. 4
Note: A cumulative average–time learning curve model applies.
TOTAL MARKS 10

An organisation was planning to launch a new product. It had
already carried out market research at a cost of R50 000 and as a
result had discovered that the market price for the product should be
R50 per unit. The organisation estimated that 80 000 units of the
product could be sold at this price before one of the organisation’s
competitors entered the market with a superior product. At this
time, any unsold units of the organisation’s product would be of no
value.
The organisation estimated the costs of the initial batch of the
product as follows:

R’000
Direct materials 200
Direct labour (R10 per hour) 250
Other direct costs 100
Production was planned to occur in batches of 10 000 units and it

was expected that an 80% learning curve would apply to the direct
labour until the fourth batch was complete. Thereafter the direct
labour cost per batch was expected to be constant. No changes to the
direct labour rate per hour were expected.
The organisation introduced the product at the price stated
above, with production occurring in batches of 10 000 units. Direct
labour was paid using the expected hourly rate of R10, and the
organisation began to review the pro tability of the product.
The following schedule shows the actual direct labour cost
recorded:
Cumulative number of batches Actual cumulative direct labour cost

R’000
1 280
2 476
4 809
8 1 376
REQUIRED Marks
Calculate the revised expected cumulative direct labour costs for the four levels of output
(a)
given the actual cost of R280 000 for the rst batch. 4
(b) Calculate the actual learning rate exhibited at each level of output. 3
(c) Discuss the implications of your answers to (a) and (b) for the managers of the organisation. 3
TOTAL MARKS 10

References
SAPPI Limited. 2018. Sappi Annual Integrated Report 2018. [Online]. Available: https://cdn-
s3.sappi.com/s3fs-public/2018-Sappi-Annual-Integrated-Report.pdf
1 The author wishes to thank Birte Schneider for preparing this appendix on learning curves.

LEARNING OBJECTIVES
• discuss the purpose and usefulness of cost-volume-pro t (CVP)
analysis
• explain how changes in activity levels, variable costs, xed costs
and selling price impact on an organisation’s contribution margin
and pro t
• understand the main differences between the economist’s and
accountant’s model of CVP analysis
• calculate the break-even point using the pro t formula, the
contribution margin formula or a break-even chart
• apply CVP analysis to a number of ‘what if’ scenarios
• apply CVP analysis to multiple products and services and
explain the impact that a change in the sales mix has on an
organisation’s contribution margin and pro t
• explain the limitations of CVP analysis.
SAA and cost-volume-pro t relationships
In 2019 the nancial presses estimated that SAA may have recorded ‘a loss of more
than R9bn’ in the 2018/19 nancial year. Reasons for the large loss included revenue
not growing as a result of low economic growth and strong competition from low-
cost airlines within South Africa as well as international airlines globally; increasing

fuel prices; and the weakening of the rand. They predicted that the extent of the loss
was likely to result in the need for further government bail-outs using taxpayers’
money. SAA then went into business rescue in December 2019. As part of the
business rescue process, draft nancial reports presented to the Standing
Committee on Public Accounts in May 2020 revealed estimated losses for the
2016/17, 2017/18 and 2018/19 nancial years to have totalled R16 billion.
SOURCES: HTTPS://WWW.MONEYWEB.CO.ZA/NEWS/SOUTH-AFRICA/SAA-MAY-HAVE-RECORDED-A-
LOSS-OF-MORE-THAN-R9BN-IN-THE-PAST-YEAR/;
HTTPS://BUSINESSTECH.CO.ZA/NEWS/GOVERNMENT/398403/SAA-COUNTS-R16-BILLION-IN-LOSSES-
OVER-THREE-YEARS/
Cost-volume-pro t (CVP) analysis considers relationships between costs, volumes

and pro t. Given that the South African government has indicated that it will not
continue to bail SAA out with tax payers’ money, CVP analysis can be applied to
answer many questions, such as:
1 How many ight tickets does SAA need to sell to ensure that it does not make a
loss?
2 What selling price per ticket does SAA need to charge to make a R900 million
pro t?
3 If a 5% decrease in the price per ticket is expected to increase sales volume by
10%, should such a price decrease be considered?
4 Should a new model of aircraft be purchased if it results in a reduction in fuel
costs?
4.1 Introduction
Key term: cost-volume-pro t (CVP) analysis
This chapter explores how cost behaviour, production levels and

sales volumes impact an organisation’s pro t. The interrelationship
between activity levels, costs and an organisation’s pro ts is
commonly referred to as cost-volume-pro t (CVP) analysis.

CVP analysis – the accountant’s and
4.2
economist’s models
Key terms: accountant’s model, economist’s model, relevant

range
There are two main models for conducting CVP analysis – the
economist’s model and the accountant’s model.
The economist’s model recognises that the rate of change in total
costs and total revenue is unlikely to remain constant as volumes
change. This is illustrated in Figure 4.1. At low levels of activity, it
may not be possible to operate a production plant ef ciently,
resulting in total costs rising steeply. As production increases, it is
possible to take advantage of production ef ciencies, resulting in
total costs rising less steeply. Once the level of activity exceeds the
optimum production level for which a plant was designed,
bottlenecks start occurring, plant breakdowns occur and production
schedules become more complex. These result in total costs rising
more steeply once again.
Figure 4.1 Economist’s cost-volume graph

The economist’s model also recognises that initially small reductions
in selling price result in relatively large increases in sales volumes.
However, as volumes increase, larger price reductions are required
to increase sales volumes and eventually the loss of revenue owing
to price reductions exceeds that gained from increased volumes. As
is the case with the relationship between production volume and
total costs, it is unlikely that there will be a directly proportional (or
linear) relationship between sales volume and total sales revenue.
The relationship is more likely to be curvilinear, as depicted
graphically by the total revenue line in Figure 4.1.
The most signi cant difference between the economist’s and
accountant’s model is the assumption underpinning the accountant’s
model that as volumes increase, the rate of change in both total
revenue and total costs is constant (also known as a linear or
straight-line relationship). The accountant’s model is illustrated in
Figure 4.2.

Figure 4.2 Accountant’s cost-volume graph
The effect of the linear relationship assumption on total revenue is

that the selling price per unit remains xed. In other words, the
selling price per unit does not change with a change in the sales
volume. The effect of the linear relationship assumption on xed
costs is that total xed costs remain the same regardless of the level
of output. Total costs consist of both variable and xed costs. We
know from Chapter 2, Cost classi cation, that total variable costs
change in proportion to the change in levels of activity. Since we
have now seen that with the accountant’s model, total xed costs
remain constant and variable costs per unit remain constant, total
costs under the accountant’s model have a linear relationship with
levels of activity (unlike total costs under the economist’s model).
The linear relationship between volume and total revenue and costs
is depicted graphically by the straight lines in Figure 4.2 for sales
revenue and total costs.

As a result of the linear relationship assumption, the accountant’s
model is unlikely to provide perfectly accurate results across all
possible ranges of activity – selling prices may not remain xed. For
example, SAA had to reduce the price of its domestic ights owing
to increased competition from ‘low cost’ airlines. It is also more
likely that xed costs will not remain xed over all ranges of activity,
but will rather increase or decrease in a stepwise manner (refer to
Chapter 2 for a more detailed explanation of step costs) as output
increases or decreases. For example, as part of SAA’s business rescue
process, the business rescue practitioners announced that
retrenchments, a reduction in the number of routes own, and a
decrease in the size of SAA’s eet would be required (source:
https://www.iol.co.za/news/politics/saa-begins-retrenchment-process-
nearly-5000-employees-to-be-affected-44450195). This will result in an
immediate drop in xed costs. In the future, if SAA returned to
pro tability and was able to increase its number of ights and
needed to increase its eet of aircraft signi cantly, it is likely that it
would also need to employ more aeronautical engineers to service
and maintain the aircraft. The increase in the number of aircraft and
aeronautical engineers would result in an immediate increase in
xed costs, which would then remain constant until the next
signi cant change in operating activity. The stepwise increase in
xed costs is illustrated as part of Figure 4.3.
Since the accountant’s model is unlikely to provide perfectly
accurate results across all possible ranges of activity, it may be
tempting to discard this model in preference of the economist’s
model. However, the accountant’s model is simpler and easier to
apply. To overcome the problem of a lack of linearity across all
possible ranges of activity and therefore be able to apply the
accountant’s model with reasonable accuracy, the relevant range

over which the model can be applied is identi ed for each scenario
being considered. You may recall from Chapter 2 that the relevant
range de nes the range of activity over which the assumptions made
concerning the behaviour of costs and revenue remain valid. The
relevant range is illustrated in Figure 4.3.
Figure 4.3 Relevant range
It is important to remember that if the level of output being

considered falls outside this relevant range, the results obtained from
the CVP analysis may not be accurate and caution should be
exercised in interpreting the results. Identifying the relevant range
over which xed costs remain constant also eliminates the dif culty
of accounting for stepped xed costs.
Variable versus absorption costing

4.2.1
systems

You will see in Chapter 5, Absorption versus variable costing and
Chapter 10, Relevant information for decision-making that xed costs
are often irrelevant for short-term decision-making and that variable
costing systems isolate xed and variable costs, treating all xed
costs as period costs. Since CVP analysis is a decision-making tool, it
is useful to adopt a variable costing approach when performing CVP
analysis.
You will see in Chapter 5 that when calculating pro ts using an
absorption costing system, xed manufacturing overheads are
treated as a product cost, resulting in a portion of these overheads
being included in inventory balances. The impact of this is that
where the levels of production and sales differ, there will be a change
in the inventory balance that will impact on the pro t reported. This
will distort the CVP analysis. In variable costing systems, all xed
costs are treated as period costs and no xed manufacturing
overheads are included in inventory balances. Differences between
the level of production and sales will therefore not have an impact
on pro t, which is ideal for CVP analysis.
Key terms: break-even point, contribution
The most common application of CVP analysis is to perform a break-

even analysis. The break-even point represents the level of activity
where neither a pro t nor a loss is made. In other words, this is the
level of activity where total sales revenue equals total costs. There
are three methods that can be applied to calculate the break-even
point:
1 The pro t formula

2 The contribution margin formula
3 The break-even chart
4.3.1 Profit formula

Simplistically stated, the pro t made by an organisation in a period
is calculated as the difference between total revenue and total costs.
CVP analysis assumes that volume is the only revenue and cost
driver, and therefore total revenue and total costs are dependent on
the number of units of products sold or services delivered. Adopting
a variable costing approach, the total costs incurred are split between
xed and variable costs. It is therefore possible to derive the
following pro t formula which forms the basis of all CVP analysis:
P = sPx – (Fc +
vcx)
In the above formula:

P = pro t
SP = selling price per unit
x = number of units sold
FC = total xed costs per annum
VC = variable costs per unit
Example 4.1
You are considering opening a new business selling lawnmowers. Currently you are
considering selling only one make of lawnmower that you believe is the most popular.

You have estimated that annual xed costs will be R750 000, that variable costs will be
R1 000 per unit, and that you could sell the lawnmowers for R2 500 each.
Required:
Using the pro t formula, calculate the following:
1 The number of lawnmowers that must be sold to break even
2 The total sales value at the break-even point
We can use the pro t formula, P = SPx – (FC + VCx), to calculate the
number of lawnmowers that must be sold to break even. We know
that an organisation breaks even when it makes neither a pro t nor a
loss, and P is therefore 0. From the information given in the question,
the selling price (SP) is R2 500, xed costs (FC) are R750 000 per
annum, and variable costs (VC) are R1 000 per unit. Substituting
these variables into the pro t formula, it is possible to calculate the
number of break-even units (x) as follows:
0 = 2 500x – (750 000 + 1 000x)
0 = 2 500x – 750 000 – 1 000x
1 500x = 750 000
x = 750000/1 500
x = 500
Therefore 500 lawnmowers must be sold in order to break even. The

selling price of each lawnmower is R2 500 and since 500
lawnmowers must be sold, the total sales value at the break-even
point is R1 250 000.
4.3.2 Contribution margin formula

The term ‘contribution’ comes from ‘contribute’. It is calculated as
selling price less variable costs and indicates how much each unit
contributes towards covering xed costs and making a pro t.

An alternative method for calculating the break-even point is to
use what is called the contribution margin approach. Contribution is
calculated as the selling price less variable costs. Therefore, when the
total contribution equals total xed costs, the break-even point has
been reached. The contribution margin formula is therefore
expressed as follows:
Example 4.2
Required:
The information is the same as in example 4.1. Calculate the break-even number of
lawnmowers and break-even sales revenue using the contribution margin approach.
We are told that the total xed costs are R750 000 per annum. We are
not given what the contribution per unit is, but this can easily be
calculated as follows:

Substituting these values into the contribution margin formula, the
number of lawnmowers that must be sold can be calculated as
follows:
To calculate the break-even sales value, in addition to knowing what

the total xed costs are, we also need to know what the contribution
margin ratio is. We have not been given the contribution margin
ratio, but this ratio can be calculated as follows:
We can now calculate the break-even sales value as follows:

This means that sales of R1 250 000 have to be achieved in order to
break even.
4.3.3 Break-even chart

Key term: break-even chart
An additional approach that can be used to perform break-even

analysis is to construct a break-even chart. The break-even chart
depicts the break-even point graphically and is therefore sometimes
easier for non- nancial managers to understand. The break-even
chart for example 4.1 is shown in Figure 4.4.
Figure 4.4 Break-even chart for example 4.1
The vertical axis shows the rand values and the horizontal axis the
output in units. From the graph you can see that three lines have
been plotted: xed costs, total costs and sales revenue. Since total

xed costs in terms of the accountant’s model remain constant
regardless of the levels of activity, the total xed costs line remains
parallel to the horizontal axis and meets the vertical axis at R750 000
(the amount of the xed costs). Therefore, whether we sell no
lawnmowers or 1 000 lawnmowers, we still expect the total xed
costs to remain at R750 000 per annum.
The total costs line can be plotted by determining what the total
costs would be given any two activity levels. If no lawnmowers are
sold, total costs comprise only the xed costs of R750 000 per annum
as there will be no variable costs (we therefore know that the total
cost line will meet the vertical axis at R750 000, which is once again
the amount of the xed costs). Taking another activity level of, say, 1
500 lawnmowers, we can calculate the total costs as being R2 250 000
(R750 000 ( xed costs) + R1 500 000 (variable costs of R1 000 per
lawnmower × 1 500 lawnmowers)). The total costs line can then be
plotted by joining the two points: a sales volume of zero
lawnmowers with a rand value of R750 000, and a sales volume of 1
500 lawnmowers with a rand value of R2 250 000.
Similarly, we can also plot the sales revenue line by determining
what the sales revenue would be, given two activity levels. If no
lawnmowers are sold, there is no sales revenue and the sales revenue
line meets the vertical axis at zero. If, say, 1 500 lawnmowers are
sold, the sales revenue would be R3 750 000. Once again, the sales
revenue line can be plotted by joining the two points: sales volume
of zero lawnmowers with a rand value of zero, and a sales volume of
1 500 lawnmowers with a rand value of R3 750 000. It is also useful
to depict the relevant range on the chart to serve as a reminder that
outside of these activity levels, our assumption of linearity no longer
applies and our CVP analysis may no longer be accurate. The

relevant range was not given in example 4.1, but a range of 250 to 1
250 lawnmowers has been assumed and indicated on the chart.
From the chart we can see that the break-even point is where the
sales revenue line crosses the total costs line. By extending a vertical
line from this point to the horizontal axis, we can see that the break-
even point is 500 lawnmowers. Extending a horizontal line from the
break-even point to the vertical axis reveals that the break-even point
will result in sales amounting to R1 250 000.
The vertical distance (rand value) between the two lines to the
right of the breakeven point depicts the amount of pro t that will be
made for activity levels greater than the break-even number of
lawnmowers, while the vertical distance (rand value) between the
two lines to the left of the break-even point depicts the extent of
losses that will be made for activity levels less than the break-even
number of lawnmowers.
It is also possible to adapt the break-even chart to a pro t-volume
chart or a contribution chart that can then be used in the CVP
analysis scenarios discussed in the remainder of this chapter.
Constructing and interpreting the charts is, however, tedious and
time consuming, and unless graphical representation of the scenarios
is required, it is recommended that either the pro t or the
contribution margin formula be used for CVP analysis.
Key term: sensitivity analysis
In addition to being used in performing break-even calculations,

CVP analysis can be a useful tool in performing sensitivity analysis.
Sensitivity analysis indicates how sensitive one variable is to

changes in another variable in the same model. In other words,
‘what if’ questions are asked. This enables managers to assess the
impact should any of the original variables within the CVP model
change. This is useful in determining a range of possible outcomes,
including an indication of the nancial viability of alternative
courses of action. Some of the more common forms of sensitivity
analysis are illustrated in sections 4.4.1 to 4.4.5 below.
4.4.1 Amount of profit given a level of activity

Given an organisation’s selling price, variable costs and xed costs, it
is possible to calculate the pro t that will be made for any given
level of activity within the relevant range. The calculations required
are illustrated in example 4.3.
Example 4.3
Required:
Using the information given in example 4.1, calculate the pro t that will be made if 750
lawnmowers are sold.
Using the pro t formula P = SPx – (FC + VCx), we know that in this
scenario 750 units have been sold (x), the selling price (SP) is R2 500,
xed costs per annum (FC) are R750 000, and variable costs (VC) are
R1 000. We can now calculate the pro t that will be made (P) by
substituting these values into the formula:

Therefore, a pro t of R375 000 will be achieved if 750 lawnmowers
are sold.
It is also possible to calculate the pro t that will be made by
manipulating the contribution margin formula. The original formula
was:
This is manipulated to:
The pro t that will be made if 750 lawnmowers are sold can then be
calculated as:
This is the same as the pro t calculated using the pro t formula.
4.4.2 Target profits

Managers may have a speci c target pro t in mind that they want to
achieve. CVP analysis can be used to calculate the following:

• The number of units of a product or service that must be sold to
reach the target pro t given the selling price per unit
• The selling price that must be charged to reach the target pro t
given the quantity of units that can be sold
This form of CVP analysis is illustrated in example 4.4.
Example 4.4
Required:
Using the information given in example 4.1, calculate the following:
1 The number of lawnmowers that must be sold to achieve a pro t of R150 000
(assuming that the selling price remains R2 500 per lawnmower)
2 The revised selling price that must be charged for each lawnmower if 750
lawnmowers are sold and a target pro t of R450 000 is to be achieved
Using the pro t formula P = SPx – (FC + VCx), we know that in this
scenario P is the target pro t of R150 000, the selling price (SP) is R2
500, xed costs (FC) are R750 000, and variable costs are R1 000.
Substituting these values into the formula, the required number of
lawnmowers that must be sold is:
Therefore, 600 lawnmowers must be sold to achieve a pro t of R150

000.
The revised selling price that must be charged for each
lawnmower if 750 lawnmowers are sold and a target pro t of R450
000 is to be achieved can once again be calculated using the pro t

formula. In this scenario, P is R450 000, the number of units sold (x)
is 750, and xed costs (FC) of R750 000 and variable costs (VC) of R1
000 remain unchanged. We can now calculate the selling price (SP)
required as follows:
Therefore, a selling price of R2 600 per lawnmower must be charged

to ensure that a target pro t of R450 000 is reached on the sale of 750
lawnmowers.
The contribution margin formula can easily be manipulated so
that it can be used to calculate the number of units that must be sold
to achieve a target pro t. Instead of needing to meet only the xed
costs with the contribution made, both the xed costs and target
pro t must be covered by the contribution made.
In other words, the target pro t is treated as if it is a xed cost.
The contribution margin formula is therefore adapted to:
The application of this adapted contribution margin formula is

illustrated in example 4.5.
Example 4.5
Required:

With the information given in example 4.1, calculate the number of lawnmowers that
must be sold to achieve a pro t of R150 000 using the adapted contribution margin
formula.
We know from example 4.1 that xed costs per annum are R750 000,
and in example 4.2 we calculated that the contribution per unit was
R1 500. A target pro t of R150 000 has been given for this scenario.
Substituting these values into the adapted contribution margin
formula, the number of units that must be sold to obtain a target
pro t of R150 000 can be calculated as follows:
Therefore 600 lawnmowers must be sold to achieve a pro t of R150

000. This is the same answer we arrived at using the pro t formula.
The contribution margin formula can also be manipulated to
calculate the selling price required to achieve a target pro t, given
the number of units that can be sold. The manipulation required is,
however, cumbersome, and the pro t formula is therefore quicker.
4.4.3 Margin of safety

Key term: margin of safety
The margin of safety is a measure of the extent to which the current

(or expected) level of sales can drop before a loss is incurred. The
margin of safety provides a useful indicator for the amount of risk

that is associated with a particular product or service. The higher the
margin of safety, the greater the level of sales can drop before a loss
is incurred. In the same way, the lower the margin of safety, the less
sales can drop before a loss is incurred.
The margin of safety can be useful to managers when they need
to consider the impact of new competition, or where there is a
reduction in demand for products or uncertainty surrounding the
exact level of expected sales, for example when introducing a new
product onto the market.
The margin of safety can be calculated as a percentage, as a total
sales value or in terms of the number of units of the product or
service. The formulae for calculating the margin of safety are given
below, but if you can remember that the margin of safety is simply
the difference between expected sales and break-even sales, then it is
not necessary to memorise these formulae.
Note: These formulae can be used for calculating the margin of safety
only in scenarios where there is one product being sold or service
being delivered. Multiple products and services are dealt with later
in this chapter.

Example 4.6
In addition to the information given in example 4.1, assume that during the rst year
you expect to sell 750 lawnmowers.
Required:
Calculate the following:
1 The percentage by which expected sales could drop before a loss is incurred
2 The number of units by which expected sales could drop before a loss is incurred
3 The value by which expected sales could drop before a loss is incurred
The percentage, number of units and value by which expected sales

could drop before a loss is incurred is the margin of safety. The
expected level of sales is 750 lawnmowers and in example 4.1, we
calculated that the break-even level of sales was 500 lawnmowers.
The margin of safety, expressed as a percentage, can be calculated as
follows:
Expected sales could therefore drop by 33,3% before a loss would be

incurred.
The number of units by which expected sales could drop before a
loss would be incurred is simply the difference between the expected
number of units and the break-even number of units. Expected sales
could therefore drop by 250 lawnmowers (750 expected units – 500
break-even units) before a loss would be incurred.
In rand terms, expected sales could drop by R625 000 before a
loss was incurred. This is calculated by multiplying the margin of

safety units of 250 by the selling price of R2 500. It could also be
calculated as R1 875 000 (750 × 2 500 expected sales) – R1 250 000
(break-even sales computed above) = R 625 000.
Additional sales volume required to

4.4.4
cover additional costs

Situations may arise where additional xed costs per annum may be
incurred. For example, an organisation may implement an
advertising campaign to increase sales volumes. It is useful to use
CVP analysis to calculate the additional sales volume required to
cover the increased xed costs per annum arising from the cost of
the advertising campaign, in order to determine whether incurring
the increased costs is warranted.
Example 4.7
In addition to the information given in example 4.1, you are now considering moving to
larger premises. This would result in an increase of R60 000 per year in the xed rental
payable.
Required:
Calculate the additional number of lawnmowers that must be sold to cover the
additional rental costs.
Either the pro t or the contribution formula can be used in example

4.7 to calculate the additional number of lawnmowers which must
be sold. Note that we are concerned only with the additional
lawnmowers that need to be sold to cover the additional xed costs
that will be incurred. A pro t (P) of zero is therefore chosen, and
only the additional xed costs (FC) of R60 000 are relevant, not the
total xed costs of R810 000 per annum (R750 000 existing + R60 000

additional). Variable costs (VC) remain R1 000 per lawnmower as the
move to larger premises will not have any impact on variable costs.
Substituting these values into the pro t formula P = SPx – (FC +
VCx), the number of additional lawnmowers that must be sold (x)
can be calculated as follows:
Therefore, 40 additional lawnmowers must be sold to cover the

additional xed rental payable of R60 000.
Using the contribution margin formula, xed costs are R60 000
per annum and the contribution per unit is R1 500 (calculated in
example 4.2). The number of additional lawnmowers that must be
sold (x) can then be calculated as follows:
Reduction in selling price to increase

4.4.5
sales volumes
An organisation may believe that by reducing its selling price, it may
be able to increase its sales volumes and its overall pro ts. CVP
analysis provides a useful mechanism to determine whether the
increase in sales volumes is suf cient to offset the loss in sales
revenue from the decrease in selling price.

Example 4.8
In addition to the information given in example 4.1, you are considering reducing the
selling price per lawnmower to R2 250 as you believe this will increase the expected
sales of lawnmowers from 750 lawnmowers to 850 lawnmowers.
Required:
Advise whether the revised selling price should be implemented.
The selling price that results in the greatest total contribution should
be implemented. You will recall that the contribution per unit is the
difference between the selling price and the variable costs per unit.
Therefore, if the selling price per unit is R2 500, the contribution per
unit is R1 500 (selling price of R2 500 less variable costs of R1 000)
and the total contribution is R1 125 000 (R1 500 multiplied by the
expected sales volume of 750 lawnmowers). However, if the selling
price is R2 250, the contribution per unit is R1 250 (selling price of R2
250 less variable costs of R1 000). The total contribution is therefore
R1 062 500 (R1 250 multiplied by the expected sales volume of 850
lawnmowers). The revised selling price would result in a decrease in
contribution of R62 500 (R1 125 000 – R1 062 500) and should
therefore not be implemented.
Alternatively, we can use the pro t formula P = SPx – (FC + VCx)
to calculate what the expected pro t under each scenario would be.
The selling price resulting in the greatest expected pro t should be
implemented. We know from example 4.3 that the expected pro t
will be R375 000 if the selling price is R2 500 per lawnmower. If the
selling price is R2 250, we are given that the number of lawnmowers
sold (x) will be 850, and from example 4.1 we know that xed costs
(FC) will be R750 000 per annum and variable costs (VC) will be R1
000. The expected pro t generated will then be as follows:

Since the reduction in selling price would result in a R62 500 (R375
000 – R312 500) decrease in pro t, the revised selling price should
not be implemented.
Note: The decrease in contribution calculated using the
contribution margin formula and the decrease in pro t calculated
with the pro t formula is exactly the same. This is to be expected, as
the difference between pro t and the total contribution is the xed
costs. In this scenario, xed costs are unaffected by the change in
selling price and are therefore not relevant.
The scenarios detailed above deal with the most common
situations to which
CVP analysis can be applied. The same principles can be applied
to many other variations that may arise.
Sensitivity analysis enables managers to assess the impact should
any of the original variables within the CVP model change. This is
useful because it recognises that there can be a range of possible
outcomes. The use of computer software spreadsheet packages
makes sensitivity analysis quick and easy to perform.
Managers can ask ‘what if’ questions by changing one variable in
the model at a time, and instantly see the impact of the change.
Sensitivity analysis is a way of recognising that projected future
outcomes are not guaranteed, and that all decisions are subject to a
degree of risk and uncertainty. The more thoroughly managers
consider the answers to questions such as ‘But what would the pro t
be if 100 fewer units were sold?’, the better informed their decisions
will be.

4.5Break-even analysis with multiple
products
Key term: sales mix
Up to now, the CVP analysis has been limited to situations where

there is only one product being sold. However, almost all
organisations sell multiple products or deliver more than one
service. It is therefore useful to extend CVP analysis to multiple
products and services.
Each product or service may have its own break-even point as
selling prices and cost structures are likely to be different for each
product or service. A complication that often arises when using CVP
analysis with multiple products and services is xed costs that are
not directly attributable to the products or services (common xed
costs).
A few options on how to treat these common xed costs can be
considered. One option is to allocate the common xed costs to the
products and services. However, since the common xed costs are
not directly attributable to the products and services, any allocation
is likely to be arbitrary. Arbitrary allocation of costs distorts decision-
making and should therefore preferably be avoided. Another option
is simply to ignore the common xed costs. The problem with this
approach is that the organisation may then not recover the common
xed costs, which is not sustainable in the long run. A third option,
and the option most commonly used, is to use the organisation’s
sales mix to conduct the break-even analysis. An organisation’s sales
mix is the proportion in which its products and services are sold or
delivered. A simple example is where an organisation sells 2 units of
product A for every 1 unit of product B, the sales mix will be 2:1.

Using the organisation’s sales mix, a weighted-average unit
contribution margin is calculated. Applying the contribution margin
formula, the break-even number of units for the sales mix is
calculated by dividing total xed costs per annum (directly
attributable xed costs for all the products and services plus
common xed costs) by the weighted-average contribution margin.
The break-even point for each product or service can then be
calculated using the proportion of each product in the sales mix. In
the simple example used above, the break-even point for product A
is 2/3 and for product B 1/3 of the total number of break-even units
calculated.
Example 4.9
This example follows on from the previous examples in this chapter. After successfully
completing the rst year of trading, you are now considering expanding your
lawnmower business to include both a petrol and an electric model, and also to
include a garden service. The garden service will be offered on a monthly contract
basis. These are the only three products or services the organisation provides.
The following estimates have been prepared for the following year:
Required:
Calculate the break-even number of the following:
1 Electric lawnmowers
2 Petrol lawnmowers

3 Garden service contracts
First, the weighted-average contribution margin must be calculated

using the sales mix of 3:2:1. Electric lawnmowers contribute R3 450
(3 × R1 150), petrol lawnmowers R3 000 (2 × R1 500) and the garden
service R150 (1 × R150). This results in a total contribution of R6 600
and a weighted-average contribution of R1 100 (R6 600/(3 + 2 +1)).
Now that the weighted-average contribution has been calculated,
the total number of break-even units can be calculated as follows:
The break-even units for each product or service can now be

Break-even units
Electric lawnmowers 375 (750 × 3/6)
Petrol lawnmowers 250 (750 × 2/6)
Garden service 125 (750 × 1/6)
Therefore, to break even, 375 electric lawnmowers, 250 petrol

lawnmowers and 125 garden service contracts must be sold.
It is important to remember that since the break-even point for
multiple products and services is dependent on the sales mix of
those products and services, there will be different break-even points
each time the sales mix changes. For the breakeven analysis to be
meaningful and reliable, it is vital for the sales mix to be predicted

with reasonable accuracy. This may be dif cult in some situations
and care should therefore be exercised before performing CVP
analysis on multiple products and services. The impact of a change
in the predicted and the actual sales mix is illustrated in example
4.10.
Example 4.10
This example follows on from example 4.9.
During the next year of trading, you were able to sell 400 electric lawnmowers, 200
petrol lawnmowers and 200 garden service contracts. You are delighted as the total
combined sales of 800 lawnmowers and garden service contracts are in excess of the
total number of break-even units that you had calculated at the start of the year.
Taking this into account, and the fact that the actual selling prices and costs were as
anticipated at the beginning of the year, you are expecting to have made a good pro t.
Your delight is, however, short lived, as after preparing your year-end income
statement, you realise that you have actually made a loss for the year.
Required:
• Calculate the actual loss for year.
• Explain how it is possible to have made a loss despite selling more than the total
number of break-even units.
The loss for the year is as follows:

The fact that a loss has been made despite selling more than the
break-even number of units can be explained by a change in the
sales mix. The expected sales mix was 3:2:1, but the actual sales mix
changed to 4:2:2 (400 electric lawnmowers:200 petrol
lawnmowers:200 garden service contracts). Petrol lawnmowers have
the highest contribution per unit, but their weight in the weighted-
average contribution decreased from two-sixths in the expected sales
mix to two-eighths in the actual sales mix. The weighted-average
contribution per unit therefore decreased to (4 × R1 150 + 2 × R1 500
+ 2 × R 150)/(4 + 2 + 2) = R7 900/8 = R 987,50, which is R112,50 less
than the R1 100 computed in example 4.9 for the expected sales mix.
Note that the difference between the budgeted and actual pro t can
simply be calculated by subtracting the contribution on the budgeted
sales mix from the contribution based on the new sales mix. This

would be the same as the sales mix variance, which is discussed in
Chapter 13, Standard costing.
In multiple product and service scenarios, it may be useful to
calculate a range of break-even points based on a few variations in
sales mix so that managers can have a feel for the impact that a
change in the sales mix may have.
4.6CVP analysis assumptions and

limitations
It is essential when preparing and interpreting CVP analysis that the
underlying assumptions on which the information has been
prepared are understood. If this is not the case, incorrect decisions
may be made which could have serious consequences for an
organisation. The most important assumptions are detailed below.
4.6.1 All other variables remain constant

The pro t formula, contribution margin formula and break-even
chart approaches to CVP analysis assume that volume is the only
variable that will cause a change in costs and sales revenues. Other
variables are held constant.
Total costs and revenue are linear

4.6.2
functions of output in the relevant range,

which is definable
These assumptions have already been discussed in the introduction
to this chapter. In practice, dif culties may be experienced in
identifying the relevant range.

A single product exists or a constant
4.6.3
sales mix can be predicted

It has been shown that where more than one product or service
exists, it is necessary to calculate the break-even point using the sales
mix. Changes in the sales mix may have a signi cant impact on the
validity of the CVP analysis and therefore, if there are multiple
products or services, it is necessary to assume that a constant sales
mix can be predicted.
Profits are calculated on a variable

4.6.4
costing basis or, if they are calculated on

an absorption basis, the number of units
produced equals the number of units sold
In the introduction to this chapter, it was explained that it is
preferable to use a variable costing system to calculate pro ts for
CVP analysis to avoid pro t distortions arising from differences
between production and sales volumes. However, if an absorption
costing system is used, assuming that the number of units produced
equals the number of units sold will ensure that no pro t distortions
from differing production and sales levels arise. An assumption that
inventory levels remain the same from year to year will have the
same result. You will understand this better once you have studied
Chapter 5, Absorption versus variable costing.
Costs can be split between fixed and

4.6.5
variable costs

All of the CVP analysis methods (pro t formula, contribution
margin formula and the break-even chart) require a distinction
between xed and variable costs. In practice, some costs may be
semi-variable and it may be dif cult to split these costs into their
xed and variable components. If the CVP analysis is to be valid, it is
necessary for a reasonably accurate split to be made. This is where
an activity-based costing system would provide more accurate cost
information (see Chapter 6, Overhead allocation).
The analysis applies only to the short

4.6.6
term
Fixed costs are likely to remain xed only in the short term. The
costs of providing an organisation’s production capacity, for
example, are a result of long-term planning and it is not easy to
change these costs in the short term. However, in the longer term it
is possible to increase production capacity by building new plants.
Furthermore, other costs such as, for example, senior management
salaries or property rentals cannot be altered in the short term.
However, as an example, over a longer period, it is possible not to ll
senior management positions when they become vacant.
Since we need to differentiate between xed and variable costs to
be able to perform a CVP analysis, it is necessary to limit the analysis
to the short term. If a longer-term analysis is required, we will need
to reassess the split between xed and variable costs.
After reading these assumptions, it may be tempting to discard
CVP analysis as a useful tool, as it may seem highly unlikely that all
the assumptions will always hold true. However, CVP is very useful
in practice, as long as the results are correctly interpreted by
someone who understands the assumptions.

4.7 Summary
In this chapter, CVP analysis has been shown to provide managers
with a useful short-term planning tool.
The break-even point can be calculated using the pro t formula,
contribution margin formula or a break-even chart. CVP analysis can
also be applied to a number of ‘what if’ scenarios, including
calculating target pro ts and pricing and volume decisions.
Where there are multiple products or services, using the sales
mix to calculate a weighted-average contribution margin overcomes
the problem of accounting for common xed costs. Once the total
break-even units have been calculated using the weighted-average
contribution margin, the individual product or service breakeven
points can be determined using the sales mix ratios.
There are a number of underlying assumptions and limitations to
CVP analysis. Understanding the impact of these assumptions and
limitations is crucial to performing a valid and reliable CVP analysis.
Only signi cant deviations from the assumptions are likely to have
an impact on the validity and reliability of the analysis.
Conclusion: Cost-volume-profit
relationships and other topics in this book
In order to apply CVP analysis, costs have to be classi ed as either
xed or variable. A thorough knowledge of Chapter 2, Cost
classi cation is therefore required. One of the assumptions of CVP
analysis is that a variable costing system is used. Should an
absorption costing system be in use, the gures need to be restated
on a variable costing basis. Chapter 5, Absorption versus variable
costing addresses this. Restatement of gures on a variable costing

basis is necessary, because xed costs are often irrelevant for short-
term decision-making, as discussed in Chapter 10, Relevant
information for decision-making. Sensitivity analysis using CVP
principles is also a useful tool for decision-making and for assessing
the impact of a decision on an organisation’s risk.
Tutorial case study: Belmond Mount Nelson
The Belmond Mount Nelson Hotel in central Cape Town has 198 rooms and suites.
The Belmond Mount Nelson has a ve-star grading, which means it is regarded as a
hotel of superior quality by the Tourism Grading Council of South Africa. The price
charged per guest per night depends on a number of factors. These include the
room occupancy (single or sharing) and the season. The price also depends on
which type of room is chosen – the Belmond Mount Nelson has superior and deluxe
rooms.
As one might expect, Belmond Mount Nelson would like to be as successful as
possible. To ensure this, the hotel has to have a rm understanding of the
relationship between cost (how much it costs to accommodate a guest per night),
volume (how many guests sleep over) and pro t (the amount of pro t that the
Belmond Mount Nelson can contribute to the group’s bottom line).
SOURCE: HTTPS://WWW.BELMOND.COM/HOTELS/AFRICA/SOUTH-AFRICA/CAPE-
TOWN/BELMOND-MOUNT-NELSON-HOTEL/ (2019)
1 Give examples of costs incurred at the Belmond Mount Nelson Hotel which may
be regarded as:
• variable
• xed
when a one-year time horizon is considered.
2 Discuss how the Belmond Mount Nelson Hotel could use CVP analysis to
quantify the impact on the pro tability of the hotel if a suggestion were made
that the hotel should signi cantly cut back on the level of luxury offered to
guests.
3 State what assumptions would need to be made in performing the CVP analysis
in point 2 above, and explain what impact these assumptions could have on the
analysis performed.
4 As mentioned, rooms are sold at different rates depending on a number of
factors. Explain what impact this has on the CVP analysis of the hotel.

Basic questions
BQ 1
Is the break-even point:
a) where total xed costs per annum equal total variable costs?
b) where total revenue equals total xed costs per annum?
c) where total costs equal contribution margin?
d) where total xed costs per annum equal contribution margin?
BQ 2
An organisation sells its only product for R100 per unit and has a
variable cost ratio of 80%. Total xed costs are R200 000 per annum.
What is the break-even point in units?
Note: ‘Variable cost ratio of 80%’ means that variable costs are 80% of
the selling price.
BQ 3
Given the same information as for BQ2, what pro t or loss will be
made if 8 000 units are sold?
BQ 4
In addition to the information provided in BQ2, assume that
expected sales are 15 000 units. What is the margin of safety
percentage?
BQ 5
Given the following expected revenues and costs for the following
year, how many units must be sold to generate a pre-tax pro t of
R700 000?

Selling price per unit R500
Variable costs per unit R150
Total xed costs (per annum) R350 000
BQ 6
Given the same information as for BQ5, what pro t is made if one
unit more than the break-even sales volume is sold?
BQ 7
Using the information provided in BQ5, how many additional units
need to be sold to cover an increase in xed costs of R175 000 per
annum?
BQ 8
What is meant by CVP analysis, and how could such an analysis be
useful?
BQ 9
What is the limitation of basic CVP analysis relating to an
organisation’s sales mix?
BQ 10
JB Ltd manufactures and sells two products, J and B. The expected
sales mix is 5(J):3(B). Total budgeted sales for the next year are R5
million. J has a contribution to sales ratio of 35% and B 55%.
Budgeted annual xed costs are R500 000. What is the budgeted
break-even sales value?
a) 1 176 471
b) 1 233 767
c) 1 111 112

d) Cannot be calculated with the information given.
Long questions
LQ1 – Intermediated (20 marks; 36 minutes)

Salty Poppers operates a chain of outlets selling popcorn. The
following information is taken from the records of a typical outlet:
Selling price of popcorn per carton R3,00
Sales volume – cartons per month 4 000

Variable costs per carton
Corn R1,00
Supplies (carton, oil, and so on) R0,50
Total variable expenses per carton R1,50
Fixed costs per month:
Rent on premises R600,00
Utilities and upkeep R380,00
Wages R1 000,00
Manager’s salary R2 000,00
Other xed expenses R520,00
Total xed costs per month R4 500,00
The owner of the organisation is unhappy with the current level of

operating income and would like to achieve an increase in income of
at least R1 000 per month. He hopes to accomplish this by adopting
one of the following proposals, both of which are aimed at boosting
sales:
Proposal 1
Offer the outlet manager a bonus of R0,25 on every carton sold
beyond the breakeven point.

Proposal 2
Spend R500 per month on advertising and reduce the selling price
by 10%. At present, the outlets do not advertise.
REQUIRED Marks
(a) For a typical outlet, calculate the current:
(i) monthly operating income 2
(ii) break-even point in units. 2
For each of the above proposals, calculate by what percentage the sales volume would have
(b)
to increase so as to achieve the minimum pro t growth desired by the owner. 5
(c) For proposal 2, calculate the break-even point in units. 2
(d) Recommend which of the two proposals the owner should adopt and brie y explain why. 4
(e) List ve assumptions underlying the above CVP calculations and analysis. 5
TOTAL MARKS 20

JW Chefs is an airline catering business which supplies business
class and economy class meals for the airline industry. The following
budgeted information relates to the nancial year ending 31 July
202X:
Notes:
Total revenue and variable costs are based on the following:

Business class meals Economy class meals
Selling price per meal R150 R80
Variable cost per meal R60 R50
Budgeted number of meals 15 million 30 million
1 Other income consists of interest income earned on surplus cash

available.
2 Allocated head of ce overheads are apportioned between
business class and economy class meals based on the budgeted
number of meals.
Ignore the effects of taxation.

REQUIRED Marks
Based on the existing budget, calculate JW Chefs expected:
(a) total breakeven revenue for the 202X nancial year
(b) break-even revenue for business class and economy class meals
(c) break-even number of business class and economy class meals.
TOTAL MARKS 12

Some businessmen have recently opened a petrol station called TAV
Fillers. One grade of petrol is sold at R1,76 per litre. Variable charges
– cost of petrol, delivery and excise duty – total R1,60 per litre. The
xed costs per month are as follows:

After the rst six months of opening, the average monthly sales
achieved was 179 210 litres.
Owing to sustained pressure from commerce and industry, the
government has recently announced measures to deregulate the
petrol industry. In view of this and in an attempt to improve
performance, the businessmen are considering the following
proposals:
Proposal 1
Allow customers to purchase petrol on credit. It is estimated that
50% of average monthly sales (in litres) is to customers who would
take advantage of this opportunity. They are expected to purchase
exclusively from TAV in future and hence sales to these customers
should increase by 30%. Sales volumes to customers who do not take
advantage of the credit facility are expected to remain unchanged.
Additional costs arising from this proposal are anticipated to be as
follows:
a) Bad debts of 0,5% of sales value in respect of customers who use
the
b) credit facility
c) Fixed nancing costs of R500 per month
d) Fixed administrative costs of R1 000 per month

What would be the average monthly pro t if this proposal were
implemented?
Proposal 2
Ideally, the businessmen would like a pro t margin of 2% on
turnover. How many litres of petrol would need to be sold each
month to achieve this pro t margin, if the selling price was reduced
by R0,02 per litre, sales commission of R0,01 per 10 litres was offered
to petrol attendants, and R500 per month was spent on advertising?
What would be the resulting pro t?
Proposal 3
The possibility of only operating from 7am to 11pm is being
considered. This earlier closing time is expected to result in a loss of
sales of 25 000 litres on average each month. It is hoped that the
saving in xed costs resulting from a reduction in operating hours
will enable the businessmen to achieve an average monthly pro t of
at least R3 000. Taking these new circumstances into account, what
saving in monthly xed costs is necessary to yield a pro t of R3 000?
Note: Each proposal is independent of the other two.
REQUIRED Marks
(a) Before considering any of the proposals, calculate the following for the average month’s
performance:
(i) Pro t
(ii) Pro t-volume ratio
(iii) Margin of safety percentage and explain its meaning 11
(b) Explain the purpose of a pro t-volume graph and how the pro t-volume ratio is represented in
the graph. 4
(c) Evaluate each proposal by answering the speci c questions raised. 23
(d) Comment brie y on each proposal. 12
TOTAL MARKS 50

A computer software company develops and sells three computer
games, Gino, Dust and Elton. The combined sales of all the products
in 2XX7 was 9 000 units and total xed costs amounted to R726 000.
Other relevant data for 2XX7 were as follows:
Management expects sales in the current year to remain at 9 000 total

units and there is no intention to change the selling price or cost
structure. However, by reducing marketing expenditure on Gino and
spending more on Dust and Elton, the marketing director believes
that the sales mix can be changed to 2:3:5.
REQUIRED Marks
For the organisation as a whole, calculate the pro t-volume ratio, break-even sales and pro t
(a) of each sales mix respectively, and advise management whether the proposed sales mix
should be implemented or not. 19
Construct a pro t-volume graph, drawing the average pro tability line only of each sales mix
(b)
on the same graph, thereby showing the respective break-even points. 10
Discuss why a pro t-volume graph may be used in preference to a break-even or contribution
(c)
chart. 3
TOTAL MARKS 32

SOURCE: ADAPTED FROM SAICA
Mr Sizwe Umakhi is a 28-year old entrepreneur who has worked
part-time in various positions, including as an Ubex driver. Mr

Umakhi has managed to save R350 000 for starting his own business.
He plans to acquire 10 used vehicles and form partnerships with
various Ubex drivers to generate income for himself and the drivers.
Mr Umakhi has negotiated the purchase of 10 used Volkswagen
Polo vehicles from a motor dealership in Sandton. All the vehicles
are in excellent condition and have near identical mileage. The
purchase price is R170 000 per vehicle which includes a 50 000 km
service plan for each vehicle (Mr Umakhi does not have to pay for
regular services to vehicles for the next 50 000 km travelled).
Each Volkswagen Polo vehicle acquired is to be used by Ubex
drivers for the next four years. At the end of the four-year period, it
is estimated that the vehicles could be sold for R51 000 each.
Mr Umakhi procured bank nancing for the 10 vehicles on the
following terms:
• A 20% deposit per vehicle (R34 000 each)
• Equal monthly repayments in arrears for 48 months
• A xed nominal annual interest rate of 10%
Arrangements between Mr Umakhi and the drivers

Mr Umakhi has identi ed 20 drivers who are prepared to work in
partnership with him. The intention is that each vehicle will be
shared by two drivers. Each driver will have the use of a speci c
Volkswagen Polo for 12 hours daily to ensure maximum utilisation
of vehicles. Mr Umakhi and the drivers have agreed to a pro t-
sharing arrangement whereby Mr Umakhi will collect amounts
owing to them from Ubex and deduct the following expenses before
paying the net amount to drivers:
• Vehicle operating costs (fuel, tyre replacement, service and
maintenance costs, and insurance)

• Costs for usage of vehicles (this is equivalent to the monthly
vehicle loan repayment amount)
• An ‘of ce’ fee of R1 000 per month per vehicle in the rst year to
recover costs of parking at Mr Umakhi’s home, use of the outside
of ce, refreshments and monthly administration
• A xed ‘pro t share’ fee of R2 000 per month per vehicle payable
to Mr Umakhi in the rst year, which amount will escalate by 8%
per annum thereafter
Forecast revenue per vehicle

The Volkswagen Polo vehicles to be acquired will operate as Ubex
vehicles. The forecast revenue per vehicle below in the rst year of
operation is based on Mr Umakhi’s insights and knowledge of acting
as an Ubex driver in the Sandton and surrounding areas of
Johannesburg.
Annual revenue forecast per vehicle in year 1

Average hours annually that vehicle is operated by drivers 4 410 hours
Average number of trips per operational hour 0,8
Average fare per paid trip R100
Average kilometres travelled per paid trip 10 km
Vehicle operating costs

The forecast costs of operating each vehicle in the rst year of
operations is set out in the table below. The Volkswagen Polo
vehicles use diesel and are expected to be fuel ef cient.
Forecast vehicle operating costs in year 1

Fuel costs
Average annual total distance to be travelled per vehicle 50 000 km
Average number of litres to be used per each 100 km travelled 5,5 litres
Average cost per litre of diesel during the year R12,25

Forecast vehicle operating costs in year 1
Tyres
Cost of replacing all four tyres per vehicle after every 25 000 km R3 200
Insurance costs
Average annual insurance premium per vehicle R11 760
Service and maintenance costs were not included in the above table
as these will be covered by the service plan to be obtained when
purchasing the vehicles. It is estimated that the cost of servicing each
vehicle in the rst year of operations, had the service plan not been
obtained, would have amounted to R6 800, on the assumption that
each vehicle needs to be serviced after every 25 000 km travelled.
REQUIRED Marks
Estimate the monthly gross revenue that each vehicle needs to generate in the rst year of
operation in order to cover the xed monthly operating costs of that vehicle. Assume that Mr
Umakhi’s estimates for the rst year of operation are accurate. 15
TOTAL MARKS 15
References
Faul, MA, Du Plessis, PC, Van Vuuren, SJ, Niemand, AA & Koch, E. 1997. Fundamentals of
cost and management accounting, 3rd edition. Durban: Butterworths.
Hilton, WH. 2002. Managerial accounting: creating value in a dynamic business environment, 5th
edition. Boston: McGraw-Hill.
Horngren, CT, Foster, G, Datar, SM & Uliana, E. 1999. Cost accounting in South Africa: a
managerial perspective. Cape Town: Prentice Hall.
Seal, W, Garrison, RH & Noreen, EW. 2006. Management accounting, 2nd edition. Berkshire:
McGraw-Hill.
Wood, N & Skae, O. 2008. Principles of management accounting: the question book. Cape Town:
Oxford University Press Southern Africa.
Ziemerink, T, Govender, B, Ambe, C & Koortzen, P. 2005. Cost and management accounting.
Pretoria: Van Schaik.

LEARNING OBJECTIVES
• explain how absorption and variable costing (respectively) are
used in the context of reporting for nancial and management
accounting purposes
• distinguish between the different income statement formats used
under absorption and variable costing
• calculate the impact of changes in inventory levels on pro t
calculated using absorption and variable costing, and reconcile
the relevant pro t gures
• discuss the relative strengths and weaknesses of absorption and
variable costing
• understand under what circumstances each system would be
more appropriate for cost and management accounting.
BHP Billiton and absorption costing
Absorption costing is used in statutory nancial statements. In some instances, the

term is speci cally mentioned in the accounting policy notes of South African listed
companies. Below is an extract from the accounting policies of BHP Billiton:
Inventories
Regardless of the type of inventory and its stage in the production process,
inventories are valued at the lower of cost and net realisable value. Cost is

determined primarily on the basis of average costs. For processed
inventories, cost is derived on an absorption costing basis. Cost comprises
costs of purchasing raw materials and costs of production, including
attributable mining and manufacturing overheads taking into consideration
normal operating capacity.
SOURCE: BHP BILLITON ANNUAL REPORT (2018)
Reference is made to ‘costs being derived on an absorption costing basis’. This

raises the question as to what absorption costing is. This chapter explores the
concept of absorption costing and contrasts it with another popular costing system,
namely variable costing.
5.1 Introduction
Key terms: absorption costing, variable costing
Chapter 2, Cost classi cation introduces the cost behaviour of variable

and xed costs. The estimation of these is further discussed in
Chapter 3, Cost estimation. This chapter describes the reporting of this
information using two costing methods – absorption costing and
variable costing. It further details the different pro t gures which
may arise under the two systems, the reconciliation of these pro t
gures as well as the income statement format that is used for each
system.
The strengths and weaknesses of both absorption and variable
costing are highlighted. The chapter is concluded with a discussion
on which costing method is the most appropriate under which
circumstances in cost and management accounting.
Overhead allocation is brie y considered and will be discussed
more broadly in Chapter 6, Overhead allocation. While this chapter
focuses on allocating costs to inventory, the following chapter
discusses overhead allocation with a wide application to business.

The management accountant of the 21st century is faced with many
challenges. With the escalating pressures of globalisation leading to
increased competition, the management accountant must have
access to information of a high quality which is relevant and reliable
to enable sound decision-making. This information must be obtained
on a timely basis in order for the organisation to keep abreast of
changing conditions.
As you saw in Chapter 1, Introduction to management accounting,
nancial accounting reports are not suf cient to enable management
accountants to perform their duties – they require more than purely
nancial accounting information.
Within the framework of these two disciplines of nancial and
management accounting, two cost accounting concepts/systems
emerge:
1 Absorption costing
2 Variable costing
Both the variable and absorption costing systems entail inventory

valuation. The difference between them is that variable costing
assimilates only inventoriable variable costs, whereas absorption
costing assimilates both variable and xed inventoriable costs.
Inventoriable costs, or manufacturing costs, are costs incurred to
turn inventory into a saleable product. Non-inventoriable costs, also
called non-manufacturing costs or period costs, are not capitalised to
inventory but rather expensed as a period cost in the period they are
incurred (inventoriable costs were discussed in Chapter 2, Cost
classi cation).

Broadly, absorption costing involves the accumulation and
reporting of cost information within a format consistent with the
accounting standards underlying nancial accounting, which is
aligned with the principle of matching income with expenses.
Variable costing, on the other hand, involves the accumulation and
reporting of cost information within a format that enables short-term
planning, control and decision-making.
For absorption costing purposes, as used in nancial accounting,
all costs directly associated with producing the inventory (regardless
of whether these costs are xed or variable) are included in the
valuation of inventory. Remember that xed costs are de ned as
costs that in total are unresponsive to a change in the level of activity,
while variable costs are de ned as those costs where the total cost
increases or decreases in proportion to increases or decreases in the
level of activity.
Under absorption costing, when an item is sold, the revenue
associated with the sale of the inventory is recognised and the value
of the inventory sold is expensed (typically in the ‘cost of sales’ line
item). The pro t gure therefore re ects the net gain made out of the
sale of the inventory after taking into account all expenses associated
with it.
Allocating xed costs to inventory is justi ed as it ensures that
cost of sales in the income statement and the balance sheet inventory
level re ect all the associated costs of the inventory (hence
absorption costing is sometimes referred to as ‘full costing’).
Absorption costing presents meaningful information, especially
in terms of pro tability and performance, but may lead to incorrect
decision-making owing to the inclusion of xed costs in the
valuation of inventory. These costs are often irrelevant (as they
cannot be changed in the short term and will be incurred regardless

of what course of action is taken) and should be excluded from the
decision-making process over the short term. The potential relevance
and value of xed cost allocation for long-term decision-making will
be discussed in Chapter 6, Overhead allocation.
For variable costing purposes, only variable costs directly
associated with producing the inventory are included in the
valuation of inventory. Variable costing is therefore useful for short-
term decision-making as it excludes xed costs from inventory
valuation – it treats these as expenses as and when they occur. This
makes it easy to determine the incremental bene t from temporarily
increasing sales – only the relevant information is taken into account
as the xed costs associated with this course of action remain
constant.
The underlying cost information used for the two systems is the same,
but the manner in which the information is reported differs.
5.2.1 Absorption costing

Absorption costing involves the accumulation and reporting of cost
information within a format that is consistent with the accounting
standards underlying nancial accounting. International Accounting
Standard 2 (IAS 2) is the accounting standard governing inventories.
Paragraph 10 of this standard de nes the cost of inventories as
including ‘... all costs of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and
condition’. The costs of conversion are further explained in
paragraph 12 to include ‘a systematic allocation of xed and variable
production overheads that are incurred in converting materials into
nished goods’.
From this paragraph, a number of key principles emerge. The
rst is that all costs incurred in bringing the inventories to their

present location and condition should be capitalised to inventory.
‘All costs’ refers to both xed and variable costs. Thus, only
manufacturing costs will be capitalised to inventory and non-
manufacturing costs will be expensed when incurred as a period
cost. The second principle is that the cost of inventories should
include ‘a systematic allocation of xed overheads’. This simply
clari es that xed overheads must be included in the cost of inventories
(and not only variable manufacturing costs). The third principle relates
to ‘overheads that are incurred in converting materials into nished
goods’, which clari es the type of xed overheads to be included in
the cost of inventories. Fixed overheads incurred in converting materials
into nished goods are called xed manufacturing overheads.
Therefore, xed overheads must be split between manufacturing and
non-manufacturing, and only the manufacturing component must
be included in the cost of inventories together with variable
manufacturing costs.
Examples of xed manufacturing and non-manufacturing
overheads are given in Table 5.1.
Table 5.1 Examples of xed manufacturing and non-manufacturing overheads
Manufacturing Non-manufacturing
Depreciation on factory machines Depreciation on the sales representative’s vehicle
Fixed electricity costs in the manufacturing plant Fixed electricity costs in the administration building
Salaries of manufacturing staff Salaries of administration staff
Fixed or variable selling costs, xed or variable electricity costs in the

administration building, and salaries of administration staff are costs
incurred to effect the sale or carry out administrative functions, and
are not costs incurred in ‘bringing the inventories to their present
location and condition’ or ‘costs incurred in converting materials

into nished goods’. Consequently, these costs do not form part of
the cost of inventories under IAS 2.
The second principle relates to ‘a systematic allocation’. Fixed
overheads are allocated to inventory. The process of allocation is
explained in paragraph 13 of IAS 2, which requires xed overheads
to be allocated based on normal capacity of the production facilities.
Normal capacity is the production expected to be achieved on average over a
number of periods or seasons under normal circumstances, taking into
account the loss of capacity resulting from planned maintenance.
Paragraph 13 of IAS 2 further states that unallocated overheads are
recognised as an expense in the period in which they are incurred.
Now that we introduced the activity level to be used when
allocating xed manufacturing overheads to inventory, we still need
to discuss what cost should be used for this allocation. We may be
inclined to use actual xed manufacturing overheads, however this
leads to some practical dif culties in that actual xed manufacturing
overheads will only be known after a speci c period, when we need
product cost (which includes xed manufacturing overheads)
information during this period. The most obvious uses of product
cost information during a speci c period would be for the pricing
decision and pro tability measurement. To overcome this practical
problem, budgeted xed manufacturing overheads are used to
determine the allocation rate. Normal capacity is used to overcome
the potential problem of seasonality. If allocation rates, for example,
are calculated on a monthly basis, the risk arises of having different
cost allocations in different periods due to seasonal uctuations in
production.
The allocation of xed manufacturing overheads is thus
performed by taking budgeted xed manufacturing costs for a
period (normally a year) and then dividing it by normal capacity

(which is an average over a number of years). This allocation rate is
then used for allocating xed manufacturing overheads to inventory.
The total xed manufacturing overheads allocated to current
production are referred to as allocated xed manufacturing
overheads. The difference between allocated xed manufacturing
overheads (allocation rate × actual production) and actual
manufacturing overheads incurred in a speci c period is then called
an over/under-allocation. Over-allocation means that the allocation
of xed manufacturing overheads to inventory is more than actual
xed manufacturing overheads incurred. Under-allocation means
that the allocation of xed manufacturing overheads to inventory is
less than the actual xed manufacturing overheads incurred. The
over/under-allocation should be debited (under-allocation) or
credited (over-allocation) in the income statement to ensure that
actual manufacturing xed costs are debited to the income
statement. The absorbed xed manufacturing overhead amount
together with the over/under-allocation will equal actual xed
manufacturing overheads.
It is valuable to note that paragraph 13 of IAS 2 further states that
in periods of abnormally high production, the amount of xed overhead
allocated to each unit of production is decreased so that inventories are not
measured above cost.
Applying the principles of IAS 2 relating to the cost of
inventories and other costs that should be expensed, and using the
cost information in example 5.1 below, the absorption costing
income statement can be prepared.
Example 5.1
Information for the December 2X10 nancial year relating to Sweetz, a local
manufacturer of chewable mints, is as follows:

Actual sales 980 000 @ 40 cents per mint
Actual mints produced in 2X10 980 000 mints
Consisting of:
Direct materials – raw gum 980 kg @ R20,00 per kg
Direct labour – wages 980 hours @ R50,00 per hour
1 960 machine hours @ R30,00

Variable manufacturing overhead
per hour
Budgeted xed manufacturing overheads R90 000
Normal capacity 900 000 mints
Actual xed manufacturing overheads R93 000
Opening inventory for 2X10 100 000 mints
Consisting of:
100 kilograms @ R19,00 per

Direct materials – raw gum
kilogram
200 machine hours @ R28,00 per

Variable manufacturing overhead
hour
Total xed manufacturing overheads allocated (85 950/900 000)

R9 550
× 100 000
Closing inventory for 2X10 100 000 mints
Variable selling costs 5 cents per mint sold
Fixed selling costs R25 000
Additional information:
• Fixed manufacturing overheads are allocated on the basis of the number of mints
produced.
• Inventory to be valued on the FIFO* basis.

• Disclose the over/under-allocation below the gross pro t line.
* FIFO will be discussed in Chapter 7, Job costing. For this example, you only need to
know that FIFO implies that closing inventory will be valued at current year production
cost. This is the case as we assume all units in opening stock would be sold during
the current year, thus closing stock can only consist of units produced during the
current year.
Required:
Using the information provided above, prepare the actual income statement for
Sweetz on an absorption costing basis.
The income statement can be presented as follows:
Actual income statement for Sweetz for the year ending 31 December 2X10, prepared
on an absorption costing basis

The emphasis in nancial accounting is on classifying manufacturing
items separately from non-manufacturing items. In an income
statement, the gross pro t line separates manufacturing and non-
manufacturing line items. It is important to note that the
over/under-allocation can also be disclosed above the gross pro t
line as it can be seen as a manufacturing line item. All examples in

this chapter disclose the over/under-allocation below the gross
pro t line for simplicity and explanation purposes.
In terms of nancial accounting, the over/under-absorption must
be disclosed above the gross pro t line. Gross pro t is a measure of
operating effectiveness, and in the example above the R167 750 gross
pro t is arrived at by deducting cost of sales of R224 250 from
revenue of R392 000. Fixed manufacturing overheads are included as
part of the cost of production, and hence form part of cost of sales.
Please note that closing inventory is valued, in terms of xed
manufacturing overheads, using the allocation rate of the previous
period calculated and not actual xed manufacturing overheads of
that period. Because only the absorbed xed manufacturing
overheads amount is capitalised to inventory (R98 000), the
difference between actual xed manufacturing overheads of R93 000
and the capitalised amount of R98 000 must still be adjusted in the
income statement. This is performed through the over-allocation
amount of R5 000 (R93 000 – R98 000). Non-manufacturing xed
costs of R25 000 are reported below the gross pro t line on the
income statement.
The valuation principles to determine the cost of production
naturally also apply to opening and closing inventories, and
therefore under the absorption costing system, opening and closing
inventory both include a share of xed manufacturing overheads
through an allocation rate as discussed.
To summarise absorption costing:
• Absorption costing involves the accumulation and reporting of
cost information within a format which is consistent with the
accounting standards underlying nancial accounting.
• Fixed manufacturing overheads are included in the cost of
production, and consequently in opening and closing

inventories. Fixed manufacturing overheads are taken into
account, in cost of production and consequently in opening and
closing inventory, through a predetermined allocation rate
relevant to the speci c period to which it relates.
• An over/under-allocation is merely the difference between xed
manufacturing costs allocated to the current production cost and
actual xed manufacturing costs incurred and is treated as a
period cost. The allocated/absorbed amount together with
over/under-allocation equals actual xed manufacturing costs
incurred.
• Absorption costing emphasises the classi cation between
manufacturing and non-manufacturing costs as all
manufacturing costs are capitalised and all non-manufacturing
costs are expensed as period costs.
• ‘Gross pro t’, which is revenue less cost of sales, is associated
with the absorption costing reporting format.
5.2.2 Variable costing

Key terms: direct costing, marginal costing
Variable costing is the alternative form of assimilating and reporting

cost information. It leads to reporting in a format that enables
planning, control and decision-making in the short term. Variable
costing is also known as direct costing or marginal costing. It is the
reporting format preferred for management accounting, especially
for its short-term decision-making value. It utilises the same
underlying cost information as absorption costing, but presents it in
an alternative format.

The major distinguishing factor between variable costing and
absorption costing is the treatment of xed manufacturing cost.
Costs that are xed for the duration of the period under review
and cannot be altered are irrelevant to decisions pertaining to that
period. Variable costing therefore supports such short-term decision-
making as it does not ‘absorb’ xed costs into the cost of the product.
Another distinguishing factor is that in a variable costing system,
variable non-manufacturing cost is deducted higher up in the
income statement, before arriving at the contribution (all variable
costs must be deducted before the word ‘contribution’ can be used).
All xed costs are deducted only after the contribution has been
shown. The following example illustrates the variable costing
income statement.
Example 5.2
Required:
Using the information in example 5.1, prepare the actual income statement for Sweetz
on a variable costing basis.
The income statement can be presented as follows:
Actual income statement for Sweetz for the year ending 31 December 2X10, prepared
on a variable costing basis

The emphasis in variable costing is on reporting xed costs
separately from variable costs (whereas the emphasis in absorption
costing is on reporting manufacturing costs separately from non-
manufacturing costs). The contribution line (R216 300 in this case),
which is revenue less all variable costs, exists in a variable costing
system. All variable costs are reported in the income statement
above the contribution line, while all xed costs are reported below
the contribution line. The xed cost charge of R118 000 consists of
R93 000 actual xed manufacturing overheads and R25 000 non-
manufacturing xed costs. It is very important to note that there are

no xed overheads in opening and closing inventories, as all xed
costs (including xed manufacturing cost) have been expensed in the
income statement. Fixed costs are said to be treated as ‘period costs’
(i.e. not part of the cost of inventory), as they are expensed in the
period in which they arise.
Remember that direct costs are de ned as those costs which are
directly related to the cost object(s). Generally, direct costs are
assumed to be variable. Given that they are directly attributable to a
particular product (hence direct costs), it is assumed that an increase
in the product volume will naturally lead to an increase in the cost.
Variable manufacturing and variable non-manufacturing costs
are reported separately in the income statement. Variable non-
manufacturing costs, for example variable selling costs, are reported
in the income statement only after the ‘closing inventories’ line has
been brought in. This is because such costs are incurred on the units
that have been sold, and not the units that have been produced.
To summarise variable costing:
• Variable costing involves the accumulation and reporting of cost
information within a format that enables planning, control and
short-term decision-making.
• Fixed costs (manufacturing and non-manufacturing) are
expensed in the income statement and do not form part of
opening or closing inventories. Fixed costs are treated as period
costs.
• Variable costing emphasises the distinction between variable and
xed costs.
• ‘Contribution’, which is revenue less variable costs, is associated
with the variable costing reporting format.

5.2.3Conclusion on similarities and
differences between variable and
absorption costing
• Both variable and absorption costing entails inventory valuation,
thus under both concepts only manufacturing costs can be
allocated to inventory. Under both systems, non-manufacturing
costs will be treated as period costs.
• The major distinguishing factor is manufacturing xed costs.
Absorption costing would assimilate both xed and variable
manufacturing costs to inventory. Variable costing would only
assimilate variable manufacturing costs to inventory. This is also
the reason why these two systems may report different pro t
gures under certain circumstances, which will be discussed in
the section that follows.
Before continuing with the chapter, it is crucial to be entirely

comfortable with the chapter thus far.
5.3The impact of changes in inventory on

profit
This section of the text addresses whether both absorption costing
and variable costing yield the same pro t. Earlier it was stated that
both costing systems utilise the same underlying cost information,
but present the information differently. It is the presentation which
results in a change in pro t in certain circumstances. The sections
that follow explore this principle.

5.3.1 No inventory
The fact that no inventory is held implies that all units produced
were sold in the same period.
Example 5.3
Manufacturing information for the 2X10 nancial year relating to Sweetz is given
below:
Sales 980 000 @ 40 cents per mint
Mints produced in 2X10 980 000 mints
Consisting of:
Variable manufacturing overhead 1 960 machine hours @ R30,00 per hour
Actual xed manufacturing Overheads R93 000
produced.
• Inventory to be valued on the FIFO basis.
Required:
Prepare actual income statements on both the absorption costing and the variable
costing bases.
The actual absorption costing income statement looks as follows:

Given that there is no opening or closing inventory, there is no opening and
closing inventory adjustment in cost of sales. This will only be the case
when production equals sales and there is no opening inventory.
Cost of sales comprises the cost of producing all the units that are to
be sold. It was explained earlier that, under an absorption costing
system, the emphasis is on manufacturing versus non-
manufacturing costs. Consequently, cost of sales would consist of
both variable and xed manufacturing costs for the current year of
production, as all units produced were sold.
The xed manufacturing overheads charged to this particular
income statement amount to R93 000 (R98 000 absorbed minus the
R5 000 over-allocation adjustment). It is evident that actual xed
manufacturing overheads of R93 000 are expensed in total in this
particular income statement. The pro t amounts to R97 600.
The actual variable costing income statement looks as follows:

As explained above, there are no opening or closing inventory
adjustments to cost of sales in this speci c example. Remember,
under a variable costing system, the emphasis lies on separating
variable and xed costs. The apparent differences are that the cost of
production under variable costing excludes xed manufacturing
overheads. That explains why the gross pro t of R166 600 under
absorption costing differs from the contribution of R215 600 under a
variable costing system. The other difference is the fact that, under
variable costing, variable non-manufacturing costs are reported at a
higher classi cation level, that is, before contribution. This is,
however, only a classi cation issue and does not affect the ultimate
pro t gures in any way.
So where are the xed manufacturing overheads reported under
a variable costing system? As we know, variable costing separates
variable costs and xed costs. The ‘all xed costs’ amount of R118
000 is made up of R93 000 in actual manufacturing xed costs and
R25 000 in non-manufacturing xed costs.

From example 5.3, the following is apparent:
• Absorption costing and variable costing classify the cost
information differently. This leads to the following income
statement gures being different: cost of production, gross pro t
(seen in an absorption costing income statement) and
contribution (seen in a variable costing income statement).
• Although the classi cations are different, the amount charged to
the income statement for each cost element remains the same
when there are no inventories. We refer to the costs as having
expired when they are expensed to the income statement.
Therefore, we can conclude that regardless of whether an absorption
costing or a variable costing system is used, all costs have been expensed
to the income statement if there is no inventory.
This explains why the pro t gures are the same under both costing
systems.
Example 5.3 illustrates that, where there are no opening and
closing inventories, absorption costing and variable costing report
the same pro t gure.
5.3.2 Opening inventory

With opening inventory introduced into the example, the income
statements become more interesting. Consider example 5.4, where
the information in the previous example has been amended to make
provision for opening inventory.
Example 5.4
below:

Mints produced in 2X10 900 000 mints
Consisting of:
Variable manufacturing overheads 1 800 machine hours @ R30,00 per hour
Budgeted xed manufacturing overhead R90 000
Actual xed manufacturing overheads R93 000
Opening inventory for 2X10 80 000 mints
Consisting of:
Variable manufacturing overheads 160 machine hours @ R28,00 per hour
produced.
Required:
costing bases.

The cost information from the previous example has been amended
to accommodate opening inventory of 80 000 units. It is important to
remember that the value of the opening inventory will be different
under the two costing systems. Let us consider the following extracts
from the income statement reporting formats:
Total Per unit

Absorption costing
R’000 R
Opening inventory:
Direct materials 1,520 0,019
Direct labour 3,840 0,048
Variable manufacturing overheads 4,480 0,056
Fixed manufacturing overheads (R85 950/900 000 = 0,0955) 7,640 0,0955
Total Per unit

Variable costing
R’000 R
Opening inventory:
Direct labour 3,840 0,048
Opening inventory in an absorption costing system comprises the

cost of direct materials, direct labour, variable manufacturing
overheads and xed manufacturing overheads. In contrast, the value
of opening inventory in a variable costing system consists of the
same amount for direct materials, direct labour and variable
manufacturing overheads, but excludes the xed manufacturing
overheads component.
Using this understanding, let us now prepare the actual
absorption costing income statement.

This income statement raises some questions: what is the total xed
manufacturing overheads charge to the income statement? How
many years or periods of xed manufacturing cost charge are
included in the income statement?
The total xed manufacturing overheads charge to the income
statement is now R100 640. This consists of R93 000 (R90 000
absorbed xed manufacturing costs and an under-allocation of R3
000) relating to xed manufacturing overheads incurred in the
current year, as well as xed manufacturing overheads of R7 640
arising in opening inventories, which are carried forward from the
previous period, when the inventories were produced. So not only

are the current year’s xed manufacturing overheads expensed, but
xed manufacturing overheads which arose in the past when the
opening inventories were produced, are now being charged against
revenues. The total xed cost charge to the income statement is
R125 640 (R101 640 relating to xed manufacturing overheads and
R25 000 for non-manufacturing xed costs.)
Using the same information, let us prepare the actual income
statement on a variable costing system:
With the introduction of opening inventory into the example, we

have introduced additional costs for direct materials, direct labour
and variable manufacturing overheads. These same costs were also
introduced when we prepared the income statement on an
absorption costing basis. However, concentrate on the ‘all xed
costs’ charge. The total xed cost charge consists of R93 000 relating

to current year actual xed manufacturing overheads, and R25 000
relating to current year non-manufacturing overheads, the total
being R118 000. This is R7 640 less than the total xed cost charge in
an absorption costing system. This R7 640 was written off as a period
cost in the previous period under the variable costing system. This is
summarised as follows:
Absorption costing Variable costing

R R
Fixed manufacturing overheads in opening inventory 7 640 None
Current year actual xed manufacturing overheads incurred 93 000 93 000
Current year non-manufacturing xed costs incurred 25 000 25 000
Total xed cost charge in current period 125 640 118 000
Pro t 90 520 98 160
From the above, it is clear that every cost item remains exactly the
same except for xed costs. In this scenario, under the absorption
costing system, the total xed cost charged to the income statement
is higher than under a variable costing system, as the xed cost
charge includes xed manufacturing overheads arising from prior
periods of R7 640, which are included in opening inventories. The
effect is that pro t in an absorption costing system is lower than the
pro t in a variable costing system. The difference is exactly equal to
the amount of xed manufacturing overheads in the value of
opening inventory, being R7 640.
From example 5.4 the following is apparent:
• When opening inventories are introduced, the pro t under the
absorption costing system differs from the pro t under a variable
costing system.

• The reason for the difference is that the total xed cost charged in
an absorption costing system differs from the total xed cost
charge in a variable costing system.
• This difference in xed cost arises because opening inventories in
an absorption costing system include xed manufacturing
overheads, whereas the variable costing system does not.
• Variable manufacturing costs do not result in a pro t difference
as they are treated equally under the absorption and variable
costing system.
• Non-manufacturing costs (both xed and variable) do not result
in a pro t difference as they are expensed in full under the
absorption and variable costing system.
When xed manufacturing overheads are brought forward from

previous periods, as we see in our example above with absorption
costing, we say that previous costs have now expired (been expensed
to the income statement) in the current period.
Example 5.4 illustrates that, where the number of units sold
exceeds the number of units produced (implying opening
inventories and a decrease in inventory levels), the variable costing
system will show a higher pro t gure than the absorption costing
system.
Let us proceed to an example with closing inventory.
5.3.3 Closing inventory

The information from previous examples has been adapted to
accommodate closing inventory of 220 000 units in example 5.5.
Example 5.5

below:
Mints produced in 2X10 1 000 000
Consisting of:
Direct materials – raw gum 1 000 kg @ R20,00 per kg
Direct labour – wages 1 000 hours @ R50,00 per hour
Variable manufacturing overhead 2 000 machine hours @ R30,00 per hour
Budgeted xed manufacturing overhead R90 000
Actual xed manufacturing costs R93 000
Closing inventory for 2X10 20 000 mints
produced.
Required:
costing bases.
Consider the following extracts:
Total Per unit

Absorption costing
R’000 R
Closing inventory:
Direct labour 1 0,05

Fixed manufacturing overheads (R90 000/900 000) 2 0,10
Total Per unit

Variable costing
R’000 R
Closing inventory:
Direct labour 1 0,05
As discussed with opening inventory, the value of closing inventory

under an absorption costing system includes xed manufacturing
overheads. The charges for direct materials, direct labour and
variable manufacturing overheads are the same under both formats.
The income statement using absorption costing can be prepared
as follows:

Notice the reference to xed manufacturing overheads in three
places. The rst is in the cost of production, which comprises the
absorbed costs relating to units produced in the current year of R100
000. The second reference is the over-allocation of R7 000. These two
together re ects actual xed manufacturing costs of R93 000
(R100 000 – R7 000). The third reference to xed manufacturing
overheads occurs in closing inventory. This is shown as a negative of
R2 000, the effect being that the xed manufacturing overheads
charge to the income statement is being reduced to R91 000.
As 20 000 mints in closing inventory were not sold, the
corresponding costs of these units are not expensed, which is why
there is a deduction from cost of sales. Absorption costing includes
xed manufacturing overheads in inventories, so a portion of the
xed manufacturing overheads, being R2 000, remains unexpensed
at the end of the period. This is also referred to as the xed
manufacturing overheads being unexpired (not expensed to the
income statement) at the end of the period, and consequently
capitalised to the balance sheet as a current asset as part of
inventories.
In contrast, the variable costing income statement is drawn up as
follows:

The ‘all xed costs’ charge consists of actual xed manufacturing
costs of R93 000 and non-manufacturing xed costs of R25 000
relating to the current year. This amount remains unaffected by
inventories. Opening and closing inventory includes no portion of
xed cost, and hence xed costs expensed consist of the total xed
cost charge incurred for the year.
The pro ts of the two income statements are different. The reason
behind this is that the total xed cost charge under the absorption
costing system is different to the total xed cost charge in a variable
costing system. Under the absorption costing system, a portion of
xed overhead is removed from the income statement by way of
closing inventory. This is summarised as follows:
Absorption costing Variable costing

(R) (R)

Current year xed manufacturing overheads incurred 93 000 93 000
Fixed manufacturing overheads in closing inventory (2 000) None
Current year non-manufacturing xed costs incurred 25 000 25 000
Total xed cost charge 116 000 118 000
Pro t 99 600 97 600
The difference in pro t of R2 000 is explained by the fact that the

total xed cost charge in absorption costing is reduced by the
amount of xed manufacturing overhead of R2 000 which is
included in closing inventory and capitalised to the balance sheet.
Example 5.5 illustrates that, where production exceeds sales
(implying that there are closing inventories and an increase in
inventory levels), the pro t under an absorption costing system will
be higher than under a variable costing system.
From example 5.5 the following is apparent:
• When closing inventories are introduced, the pro t under the
absorption costing system differs from the pro t under a variable
costing system.
• The reason for the difference is that the total xed cost charged in
an absorption costing system differs from the total xed cost
charge in a variable costing system.
• This difference in xed cost arises because closing inventories in
an absorption costing system include xed manufacturing
overheads whereas the variable costing system does not.
• Variable manufacturing costs do not result in a pro t difference
as they are treated equally under the absorption and variable
costing system.
• Non-manufacturing costs (both xed and variable) do not result
in a pro t difference as they are expensed in full in under both
the absorption and variable costing system.

Further discussion and conclusion on
5.3.4
the effect of inventory on profit figures

All expenses (manufacturing and non-manufacturing) are dealt with
under both the variable and absorption costing system. The only
difference lies in the fact that the absorption costing system also
includes a xed manufacturing cost allocation in opening and
closing inventory, whereas the variable costing system expenses the
actual xed manufacturing cost in the year it occurs. The result of
any costs being capitalised to inventory is that these costs will only
be expensed when these speci c inventory items are sold
(accounting matching principle). Both the absorption and variable
costing system have this effect on variable manufacturing costs, they
are only expensed when sold. Fixed manufacturing costs, however,
are treated differently under these two systems since the absorption
costing system will only expense xed manufacturing costs of items
sold, whereas the variable costing system on the other hand will
expense actual xed manufacturing costs when incurred.
As only xed manufacturing costs are treated differently between
these two systems and the difference is in respect of inventory
(opening and closing) the difference in pro t gures reported must
lie in opening and closing inventory.
In example 5.3 above, we noted that the pro t gures reported
will be the same when there is no opening or closing inventory, and
this also implies that production must equal sales. Even if
production equals sales, there can still be opening and closing
inventory. In such a scenario, opening and closing inventory will be
equal in units. When production equals sales and there is opening
inventory (also implying that there will be an equal amount of
closing inventory in units), and xed costs in opening and closing

inventory differs, the absorption and variable systems will not report
the same pro t gure. Thus we cannot conclude, when production
equals sales, that the reported pro t gures under both methods will
be equal. It is highly likely that xed costs per unit under opening
and closing inventory will be different as in ation is a reality and an
allocation rate is normally recalculated at least once a year.
Table 5.2 summarises the relationships that have been explained
in this section.
Table 5.2 Relationship between sales and production
Sales > Sales <

Sales = production
production production
Decrease in Increase in
No change in inventory levels
inventory levels inventory levels
Absorption pro t = variable pro t

Absorption pro t < Absorption pro t >
Assuming fixed manufacturing cost per unit is the same
variable pro t variable pro t
under opening and closing inventory
Pro t gures reported under the absorption and variable costing

system will be different when
• production does not equal sales, and/or
• the xed manufacturing cost allocation rate differs in opening
and closing inventory.
Reconciling absorption profit to

5.3.5
variable profit
In all the examples in the previous sections, it was pointed out that
the difference in pro t arises as a result of a change in the amount of
xed manufacturing costs charged to the income statement.

In a variable costing system, only xed manufacturing costs
relating to the current period are expensed. In an absorption costing
system, the amount of xed manufacturing cost expensed is driven
by the current year’s expense, the prior year’s expense brought
forward in opening inventories, and the expense deferred to the
future period in closing inventories.
The reconciliation process is simply a reversal of the xed
manufacturing cost in opening and closing stock. Using the cost
information from examples 5.4 and 5.5, this is done as follows:
Notes:
1 Fixed overhead in opening inventories is added back, as this was
expensed in determining absorption pro t, by increasing cost of
sales.
2 Fixed overhead in closing inventories is deducted, as this was not
deducted in determining absorption pro t, resulting in a lower
charge to cost of sales than under variable pro t.
To recap, in this section we addressed the impact of inventories on

pro t and explained this impact using three scenarios. In the rst
scenario, where we had no inventories, absorption pro t was the
same as variable pro t. In the other two scenarios, where inventories
were introduced, absorption pro t differed from variable pro t. We
explained that the reason for the difference arose because of xed

manufacturing costs capitalised to opening and closing stock in
terms of absorption costing, whereas variable costing does not
capitalise xed manufacturing costs. We also illustrated the
reconciliation of absorption pro t to variable pro t.
Strengths and weaknesses of absorption

5.4
and variable costing
We have learnt about both the absorption and variable costing
methods, and should now consider which method is preferable
under which circumstances. As the choice has an impact on the
pro t gure, the issue of which method is preferable becomes
relevant.
Let us rst look at the arguments for absorption costing. We will
then counter-argue these with points in favour of variable costing. It
should become apparent that both methods have merit, depending
on for what the information provided by these systems is required.
5.4.1 Absorption costing
Inventory valuation and profit measurement

Absorption costing is the prescribed method for inventory valuation
in terms of IAS 2. It is the method used for nancial reporting
purposes. As it is based on a global standard, it ensures consistency
and comparability of nancial information.
Gross pro t, a concept which exists in terms of absorption
costing, indicates the pro tability of a company’s core business. It
makes sense to include all manufacturing costs when measuring

pro tability. Thus, absorption costing provides useful pro tability
and performance information, especially over the long term.
Emphasis on the importance of fixed costs

Unlike a variable costing system, which treats xed costs as a period
cost and potentially ignores them for decision-making purposes,
absorption costing takes cognisance of the fact that xed costs are a
real cost by absorbing overheads into the value of inventory. This
further explains why pro tability information produced by the
absorption costing system becomes useful, especially over the long
term, as it considers all manufacturing costs in terms of its core
business.
Impact on profit
The pro t gure under an absorption costing system is a function of
both production and sales volume. In other words, changes in both
production and sales volumes would have a direct effect on the
pro t of the entity. An increase in the sales volume would result in
an increase based on additional revenue and costs of sales
recognised.
Changes in production also impact pro t. If units produced are,
for example, more than units sold (refer to Table 5.2), an absorption
costing system would yield a higher pro t than a variable costing
system. This happens as more xed manufacturing costs are
deferred to the future period than what was brought in from the
previous period. This results in the possibility of pro t being
manipulated over the short term by increasing production, even if it
is known that these produced units will not be sold in the current
period. This manipulation, however, cannot be successfully executed
over the long term as the xed manufacturing costs deferred in one

period will be introduced in the following period as part of opening
inventory.
One of the advantages of capitalising xed manufacturing costs
to inventory is that it deals with seasonality. Assume a company sells
lots of their products in winter, but very little of their products in
summer. Absorption costing will defer the xed manufacturing costs
allocated to manufactured products until they are sold. The variable
costing system, on the other hand, will expense xed manufacturing
costs in the months they are incurred, possibly resulting in losses
being made in summer months and astronomic pro ts being made
in winter months. Although this may be the economic reality in
these months, absorption costing will provide a more normalised
holistic picture of pro tability by taking seasonality into account
through the allocation rate, which was based on normal annual
capacity. This further illustrates the usefulness of absorption costing
over the long term.
Performance measurement
Absorption costing can be useful as a performance measurement
tool, especially if seasonality is present. The biggest risk of using
absorption costing for performance measurement is the fact that
pro ts can be manipulated over the short term. Therefore, we may
use absorption costing for performance measurement over the long
term.
Ethical dilemma
In a situation where a manager’s bonus is based on actual
absorption pro t, the manager may be tempted to increase
production in order to increase pro t and the resulting bonus.
This is a good example of an act which might be legal but

unethical. If increasing production does not make economic
sense for the business and is purely done to increase pro ts, it
would be considered unethical.
5.4.2 Variable costing
Relevance for decision making

Variable costing provides cost information which is relevant for
short-term decision-making purposes. In the short-term, xed costs
are irrelevant because they cannot be altered, and decisions should
be based on cost information that changes in line with the decision.
As variable costing treats all xed costs as period costs, and hence
below the contribution line, it enables decisions to be made after
considering only relevant cost information for the short-term time
horizon.
Variable costing also forms the basis of break-even analysis,
which is discussed in Chapter 4, Cost-volume-pro t relationships. The
link between break-even analysis and variable costing is easily made
when one takes note of the principle that variable costing pro t will
be zero at break-even level.
Expired costs
Variable costing ensures that all xed costs which relate to a period
are expensed in the period in which they are incurred. In contrast,
the absorption costing method would include xed manufacturing
overheads as part of inventories, and hence some portion of xed
cost would be carried over to future periods. Variable costing
recognises that xed costs are irrelevant over the short-term and
therefore expenses them as they are incurred.

Impact on profit
The pro t gure under a variable costing system is only a function of
sales. Changes in sales volumes would have a direct effect on the
pro t of the entity. An increase in the sales volume would result in a
proportionate increase in the contribution, and consequently a
movement in pro t. Changes in production will have no impact on
the pro t of a variable costing system, therefore the pro t under a
variable costing system provides valuable information on the
economic reality of the company over the short term.
Performance measurement
Variable costing is argued to be the preferred method for
performance measurement purposes. Absorption costing can be
subjected to manipulation through changes in inventories as
mentioned before. A manager who is being evaluated on the basis of
pro t has an incentive to show the highest pro t possible, and one
way of achieving such pro ts is by manipulating closing inventories.
This is called ‘window dressing’: managers build up closing
inventories at year-end (provided that the organisation has the spare
capacity to do so), thereby transferring portions of xed costs to
future periods and increasing current year pro t.
5.4.3 Conclusion
It could be argued that, at a high-level, absorption costing is useful
for external reporting as it focuses on pro tability and that variable
costing is useful for internal management accounting purposes as it
focuses on short-term decision-making. Although this may be true,
both these systems provide value for internal use. The choice of

method internally depends on why the company requires
information.
It is thus crucial to understand how these systems are different in
order to understand under which circumstance each method would
be appropriate.
It should be evident that variable costing is the best method to
use for short-term decision-making as it indicates the economic
reality of a speci c period. This is also evident from the conceptual
link to break-even analysis.
Absorption costing is valuable from an inventory valuation point
of view. Inventory valuation (i.e. costing) is important for
management accounting. One example would be the relevance of
full costing for the long-term pricing decision. Another example
would be the importance of absorption costing in terms of
pro tability and performance measurement over the long term.
The importance of both these costing systems will become more
evident as you master different topics in cost and management
accounting.
5.5 Summary
In this chapter, absorption costing and variable costing were
introduced and their use for nancial accounting and management
accounting purposes was discussed. The underlying cost
information remains the same, but absorption costing emphasises
the distinction between manufacturing and non-manufacturing
costs, while variable costing focuses on the separation of xed and
variable costs. The effect is that the two costing methods result in
different income statement reporting formats.

Absorption and variable costing pro ts differ when production
and sales levels differ from one period to the next. Absorption
costing pro t is affected by changes in inventories, as a portion of
xed manufacturing overheads is carried forward in inventory. The
under- or over-recovery of overheads is not the cause of the
difference in pro t between the two systems.
Absorption costing is used for nancial accounting purposes, as
required by IAS 2. Variable costing is usually preferred for
management accounting purposes.
Conclusion: Absorption versus variable

costing and other topics in this book
To understand the difference between absorption and variable
costing, knowledge of the difference between xed and variable
costs, as explained in Chapter 2, Cost classi cation, is required.
Chapter 4, Cost-volume-pro t relationships assumes a variable costing
system, as the analysis requires xed costs to be treated as period
costs. Chapter 6, Overhead allocation further explains how xed
overheads are allocated to inventory. The potential usefulness of
inventory valuation information for decision-making over the long-
term will also be discussed in section 6.5 on activity-based costing
(ABC).
Chapter 10, Relevant information for decision-making explores the
concept of relevance further and will aid in the illustration of why
variable costing is useful in management accounting.
Tutorial case study: Chappies

Arthur Ginsburg is the creator of Chappies, the bubblegum that captured the youth
of the 60s and 70s. It was an iconic South African product, recognised by everyone
in its distinctive yellow wrapper with blue and red stripes.
In the mid-1930s, Ginsburg became the cost accountant of Chapelat while
completing a BCom degree at the University of Witwatersrand. Chapelat
manufactured expensive chocolates and toffees, but through a series of
transactions found itself having to source a new product and new business.
Ginsburg looked around the market. ‘I noticed that Wicks bubblegum was selling
at a penny each. I wondered about making a gum that sells two for a penny.’
He experimented with a bubblegum base from the US. It came in square lumps
of no particular colour – a greyish opaque mass. When heated, this base became
malleable, after which it was put into a large metal container to be mixed. Flavouring
and colourant were added, together with glucose and sugar.
From there the bubblegum went through an extruder and came out in long strips.
The strips were then sent through cutting and wrapping machines. In the old days, 1
200 Chappies could be produced every minute.
And how did he come upon the name? ‘While still in the initial experimental
stage, I decided on an abbreviation of Chapelat, and that was Chappies,’ says
Ginsburg.
Chapelat was faced with many challenges, and one of these was providing and
reporting useful cost information. This was necessary to achieve Ginsburg’s goal of
‘making a gum that sells two for a penny’.
SOURCE: HTTPS://WWW.LUCILLEDAVIE.CO.ZA/POST/2003/03/10/CHAPPIES-A-JOBURG-CREATION
1 Discuss whether an absorption costing or variable costing income statement is

likely to be seen as more appropriate for use by the management accounting
team of the Chapelat company.
2 Discuss whether an absorption costing or variable costing income statement is
likely to be seen as more appropriate for use by the nancial accounting team of
the Chapelat company.
3 If there were no opening inventory in 2XX6 but there was closing inventory,
indicate whether you would expect absorption costing or variable costing to
report the higher pro t in 2XX6, and explain why the pro ts would differ.
4 If there were no opening inventory in 2XX6 and no closing inventory in 2XX7,
discuss whether the cumulative pro t over the two years would differ under
absorption costing and under variable costing.
5 If a large order had been placed for Chappies and the minimum price to be
charged for the order had to be determined, discuss whether the use of
absorption costing or variable costing would be more appropriate.
6 If the order in question 5 above is to be repeated every year, discuss whether
and how your answer would change.

If Chappies had underallocated overheads in 2XX7, discuss whether this would
7
further contribute to its absorption costing pro t being different from its variable
costing pro t.
8 Discuss the relative advantages and disadvantages to Chappies of using an
absorption costing versus a variable costing system.
Basic questions
BQ 1
The new management accountant of a company pointed out to one
of the directors that all the company’s management reports are
traditionally drawn up on an absorption costing basis, and that he
would like to make use of variable costing instead, where
appropriate. What are the main differences between absorption and
variable costing?
BQ 2
As an accountant, on what basis (absorption or variable costing)
would you advise your clients to draw up income statements that
are going to be used exclusively for nancial reporting purposes?
Give a reason for your answer.
BQ 3
In the Big Business company, the management accounting team
prepare accounts on a variable costing basis each time senior
management ask for information on which to base decisions. Why is
variable costing useful for decision-making purposes?
BQ 4

The same set of accounts can be prepared on either an absorption
costing or on a variable costing basis. Under what circumstances will
absorption costing pro t differ from variable costing pro t and why?
BQ 5
Most generally accepted alternative methods of calculation and
presentation that accountants apply to gures have some strengths
and some weaknesses. What are the advantages and disadvantages
of the absorption and variable costing methods respectively?
BQ 6
What is the difference between an over- and under-allocation?
BQ 7
SOURCE: ADAPTED FROM CIMA P1 (MAY 2005) SECTION A, QUESTION 1.6
Summary results for Y Ltd for March are shown below:
R’000 Units
Sales revenue 820
Variable production costs 300
Variable selling costs 105
Fixed production costs 180
Fixed selling costs 110
Production in March 1 000
Opening inventory 0
Closing inventory 150
Using variable costing, what was the pro t for March?

a) R170 000

b) R185 750
c) R197 000
d) R229 250
BQ 8
SOURCE: ADAPTED FROM CIMA P1 (NOVEMBER 2005) SECTION A, QUESTION 1.1
The following data relate to a manufacturing company. At the
beginning of August there was no inventory. During August, 2 000
units of product X were produced, but only 1 750 units were sold.
The nancial data for product X for August were as follows:
R
Materials 40 000
Labour 12 600
Variable production overheads 9 400
Fixed production overheads 22 500
Variable selling costs 6 000
Fixed selling costs 19 300
Total costs for X for August 109 800
What was the value of inventory of X at 31 August, using a variable

costing approach?
a) R6 575
b) R7 750
c) R8 500
d) R10 562
BQ 9
SOURCE: ADAPTED FROM CIMA P1 (NOVEMBER 2005) SECTION A, QUESTION 1.3

A company has a budget to produce 5 000 units of product B in
December. The budget for December shows that for product B, the
opening inventory will be 400 units and the closing inventory will be
900 units. The monthly budgeted production cost data for product B
for December are as follows:
Variable direct costs per unit R6,00
Variable production overhead costs per unit R3,50
Total xed production overhead costs R29 500
The company absorbs overheads on the basis of the budgeted

number of units produced. What is the budgeted pro t for product B
for December, using absorption costing?
a) R2 950 lower than it would be using variable costing
b) R2 950 greater than it would be using variable costing
c) R4 700 lower than it would be using variable costing
d) R4 700 greater than it would be using variable costing
BQ 10
If inventory levels have increased during the period, the pro t
calculated using marginal costing when compared with that
calculated using absorption costing will be:
a) higher
b) lower
c) equal
d) impossible to answer without further information
BQ 11

A company uses a standard absorption costing system. The xed
overhead absorption rate is based on labour hours. Extracts from the
company’s records for last year were as follows:
Budget Actual
Fixed production overhead R450,000 R475,000
Output 50,000 units 60,000 units
Labour hours 900,000 930,000
The under- or over-absorbed xed production overheads for the year

were as follows:
a) R10,000 under-absorbed
b) R10,000 over-absorbed
c) R15,000 over-absorbed
d) R65,000 over-absorbed
Long questions
LQ 1 – Intermediate (54 minutes)

SOURCE: UNIVERSITY OF JOHANNESBURG ARCHIVE
Auckland Company manufactures and sells a single product. Cost
data for the product follow:
Variable costs per unit: R

Direct materials 6
Direct labour 12
Variable factory overhead 4
Variable selling and administrative cost 3
Total variable costs per unit R25

Fixed costs per month: R
Factory overhead R240 000
Selling and administrative 180 000
Total xed costs per month R420 000
The product sells for R40 per unit. Production and sales data for May
and June, the rst two months of operations, are as follows:
Units produced Units sold

May 30 000 26 000
June 30 000 34 000
Income statements prepared by the accounting department, using

absorption costing, are presented below:
REQUIRED Marks

(a) Determine the unit product cost under: 5
(i) absorption costing
(ii) direct costing.
Prepare income statements for May and June using the contribution approach with direct
(b) 10
costing.
(c) Reconcile the direct costing and absorption costing net income gures. 5
Explain the in uence of uctuations in sales volumes on pro ts or losses that are realised
(d) 5
under the variable costing method and absorption costing method.
(e) Explain the difference between variable and absorption costing. 5
TOTAL MARKS 30

SOURCE: ADAPTED FROM CIMA STAGE 1 ACCOUNTING (MAY 1993)
The following data have been extracted from the budgets of ABC
Ltd, a company which manufactures and sells a single product:
R per unit
Selling price 45,00
Direct materials cost 10,00
Direct wages cost 4,00
Variable overhead cost 2,50
Fixed production overhead costs are budgeted at R400 000 per

annum. Normal production levels are thought to be 320 000 units per
annum.
Budgeted selling and distribution costs are as follows:
Variable R1,50 per unit sold
Fixed R80 000 per annum

Budgeted administration costs are R120 000 per annum.
The following pattern of sales and production is expected during
the rst six months of 2XX3:
January–March April–June
Sales (units) 60 000 90 000
Production (units) 70 000 100 000
There is to be no inventory on 1 January 2XX3.
REQUIRED Marks
(a) Prepare pro t statements for each of the two quarters, in a columnar format, using: (i) variable
costing (ii) absorption costing. 12
(b) Reconcile the pro ts reported for the quarter January to March 2XX3 in your answer to (a)
above. 3
(c) Write up the production overhead control account for the quarter to 31 March 2XX3, using
absorption costing principles. Assume that the production overhead costs incurred amounted
to R102 400 and the actual production was 74 000 units. 3
(d) State and explain brie y the bene ts of using variable costing as the basis of management
reporting. 5
TOTAL MARKS 23
LQ 3 – Advanced (40 minutes)

SOURCE: ADAPTED FROM ACCA LEVEL 2 MANAGEMENT ACCOUNTING (DECEMBER 1982)
Note: A basic knowledge of Chapter 6, Overhead allocation is useful
in answering this question.
The Miozip Company operates an absorption costing system which

incorporates a factory-wide overhead absorption rate per direct
labour hour. For 2XX0 and 2XX1, this rate was R1,50 per hour. The
actual xed factory overhead for 2XX1 was R600 000 and this would

have been fully absorbed if the company had operated at full
capacity, which is estimated at 400 000 direct labour hours.
Unfortunately, only 200 000 hours were worked in that year, so that
the overhead was seriously under-absorbed. Fixed factory overheads
are expected to be unchanged in 2XX2 and 2XX3.
The outcome for 2XX1 was a loss of R70 000 and the management
believes that a major cause of this loss was the low overhead
absorption rate which had led the company to quote selling prices
which were uneconomical.
For 2XX2, the overhead absorption rate was increased to R3,00
per direct labour hour, and selling prices were raised in line with the
established pricing procedures, which involved adding a pro t
mark-up of 50% onto the full factory cost of the company’s products.
The new selling prices were also charged on the inventory of
nished goods held at the beginning of 2XX2.
In December 2XX2, the company’s accountant prepared an
estimated pro t and loss account for 2XX2 and a budgeted pro t and
loss account for 2XX3. Although sales were considered to be
depressed in 2XX1, they were even lower in 2XX2. Nevertheless, it
seems that the company will make a pro t for that year. A worrying
feature of the estimated accounts was the high level of nished
goods inventory held, and the 2XX3 budget provided for a reduction
in the inventory level at
31 December 2XX3 to the (physical) level existing as at 31 January
2XX1. Budgeted sales for 2XX3 were set at the 2XX2 sales level.
Production costs remained constant, and the FIFO method of
inventory valuation is used.
The summarised pro t statements for the three years to 31
December 2XX3 were as follows:

REQUIRED Marks
(a) Write a report to the board of Miozip explaining why the budget outcome for 2XX3 was so
different from that of 2XX2 when the sales revenue was the same for both years. 6
(b) Restate the pro t and loss account for 2XX1, the estimated pro t and loss account for 2XX2,
and the budgeted pro t and loss account for 2XX3 using variable factory costing for inventory
valuation purposes. 8
(c) Comment on the problems which may follow from a decision to increase the overhead
absorption rate in conditions when cost-plus pricing is used and overheads are currently
under-absorbed. 3
(d) Explain why the majority of businesses use absorption costing systems while most accounting
theorists favour variable costing. 5
Note: Assume in your answers to this question that the value of the rand and the ef ciency of
the company have been constant over the period under review.

TOTAL MARKS 22

SOURCE: ADAPTED FROM ACCA LEVEL 2 MANAGEMENT ACCOUNTING (DECEMBER 1985)
Mahler Products has two manufacturing departments, each
producing a single standardised product. The data for unit cost and
selling price of these products are as follows:
The factory cost gures are used in the department accounts for the
valuation of nished goods inventory and are used in both years.
The department pro t and loss accounts have been prepared for the
year to 30 June 2XX5. These are given separately below for the two
halves of the year:

The total sales revenue was the same in each six-monthly period.
However, in the second half of the year, the company increased the
sales of department A (which has the higher pro t mark-up) and
reduced the sales of department B (which has the lower pro t mark-
up). An increase in company pro ts for the second six months was
anticipated, but the pro t achieved was R8 000 lower for the second
half of the year than for the rst half. The pro t for department A fell
by R41 000, while the pro t for department B rose by R33 000. There
has been no change in prices of inputs or outputs.
REQUIRED Marks
Explain the situation described in the last paragraph. Illustrate your answer with appropriate
(a)
supporting calculations. 14

(b) Redraft the department pro t and loss accounts using variable costing to value unsold stock. 8
TOTAL MARKS 22

Umdoni (Pty) Ltd has two manufacturing departments each
producing a single standardised product. The departmental income
statements for 31 December 2010 have been prepared. The data for
the two six-month periods is given below:

The total sales revenue was the same in each six-monthly period, but
in the second half of the year the company increased the sales of
department A (which has the higher pro t mark-up) and reduced
the sales of department B (which has the lower pro t mark-up). An
increase in company pro ts for the second six months was
anticipated.
Assume normal capacity of A at 11 000 and that of B at 19 000.

REQUIRED Marks
Without doing the income statements, calculate the absorption pro t for the rst six months of
(a)
2011 for both departments. 5
With reference to department A, explain to management why the expected pro ts were not
(b)
what was anticipated. Motivate your answer with relevant calculations. 7
(c) Explain which assumption/s you made in (a) and (b) above. 4
(d) Discuss arguments for and against both marginal and absorption costing. 4
TOTAL MARKS 20
References
BHP Billiton. 2018. Annual report 2018. [Online]. Available:
https://www.bhp.com/-/media/documents/investors/annual-
reports/2018/bhpannualreport2018.pdf [15 November 2019].
Davie, L. 2003. Chappies: a Jo’burg creation. [Online]. Available:
https://www.lucilledavie.co.za/post/2003/03/10/chappies-a-joburg-creation.
SAICA (South African Institute of Chartered Accountants). 2010. IAS 2, Inventories (revised
December 2009). Johannesburg: SAICA.

The aim of this section is to integrate students’ knowledge of
chapters 1 to 5, and to move students toward a more advanced,
high-level understanding of the topics, the relationships
between them and the exam technique required.
Chapters 1 to 5 lay the foundation for your understanding of

management accounting. Paradoxically, the depth of your
understanding of the principles studied in these introductory
chapters may largely determine your performance in other topics
and in advanced exams. Let us discuss each chapter in turn to see
how its content helps you to tackle complex management accounting
questions.
Chapter 1, Introduction to management accounting is important
reading for students who are studying management accounting for
the rst time. It is also fundamental to your understanding of
advanced work. Higher-level questions usually feature a scenario
with a large quantity of information as well as a set of requirements
that test your practical insight into the particular organisation’s
situation. You will need to be very con dent about the role of a
management accountant – and the role of management accounting
information – in order to approach the requirements in the correct
way. For example, your answer may score poorly if you unwittingly

apply nancial accounting principles, because it may not give
information appropriate for management decision-making purposes.
Chapter 2, Cost classi cation introduces the very important
distinction between variable and xed costs. The advanced student
should have a thorough appreciation of the fact that, in the very long
term, all costs are variable. This is because all costs can ‘change’ in
the long run – consider, for example, where a factory’s lease contract
expires and is re-negotiated after a number of years, machine lease
payments and depreciation charges change when they are replaced,
staff salaries are adjusted, and so on. In other words, when we speak
of ‘variable’ and ‘ xed’ costs, technically we ought to specify the
relevant period or cost object as well. For example, we should say
the cost is ‘ xed within a one-year planning period’ or ‘variable
according to the number of units produced’. Try to use such full
sentences in your mind when you think through examples and
questions about variable and xed costs. You will see that it helps
you a great deal in more advanced questions, such as those on
relevant costing (this is dealt with in Chapter 10; it requires a
thorough understanding of cost classi cation and it is often
examined in professional examinations). Candidates who struggle to
score well in dif cult relevant costing calculations – and especially in
discursive answers on the topic – often nd that they lack an
understanding of the basic principles of cost classi cation and
behaviour.
Chapter 3, Cost estimation builds on your knowledge of cost
classi cation. It illustrates how costs are split into their variable and
xed components. An advanced question may, for example, require
the use of the high-low method to separate variable from xed costs.
However, unlike basic questions on the topic, the advanced
question’s requirement is unlikely to stipulate directly the use of this

method. The student will need to study the cost information in the
scenario in-depth and deduce from the requirement (which is likely
to be something else entirely) that such a distinction has to be made
before we can give a meaningful answer. In fact, we can formulate
the following general guideline:
To answer a question where a speci c topic is not directly asked

(an advanced question), we have to know the material more
thoroughly than we need to know it when the topic is directly
asked (a basic question). This is because the advanced
question requires us to sense intuitively that it is necessary to
process the information in a certain way before arriving at the
answer.
Chapter 4, Cost-volume-pro t relationships also relies heavily on your

understanding of the distinction between variable and xed costs. In
addition, it requires you to think about one of the very cornerstones
of the business world: how many units we need to sell, or how many
customers we need to serve, in order to earn a pro t of Rx. It should
not surprise you that almost any business proposition – whether it is
a loan application at a bank, a proposed new venture or a co-
operative agreement with another organisation – will feature an in-
depth study of the relationship between cost, volume and pro t.
This is because, bluntly put, it shows us whether things are likely to
work out. Because advanced questions are designed to test whether
you would make a good management accountant in practice,
practical topics nd their way into such questions in many different
forms and are asked from a variety of different angles. Again, to
judge when cost-volume-pro t calculations are appropriate in an

answer, you will have to understand the underlying principles
thoroughly.
The differences between nancial reporting and management
accounting are highlighted in Chapter 5, Absorption versus variable
costing. Absorption costing is appropriate for nancial accounting
purposes, because it gives the external user of nancial statements a
realistic indication of the value of the inventory sold and retained
during the nancial period. Furthermore, because organisations
apply absorption costing in the same prescribed way, external
parties can easily compare nancial results. The management of an
organisation is not, however, an external party. Managers work
inside the organisation to take decisions that improve the
performance of the organisation – they need information that helps
them to understand the impact of their decisions. Management
accounting information is therefore compiled on a variable costing
basis. As discussed in the paragraph on Chapter 1 above, an
appreciation of the role of management accounting becomes more
important in advanced questions.
Some of the aspects dealt with in chapters 1 to 5 will now be
integrated in an advanced question. The question used here comes
from Part 1 of the SAICA qualifying examination, but it has been
adapted for our purposes.
Because the question is meant to move you towards dealing with
longer and more advanced questions, you have to approach it in a
manner that will both save time and help you to write a quality
answer. Apply the following technique:
• Read the question requirements rst, to focus your thoughts on
what will be required of you.
• Read the scenario and plan all of your answers.

• Answer the requirements in the given order, starting with
requirement (a).
• Apply your answers to the speci c organisation in the scenario –
do not write general, theoretical answers.
Integrated question: Aqua-systems

Aqua-systems Ltd has two divisions. The Pumpworks division
manufactures standardised electric water pumps for industrial use
and the Agri-water division manufactures irrigation systems for
agricultural purposes.
The normal production capacity of Pumpworks is 1 000 units per
month, while an average of 970 units are sold. Pricing is based on a
set mark-up as prescribed by Aqua-systems Ltd.
During a recent meeting, the management of Aqua-systems Ltd
reviewed the budgeted income statement of Pumpworks for April
2XX5. The manager of the Pumpworks division explained that the
division was slowly but surely turning the corner. The division had
improved its performance over the past three months and
pro tability should increase soon. In fact, the manager of
Pumpworks indicated that the loss of the division had decreased
and that it should reach a break-even position in ve months’ time.
However, the management of Aqua-systems Ltd is not convinced
of this and they approach you, the management accountant of the
company, to advise them on the likelihood that the Pumpworks
division will return to pro tability soon.

Notes: relevant information
1 During June 2XX4, the Pumpworks production facilities were
damaged in a re caused by an electrical fault. After initial
problems with the insurance company, Aqua-systems Ltd
received a letter from it shortly before the completion of the April
budget to the effect that the amount of R54 300 had been
awarded to the company for the damage.
2 25% of sales and administration costs are variable.
3 Head of ce overheads include a fee per water pump sold. The fee
relates to a patent used on one of the components of the water
pump. The budgeted April 2XX5 income statement projects the
best unit sales ever. In its worst month, the Pumpworks division
sold only 850 units and head of ce overheads allocated
amounted to R171 900.
The cost of the water pump components and related labour costs are
set out below:

Pipe connectors
These units are bought from an external supplier. One connector is
used per pump system. Pumpworks recently bought 250 pipe
connectors at R20 each for use on the standard system.
Casings
One casing is used per pump. Information on the 24 casings that are
in inventory is as follows:
Impellers
One set of impellers is used per pump. Pumpworks is able to
manufacture 1 150 sets of impellers per month, at a total variable
cost of R250 per set. It can sell spare sets of impellers at R370 per set.
No impellers are currently in inventory. The total xed cost for the
production of impellers amounts to R132 000 per month and
represents depreciation on recently acquired machinery.
Shafts
Shafts are cut from standard steel bars. Each bar is cut into one shaft,
and one shaft is used per pump. According to the inventory records,
the total cost (excluding labour) amounts to R175 per shaft.
Pumpworks has the capacity to cut 1 100 standard shafts per month.
Depreciation and other xed costs (excluding labour) related to this
activity amount to R160 000 per month.
Electric motors

Electric motors are bought at R450 per unit. One motor is used per
pump system.
Labour
• Shaft cutting: Shaft-cutting labourers are highly skilled. They are
paid R60 per hour and work 160 hours per month. Because of the
high cost of training, all ve of the shaft-cutting labourers are
full-time employees of the company.
• Casings: A total of 13 labourers are employed in this section. Each
labourer receives a salary of R5 000 per month and works 160
hours per month. Each standard casing takes two hours to
manufacture. New casing casters can be trained at a cost of R5
000 per employee. The minimum employment period for these
workers is three months.
• Impellers: Labour consists of full-time machine operators. Existing
operators will be able to handle any expansion.
• Assembly: Labourers are paid R50 per hour to do the assembly.
One pump system takes two hours to assemble. Assembly hours
are not limited and can be adjusted as necessary.
Cost savings
As part of his attempts to return the division to pro tability, the
manager of the Pumpworks division recently asked Aqua-systems’
new junior nancial clerk to divide the cost of labour in the
Pumpworks division into its variable and xed components in order
to investigate whether labour costs could be saved. The clerk is
confused about this request, because as far as he knows, direct
labour costs in a factory are always variable.
REQUIRED Marks
(a) Analyse and discuss the budgeted income statement for April 2XX5 and the detailed costs of 30

Pumpworks, and:
(i) speci cally comment on the statement by the manager of Pumpworks that the division is
capable of returning to pro tability within the next ve months, and
(ii) suggest possible actions that could lead to pro tability for the division.
(b) Explain exhaustively whether the junior nancial clerk’s notion that ‘direct labour costs in a
5
factory are always variable’ is true.
TOTAL MARKS 35
Discussion
A suggested solution to the question can be found at the back of the
book. Once you have attempted the question and checked the
solution, you may nd the following discussion useful.
Requirement (a) has two parts. In part (i) you need to comment
on whether the Pumpworks division is capable of returning to
pro tability within the next ve months. Notice how the
requirement gives you very little guidance in its wording to show
you how to form an opinion. It leaves you to work through the large
amount of information in the question and to decide for yourself
how you would be able to make such a judgement. This is a good
example of a question where you have to be very con dent about the
contents of Chapter 5, Absorption versus variable costing. You have to
sense – without being told – that the way in which the budget has
been drawn up may not be a true representation of what is really
going on in the division. The fact that closing inventory has
increased over opening inventory, for example, makes the loss look
smaller than it actually is. To rectify this, we need to calculate how
much it costs to manufacture one pump. When we take this into
account, together with the xed costs of operating the business, we
can determine whether there is any chance of making a pro t under
the present circumstances. The manager believes that the division

can break even within ve months. To comment on his statement,
you need to use the information in the question to calculate the
break-even point (as illustrated in Chapter 4, Cost-volume-pro t
relationships). Knowing what the break-even point is will allow you
to comment on whether you think this is, in fact, a realistic target to
reach within the next few months.
Also notice that you need to use the high-low method (as
illustrated in Chapter 3, Cost estimation) to separate variable from
xed costs which were allocated by head of ce. Again, the question
does not speci cally mention the method – you have to realise that a
variable costing approach is required in order to arrive at an
appropriate answer, and this leads you to search for ways to
distinguish between variable and xed costs (the characteristics of
variable and xed costs were explained in Chapter 2, Cost
classi cation).
Part (ii) of requirement (a) asks you to suggest ways in which the
division could possibly return to pro tability. You will not be able to
give a sensible answer to part
(ii) if you have not answered part (i) rst – the answer to part (i)
leads you to come up with the suggestions required in part (ii). Once
you have performed the breakeven analysis in part (i), you should
realise that the formula used to calculate the break-even point is key
to understanding how its result could be changed. Remember that in
an advanced question, you have to apply your answer to the
scenario at hand. This means that as far as possible you should not
write generic statements such as ‘advertise more’, ‘cut costs’ or
‘manage the division better’. You can test the validity of what you
write by asking yourself whether it would have been applicable to
just about any company – if so, you are on the wrong track. Instead,
follow your calculations from part (i), use the information given in

the question and write an answer that speci cally helps the
Pumpworks division to return to pro tability based on its own unique
set of circumstances.
Part (b) requires you to think through the basic distinction
between variable and xed costs, as discussed in Chapter 2, Cost
classi cation. To score well, you should plan your answer before you
start writing so that you approach it in a systematic way. The
suggested solution may help you to make sure you have thought of
all the relevant aspects. Again, you should use the information in the
question as much as possible in your answer, together with the
knowledge that you gained from doing direct labour cost
calculations in part (a).
This may have been one of the rst times that you have
attempted an advanced question that was pitched at the highest
professional exam level. If you had some trouble with it, be sure to
work through the other three integration sections in this textbook as
soon as you have had a chance to revise the relevant chapters. Most
students who move from a basic to an advanced level of their
management accounting studies nd that they need to do two
things: (1) revise and make sure that there are no knowledge gaps
when it comes to the basic principles of each topic, and (2) pay
attention to exam technique. As you may expect, both of these take a
lot of time and practice, but are well worth the effort.

LEARNING OBJECTIVES
• accumulate and allocate overheads using volume-based, value-
based and activity-based techniques
• allocate support service department costs using the direct, step
down, repeated distribution and simultaneous equation
approaches
• understand the background of both the traditional approach to
overhead allocation and the activity-based costing (ABC) system
• identify the characteristics of an organisation where ABC will be
of most use
• show pro ciency in ABC and be able to calculate cost driver rates
and apply these in the costing of cost objects
• discuss the context of the various uses of ABC
• discuss the strengths and weaknesses of ABC.
The Gauteng Aids Programme and overhead allocation
The Gauteng province’s Department of Health and Social Development has an Aids
plan which sets out goals, strategic objectives, activities, service coverage targets
and budgets. It is known as the Gauteng Aids Programme.
In April 2010, the department launched an HIV counselling and testing campaign,
which included health screening. The campaign was originally conducted in all of

the province’s clinics and hospitals, and later expanded to hostels, public transport
hubs and shopping malls. In 2010, big events such as Worker’s Day, the FIFA World
Cup and Women’s Day were used as opportunities to encourage testing. HIV-
positive people were enrolled in the anti-retroviral component of the programme.
However, the department is simultaneously conducting a number of other
programmes and providing a wide range of services. It is, for example, very
concerned about the continuing prevalence of TB in the province.
SOURCES: GAUTENG PROVINCE DEPARTMENT OF HEALTH AND SOCIAL DEVELOPMENT (2011);
SOUTH AFRICAN GOVERNMENT (2010)
How will the province determine the cost of its Aids programme?
The costs that are directly traceable to the programme, such as the
cost of anti-retroviral drugs, can easily be identi ed. However, there
are a number of other costs that may not be directly traceable to the
programme. Clinics, for example, treat HIV, TB and numerous other
illnesses. What portion of the overhead costs of running each clinic
should be regarded as part of the cost of the Aids programme? This
chapter explains the allocation of overhead costs – those costs which
are not directly traceable to a cost object.
According to the province, the Gauteng Aids Programme’s
services were costed for 2009 to 2014 using activity-based costing.
Activity-based costing is a popular and sophisticated way of
allocating overheads to cost objects, and is also discussed in this
chapter.
6.1 Introduction
This chapter deals with the problem of how to allocate overheads to
a variety of cost objects, ranging from products and services to
departments and other business units.
Allocating overheads to products, services and other business
categories is a problem, because the relationship between the cost

object (product, service, and so on) and how the overhead cost is
incurred is not clear. As a result, there is no immediate or easy
answer to the questions ‘How much of the overhead cost should I
allocate to a particular product?’ or ‘On what basis should overheads
be divided between products?’
As already discussed in Chapter 2, Cost classi cation, for
management accounting purposes, a distinction is drawn between
direct costs and overhead (or ‘indirect’) costs. This distinction is
based on the ease of traceability of the cost to the cost objects to
which the costs relate – direct costs are by de nition easily traceable,
while overhead costs, on the other hand, are not traceable in an
economically feasible way. If an organisation wishes to attach these
costs to products or services, then that organisation must devise
some reasonable means of allocating these costs to the cost objects. In
practice, a vast number of cost allocation approaches exist, which are
usually customised to suit the purposes of the organisation by which
they are used. While a great deal of variety may exist between
systems, the basic considerations that should inform what kind of
costing system would be the most suitable to the organisation are the
same.
Before working through this chapter, it is important to
understand that there is no ‘one size ts all’ approach to cost
allocation. Accounting information is used by a variety of different
organisations, with diverse operations, product ranges and cost
structures. In addition, accounting information is used for different
purposes within an organisation, each with very different cost
information needs. An obvious example of different cost information
is the contrast between the requirements of the accounting standards
with regard to nancial reporting, and the information requirements
of management for internal purposes. Many readers of this text will

be familiar with the requirements of the accounting standards, more
speci cally IAS 2, with regard to overhead allocation, and should be
careful to note that these nancial reporting requirements are not
necessarily relevant or useful from a management accounting
perspective.
It is the objective of management to manage the organisation in
such a way that shareholder value is enhanced through the decisions
that are taken by management and by controlling the actions of the
organisation’s agents (employees). From a management accounting
perspective, cost information should be presented in whatever way,
and to whatever extent, is useful for the purpose of decision-making
and control. Keeping this principle in mind, the focus of this chapter
is to identify the basic techniques and principles on which overhead
cost allocation systems are usually built and highlight the core
objectives that these basic techniques and systems are designed to
meet.
While many different overhead allocation techniques exist, the
basic techniques can be divided into two parts: (1) volume- and
value-based techniques, and (2) activity-based overhead allocation
techniques.
Key terms: ‘traditional’ overhead allocation system, value-

based overhead allocation system, volume-based
overhead allocation system
A volume-based overhead allocation system refers to any method

of allocating overhead costs that is based on some measure related to
production or service volumes. A volume-based system is frequently

referred to in the management accounting literature as a ‘traditional’
overhead allocation system. The reason for this is that volume-
based allocation systems originated at a time where production
processes were simple and where very little complexity or variety
existed in the product range (think of Henry’s Ford’s famous
statement about his rst Ford cars: ‘You can have any colour you
want, as long as it’s black’ – there was not much variety in the Ford
product range at that time). As a result of the lack of variety in
production processes and product range, the organisation’s various
products tended to use resources very similarly. Adding up the
organisation’s total overheads and dividing this total overhead cost
by one measure of volume (such as the total number of units
produced, or the total number of labour hours worked, or other
similar measures) was the method used in order to calculate a at
rate that was then applied to all of the organisation’s products. This
made sense and was a reasonably accurate method.
Another ‘traditional’ overhead allocation basis is that of relative
sales values (a value-based overhead allocation system): overheads
are allocated in proportion to the selling prices of products.
There are two basic considerations that apply to a traditional
volume- or value-based overhead allocation system. The rst
consideration is the decision as to what volume or value measure
should be used (should the overhead cost be calculated and
allocated on the basis of units, or hours, or weight, and so on), and
the second is the level of detail that is required in order to achieve a
reasonably accurate allocation of costs.
Selecting an appropriate basis:

6.2.1
volume- and value-based measures

Volume-based measures
Where the products that the organisation produces, or services that
the organisation supplies, are largely homogeneous, using the
number of units of output as a volume measure may be appropriate.
In other words, in order to determine the overhead cost of producing
one unit of product, the organisation could simply take the total
overhead cost incurred for the year and divide this by the total
number of units produced during the year. This method would
result in every unit produced bearing exactly the same overhead
cost. This would be appropriate where all the units produced were
exactly the same, or at least very similar.
Example 6.1
DecoChair (Pty) Ltd manufactures a single product: a decorative hand-woven rope
chair. While the chairs are produced in two different colours (rope is purchased in
either neutral or purple), only one design of chair is currently made and consequently,
DecoChair believes that all chairs take the same amount of time to produce. The table
below shows certain revenue and cost information relating to the two colours of chair
that have the highest and lowest direct materials costs:
Neutral chair Purple chair

R R
Selling price per chair 890 1 000
Direct materials:
Rope (200) (320)
Frame (90) (90)
Labour hours per chair 2,5 hours 2,5 hours
Number of chairs produced per month 100 50

The total monthly cost of overheads (including labour) is R45 000.
Required:
Calculate the overhead cost per chair:
1 allocating overheads based on the number of chairs produced (an output measure)
2 allocating overheads based on the number of labour hours (an input measure).
In this situation, would it be more appropriate allocate overheads on

the basis of units of output, or labour hours?
To calculate the overhead cost per chair based on the number of

chairs produced, the total overhead cost is divided by the total
number of chairs produced:
To calculate the overhead cost per chair based on labour hours, the
total overhead cost for the month is rst divided by the total number
of labour hours worked for the month, in order to calculate a rate per
labour hour:
Overhead cost per chair:

Neutral chair R120/hour × 2,5 hours = R300 per chair
Purple chair R120/hour × 2,5 hours = R300 per chair

From a numerical perspective, it does not matter whether overheads
are based on output (units produced) or input (labour hours
worked), as the overhead cost per chair is the same. This is because
the labour hours required to produce a chair is same for all chairs
regardless of the colour of rope used. As a result, the amount of
overhead allocated to each colour of chair is the same.
In this instance, allocating overheads on the basis of input is
more time consuming, and does not produce a more accurate
overhead cost than the allocation based simply on units produced.
Using the simpler, more time-ef cient method of units produced is
perfectly appropriate in this situation where the product range is
homogenous in terms of its consumption of resources.
However, where the units differ in terms of how they are
produced, an input measure such as labour hours or machine hours
may be a more accurate measure of the overheads consumed by the
various products. If one product takes more time and resources to
produce than another, then allocating overheads in accordance with
a measure that re ects the higher resource utilisation (such as the
number of labour hours used by the product) is preferable to
allocating the same amount of overheads to each product unit. The
total overhead cost incurred during the year is divided by the total
number of labour hours worked during the year, in order to
determine the overhead cost per labour hour. Then, to establish the
overhead cost of a particular product, the number of hours required
to make that product are multiplied by the overhead cost per hour.
Example 6.2
Consider the information presented in example 6.1. Suppose that the purple chairs
produced be DecoChair do in fact take longer to weave, as the rope is thinner,
requiring more weaves per chair and more joins, and it is also more dif cult to work

with, requiring weavers to work more slowly. As a result, it takes 4 hours to produce a
purple chair, not 2,5 hours like the neutral chair, as originally thought.
Required:
1 Calculate the overhead cost per chair based on labour hours, given this new
information.
2 Compare this overhead cost to the overhead cost per chair based on the number
of chairs produced calculated in example 6.1.
In order to calculate the overhead cost per chair based on labour

hours, the total overhead cost for the month is rst divided by the
total number of labour hours worked for the month in order to
calculate a rate per labour hour:
Overhead cost per chair:

Neutral R100/hour × 2,5 hours = R250 per chair
Purple R100/hour x 4 hours = R400 per chair
If overheads are allocated on the basis of number of units produced,

each chair is allocated R300 of overheads. If overheads are allocated
on the basis of labour hours used to produce a chair, the neutral
chair is allocated a lower amount of the over-head cost per chair
(R250) as it uses proportionately less labour time, while the purple
chair is allocated a higher amount (R400) of overheads per chair, as a
result of using a greater number of labour hours.
Which overhead allocation is more accurate? As the purple chairs
use more labour hours, they would certainly cause the organisation
to incur a higher labour cost than the neutral chair, and as the cost of

labour is included in the total overhead cost, it would certainly be
more accurate for a higher proportion of the labour cost to be
allocated per chair.
However, the cost of labour is only one cost bundled together in
total overheads. Are all other overheads equally affected by working
a higher number of labour hours? Costs such as consumables,
utilities and depreciation may well be more closely related to the
number of chairs produced than the amount of labour hours worked
on a chair.
Value-based measures
Overheads are sometimes assigned to products or services on the
basis of sales value (selling price). This re ects the belief that a
product with a higher sales value has been more costly to produce.
In other words, the assumption is that the relative sales value of
products is representative of their relative cost of production. Where
this assumption is false, value-based measures lead to the
accounting cost of the item being different from its real cost, and
therefore to potentially incorrect decision-making.
Notice that the above three methods of overhead allocation do
not actually measure the amount of overhead used to produce each
type of product or service. They would be suitable in organisations
where products or services are largely homogeneous. However,
many organisations produce diverse products or services. There is
also an increased trend towards customisation, giving customers
more options from which to choose. The production of products and
carrying out of services are therefore often so complex in modern
organisations that the use of volume- or value-related measures may
not provide a good approximation of cost. This has given rise to the
development of costing systems that are designed to measure the

resource usage of products or services, in order to measure more
accurately the overhead cost attributable to each (activity-based
costing, discussed in section 6.5). These kinds of costing systems are
more complex and costly to operate. It is the responsibility of
management to understand the resource demands of the various
products or services that their organisation produces, and to select a
cost allocation basis that adequately re ects the overhead cost
associated with their respective demand for common resources.
6.2.2 Level of detail and accuracy

It is also important that management is able to apply judgement
regarding the level of accuracy of the cost allocation system, given
the set of circumstances that the business faces. Where different
products or services consume overheads similarly, where overheads
do not constitute a signi cant portion of the organisation’s cost
structure, or where competition is not particularly intense, it may be
adequate to operate a moderately accurate overhead allocation
system.
Example 6.3
SA Paints manufactures a wide variety of paints. The managing director, Paul, has
been comparing their pro t margins. He wants to instruct sales staff to try to sell more
of the paints with higher pro t margins. If a particular line of paint is making a loss, he
intends to stop manufacturing that paint altogether.
The cost of materials (which are added according to a paint ‘recipe’) can easily be
traced to each type of paint. A transport company charges a set rate per drum of paint
transported to SA Paints’ customers for every kilometre travelled, so transport costs
are also easily traced to each type of paint.
All other manufacturing costs, including labour, are dif cult to trace directly to the
paints manufactured. Labourers do not work directly on the paint itself, but instead
spend their time on tasks such as setting up machinery, loading materials into the

mixing pots, washing out the mixing pots, opening and closing seals, removing
nozzles, and similar tasks. Labour is therefore not directly related to the number of
litres of each type of paint produced. Labour is also not directly related to the time it
takes to manufacture each type of paint. Some paints take longer than others to mix
because the materials take longer to combine and settle.
Each type of paint is manufactured in the same batch size each time, but the batch
size is different for each type of paint. Because there is limited warehouse space, less
popular paints are produced in smaller batches. Paints that are in high demand are
manufactured in large batches.
Below are the costs for two of the paints: Red Marine and Green Exterior. Both
paints are sold in 20-litre drums. Red Marine is produced in smaller batches than
Green Exterior, which is more popular.
During the 2XX8 nancial year, 3 120 000 litres of paint were produced.
Income statement for SA Paints for the 2XX8 nancial year

R
Pro t after direct costs and manufacturing overheads 48 792 000
Non-manufacturing overheads 34 752 000 25%*
Pro t 14 040 000
*Percentage of total costs of R141 960 000
Required:
Calculate the pro t after direct costs and manufacturing overheads per drum of Red
Marine paint and per drum of Green Exterior paint, allocating the manufacturing
overheads on each of the following two bases in turn:
1 Volume (total number of litres produced)
2 Sales revenue
To allocate overheads on the basis of volume, overheads per litre of

paint have to be calculated. The total manufacturing overheads for

the year were R70 080 000, and 3 120 000 litres were produced.
Manufacturing overheads per litre produced amount to R22,46. For a
drum containing 20 litres of paint, R22,46 × 20 litres = R449,20 is
allocated. The cost of a drum of each type of paint can be
To allocate overheads on the basis of sales revenue, overheads per

rand of sales has to be calculated. Total manufacturing overheads of
R70 080 000 are divided by sales revenue of R156 000 000.
Manufacturing overheads per rand of sales revenue are R0,45. For a
drum of Red Marine paint, R1 150 (sales value) × R0,45 = R517,50 is
allocated. For a drum of Green Exterior paint, R980 (sales value) ×
R0,45 = R441 is allocated. The cost of a drum of each type of paint
can be summarised as follows:

If the rst allocation basis – that of litres – is used, the managing
director gets the impression that Red Marine paint earns a healthy
33,9% pro t per drum, while Green Exterior paint earns 26,4%. Just
by changing the overhead allocation basis to sales revenue, the
picture changes. Now it seems that Red Marine paint earns 28%
pro t, while Green Exterior paint earns 27,2%. Changing the
overhead allocation basis can have a signi cant impact on the
calculated product costs and the way products lines are regarded,
especially in an organisation such as SA Paints, where a large
portion of total costs (49%) consists of manufacturing overheads.
It is important to understand that SA Paints’ overall pro t is not

affected by the method of overhead allocation that is used. It is
only the allocation of overheads to the different types of paint
(and therefore their relative pro tability) that is affected.
However, costs may be saved in future periods (or pro ts may
be improved as a result of better pricing of the paints) if

management take better decisions based on a change in the
overhead allocation base.
Example 6.4
The same information applies as in example 6.3.
Required:
1 Critically discuss the usefulness of allocating non-manufacturing overheads to
products.
2 Calculate the pro t per drum of Red Marine paint and per drum of Green Exterior
paint when overheads (manufacturing and non-manufacturing overheads) are
allocated on each of the following two bases in turn:
• Volume (total number of litres produced)
• Sales revenue
The rst requirement of this example asks us to discuss whether

non-manufacturing overheads could be allocated to products. From
an organisational perspective, in order to earn a pro t, a product
needs to earn suf cient revenue to cover not only the costs of
manufacturing the product but also storing, marketing and selling it.
However, while the relationship between the manufacturing
overheads and individual units of product is not easy to trace, the
relationship between the non-manufacturing overheads that the
organisation incurs, and the individual units of product that are
produced, is even more dif cult to establish.
For the purposes of nancial accounting, only manufacturing
overhead is allocated to products. Non-manufacturing overhead is
expensed as a period cost in the income statement, as required by
IAS 2. For management accounting purposes, however, management
needs determine what allocation will yield the best management
information.

In our SA Paints example, Paul needs to determine the relative
pro tability of the products that the organisation produces. Paul
needs a per-product-unit pro t gure that is reliable in the sense that
it represents the nancial impact on the organisation of selling one
additional drum of each type of paint, or selling one less drum of
each type. The costs that are allocated must be relevant to the
decision he will be making (refer to section 2.4 in Chapter 2, Cost
classi cation and Chapter 10, Relevant information for decision-
making).
The distinction between manufacturing and non-manufacturing
overheads is not important from a decision-making perspective, and
non-manufacturing costs may therefore be allocated if relevant.
The costs that Paul should not allocate to products are those that
are not affected by the decision he faces, for example audit fees.
The second requirement of this example asks that we again
allocate overheads on the basis of volume and sales value in turn, as
we did in example 6.1.
In the case of SA Paints, ‘non-manufacturing overheads’ consists
of indirect costs that are incurred outside the manufacturing process.
Total manufacturing overheads (R70 080 000) plus non-
manufacturing overheads (R34 752 000) amounts to R104 832 800.
When divided by the total number of litres produced (3 120 000), the
result is total overheads of R33,60 per litre of paint. For 20 litres,
R33,60 × 20 litres = R672 in overheads is therefore allocated. The cost
of a 20-litre drum of each type of paint can be summarised as
follows:

To allocate total overheads on the basis of sales revenue, overheads
per rand of sales has to be calculated. Total overheads of R104 832
000 is divided by sales revenue of R156 000 000. Total overheads per
rand of sales revenue is R0,67. For a 20-litre drum of Red Marine
paint, R1 150 (sales value) × R0,67 = R770,50 is allocated. For a 20-
litre drum of Green Exterior paint, R980 (sales value) × R0,67 =
R656,60 is allocated. The cost of a 20-litre drum of each type of paint

On the rst allocation basis in example 6.3, we allocate the same
amount of overheads to each drum of paint. What this volume-based
allocation implies is that every 20-litre drum of paint costs the same
amount in overheads to produce and sell. However, some paints
may use more labour time, more factory time and more warehousing
space than others.
When sales revenue is used as the allocation basis, example 6.3
shows that more overheads are allocated to each drum of red paint
than to each drum of green paint because red paint has the higher
selling price. The underlying assumption is that a higher selling
price re ects a larger amount of resources consumed. This is not
necessarily true – the selling price is often a result of market forces
rather than product cost.
Section 6.2.1 dealt with selecting an appropriate allocation basis.
You may wonder whether SA Paints would arrive at a more
equitable allocation of overhead if it based its allocation on the

number of labour hours used in the manufacture of each type of
paint.
The number of labour hours is one of the resources used to make
and sell each product. By allocating overheads based on the number
of labour hours put into the production of the product, the
overheads would be allocated in accordance with how the product
uses some of the organisation’s resources to which the overheads
relate. However, in this scenario, although red paint takes longer to
manufacture and therefore takes up more factory time, it does not
take up any more labour time than green paint. Furthermore, labour
does not work directly on the paint. Most of the tasks that labour
carries out are at a higher level and are more general tasks that apply
to either a batch, or to the factory as a whole. In the SA Paints
example, labour itself is an indirect cost that must be allocated to the
different paints. Therefore, in this example, using the number of
labour hours as the basis on which overheads are allocated is
unlikely to be any more accurate in allocating the overheads to the
various types of paint in proportion to the actual resources the
product uses.
Example 6.5
Consider the same information as in example 6.3.
Required:
Discuss the different perspectives with which SA Paints’ auditors and its management
team may regard the choice of overhead allocation base.
IAS 2 is the accounting standard that speci es what costs are to be

included in inventory and the statement also dictates the exclusion
of certain costs from inventory. Paragraphs 12 and 13 of IAS 2 deal

with the allocation of overheads to inventory. There are three key
points that should be noted:
1 The purpose of IAS 2 is to specify what costs may be included in
the inventory gure which is reported in the organisation’s
annual nancial statements. It is a nancial accounting statement
with no bearing on management accounting, which is governed
by management’s information needs.
2 The statement allows only manufacturing costs to be included in
inventory. Non-manufacturing costs such as selling and
administrative costs are not to be included in the inventory value
reported on the statement of nancial position.
3 The statement requires costs to be allocated on a reasonable basis
that re ects normal production volumes.
For statutory nancial reporting purposes, the organisation’s

auditors would therefore be satis ed with any approach that
allocates the manufacturing overheads at normal production
volumes. Whether or not the amount of overheads allocated to a
product re ects the amount of resources that are used to make that
product is not an issue. Furthermore, the statement requires all
manufacturing overheads to be allocated. The relevance of those
costs to decision-making is not a consideration.
However, for management accounting purposes, the cost
allocation in our SA Paints example is going to be used as a basis for
a decision that will be aimed at increasing the organisation’s pro t.
Note the difference here between the nancial accounting objective
and the management accounting objective. The nancial accounting
objective is to calculate the cost at which the inventory will be
re ected on the nancial statements, before it is sold. The
management accounting objective is to calculate the amount by
which that product contributes to pro t when the product is sold.

These are two different objectives – for nancial accounting
purposes, we would be trying to determine the costs incurred to
manufacture the paint, and only the manufacturing cost should be
considered. However, for decision-making purposes, Paul is trying
to determine the ideal product mix by investigating how much each
product contributes to pro t. Therefore, as previously stated, all
costs that are relevant to this decision ought to be taken into account.
Example 6.6
Consider the same information as in example 6.3.
Required:
Discuss the factors mentioned in the SA Paints example which indicate that a simple
volume-or value-based overhead allocation method may not provide information that
is reliable for the purposes of Paul’s decision.
The following factors must be taken into consideration:

• SA Paints’ products do not all follow exactly the same production
process and as a result, they use resources differently. The paint is
produced in batches and a bigger batch is cheaper to produce per
litre than a small batch (because activities such as set-ups and
cleaning take place per batch). In many modern organisations,
product ranges are diverse, increasing the need for accurate
overhead allocation.
• Indirect costs (overheads) comprise a high percentage of total costs. In
fact, only 26% of SA Paints’ total costs are direct costs. Accurate
allocation of overheads is very important in a situation where
overheads are so signi cant. In many modern organisations, due
to increased mechanisation, overhead costs are making up a
larger and larger percentage of total costs, increasing the need for
accurate overhead allocation.

• SA Paints’ pro t margins are slim (pro t before tax is only 9% of
revenue). Slim pro t margins mean that only a slim margin of
error exists. A slight overallocation of costs may result in
pro table products seeming to be loss-making. Conversely, loss-
making products may actually show a small pro t, if costs are
under-allocated by a small amount. As a result of globalisation,
many organisations face erce competition and small pro t
margins, increasing the need for accurate overhead allocation.
As with any management decision, the costs (in terms of tangible

and intangible resources) of implementing a more sophisticated
system should be weighed against the expected bene ts of such a
system. For an organisation such as SA Paints, it may be bene cial to
re ne the costing system further by allocating overheads in a more
sophisticated manner. The implementation of an activity-based
costing system (ABC system) is an ideal way of addressing SA
Paints’ overhead allocation problems. This is discussed in section 6.5.
Plant-wide rate versus departmental rate

Key terms: departmental rate, plant-wide rate
The level of detail with which overhead costs are allocated to

products can vary considerably. Overheads may be aggregated and
allocated to products on one common basis, or costs may be
aggregated and allocated at a departmental level. In other words, an
organisation can decide either to determine a single overhead rate
for the organisation in its entirety, commonly referred to as a plant-
wide rate, or to have a departmental rate determined for each
department.

A single plant-wide rate is determined by accumulating the total
overheads incurred across the organisation and dividing that by the
allocation base that has been determined as the most suitable. As the
use of a single average rate is applied to all products, the costs of
each department are charged uniformly to all products. This
approach ignores the fact that certain products may use more of the
resources of the different departments. This may even result in costs
of certain departments being allocated to a product where that
product does not use the resources of the department at all.
Where an organisation requires a more accurate cost allocation
system, it would be preferable to calculate a rate per department,
instead of a plant-wide rate.
Table 6.1 Comparison between plant-wide and departmental rate overhead allocation
rates
Departmental overhead allocation rate and cost

Plant-wide overhead allocation rate
centre overhead rate*
A single overhead rate is calculated for the
Multiple overhead rates are calculated
organisation as a whole
A different allocation base can be used for different

One allocation base is used departments (labour hours, machine hours, number of
employees, oor space, and so on)
Overheads are assigned to products based on Overheads are assigned to products based on the
the total use of a single resource (allocation amount of resources used by the product in each
base) throughout the organisation department
Result: Overheads are averaged out between Result: Overheads are averaged out, but less
products extensively than if a plant-wide rate had been used
*Cost centre overhead rate is the same in concept as the departmental overhead rate, except that rates are
calculated per cost centre, instead of per department. A cost centre may often be a sub-unit of a department.

Example 6.7 illustrates the difference between the use of a single
plant-wide rate and the use of departmental rates to allocate
overheads to products.
Example 6.7
SA Paints has divided its production process into three departments, each of which is
responsible for one of the three steps required in producing a drum of paint. The rst
operating department, the colour-coding department, is used only where customers
require a speci c colour of paint that is not one of the standard colours. The mixing
department is responsible for mixing the ingredients. The lling department is
responsible for receiving the paint from the mixing department, lling the paint drums,
printing and attaching the appropriate stickers, and packaging the drums on pallets for
delivery.
For purposes of this example, assume that manufacturing overheads are allocated
based on the number of direct labour hours.
The following information is supplied:
Required:
Determine the manufacturing overhead cost to be assigned to one drum of Red
Marine paint if:
• a plant-wide overhead allocation rate is used
• departmental overhead allocation rates are used.

The overhead allocation rates were arrived at by dividing the
relevant manufacturing overhead gure by the number of labour
hours given. Using the plant-wide overhead allocation rate of
R159,27, we can calculate that each drum of Red Marine paint will
receive R159,27 × 3 labour hours = R477,81 in manufacturing
overheads.
If departmental overhead allocation rates are employed instead
of one plant-wide rate, a drum of Red Marine paint will receive
overheads as follows:
Notice that the manufacturing overhead cost per drum has changed
from R477,81 to R450,43. Why has the cost diminished? The R447,81
was calculated by including the manufacturing overhead costs of all
departments, including those incurred in the colour-coding
department. However, as Red Marine paint is a standard paint, the
colour-coding department is not used to produce it and its
manufacturing overheads should not have been included in the cost
of the Red Marine paint. The plant-wide rate makes the basic
assumption that the proportion of its total production time that each
product spends in each department is the same across all products.
This is clearly not the case where there is a difference in the
production process of the various products, as in this example.

Allocation of support service
6.3
department costs
Key terms: production departments, support service

departments
In example 6.7, all three departments are production departments –

they are directly involved in producing paint. Support service
departments, on the other hand, have no direct input into products,
but instead support or ‘service’ the departments that do have direct
input into products. Typical examples of support service
departments are information technology and administration
departments.
Support service departments’ costs are allocated to the
production departments before the departmental overhead
allocation rate is calculated. The departmental overhead allocation
rate of production departments is then applied to products, as
already illustrated in example 6.7. The allocation of support service
department costs can be performed in a number of ways. These are
described below and then illustrated in example 6.8.
6.3.1 Direct approach

The direct approach requires management to allocate the support
service departments’ costs directly to production departments. This
is often done in proportion to how the production departments
make use of the resources of the support service departments.
Organisations can also use other bases such as revenue. This
approach ignores the fact that the support service departments may
also be using each other’s services. In reality, support service

departments may very well use each other’s services. For example,
in an organisation with an administration department and an
information technology department, both of these departments are
likely to use the services of the other. The direct approach may
sometimes be preferred because of its simplicity. However, if support
service departments consume a signi cant amount of each other’s
resources, the results will be less accurate than with other
approaches.
Employing the direct approach (see Table 6.2)

Under the direct approach, the costs of both support service
departments are allocated to production departments only. The
fact that the two departments also supply services to each
other is ignored.
Step-down approach (specified order

6.3.2
of closing)
Here the fact that support service departments may use each other’s
services is taken into consideration to some extent. Support service
departments are ranked in order of total costs and the costs of the
highest-ranking departments are allocated to production and other
support service departments rst and then ‘closed off’ (in other
words, these departments are no longer available to receive any
further costs). The process is repeated for each ranked department,
but costs accumulated in lower-ranked support service departments
are not allocated to the higher-ranked support service departments
that have already been closed off. A disadvantage of this technique

is that if lower-ranked departments use the higher-ranked
departments’ services, this fact is ignored.
Employing the step-down approach (see Table 6.3)

To employ the step-down approach, the two support service
departments rst have to be ranked based on the total costs
recorded in the departments. The administration department
(R20 851 200) is ranked rst and the IT department (R13 900
800) second. The costs of the administration department are
therefore allocated rst, the department is ‘closed off’ to prevent
it from receiving any further costs (from the IT department), and
the new higher total IT costs are then allocated to the
production departments only.
6.3.3 Repeated distribution approach

The repeated distribution approach is an expanded version of the
step-down approach. Here, the fact that support service departments
use each other’s services is taken fully into account. The support
service departments’ costs are allocated to production departments
and other support service departments, again starting with the
support service department with the highest ranking, based on total
cost.
There is no ‘closing off’, and support service departments can
continue to receive costs from lower-ranked departments. This
process is repeated for each support service department until the
costs remaining in the support service departments are considered
insigni cant. This approach is more complicated and laborious, but

renders the most accurate information of the three approaches
discussed so far.
Employing the repeated distribution approach (see Table 6.4)

Each support service department receives a portion of the costs
of the other department. As under the previous approach, the
departments are ranked and costs of the highest-ranking
department (administration) are allocated rst, followed by those
of the second-ranked department. Theoretically, the allocation
steps can be repeated in nitely, but in practice the process is
stopped when the remaining unallocated costs are deemed to
be immaterial. In Table 6.4, after four rounds of allocating
administration costs and three rounds of allocating IT costs, the
remaining amounts were no longer considered material.
6.3.4 Simultaneous equation approach

The simultaneous equation approach is based on the same principles
as the repeated distribution approach. However, the problem is
solved mathematically instead of through repetition. This approach
requires total overheads for each support service department,
including the costs of using other service departments, to be
formulated as an equation. One equation is formulated per support
service department. The unknown variables are then calculated by
considering the equations simultaneously. Overheads are allocated
to the production and service departments according to the
equations. Unlike under the previous approach, the allocation is
carried out only once. Although there are mathematical ways to
solve many equations, if there are more than two support service

departments, this becomes a rather complicated process and it is best
done using computer software.
Employing the simultaneous equation approach (see Table 6.5)

The rst step is to present the costs of the support service
departments as equations and to solve for the unknown
variables:
Let x = total overhead costs of the IT service department
Let y = total overhead costs of the administration service
department
Then: x = R13 900 800 + 0,25y (1)
y = R20 851 200 + 0,20x (2)
Therefore x – 0,25y = R13 900 800 (3)
–0,20x + y = R20 851 200 (4)
(3) × (4) 4x – y = R55 603 200 (5)
(4) + (5) 3,8x = R76 454 400
x = R20 119 578,95
Example 6.8
The functions that give rise to SA Paint’s R34 752 000 non-manufacturing overheads
are carried out in two departments: information technology (IT) and administration. The
IT department maintains the computer systems used by the three production

departments and by the administration department. The administration department is
responsible for salary calculations, processing of invoices and other administrative
procedures for all three production departments as well as the IT department. Of the
total non-manufacturing overheads of R34 752 000, 40% (R13 900 800) relate to the
running of the IT department and the remaining 60% (R20 851 200) are incurred in the
administration department.
Non-manufacturing overheads are allocated based on direct labour hours.
The following breakdown of departmental cost and resource information is
supplied:
Required:
Determine the overhead cost to be assigned to one drum of Red Marine paint under
each of the following allocation approaches:
1 Support service department costs are allocated to production departments directly.
2 Support service department costs are allocated to production departments on a
step-down basis.
3 Support service department costs are allocated to production departments on a
repeated distribution basis.
4 Support service department costs are allocated to production departments using
simultaneous equations.
Tables 6.2 to 6.5 show the four approaches in turn.

Table 6.2 Employing the direct approach
Table 6.3 Employing the step-down approach

Table 6.4 Employing the repeated distribution approach

Table 6.5 Employing the simultaneous equation approach
Key terms: activity-based costing, cost drivers, cost pool
Activity-based costing (ABC) is a sophisticated form of overhead

allocation. Overhead costs are assigned to cost objects based on the
activities that drive those costs.

The activities that cause the overhead costs to be incurred are
called cost drivers. Examples of cost drivers are the number of
orders received or the number of batches manufactured. Different
costs that have the same cost driver are grouped together in what is
known as a cost pool. The costs in each cost pool are then assigned
to a cost object according to how much it makes use of the relevant
cost driver.
6.4.1 Steps in ABC
Step 1: Identify activities and group them into cost

pools
Cooper (1990) developed a cost hierarchy that is helpful in guiding
organisations on how to group activities. Activities are organised in
four levels:
1 Unit-level activities: These are performed each time a product is
produced or a service is performed. These activities are also
known as volume-related activities.
2 Batch-level activities: These are performed each time a batch is
handled or produced. An example is setting up the machine for
each batch. Costs related to such activities are incurred in
proportion to the number of batches handled. These costs behave
as stepped xed costs (refer to Chapter 2, Cost classi cation).
3 Product-level activities: These activities relate to product or service
lines and are incurred regardless of how many units are
produced or how many batches are handled. The costs relating to
these activities are incurred to maintain individual products and
product ranges, from designing the product to marketing.

4 Facility-sustaining activities: These activities are incurred to
maintain the organisation in general. In the short term, they are
performed regardless of the number of units or batches produced
and regardless of the number of different products produced. It is
often dif cult to identify a cost driver that represents the cause-
and-effect relationship between the activity and the costs
incurred, or none may exist. Consequently these costs would be
irrelevant to decisions relating to sales and production volumes,
as they would be unchanged by them. For this reason, facility
sustaining costs are usually not allocated to products for
management decision-making and control purposes.
Example 6.9
Consider again the example of SA Paints, which manufactures different paints. Raw
materials such as pigment, a pigment vehicle, binder, solvents and additives are mixed
in quantities ranging from 1 000 litres to 20 000 litres. Each time a batch of paint is
produced, the machines have to be set up and cleaned. The paint is then canned and
distributed.
The following activities are carried out by SA Paints:
• Researching new shades of paint
• Cleaning of machines
• Setting up of machines
• Handling of raw materials and paint
• Mixing (by machine)
• Marketing of different paint types
• Marketing of SA Paints’ products in general
• Rent and general plant-related expenses
Required:
Classify each of the activities according to Cooper’s cost hierarchy, using a short-term
planning horizon of one month.

Based on the information available to us, the following would be a
reasonable classi cation:
Activity Level
Researching new shades of paint Product-level activity
Cleaning of machines Batch-level activity
Setting up of machines Batch-level activity
Handling of raw materials and paint Unit-level activity
Mixing (by machine) Unit-level activity
Marketing of different paint types Product-level activity
Marketing of SA Paints’ products in general Facility sustaining activity
Rent and general plant-related expenses Facility sustaining activity
Notice that SA Paints has identi ed eight activities in its operations

and these activities are now each regarded as a cost pool. The
number of cost pools could be changed, however, according to
preference. SA Paints could further re ne its costing system by, for
example, splitting up the ‘marketing of different paint types’ cost
pool between a ‘market research’ cost pool and a ‘promotion’ cost
pool (if it is possible and practical to record such costs separately).
Alternatively, it could simplify its costing system by, say, grouping
the ‘cleaning of machines’ cost pool and the ‘machine set-up’ cost
pool together into a ‘cleaning and set-up of machines’ cost pool (if it
is satis ed that it would be reasonable to apply the same cost driver
to both).
The decision as to how many cost pools there should be is one
that should be taken on a cost–bene t basis. In general, costs that are
incurred at different levels of Cooper’s cost hierarchy would not be

grouped together into the same cost pool, as they would have very
different cost drivers.
Step 2: Identify cost drivers

A cost driver is identi ed for each cost pool. It is important for the
cost driver to represent a cause-and-effect relationship between the
activities in a cost pool and the cost incurred. There are three
categories of cost drivers:
1 Transaction driver: This is the most common type of cost driver
and is based on the assumption that overhead costs are driven by
the number of times an activity is performed. For example, if
machine set-up costs in example 6.9 were found to increase in
relation to the number of set-ups, this is a transaction driver and
the cost driver would be identi ed as ‘number of set-ups’.
2 Duration driver: These cost drivers are used where the level of
costs incurred is affected (driven) by the length of time that it
takes to perform an activity. For example, it may take longer to
research a new shade of one kind of paint than of another kind of
paint. In such a case, the cost driver of the ‘researching new
shades of paint’ cost pool would be a duration driver, and could
be described as ‘research hours’ or ‘research time’.
3 Intensity driver: This type of cost driver recognises that certain
types of products may use resources more intensely than others.
For example, some of SA Paints’ products have proved to be
more dif cult to market than others – SA Paints’ marketers call
them ‘complex’ and ‘simple’ products. To market ‘complex’
products successfully takes three times more effort (for example,
SA Paints sends an expert marketer to the customer). Products
classi ed as ‘complex’ ought to carry three times the marketing
costs of those classi ed as ‘simple’. The ‘marketing of different

paint types’ cost pool has an intensity cost driver, which can be
called ‘marketing classi cation’.
Step 3: Calculate activity rates

Key term: practical capacity
The activity rate is expressed as, for example, R5 per order (where
the number of orders is the cost driver) or R10 per machine set-up
(where machine set-ups are the cost driver). This rate is calculated by
dividing the total cost per activity cost pool by the organisation’s
capacity for that cost driver (in this case, its capacity for orders or
machine set-ups for the period).
Under traditional volume- or value-based overhead allocation
systems, this rate is calculated using budgeted overhead costs and a
budgeted level of capacity. This can result in the cost of idle capacity
being allocated to products or services. It also causes product cost
instability: if the budgeted level of activity changes, so will the
predetermined overhead rate and consequently, the product cost
uctuates. ABC, however, uses practical capacity to calculate
activity rates. Practical capacity is not a theoretical capacity and
allows for normal downtime. It is also not necessarily the same as
‘normal capacity’ prescribed by IAS2 for nancial reporting
purposes, which is the average capacity over a number of periods
(see Chapter 5, Absorption versus variable costing). ABC allocates
overheads to products or services only to the extent that the product
or service consumes resources. The remaining unallocated overheads
represent the cost of idle capacity, and this cost is then treated as a
period cost and expensed as part of cost of sales. The cost of idle
capacity is important when making long-term decisions, as this cost
can be eliminated by reducing capacity.

Step 4: Assign costs to cost objects
The amount of overheads that is allocated to the cost object depends
on how much use the cost object makes of the activity. Overheads are
assigned by multiplying the activity rate by the number of activity
measures for that speci c cost object.
Example 6.10 is used to illustrate two principles:
1 The calculations necessary for ABC
2 The differences and similarities between the traditional system
and ABC
It also considers the appropriateness of allocating certain xed costs

to product units.
Example 6.10
We continue the example of SA Paints, still assuming that SA Paints manufactures
only two types of paint, Red Marine and Green Exterior. 39 000 drums of Red Marine
and 117 000 drums of Green Exterior paint are normally produced and sold each year.
Information regarding their manufacture is as follows:
Red Marine Green Exterior

Labour hours per drum 3,0 2,0
Machine hours per drum 2,0 1,0
Batch size (number of drums) 250 1 000
SA Paints has had time to consider the activities in example 6.9 above and has
chosen to group them into nal cost pools as follows:
Cost pool name Cost driver

Researching new shades of paint Research time
Cleaning and set-up of machines Number of machine set-ups

Handling of raw materials and paint Labour hours
Mixing (by machine) Machine hours
Marketing of different paint types Marketing classi cation
Marketing of SA Paints’ products in general –
Rent and general plant-related expenses –
The overheads for the 2XX8 nancial year can be presented as follows, grouped
according to activities:
Manufacturing overheads are currently allocated based on the number of labour hours
at normal production levels. The organisation has a total practical capacity of 360 000
labour hours.
Below is a summary of the capacity of other cost drivers:
Cost driver Practical capacity

Research time 500 hours
Number of machine set-ups 300 set-ups
Machine hours 240 000 hours

Research related to new shades of Red Marine paint (such as the ‘Scarlet’ and
‘Tomato’ shades) takes only half of the time that it takes to research new shades of
Green Exterior paint (where customers are more concerned about using the right
shade). Only 450 hours are normally spent on such research each year.
Marketing staff classify Red Marine paint as a ‘complex’ product to sell, while
Green Exterior paint is regarded as ‘simple’. Complex products incur three times the
marketing costs of simple products. At present there is no unused marketing capacity.
Required:
Calculate the overhead costs that would be allocated per unit and in total for each
product line, under the traditional system and under ABC at the normal production
level.
The traditional allocation would be done as follows:
Workings:
Number of labour hours based on normal production levels:
(39 000 drums × 3 hours) + (117 000 drums × 2 hours) = 351 000
hours
Overhead rate per labour hour: R70 080 000/351 000 hours =
R199,6581 per hour
Per unit cost: Red Marine Green Exterior

Rate per hour 199,66 199,66
× Labour hours per unit 3 2
= Cost per unit 598,98 399,32
Manufacturing overheads for Red Marine paint:

R598,98 per unit × 39 000 drums = R23 360 220 (or R23 360 000 if
the rate per hour is not rounded)
Manufacturing overheads for Green Exterior paint:

R399,32 per unit × 117 000 drums = R46 720 440 (or R46 720 000 if
the rate per hour is not rounded)
In contrast, an activity-based approach would result in the following

product costs:

Workings:
Number of machine set-ups:
You can assume machines are set up each time before a new
batch is produced. Therefore:
Cleaning and set-up of machines: R7 800 000/300 batches = R26 000

per batch
• Red Marine paint: 39 000 drums/250 drums per batch = 156
batches 156 batches × R26 000 per batch = R4 056 000
• Green Exterior paint: 117 000 drums/1 000 drums per batch = 117
batches 117 batches × R26 000 per batch = R3 042 000
• Unused capacity: 27 batches (300 – 156 – 117) × R26 000 = R702
000
Handling of raw materials and paint: R5 400 000/360 000 hours =

R15 per hour
• Red Marine paint: 39 000 drums × 3 hours per drum × R15 per
hour
= R1 755 000
• Green Exterior paint: 117 000 drums × 2 hours per drum × R15
per hour
= R3 510 000
• Unused capacity: 9 000 hours [360 000 hours – (39 000 drums × 3
hours) –
(117 000 drums × 2 hours)] × R15 per hour = R135 000
Mixing (by machine): R12 960 000/240 000 hours = R54

• Red Marine paint: 39 000 drums × 2 hours per drum × R54 per
hour
= R4 212 000

• Green Exterior paint: 117 000 drums × 1 hour per drum × R54 per
hour
= R6 318 000
• Unused capacity: 45 000 hours [240 000 hours – (39 000 drums × 2
hours)
– (117 000 drums × 1 hour)] × R54 per hour = R2 430 000
Researching new shades of paint: R1 755 000/500 hours = R3 510 per

hour
Of the 450 hours normally spent on research, 450 hours/3 = 150
hours are spent on Red Marine paint and 150 hours × 2 = 300 hours
on Green Exterior paint.
• Red Marine paint: R3 510 per hour × 150 hours = R526 500
• Green Exterior paint: R3 510 × 300 hours = R1 053 000
• Unused capacity: 50 hours (500 hours – 450 hours) × R3 510 =
R175 500
Marketing of different paint types: R16 000 000/4 = R4 000 000

• Red Marine paint: R4 000 000 × 3 = R12 000 000
• Green Exterior paint: R4 000 000 × 1 = R4 000 000
Notice that the ABC costing method allocates both manufacturing

and non-manufacturing overheads to products, while only
manufacturing overheads were allocated under the traditional
method.
Furthermore, notice that the ABC method allocated
manufacturing overhead differently to the traditional method. Red
Marine paint received R23 360 000 in manufacturing overheads
under the traditional method, and R10 023 000 under ABC.
However, the lower gure under ABC is mainly due to the fact that
rent and general plant-related expenses was not allocated under

ABC because it was regarded as a facility-level activity, and the cost
irrelevant to the decision to be made. If we remove this from total
manufacturing overheads and re-calculate the allocation to Red
Marine paint under the traditional method, we nd that only R8 720
000 [(R70 080 000 – R43 920 000)/351 000 hours × 3 hours × 39 000
drums] worth of unit and batch-level manufacturing overhead was
allocated to Red Marine paint.
It is expected that ABC would allocate relatively more of these
costs (R10 023 000 compared with R8 720 000) than the traditional
method, to a lower volume product such as Red Marine paint. This
is mainly because the traditional system does not recognise that Red
Marine paint is produced in smaller batch sizes, which gives rise to
additional costs. Under the traditional system, the high-volume
product, Green Exterior paint, ‘cross-subsidised’ the Red Marine
paint by carrying too large a portion of these costs. When ABC is
rst implemented, it is often found that low-volume products (such
as Red Marine paint) receive more such costs than they had in the
past. ABC highlights the activities that cause costs to be incurred
(such as the number of machine set-ups). ABC aims to eliminate
cross-subsidisation between products.
Facility sustaining costs were not allocated to products in the
ABC calculation above as such costs will not be altered by any
decision regarding a change in production (other than possibly to
cease trading altogether). There is little purpose in allocating this
cost to individual products based on machine hours, or batches, or
business units, as these allocation bases would be arbitrary.
Allocation based on space (and time) used is more realistic, but the
allocation will be useful only if scope exists to alter these expenses,
which is assumed not to be the case in the relevant time frame.
Table 6.6 A comparison between traditional allocation systems and ABC

Traditional: departmental overhead rate and
ABC
cost centre overhead rate
Overheads are accumulated and assigned to
products in accordance with organisational Overhead costs are accumulated and assigned to
structure (that is, departments or cost centres), products in accordance with activities, based on the
based on the amount of resources used by the amount of resources used by each product.
product.
Multiple overhead rates can be calculated, one Multiple overhead rates can be calculated, one per
per department or cost centre. activity.
The allocation basis is usually a volume measure

The allocation basis is referred to as a ‘cost driver’, as
and does not necessarily represent a cause-and-
a cause-and-effect relationship exists between cost
effect relationship between cost and allocation
and allocation basis.
basis.
As the allocation basis is easily measured and Because of the extensive number of cost drivers that
because only a limited number of bases is used, must be identi ed and measured, this costing system
the costing system is not prohibitively expensive can be prohibitively expensive to implement and
to implement and operate. operate.
Overhead costs accumulated in service Overhead costs related to service activities are not
departments are allocated to production allocated to production departments or activities rst
departments. A rate which is applied to products and then to the products. The cost driver for the service
is then determined for each production cost is used to allocate the service-related overhead
department. directly to the products.
Result: Overheads are averaged out between Result: The allocated overhead re ects the extent to
products. The overheads assigned to products which that product causes costs to be incurred. In
may not be representative of the long-term cost other words, the overhead allocated represents the
savings if the product in question were not amount that could be saved in the long term if the
produced. Consequently, this method of allocation product were not produced. Consequently, this method
does not support strategic or long-term decision- of allocation supports strategic or long-term decision-
making. making.
6.4.2 Limitations of ABC

A drawback of ABC is that the process of gathering information and
identifying activities can be expensive and time consuming. The
bene t of implementing ABC is not always greater than its cost. This

would be the case where the distortion in cost allocation created by a
simpler (traditional) system is not signi cant because resources are
consumed homogeneously, because overhead costs are insigni cant
or because competition is not particularly intense and accurate
costing is therefore not crucial.
The reliability of the cost information generated by an ABC
system is undermined by certain impracticalities. As with any
system, if the input is incorrect (the activity measures), the output
will be incorrect. Worse yet is that if the system itself is faulty, the
output will also be incorrect: the cost information is only as accurate
as the accuracy with which the cost drivers have been identi ed.
Many costs in reality have multiple cost drivers. Furthermore,
facility sustaining costs are still left unallocated when ABC is used.
ABC can create a false impression of the relevance of overhead
costs to decision-making. When making a decision, the time frame
and scope of the decision must always be considered. The
impression can be created that all costs that are allocated to cost
objects by ABC are variable in the short term, when some may, in
fact, actually be stepped xed costs or xed costs that will not be
affected by a small change in the cost driver. Stepped xed costs can
be saved in the short term, provided that the organisation is aware of
and takes action on the information. However, xed costs are
normally determined by the capacity of an organisation and will
change only if the organisation expands or downsizes its capacity.
This can be done only in the long term (most costs are variable in the
long term). ABC is therefore more suited to long-term decision-
making rather than short-term decision-making.
Ethical issues relating to costing and an ABC system

The main theoretical reason for using an ABC system is that it can
achieve a reasonably accurate and transparent cost allocation, which
can consequently by relied upon for decision-making and cost
control.
Does this give rise to a general ethical dilemma? If management
is unsure of whether their cost system allocates overheads with a
suf cient degree of accuracy, is it unethical to be basing decisions on
the costings that come out of the system? Would you argue:
• ‘Yes, as wrong decisions may affect shareholder returns
negatively, and management have a duciary responsibility to
shareholders?’ or
• ‘No, a wrong decision is just like any other bad business decision,
management is making the best decisions they can on the basis of
the information available to them.’
Is it unethical for management not to consider whether their costing

system is suf ciently accurate?
The perception that ABC allocations are accurate and reliable can
be particularly useful in managing relationships with stakeholders
where cost allocation is a sensitive issue, affecting entities outside of
the enterprise itself. One example can be found in the
telecommunications industry where the sharing of infrastructure
between telecommunication providers is not uncommon. A new
mobile service provider might piggy-back off the infrastructure built
and owned by a more established provider. International calls are
routed through the infrastructure of various telecommunication
companies as the call travels through different countries. How the
telecommunications provider owning the infrastructure charges1 for
use of its infrastructure is a major issue. Potential exists for the entity
that owns the infrastructure to pass too great a portion of the cost to
those using it, negatively affecting the ability of these entities to offer

competitive rates for their services. With which of the statements
below would you agree:
• Overcharging competitors for use of infrastructure is not an
ethical concern. It is fair business practice for a for-pro t entity to
make a pro t and positive investment returns from its asset base.
• Overcharging competitors for the use of infrastructure is an
ethical issue if it is done so knowingly by management, as it
represents anti-competitive behaviour.
• If overcharging competitors for use of infrastructure does
constitute anti-competitive behavior, it is irresponsible, and thus
unethical, of management to be unsure of whether their costing
systems provide a reasonably accurate costing of infrastructure
use.
Then there are further issues relating to the practical challenges of

operating an ABC system. Suppose employees did not see any value
in carefully allocating their time between activities and as a result,
the information going into the system was inaccurate, sometimes
double-counted and other times omitted. The result would be that
activity rates in the ABC system would be incorrect. Is such
behaviour by employees unethical? If management is aware of
inputs into the system being unreliable, is it ethical of management
to make decisions, or base charges to third parties, on the ABC
system? Suppose that the entity was a bank, and that the fees
charged to its customers for the multitude of services that it
provided through ATMs as well as in-branch were based on an ABC
costing system. If the costings were inaccurate due to incorrect
information being input into the system, then the result might be
that customers were over- or undercharged for transactions such as
withdrawals and deposits, and monthly service fees might be higher

or lower than justi ed by actual cost. With which statement would
you agree more?
• The cost of banking to consumers is a sensitive issue to the
general public and overcharging, even inadvertently, as a result
of knowingly using an ABC system that has inaccurate inputs is
consequently unethical.
• A bank is entitled to charge for its services on whatever bases it
considers to be appropriate, and if it gets its fees wrong because
its costing system is not reliable, this is a poor business decision
that will cost the bank through loss of pro ts or loss of
customers. It is a bad business decision, but it is not unethical.
Management have to make decisions based on uncertain information

all the time and they have to decide whether using more of the
entity’s resources and incurring greater cost to obtain more accurate
information on any subject is worthwhile or not. Various guidelines
and codes of conduct exist to help clarify what constitutes ethical
behavior in a profession. What speci c items would be of use in
clarifying the ethical dilemmas that exist in this speci c area?
Activity-based management and

6.5
activity-based budgeting
Key terms: activity-based budgeting, activity-based

management
When activity-based costing is used in an organisation, management

becomes aware of how activities drive costs. It follows that
management is likely to focus on minimising activities as far as is
practical. This way of running an organisation is known as activity-

based management (ABM), which is discussed in more detail in
Chapter 17, Competitive advantage. Furthermore, when budgets are
drawn up, managers will budget for the number of activities (for
example, the number of orders received or the number of machine
set-ups) that they expect, and then calculate the budgeted costs from
there. This is known as activity-based budgeting (ABB). Budgeting
is discussed in more detail in Chapter 12, Budgets, planning and
control.

Newly emerging digital technologies may offer superior and more
effective cost management opportunities than either traditional or
ABC systems. Arti cial intelligence and machine learning may
provide insights into identifying cost drivers beyond that which
people are able to identify and be useful in predicting future costs
and changes in costs in response to changes in resources, beyond
that provided by ABC costing systems. Predictive analytics includes
a range of statistical techniques (encompassing many regression
techniques, including linear regression and machine learning
techniques) that analyse past information for relationships and
patterns, to predict/model what may happen in the future.
Predictive analytics is widely used in commerce and, in the
context of costing, can be used to understand better the cost–cost
driver relationship, and model how costs may change in response to
a change in the business, its use of resources and its products.
Predictive analytics takes into account many explanatory variables,
in a more complex manner than that which typical ABC systems are
able to do, and so can be of greater assistance in cost management
than typical activity-based budgeting and activity-based

management. The use of predictive analytics requires an
understanding of both digital analytics and business operations, in
order to identify and formulate appropriate problems to be modeled.
6.7 Summary
This chapter discusses the aspects that management should consider
when choosing the method and level of detail with which overhead
costs are allocated to products or services. Simple, volume- or value-
based measures can be used with a reasonable degree of accuracy
where the organisation’s product range consists of products that use
resources more or less homogeneously, overhead costs are
proportionately small or where competition is not particularly
intense. However, where a more accurate allocation of overhead
costs is required, this is done with reference to the activities that
cause the overhead costs to be incurred (activity-based costing).
Overheads should be allocated only to the extent that they are
relevant to the decision that management is facing, or to control
measures that management wishes to institute.
Just as traditional overhead allocation methods have
disadvantages, ABC has limitations of its own. It is important to
understand that, regardless of what method of overhead allocation is
used, the total amount of overheads incurred by the organisation
does not change. Different amounts of overheads may be allocated to
cost objects depending on the basis used, but the total amount of
overheads is not affected by a change in allocation. However,
management may save overhead costs in future periods if they make
better decisions because of their improved understanding of how
costs behave. In addition, where selling prices are determined by
applying a mark-up to cost, more realistic selling prices based on

more accurate product costs may lead to improved pro tability for
the organisation.
Conclusion: Overhead allocation and

This chapter deals with the allocation of overheads to cost objects.
The costs that ought to be assigned to a cost object in a given
situation are the costs that are relevant to the decision at hand. A
detailed understanding of what constitutes a relevant cost for
decision-making can be obtained from Chapter 2, Cost classi cation
(see section 2.4) and Chapter 10, Relevant information for decision-
making.
The appropriate manner in which to allocate overheads for
management accounting purposes stands in contrast with the
nancial accounting approach to overheads allocation, namely
absorption costing. The contrast is the result of the different
objectives of the two disciplines. More detailed discussions of
absorption costing can be found in Chapter 2, Cost classi cation (see
section 2.6), Chapter 5, Absorption versus variable costing and Chapter
13, Standard costing (see section 13.5.6).
An understanding of the basis on which overheads are allocated,
which activities they respond to, and the varying extents to which
they can be altered by various decisions, is necessary in all chapters
in this book, and is relied on in particular in Chapter 7, Job costing,
Chapter 8, Process costing and Chapter 14, Performance management
(see section 14.2.1 on controllability).
Finally, two concepts closely related to activity-based costing are
activity-based management (ABM) and activity-based budgeting

(ABB). ABM is discussed in Chapter 17, Competitive advantage, while
Chapter 12, Budgets, planning and control explains budgeting.
Tutorial case study: Gauteng Aids Programme
Refer to the information on the Gauteng Aids Programme at the beginning of this
chapter, and perform the following tasks. (Because this case study deals with a
public service rather than a manufacturing organisation, you may nd the context
challenging.)
1 Explain to what extent it would be appropriate to allocate the overheads of
Gauteng’s Department of Health and Social Development to its various
programmes (such as the Aids Programme) using a volume-based measure,
namely the number of patients treated.
2 Identify the cost objects in question 1 above.
3 Explain whether a value-based overhead allocation basis could be relevant in
this scenario.
4 Give examples of cost pools that may possibly be used when the overhead
costs of the Department of Health and Social Development are allocated to its
various programmes (such as the Aids Programme).
5 Discuss in detail whether – in your opinion – a re ned overhead allocation
system such as activity-based costing may be appropriate for allocating
overhead costs to the Gauteng Aids Programme.
Basic questions
BQ 1
X Ltd has two production departments, assembly and nishing, and
two service departments, stores and maintenance.
Stores provides the following service to the production
departments: 60% to assembly and 40% to nishing.
Maintenance provides the following service to the production
and service departments: 40% to assembly, 45% to nishing and 15%
to stores.

The budgeted information for the year is as follows:
Budgeted fixed production overheads

Assembly R100 000
Finishing R150 000
Stores R50 000
Maintenance R40 000
Budgeted output 100 000 units
At the end of the year, after apportioning the service department

overheads, the total xed production overheads debited to the
assembly department’s xed production overhead control account
were R180 000. The actual output achieved was 120 000 units. What
was the under- or over-absorption of xed production overheads for
the assembly department?
BQ 2
CJD Ltd manufactures plastic components for the car industry. The
following budgeted information is available for three of their key
plastic components:

The total number of activities for each of the three products for the
period is as follows:
Overhead costs have been analysed as follows:
Receiving and inspecting quality assurance R1 400 000
Production scheduling and machine set up R1 200 000
What is the budgeted pro t per unit for each of the three products,
using activity-based budgeting?
BQ 3
The total costs incurred in the invoice process department of a life
insurance company was budgeted at R1 000 000 for the 2XX7 year,
and R1 100 000 was actually spent during the year. All the costs
incurred in this department are xed costs. The only activity that this
department caries out is the processing of invoices, and the company
wishes to charge the costs incurred in this department to the various
business units for which the invoices are processed. The number of
company invoices budgeted to be processed for the year was 20 000.
The department actually processed 22 000 invoices during the year.
The maximum number of invoices that could theoretically be
processed by this department in one year is 26 000, but the practical
capacity of the department is 25 000 invoices per annum.
What is the amount per invoice that the business units should
have been charged, using ABC?
a) R40 per invoice

b) R44 per invoice
c) R50 per invoice
d) R55 per invoice
BQ 4
An information technology (IT) department is trying to determine
the cost per page that should be charged to user departments. The IT
department is responsible for managing the overall printing cost of
the company, and the user departments are responsible for the
amount of printing that they do. There are three signi cant costs
associated with printing and the budgeted costs for the year are as
follows:
R
Depreciation of printers 1 000 000 ( xed cost)
Paper 2 000 000 (variable cost)
Ink/toner 5 000 000 (variable cost)
The total number of pages that the printers are capable of printing
during the year (practical capacity) is 12 000 000 pages. The
budgeted number of pages to be printed is 10 000 000 pages.
At what cost per page should the printing costs be allocated to
the user departments, using ABC?
a) R0,67
b) R0,68
c) R0,78
d) R0,80
BQ 5

In order to determine the relative pro tability of the products within
an organisation’s product range:
(i) manufacturing overheads can be allocated to products using
ABC
(ii) ABC cannot be applied to indirect costs that are non-
manufacturing in nature (that is, non-manufacturing overheads)
(iii) all manufacturing overheads should be included in the cost
pools that are to be allocated to products.
Which of the above statements are true?

a) (i) and (iii)
b) (ii) and (iii)
c) (i) only
d) (ii) only
BQ 6
FluffyBunny (Pty) Ltd manufactures soft toys. Raw materials are
imported in bulk (this is cheaper than purchasing smaller quantities
at a time) and stored in one of several warehouses that it rents close
to the factory. Raw materials are fetched from the warehouses as
required and loaded on to a laser cutting machine, which can cut 40
layers of fabric at a time. The number of units that are cut out of 40
layers of fabric varies, depending on the size of the toy (very small to
very large) and width of the fabric. The toys are sewn and stuffed by
employees who earn a monthly wage. The nished goods are then
stored in the same warehouses in which raw materials are stored.
The soft toys are of different sizes and remain in the warehouse for
different lengths of time, depending on demand.
The following potential cost drivers have been identi ed:
1 Number of m2 of warehouse space

2 Number of m2 of warehouse space per day
3 Number of materials and nished goods requisitions
4 Number of materials movements
5 Number of units of nished goods (that is, the number of toys)
6 Labour time (sewing and stuf ng)
7 Number of cuts
8 Cutting hours
9 Factory hours
Which cost driver (from the list provided) would be the most
appropriate for the following overhead costs associated with
running the warehouses?
a) Maintenance of uorescent overhead lights in the factory
b) Deprecation and maintenance of forklifts
c) Depreciation of computers, printers (for labels to stick on all raw
materials and nished goods receipted into the warehouse) and
scanning equipment (every item leaving or entering the
warehouse must be scanned)
BQ 7
The same information as in BQ 6 applies. Which cost driver (from
the list provided) would be the most appropriate for the following
overhead costs associated with running the warehouses?
a) Salaries of warehouse personnel
b) Rent of warehouse premises
BQ 8
The same information as in BQ 6 applies. Which cost driver (from
the list provided) would be the most appropriate for the following
overhead costs associated with the manufacturing process? What

concerns do you have regarding the use of the particular cost driver
you have selected?
a) Electricity, depreciation, maintenance and salaries costs
associated with the cutting of material
b) Electricity, depreciation, maintenance and salaries costs
associated with the sewing and stuf ng of toys
c) Factory rental
BQ 9
A company has three operational divisions, L, M and N, and two
service departments (P and Q). R4 million and R3 million of
overheads are incurred in service departments P and Q respectively.
An analysis of the service departments records indicate that their
services are used in the following proportions:
Service department P Q
Percentage use by other departments:
L 20% 30%
M 25% 10%
N 40% 20%
P – 40%
Q 15% –
What amount of the service departments’ overheads should be

allocated to each of the three production departments under the
direct approach?
a) L: R2 441 176 M: R1 676 471 N: R2 882 353
b) L: R1 700 000 M: R1 300 000 N: R2 200 000
c) L: R2 123 529 M: R1 829 412 N: R3 047 059

BQ 10
The same information as in BQ 9 applies. What amount of the
service departments’ overheads should be allocated to each of the
three production departments under the step-down approach? Start
by allocating the costs of the service department that renders the
largest value of services to another service department.
a) L: R2 441 176 M: R1 676 471 N: R2 882 353
b) L: R1 700 000 M: R1 300 000 N: R2 200 000
c) L: R2 123 529 M: R1 829 412 N: R3 047 059
Long questions

SOURCE: UCT (RICHARD CHIVAKA)
Cookwell manufactures household pots that bear the ‘Proudly South
African’ logo. The organisation makes three different pots of the
same size, namely copper, aluminium and steel pots. Cookwell
started making copper pots (CP) in 1980, taking advantage of cheap,
high-quality copper which was imported from Zambia. It was the
only organisation manufacturing and supplying copper pots to the
South African market until 1990, when other organisations entered
the market. The organisation introduced their aluminium pots (AP)
and steel pots (SP) in 2XX0, both of which immediately became more
popular than the copper pots. The organisation uses a full-cost-plus
pricing method to calculate the selling prices for the three different
pots. The current mark-up is 20% on cost. Currently, the most
popular pot brand is the aluminium pot.
However, despite the popularity of the AP brand, and the
organisation’s traditional dominance in the CP market, the
organisation’s pro ts have signi cantly dropped since the

introduction of the AP and SP brands. Competition in the SP market
is erce and the organisation’s competitors offer similar pots at
lower prices. Also, the CP market is slowly slipping away as a result
of the entry of other organisations since 1990. This is very confusing
to the organisation’s management, because every day the sales
manager reports that retail shops are placing more orders for the AP,
which should more than compensate for the loss of the CP market
share.
Cookwell’s managing director, who is very anxious to
understand the source(s) of the huge pro t reductions that the
organisation has experienced since 2XX0, has convened an
emergency meeting. Present in the meeting are the managing
director, the production manager, the purchasing manager, the
nance manager, the sales manager and the management accountant
(you).
The organisation’s production manager has produced the
following information that relates to the three products for the
current nancial year.
All direct factory employees are paid R60 per hour. The
organisation’s policy is to assign all production overheads using
machine hours. The production manager indicates that the current
recovery rate is R80 per machine hour. Using this overhead recovery
rate, there is no under- or over-recovery of overheads.

After three hours of discussion and deliberation, the
organisation’s production manager suggests that the possible reason
for the fall in the organisation’s pro ts could be due to the costing
system in use. The managing director takes the nance manager to
task. He wants an informed response to the alleged weaknesses in
the organisation’s costing system. However, the nance manager is
at a loss as to what could be wrong with the current costing system.
The sales manager suggests that perhaps the management
accountant (you), as a recent graduate from university, could offer
insights into the matter. You then respond by suggesting the
assignment of costs using activity-based costing (ABC). The
managing director is both excited and anxious. He wants you to
demonstrate the impact that the application of ABC would have on
the organisation’s pro tability.
Before the meeting ends, the production manager gives you a le
that contains more information about the organisation’s production
overhead cost. Your analysis of the overheads yields the following
information, as shown in tables 1 and 2 below.
Table 1
%
Set-up costs 40
Materials handling costs 20
Inspection costs 25
Machine-related costs 15
Total overheads 100
Table 2

SOURCE: UCT (PETER CRAMER)
Electrohealth (Pty) Ltd manufactures a diverse range of consumer
electronic products aimed at the health-conscious market. The
organisation has a solid brand image and a reputation for delivering
high-quality, reliable products.
The organisation has a new product development team that has
the task of assessing opportunities in the organisation’s market
segment and proposing new products. Once the investigation of a
new product has been approved in principle, including a proposed
selling price, the design and engineering department determines
draft product speci cations, including production methods and
materials speci cations.

The new product development team has recently proposed the
introduction of a new product, the XRunna, which it believes will be
able to compete very successfully in the personal tness market. The
XRunna is planned to be a compact and unobtrusive device to
measure various items that are of importance to runners, including
distance, heart rate, speed, acceleration and hydration factors. The
XRunna will be sold at R250 per unit.
The design and engineering department has speci ed the
following direct materials and labour in respect of the XRunna:
• Each unit will require one unit of component A, which comprises
the basic integrated circuitry that will be sourced from a supplier
in Shanghai, China, at a landed cost of R40 per unit, calculated at
the current exchange rate.
• Each unit will require two units of component B, which will be
sourced from the organisation’s holding company in Japan at a
landed cost of R15 per unit calculated at the current exchange
rate.
• Other materials, including the rubberised housing and Velcro®
strap, will be sourced locally at a cost of R30.
• Labour (skilled technicians) will be charged at R850 per hour of
assembly time, which is 35 hours per batch of 1 000 XRunnas –
see below.
Indirect costs will be allocated to the XRunna on the basis of ABC

cost information. The XRunna will be manufactured in batches of 1
000 units. Activity requirements for 1 batch of XRunna are as
follows:
Activity Required for 1 batch of 1 000 units

Purchase ordering 2 purchase orders
Set-up time 5 hours

Assembly time 35 hours
Materials movement 3 movements
Inspection 3,5 hours
You have recently joined the organisation and have been co-opted to
the new product development team as the nancial representative.
In preparation for an important meeting later today where you will
be required to present a rm cost estimate in respect of the XRunna,
you have been trying to locate the appropriate ABC information.
You have established that the hard drive of the computer used by the
previous management accountant has ‘crashed’ and cannot be
accessed at present. Fortunately, you have managed to obtain two
documents containing all of the ABC information that you require.
Unfortunately, coffee has been spilled over both documents and
certain information is obscured. The rst document (doc 1) contains
details of the total indirect costs, analysed by activity. The last two
lines are unreadable, but you are con dent that you can obtain the
information you require from the second document (doc 2) which
contains details of the costing of another product – product X –
which was performed on the basis of the information contained in
doc 1. Note that product X is manufactured in batches of 500 units.
The documents are as follows:

*Because of the nature of the product, it is extremely important that the components are properly embedded
in the product’s rubberised housing. The assembly process will therefore require the use of a variety of the
robotic equipment that is present in the Electrohealth factory, in addition to the skilled technicians (referred to
previously).
The indirect assembly cost is made up as follows:

• 60% of the total cost relates to power and maintenance of the
various types of robotic equipment used in the Electrohealth
factory. Maintenance is largely driven by operating hours,
although the service intervals and costs vary from machine to
machine.

• 40% of the total costs relate to the factory rent, cleaning, lighting,
factory managers’ salaries, and other related expenses. These
costs are allocated on a time proportion basis, as various different
products spend different amounts of time in the factory.
You have been advised that there is suf cient spare capacity within
the organisation to accommodate the production of the XRunna. The
organisation would like to earn a gross margin of 30%.
REQUIRED Marks
(a) Calculate:
(i) the cost driver rate for each activity
(ii) the current estimate of the actual cost to produce one unit of the XRunna. 17
(b) Describe the key factors you think would have been taken into account in setting the
2
organisation’s target gross margin of 30%.
(c) The marketing manager has enquired why you are bothering with the ABC costing
information. She has mentioned that in the past, indirect costs have frequently been allocated
on the basis of direct labour hours and enquires why this would not be suitable for the 3
purposes of estimating the cost of the XRunna. Brie y explain why the use of the ABC cost
information may be preferable in this situation.
(d) Discuss the shortcomings that may exist regarding the ABC cost allocation. 2
(e) Discuss another risk that is evident in the costing of the XRunna, and action(s) that you think
3
need to be taken to manage the risk.
Format and presentation 2
TOTAL MARKS 29

F Ltd supplies pharmaceutical drugs to drug stores. Although the
company makes a satisfactory return, the directors are concerned
that some orders are pro table and others are not. The management

has decided to investigate a new budgeting system using activity-
based costing principles to ensure that all orders they accept are
making a pro t.
Each customer order is charged as follows.: customers are
charged the list price of the drugs ordered plus a charge for selling
and distribution costs (overheads). A pro t margin is also added, but
that does not form part of this analysis.
Currently F Ltd uses a simple absorption rate to absorb these
overheads. The rate is calculated based on the budgeted annual
selling and distribution costs and the budgeted annual total list price
of the drugs ordered.
An analysis of customers has revealed that many customers place
frequent small orders with each order requesting a variety of drugs.
The management of F Ltd has examined more carefully the nature of
its selling and distribution costs, and the following data have been
prepared for the budget for next year:
Total list price of drugs supplied: R8 million
Number of customer orders 8 000
Selling and distribution costs: R’000 Cost driver
Invoice processing 280 See Note 2
Packing 220 Size of package – see Note 3
Delivery 180 Number of deliveries – see Note 4
Other overheads 200 Number of orders
Total overheads 880
Notes:
1 Each order will be shipped in one package and will result in one
delivery to the customer and one invoice (an order never results

in more than one delivery).
2 Each invoice has a different line for each drug ordered. There are
28 000 invoice lines each year. It is estimated that 25% of invoice
processing costs is related to the number of invoices and 75% is
related to the number of invoice lines.
3 Packing costs are R32 for a large package and R25 for a small
package.
4 The delivery vehicles are always lled to capacity for each
journey. The delivery vehicles can carry either 6 large packages or
12 small packages (or appropriate combinations of large and
small packages). It is estimated that there will be 1 000 delivery
journeys each year, and the total delivery mileage that is speci c
to particular customers is estimated at 350 000 miles each year.
5 R40 000 of delivery costs are related to loading the delivery
vehicles and the remainder of these costs are related to speci c
delivery distance to customers.
Management has asked for two typical orders to be costed using

next year’s budget data, using the current method and the proposed
activity-based costing approach. Details of two typical orders are
shown below:
Order A Order B
Lines on invoice 2 8
Package size small large
Speci c delivery distance 8 miles 40 miles
List price of drugs supplied R1 200 R900

SOURCE: UCT (PETER CRAMER)
Azanian Bank Ltd (AZBA) is a large South African commercial
banking operation. The bank has three main business units, namely
home loans, cheque accounts, and savings accounts. In addition, the
bank has a corporate services department which houses the shared
services, such as information technology, legal services and
accounting services, which support the operations of the business
units.
AZBA is considering the introduction of a corporate nance
division, aimed at the supply of corporate nance services to its
existing corporate customer base and, hopefully, to a growing
number of new corporate customers. However, the bank’s
management have some concerns regarding the pro tability of the
existing operations and would like these resolved before
undertaking the development of a new business unit.
The three existing business units all earn a combination of fee
and net interest income, much in line with the banking industry in
general. The direct costs of each business unit include the salaries
and related costs in respect of dedicated staff, depreciation of

dedicated property, plant and equipment, bad debts written off and
provided for, and all other costs which are directly traceable to the
business unit. Traditionally, AZBA has determined the pro tability
of the business after re-allocating the corporate (or shared) costs to
the three business units in proportion to the income (that is, the sum
of fee and interest income) of each unit.
However, it has recently been suggested that this method of
allocating the costs might be resulting in pro t calculations which
are a poor re ection of the true pro tability of the respective
business units. In view of this, the bank’s nance director has
initiated a study based on the principles of activity-based costing.
The results of this study are due to be presented at the bank’s
forthcoming board meeting, which is scheduled for one week from
today. The consultant who originally prepared the data has
unfortunately taken ill and will not be able to complete the analysis
of the data or be present at the board meeting.
AZBA’s board is eagerly awaiting the results of the ABC exercise
and the nance director does not consider postponement of the
presentation as an option. The consultant, who is a recognised expert
in the area of ABC in relation to the nancial services industry, has
left a le containing the data necessary to complete the exercise. The
nance director is satis ed that the data is completely reliable, but
does not have the time to complete the analysis herself. She has
tasked you with the recalculation of the pro ts of the business units
using the consultant’s data, and the consideration of a few other
points, in anticipation of questions the board might raise.
An exhibit re ecting the pertinent extracts from the consultant’s
les appears below. All of the information is complete, with the
exception of the net income of the business units, which the
consultant had left in a near-complete state.

Exhibit 6.1 Relevant extracts from consultant’s les
The corporate services costs comprise the following departments:
R’000
ATM security and control 1 300
Legal services 1 200
Real estate services 1 600
IT services 3 400
Human resources 800
Accounting 1 100
9 400
The corporate services costs have been traced to the activities

speci ed as follows:

Note:
1 Included in the premises management costs of R1 700 000 is R300
000 in refurbishment costs which arose because of re-branding by
the home loan business unit. The remaining R1 400 000 costs are
general property maintenance costs.

REQUIRED Marks
(a) Calculate the net income, after all direct and allocated costs, of the three business units, using
4
AZBA’s existing cost allocation basis.
(b) Calculate the net income of the three units on an activity-based costing basis. 21
(c) Comment brie y on the results of your two calculations and discuss why they may be of
interest to AZBA’s board. Recommend what action, if any, could be considered as a result of 5
the information provided by the ABC exercise.
(d) While the nance director is satis ed that the data presented in Exhibit 6.1 above is accurate,
she asks you whether you have any reservations concerning the application of ABC to the
corporate costs, the cost drivers identi ed, and whether there are any other issues concerning 5
the activity-based costing exercise that the board should be made aware of. Comment on any
reservations (or lack thereof) you may have in these areas.
Round off all calculations to the nearest rand.
TOTAL MARKS 35

Total Solutions Ltd is a large South African organisation which
provides a wide range of nancial services. Total Solutions has
numerous operating divisions, each of which focuses on a single
service line. Group Retirement Solutions (GRS) is the operating
division that is responsible for managing organisation-speci c
pension and provident funds (an example of a typical fund that GRS
might manage would be the ‘University of Cape Town (UCT)
Retirement Fund’). GRS manages 80 funds, with an average
membership of 1 100 members per fund.
GRS charges each retirement fund a monthly administration fee
of 1,5% of the members’ monthly retirement funding contributions
(not contributions in respect of bank guarantees – see below).
Members’ contributions are based on a percentage of the member’s
salary (usually 15%). The membership of the various funds

administered by GRS ranges from funds that are dominated by low-
income workers in the construction industry (average monthly
contributions of R500 per employee), to funds dominated by higher
income earners in more corporate environments (average monthly
contribution of R1 600 per employee).
There is signi cant tension in the nancial services industry
regarding administrative fees charged to clients and GRS is under
pressure to keep administrative fees as low as possible. GRS is also
mindful that they may need to be able to justify their fees to a
regulatory body. As a result of these concerns, GRS has decided to
perform an activity-based costing exercise in order to get a better
insight into the cost of managing a pension (or provident) fund. The
income statement for GRS, including information on actual activities
performed, is presented immediately below. Additional information
regarding the activities then follows.
Actual costs and income incurred by GRS for the 12 months ended 30 June 2XX6

Notes:
1 Salaries: Given that the bulk of administrative costs are labour
related, GRS has divided the salaries expense according to the
various activities carried out. This was easy enough to do, as
GRS’s employees (of which there are more than 150) are grouped
according to these tasks. Included in the table below is a list and
description of the core activities performed in managing a fund
and the amount of time required to carry out each activity (to
ascertain this, employees were asked to estimate the amount of
time they required to perform each activity listed below and the
average time per activity was calculated from their responses):

Activities 2, 3 and 4 above are performed by payclass 4
employees, who earn R40 per hour, and activities 1 and 5
above are performed by payclass 8 employees, who earn R80

per hour. Both payclass 4 and payclass 8 employees are
permanent employees who receive a xed monthly salary.
2 Insurance, IT support and similar costs: Insurance, maintenance and

cleaning costs are all outsourced by Total Solutions to various
suppliers, in terms of xed annual contracts. These costs are
allocated to every operating division based on a xed rate per
square metre of oor space. IT support costs relate to costs
incurred by the IT support department, which are allocated on a
per square metre basis to the various divisions. The argument for
this simplistic allocation basis is that the various operating
divisions have very similar IT needs and the number of
employees (and computers) per square metre is consistent
between divisions.
REQUIRED Marks
(a) Calculate the annual activity-based charges per activity, as appropriate. Comment on the
merit of applying ABC to the last three items (entertainment, insurance/maintenance/cleaning 10
and IT support).
(b) The ABC exercise was intended to provide insight into cost and resource management, of
which labour is the most signi cant. Discuss the concerns that arise regarding the labour
7
costs (support your answer with an appropriate calculation(s)), and shortcomings that may
exist regarding the labour activity analysis (refer to Note 1).
(c) Comment on the consequences of the current method of charging administration fees to the
3
retirement funds, given the ABC information provided.
TOTAL MARKS 20
References
Cooper, R. 1990. Cost classi cation in unit-based and activity-based manufacturing cost
systems. Journal of Cost Management, 4–14, Fall.
Gauteng Province Department of Health and Social Development. 2011. Gauteng Aids
Programme. [Online]. Available:

http://www.healthandsocdev.gpg.gov.za/Programmes/Pages/GautengAidsProgramme
.aspx [24 March 2011].
Major, M & Hopper, T. 2003. Managers divided: resistance and consent to ABC in a Portuguese
Telecommunications Company. [Online] Available:
https://www.researchgate.net/publication/223068702_Managers_Divided_Implementin
g_ABC_in_a_Portuguese_Telecommunications_Company [15 November 2019].
SAICA (South African Institute of Chartered Accountants). 2010. Statements of Generally
Accepted Accounting Practice: IAS 2, Inventories (revised January 2010). Johannesburg:
SAICA.
South African Government. 2010. Media statement by Gauteng Health and Social Development
MEC, Q Mahlangu. [Online]. Available: https://www.gov.za/media-statement-gauteng-
health-and-social-development-mec-q-mahlangu [15 November 2019].
1 ABC has in fact been used in the telecomunications industry to respond to the costing challenge of
shared infrastructure (Major & Hopper, 2003).

LEARNING OBJECTIVES
• explain the nature of a job costing system and the type of
organisations for which its use is appropriate
• describe the procedure for recording the cost of materials issued
for a particular job, including the rst-in- rst-out (FIFO),
weighted average and speci c identi cation methods of pricing
raw materials issues and inventory
• explain how the total cost of labour and the hourly rate at which
labour is charged to each job are determined, and how these costs
are accounted for
• calculate the cost of a job by assigning and allocating the various
elements of cost to the job
• prepare journal entries and general ledger accounts for a job
costing system
• explain the difference between an integrated and an interlocking
accounting system.
maxEnergy and job costing
Due to the prevailing energy crisis in South Africa, there has been an increase in the
number of alternative energy-generating products from all over the world launching
into the local South African market. maxEnergy is a Cape Town-based organisation

that helps its clients determine which alternative energy product is best suited to
their needs. One of the solutions provided by maxEnergy is solar based. A typical
solar-based offering requires solar panels to capture the energy produced by the
sun, an inverter to convert the sun energy into energy that can be used in
businesses and homes, batteries for storing the energy and also a charger to keep
the batteries charged. The number of solar panels, the size of the inverter and the
number and type of batteries and chargers required can vary signi cantly depending
on each individual client’s needs. Therefore a unique energy solution and installation
plan is designed for each client and a quote is calculated accordingly.
SOURCE: WWW.MAXENERGY.CO.ZA
(2019)
Since each energy solution is unique, the cost incurred by maxEnergy to ful l each
order is different. It is therefore necessary to determine the costs associated with
each order so that the selling price of and the pro t on each order can be
determined. Job costing is a system of tracing and assigning costs to speci c
individual orders or ‘jobs’.
7.1 Introduction
Key terms: job costing
Job costing is used for accumulating costs and determining the price
of the goods or services in situations where each product produced
or service rendered (‘job’) differs from the next. Job costing systems
can be differentiated from process costing systems (discussed in
Chapter 8, Process costing) and joint and by-product costing systems
(discussed in Chapter 9, Joint and by-product costing), which are used
where a large number of similar items are produced.
A job costing system is therefore a system designed to deal with
the calculation of the cost of jobs, each of which is unique, requiring
an input of differing quantities of materials, labour and allocated
overhead cost.

A job can be anything from a multimillion-rand bridge over a
river to the restoration of an antique piece of furniture, or even the
repair of a pair of shoes. Jobs are not restricted to tangible products,
but include services. Examples of job-related services include the
work of electricians, plumbers, garden maintenance companies and
television repairers. Often with larger jobs, such as a contract to
build a bridge or a toll road, it is also necessary to employ contract
costing to determine the amount of revenue that should be
recognised in each nancial period. Contract costing, however, falls
outside the scope of this textbook, and this chapter focuses on jobs
which are completed in a relatively short period of time.

When a car is collected from a vehicle repair shop, the client receives
an invoice setting out the cost of the repairs. The repairs carried out
on any particular car are likely to be different from the repairs
carried out on other cars. In order to produce an accurate invoice, it
is therefore necessary for the vehicle repair shop to have a costing
system in place that can differentiate between the repairs carried out
on different cars, and their associated costs.
A job costing system enables a vehicle repair shop to:
• determine the estimated costs for carrying out a particular repair
job and provide a quote to a customer
• determine the cost of sales to be recognised in a reporting period
by accumulating the costs of each repair job undertaken during
the period
• budget for future costs and revenue and thereby exercise control
over deviations of actual cost and revenues from the budget.

7.3The elements of cost in a job costing
system
Each individual job undertaken by an organisation involves
materials and labour, or machinery, and collectively, an
infrastructure in which to do the work. In the context of a vehicle
repair shop, materials include spare parts and cleaning products,
labour includes the mechanics, while the infrastructure includes the
repair shop building and the machinery used in repairing cars.
In Chapter 2, Cost classi cation the distinction between direct and
indirect costs and overheads was made. Direct costs are those that
can be traced to a cost object in a cost-ef cient manner, while indirect
costs are those that cannot. This distinction is important in job
costing systems. Spare parts used in repairing a car would be an
example of direct materials, while the cleaning products would be an
example of indirect materials. Mechanics working on cars constitute
direct labour, while the cost of workers who move articles around,
fetch and carry, or provide general assistance constitute indirect
labour. Overhead costs consist of any indirect materials and indirect
labour together with other overall infrastructure costs (the overall
cost of the infrastructure relates to all activities undertaken that
cannot be directly traced to individual jobs).
The costs involved in a job are therefore:
• direct materials
• direct labour
• overheads, including indirect materials, indirect labour and
• infrastructure.
The allocation of overheads was discussed in Chapter 6, Overhead

allocation. For a job costing system, a commonly used cost driver for

the purposes of allocating overhead costs to individual jobs is direct
labour. This is reasonable as each job is different and, to
accommodate this, the intervention of labour is needed.
7.3.1 Determining the cost of materials

Key terms: job card
The materials needed for the jobs to be undertaken may be ordered

as required (a just-in-time system, which is discussed in Chapter 16,
Contemporary management accounting concepts) or kept in store until it
is issued to a speci c job. In a vehicle repair shop, for example,
certain expensive parts are ordered as required, while other less
costly items are kept in inventory. Irrespective of the inventory
system, the materials used for each job together with the cost are
recorded on a job card.
A simpli ed materials ordering and handling system is
illustrated in Table 7.1.
Table 7.1 A materials ordering and handling system
When the inventory re-order point is reached, the storeman issues a purchase
Purchase requisition to the purchasing department
requisition issued Note that the purchase requisition may automatically be generated if a computerised
materials handling programme is used
Purchase order
The purchasing department then issues a purchase order to the appropriate supplier
raised
Once the order has been received, the storeman inspects the goods and issues a
Goods received goods received note
note issued
The stores ledger account is updated for the receipt
Materials issued When materials are issued to a job, the workshop or factory foreman issues a stores

requisition
The issue of the materials is then recorded on the stores ledger account
The value at which materials are issued to the workshop can be

determined in a number of ways:
1 Where materials or components are ordered as they are required,
they are issued at actual cost. In most cases, the actual cost of
materials, or a component, is simply the amount recorded on the
purchase invoice. In other cases, a delivery charge or other
charge, such as customs and clearing costs, may be re ected on
the invoice and added to the cost of materials purchased. This
additional charge would have to be allocated to all the items on
the purchase invoice, either per item where all items cost the
same, or in proportion to the cost of the items, where costs differ.
The value-added tax charge re ected on the invoice would be
excluded where the organisation is able to claim the tax as a
value-added input tax deduction. Furthermore, some
organisations add the cost of ordering and handling materials.
They use activity-based costing to allocate materials ordering and
handling costs to materials using the purchase price, size or
volume of the materials as the cost driver.
2 Where items are ordered in bulk in advance of their use, the
value at which they are issued would be calculated by one of the
following methods: rst-in- rst-out (FIFO); weighted average;
last-in- rst-out (LIFO); speci c identi cation; or standard costs.
The LIFO method, where the issue price is assumed to be the cost
of the last item purchased, is not acceptable for nancial
accounting purposes and this method will not be dealt with in
further detail in this chapter, as it is also not particularly useful to

management accountants. The other methods are discussed
below.
The FIFO method of inventory valuation

Key terms: FIFO
The FIFO method assumes that materials are issued in the sequence
in which they were ordered, and assigns an issue price accordingly.
Example 7.1
At the beginning of the month, the inventory on hand in a vehicle repair shop was as
follows:
200 litre cans of motor oil @ R15,00 per can (purchased on the 20th day of the previous R3
month) 000
400 litre cans of motor oil @ R18,00 per can (purchased on the 25th day of the previous R7
month) 200
The rst materials requisition is for 300 cans of motor oil to be issued for car repairs to
be done during the particular day.
Required:
Calculate the value of the motor oil issued, as well as that of the remaining motor oil
inventory, using the FIFO valuation method.
Using the FIFO method in example 7.1 to calculate the cost of the 300
cans of oil issued, the 200 cans purchased rst at a cost of R15 per
can are assumed to be issued rst, followed by 100 cans (total of 300
cans issued less the 200 cans assumed to be issued rst) at a cost of
R18 per can. The total cost of the 300 cans issued is therefore R4 800
(200 cans × R15 per can plus 100 cans × R18 per can). Since all of the

200 cans on hand at the beginning of the month have been issued,
the remaining inventory on hand at the end of the month will consist
solely of 300 cans (400 on hand at the beginning of the month less
100 issued) at R18 per can, equal to a total value of R5 400.
The weighted average method of inventory valuation

Key terms: weighted average
The weighted average method prices the inventory at an average

price which is re-calculated each time materials are received.
Example 7.2
At the beginning of a month, a vehicle repair shop had 10 clutch plates on hand at an
average cost of R1 200 per clutch plate. The following receipts were issued during the
month:
5 April 5 clutch plates costing R1 400 each received
7 April 9 clutch plates issued
15 April 10 clutch plates costing R1 300 each received
Required:
Calculate the value of the clutch plates issued on 7 April and the value of inventory on
hand at the end of the month, using the weighted average valuation method.
In example 7.2, the cost of the clutch plates issued on 7 April will be
the weighted average cost of the inventory on hand immediately
prior to the issue. This cost is simply the total value of the inventory
on hand immediately prior to the issue divided by the total number
of clutch plates on hand immediately prior to the issue. The total
value of inventory on hand immediately prior to the issue was R19

000 (opening inventory of 10 clutch plates multiplied by the average
cost of R1 200 each, plus the receipt of 5 clutch plates on 5 April
multiplied by the cost of R1 400 each). The total number of clutch
plates on hand immediately prior to the issue was 15 (opening
inventory of 10 plus the receipts of 5 on 5 April). Therefore, the
weighted average cost of the clutch plates issued on 7 April was R1
266,67 (R19 000 divided by 15) or a total of R11 400 (average cost of
R1 266,67 × 9 clutch plates issued).
The value of inventory on hand on 7 April in example 7.2
immediately after the issue of the clutch plates was R7 600 (R19 000
less R11 400). The value of inventory at the end of the month will
therefore be R7 600, adjusted for any receipts or issues after 7 April
but before the end of the month. During this period, there was only
the receipt of 10 clutch plates at R1 300 each. The value of inventory
at the end of the month will therefore be R20 600 (R7 600 plus R1 300
× 10) and each clutch plate in inventory will have a weighted
average cost of R20 600/16 (opening inventory of 10 plus the receipt
of 5 on 7 April, less the issue of 9 on 7 April, plus the receipt of 10 on
15 April) = R1 287,50.
Specific identification
Key terms: speci c identi cation
The speci c identi cation method values inventory at the speci c

price paid for each individual item. This method therefore requires
each item of inventory to be identi ed, usually by purchase date and
serial number.
Example 7.3

A friend of yours started a used car dealership last month. During her rst month of
trading, the following vehicles were purchased and sold:
Purchases
Registration: Purchase price:
BBB 000 EC R20 000
CCC 111 L R R80 000
DDD 222 MP R R120 000
FFF 444 NW RR100 000
CA 888 888 RR200 000
Sales
Registration: Sales price:
CCC 111 L R90 000
DDD 222 MP R150 000
FFF 444 NW R130 000
Required:
Calculate the cost of sales for the rst month of trading as well as the value of closing
inventory at the end of the month using the speci c identi cation method.
The speci c cost of each vehicle purchased and sold in example 7.3
can be identi ed using the registration number of each vehicle. To
calculate the cost of sales, it is necessary to add up the cost of the
three speci c vehicles sold: R80 000 (CCC 111 L) + R120 000 (DDD
222 MP) + R100 000 (FFF 444 NW), which equals R300 000. The rst
step in calculating the value of inventory at the end of the month is
to identify which cars have not been sold. From the purchases and
sales information given, we can tell that BBB 000 EC and CA 888 888
have not been sold. This may be veri ed by physically checking that
these are the cars on hand. The value of closing inventory is then the
actual cost of each of these two vehicles, which is R220 000 (R20 000
paid for BBB 000 EC and R200 000 paid for NNN 888 GP).

Examples 7.1 and 7.2 featured a vehicle repair shop. If a speci c
identi cation system were implemented in a vehicle repair shop, this
would mean that each part used in a repair would have to be
speci cally identi ed and traced to the job. In other words, if a car’s
silencer were replaced, the information system would have to be
sophisticated enough to track exactly which silencer was used in a
particular repair job. The cost of that speci c silencer would be
deducted from inventory, and it would be assigned to the particular
repair job.
Standard costs
Key terms: standard cost
The materials pricing systems described above make use of actual

costs. Many organisations which operate a standard costing system
determine standard costs in advance and use these costs throughout
the ensuing period. In these circumstances, the predetermined
standard cost remains constant throughout the period and the cost
accounting records are therefore usually maintained in terms of
physical purchase and issue quantities only. At the end of the
nancial year, any variances between standard cost and actual cost
have to be apportioned between the year’s cost of sales and closing
inventory, to ensure that inventories are valued in terms of nancial
accounting standards. Standard costs are dealt with in more detail in
Example 7.4
At the beginning of the 2XX1 nancial year, a vehicle repair shop set the standard cost
of oil at R17,50 per can. At the beginning of the current month, 8 cans at R17,00 were

in inventory, and a further 10 cans at R18,00 were purchased during the month.
Required:
Calculate the cost of oil for a job requiring 5 cans of oil.
In example 7.4, the cost of oil for a job requiring 5 cans of oil will be
the standard cost of R17,50 per can multiplied by the 5 cans required,
giving a total cost of R87,50.
Note that the standard cost is used instead of the actual purchase
cost.
7.3.2 Determining the cost of labour

To calculate the cost of a job, the hourly rate of direct labour is
required. The hourly rate of direct labour is determined by
calculating the total cost of direct labour for a speci c period and
dividing this by the number of productive hours of direct labour
available during the period.
It is not feasible to use actual direct labour costs and actual direct
labour hours to set an hourly rate for direct labour, because the
organisation would then have to wait until the end of the period
before the hourly rate is known. Organisations therefore use the
budgeted direct labour cost for the coming budget period and the
estimated number of productive direct labour hours during the
period to calculate the budgeted direct labour cost per unit of
product or service. At the end of the nancial year, any variances
between the budgeted direct labour cost and the actual direct labour
cost have to be debited or credited to cost of sales.
The wage system and the total cost of direct labour

Key terms: cost to company, clock cards, time sheets

Organisations operate a payroll system to calculate the wage or
salary payable to employees, using individual employee personnel
records to determine the gross salary or wage, and clock cards or
time sheets to record their presence at work.
The total budgeted cost of direct labour is needed in order to
determine the hourly rate of direct labour. The total budgeted cost is
the budgeted ‘cost to company’. This cost would include the
following:
• The basic salary or wage of the employee concerned (before
deducting contributions to funds)
• The organisation’s share of contributions to the employee’s
pension fund, medical aid fund, unemployment insurance fund,
trade union and, possibly, a group life insurance fund
• Payments by the organisation to the Workmen’s Compensation
Fund and other tax levies based on the salary bill, such as the
skills development levy
Example 7.5
The following estimated direct labour costs were included in Joe’s Vehicle Repair
Shop’s budget for the forthcoming year:
Basic salaries and wages (including employees’ medical aid contributions) R1 500 000
Bonuses R150 000
Employer’s contribution to UIF R33 000
Employer’s medical aid contributions R67 000
Employer’s pension fund contributions R100 000
Skills development levy R150 000
Required:

Calculate the total budgeted cost of direct labour.
The total budgeted direct labour cost for Joe’s Vehicle Repair Shop in
example 7.5 includes the estimated cost of bonuses; employer’s
contributions to UIF, medical aid and pension fund; and the skills
development levy payment, in addition to the basic salary and
wages cost. The total direct labour cost is therefore R2 000 000 (R1
500 000 + R150 000 + R33 000 + R67 000 + R100 000 + R150 000).
Productive direct labour hours available

Key terms: productive hours, idle time
Employees are paid their wage or salary throughout the year, but are
not productive throughout the year. They are entitled to take paid
leave, they may be granted sick leave at full pay, and during each
working day, there are times when they are not at the workbench
(for example, during the regularly scheduled tea break). The
organisation estimates the total number of productive hours for the
budget period in order to calculate the hourly direct labour rate.
There may also be times when the labour force is idle. This could
be due to a machine breakdown, strike action, waiting for materials,
or no work to be done. These idle hours are usually recorded on an
idle time card, and the costs written off as a period cost.
Example 7.6
The workshop manager at Joe’s Vehicle Repair Shop has made the following
estimation of direct labour hours that will be available during the forthcoming year:
Total paid labour hours 10 000 hours

Scheduled paid tea and lunch breaks 1 750 hours
Scheduled ‘down time’ for maintenance of hi-tech tuning machines 250 hours
Estimated idle time during which no work will be available 750 hours
Required:
Calculate the estimated number of productive direct labour hours available in the
forthcoming year.
Since we are interested only in the number of productive direct

labour hours, any hours during which no active work is expected
should be excluded. Therefore, when calculating the number of
productive direct labour hours available in example 7.6, the
scheduled tea and lunch breaks, down time for scheduled
maintenance and the idle time during which no work will be
available must be excluded from the total hours available. The
number of productive direct labour hours is therefore 7 250 (10 000 –
1 750 – 250 – 750).
Once the total cost of direct labour and the productive direct
labour hours for the period are known, the hourly rate of direct
labour can be calculated as illustrated in example 7.7.
Example 7.7
Required:
Using the information given in examples 7.5 and 7.6, calculate the hourly cost of direct
labour for Joe’s Vehicle Repair Shop.
In example 7.5, the total direct labour cost was calculated as R2 000
000 and the total number of productive direct labour hours was
calculated in example 7.6 as 7 250. However, if we want to write off
idle time separately as a period cost, we need to calculate the rate

based on productive direct labour hours (7 250 hours) plus the
estimated idle time during which no work will be available (750
hours). The hourly cost of direct labour is therefore R250 (R2 000 000
divided by 8 000). Of this, R1 812 500 (R250 × 7 250) will be allocated
to jobs and R187 500 (R250 × 750) will be written off as idle time. It is
important to remember that since we need to have a direct labour
rate to apply during the period, the estimated direct labour cost and
estimated hours for the period are used. It is also important to note
that if, for example, there were two additional hours of idle time
while waiting for spare parts to arrive for a repair job (in other
words, actual idle time is two hours more than estimated idle time),
those hours would not be allocated to the job but would be
recognised as a period cost.
Indirect labour
Some labour costs cannot be directly traced to a speci c job, and
these costs are known as indirect labour costs. The cost of indirect
labour is usually debited to the overhead control account and
allocated as part of the total overhead cost to individual jobs, using
an appropriate cost driver. The allocation of overheads to jobs is
discussed next.
7.3.3 Overhead expenses

The cost of each job includes an allocated overhead cost. Overhead
costs usually consist of a variable component and a xed
component. The separation of total overhead cost into the variable
and xed elements was dealt with in Chapter 3, Cost estimation.
Variable overheads

The variable component may include materials and labour, which
vary in relation to the volume of jobs worked on, but cannot be
traced directly to individual jobs. In other words, variable overheads
may include indirect materials and indirect labour. Variable
overhead costs could also include the cost of power used for
machines and similar costs. Chapter 6, Overhead allocation explored
how appropriate cost drivers are selected and used to allocate
variable overhead costs to each job.
Fixed overheads
Fixed overhead costs are costs that do not change within a speci ed
period. In a vehicle repair shop, costs that are xed in the short term
could include the cost of establishing and maintaining the
infrastructure of the workshop, rental paid (or property rates and
insurance where the organisation owns the property), lighting and
heating, insurance, the cost of supervision, and so on.
Some mechanism has to be used to allocate xed overhead costs
to individual jobs, to ensure that the total cost of each job carries its
equitable share of the cost. In a job costing system, the cost driver
often used for this purpose is direct labour. Fixed costs are allocated
either per direct labour hour or in relation to the labour cost charged
to each job.
The budgeted overhead cost and the estimated number of cost-
driver units (hours of direct labour, for example) during a particular
period are used to set the overhead allocation rates, as the actual cost
and the actual activity level will be known only after the end of the
period. It is unlikely that the actual cost incurred during the period
will be exactly the same as the budget or the standard set, and the
variances between the actual cost and the budgeted or standard cost
will have to be disposed of for nancial accounting purposes. The

estimated and the actual capacity level would also differ, and this
would give rise to an under- or over-recovery of xed overhead
costs, which would also have to be disposed of for nancial
accounting purposes. The calculation of the under- or over-recovery
of overheads and the manner in which they are disposed of for
nancial accounting purposes is discussed in Chapter 5, Absorption
versus variable costing.
Example 7.8
The following overhead costs have been extracted from the budget of Joe’s Vehicle
Repair Shop for the forthcoming year:
Indirect materials R50 000
Indirect labour R400 000
Workshop rental R250 000
Workshop cleaning R75 000
Electricity R25 000
Insurance R20 000
Depreciation R30 000
Overheads are allocated to jobs based on direct labour hours. A total of 8 500
productive direct labour hours are estimated to be available for the forthcoming year.
Required:
Calculate the overhead allocation rate for the forthcoming year.
The overhead allocation rate for example 7.8 can be calculated by

dividing the total estimated overhead expenditure by the total
estimated productive direct labour hours. The total estimated
overhead expenditure is R850 000 (R50 000 + R400 000 + R250 000 +

R75 000 + R25 000 + R20 000 + R30 000), and the total number of
estimated productive direct labour hours is given as 8 500. The
overhead allocation rate is therefore R100 per productive direct
labour hour (R850 000/8 500).
Integrating the costing and financial

7.4
accounting systems
Key terms: integrated accounting system, interlocking

accounting system
The costing system may be fully integrated with the nancial

accounting system by making use of a number of control accounts
(and possibly subsidiary ledger accounts). Such a system is called an
integrated accounting system. Organisations may also make use of
an interlocking accounting system. An interlocking system
comprises two entirely separate accounting systems, running side by
side, with only one control account linking the two systems.
Accounting entries for an integrated

7.4.1
job costing system

Materials, labour and overhead costs incurred during a reporting
period are recorded in the control accounts via a series of journal
entries. You should be familiar with the journal entries from your
nancial accounting studies and therefore detailed explanations of
the journal entries have not been given, but an overview of the
entries required is given in Table 7.2.
Table 7.2 Journal entries for an integrated job costing system

Note: The balance of the work-in-progress (WIP) account will consist
of the cost of a number of jobs, unless the organisation is working on
only one job.
Non-manufacturing overheads Cost of sales and inventory valuation

Record costs incurred: Completion of jobs:
Dr Non-manufacturing overheads control Dr Finished goods inventory
Cr Accounts payable Cr WIP control
Invoicing of jobs:
Dr Costs of sales
Cr Finished goods inventory
Dr Accounts receivable
Cr Sales

Note: No closing journal entries have been shown. These would be
the same as those covered in nancial accounting texts.
Accounting entries for an interlocking

7.4.2
job costing system

With an interlocking accounting system, the costing accounts are
maintained independently from the nancial accounts, so a control
account must be maintained in the costing accounts to record the
corresponding entries that would have been recorded in the nancial
accounts if the systems had been integrated. This control account is
commonly referred to as the ‘cost control account’ and ensures that
the double entries are maintained in the costing accounts.
The journal entries for an interlocking job costing system would
be the same as for an integrated system shown in Table 7.2, except
that entries in the accounts payable, bank, PAYE, UIF, accumulated
depreciation and accounts receivable accounts would be replaced
with entries to the cost control account.
Example 7.9
The following transactions occurred in Joe’s Vehicle Repair Shop during July:
1 Materials amounting to R1 million were purchased.
2 Direct materials totalling R800 000 were issued to jobs.
3 Stores requisitions for indirect materials totalled R150 000.
4 Total wages of R2 million were paid. This consisted of wages paid to employees of
R1 460 000, PAYE of R500 000 and UIF of R40 000. 80% of the total wages paid
related to direct labour and the rest to indirect workshop labour.
5 Indirect workshop expenses of R250 000 were incurred.
6 Depreciation on workshop machinery amounted to R50 000.
7 Total overheads of R825 000 were allocated to jobs based on the overhead
allocation rates.
8 Other overheads not directly related to repair vehicles of R200 000 were incurred.

9 Jobs with a total cost of R3 200 000 were completed.
10 Customers were invoiced a total of R4 000 000 for completed jobs. This
represented a cost of R3 100 000.
Required:
Prepare general ledger T-accounts for the above transactions, assuming that the
organisation uses:
1 an integrated system
2 an interlocking system.
Closing entries are not required.
The T-accounts for the integrated system are summarised in Table

7.3. The purchase of the materials is recorded by debiting the stores
ledger control account and crediting the accounts payable account.
The issue of direct materials to jobs is recorded through a debit to the
WIP account and a credit to the stores ledger control account. Stores
requisition for indirect materials is recorded via a debit to workshop
overhead control and a credit to the stores ledger control accounts.
The payment of wages to employees, PAYE and UIF is recorded with
a debit to the wages control and credits to the bank, PAYE and UIF
accounts. The 80% portion of total wages paid to direct labour
amounting to R1 600 000 (R2 million × 80%) will be allocated to WIP,
with a debit to the WIP account and a credit to the wages control
account. The remaining R400 000 (R2 million – R1 600 000) is
allocated to the workshop overhead account, as it relates to indirect
overheads, with a debit to the workshop overhead account and a
credit to the wages control account. As with the recording of indirect
materials, indirect workshop expenses are recorded as a debit to
workshop overhead control and, unlike indirect materials, a credit to
accounts payable.
The depreciation on workshop machinery represents an indirect
cost and is therefore recorded through a debit to workshop overhead
control and a credit to accumulated depreciation. The allocation of

overheads to jobs is recorded by debiting WIP and crediting the
workshop overhead control account. Note that the difference
between the workshop overheads actually incurred and the
overheads allocated to jobs represents an under-recovery of
overhead as more overhead expenses have been incurred than were
allocated. The other overheads not directly related to the repair of
vehicles are recorded in a separate control account, non-repair-
related overheads. When jobs are completed, the cost of the jobs
completed is recorded by crediting WIP and debiting nished goods.
The cost of completed jobs invoiced to clients is recorded with a
credit to nished goods and a debit to cost of services rendered. The
invoice value of completed jobs invoiced is recorded with a debit to
accounts receivable and a credit to sales.
Table 7.3 T-accounts for an integrated system

The T-accounts for an interlocking system are summarised in Table
7.4. These T-accounts are the same as for an integrated system shown
in Table 7.3, except that entries in the accounts payable, bank, PAYE,
UIF, accumulated depreciation and accounts receivable accounts are
replaced with entries to the cost control account.
Table 7.4 T-accounts for an interlocking system

7.5 Summary
Job costing is used in industries in the manufacturing sector, and
examples include designing and installing security systems,
restoring or repairing various types of asset, or producing articles to
the speci cations of the client – dressmaking and tailoring, furniture
and upholstery, and innumerable others. Job costing systems are also
used in the service industry, and examples include the services of
electricians, plumbers, carpenters, decorators and many others.
Each job is unique and requires a different input of materials,
labour and variable overhead. Each job carries its share of the overall
xed overhead cost of the organisation. A job costing system is
designed to provide the information necessary to allocate the correct
cost to each job, to account for the cost of sales and the value of
inventory, and to provide cost information for decision-making and
for budgeting and control purposes.
Conclusion: Job costing and other topics

in this book
Many of the concepts explained in this chapter can be applied when
studying other topics. Determining the cost of materials and the

issue price, determining the cost of and accounting for direct labour,
and allocating variable and xed overheads are actions that are also
required for process costing (see Chapter 8), joint and byproducts
(discussed in Chapter 9), relevant costing (see Chapter 10) and
standard costing (covered in Chapter 13).
Tutorial case study: PricewaterhouseCoopers
PricewaterhouseCoopers (PwC) provides industry-focused assurance, advisory and

tax services to public, private and government clients in all markets.
SOURCE: PWC (2019)
1 Discuss whether it would be appropriate for PwC to use a job costing system for
accumulating the costs involved with each client.
2 Assume that PwC did adopt a job costing system. Working in pairs, prepare a
written report which addresses each of the following requirements. Give reasons
for your viewpoints, where relevant:
3 Explain how the cost of the labour used in providing services to its clients would
be determined.
4 Describe what overheads you would expect to be allocated to clients and how
this allocation would be calculated.
5 Identify which journal entries would be required to record the costs assigned to
clients.
Basic questions
BQ 1
An organisation issues raw materials from inventory on the
weighted average basis and uses this basis to value closing
inventory. Using the following information, how would the closing
inventory of material M be valued?

BQ 2
What costs, other than the cost of the raw materials themselves, are
often incurred in respect of the purchase of raw materials, and how
are these costs dealt with for cost accounting purposes?
BQ 3
There are two valuation methods most commonly used to price the
issue from inventory of raw materials to individual jobs for cost
accounting purposes. Describe the two methods and distinguish
between them. Would either of these methods be appropriate for
decision-making purposes and, if not, what method should be used?
BQ 4
How is the hourly cost of direct labour calculated? List the various
labour-related costs that may be involved. How is each dealt with in
calculating the hourly direct labour ‘cost to company’?
BQ 5
An organisation uses productive direct labour hours to allocate
indirect overheads to jobs. If the total estimated productive direct

labour hours are 5 000 and the total estimated overheads are R1
million, what amount of overheads should be allocated to a job
which took two direct labour hours?
BQ 6
SOURCE: ADAPTED FROM RHODES UNIVERSITY
Assume that the organisation uses the weighted average method to
issue raw materials to individual jobs. What will this store’s ledger
card look like if you ll in the missing information?
BQ 7
Which of the following companies would not use a job costing
system, and why not?
1 Norton Rose Fulbright
2 Sasol

3 WBHO Construction
4 Coco Cola
BQ 8
Job 77 was started and completed on 3 December. The following
details appeared on the job card:
Direct materials issues R30 000
R5 000
R15 000
Direct labour 200 hours @ R100 per hour
Overheads R50 per direct labour hour
The mark-up on job 77 was 100% of cost.

What are the journal entries to record the above costs, the
completion of job 77 and the sale of job 77?
BQ 9
The following information relates to a job costing system:
R
Direct materials issued 500 000
Indirect materials issued 100 000
Direct labour (1 000 hours) 1 000 000
Indirect labour 200 000
Depreciation of factory building and machinery 50 000
Other factory overheads 150 000
Factory overhead allocation rate (per direct labour hour) 50

What total amount should be credited to the store’s ledger control
account?
BQ 10
The following information relates to a job costing system:
R
Direct materials issued 500 000
Indirect materials issued 100 000
Direct labour (20 000 hours) 1 000 000
Indirect labour 200 000
Depreciation of factory building and machinery 50 000
Other factory overheads 150 000
Factory overhead allocation rate (per direct labour hour) 25
Increase in work-in-progress balance 300 000
What total amount should be debited to the nished goods account?
Long questions

TMU CC produces custom hardwood furniture in two production
departments, which are supported by two service departments. The
budgeting committee of TMU CC drew up the following budget for
2XX9:

The cost of machinery is included in xed overhead costs.
The expenses of the service departments are apportioned as
follows:
The actual production data for 2XX9 was as follows:

There was no un nished work at the beginning of 2XX9.
REQUIRED Marks
(a) Calculate the total budgeted overhead cost for production departments 1 and 2 for 2XX9. 9
(b) Calculate the predetermined overhead rates for:production department 1, as a percentage of

direct material costproduction department 2, in cents per labour hour.Rounding must be to 2
one decimal place.
(c) Justify the use of budgeted overhead rates as a means of allocating overhead expenditure
2
rather than actual overhead rates.
(d) Calculate the total cost of completing job 100. 4
Effective communication skills 2

TOTAL MARKS 19

Robertsons Service Centre repairs all types of motor vehicle and has
a highly trained team of motor technicians. The owner of the
business is concerned because, despite the increase in turnover, the
pro ts have not increased to the same extent. He suspects that the
charge-out rate for skilled labour may be too low.
You are presented with the following information relating to the
previous 12 months:
Extracts from the accounting records

• Gross basic wages paid: 10 technicians at R2 500 each, per week
• Income tax deducted from wages: R483,60 each, per week
• Employee contributions to a pension fund: 7,5% of the gross basic
• wage, deducted from the weekly wage; the employer makes a
further
• contribution of 7,5% of the gross basic wage
• Employee contribution to a medical aid fund: R200 per week,
deducted from the weekly wage; the employer makes a further
contribution of R100 per employee per week
• Contribution to the Unemployment Insurance Fund: each
employee and the employer contribute 1% of the gross basic
wage
• Contributions to the Workmen’s Compensation Fund: the
employer contributes R160 per month per employee to the fund
• Other levies based on gross basic wages paid: the employer
contributes 3% of gross basic wages
Terms of employment

Employees work eight hours a day for ve days a week. They are
granted two weeks of fully paid leave each year. In addition, there
are ten fully paid public holidays during the year.
Productivity
Over the past 12 months, the records show that a total of 50 working
days were lost owing to fully paid sick leave and that, of the
remaining available time, a 95% productivity level was achieved as a
result of unproductive time from scheduled tea breaks and normal
maintenance requirements.
Details relating to the next 12-month period

Wage negotiations with employees are expected to result in a basic
wage increase of 5% across the board. Medical aid contributions are
expected to increase by 10% and Workmen’s Compensation
insurance by 8%.
REQUIRED Marks
Calculate the hourly direct labour rate to be budgeted for for the coming 12-month period. 7
TOTAL MARKS 7

Bandle Ltd (Bandle) operates in the building industry and
manufactures a number of custom-made products for a variety of
roo ng-related applications. Bandle operates a job costing system
which identi es costs directly with a speci c job where this is
possible and reasonable. In addition, production overhead costs are
absorbed into the cost of jobs at the end of each month at an actual
rate per direct labour hour for each of the two production

departments, namely the assembly shop and the painting
department.
The accountant of Bandle has prepared the following accounting
data for the month of February 2XX9 relating to the two production
departments:
Notes:
1 All direct labour in the assembly shop (2 020 hours) is paid a
basic wage of R45,00 per hour and in the painting department (2
800 hours), R40,00 per hour. The assembly shop direct labour
includes a total of 20 hours spent on recti cation work, which is
considered a normal business overhead.
2 Assembly shop overtime premium is a general manufacturing
overhead. All painting department overtime is allocated directly
to the speci c job requiring early completion.
Direct materials are costed at the end of each month on a weighted

average basis. Relevant information relating to two direct materials
used during February 2XX9, namely X1 and X2, is presented below:

One of the jobs carried out during the last week of February 2XX9
was for a client called Roof Rite (Pty) Ltd. The following information
relates speci cally to the Roof Rite (Pty) Ltd job:
• 400 metres of X1 were withdrawn from the raw materials
warehouse.
• 76 direct labour hours were worked in the assembly shop.
• 300 litres of X2 were issued to the painting department. The
painting department returned 35 litres to the warehouse as it was
excess to the requirements for the job.
• 110 direct labour hours were worked in the painting department.
• The painting department discovered some defects in the Roof
Rite (Pty) Ltd work performed by the assembly shop and
returned the items for recti cation. 3 labour hours were worked
in the assembly shop on recti cation (these are additional to the
76 hours mentioned above). Such recti cation is regarded as a
normal part of Bandle’s business.
REQUIRED Marks
(a) Calculate:(i) the overhead rate for each production department(ii) the cost of the Roof Rite (Pty) 18

Ltd job.
(b) Critically discuss the manner in which Bandle calculates production overhead allocation rates
4
for each of the two production departments.
TOTAL MARKS 22

You have been asked to price a special order for 100 ornamental
wooden screens. You have been provided with the following
information in order to do so:
Wood
The organisation issues its wood from the store to individual jobs on
the FIFO basis.
It has 400 kg of suitable wood in store at a stores price of R10,10
per kg. It has just placed an order to purchase 2 000 kg of wood at a
cost of R9,95 per kg.
Each screen uses 10 kg of wood. In addition, the cost of sundry
materials consumed in producing the screens amounts to R1,20 per
kg of wood used.
Direct labour
The organisation employs 20 craftsmen at a total cost to the company
of R235 200 per month. There are on average 20 working days in a
month (of 8 hours a day). The organisation has just agreed to a 10%
increase in the basic wage (which amounts to an 8% increase in the
cost to company), with immediate effect.
Each screen takes 4 hours to produce. Because the order is urgent
and the organisation is working at close to full capacity, the

craftsmen have to work overtime to produce the whole order. The
overtime rate is charged out at 1,5 times the normal rate.
Overheads
Variable overhead costs amount to R5,00 per direct labour hour and
xed overhead costs amount to R2,00 per direct labour hour.
Mark-up on cost
The organisation applies a mark-up suf cient to earn a gross pro t
percentage of 50%.
REQUIRED Marks
Calculate the amount to be quoted for the special order for the ornamental wooden screens. 10
TOTAL MARKS 10

One of the departments in a furniture factory restores antique
furniture. The work is carried out by highly skilled workmen, using
hand tools. As there are no direct materials involved, all the indirect
materials are debited to the overhead account.
You have been asked by the director of the organisation to
calculate the price to be charged for a job involving the restoration of
an antique dining room suite. The dining room suite consists of a
table, 24 chairs and two buffets. You are presented with the
information set out below:
Factory overhead costs

The budgeted overheads for the factory as a whole for the year are as
follows:

R
Rent, lighting, heating and cleaning 400 000
Factory supervisor’s salary and the cost of his of ce administration 150 000
The furniture restoring department occupies 20% of the oor space

in the factory and employs 5 skilled workers and 10 casual labourers.
The total workforce in the factory amounts to 100 workers.
Overhead costs of the furniture restoring department

In addition to the overhead costs of the entire factory allocated to the
department, it will incur the following budgeted overhead costs
during the year:
Indirect materials 50 000
Depreciation of tools and other xed costs 80 000
Power 11 500
Wages of casual labourers 160 000
Allocation of overhead costs

All overhead costs are allocated on the basis of budgeted available
skilled labour hours.
Skilled labour costs

The 5 skilled workmen earn R120 000 each per annum and each
workman works, on average, 2 000 hours per year.
The restoration job to be priced

The factory foreman estimates that the restoration of the dining
room suite will take 120 hours of skilled labour time.

Mark-up
The organisation uses a mark-up of 50% on selling price in setting
prices.
REQUIRED Marks
Calculate the price to be charged for the job of restoring the antique dining room suite. 12
TOTAL MARKS 12
References
maxEnergy. 2019. Must know. [Online]. Available: http://maxenergy.co.za/must-know/ [21
October 2019].
PricewaterhouseCoopers. 2019. About us. [Online]. Available: https://www.pwc.co.za [21
October 2019].

LEARNING OBJECTIVES
• calculate:
• the number of equivalent units produced during a particular
period, and
• the cost per unit incurred during a particular period
• prepare a production cost statement re ecting the cost of nished
goods and the cost of work-in-progress at the end of the period
• calculate, account for and discuss the impact on cost of normal
losses, abnormal losses, and abnormal gains in a process, during
a particular period
• understand the impact that the point at which the units are
inspected and losses in process are identi ed has on:
• the equivalent production costs
• the unit cost, and
• the production cost statement re ecting the cost of nished
goods, closing work-in-progress, and abnormal losses or
gains
• discuss the difference between the weighted average method of
valuing nished goods and work-in-progress, and the rst-in-
rst-out (FIFO) method, and discuss when it is appropriate to use
each method
• discuss and account for the effect of the sale of scrap.

Coca-Cola and process costing
Coca-Cola is the largest beverage company in the world and has over 500 brands.
The company’s products are sold in more than 200 countries in 24 million retail
outlets across the world. Coca-Cola is produced in a process consisting of a
number of steps: water treatment, syrup preparation, carbonating and bottling.
Coca-Cola brands in South Africa include Coca-Cola Original, Coca-Cola No
Sugar and Coca-Cola Light.
SOURCE: THE COCA-COLA COMPANY (2019)
The batches of Coca-Cola Original produced during any given period go through the
same process and each litre produced is the same. It is therefore not necessary to
accumulate costs individually for each litre of Coca-Cola Original produced during a
given period. Instead, a process costing system can be used to accumulate the total
costs incurred in the manufacturing process and these total costs can then be
allocated to individual bottles of Coca-Cola Original. This can be contrasted with the
motor repair shop examples in Chapter 7, Job costing, where each individual job
had to be costed separately, as each job was unique.
8.1 Introduction
Key terms: process costing
Process costing is a system used to determine the cost of a large

number of identical product units produced in a continuous process.
Each unit consumes an identical amount of variable and xed cost.
Unlike job costing systems, which trace and allocate costs to each
unique job, process costing systems do not trace and allocate costs to
individual product units. Costs incurred during a particular costing
period are accumulated and allocated to all units produced during
the period. The price of each unit produced during the costing
period is then calculated as follows:

Unit cost = total cost ÷ total number of
units
The Chartered Institute of Management Accountants (CIMA) (2000)

de nes process costing as follows:
The costing method applicable where goods or services result

from a sequence of continuous or repetitive operations or
process. Costs are averaged over the units produced during the
period.
The types of cost involved in a process manufacturing system are the

same as in any other mode of production: direct materials, direct
labour, other direct costs and indirect overhead costs. Materials are
introduced at the start of the process and, possibly, additional
materials are added at a later stage in the process. The direct labour
cost and the direct and indirect overhead costs are usually combined
as ‘conversion costs’. Labour and machinery may not work in
unison, but may be applied at different stages of the process. A batch
of products may be subjected rst to manual processing and then
progress through a mechanised processing stage. In this case, the
two types of cost are allocated separately – labour costs as one cost
category, and variable and xed costs relating to the use of
equipment as another. The ow of costs in a simple process costing
system is illustrated in Figure 8.1.
Figure 8.1 Flow of costs in a simple process costing system

8.2Calculations in a process costing
system
The objective of a process costing system is to calculate the unit cost
of the products produced during the period. Typically, the
calculation of the unit cost is supported by three statements: the
statement of equivalent production, the unit cost statement, and the
production cost statement. The statement of equivalent production is
used to calculate the number of units produced during the period.
The unit cost statement calculates the average cost of producing one
unit during the period, while the production cost statement
reconciles the costs allocated to units during the period with the cost
of production during the period.
The rst example illustrates the most basic situation encountered
in a process costing system.
Example 8.1
Details relating to ABC Ltd’s production during November:

Units Started and completed during November 20 000
Cost Direct materials R40 000
Direct labour R190 000
Manufacturing overhead cost R70 000
Required:
Draw up the following statements:
1 Equivalent production
2 Unit cost
3 Production cost
The equivalent production, unit cost and production cost statements

for example 8.1 are given in Table 8.1. Note that the equivalent
production statement re ects that 20 000 units were started (re ected
in the input units column) in the process during November and 20
000 units were completed (re ected in the total column under output
units). Note also that the total output is shown as the number of
units that incurred materials and conversion costs during the period.
The signi cance of this will become more evident once the
complexity of work-in-progress has been discussed (refer to section
8.2.1 below).
The total materials, labour and overhead costs are re ected in the
unit cost statement. Note that both labour and overhead costs form
part of the conversion costs. The unit materials cost is calculated by
dividing the cost of materials, R40 000, by the equivalent units
processed, 20 000, as re ected in the ‘materials’ column in the
statement of equivalent production. The unit conversion cost is
calculated in the same way. The total unit cost (R15) is calculated by
adding the unit materials cost (R2) to the unit conversion cost (R13).
The total unit cost is not calculated by dividing the total cost by the
total unit column. In this simple example, the result would be the

same (R300 000/220 000 = R15), but if the elements of cost were at
different stages of completion or losses in the process were involved,
the wrong result would have been obtained.
The production cost statement re ects that during the period, 20
000 units at a unit cost of R15 were completed and included in the
nished goods inventory.
The total cost allocated to nished goods was R300 000 (20 000
units × R15 per unit). Note that the total cost re ected in the unit cost
statement (R300 000) and the total of the production cost statement
(R300 000) are the same, indicating that all costs have been
accounted for.
Table 8.1 Equivalent production statement, unit cost statement and production cost
statement for example 8.1
8.2.1 Work-in-progress

Key terms: work-in-progress, equivalent full units
One of the main problems that arises in process costing systems is

that, at the end of a costing period, some units may be only partially
completed. These partially completed units are referred to as work-
in-progress (hereafter ‘WIP’). As the WIP units are not fully
completed, additional costs will be incurred in the following period
to complete them. Therefore, if WIP units were treated as fully
completed units or were ignored in order to calculate a unit cost, it
would mean that costs would not be accurately allocated. Incorrect
inventory valuation would result.
The problem is solved by expressing partially completed units as
equivalent full units, using the percentage of completion. As an
example, 5 000 litres of Coca-Cola that have gone through 30% of the
process is expressed as being equivalent to 1 500 (5 000 × 30%)
complete litres.
Closing work-in-progress
Example 8.2 introduces the complexity of the situation where there is
work-in-progress. The statement of equivalent production, unit cost
statement and production cost statement for this example are given
in Table 8.2.
Example 8.2
Details relating to CDE Ltd’s production during December:
Units Started during December 14 000
Completed 13 000
Closing work-in-progress (75% complete) 1 000

Note: This means that 1 000 un nished units are in work-in-progress at the end of the period,
and they are 75% complete.
Direct materials R14 000
Cost Direct labour R55 000
The cost driver for overhead cost is direct labour hours, and all direct materials are
added at the beginning of the process.
Required:
2 Unit cost
3 Production cost
Table 8.2 Statement of equivalent production, unit cost statement and production cost

As with example 8.1, the units started are re ected in the input units
column of the statement of equivalent production. However, here the
units started have to be split up in the output units column between
the units that have gone through the whole process and were
therefore completed (the 13 000 units) and those that are still in
progress at the end of the period (the 1 000 units). It is important to
note that since the 13 000 units have been through the whole process,
they will have incurred the full materials and conversion costs and

therefore the full 13 000 units are re ected in the materials and
conversion columns.
The 1 000 un nished units have incurred all of the direct
materials costs, since direct materials are added at the beginning of
the process. The full 1 000 units are therefore re ected under
materials in the output units column. However, since the 1 000 units
are only 75% complete, they would have incurred only 75% of the
conversion costs, which is equivalent to 750 (1 000 × 75%) full units
incurring the full costs. Therefore only 750 units are re ected under
conversion in the output units column. In the same way as in
example 8.1, the total of the input units column and the total of the
output units column are the same, con rming that all units have
been accounted for.
The materials, labour and overhead costs are recorded in the unit
cost statement in the same manner as in example 8.1. Once again, the
unit materials cost (R1) is calculated by dividing the cost of materials
by the equivalent units processed (obtained from the equivalent
production statement), and the unit conversion cost (R6) is
calculated in the same way. Remember that the total unit cost (R7) is
calculated by adding the unit materials cost to the unit conversion
cost. The total unit cost is not calculated by dividing the total cost by
the total units column. As illustrated with this example, this would
result in the incorrect total unit cost (R96 500/14 000 gives an
incorrect answer of R6,89 instead of R7).
The production cost statement now re ects the cost allocated to
WIP, in addition to the costs allocated to nished goods. Note that
since a different number of equivalent WIP units has incurred
materials and conversion costs respectively, a separate allocation of
materials and conversion costs is required. Once again, the total cost

re ected in the unit cost statement and the total of the production
cost statement agree.
Opening work-in-progress
In example 8.3 which follows, incomplete units are brought forward
from the previous reporting period, and there are un nished closing
work-in-progress units at the end of the current reporting period. As
partly completed units are brought forward from the previous
period (and therefore also the costs which were incurred in the
previous period on these units), it is necessary to stipulate the
valuation method that is to be used.
In Chapter 7, Job costing it was noted that there are various
inventory valuation methods: the weighted average method, the
rst-in- rst-out (FIFO) method, the last-in- rst-out (LIFO) method,
speci c identi cation, and standard costing. As noted in Chapter 7,
the LIFO method is generally not particularly useful and is not an
acceptable method for valuing inventory for nancial reporting
purposes. Speci c identi cation is useful for job costing only and
will not help us to value the large number of identical units
encountered in a process costing system. Standard costing is dealt
with in Chapter 13, Standard costing. The LIFO, speci c identi cation
and standard costing valuation methods are therefore not considered
further in this chapter. This leaves us with two valuation bases to
consider: weighted average and FIFO.
The weighted average method merges opening work-in-progress
units and costs with new units started during the accounting period
and the costs incurred during the period, in order to calculate the
unit cost and the cost of production for that
period. Therefore, under the weighted average method:

• opening work in progress equivalent units are added to the units
started during the current period
• the costs brought forward from the previous period are added to
the costs incurred during the current period
• the total of the costs brought forward from the previous period
and the costs incurred in the current period are divided by the
total number of equivalent units for the period plus the opening
WIP equivalent units in order to calculate the unit cost.
When calculating current period costs, the FIFO method takes into
account only the units started during the current period. It
accumulates the costs incurred in the current period to complete
these units as well as the costs incurred to complete the equivalent
units that were incomplete at the start of the period. The equivalent
units that were incomplete at the start of the period and their
associated costs are then added to the current period equivalent
units and the current period costs, in drawing up the production cost
statement. Notice that the choice of valuation method (weighted
average cost versus FIFO) is relevant only when there is opening
work-in-progress, because it determines the value of the units
brought forward from the previous period. Where there is no
opening work-in-progress, both methods result in the same
valuation.
In example 8.3, the weighted average cost method is used, and
example 8.9 illustrates the FIFO method.
Example 8.3
Details relating to XYZ Ltd’s production during January:
Units Opening work-in-progress (60% complete) 2 800

Started during January 14 000
Completed 14 680
Closing work-in-progress (30% complete) ?
Opening work-in-progress:
Note: Notice that these costs were incurred in the previous period to bring the opening work-
in-progress of 2 800 units to its 60% stage of completion. The opening work-in-progress is
Cost
processed further in the current period (40% of the work is done in the current period) and the
costs associated with their completion are included in the ‘current period’ costs below.
Costs incurred during the current period:
added at the beginning of the process. The company uses the weighted average
method to value its inventory.
Required:
2 Unit cost
3 Production cost

for example 8.3 are given in Table 8.3. As with the two previous
examples, the units started during the current period are re ected in
the input units column in the equivalent production statement. Since
the opening WIP brought forward from the previous period is an

input into the current period’s process, these 2 800 WIP units are also
re ected in the input units column. The question states that 14 680
units were completed in the period, so these units are recorded in the
output units column. Once again, since these units would have gone
through the whole process and incurred the full materials and
conversion costs, the full 14 680 units are re ected under both
materials and conversion in the output units column. Note that these
completed units include units from the opening WIP (which still had
to be nished in the current period) and units from those started in
the period, but that all 14 680 units are now complete in terms of
materials and conversion. The information given indicates that there
is also closing WIP, but does not provide the number of units. Since
we know that the total of the input and output columns should
agree, the number of closing WIP units can be calculated. As with
the treatment of closing WIP in example 8.2, the closing WIP units
would have incurred the full materials costs (because all direct
materials are added at the beginning of the process), but since they
are only 30% complete, they would have incurred only the
equivalent of 636 units (2 120 units × 30%) in conversion costs.
In addition to recording the materials and conversion costs
incurred in the current period in the unit cost statement, the costs
that were incurred in producing the opening WIP in the prior period
are also recorded in the unit cost statement. The total unit cost,
materials unit cost and conversion unit cost are calculated in the
same manner as in the two previous examples.
In the same manner as in example 8.2, the total costs allocated to
nished goods and the materials and conversion costs allocated to
closing WIP are recorded in the production cost statement.

8.2.2 Losses and gains in the process

Key terms: abnormal losses or gains, inspection, normal losses
A further problem that needs to be dealt with relates to losses in the

production process. For example, the total volume of Coca-Cola that
is produced is likely to be less than the total quantities of water and
other materials put into the process. It is necessary to differentiate
between normal losses and abnormal losses or gains. Normal losses
are expected or anticipated and arise when the process is running
according to plan. Normal losses may arise from the anticipated
shrinkage or evaporation of materials or from cut-off fabric that is
discarded, such as wood shavings, metal lings, cloth discarded in
the clothing industry, and so on. Abnormal losses or gains, on the
other hand, arise where actual losses in the process differ from the
anticipated (budgeted) losses. Examples of abnormal losses include
losses arising from wastage, machine breakdowns or spillage. The
process costing system has to provide for normal losses by
incorporating such budgeted losses in the normal cost of production,
but abnormal losses or gains are accounted for separately.
Where the actual losses during the production process exceed the
planned losses, these are referred as abnormal losses. Likewise,
where the actual losses during the production process are less than
the planned losses, these are referred to as abnormal gains. Unlike
normal losses, abnormal losses and gains are re ected separately in
the production cost statement. Abnormal losses are written off as
period costs, and abnormal gains are recorded as revenues in the
costing income statement. How they are dealt with for nancial
accounting purposes in the annual nancial statements will depend
on the reason for their occurrence, as well as the monetary amount
involved. If the amount involved is not material, the abnormal losses
or gains could be transferred to the overhead account and re-

allocated as part of the over- or under-recovery of overheads. If the
amount is material, separate disclosure may be required.
Losses are identi ed by inspection of the production output.
Units are counted, measured or weighed and inspected for faults.
Normally, inspection takes place at the end of the process, and
example 8.4 illustrates this. However, inspections could also occur at
a different point in the process, and this is illustrated in example 8.5.
Normal losses identified at the end of the process

Example 8.4 illustrates the impact of normal losses when the losses
are identi ed at the end of the process. To simplify the illustration,
no WIP and no abnormal losses feature in this example.
Example 8.4
Details relating to DEF Ltd’s production during January:
Anticipated normal losses – 10%
Units Inspection point – at the end of the process
No opening or closing work-in-progress
No abnormal losses or gains

Cost
Conversion R54 000
Required:
• Equivalent production
• Unit cost
• Production cost

for example 8.4 are given in Table 8.4. As the loss was discovered
only at the end of the process, it affected all the units worked on
during the period. Since the only units worked on during the period
were the units started (there was no WIP), the normal loss units are
calculated as being 10% of the units started. These normal loss units
are recorded in the output column of the equivalent production
statement in order to balance the total of the input unit column and
the total of the output unit column. The normal loss units are also
extended across the materials and conversion columns to re ect that
these units would also have incurred materials and conversion costs.
Since the normal losses are considered to be a normal part of the
process, the cost of the normal loss is included in the total cost of
nished goods.
This is also consistent with the requirements of IAS 2, Inventories
and therefore with the requirements for nancial reporting.

* Note that the total costs included in the production cost statement equal the total costs incurred during the
period (as given in the information).
Losses identified before the end of the process

Example 8.5 illustrates two additional aspects that did not feature in
the previous example: an inspection point at the 50% stage of
production, and closing work-in-progress at the end of the period.
When working with losses before the end of the process, it is
assumed that conversion costs are incurred evenly throughout the
process (in other words, in this case, 50% of conversion costs are
incurred before the inspection point).
Example 8.5

Details relating to MNO Ltd’s production during December:
Started during December 12 000
Units Inspection point – 50% stage of production
Completed 9 500
Closing work-in-progress, 40% complete 2 000

Cost
Conversion costs R47 475
All direct materials are added at the beginning of the process. Conversion costs are
incurred evenly throughout the process.
Required:
2 Unit cost
3 Production cost

for example 8.5 are given in Table 8.5. The units started, completed
units and closing WIP units are re ected in the equivalent
production statement in the same manner as in example 8.2. The
calculation of the loss units is based on the number of units that
reached the inspection point at the 50% stage of production.
In determining the number of units that reached the inspection
point, it is important to determine whether any WIP units reached
the inspection point during the current period. If they did, then the
loss affected WIP as well. However, if the WIP units did not reach
the inspection point in the current period, they should be excluded
from the loss calculation. In example 8.5, closing WIP is 40%
complete and since the inspection point is at the 50% stage, the

closing WIP units would not have passed through the inspection
point where the loss occurred. The closing WIP units should
therefore be excluded from the number of units reaching the
inspection point. 10 000 units would have reached the inspection
point (12 000 started less the closing WIP of 2 000 units). The normal
losses are 500 units (10 000 units reaching the inspection point × 5%
normal loss). These 500 normal loss units are re ected in the
equivalent production statement in the same manner as in example
8.4 except that, since the inspection point is at the 50% stage, only
50% of the conversion costs will have been incurred. The equivalent
normal loss units relating to conversion are therefore only 250 units
(500 normal loss units × 50% completion at the inspection point).
The unit cost statement and production cost statement are drawn
up using the same principles that were illustrated in examples 8.2
and 8.4. Note that the full cost of the normal loss has been allocated
to nished goods. This is because work-in-progress has not yet
reached the inspection point. If the work-in-progress had passed the
inspection point in the current period, the normal loss would need to
be pro-rated between nished goods and work-in-progress. This
could be done on the basis of units or cost. In practice, the tedious
allocation would automatically be done by process costing software.
Note once again that when the equivalent production statement
is drawn up, the input units column and the output units column
both add up to 12 000 units. This is an indication that all units have
already been accounted for, and it is therefore apparent that no
abnormal losses or gains occurred. This is, however, not the case in
the next example.

Opening and closing work-in-progress and abnormal
losses
Example 8.6 has opening and closing work-in-progress, normal and
abnormal losses and an inspection point when the process is 60%
complete.

Example 8.6
Details relating to PQR Ltd’s production during January:
Units
Opening work-in-progress on 1 January (80% complete) 2 000
Inspection point – 60% stage of production
Completed 6 000
Closing work-in-progress, 40% complete 3 000
Cost
Current costs:
All direct materials are added at the beginning of the process. Conversion costs are
incurred evenly throughout the process.
The weighted average method is used for inventory valuation.
Required:
2 Unit cost
3 Production cost

for example 8.6 are given in Table 8.6. The opening WIP, new units
started, completed units and closing WIP units are re ected in the
equivalent production statement in the same manner as in examples
8.2 and 8.3. The calculation of the loss units is based on the number
of units that reached the inspection point at the 60% stage of
production.
8 000 units started the process and since closing WIP was 40%
complete, only 5 000 units (8 000 started – 3 000 closing WIP) would
have progressed past the 60% inspection stage. In addition, since the
opening WIP was 80% complete, it would have passed through the
inspection point in the previous period. These opening WIP units are
therefore excluded from the current period normal loss calculation.
A total of 5 000 units (8 000 started – 3 000 closing WIP) would have
passed through the inspection point, and the normal losses are
therefore 500 units (5 000 units reaching the inspection point × 10%
normal loss). These 500 normal loss units are re ected in the
equivalent production statement in the same manner as in examples
8.4 and 8.5. Once again, note that since the inspection point is at the
60% stage, only 60% of the conversion cost would have been
incurred on the normal loss units and therefore only 300 equivalent
normal loss units (500 normal loss units × 60%) are re ected in the
conversion column.
In the previous example, it was stated that there were no
abnormal losses. In this example, it is important to determine
whether there are any abnormal losses or gains. The easiest method
is to see whether the input and output columns of the equivalent
production statement balance without including abnormal losses. In
example 8.6, it can be seen that if no abnormal losses are accounted
for, the total input column of 10 000 units (2 000 units + 8 000 units)

would not agree with the total output column of 9 500 units (6 000
units + 3 000 units + 500 units). Therefore, there must have been 500
abnormal loss units (10 000 units – 9 500 units).
Similarly to normal loss units, when the abnormal loss was
detected at the inspection point, these units had already received all
of their materials, since materials are added at the beginning of the
process. However, once the loss was detected, the units would not
have been subjected to any further processing. The abnormal loss
units are therefore 100% complete in terms of materials (500 units of
materials have been lost) and only 60% complete in terms of
conversion costs (500 abnormal loss units × 60% complete = 300
units of conversion costs have been lost).
The unit cost statement is drawn up using the same principles
that were illustrated in example 8.3. The nished goods and closing
WIP portions of the production cost statement are prepared in
exactly the same manner as in example 8.5. However, note that an
extra component is added for the costs that are allocated to the
abnormal loss units. Since these losses are not expected and are not
part of the normal process, the cost of the abnormal losses is
accounted for separately. This cost is treated as a period cost in the
pro t and loss account. Notice that, as in example 8.5, the cost of the
normal loss has been allocated to nished goods only. Once again,
this is because neither opening nor closing WIP passed through the
inspection point in the current period. If either or both opening and
closing WIP had passed through the inspection point in the current
period, the cost of the normal loss would need to be pro-rated across
those units which had passed through the inspection point. As
discussed above, this pro-ration could be based on either units or
cost.


Normal and abnormal loss units sold as scrap
In many processes, loss units that are damaged or of unacceptable
quality can be sold as second-grade units (if they are still functional)
or as scrap. The income from the sale of these rejected units is dealt
with as follows.
Normal loss units

Units which are within the planned normal loss limits and which are
sold as second-grade units or as ‘scrap’ give rise to anticipated
revenue. In other words, because the loss is ‘normal’, it is expected
that such revenue will arise. The proceeds from such a sale are
deducted from the cost of production for the period. This means that
it is set off against the value of all inventory items that have passed
through the inspection point.
Example 8.7
In addition to the information in example 8.5 (MNO Ltd), assume that loss units can be
sold as scrap for R1,00 per unit.
Required:
Prepare the unit cost statement and the production cost statement.
The unit cost and production cost statements for example 8.7 are
shown in Table 8.7. In example 8.5, there were 500 normal loss units
and therefore the proceeds on the sale of loss units in example 8.7
would be R500 (500 units × R1). To account for revenue from the sale
of normal loss units, the cost of nished goods and closing WIP
re ected in the production cost statement are proportionately
reduced by these proceeds. In example 8.5, it was noted that since
the inspection point was at the 50% stage and closing WIP was only

40% complete, closing WIP would not have passed through the
inspection point during the current period. Closing WIP therefore
did not include any portion of the cost of the normal loss units. It
would therefore be inappropriate to reduce the cost of closing WIP
by any portion of the proceeds from the sale of the normal loss units.
The cost of nished goods in the production cost statement is
therefore reduced by the full proceeds from the sale of the normal
loss units. Note that if WIP had passed through the inspection point
during the current period, the proceeds from the sale of the normal
loss units would be pro-rated across both nished goods and closing
WIP. This pro-ration should be on the same basis on which the cost
of the normal loss was pro-rated with regard to nished goods and
closing WIP.
Table 8.7 Unit cost statement and production cost statement for example 8.7
Three other methods of dealing with the proceeds from the sale of
normal loss units exist. Firstly, the proceeds could also be deducted
from the input cost of materials before the unit cost is calculated,

particularly if the scrap consists mainly of materials. Two other
methods are for the proceeds from the sale of scrap to be
proportionally allocated to and deducted from input costs (both
materials and conversion costs) on the basis of:
• the ratio of materials costs to conversion costs, or
• the ratio of equivalent materials units to the equivalent
conversion units.
Note that these three methods work only when closing WIP has
passed through the inspection point during the current period. If this
is not the case, the value of closing WIP is incorrectly reduced by a
portion of the proceeds from the sale of normal loss units. This is
incorrect because in such a scenario, the value of closing WIP would
be incorrectly understated. Closing WIP will not include any of the
costs of normal losses, and its value should therefore not be reduced
by any revenue from the sale of rejected units.
Abnormal loss units

The revenue from the sale of abnormal loss units is treated in a
manner consistent with the way in which the cost of the abnormal
losses was treated. Since the cost of abnormal losses is accounted for
as a separate item in the production cost statement, the proceeds
from the sale of these units should also be treated as a separate item.
The proceeds are therefore simply deducted from the cost of the
abnormal losses as re ected in the production statement. A simple
example to illustrate this is to assume that the 500 abnormal loss
units identi ed in example 8.6 are sold for R1 each. The R500
proceeds (500 units × R1 per unit) would then be deducted from the
abnormal loss cost of R3 060 to re ect a net cost of R2 560.

Abnormal gain units
An interesting problem arises when there are abnormal gains in
process. An abnormal gain arises when the normal loss is smaller than
anticipated. Example 8.8 illustrates this situation.
Example 8.8
• Units started during the period: 1 000 units
• Units completed: 920 units
• Budgeted normal losses based on units started: 100 units
• Loss units can be sold as scrap at R3 per unit.
• There is no opening or closing work-in-progress.
• The inspection point is at the end of the process.
Current costs are:

Materials: R2 730
Conversion: R4 050
Required:
2 Unit cost
3 Production cost
Using the information above, we can calculate that an abnormal gain

of 20 units [920 – (1 000 – 100)] exists. The equivalent production,
unit cost and production cost statements for example 8.8 are
provided in Table 8.8. The normal loss units are treated in the same
manner as in examples 8.4 and 8.6, and the abnormal gain the same
way as the abnormal losses in example 8.6, except that the abnormal
gain is shown as a reduction in the number of units in the equivalent
production statement and a reduction in cost in the production cost
statement.

The full normal loss units are re ected in the equivalent
production statement as this is the loss that is an expected part of the
process and it should therefore be included in the cost of the process.
The abnormal gain in the equivalent production statement re ects
the reduction required to account for the net total losses of 80 units
(1 000 units started – 920 units completed). The abnormal gain is
therefore 20 units (100 units expected – 80 units actually lost).
It is important to note that the value of nished goods is
increased by the cost of the expected normal loss of 100 units and
since normal losses of 100 units were expected, it is necessary to
reduce value of nished goods by the expected or ‘normal’ revenue
of R300 on the sale of these 100 units as scrap, despite actual scrap
sales being only R240 (actual loss of 80 units × R3). This effectively
means that we need to account for an opportunity cost of R60 (20
units × R3). This opportunity cost re ects the fact that since the total
losses were 20 units less than expected, the organisation has lost out
on the scrap sales revenue of these 20 units. This opportunity cost is
not re ected in the production cost statement but is treated as a
period cost directly in the pro t and loss section of the statement of
comprehensive income.

Process costing using the first-in-first-out (FIFO) method
The weighted average method of process costing has been used in all
the examples up to this point. To recap, with the weighted average
method, opening WIP units together with the related costs are
simply added to the current month’s production and costs, and the
nal cost calculated as an average. When the FIFO valuation method
is used, opening WIP is assumed to be completed rst and these
units are accounted for separately. Since only the equivalent units
produced in the current year (started and completed units, as well as

the equivalent units of opening and closing WIP produced in the
current year) are accounted for in the materials and conversion
output columns of the equivalent production statement, the opening
WIP costs accumulated in prior periods are not included in the unit
cost statement (as they would be under the weighted average
method).
In IAS 2 paragraph 25, the use of the weighted average method
as well as the FIFO method for valuing inventory is permitted. Both
are therefore acceptable for nancial accounting purposes. The
weighted average method may not, however, necessarily be
adequate for all decision-making problems.
Where there is no opening WIP, it makes no difference whether
the weighted average or the FIFO method of process costing
valuation is used, as there are no opening WIP units or costs brought
forward from the previous accounting period
to account for. It also follows that, where opening WIP is too
small to be material, the weighted average valuation method will be
adequate for decision-making purposes.
Example 8.9 illustrates the FIFO method of inventory valuation
in a situation where there is opening and closing WIP.
Example 8.9
Required:
Using the information in example 8.3, and assuming that XYZ Ltd uses the FIFO
method to value its inventory, draw up the following statements:
2 Unit cost
3 Production cost

The equivalent production, unit cost and production cost
statements for example 8.9 are set out in Table 8.9. The opening WIP
units and units started during the period are re ected in the input
column of the equivalent production statement in the same manner
as in example 8.3. However, in the output column with the FIFO
method, we need to split the units completed during the year into
those from opening inventory and those started and completed.
Furthermore, only the equivalent units produced in the current year
are included in the materials and conversion output columns. The 2
800 opening WIP units are therefore included in the total column,
but since the opening WIP would have incurred the full materials
costs in the prior period, there are no more materials costs incurred
in the current period and therefore no equivalent units need to be
re ected in the materials column. Since the opening WIP was 60%
complete, 40% (100% – 60%) of the conversion costs are incurred
during the current period, which is equivalent to 1 120 units (2 800
units × 40%). Therefore 1 120 units are re ected in the conversion
column. Since the opening WIP units have been isolated, the
remaining 11 880 units (14 680 total units completed – opening WIP
of 2 800 units) that were completed during the period are shown.
Since the 11 880 units would have gone through the whole process
during the current period, the full number of units is re ected in all
of the output columns. Closing WIP is calculated as in example 8.3.
Notice that in the unit cost statement, only the current period
costs are re ected under the FIFO method. This is due to the
equivalent opening WIP units completed in the prior period not
being included in the equivalent production statement. Since the
opening WIP costs accumulated in the prior periods have actually
been incurred and are not included with current period costs in the
unit cost statement, they are added to the cost of nished goods in

the production cost statement. The total for the production cost
statement is therefore R108 652. The difference of R12 656 between
the total for the production cost statement and the total costs for the
unit cost statement is due to the opening WIP costs of R12 700 and a
difference of R44 as a result of rounding the conversion unit costs to
R6,01.

Example 8.10 illustrates both the weighted average and FIFO
methods using one example.

Example 8.10
Details relating to KLM Ltd’s production during January:
Opening work-in-progress (40% complete) 1 000
Anticipated normal losses – 10% (allocated on the relative number of units)

Units
Inspection point – 80% stage of production
Completed 8 100
Direct labour and manufacturing overhead cost R6 000

Cost
Costs incurred during the current period:
Direct labour and manufacturing overhead cost R142 400
Required:
1 Assuming that KLM Ltd uses the FIFO method to value its inventory, draw up the
following statements:
• Unit cost
• Production cost
2 Assuming that KLM Ltd uses the weighted average method to value its inventory,
draw up the following statements:
• Unit cost
• Production cost

for example 8.10 are set out in Table 8.10. These have been prepared

using the same principles described in examples 8.6 (for the
weighted average method) and example 8.9 (for the FIFO method).
This discussion therefore focuses mainly on the key differences
between the two methods.
As illustrated in example 8.5, when calculating the normal loss
units, it is necessary to determine the number of units which reached
the inspection point during the current period. The inspection point
is at the 80% stage. Since opening WIP was 40% complete, these
units reached the inspection point in the current period. However,
closing WIP was only 60% complete and so would not have passed
the inspection point. The number of units reaching the inspection
point is therefore calculated as the 1 000 opening WIP units plus the
10 000 units started less the 2 000 closing WIP units, which equals 9
000 units. The normal loss units are therefore calculated by
multiplying 9 000 by 10% (900 units). Note that 100 (1 000 × 10%) of
these units relate to opening WIP. In Chapter 7, Job costing, it was
noted that the FIFO method assumes that materials are issued in the
sequence in which they were ordered and that therefore the issue
price is assigned accordingly. Similarly, conversion costs are assigned
to units in the sequence in which they were incurred. In addition, an
underlying assumption of the FIFO method is that the rst units
issued to production will be completed rst. Since the opening WIP
units are processed further during the current period, costs assigned
to these units when using the FIFO method will therefore consist of
both the costs incurred on these units in prior periods as well as
costs incurred to complete these units in the current period. In
contrast, the units that were started and completed in the current
period will incur costs only in the current period. It is therefore
necessary for the opening WIP units to be isolated from the total
number of units completed during the period. This enables the costs

incurred in the prior period (which have been assigned to opening
WIP) to be assigned to the opening WIP units only; and the costs
incurred during the current period to be assigned to the further
processing of opening WIP units as well as to units started in the
current period (and either completed or included in closing WIP). In
contrast, when the weighted average method is used, there is no
need to isolate opening WIP units as the weighted average of the
prior period costs and the costs incurred in the current period are
simply assigned to all units processed during the period.
As a result of the need to isolate opening WIP units from the
units completed during the current period when using the FIFO
method, the 8 100 units completed during the current period (after
normal losses have been deducted) are split into the 900 opening
work-in-progress units (1 000 – 100 normal loss) and the remaining 7
200 units (8 000 × 90%), which were both started and completed in
the current period. These units are re ected in the output columns of
equivalent production statement using the same principles
explained in example 8.9. Note the equivalent of 540 opening WIP
units re ected in the conversion column. The opening WIP is only
40% complete and therefore these units still need to complete the
remaining 60% of the process. No opening WIP units are re ected in
the materials column as all the materials costs were incurred at the
start of the process in the prior period (and will therefore be
included in the opening WIP costs). When using the weighted
average method, however, the full 8 100 units completed are
re ected in the output columns of the equivalent production
statement as there is no need to isolate the opening WIP from the
total units completed.
Students may question why the full 8 100 units completed are
re ected in the materials and conversion columns as it effectively

means that the current period equivalent production statement
re ects part of the process that was actually undertaken in a prior
period. For the weighted average method, this is, however, correct.
As explained above, when the weighted average method is used, the
unit cost is calculated as the weighted average of both the prior
period costs assigned to opening WIP and the costs incurred in the
current period on processing all units. Since this calculation includes
the costs of opening WIP in the unit cost statement, the equivalent
production statement also needs to re ect the processing of opening
WIP which took place in prior periods. The 8 100 units completed
have incurred 100% of both the materials and conversion costs and it
is therefore correct to include all 8 100 units in both the materials and
conversion columns.
When completing the unit cost statement using the FIFO method,
it is necessary to isolate the cost of opening WIP units so that these
costs are allocated to opening WIP units only and not to units started
in the current period. Therefore, the cost of opening WIP is not
included in the unit cost statement, but rather directly included
under nished goods in the production cost statement. However,
under the weighted average method, the cost of opening WIP is
shown in the unit cost statement. This is consistent with the
principles explained above, where the weighted average unit cost
includes both the costs of opening WIP and the costs incurred in the
current period.
One of the key differences between the weighted average and
FIFO methods when completing the production cost statement is the
allocation of the opening WIP costs to nished goods. As explained
above, the FIFO method excludes the cost of opening WIP from the
unit cost statement, because the opening WIP units are isolated.
These costs therefore need to be included as a separate line item in

the production cost statement. Note that when using the weighted
average method, the cost assigned to nished goods is simply the 8
100 units completed during the period multiplied by the weighted
average cost. This is because under the weighted average method, it
is not necessary to distinguish between opening WIP units and units
that were started during the period, because a weighted average cost
is simply applied to all units completed during the period. The
normal loss can be allocated to nished goods and opening WIP
based on the relative number of units. However, this is not necessary,
as all of these units are included in nished goods. No normal loss is
allocated to closing WIP as it did not pass through the inspection
point.
The difference between the total costs assigned (to both nished
goods and WIP) under the two methods in this example (R186 899,66
as opposed to R186 896) is simply due to rounding. However, the
split of the total cost (the amount allocated to WIP versus the
amount allocated to nished goods) will differ as a result of the
different inventory valuation methods used.

Note that in the very long term, it does not matter whether the
weighted average or FIFO valuation method is used, as the average
unit costs would be virtually the same. The difference depends on

the extent of the materials and conversion cost increases or
decreases.

Up to this point, examples have dealt with only a single process. The
manufacture of a product may, however, involve a series of
consecutive processes where the output from the rst process
becomes the input for the next process (consider this chapter’s
introductory case study on SAB, for example). Each separate process
is subject to its own calculation of costs, using the process costing
system. This is illustrated in Figure 8.2.
Figure 8.2 Process ow in consecutive processes
The output from process 1 becomes the input into process 2, and so
on. Further raw materials may also be added at any stage of any of
the processes. The same process-costing principles still apply. Each
of the consecutive processes is dealt with as a separate process for

costing purposes. As the total cost of the nished goods from process
1 constitutes an input cost for process 2 (and so on if there are more
than two processes), the cost of completed units in the nal
production statement combines the costs of all processes. If, for
example, there are three processes, there may be three work-in-
progress balances, one from each separate process. There may also
be abnormal losses or gains from each process. These amounts
would be allocated on some equitable basis for nancial accounting
purposes (as discussed earlier), but it may be necessary to disclose
the amounts separately for management accounting purposes, in
order to highlight them for further investigation.
8.4 Decision-making
The decisions that need to be taken based on process costing
information may, for example, relate to issues such as the use of
alternative (better or poorer quality) raw materials in the process,
altering the proportions of skilled or unskilled labour, or the use of
more ef cient equipment. These decisions involve a change in cost
as well as in production ef ciency (possibly higher or lower ‘normal’
losses in process). Another type of problem may involve a decision
as to whether units ought to be inspected at an earlier or later stage
in the production process, or at multiple stages, affecting the costs
relating to loss units. Example 8.11 illustrates one type of decision-
making problem.
Example 8.11
Spartan (Pty) Ltd operates a process costing system in which anticipated losses of
10% are identi ed by inspection at the end of the process. The budget for a four-week
costing period is as follows:

Units started 20 000 units
Units completed 18 000 units
Production costs:
Raw materials R360 000
Direct labour – variable R720 000
Variable manufacturing overheads R180 000
Fixed manufacturing overheads R270 000
added at the beginning of the process. Conversion costs are incurred evenly
throughout the process.
Spartan (Pty) Ltd is investigating whether it would be advisable to have two
inspection points: one at the 40% stage of completion and one at the end of the
process. This system has been tested over a number of weeks and it has been
established that 80% of the losses can be identi ed at the 40% stage of completion.
The xed cost relating to the additional inspection point amounts to R15 000
during a four-week costing period.
Required:
Advise whether Spartan (Pty) Ltd should implement the additional inspection point at
the 40% stage of completion.
The advantage of having two inspection points, with 80% of the

losses being identi ed at the 40% stage and 20% at the 100% stage
instead of all of the losses being identi ed at the end of the process,
is that loss units rejected at the 40% stage will not incur any
additional conversion costs after this point (that is, they will be
rejected and not processed further). It is therefore necessary to
determine whether the savings in conversion costs are greater than
the increased cost of having two inspection points.

In order to do this, we compare the costs incurred by having only
one inspecting point with the costs incurred with the two inspection
points. We then calculate the equivalent number of units under each
of the scenarios. These calculations are shown in Table 8.11. The
normal losses are calculated and re ected in the same manner as in
example 8.4, but note that under the proposed inspection system,
two calculations are required. The rst is at the 40% stage and we
know that 1 600 units will be identi ed at this stage (as 80% of the
total loss units of 2 000 will be identi ed at this stage). Since these
units have incurred only 40% of the conversion costs, this is
equivalent to 640 units incurring 100% of the conversion costs. 640
units are therefore re ected in the conversion column. However,
since these units will have incurred the full materials costs, the full 1
600 units are shown in the materials column. The remaining 400 loss
units will be identi ed at the end of the process and since these loss
units would have incurred the full conversion costs, the full 400 loss
units are included in the conversion column.
It is now necessary to determine which costs will be affected by
the change in the inspection system. Materials costs will remain the
same, as materials costs are incurred at the start of the process before
any inspection has taken place. Conversion costs will, however,
change. In Table 8.11, we can see that under the proposed inspection
system, an equivalent of 19 040 units have incurred conversion costs
in comparison with 20 000 units under the current inspection system.
Since only the variable portion of the existing conversion costs will
be impacted by a change in volume (recall the de nition of ‘variable
costs’ in Chapter 2, Cost classi cation), we need to consider only the
variable portion of the conversion costs.
This has been given as the direct labour cost of R720 000 and the
variable manufacturing overhead cost of R180 000. This total

variable conversion cost of R900 000 has been based on 20 000 units.
The unit cost will therefore be R45 (R900 000/20 000) and the
resulting savings in conversion costs from implementing the
proposed inspection system will be R43 200 ((20 000 units – 19 040
units) × R45). This cost saving needs to be compared to the increased
cost of the proposed inspection system of R15 000. There is therefore
a net saving of R28 200 (R43 200 – R15 000), and if we base our
decision solely on this quantitative analysis, the proposed inspection
system ought to be implemented.
Table 8.11 Calculation of equivalent units for example 8.11
8.5 Summary

Process costing systems are designed to cost a large number of
identical units and stand in contrast to job costing systems as
described in Chapter 7, Job costing.
The process costing systems discussed and illustrated in this
chapter enable their users to:
• calculate the average cost of the output generated by the process
• apply either the weighted average or FIFO valuation methods for
dealing
• with opening work-in-progress units
• account for normal losses, abnormal losses and abnormal gains
occurring during a speci c costing period
• account for the revenue arising from the sale of second-grade
units or scrap
• provide relevant cost information for the purposes of decision-
making.
In conclusion to this chapter, it may be useful to summarise the

principles applied in dealing with losses in a process costing system
where there is opening and/or closing WIP.
Closing WIP units (in other words, units that are incomplete at
the end of a period) should receive a share of the normal loss only if
they passed through the inspection point in the current period. If
they will pass the inspection point only in the next period, they will
share in the normal loss in the next period.
Similarly, opening WIP units (in other words, units that were
incomplete at the beginning of the period) share in the normal loss
only if they passed through the inspection point in the current
period. If they had already passed the inspection point in the
previous period, they would already have shared in the normal loss
in the previous period.

Conclusion: Process costing and other
topics in this book
In the introduction to this chapter, we saw the differences between
job costing systems, which were dealt with in Chapter 7, Job costing,
and process costing systems.
Process costing systems are also closely linked to joint and by-
products. Where more than one product is manufactured in a
process, it is necessary to have a costing system to allocate that
process costs between these products. Such costing systems are
discussed in Chapter 9, Joint and by-product costing.
Furthermore, section 8.4 of this chapter links closely with issues
regarding decision-making in organisations, as discussed in Chapter
10, Relevant information for decision-making.
Tutorial case study: President Cheese
President Cheese manufactures cheese in the heart of South Africa’s dairy land. It
produces a number of cheeses that are readily available on South African
supermarket shelves, including cream cheese, camembert and brie.
Simonsberg’s production of brie started in 1979 when it purchased the
Wechmarshof cheesery. Brie is a traditional French white rind cheese, which is
milder and creamier than camembert. It is made from cow’s milk. The curd to make
brie cheese is obtained by adding rennet to raw milk and heating it. The cheese is
then cast into moulds. The moulds are lled with several thin layers of cheese and
drained for several hours. The cheese is then taken out of the moulds, salted,
inoculated with cheese mould and aged for a few weeks.
SOURCE: PRESIDENT CHEESE (2019)
1 Assess whether it is likely to be appropriate for President Cheese to use a

process costing system.
2 Discuss the impact of work-in-progress at the end of a nancial year on the
process costing calculations performed by President Cheese.

3 Speculate about the factors that may in uence a decision regarding the number
of inspection points (if any) along the brie cheese-making process.
4 Use the information given to discuss the kind of normal losses that occur when
brie is produced and how they should be treated in a process costing system.
5 Identify some examples of possible abnormal losses in a cheese factory and
explain how they would be accounted for in a process costing system.
6 Discuss whether you expect that President would receive any revenue from the
sale of second-grade cheese or scrap.
7 At a rather late stage in the brie-making process, two new ‘materials’ – salt and
cheese mould – are added. Explain in what respects a process costing system
would differ because of these later additions from a process where all materials
are added at the beginning of the process, as the illustrative examples in this
chapter have assumed.
Basic questions
BQ 1
The following information relates to two independent scenarios:
Scenario 1 Scenario 2
Opening WIP – units 0 5 000
Opening WIP – % complete n/a 50%
Additional input – units 10 000 10 000
Normal loss % 10% 10%
Closing WIP – 50% complete 2 000 2 000
Inspection point 100% 40%
For each of scenarios 1 and 2 respectively, what are the normal loss
units?
a) 800
b) 1 000

c) 1 500
d) None of the above
BQ 2
Opening WIP – units 0 5 000
Opening WIP – % complete n/a 50%
units?
a) 800
b) 1 000
c) 1 300
d) None of the above
BQ 3
Opening WIP – units 5 000 5 000
Opening WIP – % complete 40% 80%

units?
a) 800
b) 1 000
c) 1 200
d) 1 300
e) 1 500
f) 1 700
g) None of the above
BQ 4
SA Manufacturers (Pty) Ltd operates a process costing system using
the weighted average valuation method. The following information
relates to one four-week costing period:
• Opening work-in-progress 2 000 units
Materials costs R9 000
Conversion costs (units are 40% complete) R13 200
• New units introduced 12 000 units
Current costs:
Materials costs R54 700

• Units completed 10 600 units
• Closing work-in-progress (units are 60% complete) 3 400 units
There were no losses in process and all direct materials are added at
the beginning of the process.
What will the statement of equivalent production, the unit cost
statement and the production cost statement for the current costing
period look like?
BQ 5
Rhodes Ltd presents you with the following (incomplete) equivalent
production statement for the four-week costing period ending 26
January:
There were no losses in process and all direct materials are added at
the beginning of the process.
What are the missing gures in the statement of equivalent
production, assuming that the company uses the weighted average
method of inventory valuation?
BQ 6

Using the same information as in BQ 5, what are the missing gures
in the statement of equivalent production (for the current period’s
production), assuming that the company uses the FIFO method of
inventory valuation?
BQ 7
Details relating to a certain process – process alpha – for the
November costing period were as follows:
Units
Opening work-in-progress (100% complete as to materials and 50% complete as to conversion) 500
New units introduced during the costing period 3 000
Units completed and transferred to nished goods inventory 2 700
Closing work-in-progress (100% complete as to materials and 70% complete as to conversion) 450
Normal losses – 10% of units reaching the 60% stage of completion
Conversion costs are incurred evenly throughout the production

process, while materials are introduced at the beginning of the
process.
What will the statement of equivalent production look like in
units if the weighted average method of inventory valuation is used?
BQ 8
Using the same information as in BQ 7, what will the statement of
equivalent production in units (for the current period’s production)
look like if the FIFO method of inventory valuation is used?
BQ 9

East London Paint Ltd produces industrial paint for use on heavy
machinery. During processing, normal losses amount to 10% of the
raw materials input at the start of the process. There are no materials
added at a later stage. These losses are identi ed halfway through
the process and allocated based on the relative number of units.
Most of the processing is done with equipment, so that machine
hours are used as the cost driver for manufacturing overhead costs
(which include xed labour costs). No direct labour costs are
incurred.
The following details relate to the month of April:
R Litres
Opening work-in-progress (40% complete) 10 000
Materials costs 16 500
Overhead costs 6 060
New materials introduced at the start of the process 50 000
Completed production 46 600
Current costs:
Materials costs 69 900
Overhead costs 77 826
Conversion costs are incurred evenly throughout the production

process.
Assuming that the company uses the weighted average method
of inventory valuation, what will the statement of equivalent
production, the unit cost statement and the production cost
statement look like?

BQ 10
A company is constructing a submarine and an aircraft carrier for
use by the navy. At the end of the reporting period, the submarine is
40% complete, while the aircraft carrier is 66% complete. Some
materials used in their construction have been damaged and sold as
scrap, but the damage was expected and was regarded as a normal
loss. To what extent are process costing principles useful in this
scenario?
Long questions

SOURCE: ADAPTED FROM ACCA CERTIFIED ACCOUNTING TECHNICIAN EXAM P4
A company manufactures a product by means of two successive
processes, process 1 and process 2. The following relates to the
period just ended:
Process 2
Units Cost (R)
Opening work-in-progress Nil Nil
Transfer from process 1 2 160 22 032
Materials added 5 295
Conversion costs 8 136
Transfer to nished goods warehouse 1 950
Closing work-in-progress 210
The work-in-progress at the end of the period was 80% complete

with respect to materials added and 40% complete with respect to
conversion costs in process 2.

REQUIRED Marks
Calculate for the period the:
(a) production cost per equivalent unit of the product 6
(b) value of the transfer to the nished goods warehouse 2
(c) value of the closing work-in-progress in process 2. 3
TOTAL MARKS 11

SOURCE: ADAPTED FROM ACCA CERTIFIED ACCOUNTING TECHNICIAN EXAM P4
600 tons of raw materials, costing R430 032, were input to a process
during a period. Conversion costs totalled R119 328. Losses, in the
form of reject product, are normally 12% of input. Reject product is
sold for R260,00 per ton.
521 tons of nished product passed inspection (which occurred at
100% completion) during the period. The remaining output was sold
as reject product. There was no work-in-progress either at the
beginning or the end of the period.
REQUIRED Marks
For the period:
(a) calculate the cost per unit of normal output 8
(b) prepare the process account, including any abnormal losses/gains. 6
TOTAL MARKS 14

SOURCE: RHODES UNIVERSITY
Converse is an American shoe company that is famous for its All
Star high-top sneakers. These shoes are now considered to be the

most iconic sneakers in the world. Converse recently set up a
manufacturing plant in Cape Town in order to supply customers in
South Africa.
These sneakers must pass through two departments before they
may be boxed and sold. Department 1 manufactures the rubber
soles, and department 2 attaches the material to the sole and applies
the branding. All materials are added at the beginning of the
process.
The manufacturing plant uses a process costing system and
management have chosen to value inventory using the FIFO
method. The inspection point is at the end of the process; however,
under normal conditions, no shoes are damaged or lost during the
process. Once the shoes are completed and boxed, they are sold to
retailers around the country for R500 a pair.
The following production and costs relate to department 2 for
September 20XX:
• No nished sneakers were bought forward from August 20XX.
• Materials for 400 pairs at 60% completion were carried forward
from August 20X5 with the following costs:
Department 1 12 000
Materials 20 000
Conversion 80 000
Materials for 3 000 pairs were introduced in September 20X5 with

the following costs:
Department 1 105 000

Materials 120 000
Conversion 750 000
Closing WIP consisted of materials for 200 pairs at 60% completion

and 3 300 pairs of sneakers had been boxed and were ready to be
sold on the 30 September 20X5.

SOURCE: ADAPTED FROM CIMA P1 PILOT PAPER
PQR Ltd is a chemical processing company. The company produces
a range of solvents by passing materials through a series of
processes. The FIFO valuation method is used.
In process 2, the output from process 1 (XP1) is blended with two
other materials (P2A and P2B) to form XP2. It is expected that 10% of
any new input to process 2 (that is, transfers from process 1 plus
process 2 materials added) will be immediately lost and that this loss
will have no resale value. It is also expected that in addition to the
loss, 5% of any new input will form a by-product, Z, which can be
sold without additional processing for R2,00 per litre.
No normal losses occur in process 1.
Data from process 2 for November were as follows:
Opening work-in-progress

Process 2 had 1 200 litres of opening work-in-progress. The value
and degree of completion were as follows:
R % degree of completion
XP1 1 560 100
P2A 1 540 100
P2B 750 100
Conversion costs 3 790 40
7 640
Input
During November, the inputs to process 2 were as follows:
XP1 5 000 litres 15 679
P2A 1 200 litres 6 000
P2B 3 000 litres 4 500
Conversion costs 22 800
Closing work-in-progress
At the end of November, the work-in-progress was 1 450 litres. This
was fully complete in respect of all materials, but only 30% complete
for conversion costs.
Output
The output from process 2 during November was as follows:
Z 460 litres
XP2 7 850 litres

REQUIRED Marks
Prepare the process 2 account for November 2003, assuming that normal losses are allocated
based on the relative number of units. By-product 2 is not separately valued, but is set off against 20
XP2.
TOTAL MARKS 20

SoundLab (Pty) Ltd (‘SL’) manufactures sound equipment in its
factory. The process is highly sophisticated and requires work in
several different departments. SL recently introduced a new type of
speaker, the SAAA. The new speaker has been received with mixed
reactions by the market. A survey conducted by JW Consulting has
identi ed that customers are not willing to pay the premium on the
selling price which SL is asking. Management is concerned about
this, as they never intended to charge a price higher than that of their
main competitors. The nancial manager has requested that you
investigate why the selling price is too high, since a mark-up of
33,3% has always been charged on the cost of their products.
After careful investigation, you have identi ed that one
particular department – responsible for the magnet addition process
(MAP) – is not performing as it should. Your rst course of action
will be to do an analysis of the costs accumulated in the MAP. The
following information in the notes relates to the MAP for the month
ended 31 December 20XX:
Only one component is added in this process, a magnet which
consists of two halves. The total cost related to purchases of
magnets during the current period amounted to xx has not yet
been calculated for the MAP and management has requested that

you assist with this. Through discussions with management, you
have ascertained the following:
• Employees assisting in the assembly of the speaker are each
paid a xed wage rate of R1 000 per week and there are ve
such employees in the MAP.
• Furthermore, an amount of R3 is paid to each of these
employees for each speaker transferred to the next
department.
Production information relating to the MAP for December 20XX is as

follows:
Speakers partially completed from previous month with a value as

5 000 units 20% complete
follows:
Previous process R40,00 per unit
Material R118 750
Labour R27 000
Overheads R81 000
Speakers started in the current month with a value as follows: 15 000 units
Same value per unit as the

Previous process
previous month
The other costs have not yet been calculated by management. (Refer to
?
notes 1 and 2 above.)
Speakers partially complete at the end of the current month 2 000 units 80% complete
Speakers transferred to the next department 16 250 units
• Inspection takes place at the end of the process. Expected losses
amount to 5% of units that reach the inspection point.

• SL uses the weighted average method of inventory valuation.
REQUIRED Marks
(a) Calculate the total labour costs for the MAP for the month of December 20XX. You are to
2
assume that there were 4 weeks in December.
(b) Prepare the following statements:

(i) Unit production statement
(ii) Unit cost statement
(c) The production cost statement in so far as it relates to calculating the value of closing work-
33
in-progress at 31 December 20XX
TOTAL MARKS 35
References
President Cheese. 2019. Our story. [Online]. Available:
http://www.presidentcheese.co.za/#story [7 December 2019].
The Coca-Cola Company. 2019. Coca-Cola at a glance. [Online]. Available:
https://www.coca-colaafrica.com/coca-cola-in-africa/infographic-coca-cola-at-a-glance
[9 November 2019]
APPENDIX 8.1: NORMAL LOSSES REVISITED –

THE ‘SHORT CUT’ METHOD OF ACCOUNTING
FOR NORMAL LOSSES
In section 8.2.2, you were introduced to losses and gains arising in a
process costing system. There are two generally accepted cost
accounting methods for dealing with normal losses arising in a
process costing system. The rst method has been used in all
examples up to this point (it will be referred to as the ‘long method’
for ease of reference). A second method, commonly referred to as the
‘short cut’ method, is also taught by some universities.

In the long method, normal loss units are included in the ‘total’,
‘materials’ and ‘conversion’ columns in the equivalent production
statement. The cost of normal losses is then allocated proportionally
to the completed units and, if applicable, to work-in-progress units
(depending on the point of inspection).
However, in the short-cut method, normal losses are only
included in the ‘total’ column of the equivalent production statement
and are not extended to the ‘materials’ and ‘conversion’ columns.
The effect of this is that the cost of normal losses is automatically
allocated to nished goods and work-in-progress units.
Before reading the rest of this appendix, please check with your
lecturer which method you should be using and whether you are
required to know about the differences between the two methods.
Only continue with this appendix if you are required to know the
short-cut method and/or need to know about the differences
between the two methods. Examples 8.12 and 8.13 illustrate these
differences.

Minerva Ltd operates a process costing system. The monthly budget is as follows:
Costs R
Direct materials 160 000
Direct labour (variable) 480 000
Manufacturing overheads (allocated using direct labour hours):
Variable manufacturing overhead costs 120 000
Fixed manufacturing overhead costs 200 000
R 960 000

Units started: 10 000
Units completed: 8 000
Normal losses: 2 000 (identi ed at the end of the process)
Required:
Using the two different methods of treating normal losses, draw up the following
statements:
• Unit cost
• Production cost

for example 8.12 are given in Table 8.12. The statements drawn up
for method 1 (the long method) have been done using the same
principles as explained in example 8.4 and are therefore not
discussed here. With method 2 (the short-cut method), the normal
loss units are shown in the total column only. By not extending the
normal losses to the materials and conversion columns, the cost of
the normal losses is automatically allocated to the unit costs
calculated in the unit cost statement (and therefore the difference in
the unit costs calculated using the two different methods).The
impact of this is that the cost of the normal loss is automatically
allocated to nished goods.
Except for the change in unit costs, there is no impact on the unit
cost statement. However, you will notice a change in the production
cost statement. With the long method, because the normal loss units
have been isolated as part of the materials and conversion equivalent
units, the cost of the normal losses must be included as part of the
costs allocated in the production cost statement. However, with the
short-cut method, the cost of the normal loss has automatically been
allocated to the nished goods (and work-in-progress, if there was
any), therefore it is not necessary to include the cost of the normal
loss as a separate line item.

In this example, there is no closing WIP and so the full loss is
included with the costs of completed units. However, where there is
closing WIP (and if the WIP passed the inspection point), the cost of
the normal losses should be allocated between nished goods and
closing WIP. This allocation would be done on the basis of nished
good units/( nished goods units + closing WIP units) and closing
WIP units/( nished goods units + closing WIP units).
Method 1 – the long method (as used in examples 8.4 to 8.7)
Method 2 – the short cut method

You will note that in this example, the two methods result in exactly
the same valuation of the completed units. This will not, however,
always be the case. As illustrated in example 8.13, where there is
work-in-progress which has not passed through the inspection point
during the period (and therefore should not share in the cost of
normal losses), the two methods result in a difference in the
valuation of completed units.

Use the information given in example 8.12 (Minerva Ltd), but assume that 13 000 units
were started, that there were 3 000 closing WIP units (60% complete), materials costs
were R208 000 and conversion costs were R944 000.
Required:

• Unit cost
• Production cost

for example 8.13 are given in Table 8.13. The equivalent production
statements for both methods are the same as for example 8.12 except
that 13 000 units started and not 10 000 are re ected and the closing
WIP units are shown (based on the same principles as example 8.2).
Note that the normal losses are still 2 000 units. The closing WIP has
not reached the inspection point and therefore the normal losses are
based on the 13 000 units started less the closing WIP of 3 000 units.
The unit cost statements for both methods are similar to that in
example 8.12, but in example 8.13 they re ect the materials costs of
R208 000 and total conversion costs of R944 000. For the long
method, this still results in unit costs of R16 and R80 for materials
and conversion respectively. In contrast, with the short-cut method
the unit costs are R18,91 and R96,33 for materials and conversion
respectively. This difference, for the same reason explained in
example 8.12, is due to the cost of the normal losses automatically
being allocated to the unit costs.
The costs of the normal losses are re ected in the production cost
statements using the same principles as example 8.12. It is worth
noting that under the long method, the full cost of the normal losses
is allocated to nished goods. This is as a result of closing WIP not
reaching the inspection point in the current period.
Method 1 – long method

Method 2 – the short-cut method

Unlike example 8.12 where the two methods resulted in the same
valuation of completed units, you will notice that the two methods
now result in differences in the valuation of completed units and
closing work-in-progress units. Why do these differences arise?
Which method is correct? The effect of the short-cut method
automatically including the cost of normal losses in the calculation
of the materials and conversion unit costs is that the cost of normal
losses is automatically allocated to closing work-in progress even
though it did not reach the inspection point during the current
period. The long method is therefore the technically more correct of
the two methods. (Note: this issue did note arise in example 8.12 as it

was only in example 8.13 that we introduced work-in-progress
which did not reach the inspection point during the current period.)
While the rst method results in a technically more correct
answer, in most circumstances the differences between this method
and the short cut method are unlikely to be materially different.
However, should an organisation be operating a complex process
costing system and accurate costing information is essential, for
example for decision-making purposes, then the rst method is
preferable.

LEARNING OBJECTIVES
• distinguish between joint and by-products, scrap and waste
• account for the proceeds and costs relating to the sale or disposal
of by-products, scrap and waste
• allocate joint costs to joint products by applying the following
methods:
• physical measures method
• market value at the split-off point
• relative market value of the nal products (net realisable
value)
• constant gross pro t percentage method
• discuss why the allocation of joint costs is not relevant for the
purposes of decision-making.
Clover and joint and by-product costing
Clover Industries Limited is a branded foods and beverages (drinks) group operating
in Africa. One of Clover’s main lines of business is the production of dairy products.
Clover purchases raw milk from dairy farmers which is then processed into milk,
butter, cheese, cream, amasi and yoghurt.
SOURCE: CLOVER 2018

During the processing of raw milk, a number of costs are incurred by Clover. A key
question arises: how can these costs be optimally assigned to all the different
products emanating from the process?
9.1 Introduction
Key terms: joint costs, joint process
A process costing system, as discussed in Chapter 8, Process costing is

used to calculate the average unit cost of identical products. In some
processes, more than one product is produced, such as Clover’s raw
milk processing mentioned above, which yields milk, butter, cheese,
cream, and so on. Such a process is referred to as a joint process.
One of the main cost accounting problems arising from a joint
process is how the costs (commonly referred to as joint costs) that
are incurred before the joint products become separately identi able
should be assigned to the products emanating from the process. The
materials and conversion costs accumulated during the joint process
cannot be traced directly to the speci c products as they relate to all
the products. It is therefore necessary to have a method of allocating
the joint costs in one or other equitable manner. Common methods
of allocating joint costs are described in section 9.2 below.
International Accounting Standards for joint costs are discussed in
section 9.3.
In addition to the problem of how to allocate joint costs, it is also
necessary to consider how to treat joint costs in decision-making
scenarios, as often these costs are unavoidable and therefore
irrelevant to the decision. The issue of joint costs and decision-
making is discussed in more detail in section 9.4.

Joint costs need to be allocated to the products arising from a joint
process to ensure a reasonable valuation of inventory. To determine
the appropriate cost accounting treatment of the costs arising from a
joint process, it is necessary to differentiate between joint products,
by-products, scrap and waste. All four of these product types could
arise from a joint process.
Joint products are two or more products produced
simultaneously during the joint process which are distinguishable
from each other only at the end of the joint process. The point at
which joint products are distinguishable is referred to as the split-off
point. In contrast to joint products, which have a signi cant sales
value, a joint process may also give rise to one or more by-products
which have a minor sales value in relation to the joint products.
In certain instances, the joint and/or by-products can be sold at
the split-off point; in other cases, further processing is required.
Scrap was discussed in Chapter 8, Process costing, but it may also
arise from a joint process. Whereas a by-product is different from the
original materials that went into the process, scrap consists of raw
materials left over at the end of the process, which are still
identi able in the scrap. Note that, for a product to be classi ed as
either a by-product or scrap, it must have some value (even if only a
very small value). Waste, unlike a by-product or scrap, has no value.
It may even have to be disposed of at a cost to the organisation.
To illustrate the distinction between the four different product
types, consider an organisation that produces and packages meat for
sale in supermarkets. The organisation slaughters cattle in its
abattoir and further processes the meat in its processing facility. Two
of the popular cuts obtained in this manner, T-bone steak and rump

steak, are joint products in that they originate from the same joint
process up to the point where they are separated. The same process
also yields raw cattle hides that are further processed into low-
quality leather goods in the organisation’s tannery. Because the
organisation is primarily focused on producing meat and the
production of leather is incidental to its main business, it regards the
low-quality leather goods as by-products.
The organisation also earns a small amount of revenue from
selling the less popular parts of the cattle carcass as tripe. The tripe is
simply packaged in the meat processing plant – it requires no further
processing before sale. The organisation regards the income from
tripe sales as revenue generated through the sale of scrap. The
remainder of the carcass that is of no use is removed from the meat
processing plant and disposed of according to health regulations – it
constitutes waste. Table 9.1 summarises the product characteristics.
Table 9.1 Summary of product types
Figure 9.2 illustrates a joint process.
Figure 9.2 A joint process

The main characterising features of by-products are the following:
• Their production arises incidentally as a result of producing the
main product(s).
• They are not crucial to the commercial success of the
organisation.
• Their production does not normally in uence the selling prices of
the main products.
Unlike joint products, by-products are therefore not allocated any of

the joint costs. Where by-products have some sales value (either at
the split-off point or after further processing), the sales value or the
net sales value, after deducting the further processing costs, is
deducted from the joint costs and in this way is allocated to the joint
products. This treatment is illustrated in example 9.1.
Example 9.1
AmiNam (Pty) Ltd produces two products in a joint process, which also yields a by-
product. The following details relate to a normal production run:
Joint costs

Direct (variable) labour and overheads R50 000
Fixed production overheads R100 500
R300 500
Production at the split-off point Units
Joint product – Amm 20 000
Joint product – Namm 10 000
By-product – Tramm 500
At the split-off point, Amm can be sold at R10 and Namm at R30. Tramm requires
further processing, during which additional variable costs of R2 per unit are incurred,
before it can be sold at R3 per unit.
Required:
1 Describe the cost accounting treatment of Tramm.
2 Calculate the total joint costs of a normal production run.
In example 9.1, we can con rm that Tramm is a by-product as it has

a total sales value of R1 500 (500 units × R3 per unit) which is
relatively small in comparison with the total sales value of the joint
products of R500 000 (20 000 × R10 + 10 000 × R30). Therefore,
Tramm will not be allocated any of the joint costs, but the proceeds
on the sale of Tramm less the further processing costs will be off set
against the joint costs of the process. The total joint costs will
therefore be R300 000 (R300 500 given, plus further processing costs
of R1 000 (500 × R2) less proceeds on the sale of the by-product of R1
500).
9.2.1 Scrap

The cost accounting treatment of scrap is exactly the same as that of
by-products. No joint costs are allocated to the scrap and any
proceeds on the sale of the scrap are set off against the joint process
costs.
9.2.2 Waste
Similarly to by-products, waste is not allocated any joint costs. In
addition, if there are costs involved in getting rid of waste, these
should be added to the joint costs and allocated to the joint products.
Note that there will not be any proceeds on the sale of waste, as by
de nition waste has no value. The treatment of waste is illustrated in
example 9.2.
Example 9.2
In addition to the information given in example 9.1, assume that one production run of
the joint process also usually yields 6 000 litres of toxic waste. The disposal costs of
the toxic waste are R2 per litre.
Required:
1 Describe the cost accounting treatment of the toxic waste.
2 Re-calculate the total joint costs of a normal production run.
The toxic waste produced as part of the AmiNam process in example

9.2 will not be allocated any joint costs, and the R12 000 (6 000 litres
× R2 per litre) disposal costs will be added to the joint costs. This will
result in total joint costs of R312 000 (R300 000 calculated in example
9.1 plus R12 000 waste disposal cost).
As discussed and illustrated in Chapter 8, Process costing, where
abnormal loss units were treated as a period cost, if there are
abnormal waste units, the cost of disposing of the abnormal waste

should not be treated as part of the joint costs but should be
expensed in the pro t and loss account as a period cost. A simple
example to illustrate this is if a particular AmiNam production run
yielded 6 500 litres of toxic waste. Because the process usually yields
only 6 000 litres of toxic waste, the additional 500 litres would be
treated as abnormal, and the cost of R1 000 (500 litres × R2 per litre)
of disposing of these 500 litres would be expensed as a period cost.
Once again, only the R12 000 costs of disposing the expected
‘normal’ waste would be added to the joint costs.
9.2.4 Joint products

It has already been seen that joint costs are not allocated to by-
products, scrap or waste. In addition, since joint products are
separately distinguishable only at the end of the joint process, joint
costs cannot be directly traced to any of the products. It is therefore
necessary to allocate the full joint costs to the joint products. This
allocation can be made on the basis of physical units, sales value of
products at the split-off point, net realisable value of the products (if
further processing is required), or by means of a constant gross pro t
calculation. Each of these methods is based on a set of assumptions,
has its own advantages and disadvantages, and is suitable in
different circumstances. These four methods are discussed further
below.
Physical measures
With the physical measures method, joint costs are allocated to joint
products on the basis of the volume of output of each joint product.
The method assumes that the bene t enjoyed by each joint product
is in proportion to its volume of output and that therefore the cost

per physical output unit is the same. This method is illustrated in
example 9.3.
Example 9.3
Required:
Using the information given in examples 9.1 and 9.2, calculate the cost of each joint
product using the physical measures method to allocate joint costs.
The total joint costs were calculated in example 9.1 to be R312 000.
From the information given in example 9.1, we know that output is
measured in terms of the number of units produced, and that a total
of 30 000 units of Amm and Namm will be produced (20 000 + 10
000). The unit cost will be R10,40 (R312 000/30 000) and therefore the
costs of Amm will be R208 000 (20 000 × R10,40) and Namm will be
R104 000 (10 000 × R10,40).
The physical measures method is seldom an appropriate method
of allocating joint costs. In the example above, output of both Amm
and Namm could be measured in number of units. However, if the
joint products emerge from the process in a different form, for
example a gas and a liquid, or a liquid and a solid, the physical
measures used to measure the output would be completely different.
It would not make sense to use this method if, for example, the joint
process in the example yielded 20 000 kilograms of Amm and 10 000
litres of Namm.
A further disadvantage of the physical measures method is that
where the market prices of joint products differ, allocating the same
unit costs to all products could result in widely varying product
pro tability. In addition, inventory may be valued at an amount
which is greater than its net realisable value. In example 9.3, each
unit of Amm was valued at a cost of R10,40 per unit, but the selling

price is only R10,00. For nancial accounting purposes, unless it is
written down to net realisable value, this valuation would not meet
the requirements of the accounting standard IAS 2, which states:
‘Inventories shall be measured at the lower of cost and net realisable value’
(SAICA, 2010).
The physical measures method would therefore be suitable only
where the outputs from a joint process are all measured in the same
way (number of units, weight or volume) and where the selling
prices are fairly similar.
Market values at the split-off point

The market values at the split-off point method allocates joint costs
based on the estimated sales value of the joint products at the point
where they rst become separately identi able. Example 9.4
illustrates this method.
Example 9.4
Required:
Using the information given in examples 9.1 and 9.2, calculate the cost of each joint
product using the market values at the split-off point method to allocate joint costs.
The total joint costs were calculated in example 9.2 to be R312 000.
From the information given in example 9.1, we can calculate that the
market value of Amm is R200 000 (20 000 units × R10 sales price)
and Namm is R300 000 (10 000 units × R30 sales price). This results
in a total market value of the joint products amounting to R500 000
(R200 000 + R300 000). The joint costs allocated to Amm will
therefore be R124 800 (R312 000 × R200 000/R500 000) and to Namm
will be R187 200 (R312 000 × R300 000/R500 000).

If the products are actually sold at the split-off point, this method
of allocating the joint costs results in each joint product making a
pro t and each having the same gross pro t percentage. Unlike the
physical measures method, this method can also be used for
products that have different forms and signi cantly different selling
prices. Inventory on hand would also be suitably valued. The
method would not be suitable for products for which we are unable
to determine the market value at the split-off point.
Net realisable value

Certain joint products require further processing. This may be either
because they are not ready to be sold at the split-off point, or because
further processing increases the pro tability of the product. Where
further processing takes place, joint costs may be apportioned in
relation to the nal selling price, less the cost of further processing
(the relative market value or net realisable value). This method is
illustrated in example 9.5.
Example 9.5
In addition to the information given in examples 9.1 and 9.2, if further variable
processing costs of R6 per unit are incurred, Amm can be sold as a new product,
Samm, at R18 per unit.
Required:
Assuming that the additional processing of Amm into Samm occurs, calculate the cost
of each joint product using the net realisable method to allocate joint costs.
Once again, the total joint cost of R312 000 calculated in example 9.2
is used. It is then necessary to calculate the net realisable value of the
two joint products Samm and Namm. The net realisable value is
calculated by deducting the additional processing costs from the

nal selling price. For Samm, the net realisable value will therefore
be R240 000 (20 000 units × (R18 selling price – R6 further processing
costs)). Since no further processing of Namm takes place, the net
realisable value for Namm will simply be the market value of R300
000 calculated in example 9.4. The total net realisable value of the
joint products is therefore R540 000 (R240 000 + R300 000). Joint costs
allocated to Amm (which later becomes Samm) will be R138 667
(R312 000 × R240 000/R540 000), while joint costs allocated to Namm
will be R173 333 (R312 000 × R300 000/R540 000).
The main advantages of the net realisable value method are that
inventory will always be recorded at an amount which is below its
net realisable value (unless the total joint cost exceeds the total net
realisable value), and that when allocating joint costs, the impact of
further processing costs is taken into account. A disadvantage of this
method, however, is as illustrated in example 9.5, where the gross
pro t percentages of the products are different. It could be argued
that joint products produced by the same joint process should yield
the same gross pro t percentage and that, for this reason, the
method is not suitable. For those who hold this view, the next
method may be preferable.
Constant gross profit percentage

Some organisations believe it may be more reasonable to allocate
joint costs in such a way that each joint product yields the same
gross pro t percentage. The constant gross pro t percentage method
assumes that the relationship between sales value and costs incurred
for each of the joint products is the same. The constant gross pro t
percentage method is illustrated in example 9.6.

Example 9.6
Required:
Using the information given in examples 9.1, 9.2 and 9.5, calculate the cost of each
joint product using the constant gross pro t percentage method to allocate joint costs.
The starting point with the constant gross pro t percentage method
is to calculate the overall gross pro t percentage for the joint
products combined. The overall gross pro t percentage is then used
to calculate the gross pro t for each joint product. The difference
between the sales value and gross pro t represents the total cost.
Any further processing costs are deducted from total costs, leaving
the joint cost allocation which will result in the constant gross pro t
percentage. In example 9.5, the combined sales revenue is R660 000
(20 000 units of Samm multiplied by the unit selling price of R18 plus
10 000 units of Namm multiplied by the unit selling price of R30),
the joint costs are R312 000 (calculated in example 9.2), and the
further processing costs are R120 000 (20 000 units of Samm × R6 per
unit plus nil, as Namm is not processed further). The overall gross
pro t percentage is therefore 34,6 (R660 000 – R312 000 – R120
000)/R660 000).
Based on the sales values of R360 000 and R300 000, the gross
pro t for Samm and Namm will be R124 364 (R360 000 × 34,6%) and
R103 636 (R300 000 × 34,6%) respectively. Total costs are therefore
R235 636 (R360 000 – R124 364) for Samm and R196 364 for Namm
(R300 000 – R103 636). The joint costs allocated to Amm (which later
becomes Samm) will therefore be R115 636 (R235 636 – 120 000), and
R196 364 will be allocated to Namm, which adds up to R312 000 in
total. Note that the percentage was not rounded for the purpose of
this calculation.

9.3 Joint costs and financial reporting
IAS 2, Inventories, which is applied in South Africa in accordance
with IFRS, prescribes the manner in which joint costs should be
allocated when valuing inventories for nancial reporting purposes.
Paragraph 14 of IAS 2 is particularly relevant to the treatment of
joint costs. Paragraph 14 states the following:
A production process may result in more than one product

being produced simultaneously. This is the case, for example,
when joint products are produced or when there is a main
product and a by-product. When the costs of conversion of
each product are not separately identi able, they are allocated
between the products on a rational and consistent basis. The
allocation may be based, for example, on the relative sales
value of each product either at the stage in the production
process when the products become separately identi able, or
at the completion of production. Most by-products, by their
nature, are immaterial. When this is the case, they are often
measured at net realisable value, and this value is deducted
from the cost of the main product. As a result, the carrying
amount of the main product is not materially different from its
cost.
From paragraph 14, it is clear that the treatment of joint costs when
valuing inventories for nancial reporting purposes is consistent
with the management accounting treatment described in section 9.2
above (with the exception highlighted above of the physical
measures method of allocating joint costs, which in some instances
results in inventory being valued at an amount which is above net
realisable value). While paragraph 14 does not speci cally refer to

‘scrap’ and ‘waste’, the same treatment as for by-products can be
applied, as these products by their nature are also immaterial.
Joint costs in relation to decision-

9.4
making
The main purpose of allocating joint costs is for inventory valuation,
but particular care in dealing with joint costs is required when
considering decision-making scenarios. Even though some of the
methods of allocating joint costs are more appropriate in some
circumstances than other methods, each of the methods results in an
arbitrary allocation of the costs. This is because it is impossible to
trace the costs directly to any of the joint products.
Furthermore, joint costs that have, for example, been allocated to
Amm are unavoidable if a special order is received for Namm (as
illustrated in example 9.8 below). This is because in order for any of
the joint products to be produced, all of the joint costs have to be
incurred. Examples 9.7 and 9.8 illustrate the problem of joint costs in
relation to decision-making.
Example 9.7
Required:
Using the information given in examples 9.1, 9.2 and 9.5, advise whether Amm should
be further processed into Samm.
The joint costs of R312 000 are irrelevant to the decision as to

whether Amm should be further processed as the costs will be
incurred irrespective of whether Amm is sold at the split-off point or
whether it is processed into Samm. It also does not matter what

portion of the joint costs were allocated to Amm, because for
purposes of the decision this is simply an arbitrary allocation of an
irrelevant cost. Only the incremental revenue of R8 per unit (the
selling price per unit of Samm less the selling price per unit of Amm)
and the additional processing costs of R6 per unit are relevant to the
decision. Since the incremental revenue of R8 per unit exceeds the
incremental costs of R6 per unit, from a nancial perspective, Amm
should be processed into Samm.
Example 9.8
In addition to the information given in examples 9.1, 9.2 and 9.5, assume that the
organisation receives a special once-off order to sell 1 000 units of Namm at a selling
price of R25 000. Owing to the market for Amm, Samm and Tramm being saturated,
the organisation currently has suf cient spare capacity to produce the additional units
during the current production run.
Required:
Calculate the relevant net cost of the special order.
In order to produce the 1 000 additional units of Namm, the

organisation will have to undertake the joint processing of both
Amm and Namm, as the products emerge as distinct products only
at the split-off point. The same joint processing costs will therefore
be incurred irrespective of whether the additional units of Amm are
required or not. Therefore, the full additional joint process costs need
to be considered when determining whether the once-off order
should be accepted. It should be noticed that only additional
variable joint process costs will be incurred. The organisation has
suf cient spare capacity during its current production run and
therefore no additional xed costs will be incurred (the R100 500
existing xed costs will be incurred irrespective of whether the once-

off order is accepted). The additional variable joint processing costs
will be R20 000 ((R150 000 direct materials costs plus R50 000 direct
labour costs and variable overheads) divided by 10 000 units of
Namm currently produced multiplied by 1 000 additional units of
Namm).
Note that in this example the joint costs are relevant, because a
decision has to be taken as to whether or not they should be
incurred. However, how these joint costs are allocated to individual
products (in other words, which of the four methods in section 9.2.4
is used) remains irrelevant for decision-making purposes.
The organisation will also incur waste disposal costs on the
additional waste that is produced. 10 000 units of Namm resulted in
6 000 litres of toxic waste, and therefore it is assumed that the
additional 1 000 units of Namm will result in an additional 600 litres
of toxic waste. The additional toxic waste disposal costs will be R1
200 (600 × R2).
Since the market for Amm, Samm and Tramm is saturated, no
additional revenue can be earned from the sale of these products. It
will therefore also make sense for the organisation not to process
Amm further in Samm or to process the by-product Tramm further.
No further processing costs will be incurred, and no income from the
by-product can be set off against the joint processing costs.
The total relevant net costs of the special order will therefore be
R21 200 (R20 000 variable joint process costs plus R1 200 cost of
disposing the additional toxic waste). It should be noted that in
arriving at this cost, it has been assumed that disposing of the
additional units of Amm and Tramm will not cost the organisation
anything.
As the total relevant costs are less than the income of R25 000,
based on quantitative factors, the order should be accepted.

To summarise our discussion on the allocation of joint costs to
products, it is important to emphasise speci cally the arbitrary
nature of all the allocation methods discussed in this chapter. The
allocations are performed for accounting (speci cally inventory
valuation) purposes, and serve no other economic purpose. It should
be clear from the examples above that the method chosen for the
allocation of joint costs is irrelevant for decision-making purposes.
9.5 Summary
In some processes, different joint and by-products emerge from the
production process. Costs that are incurred up to the point where the
joint and by-products become separately identi able (the split-off
point) are not directly attributable to any individual product and
must be allocated on a logical and fair basis. The products which
emerge may take on different forms (solids, liquids or gases) or may
have very different potential market prices. Some joint products can
be sold at the split-off point; others require further processing or
have a higher market value if processed further.
There are four methods that can be used to allocate joint costs
that are incurred up to the split-off point: the physical measures
method, the method based on market values at the split-off point,
the net realisable value method, and the constant gross pro t
percentage method. Each of these methods has advantages and
disadvantages and may be applicable only in particular
circumstances, and all of the methods are used purely for product-
costing purposes and not for decision-making.
By-products have a minor sales value (either at the split-off point
or after further processing) and the proceeds from their sale are
deducted from the joint costs before the costs are allocated to joint

products. Unlike by-products, scrap is not processed, and the raw
materials are still identi able. Any proceeds from its sale are also
deducted from joint costs before their allocation. Waste may result
from the joint process and there may be a cost involved in the
disposal of waste. This cost is added to the joint costs before
allocation.
For decision-making purposes, relevant costs, not allocated costs,
are important. This principle is discussed further in Chapter 10,
Relevant information for decision-making.
Conclusion: Joint and by-product costing

and other topics in this book
In chapters 7 and 8, we differentiated between a costing system that
would be required to assign costs in scenarios where each product
manufactured or service delivered was unique (in Chapter 7, Job
costing) on the one hand, and the system required where masses of
identical products were produced from a process (in Chapter 8,
Process costing) on the other hand. Joint and by-product costing is
similar to process costing except that joint and by-product costing
systems need to be able to allocate the process costs to more than one
type of product produced during the process, these products being
separately identi able only at the end of the joint process.
Tutorial case study: Clover
In small groups, prepare a short presentation that covers the following points (hint:
you may need to do a little research):
1 Discuss the characteristics you would need to take into account in determining
whether the dairy products produced by Clover are joint products, by-products,
scrap or waste.

From the dairy products produced by Clover, identify at least one joint product
2 and one by-product.
3 Identify under which circumstances scrap and waste products may arise during
Clover’s dairy production processes.
4 Explain how the cost accounting treatment differs for each category of product
discussed in 1 above.
5 Suggest which of the four methods for allocating joint costs you believe is most
appropriate to Clover.
6 Indicate which production costs incurred during Clover’s dairy production
process would most likely be relevant to Clover in any decision-making
scenarios it may evaluate.
Basic questions
BQ 1
What is the difference between accounting for a process that
produces batches of identical products and for a process from which
different joint and by-products emerge?
BQ 2
How does the method of allocation of joint costs affect decision-
making where joint and by-products are concerned?
BQ 3
YoSi Ltd manufactures two raw materials – S and Y – used in the
making of perfumes in a joint process. These raw materials are then
subject to further processing into perfumes – S to produce Simphiwe
and Y to produce Yonela. The following statement was drawn up for
September:

The joint costs were allocated on the basis of the market value at the
split-off point. Management believes that the joint costs should be
allocated on the basis of the net realisable value.
If joint costs are allocated on the basis of the net realisable value,
what would the joint cost allocated to Yonela be? Show your
workings.
a) R1 376 471
b) R1 300 000
c) R1 444 444
d) R1 536 364
e) None of the above
BQ 4
In addition to the information given in BQ3, management has
recently found a market for a by-product of the joint process –
‘Scent’. The following information for September relates to this by-
product:
Sales value of the production of ‘Scent’ R200 000
Further processing costs required to make the by-product marketable R100 000

What will the joint costs to be apportioned to the joint products now
be? Show your workings.
a) R2 500 000
b) R2 600 000
c) R2 300 000
d) R2 400 000
BQ 5
Using the information provided in BQ 3 and BQ 4, what is Yonela’s
gross pro t/ (loss) as re ected in the income statement for
September? Show your workings.
a) R100 000
b) Loss R100 000
c) R50 000
d) R0
BQ 6
In a joint process, expenses incurred before the split-off point are as
follows:
Labour and overheads (conversion costs) R125 000
The joint products manufactured are as follows:
Alpha 2 000 units
Beta 4 000 units
Charlie 6 000 units

How would the joint costs be allocated using the physical measures
method?
BQ 7
In addition to the unit and cost information provided in BQ 6 above,
assume that:
• product Alpha sells at R60,00 per unit
• product Beta sells at R75,00 per unit
• product Charlie sells at R30,00 per unit.
How would the joint costs be allocated using the market value at the
split-off point method? What is the gross pro t from each joint
product?
BQ 8
In addition to the information relating to costs and units provided in
BQ 6 and BQ 7, assume the following:
How would the joint costs be allocated using the net realisable value
method? What is the gross pro t arising from each joint product?
BQ 9
Using the same information as provided in BQ 6, BQ 7 and BQ 8,
how would the joint costs be allocated using the constant gross pro t

method of allocation?
BQ 10
Joint production costs of R1 000 000 are incurred in producing
products M and N, which can be sold as follows at the split-off point:
Product M: 50 000 units at R16 per unit
Product N: 50 000 units at R 8 per unit
If additional processing costs of R60 000 are incurred on product N

after the split-off point, it can be processed into product P and sold at
R10 per unit. Each product N renders one unit of product P. Should
the additional processing of product N take place?
Long questions

Envoy (Pty) Ltd produces two products, En and Voy, in a joint
process. During a standard four-week period, the following
particulars apply:
Joint costs R500 000
Production:
En: 60 000 units which sell at R22,00 each
Voy: 40 000 units which sell at R9,00 each
The joint costs consist of the following:

Envoy (Pty) Ltd presently operates at 80% of its capacity. The market
for En is saturated.
The organisation receives a special order for 4 000 units of Voy, to
be delivered within the following four-week period, at a selling price
of R8,00 each.
REQUIRED Marks
Advise whether or not the organisation should accept the special order. 10
TOTAL MARKS 10

The following information relates to 4 products produced following
a joint process:
Output (litres) Sales price (per litre)

Product 1 200 000 R40
Product 2 250 000 R48
Product 3 45 000 R2
Toxic waste 5 000 –
Inputs into the process were as follows:
Input (litres) Cost (per litre)

Raw materials 1 300 000 R15
Raw materials 2 200 000 R50

Product 3 incurs additional processing costs of R40 000 before it can
be sold at R2 per litre.
It costs the organisation R100 per litre to dispose of the toxic
waste. Toxic waste of 0,5% of input is considered normal.
REQUIRED Marks
(a) Calculate the total process costs for the joint process. 8
(b) Assuming that joint costs are allocated based on the market value of the joint products,
4
calculate the joint costs that should be allocated to each product.
TOTAL MARKS 12

Afri-Can (Pty) Ltd (Afri-Can) specialises in manufacturing canned
alcoholic beverages, but also produces other products as part of their
joint production process. Traditionally, Afri-Can focused on the
brewing of beer. However, seeing the enormous and rapidly growing
popularity of Gin (an alcoholic spirit avoured with various spices
and herbs) among South African drinkers, Afri-Can launched a
second product line of canned gin and tonic, called ñGini-in-a-canî.
The process of manufacture involves distilling gin and then mixing it
with tonic water, carbonating the mixture (making it zzy) and
canning the nished product. The success of this product has taken
Afri-Can by surprise and they plan to expand production of this
product line in future.
Gin is a joint product produced in a joint manufacturing process.
It is made along with rubbing alcohol which is sold to pharmacies
and hospitals for sterilising medical equipment and surgery sites on
patients.

Joint manufacturing costs incurred for the most recent nancial
year were as follows:
Materials R320 400
Labour R185 600
Overheads R68 300
The joint process yielded 78 400 litres of gin at the split-off point and
46 600 litres of rubbing alcohol. The market values at this point were
R18,40/litre of gin and R9,60/litre of rubbing alcohol.
Further processing costs for gin with regard to distilling,
carbonating and canning amounted to R5,80 per litre. Tonic water is
added to gin in the ratio 3:1 and costs R4,10 per litre of tonic water.
After further processing, the market value of gin was R28,60/litre.
Rubbing alcohol was also processed further at a cost of R3/litre and
was sold for R18/litre after further processing. No losses were
expected during the further processing of either joint product.
Gin and rubbing alcohol are not sold at the split-off point, only
after further processing. The demand for rubbing alcohol has been
satis ed by current production.
REQUIRED Marks
(a) Contrast the pro t per joint product using the market value at split-off method and the net
realisable value method of joint cost allocation.
(b) Critically evaluate Afri-Can’s planned expansion of the Gini-in-a-can product line and its
impact on the potential pro ts earned from Gini sales.
TOTAL MARKS 21


Miro Ltd produces four products, M, A, N and U, as part of a joint
process. The following information has been extracted from the
organisation’s nancial and production records for May 2XX7:
* The sales revenue column refers to the sales revenue from units produced (not sold) during the year.
The following costs relating to the manufacture of the four products

were incurred during May 2XX7:
R’000
Direct costs 1 500
Overheads 450
Waste disposal costs (see note 1) 200
2 150
Starting from June 2XX7, the organisation is planning on processing

product A further, as it will result in a better quality product and
therefore a 25% increase in the sales price. Further processing costs,
all variable, of R50 per unit will be incurred.
Notes:
1 During the month, production dif culties were experienced,
resulting in an additional 50 units of N being produced. These 50
units are included in the 200 units of N produced, but should be

treated as abnormal. The disposal costs of the 50 units are
included in the R200 000 waste disposal costs given above.
There were no opening inventories at the beginning of May 2XX7.

Miro uses the sales value at the split-off point method of
apportioning joint costs.
REQUIRED Marks
(a) Calculate the value of closing inventory at the end of May 2XX7 for nancial reporting
10
purposes.
(b) Ignoring the impact of the abnormal waste units, but assuming the rest of the production and
nancial information given for May 2XX7 can be used to estimate future costs and revenues, 4
recommend whether the further processing of Product A should be undertaken.
TOTAL MARKS 14

The ght against invasive alien plants in South Africa is led by the
Department of Water Affairs and Forestry’s Working for Water
Programme (‘WFW’), which was launched in 1995. This programme
works in partnership with local communities and has, since its
inception, cleared more than one million hectares of invasive alien
plants. WFW currently runs over 300 projects in all nine of South
Africa’s provinces (Department of Water Affairs and Forestry, 2017).
Makana Timbers (Pty) Ltd (‘MT’ or ‘the company’) is a small
timber sawmill operating in the industrial area of the Makana
Municipality. The company was established on the basis of a long-
term agreement it entered into with WFW, who have major ongoing
projects in the Eastern Cape. MT’s intention is to produce timber for
a local carpentry business and for rewood. The sawmill process
also yields a by-product, known as mulch.

In terms of the agreement with WFW, MT collects the felled trees
each week from a WFW site and transports them back to its
processing facility. WFW does not charge MT for the felled trees.
When the trees are delivered to the sawmill, they are trimmed and
planed to a standard size using specialised plant called a thicknesser.
This process is referred to as process 1. The output of process 1,
which is the split-off point, is measured in cubic metres (m3), and
classi ed as timber, rewood and mulch:
• Timber is cut to standard lengths in process 2 and sold to
carpenters.
• Firewood is bundled in process 3 and then sold to retailers in the
district.
• Mulch is bagged in process 4, before being sold to the Makana
Municipality and local landscaping businesses.
The costs associated with the four processes for May 2017 are as
follows:
*Production overhead is allocated to processes on the basis of the percentage of direct wages.
The output of the further processes in May 2017 is as follows:

MT operates at full capacity and sells 100% of its production. There
are no expected losses in the processes as all input not sold as timber
or rewood can be sold as mulch. Process 1’s costs are allocated to
joint products on the basis of net realisable value.
The nancial manager of MT is currently reviewing the basis for
allocation of joint costs. She believes that the net realisable value
method should be replaced with a method based on physical
measurement or a constant gross pro t percentage.
Special order
MT has received an offer from Coega Brick and Tile CC (‘CBT’), a
company which manufactures clay bricks and tiles for the local
market. CBT is experiencing a shortage of wooden pallets, which are
used to stack bricks for transport. Their regular supplier in Port
Elizabeth is unable to meet their pallet requirements. In terms of the
offer, MT would deliver 1 000 pallets to CBT in July 2017, which
would be purchased by CBT for R18 per pallet.
The nancial manager has completed a costing estimate. One
cubic metre of timber at the split-off point would be suf cient
material to manufacture 10 pallets. MT would employ 5 semi-skilled
workers for 10 working days at a cost of R150 per worker per
working day. Overheads would amount to R2 per pallet. For the
purposes of the costing estimate, the nancial manager assumes that
transport costs, direct wages and production overheads of process 1
would be the same as in May 2017.
REQUIRED Marks
(a) Calculate the pro t or loss of each of MT’s joint products for May 2017.
(b) Brie y discuss the signi cance of the allocation of joint costs in the context of evaluating MT’s
nancial performance.
(c) Discuss the suitability of the two alternative methods for joint cost allocation proposed by the

nancial manager in the context of MT’s operations.
(d) Determine whether the special order, proposed by CBT, should be accepted. Base your answer
on nancial considerations only
TOTAL MARKS 28
References
Clover. 2018. Meet Clover. [Online]. Available: https://www.clover.co.za/investors/annual-
reports/2018/introducing/meet-clover.html [4 November 2019].
SAICA. 2010. Statements of Generally Accepted Accounting Practice: IAS 2, Inventories
(revised January 2010). Johannesburg: SAICA.

chapters 6 to 9, and to move students toward a more advanced,
high-level understanding of the topics, the relationships
between them and the exam technique required.
As you already know from earlier chapters in this book, a thorough

understanding of how costs behave is fundamental to management
accounting. When assigning costs to a cost object, the rst step is to
assign those costs that are directly traceable. This is usually fairly
straightforward. For example, we can quite easily determine that
each plastic bucket that we manufacture uses 500 grams of plastic
and 5 minutes of direct labour time (the cost of which we can then
easily assign to each bucket). The more complex question, however,
is how we assign those costs that are not directly traceable to the cost
object – those costs that are regarded as overhead costs (for example,
the monthly water bill of the plastic goods factory). Because
overhead costs cannot be traced to cost objects in an economically
feasible manner, they have to be allocated. Chapter 6 deals with
overhead allocation. Overheads can be allocated in a number of
ways and some decisions will have to be made in order to choose the
optimal overhead allocation in a given scenario. As with any
management accounting topic, these decisions should be guided by

how the information will be used – the optimal allocation under the
circumstances is the one that will provide the best management
information. The choice between a simple volume-based allocation
system and a more sophisticated system such as ABC, as well as the
choice regarding the number of cost pools used, therefore depends
on the circumstances.
Chapter 7, Job costing is applicable in situations where products
or services are unique and consume resources differently. The
appropriate amount of costs relating to materials, labour and
overheads is assigned to each individual job. Notice that you need to
understand the previous chapter on overhead allocation in order to
apply job costing, because while direct costs are traced to each
individual job, overhead costs are also assigned to each individual
job according to the chosen overhead allocation method.
In contrast with job costing, process costing applies in situations
where many identical units progress through the same process and
consume resources in an identical manner. Chapter 8, Process costing
describes how the cost of materials as well as the cost of labour and
overheads (‘conversion costs’) is assigned to units in a process
costing system. Because all units are identical, each unit carries the
same amount of direct and overhead costs. It is important to
understand that the valuation method applied, namely the weighted
average or the rst-in- rst-out method, affects only the value placed
on inventory. The physical units are the same, regardless of how they
are valued.
Chapter 9, Joint and by-product costing is applicable only in certain
limited situations. There has to be a process that results in more than
one end-product. It is usually not dif cult to determine which costs
are to be assigned to which products once the products have become
separately identi able. Rather, the question is how the costs that

were incurred before the products became separately identi able are
to be allocated to the different products in a meaningful manner.
These costs are called joint costs and their treatment depends largely
on whether products are regarded as joint products or by-products.
A question that appeared in Part 1 of SAICA’s qualifying exam a
number of years ago has been used as a basis for setting the question
that follows below. It integrates some important aspects of chapters 6
to 9, and you should be ready to attempt it now.
In an advanced question like this one, it is important to
understand exactly what is expected of you. You therefore need to
read the question requirements very carefully. In order to save time,
you should read the requirements before you read the scenario – this
will enable you to be alert to relevant information when you read the
scenario and will focus your thoughts while you are reading. Once
you have nished reading through the scenario, you should nalise
your answer. Plan your answers to all of the requirements before
writing out any of the formal answers – this will ensure that you do
not accidentally write an answer in the wrong place. Once your
plans are in place, you can start writing the formal answer to
requirement (a), followed by (b), (c) and (d), in the logical order.
When you plan and write your answers, make sure that you are
applying your thoughts to the particular scenario. At a high
academic or professional level, you are unlikely to earn marks for
regurgitating theory or for writing answers that – although they may
contain facts – are not directly relevant to the case at hand.
Integrated question: M3
M3 is a company that produces a wide range of products for use in a
number of industries such as health care, transport, automotive,

manufacturing, building and construction, and so on. Included in its
product portfolio are two types of industrial sealant, ‘SealTight’,
‘SealTight Waterproof’ and ‘SealLight’. The rst two products are
identical except that SealTight Waterproof is used where a
waterproof sealant is required, for example when sealing swimming
pools. The sealants are manufactured in the same process but, after
the initial manufacturing process has been completed, additional
raw materials are added to SealTight Waterproof to ensure that it has
the waterproo ng properties required to differentiate it from
SealTight. The manufacturing of SealTight results in a lower grade
sealant called SealLight which is treated as a by-product for cost
accounting purposes.
The following sales, production and cost information has been
gathered for January 2XX2:
Note
Sales
SealTight (units) 1 50 000
SealTight Waterproof (units) 1 30 000
SealLight (units) 1 6 000
Production 2
Joint costs
Raw materials R1 785 000
Overheads 3 R1 190 000
Additional processing costs (SealTight Waterproof) 4
Overheads R192 000

Notes:
1 All three sealants are sold in 25-litre units. The average selling
price per unit was R50 for SealTight, R75 for SealTight
Waterproof and R20 for SealLight.
2 During January, production commenced on a total of 100 000
units that were to be produced from the joint process. A normal
loss of 2,5% is expected immediately after the raw materials have
been added at the start of the process. At the end of January, 5
000 units had completed 75% of the joint process. The following
units were fully completed during January:
Units
SealTight (excluding units further processed to produced SealTight Waterproof) 53 000
SealTight Waterproof 32 000
SealLight 7 500
There was no opening or closing raw materials inventory, no

opening work-in-progress inventory and no closing work-in-
progress inventory of SealTight Waterproof.
1 Overheads are incurred evenly throughout the joint process.
2 The losses that were expected on the further processing of
SealTight into
SealTight Waterproof were not actually incurred.
M3 is concerned about the number of complaints they have received

about SealTight Waterproof not being fully waterproof. On
investigation, they have discovered that in almost all of these
instances, customers had not applied the sealant correctly. M3 have
therefore decided that from the next nancial year they will
introduce a service whereby skilled staff will go to the customer’s

site and apply the SealTight Waterproof directly for the customer.
The customer will be charged a fee based on a recovery of the
distance travelled and time spent on application. The nancial
director has stated that he does not want to incur any additional
costs on developing and implementing a new cost accounting
system for the new service and will therefore be using that same
costing system as is used for SealTight, SealTight Waterproof and
SealLight.
REQUIRED Marks
(a) Calculate the value of work-in-process and nished goods inventory at 31 January 2XX2 using
20
the physical units method to allocate joint costs.
(b) Critically discussion the nancial director’s decision to use the same costing system for the
5
new service as currently used for SealTight, SealTight Waterproof and SealLight
TOTAL MARKS 25
Discussion
A suggested solution to this question can be found at the back of the
Part (a) tests your understanding of and ability to integrate
process costing, job costing, and joint and product costs. Part (a)
requires you to apply absorption costing, and you may wonder why
a split between xed and variable costs is not given. However, since
absorption costing treats xed manufacturing costs as product costs,
this split is not required.
In this question, process costing is required to calculate the unit
costs of the joint process. This enabled the joint costs to be allocated
to the two joint products so that the value of inventories could be

calculated. We can recognise this because we know that process
costing is relevant where masses of identical units (in this case, litres
of industrial sealant) move through the same production process and
consume an identical amount of resources.
Part (b) requires you to discuss whether speci ed alternative
costing systems may be applicable. The function of the management
accountant is to provide the best quality of relevant information for
decision-making purposes. It follows that the management
accountant should be able to justify not only why information (such
as cost and budget information) is compiled in a certain why, but
also why it is not compiled in a different way.
Note the wording in part (b). ‘Critically discuss’ does not mean
that you should necessarily disagree with the manager outright – it
calls for a balanced (‘critical’) discussion of what you feel is valid
and invalid about his statement. It would have been easier to answer
part (b) if you had addressed the requirements in the logical order,
because then you would likely already have thought about the
principles of process costing to answer part (a). In part (b), you need
to assess the applicability of process costing in a different line of
business. It is not enough to know that it is not the ideal costing
system for the proposed service – you have to be able to explain why
this is the case.

LEARNING OBJECTIVES
• distinguish between long-term and short-term decisions
• understand the concept of relevance and its various elements,
and distinguish between relevant and irrelevant information
• calculate the relevant costs of special order, make-or-buy and
closing-down decisions
• apply the concept of relevance to the basic cost elements of
materials and labour
• discuss qualitative factors to be considered in evaluating a
particular decision
• calculate the relevant cost of a decision, where one or more cost
elements are uncertain
• understand the pricing decision and what it entails.
Golden Arrow Bus Services – introducing an electronic

ticketing system
Golden Arrow Bus Services (GABS) provides scheduled passenger services in Cape
Town. GABS recently introduced an electronic ticketing system which entails
passengers using smart cards. Smart cards are pre-paid and pre-loaded with
individual passenger routes. Passengers tap their smart card on an automatic fare
collection (AFC) console when they board a bus. The system automatically registers
the route taken and deducts the route from the smart card.

When GABS made the decision to introduce this system, many relevant factors
had to be considered. Firstly, the cost had to be determined. Relevant costs would
have included the following:
• The cost of electronic equipment required at sales points
• The cost of providing each bus with an AFC console
• Costs of electronic infrastructure to operate the system
• Software costs
• Costs of training staff
The bene ts of introducing such a system had to be identi ed and considered in

order to make the decision. One can argue that the perceived bene ts outweighed
the costs at the time the decision was made. A few examples of bene ts would be
as follows:
• A signi cant reduction in the administration and risk accompanying cash
payments
• Easier for bus drivers to perform their duties
• Faster boarding
• Improved passenger service
It is worthy to note that one of the major bene ts of introducing an electronic

ticketing system is that GABS now obtains a better understanding of the travel
requirements of their passengers. In the past, passengers only purchased tickets for
individual routes. The technology now enables them to understand their passengers’
entire travel journey (and not only routes they take to reach their nal destination)
and as a result, they can amend their routes where necessary to improve their
service offering. Amending routes will most likely not only bring bene ts to their
passengers but also result in cost savings due to improved ef ciency.
SOURCES:
HTTPS://WW.GABS.CO.ZA
HTTPS://WW.IOL.CO.ZA/BUSINESS-REPORT/COMPANIES/GOLDEN-ARROW-LAUNCHES-AN-AUTOMATIC-
FARECOLLECTION-SYSTEM-IN-BUSSES-13030803
HPL&R 2018 INTEGRATED ANNUAL REPORT
This example highlights some of the factors that would need to be

considered when making a decision. The chapter focuses on
decisions like these and introduces a quantitative framework in
order to evaluate such decisions. Qualitative factors are of utmost
importance and are also discussed.

10.1 Introduction
This chapter focuses on the decision-making aspect of the
management accountant’s role.
Broadly, the management accountant is exposed to two types of
decisions in the normal course of business. These are long-term and
short-term decisions. Long-term decisions typically are decisions
that have a time frame exceeding one year. They are often
characterised by large capital investments and the bene ts accrue
over a period of more than one year. The decision of Golden Arrow
to introduce an electronic ticketing system is an example of a long-
term decision. Short-term decisions are those which mainly impact
the business during the course of the next few months (i.e. within a
year).
This chapter will focus on short-term decisions and will therefore
introduce various short-term decision examples. You will learn to
consider decisions based on differential cash ows: only the costs
and revenues that differ between the alternatives are relevant and
are taken into consideration.
Because all costs and revenues, even those that are considered
xed in the short term, can be changed in the long term, short-term-
relevant costing principles are not particularly useful for long-term
decisions. The differences between short-term and long-term
decisions will be further dealt with in Chapter 11, Decision-making
under operational constraints.
The typical short-term decisions to be covered are:
• special orders
• make-or-buy decisions
• closing down of a part of the business.

This chapter will also discuss the pricing decision with reference to
the short as well as the long term.
Optimisation, which entails the optimal use of scarce resources, is
also a short-term decision. However, this topic will be covered in
Chapter 11, Decision-making under operational constraints.
An understanding of the key terminology and principles
associated with short-term decisions is needed to apply these
concepts to basic cost items and revenue. This is covered in the
section that follows.
10.2Understanding the concept of

relevance
Key terms: opportunity cost, relevance, sunk costs
10.2.1 What is relevance?

The concept of relevance has already been introduced in Chapter 2,
Cost classi cation. Costs and revenues will differ in various scenarios.
Information is relevant to a decision when the information differs
between alternative courses of action evaluated. By contrast,
information is irrelevant to a decision when the information remains
the same regardless of the course of action taken.
Consider the information in example 10.1.
Example 10.1
It is the end of January and Jo Tshabalala is busy contemplating whether he should
travel to work using his car (from Pretoria to Johannesburg, and back) or the Gautrain
for the month of February. He has determined that a weekly Gautrain ticket will cost

him R200. Jo already has one weekly ticket, which he purchased a few months ago for
R175 (these cannot be sold or refunded) and if he decides to travel by train, he need
only purchase three more tickets for the remainder of the month. He has calculated
that fuel costs to use his car will amount to R400 for the month. Jo uses his car for
private purposes as well. Insurance for his car for a month amounts to R300 and will
not increase if he uses the car to go to work.
Jo will travel either in his own car or by Gautrain for the entire month of February
(i.e. not a combination between the two options)
Example 10.1 is a simple decision that requires the identi cation of

relevant and irrelevant information. This requires an understanding
of the concept of relevance. Figure 10.1 illustrates the concept of
relevance, and serves as a guide to identifying relevant and
irrelevant information.
Figure 10.1 Elements of relevant and irrelevant information
Relevant information versus irrelevant information

The fundamental difference between relevant and irrelevant
information, as mentioned above, comes down to whether the
information differs between the alternative courses of action
evaluated.
In example 10.1, the decision is whether Jo should travel to work
by car or by Gautrain for the month of February. Therefore, there are
two possible courses of action considered in this decision:
1 Travel by car
2 Travel by Gautrain
Applying the fundamental difference between relevant and

irrelevant information, if the cost or income information is the same
for travel by car or Gautrain, then it will be irrelevant. However, if
the cost or income information differs for travel by car or Gautrain,
then it will be relevant.
Elements of relevant and irrelevant information

A future cost and future income can be relevant or irrelevant, as
shown in Figure 10.1. This is a very important point and care must
be taken not to draw a conclusion that all future costs or income are
relevant. A future cost or income can be irrelevant when it remains
the same regardless of the course of action followed in a decision. In
example 10.1, the insurance cost of R300 is a future cost. However, it
is a future cost that will be incurred regardless of whether the car or
Gautrain options are followed. As Jo uses his car for private
purposes as well, if he chooses to travel by Gautrain, he would still
have to insure his car. He would therefore incur the insurance cost
whether he travels to work by car or by Gautrain, and the insurance
cost would be irrelevant for the purposes of the decision. One could
also argue that the R300 is unavoidable. Unavoidable costs are

irrelevant as they need to be incurred irrespective of the course of
action taken.
In contrast, the fuel cost of R400 is also a future cost. However, it
will be incurred only if Jo travels to work by car. It will not be
incurred if he travels by Gautrain. Given that the cost information
differs between the courses of action, the fuel cost of R400 is relevant
to the decision. One could also argue that the R400 would be
avoidable if Jo travels by Gautrain. Costs which are avoidable when
a certain course of action is taken are relevant. Thus avoidable costs
are relevant and unavoidable costs are irrelevant.
Now let us look at the cost of the weekly ticket. Jo already has
one weekly ticket in his possession and needs to purchase only a
further three if he chooses to travel by Gautrain.
The rst issue that arises is whether the R175 cost of the rst
ticket has any relevance to this decision. The R175 cost of the rst
ticket is referred to as a sunk cost. It is a cost that Jo incurred in the
past and can also be called past costs. Hence sunk costs are costs
that were incurred in the past or costs that were committed to in the
past and that can no longer be avoided or changed, regardless of
what course of action is taken.
For decision-making purposes, sunk costs are always irrelevant.
How do we reach this conclusion? Jo incurred a cost of R175 prior to
this decision. Whether Jo travels by car or by Gautrain, he would still
have incurred the R175. The cost was incurred in the past and a
future decision would not have an impact on the cost of the past,
therefore it is irrelevant.
Figure 10.1 illustrates, among other things, the link between
irrelevant information and sunk costs. Take speci c note that sunk
costs have no link to relevant information – they are always irrelevant
for decision-making. The same logic applies to income that has

already been received, or that will be received regardless of what
course of action is taken.
Now let us turn our attention to the remaining three weekly
tickets. As Jo has yet to purchase these, they represent future costs.
As mentioned above, future costs can be relevant or irrelevant. As Jo
would purchase these tickets only if he were to travel by Gautrain,
we can conclude that the cost of the remaining three weekly tickets
would be relevant.
Below is a summary of the cost information in example 10.1:
Travel by: Car Gautrain

Relevant items:
Ticket – three weekly tickets – R600
Fuel R400 –
Irrelevant items:
First weekly ticket R1751 R1751
Insurance R3002 R3002
Notes:
1 This cost was incurred in the past and a future decision will have
no impact on it.
2 This cost will be incurred if Jo travels to work by car and will still
be incurred if he travels to work by Gautrain, as he uses the car
for private purposes as well. The cost is irrelevant to the decision
because it does not differ between the two alternatives.
Future cost versus opportunity cost

In example 10.1, Jo uses his car for private purposes. Fortunately, Jo’s
car is available to be used for travel to work as well. This is usually

referred to as spare capacity. We say that Jo has spare capacity with
respect to the use of his car and is able to use it for travel to work.
A situation could arise where Jo’s car is not available, for
example if Jo’s brother pays Jo to use the car on weekdays at exactly
the times that Jo has to travel to work and back. One of the options
available to Jo would be to hire an additional car. This would
represent a future cost that would be relevant to the decision. In
management accounting terms, we could say that Jo would be
obtaining additional capacity.
But now let us make the scenario even more interesting. Jo might
be unable to obtain additional capacity – perhaps Jo does not have
money available to hire another car. In management accounting
terms, we would say that Jo has capacity constraints and that
capacity is now limited.
A capacity constraint is identi ed by comparing resources
available versus resources required. Whenever the resources
available are less than resources required, a capacity constraint
exists. This chapter will explore the impact on relevant costs when a
capacity constraint exists. Chapter 11, Decision-making under
operational constraints will further examine the impact capacity
constraints will have on choosing products or services which will
utilise the scarce resource in the most pro table manner.
As Jo is experiencing a capacity constraint in our example, there
is no future cost in the form of hiring costs. The problem that Jo now
has is one of opportunity costs. Jo must decide whether he should
forgo the money that his brother pays him for the use of the car in
order to use the car himself to travel to work. Opportunity cost is
the net income forgone when an option is taken which would result
in net income previously received, now becoming impossible. In our
example, the money Jo’s brother would have paid him for the month

of February is the opportunity cost. This opportunity cost would be
relevant to his decision.
Opportunity cost arises when a capacity constraint exists. A
capacity constraint arises when additional required capacity cannot
be acquired (i.e. there is a scarce resource). Under this circumstance,
there would be no future cost in respect of capacity as additional
capacity cannot be acquired. Although opportunity cost is a cost, it
arises because future income would be lost in order to free up
capacity. Opportunity cost is depicted by the dotted line in Figure
10.1 between future income and opportunity cost. To conclude, an
opportunity cost arises when the decision can only be executed by
giving up existing income; existing income is given up to create the
capacity needed.
The next section focuses on applying the concept of relevance to
the three types of short-term decisions mentioned in section 10.1:
special orders, make-or-buy and closing down part of the business.

In practice, decisions are usually characterised by a high degree of
uncertainty that needs to be dealt with. However, for the sake of
simplicity, we will assume in our discussion that the variables within
a decision are known with certainty. The use of probability
distributions to assist in making decisions under conditions of
uncertainty will be discussed later in this chapter. Short-term
decisions by nature are exposed to less risk thank long-term
decisions.
As already mentioned, we will address the following three types
of decisions:
1 Special order

2 Make-or-buy
3 Closing down a part of the business
Decisions cannot be taken on the basis of a quantitative assessment

only. In practice, one would rstly identify all relevant information,
this will be performed by identifying all factors which is different
between status quo and what is being considered. This relevant
information obtained would then be examined in detail. This is
performed by accurately quantifying quanti able information,
information which cannot be accurately quanti ed will be carefully
considered. The relevant information which cannot be accurately
quanti ed is called additional factors or qualitative factors.
Qualitative factors, such as the strategic importance of the decision,
and other non-quanti able aspects, are thus relevant information
which should be considered and should not be seen as less
important.
10.3.1 Special order decisions

Key term: special order decision
A special order decision is generally characterised by an organisation

being approached by an external party:
• to supply a similar product to its existing product line in a
different market
• to modify the existing product to suit the needs of the external
party.
Special orders are intended to be ‘once off’, which is why they fall
within the ambit of a short-term decision. Should the special order
become repetitive, the focus changes, making it a strategic issue, and

the organisation would need to take into account the long-term
consequences, including whether the order should become part of
the permanent product line.
Example 10.2
Bubbles Galore Ltd is a manufacturer of bubblegum. Their available production
capacity for a month amounts to 1 000 000 units of bubblegum, while sales are
only 800 000 units in a month. The bubblegum is sold at R4 per unit.
At the end of December, a leading toy manufacturer approaches Bubbles Galore to
supply 150 000 units of bubblegum which will have to be modi ed in size in order to t
into their newest toy – the bubble ship. The toy manufacturer has offered a total
contract price of R450 000 for delivery in January. The variable cost of the special
bubblegum will be the same as normal bubblegum, except that an additional R75 000
will be incurred for the modi cation. The variable cost of normal bubblegum is R1 per
unit. Fixed costs for the Bubbles Galore facility amount to R300 000 per month.
Required:
Assess whether the toy manufacturer’s order ought to be accepted.
Quantitative issues
There are two courses of action in this decision:
1 Accept the special order.
2 Reject the special order.
Bubbles Galore has been approached to ful l a special order

of 150 000 units. During a month, Bubbles Galore has spare capacity
of 200 000 (1 000 000 – 800 000) units of bubblegum. This is within its
capacity and therefore opportunity cost is irrelevant.
Future costs and income can be relevant or irrelevant, while sunk
costs and income already received are always irrelevant (refer back
to Figure 10.1). Hence the next step is to identify all the future costs

and income, and then to test whether they differ between the
different courses of action.
From the information above, we can extract the following future
costs and income for the month of January:
• Normal sales of 800 000 units per month amounting to R3 200 000
(800 000 × R4) • Special order sales of 150 000 units for the
month, with a contract price of R450 000
• Variable cost of normal sales of R800 000 (800 000 × R1)
• Variable cost of special order sales of R150 000 (150 000 × R1) plus
additional R75 000 for modi cation = R225 000
• Fixed cost for the Bubbles Galore facility of R300 000 per month
This information can be presented in a table as follows:
Notes:
1 Bubbles Galore will receive the R450 000 only if it accepts the
special order. The special order sales are therefore relevant to the
decision. In contrast, Bubbles Galore will continue to sell
its 800 000 units regardless of whether the special order is

accepted or not. The sales proceeds of R3 200 000 will therefore
be irrelevant to this decision.
2 Bubbles Galore will incur variable costs of R225 000 (i.e. 150 000 ×
R1 plus R75 000 modi cation costs) only if it ful ls the special
order. The variable costs of special order sales of R225 000 are
therefore relevant to the decision. In contrast, the variable costs of
normal sales of R800 000 will be incurred regardless of whether
the special order is accepted or not. This cost of R800 000 is
therefore irrelevant to this decision.
3 A xed cost of R300 000 for the Bubbles Galore facility is incurred
for the production capacity of 1 000 000 units. This cost will not
change in the short term and will be incurred regardless of
whether the special order is accepted or not (the very nature of a
xed cost is such that it does not change in terms of production
units). The xed cost of R300 000 is irrelevant as the cost will not
change irrespective of the decision taken.
On the basis of relevant items above, Bubbles Galore will receive an

additional income of R450 000 and will incur an additional cost of
R225 000 if it accepts the special order. This yields a net additional
(incremental) bene t of R225 000 from accepting the special order.
If we did not know that Bubbles Galore could earn R450 000
from the special order, we could stipulate that Bubbles Galore
should accept this special order only for a minimum price of
R225 000. At this special order price, they would be in the same
position as before, i.e. neither worse nor better off than before.
If Bubbles Galore required a R100 000 pro t on this special
order, the minimum order price Bubbles Galore would accept
would then be R325 000 (R225 000 + R100 000). When the

special order price is unknown and Bubbles Galore should thus
determine a selling price, the scenario is then referred to as a
short term pricing decision (refer to 10.6.4 later in this chapter).
To come to a nal decision, Bubbles Galore would also have to

consider qualitative factors such as whether their workforce has
suf cient skills to ful l the special order to an acceptable standard
and whether they are willing to accept the risk of litigation if small
children accidentally swallow the bubblegum placed inside the toy.
However, on a purely quantitative basis, Bubbles Galore should
accept the special order.
Example 10.3
The information is the same as in example 10.2, except that the order is for 250 000
units instead of 150 000 units, and additional production capacity of 150 000 units can
be obtained at a cost of R100 000 per month. This cost for additional capacity remains
R100 000 regardless of how many additional units are actually produced.
The contract price is R750 000 and modi cation variable costs increase
proportionately and therefore amount to R125 000.
Required:
Assess whether the toy manufacturer’s order should be accepted.
The following table depicts the availability of capacity for both

courses of action:
Accept the special order Do not accept the special order

Capacity Units Units
Available 1 000 000 1 000 000
Normal sales (800 000) (800 000)
Special order (250 000) –

(Short)/spare (50 000) 200 000
From the table above, the following can be noted:

• Bubbles Galore is able to maintain its normal sales level
of 800 000 in both courses of action.
• In order to accommodate the special order, Bubbles Galore will
have to incur a future cost of R100 000 to extend its production
capacity. This cost would be incurred only if the special order
were to be accepted. This cost is therefore relevant to the
decision. The organisation can incur a future cost of R100 000 to
extend its capacity, and hence avoid the sacri ce of any normal
sales (opportunity cost).
After identifying the courses of action in the decision, and the future
costs and income, we can prepare the following schedule:
Notes:
1 The special order sales of R750 000 would be received only if the
special order were accepted. This makes the R750 000 relevant to

the decision. The same applies to the variable costs of R375 000.
2 In contrast, normal sales and their variable costs of R3 200 000
and R800 000 respectively would continue regardless of whether
the special order were to be accepted or not. This makes these
items irrelevant to the decision.
3 The xed cost for the existing 1 000 000 unit production facility
would be incurred, regardless of whether the special order were
accepted or not. This makes this cost irrelevant to the decision.
4 Bubbles Galore would need to extend its production facility only
if it accepted the special order. Hence the cost of R100 000 would
be incurred only if the special order were accepted. This makes
the cost relevant. (Note that although this is a xed cost (i.e. does
not change per unit of production), it is a relevant xed cost as it
increases as a result of the decision.)
Bubbles Galore will receive an additional income of R750 000 and

will incur additional costs of R475 000 if it accepts the special order.
This yields a net additional (incremental) bene t of R275 000 from
accepting the special order. On a purely quantitative basis, Bubbles
Galore should accept the special order.
Example 10.4
The information is the same as in example 10.2, except that the order is for 250 000
units instead of 150 000 units, and additional production capacity cannot be obtained
within the decision-making time frame.
The contract price is R750 000 and modi cation variable costs increase
proportionately and therefore amount to R125 000.
Required:
Assess whether the toy manufacturer’s order ought to be accepted.

Once again, we commence by looking at the spare capacity. We can
prepare the following table to depict the availability of capacity for
both courses of action:
Accept the special order Do not accept the special order

Capacity Units Units
Available 1 000 000 1 000 000
Normal sales (800 000) (800 000)
Special order (250 000) –
(Short)/Spare (50 000) 200 000
As Bubbles Galore has not been able to extend its production facility,
there is no future cost in this regard. In order to obtain 50 000 units
to satisfy the special order, Bubbles Galore will have to sacri ce
50 000 of its normal sales. This means that without the special order,
Bubbles Galore would sell 800 000 normal sales units, and with the
special order, it would sell only 750 000 units. Normal sales (and
their related costs) now become relevant to the decision. With the
sacri ce of 50 000 units, Bubbles Galore would lose sales amounting
to R200 000 (R4 × 50 000 units), but at the same time save variable
costs of R50 000 (R1 × 50 000 units), thus yielding a net loss of
R150 000. This is the contribution yielded by the 50 000 units ([R4 –
R1] × 50 000). The opportunity cost is therefore the contribution lost
through not selling the 50 000 standard units.
After identifying the courses of action in the decision, and the
future costs and income, we can prepare the following schedule:

Bubbles Galore will receive a total relevant income of R2 625 000 if it
accepts the special order and R2 400 000 if it does not accept the
special order. Accepting the special order would mean that Bubbles
Galore is quantitatively better off by R225 000. On a purely
quantitative basis, Bubbles Galore should accept the special order.
A simpler approach
There is a simpler approach to follow to assess whether a special
order should be accepted. This is expressed in terms of the following
function:
Incremental bene t of a special order = additional

income from accepting the special order – additional
costs that will be incurred if the special order is accepted
The additional income and additional costs represent the difference

in relevant items between the ‘accept the special order’ and ‘do not

accept the special order’ courses of action. Using this, we can reach
the following conclusion:
Additional income Sales of special order
Additional costs Variable costs of special order
Difference in xed costs
Opportunity costs
Applying this to the information in example 10.4, we can calculate

the following:
Additional income Contract price R750 000
Variable costs of special order (R375 000)
Additional costs Difference in xed costs –
Opportunity costs1 (R150 000)
Incremental bene t R225 000
Note:
1 Here the opportunity cost is calculated as the lost contribution
arising from lost sales. Bubbles Galore has to sacri ce 50 000
units of normal sales, for which it would have earned a
contribution of R3 per unit (sales (4) – variable costs (1)). There is
therefore a total opportunity cost of R150 000.
The incremental bene t amounts to R225 000, which is the same

conclusion that was reached using the more detailed approach
earlier. The more detailed approach is called the total approach
where a calculation is performed for both the options considered
(accept/do not accept). The simpler approach is called the

incremental approach as it entails only one calculation of what
happens incrementally (assuming we accept).
Qualitative issues
Decisions should, however, not be made on the basis of a
quantitative assessment only. Qualitative issues such as the
following also need to be considered:
• Sometimes special orders are sold at a slightly cheaper price than
normal sales and concerns arise regarding competitors’ reactions,
as well as those of existing customers, should they hear about the
cheaper price. The long-run implication of the lower price must
therefore be considered.
• If the special order is to be exported, international trade issues,
including potential ‘dumping’ allegations, could arise. The term
‘dumping’ refers to the practice where products are exported at a
price which is below the price the exporter charges in its home
market. The practice is often opposed by those who believe that
local businesses and labourers in the receiving country suffer
negative consequences owing to unfair international competition.
• Issues may arise regarding the sacri ce of existing sales in order
to accommodate the special order. In the quantitative assessment,
the opportunity cost would have been quanti ed, but the effect of
the lost sales must be assessed on a permanent level with respect
to the impact on customer goodwill and potential damage to
reputation.
• As mentioned earlier, the idea with a special order is that it
should be once-off. However, the possibility of repeat orders
must be considered. Also, sometimes a special order may not
initially yield a positive quantitative assessment, but the
organisation may see the order as an opportunity to penetrate a

new market. In such cases, the special orders are accepted with a
view to improving other lines of business in the long run.
• The fact that spare capacity is ‘committed’ must also be
considered. Generally, organisations maintain a level of safety
capacity for the event of breakdowns and similar contingencies.
However, with special orders, this safety capacity could be
committed, and the impact in the case of a breakdown or similar
event must be considered.
In a decision regarding the acceptance of a special order, both

quantitative analysis (the calculation of relevant income and costs),
and a thorough consideration of qualitative factors ought to be taken
into consideration.
10.3.2 The make-or-buy decision

Key terms: make-or-buy decision, outsourcing decision
The make-or-buy decision, also known as the outsourcing decision,

entails evaluating the costs of manufacturing a component internally
in contrast to acquiring it from an external party (outsourcing). Once
again, quantitative and qualitative factors must be taken into
account before a decision is made.
Example 10.5
Manyane (Pty) Ltd operates a lodge and conference centre in the Limpopo Province.
The board is currently evaluating the possibility of outsourcing the catering at the
lodge. The management accountant has prepared the following cost schedule and has
also expressed the costs on a per-head basis (based on current levels of 5 000 heads):
R Cost per head in R

Cost of meals 250 000 50
Catering labour 125 000 25
Variable catering overheads 100 000 20
Fixed catering overheads 80 000 16
Total 555 000 111
A catering organisation has offered to do the catering at an all-inclusive price of R85

per head. Catering will be done at the lodge. Should Manyane accept the catering
organisation’s offer, 40% of the catering labour can be released, with no retrenchment
costs. The other 60% will be transferred to other parts of the organisation where they
can be productively employed.
Fixed catering overheads for the eating areas comprise an allocation of the rental
that Manyane pays to the landlords of the lodge.
Assume all gures are annual.
Required:
Assess whether the catering ought to be outsourced.
Quantitative issues
On an initial quantitative level, it appears that the organisation
should accept the catering organisation’s offer of R85 per head, as it
is signi cantly lower than the current costs of R111 per head (total
cost). However, such a decision cannot be made without
distinguishing between relevant and irrelevant information.
In this decision, we are evaluating two possible courses of action:
1 Providing meals in-house (the ‘make’ option)

2 Utilising a catering organisation (the ‘buy’ option)
The next step is to identify the future costs and future income, and
their relevance, under each alternative, when catering for 5 000
heads. This is summarised in the table below:

Notes:
1 The cost of meals will be incurred if Manyane chooses to provide
its own meals. However, should they choose to outsource, this
cost will not be incurred (and will therefore be saved). As the
future cost differs between the two courses of action, it is relevant
to the decision. The same applies for variable catering overheads.
2 If Manyane chooses to provide its own meals, it will incur
R125 000 in labour cost. However, if Manyane chooses to
outsource, it will continue to incur labour costs amounting to
R75 000 relating to the employees that it transfers to elsewhere in
the organisation. The amount of R75 000 is therefore irrelevant, as
it will be incurred in both courses of action. The remaining
R50 000 is relevant, as it will be incurred only if the ‘make’ option
is chosen.
3 External catering fees of R425 000 will be incurred only if the
‘buy’ option is chosen. This makes this cost relevant.
4 Fixed catering overheads relate to the rentals paid for eating
areas at the lodge. Both courses of action would require the use of
the eating areas and this is therefore irrelevant.

After performing a relevant cost assessment, the external catering
option comes out as being the more expensive of the two options,
which is contrary to the initial assessment. This emphasises the
importance of relevant costs and the correct calculation thereof.
Before a nal conclusion can be reached, however, certain qualitative
aspects must also be considered.
Qualitative issues
The decision involves a signi cant degree of reliance on an external
party to perform the catering and consideration should therefore be
given to:
• the reputation of the external caterer
• the quality of meals provided by the external caterer
• the ability of the external caterer to deliver catering on time
• the nancial stability of the external caterer, and its ability to
handle an order of this size
• the service level agreement with the external caterer, and
• other relevant factors.
Another consideration that may be relevant in the South African

context is whether the catering organisation is black economic
empowerment (BEE) compliant and at what level.
As staff may be released or retrenched, staff-related issues such
as trade union involvement and loss of existing staff morale are also
factors that need to be considered.
Ethical dilemma
Assume you are the management accountant of Manyane (Pty)
Ltd. You are currently busy preparing relevant information to
assist the board in deciding whether catering should be

outsourced. The catering organisation meets with you and
informs you that they would sponsor you and your family to go
on a two-week, all-expenses-paid holiday if they were awarded
the catering contract.
This is clearly a bribe to which you cannot agree. Manyane
(Pty) Ltd should not enter into business with this catering
organisation. Manyane (Pty) Ltd should, rstly, do business in an
ethical manner and, secondly, avoid doing business with an
unethical organisation which could expose them to reputational
risk.
10.3.3 The closing-down decision

In the closing-down decision, an organisation evaluates whether it
should close down a particular line of business, product line or even
an entire division. Once again, both qualitative and quantitative
factors must be taken into account.
Although closing-down decisions are treated in this chapter as
being short-term decisions, the consequences of closing down are
very often of a long-term nature. Closing-down decisions therefore
carry long-term consequences. However, these consequences are
addressed through qualitative factors. The long-term quantitative
consequences of closing down fall outside the scope of this text.
Many organisations close down a line of business, product line or
division on the grounds that it is not ‘performing adequately’. This
could be a mistake if the organisation bases this decision on the
division’s performance, as depicted by an absorption costing income
statement. In the chapter on absorption costing (Chapter 5,
Absorption versus variable costing), it was stressed that variable costing
is more appropriate for decision-making. Should the nancial

information be based on absorption costing, your rst reaction
should be to realise that such an income statement probably needs to
be restated on a variable costing basis in order to re ect the
information in a relevant form for decision-making.
There are multiple approaches available to determine whether a
division should be closed down. We will address two of these
approaches. Consider the following illustration in example 10.6.
Example 10.6
Nongoma Ltd operates two manufacturing sites, one in Johannesburg and one in
Richards Bay. Given the poor performance of the Richards Bay division, the
organisation is evaluating whether it should close it down. The following income
statements are available for the latest nancial year:
Johannesburg Richards Bay

R’000 R’000
Sales 130 000 50 000
Less: Costs
Direct materials 45 000 25 000
Direct labour 20 000 15 000
Salaries 25 000 20 000
Rental of premises 10 000 5 000
Head of ce allocated costs 9 000 4 000
Pro t/(loss) 21 000 (19 000)
Nongoma Ltd’s cost accountant has determined that, should the Richards Bay division
be closed down, the following factors must be taken into account:
• 75% of salaries would be saved and retrenchment costs of R1 000 000 incurred.
Staff making up the remaining 25% of the salary bill will be accommodated in the
Johannesburg division.

• The Richards Bay premises are leased in terms of a contract that cannot be
cancelled in the short term.
• Head of ce costs are allocated on the basis of sales.
Required:
Assess whether the Richards Bay division ought to be closed down.
Quantitative issues
On an initial quantitative level, it appears that Nongoma Ltd should
close down the Richards Bay division, as it is making a loss of R19
million per annum. However, such a decision cannot be made
without distinguishing between relevant and irrelevant information
and considering the overall impact on the organisation.
As mentioned earlier, the starting point of any decision must be
to understand fully the various courses of action available. In this
decision, we are evaluating two courses of action:
1 Close down the Richards Bay division.
2 Do not close down the Richards Bay division.
The second step is to identify the future costs and future income,
under each alternative. The secret to closing down a division is not
to focus on a divisional level, but rather to view the decision and its
impact on the overall organisational level. In evaluating the ‘close
down’ course of action, the organisation should therefore ask itself
what future costs it will incur, and what future income it will receive.
The answer to these questions is that it would incur future costs and
earn future income relating to operating the Johannesburg division,
and also incur future costs relating to the Richards Bay division that
could not be saved after closing down.
In evaluating the ‘do not close down’ course of action, the
organisation should once again ask itself what future costs it will
incur and what future income it will earn. In this case, it will incur

future costs relating to operating the Johannesburg and Richards Bay
divisions and will also earn future income from both these divisions.
The relevance of each future cost and income is assessed by
analysing which of these costs and income differ between the
courses of action. The example below will be performed on the total
approach. The following table summarises the future costs and
income, as well as their relevance and irrelevance:
Notes:
1 Richards Bay sales would be earned only if the division is kept
open. If the division is closed down, Nongoma Ltd would lose
these sales. Therefore, the sales gure of R50 million is a future
income that is relevant.
2 Direct materials and direct labour of the Richards Bay division
would be saved if the Richards Bay division were to be closed

down. However, they will be incurred if the division is kept
open. Hence, the variable costs are also relevant to the decision.
3 75% of the salaries would be saved (avoided) if the division were
closed down. However, if the division is kept open, this amount
would be incurred. Therefore, this amount is relevant to the
decision.
4 Retrenchment costs of R1 million would be incurred only if the
division is closed down, and not if the division is kept open. This
makes this cost relevant to the decision.
5 The Johannesburg division would continue to operate regardless
of the course of action followed with respect to the Richards Bay
division. Therefore, this division would continue to earn its sales
of R130 million, and still incur R109 million in costs, regardless of
which course of action is followed. However, if the Richards Bay
division is closed down, the Johannesburg division’s costs will
increase as a result of the higher salary bill. This is discussed in
point 6 below.
6 Should the Richards Bay division be closed down, 25% of the cost
of its salaries would be incurred in the Johannesburg division. If
the Richards Bay division is kept open, 25% of the salaries cost
would be incurred in this division. From Nongoma’s point of
view, the cost is being incurred regardless of which course of
action is followed, and the cost is therefore irrelevant to the
decision. The 25% of the cost of salaries is a future cost
irrespective of the decision taken and therefore irrelevant.
7 As the rental costs cannot be avoided in the short term, they
would still be incurred if the Richards Bay division were to be
closed down. As the costs will be incurred regardless of the
course of action followed, they are irrelevant for the purposes of
the decision.

Head of ce costs are allocated on the basis of sales. As far as the
8 information indicates, the decision being taken will simply
change the basis of the allocation, but not the actual cost. The
head of ce cost is therefore irrelevant to the decision.
Total relevant costs of closing down are less (by R4 million, to be

exact) than the relevant costs of keeping the Richards Bay division
open. Therefore, on a quantitative basis, it would be better to close
down the division.
A simpler approach
We can reach the same conclusion using an alternative approach, the
incremental approach. This approach is simpler and is really the
difference between the ‘close down’ and ‘do not close down’ courses
of action. This difference is costs saved (avoidable costs), income lost
and additional costs incurred, if the division is closed down.
The following expression can be used to assess whether it is
worthwhile to close down the division (using the incremental
approach):
Incremental bene t = costs saved from closing down –

income lost from closing down – additional costs
incurred in closing down
Using this method, the costs saved from closing down the Richards
Bay division would be as follows:
R’000
Richards Bay direct materials 25 000

Richards Bay direct labour 15 000
Richards Bay salaries (75%) 15 000
The income lost from closing down the Richards Bay division would
be:
R’000
Richards Bay sales (50 000)
The additional costs incurred in closing down the Richards Bay

division would be:
R’000
Retrenchment costs (1 000)
The incremental bene t, which is the net of all of the above, is R4

million. Based on this, we can interpret the incremental bene t by
saying that Nongoma Ltd will save R4 million if the Richards Bay
division is closed down. You will notice that this R4 million is
exactly the same as the difference between the relevant costs of R1
million relating to the closing down and R5 million relating to
keeping the division open, which we calculated earlier using the
total approach. Therefore, we can conclude that when we save
(avoid) more costs than what we lose sales (plus additional costs) it
makes economic sense to close down.
Qualitative issues
We cannot conclude a discussion of the closing-down decision
without considering the qualitative issues:

1 Closing down a business, product line or division entails
discontinuing the manufacture and marketing of a particular
product in a particular location or industry. This raises concerns
about the market’s reaction to such a decision.
2 There are several staff-related issues arising from a closing-down
decision. There may be trade union issues that need to be
considered – staff may go on strike, for example. The quantitative
aspects of retrenchment costs have been taken into account, but
the effect of disruptions on existing operations must be noted.
The fact that certain staff members have been retrenched may
raise concerns among the existing staff as to the security of their
own jobs. This would have an impact on staff morale and
ultimately on the quality of the products produced.
3 The closing decision would have an impact on the organisation’s
regular customers. Concerns may arise regarding the provision of
after-sales service, and the issues around the honouring of
guarantees and warranties. There may be considerations
regarding the loss of customer goodwill and the resulting impact
on the reputation of the organisation. This could have subsequent
effects on the other product lines and business of the
organisation.
These are just some of the considerations worthy of note, and

attention must be given to the speci cs of every situation.
Notice that you could also consider adding a particular line of
business, product line, or even an entire division. Once again, both
qualitative and quantitative factors must be taken into account. This
decision would entail the consideration of future income and costs. If
future income exceeds future costs, it would make economic sense to
add this particular line of business, product line or division. It is also
important to note that, similarly to the closing down decision, this

decision affects the long term and should thus be considered
through qualitative factors.
Applying the concept of relevance to

10.4
basic cost elements
This section addresses some of the challenges speci c to materials
and labour which may be experienced in calculating a relevant cost.
10.4.1 Materials
To put the challenges in perspective, consider the special order
decision. A special order may require a particular type of material
that is used in the manufacture of another product. What will the
consequences and the future costs be if the organisation uses that
material? Alternatively, the special order may utilise a material that
the organisation already has on the inventory record. What will the
future cost of that material be for purposes of the special order?
Example 10.7
Amandla Ltd manufactures hair care products for sale to the retail market. A
Zimbabwe-based organisation has approached Amandla Ltd with a special order for a
product which is different from current products sold by Amandla. In order to meet the
order, Amandla will have to use certain raw materials, some of which are in inventory.
The following schedule summarises the materials required as well as those which are
in inventory:

Notes:
1 AAA is used in the manufacture of Amandla’s hair dye product. There is no
shortage in supply of AAA.
2 BBB was purchased a few months ago in order to ful l another special order. The
special order was cancelled. Amandla has no other use for this material and
intends to sell it for scrap.
3 CCC is used in the manufacture of Amandla’s hair shampoo product. There is no
shortage in supply of CCC.
4 DDD is used in the manufacture of Amandla’s hair conditioner product. One litre of
DDD is used per 5-litre bottle of hair conditioner. There is currently such a serious
shortage in supply of DDD that it is impossible to obtain in the short term.
Amandla’s hair conditioner product sells for R60 per 5-litre bottle and incurs a
variable cost (including the cost of DDD @ R35 per litre) of R50 per 5-litre bottle.
Required:
Determine the relevant costs related to the special order received.
Based on the information supplied in example 10.7, we can draw the

following conclusions:
Future
Materials cost/
Reason
code opportunity
cost
AAA is not in inventory. Therefore, it will have to be acquired for the purposes of
Future cost
AAA the special order at R10 per litre. The relevant future cost is therefore R10 per
= R1 000
litre × 100 litres = R1 000.
BBB BBB is in inventory. The cost price of R5 per litre is a sunk cost and is therefore Opportunity
irrelevant. cost = R100
BBB could have been sold as scrap. This means that there is an opportunity cost
of R2 per litre × 50 litres = R100 less the income from the sale as scrap that is
forgone.

Note that if BBB is used for this order, it would not have to be replaced into
inventory (Amandla does not need BBB for any other purpose).
The opportunity cost of R100 is therefore the only relevant cost.
CCC is in inventory. The cost price of R20 per litre is a sunk cost and is therefore
irrelevant.
Future cost
CCC CCC is also used in Amandla’s hair shampoo product. This means that any CCC
= R750
litres used for the special order will have to be replaced. The replacement cost is
R30 per litre × 25 litres = R750
DDD is in inventory. The cost price of R35 per litre is a sunk cost and is therefore
irrelevant.
DDD is also used in Amandla’s hair conditioning product. This means that any
Opportunity
DDD litres used for the special order ought to be replaced. However,
cost =
replacement is not possible owing to scarcity. This means that, unlike CCC
DDD R450(see
above, DDD does not have a relevant replacement cost (and the R40 per litre is
calculation
therefore irrelevant). However, the fact that the last units of DDD on the
below)
inventory are required to ll the special order now means the hair conditioner
cannot be manufactured. The opportunity cost of not being able to sell hair
conditioner has to be calculated.
Calculation of opportunity cost relating to material DDD

Opportunity cost can be calculated on the contribution lost method
as well as the sales lost method. The relevant opportunity cost
calculation as a result of a shortage of material DDD is shown below.
Opportunity cost calculation on the contribution lost method:
Lost external sales (R60)
Saved variable costs 50
Contribution lost (R10)
Additional variable costs (scarce resource) (R35)
Total opportunity cost (R45)
OR opportunity cost calculation on the sales lost method:

Lost external sales (R60)
Saved variable costs* R15
Total opportunity cost (R45)
*The cost of DDD will not be saved, as it is being used in the special order. Only R15 (other variable
costs) will be saved.
One litre of DDD is used per hair conditioning product. Therefore 10

5-litre bottles of the hair conditioning product will have to be
sacri ced. The opportunity cost is 10 bottles × R45 = R450.
10.4.2 Labour
For the purposes of this discussion, it is important to distinguish
between the variable cost component and the xed cost component
of labour.
Variable labour
When labourers are paid on an hourly basis and can be sourced and
dismissed as and when needed, their wages constitute a variable
cost. With this type of labour, there should be no idle capacity, as it is
expected that the correct amount of labour would be obtained as and
when needed. In a special order that requires the use of such
labourers, generally the future cost would be the cost per hour
multiplied by the number of hours required for the special order.
This assumes that we are able to source suf cient labourers in order
to ll the special order within normal business hours. However,
situations could also arise where overtime is required, or where
labourers who ordinarily work on other products of the organisation
are required to work on the special order.

Fixed labour
In the case of salaried staff, the monthly salaries paid represent a
xed labour cost. More skilled, higher-level staff usually receive
salaries. Regardless of the actual number of hours worked, they
receive their xed salaries. Therefore, it is possible that such labour
can be under-utilised, and that spare capacity may exist.
The same is true of wage workers who have a contractual
agreement with the organisation and cannot be sourced and
dismissed at will.
Let us apply these principles to the information in example 10.8.
Example 10.8
Amandla Ltd manufactures hair care products for sale to the retail market. A
Zimbabwe-based organisation has approached Amandla Ltd with a special order for a
product which is different from current products sold by Amandla. In order to meet the
order, Amandla will have to use certain types of labour, all of which are currently either
already employed or readily available. The following schedule summarises the labour
hours required as well as the availability thereof:
Type Cost Hours required for special order

Unskilled type A R50 per hour 500
Unskilled type B R75 per hour 700
Unskilled type C R100 per hour 300
Semi-skilled R40 000 per month 1 000
Skilled type D R80 000 per month 600
Skilled type E R120 000 per month 300
• Unskilled type A labour can be sourced and dismissed as needed. There is no

limitation on the maximum number of labourers available.
• Unskilled type B labour can be sourced and dismissed as needed. A maximum
of 500 normal hours are available for the special order; thereafter staff are prepared

to work overtime at a 50% premium on the normal rate.
• Unskilled type C labour can be sourced and dismissed as needed, but these
workers are in short supply. Overtime is not an option. The labourers are currently
being used on a hair shampoo production line. This production line generates a
contribution of R125 per type C labour hour.
• Semi-skilled labourers receive a xed salary. 1 200 hours are available for the
special order.
• Skilled type D labourers receive a xed salary. Only 500 hours are currently
available for the special order. An additional staff member can be employed at
R20 000, which will make an additional 200 hours available.
• Skilled type E labourers receive a xed salary. Only 100 hours are available for the
special order, and this type of labour is in short supply. Hours can be freed up by
reducing the scope of the hair conditioner production line, which currently yields a
contribution of R175 per type E labour hour.
Required:
Determine the relevant future and opportunity cost related to the special order
received in respect of each type of labour.
The future cost of each type of labour is as follows:

• Unskilled type A is a variable cost, as it can be sourced as and
when needed. As there is no limitation, the future cost would be
R25 000 (50 × 500).
• Unskilled type B is a variable cost. 500 normal hours are available,
which means 200 are short. However, overtime is available.
Therefore, the future cost would be R60 000 (500 × 75 normal
hours) + (200 × 75 × 1,5 overtime hours).
• Unskilled type C is a variable cost, but in short supply. Overtime is
not an option; therefore, there is no future cost. This triggers an
opportunity cost. The opportunity cost would be R37 500 (300
× 125).
• Semi-skilled labour is a xed cost, but suf cient hours are available
for the special order. As the cost is xed, there is no relevant
future cost.

• Skilled type D is a xed cost. 100 hours are short and an additional
staff member will have to be employed. Therefore, the future cost
amounts to R20 000. As these types of employee receive a xed
salary, the R20 000 will have to be paid, regardless of how many
additional hours are actually needed. There is no relevant future
cost for the 500 hours currently available, as they constitute spare
capacity.
• Skilled type E is a xed cost. 200 hours are short and there is no
alternative supply. Therefore, there is no future cost and an
opportunity cost is triggered. The opportunity cost will be
R35 000 (200 × 175).
Decisions under conditions of

10.5
uncertainty
In practice, decisions involve a large degree of uncertainty regarding
the costs that will be incurred or the income that will be received,
and this section of the chapter looks at techniques to quantify and
account for this risk and uncertainty.
10.5.1 Probabilities
The likelihood that an event will occur is known as its probability
and this is normally measured on a scale of 0 to 1 (which can also be
expressed as 0% to 100%). For example, the weatherman refers to a
20% chance of rain occurring in Gauteng. What does this mean? The
event is rain and the probability of rain is 20% (or 0,2). A probability
of 0 would mean that there is no likelihood of the event occurring,
while a probability of 1 (or 100%) implies that the event will
de nitely occur.

There are two outcomes in our simple example – rain will occur
versus rain will not occur.
When we are dealing with a number of mutually exclusive
possible outcomes for an event, each with a probability of
occurrence, the sum of all the probabilities equals 1 (or 100%). In our
simple rain example above, the probability of rain occurring is 0,2
(or 20%) and the probability of rain not occurring is 0,8 (or 80%).
This information can be presented in a probability distribution. A
probability distribution is a list of all possible outcomes associated
with a particular event and the probability attached to each one. The
probability distribution for our rain example is as follows:
Event: Rain
Outcome Probability
Rain will occur in Gauteng 0,2
Rain will not occur in Gauteng 0,8
1,00
Probability distributions are useful in management decisions, since

they allow management to consider not only the potential outcomes
in a particular decision but also the probabilities attached to each
outcome. Consider the information in example 10.9.
Example 10.9
An organisation is contemplating whether it should manufacture hair shampoo or body
soap. A research survey yields the following probability distribution for the pro t that
can be made from each product in the rst year:
Event: Make hair shampoo

A B
Outcome (pro t) Probability
R100 000 0,05
R110 000 0,25
R120 000 0,40
R130 000 0,20
R140 000 0,10
Total 1,00
Event: Make body soap
Outcome (pro t) Probability
R80 000 0,15
R110 000 0,10
R120 000 0,40
R140 000 0,10
R150 000 0,25
Total 1,00
Required:
Determine whether the organisation ought to manufacture hair shampoo or body soap.
The expected value for each alternative can be calculated as follows:
Event: Make hair shampoo
A B A×B
Outcome (pro t) Probability Weight
R100 000 0,05 R5 000

R110 000 0,25 R27 500
R120 000 0,40 R48 000
R130 000 0,20 R26 000
R140 000 0,10 R14 000
Total 1,00 R120 500
Event: Make body soap
Outcome (pro t) Probability Weight
R80 000 0,15 R12 000
R110 000 0,1 R11 000
R120 000 0,4 R48 000
R140 000 0,1 R14 000
R150 000 0,25 R37 500
Total 1,00 R122 500
The probability distribution in example 10.9 shows that there is 5%

chance that a pro t of R100 000 will be yielded if the organisation
manufactures hair shampoo. We can also add together probabilities
and say that there is 70% chance (40% + 20% + 10%) that pro ts will
be R120 000 or more, and 30% chance (5% + 25%) that pro ts will be
less than R120 000. We can do a similar expression for the body soap
product and say that there is a 75% chance (40% + 10% + 25%) that
pro ts will be R120 000 or more, and 25% chance (15% + 10%) that
pro ts will be less than R120 000.
10.5.2 Expected values

Expected values are calculated by weighing each of the outcomes
(pro ts in example 10.9) by its related probability. This yields a
single value, which is often referred to as the ‘expected value’.
Statistically, the expected value is therefore the weighted
arithmetic mean of the possible outcomes. The expected values for
the products in example 10.9 are R120 500 for the hair shampoo and
R122 500 for body soap.
A pro t of R120 000 has the highest chance of occurring for both
products (it has a 40% chance of occurring for hair shampoo and the
same for body soap). However, if the events were to be repeated
several times over in the long run, it is expected that a R120 500
pro t would result from manufacturing hair shampoo and a
R122 500 pro t from body soap.
Management would be inclined to choose to manufacture body
soap owing to its higher expected value. However, management
should also note that there is 15% chance that pro ts for body soap
could be only R80 000. The hair shampoo product has only 5%
chance of a lowest pro t of R100 000. So it appears that the body
soap product has the higher expected value, but may carry a higher
risk.
10.5.3 Decision trees

So far in this chapter we have concentrated on uncertainty in one
variable – in example 10.9, future pro ts were uncertain. However,
in practice, the outcome of one event may be dependent on the
outcome of another. In such circumstances, a decision tree may be
employed.
A decision tree diagram consists of several branches to re ect the
various choices, events and possible outcomes for a decision. A
decision tree is intended to depict all the possible outcomes and the

probability of each. The workings of a decision tree are illustrated in
example 10.10.
Example 10.10
Coega Ltd is an oil drilling organisation operating on the east coast of South Africa.
They are currently contemplating the drilling of a new site.
Coega will have to drill 30 metres into the ground in order to establish whether oil
lies below. This will cost R1 000 000 per drill. Experts say that there is 60% chance of
nding oil. If oil is found, demand is uncertain, and the following probability distribution
will apply for the different demand levels:
Demand Probability Profit/(loss)(drilling expense has not been deducted)
High 0,3 R11 000 000
Medium 0,3 R7 000 000
Low 0,4 (R500 000)
Required:
Employ a decision tree to advise whether Coega should drill for oil at the new site.
There are two uncertain variables:

1 Existence of oil
2 Demand
Furthermore, a dependency exists between the variables. The

demand for oil will need to be considered only if oil exists.
Therefore, a decision tree is required. See Figure 10.1.
Figure 10.1 Decision tree for example 10.10

Take note of the use of boxes and circles in the decision tree. The
boxes indicate a point where a decision needs to be taken, for
example whether the drilling should proceed or not. In contrast, a
circle re ects a point where an event occurs, the outcome of which is
uncertain. The organisation has no control over the outcome, and
probabilities are attached to do the different outcomes that ow from
the event.
Also take note that demand is dependent on oil being found:
Coega would not be concerned about the level of demand if oil were
not found. Therefore, we can calculate the joint probability of oil
being found AND demand being high by multiplying the
probability of oil found (60%) by the high demand probability of
30%, which amounts to a joint probability of 18%. We can calculate a
joint probability of 18% for the oil found and medium demand

combination, and a joint probability of 24% for oil found and low
demand. Using these probabilities, we can prepare the following
probability distribution for each decision and its related expected
value:
Decision: Drill
Decision: Do not drill

E: Expected value = R0
Take note that the total of all probabilities for the drill decision is
equal to 1. Using these probabilities, we can calculate an expected
value of R2 120 000. Remember, the expected value is not a
guaranteed pro t, but rather represents the long-run average pro t
that would result if the actions were performed many times over. If
the organisation does not drill, the expected value is zero. Given the
expected value, the decision should be accepted as it yields an
expected net cash in ow of R2 120 000. However, the organisation
must take speci c note that there is 64% (outcome C’s 24% +
outcome D’s 40%) chance of a loss arising, and only 36% (outcome
A’s 18% + outcome B’s 18%) chance that a pro t will arise. Therefore,

the ultimate decision will be based on the organisation’s appetite for
risk.

This chapter focuses on the decision-making aspect of the
management accountant’s function. We have already covered short-
term decision-making. The management accountant’s role, however,
also includes the pricing decision. The pricing decision simply
entails the process of deciding on the best selling prices for an
organisation’s standard products or services. The pricing decision
should not be confused with the pricing decision of a special order.
Pricing a special order uses relevancy principles and is relevant to
the short term only – it entails a once-off decision. The pricing
decision affects basically all organisations as all their products or
services must be priced. The pricing decision is of utmost
importance as the selling price directly affects the performance and
ultimately the value of an organisation.
It is important to understand what the effect of the pricing
decision will be on pro tability and ultimately the performance of an
organisation. Gross pro t of an organisation consists of both sales
and cost of sales (product costs). In order to improve the gross pro t
percentage of an organisation, either the selling price must be
increased and/or the cost of sales (product costs) must be reduced.
Gross pro t will also increase in absolute terms when sales volume
increases. Sales volume can be increased through several actions.
One of these techniques is to reduce the selling price of a
product/service. A reduced selling price may increase demand and
although this would have a negative impact on the gross pro t
percentage, it may lead to an increased gross pro t in absolute terms.

It is evident that the correct sales price is of utmost importance as it
not only affects the gross pro t percentage but also gross pro t in
absolute terms.
This section will rstly look at the difference between a price
setter and price taker. We will then discuss the impact of selling
prices on the demand of products/services. The difference between
cost-plus pricing and target costing will be explored. The pricing
decision differs over the short and long term, this difference will be
explored further and nally, a number of pricing strategies will be
brie y discussed.
10.6.1 Price takers versus price setters

Organisations are, in terms of their products/services, either ‘price
setters’ or ‘price takers’. Before a price can be decided upon,
organisations should know which one they are. A price taker is
when the product/service price is determined by market supply and
demand. These products/services are normally not differentiated in
the market and the organisation’s product is as good as its
competitor’s. Organisations selling commodities are usually price
takers.
A price setter is where the organisation supplying the
product/service can set the price. Normally this will be the case
where the organisation is the market leader or its product is
signi cantly different to what is available on the market and there is
low competition for the product. DSTV in South Africa was
considered a price setter for many years as there was no real
competition. With Net ix and other TV streaming options entering
the market, DSTV is moving towards becoming a price taker.

10.6.2 Price elasticity
Price elasticity simply refers to the price–demand relationship of a
speci c product or service. Generally, as the selling price of a
product or service is increased, the demand will decrease, and if the
selling price of a product or service is reduced, the demand will
increase. Consider the automotive industry, as an example. There are
generally much more affordable cars on our roads than expensive
cars. This is the case because their lower selling prices result in
higher demand.
Selling price will have little or no impact on the demand for
certain products/ services – we say these products/services are
inelastic. However, selling price will have a large or signi cant
impact on demand for other products/services – we say these
products/services are elastic. Price elasticity of a product/service
should be determined before deciding on a selling price. An example
of an inelastic product is luxury items such as ‘brand name’ clothes.
The demand is not signi cantly affected by the selling price. An
example of an elastic product is bread: if the selling price is increased
by one supplier, demand decreases signi cantly, because the
customer is likely to buy bread (or a similar product) from another
supplier. In practice, no product or service is completely inelastic, as
this would mean that any price could be charged without reducing
demand. It is rather a question of how elastic the product or service
is, and how this information can best be used when making a pricing
decision.
An organisation estimates and calculates which combination of
selling price and unit sales (demand) will maximise contribution.
Fixed costs – those that are xed over the timespan of the pricing
decision – are ignored, as they are irrelevant.

10.6.3 Cost-plus pricing versus target costing
Key terms: cost-plus pricing, target cost, target costing
Cost-plus pricing is a simple yet widely used method of pricing. It

involves accumulating product costs and then adding a pro t
margin to determine the selling price. Accumulating product costs is
also known as inventory valuation and can be done using variable or
absorption costing (refer to Chapter 5, Absorption versus variable
costing).
The principle behind using inventory valuation as a starting
point for determining a selling price is to ensure that all costs
incurred that relate to the product or service are recovered. Although
this method ignores many other important considerations, it can
often be a valuable starting point to the pricing decision. Some
practical dif culties with cost-plus pricing are that it is dif cult to
decide on the pro t margin, and that the resulting calculated selling
price may not be the optimal selling price in the market.
Target costing, on the other hand, starts by determining the
selling price that will be accepted by the market. In other words, the
selling price is determined by performing market research, taking
into account estimated market share, assumed market demand,
growth opportunities, and so on. After the selling price is
determined, the required pro t margin is deducted (again, it may be
dif cult to decide on an appropriate pro t margin). The amount
remaining after this deduction is then referred to as the target cost.
The organisation proceeds by designing and redesigning the product
or service as best it can in an effort to produce it within the target
cost.

Note that, very often, organisations that use target costing base
their decisions on medium- to long-term projections. They may not
make a pro t in the short term, but may be willing to accept such
losses, because over time they are expecting signi cant cost savings
owing to economies of scale and the learning effect (which means
that, in theory, every unit produced should cost slightly less than the
previous one).
In conclusion: the cost-plus approach starts with the cost and
calculates the selling price, whereas target costing starts with the
selling price and calculates the target cost.
Target costing is also discussed in Chapter 17, Competitive
advantage.
10.6.4 Short-term pricing

Key terms: short-term pricing
Organisations may encounter short term, once-off, special order

decisions from time to time. When this situation occurs, short-term
relevancy principles (as already discussed in this chapter) should be
applied (refer to example 10.2). A price setter would most likely
need to determine the selling price of such a short-term special order
and it is important to apply relevancy principles to ensure that the
organisation covers at least all relevant costs. A price taker would
most likely be given a price for the special order and then have to
decide if they will accept this special order or not. In essence, this is
not a pricing decision but rather a pure accept-or-reject decision.
10.6.5 Long-term pricing

Key terms: long-term pricing
Short-term pricing is relevant to once-off special orders. When

deciding on a selling price of a once-off special order, we therefore
ignore xed costs, as we argued their irrelevance. The reality,
however, is that xed costs must be covered over the long term in
order to be pro table. Therefore, when deciding on a selling price for
products or services over the long term, an organisation must ensure
that all costs relating to these products or services are covered. All
costs must be covered by sales revenue irrespective of whether these
costs are xed or variable in nature. This is known as long-term
pricing.
When considering an organisation as a whole, it is evident that
sales must cover all the expenses the organisation incurs in order to
ensure a pro t is made. It is important to track all these expenses to
speci c products or services in order to price them accurately. If too
few costs are allocated to a product and cost-plus pricing is used,
there is a risk of making a loss, as prices may be set too low. If too
many costs are allocated and cost-plus pricing is used, the risk arises
that the selling price could be set too high and potential sales may be
lost. It may be impractical for all costs to be allocated to speci c
products or services, but to ensure pro tability, the organisation’s
total costs must be lower than the total sales revenue.
Activity-based costing can be used as a tool to allocate overhead
costs accurately to products or services (refer to Chapter 6, Overhead
allocation).
10.6.6 Pricing strategies

Key terms: loss leader, penetration pricing, premium pricing,
price skimming, pricing strategies, product bundling,
product differentiation
The pricing decision does not involve only mathematical

calculations – customer behaviour should also be considered.
Various pricing strategies exist which can assist organisations in
their pricing decisions. A number of these strategies are brie y
explained below.
Price skimming
Price skimming entails setting a high initial price while the product
or service is new on the market and while certain customers are
willing to pay this high price. As this market becomes saturated, the
price is reduced to attract the more price-sensitive customers.
Premium pricing
A premium pricing strategy entails the setting of a high selling price
to encourage a favourable perception of the product or service
among customers. This strategy relies on the perception that
expensive products are of a better quality.
Penetration pricing
Penetration pricing entails a low initial selling price in order to enter
the market quickly and to build up market share. This strategy is
normally adopted when substitute products or services exist. The
price may be increased later when the product or service is well-
established in the market.

Loss leader
A loss leader is a product or service sold at a very low price
(sometimes below cost) to attract customers in the hope that they
will buy other pro table goods. This pricing strategy is often
followed by supermarkets or by the manufacturers of items such as
razors for shaving (the razor is often reasonably priced in order to
‘hook’ the customer, who must then repeat-purchase speci c razor
blades that t the razor. The company primarily makes its pro t on
the blades).
Product bundling/optional extras

Product bundling entails selling multiple products or services
together in a package deal. The reasoning behind this is that
customers feel they receive good value for money, so they buy more
products. This pricing policy is widely used in the fast food industry
(for example, a special price for a meal consisting of a burger, chips
and a soft drink).
Product differentiation
In order to sell a product or service, the offering must either be
competitively priced or must be different from that offered by
competitors. Making a product or service different from the ones
already on the market is called product differentiation. When a
product or service is not different from other products available on
the market, an organisation could end up being a price-taker and as
a result not have much pricing power. Differentiation could ensure
more pricing power by allowing an organisation to move towards
becoming a price setter.

A product or service can be differentiated in many ways, such as
offering a different level of quality, different features, a different level
of sales or after-sales service, and so on. Note that in a differentiation
strategy, the emphasis is on making the product or service different.
Also refer to Chapter 17 for a discussion on Porter’s generic
strategies (see section 17.2).
10.7 Summary
The most important principle underlying decision-making is that
only costs and income that differ between alternatives are relevant.
This chapter illustrated this principle in three frequently
encountered situations, but it can be applied in other decision-
making scenarios as well. The chapter also addressed the problem of
inputs into a decision often not being known with certainty in
practice. The last part of the chapter addressed the importance of the
pricing decision for the management accountant.
Conclusion: Relevant costs for decision-

making and other topics in this book
Because management accountants supply information to facilitate
management’s decision-making, the issue of relevant costs and
income is key to many aspects of their work. Relevant costing
principles are frequently examined by professional bodies, because
they are key to understanding management accounting and easily
integrated with other topics.
Tutorial case study: Tendering in the pharmaceutical

industry

Manufacturers of pharmaceutical products in South Africa, such as Enaleni and
Adcock Ingram, have seen unprecedented growth, despite strict regulation of the
pharmaceutical industry by the government.
Let us assume that one of these manufacturers is tendering for a size-able
government order for the production of antiretroviral drugs, something that has not
been done by the organisation in the past.
Since pricing is strictly regulated, the organisation runs a lean operation, with
limited amounts of excess capacity. In order to ful l the government order, they may
have to cease production temporarily of certain over-the-counter drugs.
Fixed overheads are low (they rent factories in low-cost regions, such as the
Eastern Cape), and the majority of the labour force is permanently employed, as this
works out cheaper in the long run than using temporary labour.
Assume that the management of the pharmaceuticals organisation is not too
concerned about having to cease production temporarily of certain over-the-counter
drugs, as they believe that customers will always continue to buy the drugs, even
though they may be unavailable for a few weeks. As an alternative, they could
expand an existing factory, and use the capacity created to focus on special
government tenders.
From a regulatory perspective, the organisation would have to appoint a
supervisor accredited by the Medicines Control Council and ensure that they meet
the appropriate empowerment criteria. Given the social impact of antiretroviral
drugs, government has promised certain tax incentives in future for producers of
these drugs, such as accelerated ‘wear-and-tear’ allowances on equipment.
1 Describe how you would assess whether you agree with management’s decision
to cease production temporarily of certain over-the-counter drugs.
2 Discuss how the temporary halting of production of certain over-the-counter
drugs may impact on the pricing of the government tender.
3 Discuss how the expansion of the factory should be evaluated, and whether this
is a long-term or a short-term decision.
4 Discuss whether management should consider discontinuing a portion of the
existing product lines to create capacity in order to focus exclusively on
government tenders.
5 Speculate on what qualitative factors government might consider in awarding the
tender.
6 Discuss whether the tax incentives proposed, but not yet enacted, are a relevant
factor to consider in the decision regarding the government tender.
Basic questions

BQ 1
What is the difference between relevant costs and irrelevant costs?
BQ 2
What are the quantitative and qualitative considerations of a special
order decision?
BQ 3
What quantitative and qualitative aspects would we consider when
making a make-or-buy decision?
BQ 4
What are some of the qualitative aspects to consider in a closing-
down decision?
BQ 5
How would you go about deciding between two investments with
different returns and risks? Explain your understanding of the
measures of risk and return.
BQ 6
What is the difference between qualitative and quantitative relevant
information?
BQ 7
How can uncertainty be taken into account in the short term?
BQ 8
What is an opportunity cost and how does it arise?

BQ 9
SOURCE: ADAPTED FROM ACCA PAPER 1.2 (DECEMBER 2002), QUESTION 3
An organisation wants to purchase a new machine for R150 000 to
perform a contract. The machine will cost R25 000 to install and will
have a scrap value of R10 000 in 5 years. It is depreciated on the
straight-line basis over 5 years. What is the relevant cost of the
machine for the contract?
A R140 000
B R150 000
C R165 000
D R175 000
BQ 10
(i) Materials can never have an opportunity cost, while labour
can.
(ii) The annual depreciation charge is not a relevant cost.
(iii) Fixed costs will have a relevant cost element if a decision
causes a change in the total expense.
Which statements are true?

A (i) and (ii) only
B (i) and (iii) only
C (ii) and (iii) only
D (i), (ii) and (iii)
BQ 11
SOURCE: ADAPTED FROM CIMA PAPER 2 (MAY 2008), QUESTION 1.8
A company is considering a short-term pricing decision to utilise
some spare capacity. The item to be manufactured and sold would

use 1 500 kg of raw material Q.
Material Q is in regular use by the company. It currently has 1 000
kg in inventory, which was purchased last month at a cost of R4 per
kg. The current replacement cost of material Q is R4,80 per kg and
the current inventory could be sold for R4,30 per kg.
Calculate the relevant cost of material Q for the purposes of this
decision.
BQ 12
SOURCE: UNIVERSITY OF JOHANNESBURG ARCHIVE.
A company is considering a contract which will require, among
other inputs, 50 kg of material M. 80 kg of material M, which were
purchased for R1,60 per kg, are in stock. The replacement price of M
is R1,75 per kg. The material is in stock as a result of a buying error
and the company has no other use for it. If not used on this contract,
it could be sold for R1,20 per kg. Determine the relevant cost of the
material to be used in this contract.
BQ 13
SOURCE: ADAPTED FROM ACCA PAPER 1.2 (JUNE 2006), QUESTION 18
An organisation’s skilled labour, which earns R8 per hour, is fully
utilised in manufacturing a product with the following pricing:
• Selling price: R60 per unit
• Variable cost: R35 per unit (R20 skilled labour and R15 other
costs)
The organisation considers a contract requiring 90 skilled labour

hours. No other skilled labour is available. What is the relevant
skilled labour cost for the contract?
A R720

B R900
C R1 620
D R2 160
BQ 14
An organisation considers a contract that requires two types of
materials, T and V.
Material T is regularly used. Material V is no longer used and has no

alternative use in the business. What is the total relevant cost of
materials for the project?
A R40 400
B R40 900
C R43 400
D R43 900
Long questions

SOURCE: ADAPTED FROM ACCA LEVEL 2 MANAGEMENT ACCOUNTING (JUNE 1986)
A small contractor has been asked to quote for a contract which is
larger than he would normally consider. The contractor would like
to obtain the job as he has surplus capacity.

The estimating and design department has spent 200 hours in
preparing drawings and the following cost estimate:
Notes:
1 A suf cient stock of raw material X is held in the stores. It is the
residue of a quantity bought some 10 years ago. If this stock is
not used on the prospective contract, it is unlikely that it will be
used in the foreseeable future. The net resale value is thought to
be R20 000.

2 Material Y is regularly used by the contractor on a variety of jobs.
The current replacement cost of the materials is R130 per unit.
3 This is the estimated cost of the required materials.
4 Staff are paid on a time basis for a 40-hour week. The hourly
labour rate includes a charge of 100% of the wage rate to cover
labour-related overhead costs. It is estimated that, at the current
level of operations, 80% of the overheads are variable. It is
considered that one extra worker will be required temporarily for
3 months if the contract is obtained. His salary of R100 per week
(and the associated amount of labour-related overhead expense)
is included in the estimate of R13 600.
5 No additional trainees would be taken on. The trainees’ wage
rate is R1 per hour, but their time is charged out at R2 to allow for
labour-related overheads on the same basis as in note 4 above.
6 The curing press is normally fully occupied. If it is not being used
by the contractor’s own workforce, it is being hired out at R500
per week.
7 This is the estimated cost for the work.
8 It is not considered necessary to employ any additional
supervisory staff. The estimated cost of R6 150 includes an
allowance of R1 000 for overtime which it may be necessary to
pay to the supervisors.
9 The expense of this department is predominantly xed, but the
overtime payments were speci cally incurred to get the drawings
and plans out in time.
10 The administrative expense is a xed cost. This is the established
method of allocating the cost to speci c contracts.
REQUIRED Marks
(a) It is considered that any quotation higher than R100 000 will be unsuccessful. You are 15
required to prepare a revised cost estimate using an opportunity cost approach. State whether

you consider that the revised calculations can provide support for a quotation below
R100 000.
(b) Comment on the use of opportunity cost for decision-making. 7
TOTAL MARKS 22

SOURCE: UNIVERSITY OF JOHANNESBURG ARCHIVE.
The management of Computer Development Ltd is considering
marketing a new application software package. The package will
also include a hardware portion in the form of a graphic monitor.
The costs associated with this project are as follows:
• Development costs of R200 000 with a 70% chance of success
• Manufacturing costs:
• Management could service the existing machinery (book
value R nil and remaining life 14 years) which could
manufacture the hardware at a cost of R1 000 000. The
variable costs per package which will be offered for sale will
in this case amount to R2 000 per package.
• Alternatively, they could invest in new machinery (which also
has an expected life of 14 years) at a cost price of R2 000 000.
However, the difference lies in the fact that the variable costs
per package will now amount to only R1 000.
• Marketing information
• Management is considering a selling price of R6 000 per
package.
• The following information was obtained through market
research:
Condition of Sales volume (number of Probability to sell @ a price of R6 000 per

economy packages) package

Boom phase 1 000 40%
Recovery phase 500 40%
Recession 50 20%
REQUIRED Marks
By means of a decision tree, advise the management of Computer Development Ltd on whether or
15
not they should undertake the project
TOTAL MARKS 22
Note: Management wishes to write off the cost price of the machinery
completely within the rst year of production.

SOURCE: ADAPTED FROM CIMA STAGE 1 OPERATIONAL COST ACCOUNTING
You have received a request from EXE Ltd to provide a quotation for
the manufacture of a specialised piece of equipment. This would be a
one-off order, in excess of normal budgeted production. The
following cost estimate has already been prepared:

Notes:
1 The steel is regularly used, and has a current stock value of R5,00
per m2. There are currently 100 m2 in inventory. The steel is
readily available at a price of R5,50 per m2.
2 The brass ttings would have to be bought speci cally for this
job. A supplier has quoted the price of R20 for the ttings
required.
3 The skilled labour is currently employed by your organisation
and paid at a rate of R8,00 per hour. If this job were undertaken,
it would be necessary either to work 25 hours overtime, which
would be paid at time plus one half, or to reduce production of
another product which earns a contribution of R13,00 per hour.
4 The semi-skilled labour currently has suf cient paid idle time to
be able to complete this work.

5 The overhead absorption rate includes power costs which are
directly related to machine usage. If this job were undertaken, it
is estimated that the machine time required would be 10 hours.
The machines incur power costs of R0,75 per hour. There are no
other overhead costs which can be speci cally identi ed with this
job.
6 The cost of the estimating time is made up of the four hours
taken by the engineers to analyse the drawings and determine
the cost estimate given above.
7 It is the policy of the organisation to add 20% to the production
cost as an allowance against administration costs associated with
the jobs accepted.
8 This is the standard pro t added by your organisation as part of
its pricing policy.
REQUIRED Marks
(a) Prepare, on a relevant cost basis, the lowest cost estimate that could be used as the basis for
12
a quotation. Explain brie y your reasons for using each of the values in your estimate.
(b) There may be a possibility of repeat orders from EXE Ltd which would occupy part of normal
production capacity. Discuss the factors that need to be considered before quoting for this 7
order.
(c) When an organisation identi es that it has a single production resource which is in short
supply, but is used by more than one product, the optimum production plan is determined by
ranking the products according to their contribution per unit of the scarce resource. Using a 6
numerical example of your own, reconcile this approach with the opportunity cost approach
used in (a) above.
TOTAL MARKS 25
LQ4 – Intermediate (36 minutes)


Klipfontein Construction CC produces metal drums that the mines
use to move equipment. The company’s normal production volume
is 3 000 units, which is also its budgeted monthly sales.
Information regarding June 2010:
Production volume 3 000 units 4 000 units
Manufacturing costs per unit: R R
Material 100 100
Variable labour 150 150
Variable overheads 50 50
Fixed overheads allocation rate 120 120
Total marketing costs R570 000 R620 000
• The normal selling price per unit is R740.
• Marketing costs are composed of a monthly contract fee and a
commission fee charged to every unit sold locally. This will be
payable on all special orders locally.
• The production capacity of the company is 4 000 units.
• Actual xed overheads were equal to budgeted xed overheads.
• The company does not hold stocks of nished goods.
Unless otherwise stated you are to assume that there is no connection

between the situations described in the respective sections required.
Foreign market proposal

The CC has an opportunity to enter a foreign market in which price
competition is strong. Klipfontein Construction CC is keen to follow
up this opportunity because the foreign market demand occurs

when local demand is at its lowest. An order for 1 000 units is being
sought, but this order will need to be priced below the normal
market price to be competitive. For this order, there will be
additional cost of R75 per unit for shipping costs. Klipfontein
Construction CC will have to pay an agent fee of R4 000 if the order
is accepted. Klipfontein Construction CC also needs to buy a
wrapping machine for wrapping units before shipping. The cost of
the wrapping machine will be R300 000 and it will be sold after the
order for an estimated amount of R280 000.
Business Forum special order

On 10 June 2010, the Johannesburg Business Forum requests the
supply of 1 500 units to restock the mines for a 30 June 2010 delivery.
They are willing to pay R600 per unit.

Umdoni Ltd currently publishes, prints and distributes a range of
catalogues and instruction manuals. The management have now
decided to discontinue printing and distribution, and concentrate

solely on publishing. Nongoma Ltd will print and distribute the
range of catalogues and instruction manuals on behalf of Umdoni
Ltd commencing either at 30 June 2010 or 30 November 2010.
Nongoma Ltd will receive R65 000 per month for a contract which
will commence either at 30 June 2010 or 30 November 2010.
The results of Umdoni Ltd for a typical month are as follows:
Other information has been gathered relating to the possible closure

proposals:
• Two specialist staff from printing will be retained at their present
salary of R1 500 each per month in order to ful ll a link function
with Nongoma Ltd. One further staff member will be transferred
to publishing to ll a staff vacancy through staff turnover,
anticipated in July. This staff member will be paid at his present
salary of R1 400 per month, which is R100 more than that of the
staff member who is expected to leave. On closure, all other
printing and distribution staff will be made redundant and paid
an average of two months redundancy pay.
• The printing department has a supply of materials (already paid
for) which cost R18 000 and which will be sold to Nongoma Ltd
for R10 000 if closure takes place on 30 June 2010. Otherwise the
material will be used as part of the July 2010 printing
requirements. The distribution department has a contract to

purchase pallets at a cost of R500 per month for July and
August 2010. A cancellation clause allows for non-delivery of
pallets for July and August for a one-off payment of R300. Non-
delivery for August only will require a payment of R100. If the
pallets are taken from the supplier, Nongoma Ltd has agreed to
purchase them at a price of R380 for each month’s supply which
is available. Pallet costs are included in the distribution material
and supplies cost stated for a typical month.
• Company expenditure on apportioned occupancy costs to
printing and distribution will be reduced by 15% per month if
printing and distribution departments are closed. At present, 30%
of printing and 25% of distribution occupancy costs are directly
attributable costs which are avoidable on closure, whilst the
remainder are apportioned costs.
• Closure of the printing and distribution departments will make it
possible to sub-let part of the building for a monthly fee of R2500
when space is available.
• Printing plant and machinery has an estimated net book value of
R48 000 at 30 June 2010. It is anticipated that it will be sold at a
loss of R21 000 on 30 June 2010. If sold on 30 November 2010, the
prospective buyer will pay R25 000.
• The net book value of distribution vehicles at 30 June 2010 is
estimated as R80 000. They could be sold to the original supplier
at R48 000 on 30 June 2010. The original supplier would purchase
the vehicles on 30 November 2010 for a price of R44 000.

LQ6 – Advanced (45 minutes)
SOURCE: ADAPTED FROM CIMA P2 (MAY 2007) SECTION C, QUESTION 6
H, a printing company, uses traditional absorption costing to report
its monthly pro ts. It is seeking to increase its business by winning
work from new customers. It now has the opportunity to prepare a
quotation for a large organisation that currently requires a new
catalogue of its services.
A technical report on the resource requirements for the catalogue
has been completed at a cost of R1 000 and its details are
summarised below:
Production period
It is expected that the total time required to print and despatch the
catalogue will be one week.
Material A
10 000 sheets of special printing paper will be required. This is a
paper that is in regular use by H and the company has 3 400 sheets
in inventory. These originally cost R1,40 per sheet, but the current

market price is R1,50 per sheet. The resale price of the sheets held in
inventory is R1,20 per sheet.
Material B
This is a special ink that H will need to purchase at a cost of R8 per
litre. 200 litres will be required for this catalogue, but the supplier
has a minimum order size of 250 litres. H does not foresee any other
use for this ink, but will hold the surplus in inventory. H’s inventory
policy is to review slow moving items regularly. The cost of any
inventory item that has not been used for more than 6 months is
accounted for as an expense of the period in which that review
occurs.
Direct labour
Suf cient people are already employed by H to print the catalogue,
but some of the printing will require overtime hours due to the
availability of a particular machine that is used on other work. The
employees are normally paid R8 per hour, the order will require 150
hours of work and 50 of these hours will be in excess of the
employees’ normal working week. A rate of R10 per hour is paid for
these overtime hours. Employees are paid using an hourly rate with
a guaranteed minimum wage for their normal working week.
Supervision
A supervisor will take responsibility for the catalogue in addition to
her existing duties. She is not currently fully employed and receives
a salary of R500 per week.
Machinery
Two different types of machine will be required. Machine A will
print the catalogue. This is expected to take 20 hours of machine

time. The running cost of machine A is R5 per hour. There is
currently 30 hours of unused time on machine A per week that is
being sold to other printers for R12 per hour.
Machine B will be used to cut and bind the catalogue. This
machine is being used to full capacity in the normal working week,
hence the need to work overtime. The catalogue will require 25
machine hours and these machines have a running cost of R4 per
hour.
Despatch
There will be a delivery cost of R400 to transport the catalogue to the
customer.
Fixed overhead costs

H uses a traditional absorption costing system to attribute xed
overhead costs to its work. The absorption rate that it uses is R20 per
direct labour hour.
Pro t mark-up
H applies a 30% mark-up to its costs to determine its selling prices.
REQUIRED Marks
(a) To assist the management of H in preparing its quotation, prepare a schedule showing the
relevant costs for the production of the catalogue. State clearly your reason for including or 15
excluding each value that has been provided in the above scenario.
(b) Explain how the use of relevant costs as the basis of setting a selling price may be appropriate
for short-term pricing decisions but may be inappropriate for long-term pricing decisions. Also
10
discuss the con ict between reporting pro tability within a traditional absorption costing
system and the use of relevant cost-based pricing.
TOTAL MARKS 25

LEARNING OBJECTIVES
• understand constraints and their relevance in solving business
problems
• understand the concept of contribution per limiting factor and
how to apply it in relevant scenarios
• apply linear programming to resolve contribution maximisation
problems where there are two products and two or more scarce
resources
• calculate and interpret shadow prices
• interpret the nal table of a simplex tableau
• evaluate the use of linear programming.
Butter and decision-making under operational

constraints
South Africa has recently become a net importer of butter and this will most likely
remain the case. Why has milk-rich South Africa started to experience a shortage of
butter? The rst shortage occurred in 2017 when the Banting diet (among other
factors) gained popularity and resulted in many consumers moving to full cream milk
(instead of low fat) and butter (instead or margarine). This change in consumer
behaviour coupled with decreased milk production as a result of drought, led to the
rst shortage of butter experienced in 2017. Subsequently, a number of shortages
occurred.

Cream is skimmed off milk to obtain low fat milk and is then used to produce
butter. The current predicament in dairy production is that the demand for butter has
increased substantially, while the demand for low fat milk has concurrently reduced
dramatically.
Changing consumer behaviour therefore resulted in changes in demand for
different products, which in turn resulted in operational constraints.
SOURCE: BASED ON INFORMATION FROM HTTPS://WW.BUSINESSINSIDER.CO.ZA/BRUCE-WHITFIELD-
ONBUTTERNOMICS-2019-4
In this case study, the dairy industry is faced with what is known as
an operational constraint. The constraint is a scarce resource, namely
cream obtained from milk. A key question that arises is how the
industry and more speci cally an individual dairy producer could
best make use of the limited amount of cream that it has available.
Should a dairy producer only focus on milk and cheese? Or should it
produce a limited amount of butter as well? What is the consequence
if butter is produced, but a consistent shortage is experienced by
consumers? What is the possible reputational damage? The
principles in this chapter help organisations such as dairy producers
to make the most sensible decisions when faced with operational
constraints.
11.1 Introduction
Key terms: constraints, long term, short term
In every organisation, it would most likely be possible to nd

constraining factors preventing unimpeded growth and expansion.
Constraints experienced over the short term are typically operational
in nature, such as a shortage of manpower, limited machine capacity
or scarce raw materials. In the medium to long term, these problems

can usually be overcome by, for example, appointing more staff,
purchasing another machine or importing raw materials.
In the short term, however, while more sustainable solutions are
being sought and implemented over the long term, the organisation
will have to manage the current constraining factors to the best of its
ability. Alternatively, an organisation may nd itself in a position
where there is a temporary capacity constraint, such as when a once-
off special order has been received or a fad diet takes hold, as
happened in the opening case study.
Whatever the cause of the constraint, management have to decide
which products or services should receive preference. From a purely
nancial perspective, these should be those that utilise the current
scarce resource(s) in the most pro table manner.
Although most constraints experienced over the short term may
be alleviated over the long term, another constraint becomes a reality
over the long term – namely capital (i.e. available funding). Long-
term constraints (such as capital) and how to deal with them do not
fall within the scope of this chapter.

This chapter deals with the maximisation of pro tability over the
short term, given short-term constraints. Further, as the chapter
deals with decision-making over the short term, short-term
relevancy principles as introduced in Chapter 10, Relevant information
for decision-making will be used. Short-term relevancy principles
ignore xed costs as they cannot be changed within the time frame
and are therefore immaterial.
This chapter will consider how contribution can be maximised
over the short term given short-term constraints.

11.3.1 A single limiting factor

Key terms: constraint, limiting factor
A limiting factor or constraint is a scarce resource of which there is

a limited supply and which affects the ability of the organisation to
earn maximum pro ts.
As already mentioned, examples of limiting factors are:
• shortage of manpower (e.g. skilled labour)
• limited machine capacity
• scarce raw materials (e.g. some metal ores).
We will now explore an example where one limiting factor over the
short term exists. The purpose of our calculation will be to determine
how we can maximise contribution over the short term given this
constraint.
Example 11.1
Mary Craven produces two products, pillows and duvets, from the down that she gets
from the geese on her Karoo farm. Contribution per unit is as follows:
Pillow R Duvet R
Selling price 300 1 000
Direct labour at R25/hour (50) (200)
Goose down at R100/kg (100) (300)
Other fabrics (40) (200)
Variable overheads at R15/labour hour (30) (120)

Contribution 80 180
Owing to a lack of poultry farming activities in the area, the availability of goose down
is limited to 300 kg per month. The monthly demand for Mary’s products is 240 pillows
and 150 duvets.
Required:
Determine the product mix that would maximise Mary’s contribution.
Our rst reaction may be to argue that duvets have a higher

contribution per unit than pillows (R180 compared to R80) and that
Mary should therefore focus her effort on the production of duvets.
We can see that one duvet requires 3 kg of goose down
(R300/R100/kg). If only duvets were produced, she would be able to
produce 100 duvets per month (300 kg down available/3 kg per
duvet). Mary’s total contribution would be R18 000 per month (100
duvets × R180 contribution).
However, we cannot simply focus on the contribution per unit
alone. We need to establish to what extent a product consumes the
speci c scarce resource.
If Mary, for example, opts to produce 240 pillows in order to
satisfy the total monthly demand and then use the remaining 60 kg
[(300 kg – (R100/R100/kg) × 240)] to produce a further 20 duvets
(R60 kg/3 kg per duvet), she could increase the total contribution as
follows:
Contribution from 240 pillows (240 × R80) 19 200
Contribution from 20 duvets (20 × R180) 3 600
22 800

Owing to their economical use of the scarce resource, the preferential
production of pillows results in a contribution of R22 800 instead of
R18 000. Pro t is therefore maximised when the maximum possible
number of pillows is manufactured.
The calculation to determine the more pro table of the two
products is as follows:
Pillow Duvet
Contribution R80 R180
Kg of down used 1 3
Contribution per kg of down used R80 R60
Ranking 1 2
Pro t is optimised by producing the maximum number of pillows

(240 pillows) and using the remaining down to produce 20 duvets.
Pillows have the highest contribution per limiting factor.
A more formal approach to the above is as follows:
• Firstly, con rm that the limiting factor is something other than
sales demand. This is done by comparing available resources to
resources required to satisfy the total demand. If there is an
unlimited demand for the organisation’s products, resources
would be the limiting factor(s).
Kg
Down needed
690
(240 pillows × 1 kg) + (150 duvets × 3 kg)
Down available (300)
Shortfall 390

• Secondly, calculate the contribution per limiting factor. This is
done by dividing the contribution that each product renders by
the amount of scarce resources used. The products are then
ranked in the order of how economically they use the scarce
resource.
Pillows: R80/1 kg = R80/kg
Ranking: 1 Duvets: R180/3 kg = R60/kg
Ranking: 2
• Lastly, we determine the optimum sales mix. Production of the
product with the most economical use of the scarce resource
should be maximised, so 240 pillows should be produced (up to
demand). If there is still some of the scarce resource left unused
after the full market demand for the most economical product
has been met, the remaining resources can now be used to
produce the rest of the products in descending ranking order.
After 240 pillows have been produced, there will be left: 300 kg –
(240 pillows × 1 kg) = 60 kg
Number of duvets that can be produced: 60 kg/3 kg = 20 duvets
The method used to solve this problem is often referred to as ‘CULF’,

which is contribution per unit of limiting factors.
Example 11.2 illustrates the situation where a short-term
opportunity exists to increase pro ts by taking on a special order.
However, in order to meet the resources requirements of the order,
production of one of the products normally produced will have to be
reduced.
Example 11.2
Consider the information in example 11.1. In addition, Mary Craven has recently
received a request from Simple Linen to supply them with customised pillows. Simple

Linen will buy the pillows at R360 each. The additional costs of customising the
pillows will be R4 per pillow. The order is for 80 pillows which must be delivered within
the next month.
Required:
Discuss the changes to production that Mary will have to make if she decides to
accept the order and determine whether Mary should take on this new project.
Only 300 kg of goose down is available. If Mary accepts the order,

she will have to cut down on regular production.
The goose down presently used is the whole of the 300 kg (240 kg
for pillows and 60 kg for duvets, as previously calculated). The
special order requires 80 kg of goose down. There is therefore a
shortfall of 80 kg of goose down.
This shortfall must be sourced from somewhere. In this case,
more goose down cannot be purchased. The only way to get extra
goose down is to cut back on the production of existing products. In
example 11.1, we saw that duvets have the lowest contribution
margin per kilogram of goose down.
Mary will therefore cut back on duvets rst. However, cutting
back on duvets frees up only 60 kg (20 duvets) of goose down. She
will also need to cut back on 20 pillows to free up the additional 20
kg needed.
The production changes that Mary will have to make if she
accepts the order are therefore to produce only 220 pillows per
month (240 less 20) and no duvets.
The calculation to determine whether she should accept the
special order is performed below using both the total approach and
the incremental approach for explanatory purposes (these were
discussed in Chapter 10, Relevant information for decision-making).

In light of these calculations, is it a good idea to accept the order at
all? In the previous example, we found that Mary would normally
earn a contribution of R22 800 per month. The special order earns
her a contribution of R10 880 [(R360 – R50 – R100 – R40 – R30 – R4) ×
80], plus R17 600 on the ‘normal’ pillows (R80 × 220). This total
contribution of R28 480 is larger than R22 800, and – based on
relevant costing principles (see Chapter 10, Relevant costs for decision-

making) – Mary should accept the order. In reality, she would also
have to consider qualitative factors before making a decision.
11.3.2 Two potentially limiting factors

We will now explore the impact if there is more than one scarce
resource. In this scenario, each of the resources should be tested to
see whether it is, indeed, a limiting factor. If only one scarce resource
is truly a limiting factor, the product or service with the higher
contribution per limiting factor should be produced. If the sales
demand for that product has been met and there is still some of the
scarce resource left, the second product or service should be
produced as explained and illustrated in example 11.1.
Example 11.3
JamChut manufactures two products, jam and chutney. Both products require labour
and machine hours in their manufacture. Variable labour cost amounts to R30 per
labour hour, and variable machine-related overhead costs are R60 per machine hour.
There are only 5 000 labour hours and 4 600 machine hours available for the month of
February.
The products consume the scarce resources as follows:
Labour hours Machine hours
Jam 30 minutes 30 minutes
Chutney 50 minutes 20 minutes
The demand for the products is limited to 6 000 containers of jam and 4 500
containers of chutney for the month of February. The contribution to be earned in the
month of February is R55 per jam container and R65 per chutney container.
Required:
Determine the optimal product combination to be manufactured for the month of
February

The time required to produce enough containers to ll the maximum
demand for jam and chutney is as follows:

Jam (6 000 × 0,5 hours); (6 000 × 0,5 hours) 3 000 3 000
Chutney (4 500 × 50/60 hours); (4 500 × 20/60 hours) 3 750 1 500
Total hours required 6 750 4 500
Hours available 5 000 4 600
(Shortfall)/excess (1 750) 100
In this example, there are two scarce resources. However, our

calculation above has shown that only one of them (labour hours) is
a limiting factor. There are enough machine hours available to meet
the maximum demand for both jam and chutney.
This means that, in order to determine the optimal product
combination, we need to maximise the contribution per labour hour
(i.e. ‘CULF’):
Jam Chutney
Contribution per container R55 R65
Contribution per labour hour (R55/0,5 hours); (R65/50 min × 60 min) R110 R78
Ranking 1 2
The contribution is maximised when the maximum demand for jam

is met and the remaining available labour hours are then used to
produce chutney. JamChut should therefore produce 6 000
containers of jam, which will use 3 000 labour hours (6 000
containers × 30 minutes). This leaves 2 000 hours (5 000 – 3 000) for
the production of chutney. In the remaining 2 000 labour hours,

JamChut can produce 2 400 containers of chutney (2 000 hours × 60
minutes/50 minutes).
At this production mix, JamChut earns a contribution of R330 000
from jam (6 000 containers × R55) and R156 000 from chutney (2 400
containers × R65). This gives a total contribution of R486 000 per
month.
Notice that there are machine hours left over when this optimal
mix is produced. The production of 6 000 containers of jam and 2 400
containers of chutney uses only 3 800 machine hours ((6 000
containers × 0,5 hours) + (2 400 containers × 0,333 hours)). This
leaves 800 machine hours unutilised (4 600 available – 3 800 used).
Example 11.4 now sketches a similar situation to that in example
11.3, but introduces a special order into the scenario. The company
will have to decide whether and how to cut back on regular
production in order to accommodate the special order.
Example 11.4
Consider the information in example 11.3. JamChut has been approached by Extreme
Chicken, a fast food franchise, to produce a special chilli chutney for the franchise’s
10th birthday celebration. Extreme Chicken wants to order 1 000 containers of the
chutney, on which JamChut will earn a contribution of R70 per container. Producing
the chilli chutney will require the same number of labour and machine hours as the
regular chutney.
Required:
Discuss the changes JamChut will have to make if it decides to accept the order, and
determine whether JamChut should in fact accept this order.
We know from example 11.3 that there are two scarce resources:
labour hours and machine hours. We must again establish whether
these resources are limiting factors, this time taking the special order
into account.

Total available 5 000 4 600
Currently being used (from example 11.3) (5 000) (3 800)
(Shortfall)/excess without special order 0 800
Special order (1 000 × 50/60 hours); (1 000 × 20/60 hours) (833) (333)
(Shortfall)/excess with special order (833) 467
Again, we nd that only labour hours are a limiting factor. In order

to make labour hours available for the special order, we will
therefore rst reduce the production of the product with the lowest
contribution per labour hour. In example 11.3, we calculated that this
product was chutney. To make 833 labour hours available for the
production of chilli chutney, JamChut has to reduce the number of
regular chutney containers manufactured by 1 000. It will now
manufacture only 1 400 (2 400 – 1 000) containers of regular chutney.
All 6 000 containers of jam (see example 11.3) will still be
manufactured.
Is it worth it to reduce the number of regular chutney containers
in order to manufacture chilli chutney? In example 11.3, it was found
that JamChut would normally earn a contribution of R486 000 per
month. It can now earn a contribution of R70 000 on the special order
(1 000 containers × R70) plus R330 000 on jam (6 000 × R55) plus
R91 000 (1 400 × R65). This gives a total contribution of R491 000 per
month, which is more than the regular R486 000. Based on relevant
costing principles only, JamChut should accept the order. In reality, it
would also have to consider qualitative factors before making a nal
decision.
In example 11.5, we introduce two scarce resources that are both
limiting factors. Now the contribution per limiting factor for both
resources needs to be considered. Where there are multiple limiting

factors and the contribution per limiting factor of each of them ranks
the products in the same order, products should be produced
according to this unanimous ranking. If a con ict in ranking arises,
linear programming should be used to solve the optimisation
problem. This will be discussed in section 11.8.
Example 11.5
Consider the information in example 11.3 again, but take into account that JamChut
now uses re-sealable containers for its chutney. The new bottling process means it
now takes 45 minutes of machine time to produce a container of chutney.
Required:
Determine the optimal product combination to be manufactured each month.
The time required in order to produce enough containers to ll the

maximum demand for jam and chutney is as follows:

Jam (6 000 × 0,5 hours); (6 000 × 0,5 hours) 3 000 3 000
Chutney (4 500 × 50/60 hours); (4 500 × 45/60 hours) 3 750 3 375
Total hours required 6 750 6 375
Hours available 5 000 4 600
(Shortfall)/excess (1 750) (1 775)
In this example, there are two scarce resources and our calculation
has shown that both of them are limiting factors.
This means that, in order to determine the optimal product
combination, we need to maximise the contribution per labour hour
and the contribution per machine hour.

We know from example 11.3 that jam has the higher contribution
per labour hour. The contribution per machine hour is as follows (i.e.
‘CULF’):
Jam Chutney
Contribution per container R55 R65
Contribution per machine hour (R55/0,5 hours); (R65/45/60 hours) R110 R87
Ranking 1 2
In addition to having the highest contribution per labour hour, jam

also has the highest contribution per machine hour. In order to
optimise production, jam should therefore get preference over
chutney.
JamChut should therefore produce 6 000 containers of jam, which
will use 3 000 labour hours (6 000 containers × 30 minutes) and 3 000
machine hours (6 000 containers × 30 minutes). This leaves 2 000
labour hours (5 000 – 3 000), and 600 machine hours (4 600 – 3 000)
for the production of chutney. In the remaining 2 000 labour hours,
JamChut can produce 2 400 containers of chutney (2 000 hours × 60
minutes/50 minutes), but in the remaining machine hours JamChut
can produce only 2 133 containers of chutney (1 600 hours × 60
minutes/45 minutes). The optimal production mix is therefore 6 000
containers of jam and 2 133 containers of chutney per month.
In example 11.5, there are two limiting factors (labour hours and
machine hours), and both happened to give the same ranking for the
products: both indicated that jam should be given preference. If,
however, the two limiting factors were to give con icting rankings
(for example, if jam had the highest contribution per labour hour
while chutney had the highest contribution per machine hour),

linear programming would be required in order to solve the
problem. Linear programming is therefore discussed in section 11.8.
11.4Make-or-buy decisions and scarce

resources
Where an organisation purchases from a third party goods or
services that the organisation had previously made itself, this is
called ‘outsourcing’. The outsourcing decision was previously
discussed in Chapter 10, Relevant costs for decision-making, but
limiting factors were not considered in detail.
In a situation where an organisation considers outsourcing work
to make up a shortfall in its own in-house capacity, the difference
between the cost of outsourcing and the cost of in-house
manufacturing has to be determined for each product. The product
for which outsourcing is the least costly when compared to in-house
manufacturing, per unit of scarce resource, is the one that should be
prioritised for outsourcing.
Example 11.6
Naledi Aviation Electronics manufactures three electronic components, K, L and M,
using the same equipment for each. Its nal product, product X, uses one of each
component. Naledi has a contract for the production of 12 000 units of product X for
the next year.
Process hours and variable cost pertaining to the three components can be
Processing time (hours) Total variable cost R

1 unit of K 2 45
1 unit of L 3 30

1 unit of M 4 36
Assembly 24 135
Only 72 000 hours of processing time will be available during the year. The
manufacturing of the components can also be outsourced, and a competitor has
quoted the following prices for supplying components:
K: R53
L: R48
M: R56
You may assume that product X generates a large enough contribution to be pro table
whether its components are manufactured or bought in.
Required:
Advise Naledi whether they should make use of the competitor’s services, and if they
do, which components should be bought in.
Total machine hours required to do all production in-house:

12 000 × (2 + 3 + 4) = 108 000 hours
Available: 72 000 hours
36 000 hours should therefore be outsourced
The aim should be to minimise the extra variable costs of

outsourcing per unit of the scarce resource saved.

The most economical production plan would be to outsource the
production of component K and to give priority to component L for
in-house production.
The optimal production plan is therefore to produce all 12 000
units of L internally as well as 9 000 units of M. This will utilise the
full capacity of 72 000 hours (12 000 units of L × 3 hours + 9 000 units
of M × 4 hours). The remaining 3 000 units of M and 12 000 units of
K should be bought in.
Key terms: shadow price
In certain cases where there are scarce resources, it may be possible

to acquire additional units of the scarce resource, but at a cost higher
than that of the original units. If, for example, scarce labour
generates a contribution of R20 per labour hour, management would
be prepared to pay up to R20 extra per labour hour if they could
acquire additional labour. R20 is then referred to as the ‘shadow
price’ of labour.
A shadow price is the increase in contribution which would be

created by having available one additional unit of a limiting
resource at the original cost.
Example 11.7
A paint factory produces two specialised products, roof paint and varnish, which earn
a contribution of R36 and R48 per 5 litre container respectively. Both products require

a scarce, imported sunlight protector, UV-40. Roof paint requires 0,5 litres of UV-40
per container, and varnish requires 1,5 litres of UV-40. Only 20 000 litres of UV-40 are
available per month. The potential demand is 25 000 containers of roof paint and
15 000 of varnish per month.
Required:
Determine the optimum production schedule as well as the shadow price of UV-40.
Roof paint renders a contribution of R72 per litre of UV-40 (R36/0,5

litres), and varnish R32 (R48/1,5 litres). The maximum amount of
roof paint should therefore be produced, and the balance of the
available UV-40 should be used for varnish.
Producing 25 000 containers of roof paint takes 12 500 litres of
UV-40. The remaining 7 500 litres of UV-40 is then used to produce
5 000 units of varnish. The total contribution is R1 140 000 (25 000 ×
R36 + 5 000 × R48).
Now, let us assume that there were an additional 1,5 litres of UV-
40 available. That would enable the factory to produce one
additional container of varnish, earning an additional contribution
of R48. The shadow price of UV-40 is therefore R32 per litre, the
additional contribution (R48) divided by the number of litres
required (1,5 litres).
Note that the shadow price relates only to the additional
contribution that can be earned by having available one extra unit of
the scarce resource. The original cost of the scarce resource is
speci cally excluded from the shadow price. Therefore, the
maximum price one would be willing to pay for the scarce resource
would be the original cost (included in the original contribution
calculations) and the shadow price calculated. See sections 11.6 and
11.7 for further discussion of shadow prices.

Linear programming: the graphical
11.6
method
11.6.1 Introduction
Linear programming is used where an organisation faces more than
one limiting factor, and where the contribution per limiting factor
does not suggest production preference for a speci c product (i.e.
there is a con ict in ranking between the contribution per unit of
limited resources). One product may, for example, be more pro table
in its use of scarce raw materials, while another product may be
more pro table in its use of scarce labour hours.
There are two linear programming techniques. The rst, the
graphical method, can only be used where there are only two
products for which contribution per limiting factor does not suggest
a production preference (i.e. there is a con ict in ranking). The
reason is simply that there is only an x-axis and and y-axis.
This implies that, where an organisation produces more than two
products, all the products’ contributions per limiting factor should
be calculated to see whether any products can be eliminated because
they perform worst (or best) in terms of contribution per limiting
factor for all of the limiting factors. Linear programming can then be
applied if this process of elimination results in only two products
remaining.
However, if more than two products remain for which
contribution per limiting factor does not suggest a production
preference, the second linear programming technique – the simplex
method – is required. This method is discussed in section of this
chapter.

11.6.2 Steps in the graphical method
A linear programming problem can be solved by applying the
following steps:
• De ne the variables. The variables are the two products or services
produced.
These two products are represented by the x-axis and the y-axis.
• Establish the objective function. The objective is to maximise the
total contribution of the two products or services. The objective
function is used in step 7 to identify the optimal mix between the
two products or services which will maximise contribution.
• Establish the limiting factors. All scarce resources should be tested
to see whether they are limiting factors.
• Determine and rank the contribution per limiting factor. This step is
done to establish whether there are con icting rankings between
the two products or services. If there is no con ict between
limitations identi ed, ‘CULF’ should be used to solve the
problem, as illustrated in example 11.5.
• Draw a graph of the constraints for which linear programming is
required. The limiting factors should be expressed as algebraic
equations and presented on a graph.
• Establish the feasible region. The feasible region can visually be
detected on the graph. The feasible region represents possible
production mixes given the constraints.
• Determine the optimal production mix. The gradient of the objective
function is used to identify the optimal point in the feasible
region (i.e. the point where contribution will be maximised).
Once the optimal point is identi ed, it is calculated by means of
simultaneous equations (i.e. solving the two equations
intersecting at the optimal point identi ed).

Example 11.8
Details of Vashumi’s two products are as follows:
Contribution per product has been determined as follows:
X Y
R R
Selling price 810 700
Raw materials (150) (250)
Labour (400) (200)
Processing time (80) (80)
Contribution 180 170
During the period under review, raw materials are limited to 18 000 kg, labour to
17 000 hours, and processing time to 16 000 hours. The demand for the period for
product X is 4 000 units and for product Y 3 000 units.
Required:
Determine the optimal number of units of product X and product Y respectively that
ought to be manufactured during the period under review.
The linear programming steps can be applied to the problem as

follows:
Step 1: Define the variables

Let x be the number of units of product X.
Let y be the number of units of product Y.

We do not at this stage know how many units of product X and
product Y should be manufactured, therefore both of these are
unknown variables.
Step 2: Establish the objective function

The objective is to maximise the combined contribution of product X
and product Y. Therefore:
Again, although we are uncertain how many units of each product

should be manufactured, the aim is to maximise the total
contribution. This equation is not a xed line on a graph, however
the gradient is of importance and can already be determined.
Step 3: Establish the limiting factors

Possible limiting factors can now be formulated and represented as
algebraic equations.

Raw materials and labour are the only limiting factors, because there
is a shortfall of both. Processing time is not a limiting factor as the
current capacity is adequate to satisfy the total demand for
Vashumi’s products.
Product X uses 3 kg of raw materials per unit, while product Y
uses 5 kg per unit. A maximum of 18 000 kg of raw materials is
available. The number of product X units manufactured multiplied
by the raw materials per unit, plus the number of product Y units
manufactured multiplied by the raw materials per unit, should
therefore not exceed 18 000. The equation for raw materials can be
formulated as:
Similarly, the equation for labour is:
The demand for product X is limited to 4 000 units, while it is limited

to 3 000 units for product Y. The limiting factors are therefore stated

as follows:
Demand x ≤ 4 000
y ≤ 3 000
It would be illogical to produce negative quantities of either of the

products. We can therefore add a ‘non-negativity’ limiting factor,
which speci es that the value of both x and y should be greater than
zero:
Non-negativity x, y ≥ 0
Step 4: Determine and rank the contribution per limiting

factor
Product X produces a higher contribution per kilogram of raw

materials, while product Y has a higher contribution per labour hour.
Ranking the contribution per limiting factor is an important step.
Linear programming is not required if a speci c product is more
pro table than another, taking into account its consumption of all of
the scarce resources. For example, if product Y had produced the
highest contribution per unit of raw materials and labour, we would
simply have given priority to the production of product Y.
Step 5: Draw a graph of the limiting factors for which

linear programming is required
The equations are as follows:

Raw materials 3x + 5y ≤ 18 000 (1)
Labour hours 4x + 2y ≤ 17 000 (2)
Processing time 2x + 2y ≤ 16 000 (3)
Demand x ≤ 4 000 (4)
y ≤ 3 000 (5)
Objective function 180x + 170y = M (max) (6)
Figure 11.1 Graph illustrating limiting factors in example 11.8
Step 6: Establish the feasible region

The feasible region includes all possible solutions to the linear
programming problem and is represented by the area ABCDE on the
graph; it is the area that falls within all of the constraints.
The optimum solution can now be found graphically by shifting
the objective function (the dotted line on the graph, determined in
step 2) away from the zero point, maintaining its gradient. The last
possible intersection that it moves through before leaving the
feasible region represents the optimum solution. This is point C.
Step 7: Determine the optimal production mix

The optimal production mix is at point C on the graph, which is
where
3x + 5y ≤ 18 000
and
4x + 2y ≤ 17 000
intercept.
These two equations should now be solved simultaneously:

The optimum product combination is therefore to manufacture 3 500
units of product X and 1 500 units of product Y. This product
combination will render a total contribution of R885 000 ((3 500 units
of X × R180) + (1 500 units of Y × R170)).
We can test the answer by also calculating the contribution at
points A, B, D and E. If they are all less than at point C (which they
are), we have chosen the correct intercept.
11.6.3 Slack
If a resource is scarce but not a limiting factor at the optimal solution,
there will be what is known as ‘slack’. This means that there will be
some units of that particular scarce resource left unutilised when the
optimal mix of products or services is produced. In the above
example, processing time is not a limiting factor. After producing
3 500 units of X and 1 500 units of Y, there will be 6 000 process hours
left unutilised [16 000 – ((3 500 × 2) + (1 500 × 2))].

Only constraints which intersect at the optimal solution will be
fully utilised at the optimal solution.
Shadow prices and linear

11.7
programming
Calculating the shadow price: adding

11.7.1
one unit to the available limited resource

As mentioned in section 11.5, the shadow price of a limiting factor is
the increase in contribution that would be created by having
available one additional unit of the limiting factor at its original cost.
For example, the shadow prices of raw materials or labour can be
calculated as follows: add 1 unit to the available kilograms of raw
materials (or the number of labour hours) and calculate the new
optimal mix. The difference between the new contribution (at the
new optimal mix) and the previous contribution gives the shadow
price of the resource in question.
This can be illustrated by following on from the previous
example:
Shadow price of raw materials:

3x + 5y ≤ 18 001
4x + 2y ≤ 17 000
Therefore (determined by following the linear programming steps):

x = 3 499,8571 units
y = 1 500,2857 units
New contribution: R885 022,86
Previous contribution: R885 000
Shadow price of raw materials: R22,86 per kg

Shadow price of labour:
3x + 5y ≤ 18 000
4x + 2y ≤ 17 001
Therefore (determined by following the linear programming steps):

x = 3 500,3571 units
y = 1 499,7857 units
New contribution: R885 027,86
Previous contribution: R885 000
Shadow price of labour: R27,86 per hour
Note that we should not use rounding when we calculate shadow

prices. The more decimals we include in the calculation, the more
accurate the shadow price that we calculate.
The original cost of raw materials was R50 per kg. The shadow
price of R22,86 means that the organisation can pay up to R72,86 per
kg for additional raw materials. Likewise, the maximum it can pay
for additional labour is R127,86 (R100 + R27,86) per hour.
Calculating the shadow price:

11.7.2
alternative method
There is an alternative method of determining the respective shadow
prices of raw materials and labour. This can be achieved by relating
the resources used for a particular product to the contribution
generated by those resources.
In the example above, each kilogram of raw materials and each
labour hour contribute to the total contribution of a product: 3 kg of
raw materials and 4 labour hours generate a contribution of R180 for
product X. Likewise, 5 kg of raw materials and 2 labour hours
generate a contribution of R170 for product Y. The question is now:
how much of the total contribution of a product is made up by each

kilogram of raw materials and by each labour hour respectively?
This contribution made by a single kilogram of raw materials or a
single labour hour is its shadow price and is an unknown variable
that can be determined.
Let the shadow price of raw materials and labour be R and L
respectively. Therefore, we can say:
In respect of product X: 3R + 4L = 180
In respect of product Y: 5R + 2L = 170
Solving the simultaneous equations:
R = R22,86
L = R27,86
Linear programming: the simplex

11.8
method
Some management accounting syllabi require students to know the
simplex method. Check your syllabus guidelines to see whether you
should study section 11.8.
11.8.1 Introduction
This section deals with the use of the simplex tableau to solve linear
programming problems. Simplex tableaux can be used to solve
linear programming problems where more than two products
and/or resources (decision variables) are involved. In this chapter,
the basic principles of the method are illustrated, with the emphasis
on the interpretation of the nal tableau.
11.8.2 The principles of the simplex method

The rst three steps of the simplex method are similar to the
graphical method. Continuing with example 11.8 above, Vashumi
(Pty) Ltd, we followed the following steps:
Step 1: Define the variables

Let x be the number of units of X that should be produced and sold.
Let y be the number of units of Y that should be produced and sold.
Step 2: Establish the objective function

Maximum contribution (M) = 180x + 170y, subject to the constraints
below.
Step 3: Establish the constraints

Raw materials 3x + 5y ≤ 18 000
Labour hours 4x + 2y ≤ 17 000
Processing time 2x + 2y ≤ 16 000
Step 4: Introduce slack variables

Key term: slack variable
In the simplex method, so-called ‘slack variables’ have to be

introduced in order to eliminate any possible inequalities. One slack
variable is used for each constraint.
Remember, a slack variable represents the amount of a scarce
resource that is left unused after the optimal production mix has
been achieved.
Let

a be the quantity of unused raw materials
b be the number of unused labour hours
c be the number of unused processing time
We can now express the original constraints as equations:
Raw materials 3x + 5y + a = 18 000
Labour hours 4x + 2y + b = 17 000
Processing time 2x + 2y + c = 16 000
The equation for raw materials above is derived as follows: 3 kg

multiplied by the number of units of product X produced, plus 5 kg
multiplied by the number of units of product Y produced, plus any
unused raw materials (denoted by ‘a’), equals 18 000 kg (the
maximum raw materials available).
The equations for labour hours and processing time are derived
in a similar manner.
Step 5: Express the objective function as an equation

With regard to the objective function, the convention is to express the
function in the same format as the constraints, that is, with the
unknown variables x and y on the left side of the equation. This
means that M = 180x + 170y is restated as:
M – 180x – 170y = 0
Step 6: Derive the final tableau

Once the above steps have been carried out, the actual calculation
involves deriving a series of simplex tableaux that eventually result
in the nal tableau. Because commercially available computer
spreadsheet packages are usually employed to perform the tedious
calculations involved, these steps are not explained here.

Step 7: Interpret the final tableau
When the objective function and the constraints for our Vashumi
example (example 11.8) are processed by a computer spreadsheet
package that performs the simplex method’s calculations, the
following nal tableau is produced by the software:
The nal tableau holds important management accounting

information and is interpreted as follows:
• The solution row at the bottom indicates the shadow price of
each of the limiting factors. The available processing time has not
all been used at the optimal production mix and therefore the
processing time column has a shadow price of zero in the
solution row. Raw materials and labour hours have been fully
utilised at the optimal production mix and their respective
shadow prices (that is, the amount by which the contribution of
R885 000 in the solution column would increase if one additional
unit of that resource became available) are shown in the solution
row. The shadow price of raw materials (denoted by a) is
R22,8571 per kg, so the contribution would increase by R22,8571
if one extra kg of raw materials could be made available at its
normal variable cost of R50 per kg. Similarly, the contribution
would increase by R27,8571 if one extra hour of labour time
could be made available at its normal cost of R100 per labour
hour.

The solution column on the right indicates that, at the optimal
• production mix, 3 500 units of product X and 1 500 units of
product Y are produced, resulting in a contribution of R885 000.
At this optimal production mix, 6 000 hours of processing time
remain unused (this also re-af rms that the shadow price for
processing time is zero, as shown in the solution row – there are
still 6 000 hours of unused processing time available when the
optimal product mix is produced).
11.8.3 Sensitivity analysis

The information in the raw materials and labour hours columns (the
columns for the two limiting factors) of the nal tableau facilitates an
analysis of the optimal production mix, and the effect of an increase
in any of the scarce resources. We can also use the information to
determine the maximum amount of a scarce resource to obtain
before we encounter the next constraint.
In the example above, the following would happen if we had one
additional kilogram of raw materials available (refer to the raw materials
column):
• The number of product X that should be produced to obtain the
optimal mix would decrease by 0,1429 units to 3 499,8571 units
(3 500 less 0,1429).
• The number of product Y that should be produced to obtain the
optimal mix, would increase by 0,2857 units to 1 500,2857 units
(1 500 plus 0,2857).
• An additional 0,2857 hours of processing time would be used up
and only 5 999,7143 hours of processing time would remain
(6 000 less 0,2857).
• As already discussed, contribution would increase by R22,8571
(the shadow price of raw materials, as seen in the solution row)

to R885 022,8571 (R885 000 plus R22,8571). Note that 0,2857
additional units of product Y increases contribution by 0,2857 ×
R170 = R48,5714. However, we would then also produce 0,1429
fewer units of product X, which would reduce total contribution
by 0,1429 × R180 = R25,7143. The net effect is an increase of
R22,8571, as shown in the tableau.
Since the demand for product Y is limited to 3 000 units, there is a

limit to the additional raw materials that Vashumi would be
interested in purchasing. This limit can be calculated as follows:
Units
Market demand for product Y 3 000
Current production of product Y (1 500)
Potential additional units of product Y 1 500
For every kilogram of raw materials purchased additionally, the

optimal number of units of product Y will increase by 0,2857 units.
The maximum additional amount of raw materials to be purchased
is therefore 1 500/0,2857 = 5 250,2625 kg.
Following the logic above, similar interpretations can be made
for the labour hours column.
Purchasing additional resources at a

11.8.4
premium above the normal cost

As already stated, each additional unit of a scarce resource that
becomes available increases contribution by the shadow price for
that resource. We can therefore add the shadow price to the original

cost of the scarce resource to determine the maximum amount that
can be paid for additional resources.
In the example above, the maximum price for raw materials
would be the original cost of R50 per kg plus the shadow price of
R22,8571, giving R72,8571. A similar calculation would apply for
labour cost.
Concluding on operational constraints

11.9
scenarios
Now that we have introduced various scenarios under operational
constraints and illustrated how these could be solved, let us
summarise:
• ‘CULF’ can deal with any number of products or services and
any number of limitations as long as there is no con ict in
ranking between limiting factors.
• Linear programming (graphical method) can deal with any
number of limitations and they can be ranked in any way (i.e.
con icting or not). Linear programming can however only deal
with two products or services.
• Linear programming (simplex method) can deal with any
number of products or services and any number of limitations,
irrespective of their ranking (i.e. con icting or not).
• When encountering an operational constraints problem over
the short term, the following steps should be taken to solve
the problem (especially relevant in an academic context):
• Identify the products or services.
• Calculate the contribution of each of the products or services
identi ed.

• Based on demand for the products or services, identify all
resources and determine if there are any limiting factors.
• Calculate the contribution per limiting factor for all limiting
factors identi ed.
• Based on the contribution per limiting factor, rank the
products or services in terms of every limiting factor.
• If there is no con ict in ranking between limiting factors,
manufacture the product ranked rst and only move to the
second ranked product if capacity exists after the demand of
the rst-ranked product was met. Continue with this process
until capacity is fully utilised.
• If there is con ict in ranking and two products or services are
present, use linear programming (graphical approach).
• If there is con ict in ranking and more than two products or
services exist, use linear programming (simplex method).
11.10.1 Introduction
Situations where organisations have only two products or services
affected by constraints may seem rather theoretical and not exactly
representative of real-life situations. However, computer programs
can deal with an unlimited number of products or services and any
number of con icting limitations. Let us explore some examples of
where linear programming is used in practice.
Practical application of linear

11.10.2
programming

Budgeting
Typical scarce resources in the South African business environment
include the following aspects:
• It may be dif cult to obtain nancing for capital equipment,
especially for start-up organisations. Fluctuating interest rates
increase the risk for organisations with excessive debt capital,
preventing these organisations from acquiring all the capital
equipment required for optimal production.
• High costs of importing raw materials and other manufacturing
resources into South Africa, and the volatility of the local
currency compared to the major currencies, have a signi cant
impact on the viability of local manufacturing. An organisation
relying on local (and sometimes scarce) resources usually bears
less risk than companies relying on imported resources.
• The shortage of skilled labour owing to the so-called ‘brain drain’
over the past decades has led to certain skills being in great
demand. Inevitably organisations operating in service-related
industries have to be selective in terms of the work they take on.
All of the above will have a signi cant impact on the budget-setting
process and may require the use of linear programming principles to
determine optimum product mixes.
Maximum payment for additional resources

The concept of shadow prices is an important indicator of the
maximum amount that should be paid to acquire additional
resources that are in short supply.
Capital investment appraisal

Where funds are limited and different projects compete, the concept
of linear programming can be used to determine capital investment
priorities over longer periods.
Computer packages
The fact that there are computer packages that are speci cally aimed
at solving linear programming problems is an indication that there is
practical use for this technique. An example of such a package is the
Microsoft Excel Solver Add-inÂ which provides Microsoft Excel
with this functionality.
11.10.3 Limitations of linear programming

Linear programming enables us to choose the most pro table mix of
products or services when faced with scarce resources. However, in
addition to short-term pro ts, qualitative factors should be
considered.
For example, it may sometimes be strategically important to offer
a product or service that is less pro table, because we suspect that it
may lead the customer eventually to purchase our more pro table
products or services. Similarly, we may wish to sell new, less
pro table ones because the new products ensure long-term survival
of the business. These are examples of valid qualitative arguments
that may override purely quantitative decisions.
The linear programming methodology may provide acceptable
answers for a given situation. This situation, for example the scarcity
of raw materials or labour, may, however, change overnight,
rendering the solution outdated. To be effective, linear programming
principles should be applied continuously, which may not be
practical.

It is not always possible to identify exactly which resources will
be in short supply, and to what extent. Figures such as market
demand for a certain product and the availability of production
resources are based on estimates and these estimates may prove to
be incorrect.
11.11 Summary
Chapter 10, Relevant costs for decision-making dealt with everyday
decisions faced by an organisation. This chapter addresses the
particular situation where decisions are taken under operational
constraints. From a purely nancial perspective, the optimal product
or service mix is the one that maximises contribution per limiting
factor. The same principle of maximising contribution per limiting
factor also applies in situations where special orders are considered.
Where there are multiple limiting factors but products or services
rank in the same order when the contribution per limiting factor is
calculated for each resource, linear programming can be avoided.
However, where ranking differs, linear programming is necessary.
Linear programming can be done using either the graphical or the
simplex method.
The shadow price of a scarce resource is the increase in
contribution created if one additional unit of the scarce resource
becomes available at the original cost.
Conclusion: Decision-making under

operational constraints and other topics in
this book

This chapter introduced the concept of contribution per limiting
factor and how to apply this principle to resolve maximisation
problems where there are two or more scarce resources. It relied
heavily on the principles studied in Chapter 10, Relevant costs for
decision-making.
In order to calculate the contribution derived from the sale of a
product, the concept of variable cost needs to be understood.
Variable costing is discussed in Chapter 5, Absorption versus variable
costing.
The necessity to determine optimal product mixes is an integral
part of budgeting. Budgeting is discussed in more detail in Chapter
12, Budgets, planning and control.
Tutorial case study: Zevenwacht estate
Zevenwacht estate on the Stellenbosch Wine Route has 200 hectares under
vineyards. The region is ideally situated for the growing of grapes. Zevenwacht’s
south- and south-west-facing vineyards are protected from the heat of summer
afternoons by the Bottelary Hills and cooled by the sea breezes blowing in from
nearby Table Bay and False Bay. The estate has varied soils, which have been
planted with both red and white grape varietals. The estate produces a wide variety
of red and white wines in its cellar.
SOURCE: ZEVENWACHT (2019)
1 Each time aged vineyards are removed and the soil is replanted, Zevenwacht has
to decide which variety of grape to plant and how many vines. Discuss the
limiting factors that may apply to Zevenwacht’s wine production.
2 If Zevenwacht had the opportunity to rent land from an adjacent farming
operation in order to plant more vineyards, discuss how it could calculate the
maximum price per hectare that it would be willing to pay for the land.
3 Assume that Zevenwacht wishes to produce only two wines (and therefore plants
only these two varietals): chenin blanc and sauvignon blanc. Outline and discuss
a seven-step method that could be employed to nd the optimal production mix.
4 Discuss how the limitations of linear programming might apply to Zevenwacht if
it used this method to determine its optimal production mix. Speci cally mention

qualitative factors that may cause Zevenwacht to take a different decision from
that suggested by linear programming.
Basic questions
BQ 1
An accounting organisation is currently assisting a large number of
clients with the completion of their tax returns. Which of the
following are probable factors limiting income?
a) Lack of computers
b) Lack of suitably quali ed accounting staff
c) Lack of secretaries assisting with administration
BQ 2
An organisation produces two components, G and H, in two
processes: process 1 has a maximum capacity of 4 000 hours per
week, while process 2 is limited to 10 000 hours. Component G
requires 6 minutes per unit in process 1 and 12 minutes per unit in
process 2. Component H requires 9 minutes in process 1 and 21
minutes in process 2. What are the equations pertaining to process 1
and process 2 for linear programming purposes?
BQ 3
A game farmer has to decide about the mix of antelope on his new
farm. The size of the farm is 1 200 hectares (ha). The farmer has only
R3 million available to invest in antelope and is considering a mix of
impala and sable. Sables cost R75 000 each and require 12 ha per
animal. Impala cost R1 200 each and require 4 ha per animal. What
are the equations pertaining to possible limiting factors for linear
programming purposes?

BQ 4
An organisation has determined that its limiting factors are as
follows:
Raw materials 14A + 8B ≤ 308 000
Labour 0,3A + 0,7B ≤ 15 850
It has also determined that the optimal product mix can be found at
the intersection of these limiting factors. What is the organisation’s
optimum product combination of product A and product B?
BQ 5
The following details relate to ready-made meals prepared by a food
processing company:
* The xed conversion costs are general xed costs that are not speci c to any type of meal.
Each of the meals is prepared using a series of processes, one of

which involves cooking the ingredients in a large oven. The
availability of cooking time in the oven is limited, and because each
of the meals requires cooking at a different oven tem-perature, it is
not possible to cook more than one of the meals in the oven at the

same time. What is the most pro table and the least pro table use of
the oven?
Most pro table Least pro table
a) Meal K Meal L
b) Meal L Meal M
c) Meal L Meal K
d) Meal M Meal L
BQ 6
AB Pharmaceutical Ltd manufactures sleeping pills that require 0,2
grams of a scarce ingredient, ZZ, per dose. The contribution per dose
is R6. The cost of ZZ is currently R80 per gram. What is the shadow
price per gram of ZZ?
a) R6
b) R30
c) R80
d) R110
BQ 7
A tax consultancy rm employs a foreign tax specialist at a monthly
salary of R60 000. On average, the specialist is able to book 120 hours
per month to clients. The specialist’s charge-out rate to clients is
R1 800 per hour. The specialist does not have the capacity to handle
the total workload and the rm is considering contract-ing in the
services of another specialist on an hourly basis. What is the shadow
price of tax consulting hours?
BQ 8

Match the following concepts with their de nitions. Write the
concept next to the letter which matches its de nition.
Concepts: Slack, limiting factor, non-negativity, shadow price
a) A scarce resource of which there is a limited supply that affects
the pro tability of the organisation
b) The increase in value which would be created by having
available one additional unit of a limiting resource at its original
cost
c) Units of a resource that are unutilised once the optimal product
combination has been determined
d) A constraint that should be included when formulating linear
programming solutions to ensure that the answer makes sense in
operational terms and that we do not end up with negative
production quantities
BQ 9
The following information pertains to products K and L:
K L
Contribution per unit R10 R12
Raw material Z per unit 2 kg 3 kg
Monthly demand 2 000 units 3 000 units
The availability of raw material Z is limited to 7 000 kg per month.

What is the product combination that will optimise the total monthly
contribution?
BQ 10
SOURCE: ADAPTED FROM CIMA MA DECISION-MAKING EXAM

An organisation produces two products, product X and product Y.
The standard variable costs per unit of the products are as follows:
X Y
R R
Materials (R3 per kg) 15 12
Other variable costs 45 50
Total variable costs 60 62
The management accountant determined the optimal production

plan by using graphical linear programming. He noticed that the
optimal plan was given at ANY point on the line indicating the
limiting factor for materials. If the selling price of product X is R100,
what is the selling price of product Y?
Long questions

A bakery produces three different-sized fruit pies for sale in its
shops. The pies all use the same basic ingredients. Details of the
selling prices and unit costs of each pie are as follows:

The fruit used in making the pies is imported and the bakery has
been told that the amount of fruit that they will be able to buy for
next week is limited to 300 kg.
The bakery has established its good name by baking its pies daily
using fresh fruit, so it is not possible to buy the fruit in advance.
REQUIRED Marks
Determine the mix of pies to be made and sold in order to maximise the bakery’s contribution for
10
next week.
TOTAL MARKS 10

AB Organix (Pty) Ltd manufactures, among its many organic health
products, two basic suntan cream products. The cream consists of
two ingredients, cream A and cream B, both imported from Italy,
which are manually mixed and sold as an environmentally friendly
alternative to the many suntan lotions available in the market.
Details pertaining to cream UV-20 and cream UV-40 are as follows:

Market demand for UV-20 is estimated at 30 000 litres a year, and for
UV-40 at 20 000 litres. The availability of cream A is limited to 3 000
litres a year, and cream B to 8 000 litres a year. There are two
labourers and they can effectively work 1 200 hours a year each.
REQUIRED Marks
(a) Determine the product mix that will optimise AB Organix’s contribution. 22
(b) Determine the shadow prices of cream A, cream B and labour. 3
TOTAL MARKS 25

SOURCE: ADAPTED FROM CIMA MA DECISION MAKING EXAM
PQ Ltd produces three products, A, B and C, from two processes.
The slack variables for process 1 hours, process 2 hours and the
maximum demand for product A are s4, s5 and s6 respectively. The
contribution per unit for each of the products is as follows:
Product A R400
Product B R200
Product C R100
The following linear programming solution has been determined in

order to maximise contribution for the forthcoming period.

*This box has deliberately been left blank.
REQUIRED Marks
(a) If the organisation could increase production time in process 1 by 10 hours, determine what
4
the increase in total contribution would be.
(b) If eight additional units of product C were produced, determine what the change in total
3
contribution would be.
TOTAL MARKS 7

David Masikela produces two different types of wooden decorative
toys in his factory, namely toy cars and toy soldiers. The production
process consists of sawing, assembling and nishing.
David buys his wood at R100 per m3. There is an unlimited
supply of wood. The weekly capacity of the sawing department
is 600 labour hours, while the assembling and nishing departments
are limited to 1 200 labour hours each.
David has a market for 300 toy cars and 375 toy soldiers per
week. The pro t per toy is as follows:

The cost of labour per department is as follows:
R/hour
Sawing department 10
Assembling department 12
Finishing department 13
REQUIRED Marks
Determine the combination of cars and soldiers that will optimise total contribution, taking into
(a) 20
account the limiting factors.
Calculate how much David should be prepared to pay per hour if additional labour can be
(b) 5
obtained for the sawing department. Also state the shadow prices of all types of labour.
TOTAL MARKS 25

A university accounting lecturer recently signed an agreement with
the nance department of one of the provincial governments to

provide additional lectures to their CTA students, all of whom are
correspondence students studying through Unisa. The agreement
stipulates that a total of 20 three-hour lectures ( ve lectures per
subject) should be presented for the next year on Saturday mornings
for a total amount of R51 000.
The lecturer has prepared his quotation as follows:
The agreement stipulates that the lecturer is allowed to involve his

colleagues, provided that he ensures that a proper standard of
lecturing is maintained.
The lecturer has wide experience lecturing in management
accounting, but will have to do considerable preparation for the
other three subjects. He estimates the preparation time required as
follows:
Management accounting: 1 hour preparation per lecturing hour
Taxation: 4 hours’ preparation per lecturing hour
Auditing: 3 hours’ preparation per lecturing hour
Financial accounting: 5 hours’ preparation per lecturing hour
Owing to work commitments, the lecturer has only 180 hours

available for both lecturing and preparation for the year and

therefore decides to involve some of his colleagues to assist him.
They are prepared to lecture at the following rates:
Management accounting, taxation and auditing: R500 per lecture
hour Financial accounting: R800 per lecture hour
It would not pose any problems should the lecturer decide to

outsource only a portion of a speci c subject.
REQUIRED Marks
Advise the lecturer with regard to a plan that will optimise his income from lecturing. 10
TOTAL MARKS 10
References
Upchurch, A. 1998. Management accounting principles and practices. Financial Times.
London: Pitman.
Zevenwacht. 2019. Zevenwacht Estate: cellars & vineyards. [Online]. Available:
http://www.zevenwacht.co.za/Page.aspx?
PAGEID=2162&Type=About&CLIENTID=3211&MENU=&Title=About%20Us [16
November 2019].

LEARNING OBJECTIVES
• explain the objectives of budgeting
• explain the concept of a principal budgeting factor
• discuss the steps in the budgeting process
• prepare a production budget
• prepare a cash budget
• explain alternative approaches to budgeting, including
incremental budgeting, zero-base budgeting and rolling budgets
• apply projection techniques such as the high-low method and
regression analysis in preparing a budget
• discuss the concepts of xed and exed budgets
• discuss the difference between imposed, participative and
negotiated budgets
• discuss the motivational impact of budgets
• explain the rationale behind the concept of Beyond Budgeting®.
Parenthood, education and budgeting
Becoming a parent is truly a life-changing experiencing (in every sense of the word).
Parents always want to give their children the best, especially when it comes to
education. Surveys have shown than in 2019 terms, a good quality school or tertiary
education will cost parents around R90 000 per year per child for tuition only. For

many households in South Africa that is a staggering amount, and this amount of
course increases every year as well as compounding as each child reaches school-
going age and then moves on to tertiary education. So it is advisable for young
couples to decide from the get-go how many children they would like to have;
project the cost of pre-school, primary school, high-school and tertiary education;
and then start to save and invest accordingly.
SOURCE: AUTHOR
Estimating the cost of education, and navigating how that education

will be funded, are only two of many nancial challenges parents
face in raising children. Within an enterprise, estimating sales and
production volumes, as well as future sales prices, becomes an
equally if not more complex challenge, especially in South Africa’s
uncertain and tough economic environment. However, whether
company or individual, it is important to plan your nancial future.
12.1 Introduction
Budgets are used in nancial planning and are drawn up by a
diverse range of individuals and organisations, all of whom feel the
need to plan ahead. A budget has the following characteristics:
• It is future-orientated.
• It aims to achieve a predetermined goal or objective.
• It is expressed in quanti able terms.
This chapter deals with various issues pertaining to budgeting,

nancial planning and forecasting.
Key terms: sales budget

The characteristics of budgets mentioned above provide an
indication of the main objectives of budgeting, which are as follows:
• Budgets facilitate the achievement of an organisation’s strategic and
tactical objectives. Divisional budgets should be prepared in such a
manner that they contribute towards the achievement of the
vision of the organisation as a whole.
• Budgets compel planning. The preparation of a budget forces a
manager to sit down and think ahead, not just about the next day
or the next week, but the next year or even longer. Without this
process, managers may become too focused on the short term,
neglecting important long-term and medium-term planning.
• Budgets promote the co-ordination of activities. The purchasing
department, for example, cannot plan future purchases of raw
materials without knowing the production department’s
requirements. The production department will not know how
many units to produce unless they receive a sales budget from
the marketing or sales department. Budgets such as the capital
expenditure budget and the human resources budget will, in
turn, be in uenced by the requirements of the production
department.
• Budgets promote communication in the organisation. Staff and
management working in different business units are brought into
contact with each other because of the budgeting process,
improving communication. Budget guidelines are also used by
senior management to communicate their vision and plans for
the organisation to the rest of the staff.
• Budgets provide a framework for control and responsibility accounting.
A typical budget system will require the organisation to be
divided into responsibility centres, with departmental managers
assuming responsibility for income and expenses in their

departments. Performance evaluation is based on a comparison
of pre-determined budgets to actual performance. Investigating
variances between actual results and budgeted results is an
important means of control in an organisation.
• Budgets serve as a framework for authorisation of decisions within the
organisation. Signi cant expenditure is often not authorised
unless it has been properly motivated and budgeted for. Budgets
prevent unplanned, spur-of-the-moment decisions about
expenditure which could later impact on pro tability.
• Budgets provide a basis for performance evaluation. Many
organisations base their performance reward system on the
achievement of budgeted results. Failure to meet budgeted
targets could also be the cause for action against an employee.
• Budgets provide motivation for employees to improve their performance.
Working towards a common goal may be bene cial to team spirit
and meeting this goal provides a sense of personal achievement.
It is important for budgets to be set at the appropriate level to
achieve the desired motivational effect. Budgets set too leniently
or too stringently may have an adverse effect on employees.
Strategic, tactical and operational

12.3
budgets
Key terms: operational budgets, strategic budgets, tactical

budgets
In the context of general business control, we distinguish between

the strategic, tactical and operational levels of planning, control and
decision-making. When preparing a budget, we need to ensure that
the budget period (the length of time to which the budget relates)

agrees with the speci c business requirements for which the budget
will be used.
Strategic budgets will usually be for a long period, perhaps
between three years and 15 years. The scope will also be much less
detailed than in the case of operational budgets. In some industries
in today’s fast-paced business world, budgets that cover too long of
a planning horizon may be of little use – if such budgets are set (for
example, to seek long-term funding), they may contain low levels of
detail and revisions will be inevitable. Tactical budgets are usually
prepared for periods of between one and three years, or even as
many as ve, while operational budgets are prepared for a single
nancial period, usually a year or less. Quarterly, monthly and daily
budgets are also examples of operational budgets. These budgets are
more detailed in terms of numbers and deadlines, and because the
planning horizon is shorter it is easier to budget accurately.
12.4.1 The budget committee

A large organisation preparing a budget will usually have a budget
committee which assumes overall responsibility for the co-
ordination and administration of the whole budget process. The
budget committee issues the budget manual or guidelines. The
budget manual is a collection of instructions setting out general
guidelines, procedures to be followed, deadlines and responsibilities.
12.4.2 Responsibility for preparing budgets

In most organisations, functional managers assume responsibility for
the budgets in their functional departments. Examples of these are
the following:
Functional manager Area of responsibility

Sales manager Sales budget
Production manager Production budget
Purchasing manager Materials purchases budget
Human resources manager Human resources budget
Cost centre managers Respective cost centre budgets (for example, IT, accounting, administration)
12.5Determining the principal budgeting

factor
Key terms: principal budgeting factor
Before starting with the preparation of the budget, it is important to

identify the principal budgeting factor: the factor that restricts
output. There is little use, for example, in preparing very favourable
sales forecasts when the organisation has limited production
capacity and a lack of funds to expand the production capacity. The
most likely principal budgeting factors are the following:
• Sales demand. In most organisations, sales demand will be the
principal budgeting factor, setting the level of production,
purchases and other supporting activities. In most cases, it will
be possible to overcome other obstacles preventing growth, as
long as the market for the organisation’s products exists.
• Availability of raw materials. Certain industries depend on the
availability of scarce raw materials. All products may be sold in
the market (at reasonable prices), but growth is hampered by the

availability of raw materials. In this case, the budget will
primarily be guided by the amount of raw materials that can be
acquired during the budget period.
• Machine capacity. In some organisations a lack of machine
capacity and the inability to expand machine capacity may be
limiting factors preventing growth in the short term. Machine
capacity is then the principal budgeting factor that in uences
how other factors will be budgeted for.
• Availability of cash and sources of funding. Organisations that lack
ready access to cash resources such as owners’ capital or bank
debt will be limited because they cannot build up adequate
inventory levels, provide suf cient credit facilities to customers
or invest in additional equipment. In such a situation, the
limitations on cash and funding are the principal budgeting
factors.

In a normal manufacturing concern, the following budgeting steps
would apply:
• Identify the principal budgeting factor. In most organisations, as
discussed above, the principal budgeting factor will be the sales
demand for the organisation’s products. Should this be the case,
the next logical step is to prepare the sales budget.
• Prepare the sales budget. Information regarding potential sales for
the budget period is sourced from the marketing department,
while the history of the organisation’s past sales provides good
indicators of what could be expected for the future.
• Prepare the production budget. The number of units to be produced
is budgeted, taking into account the desired sales budget and

closing inventory levels as well as the level of opening inventory.
Example 12.1
A furniture company selling of ce chairs wishes to maintain an inventory level of 100
chairs as buffer inventory. At the end of the previous period, they maintained a level of
80 chairs. Expected sales for the next year amount to 850 chairs. They lose an
average of 5 chairs a year as a result of theft.
Required:
Prepare the company’s production budget for the current period.
The production budget is determined as follows:
Units
Expected sales 850
Add: Units lost due to theft 5
Add: Desired closing inventory 100
Less: Opening inventory (80)
Production required 875
Once the production budget has been set, the next step is to budget
for production resources:
• Budget for production resources. Production resources include raw
materials, process time (machines and equipment) and labour.
• Raw materials purchases budget. Purchases of raw materials are
budgeted after considering the expected production
requirements, the desired raw materials closing inventory level,
the level of opening inventory, and expected scrap or wastage.
• General overhead costs budget. General overheads include aspects
such as factory rental, salaries of supervisors, electricity,

depreciation and cleaning.
• Overhead absorption rates. The cost accountant can now calculate
overhead absorption rates based on the overhead costs budgeted
and the appropriate cost drivers. These may involve traditional
cost drivers such as budgeted machine hours or labour hours, or
an activity-based approach may be followed.
• Administrative expenditure budget. This budget will include all
supporting activities such as IT-related expenditure and the
accounting function.
• Cash budget. The cash budget is an important part of the process,
as it will ensure that the organisation avoids situations where it
has insuf cient cash. Having excess cash on hand is also
detrimental to pro tability, as the returns on cash balances are
usually considerably lower than on other investments.
• Capital expenditure budget. Taking into account future production
requirements, the organisation has to decide about investment in
long-term capital assets such as equipment. These decisions are
in uenced by the production capacity required, the cash outlay
of new equipment and the required rate of return on assets.
• Master budget. The master budget is a summary of all of the
individual functional budgets discussed above, and culminates in
budgeted nancial statements, which include a statement of
nancial position, a statement of comprehensive income and a
statement of cash ows.
Note that, should the principal budgeting factor be identi ed in step

1 as something other than sales, the second step will not be to
prepare the sales budget. Instead, the budget in which the principal
budgeting factor is addressed will be prepared in step 2, followed by
the rest of the budgeting steps.

Key terms: production budget, raw materials purchases budget
The interaction between the sales budget, the production budget

and the raw materials purchases budget can be illustrated through
the following example.
Example 12.2
Tshwane Curios CC purchases unprocessed wood and then reworks it into ornaments
for resale to tourists at popular tourist destinations such as Table Mountain and the
Kruger National Park. Selling prices are directly related to the physical size of the
ornaments and are expressed in terms of kilograms sold.
The sales budget for the period September to November is as follows:
• The basic raw materials cost R200/kg of wood.

• Raw materials scrap is 20% of raw materials input.
• The target month-end raw materials inventory level is 600 kg plus 20% of the raw
materials required for next month’s budgeted production.
• The target month-end inventory level for nished goods is 800 kg plus 20% of the
next month’s budgeted sales.
Required:
Calculate the budgeted raw materials purchases for September.
To budget for September’s raw materials purchases, the calculation

is as follows:

* 2 080 kg/80% and 2 420 kg/80%
The budgeted raw materials purchases cost for September is 2 685 kg

× R200/kg = R537 000. Note that the raw materials purchases are
in uenced by the production requirements as well as the required
opening and closing inventory of raw materials. Production, in turn,
is in uenced by expected sales as well as the required opening and
closing nished goods inventory levels.
12.8 Cash budgets
Key term: cash budget

12.8.1 Drawing up a cash budget
When a cash budget is drawn up, two aspects in particular have to
be kept in mind:
• Only cash ow items are re ected in a cash budget. Non-cash
items such as depreciation or provisions do not affect the cash
budget.
• The period in which the cash ow is recorded is the period in
which the cash ow takes place. We ignore the period in which
the transaction is to be recorded for accounting purposes.
Example 12.3
Levubu Farmers’ Co-op has prepared the following budget for the period September
to December:
Notes:
• 60% of sales are for cash. 40% of sales are to debtors who pay a month later.
• Closing inventory should be 30% of the next month’s sales demand. This policy
has been in place for the whole of the period under review.
• Trade creditors are paid in the month after the purchase has been made. No other
inventoriable costs are incurred. The same applies to creditors for expenses other
than purchases. All other expenses are on credit.
• Included in expenses is an amount of R1 500 for depreciation on of ce equipment.
• Salaries are paid in the month to which they relate.
• Labour is paid in full by the end of the relevant month. Labour costs and expenses
are treated as period costs in the pro t-and-loss account.

• The organisation will sell a second-hand bakkie for R25 000, and will make an
accounting pro t of R3 500 on the sale of the vehicle. This has not been included in
the budget above. Although the sale agreement was signed in October, the buyer
has arranged to settle the amount in November.
• The organisation declared dividends of R10 000 in October, payable on 12
November. The opening cash balance for October was R5 000.
Required:
Prepare a cash budget for October and November.
The following is the cash budget for October and November. The
workings indicated next to amounts are explained in more detail
below.
Workings:

W1: Receipts from customers in October are calculated as 60% of
October sales plus 40% of September sales:
(60% × R80 000) + (40% × R70 000) = R76 000
W2: Receipts from customers in November are calculated as 60% of

November sales plus 40% of October sales
(60% × R100 000) + (40% × R80 000) = R92 000
W3: The accounting pro t on the sale of an asset does not represent a
cash ow. The only cash ow related to this transaction is the cash
received for the vehicle.
W4: The amounts provided in the budged do not represent actual

purchases in a particular month, but the cost of sales in that month.
Purchases in a particular month will depend on the opening

inventory for the month, units sold and the required closing
inventory:
Purchases in September, payable in October, can be calculated as

follows:
R
September cost of sales 38 500
Less: Opening inventory in September (30% of September cost of sales) (11 550)
Add: Closing inventory (30% of October cost of sales) 13 200
40 150

Likewise, purchases in October, payable in November, can be
R
October cost of sales 44 000
Less: Opening inventory in October (30% of October cost of sales) (13 200)
Add: Closing inventory (30% of November cost of sales) 16 500
47 300
W5: Expenses in September, October and November are paid a

month later. The cash amount payable excludes depreciation as this
is not a cash item.
Management action based on cash

12.8.2
budgets
A cash budget is one of the most important planning tools used by
an organisation. It shows the cash effect of all plans made within the
budgetary process. After a cash budget has been drawn up, the net
position could point to an anticipated short-term cash surplus, a
long-term cash surplus, a short-term cash de cit or a long-term cash
de cit. Both insuf cient and excessive cash balances are undesirable
– the goal is to have just the desired amount of cash on hand.
Insuf cient cash can threaten the survival of the business, while
excess cash can usually be employed in a more pro table manner.
Table 12.1 lists the management action that could be taken based on
the budget in each scenario in order to avoid the anticipated
insuf cient or excess balances.
Table 12.1 Management action based on various scenarios in the cash budget

Cash position Appropriate management action Additional benefit gained
predicted by cash through action taken in case of
budget surplus
Short-term de cit Obtain cash by doing one or more of the
following:
Arrange with suppliers to pay them later
Encourage debtors to pay sooner by offering
early settlement discounts Arrange a bank
overdraft
Postpone capital expenditure Postpone dividend
payments (if not yet declared)
Reduce inventory levels
Long-term de cit Obtain cash by doing one or more of the

following:
Raise long-term nance (for example, bank
loan)
Sell unused assets (for example, land)
Issue equity
Short-term surplus Eliminate surplus by doing one or more of the

following: Receive early settlement discount
Pay creditors early Increase sales
Grant credit to customers Receive interest income
Invest in interest-bearing short-term securities
Long-term surplus Eliminate surplus by doing one or more of the

Increase production capacity
following:
Increase earning potential
Invest in capital equipment
Increase earning potential,
Expand business operations
decrease risk
Diversify into other business areas
Key terms: master budget

When all the functional budgets and the cash budget have been
prepared, they are summarised and a budgeted statement of
nancial position, a statement of comprehensive income and a
statement of cash ows are prepared. This master budget provides
the overall picture of the planned performance for the budget
period.
Example 12.4
You have been presented with the following information for Zerox, a company that
manufactures and sells two types of paper, namely the Mondi and the Rotatrim, to
retailers. The paper is sold in boxes of 5 reams of paper, with each ream consisting
of 500 pages.
Sales budget
1st half of the year: Sell 3 000 boxes of Mondi and 6 000 boxes of Rotatrim
2nd half of the year: Sell 4 500 boxes of Mondi and 3 600 boxes of Rotatrim
1st half of the following year: Sell 3 600 boxes of Mondi and 7 500 boxes of Rotatrim
Selling price is R360 per box of Mondi and R450 per box of Rotratrim.
Production requirements
The company has a policy of holding suf cient opening inventory to meet 50% of the
sales for the following six months.
Direct materials
The company has a policy of holding suf cient opening inventory of material A and
material B to meet 50% of the material required for the production of both Mondi and
the Rotatrim in the following six months. You are to assume that the production in the
1st half of the following year is 4 500 units of Mondi and 6 000 units of Rotatrim.

Required:
Prepare the following budgets for each half of the current year as well as for the whole
year:
• Sales budget
• Finished goods budget
• Production budget
• Raw materials inventory budget
• Raw materials purchases budget
• Labour budget
• Budgeted income statement
Sales budget
Finished goods budget
Policy – to keep suf cient inventory on hand to meet 50% of sales in

next six-month period
Opening inventory at beginning of year

Opening inventory at beginning of second half of year
Inventory at end of year
Cost per unit of Mondi
Material A: 20 kg × R6/kg R120
Labour: 2 hours × R60/hour R120
R240
Cost per unit of Rotatrim
Material B: 10 kg × R15/kg R150
Labour: 2,5 hours × R60/hour R150
R300

Production budget
Note: The above gures have been calculated on the basis of 50% of
the sales for the next six months, for example the opening inventory
for Mondi for the 1st half of the year is 3 000 × 50% = 1 500.
Raw materials inventory budget

Policy – to keep suf cient inventory of material A and B on hand to
meet 50% of production in the next six-month period
Opening inventory at beginning of year
Opening inventory at beginning of second half of year

Inventory at end of year
Raw material purchases budget

Labour budget

Budgeted income statement – 1st half of year
Budgeted income statement – 2nd half of year

Budgeted income statement for the year
The role of ratio analysis and key

12.10
performance indicators in the budgeting
process

Key terms: key performance indicator
A key performance indicator (KPI) is a metric used to quantify the

performance an organisation aims to achieve. This could relate to
actual nancial results, budgeted nancial results or other
quantitative data.
Typical nancial key performance indicators relate to areas such
as the following:
• Pro tability (return on capital employed (ROCE), gross pro t
margin, growth in turnover)
• Management effectiveness (asset turnover, debtors’ collection
period, inventory turnover, creditors’ payment period)
• Liquidity (current ratio, quick ratio)
• Solvency (gearing ratio, debt ratio)
• Investor ratios for listed organisations (EPS, dividend cover)
An organisation that has, for example, set out in its objectives that it
wants to achieve an ROCE of 20% or a quick ratio of 1:1 should now
apply these ratios to the budgeted nancial statements to determine
whether its nancial planning supports these key performance
indicators.
12.11.1 Incremental budgeting

Key terms: incremental budgeting

Incremental budgeting is the term used for the traditional approach
to budgeting where the previous period’s results are used as a basis
for the budget. These gures are then adjusted for in ationary
increases as well as increases and decreases in budgeted volumes to
determine expected income and expenditure.
Example 12.5
KL Division produces a single product. Information for the current year (given on the
last day of the year) is as follows:
• Number of units produced: 3 400 units
• Total production cost: R425 000
• 60% of production costs are estimated to be xed, and the balance is variable
according to the number of units produced.
• The in ation rate is 8% per annum.
Required:
Determine the budgeted cost of KL Division if it expects to increase production to
4 100 units in the next nancial year.
In the current year, 3 400 units were produced. The total production
costs of R425 000 consist of R170 000 in variable costs (R425 000 ×
40%) and R255 000 in xed costs (R425 000 × 60%). Variable
production costs are therefore R50 per unit (R170 000/3 400).
In the next nancial period, 4 100 units will be produced. The
variable production costs are budgeted to increase to R54 per unit
(R50 + 8% in ation). Total variable production costs are therefore
budgeted to be R221 400 (R54 × 4 100 units), while xed costs are
budgeted at R275 400 (R255 000 + 8% in ation). The total production
cost in the budget is R496 800 (R221 400 variable + R275 400 xed).
12.11.2 Zero-base budgeting

Key terms: decision package, zero-base budgeting
Zero-base budgeting (ZBB) is an approach to budgeting which

rejects the principle of incremental budgeting. Instead, it advocates
that a budget should be prepared from ‘scratch’, or zero. Every item
in a budget has to be speci cally justi ed in order to be included.
Typical questions that should be asked when a zero-base
approach is followed are the following:
• Should this expense and the activity to which it relates be
performed at all?
• How much should the activity cost?
• What is the level of activity required?
Zero-base budgeting involves the following three stages:

1 Each discrete, stand-alone organisational activity is called a
decision package. The organisation’s decision packages should
be identi ed and described. To identify whether an activity is
independent enough to qualify as a decision package, ask
whether the activity can be outsourced or abandoned without
materially affecting another activity.
2 Decision packages are then evaluated and ranked in order of
importance.
3 Resources are allocated accordingly.
Relative advantages of zero-base

12.11.3
budgeting over incremental budgeting

• Zero-base budgeting challenges the current way of doing things.
Incremental budgeting simply preserves the status quo by

adding an in ation factor to current expenditure and adjusting
for volume changes.
• Zero-base budgeting facilitates the identi cation and removal of
unnecessary activities and expenditure. Incremental budgeting
does not question whether the activities undertaken are
necessary and is therefore unlikely to lead to such changes.
• Where activities undertaken are deemed to be necessary, zero-
base budgeting compels employees to question wasteful
expenditure. Incremental budgeting may lead to an in ation-
based increase in the budget for such expenditure.
• Zero-base budgeting leads to greater staff involvement, which
may lead to greater job satisfaction and more motivated staff.
• The identi cation of decision packages provides in-depth insight
into the organisation’s operations, while incremental budgeting
can be undertaken with a very super cial knowledge of the
organisation.
• Starting from a zero base forces staff to stay up to date with the
latest develop-ments in the organisation’s environment. For
example, management has to be informed regarding best
industry practices in order to know whether some activities are
necessary. Incremental budgeting is less likely to force managers
to study the organisation’s environment.
• Zero-base budgeting can be very advantageous to service
departments where output is sometimes dif cult to identify or
quantify. Examples of service departments are nance,
information technology and human resources. Incremental
budgeting to a large extent depends on output, as seen in
example 12.4.

Disadvantages of zero-base
12.11.4
budgeting compared with incremental

budgeting
• Incremental budgeting is less likely than zero-base budgeting to
result in radical changes to operations, which makes for a more
stable organisational environment.
• Zero-base budgeting can be very time-consuming, while
incremental budgeting is a simpler process that requires less
effort.
• Zero-base budgeting is more complicated than incremental
budgeting and could require management skills which the
organisation may not possess. The identi cation and ranking of
decision packages, for example, can be dif cult and may even
result in arbitrary allocations.
• Information systems may be inadequate to provide the
information required to identify decision packages and to rank
them for purposes of zero-base budgeting, making incremental
budgeting a more viable option in the short term.
12.11.5 Rolling budgets

Key terms: continuous budget, rolling budget
A rolling budget is also known as a continuous budget. A rolling

budget is prepared on a regular basis for the next year or other short-
term period. The organisation therefore continuously updates the
existing budget. Cash budgets are usually prepared on a rolling
basis.

Example 12.6
A not-for-pro t organisation draws up quarterly budgets for one year in advance on a
rolling basis. It is now nearly the end of quarter 1 of the 2XX8 calendar year, and it is
time to update the rolling budget.
Required:
Explain for which period the organisation should now be budgeting.
The organisation prepares its quarterly budgets one year in advance.

This means that at the beginning of quarter 1 of 2XX8, the
organisation had four quarters’ worth of budgets prepared: January
to March 2XX8, April to June 2XX8, July to September 2XX8 and
October to December 2XX8.
Now that the quarter January to March 2XX8 is nearing its end,
the organisation has to add on another quarter’s budget in order to
keep the budget rolling for the one-year planning period. To ensure
that a year’s worth of budgets is available, it now needs to prepare
the budget for January to March 2XX9 (quarter 1 of the 2XX9
calendar year). It will also revise the budgets for the three remaining
quarters of 2XX8.
The main advantage is that rolling budgets ensure that planning
is done on a continuous basis and not only once a year. Variances
between actual and budgeted gures are also more meaningful as
budgets are constantly reviewed and updated.
The major disadvantage of rolling budgets is probably the time
required to prepare them properly.
Key terms: probability theory

The concept of expected values may be used where there is a great
degree of uncertainty about future events. This is referred to as the
probability theory.
Example 12.7
Assume that an ice-cream vendor’s sales depend on the weather at the Durban
beachfront. If the weather is ne, sales in the budget period are expected to be an
average of about 300 ice creams per day. If there is rainy weather, sales are expected
to drop to only 60 ice creams per day. A long-term statistical analysis of the weather
has indicated that the chance of rain for any given day is on average 20%.
Average daily sales for the budget period can be forecast as follows:
Units Probability
Fine weather 300 80%
Rainy weather 60 20%
100%
Required:
Calculate the vendor’s expected daily sales for the budget period.
Note that, when expressed as percentages, the probabilities assigned

to mutually exclusive events must add up to 100%. In this case, the
80% average chance of sunny weather and the 20% average chance
of rain add up to 100%. To determine the expected daily sales, the
probabilities are multiplied by the expected outcomes and the results
are added together.
The expected daily sales are therefore (300 ice creams × 80%) +
(60 ice creams × 20%) = 252 ice creams per day. This can now be used
in the budget, taking all other relevant information into account as
well.

Preparing projections using historical
12.13
data
Key terms: projections
Projections are an important aspect of the budgeting process. The

Chartered Institute of Management Accountants de nes projection
as ‘an expected future trend pattern obtained by extrapolation’,
which is based on the notion that past events can serve as an
indication of what will happen in the future.
Note that some of the projection techniques in this section require
a basic knowledge of statistics. Although this chapter discusses the
techniques in the context of their usefulness for budgeting, students
who require further explanation are advised to consult statistics
textbooks and resources for a comprehensive explanation.
In this section, we brie y revisit some of the techniques learnt in
Chapter 3, Cost estimation.
12.13.1 Projections using the high-low method

Key terms: high-low method
One technique frequently used in projections is the so-called high-

low method, which was discussed in Chapter 3, Cost estimation. The
method is best illustrated by use of an example.
Example 12.8
The manager of a factory is trying to budget maintenance costs for July. The results
for the past six months to be used as a basis are as follows:

Machine hours Cost R
January 18 300 48 300
February 17 900 47 100
March 21 200 53 900
April 14 800 41 100
May 16 200 43 800
June 18 500 48 700
The factory manager expects that, based on the required production for July, the
number of machine hours for July will be 17 500 hours.
Required:
Determine the expected maintenance cost for July, using the high-low method.
The month with the highest level of activity is March, and the month
with the lowest level of activity is April. The high-low method
calculates the difference between the costs in these two months, as
well as the difference between the two cost driver values (hours in
this example) for the two months.
Hours R
Highest month – March 21 200 53 900
Lowest month – April 14 800 41 100
Difference 6 400 12 800
This enables us to surmise that the increase in maintenance cost

(R12 800) must be a variable cost and can be ascribed to the increase
in machine hours worked (6 400 hours).
The variable cost per machine hour is therefore R12 800/6 400
hours = R2 per hour.

Now the variable cost per hour can be applied to either the high
or the low gure, in order to determine the xed portion of the cost:
High: R53 900 (total cost in March) – (21 200 hours × R2) (variable
cost in March) = R11 500 ( xed cost in March)
Or:
Low: R41 100 (total cost in April) – (14 800 hours × R2) (variable
cost in April) = R11 500 ( xed cost in April)
The xed cost per month is therefore R11 500.

The projected total maintenance cost for July is (17 500 hours ×
R2) + R11 500 = R46 500.
Other methods for preparing

12.13.2
projections using historical data

Three other methods for preparing projections based on historical
data should be mentioned here, namely linear regression, scatter
diagrams and correlation:
1 Linear regression. When applying linear regression analysis, the
end result that we are trying to achieve is to ‘ t’ the historical
information available to us into a formula where we can
distinguish between the variable and xed portions. This
information can then assist us to forecast.
2 Scatter diagrams. Under this method of cost estimation, cost and
corresponding activity are plotted on a graph known as a scatter
diagram. A line of best t is then drawn through the middle of
the plotted points. This is not a very accurate method, but it
provides a visual indication of the correlation between past
activities and their related costs. The technique is discussed in
Chapter 3, Cost estimation.

Correlation. The degree of association between two variables such
3 as cost and activity is referred to as correlation. Correlation is
discussed in Chapter 3, Cost estimation.

As previously explained, the rst budget drawn up is usually the
sales budget. It is therefore important for management to try to
determine what future sales will be. They can do this in one of the
following ways:
• Obtain information on future sales from the organisation’s sales
personnel.
• Conduct market research.
• Apply mathematical methods and techniques, such as those
discussed in section 12.13.

Budgetary control is the process of comparing actual results to
budget results and, if there are signi cant undesirable variances,
taking corrective action in an attempt to prevent these variances
from recurring. Budgetary control is the cornerstone of good internal
control.
12.16 Fixed and flexed budgets
Key terms: xed budget, exed budget
Fixed budgets are not affected by changes in activity levels, for

example the volume of units produced. Instead, a xed budget is

drawn up for a speci c activity level (for example, production
of 400 000 units). A xed budget is useful to gain an overall picture
of the business plan, but as a control measure it often fails, especially
when actual activity levels vary from budgeted activity levels.
Let us assume total production cost according to a xed budget
amounts to R40 million. Actual production costs turn out to be R43
million. Using a xed budget approach, we have to conclude that the
organisation has overspent its production budget, which is
seemingly a negative outcome. However, if we assume that the
original budget was to produce 400 000 units at R100 each, and the
organisation ended up producing 440 000 units at a total cost of R43
million, then it performed better than expected. At R100 per unit we
would logically expect production cost to be around R44 million. To
prevent the wrong conclusion from being drawn, we need a exed
budget.
Flexed budgets are based on variable costs per unit and can
therefore easily be adjusted when actual activity levels differ from
budgeted activity levels. A exed budget is designed to change
according to changes in activity levels (see the next section for more
details).
12.17 Preparing a flexed budget

A exed budget is prepared by separating expected xed costs from
expected variable costs. Fixed costs are not affected by different
activity levels. Variable costs, however, increase in line with
increasing activity levels and the exed budget should be adjusted
accordingly. This can best be explained by means of an example.

Example 12.9
A review of past information has revealed the following costs for FG (Pty) Ltd for
production levels of 8 000 and 10 000 units per month:
8 000 units R 10 000 units R
Direct materials 360 000 450 000
Maintenance 54 000 60 000
Factory rental 56 000 56 000
Required:
Prepare cost budgets for production levels of 11 000 units, 11 500 units and 12 000
units per month.
Using the high-low method, we can calculate that the variable cost
for direct materials is R45 per unit, with no xed cost. The variable
portion can be determined as follows: (R450 000 – R360 000)/(10 000
units – 8 000 units) = R45 per unit.
Maintenance consists of a xed and a variable portion. Again,
using the high-low method, we determine that the variable
maintenance cost is R3 per unit, while the xed portion is R30 000.
The variable portion is determined as follows: (R60 000 –
R54 000)/(10 000 units – 8 000 units) = R3 per unit. The xed portion
is calculated by subtracting the variable cost from the total cost:
R54 000 – (8 000 × R3) = R30 000 or R60 000 – (10 000 units × R3) =
R30 000.
Factory rental is not affected by the production level and will
remain xed at R56 000.
The exed budget will be as follows:

Impact of budgeting on the
12.18
motivation of managers
Key term: budgetary slack
Managers may be negative towards the budget-setting process for

various reasons:
• Some may lack the necessary numerical skills and technical
knowledge to prepare a budget properly, leaving them with a
sense of inadequacy.
• It may be a very busy period and they may nd it dif cult to
make time for preparing a budget.
• Managers may not be aware of the importance of preparing a
budget, failing to understand the bigger picture and senior
management’s long-term strategy for the organisation.
• Managers may have the perception that the budget will be used
as a punitive device if they fail to meet targets, with the result
that they could attempt to build slack into their forecasts.
Budgetary slack is built into a budget when a manager
intentionally overestimates expenses or underestimates expected
income in order to meet set targets more easily.

• Managers may perceive the budget process as a bureaucratic
exercise and attempt to get it out of the way as effortlessly as
possible. This is often done by simply adding an in ation factor
to past budgets.
Once the budget has been set, the following performance-related

problems may be encountered:
• Managers may have an attitude of doing just enough to meet the
set targets without trying to beat the targets. In certain cases
where managers have already met the target, they may attempt
to apply smart accounting to carry some of the surplus pro ts
over to the next budget period, ensuring that it will be easier to
meet the next budgeted target as well.
• In governmental organisations, a budgeted expense is sometimes
seen as an amount that has to be spent. There are two reasons for
this: rstly, it is often feared that the budget for that particular
expense item may be reduced by the government in the next
budget period and allocated to a different department. Secondly,
public opinion could turn against the organisation if it becomes
known that tax money earmarked for speci c purposes is not
being spent as promised. ‘Use it or lose it’ is a phrase often heard
in these organisations. The result is that there is often wasteful
expenditure in the few months before the end of the budget
period.
• Managers may nd it dif cult to interpret control reports (reports
that show how actual results deviated from budgeted gures)
because of a lack of nancial training.
• In cases where control reports are not prepared timeously, such
information loses its value and managers may be more likely to
ignore it.

• Managers may resist the budgetary control process if they feel
that they have not had control over either the budget-setting
exercise or the variances between the budgeted and actual
results. In Chapter 14, Performance management, the importance of
measuring someone’s performance based only on factors over
which they have control is discussed in more detail.
Notwithstanding the potential negative aspects above, the setting of

targets (as done during a budgeting process) is an extremely
powerful motivating force in the minds of managers. Budgets
provide a way of communicating at the beginning of a period what
is expected of the entity and its managers during the period, as well
as a means of measuring actual performance against these
expectations at the end of the period.
Participation and performance

12.19
evaluation
Senior management may adopt different approaches with regard to
the extent to which they allow line managers to be involved in the
budgeting process.
On the one hand, we nd an autocratic style, where the budget is
imposed from the ‘top down’ (in other words, imposed by senior
management) on the line manager. We say that an ‘imposed’ style of
budgeting is employed. The underlying philosophy is that budgets
ought to be set in line with strategic plans for the organisation as a
whole, and that senior management is in the best position to do so.
On the other hand, there is a more democratic management style,
where line managers are encouraged to participate in the budget-
setting process – a ‘participative’ budgeting style is employed. The

underlying philosophy is that participation in the budgeting process
increases the motivation of managers to meet their targets.
Although the participative style is popular in modern
organisations, both styles have advantages and disadvantages.
Potential relative advantages of

12.19.1
imposed budgets over participative
budgets
• When imposed budgets are used, it is easy for senior
management to ensure that the budget is in line with the overall
long-term business strategy.
• It is easier to ensure co-ordination between different business
units when imposed budgets are used, because senior
management sets the budget and they have a better view of the
organisation as a whole, compared to line managers.
• Senior management may be in a position to make better decisions
than line managers owing to their experience and knowledge, a
fact that favours imposed budgets.
• Imposed budgets can be set in a shorter period of time, because
senior managers can complete the task without having to wait for
‘bottom up’ inputs from line managers. This means that the
budget may be more accurate, as the budgeting process can start
later and the budget can therefore be based on more recent
information.
• When budgets are imposed ‘top down’, line managers are not
involved in the budgeting process, which means they do not
have the opportunity to build in any budgetary ‘slack’ (in other

words, they cannot deliberately set budgets for themselves that
are easy to attain).
Potential relative disadvantages of

12.19.2
imposed budgets compared with
participative budgets
• When budgets are imposed, line managers could be dissatis ed
and feel that their position in the organisation does not receive
the necessary recognition. This could lead to a lack of ‘buy-in’
from these line managers.
• Line managers often have a better understanding and more
experience of the operations of their divisions because of their
active involvement. This insight is not applied when budgets are
imposed from the top.
• The budgeting process could be seen as an opportunity to gain
ideas from line managers about ways of improving the operation
of their units. This opportunity is not exploited when budgets are
imposed.
• Because senior management is not always in touch with the
detail of the circumstances faced by a speci c unit, they may
impose unachievable budgets which could in turn impact
negatively on the motivation of line managers.

It is important to note that a participative style of budgeting does not
necessarily imply that line managers set ‘bottom up’ budgets that are
unconditionally accepted by senior management. If this were the

case, there would be no way for senior management to ensure that
the organisation is steered in the direction of its strategic objectives.
Instead, budgets are usually the result of a process of negotiation
between line managers and senior management.
Senior management will usually communicate their ideas and
aspirations for the organisation to line managers, and from there the
budget is negotiated until both parties are satis ed that it is
challenging, yet achievable.
The major drawback of negotiated budgets is that they take
considerable time to prepare.
The major advantage is that the resulting budgets will probably
be very realistic and are therefore likely to be accepted by all the
parties involved.
Example 12.10
Mobile Heavy Equipment Hire (Pty) Ltd is a divisionalised company that hires out a
range of large construction, earth moving and related equipment to various segments
of the construction and mining industry. The company is organised in divisions, each
of which focus on a subset of this type of equipment. One of these divisions is the
Road Compaction Division.
The Road Compaction Division rents out a range of ride on rollers to a variety of
customers involved in road maintenance and road construction. Ride-on rollers are
available in different sizes and power ratings, and can be rented out for any period
from one day to one month. Competition is erce as many new suppliers of ride-on
rollers have entered the market, due to the heightened government spending on road
maintenance and infrastructure activities, including the development of the MyCiti bus
lanes in the Western Cape.
Reliability is a major factor for customers, as most are working on tight deadlines,
with much work being required to be done over weekends and at night to limit
disruption to peak-hour traf c. Not being able to adhere to strict work schedules as a
result of problematic ride-on rollers would be unacceptable to the Road Compaction
Division’s clients, as heavy penalties are incurred for any delays or deviations from the
work schedule.

The role of the Quality Control and Servicing Department within the Road
Compaction Division is thus key to customer attraction and retention.
Performance of the Quality Control and Servicing Department of the Compaction
Division The Quality Control and Servicing Department is responsible for preparing
the ride-on rollers for hire to customers and checking them when they are returned.
This involves careful cleaning and certain checks that need to be carried out. The
department is also responsible for servicing the ride-on rollers at regular intervals. The
department also manages the relationship with the customer while the roller is in use
by the customer, and in the event that a rented-out ride-on roller becomes faulty, a
replacement is taken out to the customer’s site and the faulty one retrieved. The
performance report for this department is presented below.
Performance report
Budgeted and actual costs incurred in the quality control and servicing department for
the year ended 31 May 2013 are as follows:
Notes:
1 Salaries relate to the department manager and his assistant. This is a xed amount
and neither earn overtime.
2 1/3 of the budgeted wage costs relates to servicing the ride-on rollers. The number
of services is driven by the total number of rental days. The remaining 2/3 of the
cost relates to checking and cleaning the ride-on rollers when they enter and leave
the premises, and is driven by the number of rentals. R24 750 of the total wage

cost of R233 206 was paid for overtime hours worked. This includes an overtime
premium of 50% on normal time rates.
3 Spare parts are used in services and are almost never required when preparing the
rollers for hire, or checking the rollers post-hire.
4 Consumables are primarily used in the checking and cleaning of machines in the
preparation of the rollers pre-hire, and post hire checks and activities.
Required:
1 Redraft the performance report, calculating meaningful variances in order to
evaluate the performance of the manager of the quality control and servicing
department. Split the wage variance into the ef ciency and rate variances.
2 Comment on the performance of the quality control and servicing department. Your
discussion should focus on interpreting the variances you calculated in (1) and
conclude on the overall management of the department. Your commentary should
be direct, to the point and relate to the information provided.
3 The division uses incremental budgeting to arrive at the budget for each year. What
would you consider to be the main advantage(s) and disadvantage(s) of this
approach?
Redraft of the performance report:

Commentary:
Signi cant unfavourable wages variance could be due to the

following:
• The workforce has been working overtime – perhaps tired, thus
working more slowly, or making mistakes and needing to
redo/recheck?
• If ride on rollers that are sent out become faulty, then more
checks and cleaning would be required relative to the number of
rentals, as two ride-on rollers would need to be checked and
cleaned for that rental, not just 1.
Spare parts show a small favourable variance. This could indicate

that:
• an insuf cient number of replacements are being made at
services
• service intervals are being stretched
• some services are not being performed at all.
Whichever it is, all three would result in a decline in reliability,

which would ultimately lead to a decline in market share.
There is a signi cant unfavourable variance on consumables
(10% of FB). This could be due to:
• wastage (either as a result of sloppy/tired/careless labour, or
bottles being knocked over – many of these items are liquids)
• theft
• incomplete stock count – many of these are small items easily
mis-counted.
Tools show a marginally unfavourable variance, without the budget

being exed (there is an argument that increased activity levels

would require increased tool purchases).
Clearly control is being exercised over the whereabouts and
condition of tools.
Conclusion:
Overall, management of this department appears to be sloppy, with
a lack of controls over inventories and worker ef ciency to ensure
tasks are carried out as required.
Incremental budgeting:
• It is ef cient/fast.
• The prior year results do provide a reasonable starting point,
especially if actual results are used (re ects ‘what actually
happened’).
• However, incremental budgeting perpetuates past inef ciencies
as it does not require the prior year results to be interrogated
with questions such as ‘Was the expense necessary?’, ‘Is there a
more ef cient way to do this?’ and ‘Are there opportunities for
improvement?’

The organisational unit for which the budget is set needs to receive
regular feedback on how it is performing because line managers
require time to take corrective action when unfavourable feedback is
received and because they could be motivated by favourable
feedback. Feedback should adhere to the following principles:
• Information should be communicated to a line manager who is in
a position to take corrective action. It should focus on those
income and expenditure items falling within the scope of the
manager’s control.

• Feedback reports should highlight signi cant variances so that
managers can focus their attention on exceptions (this is called
exception reporting). It means that not every negligible budget
variance is highlighted for attention, but rather that pre-set limits
determine when a variance is large enough to require the
attention of line managers (and their actions are followed up on
by senior management).
• Reports should be clear and understandable.
• Reports should be as accurate as possible.
• Reports should be timely. Note that the more time management
spends on ensuring accuracy, the less timely the reporting will
be. A balance therefore has to be struck between the quality and
the timeliness of reports.
The role of the management

12.22
accountant in the budget process
The management accountant in an organisation has an important
role to play in improving the quality of the budgetary control
system.
The management accountant needs to have regular contact with
line managers and should make time to discuss control reports with
them. The meaning and implication of information in these reports
should be explained to line managers, keeping accounting jargon to
the minimum.
Special care should be taken with the content and outlay of the
control report drawn up by the management accountant to ensure
that the information is clear and understandable. He or she needs to
ensure that information contained in report is both accurate and

timely. Accuracy is, of course, vital, and reports should be timely so
that line managers do not act on outdated information.

The Beyond Budgeting® Round Table, an independent research
body, is often in the news, and suggests that traditional budgeting
should be done away with. Their criticism of traditional budgeting
includes the following:
• Budgets are time consuming and expensive.
• Budgets provide poor value to users.
• Budgets fail to focus on shareholder value.
• Budgets can be too rigid and prevent fast response.
• Budgets protect rather than reduce costs.
• Budgets sti e product and strategy innovation.
• Budgets focus on sales targets rather than customer satisfaction.
• Budgets are divorced from strategy.
• Budgets reinforce a dependency culture.
• Budgets lead to unethical behaviour.
Beyond Budgeting® advocates adaptive management processes as

opposed to xed annual budgets. It believes that managers should
rather focus their attention on the generation of cash than on control
over expenditure. Furthermore, the organisation calls for a move
away from traditional centralised organisational hierarchy to a more
devolved network where individuals assume responsibility for their
own actions.
12.24 Summary

Although the scope of the budget is usually medium to short term,
the budget is part of the long-term strategic planning process of an
organisation. It is a practical tool for setting objectives in the short to
medium term, and to maintain control over the organisation’s efforts
in achieving these objectives. Other advantages of budgeting include
the fact that it facilitates performance measurement, motivation,
communication and co-ordination of activities.
Cash budgets deal with cash ows only, and disregard
accounting entries. Some frequently encountered budgeting
techniques include incremental budgeting, zero-base budgeting and
rolling budgets. Some of the projection techniques discussed in
Chapter 3, Cost estimation are particularly useful for budgeting
purposes.
Conclusion: Budgets, planning and control

This chapter introduced the objectives of budgets and the different
types of budgets. One of the major objectives of budgets is to
provide a framework for control and responsibility accounting. The
importance of control and responsibility accounting is discussed
further in Chapter 14, Performance management.
An integral part of budgeting is the setting of predetermined
targets and standards. This is very closely related to the concept of
standard costing, which is discussed in the next chapter, Chapter 13,
Standard costing. In Chapter 13, we will learn that one of the
objectives of standard costing is to facilitate the budgeting process.
Some of the projection techniques discussed in Chapter 3, Cost
estimation are particularly useful in the budget-setting process.

Tutorial case study: Capital Harvest
Capital Harvest provides nance to farmers and other agricultural enterprises,

primarily in the Western Cape. By the end of December, the company draws up an
annual budget detailing the budgeted income and expenditure per month for the
next nancial year. This budget is submitted to shareholders for approval. The
shareholders do not require the submission of any further budgets during the year.
In turn, Capital Harvest negotiates a budget with each one of its bankers. The
bankers are responsible for managing existing loans and for expanding the
company’s business by nding additional suitable opportunities where loans can be
granted. Extensive discussions take place between Capital Harvest and each of its
bankers which may result in modi cations. Once all parties are satis ed with the
nal budget, it is formally approved.
When Capital Harvest prepares its annual budget, the rst gure it estimates is
the rand value of loans to be granted to clients during the nancial year. Most of its
expenses are xed in the short term and are easy to budget. For the remaining
items, the company primarily bases its budget on the previous year’s results.
1 Discuss the reasons that Capital Harvest’s shareholders may require the
company to submit a budget each year, despite the fact that it takes up a great
deal of management’s time.
2 Speculate whether the budget submitted by Capital Harvest to its shareholders
is likely to be of a strategic, tactical or operational nature.
3 Identify the principal budgeting factor for Capital Harvest.
4 Advise Capital Harvest as to whether it ought to prepare a cash budget in
addition to the annual budget, even though this is not required by its
shareholders.
5 Discuss the key performance indicators that you think may be speci cally
important in the industry in which Capital Harvest operates.
6 Evaluate whether Capital Harvest uses an incremental or a zero-based approach
to budgeting.
7 Advise Capital Harvest as to whether it ought to make use of rolling budgeting
during the nancial year, even though this is not required by the shareholders.
8 Discuss to what extent projection techniques may assist Capital Harvest in its
budgeting process.
9 Discuss the style of budgeting that Capital Harvest seemingly follows in relation
to its bankers.
Basic questions

BQ 1
Name ve of the most important objectives of budgeting.
BQ 2
What is the function of a budget manual?
BQ 3
Which type of planning in the left column matches the budget
period in the right column?
Tactical planning Long term

Operational planning Medium term
Strategic planning Short term
BQ 4
Who in the organisation is likely to be responsible for preparing the
following aspects of the budget?
a) Materials purchases budget
b) Production budget
c) Sales budget
d) Budget guidelines
e) Fixed overhead absorption rate
BQ 5
What are three possible principal budget factors (factors that could
determine the volumes and amounts that should be budgeted)?
BQ 6
What three actions could management consider in order to alleviate
a short-term cash de cit?

BQ 7
What is a master budget?
BQ 8
The following gures represent a factory’s production gures and
related production costs for the past seven months. The cost
accountant has to prepare a production budget for the next ve
months. Budgeted production is 25 000 units per month. Using the
high-low method, what are the expected xed and variable
production costs, and the amount to be included in the budget for
production costs?
Production (units) Production cost R
January 20 500 366 000
February 23 200 398 000
March 26 800 441 900
April 26 000 432 650
May 29 100 469 200
June 22 300 388 000
July 25 500 425 600
BQ 9
What is the difference between an incremental budget and a zero-
base budget?
Long questions

KC Ltd purchases raw materials and then reworks them into a
product for resale. Budgeted sales are as follows:
• The basic raw materials cost R6/kg.

• A completed sales unit requires 2 kg of raw materials input.
• The target month-end raw materials inventory level is 15 000 kg
plus
• 20% of the raw materials required for next month’s budgeted
production.
• The target month-end inventory level for nished goods is 5 000
units plus 20% of the next month’s budgeted sales.
REQUIRED Marks
Calculate the budgeted raw materials purchases for October. 15
TOTAL MARKS 15

Raps (Pty) Ltd operates a supermarket. Purchases are sold at cost
plus 40%. The following budgeted gures are available:
• It is management policy to have suf cient inventory on hand at

the end of each month to meet half of the next month’s sales

demand.
• Creditors are paid in the month after the purchases are made or
the expenses incurred. Salaries are paid at the end of each month.
• Expenses include monthly depreciation of R8 000.
• 80% of sales are for cash; 20% of sales are on one month’s credit.
• No bad debts are incurred.
• The organisation will pay a dividend of R90 000 in April and will
buy equipment costing R30 000 for cash in May. The opening
cash balance at 1 April is R20 000.
REQUIRED Marks
Prepare a cash budget for April and May. 15
TOTAL MARKS 15

JD Ltd has established the following key metrics in order to assess
pro tability in the budgetary plans for the forthcoming budget
period:
• Return on capital employed = 25%
• Pro t margin = 10%
• Contribution to sales ratio = 40%.
Extracts from JD’s master budget are as follows:
R million
Budgeted statement of nancial position:
Non-current assets 3 500
Current assets 3 780
Current liabilities 2 320

Budget income statement:
Revenue 6 980
Contribution 2 560
Pro t from operations 990
REQUIRED Marks
Assess whether senior management would approve the budget in terms of the key metrics. 10
TOTAL MARKS 10

Fast ow (Pty) Ltd prepared the following budget for the month of
October:
Budgeted production and sales (units) 25 000
Sales 450 000
Raw materials (187 500)
Labour (76 000)
Total overheads (125 000)
Budgeted pro t 61 500
Labour is regarded as a xed cost, as all employees earn a xed

salary per month regardless of their ef ciency.
The budget for total overheads for September was R110 000, and
the budgeted production 20 000 units.
The actual results for October were as follows:
Actual production and sales (units) 27 000

R
Sales 472 500
Raw materials (202 500)
Labour (77 000)
Total overheads (127 600)
Actual pro t 65 400
Actual total overheads consisted of xed costs of R52 000 and the
remaining overhead costs varied with production.
REQUIRED Marks
Prepare a exed budget statement comparing budgeted pro t to actual pro t for October. Calculate
15
all variances.
TOTAL MARKS 15
References
Eaton, G. 2005. Management accounting of cial terminology. London: CIMA.
Upchurch, A. 1998. Management accounting: principles and practices. London: Financial
Times/Pitman.

LEARNING OBJECTIVES
• understand the purpose of a standard costing system
• explain how standards are set in a standard costing environment
and the design of a standard costing system
• explain how a standard costing system works
• calculate variances (labour, materials, overhead and revenue)
• reconcile actual pro t to budgeted pro t
• investigate and identify the causes of variances and
interrelationships between variances
• prepare journal entries to record standard costs and variances.
Accountability and variance analysis
Accountability is when an individual or department is held responsible for the

performance of a speci c function. Essentially, they are liable for the correct
execution of a particular task, even if they may not be the one performing the task.
Other parties rely on the task to be completed and the accountable party is the
party whose head will roll if the action is not carried out.
Standard costing, which is a form of variance analysis, is often written up in
report form by the nance staff, with explanations of why the major variances
occurred. Those charged with governance may discuss the results with each of the
responsible managers individually or may gather managers together for a monthly
meeting and go over the results of all departments. These discussions allow those
charged with governance to get more detailed explanations about why variances

occurred and discuss what each department manager intends to do to address
more serious variances by revising strategies or making changes to operations.
SOURCE: BASED ON INFORMATION FROM HILL (2019)
Standard costing offers a way of analysing performance in as much

detail as is required by management, by investigating the speci c
factors that caused actual results to differ from planned/budgeted
results. Standard costing is, however, not only an effective
performance management and budgetary control technique but also
a tool for inventory valuation as well as providing valuable
information for management decision making and internal control.
This chapter explains how a standard costing system works.
13.1 Introduction
Key terms: variance analysis
In Chapter 12, Budgets, planning and control, we learnt about the

budgeting process. If we have a budgeted set of results which shows
an anticipated pro t of R100 000 for a month, it means very simply
that the total expected revenues exceed the total expected costs for
the month by R100 000. However, assume that after receiving the
actual results for the month, a loss of R50 000 is reported. Therefore,
in total, there is a R150 000 (R100 000 + R50 000) discrepancy in terms
of pro t between what we had anticipated and what actually
happened. If we were asked to analyse the actual results compared
to the budget and determine the reasons for the poor performance,
we would clearly require more detailed information. We would need
to understand how revenues fell short of the budget, and/or which

costs were more than budgeted. Was it perhaps overhead expenses
that were out of control that caused the poor results?
This process of analysing in detail the reason for actual
performance differing from planned performance is called variance
analysis. Where costs were saved or revenues exceeded the budget
as a result of better performance, favourable variances will result.
Poor performance indicated by cost overruns or lower-than-
budgeted revenues results in unfavourable (also called ‘adverse’)
variances.
Variance analysis is critical because once the root causes of the
difference between planned and actual results have been identi ed,
corrective action needs to be taken so that performance can be
improved and the same mistakes are not repeated. Performance
measurement is therefore essential to the survival of organisations.
This chapter focuses on planning, control and measurement of
performance using standard costing.
Standard costing systems are widely used in practice because
they:
• provide a prediction of future costs and revenues that can be
used for planning purposes and decision-making
• provide information for performance evaluation
• assist in the identi cation of problem areas and areas where
attention and
• action are required within the business
• provide information for inventory valuation purposes for both
management reporting and nancial reporting functions
• provide inputs into the budgeting process.
Standard costing systems are traditionally found in the

manufacturing industry, but are equally useful in any organisational

context where meaningful standard prices and input quantities can
be determined.
Standards and the interrelationship

13.2
between standards and budgets
Before going further, it is essential to understand clearly the meaning
of a ‘standard’ and the difference between standards and budgets.
Note that a budget is usually a ‘total’ concept, for example ‘the
budgeted direct labour cost in total of division A for the month is
R300 000’. Standards, on the other hand, usually refer to the
individual cost objects or units that comprise the total budget. So, for
example, ‘the standard labour cost of one unit of product X is R100’.
In this example, the standard cost for labour refers to the R100
making up the cost of labour for each unit manufactured. From this
information, we can deduce that there were 3 000 labour hours
budgeted for the month in total (3 000 hours × R100 = R300 000).
Although the standard cost for labour of one unit of product X
was R100 as per the example, ‘standards’ can be further broken
down into their price and quantity components. In other words,
suppose that labourers are expecting to be paid R25 per hour. This
‘R25 per hour’ would be referred to as the price standard for labour.
From this, it is easy to infer that each unit of product X takes 4 hours
to manufacture (R100 per unit divided by R25 per hour). Therefore,
‘4 hours per unit‘ would be referred to as the quantity (or ‘volume’)
standard for labour. The standard cost (R100 per unit) is therefore a
product of the standard price (R25 per hour) multiplied by the
standard quantity (4 hours per unit). If either the actual price or
actual quantity of labour input is different from the price and
quantity standards anticipated, a variance will exist.

These same principles can be applied to all input costs, such as
labour (discussed above), as well as materials and both variable and
xed manufacturing overheads. In addition to standards for input
costs, it is possible to determine standards for sales as well as for
non-manufacturing costs.
13.3Standard costing and inventory

valuation
International Financial Reporting Standards (IFRS) allow the use of
standard costing for inventory valuation for external reporting
purposes. IAS 2, the IFRS accounting standard dealing with
inventory, states that valuing closing inventory at standard cost per
unit is a suitable alternative to valuing it at actual cost per unit, but
speci es that the standard costs should ‘approximate actual’ and
that standards should ‘be regularly revised in light of current
conditions’. We will come back to the accounting treatment of a
standard costing system later under section 13.12, but for now it is
important to realise that if an organisation is operating a standard
costing system, it means that closing inventory of nished goods will
be valued at the end of each reporting period at the standard
manufacturing cost per unit (that is, the sum of the unit’s standard
materials, labour, variable and xed manufacturing overhead cost
per unit).

Standard prices and input quantities are set in advance before actual
results are known. In setting price standards, an organisation should
take factors such as suppliers’ quotations, price seasonality, volume

discounts available and market prices into account. In setting
quantity standards, factors such as the quality of material and
labour, the wastage expected, time and motion studies, learning
curve effects, skills levels of staff and idle time expected should be
considered by the organisation.
Two approaches can be used to determine standards: (1) the use
of historic records and (2) engineering studies.
Historic records versus engineering

13.4.1
studies
Historic records
Historic records provide a starting point for the development of
standards, because they contain the prices and input quantities that
were recorded in previous nancial periods. This is very similar to
the incremental budgeting method discussed in Chapter 12, Budgets,
planning and control.
There are, however, a number of potential disadvantages when
standards are based on the prices and input quantities recorded in a
prior period:
• Historic records have been affected by any ef ciencies or
inef ciencies experienced in the past.
• Using historic records can promote the use of averages, resulting
in standards being set midway between past ‘good’ and ‘bad’
performances, rather than striving for best practices.
• Historic records do not re ect subsequent changes in the
organisation or its environment (such as, for example, the
introduction of a just-in-time (JIT) system). Clearly, in such

circumstances, variances based on prior performance are unlikely
to provide adequate benchmarks for managers to strive for.
Basing standards on historic records is usually time and cost

effective, but because of the potential disadvantages listed above, it
may result in less desirable standards than those obtained through
engineering studies.
Engineering studies
Engineering studies, such as time-and-motion studies and business
process re-engineering, include a detailed study of each operation,
and careful speci cations are created for each cost item. Best
practices are sought, focusing attention on nding the best
combination of resources, production methods and quality. There are
many similarities between this method and the principles of zero-
base budgeting as discussed in Chapter 12, Budgets, planning and
control. Although engineering studies encourage organisations to
strive constantly for better levels of performance by setting
standards based on the most effective execution of the value chain, it
is more costly than merely basing standards on historic records.
To set standards, organisations use either historic records or
engineering studies, or a combination of the two, and adjust for any
factors that may need to be taken into consideration. Ideally,
standards should not be affected by historic inef ciencies, and
should take into account any expected changes in the organisation
and its environment.
13.4.2 Level of difficulty

Key terms: achievable standards, basic standards, ideal
standards
Irrespective of whether historic records are used as a starting point

or whether engineering studies are performed to set standards,
management will need to decide how lenient or strict they would
like to be when it comes to the setting of standards. For example,
they have the option of setting so-called ideal standards – standards
that represent perfect working conditions, with absolutely no
allowance for spoilage or inef ciency. However, while basic
standards that are too slack may fail to motivate employees to
improve performance, ideal standards may be seen as unattainable
and may also result in demotivating employees if they believe that
their bonuses are based on budgets that are impossible to achieve.
The solution is often to set achievable standards – standards that
are not too slack, but which represent normal working conditions
and allow for a certain level of expected spoilage and inef ciency
under normal conditions.

As mentioned, a standard costing system essentially compares the
standards set at the beginning of the period to the actual
performance during the period, yielding favourable and
unfavourable variances on which management can be assessed and
improvements can be made.
These variances are of little use if not recorded, evaluated and
acted upon where necessary. After the variances have been
calculated, the relevant managers deemed responsible for the

variances should be consulted to determine the cause of each
signi cant variance and corrective action should be taken as needed.
The static budget variance, volume

13.5.1
variance and flexed budget variance

Key terms: exed budget variance, price variance, quantity
variance, static budget variance, volume variance
You will recall that a budget is an aggregate or total estimate of

results for the organisation that is used for planning purposes. The
original overall budget is usually in the form of a static budget,
which re ects the budgeted sales and production volumes. A
comparison of the static budget pro t with the actual pro t at the
end of the period yields the total budget variance – this is called the
static budget variance. This variance represents the difference
between the pro t or loss as originally planned at the budgeted level
of output, and the pro t or loss actually made.
In order to analyse the static budget variance further, we have to
determine which part of the variance is as a result of the change in
production levels (as it is unlikely that precisely the planned level of
output was achieved) and which part of the variance is as a result of
a change in the expected price or quantity of the underlying inputs.
For us to do be able to do this, the original budget has to be
adjusted to re ect the actual level of production for the period in
question. The original static budget, adjusted for actual production
levels, is called the exed budget. You may recall this from Chapter
12, Budgets, planning and control, where static versus exed budgets
were discussed.

‘Flexing the budget’
The principle of exing the budget prior to evaluating the results
of an organisation is extremely important. Although this is
normally a principle that is taught along with standard costing, it
is a crucial one that can be applied beyond the boundaries of
standard costing.
Take the example of a factory foreman who works in a pen
factory. The standard usage of plastic materials input per pen is
0,1 kg per pen. Based on a planned production level given by
top management of 100 000 pens, the procurement division
ordered 10 000 kg (100 000 pens × 0,1 kg) of plastic in order to
meet expected production demand. At the end of the period,
owing to unanticipated sales orders received for pens, 120 000
pens were manufactured. If it were determined that the factory
actually used 11 000 kg of plastic instead of the budgeted
10 000 kg, would it be correct for top management to reprimand
the factory foreman for using more plastic than budgeted?
The answer is clearly ‘No!’, as more plastic would have been
used because more pens were produced. In fact, if the factory
had used the ‘correct’ amount of plastic per pen, it would have
consumed 12 000 kg of plastic (120 000 pens × 0,1kg). The
factory in fact saved costs by using on average less plastic per
pen manufactured.
This example highlights the importance of rst ‘ exing the
budget’ prior to performance evaluation, by revising our
expectations based on the actual level of activity achieved. The
actual activity level is the gure that drives the exed budget
and all the variance calculations that will follow.

This process of ‘ exing the budget’ is achieved by re-preparing the
budget, now basing the amounts on the actual activity levels
achieved (not the budgeted levels). Note, however, that although the
exed budget depicts the ACTUAL activity levels achieved, the
input costs will still be based on the standard costs per unit (that is,
standard price and standard quantities) originally determined at the
beginning of the period.
The difference between the static budget pro t and the exed
budget pro t represents the variance owing to the difference
between planned and actual activity levels – this is called the
volume variance.
The difference between the pro t as shown in the exed budget
and the actual pro t represents the variance as a result of changes in
the expected price or quantity of the underlying inputs – this
variance is called the exed budget variance.
Example 13.1
Specialised Cycles is a manufacturer of a racing bicycle, the Madone XXI, which it
sells to cycling retail stores within South Africa. The organisation purchases
components and raw materials for the bicycle from various suppliers, then uses semi-
skilled labour to manufacture the frames and skilled labour to assemble the bicycle.
The organisation has xed costs relating to the factory and head of ce infrastructure.
The following budget has been prepared for the month of October:
Static budget October budget
Units produced and sold 1 000
Revenue R5 500 000
Raw materials (carbon bre for frame manufacture) (R1 000 000)
Components (R2 000 000)

Semi-skilled labour (R500 000)
Skilled labour (R300 000)
Variable overhead (R100 000)
Factory xed overhead (R400 000)
Head of ce overhead ( xed) (R100 000)
Budgeted pro t R1 100 000
The actual results for the month of October are as follows:
Actual results October actual
Units produced 1 300
Units sold 1 200
Revenue R6 840 000
Raw materials (carbon bre for frame manufacture) (R1 495 000)
Components (R2 431 000)
Semi-skilled labour (R716 300)
Actual results October actual
Skilled labour (R414 700)
Variable overhead (R95 000)
Factory xed overhead (R650 000)
Head of ce overhead ( xed) (R155 000)
Closing inventory (100 bicycles) R430 000*
Pro t R1 313 000
In a standard costing environment, the closing inventory is valued at the standard

manufacturing cost per bicycle multiplied by the closing inventory of 100 bicycles, i.e.

(R1 000 000 + R2 000 000 + R500 000 + R300 000 + R100 000 + R400 000)/1 000
bicycles = R4 300 per bicycle × 100 bicycles = R430 000.
Assume that there was no bicycle inventory on hand at the beginning of month of
October. In addition, there was no opening or closing inventory of raw materials or
components.
Required:
Analyse the variance between the static budget and the actual results for October in
as much detail as the information permits.
It is clear from comparing the actual budget to the static budget that
the organisation has performed better than expected by delivering
R213 000 additional pro t. This represents the total variance between
the static budget pro t and the actual pro t, and can be summarised
as follows:
Static budget variance

= Actual pro t – Static budget pro t
= R1 313 000 – R1 100 000
= R213 000 F
The variance is favourable because more pro t was made than

anticipated, and is therefore denoted by an F. Unfavourable
variances are usually denoted by a U.
Favourable and unfavourable (also called ‘adverse’) variances

Note that, from an exam technique perspective, it is important
to get into the habit of always writing ‘favourable’ or
‘unfavourable’ (or ‘F’ or ‘U’) next to each variance. In standard
costing exam questions, not only the amount of a variance
counts for marks but usually also its classi cation (‘F’ or ‘U’). To
a management accountant in practice, this becomes even more
important: one has to interpret and report whether each

variance has had a positive (‘favourable’) or negative
(‘unfavourable’) impact on the organisation.
Be aware that ‘unfavourable’ variances are sometimes also
referred to as ‘adverse’ variances, denoted by the letter ‘A’.
Do not ‘study’ when a variance is favourable or
unfavourable, for example ‘when the rst gure is larger than the
second gure in the equation, the calculator returns a positive
number and thus the variance is favourable’. This leads to
incorrect answers, because cost and revenue variances differ,
and it does not aid an understanding of the underlying
principles. Always use logic to decide on the nature of a
variance, for example ‘because the actual pro t in October was
larger than the budgeted pro t, the variance was favourable’ or
‘because more material was used than the standard amount,
the variance was unfavourable’.
At the end of October, we know that during the month 1 300 units
were actually produced and 1 200 actually sold by Specialised
Cycles, instead of the planned 1 000 units of sales and production. It
appears that much of the additional pro t earned is due to the
additional 200 units sold, resulting in additional revenue, but at the
same time, most of the input costs also exceeded the budget. For
example, the cost of skilled labour was R414 700 instead of R300 000.
In order to determine what the impact of the higher-than-anticipated
production and sales levels were on skilled labour and all the other
input costs, the static budget needs to be exed by increasing the
number of budgeted units produced to 1 300 units and the number
of budgeted units sold to 1 200 units, in other words, the same as the
actual activity levels that were achieved. In order to ex the budget,
we rst need to convert variable costs into ‘per unit’ costs:

Specialised Cycles: exed budget for October
Note that sales values are exed based on the actual number of units sold, while manufacturing cost line
items are exed using the actual number of units of production.
Note the difference in treatment between the factory xed overheads

and the head of ce xed overheads in the exed budget. Remember
that we learnt in Chapter 5, Absorption versus variable costing that
xed manufacturing overheads are allocated to inventory in an
absorption costing environment using a xed overhead allocation
rate, and these costs are ‘absorbed’ into the income statement based
on the actual production levels. The amount of xed manufacturing
overheads absorbed (that is, expensed) into the income statement
will therefore vary with production levels. Even though this may
seem strange as we know that xed manufacturing overheads are
still xed and should not vary with activity, remember that this is
recti ed in the actual results through the over- or under-absorption

so that the net amount expensed to the income statement equals the
actual xed manufacturing overheads incurred during the period.
However, non-manufacturing (head of ce) overheads are still
treated in an absorption costing system as a period cost and are
expensed in full. The amount of non-manufacturing overheads
expensed to the income statement therefore does not vary with
production levels.
If we compare the exed budget to the actual results for October
we nd that, although the organisation did well in selling an
additional 200 units, the actual pro t was R27 000 less than the pro t
in the exed budget (in other words, R27 000 less than the pro t that
‘should have been made’ based on the actual activity levels that took
place of 1 300 units produced and 1 200 units sold).
Notice that, throughout this chapter, we determine total variances

and then break them into progressively smaller parts to investigate
further the cause of each variance – in practice, this is exactly how a
standard costing system helps management to determine the precise
reasons for the difference between the nancial outcomes they had
planned for the organisation, and what actually took place.
The volume variance shows that, had Specialised Cycles sold an
additional 200 units at the standard cost, they should have made an
additional R240 000 in pro t. However, the exed budget variance
shows an unfavourable variance of R27 000 – pro t was lower by
this amount because of either higher input costs or lower selling

prices of bicycles in the market, leaving us with a higher pro t of
only R213 000 (R240 000 – R27 000). At this point, we do not know
what factors speci cally caused pro ts to be lower than they should
have been at a production level of 1 300 and sales level of 1 200. Was
the skilled labour less ef cient? Was the unskilled labour more
expensive per hour than we initially expected? Were xed factory
overheads higher than anticipated? Did we use more materials than
expected? Did materials cost more than anticipated? Did
competition for bicycles cause us to drop our selling prices in order
to retain our market share?
In order to answer these questions, we need to drill down further
into the R27 000 unfavourable exed budget variance by breaking
the exed budget variance into the parts comprising of each of the
revenue and cost items in the operating budget. Below is a line-by-
line analysis of the exed budget variance:

The exhibit illustrates the breakdown of the variance into each of the
line items comprising pro t. However, at this point we still do not
know whether each of the variances was caused by a difference in
the price or in the quantity of the input – a variance can result from
an input costing more or less than expected (price variance), or
using more or less of the input than expected (quantity variance).
We therefore need to investigate each of the variances further.
The exed budget variance for each line item shown can be
broken up into its price and quantity variance components using
two basic formulas. The basic formula for a price variance is:

The basic formula for a quantity variance is:
Although it is never advisable memorise formulas but rather to

understand the principle behind the topic that you are studying,
these formulas do help in an exam situation to ensure you calculate
the relevant price and quantity variances correctly. Note that there
are a few exceptions to the rule where these basic formulas will not
work, and these exceptions will be indicated in the text below.
Example 13.2
Consider the following information relating to Specialised Cycles in addition to that
already given in example 13.1.
Specialised Cycles produces only one type of bicycle (the Madone XXI), with a
standard selling price of R5 500 to cycle retailers. The organisation manufactures each
bicycle frame from carbon bre. Each frame requires 2,5 metres of carbon bre, and
each metre costs R400. The bicycle components are purchased as a set from the
component manufacturer. Each bicycle requires one set costing R2 000 each. Semi-
skilled labour is used in the manufacturing process, and four hours of labour are
required at a cost of R125 per hour. Skilled labour is then used to t all of the
components onto the frame and to apply nal nishes to the bicycle. Two hours of
skilled labour are required, at a standard cost of R150 per hour.
Variable overheads and xed overheads are incurred in the manufacturing process.
The appropriate cost driver for variable and xed overheads has been identi ed as
semi-skilled labour hours. The variable overhead rate is R25 per hour and the xed
overhead allocation rate is R100 per hour.
Required:
Calculate the standard revenue and standard cost of each input per bicycle.

The calculation of standard revenue and standard cost of each input
per bicycle is shown below:
Note: The last column has been inserted to illustrate how the
standard cost per bicycle can be used to calculate the exed budget.
Notice that the exed budget is the same as previously shown.
Again, it is crucial to notice that the exed budget is based on the
standard prices and standard quantities for each line item,
multiplied by the actual activity levels.
So far we have analysed the static budget variance into its volume
variance and exed budget variance components, and we have
calculated the exed budget variance for each line item in totality.
Remember that the exed budget variances are crucial for
performance measurement purposes, as these compare what actually
happened to what should have happened given the actual activity

levels at which the organisation operated. We cannot evaluate the
performance of a manager by comparing it to the static budget, as
this leads to incorrect conclusions. In order to do a further analysis,
we need to break up the variances into price and quantity variance
components.
As mentioned before, it is never advisable to memorise formulae;
they are there to help calculate the relevant price and quantity
variances correctly in an exam situation.
The basic formulae for isolating the price and quantity variances
are repeated below:
Notice how both brackets have the actual quantity but only differ on
price, hence the isolation of the price variance.
Notice how both brackets have the standard price but only differ on
quantity, hence the isolation of the quantity variance.
‘Table’ method
As shown in the table above, the exed budget variance can occur
per line item. This variance per line item can then be further split
into price and quantity as already indicated. This effectively means
that in order to isolate the price and quantity variances for every line
item, one has to memorise formulas for every line item. An
alternative to memorising formulas is the ‘Table’ method. With this
method, one only has to know the formula for the column headings

and then the differences between the columns are the price and
quantity variances:
• The original budget (column 1) is calculated by taking the budgeted

quantity multiplied by the budgeted or standard price per
quantity.
• The actual quantity × standard price (column 3) is calculated by
taking the actual quantity multiplied by the budgeted or
standard price per quantity.
• The actual quantity × actual price (column 5) is calculated by taking
the actual quantity multiplied by the actual price per quantity.
The respective variances will be calculated by taking the differences

in columns as follows:
• The volume (or ef ciency) variances (columns 2 and 8) will be
calculated by taking the difference in column 1 and column 3 for
sales; column 6 and column 3 for variable costs (i.e. direct

material, direct labour and variable overheads), and nally the
difference in columns 6 and 1 for xed overheads.
• The price (or rate) variances (columns 4, 7 and 9) will be
calculated by taking the difference in columns 3 and 5 for sales
and variable costs, and the difference in columns 1 and 5 for xed
overheads.
• The above represents the basic application of the table method,
but the various iterations of the table method will be discussed
further as we move through the revenue variances, direct
materials variances, direct labour variances, variable overheads
and xed overhead variances respectively.
13.5.2 Revenue variances

Key terms: revenue variance
To calculate the sales price variance, we must isolate the effect that
the difference between the actual and standard prices has had.
Example 13.3
Consider the information relating to Specialised Cycles given in the previous
examples.
Required:
Calculate the sales price variance.
The organisation budgeted a sales price of R5 500 per bicycle.

However, the actual results for October re ected a price of R5 700
(R6 840 000/1 200 bicycles):

The difference in sales volume of 200 units (the difference between
the actual sales of 1 200 bicycles and the budgeted sales of 1 000
bicycles) has already been re ected in the volume variance
calculated in example 13.1. Now that we are discussing revenue
variances, we can call the volume variance already calculated the
‘sales volume variance’. Specialised Cycles therefore has a
favourable sales volume variance of R240 000 (calculated in example
13.1) and a favourable sales price variance of R240 000 (calculated in
example 13.3, or as 200 units × R1 200 pro t per unit in example
13.2).
In example 13.1, we calculated the sales volume variance at pro t
level, comparing the standard pro t per unit at the actual and
budgeted sales volumes. We could, however, also have calculated
the sales volume variance at contribution level or at sales price level.
For example, at sales price level, the sales volume variance is as
follows:
Although sales volume variances can be calculated at any one of the

three levels discussed above, sales volume variances that are

calculated at sales price level ignore the fact that selling decisions
impact on pro t. It could be more appropriate to calculate the
variance at contribution or at pro t level. Contribution level would
be most appropriate where variances are calculated to reconcile the
actual and standard pro t if a variable costing system is used. A
reconciliation is given in section 13.6 (see page 417). Notice that the
sales volume variance used there for Specialised Cycles is calculated
at pro t level because Specialised Cycles is using an absorption
costing system. Pro t level is most appropriate where variances are
used to reconcile absorption costing pro ts (refer to Chapter 5,
Absorption versus variable costing), as in the Specialised Cycles
example.
If the sales volume variance can be calculated using either sales

price, contribution or pro t, how will the books balance? It is
important to note that input (‘cost’) variances are recorded in
the accounts, because in a standard costing system inventory is
valued at standard cost. However, revenue variances are
calculated for informational purposes only, giving us more
exibility to choose the calculation that yields the best
management information.
If the sales volume variance is calculated at sales price level (which

is the level at which the sales price variance is calculated), the
combination of the two give the total sales variance: the total
variance between actual sales and the static budget. The total sales
variance differs from the total cost variances for materials, labour
and variable overheads, in that it represents the whole spread from
actual results to the static budget. The cost variances represent only
the spread between actual*results and the exed budget. In the

remainder of this chapter, look at how the cost variances are derived
by ‘drilling down’ from example 13.1. You will see that it is the
exed budget variance for each line item that is further split up.
To sum up our revenue variances example: Specialised Cycles
received R1 340 000 more sales revenue than originally budgeted for.
The analysis shows us that the higher-than-budgeted price of R5 700
at which the bicycles were sold had contributed to the higher
revenue along with the fact that 200 more bicycles were sold than
had originally been budgeted for. The sales variances at sales price
level are shown below:
The alternative method (i.e. the table method) for calculating the
sales price and sales volume variance as per example 13.3. is shown
below:
Column 1 = budget price × budget volume = 5 500 × 1 000

Column 3 = budget/standard price × actual volume =
6 840 000/1 200 × 1 000
Column 5 = actual price × actual volume = 6 840 000

Where more than one product is sold, the sales volume variance can
be further analysed into sales mix and sales quantity variances, and
the sales quantity variance further broken down into market size
and market share variances. These are discussed in the appendix to
this chapter.
13.5.3 Direct materials variances

Key term: direct materials variance
The total direct materials variance is calculated as the difference

between the total actual costs of the materials and the total standard
cost of the materials as shown in the exed budget. This variance can
be broken down into two components – a price variance and a
quantity variance (also called a ‘usage variance’).
The price variance is the difference between the actual quantity of
the materials at the actual price, and the actual quantity of the
materials at the standard price. This variance expresses the
difference between what the actual quantity of materials actually
cost, and how much the actual quantity of the materials should have
cost had we acquired it at the pre-determined standard price.
The usage or quantity variance is the difference between the actual
quantity of the materials at the standard price, and the standard
quantity of the materials at the standard price. This variance
expresses the difference between the quantity of materials actually
used, and the quantity that should have been used in accordance
with the standard. It expresses this difference in terms of the
standard price per unit: the effect of the actual price on the total
materials variance has already been recorded in the price variance.

Example 13.4
examples. In October, the organisation purchased and used 2 990 m of carbon bre at
a total cost of R1 495 000 in producing the bicycle frames.
Required:
Analyse the raw materials (carbon bre) variance in as much detail as the information
permits.
Remember that no opening or closing inventory of raw materials

exists (example 13.1). Therefore, the entire 2 990 metres was used for
October production.
The direct materials variance for raw materials can be split into a
price and a quantity variance as follows:
This has helped us to gain a more in-depth understanding of the

reasons behind the total direct materials variance of R195 000 U. The
fact that we paid too much for materials had a negative impact of
R299 000, while the fact that we used materials more sparingly than
budgeted had a positive impact of R104 000.
raw material price and volume variance as per example 13.1. is
shown below:

Column 1 = exed budget (i.e. standard cost for 1 unit) × actual units
produced = 2.5 m × R400 × 1 300 units
Column 3 = actual quantity × standard price = 2 990 m × R400
Column 5 = actual quantity × actual price = given = R1 495 000
Example 13.5
examples. A new supplier of components was used, as their price per component set
was discounted to R1 700 per set. A total of 1 430 sets were purchased and used.
Required :
Analyse the components variance in as much detail as the information permits.
The calculation for the direct materials variance for components is as

follows:
component price and volume variance as per example 13.5 is shown
below:

Column 1 = exed budget i.e. standard cost for 1 unit × actual units
produced = 1 × R2000 × 1 300 units
Column 3 = actual quantity × standard price = 1 430 × R2 000
Column 5 = actual quantity × actual price = given = 1 430 × R1 700
Note that the calculations for the component variance follow the
same logic as those for the raw materials variance above. The fact
that we paid less per unit for components had a positive impact of
R429 000, while the fact that more components were used than
should have been used on 1 300 bicycles had a negative impact of
R260 000.
In our Specialised Cycles example, all raw materials and
components purchased in October were used in production in
October. In practice, more materials could have been purchased than
were actually issued to production and used in the manufacturing
process, resulting in the excess materials and components being
carried forward in closing inventory at the end of the month. In such
a situation, we may wonder whether the direct materials price
variance ought to be calculated at the time of purchase, based on the
quantity of material purchased, or at the time of use, based on the
quantity of material issued to production. The choice is a policy
decision and either one is acceptable in practice. It is recommended
that the direct materials price variance be calculated at the time of
purchase based on the quantity purchased, because the earlier we
calculate a variance, the sooner corrective action can be taken based

on the variance (if action is required). In addition, calculating the
materials price variance at the time of purchase removes the price
variance from the raw materials account with the effect that all raw
material inventories are held in the accounting records at standard
cost.
13.5.4 Direct labour variances

Key term: direct labour variance, mix and yield variances
The same approach that was followed to calculate the direct

materials variance is used to calculate the direct labour variance.
The total direct labour variance is calculated as the difference
between the total actual costs of the direct labour, and the standard
cost of the direct labour per the exed budget. This variance can also
be broken down into two components: a price variance and a
quantity variance. In the case of direct labour, the price variance is
sometimes called the ‘rate variance’ and the quantity variance is
usually called the ‘ef ciency variance’.
The price (or rate) variance is the difference between actual
quantity (generally measured in hours) of the direct labour at the
actual price of the labour, and the actual quantity of labour at the
standard price. This variance tells us the difference between what we
paid for the actual quantity of the labour, and how much we should
have paid for the actual quantity of labour if we had acquired it at
the pre-determined standard price.
The quantity (or ef ciency) variance is the difference between the
actual quantity of the direct labour at the standard price, and the
standard quantity of the direct labour at the standard price. This
variance tells us the difference between how much labour we

actually used and how much labour we should have used in
accordance with the standard. It expresses this difference in terms of
the standard price per unit of labour.
Example 13.6
examples. At Specialised Cycles, semi-skilled labourers are used in the frame
manufacturing process, while skilled labourers are used to assemble the frames and
components into a complete bicycle.
In October, the semi-skilled labourers worked for 4 940 hours and the skilled
labourers worked for 2 860 hours. Following union negotiations, both semi-skilled and
skilled workers were paid at a rate of R145 per hour.
Required:
Analyse the direct labour variances in as much detail as the information permits.
Semi-skilled labour variances are determined as follows:
Skilled labour variances are determined as follows:

The total actual cost of labour for October was more than expected
based on the standard for both semi-skilled and skilled labour. Semi-
skilled labour had an unfavourable variance of R66 300 (the higher
hourly rate paid had a negative impact of R98 800, while the fact that
fewer hours than expected were worked in terms of output
produced (higher ef ciency) had a positive impact of R32 500).
Skilled labour had an unfavourable variance of R24 700 (the lower
hourly rate paid had a positive impact of R14 300, while the fact that
more hours than expected were worked in terms of output produced
(lower ef ciency) had a negative impact of R39 000).
labour rate and ef ciency variance as per example 13.6 is shown
below:
Semi-skilled labour:
Column 3 = actual quantity × standard price = 4 940 × R125

Column 5 = actual quantity × actual price = given = 4 940 × R145
Skilled labour:
Column 5 = actual quantity × actual price = given = 2 860 × R145
In our Specialised Cycles example, the two types of direct materials

(raw materials and components) are not interchangeable – in other
words, each bicycle has to have carbon bre (the raw material) and
components, and the one cannot be substituted for the other.
Similarly, there has been no indication that the two types of labour
(semi-skilled and skilled) used by Specialised Cycles can be
interchanged, as the semi-skilled labourers, who are involved in the
manufacture of the frames, perform a function independent to the
skilled labourers, who are responsible for the assembly of the
bicycles. However, in situations where more than one type of
material is used and the materials are interchangeable to some
extent, or where more than one type of labour is used and the labour
types are interchangeable, the mix of inputs used in a particular
period may differ from the standard. In such circumstances, we can
further analyse the materials or labour quantity variance (whichever
is applicable) into mix and yield variances. These are discussed in
Appendix 13.1.
13.5.5 Variable overhead variances

Key term: variable overhead variance

We can perform an analysis similar to the ones for materials and
labour above in order to learn more about the variable overhead
variance. The total variable overhead variance is calculated as the
difference between the total actual costs of variable overhead, and
the standard cost of variable overhead as re ected in the exed
budget. This variance can also be broken down into two components
– a price variance and a quantity variance. In the case of variable
overhead, the price variance is usually called the ‘spending variance’
and the quantity variance is usually called the ‘ef ciency variance’.
Example 13.7
examples. Specialised Cycles incurs certain costs (such as the use of cleaning
materials) that are directly related to the number of semi-skilled labour hours spent in
the frame manufacturing process. These costs make up the ‘variable overhead’ cost
category.
Required:
Analyse the variable overhead variances in as much detail as the information permits.
The variable overhead variances are determined as follows:
Notice that the number of actual hours and standard hours used in
the calculation are those related to semi-skilled labour. This is
because Specialised Cycles’ variable overhead varies according to

semi-skilled labour hours. Also notice that the actual price of
variable overhead per semi-skilled labour hour was not given – it is
calculated by dividing the actual variable overhead cost for October
(R95 000) by the actual quantity of semi-skilled labour hours worked
in October (4 940). The standard price of variable overhead was
given as R25 per hour in example 13.2, but if it had not been given, it
could be calculated using the same logic: R100 000/(4 × 1 000) hours
= R25.
The lower spending per labour hour had a positive impact of
R28 500, and the fact that fewer than expected semi-skilled labour
hours (the cost driver) were worked also had a positive impact to the
extent of R6 500.
variable overhead rate and ef ciency variance as per example 13.7. is
shown below:
Column 1 = exed budget (i.e. standard cost for 1 unit) × actual units
Column 5 = R95 000 = given
13.5.6 Fixed overhead variances

Key terms: xed overhead variances, production volume
variance, spending variance

Fixed overheads are a signi cant expense in many organisations in
the modern context. Mechanised manufacturing operations lead to
large overhead expenditure. Service organisations are also renowned
for high levels of overhead costs.
The area of xed overhead variances is one where you cannot
use the ‘basic formulas’ for price and quantity variance as referred to
earlier in the chapter. The reason for this is simply that xed costs
are inherently different by nature to variable costs and revenues,
which uctuate with activity.
For non-manufacturing xed overheads, the variance calculations
are simple. The variance is calculated as the difference between the
budgeted expense and the actual expense. The variance is a price
variance, also referred to as a spending variance.
However, manufacturing xed overhead variances are more
complicated than non-manufacturing xed overhead variances when
an absorption costing system is used. This is explained further
below.
Variable costing system

You learnt in Chapter 5, Absorption versus variable costing and Chapter
6, Overhead allocation that under a variable costing system, xed
overheads are treated as a period cost (that is, they are expensed in
the period incurred). There is therefore no allocation of xed
manufacturing overheads to inventory as in an absorption costing
system. For this reason, the exed budget amount for xed
manufacturing overheads under a variable costing system would not
look the same as in our previous examples (where an absorption
costing system was assumed).
What amount do you think the exed budget would show for
‘factory xed overheads’ in our Specialised Cycles example if a

variable costing system had been assumed? If you said R400 000,
you are correct. Why do you think this is so? Remember that in an
absorption costing system, so-called ‘allocated’ xed manufacturing
overheads are allocated to the income statement by taking the
allocation rate and multiplying this by the actual production gures,
which results in the amount expensed being affected by production
volumes. This does not, however, happen in a variable costing
system, where the total amount is expensed regardless of production
activity, and therefore the exed budget amount for ‘factory xed
overheads’ should look identical to the amount in the static budget.
As for all other cost variances, the total xed manufacturing
overhead variance is calculated as the difference between the
expense as shown in the exed budget, and the actual expense
incurred for the period. Under a variable costing system, there is
only a price variance (in the case of overheads, a price variance is
usually called a ‘spending variance’). The total difference between
the static budgeted xed overhead (which equals the exed
budgeted xed overhead in a variable costing system) and the actual
xed overhead is therefore the ‘spending variance’.
There is never an ef ciency variance for xed overheads in a
variable costing system, and the total xed overhead variance is
therefore not split up into a price and a quantity component. This is
because under a variable costing system, as discussed, xed
manufacturing overheads are treated as a period cost. They are not
absorbed to the income statement based on activity levels and
therefore do not change with volume levels.
Absorption costing system

In the case of an absorption costing system, the xed manufacturing
overheads are absorbed into the income statement based on the

actual production that takes place. Even though xed manufacturing
overheads are xed in nature, the amount that is allocated to the
income statement therefore varies with production, as discussed
above. For this reason, when we are using an absorption costing
system, there is a price variance as well as a quantity variance. We
call the price variance a ‘spending’ variance, and we call the quantity
variance a production volume variance.
The price or ‘spending’ variance is calculated in the same way as
under a variable costing system and is simply the difference between
the static budgeted expenditure and the actual expenditure incurred.
The quantity or production volume variance is the difference
between the static budgeted expenditure and the exed budgeted
expenditure. Remember, in an absorption costing system, the exed
budgeted expenditure is not the same as the static budgeted
expenditure. In an absorption costing system, the exed budgeted
expenditure represents xed overhead allocated to products (or
services, in a service organisation). To determine the amount of xed
overhead allocated, the budgeted xed overhead allocation rate (as
calculated in Chapter 5, Absorption versus variable costing) is
multiplied by the standard quantity of the xed overhead allocation
base for the actual number of products produced (or services
delivered).
Example 13.8
examples. Specialised Cycles operates an absorption costing system. Fixed
manufacturing overheads are absorbed as part of the cost of bicycles and allocated to
the income statement on the basis of semi-skilled labour hours.
Required:

Analyse the xed overhead variances for Specialised Cycles in as much detail as the
information permits.
The calculation of the two xed overhead spending variances is as

follows:
Factory xed overhead variance = actual xed overhead – static

budget xed overhead
= R650 000 – R400 000
= R250 000 U spending variance
Head of ce xed overhead variance = actual xed overhead – static

budget xed overhead
= R155 000 – R100 000
= R55 000 U spending variance
The calculation of the xed overhead quantity or ‘production

volume’ variance is as follows:
Factory xed overhead quantity variance

The budgeted gure for xed factory overhead for October was
R400 000. The production volume variance is the difference between
this amount and the xed factory overhead allocated to bicycles in
October.
Factory xed overheads are allocated based on semi-skilled
labour hours. To determine the xed factory overhead allocated to
bicycles, the budgeted xed factory overhead rate should therefore
be multiplied by the budgeted semi-skilled labour hours for the
actual number of bicycles produced in October.
• The budgeted xed factory overhead rate is the budgeted xed
factory overhead of R400 000 divided by the number of semi-
skilled labour hours that the static budget makes allowance for,

therefore: R400 000/(4 hours × 1 000 units) = R100 per semi-
skilled labour hour
• The budgeted semi-skilled labour hours for the actual number of
bicycles produced in October is 4 hours per bicycle multiplied by
1 300 bicycles produced in October. Therefore 5 200 semi-skilled
labour hours are budgeted for (note that this equals the number
of semi-skilled labour hours in the exed budget).
• Fixed factory overheads allocated are therefore R100 × 5 200
hours = R520 000 (note that this equals the factory xed overhead
per the exed budget).
The quantity (or production volume) variance for xed factory

overheads is therefore:
R400 000 (static budget) – R520 000 ( exed budget/allocated) =
R120 000 F
Head of ce overhead quantity variance

None.
The alternative method (i.e. the table) method for calculating the
component price and volume variance as per example 13.8 is shown
below:
Factory xed overheads

Column 3 = original budget = budgeted quantity × standard price =
R400 000 = given
Column 5 = actual quantity × actual price = given = R650 000
Head of ce xed overheads

Column 1 = original budget = as not a manufacturing cost thus
cannot be exed
Column 3 = original budget
Column 5 = actual quantity × actual price = given = R155 000
You should notice the following from the above example:

• There is only a spending variance for the head of ce overheads
and not a quantity variance. This would be true regardless of
whether the entity is operating a variable costing system or an
absorption costing system.
• There is a spending variance and a production volume variance
for the factory xed overheads in an absorption costing system. If
a variable costing system was in operation, there would be only a
spending variance, which would be calculated in exactly the
same way as in this example (that is, R250 000 U).
• The production volume variance in this example is favourable.
This may seem odd, as the static budget expenditure is less than
the exed budget expenditure (which is based on actual activity
levels). The reason it is favourable can be explained as follows:
more xed overheads were absorbed, because more bicycles were
produced than were budgeted for. Specialised Cycles therefore
made better use of their capacity by producing more bicycles

than originally budgeted for, and the average xed cost per
bicycle is therefore proportionately less.
• The sum of the spending variance and the production volume
variance is R130 000 U (R250 000 U – R120 000 F). This equals the
difference between the amount in the absorption costing exed
budget (R520 000, as in example 13.1) and the actual results for
October of R650 000 (that is, R520 000 – R650 000 = R130 000 U).
• Finally, you should take note that R130 000 U is also the under-
recovery of xed overheads that you would have calculated for
Specialised Cycles as discussed in Chapter 5, Absorption versus
variable costing. The under-recovery equals the difference
between the absorbed factory xed overheads of R520 000 and
the actual factory xed overheads incurred for October of
R650 000 (that is, R520 000 – R650 000 = R130 000 under-
recovery).
The factory overhead variances can be summarised as follows:
Note that the production volume variance can be further split for
management purposes into so called ‘ xed overhead ef ciency’ and
‘ xed overhead capacity’ variances. Furthermore, the xed overhead
capacity variance can also be split between a pure capacity variance
and a calendar variance. A calendar variance would arise if there are

either more or fewer working days available in a calendar period,
causing the total hours of capacity available in a year to change. This
would happen if, for example, the government declared a public
holiday that was not anticipated, causing the total expected
operating hours available for a period to decrease.
Most variances (labour, materials, overheads and revenue) can be
broken down further and even further in a similar manner to that
described. We will deal with some of these later in the appendix to
this chapter. There is almost no limit to the extent to which
management could choose to break down variances further for
performance management and control purposes, however this is
beyond the scope of this chapter.
The production volume variance exists only in an absorption
costing system, a system which is usually kept for the purpose of
complying with nancial accounting rules for inventory valuation.
As you have learnt in previous chapters, absorption costing usually
holds limited informational value for management accountants.
Similarly, the resultant production volume variance is of limited use
to management accountants. It simply shows the over- or under-
recovery of xed factory overheads in a standard absorption costing
system. This over- or under-recovery may, however, be closely
monitored by senior managers for nancial accounting purposes,
because it affects the organisation’s income statement.
13.6Reconciliation of actual profit to

standard profit
A standard costing system results in a reconciliation between the
actual operating pro t and the budgeted operating pro t. The
reconciling items take the form of each of the variances that have

been calculated. The reconciliation also provides a consolidated view
of all of the variances, which is important because of the
interdependence of the variances of the different cost categories. The
reconciliation for Specialised Cycles is presented below, on the
assumption that an absorption costing system is used.
Standard costing reconciliation for Specialised Cycles

Key terms: cost–bene t model, rule of thumb model, statistical
models
Once variances have been calculated, it is necessary for the

organisation to decide which of these variances ought to be
investigated further. In most cases, not all variances, but only those
that meet a pre-determined set of criteria, will warrant further
investigation.
Cost variance investigation models in the accounting literature
include the rule of thumb model, based on arbitrary criteria, the
cost–bene t model, based on investigation costs and corrective
bene ts, and statistical models, based on statistical analysis.
13.7.1 Rule of thumb models

This process is a subjective one where management uses previous
experience and its knowledge of the business to identify problem
areas. Management may choose to investigate all variances larger
than a speci ed rand amount as these are likely to have the most
nancial impact on the organisation.
Another option is that variances can be expressed as a percentage
of the standards set, and all variances greater than a given
percentage can be investigated. In some circumstances, management
may choose to investigate even small variances of a certain kind (if
management know that they are critical performance indicators to
the organisation), and to apply value criteria to other variances that
they regard as less critical.
Real-time systems may allow managers to detect such variances
earlier and to take corrective action to prevent any further losses, or
to capitalise on any savings.

13.7.2 Cost–benefit models
A second approach would be to use a cost–bene t approach.
Management would determine the cost of investigating a speci c
variance, measured against the bene t that is likely to be obtained
from taking corrective action. Statistical models can be developed to
weigh up the costs and bene ts of investigation.
13.7.3 Statistical models

Accounting literature includes a number of statistical models based
on probabilities that can be used in variance investigation. Such
models typically assume two states of a system are possible, either in
control or out of control. If such a model labels a variance as ‘in
control’, then the uctuation is regarded as being within acceptable
limits, and no further investigation is made. If a variance is labelled
‘out of control’, the variance is investigated further and corrective
action is taken.

Once a variance has been agged for investigation, it is important
for it to be correctly interpreted. One of the factors that should
routinely be considered is whether the standards themselves may
have been inappropriately set or may have become outdated, which
resulted in large variances. It may be discovered that the standards
themselves caused the variances because they are erroneous and
have to be adjusted in future reporting periods. Another
consideration is whether the actual values were accurately recorded.
If both of these factors fail to explain the variance and it is an
unfavourable one, further action needs to be taken to address the

problem and to prevent it from recurring. However, especially before
any accountability is assigned for unfavourable variances, the
variances have to be interpreted with the utmost care by a
knowledgeable person.
Note that favourable variances – not only unfavourable ones –
may also require further investigation. For example, if an
organisation calculates a favourable sales price variance (which
means that products were sold above the standard price per unit),
this may be seen in a negative light by management if the
organisation’s mission and marketing strategy is to target discount
shoppers. There is also a good chance that a favourable price
variance in this case may result in an unfavourable sales volume
variance, especially if the organisation’s products are price elastic
and sensitive to changes in their sales prices. Furthermore, any
favourable revenue or input variances need to be investigated to
show management what ‘went right’ and how it can be built upon in
future.
Example 13.9
examples. In the Specialised Cycles factory, the components purchases manager is
responsible for purchasing raw materials, while the production manager is responsible
for the production process. In October, the components purchases manager bought
cheaper components than usual from a new supplier. The production manager used
more than the standard number of components in the production process, because a
number of the component sets purchased in October were damaged in the assembly
process. There was no opening or closing inventory of components.
Required:
Discuss how the two managers performed with reference to the variances calculated.

You will recall that we have already calculated a R429 000 favourable
price variance and a R260 000 unfavourable quantity variance for
components. Our rst impression is that the components purchases
manager has performed well, because the variance over which he
had control (that is, the price variance) was favourable, and that the
production manager has performed poorly, because the variance
over which he had control (that is, the quantity variance) was
unfavourable. However, we notice that after cheaper component sets
had been purchased, some sets were damaged. When we discuss this
variance with the production manager, we may learn that the
components purchased were of a lower quality (and therefore
cheaper), which resulted in the damaged components and ultimately
in his having to use extra components in the production process. The
unfavourable ef ciency variance may therefore be due to the inferior
components purchased by the components purchases manager and
are not necessarily due to wastage or inef ciency by the production
manager. This is a good example of why it is important to analyse
variances properly, to look for possible interrelationships between
variances, and to interpret them with care. In this example it would
have been erroneous and unfair to blame the production manager
for the entire unfavourable components ef ciency variance.
In our Specialised Cycles example, it is possible that the
management accountant may in the end have a discussion with the
two managers together, and talk about the fact that although the
inferior components resulted in an unfavourable ef ciency variance,
the savings made on purchasing the lower grade components
outweighed this negative variance, resulting in a net favourable
components variance of R169 000. Furthermore, the managers may
indicate that damaged components can be sold, further contributing
to the organisation as a whole being better off when the lower

quality components are purchased. Unless there is a speci c
qualitative reason for using high-quality components (for example,
the organisation may not want to risk the reputation of the brand
name by using low quality components in the bicycles), the
managers may then agree to revise the standards for price and
ef ciency to re ect that they will in future use the cheaper, lower-
quality components, and allow for some damaged sets.
The above is just one example of an investigation into the causes
of a variance. Reasons for variances are likely to vary between
organisations, depending on the nature of their operations, product
and environment. For example, transport companies are likely to
have large cost variances as the oil price uctuates, affecting the cost
of petrol or diesel. Such variances are beyond the control of the
transport companies, and proper corrective action may be in the
form of raising prices to pass the price increase onto customers.
Manufacturing organisations may have signi cant variances when
the quality of their raw materials is compromised. The appropriate
corrective action may be to discuss quality with suppliers, or to
change suppliers.
Some common general causes of variances follow in section 13.9
for illustrative purposes. Note that each circumstance is different
and that, in a test or exam situation, the scenario given in the
question must be analysed.
13.9.1 Inflationary effects

• Cost variances: Prices and labour rates may increase year on year
owing to in ationary pressures acting on the economy. This

could affect all price variances. In addition, imported or exported
goods would be impacted by currency uctuations.
• Revenue variances: Remember that there is normally an inverse
relationship between sales prices and sales volumes. This
relationship is known as price elasticity. Higher sales prices
resulting from in ation may impact negatively on sales volumes.
Some industries are more exposed to price elasticity than others.
13.9.2 Materials-related effects

• Quality of materials: Lower-grade materials may be available at a
discounted price, resulting in a favourable materials price
variance, but more may be used because of the inferior quality
(resulting in an unfavourable material usage variance). This may
also affect the labour ef ciency variance, as more time may be
spent because of the inferior quality of the materials.
• Inventory losses: Spoilage may arise from theft or damage caused
by careless handling, resulting in unfavourable materials usage
variances. Insuf cient care of perishable materials or the
obsolescence of non-perishable materials may result in spoilage
and additional costs, resulting in unfavourable materials usage
variances.
• Inventory management: Poor inventory planning and production
scheduling may result in an organisation running out of
materials and supplies, forcing it to make rush purchases. This
may result in the organisation not purchasing at optimal prices
(for example, no volume discounts) or purchasing from
alternative suppliers who have inventory available. Suppliers
may also charge premiums for emergency deliveries. This would
result in unfavourable materials price variances.

13.9.2 Labour-related effects
• Quality of staff: Staff not properly trained may be less expensive
(resulting in a favourable labour rate variance), but may be less
ef cient or make more mistakes than properly trained staff
(resulting in an unfavourable labour ef ciency variance). They
may even waste or damage more materials, resulting in
unfavourable materials usage variances. Well-quali ed staff may
cost more (resulting in an unfavourable labour rate variance), but
may work faster, resulting in a favourable labour ef ciency
variance.
• Experience levels: As a result of the learning curve effect, staff who
are experienced are likely to perform a task more ef ciently,
resulting in a favourable labour ef ciency variance (if standards
have not yet been revised accordingly).
• Capacity: Should there not be enough labour available, existing
labour may be overworked or hurried, which could lead to
mistakes. Overtime compensation, which is normally paid at a
premium (resulting in an unfavourable labour rate variance),
may not be suf cient to motivate workers in such circumstances
(resulting in an unfavourable labour ef ciency variance).
• Relationship factors: Industrial action (such as strikes or go-slows)
as well as incentives (or lack thereof) can have a signi cant
impact on the ef ciency of labour in a manufacturing
environment and can therefore impact the labour ef ciency
variance.
• Work environment: Machinery which workers use may break
down, or workers may take a long time initially to get used to
new equipment. Both of these factors may show up as an
unfavourable labour ef ciency variance.

The above ought to help you think through some of the reasons why
variances could occur. However, in a test or exam you should
analyse the scenario given and use it to nd the possible reasons for
the variances under those particular circumstances.
Key terms: operating variance, planning variance
As part of their investigation of variances, senior management may

sometimes wish to separate individual variances into ‘planning’ and
‘operating’ components, creating a so-called planning variance and
an operating variance. The planning component represents the
difference between the standard, and how the standard would have
been set if management had knowledge of future events at the time
of setting that standard. The planning component typically isolates
the effect of something that has fallen outside a manager’s control
and for which he would not be held accountable, such as an
unforeseen event. The operating component is the remaining part of
the variance for which a manager would typically be held
accountable.
Look at example 13.10:
Example 13.10
examples. It has already been stated that, in October, the organisation purchased and
used 2 990 m of carbon bre at a total cost of R1 495 000 in producing the bicycle
frames. The direct materials price variance that resulted from this was unfavourable in
the amount of R299 000. Specialist Cycles’ purchases manager is concerned that he
will receive a poor performance review. He has informed his superior that there was an

unforeseen general 10% increase in the cost of carbon bre owing to a temporary
shortage in the entire industry.
Required:
Calculate a planning and an operating variance to form an opinion as to whether the
purchases manager performed poorly in terms of the direct materials price variance for
carbon bre.
Earlier in the chapter the direct materials price variance for carbon
bre was calculated as follows:
However, given the information about the general carbon bre price
increase, we can argue (with hindsight) that the standard for October
would have been set 10% higher if the information had been known
at the time of setting the standard. The price variance can therefore
be analysed as follows:
From the above analysis it is clear that, although the general price
increase had a negative effect of R119 600, the purchases manager
would still be accountable for the largest part of the unfavourable

variance. This is because, even if the standard had been set 10%
higher, there would still have been an unfavourable variance of
R179 400. If the remaining variance is regarded as material and
agged for investigation, such investigation will bring to light
whether this operating variance may have been the result of poor
purchasing decisions.

It is important for standards to be revised on a regular basis. In
practice, this is often done once a year. However, it may be necessary
to revise standards more frequently if, for example, a company
imports a signi cant portion of its raw materials and the rand is
volatile. In this case, more frequently revised standards may yield
materials price variances that are more useful for control purposes.
Another example of where standards should be revised occurs
when there is a change in the nature of the activities of the
organisation. Consider, for example, an organisation implementing a
radically new production system. The implementation of such a
system will have a material effect on the organisation’s operations.
Some attributes of the new system may be better-trained staff, more
expensive multi-skilled staff, more expensive and higher-quality
inventory, improved production organisation, less production
downtime, less waste, and so on. The implementation of such a
system will therefore no doubt result in a number of variances if
standards are not revised beforehand.
If standards are outdated, the variances that are calculated
become less useful from a performance management perspective. In
addition, outdated standards mean inaccurate budgeting and
planning as well as management decision-making. Moreover,

outdated standards cannot be used for nancial accounting
inventory valuation purposes, because IFRS (as discussed earlier)
requires standards to be ‘regularly revised in light of current
conditions’.
Inaccurate inventory valuation as a result of outdated standards
in a standard costing system can lead to inaccurate pricing decisions
if the organisation bases selling prices on a sales markup above cost
price, which could have serious implications for the organisation. If,
for example, an organisation prices its products too low, this may
result in the organisation not recovering the costs incurred in
manufacturing the product. On the other hand, if an organisation
prices the product too high, it may lose customers to competitors
who are able to offer more competitive prices to the market.
Note that, while standards that are infrequently revised are prone
to becoming outdated and irrelevant, it is just as unhelpful to revise
standards too often. Standards should not be revised so frequently
that we get the impression that they are changed every time a
signi cant variance occurs – this defeats the purpose of a standard
costing system. In general, a good guideline is that standards should
be revised whenever the previous standards are outdated or no
longer relevant or re ective of the current business environment.

International Financial Reporting Standards (IFRS) specify that
inventory valuations based on standard costs may be used for
reporting purposes (provided that the standard costs approximate
the actual costs, that they are current and that they are attainable). If
standard costing is used for the valuation of inventory, all inventory
will be carried forward from the previous year at the previous year’s

standard costs, and all inventory carried into the following year will
be carried at the current year ’s standard cost (assuming all the
previous year ’s inventory has been disposed of).
IFRS also speci es that ‘abnormal amounts of wasted material,
labour or other production costs’ should be treated as an expense
(that is, not included as part of the cost of closing inventory). This is
an important concept, because assuming that all standards were up
to date and approximating actual costs, the variances calculated
should in theory represent abnormal wastage that occurred.
Variances should therefore normally be expensed. However, if the
standard costs do not approximate actual costs, the variances may
not represent abnormal wastage, in which case the inventory may
need to be restated, by apportioning the variances between cost of
goods sold, work-in-progress and closing inventory. This
apportionment of variances is referred to as ‘pro-rating’ of variances,
which is discussed further in section 13.13.
Note that even though inventory is held in the accounting
records at standard cost, accounting standards and IFRS still require
inventory to be measured at the lower of ‘cost’ or ‘net realisable
value’. In the case of a standard costing system, ‘cost’ would be the
standard cost of inventory. If the net realisable value of inventory is
lower than the standard cost, a write-off of inventory would be
necessary.
We will now consider the accounting entries required to record
the costs in the accounting records using a standard costing system.
We will use a system which records all inventories (raw materials,
work-in-progress and nished goods) at standard cost. Any
variances (differences between standard and actual) will be debited
or credited to the relevant accounts, as shown below. In such a
system, cost of sales, work-in-progress and nished goods are

re ected at standard costs. Variances are transferred to the income
statement separately. What you should note when working through
the journal entries is the general principle that price variances are
normally isolated and journalised at the time the expense is incurred
(for example, purchase of material, payment of labourers, and so on),
whereas quantity variances are normally isolated and journalised at
the time of transfer into work-in-progress (that is, when materials are
transferred into the production process, when labourers are used in
the production process, and so on).
Example 13.11
examples. As previously stated, 1 300 bicycles were produced in October and 1 200
bicycles were actually sold. Therefore, there were 100 bicycles in closing inventory at
month end.
Required:
Prepare the standard costing journal entries for Specialised Cycles for October.
Notice that the organisation will transfer 100 bicycles (1 300

produced less 1 200 sold) as inventory into the next accounting
period. These bicycles should be re ected at the standard
manufacturing cost in the accounting records.
13.12.1 Raw materials

The organisation purchased and used 2 990 m of carbon bre at a
total cost of R1 495 000. The accounting entries are as follows:

The raw materials are recorded in the inventory control account at
standard cost, and the price variance is allocated to a variance
account (called ‘raw materials price variance’).
To produce the bicycles at standard cost, 3 250 metres of carbon
bre would be required at a standard cost of R1 300 000 in total. As
only 2 990 metres were used, there is a favourable variance of 260
metres. When raw materials are issued to the production department
(that is, to work-in-progress), the following entry is recorded:
In the example, all materials that were purchased were used in

production. If more was purchased than was required, the raw
materials purchased and not used would be carried forward in the
raw materials account at standard cost.
13.12.2 Components
The organisation purchased and used 1 430 component sets at a total
cost of R2 431 000. The accounting entries are as follows:

The components are recorded in the inventory control account at
standard cost and the price variance is allocated to a variance
account, which will be transferred to the income statement. To
produce the bicycles at standard cost, 1 300 component sets should
be required. As 1 430 component sets were actually used, there is an
unfavourable variance of 130 component sets. When component sets
are issued to the production department, the following entry is
recorded:
In the example, all component sets purchased were allocated to

production. If more were purchased than required, the component
sets purchased and not used would be carried forward in the
components control account at standard cost.
13.12.3 Semi-skilled labour

During the month, a total of 4 940 hours were worked by semi-
skilled employees at a total cost of R716 300. The accounting entries
are as follows:
The wages are recorded in the wages control account at standard

cost and the rate variance is allocated to a variance account (called
wage rate variance – semiskilled). To produce the bicycles at

standard cost, 5 200 semi-skilled labour hours should be required. As
only 4 940 hours were actually billed, there is a favourable variance
of 260 hours. The wages are therefore transferred to the work-in-
progress account as follows:
13.12.4 Skilled labour

During the month, a total of 2 860 hours were worked by skilled
employees at a total cost of R414 700. The accounting entries are as
follows:
The wages are recorded in the wages control account at standard

cost and the rate variance is allocated to a variance account (called
‘wage rate variance – skilled’). To produce the bicycles at standard
cost, 2 600 skilled labour hours should be required. As 2 860 hours
were actually billed, there is an unfavourable variance of 260 hours.
The wages are therefore transferred to the work-in-progress account
as follows:

13.12.5 Variable overheads
Variable overhead cost is driven by semi-skilled labour hours.
During the month, semi-skilled labour worked for 4 940 hours and
the total variable cost incurred was R95 000.
The variable overheads are recorded at standard cost and the

spending variance is allocated to a variance account (called ‘variable
overhead spending variance’). To produce the bicycles at the
standard input quantity, 5 200 semi-skilled labour hours should be
required. As actual semi-skilled labour hours amounted to 4 940,
there is a favourable variance of 260 hours. Therefore, the transfer of
variable overheads to work-in-progress looks as follows:
13.12.6 Fixed overheads

The two xed overhead variances will be treated differently. As we
are using an absorption costing system, the manufacturing related
overheads will be allocated to inventory. Non-manufacturing related
overheads will be treated as a period cost and expensed in the period
incurred. Fixed overhead cost is allocated based on semi-skilled
labour hours. During the month, semi-skilled labour worked for

4 940 hours. Remember that the allocation rate is R100 per semi-
skilled labour hour.
When the costs are incurred, the following journal entries will be
processed:
Factory xed overhead
Head of ce overheads ( xed)
The factory xed overheads are recorded at standard cost and the
spending variance is allocated to a variance account (called factory
xed overhead spending variance). To produce the bicycles at the
standard input quantity, 5 200 semi-skilled labour hours should be
required (1 300 bicycles × 4 hours each). Fixed overheads would
therefore be allocated to production based on the standard number
of hours that would be required to manufacture the actual number of
bicycles produced.
13.12.7 Revenue

The organisation sold 1 200 of the 1 300 bicycles in inventory at a
selling price of R5 700 each. Total revenue received in cash sales was
R6 840 000. The remaining 100 bicycles are still in inventory at the
end of the month and should be recorded in inventory at standard
cost. The rst entry we need to record is the sale of the 1 200 bicycles.
Note that unlike the cost variances, sales are not recorded at the
‘standard amount’, but rather brought to book at actual amounts. It
follows that sales variances are not recorded in the accounts. This is
because standard costing is essentially an inventory valuation
technique – revenue variances are calculated for decision-making
purposes only.
The next step is to transfer the completed bicycles from the work-in-
progress account to the nished goods account. In the example, all
1 300 bicycles manufactured were completed and therefore there was
no work-in-progress at the end of the month. We therefore transfer
the entire balance on the work-in-progress account to the nished
goods account. All 1 300 bicycles will be transferred at standard cost.
If there were bicycles that had not been completed at the end of the
month, the costs relating to these that had been allocated from the
various cost categories, depending on the level of completion, would
be left in the work-in-progress account at standard cost. They would
be transferred out of the account only once complete in the following
month.

R4 300 = standard manufacturing cost per unit (R1 000 [raw materials] + R2 000 [components] + R500
[semi-skilled labour] + R300 [skilled labour] + R100 [variable factory overheads] + R400 [ xed factory
overheads])
Finally, we need to transfer the costs of the bicycles that have been
sold from the nished goods inventory account to the income
statement. We therefore transfer the standard cost of 1 200 bicycles,
leaving the cost of 100 bicycles in the nished goods inventory
account at standard cost, effectively carrying the inventory items of
R430 000 into the following month. If the 100 bicycles are sold in that
month, their costs will be transferred to the income statement cost of
goods sold line item at that time.
The journal entries are summarised in the general ledger accounts as

per the table below:

The next step would be to draft the income statement. The pro t is
re ected below:
Specialised Cycles: income statement for the month of October
R R
Revenue (net of price and volume variance) 6 840 000
Less: Cost of sales (5 160 000)
Less: Unfavourable variances (1 001 800)
Raw materials price variance (299 000)
Components ef ciency variance (260 000)
Wage rate variance (semi-skilled) (98 800)
Skilled labour ef ciency variance (39 000)
Factory xed overhead spending variance (250 000)
Head of ce overhead spending variance (55 000)
Add: Favourable variances 734 800
Raw materials ef ciency variance 104 000
Components price variance 429 000
Semi-skilled labour ef ciency variance 32 500
Wage rate variance (skilled) 14 300
Variable overhead spending variance 28 500

Variable overhead ef ciency variance 6 500
Factory xed overhead production volume variance 120 000
Less: Head of ce overheads (100 000)
Actual pro t 1 313 000
You should notice that this pro t reconciles to the pro t calculated in
the Specialised Cycles examples that we have been using from the
start of the chapter (see example 13.1).

At the end of each period, the balances on the variance accounts are
either expensed in the period by transferring them to the income
statement as period costs (as was done in section 13.12 above) or, if
material, the variances could be capitalised to the cost of inventory
by allocating them between work-in-progress, nished goods
inventory and cost of sales. If standards are up to date and variances
are not material, they are likely to represent period over-ef ciencies
and in-ef ciencies, and therefore the suggested treatment is to
charge them to the period (directly to pro t and loss). This is
considered to be an appropriate treatment as inventory should be
valued on a normal activity basis, and should not include short-
term, non-recurring uctuations as such these may affect the
organisation adversely from a strategic and pricing perspective.
If, however, standards are not considered to be up to date, or if
uctuations are material or are likely to continue, the accounting
records prepared with standard costing are not a true re ection of
the economic reality of the transactions that occurred. Large
variances that are written off to the income statement may result in

inventory being either overstated or understated. Overstated
inventory that has been left unadjusted could cause the costs in the
income statement to be understated, resulting in an overstated pro t.
If material, this could be misleading to users of the nancial
statements. As mentioned, accounting standards generally require
restatement in such circumstances. Consideration should be given to
updating standards for future periods and the variances for current
periods should be re-allocated to the relevant accounts (work-in-
progress, nished goods inventory and cost of sales). The net effect
of reallocating such variances would be to allocate a portion of the
variance to inventories instead of directly to pro t and loss,
providing a better estimate of the actual value of inventory and a
better re ection of pro t for the period.
As mentioned in section 13.12, pro-rating – a combination of the
two approaches – can also be used, reallocating to the cost of
inventory some variances considered to meet the criteria, and
expensing other variances which are considered to re ect ef ciencies
and inef ciencies. Various methods of pro-rating are suggested in
modern texts.
Example 13.12
examples. It has already been established that the total semi-skilled labour variance
was R66 300 U. This was partly because Specialised Cycles paid these labourers
more per hour, resulting in an unfavourable rate variance of R98 800. This was offset
by the fact that the labourers were more ef cient in their work, which resulted in a
favourable ef ciency variance of R32 500.
Assume that it was discovered that the wage increases were due to a permanent
increase in the legislative basic wage rate in terms of the Basic Conditions of
Employment Act 75 of 1997. On the other hand, it was discovered that the increased
ef ciency was because all semi-skilled labourers worked through their lunch break for

the month of October in order to meet production demands owing to a tight deadline
for an order of bicycles that had come in.
Required:
Discuss the accounting treatment of the variances for semi-skilled labour and
journalise the resulting effect.
The ef ciency variance in example 13.12 appears to be short-term

over-ef ciency by semi-skilled labourers. It does not appear that the
standard should be changed in future, as we cannot expect labourers
to work through lunch on a permanent basis in order to be more
ef cient in a day’s work. Therefore, this appears to be an ‘abnormal’
non-recurring factor and should therefore not impact on the cost of
inventory. This variance should be treated as an expense and
charged directly to pro t and loss.
The rate variance, however, appears to be a permanent change in
the standard price for semi-skilled labour. It is not due to a short-
term uctuation in the rate, such as an exceptional overtime
payment. Therefore, on the assumption that the variance is material,
it appears that the rate variance should be allocated to the cost of
inventory. In future, Specialised Cycles would update the standard
rate for semiskilled labour in order to re ect the change.
The journal entries would be as follows:
The above journal entry re ects transferring the ef ciency variance

for semi-skilled labour out of the variance control account and
charging the amount directly to the income statement.
The journal entry below re ects the transfer of the rate variance
out of the variance control account and the allocation of this amount

to the cost of inventory:
Note that the split between cost of sales and nished goods
inventory is calculated as (1 200/1 300 × R98 800 = R91 200) for cost
of sales and (100/1 300 × R98 800 = R7 600) for nished goods
inventory. This is because the ef ciency variance must be allocated
to the units of production which caused the variance, which were
1 300 units of production for the month of October. Of these 1 300
units, 1 200 have already been sold and the variance relating to these
units must therefore be allocated to cost of sales. Further, of the 1 300
units, 100 are still on hand and so the pro rata portion of the variance
that relates to these 100 units must be allocated to nished goods
inventory.
Standard costing has not kept pace

13.14.1
with the changing complexity of

operations and cost structures
Standard costing has been in use since the start of the industrial
revolution – an environment very different from that of today. These
days, products are more complex. Direct labour no longer comprises
the major cost category in many manufacturing organisations and

production runs are shorter, yet standard costing has remained
largely unchanged.
When manufacturing complexity increases, the investigation of
and assignment of responsibility for variances become dif cult and
require a great deal of diligence and care. A complex manufacturing
process generally involves a higher level of investment in specialised
equipment, leading to a shift in the composition of the cost base to a
more xed cost structure, which makes standard costing less
relevant (the analysis of a xed cost variance is relatively
straightforward).
Standard costing encourages

13.14.2
dysfunctional behaviour
A further argument against the use of standard costing is that it
emphasises nancial performance measures that tend to motivate
managers to manage the short-term nancial results rather than the
processes that add value and contribute to the organisation’s long-
term pro tability.
For example, types of dysfunctional behaviour encouraged by a
standard costing system include the following:
1 Creating excess direct materials (because buying in bulk can have a
positive impact on the materials price variance)
2 Using many different suppliers (because shopping around can have
a positive impact on the materials price variance)
3 Buying low-quality materials (because they are often cheaper and
have a positive impact on the materials price variance)
4 Creating excess inventory (in an absorption costing system, this has
a positive effect on the production volume variance)

All of these problems are indicative of a traditional ‘push’ system
rather than a just-in-time or ‘pull’ system driven by demand. This
has the effect of de-emphasis-ing quality and promoting competitive
behaviour among employees and production department managers.
From the perspective of the just-in-time philosophy, this behaviour
creates waste and promotes non-value adding activities (see Chapter
16, Contemporary management accounting concepts).
Standard costing does not incentivise

13.14.3
good performance
Another criticism of standard costing is that it emphasises the
achievement of a pre-determined standard – once this standard has
been reached, the system does not effectively incentivise additional
improvements. Target costing is superior in this regard.
Weighing the benefits of standard

13.14.4
costing
In defence of standard costing, we can argue that it provides a
powerful planning device and a macro performance-monitoring
system that allows middle and upper-level managers to see the big
picture on a periodic basis. The correct implementation of a standard
costing system is the key to overcoming the criticisms mentioned
above. If other non- nancial performance measurements are used in
conjunction to guide and evaluate lower-level managers, then
standard costing can still play an important role in the overall
management of the organisation, even in a just-in-time environment.
From this perspective, it is just a matter of developing a balanced
system that does not overemphasise any particular aspect of

performance, takes non- nancial factors and a variety of measures
into account, and does not emphasise performance over the short
term to the detriment of the organisation over the long term.
We should always bear in mind that standard costing was
designed as an internal, not an external, control measure.
Performance measurement systems ought to consider the impact of
customers, competitors and other external factors in addition to the
internal cost control measures implemented – this is further
discussed in Chapter 14, Performance management.
Surveys have indicated that the majority of manufacturing rms
use some form of standard costing. It is important to recognise and
remember that where people are involved, performance
measurement systems measure behaviour, but also simultaneously
in uence behaviour.
Standard costing as a control system is best used at the middle-
management level as an overall monitoring device, where monthly
aggregated actual costs are compared with estimates of what these
costs should have been. Standard costing can create problems if it is
used as a way to micro-manage in a top–down fashion, particularly
for organisations which adopt the bottom–up, employee
empowerment, self-managed team concepts associated with just-in-
time and the theory of constraints (see Chapter 16, Contemporary
management accounting concepts).
Variance analysis in modern

13.15
mechanised environments
13.15.1 Impact of cost drivers

We have concentrated up to now on a costing system where
overheads are mainly driven by labour hours. When looking at a
highly mechanised and automated factory environment, a similar
standard costing exercise can be used. Some pre-determined basis is
used to apply the overhead to production. However, in a highly
mechanised environment, we must give particular thought to the
‘cost driver’. The cost driver is the factor that is viewed as causing
costs to be incurred within an organisation. In the examples above,
direct labour hours were viewed as the primary cost driver and the
basis for assigning overheads. Labour hours may not be the most
signi cant cost driver in a mechanised setting. Machine hours,
number of set-ups, time in production or number of assembly steps
could each provide a potentially logical base for allocating overhead
(refer to Chapter 6, Overhead allocation).
These types of drivers are also typically used in an activity-based
costing environment, and it is important to remember that xed
overheads can be driven by an array of drivers in a manufacturing
environment. Although the Specialised Cycles example assumed
that semi-skilled labour hours were the cost driver, any other basis
may be considered more appropriate. The principles behind the
calculations as discussed in this chapter will, however, remain the
same. Therefore, in our Specialised Cycles example, variable
overheads might have been allocated based on, say, machine hours
instead of direct labour hours. The variable overhead ef ciency
variance would then have measured the difference between machine
hours spent versus machine hours that should have been spent,
given the output (instead of comparing labour hours).
13.15.2 ‘McDonaldisation’

In modern businesses, many organisations have produced
homogeneous products, for example motor manufacturers which
mass produce standard models, chassis, engines, and so on. The
pinnacle example in this regard is McDonalds, a company often
associated with the concept of uniform operations and ef ciency. Its
standardised machinery, uniform packaging, pre-cut cheese, bread,
burger patties and even pre-prepared phrases such as ‘Welcome to
McDonalds’ and ‘Have a nice day’ make for a consistent operation in
every aspect. In such environments, it is easier to set pre-de ned
standards as there is uniformity within the product and service
speci cations. This uniformity leads to potentially greater ef ciency
and cost savings. If the operations are uniform and can be forecast
with a high degree of accuracy, it also makes it easier to assess the
performance using standard costing. From a customer’s perspective,
this ‘McDonaldisation’ phenomenon is often wel-comed, as
customers know what to expect from what they are buying, leading
to reassurance and brand recognition.
Despite its distinct advantages and ef ciencies, the modern
business environment can lead to demotivation among staff who feel
the work is dull and boring, and can frustrate innovation or
creativity from workers.
Standard costing in service

13.16
organisations
There are a number of characteristics of service organisations that
make them quite different from manufacturing organisations.
Service organisations are renowned for being xed overhead-
intensive in their cost structures, particularly in respect of a large
salary bill (examples are airlines, nancial services,

telecommunications service providers, audit services, and so on). In
service environments, the ‘product’ is not a physical, but is
intangible. In addition, the product cannot be stored (for example, in
the case of a vacant seat on an aeroplane, if the seat is not sold today,
it cannot be booked into inventory and sold tomorrow). Services are
also normally heterogeneous, in that the service could vary each
time it is delivered (for example, the same hairdresser does not
necessarily cut the same style identically every time). For these
reasons, standard costing is often considered more dif cult to apply
within the service environment.
There are some interesting applications of standard costing
within service environments, for example in the healthcare industry,
the accountancy profession and even the retail sector.
In the healthcare environment, the so-called diagnostic-related
group system has been implemented, whereby medical conditions
have been classi ed into hun-dreds of groups (referred to as DRGs),
which are expected to have similar hospital resource requirements –
the premise being that similar medical conditions require the same
or similar healthcare treatment. In such a way, the attempt is made to
‘standardise’ healthcare. This system enables healthcare providers to
standardise their resources in terms of medication, patient treatment,
consultancy services, and wards or beds required, as well as for
medical insurance claims purposes. Of course, critics of this system
argue that healthcare is about providing patient care and not about
applying standardised treatments.
In the accountancy profession, for example, the effects of
changing the staff mix (such as articled clerks, audit managers, and
audit partners) required to complete a certain task can be analysed
using mix and yield variances. Mix and yield variances are discussed
further in the appendix to this chapter.

In a competitive business environment, organisations strive for a
competitive advantage. One way to achieve this is through the use of
benchmarking, which is the process of comparing your own
organisation’s performance to another organisation considered to be
the market leader in the industry. Benchmarking can also involve
comparing performance internally between departments, or even
against hypothetical ‘best practice’. Refer to Chapter 16,
Contemporary management accounting concepts.
An organisation can choose to set its standards at the benchmark
levels, meaning variances will show the difference between actual
performance and the ‘best-in-business’ performance benchmark.
13.18 Summary
This chapter introduced the usefulness of standard costing as a
performance management tool, a planning and decision-making
tool, and an inventory valuation technique. The chapter also
described how price and usage variances for labour, materials,
overheads and revenue are calculated. When variances are deemed
material, they are investigated in order to evaluate past performance
and improve future performance. It is important to understand not
only how variances are recorded in the accounts but also how to
interpret them, as well as the shortcomings of a standard costing
system.
In the appendix to this chapter, we investigate some more
advanced standard costing concepts such as further revenue
variances, as well as mix and yield variances. In addition, we further
analyse the labour ef ciency variance through the idle time variance.

Conclusion: Standard costing and other
topics in this book
In Chapter 12, Budgets, planning and control, the practice of budgeting
as a means of controlling operations was discussed. Note that
standard costs are effectively a ‘per unit’ budget: they express how
much one unit of a product or service ought to cost according to pre-
determined standards.
In the next chapter (Chapter 14, Performance management), the
concept of evaluating performance based on performance
measurement systems (such as standard costing systems) is explored
further.
Chapter 5, Absorption versus variable costing and Chapter 6,
Overhead allocation were critical to the discussions in this chapter.
Speci cally, the choice between variable and absorption costing
affects the manufacturing xed overhead variance. The total
manufacturing xed overhead variance equals the over- or under-
recovery of xed manufacturing overheads.
In Chapter 16, Contemporary management accounting concepts and
Chapter 17, Competitive advantage, some techniques are discussed
that clash, in principle, with the traditional standard costing
approach, because they place a strong emphasis on value creation.
These include just-in-time systems, activity-based management, and
value chain analysis. Chapter 16 also discusses benchmarking, a
concept that can be used in conjunction with standard costing, as
explained in section 13.17.
Tutorial case study: GlaxoSmithKline plc

GlaxoSmithKline (GSK) plc is a global business which researches, develops and
manufactures innovative pharmaceutical medicines, vaccines and consumer health
products. Its South African operation, GSK SA, situated in Byanston, Johannesburg
and Epping, Cape Town, manufactures and supplies some of the world’s best-loved
consumer healthcare brands such Sensodyne, Aquafresh, Voltaren and Eno. The
costing system implemented at the GSK Group is a hybrid of job-order costing and
standard costing – with most of the emphasis on standard costing and variance
analysis. The implementation of the costing system results in an accurate allocation
of costs for the product costing of its well-known brands, which provides the ability
to measure and highlight materials, labour and overhead variances.
SOURCE: GSK (2019)
From the information above, explain what bene ts GSK has gained from its
standard costing system.
1 Discuss considerations on which the GSK might have based the standards.
2 Suggest how GSK might decide which variances to investigate further.
3 Name some possible causes if GSK reports a favourable direct materials price
variance.
4 Name some possible causes if GSK reports an unfavourable direct labour
ef ciency variance.
5 Name some possible causes if GSK reports an unfavourable variable overhead
spending variance.
6 Advise GSK on how frequently the standards ought to be revised.
Appendix 13.1: Advanced standard

costing concepts
The Specialised Cycles example in this chapter has up to this point
dealt with an organisation that produces and sells only one product
(the Madone XXI bicycle) that is manufactured using speci c direct
materials and direct labour. In this appendix, we will extend our
analysis by adding multiple products, resulting in different possible
mixes of product sales. We will also add different possible direct
materials inputs, resulting in different possible mixes of direct
materials. Adding such complexity will result in new variances that

can be calculated: sales mix and sales quantity variances; and direct
materials mix and direct materials yield variances. When discussing
the sales quantity variance, we will also introduce market share and
market size variances.
Revenue variances: sales mix and sales quantity

variances
Key terms: sales mix variance, sales quantity variance
Organisations do not necessarily produce and sell only one product

as does Specialised Cycles, the organisation used in the examples in
this chapter so far. Organisations may produce and sell a number of
different products (or deliver a number of different services), supply
various models with different speci cations, and perhaps
manufacture complementary or even unrelated products. Such
products may also each have different gross margins. In such an
environment, changes in the sales price or quantity of one product
may impact on the sales of the organisation’s other products, either
positively or negatively, thereby affecting the pro tability of the
organisation as a whole. In these types of scenarios, it is therefore
important to extend our standard costing analysis of revenue
variances by further breaking up the sales volume variance into sales
mix and sales quantity variances.
The sales mix variance measures the impact from the actual sales
mix being different from the standard sales mix (in other words,
relatively more or less of a product was sold compared with the
others, than the organisation had planned), and the sales quantity
variance measures the impact of the actual sales volume being
different from the planned volume, while holding the sales mix
constant at the standard level. Like the sales volume variance

discussed in section 13.5.2, these further variances can be calculated
at sales price level, contribution level or pro t level.

In order to illustrate sales mix and quantity variances, the Specialised Cycles example
in this chapter will now be extended by adding an additional product offering to the
organisation, the Saneone XXI, a lower speci cation bicycle, which is priced below the
Madone XXI and will compete directly for sales with it. The marketing strategy of the
organisation is to sell the Madone XXI bicycle to elite athletes who are willing to spend
extra to get a higher speci cation bicycle, and to sell the Saneone XXI to less serious,
more price-sensitive riders who want the exclusivity of the brand, but do not need the
superior speci cation.
The Madone XXI information has already been given earlier in this chapter.
The Saneone XXI bicycle is produced from a mixture of carbon bre and
aluminium.
These two raw materials are interchangeable to some extent – in other words, the
one can be substituted for the other to a certain extent. The aluminium is cheaper to
use, although it is heavier, making the bicycles heavier when more aluminium is used.
The Saneone XXI division decided to use relatively more carbon bre compared with
aluminium in their raw materials mix in October to try to keep the Saneone XXI
bicycles as light as possible. There were no work-in-progress or completed Saneone
XXI bicycles in opening or closing inventory for October. The sales details for the
month of October are as follows (note that the budgeted sales gures of Madone XXI
are different from the example in the chapter):

Required:
Calculate revenue variances in as much detail as the information permits.
At rst glance, it appears as if the organisation has performed better

than expected by selling an additional 100 bicycles in total. It
appears that the sales of Madone XXI have under-performed by 300
bicycles (1 500 unit sales budgeted compared with 1 200 unit sales
actually made), and that the Saneone XXI has over-performed by 400
units (500 unit sales budgeted compared with 900 unit sales actually
made). It appears as if the decision to use more carbon bre in the
Saneone XXI bicycle has stimulated sales of the Saneone XXI (900
bicycles sold compared to budget of 500), possibly because of the
lighter-weight frame. It also appears that the increased popularity
and demand for the Saneone XXI bicycle arises from a decrease of
the sales price from the budgeted R3 800 to R3 600 per unit.
Note: You will remember in that revenue variances can be

calculated at price level, contribution level or pro t level. In the
example in the chapter, under an absorption costing system, the

sales volume variance was demonstrated at price level, and it
was mentioned that calculating the sales volume variance at
pro t level would also be appropriate (this was also
demonstrated through the ‘volume variance’ in example 13.1).
In order to illustrate the calculation of sales variances at
contribution level, for this example only, assume that a variable
costing system is operated by Specialised Cycles. In this
example, we will then show the calculation of sales variances at
sales price and at contribution level.
The sales price and quantity variances are calculated as follows:
The combined effect of the sales price and sales volume variances
Sales price variance R60 000 F

Sales volume variance at sales price level R130 000 U
Static budget variance at sales price level R70 000 U

Note that R70 000 equals the total difference between budgeted sales
and actual sales (R10 080 000 – R10 150 000).
The sales volume variance can also be calculated at contribution
level under a variable costing system:
*Contribution per unit = sales price per unit – variable costs per unit. You should check that you can calculate
the standard contribution given for the Madone XXI bicycle from the information in the previous examples in
the chapter related to Specialised Cycles (R1600 = R5 500 sales price – R1 000 raw material – R2 000
components – R500 semi-skilled labour – R300 skilled labour – R100 variable overheads). The contribution
information for the Saneone XXI is speci c to this example only.
The sales price variance arises from the difference between the actual
sales price and the standard sales price, using actual quantities. The
sales volume variance (as shown here at contribution level) re ects
the difference between the actual and the budgeted sales volumes,
using the standard contribution, in other words, what the net effect
on the contribution of the company is due to selling more or fewer
bicycles. There is an unfavourable sales volume variance of R80 000
at contribution level, which is unexpected, considering that the total
sales volume of the two products was more than expected by 100
units (2 100 actual bicycle sales compared with 2 000 budgeted
bicycle sales). This unfavourable variance has occurred because there
were proportionately fewer than expected sales of one product (the
Madone XXI) and proportionately more than expected sales of the
other product (the Saneone XXI). The overall effect of this in
currency was negative. To understand this, our next step is to break
the sales volume variance down further and explore the mix and

quantity variances of these sales. The sales mix variance at
contribution level is as follows:
*Notice that this column calculates the percentage of each type of bicycle that should have been sold
according to the standard mix. 1 500 out of 2 000 bicycles (75%) should have been Madone XXI, while 500
out of 2 000 bicycles (25%) should have been Saneone XXI.
Only 57,1% (1 200/2 100 = 57,1%) of the bicycles actually sold were
Madone XXI, compared with the budgeted 75% (1 500/2 000).
Because Madone has the higher standard contribution (R1 600
compared with Saneone’s R1 000), this has resulted in a negative
total sales mix variance.
Next we compare the actual quantity at standard mix to the
standard quantity at standard mix to determine the sales quantity
variance component of the sales volume variance. The sales quantity
variance shows us the effect of the sales quantity having been
different from the planned quantity. To isolate this aspect, the sales
mix is held constant in the calculation. We expect this variance to be
favourable, as we know that in total 100 more bicycles were sold
than planned. The sales quantity variance is as follows:

This combined effect of the sales mix and sales quantity variances
Sales mix variance at contribution level R225 000 U

Sales quantity variance at contribution level R145 000 F
Sales volume variance at contribution level R80 000 U
Splitting the sales volume variance into a sales mix variance and a
sales quantity variance has allowed us to see how a shift in the
relative mix of products (Madone XXI from a planned 75% to 57,1%
and Saneone XXI from a planned 25% to 42,9%) and a shift in the
actual quantity of sales (2 100 – 2 000) has affected pro tability. The
sales mix variance has shown that because the mix of bicycles moved
towards the Saneone XXI, which has a lower contribution than the
Madone XXI, an unfavourable variance has arisen. The sales
quantity variance, in turn, has indicated the effect of having sold 100
bicycles more in total, given the planned mix of products.
Although the total Saneone XXI sales have made more pro t than
expected, this has been at the expense of Madone XII sales, which
has resulted in lowered pro tability for the organisation as a whole
because Saneone XXI has a lower contribution than Madone XXI.
Because of this difference in contribution, from a purely quantitative
perspective, the organisation should actually have attempted to
maximise sales of the Madone XXI.
Market share and market size variances

Key terms: market share variance, market size variance
Should the required information be available, the sales quantity

variance can be further divided into a market share variance and a

market size variance. These variances re ect whether the
organisation has achieved greater sales by capturing a larger share of
the market, or whether the organisation has increased (or decreased)
sales because of an increase (or decrease) in the total market size.

The information on Specialised Cycles given in the chapter and in appendix example
13.1 still applies. In addition, the following information is available: the total budgeted
industry sales was 20 000 bicycles for the month of October, and the actual industry
sales volume for October was 14 000 bicycles.
Required:
Calculate the market share and market size variances at contribution level for October.
The organisation planned to have a 10% market share (2 000 total

budgeted bicycle sales by Specialised Cycles/20 000 total budgeted
industry sales), but in fact had an actual market share of 15%
(2 100/14 000). The market share variance is as follows:
*This is calculated as the total budgeted contribution for October (see appendix example 13.1) of R2 900 000
divided by 2 000 (the total number of bicycle sales budgeted for October).
The market share variance is favourable, because Specialised Cycles

managed to capture a larger share of the market than planned. The
market size variance is as follows:

The combined effect of the market share and market size variances
Market share variance at contribution

R1 015 000 F
level
R870 000
Market size variance at contribution level
U
Sales quantity variance at contribution
R145 000 F
level
Note that we have continued to calculate these variances at

contribution level to show how they together make up the sales
quantity variance (which was calculated at contribution level).
However, you may prefer to calculate the market share and market
size variances at sales price level instead.
The market share variance indicates the effect of the actual
market share of 15% being higher than the planned 10%, resulting in
a favourable variance of R1 015 000. It indicates that management
performed well in a dif cult (declining) market, by capturing more
market share. Meanwhile, the market size was smaller than
anticipated (20 000 compared with 14 000 units), resulting in an
unfavourable market size variance of R870 000. Such a variance
would presumably be largely outside the control of management, as
it affects the entire industry. The net variance is R145 000, which is
the sales quantity variance we have already calculated.
Production mix and yield variances

Key terms: mix variance, yield variance
In this chapter, we have investigated direct materials price and usage

variances. In many industries, there are several direct materials that
are interchangeable that combine to make a product. Notice that our
Specialised Cycles example, where only the Madone XXI was
manufactured, featured (as far as materials were concerned) only
direct raw materials (carbon bre) and components. These were not
interchangeable – carbon bre could not be substituted in any way
for any of the components, or the other way around. However, now
that we have introduced the Saneone XXI bicycle the frame of, which
is made of a mixture of carbon bre and aluminium that can be
interchanged to some extent, the issue of direct materials mix and
yield variances arises. The Saneone’s frame can have varying
combinations of carbon bre and aluminium, with the same product,
a Sameone XXI bicycle frame, being produced. The aluminium is
cheaper than carbon bre, but is inferior in the production of
bicycles as it is heavier. A lighter bicycle usually performs better.
There is therefore a trade-off between a more expensive raw material
(carbon bre), and a better product in the form of a lighter bicycle.
The mixture of direct materials actually used compared to the
standard mix is re ected in the direct materials mix variance.
The absolute amount of materials required to produce a frame
can also change, depending on the mix of carbon bre and
aluminium. As more carbon bre is added, a smaller total quantity
of material is required (therefore there is a better yield from a
standard costing perspective). The number of bicycles yielded by the
production process, given the standard mix of direct materials, is
re ected in the direct materials yield variance.

Together the direct materials mix variance and the direct
materials yield variance make up the direct materials usage
variance, which we have already dealt with in the chapter.
The same logic applies to direct labour where one or more types
of labour are interchangeable. In such circumstances, the direct
labour ef ciency variance can be split into a direct labour mix and a
direct labour yield variance.

This example follows from the previous examples. The Saneone XXI is produced from
a mix of carbon bre and aluminium. The standard is that each frame should be
manufactured using 1 m of carbon bre and 2 m of aluminium, but the two materials
are interchangeable to some extent. Carbon bre is available at a standard cost of
R400 per metre, while the standard cost of aluminium is R100 per metre.
The division used 1,5 m of carbon bre and 1 m of aluminium per frame in October.
The carbon bre was purchased at a cost of R410 per metre, and the aluminium at a
cost of R85 per metre.
Specialised Cycles budgeted to sell 500 Saneone XXI bicycles and actually produced
and sold 900.
Required:
Calculate the direct raw materials price and ef ciency variances, and split the
ef ciency variance into its mix and yield components for the Saneone XXI.
Exhibit 13.1 Direct materials price and usage variances

The actual quantities above are obtained by multiplying the actual
number of units by the actual number of metres used (900 units × 1,5
m and 900 units × 1 m). The standard quantities are obtained by
determining how much should have been used to produce 900
bicycles (900 units × 1 m and 900 units × 2 m). Note that, although
carbon bre had a negative price variance of R13 500 (R553 500 –
R540 000), this was cancelled out by a positive price variance of
R13 500 (R90 000 – R76 500) for aluminium.
The direct raw materials usage variance is unfavourable because
the actual total quantity at the standard price (R630 000) exceeded
the standard quantity at the standard price (R540 000).
Direct materials mix variance

The materials mix variance arises when the mix of raw materials
varies from the standard pre-determined mix of 1 m of carbon bre
to 2 m of aluminium. The Saneone XXI product line produced a
higher speci cation bicycle by increasing the quantity of carbon bre
relative to aluminium in the mixture. The raw materials mix variance
for the Saneone XXI can be calculated as follows (notice the
similarities to the sales mix variance calculation):

The mix variance is unfavourable because relatively more of the
expensive carbon bre was used than planned (1,5/2,5 m or 60%
instead of 1/3 m or 33,33%).
The variance therefore indicates that the mix of raw materials
changed, as more carbon bre was used, resulting in an
unfavourable variance of R240 000. Less aluminium was required as
a result, but the saving re ected in the R60 000 favourable variance
was not suf cient to offset the additional cost of the more expensive
raw materials, resulting in an overall unfavourable variance of
R180 000. It should be noted that mix variances are calculated using
standard prices to ensure that any price effect is removed from the
calculation. An additional advantage of the change in the mix of raw
materials is an increase in quality, in the form of a lighter bicycle,
which would presumably be more marketable, possibly resulting in
favourable sales variances for the product line. When interpreting
the variance, we therefore need to compare the effect of the
unfavourable mix variance to the bene t gained from any additional
sales as a result of the increased quality. We also need to consider
any other effects of the change on the business (for example, in this
case, sales of the Madone XXI were impacted negatively by the
growth in sales of the Saneone XXI.) This effect needs to be taken
into consideration when considering the total effect of the change on
the entire business.

Direct materials yield variance
The materials yield variance arises from the difference between the
total materials used (at the standard mix) and the total materials that
should have been used (at the standard mix), given the output
achieved. Specialised Cycles has a standard input of 3 m of total raw
materials to produce one Saneone XXI frame, with a standard mix of
1 m of carbon bre to 2 m aluminium. The October actual results
re ected an actual total raw materials input of only 2,5 m of raw
materials to produce one frame (lower by 0,5 m), in the proportion of
1,5 m of carbon bre to 1 m of aluminium. We therefore expect a
favourable yield variance, as less input was required to yield a
bicycle.
The direct materials yield variance is calculated as follows:
The yield variance is favourable because less material was used than
planned in October.
Notice how the sum of the direct materials mix and yield
variances equals the direct materials usage variance (R180 000 U +
R90 000 F = R90 000 U).
Notice also that, although we calculated the price and usage
variance (and its mix and yield components) in total here, we could
also calculate the variances for only one of the materials at a time.
For example, we could read off the exhibits that the usage variance

for carbon bre speci cally is R180 000 unfavourable (R360 000 −
R540 000), consisting of a R240 000 unfavourable mix variance and a
R60 000 favourable yield variance.
Labour variances: mix and yield

Where direct labour is interchangeable (for example, if the Saneone
XXI makes use of both semi-skilled and skilled labourers and they
can to a certain extent perform each other’s work), the direct labour
ef ciency variance can be split into direct labour mix and yield
variances in the same manner as shown above for direct materials.
Labour variances: idle time

Key terms: idle time variance
Various reasons for unfavourable labour variances were discussed in

the chapter, for example quality of staff, experience levels, the
learning curve effect, capacity, relationship factors and the work
environment.
Another possible factor that could affect labour variances is how
much of labourers’ time at work is spent actively working. For
example, we may expect that labourers should spend 80% of a
working day physically working on the product or service. This
expectation could be based on, for example, past experience,
industry norms or time-and-motion studies. Of course, we can
hardly expect labourers to spend 100% of a workday physically
working, as this would mean that labourers never stop for lunch or
comfort breaks, or that there is no down time or expected stoppages
in the factory whatsoever.

However, although we may expect labourers to spend, say, 80%
of their clocked hours working, unexpected stoppages, strikes,
inef ciencies, down time and go-slows that had not been originally
anticipated may occur, with the result that labourers may possibly
spend less than 80% of the workday actively working.
The difference between the hours that we expect labourers to
work actively and the hours that they actually work actively is called
idle time. It is possible to measure the rand value of how much this
idle time costs an organisation by calculating an idle time variance.
It is expressed in terms of the standard rate for labour.
Note that the idle time variance is a subcomponent of the labour
ef ciency variance and is thus also an example of a planning
variance, in that it splits out from the total labour ef ciency variance
that portion of the variance which is related to labourers’ idle time.
The balance of the labour ef ciency variance (after removing the idle
time variance) would thus be attributed to factors other than labour
idleness.
The operating labour ef ciency variance is therefore 2 431 hours
(2 860 h – 429 h), and ((2 431 h – 2 600 h) × 150) gives a R25 350
favourable variance. Together with the R64 350 unfavourable idle
time planning variance, this gives the R39 000 unfavourable total
labour ef ciency variance (example 13.6).

Assume that the information is the same as in the chapter examples for Specialised
Cycles.
Semi-skilled labour is used in the manufacturing process, and four hours of labour
are required at a cost of R125 per hour. Skilled labour is then used to t all of the
components onto the frame and to apply nal nishes to the bicycle. Two hours of
skilled labour are required, at a standard cost of R150 per hour.

Assume that all workers are expected to spend 80% of their time at the factory
actively working. This is considered normal for the industry. However, because of
lower than expected salary increases, skilled labourers went on a ‘go-slow’ in protest
strike action for a few days during October, resulting in only 65% of the total hours
clocked by the skilled labourers being spent actually working on the bicycles.
Required:
Calculate and interpret the idle time variance that may exist for October.
You should remember from the previous examples in the chapter

that, in total, the skilled labourers clocked 2 860 hours in October.
The expected number of hours that these labourers should have
actively worked is therefore 2 288 (2 860 × 80%). However, because
of the strike action, the skilled labourers actively worked for only
65% of the hours clocked, which is 1 859 hours (2 860 × 65%). In
other words, the labourers were idle for 429 total hours (2 288 –
1 859).
If we express these hours at the standard wage rate of skilled
labourers, being R150 per hour, we can conclude that the 429 hours
of idle time cost the organisation R64 350 (R150 × 429) in total. This is
the idle time variance.
Note: There is some debate around the rate that should be used
when calculating the idle time variance. In this example, we
used R150 per hour being the standard rate per hour for skilled
labour. Some argue that because the 429 hours represents idle
labour hours, that is, hours that the labourers were not
physically working on the product even though they were
expected to be, the rate that should be used should be a rate
that labourers are paid per non-idle hour. The R150 is a rate per
clocked hour, which means that they are paid R150 for each
hour clocked while at work whether they are physically working

or not. Therefore, those in support of this view say that the rate
to be used should rather be R187,50/hour (R150/80%) which
re ects the standard rate of how much labourers should be paid
for each hour they are expected to be physically working. The
amount of R187,50 can also be calculated as total budgeted
labour cost (R300 000) divided by expected active working
hours for October (2 000 budgeted labour hours × 80% = 1 600
active working hours) = R187,50/hour.
Basic questions
BQ 1
Operation B in a factory has a standard time of 15 minutes. The
standard rate of pay for operatives is R10 per hour. The budget for a
period was based on carrying out the operation 350 times. It was
subsequently realised that the standard time for Operation B
included in the budget did not incorporate expected time savings
from the use of new machinery from the start of the period. The
standard time should have been reduced to 12 minutes.
Operation B was actually carried out 370 times in the period in a
total of 80 hours. The operatives were paid R850. What is the
operational labour ef ciency variance?
a) R60 adverse
b) R75 favourable
c) R100 adverse
d) R125 adverse
BQ 2

SOURCE: ADAPTED FROM CIMA P1 – MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION
Which of the following describes a exible budget?
a) A budget which, by recognising different cost behaviour
patterns, is designed to change as volume of activity changes
b) A budget for a 12-month period which includes planned
revenues, expenses, assets and liabilities
c) A budget which is prepared for a rolling period which is
reviewed monthly and updated accordingly
d) A budget for semi-variable overhead costs only
BQ 3
The following data have been extracted from the budget working
papers of WR Ltd:
Activity (machine hours) Overhead cost R
10 000 13 468
12 000 14 162
16 000 15 549
18 000 16 242
In November, the actual activity level was 13 780 machine hours and
the actual overhead cost incurred was R14 521. What is the total
overhead expenditure variance for November?
BQ 4
SW manufactures a product known as the TRD100 by mixing two
materials. The standard materials cost per unit of the TRD100 is as
follows:

Material X 12 litres @ R2,50 = R30
Material Y 18 litres @ R3,00 = R54
In October, the actual mix used was 984 litres of X and 1 230 litres of
Y. The actual output was 72 units of TRD100. What is the total
materials mix variance for October?
BQ 5
Refer to the information given in BQ 4 above. What is the total
materials yield variance for October?
BQ 6
X Ltd operates a standard costing system and absorbs xed
overheads on the basis of machine hours. Details of budgeted and
actual gures are as follows:
Budget Actual
Fixed overheads R2 500 000 R2 010 000
Output 500 000 units 440 000 units
Machine hours 1 000 000 hours 900 000 hours
What is the xed overhead expenditure variance?

a) R190 000 favourable
b) R250 000 adverse
c) R300 000 adverse
d) R490 000 favourable
What is the xed overhead volume variance?

a) R190 000 favourable
b) R250 000 adverse
c) R300 000 adverse
d) R490 000 favourable
BQ 7
D Ltd manufactures and sells musical instruments, and uses a
standard cost system. The budget for production and sale of one
particular drum for April was 600 units at a selling price of R72 each.
When the sales director reviewed the results for April in the light of
the market conditions that had been experienced during the month,
she believed that D Ltd should have sold 600 units of this drum at a
price of R82 each. The actual sales achieved were 600 units at R86 per
unit. What are the following variances for this particular drum in
April?
a) Sales price planning variance
b) Sales price operating variance
BQ 8
PQR Ltd operates a standard absorption costing system. Details of
budgeted and actual gures are as follows:
Budget Actual
Sales volume (units) 100 000 110 000
Selling price per unit R10 R9,50
Variable cost per unit R5 R5,25
Total cost per unit R8 R8,30

a) What is the sales price variance?
b) What is the sales volume variance at pro t level?
BQ 9
Why is there no production volume variance for xed costs in a
variable costing system?
BQ 10
The section 13.14 entitled ‘Criticisms of standard costing’ includes
the following sentence:
When manufacturing complexity increases, the investigation of

and assignment of responsibility for variances become very
dif cult and require a great deal of diligence and care.
a) Why is it so important that variances should be assigned to the

correct person and why is this not a straightforward task?
Long questions

The newly appointed managing director of FX has received the
variance report for month 6, which is shown below:
Month 6 variance report
Output and sales for month 6: budget – 1 000 units; actual – 1 200 units

Background information (not seen by the managing director)
The report did not include any other information. Details relating to
the company and the product that it makes are given below:
• FX produces one type of product. It operates a variable costing
system. The standard unit cost and price of the product is as
follows:
R R
Selling price 250
Direct materials (5 kg at R20/kg) 100
Direct labour (4 hours at R10/h) 40
Variable overheads (4 hours at R5/h) 20 160

Contribution 90
• The variable overhead absorption rate is based on direct labour

hours.
• The company has budgeted xed overheads of R70 000 per
month.
• Budgeted sales and production levels are 1 000 units per month.
Month 6
The company has just completed month 6 of its operations. Extracts
from its records show the following:
• 1 200 units were produced and sold.
• The actual direct materials purchased and used were 6 300 kg,
costing R132 300.
• The actual direct labour hours worked were 5 040 hours.
REQUIRED Marks
(a) Prepare a report for the managing director of FX that explains and interprets the month 6
variance report. The managing director has recently joined the company and has very little 17
previous nancial experience.
The managing director was concerned about the materials price variance and its cause. He discovered that
a shortage of materials had caused the market price to rise to R23 per kg.
(b) In view of this additional information, calculate for direct materials:

(i) the total variance
(ii) the planning variance
(iii) the two operational variances. 7
(c) Discuss the advantages and disadvantages of reporting planning and operational variances.
6
Your answer should refer, where appropriate, to the variances you calculated in (b) above.
TOTAL MARKS 30

WC is a company that installs kitchens and bathrooms for customers
who are renovating their houses. The installations are either pre-
designed ‘off the shelf’ packages or highly customised designs for
speci c jobs.
The company operates with three divisions: kitchens, bathrooms
and central services. The kitchens and bathrooms divisions are pro t
centres, but the central services division is a cost centre. The costs of
the central services division, which are thought to be predominantly
xed, include those incurred by the design, administration and
nance departments. The central services costs are charged to the
other divisions based on the budgeted central services costs and the
budgeted number of jobs to be undertaken by the other two
divisions.
The budgeting and reporting system of WC is not very
sophisticated and does not provide much detail for the directors of
the company.
Budget details
The budgeted details for last year were as follows:
Kitchens Bathrooms
Number of jobs 4 000 2 000
R R
Average price per job 10 000 7 000
Average direct costs per job 5 500 3 000
Central services recharge per job 2 500 2 500
Average pro t per job 2 000 1 500
Actual details

The actual results were as follows:
Kitchens Bathrooms
Number of jobs 2 600 2 500
R R
Average price per job 13 000 6 100
Average direct costs per job 8 000 2 700
Central Services recharge per job 2 500 2 500
Average pro t per job 2 500 900
The actual costs for the central services division were R17,5 million.
REQUIRED Marks
(a) Calculate the budgeted and actual pro ts for each of the pro t centres and for the whole
4
company for the year.
(b) Calculate the sales price variances and the sales mix pro t and sales quantity pro t variances. 6
(c) Prepare a statement that reconciles the budgeted and actual pro ts and shows appropriate
10
variances in as much detail as possible.
(d) Using the statement that you prepared in part (c) above, discuss the performance of the
company for the year; and potential changes to the budgeting and reporting system that 10
would improve performance evaluation within the company.
TOTAL MARKS 30

SOURCE: ADAPTED FROM UNIVERSITY OF JOHANNESBURG ARCHIVE
You are the nancial director of Electro Motors Ltd, which
manufactures cooling motor systems for the local and export
markets. The company was founded in 1978 and has since
established itself as a high-quality supplier of many large fridge and
freezer manufacturers.

Current position
Since 2XX2, the company has experienced a decline in demand for
their motors. Management has categorically stated that the main
reason for the lower demand is the depressed world economy. The
decline in demand continues and the pro t-ablilty and cash ows of
Electro Motors Ltd has been put under increasing pressure.
The actual results for September 2XX4 were as follows:
R
Sales 7 263 500
Less: Cost of sales 6 240 900
Material 2 925 000
Labour 393 600
Variable manufacturing overheads 272 300
Fixed manufacturing overheads 2 650 000
Gross pro t 1 022 600
Variable non-manufacturing overheads (466 800)
Fixed non-manufacturing overheads (1 209 500)
Actual loss (653 700)
The variance analysis for September 2XX4 was as follows:

• Standard selling price R175
• Normal (budgeted) production capacity 80 000 units
• Material, labour, variable and xed manufacturing costs are
allocated on a per unit basis.
REQUIRED Marks
(a) Prepare a standard income statement as well as a budgeted income statement for September
15
2XX4.
(b) Analyse and discuss the results of Electro Motors Ltd. Also, advise the directors of Electro
15
Motors as to possible steps that they can take to improve their nancial performance.
(c) Journalise the complete accounting entries with regard to the following cost elements: 10
• Materials
• Labour
• Fixed manufacturing costs
• Variable non-manufacturing costs
• Fixed administration costs
Note: The journals for the write-down of the variances to the income statement are not required.
TOTAL MARKS 40

SOURCE: ADAPTED FROM UCT
AgriProducts is a divisionalised organisation that produces a wide
range of agricultural products. One of the divisions, AgriDrums,
manufactures a range of plastic drums designed for holding either
water or chemicals. The drums are different sizes and range from
holding 1 m3 to 12 m3 of liquid. The drums designed for chemicals
are made of a thicker, more robust plastic compound that cannot be
eroded by petrol, oil and other chemicals used by the agricultural
sector. A standard absorption costing system is used for planning
and control purposes, organisation-wide.
One of the most popular drums produced by AgriDrums is a
dark green 5 m3 reinforced drum suitable for holding chemicals, and
this drum accounts for a signi cant portion of the division’s total
sales. Information regarding this dark green drum is presented
below.
AgriDrums expects to produce and sell 1 700 of these drums per
quarter for the foreseeable future. The standard selling price of 1
drum is R4 800, which results in the division earning a standard
gross pro t of R520 per drum.
The company uses the FIFO method of inventory valuation.
Total costs for the last quarter, based on the assumption of
producing 1 700 drums, were originally budgeted to be the
following:
R Standard price per input

Plastic (litres) 1 700 000 R20 per litre
HD6 (litres) 1 487 500 R35 per litre
Colourant (litres) 986 000 R58 per litre
Valve and seal set 340 000 R200 per set (1 set is required per drum)

Direct labour (hours) 1 062 500 R25 per labour hour
Variable overheads 637 500 60% of the total labour cost
Fixed overheads 1 062 500 R25 per labour hour
The actual costs incurred during the last quarter, as well as

information regarding those costs and resources used, are as follows:
R Note
Plastic 1 696 000 2
HD6 1 306 400 2
Colourant 969 600 0
Valve and seal set 0 1
Direct labour 940 800 4
Variable overheads 660 000
Fixed overheads 1 070 000
General note: Actual production of drums amounted to 1 600 drums

for the period. Production was cut in response to reduced demand in
the last quarter of 2XX6. The general market for drums was 8%
smaller than anticipated at the time of drafting the budget for the
last quarter due to unusually good summer rains in the Western
Cape, which lead to a reduction in chemical usage (it is futile to
spray crops in rainy periods as the chemical is washed off).
Unfortunately, the decrease in production was not perfectly matched
to the decline in demand, which resulted in AgriDrums’ inventory of
drums (of this type) increasing by 250 units. All drums sold were at
the standard price of R4 800 per drum, except for 100 drums which
were sold at a discount of R150 per drum.
Notes:

1 There was neither opening nor closing inventory of raw materials
for the quarter, other than the valve and seal sets. AgriDrums had
2 000 sets on hand at the beginning of the quarter and 390 sets on
hand at the end of the quarter. One set is used per drum. Any
faulty sets are returned to the supplier for a full refund. Ten sets
were returned to the supplier this quarter. AgriDrums orders its
stock quarterly and the stock for the next quarter (January to
March 2XX7) has yet to arrive. The budgeted cost of R200 per set
was based on the price at which the sets were purchased (this is
known, since the sets are purchased in advance). The purchase
price for the current order, delivery of which is expected on 2
January 2XX7, is 8% higher, which re ects the unexpectedly high
CPI gures for October 2XX6. Every set that left inventory is
accounted for – it was either successfully xed to a drum, or
returned to the supplier.
2 Plastic and HD6 (a very tough plastic-like compound) are both
required for all plastic drums that the organisation produces. The
proportion in which the plastic and HD6 are mixed to make the
body of the drums varies, depending on how tough the drum is
required to be. The tougher the drum needs to be, the higher the
proportion of HD6 to plastic. These materials are both purchased
in litres and the organisation paid R20 and R35,50 per litre for
plastic and HD6 respectively.
3 The colourant was purchased at 3% more per litre than
anticipated.
4 AgriDrums budgeted on paying an average of R25 per labour
hour to its staff. They hired a number of new junior workers
during the period, with the result that the average wage per hour
decreased. On average 28 hours were worked per drum.

The directors of AgriProducts wish to evaluate the performance of
the manager of AgriDrums and a variance analysis as regards the 5
m3 reinforced drum is required in order to provide insights into the
management of the division.
REQUIRED Marks
(a) Calculate all variances necessary to identify any deviation of actual pro t from that which was
originally budgeted. Variances should be further analysed in as much detail as is useful to 32
provide meaningful information and insight into the management of AgriDrums.
(b) Given the results of your analysis and the information provided in the question, discuss
whether the division (including both the production and sale of drums) has been well – or 8
poorly – managed.
(c) Calculate the total value of the closing nished goods inventory using standard costs and
show the journal entry required in order to record nished goods inventory at a valuation
10
which is consistent with GAAP (IAS2). You may assume that all the variances are considered to
be material and that none of the variances re ects any abnormal amounts of waste.
TOTAL MARKS 50

SOURCE: ADAPTED FROM SAICA QE1
Signs-for-Africa (Pty) Ltd (‘Signs-for-Africa’) manufactures durable,
low-cost, plastic road warning signs at its factory situated in
Rosslyn, Tshwane. The company has historically exclusively focused
on export markets, but changed its focus to the South African market
in 2XX6 because of the growth opportunities locally. In 2XX6, the
South African National Roads Agency Ltd (SANRAL) and local
authorities in South Africa decided to replace gradually all the
existing metal road warning signs with plastic signage. The main
reasons for this change are that plastic signs are less likely to be
stolen and are safer in the event of collisions.

Signs-for-Africa manufactures two kinds of signs, namely
standard road warning signs (SRWS) and electronic road warning
signs (ERWS). The only material used to manufacture SRWS is
plastic, whereas ERWS are tted with one solar panel-driven
warning light, which is purchased from a supplier based in Japan.
The warning light is tted by skilled electricians during the
production process. Apart from this, the ERWS are identical to SRWS
and manufactured in the same process as SRWS.
Signs-for-Africa has operated a standard costing system for many
years. The manufacturing, procurement and sales divisions are all
involved in setting standards on an annual basis. Their inputs are
collectively incorporated into the company budget for the
forthcoming nancial years. The procurement division is responsible
for the ordering of materials, negotiating prices with suppliers,
logistics relating to the receipt of materials, and ongoing liaison with
suppliers and potential suppliers. The manufacturing division is
responsible for all production matters including recruiting and
managing all labourers involved in the production process.
The budget for the year ended 31 December 2XX7 was approved
by the board of directors of Signs-for-Africa in early January 2XX7.
The budget included the following relevant information and
assumptions relating to planned sales and manufacturing volumes,
and standard costs:
Signs-for-Africa (Pty) Ltd

Budget for the year ended 31 December 2XX7

Notes:
1 The standard quantity of plastic used in the manufacturing
process is 8 kg for each warning sign manufactured.
2 All inventories are accounted for at standard cost.
3 Type A labourers were budgeted to be paid a standard rate of
R25 per hour,
4 and the manufacturing standard is one hour of type A labour for
each
5 manufactured product.
6 Electricians were expected to operate at a productivity level of
90% and 54 minutes of electrician time was budgeted for each

ERWS product. Electricians were budgeted to be paid R35 per
standard clock hour.
7 Variable manufacturing overheads were budgeted at R5 per
machine hour and every product takes a standard time of three
machine hours to complete.
8 Fixed manufacturing overheads are allocated to the
manufacturing cost of products based on machine hours.
9 Signs-for-Africa is required to pay a standard patent fee of R5 per
ERWS product sold, to its Japanese supplier.
There was no opening inventory of materials or nished products at

the start of the 2XX7 nancial year. No inventories of work-in-
progress existed at the start or end of the nancial year, nor had any
been budgeted for.
The actual results for the year ended 31 December 2XX7 are
summarised below:

Results for year ended 31 December 2XX7
Quantity R
Revenue
SRWS 5 000 units 1 800 000
ERWS 7 500 units 3 750 000
Manufacturing volumes
SRWS 6 160 units
ERWS 9 240 units
Materials

Plastic purchased 150 000 kg (1 500 000)
Plastic used in the manufacturing process 138 600 kg
Solar panel driven warning lights 9 240 units (1 155 000)
Labour
Type A labourers 12 320 hours (332 640)
Electricians 8 662,5 clock hours (346 500)
Variable manufacturing overheads (207 900)
Fixed manufacturing overheads (95 480)
Patent costs (45 000)
Non-manufacturing overheads (2 680 000)
Notes:
1 Machine hours amounted to 38 500 in 2XX7.
2 Signs-for-Africa calculates sales volume variances on the gross
pro t basis.
3 Non-manufacturing overheads are xed in nature.
The divisional managers responsible for the manufacturing,

procurement and sales divisions believe that the change of focus to
the South African market has adversely affected the pro tability of
Signs-for-Africa. In their opinion, SANRAL and local authorities did
not plan the rollout of plastic road warning signs properly and tend
to place orders on an ad hoc basis. The ERWS product range has also
not taken off because of the higher price of the product compared to
the SRWS range, despite the vastly superior visibility of ERWS to
motorists.

The schedule set out below contains the list of variances which the
company normally calculates. The management accountant has
already calculated some of these variances. His calculations are
correct.

Schedule of variances for the year ended 31 December 2XX7

SOURCE: ADAPTED FROM SAICA ITC
Aero Africa Ltd (‘AA’) is an airline that listed on the JSE in June
20X0. AA is a decentralised company with the following divisions:

• Aero Africa
• Aero Africa Mobilechefs (catering division)
• Aero Africa Technical (the technical division which provides
aircraft maintenance services)
• Aero Africa Travel Centres (Aero Africa’s own branded travel
agencies)
United Auditors Inc., a rm of registered auditors, has been the

external auditor of AA for the past 10 years. United Auditors Inc.,
based in Johannesburg, is currently comprised of three audit
partners and 30 trainees. Kingston Jacobs was the audit engagement
partner for AA prior to his resignation from United Auditors Inc. in
February 20X0.
South American segment

AA has landing rights for a daily ight from South Africa to the
international airport at São Paolo, Brazil. As the agreement entails
operating a single landing slot, the airline has one return ight per
day on the Johannesburg to São Paolo (‘JNB-GRU’) route. This route
has proved to be very popular among travellers as AA is the only
African airline linking São Paolo directly to South Africa. AA
currently has no other landing slots in South America.
AA started using two new Airbus A330-200 aircraft for this route
at the beginning of the nancial year ending on 31 December 20X0.
These aircraft represent the latest technology on offer from Airbus in
Europe, with one of their most important features being their fuel
ef ciency. The aircraft are nanced by means of an operating lease
entered into between AA and a European based aviation leasing
company. The aircraft are con gured with 36 business class seats
and 186 economy class seats.

The nancial results for the JNB-GRU route for the year ended 31
December 20X0 are summarised below:
Notes:
1 The budget was based on the following key assumptions:
Number of one-way ights 732
Passenger numbers (average per one-way ight)
Business class 24
Economy class 148
Average one-way fare per passenger
Business class R27 000
Economy class R3 400
An evaluation of the actual results revealed the following:

• Two ights out of Johannesburg had to be cancelled – one for
technical reasons and the other due to low passenger
numbers. The passengers booked on these ights as well as
those booked on the return ights from São Paolo, which had
to be cancelled as well, were accommodated on AA ights on
other days.
• A total number of 19 656 business class passengers had been
carried on the route at an average one-way fare of R28 250,
while 110 656 economy class passengers had been carried on
the route at an average one-way fare of R3 200 per passenger.
It is AA’s policy to price a return ticket at double the one-way
fare on this particular route.
2 AA had budgeted to transport a total of 14 000 tonnes of cargo on
the JNB-GRU route for the year. Because AA has standing
contracts with their customers in terms of which customers are
charged for the volume of cargo transported, it considers this
revenue to be xed in nature. The actual quantity of cargo
transported was 5% more than the budgeted quantity.
3 This represents the cost of the subsistence allowance paid to each
crew member. A xed number of cabin crew works on the Airbus
A330-200 to São Paolo and the crew has a three-night stop-over in
São Paolo. The budgeted and actual allowance was US $150 per
crew member per day. The average budgeted exchange rate was
US $1:R7,40 while the average actual exchange rate was US
$1:R7,80.
4 Each passenger is served two meals on each ight and it is airline
policy not to carry any extra meals on a ight. The budgeted cost
per business class meal was R180, while the actual cost per
business class meal was R200. The budgeted and actual cost per
economy class meal was R70.

The standard ying time to and from São Paolo is 10 hours. AA
5 budgeted for the aircraft to consume 4 800 litres of jet fuel per
hour at a budgeted price per tonne of R4 654. The actual quantity
of jet fuel used on the route was 33 360 600 litres and the actual
average ying time was 9 hours and 45 minutes. Fuel is
consumed evenly throughout the ight.
6 These costs are incurred per ight. The budget was based on an
average cost per ight of R25 500.
7 This represents the annual operating lease costs of the two
aircraft deployed to this segment. The operating lease payments
amount to €4 300 000 for the year. The budget was based on an
average exchange rate of €1:R9,80.
8 This is the allocated portion of the information technology costs
of AA. A review of the allocation indicates that the correct
allocation rates have been used in respect of the budgeted and
actual allocations.
9 This represents the portion of the overheads AA incurred at
corporate level and apportioned to the different business
segments and business units.
REQUIRED Marks
(a) Calculate the following variances for the year ended 31 December 20X0:
(i) Passenger sales price variance
(ii) Passenger sales margin mix variance
(iii) Passenger sales margin quantity variance
(iv) Jet fuel price variance
(v) Jet fuel consumption variances
(vi) For the jet fuel consumption variances, provide as much detail as possible regarding the
differences between budgeted and actual amounts. 20
(b) Calculate the number of business class and economy class passengers that AA needed to 10
transport in the 20X0 nancial year in order to break even.

For the purpose of your calculations, assume the same ratio of business class passengers to
economy class passengers as the actual ratio for the year.
TOTAL MARKS 30
References
Acorn Industries. 2010. Standard costing and variance analysis. [Online]. Available:
http://www. nancedoctors.net/Notes/133.pdf [22 June 2010].
GSK. 2019. About us. GlaxoSmithKline [Online]. Available: https://www.gsk.com/en-
gb/products/our-consumer-healthcare-products/ [2 September 2019].
Hill, B. 2019. The role of variance analysis in businesses: AZ central. [Online]. Available:
https://yourbusiness.azcentral.com/role-variance-analysis-businesses-14413.html [2
September 2019].
SAICA. 2010. Statements of Generally Accepted Accounting Practice: IAS 2 (AC 108), Inventories
(revised January 2010). Johannesburg: SAICA.

chapters 10 to 13, and to move students toward a more
advanced, high-level understanding of the topics, the
relationships between them and the exam technique required.
Chapter 10, Relevant information for decision-making is one of the most

important chapters in this book. If you look back at Chapter 1,
Introduction to management accounting, you will notice that the very
thing that sets management accounting apart from nancial
reporting is the fact that the information supplied by a management
accounting system depends on the purpose for which the
information is required. In other words, we ask, ‘What information is
relevant for the speci c decision that we face?’ Providing relevant
information is what management accounting professionals do, and it
follows that management accounting is impossible without a
thorough understanding of relevance. It should not surprise you,
then, to discover that relevant costing features in many high-level
management accounting exams. Even when the topic is not
speci cally examined, it tends to nd its way into the questions via
other topics, because almost all of them require a grasp of the
principles of relevance.

Consider that as early as Chapter 2, Cost classi cation, you had to
understand that a given cost may be xed in the short term, but
variable when a longer time horizon is considered (it may therefore
be irrelevant to some decisions, but relevant to others). As late in the
book as Chapter 17, Competitive advantage, we will discuss techniques
and practices that may help to reduce certain costs in given
circumstances, but may be expensive to implement (we therefore
consider the relevant cost of implementing such changes). Although
relevant costing questions usually require calculations to arrive at a
speci c numerical answer, advanced questions frequently also
require that you consider non- nancial and qualitative factors as
part of the decision.
The concept of relevance also forms the cornerstone of Chapter
11, Decision-making under operational constraints. This chapter focuses
speci cally on situations where resources are limited and where
decisions have to be taken regarding the optimal use of such limited
resources. Again, the topic lends itself well to calculations that result
in clear-cut numerical answers, but once you have mastered the
chapter, it should not be dif cult to perform such calculations. In an
advanced question, the examiner is likely to sketch a scenario and
require the consideration of multiple factors in your decision,
including scenario-speci c non- nancial and qualitative factors.
Chapter 12, Budgets, planning and control introduces another topic
that – like relevant costing – can be integrated with many other
topics. Cost behaviour, for example, has to be thoroughly
understood in order to draw up a budget. Budgeting is also integral
to performance management, especially when it comes to the
motivational impact of budgets and the effect of budget variances on
performance assessment. Furthermore, a thorough understanding of

the concepts underlying budgeting and variance analysis is
particularly important in order to understand standard costing.
Chapter 13, Standard costing builds on the concepts of budgeting
and variance analysis. Standard costing introduces numerical
calculations that students often nd intimidating in their earlier
studies. However, once you understand that each additional
variance calculated merely aims to split the variance between the
budget and the actual results into further detail, it becomes apparent
that there is a clear pattern to the calculation of variances. Rather, it
is the interpretation of these variances that calls for a higher level of
insight into the topic. Advanced questions could ask students to
interpret variances in the particular context of a given organisational
scenario, instead of merely requiring a list of possible generic causes
for the variances.
What follows is a question that tests some of the material covered
in chapters 10 to 13. The suggested exam technique for attempting
advanced questions such as this one is to follow these steps:
• Read the question requirements rst, to focus your thoughts on
what will be required of you.
• Read the scenario and plan all of your answers.
• Answer the requirements in the given order, starting with
requirement (a). The order may be important, because long
questions are sometimes set in such a way that thinking through
the earlier answers leads you to the later answers.
• Apply your answers to the scenario by making sure that you are
considering the speci c circumstances of the particular
organisation throughout.
Integrated question: Ithemba

Pharmaceuticals Ltd (‘Ithemba’)

Ithemba Pharmaceuticals Ltd (‘Ithemba’) specialises in the
production of two types of 350 mg1 aspirin tablets, namely aspirin
dispersible tablets (i.e. that dissolve in water) (‘dispersibles’) and
aspirin chewable tablets (i.e. that can simply be chewed and
swallowed without any water) (‘chewables’).
Ithemba’s management team consists of the chief executive
of cer (CEO), nancial manager, sales and distribution manager and
production manager. The CEO is responsible for implementing the
long- and short-term strategy devised by the board of directors and
the day-to-day management decisions, and acts as a link between the
board of directors and Ithemba’s management team. The nancial
manager role includes preparing nancial reports, investment
appraisal, sourcing nancing, managing cash ows and negotiating
procurement contracts. The sales and distribution manager is
responsible for devising strategies for meeting sales targets, setting
selling prices, brand awareness and promotion, customer
relationship management (including establishing new customers)
and overseeing the distribution of the dispersibles and chewables to
customers. The production manager is responsible for overseeing the
purchasing, receipt, storage and issue of raw materials, all aspects of
the production function and storage of nished goods prior to them
being distributed to customers.
Ithemba operates a standard absorption costing system as part of
its performance management, control and inventory valuation
systems. Given that the nance manager was recently red and has
not yet been replaced, you have been tasked with preparing the
annual variance report and assisting with valuing the year-end
inventory. The variance report discloses detailed variances, identi es
the reasons for variances and who, if anyone, is responsible for the

variances arising, and is used as a basis for determining annual
bonuses for the management team.
Overview of the production process

Aspirin dispersibles are produced in batches of 100 000 tablets in the
following process:
• The active ingredient, acetylsalicylic acid (commonly referred to
as ‘ASA’), is imported from China.
• Maize starch is added to the ASA to serve as both a binding
agent and ller (binding agents assist in holding the dispersibles
together, while llers ll up the tablet to the desired size). The
ASA and maize starch are mixed together in a large mixer and
then granulated (crushed) so that the ingredients stay in the right
proportions throughout the process.
• The granules are then pressed into dispersibles using a tablet
press.
• A coating, consisting of calcium carbonate and anhydrous citric
acid, is sprayed onto the dispersibles while they are tumbled
around in a tumbling machine. The coating protects the
dispersibles from the environment and takes away the bad taste
when they are swallowed.
• The dispersibles are then packaged into packs of 25.
The production process for chewables is the same as that for

dispersibles except that the coating consists of microcrystalline
cellulose and glycine to enable the tablet to dissolve when chewed
rather than in water.
Standards and budgets

The following standards were set and budgeted information
provided for the nancial year ended 31 March 2XX6:
Sales
Dispersibles Chewables
Selling price – per pack R20,00 R22,50
Demand (packs) 4 800 000 2 400 000
Raw materials
The quantity of ASA and maize starch in each dispersible or

chewable cannot be varied, but the proportions of the other coating
ingredients can vary.
No loss of raw materials or nished dispersibles and/or
chewables is expected.
The cost of ASA is denominated in USD. The standard cost of
ASA was based on an exchange rate of R12 to one USD.
Other variable costs

Packaging materials and selling costs of R500 and R1 000
respectively are incurred per batch.
Fixed manufacturing overheads

Total xed manufacturing overheads were budgeted to be R36
million per annum.
Fixed manufacturing overheads are allocated to inventory based on
machine hours.
Each batch requires 1 machine hour.
Capacity information
Practical capacity is 2 000 machine hours per annum, while normal
and budgeted capacity is 1 800 machine hours. Based on the
expected demand, 120 million dispersibles and 60 million chewables
were budgeted to be produced.
Inventory valuation
Inventory is valued at standard cost on the FIFO basis. There was no
opening raw materials, work in progress or nished goods inventory
on 1 April 2XX5.
Information for preparing the variance report

Except as is evident from the information given below, production
and sales were uniform across the year and no other variances arose
during the nancial year.
The following information has been gathered to assist you with
the variance report:
1 Actual production (including the 8 batches of chewables that
were discarded – refer to point 3 below) was 135 million
dispersibles and 65 million chewables. A total of 2 000 machine

hours were used during the year. All goods produced during the
year were sold during the year.
2 ASA is purchased from the Chinese supplier on a cash-on-
delivery (COD) basis whereby the supplier debits Ithemba’s bank
account for the full purchase cost on the day that the ASA raw
material is delivered. The quantities of ASA purchased and the
ZAR:USD exchange rate ruling at the dates when ASA was
delivered were as follows:
During the nancial year, there were no changes in the budgeted

USD cost of ASA.
3 In June 2XX5, the mixing machine, tablet press and tumbling
machine underwent their annual planned maintenance. Due to
the negligence of the outside service provider, settings on the
mixing machine were incorrectly set, resulting in double the
amount of ASA being mixed with the maize starch. This was only
discovered at the end of the day during the daily quality
assurance testing (which takes place prior to the chewables being
packaged). This resulted in all of the production on that day
being discarded, which amounted to 8 batches of chewables. As
there was spare production capacity and suf cient raw materials,
sales volumes were unaffected. Ithemba has lodged a complaint
against the service provider who has disputed having any

liability. Given the costs of taking legal action, the CEO has
decided not to pursue the matter any further.
4 On 15 September 2XX5, Ithemba won a contract for the once off
supply of 1,5 million aspirin dispersibles to the Eastern Cape
Department of Health at a selling price of R19,75 per pack. This is
the rst government contract that Ithemba has won. The ASA
order, delivered on 1 October 2XX5 (refer to point 1 above)
included the additional ASA required for manufacturing the
additional dispersibles. The dispersibles were produced in
October and delivered on 31 October. The additional production
required to ful l the contract had no impact on standard
materials price or usage, or the ef ciency of the production
process.
5 With effect from 1 February 2XX6, the nance manager entered
into a new contract with PHARMCHEM (Pty) Ltd for the supply
of glycine (the ‘glycine contract’). The contract price was R25 per
kilogram. Due to the erratic delivery of glycine, the CEO
cancelled the contract with effect from 28 February 2XX6. A total
of 130 kilograms of glycine was delivered during February. The
change in supplier had no impact on materials usage, materials
mix, the quality of glycine delivered or the quality of chewables
produced.
From 1 March, the contract for the supply of glycine was re-awarded
to the previous supplier at the previous contract price per kilogram.
Introduction of a new product

The CEO has also asked you to assist her with evaluating the
feasibility of introducing a new 500 mg dispersible tablet in addition
to the current 350 mg dispersible tablet and chewables produced.

She expects that the 500 mg dispersible could be launched at the
beginning of the second half of the 2XX7 nancial year (i.e. on 1
September 2XX6). She has made the following information available
to you:
• The 500 mg dispersibles will also be produced in batches
of 100 000 tablets, but each batch will take 1,5 machine hours. The
500 mg dispersibles would be packaged in packs of 20 tablets. A
total of 1 020 machine hours are expected to be available in the
second half of the 2XX7 nancial year.
• Each batch of 500 mg dispersibles will require 50 kilograms of
ASA (the remaining materials remain the same as those required
for the 350 mg dispersibles). The quantity of ASA available to
Ithemba is expected to be limited to a total of 50 000 kilograms
during the second half of the 2XX7 nancial year. There will be
no restrictions on the supply of other raw materials.
• Demand for the three products during the second half of the
2XX7 nancial year is expected to be as follows:
Packs Batches
350 mg dispersibles 2 400 000 600
Chewables 1 200 000 300
500 mg dispersibles 1 250 000 250
• The 350 mg dispersibles, chewables and 500 mg dispersibles are

expected to generate a contribution of R55 000, R65 000 and
R75 000 per batch respectively during the second half of the 2XX7
nancial year.
• Should the 500 mg dispersibles not be introduced, it is expected
that R5 million worth of xed costs could be avoided in the long

term on an annual basis through reducing available and unused
practical capacity.
Discussion

Part (a) of this question requires a basic understanding of sales
budgets. You should have scored very well for this part.
The complexity of parts (b) and (c) was increased by only the
changes from the budget being given and not all actual data. This
part tested your understanding of the key principles underpinning
sales variances. Take special note of the suggested approach to
answering these types of questions that is provided in the suggested
solution. If you have struggled with this part you should spend
some time revising the key principles underpinning variance
calculations and analysis.
In addition to testing standard costing principles, part (c)
assesses your ability to calculate a xed manufacturing overhead
rate (refer to Chapter 6, Overhead allocation).
Once again, your understanding of standard costing principles
(speci cally the deferral of variances) is tested in part (d) through
discussion and application rather than calculations.
In contrast to part (d), part (e) tests your understanding of
deferring variances through detailed calculations as opposed to
discussion. Key to calculating the deferral correctly is to recognise
that from an inventory valuation perspective, it is only the most
recent purchases that will be included in inventory as all the other
price variances that arose during the year were on raw materials that
have already been used in nished goods that have already been
sold. The variances arising from the previous purchases will
therefore be expensed as part of cost of goods sold.
Parts (f) and (g) require you to demonstrate your understanding
of Chapter 10, Relevant information for decision-making, and Chapter
11, Decision-making under operational constraints. Note how part (f)
tests your ability to quantify the nancial implications of the
decision to introduce a new product, while part (g) considers the

qualitative factors needing consideration when making the decision.
Remember that when making decisions, it is important to consider
not only nancial implications but also other non- nancial
implications.
One general comment relating to integrated questions is that as
you progress to more advanced years of studying management
accounting, you will nd both an increase in the level of integration
of topics and a shift in emphasis in assessments away from
calculations to include discussion that tests understanding and
application. If you are studying advanced management accounting,
it is important for you to practice more advanced questions. SAICA
publishes its past exam papers on its website, together with
suggested solutions which include mark plans. It also publishes a
separate document which discusses how students scored in the
exam and gives feedback on each question. CIMA publishes what it
calls ‘post-exam guides’ on its website, which feature comments
from the examiner, common errors and an indication of how marks
were awarded. The respective websites are http://www.saica.co.za
and http://www.cimaglobal.com.
1 The reference to ‘350 mg’ means that each tablet contains 350 mg of the active ingredient and is
not the weight of the tablet.

LEARNING OBJECTIVES
• explain the conceptual aspects of performance measurement
• distinguish between cost centres (standard cost centres and
discretionary cost centres), revenue centres, pro t centres and
investment centres
• discuss the concepts of controllability and traceability, and apply
these concepts in the performance evaluation of units and
managers
• distinguish between centralised and decentralised management
responsibility and control structures, and discuss their relative
advantages and disadvantages
• explain and calculate return on investment, residual income,
economic value added (EVA®) and return on sales, and discuss
the advantages and disadvantages of each
• discuss multidimensional performance measures, including the
balanced scorecard, and formulate performance measures for the
different perspectives • discuss the considerations in setting
performance targets and designing
• reward structures, and advise on these matters in given
circumstances
• explain the challenges encountered in performance management
in the public and not-for-pro t sectors.

Sanlam and performance management
Sanlam is a nancial services group headquartered in South Africa. In its 2018

annual report, it states that it has achieved double-digit average growth rates in
most of its key performance indicators over the last 10 years. Sanlam states that the
company has delivered solid nancial results in relative terms during the year under
review, but in absolute terms the company was not where it had aimed to be. This
was due to challenges experienced in South Africa, Sanlam’s largest market.
Sanlam’s executive committee members are required to work towards key
performance indicators that correlate directly to the company’s four strategic pillars.
All are evaluated on growth measures appropriate for their businesses. Sanlam also
sets employment equity targets and managers are expected to drive inclusivity as
part of the company culture.
SOURCE: SANLAM (2018)
Sanlam evaluates the performance of its divisions and employees to

determine how they contribute to the overall success of the
company. This assessment also enables Sanlam to manage its future
performance. Chapter 14 focuses on the principles of performance
management as they apply to units and employees within an
organisational structure.
14.1 Introduction
Every organisation has a purpose. A retail chain such as Woolworths
may strive for exceptional quality in every product it sells, while a
state facility such as Tygerberg Hospital wants to provide affordable,
quality healthcare to patients. Organisations want to know how well
they are doing in serving their purpose. Woolworths Holdings’
shareholders, for example, may use information such as the share
price, earnings per share and dividend payout to decide how well
the company as a whole has performed. The Department of Health

may be interested in Tygerberg Hospital’s patient care statistics to
see how well the hospital is performing.
For an organisation as a whole to perform well, its parts have to
perform well. For this reason, senior managers evaluate the
performance of parts of an organisation. In both Woolworths and
Tygerberg Hospital, managers evaluate the performance of different
units within the organisation (such as the accounting department)
and the performance of the staff working in each of the units.
Performance management and

14.1.1
objectives
Key terms: objectives, performance evaluation, performance
management, performance measure
Performance evaluation can be described as ‘backward looking’: it

assesses something that has already happened. Managers, however,
need not only to evaluate past performance but also to manage
future performance.
The evaluation of past performance can provide valuable
information for the management of future performance. For
example, when the performance of a particular retail store branch is
evaluated, managers may notice that its low pro ts are largely due
to excessive shoplifting. Based on this information, they could
decide to install an improved security system to address the problem
in order to increase the future pro ts of the branch.
Apart from using ‘backward looking’ performance evaluation
information to manage future performance, managers can also use
another powerful tool to improve future performance. By
communicating how performance will be evaluated and rewarded in

a future period, managers can send a strong signal about what is
expected of units and individuals. In fact, the careful formulation of
performance evaluation criteria for future periods is one of the best
ways for managers to ensure that units and individuals within the
organisation perform in a way that bene ts the organisation.
Performance management aims to eliminate undesirable actions
and to encourage desirable actions by units and individuals. This
raises the question of what constitutes desirable action in an
organisation and what aspects of performance should be
emphasised. Woolworths’ customers, for example, are often happy
to spend time browsing through the store without the personal
assistance of a staff member. In Tygerberg Hospital’s trauma centre,
however, it is crucial that staff personally attend to patients as
quickly as possible.
The reason that organisations may choose to highlight different
aspects of performance stems from the nature and purpose of the
organisation. Organisations often formulate a vision or a mission
statement. Woolworths aspires to being ‘one of the world’s most
responsible retailers’, while Tygerberg Hospital wants ‘to provide
affordable, world-class quality health care …’. From these broad
statements of intent, organisations may formulate a number of
objectives to indicate more speci cally what they would like to
achieve.
Performance evaluation criteria are designed to measure the
achievement of these objectives. If properly formulated, performance
evaluation criteria help managers to manage the performance of the
organisation so that the objectives are achieved. When performance
evaluation criteria are formulated based on objectives:
1 the organisation focuses its performance management on the
important aspects that are addressed in its objectives, and

performance evaluation criteria are considered for each objective,
so that all of the prioritised objectives receive attention.
Information for performance

14.1.2
evaluation
Key terms: performance measure, critical success factors, key
performance indicators
As part of the management of performance, past performance is

evaluated. During performance evaluation, an opinion is formed on
how well a unit or individual has performed. To form this opinion,
performance is measured (in other words, a performance measure
such as return on investment is used) and the result is compared to a
benchmark. This is an important point to note when answering a
question on the work covered in this chapter. One cannot fairly
evaluate whether, say, a 12% per annum return on investment is
‘good’ or ‘unacceptable’ for a given unit in a speci c situation
without the use of a benchmark for comparison. The benchmark in
this example could be a similar unit or an indicator (for example,
‘Compared to unit B’s 15% per annum return on investment and the
industry average of 14,5% per annum, unit A has performed
poorly’), a speci c target that has been set (for example, ‘Compared
to the target return on investment of 10% per annum, unit A has
performed well’), or a prior period (for example, ‘Unit A has
improved its return on investment from 11% per annum in 2XX8 to
12% per annum in 2XX9’).
When comparing one unit or individual with another, keep in
mind that they do not have identical characteristics and
circumstances. Ideally, adjustments should be made to performance

results to neutralise these differences or different benchmarks should
be applied to the entities. When a unit within an organisation is
compared to a similar independent organisation, one has to be
particularly careful, as the unit bene ts from being part of the larger
organisation. For example, a unit may bene t from legal advice or
public relations provided by head of ce, and the full bene t and cost
thereof may not be recorded at unit level. An independent
organisation, on the other hand, has to fund all such expenses by
itself.
When units operate in different sectors, or in different
geographical locations, keep in mind that economic conditions in the
relevant sectors or regions would have impacted their results in
different ways.
Organisations have multiple objectives, but they may not all be

equally important. For example, an airline may strive to serve
tasty meals, but this is not as important as maintaining a good
safety record. Areas where an organisation must perform well in
order to succeed are called a critical success factors (CSFs).
Similarly, all performance measures are not equally
important. The most important performance measures are
called key performance indicators (KPIs). Performance
measures measure how well objectives are achieved. KPIs
measure how well CSFs are achieved.
14.1.3 Management accounting information

Accounting students know that organisations have to keep nancial
records in order to prepare nancial statements, calculate taxes and
comply with other legal and management requirements. For the

purpose of performance management, however, nancial accounting
information alone may not be suf cient. Information internal to the
organisation, which may not necessarily be reported externally or
may not be of a nancial nature, is also required to manage the
performance of units and individuals inside the organisation. The
information used for managing performance inside an organisation
is management accounting information. It forms part of the
information that managers need in order to perform their tasks.
Key terms: cost centre, investment centre, pro t centre,

responsibility centre, revenue centre
A responsibility centre is responsible for speci c activities and its

performance is the responsibility of a speci c manager. Nedbank’s
Helderberg Business Bank branch could, for example, be seen as a
responsibility centre within Nedbank. The branch itself also consists
of other, smaller responsibility centres (such as the sales team and
the credit team), and forms part of a larger responsibility centre
(Nedbank Business Bank, Winelands Region).
Responsibility accounting is used to manage the performance of
responsibility centres. Responsibility accounting asks: what revenue
and what costs should we record in the management accounts of this
unit to measure its performance? There are four main types of
responsibility centres in organisations:
1 A cost centre is held responsible for its costs only. Performance
management in a cost centre mostly focuses on minimising cost.
There are two types of cost centre. In a standard cost centre, there
is a clear relationship between inputs and outputs. Production

departments are sometimes classi ed as standard cost centres. If
we know, for example, that it should cost R10 to manufacture one
box, we can compare the actual cost per box to this standard. In a
discretionary cost centre, there is no clear relationship between
inputs and outputs. Research and development departments are
sometimes classi ed as discretionary cost centres. Performance
management is dif cult in discretionary cost centres: low
spending could mean the department is doing too little, while
high spending may mean it is wasting money. The absence of a
clear input/ output relationship always makes performance
measurement more dif cult.
2 A revenue centre is held responsible for its revenues only. Sales
departments that directly generate sales income are sometimes
classi ed as revenue centres. Performance management in a
revenue centre focuses primarily on maximising revenues.
Sometimes revenue centres are also held responsible for
marketing-related costs.
3 A pro t centre is held responsible for its costs and revenues. A local
branch of an organisation is sometimes classi ed as a pro t
centre and is thereby held responsible for both the revenues that
it generates and the costs that it incurs. Performance
management in a pro t centre focuses primarily on maximising
pro t.
4 An investment centre is held responsible for its costs and revenues, as
well as for investments in the centre. A local branch of an
organisation may be classi ed as an investment centre, and
thereby be held responsible for the revenues that it generates, the
costs that it incurs and the money that is invested in the branch.
Performance management in an investment centre focuses
primarily on maximising pro t per rand invested.

Keep in mind that in management accounting there are no xed
‘rules’ (such as the international nancial reporting standards that
apply to nancial accounting) that prescribe, for example, whether a
unit should be classi ed as a cost, revenue, pro t or investment
centre. One should choose the option that will provide the best
possible management information and encourage the most
appropriate behaviour under the circumstances.
14.2.1 Performance of units and managers

Key terms: controllability, traceable
There is a difference between the performance of a unit in an

organisation and the performance of the manager in charge of that
unit. An excellent manager may, for example, be put in charge of a
struggling unit or a bad manager may prevent a well-performing
unit from performing even better. Unit performance evaluation
assists senior management in deciding on the allocation of scarce
resources between units. Ideally, the performance evaluation of a
manager should be based on those aspects over which the manager
has had control. The following example illustrates this.
Example 14.1
On 1 January 2XX8, James was appointed manager of the West Coast branch of
StayRSA, a company that leases self-catering cottages to tourists. The following is an
extract of actual results from the management accounts of the West Coast branch for
the year ended 31 December 2XX8:

Notes:
1 In 2XX8, the West Coast branch charged R480 per cottage per night, irrespective
of the season and the number of occupants. The corresponding rate in 2XX7 was
R450 per night. Cottages can be rented 365 days a year. The branch has 10
cottages.
2 James is of the opinion that inadequate maintenance had been performed on most
cottages in the years prior to his appointment.
3 James marketed the West Coast cottages at trade fairs in July and August.
4 A winter storm caused extensive damage to some buildings. The amount of
R75 500 was not covered by the insurance policy. All insurance matters are
administered by StayRSA’s head of ce.
5 The actual costs of central reservation administration incurred at head of ce is
allocated to branches based on their usage of head of ce reservation resources.
On budgeted costs, the allocations would have been R50 000 in 2XX8 and R8 000
in 2XX7. It appears that the budget overruns were due to poor cost control at head
of ce.
Required:
Comment on the performance of the West Coast branch and its manager in 2XX8.
At rst glance it seems that the West Coast branch and its manager
have performed poorly – the branch income has declined by 11,2%.
However, the information should be properly analysed:
1 In 2XX8, revenue was received for 2 500 nights
(R1 200 000/R480), an average of 250 nights per cottage (2 500
nights/10 cottages). This implies a 68,5% occupancy rate (250
nights occupied/365 nights in a year). In 2XX7, 1 800 nights’

income was received (R810 000/R450), an average of 180 nights
per cottage (1 800 nights/10 cottages). This implies a 49,3%
occupancy rate (180 nights/365 nights). Revenue has not only
increased because of in ation (as re ected in the price increase),
but also due to much higher occupancy. The branch and its
manager have signi cantly improved the occupancy rate despite a price
increase from R450 to R480 per night.
2 The increases in administration and municipal expenses are small
in comparison with the increase in revenue. Because some of the
expenses, such as electricity, are likely to increase with higher
occupancy, these modest increases could mean that costs were
well controlled. One can calculate that these expense categories
equaled 36,6% of revenue in 2XX8 ([R382 000 + R57 500]/
R1 200 000), while they equaled 50,9% of revenue in 2XX7
([R362 500 + R50 000]/R810 000). The branch and its manager seem
to have improved control over costs in these categories, as the expenses
have declined relative to revenues.
3 Signi cantly more was spent on maintenance in 2XX8 compared
to 2XX7. The average maintenance expense of R102 500 over the
two years ([R190 000 + R15 000]/2) equals 10,2% of the average
revenue (C102 500/[R1 200 000 + R810 000]/2]). StayRSA could
compare this percentage to that of its other branches to determine
whether the average expenditure was acceptable. However, it is
possible that maintenance may have been neglected even before
2XX7, which would make the large 2XX8 expense even more
defensible. Head of ce may have preferred a more even spread over
time in the branch’s accounts. James believes that some of the cottages
were poorly maintained before he was appointed. If head of ce agrees
with this view, he will be able to justify the large expense. Managers
are often tempted, in the same way as James’s predecessor, to

postpone expenses such as maintenance to improve short-term
results. In the longer term the branch will perform poorly if
maintenance is not done.
4 The arguments related to maintenance apply to marketing as
well. In addition, it is dif cult to assess the impact of a speci c
marketing campaign on revenue. In this case, it is possible that
some of the increased revenue of 2XX8 may have resulted from
the increased marketing effort. The marketing may also hold a
longer-term future bene t. It may be wise to consider tracing
revenue to marketing campaigns by, for example, offering a
discount if a voucher is shown on check-in or if customers quote
a reference number from an advertisement. Head of ce might have
preferred a more even spread over time in the branch’s accounts, but the
increased expenditure seems to have paid off. James is spending more on
marketing than his predecessor and it seems to be resulting in more
bookings.
5 The storm damage is a result of the location of the branch. If this
branch’s property is often damaged by natural disasters, this
would in uence decisions made by head of ce managers as to
whether they want to keep doing business there. James, on the
other hand, could not control the storm and could not control the
fact that the insurance policy did not cover all the damage
(insurance policies are controlled at head of ce). If James were
the manager of another branch unaffected by the storm, he
would not have incurred this expense. The branch’s performance
evaluation should take the repair expense into account. However, unless
head of ce managers believe that James has overpaid for the repair work,
the entire R75 500 should be disregarded in his performance evaluation.
6 Head of ce reservation administration costs have been allocated
to the branch based on its usage of head of ce resources. Had the

branch been an independent organisation, it would have incurred
reservation expenses. The budget overruns should, however,
affect the performance evaluation of head of ce and not the
branch, as the cause was poor cost control at head of ce. In the
performance evaluation of the branch and James, only R50 000 (the
budgeted amount) should be subtracted from income. James had control
over how much use the branch made of head of ce reservation resources,
but no control over head of ce’s actual spending overruns.
Think about how online marketing helps organisations to

measure whether their marketing expenses are paying off. If
James had paid to list the cottages on a number of
accommodation websites, he could trace how many enquiries
and how many actual bookings were coming from each
website.
Evaluating managers’ performance based on those aspects over

which they have control is called the ‘controllability concept’.
Despite the fact that controllability makes sense, some organisations
still choose to include uncontrollable aspects in managers’
performance evaluations. This can be for a number of reasons, such
as the fact that it is dif cult to separate controllable from
uncontrollable costs, or the fact that the organisation wants to draw
managers’ attention to expenses beyond their control and the need
for them to be recovered. To stick to controllability, organisations can
consider showing uncontrollable costs on the performance
evaluation report, without taking them into account in managers’
performance evaluations.
When unit performance is evaluated, allocated amounts are
usually subtracted from income to the extent that they are traceable

to the unit. In our example, head of ce reservation administration
costs were traced based on the branches’ usage of head of ce
reservation resources (we assume that this was measured in an
appropriate activity-based manner). Not all costs are traceable to
units. Consider, as an example, the cost of employing staff at head
of ce to administer VAT and income tax returns for the company.
These cannot be traced to the West Coast branch, because the costs
would have existed even if there had been no branch on the West
Coast. Still, as is the case with the controllability concept, some
organisations choose to subtract non-traceable allocated amounts
when evaluating unit performance. Their argument is that the unit
would have had to incur the costs if the larger organisation did not
exist.
Centralised and decentralised

14.3
organisational structures
Key terms: autonomous, centralisation, decentralisation,

strategic business units, sub-optimal decisions
As organisational structures differ, management responsibility and

control may be assigned differently within organisations. In the
context of performance management, centralisation versus
decentralisation refers to the extent of delegation of decision-
making responsibility to lower organisational levels.
Where an organisation’s senior managers have extensive control
over strategic and operational decisions at all levels of the
organisation, the structure is said to be one of centralised
management control. On the other hand, where senior managers
delegate many decision-making responsibilities to lower levels, a

decentralised structure exists and the units are said to be
‘autonomous’. When autonomous units are responsible for
developing and marketing their own products or services, they are
called ‘strategic business units’. Each organisation lies somewhere
on the continuum between the theoretical extremes of centralised
and decentralised structures. Also, inside a single organisation, some
decisions are decentralised while others are centralised. Many
organisations start off with a centralised control structure and
become increasingly decentralised as they grow. The optimal extent
of decentralisation changes as the organisation and its environment
change.
14.3.1 Potential benefits from decentralisation

1 Greater responsiveness to needs at lower levels. Lower-level
managers have the freedom to make decisions about the units for
which they are responsible. These managers are likely to have the
best understanding of the speci c unit under their control.
2 Faster decision-making. Because decisions are taken at unit level
instead of at organisational level, each manager can respond to
local needs quickly, without having to wait for a response from
senior management.
3 Increased motivation. Managers control their own units and are
held responsible for their decisions by way of performance
evaluation. Because managers have the freedom to manage units
according to their own judgement, increased motivation and
entrepreneurial spirit are likely.
4 Improved senior management focus. Senior managers spend less
time and effort managing lower organisational levels and can pay
more attention to strategic issues.

5 Division into manageable size. One of the main reasons for the
decentralisation is that modern organisations are often so large
that senior managers have no choice but to delegate authority.
Decentralisation divides the organisation into units of
manageable size, run by unit managers.
6 Management development. Increased responsibility allows lower
level managers to develop and re ne management skills. The
organisation then has a pool of managers at lower levels with the
skills to move into more senior positions as required.
7 Elimination of internal inef ciencies. In a decentralised management
structure, internal inef ciencies are often eliminated in
transferring units, as managers of receiving units have the
freedom to purchase the goods and services needed from
external organisations rather than being forced to accept internal
transfers. Chapter 15, Transfer pricing explores this further.
Potential negative consequences of

14.3.2
decentralisation
1 Increased risk of acting against the best interest of the organisation as a
whole. In a decentralised structure, managers may be tempted to
make decisions with the best interest of the unit under their
control in mind, at the exclusion of other considerations. In
instances where the best interest of the unit con icts with the best
interest of the organisation as a whole, ‘sub-optimal’ decisions
may be taken. This means that lower-level managers may not
take the decision that is best for the organisation as a whole – a
situation that is clearly undesirable.
2 Undesirable duplication of assets and activities. Centralised decision-
making enables senior managers to prevent unnecessary

duplication of assets and activities within the organisation. In a
decentralised structure, lower-level managers have the freedom
to take decisions for their own units, which could lead to
unwanted duplication.
3 Risk of competition between units rather than co-operation. In a
decentralised structure, units commonly compete with each other
for organisational resources, which are often distributed based on
performance evaluation results. This may lead to a culture
among individuals of loyalty to the unit to the extent that
valuable opportunities for co-operation and information sharing
between units may be lost.
4 Higher information management costs. Decentralised organisations
incur higher costs in monitoring and controlling the activities of
units and managers, and may have to perform complex
procedures to agree transfer prices. Higher information
management costs include direct nancial costs as well as the
cost of all the resources consumed by the process such as time,
staff and of ce space.
5 Loss of control and knowledge by senior management. The fact that
unit managers take decisions may shield top management from
maintaining adequate control over and knowledge of unit
activities.
Requirements for successful

14.3.3
decentralisation
Key terms: goal congruence, independent, interdependent
Successful decentralisation means the potential negative

consequences of decentralisation are addressed without

compromising the potential bene ts from decentralisation.
For autonomous units in an organisation to work well together,
something that strategists refer to as goal congruence is required.
Goal congruence in an organisation means that individuals and units
take actions that are in their self-interest and simultaneously also in
the best interest of the organisation as a whole. This is usually
achieved by carefully planning the organisation’s performance
management system. Each individual and each unit within the
organisation should prefer to act in the best interest of the
organisation as a whole at all times, because they are simultaneously
acting in their own best interests (such as when the individual
receives a bonus based, in part, on the organisation’s overall
performance). Complete goal congruence may not be attainable in
practice, but organisations strive towards it as best they can.
Notice how goal congruence addresses the problems mentioned
in numbers 1 to 3 of the potential negative consequences of
decentralisation (section 14.3.2). In a goal-congruent system,
managers (1) act in the best interest of the organisation as a whole;
(2) do not duplicate resources if doing so con icts with the
organisation’s best interests; and (3) are not loyal to the unit at the
expense of the organisation as a whole. Furthermore, goal
congruence suggests that managers (4) will not allow information
management costs to increase to the extent that they eradicate the
bene ts of decentralisation.
The potential loss of control and knowledge by senior
management (5) may be more of a concern in organisations where
units perform related operations that need to be closely co-
ordinated. In such a case, units are said to be interdependent. If, on
the other hand, units undertake very different activities, such units
are referred to as independent. A decentralised structure works well

in organisations with independent units. In practice, the relationship
between the units may lie somewhere on the continuum between the
extremes of complete interdependence and total independence.
Key terms: Du Pont analysis, economic value added, residual

income, return on investment, return on sales
Example 14.2 illustrates the performance measures of return on

investment, residual income, return on sales and economic value
added. Keep in mind that the choice of performance measures is
likely to in uence behaviour: if units and individuals know in
advance how their performance will be measured, they are likely to
act in a manner that will result in a positive evaluation based on the
measures in question.
Example 14.2
Apart from the West Coast branch, StayRSA also operates an East Coast branch and
a South Coast branch. All three branches let self-catering cottages to guests. Branch
managers enjoy a large degree of autonomy in decision-making and the branches are
managed as investment centres. Below is an extract of actual results from the
management accounts for the year ended 31 December 2XX8. Recall from example
14.1 that only R50 000 (not R70 000) of the xed head of ce reservation administration
costs are subtracted to arrive at the West Coast branch’s income – the correct income
to use is therefore R350 000.

Required:
Evaluate the performance of the West Coast branch using nancial performance
measures.
Based on branch income, the West Coast branch was the worst
performer, followed by the East Coast branch. The South Coast
branch performed best. However, the assets and liabilities indicate
that the West Coast branch also has less money invested in it than
the other two branches. Organisations are interested in knowing
how well their units and managers perform given the resources at
their disposal, because this indicates whether the funds could have
been invested more wisely elsewhere. Several performance measures
have been developed to this end.
14.4.1 Return on investment

Return on investment (ROI) is a popular nancial performance
measure based on accounting information and is expressed as a
percentage. The formula is:

A higher ROI is preferred to a lower ROI – the higher the ROI, the
more income generated per rand invested. The ROI for each of
StayRSA’s three branches is as follows:
Based on ROI, the West Coast and East Coast branches performed
equally in 2XX8, while the South Coast branch performed better than
the other two.
As early as 1918, the Du Pont company further analysed ROI to
provide managers with more detailed performance information. Du
Pont used the following formula, known as the Du Pont analysis, to
investigate the relationship between revenues, income and
investment:
The rst part of this formula focuses on the revenue generated per
rand invested and is often called ‘asset turnover ’. The second part of
the formula expresses income generated per rand of revenue and is
known as ‘return on sales’. ROI can therefore be improved by either
(1) earning more revenue from the investment, or by (2) retaining a
larger part of revenue as income. The ROI of each of StayRSA’s three
branches can be further analysed as follows:

When the ROI is further analysed, it is apparent that the South Coast
branch had a high ROI because of its very high return on sales. Its
asset turnover was lower than that of the other two branches. The
East Coast branch had the best asset turnover, but the lowest return
on sales. Note that one can also make a very good case for
subtracting current liabilities to arrive at the ‘investment’ gures
used in the calculations. The de nition of ‘investment’ is discussed
more fully in section 14.4.5.
Return on investment has the following advantages:
1 ROI is easy to calculate and to interpret, because it has a simple
formula for which the inputs are readily available in
organisations’ nancial information systems.
2 Because ROI relates income generated to the size of the
investment in assets, managers are encouraged to use assets
productively.
3 Because ROI is expressed as a percentage, a unit’s ROI can easily
be compared to that of other entities and to indicators such as the
cost of capital, prime interest rate, or bond yields.
Return on investment has the following potential disadvantages:

1 ROI may lead to goal incongruence. As an example, assume that the
South Coast branch is considering investing R2 000 000 in a
project that is likely to yield operating income of R260 000 in the
rst year. Because the project has a 13% ROI
(R260 000/R2 000 000), it would likely be in the interest of
StayRSA to invest in the project if StayRSA’s overall ROI is less
than 13%.
However, if the South Coast branch’s performance is evaluated
based on ROI, the branch is unlikely to invest in the project.
This is because the South Coast branch is earning a 15% ROI. A
project that earns 13% decreases the South Coast branch’s ROI
((R1 500 000 + R260 000)/(R10 000 000 + R2 000 000) = 14,7%).
The project will likely be rejected by the branch, even if
investing in the project would have been in the best interest of
StayRSA as a whole.
2 ROI is calculated using accounting information. Students of
management accounting know that future cash ows, not
accounting gures, should be used in decision-making. Because
managers strive for a positive performance evaluation result,
managers whose actions are measured in terms of ROI could
focus their efforts on improving reported accounting gures at
the expense of future cash ows.
3 ROI is a short-term measure based on historical results. It re ects only
the return earned over the period for which it is measured, at the
exclusion of all potential future results. If the East Coast branch,
for example, considered building a restaurant on its premises and
were evaluated based on ROI alone, it could decide against the
project if building the restaurant would increase assets without a
suf cient accompanying increase in income in the short term.
Even if the restaurant is projected to make healthy pro ts in later

years, the branch manager might not be willing to risk the poor
performance evaluation results in the short term.
4 It may be dif cult to decide what to include and what to exclude
when calculating ‘investment’ and ‘income’.
14.4.2 Residual income

Residual income (RI) is a nancial performance measure based on
accounting information and is expressed in monetary terms. The
formula is:
Study the formula carefully – essentially it asks: how much more

income was earned than what was required, given the level of
investment? A higher RI is preferred to a lower RI, while a negative
RI is undesirable as it means less than the required income was
earned. The required rate of return that the organisation chooses to
use in this formula will to a large extent re ect the level of risk
associated with the unit. If the formula returns a negative answer, it
indicates that the income earned was too low, given the level of risk
and the organisation’s requirements.
If we assume StayRSA uses a required rate of 11% per annum in
RI calculations, the RI for each of StayRSA’s three branches is as
follows:

Measured in terms of RI, the South Coast branch is performing best,
while the East Coast branch has the largest negative RI and is the
worst performer. Again, one can make a very good case for
subtracting current liabilities to arrive at the ‘investment’ gures
used in the calculations. The de nition of ‘investment’ is further
discussed in section 14.4.5.
Residual income has the following advantages:
1 A different required rate of return can be used in the calculation
of each unit’s RI. For example, the RI of a unit that is involved in
more risky projects can be calculated using a higher required
rate. This would re ect the relationship between risk and return.
2 RI is not subject to the same potential goal congruence problem
as ROI. Again, assume that the South Coast branch is considering
a R2 000 000 investment that is likely to yield operating income of
R260 000 in the rst year. Had the branch’s performance been
measured based on ROI, it would have rejected the 13% return
because it is lower than its present 15% ROI. However, if the
branch’s performance were evaluated based on RI, the project
would increase the branch’s RI by R40 000 (R260 000 –
[R2 000 000 × 11%]). Goal congruence is achieved, as the South
Coast branch is likely to invest in the project because it improves
its own RI, while simultaneously acting in the best interest of
StayRSA. This is because the ROI formula results in a unit’s ROI
being the weighted average of the ROIs of its investments, while
the RI formula results in the RI of a unit being the sum of the RIs
of its investments.
Residual income has the following disadvantages:

1 Because RI is expressed in unit of currency terms instead of in
percentage terms, it is more dif cult to interpret than ROI. ROI
relates income to the size of the investment and allows for easy

comparison with other entities or indicators. RI, on the other
hand, is affected by size – it tends to be larger for larger units.
This problem may be addressed by setting RI targets instead of
comparing absolute amounts between units.
2 As is the case with ROI, RI is calculated using accounting
information. Managers whose actions are measured in terms of
RI could focus their efforts on improving reported accounting
gures at the expense of future cash ows.
3 As is the case with ROI, RI is a short-term measure based on
historical results. It re ects only the return that has been earned
over the period for which it is measured, to the exclusion of all
potential future results.
when calculating ‘investment’ and ‘income’, and what to use as
the ‘required rate of return’.
14.4.3 Economic value added

Economic value added (EVA®) is a nancial performance measure
based on accounting information that takes the organisation’s
weighted average cost of capital into account and is expressed in
monetary terms. The consulting rm Stern Stewart & Co developed
EVA®. The formula is:
Notice that EVA® is the RI formula rewritten, but using speci c

de nitions of the terms ‘income’ (namely adjusted operating income
before interest, after tax), ‘required rate of return’ (namely the

weighted average cost of capital) and ‘investment’ (namely total
adjusted assets less current liabilities, as at the beginning of the
period). EVA® aims to concentrate managers’ efforts on delivering
shareholder value. The ‘adjustments’ that are made to income and
assets are attempts to eliminate undesirable accounting conventions.
These may include revaluing assets and treating items such as
research and development (R&D) and marketing as depre-ciable
assets. Accounting depreciation is also added back and replaced
with ‘economic depreciation’ (i.e. the true change in the value of
assets during the period). As with RI, a higher EVA® is preferred to
a lower EVA®, while a negative EVA® is undesirable as it means too
little income is earned in relation to the risk.
Assume that StayRSA’s after-tax weighted average cost of capital
calculated at its target capital structure (i.e. the rate recommended
for use as a discount rate in net present value calculations when
potential investments are evaluated) is 10%. Furthermore, assume
that the necessary adjustments to income and assets have been
calculated as given below. The EVA® for each of StayRSA’s three
branches is as follows:

*For the purpose of our EVA® calculations, assume that these were the gures for ‘investment’ at the
beginning of the period. EVA® aims to calculate the value added based on the investment for the full period.
West Coast branch: R302 400 – (10% × R3 288 200) = (R26 420)
East Coast branch: R511 200 – (10% × R5 710 000) = (R59 800)
South Coast branch: R1 296 000 – (10% × R10 100 000) = R286 000
Based on EVA®, the South Coast branch is performing best, while

the West Coast and East Coast branches are both destroying
economic value.
EVA® has the same advantages and disadvantages as RI, except
for (1) the fact that the dif culty of choosing de nitions for
‘investment’, ‘required rate of return’ and ‘income’ is addressed by
the EVA® formula, and (2) the accounting information has been
restated to re ect economic reality more closely. However, EVA® has
an additional disadvantage in that adjustments have to be made to
income and assets. These adjustments can be dif cult to calculate
and may be seen as arbitrary.
Notice that whether ROI, RI or EVA® is used as the performance
measure, there are generally three ways in which performance can
be improved: increase income without investing more, make
investments that yield more than the target return, or sell
investments that yield less than the target return.
14.4.4 Return on sales

Recall that ROI can be further analysed into ‘asset turnover’
(revenue ÷ investment) and ‘return on sales’ or ROS (income ÷
revenue). ROS is often used as a performance measure. As calculated
in section 14.4.1, the East Coast branch of StayRSA performed worst
in terms of ROS (27,3%), with the South Coast branch performing
best (45,5%).

Return on sales has the following advantages:
1 ROS is easy to calculate and to interpret, because it has a simple
formula for which the inputs are readily available in
organisations’ nancial information systems.
2 Because ROS is expressed in percentage terms, a unit’s ROS can
easily be compared to that of other entities.
Return on sales has the following disadvantages:

1 It does not indicate whether assets have been used productively.
2 ROS is calculated using accounting information. Managers whose
actions are measured in terms of ROS could focus their efforts on
improving reported accounting gures at the expense of future
cash ows.
3 ROS is yet another short-term measure based on historical
results. It only re ects the return that has been earned over the
period for which it is measured, at the exclusion of all potential
future results.
when calculating ‘income’.
14.4.5 Determining ‘investment’

An important potential problem with the calculation of many
popular performance measures such as ROI and RI is to know what
gure to use as the ‘investment’ – different investment gures yield
different formula results. Three problems arise: how investment
should be de ned, at what point in time investment should be
calculated, and whether depreciation should be subtracted from
assets.
Definition of investment

When managers are evaluated, the income under their control is
taken into account. Likewise, only the assets under their control
should be used as the investment base, less the current liabilities
under their control. When units are evaluated, it is best to apply a
wider de nition of ‘investment’, as many assets not controlled by the
unit’s manager may nevertheless be necessary for the unit to
operate. The following de nitions may be appropriate for unit
performance evaluation:
• Total assets held. This includes all the assets held by the unit. This
de nition was used in the ROI and RI examples for StayRSA.
Note that one can make a case for also including intangible assets
that are not usually recorded in the same manner as physical
assets, such as investment in research and development. The
dif culty in objectively measuring these intangibles often
prevents them from being included in the ‘investment’ gure.
Remember that EVA® speci cally requires that intangibles
should be treated as assets.
• Total assets employed. Only assets that are currently in use are
included. Idle assets and assets held for future use are excluded.
This de nition is useful where, for example, senior management
dictates that certain unproductive assets are to be held by units.
This de nition was not used in the ROI and RI examples for
StayRSA, because no information on idle assets was given.
• Total assets less current liabilities. We could recalculate the ROI and
RI examples for StayRSA using this de nition, which
acknowledges branches’ performance in optimising the use of
current liabilities as a source of funding. Remember that the
EVA® formula requires current liabilities to be subtracted from
total assets.

Point in time
When we calculate measures such as ROI and RI, ‘income’ is the
income earned during the period under review. In our StayRSA
example, it is the income earned from 1 January 2XX8 to 31
December 2XX8. The question arises whether ‘investment’ should be
taken as the investment at the beginning of the period, at the end of
the period or somewhere in between. If the West Coast branch of
StayRSA had built one additional cottage during the year, was the
branch income earned from renting out 10 or 11 cottages? In other
words, should the value of all 11 cottages be used as part of the
‘investment’?
The Chartered Institute of Management Accountants (CIMA)
de nes a speci c form of return on investment, namely return on
capital employed (ROCE). The formula is as follows:
Again, as with the term ‘investment’, the exact meaning of ‘capital

employed’ may vary as discussed. Notice, however, that the
denominator is calculated as the average capital employed at the
beginning and end of the period. This is because the formula tries to
nd the amount of capital on which we can fairly say the income
had been generated. Furthermore, CIMA (in Eaton, 2005) envisages
that, where there are ‘problems of seasonality, new capital
introduced or other factors’, it could even be necessary to use the
average capital employed over a number of periods within the
period of measurement. In contrast, the EVA® formula prescribes
that assets at the beginning of the period should be used.

Remember that one way of improving ROI, RI and EVA® is to
reduce assets that do not produce the desired level of income. This
implies that better management of working capital improves results:
better debtors’ collection, for example, improves ROI, RI and EVA®
because the value of debtors included in ‘investment’ is reduced,
while ‘income’ may remain largely unaffected.
Depreciation
The question arises whether gross carrying amounts (the value of
assets before subtracting accumulated depreciation) or net carrying
amounts (the value of assets after subtracting accumulated
depreciation) should be used.
Example 14.3
Assume that, in addition to the branches already introduced, StayRSA also operates a
Drakensberg branch and a Karoo branch. Assume that cottages and cottage
furnishings are the only assets held by these two branches, and that they are
individually depreciated over their estimated useful lives. The following is an extract of
actual results from the management accounts for the year ended 31 December 2XX8:
Drakensberg Karoo
Branch income R2 040 000 R400 000
Age of branch cottages and cottage furnishings 2 years 7 years
Net carrying amount of total branch assets at historic cost R10 200 000 R1 600 000
Gross carrying amount of total branch assets at historic cost R11 000 000 R3 300 000
Required:
Calculate the return on investment of the Drakensberg and the Karoo branches, using
the net and gross carrying amounts of assets respectively.

ROI based on net and gross carrying amounts respectively is
calculated as follows (similar calculations can be made for RI and
EVA®):
Drakensberg Karoo
ROI based on net carrying amount R2 040 000/R10 200 000 R400 000/R1 600 000
= 20% = 25%
ROI based on gross carrying amount R2 040 000/R11 000 000 R400 000/R3 300 000
= 18,5% = 12,1%
Based on net carrying amounts, the Karoo branch performs best. The
Karoo branch is ve years older than the Drakensberg branch and
has had more years’ depreciation subtracted from its assets. As
assets get older, their net carrying amount decreases and the return
on investment increases (even if no extra income is generated),
simply because more depreciation is subtracted from the assets each
year. The use of net carrying amounts can be deceptive, as it favours
branches with older assets.
Based on gross carrying amounts, the Drakensberg branch
performs best. This is not unexpected, as its newer assets are likely
to have a higher income-generating ability. The use of gross carrying
amounts highlights the fact that the Karoo branch (with its older
cottages and furnishings that have not been replaced in seven years)
is generating less income per rand invested. Critics argue that the
decrease over time in income-earning capability of assets is ignored
when gross carrying amounts are used. In the EVA® formula, the
problem regarding carrying amounts is overcome by using assets
less economic depreciation. This re ects the true value of assets but
can be dif cult to calculate.

14.4.6 Determining ‘required rate of return’
A required rate of return has to be determined if the RI formula is
used. In the EVA® formula, which is an adaptation of RI, the
weighted average cost of capital is used as the required rate of
return. This is conceptually correct, as it is the same rate used to
determine the desirability of potential investments and therefore
promotes goal congruence. This required rate should, as previously
explained, be adjusted to re ect the risk pro le of the unit if
necessary. Furthermore, two things have to be kept in mind to
ensure consistency within the formula:
1 The length of the period re ected in ‘income’ should correspond
to the length of period re ected in the required rate. If, for
example, a year’s worth of ‘income’ is used, the rate should also
be the rate of return required per year.
2 If the weighted average cost of capital is used for calculating RI
(or a rate derived from it, but adjusted for the unit’s risk pro le),
the rate is after tax. ‘Income’ should therefore also be after tax (as
prescribed by the EVA® formula).
14.4.7 Determining ‘income’

The EVA® formula requires the use of after-tax operating income.
An important potential problem with the use of ROI, RI and ROS is
that an appropriate de nition for ‘income’ has to be sought:
• The conceptually correct de nition is usually ‘income before
interest on long-term liabilities, after tax’. Note that this is the
de nition used in the EVA® formula. This means that tax, which
is an operating cost, is subtracted from the unit’s income. The
argument is that managers of autonomous units should seek to
minimise the tax liability as part of operational performance and

their performance should therefore be measured after tax.
Interest on long-term liabilities, on the other hand, is not an
operating cost but rather a cost of nance. It is conceptually
correct to use income before interest on long-term liabilities, as
the amount of debt in the capital structure should not in uence
the calculation of the return earned. This also provides for
consistency in the formula: long-term liabilities are not
subtracted from ‘investment’, so the interest on them should not
be subtracted from ‘income’. If the information is available, it
would be correct to subtract interest on current liabilities from
‘income’ if current liabilities are subtracted from ‘investment’.
• There may be circumstances where the performance results of
units that operate under different tax laws need to be compared.
‘Income before interest and tax’ is useful here, as the effect of tax
on earnings is not taken into account. Organisations may prefer
to use income before tax in any case, simply because tax may not
be recorded in the unit income statements. Notice that the ROCE
formula in section 14.4.5 uses pro t before tax.
Once ‘income’ has been determined, it is important that the required

rate of return used when a residual income calculation is performed
be consistent with this choice. In other words, the required rate of
return should also be an after-tax rate if after-tax income is used.
Similarly, the required rate of return should be before tax if income
before tax is used. Note that the EVA® formula is consistent in this
regard: it prescribes after-tax income and uses the WACC (an after-
tax rate) as its required rate of return.
Throughout this chapter, ‘income’ is taken after subtracting
depreciation, even where the gross value of assets is used to
determine ‘investment’. Some organisations may choose to add back
depreciation when calculating ‘income’ (because it is an accounting

gure instead of an actual cash out ow), but this fails to
acknowledge that assets lose value of time. When calculating EVA®,
depreciation is added back and replaced with economic
depreciation.
Where units have investments not only in operating assets, but
also other non-operating assets (such as shares in another company
or property earning rental income), income from such assets is often
excluded from ‘income’, and the value of such investments excluded
from ‘investment’. The result indicates the unit’s own operating
performance at the exclusion of the performance of its external
investments. Where units and managers are free to make their own
non-operating investment decisions, it does, however, make sense
also to calculate the performance measures including the income
from, and investment in, non-operating assets. The required rate of
return used in a residual income calculation should then also re ect
the risk pro le of the unit, including its non-operating assets.
It is apparent that, because management accounting aims to
provide the best possible management information given the
circumstances, there is no single ‘correct’ way to calculate
performance measures. Instead, what is fundamental is that
calculations should suit the circumstances, should be internally
consistent and should be thoroughly understood for them to be
correctly interpreted in performance evaluation. Generally, the
‘income’ and ‘investment’ used to measure a unit’s performance
should take into account all aspects that can fairly be traced to the
unit and should disregard all untraceable aspects. Similarly, the
‘income’ and ‘investment’ used to measure a manager’s performance
should take into account all aspects that can fairly be deemed
controllable by the manager and should disregard all uncontrollable
aspects.

14.4.8 Multinational considerations
When organisations operate in multiple countries, comparing the
performance of units becomes more complex. Not only are political,
economic, social and technological conditions different in different
countries, but units may also conduct business in different
currencies.
If StayRSA had a branch in Botswana and wanted to use ROI, RI,
EVA® and ROS to compare its performance with that of the South
African branches, it would have to decide whether to convert the
Botswana branch’s results to rands before calculating the
performance measures, or whether to use Botswana pula in the
calculations. StayRSA would nd that it would be wiser to convert
the Botswana pula to rands before performing the calculations. This
is because the differences in economic factors such as in ation are
addressed when the currency conversion is made. In theory, the
difference in exchange rates between the countries compensates for
the relative in ation levels. The performance of the Botswana branch
can therefore more fairly be compared to that of the South African
branches if the Botswana pula are converted to rands. Income is
converted at the average exchange rate for the period under review,
while investment is converted at the prevailing exchange rate on the
date relating to the investment. StayRSA still has to take care to
ensure that it understands properly all the unique factors that have
impacted the Botswana branch’s performance before drawing
conclusions on its relative performance.
Multidimensional performance
14.5
measures

Key terms: stakeholder, triple bottom line
Several corporate scandals and industry-wide problems in many

countries in the past few decades have been blamed on an over-
emphasis of nancial performance measures that were designed to
measure short-term shareholder bene t. If a company, for example,
adopts a strong singular focus on improving its outwardly reported
earnings per share (EPS) in each reporting period, the pressure on
managers to improve this measure at the expense of all others could
be intense. Performance measurement, by its very nature, is at risk of
encouraging unethical behaviour. Unethical actions can range from
misrepresenting results to deliberately setting low targets in order to
exceed them with greater ease.
In 2018, the collapse of the JSE-listed retail company Steinhoff

International shocked the South African investment community.
Based on what you know about the case, what type of
performance measures do you think may have been
emphasised by the company? How do you think a performance
management system should be designed to encourage
sustainable performance?
Today management accountants and other professionals work to

nd ways to measure and manage performance in a more balanced
manner. They wish to address the traditional over-emphasis of
nancial measures, short-term measures and shareholder interests
(Roos 2005: 12). Good performance management systems are
increasingly designed to include the following:

• Financial measures (that which is measured in monetary terms,
such as earnings per share); non- nancial measures (that which is
not measured in monetary terms, such as the number of defects
per 1 000 units produced, market share or sales volume);
quantitative measures (that which is measured using numbers,
either nancially such as earnings per share, or non- nancially
such as the number of defects per 1 000 units produced); and
qualitative measures (that which is measured without numbers,
such as the attractiveness of a product’s packaging). A mix of
these different types of measures is used so that they supplement
each other.
• Long-term as well as short-term measures. If, for example, quarterly
performance evaluation is carried out based solely on ROI,
managers may be more likely to take decisions that go against the
organisation’s long-term best interests in order to deliver
satisfactory short-term performance. A longer-term orientation
can be gained by evaluating performance based on the ROI over
multiple periods, for example by monitoring the ROI over a
three-year period. Incorporating measures with a longer-term
focus, such as measuring the efforts made towards product
innovation, would also encourage a more balanced management
effort. Organisations should not, however, disregard short-term
performance to the extent that long-term survival is threatened: a
cash ow crisis could, for example, threaten the existence of the
organisation if it is not quickly identi ed by short-term nancial
performance measures and recti ed. Care should therefore be
taken that performance feedback is delivered at optimal intervals.
Performance evaluation periods should not be so short that they
impose an unnecessary administrative burden and encourage an
excessive short-term focus, but should also not be so long that the

bene t of timely feedback and intervention is lost. The nature of
a performance measure often dictates the ideal frequency for
reporting that particular measure.
• Measures that focus on the interests of stakeholders who are not
shareholders. A stakeholder is any group or individual with a
legitimate interest in the activities of an organisation. John
Elkington advocates that performance should be managed on
three fronts known as the ‘triple bottom line’, referring to an
organisation’s performance in terms of economic prosperity,
environmental quality and social justice. South Africa’s King IV
Report on Corporate Governance™ de nes corporate governance as
ethical and effective leadership by the governing body to achieve
an ethical culture, good performance, effective control and
legitimacy. It advocates that unintended consequences of
performance measurement should be addressed, and that
performance should be assessed over the longer term and in the
‘triple context’ (economy, society and the environment).
Organisational performance is the result of the value creation
process in terms of this triple context. The governing body
should not only oversee organisational performance, but should
also look inward: every alternate year, it should consider, re ect
on and discuss its own performance. The Integrated Reporting
Committee of South Africa advocates for integrated reporting in
our country, in line with international standards. According to
the international framework, an integrated report communicates
‘how an organisation’s strategy, governance, performance and
prospects, in the context of its external environment, lead to the
creation of value over the short, medium and long term’.
Management accountants play an important role in producing
integrated reports in organisations if required.

At the beginning of this chapter, we saw that Sanlam sets
employment equity targets and measures its internal performance
against these targets. Many South African companies do the same.
Employment equity targets are non- nancial and often include
longer-term targets. They are also targets that emphasise the
interests of stakeholders who are not necessarily shareholders.
14.5.1 Balanced scorecard

Key terms: balanced scorecard
A widely used modern multidimensional performance management

system is the balanced scorecard, developed by Kaplan and Norton
(1996). Objectives are set for each of four perspectives suggested by
the authors: nancial, customer, internal business process, and
learning and growth. The authors suggest what kinds of objectives
could be set in each perspective:
• Financial objectives for revenue growth, productivity
improvement and cost reduction, asset utilisation, and risk
management. The nancial perspective summarises the readily
measurable economic consequences of actions already taken.
• Customer objectives for product and service, customer
relationships, and image and reputation attributes. The customer
perspective measures performance in the customer and market
segments in which the organisation competes.
• Internal business process objectives for operations, innovation and
post-sale service processes. The internal business process
perspective focuses on the critical internal processes in which the
organisation must excel.

• Learning and growth objectives for employees, systems and
organisational alignment of procedures. The learning-and-
growth perspective addresses the infrastructure that the
organisation must build to create long-term growth and
improvement.
Performance is measured for each perspective according to

objectives set, establishing a link between strategy (the setting of
objectives) and performance measurement. Traditionally
organisations tended to focus on nancial performance measures
(that measure past success), often neglecting the other three
perspectives (that build future success). Notice how the nancial
perspective looks back in time; the learning and growth perspective
looks forward in time, the customer perspective looks from the
outside into the organisation, and the internal business process
perspective looks from the inside outward. The balanced scorecard
steers organisations towards a balance between different
perspectives on performance (that include nancial and non-
nancial aspects), performance over different time horizons, and
different stakeholder interests.
Many modern performance management systems use multiple
performance measures, preferably from different categories. This is
to avoid a situation where, for example, a unit is measured almost
exclusively with reference to ROI and is likely to focus its efforts on
maximising ROI at the expense of all other important performance
areas. On the other hand, too many performance measures can lead
to confusion and a lack of focus. A good performance measurement
system limits the number of measures per category.

14.6Agreeing on targets and rewarding
performance
Performance management systems enable managers to send signals
to employees, indicating what actions and behaviour are expected of
them. Frequently the results of performance evaluations are used to
reward units and individuals for achievements in past periods.
Reward systems serve as an incentive to improve performance.
In the interest of fairness, motivation and participation, many
researchers believe that units and individuals should be, at least to
some extent, involved in setting their own performance evaluation
targets before the start of a performance period. This ensures that
targets are not set ‘from the top down’ by managers who may be
unaware of the unique challenges in a given environment or
situation. During target-setting, units or individuals can, for
example, explain why particular levels of performance may not be
realistically achievable. Furthermore, units and individuals know the
exact performance targets (to which they have themselves agreed) in
advance. They have a fair opportunity to work towards the targets
throughout the period and can justi ably be held accountable if
targets are not achieved. Some of the dangers of employee
involvement in target-setting is the fact that targets may be
deliberately set too low so that actual performance easily looks
impressive in comparison, or the fact that particular employees may
in some circumstances be inclined to perform better when working
towards stringent ‘top–down’ targets.
Favourable performance by individuals can be rewarded in
different ways, such as through increased remuneration, promotion
to higher status or non- nancial bene ts such as a better of ce or
parking. Remuneration may consist of cash and non-cash

components. Senior managers, for example, often receive share
options in addition to cash bene ts. Share incentive schemes work
on the principal that
managers are likely to act in the interest of shareholders, because
they themselves are shareholders (or hold options that entitle them
to become shareholders). If the company performs well and its share
price increases, managers’ shares are worth more. The schemes do
not, however, directly encourage managers to work in the interest of
other stakeholders. The following should be noted in relation to
share incentive schemes:
• Share incentives are often more likely to be given to more senior
employees, because seniority often determines an employee’s
ability to in uence a company’s share price (the controllability
principle).
• Options to purchase shares at a future date at a particular
exercise price are often given, rather than the shares themselves.
A condition may apply that the option can only be exercised if
the individual is still employed by the company at that time. This
encourages individuals who are regarded as valuable employees
to remain attached to the company, at least until the options may
be exercised.
Cash remuneration itself may also consist of different elements.

Consider a hairdresser who applies for a position at a salon. She is
offered a salary, commission and the possibility of a performance
bonus based on the salon’s annual income. The xed element of the
offer is the salary, while the commission and bonus elements are
variable. The higher the xed salary in relation to the variable
elements, the more risk is borne by the salon: it has to pay the salary
even when pro ts are low, but is better off if pro ts are high.
Conversely, the higher the variable elements in relation to the xed

salary, the more risk is borne by the hairdresser: she is assured of
little income if she performs poorly, but high income if she performs
well.
Not-for-profit and public sector

14.7
organisations
Key terms: not-for-pro t organisation, public sector

organisation, value for money
The principles of performance management apply not only to pro t-

seeking organisations but also to not-for-pro t and public sector
organisations. These organisations do, however, have unique
characteristics that have to be considered in designing a performance
management system. Achieving optimal performance management
in not-for-pro t and public sector organisations poses an interesting
challenge to management accountants’ skills.
The primary purpose of a not-for-pro t organisation is not one
of pro t maximisation, although it may – to a limited extent –
engage in economic activity in pursuit of its primary purpose. The
Animal Welfare Society of South Africa is an example of a not-for-
pro t organisation. The purpose of a public sector organisation is to
serve the public, and it is funded by the government. An example of
a public sector organisation, the Tygerberg Hospital, was introduced
at the beginning of this chapter.
The demand for goods and services provided by private sector,
pro t-seeking organisations is limited by how much the market can
absorb. Not-for-pro t and public sector organisations, on the other
hand, face the problem of having to address a seemingly unlimited
demand, but with limited resources at their disposal. In these

organisations, performance is often managed with reference to
‘value for money’ (VFM) which refers to ‘three Es’:
1 Economy. Performance is economical when the least possible
money is spent.
2 Ef ciency. Performance is ef cient when the minimum of
resources is consumed.
3 Effectiveness. Performance is effective when objectives are
achieved.
Economy and ef ciency are usually fairly easy to measure and are
therefore often measured by performance management systems.
Effectiveness is often more dif cult to measure: how, for example,
does one know that the Tygerberg Hospital has given the best
quality healthcare to the most patients that it could possibly have
assisted? Effectiveness is also the most important of the ‘three Es’: if
objectives are not achieved, the level of economy and ef ciency with
which they are not achieved is unimportant. Not-for-pro t and
public sector organisations should therefore take great care in
managing the effectiveness of their performance, in addition to
controlling the economy and ef ciency thereof.
14.8 Summary
Organisations measure performance in order to evaluate the past
achievements of managers and organisational units. They also
communicate how performance will be measured in future in order
to manage the performance of individuals and units in those future
periods. Performance is measured in line with the organisation’s
overall objectives and is compared to an appropriate yardstick to
make it possible to draw meaningful conclusions.

Under responsibility accounting, individuals are held responsible
for speci ed revenues, costs, assets and liabilities. As a basic point of
departure, managers are ideally held accountable for those items
which are within their control, while the performance of units is
measured based on that which is traceable to the unit.
In highly decentralised organisational structures, unit managers
have a large degree of freedom when it comes to decision-making.
Decentralisation should, however, be executed in such a manner as
to ensure goal congruence: the performance management system
should ensure that individuals automatically act in the best interest
of the organisation as a whole, while pursuing their own self-
interest.
Popular nancial performance measures include return on
investment, residual income, economic value added (EVA®) and
return on sales. These measures all have advantages and
disadvantages, so ideally none of them should be used in isolation
and they should rather form part of a balanced portfolio of
performance measures. The precise de nitions of the input variables
used to calculate the measures should be chosen carefully: the
‘investment’, ‘required rate of return’ and ‘income’ used in the
formulae should be appropriate under the circumstances.
These days, multidimensional performance measures, most
notably the balanced scorecard, are particularly prominent in that
they take a balanced view of what ought to be achieved in an
organisation. Performance measures should ideally not focus
exclusively on nancial performance, should not over-emphasise the
short term, and should take a stakeholder rather than merely a
shareholder view.

Conclusion: Performance management
As a conclusion to performance management, it is important to note
how large a part of management accounting it comprises. Topics
such as standard costing, benchmarking, budgeting, continuous
improvement, costing systems and cost allocation can all be directly
linked to performance management, because they deal with ways in
which objectives are set, results are recorded and performance is
measured. As the topics do not exist in isolation, performance
management principles are applicable throughout the eld of
management accounting.
Tutorial case study: Stellenbosch University
The main campus of the Stellenbosch University is located in the town of

Stellenbosch in the Western Cape. It also has a presence in some other locations –
for example, its business school is on a separate campus in the city of Bellville, its
military academy is located in Saldanha, and Tygerberg Hospital in Parow is the
teaching hospital for its health sciences faculty. The university’s mission is to be ‘a
research-intensive university where we attract outstanding students, employ
talented staff and provide a world-class environment; a place connected to the
world, while enrich-ing and transforming local, continental and global communities’.
SOURCE: STELLENBOSCH UNIVERSITY (2019)
Although the case study information relates speci cally to Stellenbosch University,
knowledge of the tertiary institution through which you study may prove helpful in
answering the following questions:
1 Indicate whether the university can best be described as a pro t-orientated
private sector organisation, a not-for-pro t organisation or a public sector
organisation.
2 Explain what objectives you think the university may set for itself.
3 Indicate along what lines you think the university may divide itself into units and
sub-units.

4 Give one example of each of the following, and explain the reasons for your
choices: a unit within the university that you think the university management
may wish to classify as–
• a cost centre
• a revenue centre
• a pro t centre
• an investment centre.
5 Give two examples of nancial performance measures and two examples of non-
nancial performance measures for each of the units you named in response to
question 4.
6 For each of the nancial performance measures formulated in response to
question 5, explain what yardsticks could be used to evaluate how well the units
have performed.
7 For one of the units named in response to question 4, explain by way of example
how the performance measurement of the manager of the unit may differ from
the performance measurement of the unit.
8 Discuss whether you would recommend a largely centralised or a more
decentralised management control structure for the university. Also indicate
whether you think the same extent of decentralisation should be applied
throughout the university.
9 Give examples of how the performance management system of the university
could promote goal congruence where units have a large degree of autonomy.
10 Discuss whether the balanced scorecard could be of value to the university in
designing its performance management system.
11 Describe performance measures that encourage ethical behaviour that could be
formulated for the university.
Basic questions
BQ 1
A transport company operates a number of divisions. One of the
divisions, the Trucking Division, has just submitted its management
accounts for the nancial year ended 31 July 2XX6 to head of ce. The
Trucking Division reported a return on investment of 12% and
operating income of R1 000 000 for the year ended 31 July 2XX6.
How did the division perform in terms of return on investment and

operating income during the year ended 31 July 2XX6? What
additional information would you need before evaluating its
performance?
BQ 2
The copy department of a university reproduces hard copies of
course material for students as required. Below are three scenarios
explaining the performance measurement of the department:
• Scenario A: Detailed records are kept of the cost of paper, ink and
other operating expenses attributable to the department. These
are compared to the budget on a monthly basis and all negative
budget variances greater than 5% are investigated.
• Scenario B: As in scenario A, detailed records of costs are kept.
The department charges academic and other service departments
12 cents per page requested. This is recorded as income in the
department’s accounts and costs are subtracted from the income.
Income and costs are compared to the budget on a monthly basis
and all negative budget variances greater than 5% are
investigated.
• Scenario C: As in scenario B, detailed records of costs are kept and
the department charges other departments 12 cents per page
requested. The manager of the department uses his own
discretion in the purchase and sale of capital equipment. The
performance of the department is measured with reference to
‘pro t’ generated relative to assets employed.
What kind of responsibility centre is likely to apply in each of

scenarios A, B and C?
BQ 3

Head of ce costs of R662 000 have been allocated to the Cape Town
hotel, which is part of a hotel group. The costs comprise R600 000 in
head of ce administration costs allocated and R62 000 in respect of
wine supplied by head of ce with the hotel logo on the bottle. The
following also apply:
• Head of ce administration costs are allocated equally among
hotels in the group. The budget corresponds to the actual head
of ce administration costs for the year.
• Hotels in the group can order wine bottles with the hotel logo
from head of ce. The budgeted cost per bottle has been set at
R300. In her budget for the year, the Cape Town hotel’s manager,
Thandi, made provision for 150 such bottles, but ended up
ordering 200.
• An error occurred at head of ce, and as a result the bottles were
initially incorrectly labelled. The supplier had to be paid to
remove and replace the incorrect labels. The actual cost per bottle
was R310 as a result of this blunder.
How should the item ‘head of ce costs allocated’ be taken into

account in Thandi’s performance evaluation?
BQ 4
Treesaver is a not-for-pro t organisation that was established in the
Garden Route a year ago and aims to save trees of particular historic
interest. After a successful year, it is already considering establishing
branches in other parts of the country where important trees grow.
However, the founding members nd the idea of managing
organisational branches that are so far apart a daunting task. After
some deliberation, they conclude that it may be in their best interest
to exercise extensive control over the activities of the branches and

that all signi cant decisions taken at branch level should be
approved by themselves before being implemented. What are the
potential relative advantages and disadvantages for Treesaver of
implementing this planned management control structure?
BQ 5
Two of the divisions of a large retail organisation have approached
the central management team to resolve a dispute between them.
The security division is tasked with providing effective, visible
security at the organisation’s retail outlets. The primary objectives of
the security division are to prevent shoplifting and to protect the
safety of customers and staff. In doing so, they insist on searching an
increasing number of bags and other personal effects of customers to
detect shoplifting. The sales division is furious about the constant
security checks. They can prove that they are losing revenue to
competitor organisations where the public can shop without security
interference. The primary measure used to evaluate the performance
of the security division is the percentage increase or decrease in the
absolute value of losses as a result of shoplifting. The following
gures were recorded in 2XX5 and 2XX6 respectively:
2XX6 2XX5
Total sales income R315 000 000 R300 000 000
Losses resulting from shoplifting R40 000 000 R39 000 000
Keeping goal congruence in mind, how can a change in the way

performance is measured help to resolve the con ict?
BQ 6

The following is an extract from the accounting records of company
C:
Item 2XX2 2XX1

Total assets R67 675 000 R65 730 000
Net income before interest, after tax R8 130 000 R10 140 000
Revenue R64 555 000 R59 590 000
Company C calculates return on investment based on the average

investment. Its return on investment for 2XX2 has been calculated as
12,2%. The directors are very disappointed, as they were expecting a
15% return. What can be learnt about company C’s return on
investment if the Du Pont analysis is applied?
BQ 7
Produ (Pty) Ltd has several factories and a highly decentralised
management structure. Each factory’s performance is primarily
evaluated based on return on investment. The weighted average cost
of capital of the company is 11% per annum. Alice, the Cape Town
factory manager, is considering selling machinery worth R200 000.
She estimates that the machinery generates annual after-tax
operating income of R24 000. In the previous nancial year, the Cape
Town factory’s return on investment was 14% per annum. The risk
pro le of the Cape Town factory is in line with that of the company.
Why may Alice possibly be contemplating the sale of the machinery?
Would it be in the best interest of Produ (Pty) Ltd to sell the
machinery?
BQ 8

The following applies to a company with no long-term liabilities in
respect of the 2XX7 year:
Sales R3 000 000
Operating expenses ( xed and variable) (R2 000 000)
Income R1 000 000
Assets R8 000 000
For purposes of the residual income formula, management requires

a return of 10% per annum. Similar companies yield a return on
investment of 11% per annum and a return on sales of 30% per
annum. How well did the company perform nancially, especially
with reference to return on investment, residual income and return
on sales?
BQ 9
Peter has calculated the following performance measure of the
company he works for:
Income less (required rate of return × assets)

= R1 368 000 – (12% × R10 500 000)
= R108 000
The manager he reports to has subsequently asked him to state

whether he had performed a calculation of economic value added
(EVA®). Peter explained that he had intended to calculate residual
income, but that the same calculation might just as well be seen as a
calculation of EVA®. To calculate ‘assets’, Peter used total assets less
current liabilities. Do you agree that a residual income calculation
could just as well pass for a calculation of EVA®? What questions

would you ask Peter in order to assess whether his calculation is
indeed the same as a calculation of EVA®?
BQ 10
The Global Company sells leather covers that protect tablet
computers. The covers are manufactured exclusively for the Global
Company in the Far East. They are then shipped to London, where
the Global Company’s brand name is applied to the covers and
where they are individually packed in branded packaging. From
London, the covers are distributed worldwide. Can you think of
three stakeholder groups, other than shareholders, whose needs may
be addressed in the performance measures of the Global Company?
Broadly speaking, what information could such performance
measures focus on? You do not have to formulate detailed
performance measures.
Long questions

This year’s pro t for a multinational group of companies was
signi cantly below expectations. Concern has been expressed about
the reporting and performance measurement systems used by the
group. A review of the performance measures currently used by the
group has been carried out and has identi ed a number of issues:
• Return on investment (ROI) is used throughout the group to
evaluate the performance of the managers of the subsidiaries.
• Performance measures are predominantly of a nancial nature.
• The number of customer complaints in some subsidiaries had
increased signi cantly during the year. This had not been

reported to the parent company.
REQUIRED Marks
(a) Discuss three problems that could occur as a result of using return on investment to evaluate
5
the performance of managers.
(b) Explain three reasons why a performance measurement system based solely on nancial
5
measures may not be effective in evaluating the long term performance of companies.
(c) Discuss how the use of a balanced scorecard could have helped to avoid the customer
complaint issues. 3
List four performance measures which could be used to monitor customer satisfaction. 2
TOTAL MARKS 15

A rm of attorneys is using budgetary control during 20X0. The
senior partner estimated the demand for the year for each of the
rm’s four divisions: Civil, Criminal, Corporate, and Property. A
separate partner is responsible for each division.
Each divisional partner then prepared a cost budget based on the
senior partner’s demand estimate for the division. These budgets
were then submitted to the senior partner for his approval. He then
amended them as he thought appropriate before issuing each
divisional partner with the nal budget for the division. He did not
discuss these amendments with the respective divisional partners.
Actual performance is measured against the nal budgets for each
month, and each divisional partner’s performance is appraised by
asking the divisional partner to explain the reasons for any variances
that occur.
The corporate partner has been asked to explain why her staff
costs exceeded the budgeted costs for last month while the

chargeable time was less than budgeted. Her reply is as follows:
‘My own original estimate of staff costs was higher than the nal
budgeted costs shown on my divisional performance report. In
my own cost budget I allowed for time to be spent developing
new services for the rm’s corporate clients and improving the
clients’ access to their own case les. This would improve the
quality of our services to clients and therefore increase client
satisfaction. The trouble with our present system is that it focuses
on nancial performance and ignores the other performance
indicators found in modern performance management systems.’
REQUIRED Marks
(a) Discuss the present budgeting system and its likely effect on divisional partner motivation. 6
(b) Explain two non- nancial performance indicators (other than client satisfaction and service
4
quality) that could be used by the rm.
TOTAL MARKS 10

SOURCE: ADAPTED FROM ACCA P5
The Health and Fitness Group (HFG), which is privately owned,
operates three centres in the country of Mayland. Each centre offers
dietary plans and tness programmes to clients under the
supervision of dieticians and tness trainers. Residential
accommodation is also available at each centre. The centres are
located in the towns of Ayetown, Beetown and Ceetown. The
following information is available:
• Summary of nancial data for HFG in respect of the year ended
31 May 2XX8:

HFG de nes residual income (RI) for each centre as operating
•
pro t minus a required rate of return of 12% of the total assets of
each centre.
• At present HFG does not allocate the long-term borrowings of
the group to the three separate centres.
• Each centre faces similar risks.
• Tax is payable at a rate of 30%.
• The market value of the equity capital of HFG is R9 million. The
cost of equity of HFG is 15%.
• The market value of the long-term borrowings of HFG is equal to
the carrying amount.
• The directors are concerned about the return on investment (ROI)
generated by the Beetown centre and they are considering using
sensitivity analysis in order to show how a target ROI of 20%
may be achieved.
• The marketing director stated the following at a recent board
meeting: ‘The Group’s success depends on the quality of service
provided to our clients. In my opinion, we need only to concern
ourselves with the number of complaints received from clients
during each period as this is the most important performance
measure for our business. The number of complaints received
from clients is a perfect performance measure. As long as the
number of complaints received from clients is not increasing
from period to period, then we can be con dent about our future
prospects.’

SOURCE: ADAPTED FROM ACCA PM
Best Night Co operates a chain of 30 hotels across the country of
Essland. It prides itself on the comfort of the rooms in its hotels and
the quality of service it offers to guests. The majority of Best Night
Co’s hotels are located in major cities and have previously been
successful in attracting business customers. In recent years, however,
the number of business customers has started to decline as a result of
tough economic conditions in Essland. Best Night Co’s policy is to
set standard prices for the rooms in each of its hotels, with that price
re ecting the hotel’s location and taking account of competitors’
prices. However, hotel managers have the authority to offer
discounts to regular customers and to reduce prices when occupancy
rates in their hotel are expected to be low. The average standard
price per night, across all the hotels, was R1 400 in 20X7, compared
to R1 350 in 20X6. In addition to room bookings, the hotels also

generate revenue from the additional services available to
customers, such as restaurants and bars.
Summary from Best Night Co’s management accounts:
Year ended 30 June 2XX7 Year ended 30 June 2XX6

R’000 R’000
Revenue – rooms at standard price per

111 890 104 976
night
Room discounts or rate reductions given (16 783) (11 540)
Other revenue: food, drink 24 270 23 185
Total revenue 119 377 116 621
Operating costs (95 462) (92 379)
Operating pro t 23 915 24 242
Other performance information:
Year ended 30 June 20X7 Year ended 30 June 20X6
Capital employed (Note 1) R39,5m R39,1m
Average occupancy rates (Note 2) 74% 72%
Average customer satisfaction score (Note 3) 4.2 4.5
Notes:
1 Capital employed is calculated using the depreciated cost of non-
current assets at all Best Night Co’s hotels.
2 Occupancy rates for the year ended 30 June 20X7 were budgeted
to be 72%.
3 Customer satisfaction scores are graded on a scale of 1–5 where
‘5’ represents ‘excellent’. On average, in any given town in
Essland, the top 10% of hotels earn a score of 4·5 or above and the
top 25% of hotels earn a score of 4·2 or above.

Two themes are becoming increasingly frequent in the comments
Best Night Co’s customers make alongside the scores:
1 Repeat customers have said that the standard of service in recent
visits has not been as good as in previous visits.
2 The rooms need redecorating, and the xtures and ttings need
replacing. For example, the beds need new mattresses to improve
the level of comfort they provide. Best Night Co had planned a
two-year refurbishment programme beginning in 20X7 of all the
rooms in each hotel. However, this programme has been put on
hold in order to reduce expenditure.
REQUIRED Marks
Using the information provided, discuss Best Night Co’s nancial and non- nancial performance
for the year ended 30 June 20X7.
Note: There are 5 marks available for calculations and 15 marks available for discussion. 20
TOTAL MARKS 20

The Benjamin Education College (BEC), which is partially
government funded, is a well-established provider of professional
courses for students of accounting, law and marketing in the country
of Brightland.
Its mission statement states that the college ‘is committed to
providing high quality education to all students’. BEC provides
education to private fee-paying students as well as to students who
are funded by the government.
The Jackson Business Centre (JBC), which commenced trading
during 2XX4, is also a provider of professional courses for students
of accounting, law and marketing in the country of Brightland. It is a

privately owned college and all its students are responsible for the
payment of their own fees.
Relevant operating data for BEC and JBC for the year ended 30
November 2XX9 are as follows:
1 Both BEC and JBC offer a range of courses in accounting, law and
marketing on a twice per annum basis.
2 Fees (budget and actual) payable to BEC and JBC in respect of
each student who enrolled for a course were as follows:
3 Salary costs per staff member were payable as follows:
4 Budgeted costs for the year based on 8 000 students per annum
for BEC were as follows:

5 Variable costs vary according to the number of students
attending courses at BEC.
6 Actual costs (other than salary costs) incurred during the year
were as follows:
BEC R JBC R
Tuition materials 741 600 730 000
Catering 95 680 110 000
Cleaning 40 950 40 000
Other operating costs (including costs of freelance staff) 646 800 645 000
Depreciation 40 000 60 000
7 The management of JBC is considering introducing online tuition

support by its lecturing staff.
8 Both BEC and JBC operated according to a policy which aimed to
employ 60 lecturers throughout the year.
9 The appendix below shows budget and actual statistics for BEC
and actual statistics for JBC.
10 Sundry statistics for the year ended 30 November 2XX9:

REQUIRED Marks
The senior management team of BEC has asked you, as management accountant, to prepare a
report providing them with the following:
(a) A statement which shows actual and budgeted income statements of BEC and an actual
income statement for JBC in respect of the year ended 30 November 2XX9 on a comparable
basis. 10
(b) An assessment of the performance of BEC and JBC using both nancial and non- nancial
measures based on the information contained in the question. You should identify other 10
measures of performance which you consider relevant to BEC.

(c) A discussion of the issues that might restrict the extent to which a performance measurement 6
system is accepted and supported by management and employees.
Professional marks will be awarded for appropriateness of format, style and structure of the
4
report.
TOTAL MARKS 30
References
CIMA (Chartered Institute of Management Accountants). 2002. Business transparency in a
post-Enron world. Executive Brie ng, August. London: CIMA.
Elkington, J. 1998. Cannibals with forks: the triple bottom line of 21st century business. Gabriola
Island, BC: New Society.
Garrett, K. Performance indicators. [Online]. Available:
https://www.accaglobal.com/gb/en/student/exam-support-resources/professional-
exams-study-resources/strategic-business-leader/technical-articles/performance-
indicators.html [25 August 2019].
International Integrated Reporting Council. 2013. The international IR framework, December.
London: International Integrated Reporting Council.
Johnson, HT & Kaplan, RS. 1987. Relevance lost – the rise and fall of management accounting.
Boston, MA: Harvard Business School.
Kaplan, RS & Norton, DP. 1996. The balanced scorecard. Boston, MA: Harvard Business
School. 14, 25, 26, 28, 61, 85, 115–116.
Rappaport, A. 1998. Creating shareholder value: a guide for managers and investors, revised
edition. New York: Free Press.
Roos, S. 2005. Involving the management accountant in external reporting to prevent
corporate accounting scandals. Southern African Business Review, 9(2):12–21.
Sanlam. 2018. 2018 Annual results. [Online]. Available:
https://www.sanlam.com/investorrelations/ourperformance/annualresults2018 [20
August 2019].
Stellenbosch University. n.d. Vision 2040 and strategic framework 2019–2024. [Online].
Available: https://www.sun.ac.za/english/about-us/strategic-documents [22
August 2019].
Western Cape Government. Tygerberg hospital: overview. [Online]. Available:
https://www.westerncape.gov.za/your_gov/153 [20 August 2019].
Woolworths Holdings. n.d. Our purpose, vision and values. [Online]. Available:
https://www.woolworthsholdings.co.za/overview/our-purpose-vision-and-values [20
August 2019].

LEARNING OBJECTIVES
• explain the conceptual aspects of transfer pricing
• explain the need for transfer pricing within an organisation
• calculate and discuss the level of internal transfers and the level
of external sales that result in the best outcome for the
organisation as a whole
• calculate and discuss market price-based and cost-based transfer
prices
• calculate and discuss transfer prices where the transferring and
receiving units respectively operate in both perfect and imperfect
markets (see Appendix 15.1)
• discuss methods of resolving transfer pricing problems,
including pro-rating the difference according to variable costs,
supplementing the transfer price by a recurring fee, dual pricing,
supplementary performance measures and additional unof cial
accounting records
• discuss and calculate transfer prices for international transfers
• discuss the strategic and ethical considerations relevant to
transfers and transfer pricing.
Bidvest and transfer pricing

A number of businesses and divisions form part of the Bidvest group of companies,
and some of them trade with each other. Bidvest Automative, for example, supplies
vehicles to Bidvest Services. Bidvest Services, in turn, renders services to Bidvest
Properties. Bidvest Financial Services centrally manages the group’s treasury
matters and acts as a business partner to Bidvest’s businesses on specialised
nancing arrangements.
SOURCE: HTTPS://WWW.BIDVEST.CO.ZA/ (2019)
Although Bidvest’s divisions all work together to earn pro ts for the
group as a whole, performance of the individual divisions also needs
to be managed. A number of transfer pricing issues arise, for
example:
• What would be a reasonable price for Bidvest Automative to
charge for the vehicles it supplies to Bidvest Services?
• What would be a reasonable price for Bidvest Services to charge
for the services it renders to Bidvest Properties?
• Does Bidvest Automative have to pay for the services it receives
from Bidvest Financial Services? If so, should it pay the same
price that Bidvest Properties and Bidvest Services pay for the
services that they receive from Bidvest Financial services?
Chapter 15 explores the issues that organisations face when

determining transfer prices.
15.1 Introduction
Key terms: transfer price
Chapter 14, Performance management explained the need for

managing the performance of units within an organisation. Where
units transact with each other, transfer pricing is necessary to enable

units to record internal transactions in their nancial records, and for
the measurement, evaluation and management of nancial
performance of units. Transfer pricing in effect allocates pro ts to
units and can support the autonomy of units in a decentralised
organisational structure. Transfer pricing can also be used as a
means of promoting goal congruence in an organisation. These aims
of transfer pricing will be discussed in more detail in this chapter.
The term ‘unit’, as used here, means any part of an organisation
whose performance is separately recorded and evaluated. Some
organisations may refer to such units as branches, departments or
divisions. A unit may even be a company that forms part of a larger
group of companies. Transfer pricing issues arise when such units
transact with each other – a transfer price is the price at which goods
or services are transferred between different units of the same
organisation.
Example 15.1
Unit A of the Paper Company manufactures A4-size blank paper sheets for use in
printers and copiers. Unit A incurs variable costs of R65 in manufacturing each
standard box of paper. Unit B of the Paper Company operates a large warehouse and
distributes the paper throughout South Africa. Unit B incurs incremental costs of R20
per box of paper. Stationery retail stores pay the Paper Company R100 per box of
paper.
Unit A (supplying division) Unit B (receiving division)
Required:
Indicate how the contribution earned could be shared between units A and B.
The Paper Company earns a contribution of R15 (R100 – R65 – R20)

per box of paper. How this is divided between the two units
depends on how much unit A charges unit B for the paper
transferred (in other words, it depends on the transfer price). If unit

A charges R80 per box, unit B will earn no contribution: unit B will
‘purchase’ each box of paper for R80, incur further costs of R20 and
sell it for R100. The entire contribution that the company earns,
namely R15 per box, will be recorded in the books of unit A (R80 –
R65). The reverse is true if unit A charges R65 per box. Unit A will
earn no contribution, while the entire R15 company contribution is
recorded in the books of unit B (R100 – R65 – R20). It seems that a
transfer price of between R65 and R80 is desirable – one that fairly
allocates a portion of the contribution to each unit.
The need to establish transfer prices often arises from the need to
manage the performance of units within an organisation – the
transferring division records a ‘sale’, while the receiving division
records a ‘purchase’. This allows managers to keep an internal set of
accounts for each unit within the company, which can be used to
assess the performance of units and their managers. Note that the
transfer price that units A and B nally agree on in example 15.1 is
not recorded in the annual nancial statements of the Paper
Company and does not impact on the contribution recorded by the
Paper Company as a whole. This is because, in the books of the
company as a whole, the ‘sale’ by unit A is cancelled out by the
‘purchase’ by unit B. The Paper Company records a contribution of
R15 per box of paper, irrespective of the transfer price agreed upon.
Where units take the form of separate legal entities, such as
companies that form part of a larger group, each company records
transfer prices paid or received in its own annual nancial
statements. Related party disclosure has to be supplied in the annual
nancial statements in accordance with IAS 24. Upon consolidation
of the group results, intra-group transactions cancel each other out
and only the net result (equivalent to the R15 contribution in
example 15.1) is recorded in the consolidated accounts. Where units

are legal entities and have goods for transfer on hand at the end of
the nancial year, care has to be taken that the value placed on such
inventory items complies with the requirements of IAS 2. Even
where units are not legal entities but are signi cant segments of a
company, the company may have to produce segment reports in
accordance with IFRS 8.
Key terms: autonomous units, decentralised organisations
By their very nature, transfer prices occur only in organisations that

consist of different units for which performance is separately
recorded. Such organisations often have some degree of
decentralised management control, which means that decision-
making responsibility is to some extent delegated to unit managers.
While some organisations may prescribe transfer prices or set
transfer price boundaries, highly decentralised organisations
(where units are said to be autonomous units) allow transfer prices
to be determined through negotiation between the units concerned.
Decentralisation and negotiation of transfer prices often result in
very favourable outcomes for an organisation, as units are
encouraged to develop aggressively ways of conducting business
ef ciently in order to secure internal sales. However, transfer prices
can potentially be a source of great con ict between units, as they
directly affect the performance measurement results of the units
concerned. Even a highly decentralised organisation’s central
management may sometimes wish to intervene in negotiations that
cause undesirable levels of con ict or unacceptable outcomes,
through the setting of transfer prices or transfer price boundaries.

Key terms: goal congruence
Complicated transfer pricing issues can arise in organisations with a

decentralised management control structure. Although the
delegation of authority has substantial potential advantages, as
discussed in Chapter 14, Performance management, particular care has
to be taken to avoid the setting of transfer prices that con ict with
the best interests of the organisation as a whole.
Example 15.2
The same information as in example 15.1 applies, but with the following additional
points:
• Unit A’s manufacturing capacity is limited to 20 000 boxes of paper per month.
• Units A and B have agreed on a transfer price of R72,50 per box of paper.
• AfriWrite, a stationery warehousing and distribution company, has now offered to
purchase all the paper boxes from unit A each month for distribution in
neighbouring countries.
• AfriWrite has agreed to pay R75 per box of paper.
Unit A (supplying division) AfriWrite (receiving division)
Required:
Determine whether unit A should agree to sell paper to AfriWrite.
AfriWrite is willing to pay unit A R2,50 more per box of paper than
the internal transfer price. This means that unit A can increase its
monthly contribution by R50 000 (20 000 boxes × R2,50). However, if
unit A supplies to AfriWrite, it will be acting in its own best interest
but not in the best interest of the Paper Company as a whole. The
Paper Company earns a contribution of R15 (R100 – R65 – R20) per

box of paper on internal transfers to unit B, but only R10 (R75 – R65)
per box of paper sold to AfriWrite. The transfer price of R72,50 per
box will have to be revised, as it encourages unit A to act against the
best interest of the organisation as a whole.
Chapter 14, Performance management discussed the concept of goal
congruence. Goal congruence means that individuals and units take
actions that are in their self-interest and simultaneously also in the
best interest of the organisation as a whole. The ideal performance
management system, which includes the transfer pricing system, is
designed in such a way that each individual and each unit within the
organisation prefers to act in the best interest of the organisation as a
whole at all times because they are simultaneously acting in their
own best interests. The overriding requirement for a transfer pricing
system is therefore that it should ensure that transfer prices
encourage unit managers to act in the best interest of the
organisation as a whole. In example 15.2, this can be achieved by
setting a transfer price of between R75 and R80. Because unit A will
now earn at least R75 per box of paper transferred, the sub-optimal
decision to sell paper to AfriWrite will not be taken.
Note that, in example 15.1, the acceptable range of transfer prices
was R65 to R80. In example 15.2, the minimum transfer price has
increased to R75, owing to the presence of AfriWrite in the market.
Apart from encouraging goal congruence, a transfer pricing
system should also be effective and ef cient. A transfer pricing
system is effective when its objectives are achieved – an effective
system, for example, ensures that the performance of units is
accurately and fairly recorded. An ef cient transfer pricing system
consumes the minimum resources in the achievement of its
objectives, in other words it does not place an unnecessary nancial
or administrative burden on the organisation.

Key terms: intermediate product or service, perfectly

competitive market
An intermediate product or service is the product or service that is

transferred from one unit of an organisation to another unit in the
same organisation. If the transferring unit can sell the intermediate
product or service externally in a perfectly competitive market, the
market price may be the ideal transfer price. A perfectly competitive
market exists when a homogeneous product or service with equal
buying and selling prices is sold in a market where individual
buyers and sellers cannot affect prices by their own actions.
Example 15.3
points:
• Paper manufacturers sell standard A4-sized paper for use in printers and copiers to
stationery warehousing and distribution companies in the open market at R75 per
box.
• There is a large number of sellers and buyers.
• A perfectly competitive market exists.
Required:
Recommend a transfer price per box of paper transferred from unit A to unit B.
In this case, the market price of R75 per box is the ideal transfer
price. Unit A can sell its paper in the open market for R75 per box
and unit B can purchase paper in the open market at R75 per box. A
transfer price of R75 per box will leave both units no worse off if an
internal transfer takes place. However, should there be any cost

savings associated with an internal transfer, there is more room for
negotiation. Assume that it costs unit A R1 per box to have the paper
delivered at the premises of an external paper warehousing and
distribution company. Unit A incurs no such cost when it transfers
paper to unit B, as unit A’s factory is on the same premises as unit
B’s primary warehouse. Unit A effectively earns only R74 (R75 – R1)
per box when it sells paper externally. Unit B can purchase paper
externally at R75 per box. A transfer price of between R74 and R75
should therefore be negotiated.
Practical examples of savings that frequently occur on internal
transfers include not only transport costs, as in the example above,
but also savings in marketing costs (entertainment, for example) and
nancing costs (if the external purchaser buys the product on credit).
In example 15.3, we have assumed that all manufacturers
produce standard, identically packaged paper. In practice, there may
be variations in aspects such as the quality, packaging, service levels
offered or discounts granted, meaning that an accurate market price
for the exact product or service may not be available.

One way of setting a transfer price is for the organisation’s central
management to decide to calculate transfer prices based on the cost
of the intermediate product or service. Organisations sometimes
choose to add a speci ed mark-up percentage to the cost base.
Example 15.4
points: unit A’s xed costs amount to R5 per box of paper, while unit B’s xed costs
are R1 per box of paper.

Required:
Calculate the transfer price per box of paper if the Paper Company’s central
management stipulates that all boxes of paper should be transferred to unit B at a
transfer price of (a) variable cost plus 20%, and (b) full cost plus 20%.
The transfer prices are as follows:

• Based on variable cost: R65 plus 20% = R78
• Based on full cost: (R65 plus R5) plus 20% = R84.
Cost-based transfer prices can lead to sub-optimal decisions if the

organisation’s units are autonomous. Assume that unit B can
purchase paper from another manufacturer, Pulp World, at R75 per
box. If unit B has the autonomy to purchase paper either from unit A
or from an external supplier, unit B will rather purchase externally
than receive a transfer from unit A under both scenarios (a) and (b)
above. However, the Paper Company’s best interest would not be
served by such a decision. The company earns a contribution of R15
(R100 – R65 – R20) per box on internal transfers, but a contribution
of only R5 (R100 – R75 – R20) per box if unit B buys paper from Pulp
World.
If a transfer price based on variable cost without any mark-up is
used, the disadvantage is that the transferring division does not
recover its xed costs. Transfer prices based on full cost, on the other
hand, have the disadvantage that indirect costs could be
questionably allocated owing to the use of inappropriate cost pools,
cost drivers or allocation bases.
Whenever the transfer price is set higher than the transferring
unit’s incremental cost, as in example 15.4 above, receiving divisions
reimburse transferring divisions for more than just the cost of
supplying the product or service. The longer the chain of intra-
company transfers (in other words, unit A supplies to unit B, which

supplies to unit C, and so forth), the more internal pro t is added on
top of pro ts already recorded by preceding divisions. The process
increases the danger of units taking decisions that con ict with the
best interest of the company as a whole.
An additional point to remember is that, to prevent any cost
inef ciencies in the transferring unit from being carried over to the
receiving unit, the transfer price should be based on standard costs
or budgeted costs rather than actual costs.

Where units are highly autonomous, transfer prices are agreed
through negotiation. In order to ensure that the transfer price does
not lead to decisions that con ict with the best interest of the
company as a whole, a range of goal-congruent transfer prices can
rst be determined. A nal transfer price is then negotiated within
this range. The following steps apply:
• Establish the level of internal transfers (to other units in the
organisation) and the level of external sales (to other
organisations) that will result in the best outcome for the
organisation as a whole.
• Determine the minimum and the maximum transfer prices that
will result in autonomous units choosing to operate at the level
determined in step 1.
15.6.1 General guidelines

Key terms: autonomous receiving unit, autonomous transferring
unit, maximum transfer price, minimum transfer
price

In order to carry out step 2 above, a minimum and a maximum
transfer price have to be determined that will lead autonomous units
to act in a goal-congruent manner.
The minimum transfer price is the smallest amount an

autonomous transferring unit would be willing to receive and
still choose to act in the best interest of the organisation as a
whole. The maximum transfer price is the largest amount an
autonomous receiving unit would be willing to pay and still
choose to act in the best interest of the organisation as a whole.
The minimum transfer price should at least cover the transferring

unit’s incremental cost of producing the product or service. Where
opportunity cost is incurred owing to the transfer of the product or
service, the minimum price should also ensure that the transferring
unit is compensated for revenue forgone. This may be the case
where, for example, there is an external market for the intermediate
product or service and revenue from external sales are forgone, or
where the transfer of the product or service has an impact on the sale
of other products or services. The minimum price should therefore
be the transferring unit’s incremental cost per unit of product or
service, plus opportunity cost per unit of product or service. This
guideline ensures that where there is no external market and no
other kind of revenue forgone (in other words, the opportunity cost
is zero), the minimum price is simply the incremental cost per unit of
product or service.
To ensure that the receiving unit earns some contribution, the
maximum transfer price should not exceed the incremental
contribution the receiving unit earns per unit of product or service.
However, should the receiving unit be able to purchase on the

intermediate market at an even lower price, the maximum transfer
price should be limited to the intermediate market price. This
prevents the receiving unit from purchasing externally when an
internal transfer is in the best interest of the organisation as a whole.
The general guidelines can be summarised as follows:
• The minimum transfer price per unit of product or service is: the
transferring unit’s incremental cost per unit of product or service
plus the transferring unit’s opportunity cost per unit of product
or service.
• The maximum transfer price per unit of product or service is the
lesser of: the receiving unit’s incremental contribution per unit of
product or service (before subtracting the transfer price)* and the
market price at which the receiving unit can purchase each unit
of product or service from an external supplier.
*If a single batch of transfers takes place at a contracted price,

the receiving unit’s cumulative contribution per unit of
product or service (before subtracting the transfer price) is
used here instead. This is an advanced aspect and is dealt with
in the appendix examples at the end of this chapter.
The examples contained in Appendix 15.1 at the end of this chapter

are advanced and illustrate the above general guidelines in complex
situations. Students are advised to con rm with their lecturers
whether knowledge of the examples in the appendices is required in
the speci c course that they are registered for.
Example 15.5 below, which expands on the Paper Company
examples, illustrates the application of the general guidelines in a
simple yet comprehensive scenario.

Example 15.5
Unit A of the Paper Company manufactures A4-size blank paper sheets for use in
printers and copiers. Unit A incurs variable costs of R65 in manufacturing each
standard box of paper. Unit B of the Paper Company operates a large warehouse and
distributes the paper throughout South Africa. Unit B incurs incremental costs of R20
per box of paper. Stationery retail stores pay the Paper Company R100 per box of
paper.
Unit A’s manufacturing capacity is limited to 20 000 boxes of paper per month.
AfriWrite, a stationery warehousing and distribution company, has now offered to
purchase 60% of unit A’s capacity (12 000 paper boxes) from unit A each month for
distribution to neighbouring countries. AfriWrite has agreed to pay R81 per box of
paper. Unit B can also purchase paper on the open market at R81 per box of paper,
but will then have to incur transport costs of R1 per box.
Suggest an appropriate transfer pricing strategy for the Paper Company.
Step 1: Establish the level of internal transfers and the level of

external sales that will result in the best outcome for the organisation
as a whole.
The Paper Company earns a contribution of R15 (R100 – R65 –
R20) per box of paper on internal transfers. The company earns R16
(R81 – R65) in contribution per box of paper sold to AfriWrite. Based
on nancial considerations alone, the company should therefore sell
as many boxes of paper as possible to AfriWrite and transfer the
remaining boxes of paper internally.
It is not viable for unit B to purchase paper on the open market,
as the company would earn a negative contribution of R2 per box of
paper (R100 – R81 – R1 – R20).
The optimal plan is therefore:
• sell 12 000 boxes of paper per month to AfriWrite
• transfer 8 000 boxes of paper (20 000 – 12 000 boxes) per month
internally to unit B.

Step 2: Determine the minimum and the maximum transfer prices
that will result in autonomous units choosing to operate at the level
The minimum transfer price is as follows: unit A’s incremental cost
(unit A incurs incremental costs of R65 per unit) PLUS unit A’s
opportunity cost (on the rst 12 000 boxes of paper, unit A could earn
R16 contribution (R81 – R65) per box; the remaining 8 000 boxes
cannot be sold in the open market and carry no opportunity cost).
The minimum transfer price for the rst 12 000 boxes of paper is
therefore R81 (R65 + R16) and the minimum price for the remaining
8 000 boxes of paper is R65 (R65 + R0).
The maximum transfer price is the lesser of the following: unit B’s
incremental contribution per box of paper (before subtracting the transfer
price) (unit B can sell the paper at R100 per box and incurs R20 in
incremental costs; its incremental contribution is therefore R80
(before subtracting the transfer price) and the market price at which
unit B can purchase from an external supplier (unit B can purchase
paper in the open market at R81 per box, plus R1 in additional
transport costs).
The maximum transfer price is therefore the lesser gure of R80
per box of paper for all 20 000 boxes.
The optimal transfer price for the rst 12 000 boxes of paper per
month is between R81 (minimum price) and R80 (maximum price).
The minimum transfer price exceeds the maximum transfer price
and the transfer will not take place. This is the correct result, as the
rst 12 000 boxes of paper should rather be sold to AfriWrite.
The optimal transfer price for the remaining 8 000 boxes of paper
is between R65 and R80. These boxes should be transferred, and
units A and B should negotiate a nal price within this range.

15.6.2 Transfer pricing and shadow prices
Key terms: shadow price
Linear programming (refer to Chapter 11, Decision-making under

operational constraints) is sometimes used to determine the optimal
product or service mix in organisations where there is a scarcity of
resources. Where a linear programming problem is combined with a
transfer pricing problem, the receiving unit’s incremental
contribution per unit of product or service, as used in determining
the maximum transfer price, is the shadow price per unit of product
or service. As discussed in Chapter 11, the shadow price is the value
which would be created by having available one additional unit of a
limiting resource at its original cost.
Key terms: dual pricing
There may be instances, most notably where there is no intermediate

market for the product or service, where the transferring unit is in a
weak negotiating position and is unlikely to secure a transfer price in
excess of incremental cost. In such situations, it should be considered
whether the transferring unit should in future be operated as a cost
centre rather than a pro t or investment centre. Chapter 14,
Performance management discusses different types of responsibility
centres and explains that a cost centre is held responsible for its costs
only. It follows that, where the transferring unit is a cost centre, there
is no need to establish a transfer price that allocates a portion of the
contribution to it. A transfer price that reimburses the cost centre for

costs incurred will therefore be suf cient. Another option to consider
is whether the transferring and receiving units should perhaps be
merged.
The examples in this chapter have illustrated that there is often a
range of goal-congruent transfer prices within which autonomous
units can negotiate a nal transfer price. The nal transfer price
depends on many factors, such as the relative strengths on the units’
negotiating positions and the negotiation skills of unit managers.
Units may choose to calculate the transfer price on another basis
(such as a straightforward cost basis) in order to use the gure as a
starting point for negotiations. The following are some ways in
which transfer pricing negotiations or a transfer pricing dispute may
be resolved.
Option 1: pro-rating the difference

15.7.1
according to variable costs
Example 15.6
Units A and B of a company have to negotiate a transfer price of between R40 and
R52 for components transferred from unit A to unit B. Unit A’s variable costs are R30
per component, while unit B’s variable costs are R60 per nal product.
Required:
Suggest an appropriate transfer price by pro-rating the difference between the
minimum and maximum transfer prices according to variable costs.
Unit B’s variable costs are twice that of unit A. Of the R12 (R52 –
R40) spread between the minimum and maximum price, one-third
(30/[60+30]) should be allocated to unit A and two-thirds
(60/[60+30]) to unit B. The transfer price is therefore set at the

minimum price plus one-third of the spread: R40 + (R12/3) = R44.
Alternatively, it can be calculated as the maximum price minus two-
thirds of the spread: R52 – ((R12/3) × 2) = R44.
A disadvantage of pro-rating the difference according to variable
costs is the fact that both divisions have an incentive to overstate
and/or not properly control variable costs.
Option 2: supplementing the transfer

15.7.2
price by a recurring fee

In addition to agreeing on a transfer price per unit of product or
service, the receiving unit may also be held liable to pay the
transferring unit a recurring fee per period (for example, a xed fee
of R10 000 per month). This means that the transferring unit has two
sources of internal revenue: the transfer price received and the
recurring fee received. This is a particularly useful solution in
situations where there is no external market for the intermediate
product (in other words, the minimum transfer price is the
transferring unit’s incremental cost) and there is a need for the
transferring unit to recover its xed costs.
Kaplan and Cooper (1998) use activity-based costing to
determine the optimal transfer price and recurring fee. The
incremental cost used to determine the transfer price is the sum of
unit-level and batch-level costs. The recurring fee is made up of
product and facility sustaining costs, and re ects the percentage use
that the receiving unit makes of the transferring unit’s capacity (for
the same reasons as stated before, standard or budgeted costs are
again preferred to actual costs). If the receiving unit, for example,
intends to purchase 40% of the products in a speci c product line
and intends to use 30% of the capacity of the transferring unit, the

recurring fee should be 40% of the relevant product sustaining costs
plus 30% of the transferring unit’s facility sustaining costs. The
capacity that has been paid for is then reserved for the receiving
unit. Paying for reserved capacity provides a good incentive for the
receiving unit not to over-estimate the capacity that the transferring
unit should reserve for it. If inappropriate estimates were made, the
receiving unit and other customers that purchase the intermediate
product can ‘rent’ excess capacity in the transferring unit from each
other as required.
(Chapter 6, Overhead allocation describes the classi cation of costs
into unit level, batch level, product sustaining costs and facility
sustaining costs.)
15.7.3 Option 3: dual pricing

Where transfer pricing disputes cannot be resolved, a dual pricing
system may be employed in order to satisfy both the transferring
and the receiving unit. Under dual pricing:
• the transferring unit is credited with a transfer price that is
deemed to be a fair representation of the revenue it should
receive
• the receiving unit is debited with a transfer price that is deemed
to be a fair representation of the price it should pay (the price at
which the receiving unit records the purchase does not have to be
the same as the price at which the transferring unit recorded the
sale)
• the difference between the selling price recorded by the
transferring unit and the purchase price recorded by the
receiving unit is recorded in a central company account.

Dual pricing is not an ideal solution to transfer pricing problems, as
it creates an arti cial environment in which unit managers are
shielded from market forces and effective negotiation. This con icts
with the rationale behind the establishment of autonomous
organisational units.
Option 4: supplementary performance

17.7.4
measures
Performance measures other than those based on a unit’s pro t may
be used in order to encourage internal transfers that are in the best
interest of the organisation as a whole, but unattractive from a unit
perspective. A company may, for example, speci cally reward
managers for internal transfers made, or may base part of the bonus
of the manager responsible for the transferring unit on the pro t of
the receiving unit.
Option 5: additional unofficial

17.7.5
accounting records
Where the transfer price that is in the best interest of the organisation
as a whole is unfair towards individual units (as is the case in
example 15.8 below), an additional, separate set of unof cial
accounting records can be kept in which a transfer price is recorded
that is more appropriate for internal performance management
purposes. Transfers then take place at the price that is best for the
organisation as a whole, but the unof cial records are used for
performance management.

IAS 16, Property, plant and equipment determines that, where a
product is constructed by one unit of an organisation and transferred
to another unit where it is treated as a xed asset, internal pro ts are
not regarded as part of the cost of the asset. If the transferring unit
manufactures similar products for sale in the normal course of
business, the cost at which the transferred product is recorded in the
books of the receiving unit is therefore usually the same as the cost
of constructing products that were sold externally.
Example 15.7
Unit A manufactures machines at a cost of R20 000 each. One of the machines is
transferred to unit B of the same company, where the machine is used in the
production process. Units A and B agree on a transfer price of R23 000 for the
machine.
Required:
Give the amount at which the machine should be recorded in the company’s nancial
statements according to IFRS.
The cost to manufacture the machine was R20 000 and this is the cost
of the asset in the company’s accounts. The internal pro t of R3 000
is not regarded as part of the cost.

It has already been stated that the need to establish transfer prices
often arises from the need to manage the performance of units
within an organisation. However, where the organisation’s units are
located across international boundaries, legal requirements in the
respective countries also require transfers to be valued. Most notably,

taxation laws and customs requirements in most countries require
that the value of transferred goods and services be declared.
Organisations which transfer goods or services across
international borders are inclined to favour transfer prices that
minimise the tax, duties and levies payable by the organisation as a
whole. As in any other transfer pricing problem, the rst step in
setting transfer prices in such organisations should be to determine
the range of prices that will serve the best interests of the
organisation as a whole. The following aspects in particular should
be kept in mind:
• Income tax
• Value-added tax or general sales tax
• Import/export duties
• Customs requirements
• Anti-dumping legislation (legislation that protects local
industries by preventing companies from transferring goods into
the country at prices below market value)
In addition to the above, some countries may place restrictions on

the repatriation of dividends. This means that the host government
does not allow unlimited funds to leave the country in the form of
dividends paid to foreign shareholders, as it may be seen as an
exploitation of the host country’s resources. In such cases, a
company may consider lowering the price of transfers out of such a
country (or increasing the price of transfers into such a country), as
this offers an alternative way of taking funds out of the country.
However, many countries’ income tax laws contain measures to
prevent this potential loophole from being exploited.
Section 31(2) of the South African Income Tax Act 58 of 1962
discourages companies from exploiting South African resources and
recording excessive pro ts in foreign countries. It does so by

granting the commissioner of the South African Revenue Service the
right to amend the value placed on goods or services transferred
between related parties for income tax purposes. Where the value is
not market related, the commissioner may tax the parties as if the
market value had been used (that is, the price that would have been
set in an ‘arm’s length’ transaction if the transaction had taken place
in the open market between unrelated parties).
Example 15.8
A company has a manufacturing unit located in country U which transfers nished
products to the company’s retail unit located in country V. The full cost of
manufacturing each product is R400. In country U, similar products sell in the open
market at R500 each. The retail unit incurs additional costs of R50 per unit and sells
the products at R550 each in country V. The tax authorities in country U retain the right
to amend the tax value placed on goods or services transferred between related
parties in order to bring it in line with the market value of the goods or services. The
company income tax rate in country U is 28%. The company income tax rate in
country V is 15%.
Country U (supplying division) Country V (receiving division)
Required:
Recommend an appropriate transfer price.
The company as a whole makes a pro t of R100 (R550 – R400 – R50)

per product. The company should try to record as much as possible
of the R100 income in country V instead of country U, as country V’s
tax rate is signi cantly lower. This means that the transfer price has
to be kept as close to the minimum as possible, namely R400 per
product. However, if a transfer price of R400 is chosen, the tax
authorities in country U will deem the value to be R500 for income
tax purposes. Income tax of R28 [(R500 – R400) × 28%] is due in
country U and R15 [(R550 – R50 R400) × 15%] in country V.

The best solution in this case is therefore to set the transfer price
at market price. If the market price of R500 is used, tax in country V
is avoided [(R550 – R50 –
R500) × 15% = R0]. The total income tax liability is R28 payable in
country U.
In the above example, a transfer price of R500 was in the best
interest of the organisation as a whole, but resulted in the receiving
unit recording zero income, which is problematic from a
performance measurement perspective. Options 3, 4 and 5 discussed
in section 15.7 of this chapter may be appropriate in overcoming this
problem.
When working with transfers across international borders, the
issue of exchange rates may arise. Fluctuations in exchange rates
may have a positive or negative impact on the pro ts of an
organisation’s individual units. However, unless exchange rate
uctuations lead to changes in behaviour (such as setting a transfer
price outside the goal-congruent range), they should not impact the
pro ts of the organisation as a whole at intermediate product level
because internal ‘sales’ and ‘purchases’ cancel each other out.
Key terms: strategic and ethical considerations
Transfer pricing calculations can become quite complex and a high

level of technical skill is required to solve advanced transfer pricing
problems. When so much effort is directed at mastering calculations,
the qualitative and non- nancial aspects of the topic are often
overlooked. Strategic and ethical considerations could, however,
dictate that a different transfer price should be used.

A company may, for example, for strategic reasons set transfer
prices in such a manner that low pro ts are recorded in a speci c
business unit in order to make the market appear unattractive to
potential competitors.
Ethical considerations become particularly prominent when
transfers are made across international borders. If, or example, a
company conducts mining operations in a developing country and
transfers all goods to a developed country at a very low transfer
price, the company may be seen as exploiting a developing nation’s
resources without due compensation. Even if the minimum transfer
price is the correct transfer price to use from a nancial perspective,
and even if the host country’s tax and other laws do not discourage
or prohibit such an action, the company could be doing irreparable
damage to its corporate image. The triple bottom line, as introduced
in Chapter 14, Performance management, should be kept in mind:
modern organisations are expected to strive simultaneously for
economic prosperity, environmental quality and social justice
(Elkington, 1998: 2).
15.11 Summary
A transfer price is the price at which goods or services are
transferred between different units of the same organisation. Because
it impacts on the performance evaluation of the units involved,
transfer pricing can potentially cause goal congruence problems in
decentralised organisations.
Transfer prices may be based on market prices or costs, as
deemed appropriate, but the nal price is often negotiated between
units in a decentralised organisation. In order to ensure goal
congruence, negotiations ought to take place between the minimum

transfer price (the smallest amount the transferring unit would be
willing to receive while still choosing to act in the best interest of the
organisation as a whole) and the maximum transfer price (the largest
amount the receiving unit would be willing to pay while still
choosing to act in the best interest of the organisation as a whole).
These limits are in uenced by the particular circumstances, such as
whether there is a market for the intermediate product, and whether
the intermediate and nal products are sold on perfect or imperfect
markets (see the appendices at the end of this chapter for advanced
examples).
Because transfer pricing scenarios are often complex, a
straightforward, universally acceptable transfer price may not
always be found. A number of options are available to resolve
transfer pricing problems. Other issues such as tax implications and
legislation, strategic factors and ethical considerations further affect
the transfer price chosen.
Conclusion: Transfer pricing and other

chapters in this book
As the need to manage the performance of units within an
organisation is often one of the primary reasons for establishing
transfer prices, this chapter should be studied together with Chapter
14, Performance management.
Other topic links include the following: standard or budgeted
costs should be used instead of actual costs in the setting of transfer
prices. The use of transfer prices and shadow prices was discussed in
section 15.6.2, while the use of transfer pricing with activity-based
costing was discussed in section 15.7.2.

Tutorial case study: Clover group
The Clover group has two divisions: Clover Bulk Trading and Clover Bulk
Ingredients. Clover Bulk Trading supplies raw milk and related raw dairy products
through dairy farms. Clover Bulk Ingredients uses raw milk and related raw dairy
products to produce well-known brand products such as Clover 2% low fat milk and
Clover feta cheese.
SOURCE: HTTPS://WWW.CLOVER.CO.ZA/ (2019)
1 Discuss whether and why it may be necessary for the Clover group to make use
of transfer pricing.
2 Explain what the main principle should be that guides all of the Clover group’s
transfer pricing decisions.
3 Discuss the characteristics that a transfer pricing system in Clover may have in
order for it to be regarded as goal congruent, effective and ef cient.
4 Discuss the possible disadvantages of using a cost-based transfer price when
raw dairy products are transferred from Clover Bulk Trading to Clover Bulk
Ingredients.
5 Explain whether Clover Bulk Ingredients would favour the minimum or the
maximum transfer price when raw dairy products are transferred from Clover
Bulk Trading to Clover Bulk Ingredients.
6 Explain whether Clover Bulk Trading would favour the minimum or the maximum
transfer price when raw dairy products are transferred from Clover Bulk Trading
to Clover Bulk Ingredients.
7 Discuss three ways in which the Clover group may resolve a transfer pricing
dispute.
Appendix 15.1 Determining transfer prices

in perfect and imperfect markets
This appendix contains three examples which illustrate how transfer
prices are determined under different intermediate and nal market
conditions where units are highly decentralised. For the sake of
consistency, the steps set out in this chapter are followed throughout.

This appendix is an advanced section of the chapter which
contains highly technical calculations. Care should be taken not to
lose sight of the basic principles of transfer pricing, as illustrated in
the body of the chapter. Notice how, in each case, the optimal
number of units that should be transferred in order to act in the best
interest of the organisation as a whole is determined rst. Thereafter
the minimum and maximum prices are set in such a way that the
transferring and receiving units respectively choose to transfer the
optimal number of units.

Transferring unit has no external market, and receiving unit sells on an imperfect
market Unit A of a company manufactures component X, which is transferred to unit
B, where it is used to manufacture product Y. There is no external market for
component X. Unit B sells the nal product, product Y, on an imperfect market (the
imperfection of the market is illustrated by the fact that different quantities sold
command different prices, as can be seen in the table below). One component X is
used in the manufacture of each product Y. Unit A incurs variable costs of R10 per
component X, as well as xed costs of R50 000 per month that are unavoidable in the
short term. Unit B incurs variable costs of R5 per product Y and R30 000 worth of
xed costs per month that are unavoidable in the short term. Unit B can sell product Y
as follows:
Selling price of product Y Quantity sold in units per month
R50 10 000
R38 20 000
R25 30 000
A consultant has suggested a transfer price of R22 per component X.
Unit A – product X (supplying division) Unit B – product Y (receiving division)
Required:

Determine whether a transfer price of R22 per component X is appropriate and, if not,
suggest an appropriate range of transfer prices for component X.
At a transfer price of R22 per component X, unit A’s outlook is as

follows:
As the schedule indicates, unit A will choose to transfer the

maximum number of components.
At a transfer price of R22 per component X, unit B’s outlook is as
follows:
As the schedule indicates, unit B will choose to sell 10 000 of product

Y if the transfer price is R22.
The outlook for the company as a whole is as follows (note that
the internal transfer is ignored here, as the ‘selling’ and ‘purchasing’
of transferred components cancel each other out):

It is in the best interest of the company as a whole to sell 20 000 of
product Y, so 20 000 of component X must be transferred from unit A
to unit B. However, the transfer price of R22 causes unit B to order
only 10 000 of component X and is therefore inappropriate.
In order to suggest a more appropriate transfer price, follow these
steps:
• Step 1: Establish the level of internal transfers and the level of
external sales that will result in the best outcome for the
organisation as a whole. It has been calculated that 20 000 of
component X should be transferred.
• Step 2: Determine the minimum and the maximum transfer prices
that will result in autonomous units choosing to operate at the
level determined in step 1.
The minimum transfer price is as follows: unit A’s incremental cost (in
this example, incremental cost equals variable cost, and amounts to
R10 per component X) PLUS unit A’s opportunity cost (there is no
intermediate market for component X; the opportunity cost is zero).
The minimum transfer price is R10 per component X.
incremental contribution before subtracting the transfer price – see the
schedule below (at a sales level of 20 000, unit B’s contribution is
R660 000, while it is R450 000 at the lower sales level of 10 000; at the
optimal sales level of 20 000, the incremental contribution per
product Y is R21 calculated as (R210 000/10 000) or ([R660 000 –

R450 000]/ [20 000 – 10 000])) and the market price at which unit B can
purchase from an external supplier (there is no intermediate market for
component X, so there is no such option). The maximum transfer
price is R21 per component X.
Solving using a simultaneous equation

(Selling price of D2 at current desired level for D2 – variable
costs of D2 – required transfer price) × units at current desired
level for D2 = (Selling price of D2 at desired level for company –
variable costs of D2 – transfer price) × units at desired level for
company
Units A and B should negotiate a transfer price of between R10 and

R21 per component X. That price range will ensure that, if individual
units of component X are transferred from unit A to unit B, both
units will prefer to continue with such transfers until 20 000
components have been transferred. Each component X will be

transferred at no more than R21, ensuring that unit B will choose to
purchase 20 000 components. The maximum price of R21 prevents
unit B from ceasing orders after the rst 10 000 transfers have been
received.
However, a situation could arise where the two units enter into a
contract in which they agree in advance to transfer 20 000
components. This increases the maximum transfer price. Now,
instead of considering unit B’s incremental contribution per product
Y in formulating the maximum price, the correct value to consider is
unit B’s cumulative contribution per product Y. At a sales level of
20 000, unit B’s cumulative contribution is R33 per component
(R660 000/20 000). The maximum is higher in case of a contracted
transfer of 20 000 components, because the contribution is evenly
spread over the components. A transfer price of between R200 000
(R10 × 20 000) and R660 000 is appropriate for a contracted transfer
(in case of such a transfer, the consultant’s suggested R22 per
component transfer price falls within the goal-congruent range – the
consultant may have been working on this assumption).
Range of transfer prices

Assume that any number of individual components can be
transferred at a time, and that a transfer price of R20 is negotiated
(which falls within the goal-congruent R10 to R21 range). Unit A will
choose to transfer as many of component X as possible to increase its
own contribution. Unit B, however, will order 20 000 components
and thereby ensure that the company’s best interests are served. This
is because unit B will earn a contribution of R260 000 ([R38 – R20 –
R5] × 20 000) at a sales level of 20 000, compared to a contribution of
R250 000 ([R50 – R20 – R5] × 10 000) at a level of 10 000 and R0 ([R25
– R20 –R5] × 30 000) at a level of 30 000.

The following proves that the transfer price range divides the
contribution earned by the company between the two units:
Company contribution with optimal transfer level of 20 000 units (see company schedule) R460 000
Contribution divided between units A and B: R660 000 – (R10 × 20 000) R460 000

Transferring unit has an imperfect intermediate market, and receiving unit sells on a
perfect market
Unit A of a company manufactures component S, which is transferred to unit B where
it is used to manufacture product T. Unit B sells the nal product, T, on a perfect
market at a selling price of R160 (the perfect market is illustrated by the fact that there
is only one price per unit, regardless of the number sold). One component S is used in
the manufacture of each product T. Unit A can produce a maximum of 15 000
components per month. Unit A incurs variable costs of R55 per component S. Unit B
incurs variable costs of R90 per product T. Unit A can also sell component S as
follows:
Selling price of component S Quantity sold in units per month
R116 5 000
R86 10 000
R73 15 000
Unit A – product S (supplying division) Unit B – product T (receiving division)
Required:
Suggest an appropriate range of transfer prices for component S.

as a whole. Unit A will attempt to maximise the pro t gained from
external sales.

Unit A maximises its contribution if it sells 10 000 of component S
externally. Unit A will therefore be willing to transfer the remaining
5 000 components it can manufacture at any transfer price above
incremental cost, because there is no opportunity cost associated
with the components that unit A does not wish to sell externally.
Unit B sells product T on a perfect market and will prefer to sell as
many of them as possible in order to maximise its contribution.
The outlook for the company as a whole is as follows:
The company’s contribution is maximised when unit A sells 5 000 of

component S externally, transfers 10 000 components to unit B, and
unit B sells 10 000 of product T. Unit A therefore has to be convinced
to transfer 10 000 components per month to unit B, instead of selling
10 000 externally and transferring just 5 000. However, for unit A to
be willing to transfer an additional 5 000 components per month,
unit B will have to compensate unit A for the contribution lost (in
other words, for the opportunity cost of transferring the components
instead of selling them externally).

(in this example, incremental cost equals variable cost, and amounts
to R55 per component S) PLUS unit A’s opportunity cost (for 5 000 of
the components, there is no incremental revenue lost, as unit A
would not have chosen to sell them externally; for the other 5 000 of
the components, contribution from external sales is lost, namely the
difference in unit A’s contribution between when it sells 10 000
components externally and when it sells only 5 000 components
externally). The contribution forgone per component (see the
schedule for unit A) is R5 000 (R310 000 – R305 000) divided by the
incremental quantity of 5 000, therefore R1.
The minimum transfer price for 5 000 of the components is R55,
while the minimum price for the other 5 000 components is R56 (R55
+ R1) per component S.

costs of D1) × desired external demand for D1 + (desired
internal demand for D1) × (required transfer price – variable
costs of D1) = (Selling price of D1 at current desired level for
overall company – variable costs of D1) × desired external
demand for overall company + (desired internal demand for
overall company) × (required transfer price – variable costs of
D1)

incremental contribution before subtracting the transfer price (see the
schedule below; at the optimal sales level of 10 000 products, the
incremental contribution per product T is R70) and the market price at
which unit B can purchase from an external supplier (considering unit
A’s market information, the market price could range from R73 to
R116 per component S; however, because the market is imperfect, it
is dif cult to predict the price that an external supplier would quote
in the absence of further information). The maximum transfer price
for the 10 000 components is R70 each.
This means that 5 000 components should be transferred at a price of

between R55 and R70 each. The remaining 5 000 components should
be transferred at a price of between R56 and R70 each.
If the parties enter into a contract for the transfer of 10 000
components, unit B’s cumulative contribution per product T has to
be considered. At a sales level of 10 000, unit B’s cumulative

contribution is R70 (see the schedule). In this example, it is the same
as the maximum already determined. The contract price should be
between R555 000 [(R55 × 5 000) + (R56 × 5 000)] and R700 000 (R70 ×
10 000).
Company contribution with optimal transfer of 10 000 units (see company schedule) R455 000
Maximum contribution that could be earned by unit A in the external market (R310 000)
Contribution gained through optimal transfer arrangement R145 000
Contribution divided between units A and B: R700 000 – (R55 × 5 000) – (R56 × 5 000) R145 000

Both units sell on imperfect markets
Unit A of a company manufactures component G, which is transferred to unit B, where
it is used to manufacture product H. Unit B sells the nal product, product H, on an
imperfect market. One component G is used in the manufacture of each product H.
Unit A can produce a maximum of 60 000 components per month. Unit A incurs
variable costs of R9 per component G. Unit B incurs variable costs of R36 per product
H as well as xed costs of R100 000 per month that are unavoidable in the short term.
Unit A can also sell component G on an imperfect intermediate market. The sales
levels and corresponding external market prices for units A and B are as follows:
Selling price of component G Selling price of product H Quantity sold in units per month
R40 R65 20 000
R29 R60 40 000
R22 R57 60 000
Unit A – component G (supplying division) Unit B – product H (receiving

division)
Required:

Suggest an appropriate range of transfer prices for component G.

as a whole.
Unit A will attempt to maximise the pro t gained from external
sales.
Unit A maximises its contribution if it sells 40 000 of component G

externally. Unit A will therefore be willing to transfer the remaining
20 000 components that it can manufacture at any transfer price
above incremental cost, because there is no opportunity cost
associated with the components that unit A does not wish to sell
externally.
The outlook for the company as a whole is as follows:
The company’s contribution is maximised when unit A sells 20 000

of component

G externally, transfers 40 000 components to unit B, and unit B
sells 40 000 of product H. Unit A therefore has to be convinced to
transfer 40 000 components per month to unit B, instead of
transferring just 20 000. However, for unit A to be willing to transfer
an additional 20 000 components per month, unit B will have to
compensate unit A for the contribution lost (in other words, for the
opportunity cost of transferring the components instead of selling
them externally).
(in this example, incremental cost equals variable cost and amounts
to R9 per component G) PLUS unit A’s opportunity cost (for 20 000 of
the components there is no incremental revenue, as unit A would not
have chosen to sell them externally; for the other 20 000 of the
components, contribution from external sales is lost, namely the
difference between unit A’s contribution when it sells 40 000
components externally, and when it sells 20 000 components
externally). The contribution forgone per component (see the
schedule for unit A) is R180 000 (R800 000 – R620 000) divided by the
incremental quantity of 20 000, and is therefore R9. The minimum
transfer price for 20 000 of the components is R9, while the minimum
price for the other 20 000 components is R18 (R9 + R9) per
component G.

costs of D1) × desired external demand for D1 + (desired
internal demand for D1) × (required price – variable costs of D1)

= (Selling price of D1 at current desired level for overall
company
incremental contribution before subtracting the transfer price (see the
schedule below; at the optimal sales level of 40 000 products, the
incremental contribution per product H is R19) and the market price at
which unit B can purchase from an external supplier (considering unit
A’s market information, the market price could range from R22 to
R40 per component G; however, because the market is imperfect, it is
dif cult to predict the price that an external supplier would quote in
the absence of further information). The maximum transfer price for
the 40 000 components is R19. This means that 20 000 components
should be transferred at a price of between R9 and R19 each. The
remaining 20 000 components should be transferred at a price of
between R18 and R19.
If the parties enter into a contract for the transfer of 40 000

components, unit B’s cumulative contribution per product H has to be

considered. At a sales level of 40 000, unit B’s cumulative
contribution is R24 per component (see the schedule). A transfer
price of between R540 000 ((R9 × 20 000) + (R18 × 20 000)) and
R960 000 (R24 × 40 000) is appropriate for a contracted transfer.
Company contribution with optimal transfer level of 40 000 units (see company schedule) R1 220 000
Maximum contribution that could be earned by unit A in the external market (R800 000)
Contribution gained through optimal transfer arrangement R420 000
Contribution divided between units A and B: R960 000 – (R9 × 20 000) – (R18 × 20 000) R420 000
Basic questions
BQ 1
The baking division of the Pie Company bakes ready-to-eat pies for
distribution to the Pie Company’s 25 retail outlets. The retail outlets
charge R8 per pie sold and incur variable costs of R1 per pie. It costs
the baking division R4 (variable costs) to bake each pie. The manager
of the baking division and those of the retail outlets all have vast
decision-making responsibilities within their units, but pies may not
be sold to or purchased from external suppliers. The units are not
separate legal entities. Is there a need for transfer pricing within the
Pie Company? What transfer price should be used (a) for transfers
between units, and (b) in the statutory, audited income statement of
the Pie Company?
BQ 2
What are the merits and demerits of negotiation between unit
managers as a means of arriving at a transfer price?

BQ 3
Every year unit A of a company transfers 5% of its output to unit B
of the same company. Five years ago, the two unit managers
negotiated a formula to arrive at a transfer price which they both
regarded as fair, and every year since then they have merely
substituted the formula inputs with the latest available information.
A consultant recently investigated the transfer price and found that,
although the price is goal congruent, there was room for improving
the formula. Should the consultant be appointed to carry out a more
thorough investigation, the classi cation of xed and variable costs
could possibly be revised and improved, and this might result in a
slightly different and more accurate transfer price. Should a
thorough investigation of the transfer price be requested?
BQ 4
The farming division of AgriFarms is located in the Eastern Cape
and produces eggs, which are transferred to AgriFarms’ marketing
division. The marketing division packages the eggs in attractive
boxes and sells them to upmarket retail outlets in Gauteng. The eggs
are all ‘jumbo’ size and divisional managers are free to transact with
external parties as they please. Would market price be an
appropriate transfer price for the transfer of eggs from the farming
division to the marketing division?
BQ 5
Division one of a company transfers manufactured components to
division two of the same company. Division two pays division one
the incremental cost per unit, plus a xed fee of R20 000 per year for
the usage of division one’s capacity. Division one incurs an
incremental cost of R10 on each unit that it manufactures. In the year

2XX3, division one transferred a total of 10 000 components to
division two. What was the total transfer price (expressed as a price
per unit) in 2XX3?
BQ 6
Division A and division B are highly decentralised units of company
C. Division A incurs an incremental cost of R12 per unit
manufactured. Some of division A’s manufactured units are
transferred to division B. Division B can purchase products that are
almost identical to the ones manufactured by division A at a cost of
R14 per unit in the open market. One of company C’s nancial
managers recently made the following remark: ‘It is company policy
to place a mark-up of 20% of incremental cost on all products sold. I
don’t see why this should not also apply to transfers from division A
to division B.’ Assuming that it is in the best interest of the company
as a whole that the internal transfers should take place, do you agree
with the nancial manager? If not, what transfer price would you
suggest?
BQ 7
What is meant by a ‘range of goal-congruent transfer prices’?
BQ 8
Liquichem has a division that manufactures a chemical powder and
transfers it to another division of Liquichem, where a liquid
chemical is manufactured. The powder costs R200 per gram to
manufacture (all variable costs), and 25 grams of powder is required
per 100 millilitres of liquid chemical. The liquid costs R300 per 100
millilitres to manufacture (all variable costs). The powder can be
sold to another company at R220 per gram. There is also a third-

party manufacturer that can supply Liquichem with powder at a
cost of R230 per gram, but the properties of the powder are such that
only 20 grams of powder are required per 100 millilitres of liquid
chemical. Should powder be internally transferred and, if so, what
would be an appropriate transfer price?
BQ 9
Unit A of a company transfers products to unit B of the same
company. The optimal transfer price is between R50 and R100 per
unit, and the optimal production plan is for unit A to
transfer 100 000 units of the product to unit B every month. Unit A
manufactures 200 000 units per month, its variable costs are R50 per
unit, and it incurs xed costs (in the nature of product and facility
sustaining costs) of R800 000 per month. Unit B’s variable costs are
also R50 per product received from unit A. The managers of unit A
and unit B have reached a deadlock in their negotiations to decide
on a nal transfer price. How may the transfer pricing dispute be
resolved?
BQ 10
A company’s manufacturing division is located in South Africa,
while its sales division is located in Asia. The manufacturing
division transfers 100 000 units of product to the sales division each
year. The manufacturing division incurs variable costs of R15 per
unit. The sales division incurs variable costs of R5 per unit and sells
the product at R30 per unit.
What is the most appropriate transfer price per unit for transfers
from the manufacturing division to the sales division under each of
the following circumstances? For purposes of part (a), regard the
income tax rate as the only relevant tax issue:

The tax rate in South Africa is 28% and in the relevant Asian
•
country it is 15%.
• The tax rate in South Africa is 28% and in the relevant Asian
country it is 35%.
What other tax considerations, apart from the income tax rate,
should be taken into account in setting the transfer price?
Long questions

The Better Agriculture Group (BAG), which has a divisional
structure, produces a range of products for the farming industry.
Divisions B and C are two of its divisions. Division B sells a fertiliser
product (BF) to customers external to BAG. Division C produces a
chemical (CC) which it could transfer to division B for use in the
manufacture of its product BF. However, division C could also sell
some of its output of chemical CC to external customers of BAG.
An independent external supplier to the Better Agriculture
Group has offered to supply division B with a chemical which is
equivalent to component CC. The independent supplier has a
maximum spare capacity of 60 000 kilograms of the chemical which
it is willing to make available (in total or in part) to division B at a
special price of R55 per kilogram.
Forecast information for the forthcoming period is as follows:
Division B:
Production and sales of 360 000 litres of BF at a selling price of R120
per litre. Variable conversion costs of BF will amount to R15 per litre.

Fixed costs are estimated at R18 000 000.
Chemical (CC) is used at the rate of 1 kilogram of CC per 4 litres of
product BF.
Division C:
Total production capacity of 100 000 kilograms of chemical CC.
Variable costs will be R50 per kilogram of CC.
Fixed costs are estimated at R2 000 000.
Market research suggests that external customers of BAG are willing

to take up sales of 40 000 kilograms of CC at a price of R105 per
kilogram. The remaining 60 000 kilograms of CC could be
transferred to division B for use in product BF. Currently no other
market external to BAG is available for the 60 000 kilograms of CC.
REQUIRED Marks
(a) State the price/prices per kilogram at which division C should offer to transfer chemical CC to
division B in order that the maximisation of BAG pro t would occur if division B management 6
implement rational sourcing. decisions based on purely nancial grounds.
(b) Division C is considering a decision to lower its selling price to customers external to the 6
group to R95 per kilogram. If implemented, this decision is expected to increase sales to
external customers to 70 000 kilograms.
For both the current selling price of CC of R105 per kilogram and the proposed selling price of
R95 per kilogram, prepare a detailed analysis of revenue, costs and pro ts or loss of BAG.
(Note: In addition, comment on other considerations that should be taken into account before
this selling price change is implemented.)
TOTAL MARKS 12


The G group has a divisionalised structure. One of the divisions
manufactures engines and one of the other divisions assembles
motorcycles. The performance of the divisional managers, and
consequently their bonuses, is based on the return on capital
employed (ROCE) of their individual divisions. Both of these
divisions operate in highly competitive markets.
Motorcycle division
A key component in a motorcycle is the engine. Engines are readily
available on the open market, but the division currently buys 3 600
engines each year internally from the engines division for R1 375 per
engine. The manager has just received the following message from
the manager of the engines division:
Engine prices: As a result of recent cost increases, the price per engine
will now be R1 600.
On receiving the message, the manager of the motorcycle division

contacted several external manufacturers and found one that would
supply the required engines at R1 375 per engine. However, she has
since received a directive from the managing director of the group
that states that she must buy the engines internally.
Engines division
Following the recent cost increases, the full absorption cost of a
motorcycle engine is R1 450. This includes R400 for xed production
overheads. This type of motorcycle engine is one of many different
engines produced by the division.
The manager of the engines division is aware of the competitive
external market that he faces and knows that it will be dif cult for
him to charge external customers more than R1 375 per engine.
However, he is also aware that the rising costs will have an impact

on his bonus. He is trying to protect his bonus by passing these costs
on to the motorcycle division. He is keen to make as much pro t as
he can from these internal sales because the division is currently
working below capacity.
The engines division has now developed a new ‘lean burn’ car
engine that is sold exclusively to external customers. The production
of this engine will utilise the spare capacity of the division and will
earn the division a contribution of R40 per machine hour. The
demand is so high for the car engines that their production could
also use 9 000 machine hours that are currently used to make 1 000 of
the motorcycle engines which are transferred to the motorcycle
division.
REQUIRED Marks
(a) Calculate the impact on the annual pro ts of each of the two divisions and the G group as a
whole of the directive that the engines must be purchased internally for R1 600 per engine 6
instead of from the external supplier.
(b) Explain, with supporting calculations, the minimum and maximum transfer prices that could
7
now be charged for the motorcycle engines.
(c) Brie y explain three aims of a transfer pricing system. 5
TOTAL MARKS 18

DEF is a trading company that is divided into three divisions: D, E
and F. Each division maintains its own accounting records and
prepares an annual summary of its results. These performance
summaries are shown below for the year ended 30 September 2XX9:

The following additional information is available:
• Divisions are free to trade with each other without any
interference from head of ce. The managers of the respective
divisions negotiate transfer prices between themselves. Included
in the above costs and revenues are the following transactions
which took place during the year:
• Division D sold goods for R20 000 to division E. The price
negotiated was agreed on a unit basis between the managers
of the two divisions. The variable production cost of these
items in division D was R18 000. Division D was operating
under capacity and agreed to a transfer price that was little
more than its own variable cost.
• Division F sold goods for R15 000 to division E. The price
negotiated was agreed on a unit basis between the managers
of the two divisions. The variable production cost of these
items in division F was R9 000. Division F was operating
under capacity and negotiated a transfer price based on its
total production cost.
• Included in the administration costs for each division are the
following management charges from head of ce:

• At the start of each year, head of ce sets each division a target
return on capital employed. The target depends on their nature of
the work and their industry sector. For the year ended 30
September 2XX9 these targets were as follows:
D: 6% E: 3% F: 15%
REQUIRED Marks
(a) Discuss the shortcomings of the above performance summaries when measuring the
5
performance of each division.
(b) Discuss the potential problems of negotiated transfer pricing, and how these have impacted
6
on the performance of each of Divisions D, E and F for the year ended 30 September 2XX9.
(c) Prepare an alternative statement that is more useful for measuring and reporting the
8
performance of divisions D, E and F.
(d) Discuss how the use of ‘dual’ transfer prices could affect the measurement of divisional
6
performance within DEF. Illustrate your answer with suggested dual prices.
TOTAL MARKS 25

SOURCE: ADAPTED FROM UWC
Yisivikelo (Pty) Ltd is a divisionalised company that manufactures

insulating panels for cold rooms. These panels are considered to be
the nest panels available on the market. Two divisions are involved
in manufacturing these panels: the Ukushisa division and the
Iphaneli division.
Ukushisa division
Ukushisa manufactures high-density polystyrene sheets. All sheets
are of identical size. These sheets are the insulating material used to
form the interior of the panels that are manufactured by Iphaneli.

Ukushisa has the capacity to manufacture 33 000 polystyrene sheets
per annum. External demand for these sheets is only 9 500 sheets. As
the sheets are of unusual density, only two customers (both graphic
design artists) purchase the polystyrene. Even if Ukushisa dropped
their selling price, they would not be able to sell more sheets and
their two customers would not pay more for the sheets than the
current selling price.
Besides, as the high-density polystyrene gives rise to Iphaneli’s
competitive advantage (i.e. the high level of insulation), Yisivikelo is
not keen to market the polystyrene sheets more widely. Financial
information relating to the production of polystyrene sheets in the
Ukushisa division is as follows:
Per sheet
(R)
Selling price per unit (9 500 sheets sold externally) 325
Variable production costs 130
Fixed production costs* 90
Net pro t per unit 105
Investment in operating assets 3 900 000
*Fixed costs per sheet are based on total xed costs of R2 970 000 divided by full capacity of 33 000 sheets.
Iphaneli division
Iphaneli receives the high-density polystyrene sheets from Ukushisa.
These sheets are transferred from Ukushisa to Iphaneli at the full
manufacturing cost per sheet (R220). Iphaneli builds a protective
shell around each of these sheets and sells the completed panels to a
number of cold room specialists in the building industry. As Iphaneli

is the only provider of insulating panels of this grade, the price they
charge affects the number of panels that can be sold. The rst 15 000
panels are sold to Iphaneli’s ‘crown jewel’ customers at a price per
panel of R520 each. Iphaneli could sell a further 12 000 panels to
smaller operators, if this price were reduced to R395 per panel for
the remaining panels. Panels sold to smaller operators do not need
to be as neatly nished as those supplied to crown jewel customers,
and Iphaneli can save R10 in nishing costs (included in variable
costs below) on all panels supplied to smaller operators. The rst
15 000 panels can always be sold for R520 per panel, regardless of
whether any additional panels are sold or not.
Financial information relating to the production of panels in
Iphaneli is as follows:
Per panel Per panel

(the rst 15 000 (additional panels up to
panels) 12 000)
R R
Variable production costs (excluding transfer

190 180
price)
Transfer price 220 220
Fixed production costs** 18 18
Net pro t per unit 92 −23
Investment in operating assets 4 576 000
**Fixed costs per unit are based on total xed costs of R486 000 divided by full capacity of 27 000 panels.

As both divisions are investment centres, Yisivikelo has recently
begun using ROI and RI in order to evaluate divisional performance.
(Management’s bonuses are based on RI only. ROI is only used to
compare divisional performance.) Yisivikelo has a weighted average
cost of capital (WACC) of 17%. Other manufactures of polystyrene
sheets have an average ROI of 18%, and other panel manufacturers
an ROI of 19%.
Shortly after Yisivikelo announced the changes to the
performance evaluation method of the company, the divisional
manager of Ukushisa (Vuyani Nkosi) and the divisional manager of
Iphaneli (Sizwe Tau) had the following argument:
Vuyani: ‘Look – I think that it’s unfair that Ukushisa doesn’t

earn any pro t on the sheets we transfer to Iphaneli. To sustain
the capacity that Ukushisa has, I have a large investment in
assets and substantial xed costs, and this has a huge impact
on my ROI. I think that we should transfer sheets to you at our
current market price of R325 per sheet. That will result in a
good indication of the pro ts we earn for the rm in total.’
Sizwe: ‘No way! That is completely unreasonable. At the
moment, we’re covering the bulk of your division’s xed costs!
From a relevant costing perspective, all it costs you to make the
sheets is your variable cost! We’re doing you the favour
already. I think that the transfer price should be Ukushisa’s
variable cost.’
Vuyani: ‘Sizwe, you’re dreaming. You guys wouldn’t exist if it
weren’t for our sheets. If you are not prepared to give me
market price for our sheets, I’m not prepared to sell them to
you. We can last longer than you can.’
Sizwe: ‘Fine – let’s see what Bon has to say about this.’

The matter was duly escalated to Bonang Khumalo, Yisivikelo’s
head of ce accountant.
REQUIRED Marks
(a) Determine the respective number of polystyrene sheets and number of panels that should
be sold externally in order to optimise pro ts for the rm. Calculate the optimum pro t to the 10
rm under this plan.
(b) Suggest a suitable transfer price (or range of transfer prices), based on relevant costing
5
principles, that will result in pro t being maximised for the rm. Brie y explain your answer.
(c) Comment (brie y) on Vuyani’s suggestion that the transfer price should be the current market
5
price (R325 per sheet).
TOTAL MARKS 20
LQ 5 Advanced (35 marks, 63 minutes

SOURCE: ADAPTED FROM SAICA ITC
Mechanics (Pty) Ltd is a large company with fully autonomous
subsidiaries throughout South Africa. A dispute has arisen between
two of its subsidiaries in Gauteng over the transfer price of product
A, which is manufactured by Uniproduct (Pty) Ltd and supplied to
Britten (Pty) Ltd.
Uniproduct (Pty) Ltd manufactures a standard product A and
sells 20 000 units per annum in the open market at a price of R50
each and 10 000 units to Britten (Pty) Ltd at a transfer price of R48
each. The reduction in selling price of R2 is possible as no selling
expenses are incurred. Uniproduct (Pty) Ltd has a total production
capacity of 40 000 units of product A per annum.
Britten (Pty) Ltd uses product A as a component in the
manufacture of an advanced product called CA1, which is sold on
the open market at a price of R200 per unit.
The following table gives details of the selling price and cost for
each product:

A recent market survey commissioned by Mechanics (Pty) Ltd
revealed the following open market demand at different selling
prices:
Product A
Product CA1
The manager of Britten (Pty) Ltd argues that the transfer price
should be variable cost plus a reasonable mark-up of (say) 20%, as

Uniproduct (Pty) Ltd cannot sell all its output at R50. He believes
that a 20% mark-up on variable cost will allow both subsidiaries to
make a reasonable pro t as well as improving overall group pro ts.
The manager of Uniproduct (Pty) Ltd believes that it is
unreasonable to squeeze the price down to variable cost plus 20%.
He believes that there is room for a transfer price negotiation, but a
drop to variable cost plus 20% is unacceptable.
REQUIRED Marks
Prepare a report for presentation at the next management meeting of Mechanics (Pty) Ltd
detailing, with comments, the following:
(a) The pro t that would be made by Uniproduct (Pty) Ltd and Britten (Pty) Ltd if current sales
5
levels are maintained and product A is transferred at R48
(b) The minimum price at which product A could be transferred without Uniproduct (Pty) Ltd
incurring a loss, as well as the pro ts of Uniproduct (Pty) Ltd and Britten (Pty) Ltd at the 15
various potential sales levels, if this transfer price is used
(c) The upper limit transfer price that would maximise group pro ts and at the same time have
the minimum adverse effect on Uniproduct (Pty) Ltd. Calculate the pro t which each 15
subsidiary would make at this transfer price.
TOTAL MARKS 35
References
Elkington, J. 1998. Cannibals with forks: the triple bottom line of 21st century business. Gabriola
Island, BC: New Society.
Kaplan, RS & Cooper, R. 1998. Cost and effect: using integrated cost systems to drive pro tability
and performance. Boston, MA: Harvard Business School Press.
SAICA (South African Institute of Chartered Accountants). 2009. IAS 2 Inventories (issued
January 2009). Johannesburg: SAICA
SAICA (South African Institute of Chartered Accountants). 2009. IFRS 8 Operating
segments (issued January 2009). Johannesburg: SAICA
SAICA (South African Institute of Chartered Accountants). 2009. IAS 16 Property, plant and
equipment (issued January 2009). Johannesburg: SAICA

SAICA (South African Institute of Chartered Accountants). 2010. IAS 24 Related party
disclosures (issued January 2010). Johannesburg: SAICA

LEARNING OBJECTIVES
• de ne and discuss the theory of constraints
• explain and apply the steps outlined in the theory of constraints
• explain how the theory of constraints differs from and
complements activity-based costing in product pro tability
decisions
• explain cost control, cost reduction and business process re-
engineering
• explain how a just-in-time system operates
• explain the concept of benchmarking.
Skills shortages in the tool, die and mould-making

industry
According to the Department of Trade and Industry, there are approximately 1 800
companies operating in South Africa’s plastics converting industry. Key barriers for
growth in this manufacturing sector are a skills shortage and slow technological
upgrading. Highly skilled plastics engineers are scarce, while mould-setters and
plant operators are also in short supply due to new competency demands arising
from innovation and technological development.
SOURCE: DTI (2019)

Manufacturers sometimes experience short-term constraints which
prevent them from producing enough inventory to meet market
demand. The theory of constraints (TOC) helps organisations to deal
with the short-term problem by maximising the throughput of the
constrained resource. This means, among other things, that some
product lines are given preference over others in order to best utilise
the scarce resource. TOC then leads the organisation to search for
long-term solutions to alleviate the constraint. In the case study
above, training more skilled professionals would be an example of a
long-term solution. The theory stipulates that the organisation
should then identify and turn its attention to the next constraint.
This chapter discusses TOC, followed by the contemporary
concepts of business process re-engineering, just-in-time and
benchmarking.
16.1 Introduction
In the face of globalisation, advances in technology and increasingly
discerning customers, organisations are having to modernise the
production and information assimilation techniques they have
traditionally applied. We start our discussion with the theory of
constraints.
A note about this chapter:

The concepts in this chapter were developed in a manufacturing
environment and are therefore best understood when explained
in the context of a factory. Once you understand the concepts,
you may wish to consider how they, in adapted form, could
bene t other organisations, including those in the services
sector.

Key terms: bottlenecks, theory of constraints
The theory of constraints (TOC) holds that a system’s achievements

are limited by a small number of constraints, and that there is always
at least one constraint. It focuses on factors such as bottlenecks,
which act as constraints to the maximisation of the throughput from
the system.
The TOC originated from the work done by Goldratt, which
started in the 1970s. He was interested in rectifying scheduling
problems after realising that suf cient production capacity in a
factory was not necessarily available nor easily created.
A bottleneck is an activity in the production process where a
constraint is experienced. The example below is used to illustrate the
concept.
Example 16.1
There are two activities in a factory: manufacturing and assembly. The manufacturing
staff are able to manufacture 100 units of the product per day, but owing to a skills
shortage, only two assemblers work in the factory at any given time. The assemblers
are able to assemble only 50 units per day. The market demand for the product is 200
units per day.
Required:
Identify the bottleneck activity and calculate how many units of the product the factory
can produce per day.
In this example, assembly is experiencing the most critical

capacity constraint, and it is therefore the factory’s bottleneck

activity. Notice that irrespective of how hard the manufacturing staff
work, the factory is not able to produce more than 50 units per day
because the units have to pass through the bottleneck activity
(assembly) after they have been manufactured. We can generalise
that the output of other activities that occur in a process
(manufacturing, in this example) is limited to the number of units
that can be processed by the bottleneck activity.
Because in practice factories deal with limited production
capacities, it is important to focus on the management of bottlenecks.
In the example above, management would have to focus their
attention on assembly if they wanted to increase the factory’s daily
production output.
16.2.1 Constraints
Key terms: external constraints, internal constraints, inventory,
operating expenses, throughput, throughput
accounting, throughput ratio
In later work, Goldratt broadened the scope of his work from

focusing on production bottlenecks only, to studying any factor that
limits the ability of a system to perform in line with the goal of the
organisation. Such a factor is referred to as a ‘constraint’. Goldratt
called the theory he devised the ‘theory of constraints’.
Constraints can be internal or external. Internal constraints arise
from the internal operations of an organisation, such as insuf cient
staff training or inadequate machine capacity. External constraints
arise from the environment within which an organisation operates
and on which it relies in order to achieve its goals. Examples of
external constraints would be insuf cient supply of inputs and lack

of customer orders. In order to achieve improved pro tability, it is
important for a factory to manage the constraints as a way of
enhancing throughput, while at the same time keeping inventory
and operating expenses to the minimum. The three terms
‘throughput’, ‘inventory’ and ‘operating expenses’ as used here have
very speci c meanings in the context of the TOC and are discussed
below:
• Throughput is the rate at which money is generated. To calculate
throughput, we deduct the money paid to suppliers (for direct
materials and direct services) from the money obtained from
customers (in the form of sales). Notice that labour expenses are
not deducted from sales when throughput is calculated.
• Inventory, for the purposes of the TOC, is the sum of direct
materials inventory, work-in-progress inventory, nished goods
inventory (all of which are valued at the amount paid to
suppliers in respect thereof), research and development cost,
plant and machinery, and buildings.
• Operating expenses in this context include all operating costs
(other than direct materials and direct services) incurred to
generate throughput. They include labour costs, whether direct
or indirect, and both idle time and operating time. They also
include expenses such as rent, electricity and depreciation.
The aim is to maximise throughput and to minimise inventory and

operating expenses.
The management accounting technique that focuses on achieving
the maximum return per unit of constrained activity is called
throughput accounting.
One of the main ratios calculated when throughput accounting is
applied is the throughput ratio (sometimes called the throughput
accounting ratio, or TPAR). It is calculated as the throughput per

unit of constrained activity, divided by the operating expenses per
unit of constrained activity. In example 16.1 above, the constrained
activity would be assembly hours. If more than one product were
manufactured, the throughput ratio for each product could be
calculated and the products could be ranked accordingly.
Example 16.2
The same information applies as in example 16.1. The factory manufactures two
products, A and B. It takes 16,8 minutes to assemble each unit. Product A sells for
R500 per unit and its direct materials cost R400 per unit. Product B sells for R450 per
unit and its direct materials cost R300 per unit, while it also consumes direct services
of R70 per unit. Each day the factory as a whole spends R1 000 on wages and R800
on overheads.
Required:
Determine whether the production of product A or product B should be favoured,
using a throughput accounting approach.
Product A’s throughput is R100 (R500 – R400), while product B’s

throughput is R80 (R450 – R300 – R70). Throughput per assembly
minute is therefore R5,95 (R100/16,8 minutes) for product A and
R4,76 (R80/16,8 minutes) for product B.
Operational expenses per day of R1 800 (R1 000 + R800) divided
by the total assembly minutes available per day of 840 (16,8 minutes
× 50 units, given in example 16.1) gives a cost per assembly minute
of R2,14.
The throughput ratio for product A is 2,78 (R5,95/R2,14) and it is
2,22 (R4,76/ R2,14) for product B. Product A should therefore be
favoured over product B, as it has a higher throughput ratio. Notice
that both ratios are greater than one, which means the factory is
gaining money by producing the products (the revenue earned per

unit of constrained activity is proportionately greater than the cost
per unit of constrained activity).
The product ranking obtained when throughput accounting is
applied could potentially differ from that obtained if variable costing
is used (refer to Chapter 5, Absorption versus variable costing). This is
because costs are classi ed differently under the two approaches:
variable costing would deduct all manufacturing variable costs from
sales to obtain the contribution, and the ranking would then be
made according to the highest contribution per limiting factor (as
explained in Chapter 11, Decision-making under operational
constraints).
16.2.2 Steps in the theory of constraints

Key terms: drum-buffer-rope
The TOC argues that managers should focus their attention on the
management of constraints within the factory’s system, rather than
on cutting costs. Focusing on the constraint enables the factory to
streamline its operations and to be more ef cient.
The TOC lists a series of chronological steps that should be
followed. The steps are designed with the objective of maximising
throughput for the entire factory, and are as follows:
Figure 16.1 Series of steps in implementing TOC

Step 1: Identify the constraint
A constraint is any factor that limits the ability of a system to
perform in line with the goal of the organisation. The TOC identi es
and resolves one constraint at a time.
In example 16.1 above, we identi ed the assembly activity as the
constraint that needs to be addressed rst – it is presently the most
serious inhibiting factor that is preventing the factory from meeting
the demand for its products.
In practice, the identi cation of constraints can be done in a
number of ways. In a manufacturing environment, the identi cation
of an internal constraint can involve the detection of the
accumulation of work-in-progress inventory. A constrained activity
in a production line may cause work-in-progress to accumulate in
front of it. The identi cation of an internal constraint can also be
achieved by the comparison of the resource needs against the
availability of those resources. In this case, managers compare, for
example, the hours available for each class of labour with the hours
required for each class of labour. The same can be done for resources

such as machine capacity and storage. In the case of external
constraints, managers investigate both supply (whether suppliers
are able to ll the organisation’s orders) and demand (orders from
customers) to identify constraints.
Step 2: Exploit the constraint

The next step is to make sure that the constrained activity operates at
maximum capacity. In other words, the aim is to ensure that the
maximum throughput is gained per unit of constraint. The
organisation cannot afford any sub-optimal performance in the
constrained activity, because the constraint limits the performance of
the organisation as a whole.
The constraint in our chapter example is the bottleneck
experienced at the assembly activity. In step 2, the aim should be to
maximise the throughput per assembly labour hour. There are three
things that management could do to maximise throughput:
1 Insert an inspection point before the assembly activity, where units
can be inspected to ensure that no time is wasted in processing
faulty units.
2 Keep buffer inventory. A number of units that have already been
manufactured may be placed in the assembly area to make sure
assemblers are never idle while they wait for units to be
manufactured. Note, however, that because the manufacturing
activity can work at much greater speed than the assembly
activity, manufactured units are likely to pile up here awaiting
assembly. This should be avoided by slowing down the rate at
which the manufacturing staff work (see step 3 below). Only a
small buffer inventory should be kept.
3 The product mix can be altered, as was illustrated in example 16.2.

Step 3: Subordinate other activities to the constrained
activity
The factory should not create excess work-in-progress inventory by
allowing the non-constrained activities to produce more units than
the constraint can process. In other words, all activities that are not
in short supply should be aligned with the activity that is in short
supply. This ensures that costs are reduced, particularly those related
to inventory.
Refer again to example 16.1. The manufacturing activity should
not be allowed to produce 100 units per day, as the assembly activity
can process only 50 units per day. If the manufacturing activity
continues to produce 100 units per day, this does not increase the
output of the factory – instead, it results in piles of work-in-progress
inventory. Excess inventory
• ties up valuable funds
• takes up space
• may need be moved around, consuming resources
• may be stored at extra cost
• may be insured
• could be damaged
• could spoil or become obsolete with age, depending on the type
of product.
The manufacturing activity should produce only 50 units per day

until the constraint in the assembly activity has been removed. There
should, however, be a small number of manufactured units in need
of assembly (work-in-progress units) that are kept as buffer
inventory to make sure the assembly activity never runs out of work
(see step 2 above).

Note that in order for other activities to be subordinated, the
performance measures that are traditionally used to measure the
results of those activities should also be subordinated to the
performance measures of the TOC. For example, in the factory in
example 16.1, management cannot continue to measure the
ef ciency of workers in the manufacturing activity in the same way
that they did before. These workers will now be required to produce
fewer units per day and should not be penalised for it.
Step 3 comes with its own set of terminology, namely drum-
buffer-rope (DBR). The constrained activity is referred to as the
‘drum’ – it dictates the ‘beat’ to which all the other activities should
perform. The ‘buffer’ is the work-in-progress inventory units that are
kept on hand and act as a buffer to the drum to protect the
constrained activity from running out of work. The buffer is
measured in terms of time rather than physical units (in other words,
X minutes’ worth of inventory is kept as a buffer). The activities
before the constrained activity are called the ‘rope’. They pull units
towards the constrained activity when required, and the rope is slack
when units are not required.
In example 16.1, the assembly activity is the drum, the work-in-
progress product units kept on hand to keep the assembly unit busy
are the buffer, and the manufacturing activity is the rope.
Step 4: Elevate the constraint

The steps that have been taken so far have helped to address the
immediate short-term problem of dealing with the constraint. In the
long term, however, the factory does not have to accept the existence
of the constraint. It can take active steps to remove or ‘elevate’ the
constraint. Elevating the constraint means transforming the
constraint into a non-constraint.

In example 16.1, management may wish to fund a training
programme to equip more workers with the skills to assemble the
product. Once these workers are ready to start working in the
assembly activity on the factory oor, the constraint has been
elevated and a longer-term solution (more comprehensive than the
short-term measures taken in step 3) has been found.
Step 5: Return to step 1

Following the steps in the TOC is a repetitive process. As soon as
one constraint has been elevated, the next factor that limits the
ability of the factory to perform in line with its goals is identi ed.
Let us assume that, for the assembly activity constraint illustrated
in example 16.1, step 4 of the TOC resulted in additional workers
being trained to assemble the product and that the factory is now
able to assemble 150 units per day. Next the attention will be focused
on the manufacturing activity where it is presently possible to
produce only 100 units per day, while the market demand is 200
units per day. The steps of the TOC are repeated – this time with the
manufacturing activity as the constraint. Once this constraint has
also been elevated, the assembly activity in this example will once
again become a constraint, as it is now producing 150 units per day –
still short of the required 200 units per day.
16.2.3 Theory of constraints reports

TOC reports should be produced in order to provide useful insights
to management about the improvements or otherwise in the process.
These reports should clearly highlight throughput margins as well as
throughput margins per unit of the constraint. It places management

in a position to evaluate the real bene ts of the effort expended in
applying the TOC.
Theory of constraints and activity-

16.2.4
based costing
Both TOC and activity-based costing (ABC) to some extent provide
information regarding the pro tability of products and services.
However, they have fundamental differences in terms of (1) time
horizons, and (2) the nature of pro tability decisions.
TOC works with a very short-term horizon, because it focuses on
exploiting constraints to address an immediate problem. In the long
term, these constraints are elevated (step 4). The short-term horizon
explains the con ict between throughput accounting and variable
costing, because in the very short term, only direct materials and
direct services are truly variable costs. If variable costing had been
used for decision-making, labour would also have been included as
a variable cost. ABC, on the other hand, takes an even longer-term
perspective by accumulating almost all costs (as discussed in
Chapter 6, Overhead allocation).
Furthermore, TOC plays a unique role in pro tability decisions in
that it emphasises the bene t realised from using a scarce resource in
the production process. The nature of pro tability decisions that
TOC can support therefore involves short-term product-mix
decisions based on the maximisation of throughput per unit of a
constrained resource. ABC cannot be used for such decisions owing
to its emphasis on accurate product costs and cost driver analysis,
both of which support strategic decisions such as pricing.
Despite their differences, TOC and ABC can be used together.
TOC supports short-term pro tability decisions and as such can be

used to enhance the pro t of an organisation in the short term. ABC,
on the other hand, takes a long-term perspective and therefore
supports long-term pro tability decisions such as pricing and pro t
planning.
Key terms: cost control, cost reduction, business process re-

engineering
Organisations constantly strive to minimise costs. Cost control refers

to the daily routine of attempting to keep costs at acceptable levels.
Analysis of budget variances and standard costing are examples of
cost control measures. When costs exceed targets, actions are taken
to bring the costs back in line with expectations. Cost reduction,
however, is not a routine task. Rather, it requires a fundamental
change that impacts not only the costs but also the targets that are set
for those cost categories. The re-design of a product or service can
result in cost reduction (for example, if the redesigned product
requires fewer parts).
Similarly, organisational processes are redesigned through
business process re-engineering (BPR). A business process (for
example, materials handling in a factory) is made up of a collection
of activities (for example, inspecting bought-in parts on arrival,
storing and issuing parts for production). Business process re-
engineering occurs when the process is re-designed in a radical way
so that the entire process functions differently. BPR is a complete
overhaul of the way in which a process is carried out. An example of
BPR – and one that would affect multiple processes if it were to be

implemented in a traditional factory – is a just-in-time system. This
is discussed next.
Key terms: just-in-time system, manufacturing cells, internal

failure costs, external failure costs
Just-in-time (JIT) focuses the organisation’s efforts on performing

value-adding activities on demand while minimising waste.
Activities that add value to a product are those that increase the
value of the product in the eyes of the customer. Although vehicle
manufacturers (most notably Toyota of Japan) are widely credited
with developing JIT, JIT principles enjoy widespread popularity.
A pull system is at the heart of the JIT system – in other words,
products are produced only once they are required by a customer. In
turn, materials to produce the products are procured only once
required by the production process. This stands in contrast to the
more traditional manufacturing systems, where demand is projected
and products are produced accordingly and kept in inventory until
they are sold. The traditional system is one of ‘pushing’ product
units through the factory and thereby increasing output, while
preventing idle time.
In a traditional system, inventory units act as buffers between the
different parts of the system, such as procurement, production and
sales. In contrast, in a JIT system, a workstation works on a unit only
once it has received a formal request to do so from the next station in
the production line.
JIT systems aim to minimise non-value-adding activities.
Keeping inventory is seen as such an activity (step 3 of TOC in 16.2.2

details the costs associated with keeping inventory). The costs
related to the storage, transport, insurance, protection and handling
of excess inventory items has traditionally been underestimated – JIT
manufacturers save money by minimising these expenses and gain
customer goodwill by ef ciently ‘pulling’ requested products
through the factory and delivering the items on demand.
JIT systems also aim to eliminate all activities related to the
production of units of poor quality. Just as the costs related to excess
inventory are minimised, so are the internal and external failure
costs related to poor quality. Internal failure costs are costs
associated with defective units discovered inside the factory, for
example the cost of re-working or scrapping defective units.
External failure costs are the costs related to defective units that
have left the factory before their defects were discovered and include
the cost of honouring warranties as well as the opportunity cost of
sales lost because of a damaged reputation. JIT systems allow for
more spending on prevention costs (such as purchasing materials of
a high quality from a reliable supplier) and inspection costs (to
ensure that defects are prevented). Total quality management is
discussed more fully in Chapter 17, Competitive advantage.
While it is unacceptable in a JIT environment for any units to be
defective (JIT factories usually aim for zero defects), it is just as
unacceptable for production machines to break down. Because JIT
systems are usually employed in highly mechanised factories where
a relatively small portion of the work is performed manually, the
proper maintenance of machines is an important objective.
Maintenance work is usually performed by the worker who uses
that particular machine, and in a JIT system it is usually not dif cult
for the worker to nd the time to carry out preventative
maintenance. Where traditional manufacturing systems ‘push’ as

many inventory units through the factory as possible and aim to
keep workers and machines busy, workers and machines in a JIT
system are often purposefully kept idle while they wait for the next
work station to place an ‘order’ for another unit. This idle time is
spent on preventative machine maintenance.
Although every effort is made to prevent defective units and
machine breakages, both of which take up production time, these
could still occur on occasion. In traditional factories, the effect of
such errors and stoppages is minimised by having enough work-in-
progress inventory units on the factory oor to continue work on
them. In a JIT system, however, where each unit is produced only
when needed and where on-time delivery to the next workstation
and eventually to the customer are paramount, any errors or
stoppages are a major cause for concern. Yet no effort is made to
negate the effects of these events – the factory is brought to a
standstill until the problem has been resolved. This ampli es the
error, emphasises quality, and highlights the unacceptability of
defects in product units and machines, resulting in an absolute
dedication to eliminating a repeat of the problem.
JIT factories have a unique layout. They usually have U-shaped
workstations known as manufacturing cells. Each product group is,
as far as practical, produced within such a cell, so that minimal
movement of work-in-progress inventory is required (because
moving inventory does not add value to the product). Workers are
multi-skilled – each worker is trained to both operate and maintain
the machines within the cell. Furthermore, units are said to be
produced in ‘batch sizes of one’. This means that, unlike in
traditional factories, where large batches of identical units are
produced before the machines are reset to produce a different type of
unit, each individual unit is regarded as a batch that justi es

machine set-up. Traditional factories reduce set-up costs by reducing
the number of machine set-ups, and one would be inclined to
assume that JIT systems would also aim to minimise machine set-
ups because of the non-value-adding nature of the activity. However,
the system does not allow for the advance production of any product
units that will end up in inventory, and therefore rather directs
efforts at automating the set-up process through advanced
technology, to the extent that the cost of resetting machines is
minimal. Furthermore, products are designed in such a way as to
minimise the number of set-ups needed.
16.4.1 The just-in-time environment

JIT factories do not exist in isolation, but rather operate within a just-
in-time supply chain. More than traditional factories, JIT factories
need their suppliers to help them run operations smoothly. For
materials to be purchased on a JIT basis (in other words, only the
exact number of units are purchased once they are already required
in production), suppliers have to make frequent deliveries of small
quantities of materials.
Because the supply function is so crucial to the success of the
system, JIT factories do not ‘shop around’ for the cheapest materials
or regularly switch between suppliers. The costs incurred by
traditional factories in sourcing the cheapest supplier for each batch
of materials to be delivered are saved in a JIT system. A long-term
relationship is established with a reliable, punctual supplier; the
quality of materials and the reputation of the supplier are more
important than the price of the materials. Suppliers often have
representatives stationed at the factory itself to ensure that a
seamless and defect-free passage of goods from the supplier to the
factory oor takes place. Automation, fast response times, and cost

savings on activities that do not add value are central to a JIT system
and orders are therefore placed to the supplier electronically and
automatically through an electronic data interchange system.
Performance measurement in a just-in-

16.4.2
time environment
Because JIT systems in many respects represent a signi cant move
away from traditional manufacturing philosophies, some of the
management accounting techniques that were developed in a
traditional setting are less appropriate or even harmful in a JIT
environment. The most notable is standard costing (refer to Chapter
13, Standard costing).
In a standard costing system, variances are calculated and
unfavourable variances that are deemed to be signi cant are
investigated and acted upon. A negative direct materials price
variance, for example, would indicate to management that cheaper
materials should have been sourced or that materials should have
been purchased in bulk in order to be charged at a lower unit price.
Both of these actions work against the JIT philosophy, which strives
for quality over price when it comes to materials and opposes the
stockpiling of materials not yet required by production. Similarly,
the direct labour ef ciency variance inspires incorrect action. It
measures how ‘busy’ workers have been in producing maximum
inventory, while the JIT system would prefer them to keep idle or
attend to machine maintenance instead of producing un-needed
units.
Although standards can be adjusted to align them with a new
system, JIT systems are better served by performance measures that
work in harmony with the philosophy of the system. Non- nancial

measures are emphasised in a JIT environment. For example,
management is likely to be interested in quality measures, such as
the number of defects per 1 000 units produced.
When a decision has to be taken regarding the possible
implementation of a JIT system, relevant costing principles (see
Chapter 10, Relevant information for decision-making) are applied to
perform a quantitative analysis. This compares the cost of
implementing the system with the savings obtained in eliminating
non-value-adding activities, including those related to excess
inventory, poor quality and manual work where automation is
possible. Qualitative factors are then also considered in weighing the
costs and bene ts of implementing the system.
Once you have studied JIT, work through the text again and
make a detailed list of the advantages and disadvantages of a
JIT system. This is a good way to strengthen your
understanding of JIT.
16.5 Benchmarking
Key terms: benchmarking
How long should it take from the time you call to place an order for
a pizza, to the time it is delivered to your home? How long should a
bank take to approve a student loan? What is a reasonable amount to
spend on internet services at an of ce? When you need to answer
such questions, the rst point of departure is usually to think of a
company that you have some knowledge of. You may try to recall
how long Debonairs took to deliver a pizza the last time you ordered

one, you may remember how long you waited for the approval of
your own student loan, and you may refer to your own monthly
internet service charges. These departure points are likely to form
the basis of your answers, because you know that ‘it has been done
that way before and therefore the answer is reasonable’.
Organisations constantly ask themselves similar questions about
their own performance. Debonairs, for example, may have enough
data on their own operations to be able to calculate the average time
it takes them to deliver a pizza, but how do they know whether this
should be good enough for them? When these questions arise,
organisations look for data that show them how the same operation
is performed elsewhere, through a process called benchmarking.
Benchmarking is about measuring relative performance levels.
Organisations that perform benchmarking are usually interested
in two main sets of data: the average performance of other entities as
well as the performance of the entity that is presently achieving the
best results in that particular eld. In both cases, they compare their
own performance against these benchmarks and take corrective
action as needed.
There are four main types of benchmarking:
1 Competitive benchmarking compares the performance of one
organisation to that of a direct competitor. Debonairs could, for
example, compare its pizza delivery time to that of Pizza Hut.
2 Internal benchmarking compares the performance of one unit of an
organisation to that of another unit inside the same organisation.
The student loan division of a bank could, for example, compare
its loan application turnaround time to that of the vehicle nance
division of the same bank.
3 Functional benchmarking compares the performance of one
function of an organisation to the same function of another

organisation, regardless of whether they operate in the same eld
of business. Parmalat could, for example, compare its head of ce
internet service charges to those of Foschini.
4 Strategic benchmarking is aimed at strategic action and
organisational change. An organisation could investigate the
strategies employed by other organisations, and compare its own
strategies to those.
Competitive benchmarking poses a problem: how does one get hold

of the relevant data from competitors? Where competition is intense,
organisations are unlikely to exchange information that could
potentially help the other party.
Organisations sometimes use ‘reverse engineering’ (analysing a
competitor ’s product by taking it apart and studying it) to obtain
benchmarks related to the physical product. For other issues, the
answer lies in third-party organisations (usually consulting rms)
which specialise in gathering and analysing industry data.
Organisations in a particular industry are invited to submit their
own data according to relevant performance categories, and in turn
receive a report from the third party detailing the data submitted by
all industry players. The data are made available to all participants,
but the names are usually kept anonymous. Although this kind of
benchmarking is often done, some care has to be exercised in
interpreting results. All organisations in the industry do not
necessarily record their performance results and costs in the same
manner, which could result in misleading points of comparison.
Furthermore, no two organisations are the same and operate under
the same circumstances, and environmental factors could affect them
in different ways.
In the case of internal and functional benchmarking, it is
theoretically more likely that information will be shared freely by the

parties involved, as the competitive threat is absent. However, where
internal benchmarking is performed in an organisation which
actively compares the relative performance of its units and models
its reward structure accordingly, there is a danger that managers
may be unwilling to co-operate and assist each other in a
benchmarking exercise.
The primary advantage of setting targets through benchmarking
is that, no matter how dif cult they may seem to achieve, one is
assured that the targets are realistic, because they have already been
achieved by others. Many uncontrollable factors, such as general
economic conditions or national power supply issues, may affect
entities more or less equally and therefore do not have to be taken
into account in interpreting the results. Benchmarking can also help
organisations to avoid the mistakes made by others.
On the negative side, apart from the security risk in sharing
information and the cost of carrying out a benchmarking exercise,
benchmarking is also often criticised for sti ing creativity because it
is essentially a catching-up exercise aimed at copying others.
Furthermore, benchmarking tends to focus attention on ef ciency
(employing the minimum resources in carrying out a task), while
effectiveness should ideally take precedence (ensuring that the
stated goal is obtained). In other words, benchmarking may
encourage doing things as ef ciently as possible rather than
questioning whether the right things are being done.
In the public sector, government can force organisations to

share data for purposes of comparison. Provincial education
departments, for example, compare the results of standardised
tests to let schools know how well their learners are doing
relative to learners in other schools.

16.6 Summary
Some production and information assimilation techniques have
gained prominence in modern factories. These may, in adapted form,
be useful in non-manufacturing organisations. A number of these
techniques were discussed in this chapter, because management
accountants need an understanding of the concepts in order to add
value in providing information and making decisions where such
techniques have been implemented.
The TOC identi es and addresses the problems that occur in the
short term when manufacturing constraints result in bottlenecks.
Throughput accounting is used to optimise production by focusing
on direct materials and direct service costs in calculating throughput,
as they are the only costs that are variable within a very short-term
time horizon. Once the immediate bottleneck situation has been
dealt with, TOC then seeks to alleviate the constraints in the longer
term.
While cost control on an ongoing basis is important in any
organisation and keeps costs in line with expectations, cost reduction
is a way to reduce costs by making signi cant changes. When
business process re-engineering is carried out, radical changes are
made to the way in which a process is performed.
JIT systems focus organisations’ efforts on performing value-
adding activities on demand while minimising waste. This implies,
among other things, dramatically reducing inventory levels and
placing a strong emphasis on quality and on-time delivery. JIT ts
well with the contemporary feel of this chapter – it is characterised
by extensive automation and by its exploitation of advances in
information technology.

Benchmarking is a way in which organisations can compare their
performance to current best practices. It therefore implicitly sets
targets that are realistic and attainable.
Conclusion: Contemporary management

accounting concepts and other topics in
this book
The modern environment in which organisations nd themselves, as
addressed in this chapter, gives rise to the need for organisations to
seek competitive advantage. This is further explored in Chapter 17,
Competitive advantage.
In the section on the TOC, it was pointed out that throughput
accounting calculates a throughput contribution which is different
from the contribution calculated in Chapter 5, Absorption versus
variable costing and in Chapter 11, Decision-making under operational
constraints. This is because throughput accounting works with a
shorter time horizon within which fewer costs are truly variable, a
principle which is best understood after Chapter 10, Relevant
information for decision-making has been studied. The section on TOC
also contrasted the concept with activity-based costing, as discussed
in Chapter 6, Overhead allocation.
Costs are controlled through budgeting (see Chapter 12,
Budgeting) and, in some organisations, through standard costing (see
Chapter 13, Standard costing). Cost control stands in contrast with
cost reduction, which requires the redesign of a product, service or
process.
Some modern techniques con ict with traditional management
accounting techniques. Most notably, the JIT philosophy (a ‘pull’
technique) is at odds with standard costing, which discourages idle

time and potentially encourages producing excess units, keeping
excess materials, purchasing cheaper materials, and so forth.
Standard costing and its variance calculations are discussed in
With the application of all of the concepts discussed in this
chapter, it is of great importance that the performance measures
employed by the organisation should be in harmony with the
objectives of the system. In the case of benchmarking, the technique
can, in itself, be regarded as a form of performance measurement.
The principles studied in Chapter 14, Performance management are
therefore relevant here.
Volkswagen Group South Africa
Volkswagen South Africa is located in Uitenhage, an industrial town some 35 km

from Port Elizabeth in the Eastern Cape. The Eastern Cape is home to the largest
automotive cluster in South Africa. Volkswagen Polo, Volkswagen Cross Polo and
Volkswagen engines are manufactured at the Uitenhage plant.
SOURCE: VOLKSWAGEN (2019)
1 Explain and describe ve steps that Volkswagen South Africa might follow if it
found that a production constraint at its Uitenhage plant was preventing it from
manufacturing the number of Polos that it strives to supply.
2 Identify two business processes that you think may exist within the factory.
Discuss how costs within these processes may be controlled.
3 Recommend and justify whether you think it would be feasible for Volkswagen
South Africa to follow the JIT approach at its Uitenhage plant.
4 List ve performance areas related to production that Volkswagen South Africa
could wish to benchmark against its local rival, the Ford Motor Company of
Southern Africa, which also operates a factory near Port Elizabeth.
Basic questions

BQ 1
The following data relate to a manufacturing company.
At the beginning of August there was no inventory. During
August, 2 000 units of product X were produced, but only 1 750 units
were sold. The nancial data for product X for August were as
follows:
Materials 40 000
Labour R12 600
Variable production overheads R9 400
Variable selling costs R6 000
Total costs for X for August R109 800
Which of the values below was the value of inventory of X at 31

August using a throughput accounting approach, as would be used
when applying the TOC?
a) R5 000
b) R6 175
c) R6 575
d) R13 725
BQ 2
How does throughput accounting (as used when the TOC is
employed), differ from variable costing?

BQ 3
JJ Ltd manufactures three products: W, X and Y. The products use a
series of different machines, but there is a common machine that
creates a bottleneck.
The standard selling price and standard cost per unit for each
product for the forthcoming period are as follows:
40% of the overhead cost is classi ed as variable.

Using a throughput accounting approach, what would be the
ranking of the products to allow for best use of the bottleneck?
BQ 4
The production manager of Manufacturing4Africa recently made the
following remark:
We have a real problem in the factory. Our two newest
production machines, the MHP2008 and the ExpressRT, are not
performing as well as we had hoped. Unfortunately, our
product has to pass through both of them. At least the
ExpressRT should be able to produce about 300 000 units per
month, but the MHP2008 has been turning out only 250 000

units each month. The sales team is really angry – they say
we’re holding them back. The product is very popular and
they could easily sell much more, if only we could
manufacture enough!
What steps should the production manager follow in order to

address the problem, and how do they apply to
Manufacturing4Africa?
BQ 5
Consider the following two de nitions:
• De nition A: ‘an approach to production management which aims
to maximise sales revenue less materials’
• De nition B: ‘a system whose objective is to produce or procure
products or components as they are required by a customer or for
use, rather than for inventory’
Which of the following pairs of terms correctly matches the

de nitions in A and B above?
De nition A De nition B
a) Benchmarking JIT
b) Business process re-engineering TOC
c) TOC Business process re-engineering
d) TOC JIT
BQ 6
Consider the following two de nitions:

•
De nition 1: ‘the act of recreating a core business process with the
goal of improving output, quality, or reducing costs’
• De nition 2: ‘an accounting system that focuses on ways by which
the maximum return per unit of bottleneck activity can be
achieved’
Which of the following pairs of terms correctly matches de nitions 1

and 2 above?
De nition 1 De nition 2
a) Manufacturing resource planning TOC JIT
b) Business process re-engineering Throughput accounting
c) Cost reduction TOC
d) Benchmarking Throughput accounting
BQ 7
Which of the following de nitions is/are correct?
(i) JIT systems are designed to produce or procure products or
components as they are required for a customer or for use,
rather than for inventory.
(ii) Cost reduction occurs when budget variances are analysed and
corrective action is taken to address any instances where costs
exceed budgets.
a) None
b) (i) only
c) (ii) only
d) (i) and (ii)

BQ 8
CSIX Ltd manufactures fuel pumps using a JIT manufacturing
system. The transactions during the month of November were as
follows:
Purchase of raw materials R5 575 000
Conversion costs incurred:
Labour R1 735 000
Overheads R3 148 000
Finished goods completed (units) 210 000
Sales for the month (units) 206 000
Can the JIT system operated by CSIX Ltd be regarded as ‘perfect’?

What are the reasons for your answer?
BQ 9
T Ltd is a large insurance company. The claims department deals
with claims from policy holders who have suffered a loss that is
covered by their insurance policy. Policy holders can claim, for
example, for damage to property or for household items stolen in a
burglary. The claims department staff investigate each claim and
determine what, if any, payment should be made to the claimant.
The manager of the claims department has decided to benchmark
the performance of the following two areas in the department:
(i) The detection of false claims
(ii) The speed of processing claims

For each of the above two areas:
a) What would be an appropriate performance measure?
b) How could the relevant benchmarking data be gathered?
BQ 10
Academic studies argue that the annual budget model may be seen
as acting as a barrier to the effective implementation of alternative
models for use in the accomplishment of strategic change.
In what way(s) may the traditional budgeting process be seen as
a barrier to the achievement of the aims of benchmarking?
Long questions

A company produces three products using three different machines.
No other products are made on these particular machines. The
following data are available for December:
Maximum machine capacity in December will be 400 hours per

machine.

REQUIRED Marks
(a) Calculate the machine utilisation rates for each machine for December. 2
(b) Identify which of the machines is the bottleneck machine. 2
(c) State the recommended procedure given by Goldratt in his TOC for dealing with a bottleneck
2
activity.
(d) Calculate the optimum allocation of the bottleneck machine hours to the three products. 3
TOTAL MARKS 9

SM makes two products, Z1 and Z2. Its machines can work on only
one product at a time. The two products are worked on in two
departments by differing grades of labour. The labour requirements
for the two products are as follows:
Minutes per unit of product
Z1 Z2
Department 1 12 16
Department 2 20 15
There is currently a shortage of labour and the maximum time

available each day in departments 1 and 2 is 480 minutes and 840
minutes, respectively.
The current selling prices and costs for the two products are shown
below:
Z1 Z2
R per unit R per unit
Selling price 50,00 65,00

Direct materials (10,00) (15,00)
Direct labour (10,40) (6,20)
Variable overheads (6,40) (9,20)
Fixed overheads (12,80) (18,40)
Pro t per unit 10,40 16,20
As part of the budget-setting process, SM needs to know the

optimum output levels. All output is sold.
REQUIRED Marks
(a) Calculate the maximum number of each product that could be produced each day and identify
3
the limiting factor/bottleneck.
(b) Using traditional contribution analysis, calculate the ‘pro t maximising’ output each day and
3
the contribution at this level of output.
(c) Using a throughput approach, calculate the ‘throughput maximising’ output each day and the
3
‘throughput contribution’ at this level of output.
TOTAL MARKS 9

Ride Ltd is engaged in the manufacturing and marketing of bicycles.
Two bicycles are produced. These are the ‘Roadster’, which is
designed for use on roads, and the ‘Everest’, which is a bicycle
designed for use in mountainous areas. The following information
relates to the year ending 31 December:
• Unit selling price and cost data are as follows:
Roadster Everest
R R

Materials cost 80 100
Variable production conversion costs 20 60
• Fixed production overheads attributable to the manufacture of

the bicycles will amount to R4 050 000.
• Expected demand is as follows:
Roadster 150 000 units
Everest 70 000 units
• Each bicycle is completed in the nishing department. The
number of each type of bicycle that can be completed in one hour
in the nishing department is as follows:
Roadster 6,25
Everest 5,00
There is a total of 30 000 hours available within the nishing
department.
• Ride Ltd operates a JIT manufacturing system with regard to the
manufacture of bicycles and aims to hold very little work-in-
progress and no nished goods inventory whatsoever.
REQUIRED Marks
(a) Using variable costing principles, calculate the mix (units) of each type of bicycle which will
6
maximise pro t and state the value of that pro t.
(b) Calculate the throughput accounting ratio for each type of bicycle and brie y discuss when it
is worth producing a product where throughput accounting principles are in operation. Your
5
answer should assume that the variable overhead cost amounting to R4 800 000 incurred as
a result of the chosen product mix in part (a) is xed in the short term.
(c) Using throughput accounting principles, advise management of the quantities of each type of
bicycle that should be manufactured which will maximise pro t and prepare a projection of 5
the net pro t that would be earned by Ride Ltd in the year ending 31 December.
(d) Explain two aspects in which the concept of ‘contribution’ in throughput accounting differs
4
from its use in variable costing.

TOTAL MARKS 20

The X Group is a well-established manufacturing group that
operates a number of companies using similar production and
inventory-holding policies. All of the companies are in the same
country, although there are considerable distances between them.
The group has traditionally operated a constant production
system whereby the same volume of output is produced each week,
even though the demand for the group’s products is subject to
seasonal uctuations. As a result, there is always nished goods
inventory in the group’s warehouses waiting for customer orders.
This inventory will include a safety inventory equal to two weeks’
production.
Raw materials inventories are ordered from suppliers using the
economic order quantity (EOQ) model in conjunction with an
inventory control system which identi es the need to place an order
when the re-order level is reached. The purchasing department is
centralised for the group. On receiving a noti cation from the
inventory control system that an order is to be placed, a series of
quotation enquiries is issued to prospective suppliers so that the best
price and delivery terms are obtained for each order. This practice
has resulted in there being a large number of suppliers to the X
group. Each supplier delivers directly to the company that requires
the materials.
The managing director of the X group has recently returned from
a conference on world class manufacturing and was particularly
interested in the possible use of JIT within the X group.

REQUIRED Marks
Write a report, addressed to the managing director of the X group, that explains how the adoption
10
of JIT may affect its pro tability.
TOTAL MARKS 10

E5E is a charity concerned with heart disease. Its mission statement
is:
To fund world class research into the biology and the causes of heart
disease.
To develop effective treatments and improve the quality of life for
patients.
To reduce the number of people suffering from heart disease.
To provide authoritative information on heart disease.
E5E obtains funding from voluntary donations from both private

individuals and companies, together with government grants. Much
of the work it does, in all departments, could not be achieved
without the large number of voluntary workers who give their time
to the organisation and who make up approximately 80% of the
workforce.
E5E does not employ any scienti c researchers directly, but funds
research by making grants to individual medical experts employed
within universities and hospitals. In addition to providing policy
advice to government departments, the charity’s advisors give
health educational talks to employers and other groups.
The board recognises the need to become more professional in
the management of the organisation. It feels that this can be best

achieved by conducting a benchmarking exercise. However, it
recognises that the introduction of this process may make some
members of the organisation, particularly the volunteers, unhappy.
REQUIRED Marks
As nancial controller:
(a) Discuss the advantages and disadvantages of benchmarking for E5E. 8
(b) Provide advice on the stages in conducting a benchmarking exercise in the context of E5E. 13
Provide advice on how those implementing the exercise should deal with the concerns of the
(c)
staff, particularly the volunteers. 4
TOTAL MARKS 25
References
Blocher, EJ, Chen, KH, Cokins, G & Lin, TW. 2007. Cost management: a strategic emphasis,
3rd (international) edition. New York: McGraw-Hill.
Blocher, E, Stout, DE, Cokins, G & Chen, K. 2008. Cost management: a strategic emphasis, 4th
edition. New York: McGraw-Hill.
Department: Trade and Industry, Republic of South Africa. 2019. Plastics. [Online].
Available: http://www.dti.gov.za/industrial_development/plastic.jsp [14 October 2019].
Goldratt, EM & Cox, J. 1986. The goal: a process of ongoing improvement, 2nd edition. Great
Barrington, MA: North River Press.
Reeve, JM. 2003. Readings and issues in cost management, 2nd edition. New York: Thomson
Learning.
Volkswagen. 2019. Volkswagen Group South Africa, Ltd. Uitenhage. [Online]. Available:
https://www.volkswagen-newsroom.com/en/press-releases/volkswagen-group-south-
africa-ltd-uitenhage-1296 [14 October 2019].

LEARNING OBJECTIVES
• describe, from a management accounting perspective, the
following techniques, practices and philosophies which support
competitive advantage:
• Porter’s generic strategies
• activity-based management
• total quality management
• target costing, including kaizen costing
• environmental management accounting
• life-cycle costing
• supply chain management
• value chain analysis.
Ford’s Puma engine
Claims attributed to fraud, waste and abuse cost the South African medical aid
sector between R22 billion and R28 billion a year. In one instance, the Government
Employees Medical Scheme uncovered irregular claims of R93 million by a service
provider who had 36 practices registered under its name. Discovery Health, in turn,
estimates that 7% to 15% of its total healthcare spend goes to fraudulent claims.
Medical aids therefore compete, to some extent, based on which competitor
manages fraud better. Schemes and administrators that are more adept at detecting

and mitigating fraud, enjoy lower operating costs and thus have a competitive
advantage.
SOURCE: BASED ON INFORMATION FROM TSHWANE (2019)
This case study illustrates an unlikely source of competitive advantage in an

industry, namely fraud management. Pro t-seeking companies, such as privately
held medical aid schemes, continuously look for ways to outplay their competitors.
They formulate strategies in an attempt to gain competitive advantage. Once they
have gained such an advantage, they work to exploit the advantage to its full
potential.
17.1 Introduction
Key terms: Competitive advantage
There is increasingly intense competition in today’s global economic

environment. A company’s competitive advantage is the attribute
that gives that organisation the potential to perform better than its
competitors.
Global competition and competitive advantage apply to pro t-
seeking organisations in particular and are less relevant in the public
and not-for-pro t sectors. Business strategies to gain competitive
advantage are supported by relevant information such as that
supplied by the management accounting system. Management
accounting should support an organisation’s strategy by employing
relevant tools and practices. There are many ways to gain
competitive advantage, so there are many ways to supply
management information that supports competitive advantage.
Some potentially useful techniques, practices and philosophies
include Porter’s generic strategies, activity-based management, total
quality management, target costing, environmental management

accounting, life-cycle costing, supply chain management, and value
chain analysis.
The concepts discussed in this chapter are large and complex,
and have been the subjects of in-depth research by numerous
academics and business practitioners. This chapter aims to provide a
basic background to these topics. However, if students are interested
in learning more about these topics, there is a wealth of resources
available that elaborate on their theory, importance and application.
Key terms: generic strategies
Porter (1985) advocates that each organisation has to choose one of

three generic strategies. The three options are as follows:
1 Cost leadership. When an organisation chooses a cost leadership
strategy, it aims to be the lowest-cost producer in the industry.
The cost leader is often a large, well-established organisation that
can exploit economies of scale. The cost leader can earn bigger
pro ts at the same selling price as its competitors, because its
costs are lower. However, it may choose to match its low cost
with a low selling price, thereby undercutting competitor prices
and dominating the market.
2 Differentiation. There can be only one cost leader in each industry,
as only one organisation can truly be the industry’s lowest-cost
producer at any given time. The remaining organisations
therefore need to distinguish their products or services from
those offered by competitors by differentiating them – by making
them different in the eyes of the customer. This can be done in a
number of ways, for example by offering unique features or

superior customer service, exploiting unique distribution
channels, using attractive packaging, and other similar means.
One of the most frequently encountered ways in which
organisations differentiate their products or services is by
attaching a brand name to it in order to signify its uniqueness.
3 Focus. There are two types of focus strategy, namely cost
leadership and differentiation. A focus strategy (also sometimes
called a ‘niche’ strategy) applies either cost leadership or
differentiation to a speci c niche within the market. In other
words, instead of serving the whole market, the market is
divided up into segments by the organisation, and the strategy is
applied only to a speci c part or part(s) of the market on which
the organisation chooses to focus. Market segmentation takes
place based on criteria deemed appropriate by the organisation.
For example, one organisation may choose to segment its market
based on the age of customers and decide to strive for, say, cost
leadership in the market segment that serves customers over the
age of 60. Another may choose to segment its market based on
gender and employ a differentiation strategy which targets
female customers.
Porter contends that every organisation has to choose one of these

three generic strategies in order to determine the basis on which it
will compete.
Key terms: activity-based management, operational ABM,

strategic ABM

Activity-based management (ABM) uses the same activity and cost
information as an activity-based costing system (see Chapter 6,
Overhead allocation) to support operational and strategic management
decisions. Using ABM, organisations are able to realise the goals that
management wishes to achieve, but can do so with fewer resources
(Cooper & Kaplan, 1999). ABM focuses management’s attention on
activities as a way of improving the value that customers receive and
the pro t realised by an organisation. Owing to its focus on activities
performed in product and service delivery, ABM helps management
to concentrate on the organisational key success factors that enhance
competitive advantage.
ABM identi es the major activities that take place in the
organisation and groups them into homogeneous cost pools. It then
determines the cost driver of each such activity. This allows for the
effective management of the activities, because managers now
understand what causes costs to be incurred. If the organisation then
wishes to make use of activity-based costing, it proceeds to assign
the cost of the activities to products or services based on their
consumption of the respective cost driver resources.
ABM improves processes in order to reduce waste, so products
and services are produced at lower cost. Management can examine
the real contribution of each of the activities in meeting customer
needs. ABM is applied at both the operational and strategic levels of
organisations.
Operational ABM is concerned with management actions that are
aimed at increasing ef ciency, lowering costs and enhancing asset
utilisation (Cooper & Kaplan, 1999). It assumes that the demand for
organisational activities is reasonable and the challenge for
management is to meet this demand with fewer human, equipment
and working capital resources. Operational ABM does not question

why activities are being performed, it merely addresses ef ciency, in
other words, doing things right.
The application of operational ABM has several bene ts. Due to
better resource utilisation, organisations record higher pro ts. More
output is delivered with the same resource quantity and quality.
Operational ABM also increases pro t by cutting expenses. A
number of process improvement tools, such as cost driver analysis,
activity analysis and performance management, are employed. Cost
driver analysis involves all efforts expended in examining,
quantifying and explaining the effect of cost drivers on the cost of
activities. Activity analysis is the process of assessing each of the
main activities performed within a company.
Strategic ABM is based on the principle of effectiveness, in other
words, doing the right things. It assumes that the ef ciency levels
within the organisation are given and management’s task is to make
sure that organisational resources are being used on opportunities
that generate the maximum bene ts. The information generated by
an ABC costing system gives management a better picture of the
pro tability of different products and services. Through strategic
ABM, management takes this information and directs organisational
attention towards more pro table products and services. This is
achieved by shifting the activity mix away from unpro table
products and services to more pro table ones (Cooper &
Kaplan, 1999: 277). As such, strategic ABM includes decisions such
as:
• product/service design
• product/service development
• product line and customer mix
• customer relationships (covering issues such as order size,
delivery, pack-

• aging and pricing)
• supplier relationships (covering issues such as supplier cost
analysis, on-time delivery and quality)
• distribution channel analysis
• market segmentation.
Operational and strategic ABM work together to ensure that

organisations perform a given quantity of activities with fewer
resources (operational ABM), and at the same time shift the
organisational activity mix to more pro table products, services,
processes and customers (strategic ABM) (Cooper & Kaplan, 1999).
One of the most prominent applications of ABM is customer
pro tability analysis, whereby customers or customer groups are
regarded as cost objects and the cost of serving them is analysed in
an activity-based manner.
Key terms: total quality management
In today’s global market, customers have a wide variety of products

and services from which to choose. This has brought to the fore the
need to produce quality products and provide quality services. Total
quality management (TQM) requires all business functions to work
towards continuous quality improvement, so that the customer
receives a product or service of consistent high quality and receives
it on time. TQM forms an essential part of a just-in-time system, as
described in Chapter 16, Contemporary management accounting
concepts.

17.4.1 Definition of quality
Key terms: quality
Quality is de ned as the extent to which a product or service meets

customer expectations by conforming to the required design or
speci cations at the price customers are willing to pay. It is
important to note that the de nition and measures of quality come
from the market and not from boardrooms. The point here is that if
organisations are to provide quality products and services, it is not
the organisations themselves that judge whether the quality is
acceptable or not. Quality should therefore be regarded as an
external measure of the attributes of products and services.
17.4.2 Dimensions of quality

Quality is a composite measure of a number of attributes that
customers desire and demand in a product or service. Table 17.1
shows some of the key facets of quality that collectively make up
what customers would deem a quality product or service
(Hoque, 2005: 242).
Table 17.1 Dimensions of quality
Performance How well and consistently a product or service functions
The appearance of a physical product, that is, how appealing it is in the eyes of the
Aesthetics
customer
Serviceability How easily a product can be maintained or repaired
Features The characteristics of a product that differentiate it from functionally similar products
Reliability The probability of a product performing its intended function for a speci ed length of time
Durability The length of time that the product functions in the hands of the customer

Conformance How well a product meets the speci cations set during the development stage
Fitness of use The suitability of the product to carry out its advertised functions
17.4.3 Elements of total quality management

Total quality management (TQM) is based on the principle of ‘get it
right rst time’. TQM is the unyielding and continuous effort
expended by everyone in the organisation to understand, meet and
exceed the expectations of customers (Blocher, Chen, Cokins &
Lin, 2005: 681). It emphasises preventative measures. The aim is
therefore to design and build in quality – rather than to deal with the
results of poor quality later – by focusing on the causes instead of the
symptoms of poor quality. In the quest for TQM, quality-related
costs are identi ed and reduced.
TQM elements include the following (Lord, 1999):
• Eliminating or reducing non-value-adding activities (such as
setting up machines and ordering materials)
• Reducing inventories, lead times and defects
• Streamlining production ow
• Co-operating with suppliers and synchronising production plans
with
• supplier delivery schedules
• Increasing exibility and productivity of the workforce
• Encouraging operators to maintain their own equipment and to
detect, record and solve their own problems
For TQM to be successful, it should be regarded as a culture that

permeates every structure, process and activity performed in the
organisation.
Figure 17.1 Critical total quality management success factors

SOURCE: BLOCHER ET AL. (2005:682)
If organisations are to bene t from TQM, it is necessary to set targets
for continuous quality improvement and cost reduction (see ‘kaizen
costing’ in section 17.5.5). Such targets are supposed to be in the
context of a well-understood quality improvement programme, the
aim of which is to better the previous period’s quality level. In other
words, quality is not a static measure that can be achieved by an
event. It needs to be improved all the time if an organisation is to
sustain its competitive advantage.
17.4.4 Cost of quality

Key terms: cost of quality, prevention costs, appraisal costs,
internal failure costs, external failure costs, cost of

quality report
Cost of quality is the sum of the costs that arise from ‘activities
associated with prevention, identi cation, repair, and recti cation of
poor quality and opportunity costs from lost production time and
lost sales as a result of poor quality’ (Blocher et al., 2005: 691).
Costs of quality are generally classi ed into four broad
categories, namely prevention costs, appraisal costs, internal failure
costs and external failure costs (Juran, 1974).
Prevention costs
Prevention costs arise from initiatives aimed at preventing the
production of defective products. The principle behind initiatives
that give rise to these costs is ‘prevention is better than cure’.
Prevention costs occur before production in order to eliminate or
reduce the chances of producing defective products. Product design
and quality training are examples of preventative activities that give
rise to prevention costs.
Appraisal costs
Appraisal costs arise from activities that are performed to detect,
measure and analyse data to ensure that products and services
conform to speci cations. These costs occur during production but
before products are delivered to the customers. Examples of
activities undertaken to detect quality problems include inspection
and quality audits.
Internal failure costs

The appraisal function generates useful feedback about the quality-
related problems that exist despite the preventive measures put in
place. Activities aimed at the recti cation of defective products and
services give rise to internal failure costs. These costs are called
internal failure costs because they occur before the product leaves
the premises of the organisation. Examples of activities that incur
internal failure costs include re-work and re-inspection of products.
External failure costs

The measures put in place to prevent, detect and rectify defective
products and services sometimes fail to eliminate the production and
delivery of unacceptable products and service to end-use customers.
When that happens, the defects in the products and services are
detected and experienced by customers. In other words, in the case
of external failure costs, the quality problems are detected outside
the boundaries of the organisation. Examples of external failure costs
include the cost of repairing units already delivered, replacement
costs and product recall. A very expensive (although dif cult to
quantify) external failure cost is the opportunity cost of sales lost as a
result of a damaged reputation.
Cost of quality report

The management accountant is integral to continuous improvement
in quality, as he or she emphasises quality by reporting on it. A cost
of quality report shows the various categories of quality costs
expressed as a percentage of revenue (Hoque, 2005). Table 17.2 gives
examples of the components of quality costs.
Table 17.2 Components of quality costs
Cost of quality Examples

category
Prevention costs Quality engineering
Quality training programmes
Quality planning
Product design
Quality circles or cells
Supplier selection and evaluation
Appraisal costs Raw materials inspection and testing

Work-in-progress inspection
Finished goods inspection
Packaging inspection
Test equipment (acquisition, maintenance, salaries and wages)
Internal failure costs Rework

Scrap
Loss as a result of downgrades Re-inspection
Retesting
Loss due to work interruptions Design changes
External failure costs Cost of recalls

Sales returns and allowances due to quality de ciency
Repairs
Product liability
Warranty costs
Contribution lost (from cancelled orders owing to poor quality and to perceived
poor quality)
SOURCE: ADAPTED FROM HOQUE (2005: 245); BLOCHER ET AL. (2005: 692); WANG, GAO & LIN
(1998)
The cost of quality increases as one moves down the order of

prevention, appraisal, internal failure and external failure costs. The
total cost of quality is minimised when more emphasis is placed on
the earlier categories. This implies that more money ought to be
spent early on, such as on designing a quality product and
purchasing quality materials. Organisations that achieve and sustain

competitive advantage using TQM therefore focus on prevention
and appraisal in order to eliminate internal and especially external
failure.
As discussed in Chapter 16, Contemporary management accounting
concepts, modern manufacturers may employ a just-in-time (JIT)
system which minimises inventory and relies on the prompt delivery
of goods to the factory, and ultimately to customers. Quality is
essential in a JIT system, as there is no excess inventory on hand to
replace units with quality problems and no room for error. In such
scenarios, the timeliness with which goods are delivered is also seen
as a dimension of quality.
Example 17.1
VlogEquip manufactures desk-level microphone stands, such as those used by people
posting videos online. In the past nancial year, the company spent R600 000 on
preventative maintenance, R400 000 on the testing of manufacturing equipment and
R900 000 on the repair of defective units returned by customers. VlogEquip estimates
that downtime due to quality problems cost the company in the region of R700 000
during the same year. Sales revenue earned during the year in question was
R20 000 000.
Required:
Prepare a cost of quality report for VlogEquip and advise management about quality
issues based on the report.
VlogEquip’s cost of quality report can be summarised as follows:
R’000 Percentage of sales

Prevention costs
Preventative maintenance 600 3
Appraisal costs
Testing manufacturing equipment 400 2

Internal failure costs
Manufacturing downtime 700 3.5
External failure costs
After-sales repairs 900 4.5
Total quality costs as a percentage of sales 13
The percentage of sales is calculated by dividing each cost category

by the R20 000 000 in sales revenue.
VlogEquip’s cost of quality report shows that it is spending
comparatively too much on the last two quality categories. Ideally,
the cost of quality problems should be higher in the rst stages
(preventative and appraisal costs) and lower in the latter stages.
VlogEquip’s factory is allowing many defective units to pass
through it, resulting in customers receiving defective units. Under
external failure costs, only the cost of repairs was available. It is also
possible that damage to the brand has resulted in an opportunity
cost, meaning the true cost of external failure is even higher.
Spending more on prevention and appraisal will likely result in
higher quality products and a lower total cost of quality for the
company.
17.5 Target costing
Key terms: target costing, reverse costing
Given the somewhat con icting objectives of providing innovative

products and services at a lower cost than one’s competitors, and at
the same time ensuring the pro tability of the organisation, cost
management is a key element in the survival of organisations.

17.5.1 Definition of target costing
Target costing is a way of reducing the costs of future products by
concentrating on cost management during product development. It
is an approach that entails the establishment of allowable product
cost by subtracting an organisation’s desired pro t margin from the
estimated selling price (which is to a large extent determined by
estimating what customers would be willing to pay).
Target costing is also known as reverse costing, because it
reverses the thinking used in traditional cost-plus pricing (see
Chapter 10, Relevant information for decision-making). Instead of
aggregating costs and adding a pro t margin to arrive at a selling
price, target costing starts from the selling price, subtracts the pro t
margin, and calculates how much the product may cost. It asks ‘what
may this product cost?’ rather than ‘what does this product cost?’.
17.5.2 Establishing a selling price

Establishing the selling price of the proposed product is done in such
a way that it takes into account expected market conditions at the
time of launching the product. In addition, the proposed product
selling price should take into account certain internal and external
factors. Internal factors worth considering include the position of the
product in the organisation’s product portfolio and how it ts with
the company’s product strategies.
External factors that are considered in setting a target selling
price include:
• the organisation’s image in the market
• the level of customer loyalty in the product’s market
• the product’s expected quality level, functionality and price
compared to competing products.

In addition, the organisation’s expected market share in the targeted
market is taken into account to make sure that the organisation does
not price itself out of the market.
17.5.3 Determining the desired profit margin

The desired pro t margin applied in establishing a product’s target
cost is determined by considering, among other things, stakeholder
needs and funding for future research and development of new
products. It is important therefore to remember that not only is the
desired pro t margin in uenced by the required return of
investment (as determined by shareholders), but that the
organisation’s future nancial needs for developing products are
also an in uencing factor.
17.5.4 Product-level target cost

Key terms: product-level target cost
After the proposed selling price and the desired pro t margin have
been determined, the difference between the two is what is known as
the product-level target cost. From Figure 17.2, we can see that the
product-level target costing process principles of management
accounting involves comparing the theoretical product-level target
cost and the actual cost of the product prototype (shown as ‘current
cost’). This process often shows the current product cost to be higher
than the product-level target cost. This then brings about a strategic
cost reduction challenge, where the organisation has to determine
how to reduce the prototype cost (current cost) to a level that is equal

to or below the product-level target cost. This requires breaking
down the product-level target cost into component-level target costs.
Figure 17.2 Product-level target costing processes
SOURCE: ADAPTED FROM COOPER AND SLAGMULDER (1999: 32)
17.5.5 Component-level target costs

Key terms: component-level target costs, kaizen costing
The product-level target cost is further broken down into

component-level target costs, which are communicated to all key
players within the organisation. The component-level target costs are

also communicated to all suppliers to design and manufacture
components or inputs that meet the required functionality and
quality at the speci ed costs. Therefore, the process of setting a
product’s target cost takes place at two levels (product and
component level), as shown in Figure 17.2.
Costs are usually driven down to the target level in three ways.
Firstly, reverse engineering is applied to competitors’ products,
meaning they are taken apart and studied. Secondly, value
engineering takes place, meaning experts from different departments
get together to discuss how the product could be designed to save
money while remaining t for purpose. Finally, process
improvement is implemented, in an attempt to reduce the money
spent on the processes needed to produce the product.
Even once production of the new product line has started, the
target cost may still be below the initial cost of producing the units.
However, the target cost is expected to be achieved by the time the
product reaches the ‘mature’ stage (see section 17.6 on life-cycle
costing for a discussion of the stages in the product life cycle).
Kaizen costing
While most of the cost reductions are realised during product
design, incremental cost reductions can be effected during
product or component manufacture. Kaizen costing (a Japanese
term) is used when an organisation strives for continuous
improvement. It is a deliberate programme that is in synch with
the organisation’s strategic objectives and is designed to
support the cost management efforts inherent in target costing.
It involves a clearly understood plan of how the cost reductions
are to be achieved, in addition to a feedback loop that tells the

organisation the extent to which the cost reduction objectives
have been realised.
Example 17.2
Recall from example 17.1 that VlogEquip manufactures microphone stands. The
company wishes to introduce a new model, the Swivel360. Market research has
shown that a high-quality swivel microphone stand could capture a healthy market
share at a selling price of R900. Engineers estimate that it will cost R600 per unit to
manufacture the swiveling metal frame, while the rubber grip will cost R200 per unit to
manufacture. Attaching the rubber to the frame will likely cost R10 per unit.
VlogEquip’s management will only commit to the production of the Swivel360 if it can
yield a pro t equal to 20% of the selling price.
Required:
Use your knowledge of target costing to advise the management of VlogEquip as to
how the company should proceed with the design and manufacture of the Swivel360.
At a selling price of R900 and a 20% target pro t, the product should
incur no more than R720 [R900 – (R900 × 20%)] in product-level
costs. Assembly costs R10 per unit. This means the two component-
level costs (metal frame and rubber grip) will have to be reduced
until their combined per-unit cost, which is presently R800 [R600 +
R200], is equal to or below R710 per unit [R720 – R10]. VlogEquip
could start by reverse engineering one or more competing products
to look for ways in which the product may be designed without
losing its value. It could then apply value engineering by getting
people across the organisation involved in designing the product in
such a way that component-level (and ultimately product-level)
costs are lowered. The team could include many employees, from
procurement of cers and engineers (who may reduce or replace
parts to save money) to marketers (who make sure the product does

not lose value in the eyes of the customer). Suppliers could also be
asked for input, as they may advise on how the cost of materials
could be lowered (for example, by designing the product to use
standard instead of specialised parts). VlogEquip could then look for
process improvement opportunities. If, for example, assembly cost
can be reduced to R8 per unit, materials can cost as much as R712
per unit [R900 – (R900 × 20%) − R8].
If VlogEquip’s efforts result in a product-level cost just above the
target, management may decide to proceed with its manufacture if
kaizen costing can be employed to drive down costs during the
production phase, to the extent that the Swivel360 is likely to reach
the target cost by the maturity stage of its life cycle.
Environmental management
17.5.6
accounting
Key terms: environmental management accounting
In Chapter 14, Performance management, we discussed how

organisations are increasingly considering the needs of multiple
stakeholders, not just shareholders. These stakeholders include
society and the environment. Environmental management
accounting supplies management information onorganisational
activities that affect the environment as well as environment-related
impacts on the organisation. According to Chartered Global
Management Accountant (CGMA) quali cation framework, such
management information could include the following:
• Identifying and estimating the costs of environment-related
activities

• Identifying and monitoring the use and cost of resources such as
water, electricity and fuel, so costs can be reduced
• Making sure environmental considerations form part of capital
investment decisions
• Assessing the likelihood and impact of environmental risks
• Including environment-related indicators as part of routine
performance monitoring
• Benchmarking activities against environmental best practice
Environmental costs can be categorised as follows:

• Prevention costs: costs associated with preventing adverse
environmental impacts
• Appraisal costs: costs of assessing compliance with environmental
policies
• Internal failure costs: costs of eliminating environmental impacts
that have been created by the organisation
• External failure costs: costs incurred after environmental damage
has been caused outside the organisation
Notice how the cost categories of environmental costs correspond to

the cost categories we use when we work with the cost of quality in
section 17.4 on total quality management (TQM). Just like a cost of
quality report, an environmental cost report may express each cost
category as a percentage of revenue. Most importantly, the focus
here should also be on keeping the last cost categories (internal and
especially external failure costs) as low as possible, to protect the
reputation of the organisation and to reduce total environmental
costs. The similarities arise because environmental costing is closely
linked to total quality management and continuous improvement.
TQM focuses on how customers regard the organisation’s products
and the public is increasingly demanding environmental

responsibility from organisations. In today’s competitive
environment, a quality product or service is one that meets multiple
criteria in the eyes of the customer, including respect for the
environment. In addition, regulatory nes resulting from poor
environmental management can be large, and they are a non-value-
adding cost – something TQM works to eliminate. Organisations
that strive for zero defect may also strive for zero pollution.
Successful environmental cost management helps the organisation to
improve revenue, to reduce costs, to reduce the cost of failure and to
improve the organisation’s image.
Two ways of highlighting environmental costs in an organisation,
are environmental activity-based accounting and environmental life-
cycle costing:
1 Environmental activity-based accounting allocates environmental
costs using cost pools, cost drivers and cost objects.
2 Environmental life-cycle costing summarises all environmental
costs throughout the life cycle of a product, regardless of who
bears the costs. The practice extends life-cycle costing to include
environmental and even social costs. Life-cycle costing is
discussed in the next section of the chapter.
Key terms: product life cycle, life-cycle costing
In theory, every product and service has a life cycle. For some, the
life cycle may be so long that many of us do not notice the changes.
Yet today’s highly competitive environment is shortening many
product life cycles, putting pressure on companies to understand
and exploit life cycles, and to keep innovating.

The product life cycle is the time from when the rst money is
spent on research and development of the product, to the time when
customer support for the product is terminated. The product life
cycle has four phases: introduction, growth, maturity and decline.
Life-cycle costing (LCC) is the maintenance of cost records that
accumulate the costs incurred over the lifespan of a product, service
or physical asset. Making useful decisions that result in attaining
competitive advantage requires adequate visibility of costs at each
stage of the life cycle. The following sections discuss each of these
stages.
17.6.1 Pre-production costs

Pre-production costs are incurred in the introduction stage of the
product life cycle. Research has shown that the bulk (up to 80%) of a
product’s total life-cycle costs is committed during the research,
development and engineering cycle (Monden & Hamada, 1991;
Kaplan & Atkinson, 1998; Dekker & Smidt, 2003; Atkinson, Kaplan &
Young, 2004). Committed costs are costs that arise from the product
features, the production process design and any specialised tooling
required for the manufacture of the product. From an LCC point of
view, the decisions that product designers, engineers and managers
make during this stage are critical in saving money later. It is
therefore advisable to spend enough money on pre-production
activities such as research and development in order to ensure a
lower total LCC for the product. (In the previous section of this
chapter, we saw that target costing focuses on designing a product or
service with a speci c target cost in mind.)
Notice that the adoption of LCC means that pre-production costs
such as research and development costs need to be allocated to

speci c product lines. This may not previously have been done in
many organisations.
17.6.2 Production costs

Production costs are incurred in all four stages of the product life
cycle. Production commences once a product has been declared
commercially viable. Once the production cycle starts, there is little
room for design changes. Cost savings that can be achieved are now
limited to the opportunities presented by the production methods.
Organisations can achieve production cost savings by, for example,
employing activity-based management, continuous improvement,
kaizen costing and just-in-time manufacturing (see Chapter 16,
Contemporary management accounting concepts).
Production costs are not evenly incurred over the time during
which a particular product line is manufactured, as is often assumed
in simpli ed calculations in management accounting. The product
goes through an introductory stage (where costs are typically high
and sales grow rapidly), a growth stage (where per-unit costs
decrease and sales continue to grow), a maturity stage (where costs
and sales have stabilised and healthy cash in ows are achieved), and
a decline stage (where the market has become saturated, and where
a point is eventually reached where it is no longer viable to produce
the product). Per-unit costs are often highest in the introductory
stage of the life cycle. During the growth phase, economies of scale,
learning curves and other ef ciencies emerge. By the time the
maturity stage is reached, costs are stable.
Figure 17.3 Life-cycle costs of a product or service

SOURCE: ADAPTED FROM CIMA (2000: 36)
17.6.3 Marketing, service and support costs

Most of the costs incurred in this stage result from product design
and production in terms of quality, form and functionality. These
costs include marketing costs (allocated to speci c product lines by
LCC) and repairs and maintenance costs as well as warranty costs.
A lower total LCC of a product or service can be a signi cant
source of competitive advantage.
The de nition of LCC suggests that it can be applied not only to
products or services, but also to physical assets held by the
organisation, such as plant and machinery. This means that all the
costs relating to the asset that are incurred in the time during which
the asset is held are accumulated. It includes the costs incurred by
the organisation in disposing of the asset. When the LCC concept is
applied to physical assets such as plant and machinery, the
estimated LCC of the asset can be considered when the investment
decision is taken, instead of focusing exclusively on the purchase
price. In considering the purchase of a eet of vehicles, for example,

LCC will lead the organisation to include the cost of the vehicles;
fuel, maintenance and insurance costs; and resale value in its
calculations.
Key terms: supply chain, supply chain management
A supply chain is a network of organisations that produces value to

end-use customers. A particular organisation, its suppliers and the
suppliers of those suppliers, form part of the chain. Similarly, that
same organisation’s customers and their customers form part of the
chain, until the product or service ultimately reaches the end-use
customer.
Supply chain management (SCM) involves the co-ordination of
the ows of materials, information and nance in a supply chain, to
satisfy the end-use customer and to ensure the pro tability of the
entire supply chain. Organisations within a supply chain naturally
work together, but some organisations speci cally focus on
strengthening the supply chain.
The 1990s saw customers becoming very demanding, expecting
higher levels of product and service performance. As a result of the
globalisation of many industries, customers had access to
competitive products and better alternatives, which made them
expect greater product and service customisation, and at the same
time they became used to a constant stream of innovations in the
goods and services they use. Organisations realised that the purpose
of supply chain integration is not solely to reduce costs. Instead,
higher levels of customer satisfaction create long-term relationships
that increase pro tability. SCM strategy changed from being

internally focused with the objective of cost reduction, to being
externally focused with the objective of achieving greater customer
satisfaction (which bene ts all supply chain partners). In today’s
business environment, many organisations have established tightly
integrated, synchronised supply chains, made possible by advances
in information technology.
SCM goes beyond the scope of logistics to include the
establishment of long-lasting, trust-based collaborative relationships
between organisations within a supply chain. Information is
willfully shared inside the supply chain. As an example, you will
recall from section 17.5 on target costing that organisations may
involve their suppliers in product design decisions.
Consider Figure 17.4, which shows the supply chain of a ctional
organisation, SA Manufacturers. SA Manufacturers purchases the
components that it uses in the manufacturing process from SA
Components. SA Components buys its input materials from SA Raw
Materials. SA Manufacturers sells its product to SA Distributors.
Notice the arrows between the blocks representing the various
organisations in the sketch. If we want to draw a highly-integrated
supply chain, we can shorten the distance between the organisations
and place the blocks right next to each other (or even show them
overlapping) to indicate the level of co-operation and integration
that has been achieved through optimal supply chain management.
Figure 17.4 The supply chain of SA Manufacturers

How supply chain management
17.7.1
confers competitive advantage

Organisations that form part of an integrated supply chain are able
to meet customers’ needs more quickly and more ef ciently than
where organisations have an arm’s-length relationship. The nature of
competition has changed to the extent that, increasingly, entire
supply chains compete against each other (instead of individual
organisations competing against each other).
Chapter 16, Contemporary management accounting concepts
discussed how organisations can only employ a successful just-in-
time system if they work closely with supply chain partners.
Information is critical to all the operations of a supply chain. An
information system such as management accounting is therefore
expected to play an important role in supporting the entire supply
chain. Organisations across the supply chain require the contribution
of ideas and information from management accounting.
Pro t-seeking organisations compete with each other and use

concepts such as supply chain management to gain
competitive advantage. In the public sector, competition is less
relevant, so much of the focus around supply is on the strict
regulations that apply to procurement. Great care is needed
when public money is spent, so the procurement process
should be transparent and defensible.
Key terms: value chain, value chain analysis, value system

A value chain is de ned by CIMA as the sequence of business
activities by which, in the perspective of the end user, value is added
to the products or services produced by an organisation.
Value chain analysis is a tool that organisations can use to attain
competitive advantage. The organisation is studied according to its
strategically relevant activities in an attempt to understand cost
behaviour as well as existing and potential sources of differentiation.
If the organisation can perform value-creating activities in a more
cost-effective or better way than its competitors, this is a source of
competitive advantage. For an organisation to realise the bene ts
arising from its internal value chain, it has to understand all the
activities inside the organisation that create value. Once these
activities have been identi ed, they should be managed in a more
effective and ef cient way compared to competitors’ activities.
Figure 17.5 shows the generic internal value chain for an
organisation as depicted by Porter. Each organisation’s primary
activities consist of the following:
• Inbound logistics (receipt and handling of inputs)
• Operations (transforming of the inputs)
• Outbound logistics (handling and distributing outputs)
• Marketing and sales (of outputs)
• Service (post-sales service to customers)
There are also four support activities, namely rm infrastructure

(where, among others, the accounting function would be classi ed),
technology development, human resource management and
procurement. The ‘margin’ in Porter’s sketch shows the value that
has been created by the value chain – that amount by which the
value of outputs exceeds the value of inputs.

Figure 17.5 Porter’s value chain
SOURCE: PORTER (1998:37)
The value chain shows the relationship between activities (described

as the ‘linkages’) and recognises that activities are interdependent.
Donelan and Kaplan (1998) argue that an organisation’s value chain
activities are interrelated in such a way that no activity should be
managed independently without considering the potential impact
on all other activities. Achieving competitive advantage by using
value chain analysis involves the management of value chain
activities and the exploitation of linkages between activities (for
example, in a just-in-time system, an electronic input of an order by
a sales clerk seamlessly triggers production). Adequate resources
should be devoted to value chain activities that confer the maximum
bene ts to the organisation. Other activities should be streamlined,
reduced or outsourced in order to ensure that the organisation’s
efforts are geared towards activities that have the greatest impact on
its ability to achieve and sustain competitive advantage.
Consider how the value chain is streamlined by employing other
practices discussed in this chapter, such as strategic activity-based
management (which asks which activities add value), total quality
management (which saves quality costs that do not add value) and

environmental management accounting (which saves environmental
costs that do not add value).
Using our knowledge of supply chain management from the
previous section, we can contend that an organisation’s internal
value chain does not operate in isolation – it forms part of an
industry value chain or a ‘value system’. The value system is made
up of all the value-creating activities within the supply chain,
starting with the basic raw materials and ending with the delivery of
the nal product into the hands of the end-use customer.
17.9 Summary
This chapter has dealt with a number of techniques, practices and
philosophies that enable organisations to build and maintain
competitive advantage in today’s highly competitive, global
economy.
Activity-based management is a technique that requires mangers
to identify and manage the underlying activities that cause costs to
be incurred. Where activity-based costing uses this knowledge to
determine accurately the cost of products and services, activity-
based management improves the organisation’s competitive position
by studying which activities are necessary (strategic ABM) and how
they can be managed most ef ciently (operational ABM).
Total quality management comes from the realisation that, in
today’s global economy, delivering a quality product or service to
customers is crucial to the survival of the organisation. Quality has
many dimensions, all of which depend on how the customer
perceives the product or service. At the heart of total quality
management is a realisation that it is better (and in total, cheaper)

rather to spend money early on to ensure quality, instead of
delivering a product or service of poor quality.
Many accounting students, when asked to recommend a selling
price for a product, would be inclined to perform a detailed cost
calculation and add a mark-up percentage to arrive at the selling
price (cost-plus pricing). Target costing challenges this view,
contending that the selling price should be what the customer is
willing to pay. When a desired pro t is deducted from this price, the
target cost is known. The product is then designed in such a way
that the target cost is achievable. Once production has started, the
kaizen costing technique, which aims to drive production costs
down steadily in each period, may be employed to help reach the
target cost level. Organisations that make use of target costing are
usually willing to accept losses in the short term, but are likely to
gain market share and customer loyalty early on because the product
is priced just right for its market.
The environment is an important stakeholder in modern
organisations. Environmental management accounting focuses on
the costs associated with the environment. It uses existing
management accounting techniques, such as activity-based costing
and life-cycle costing, to highlight environmental costs.
Environmental cost management is approached in a similar way to
quality cost management.
Each product and service has a life cycle, which is divided into
the four phases of introduction, growth, maturity and decline. Life-
cycle costing is a way of making sure managers see and interpret all
the costs that a product or service has incurred during its life cycle:
pre-production costs; production costs; and marketing, service and
support costs. It keeps a cost record per product line, which
aggregates all the costs throughout the life cycle.

In this time of intense competition, organisations have to look
beyond their own borders to nd competitive advantage. They are
increasingly realising that cooperation between organisations in the
supply chain is key: suppliers and customers along the length of the
supply chain are moving closer together and nding ways to
improve the competitive position of the chain as a whole.
Value chain analysis allows managers to group organisational
activities into categories in order to get a clear view of how value is
added by the organisation. This knowledge is then further exploited
to improve competitive advantage, for example by investigating
how key activities can be linked to each other more ef ciently, and to
see which activities may not be necessary at all.
Conclusion: Competitive advantage and

other chapters in this book
Various management accounting topics and techniques have been
discussed in this book. All assume a viable and functioning
organisation. However, owing to increasing competition and
increasingly demanding customers, the very survival of many
modern pro t-seeking organisations is threatened. This chapter has
explored ways in which competitive advantage is achieved and
sustained in the contemporary business environment.
Some of the concepts in this chapter speci cally tie in with the
just-in-time manufacturing philosophy discussed in Chapter 16,
Contemporary management accounting concepts. These include total
quality management, target costing and supply chain management.
Activity-based management is closely linked to activity-based
costing, which was discussed in Chapter 6, Overhead allocation. Target

costing stands in contrast with cost-plus pricing, discussed in
Chapter 10, Relevant information for decision-making.
Finally, it is crucial that performance should be managed (see
Chapter 14, Performance management) in a way that supports the
strategy that was chosen to pursue competitive advantage. For
example, if the organisation strives for the elimination of waste, an
emphasis on quality and tight links with suppliers and customers,
performance measures should focus on these goals in order to
encourage their achievement.
Tutorial case study: Distell Group
The Distell Group produces and markets wine, spirits, ciders and ready-to-drink
beverages. Its wine brands include Nederburg, Drostdy-Hof and Autumn Harvest
Crackling. Well-known spirit brands are Amarula, Klipdrift and Viceroy, while ciders
and ready-to-drink brands such as Hunters, Savannah, Bernini and Extreme are also
manufactured. Distell is listed on the JSE.
Distell published the following as part of its 2019 integrated report: ‘Our
operating environment is highly competitive, and if we want to be a proudly African
company that can compete with the top players in the world, benchmarking showed
us that we needed to make certain changes. The fourth industrial revolution means
that companies need to reinvent themselves to remain nimble and competitive. For
Distell, this included the restructuring of our supply chain network and head of ce
functions to improve ef ciency and unlock growth potential.’
SOURCE: DISTELL (2019)
1 Distell has a strong focus on branding and refers to its employees as ‘brand-
crafters’. Explain how branding ts into Porter’s generic strategies and how this
may provide a competitive advantage in the highly competitive environment in
which Distell operates.
2 Describe a few main activities that you think may be identi ed in the
manufacturing process if Distell were to implement activity-based management.
3 Describe one cost of quality that may form part of each of the following
categories in Distell: prevention cost, appraisal cost, internal failure cost and
external failure cost.
4 Describe to what extent target costing may be a suitable technique for Distell to
employ in its wine production operations.

5 Discuss whether you think that environmental management accounting has a
role to play in a manufacturer of beverages such as Distell.
6 Discuss the impact of the recipe design of one of Distell’s ready-to-drink
beverages on the costs that would be incurred during the life cycle of that
beverage. (During recipe design, the ingredients are chosen and their relative
proportions are set.)
7 Identify the organisations that would form part of Distell’s supply chain. You are
not required to name speci c organisations, but rather the types of organisations
(for example, ‘farmer’).
8 Apply Porter’s value chain to Distell by identifying the activities that would likely
represent each type of primary activity.
Basic questions
BQ 1
What is the difference between activity-based costing (ABC) and
activity-based management (ABM)?
BQ 2
Note: This question assumes that you have already studied JIT in
Chapter 16, Contemporary management accounting concepts.
Why is the adoption of total quality management (TQM) particularly

important within a just-in-time (JIT) production environment?
BQ 3
Would kaizen costing ordinarily be applied during the product
design stage? Explain your answer.
BQ 4

What are the basic steps in determining a product’s (or a service’s)
target cost?
BQ 5
A manager recently said: ‘In the time during which we produced
this product, we sold 50 000 units of it, bringing in total revenue of
R5 million. It cost us only R80 per unit to manufacture (which
includes materials, labour and overheads), so we made a lot of
money.’ What do you think of his statement from a life-cycle costing
point of view?
BQ 6
How do you think Porter would describe the generic strategies
followed by some of South African Airways’ local rival airline
services such as Kulula.com and Mango?
BQ 7
When supply chain management is practised, does this necessarily
mean that an organisation will work together more closely with its
suppliers? Explain why.
BQ 8
In Porter’s sketch of the generic internal value chain of an
organisation, will each organisation necessarily have a ‘margin’?
Explain your answer.
BQ 9
To what extent is knowledge of an organisation’s supply chain
necessary in order to perform value chain analysis?

BQ 10
How has the modern business environment become so competitive
that organisations now all strive to attain some form of competitive
advantage?
Long questions

SOURCE: ADAPTED FROM ACCA PAPER 3.3 PERFORMANCE MANAGEMENT
Quicklink Ltd operates in the distribution and haulage industry, and
has achieved signi cant growth since its formation in 1997. Its main
activities comprise the door-to-door delivery of mail, parcels and
industrial machinery. The board of directors agreed to purchase
Celer Transport, an unincorporated business. Celer Transport has
main activities comprising the delivery of mail, parcels and
processed food.
REQUIRED Marks
Discuss the main bene ts that might accrue from the successful implementation of a total quality
5
management programme by the management of the combined entity.
TOTAL MARKS 5

SOURCE: ADAPTED FROM ACCA PAPER 2.4 FINANCIAL MANAGEMENT AND CONTROL
Sassone (Pty) Ltd is a medium-sized pro table organisation that
manufactures engineering products. One of its stated objectives is to
maximise shareholder wealth. The directors of Sassone need to
increase capacity to meet expected demand for a new product,
product G, which is to be used in the manufacture of new-generation
computers. Product G cannot be manufactured on existing machines.

The directors have identi ed two machines which can manufacture
product G, each with a capacity of 60 000 units per year.
REQUIRED Marks
Discuss how life-cycle costing and target costing may assist Sassone in controlling costs and
8
pricing engineering products.
TOTAL MARKS 8

SOURCE: ADAPTED FROM ACCA PAPER 3.5 STRATEGIC BUSINESS PLANNING AND DEVELOPMENT
Good Sports Ltd is an independent sports goods retailer owned and
operated by two partners, Alan and Bob. The sports retailing
business has undergone a major change over the past 10 years.
Firstly, the supply side has been transformed by the emergence of a
few global manufacturers of the core sports products, such as
training shoes and football shirts. This consolidation has made them
increasingly unwilling to provide good service to the independent
sportswear retailers too small to buy in suf ciently large quantities.
These independent retailers can hold popular global brands in
inventory, but have to order using the internet and have no
opportunity to meet the manufacturer’s sales representatives.
Secondly, sportswear retailing has undergone signi cant structural
change with the rapid growth of a small number of national retail
chains with the buying power to offset the power of the global
manufacturers. These retail chains hold a limited range of high-
volume branded products in inventory and charge low prices which
the independent retailer cannot hope to match.
Good Sports has survived by becoming a specialist niche retailer

catering for team sports such as cricket, hockey and rugby. They are

able to offer specialist advice and keep a supply of the goods that
their customers want.
Since 2XX0, Good Sports has become increasingly aware of the
growing impact of e-business in general and e-retailing in particular.
They employed a specialist website designer and created an online
purchasing facility for their customers. The results were less than
impressive, with the internet search engines not picking up the
organisation’s website. The seasonal nature of Good Sports’
business, together with the variations in sizes and colours needed to
meet an individual customer’s needs, meant that the sales volumes
were insuf cient to justify the costs of running the site.
Bob, however, is convinced that developing an e-business
strategy suited to the needs of the independent sports retailer such
as Good Sports is integral to business survival. He has been
encouraged by the growing interest of customers in other countries
in the service and product range they offer. He is also aware of the
need to integrate an e-business strategy with their current
marketing, which to date has been limited to the sponsorship of local
sports teams and advertisements taken in specialist sports
magazines. Above all, he wants to avoid head-on competition with
the national retailers and their emphasis on popular branded
sportswear sold at retail prices that are below the cost price at which
Good Sports can buy the goods.
REQUIRED Marks
Good Sports Ltd has successfully followed a niche (or focus) strategy to date. Assess the extent to
8
which an appropriate e-business strategy could help support such a niche strategy.
TOTAL MARKS 8

SOURCE: ADAPTED FROM ACCA PAPER P3 BUSINESS ANALYSIS PILOT PAPER
DRB Electronic Services is located in X, a developed country, and
imports electronic products from the Republic of Korea. It re-brands
and re-packages them as DRB products and then sells them to
business and domestic customers in the local geographical region. Its
only current source of supply is ISAS electronics, based in a factory
on the outskirts of Seoul, the capital of the Republic of Korea. DRB
regularly places orders for ISAS products through the ISAS website
and pays for them by credit card. As soon as the payment is
con rmed, ISAS automatically e-mails DRB a con rmation of order,
an order reference number and a likely shipping date. When the
order is despatched, ISAS sends DRB a notice of despatch e-mail and
a container reference number.
ISAS currently organises all the shipping of the products. The
products are sent in containers and then trans-shipped to EIF, the
logistics organisation used by ISAS to distribute its products. EIF
then delivers the products to the DRB factory. Once they arrive, they
are quality inspected and products that pass the inspection are re-
branded as DRB products (by adding appropriate logos) and
packaged in specially made DRB boxes. These products are then
stored ready for sale. All customer sales are from inventory. Products
that fail the inspection are returned to ISAS.
Currently 60% of sales are made to domestic customers and 40%
to business customers. Most domestic customers pick up their
products from DRB and set them up themselves. In contrast, most
business customers ask DRB to set up the electronic equipment at
their of ces, for which DRB makes a small charge. DRB currently
advertises its products in local and regional newspapers. DRB also
has a website which provides product details. Potential customers
can enquire about the speci cation and availability of products

through an e-mail facility on the website. DRB then e-mails an
appropriate response directly to the person making the enquiry.
Payment for products cannot currently be made through the website.
Feedback from existing customers suggests that they particularly
value the installation and support offered by the organisation. The
organisation employs specialist technicians who (for a fee) will instal
equipment in both homes and of ces. They will also come out and
troubleshoot problems with equipment that is still under warranty.
DRB also offer a helpline and a back-to-base facility for customers
whose products are out of warranty. Feedback from current
customers suggests that this support is highly valued. One
commented that ‘it contrasts favourably with your large competitors,
who offer support through impersonal off-shore call centres and a
time-consuming returns policy’. Customers can also pay for
technicians to come on-site to sort out problems with out-of-
warranty equipment.
DRB now intends to increase its product range and market share.
It plans to grow from its current turnover of R5 million per annum to
R12 million per annum in two years’ time. Dilip Masood, the owner
of DRB, believes that DRB must change its business model if it is to
achieve this growth. He believes that these changes will also have to
tackle problems associated with the following:
• Missing, or potentially missing, shipments. Shipments can be
tracked only through contacting the shipment account holder,
ISAS, and on occasions they have been reluctant or unable to
help. The trans-shipment to EIF has also caused problems and
this has usually been identi ed as the point where goods have
been lost. ISAS does not appear to be able to track reliably the
relationship between the container shipment and the waybills
used in the EIF system.

The likely delivery dates of orders, the progress of orders and the
• progress of shipments are poorly speci ed and monitored. Deliveries
are therefore relatively unpredictable and this can cause
congestion problems in the delivery bay.
Dilip also recognises that growth will mean that the organisation has
to sell more products outside its region and that the technical
installation and support so valued by local customers will be
dif cult to maintain. He is also adamant that DRB will continue to
import only fully con gured products. It is not interested in
importing components and assembling them. DRB also does not
wish to build or invest in assembly plants overseas or to commit to a
long-term contract with one supplier.
REQUIRED Marks
(a) Draw the primary activities of DRB on a value chain. Comment on the signi cance of each of
9
these activities and the value that they offer to customers.
(b) Explain how DRB might re-structure its upstream supply chain to achieve the growth required
10
by DRB and to tackle the problems that Dilip Masood has identi ed.
(c) Explain how DRB might re-structure its downstream supply chain to achieve the growth
6
required.
TOTAL MARKS 25
LQ5 – Advanced (25 marks; 45 minutes)

SOURCE: CIMA P6
2B is a medium-sized retailer of sports equipment and leisure
clothing. It was established in 1987 and currently operates from three
retail shops in town centre locations.
The management team of 2B is very careful about how it recruits
staff. In addition to the speci c skills required to do the job, any

applicant must also have a passion for sport. This has resulted in
2B’s gaining a reputation for excellent customer service and
enthusiastic staff. A large proportion of staff time is also devoted to
training, both on the product range and customer service techniques.
According to a recent survey conducted by the store managers, the
customers believe that 2B employees are helpful and knowledgeable.
The customers also praised the 2B shops for being well designed and
said that it was easy to nd what they were looking for.
Another feature of 2B that is appreciated by the customers is the
range of goods in inventory. By developing close relationships with
the major manufacturers of sports goods and clothing, 2B is able to
keep in inventory a far wider range of items than its rivals. Control
of this inventory was made easier last year by the development of a
sophisticated computerised inventory control system. Using the
system, any member of staff can locate any item of inventory in any
of the shops or the warehouse. If the required item is not in
inventory at 2B, it is also possible to check automatically the
availability of inventory with the manufacturer.
At a recent management meeting, one of the store managers
suggested that 2B consider developing its very basic website into
one capable of e-retailing. At present, the website gives only the
location of stores and some very basic details of the range of
inventory carried. Although the development of the website would
be expensive, the managers have decided to give the suggestion
serious consideration.
REQUIRED Marks
(a) Using the value chain model, explain those activities that add value in the 2B organisation,
10
BEFORE the e-retail investment.
(b) Identify those activities in the value chain of 2B that may be affected by the e-retail 15
investment, explaining whether the value added by each of them may increase or decrease as

a result of the e-retail investment.
TOTAL MARKS 25
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chapters 14 to 17, and to move students toward a more
advanced, high-level understanding of the topics, the
relationships between them and the exam technique required.
Performance management forms a large and important part of

management accounting syllabi. It is a topic that builds on the
principles of management accounting theory – one needs an in-
depth understanding of costs and revenues in order to appropriately
analyse the performance of an organisation. When considering
nancial information with the purpose of assessing performance, it
is necessary to understand how costs were classi ed, how they
would behave (both individually and in relation to each other), how
they were recorded (for example, absorption costing was applied for
nancial accounting purposes) and what techniques were used to
assign costs to cost objects (for example, how overheads were
allocated, whether job or process costing was used, whether
standard costing techniques were employed). Performance
assessment requires one to analyse a set of information, to apply
judgement to form an opinion and to communicate ndings in a
convincing manner. It follows that performance management is an

ideal theme for examiners to use in advanced questions that
integrate a number of management accounting topics in a single case
study scenario. For this reason, you will nd that many questions in
advanced courses, as well as professional exam questions, feature
this important topic.
Transfer pricing could potentially require intricate numerical
calculations and pose many technical dif culties, although advanced
exam questions often prefer to test students’ understanding of the
topic together with other related topics. A potentially complex topic
such as transfer pricing is one that is best mastered when focusing
on the basic underlying principles. It is important to understand that
transfer pricing results in intra-organisational entries, in other
words, the transactions between different units within an
organisation cancel each other out and do not affect the results of the
organisation as a whole. However, should an organisation’s units be
autonomous (meaning that unit managers have a great degree of
decision-making power), the decisions that managers make based on
transfer prices may indeed affect the results of the organisation as a
whole. The management accountant should assess the transfer price
and determine whether it leads to optimal decision-making within
the organisation. The reason that unit managers may take sub-
optimal decisions based on inappropriate transfer prices is that
transfer pricing affects the performance assessment of the unit. Your
understanding of transfer pricing should therefore be informed by
your knowledge of performance management.
One of the biggest growth areas in the eld of management
accounting is strategic management. Increasingly, management
accounting syllabi include theories on strategy and high-level
management accounting questions are set in the form of case studies
where the answers have to be applied in the context of the strategy

and circumstances of the particular scenario in the question. The topics
dealt with in chapters 16 and 17 of this book are likely to feature in
such case study scenarios, interwoven with background information
on the organisation and nancial as well as qualitative facts. It is
imperative to understand that decisions are based on the
information supplied by a management accounting system and that
those decisions have to be in line with the strategic direction that the
organisation wishes to take. Strategy impacts on management
accounting and, in turn, management accounting information
informs strategy. For example, how performance is managed in an
organisation depends on the organisation’s strategy (an organisation
that has, say, decided to place strategic emphasis on customer
retention ought to build prominent customer retention measures into
its performance management and reward system). However, the
results of performance measurement in this organisation may have
indicated that it is particularly good at retaining customers, which
may have informed the decision to direct strategic focus at this core
competence in the rst place.
Now that you have studied all the chapters and the integration
sections in this book, you should spend some time re ecting on
how to prepare for advanced questions in management
accounting.
As you progress through your studies of management accounting,

you will likely nd the questions that you have to answer moving
increasingly in the following directions as the work becomes more
advanced:
• Questions require more reading, as an increasingly detailed
scenario is sketched as background to the question requirements.

• More and more topics are combined within a single question and
the topics are increasingly interwoven to test your understanding
of the situation as a whole.
• Answers require more writing, while a smaller portion of the
answer is made up of purely numerical calculations. Many
management accounting students have strong numerical skills
and nd this intimidating. However, consider that your high-
level understanding of topics can be tested only if you are asked
to discuss, comment, analyse, interpret and recommend (as you
would be asked to do when employed in a senior management
position).
• Questions become less likely to have one speci c, clear-cut
answer. In the previous point, it was mentioned that more
discussion is required, which makes it less likely that candidates’
answers will be similar. Even where the answer requires
calculation, the advanced nature of the question may allow for
multiple answers, as long as each answer is internally consistent
in its logic.
• You are likely to have to consider uncertain outcomes,
assumptions and estimates. In practice, management cannot be
certain, for example, that 50 000 units of a product will be sold in
the rst year. At best they can estimate sales at 50 000 units –
when decisions are based on this gure, they need to take into
account that they are working with an estimate. Advanced
questions mimic real-life problems more closely.
• Fewer marks are awarded for stating facts or performing
calculations that could have been memorised. While it is
important to study the theory and master the calculations in your
early studies, advanced studies require that you apply this
knowledge to a particular scenario. If, for example, you are asked

whether a given transfer pricing policy would be appropriate,
you do not receive marks for discussing the general advantages
and disadvantages of the policy. Only advantages and
disadvantages that ow from the speci c scenario would be
valid. Because these are speci c to the scenario, the fact that you
can identify them illustrates that you understand both the topic
and the case study.
Integrated question: Outdoor Africa

Outdoor Africa operates a retail store on premises of 4 000 square
metres in the Limpopo province. The company consists of three
divisions that are all located on the same premises. The garden
division sells plants, garden decorations and garden implements,
while the furniture division sells outdoor furniture. The third
division is the cafeteria, where clients can enjoy light meals. Outdoor
Africa is open every day of the year, including weekends and public
holidays.
Outdoor Africa’s head of ce, which houses senior management
and administrative staff, is at a different location.
Results: year ended 29 February 2XX8

The following information is available in respect of the nancial year
ended 29 February 2XX8:

Numerous permanent staff members worked at Outdoor Africa’s
retail premises during the year. Each of the three divisions has a
manager which earned a total salary package of R150 000 per
annum. Furthermore, the garden division and the furniture division
each have one assistant per 250 metres of oor space, each of whom
received a total salary package of R90 000 for the year. A total of nine
permanent waiters and kitchen staff members work in the cafeteria,
each of whom received a total salary package of R75 000 for the year.
Indirect costs are apportioned to divisions as follows:
Amount Allocation base

Rent, electricity and cleaning services R1 080 000 Floor space
Advertisements* R315 000 Divided equally
* From time to time, Outdoor Africa places a standard advertisement in local newspapers. The advertisement
features contact details and a map to the premises – individual products are not advertised.
Other expenses not allocated to divisions amounted to R1 125 000.
Staff meals
A group of Outdoor Africa employees complained to the managing
director in late February 2XX8 that it was expected of them to take
lunch to work at their own expense, while there is a cafeteria on the
premises. He asked the management accountant to investigate the
possibility of providing meals to staff at the cafeteria at the expense
of their own divisions, starting from March 2XX8. The management
accountant has gathered the following information:
• All staff members working at Outdoor Africa’s trade premises
would be interested in having free lunches at the cafeteria. It is
important to management that all workers enjoy the same

bene ts, regardless of the division they work for. The cafeteria
has 25 tables, and four persons can sit at each table.
• The cafeteria’s busiest time is between 13h00 and 14h00. Should
staff meals be served, staff will not be allowed to eat during this
rush hour. The staff of each division will be divided up so that
Outdoor Africa’s staff members eat in two equal groups: one
group will eat in the hour before the lunchtime rush hour, while
the other group will eat in the hour after the lunchtime rush hour.
There will therefore be staff available in each division to proceed
with normal tasks while their colleagues have lunch.
• The variable cost per lunch per staff member will be R40 for a
standard meal, as approved by management. Staff will not order
from the existing menu.
• Staff will be seated at speci c, reserved tables in order to cause
the least possible disruption to clients.
• The cafeteria’s divisional manager has the authority to refuse the
supply of lunches to Outdoor Africa’s staff, even if the managing
director decides that all staff should be given lunch. In such an
instance, staff will have lunch at the expense of their divisions at
the restaurant across the street, at a cost of R55 per lunch per staff
member.
• All staff members have to enjoy the same meals, in other words it
is not permissible for some of Outdoor Africa’s staff members to
eat in the cafeteria and for others to eat across the street.
• The following statistics could be gathered from information
extracted from the cafeteria’s point-of-sale software:
Average number of tables occupied by Average rand value per table spent by
clients clients
12h00 to
22 R200
13h00

13h00 to 25 R250
14h00
14h00 to
20 R200
15h00
Suggestions for change

Although everyone who works for Outdoor Africa generally gets
along well, some employees have become quite annoyed with
Charles, the son of the company’s founder. Charles does not
of cially work for the company, but claims to read management
accounting material in his spare time and is quick to make
suggestions to any employee he comes across. Some recent incidents
that have fueled the irritation of employees are the following:
1 Charles called the procurement clerk in the garden division an
‘ignorant fool’ for still not having implemented a just-in-time
system, as he ‘should have done years ago’.
2 Charles tore up a copy of the August 2XX7 monthly management
accounts at Outdoor Africa’s head of ce, shouting, ‘These
accounts are useless for performance assessment – clearly the
only way to get quality information is to benchmark the garden
division against the furniture division!’
3 He was overheard saying that the company ‘will go out of
business if it doesn’t change its pricing policy from cost-plus
pricing to target costing’.
4 In December 2XX7, a routine meeting took place between the
manager of the garden division and its main supplier, a
prominent local nursery. Charles showed up unannounced and
told the supplier’s representative that he would not be doing
business with Outdoor Africa for much longer, because ‘proper

supply chain management dictates that the company should
rather start its own nursery’.
REQUIRED Marks
(a) Draft a basic income statement for the year ended 29 February 2XX8 for each of the three
6
divisions and for Outdoor Africa as a whole. Use a table format with a column for each.
(b) Comment comprehensively on the relative performance of the three divisions for the year
15
ended 29 February 2XX8 and recommend how Outdoor Africa could improve its pro tability.
(c) Determine the impact on the annual pro t of Outdoor Africa as a whole of the proposal to
6
provide lunch to staff members at the cafeteria.
(d) Assuming that the managing director requests that lunch indeed be provided to staff members
in future, calculate the price per lunch per staff member that the garden division and the 6
furniture division ought to pay to the cafeteria.
(e) Give your reasoned opinion as to the validity, from a management accounting perspective, of
Charles’s views re ected in the four recent incidents described (use the numbers 1 to 4 to 12
discuss each incident in turn).
(f) Discuss whether the cafeteria is likely to follow a cost leadership strategy or a differentiation
5
strategy (as identi ed by Porter), based on the limited information available.
Ignore tax throughout.
TOTAL MARKS 50
Discussion
Part (a) should be straightforward for most students. Advanced
scenario questions often start with a rather basic rst requirement to
ease you into the question. Part (a) requires you to set out the
information in an orderly format, which helps you to interpret it
further. You should make sure that you score well in part (a). Notice

that part (b) follows part (a), so this is an example of a question
where it is important to attempt the requirements in the correct
order.
Part (b) is typical of an advanced question in management
accounting. It asks you to comment on the relative performance of
the divisions. Notice that you are not able to comply with this
requirement if you either perform calculations only (because then
you have not commented) or offer a narrative discussion only
(because then you would have very little to discuss – you need to do
a substantial number of calculations on which to base your
comments). It is also important to note that part (b) asks you to
perform two tasks. You rst have to comment on the performance
and then you have to make recommendations based on your
comments. This is an example of the importance of reading the
requirements very thoroughly before writing your answer. If you
had followed the suggested technique, you would have read
through the requirements before reading through the scenario, so
you would have been alert to information that could be useful in
your answer. You would also have planned the answer to part (b)
before starting to write, by making two headings (one for comments,
and one for recommendations) to make sure you addressed both
parts of the requirement. In an advanced question, the examiner is
unlikely to allow you to gain anywhere near full marks for a
requirement if you have addressed only part of the tasks (in part (b)
it is likely that a ‘ceiling’ or maximum mark will apply for
commenting and another maximum mark for recommending).
There are a number of common errors that you may have made
in your answer to part (b). First, make sure you know that an
organisation cannot improve its pro ts by allocating its expenses
differently between divisions. The only scenario in which this would

be possible requires a long and carefully worded explanation. If
Outdoor Africa were to allocate its expenses more equitably for
purposes of performance evaluation of divisions, you may argue
that divisional workers could feel more motivated by the improved
performance measurement system. If improved motivation then
actually led to their working more effectively, the division’s results
could improve (which would then mean more total pro t for
Outdoor Africa). It is therefore incorrect simply to write as part of
your recommendations that Outdoor Africa would improve its pro t
through better cost allocation. Allocation can, however, impact on
the relative performance of the divisions (the rst part of
requirement (b)), but to earn marks for this, performance should be
evaluated before the incorrectly allocated expense.
If you look at the suggested solution to part (b), you may nd
that it is easy, even though you may not have scored as well as you
had hoped. The information given in the question should be used to
assess performance (for example, oor space, income statement
information, and so on), rather than forcing preconceived theoretical
ideas (for example, ROI or RI) on a scenario where they could not be
applied.
You may have been tempted to make some generic
recommendations in your answer, for example that the company
should ‘try to increase sales by advertising more’ or ‘try to cut costs’.
Such recommendations are not speci c to your understanding of the
scenario and your analysis of the performance of the respective
divisions and are unlikely to earn marks.
Lastly, it is important to notice that the suggested solution to part
(b) could be worth much more than 15 marks, although only 15
marks are available. Furthermore, the suggested solution is by no
means comprehensive and you could have made many other valid

remarks. The more advanced a question, the less likely it is to have a
single, correct, model answer. To score well, you need to have the
con dence to write what you nd appropriate – a con dence that
comes from understanding the material and being sure that you are
interpreting the question correctly.
Part (c) is a relevant costing question and a good example of how
transfer pricing (see part (d)) requires an understanding of relevant
costing. Again, you needed to answer part (c) rst before moving on
to part (d). It is not necessary to recognise part (c) consciously as a
relevant costing question in order to score full marks – all that is
necessary is to read the requirement thoroughly and to apply logic to
arrive at the answer.
Part (d) is a good example of a transfer pricing requirement that
requires you to think logically and apply the basic principles, as it is
often examined in advanced questions. It gives the examiner the
opportunity to distinguish between students who understand the
principles and those who do not, without repetitive calculations or
setting aside a large number of marks at the expense of other topics.
If you scored well in part (d), this is a good indication that you grasp
the topic.
Part (e) is a rather advanced question. It tests some knowledge
from chapters 16 and 17, but in a context where you have to apply it
very carefully to the scenario. As for most advanced requirements,
the suggested solution is by no means comprehensive, but it does
indicate the main issues that you should have discussed. The
suggested solution to part (e) may help you to gain further insight
into the topics if you did not master them fully when you studied
the text.
Part (f) is dif cult to answer because of a deliberate lack of
information in the scenario and because it requires the application of

Porter’s theory to a single division within a company. You could,
however, gain the basic marks by showing that you understand the
meaning of the theory, using the case study to illustrate the concepts.
From there, some speculation and discussion are needed to gain
further marks.

Integration section: chapters 1 to 5 –
Aqua-systems solution
Part (a)(i)
The budget was drawn up using absorption costing. From the

information, we can see that opening and closing inventory, as well
as cost of sales, were calculated after adding (‘absorbing’) xed
manufacturing costs to the value of inventory.
Inventory increased from zero nished pumps (only components
in the form of 24 casings were in opening inventory) to 30 nished
pumps in closing inventory. The increase would have had a positive
effect on the absorption costing pro t, because xed costs are
included in closing inventory. This has created the false impression
that the division’s position has improved. The actual position is even
worse than suggested by the loss of R142 620.
A better understanding of the budget can be gained if the
variable costing approach is used. For this analysis, the variable
costs need to be separated from the xed costs.
The division’s variable and xed costs can be summarised as
follows:
Variable costs per pump R
Pipe connector (one per pump)* 20,00
Casing (one per pump)* 230,00
Impellers (one set per pump) 250,00
Shaft** 15,00

Electric motor 450,00
Labour: shaft cutting, casings & impellers – all xed 0,00
Labour: assembly (R50 per hour × 2 hours) 100,00
Sales and administration costs*** 38,25
Head of ce costs**** 14,00
Total variable cost R1 117,25
*To determine the future pro tability of the division, we are looking for the best estimate of the costs that will
be incurred to manufacture pumps during the next few months. Our best indication of what a pipe connector
is likely to cost is R20. The replacement cost of R230 is the best indication of what a casing is likely to cost
(also note that the R205 cost price that applies to the 24 units in inventory is a sunk cost as it has already
been incurred. As it is a sunk cost, it is not relevant).
**Shafts: Fixed costs allocated to shafts are R160 000/1 000 units = R160 per unit. We divide by 1 000 units
because the normal production capacity of the division is 1 000 pumps per month (refer to the second
paragraph of the question). The variable cost is therefore R175 – R160 = R15 per shaft.
***Sales and administration costs: R37 100 (R148 400 × 25%) is variable. This is R38,25 per pump sold (R37
100/970 pumps sold).
****The portion of head of ce costs relating to the patent is directly attributable to the division and is variable
per pump sold. This amount therefore needs to be included here. To determine the variable portion, the high-
low method is used. April is the ‘high’ month and information for the ‘low’ month is given. Therefore [R173
580 (April) – R171 900 (lowest month)]/(970 units – 850 units) = R14 per pump sold.
Fixed costs
The total production cost is given as R1 622 000 in the budgeted
income statement and relates to the production of 1 000 pumps
during the month. Therefore, each unit was assigned a cost of R1 622
(R1 622 000/1 000 pumps) under the absorption costing system.
To determine the xed costs assigned to each unit, we need to
deduct the variable costs that would have been included in this
amount. All variable manufacturing costs would have been
included:
R1 622 total cost – R20 (connector) – R230 (casing) – R250
(impellers) – R15 (shaft) – R450 (electric motor) – R100 (labour:

assembly) = R557 xed costs allocated per pump
This means the total xed cost of production is estimated as R557

000 (R557 × 1 000 pumps) per month. Note that no under- or over-
allocation is included in the income statement; therefore the
allocated xed cost is equal to the incurred xed cost of production.
The xed portion of sales and administration cost is R148 400 ×
75% = R111 300. The xed portion of allocated head of ce costs is
(R173 580 – R14 variable cost × 970 pumps sold) = R160 000. These
costs should be deducted from divisional pro ts in our analysis,
because the head of ce does some work for the division and
therefore these central costs would theoretically have been incurred
if the division had been a stand-alone company (on the assumption
that the allocation is fair). Do not worry too much if you made an error
here: this principle is dealt with later in the book (Chapter 14,
Performance management).
Total xed costs per month for the division are R557 000 ( xed
production cost) + R111 300 ( xed sales and administration cost) +
R160 000 ( xed head of ce cost allocated to the division) = R828 300.
The insurance income is a once-off item – it is non-recurring and
therefore it does not help us to project the future pro tability of the
division. The income should be ignored for purposes of this analysis.
Break-even point
The selling price per pump is R1 703 320/970 pumps sold = R1 756.
The contribution per pump is therefore R1 756 – R1 117,25
(variable cost per pump as calculated) = R638,75.
The break-even point is R828 300 (total xed costs of the
division)/R638,75 (contribution per pump) = 1 296,75 pumps.
The contribution that could be earned from selling excess
impellers is not taken into account. This is because the break-even

point for pumps calculated above is 1 297 pumps while only 1 150
sets of impellers can be manufactured every month. Pumpworks will
use the limited number of impellers to manufacture pumps rather
than to sell them, because Pumpworks earns a higher contribution
per pump than the R120 (R370 – R250) it can earn from selling
impellers. In other words, at the break-even point there will be no
spare impellers to sell.
This brings us to the next question: can the Pumpworks division
manufacture 1 297 pumps per month? From the information we see
that it can manufacture only 1 150 sets of impellers and 1 100 shafts
per month. Furthermore, labour information points to the fact that
there are 13 workers in the casings department that each work 160
hours per month and it takes 2 hours to manufacture one casing.
This means only 1 040 casings (13 workers × 160 hours/2 hours) can
be manufactured per month. The capacity of the Pumpworks
division is therefore limited to the smallest of these capacity
constraints, namely the casings labour. A maximum of 1 040 pumps
can be manufactured per month, because a maximum of 1 040
casings can be manufactured per month.
The break-even point of 1 297 is in excess of the capacity of 1 040.
This means, given the present production capacity, the Pumpworks
division cannot break even. The picture is much bleaker than what
the manager of the Pumpworks division has alleged it to be. Given
the present production capacity and projected demand level for
April (sales of only 970 units), the division cannot break even. Unless
signi cant changes are made very soon, the division cannot reach
the break-even point in ve months’ time.
Part (a)(ii)

If we look at how a break-even point is calculated, we can see that
there are three factors that could result in a lower break-even point:
(i) xed costs can be reduced, or contribution can be improved,
meaning that either (ii) variable costs are reduced or (iii) the selling
price is increased.
These would therefore be the three areas that we would want to
focus on in order to improve the pro tability of Pumpworks. An
improvement in any of the three, or in a combination of the three
factors, would lower the break-even units and make the target easier
to attain:
• (i) and (ii): At normal capacity, the total variable costs are R1 117
250 (R1 117,25 per unit × 1 000 units). Total costs are therefore R1
945 550 (R1 117 250 variable + R828 300 xed). Variable costs
represent 57,4% of total costs at normal capacity. It follows that a
saving in variable costs could have a signi cant impact on total
costs. Pumpworks could, for example, investigate the possibility
of manufacturing the bought-in connectors and/or electric
motors itself if practical. Alternatively, other suppliers or a price
re-negotiation with existing suppliers could be explored.
Pumpworks could also investigate the productivity of its labour
force – the fact that the manager of the Pumpworks division
asked a junior nancial clerk to look into this may suggest that
the manager already suspects labour is an area where costs can
be saved. Only a small portion of the cost of labour is variable –
the xed component of labour cannot be saved in the short term
and we would therefore rather seek to improve labour ef ciency
(however, keep in mind that if labour manufactures more units
per hour, a market for these additional units has to exist).
• (iii) We can calculate by how much the selling price would have
to be increased in order to break even if all other factors remain

constant: unit sales is presently 327 units (1 297 – 970) below the
break-even point. This means there is a shortfall in contribution
of R208 871 (327 units × R638,75 contribution per unit). The price
increase required is therefore R215,33 per unit (R208 871/970
units). This represents a 12% price increase (R215,33/R1 756).
This may be regarded as a signi cant increase, and we would
have to determine whether the market would accept this.
Furthermore, a price increase may cause a decrease in demand.
In addition to the above, there are some other factors speci c to the
Pumpworks division that could help it to improve its performance:
• If capacity is increased, the problem of having a break-even point
in excess of maximum production capacity will be addressed.
This means that the capacity of labour in the casings department
would have to be addressed rst. This principle is emphasised in
Chapter 16, Contemporary management accounting concepts,
where the theory of constraints holds that the bottleneck activity which
restricts the capacity of the factory should be identi ed and addressed.
However, no knowledge of Chapter 16 was required in order to answer
this question.
• It would be of little use if capacity were increased without a
corresponding increase in demand. Methods of stimulating
demand will therefore have to be explored so that the full
monthly production capacity can be sold.
• Alternatively, if demand cannot be increased, the division could
explore alternative uses for any spare capacity. For example, the
opening sentence of the case study mentions another division in
the company: perhaps there is a possibility of supplying
agricultural pumps to the Agri-water division.

Part (b)
The notion is untrue. Although direct labour in a factory may often

be variable according to the number of hours worked, this is not
necessarily always the case. We can discuss the problematic nature of
the statement as follows:
1 When we say that a cost is variable, we should understand in
relation to what it is variable. Does it vary according to the number
of units produced, the number of hours (which is often the case
with labour, and which can be closely related to the number of
units produced if units are very similar), or some other cost
driver? Each cost in each organisation is unique, and we should
speci cally investigate and determine the cost/cost driver
relationship.
2 This leads us to the next problem: the generalisation of the
statement. The terms ‘in a factory’ and ‘always’ show us that the
clerk has never considered the uniqueness of each organisation. It
appears that he may have attempted to formulate a ‘rule’ for
himself, with no regard for the actual situation at hand.
3 If we look at the labour information that we have on
Pumpworks, we can see that only a small portion of labour costs
are, in fact, variable per unit (2 assembly hours per unit). All
other labour costs are xed in the short term (see the next point).
4 The distinction between variable and xed costs has a time aspect
to it. In the very long term, no cost is ‘ xed’. The labour costs that
we regard as ‘ xed’ for purposes of this solution are xed for our
planning horizon. In part (a), we re-drafted the budget for one
month only (April 2XX5) and we made projections on the
possibility of returning the division to pro tability within the
next ve months. It is within this short planning horizon that we

were comfortable to assume that the portion of labour which we
classi ed as xed would remain constant.

M3 solution
Part (a)
The crux of answering this part of the question is to identify the need
to use process costing to calculate the unit costs of the joint process.
Once this has been done, it is possible to allocate the joint costs to the
joint products. Remember, that from Chapter 9, we know that joint
costs are not allocated to by-products but that the proceeds from the
sale of by-products are offset against the joint costs incurred. Once
the joint costs have been allocated, the further processing costs for
SealTight Waterproof can be added to the joint costs allocated to it
(note that since SealTight does not undergo any further processing
the valuation of SealTight will only consist of the joint costs that
have been allocated to it).
To assist with calculating the unit cost of the joint process, an
equivalent production statement and unit cost statement of
production should be drawn up. The equivalent production
statement is as follows:

Notes:
1 Note 2 in the question stated that 100 000 units were started
during January.
2 The total of 92 500 units is the sum of the completed units of
SealTight, SealTight Waterproof and SealLight (i.e. 53 000 + 32
000 + 7 500). However, since SealLight is a by-product and
therefore joint costs are not allocated to it, we need to exclude the
SealTight units from materials and conversion columns (in other
words, the materials and conversion columns are the sum of only
the completed 53 000 units of SealTight and 32 000 units of
completed SealTight Waterproof). This treatment will ensure that
only SealTight and SealTight Waterproof will attract joint costs.
3 Note 2 in the question tells us that a normal loss of 2,5% is
expected immediately after the raw materials have been added at
the start of the process. Since 100 000 units were introduced at the
start of the joint process, the normal loss will be 2 500 units (100
000 × 2,5%). Given that the normal loss is identi ed after the raw
materials have been introduced, the full 2 500 normal loss units
are included in the materials column. However, since the normal
losses are incurred at the start of the joint process, no conversion

costs would have yet been incurred and therefore no normal loss
units are re ected in the conversion column.
4 In note 2 of the question, we are told that there are 5 000 units
that are 75% complete. We have already seen that raw material
costs are incurred at the start of the process and therefore all
work-in-process units would have incurred the full proportion of
material costs. However, given the overheads are incurred evenly
through the joint process (refer to note 3 in the question), work-
in-process units will only have incurred 75% of the conversion
costs, which is equivalent to 3 750 units incurring 100% of the
costs. 3 750 units are therefore included in the conversion
column.
Now that we have completed the equivalent production statement,

we can prepare the unit cost statement as follows:
Notes:
1 It is necessary to split the proceeds from the sale of SealLight
across the raw materials and conversion costs on a rational basis.
This split has been done based on the proportion of cost incurred
on materials/conversion costs to total costs. R72 000 has therefore
been allocated to materials (i.e. 1 785 000/ (1 785 000 + 1 190 000)

× 120 000) and R 48 000 to conversion costs (i.e. 1 190 000/(1 785
000 + 1 190 000) × 120 000).
Having completed the unit cost statement, we now have suf cient
information to calculate the value of inventories. (You may be
concerned that in the question we have not been given a breakdown
of xed and variable costs, however we have been asked to value
inventories. In terms of nished goods inventories, there are 3 000
units of SealTight (53 000 produced – 50 000 sold), 2 000 units of
SealTight Waterproof (32 000 produced – 30 000 sold) and 1 500 units
of SealLight (7 500 produced – 6 000 sold). Even though there is
closing inventory of SealLight, since it is a by-product it will not
have any costs associated with it and therefore the value of SealLight
nished goods will be NIL. The nished goods inventory can be
Finished goods R R
SealTight
Joint costs (3 000 × R31.39) (note i) 94 170
Normal loss (3 000/(53 000 + 32 000 + 5 000) × 2 500 × R31.39 (Note ii) 2 616 96 786
SealTight Waterproof
Joint costs (2 000 × R31.39) (note 1) 62 780
Normal loss (2 000/(53 000 + 32 000 + 5 000) × 2 500 × R31.39 (note 2) 1 744
Further processing costs (note 3) 30 000 94 524
SealLight 0
Total nished goods inventory 191 310
Notes:

1 The unit cost calculated in the unit cost statement has been based
on equivalent units which is consistent with using the physical
units basis to allocate joint costs. The joint costs included in
inventory have therefore been based on the unit cost calculated in
the unit cost statement above.
2 You will recall from Chapter 8, Process costing that normal losses
are treated as a product cost and therefore need to be included in
the valuation of inventory. The normal loss allocated to each
category of nished goods needs to be based on the proportion of
the total normal loss that related to the nished goods. So we
know that the normal loss need to be allocated across a total of 53
000 units of Seal Tight and 32 000 units of SealTight Waterproof
produced and the 5 000 units of work-in-process, giving a total of
90 000 units. Therefore, for SealTight the allocation is based on
the 3 000 units of nished goods as a proportion of 90 000.
Similarly the allocation of the normal loss to SealTight
Waterproof will be 2 000 units of nished goods as a proportion
of 90 000.
3 The unit cost for the further processing costs is R15 ((R288 000 +
R192 000)/ 53 000) and therefore R30 000 (2 000 units of closing
inventory × R15) further processing costs need to be included in
nished goods inventory.
All that is now required to complete part (a) is to calculate the value
of closing work-in-process. The only work-in-progress relates to the
joint products. Using the information from the equivalent
production and unit cost statements, the value is calculated as
follows:
R R
Work-in-progress:

Raw materials (5 000 units × R18,52) 92 600
Conversion (3 750 units × R12,87) 64 350
Normal loss (Note ii above) (5 000/(53 000 + 32 000 + 5 000) × 2 500 x R31,39 8 719 165 669
Part (b)
The system used in part (a) to apply absorption costing to the

sealants is process costing. The proposed new venture is one in
which M3 will transport the sealant directly from the factory to the
client and will apply the product. The problem with using process
costing in this new venture is not the fact that we are dealing with a
service instead of a product. Process costing is applicable where a
large number of identical products move through the same process
and consume identical resources. In a situation where one can
merely substitute the words ‘identical products’ with ‘identical
services’, process costing would still be applicable. That, however, is
not the case here.
To start with, a different travelling distance (distance over which
the sealant is transported) would apply each time, resulting in an
uneven consumption of resources. Furthermore, we can therefore
say that each instance in which such a service is delivered, is a ‘job’
on its own. Each job requires a unique mix of transportation and
labour. Job costing is therefore the appropriate costing system to be
used. Chapter 7, Job costing features examples of scenarios where job
costing would be appropriate: a manufacturer of custom-made
kitchen cupboards, a vehicle repair shop, and a manufacturer of
aircraft where the customers (airlines) stipulate custom
speci cations. We can recognise this new service proposed by M3 as
one that ts well with those examples, because each job is unique.
The nancial director is concerned about the costs that will be

incurred to have two costing systems within the same company. He
or she is correct in that implementation decisions should be
subjected to a cost/bene t analysis – if the ‘cost’ (both in rand terms
as well as in terms of qualitative negative factors) outweighs the
likely bene ts to be gained, the system should not be implemented.
However, in this case, using the appropriate costing system (job
costing) will result in accurate management information, which is
the core purpose of a management accounting system. Forcing the
inappropriate process costing system onto this new service simply
because it is used elsewhere in the company, would lead to incorrect
costing, which is inappropriate for all types of management
decisions, including the pricing of the jobs (clearly, each job should
be individually priced). The bene ts of using job costing therefore
outweigh the rather unconvincing qualitative costs that have been
mentioned.
(What could be relevant here is a combination of job costing and
standard costing – it may be possible to set realistic standard costs
for, say, each kilometre travelled, each different application
technique used, and so on. Standard costing is described in Chapter
13, Standard costing.)

Ithemba solution
Part (a)
This requires a straightforward calculation using the sales volume

and price for both products given in the scenario. The budgeted
revenue is:
Tablets (4,8 million packs × R20 per pack) 96 000 000
Chewables (2,4 million packs × R22 per pack) 54 000 000
Total revenue 150 000 000
Part (b)
In a number of standard costing questions, you will be given the full

actual results for the period. However, in this question only
information relating to instances that resulted in a variance has been
given. For parts (b) and (c), it is therefore necessary to extract the
information needed to calculate the variances required from the
‘stories’ given in points 1 to 5 in the question. The recommended
approach to answering questions structured in this way is initially to
read each point on its own and identify which variances will have
arisen as a result of the incident(s) given in each point. Once you
have done this, you can then extract the numerical information from
the discussion given.

The background information in the scenario can be a helpful
guide to identifying which variances could potentially arise. For
example, the section on ‘Overview of production process’ refers to a
number of different raw materials and therefore there is a possibility
of a materials mix variance arising. Since parts (b) and (c) both
require variance calculations, for the purposes of reading through
the information given in points 1 to 5, it is best to treat them as one
part so that the points can be read through sequentially once. Each of
the points given result in the following variances:
Point Variances arising
1. This point provides information on the total production and the number of machine hours used. The
actual number of tablets produced can be compared to the budgeted number of tablets which will
provide information for a xed manufacturing overhead (FMO) capacity variance. Furthermore, the
actual number of machine hours can be compared to the expected number of machine hours (i.e.
the budgeted number of hours per batch × the actual number of batches produced) ef ciency and
capacity which will provide information for calculating an FMO efficiency variance.
2. Given that the cost of ASA is denominated in USD, any changes in the ZAR:USD exchange rate will
result in a raw materials price variance. The actual exchange rates given can therefore be
compared to the budgeted exchange rate. (Note that since we are told there was no change in the
USD cost of ASA, not other price variance will arise.)
3. The discarding of 8 batches of chewables will result in the wastage of machine hours (linked to
point 1 above) and raw materials. The wastage of machine hours will be captured in the FMO
efficiency variance referred to in point 1 above. The wastage of raw materials results in a raw
materials usage variance.
4. The once-off Department of Health contract results in an increase in the budgeted sales and
therefore a sales volume variance will arise. However, since chewables and dispersibles are similar
products, with one product being able to be substituted by the other product, selling more
dispersibles will impact the budgeted sales mix and therefore the sales volume variance can be
broken down into the sales quantity and sales mix variances Furthermore, given that the
contract price was below the budgeted price, a sales price variance also arises.
5. The new glycine contract was at a different price to the budgeted price and therefore a materials
price variance will arise.

Having identi ed all the variances, we can go ahead and complete
parts (b) and (c). For part (b), we are only interested in sales
variances and the information from point 4 in the question can be
used to calculate the sales variances as follows:
Sales price variance
Quantity of tables sold to Department of Health (1,5m/25) 60,000
Change in sales price (R20 − R19,75) −0.25
Price variance −15,000
Sales quantity and mix variances

You will recall from chapter 13, standard costing, that to calculate the
sales quantity and mix variances, it is necessary to restate the actual
sales volumes into the standard sales mix. This is done as follows:
Note that the above calculations were based on the number of

batches. It is also possible to do the calculations based on the
number of packs or the number of tablets. These alternative
calculations are given at the end of part (b).
The sales quantity variance can be calculated by comparing the
actual sales in the standard mix with the budgeted sales and
multiplying the differences by the standard gross pro t for each
tablet:

The standard gross pro t is calculated as follows:
Quantity variance Tablets Chewables
Difference in batches (1 328 − 1 200; 664 − 600) 128 64
Standard gross pro t (refer below) 57 700 67 550
Quantity variance 7 385 600 4 323 200
Standard gross profit per batch Tablets Chewables
Revenue (R20 per pack/25 tablets per packs × 100 000 tablets per batch; R22,50
80 000 90 000
per pack/25 tablets per packs × 100 000 tablets per batch)
Variable costs 2 300 2 450
Raw materials 1 800 1 950
Packaging materials 500 500
Selling - -
Contribution 77 700 87 550
Fixed manufacturing overheads (R20 000 (refer discussion below) × 1 hour) 20 000 20 000
Gross pro t 57 700 67 550
Note that since sales volumes have been based on batches, it is

necessary to calculate the gross pro t per batch. However, the sales
prices have been given per pack, while the size of the batches have
been given in the number of tablets. It is therefore necessary to
convert the price per pack to a price per tablet by dividing the price
per pack (R20) by the number of tablets per pack (25) and then
multiplying the price per tablet by the number of tablets per batch
(100 000) to get the sales price per batch. The raw materials and
packaging materials are given as a cost per batch and therefore no
conversion of these costs is necessary. Note that since selling costs
are not product costs, they are excluded from the gross pro t

calculation. We are told in the scenario that each batch of tablets
requires one machine hour. The budgeted xed manufacturing
overhead rate has not been given, but it can be calculated as follows:
Total xed manufacturing overheads 36 000 000
Total machine hours (based on normal capacity) 1 800
Allocation rate per hour 20 000
The sales mix variance is calculated as follows:
Difference in batches (1 350 − 1 328; 642 − 664) 22 −22
Standard gross pro t (refer workings above) 57 700 67 550
Mix variance 1 269 400 −1 486 100
The calculations for using packs and tablets as an alternative to

batches are given below:
Alternative – based on packs
Difference in packs 512 000 256 000
Standard gross pro t (w1/100*25) 14,43 16,89
Mix variance

Difference in packs 88 000 −88 000
Standard gross pro t (w1) 14,43 16,89
Mix variance 1 269 400 −1 486 100
Alternative – based on tablets
Difference in packs 12 800 000 6 400 000
Standard gross pro t (w1/100*25) 0,58 0,68
Mix variance
Difference in packs 2 200 000 −2 200 000
Standard gross pro t (w1) 0,58 0,68
Mix variance 1 269 400 −1 486 100
Part (c)
Part (c) requires you to calculate the variances that have arisen as
well as identify who is responsible for them. This requires an
understanding of the principles underlying each variance and for
you to use the background information given in the question which
details the responsibility areas for each manager. The variance report
is as follows (note that since the format required for the report was

stipulated, if you did not follow it you will be penalised a
presentation mark):
W1 Fixed manufacturing capacity variance
Budgeted hours 1 800

Actual hours 2 000
Increase 200
Rate (refer workings above) 20 000
Total variance 4 000 000
Less arising from production of 8 additional batches (reported separately) −160 000
Net variance 3 840 000
Fixed manufacturing ef ciency variance
Standard hours ((135m + 65m) × 1 hour/100 000) 2 000
Actual hours 2 000
Variance 0
W2 ASA price variance
Total cost 3 870 625
Standard cost (72 000 kg × R48) 3 456 000
−414 625
W3 Fixed manufacturing capacity and efficiency variances
Given that the 8 batches of production had to be discarded, an adverse xed manufacturing ef ciency
variance would arise:
Fixed manufacturing overhead allocation rate:

Total xed manufacturing overheads 36 000 000
Total machine hours (based on normal capacity) 1 800
Allocation rate per hour 20 000
Machine hours wasted (8 batches × 1 hour) 8
Total ef ciency variance −160 000
However, since an additional 8 batches were produced, a favourable capacity variance will arise:
Additional machine hours 8
Allocation rate 20 000
Total capacity variance 160 000
In W4, note the calculation of the kgs of ASA actually used. We were
speci cally told that for the 8 batches the ASA usage was doubled.
W5 Raw materials price variance
Quantity glycine purchased at new price 130
Increase in price (R25 − R18) −7
Variance −910

Part (d)
Defer/
Variance Reasons
expense
The favourable capacity variance would have resulted from actual production
Fixed
being greater than budgeted. IAS 2 requires the xed manufacturing overhead
manufacturing Defer
rate to be adjusted where actual production exceeds normal production to avoid
capacity
inventory being stated at an amount above cost.
Given that the variances arose due to abnormal wastage, the variance must be
Materials
Expense expensed in full to comply with the IAS requirement that abnormal amounts of
usage
waste cannot be included in the valuation of inventory.
Part (e)
The rst step to answering this part of the required is to determine
the amount of ASA inventory that was on hand at year-end:
We can now calculate the standard cost of the 1 720 kg on hand:
Kg raw material on hand 1 720
Standard cost per kg 48
Total standard cost 82 560

The next step is to calculate the amount of the ASA price variance
that needs to be deferred to closing inventory. Since the total ASA in
raw materials inventory is less than the nal purchase of ASA on 4
January, we know that only the price variance arising from this
purchase needs to be pro-rated (the other variances will all be
included in cost of goods sold as the goods to which they relate will
already have been sold). Thus, the variance to be deferred is
Price variance arising on 4 Jan purchases:
Actual cost 1 126 125
Standard cost (17 875 kg × R48) 858 000
Price variance −268 125
Variance per kg (rand) (268 125/17 875) 15,00
Kg on hand (w8) 1 720
Price variance included in ASA raw materials inventory (1 720 × R15) 25 800
Therefore, the total value of the ASA materials inventory is:
Total standard cost 82 560
Deferral of raw materials price variance 25 800
Total value per IAS 2 108 360
Part (f)
We rst need to determine whether there is suf cient production
capacity (machine hours) and ASA available or whether any existing
production would need to be sacri ced:

Since there are not suf cient machine hours, it is therefore necessary
to rank the products based on contribution per machine hour:
Given that The 500 mg tablets have the lowest contribution per
machine hour, it will not be worthwhile sacri cing any existing
production to produce The 500 mg tablets, however it is necessary to
determine whether it is worthwhile using the spare machine hours
after producing The 350 mg dispersibles and chewables tablets:
500 mg tablets
Spare machine hours (1020 − (600 + 300)) 120
Hours per batch 1,5

Number of batches that can be produced 80
Contribution (80 batches × R75 000) 6 000 000
Opportunity cost of not avoiding xed costs (as introducing a new product is likely to be a long-
2 500 000
term decision) (5m/2 as 6 months)
Incremental pro t per 6 months 3 500 000
Therefore The 500 mg tablets should be introduced, but should be limited to:
Number of packs (80 × 100 000 per batch/20 per pack) 400 000
Part (g)
Other factors to consider:

1 What is the likelihood of winning more government tenders as
these may be more pro table than introducing The 500 mg
tablets?
2 Given their similar nature, the introduction of The 500 mg tablets
is likely to cannibalise sales of the existing 350 mg tablets. This
has not been taken into account in the above analysis.
3 Would it not be possible to use the spare capacity more pro tably,
for example expanding into new markets rather than a new
product?
4 Would introducing the new product be in line with Ithemba’s
strategy?
5 Has research been undertaken to determine what the demand
trends for 500 mg tablets are?
6 How sustainable is it to operate at full practical capacity?
7 Other valid points will be awarded marks.

Outdoor Africa solution
Part (a)
Part (b)
Performance analysis
Some facts that are apparent from the analysis in part (a) are the
following:
• Measured on absolute turnover, the garden division performs
best, followed by the furniture division and the cafeteria.
• Measured on absolute gross pro t, the garden division performs
best, followed by the furniture division and the cafeteria.

• Measured on absolute pro t, the garden division performs best,
followed by the cafeteria and the furniture division.
• Measured on gross pro t percentage, the cafeteria performs best,
followed by the furniture division and the garden division.
• The garden division therefore relies on volume rather than on a
large mark-up percentage to ensure its pro tability.
Further calculations:
In some of the above calculations, advertisements were speci cally

left out, as it could be argued that, on the facts, they should not be
allocated to divisions.
Some of the ndings from the further calculations are as
follows:
• It is clear that the garden division is the largest in all respects and
in absolute terms the most pro table.

• The garden division is also the one with the highest pro t
percentage, and therefore performs best nancially.
• The cafeteria, however, has the smallest oor space but generates
the highest turnover per square metre. However, as soon as pro t
is considered, the cafeteria does not perform well.
• The problem with the cafeteria is its large salary bill.
• Further evidence of the above is that the cafeteria performs
relatively poorly per staff member/assistant.
• The furniture division performs worst throughout.
Recommendations
The following recommendations ow from the performance analysis
carried out:
• Outdoor Africa can improve pro tability by concentrating on the
garden division.
• The cafeteria could be more pro table if smaller salaries were
paid. It should be considered whether all the staff members are
necessary.
• As the cafeteria performs well per square metre, the expansion of
the cafeteria (greater oor space) could be considered. This may
enable more clients to be served if the staff lunch proposal is
accepted in 2XX8/2XX9.
• Especially since the cafeteria earns the highest gross pro t
percentage, it would be in Outdoor Africa’s interest to expand
this division so that its sales may increase.
• The oor space of the furniture division could possibly be
reduced. Outdoor Africa should, however, be careful in deciding
to close the furniture division altogether – there may be cross-
selling between the divisions in this type of organisation (in other
words, more people may visit the premises because everything is

sold under one roof – if one division closes, it could have a
negative impact on the pro tability of the remaining divisions).
Outdoor Africa could consider establishing a new division that is

related to the existing divisions (for example, swimming pool
equipment, water fountains, paint or paving) that could possibly
bring further cross-selling opportunities and may turn a higher
pro t on part of the furniture division’s oor space. A problem with
scaling down the furniture division without closing it, however, is
the fact that furniture items by their very nature take up a lot of
space.
Part (c)
• There are 26 staff members at Outdoor Africa’s retail premises

(head of ce staff, including the managing director, do not work
at the premises and are excluded from this calculation). (3
divisional managers + 8 assistants in the garden division + 6
assistants in the furniture division + 9 in the cafeteria = 26) •
Meals will cost Outdoor Africa 26 × R40 = R1 040 per day,
therefore R1 040 × 365 days in the year to 28/2/2XX9 = R379 600
per annum.
• During each sitting, staff occupy 26 persons/2 groups/4 chairs =
3,25 tables. They therefore occupy four tables.
• Between 12h00 and 13h00, 22 of the 25 tables are already
occupied. There is therefore one table short. This represents an
opportunity cost of R100 contribution × 365 days = R36 500 per
annum.
• Between 14h00 and 15h00 there is enough spare capacity to
release 4 tables.

Total impact on Outdoor Africa:
R379 600 + R36 500 = R416 100 smaller pro t for the year
Tip: Work with opportunity cost per table (we cannot prove, for example,
that there are four clients sitting at a table on average, and we also do not
need income per client). Furthermore, it is wrong to assume that clients’
meals cost R40 each – they order from the menu. Rather work backwards
from R200 per table to calculate opportunity cost, because gross pro t
mark-up is known.
Part (d)
It is in the best interest of Outdoor Africa as a whole rather to lose

R416 100 on internal cafeteria meals, instead of paying 26 × R55
× 365 = R521 950 across the street.
Minimum price
The divisions should pay R40 per lunch per staff member, plus
opportunity cost.
Between 12h00 and 13h00, there is opportunity cost for one table.
A table brings in R200 in sales; therefore (at a gross pro t percentage
of 100%) the contribution is R100. This R100 has to be spread across
all 26 staff members; therefore, the minimum price is R40 + R3,85 =
R43,85.
Alternative: calculate separate prices for morning and afternoon
sittings. Then the minimum price is R40 + (R100/13) R7,69 = R47,69 in
the morning and R40 in the afternoon. (Proof that it amounts to the
same as the above: (R47,69 × 13) + (R40 × 13) = R1 140 and R1 140/26
= R43,85)
Maximum price

The maximum price is R55 per lunch per staff member.
A price of between R43,85 and R55 is acceptable.
Notice that cafeteria employees also eat. By charging the above price per
staff member to the other two divisions, it is implied that the cafeteria
carries the cost of its own staff lunches.
Alternative for minimum price: if the assumption is made that the
cafeteria manager demands that opportunity cost be carried by the other
two divisions in full (because there would be enough tables available if only
his own staff were to eat there), the minimum price changes to: R40 +
(R100/16) = R46,25, or R40 + (R100/8) = R52,50 in the morning and R40
in the afternoon.
Part (e)
Charles’s views are typical of someone who has a little bit of

knowledge of the topics, but who lacks an in-depth understanding
of the theory underlying the concepts. In particular, Charles’s insight
is hampered by the fact that he is not of cially employed by Outdoor
Africa. As an outsider, he is attempting to bring super cial
‘textbook’ knowledge into a practical situation where it may not
necessarily be appropriate (this is the equivalent of answering an
advanced management accounting question without considering the
scenario). There is therefore some validity in some of his statements,
but the application of his ideas has not been properly thought
through. Each incident is now discussed in turn.
Incident 1
It appears that Charles has heard of the bene ts of just-in-time
systems, which are indeed valid. Many modern organisations bene t
greatly from such a system. However, there are a number of

problems with this comment, all of which relate to Charles’s lack of
consideration for the particular environment:
• His comment was directed at the procurement clerk of the garden
division.
Charles does not appreciate that just-in-time is an all-
encompassing system that has to be implemented throughout an
organisation. In fact, for the system to work, the entire supply
chain ought to operate in a just-in-time fashion. The clerk
certainly cannot, to name but one example, decide on his own to
order plants ‘just-in-time’ if the supplier cannot deliver according
to these demands.
• The garden division sells plants, which is an unlikely product to
subject to a just-in-time system. Plants take time to nurture and
grow, and an optimal balance has to be found between the
amount of time spent in the nursery (at the supplier’s premises)
and at the retail store. This is a unique scenario which is not
anticipated by classic just-in-time theory (which was developed
in the manufacturing sector and is particularly relevant in highly
automated factories).
• Flowing from the previous point, one should consider that –
although the retail sector could bene t greatly from the just-in-
time philosophy – many of the aspects of just-in-time were
speci cally developed for and are applicable to the
manufacturing sector (again, speci cally highly automated
modern factories).
• A cost–bene t analysis should be carried out before any system
change is recommended, but in this case a just-in-time system is
likely to be ruled inappropriate before it is necessary to consider
such detail. Perhaps whatever is bothering Charles about the
procurement process in the garden division can be better

addressed through optimised supply chain management, as
discussed under incident 4.
• Just-in-time has indeed been practised and well-documented, for
a number of years (hence Charles’s wording ‘years ago’), but the
fact that it is a tried-and-tested popular business philosophy does
not render it appropriate regardless of the circumstances.
Incident 2
Charles is correct in that the two divisions could indeed be
benchmarked against each other for performance assessment
purposes, at least to some extent. In many circumstances,
benchmarking is a useful tool – this is an example of internal
benchmarking (where two divisions within the same organisation
are compared). Performance measures such as the divisions’
respective returns per square metre, costs per employee and the like
could be compared (part (b) of this solution gives examples). The
relevant information appears to be obtainable from the present
information system and (although part (b) of the question works
with annual gures) it would be possible to perform such a
benchmarking exercise on a monthly basis. However, there are again
a number of problems with Charles’s remark:
• The divisions can be benchmarked against each other only to the
extent that they are in fact comparable. They sell different
products and are exposed to different external factors which
should be kept in mind (both in the type of measures that are
benchmarked, as well as in the interpretation of the results).
• Monthly management accounts should strike the optimal balance
between comprehensiveness and brevity. An informed decision
should be taken as to what information would be the most useful

for managers to receive on a monthly basis, and the report should
focus on that.
• It is incorrect that benchmarking the two divisions against each
other is ‘the only way’ to perform proper performance
assessment of the divisions. Many other types of information
could also be relevant. Even as far as benchmarking itself is
concerned, Outdoor Africa may wish to consider benchmarking
the company as a whole against a competitor instead or
benchmarking the individual divisions against those of
competitors (although comparable information would be more
dif cult to nd).
• It seems that Charles is suggesting that the entire contents of the
monthly management accounts should be the benchmarking of
the garden and the furniture divisions. This, of course, is not
optimal, as it does not address the performance of the cafeteria,
the head of ce or Outdoor Africa as a whole. It also does not
consider qualitative factors.
• The most important aspect that Charles should remember is that
management accounting information is supplied according to the
needs of management. One therefore rst has to nd out what
information will lead to optimal management decisions and then
work backwards to discover how such information can best be
supplied. Benchmarking should not be forced purely for the sake
of benchmarking.
Incident 3
Charles’s third comment is problematic. Increasingly, we get the
impression that Charles becomes aware of techniques that he seems
impressed by, but then he tries to force them onto situations where
they are not applicable:

Target costing is not a straight-forward alternative to cost-plus
• pricing, because target costing is not merely a pricing technique.
Target costing does start by assessing what selling price the
market would absorb (in other words, what customers are likely
to be willing to pay for a speci c product). This is the only part of
target costing that may be relevant to Outdoor Africa, but it
would be very dif cult and costly in practice to research such a
price for each plant, implement, piece of furniture and cafeteria
meal.
• Target costing then proceeds to design the product in such a
manner that – over time – costs will be low enough to make a
satisfactory pro t at the target selling price. This implies that it is
applicable in a manufacturing environment and should be
carried out at the product design and development stage. These
are irrelevant in the context of Outdoor Africa.
• Outdoor Africa is a retail business that sells a wide range of
plants and related products, furniture and cafeteria meals. The
practical pricing policy for Outdoor Africa to follow would be a
cost-plus approach, tempered by qualitative factors. For example,
it could decide to forgo some pro t on speci c product lines each
week in order to offer specials that attract customers to the store
(and thereby cross-sell other items or turn new customers into
repeat customers).
Incident 4
There is ample research evidence that suggests tighter linkages
within a supply chain lead to improved pro ts for the organisations
within the chain. Charles seems to believe that Outdoor Africa
should pay attention to proper supply chain management, which is a
valid recommendation. It is also true that one way of tightening a

supply chain would be to integrate the organisations inside the
supply chain. If Outdoor Africa started ‘its own nursery’ as he
suggested, this could indeed lead to a more optimised value chain
because both the supply of plants and the retail thereof would be
controlled by the company. However, vertically combining
organisations inside the chain is not the only way to optimise a
supply chain and there are a number of factors that Charles may not
have considered before he made the comment:
• Even if Outdoor Africa started ‘its own nursery’ it would still
need supply chain management. The suppliers to the nursery are
companies that manufac ture pesticides, packaging, compost,
seeds and a host of other inputs. Outdoor Africa would also still
have a ‘downstream’ supply chain (its own customers) that needs
to be managed.
• Starting a nursery to supply the garden division with plants is a
major expansion decision that has to be taken on strategic and
nancial grounds. It is unclear whether Outdoor Africa has the
expertise, capital and other resources to undertake this, and
whether this is part of the strategic direction that the company
would like to take. If Outdoor Africa were thinking along those
lines, it would also have to consider the option of taking over an
existing supplier instead of starting a nursery from scratch (in
which case Charles may just have made an enemy of yet another
future employee of Outdoor Africa).
In general, relating to all the incidents, one could comment that

Charles’s behaviour is inappropriate and unlikely to have a positive
impact on Outdoor Africa. He is alienating employees and suppliers,
shouting, tearing up reports, showing up at meetings unannounced
and insulting people. (We do not elaborate on these issues here, as

the requirement speci cally asks us to focus on the management
accounting aspects.)
Part (f)
Porter identi ed three generic strategies: cost leadership (being the

lowest cost producer in the industry), differentiation (making the
product or service desirable by offering something different) and
focus ( nding a niche market and applying either cost leadership or
differentiation within that market). The requirement asks us to
consider only the rst two strategies.
In this scenario, cost leadership would mean that Outdoor
Africa’s cafeteria would have the ability to prepare meals at the
lowest cost in the industry. The dif cult aspect to consider here is
what we mean by ‘industry’. If we look at the restaurant and fast
foods industry as a whole, it is unlikely that the cafeteria can
produce meals at a lower cost than, say, McDonalds, which enjoys
economies of scale. In fact, even if we de ne the ‘industry’ more
narrowly as sit-down restaurants in the Limpopo province only
(excluding fast food outlets), Outdoor Africa’s cafeteria may be
unlikely to enjoy the kind of economies of scale that would cause it
to be the cost leader.
Outdoor Africa’s cafeteria is, however, likely to be different from
most other industry players. It is located on the premises of a large
garden and outdoor store – even based on the very limited
information that we have about the cafeteria, we can surmise that it
is at least differentiated from most other restaurants in terms of its
location.
The likely answer would therefore be to say that the cafeteria is
differentiated based on its location and that it could choose to

differentiate itself even further (by, say, offering a playground for
children or exotic meals named after plant species that are sold by
the garden division). However, should one de ne the ‘industry’ as
narrowly as ‘cafeterias located in plant retail outlets in the Limpopo
province’, we would again have to consider whether it might be the
cost leader. What is therefore clear from this discussion is the
importance of the de nition of ‘industry’ in applying Porter’s theory.
(The real bene t, however, of applying the theory is the fact that it
forces us to think through these strategic issues in order to decide on
how the cafeteria could position itself in the market.)

Glossary
A
abnormal gains: occur where actual losses in the production process are less than the
planned losses; re ected separately in the production cost statement
abnormal losses: arise where actual losses in the production process exceed the anticipated
(budgeted or planned) losses; re ected separately in the production cost statement
absorption costing: a costing system which is useful for internal reporting and decision-
making purposes, where xed manufacturing overheads are treated as a product cost,
resulting in a portion of these overheads being included in any inventory balances;
involves the accumulation and reporting of cost information within a format which is
consistent with the accounting standards underlying nancial accounting, which is
aligned with the principle of matching income with expenses
accountant’s model: an approach to CVP analysis which recognises that total xed costs
remain constant and variable costs per unit remain constant, and have a linear or straight-
line relationship with levels of activity
achievable standards: these are not too slack, but represent normal working conditions and
allow for a certain level of expected spoilage and inef ciency under normal conditions
activity-based costing (ABC): a system used for tracing indirect (overhead) costs to cost
objects such as products, services, customers, business units and related organisational
elements, based on the activities that cause the overhead costs to be incurred and which
drive those costs
activity-based management (ABM): utilises the same activity and cost information as that
supplied by an activity-based costing system to support operational and strategic
management decisions; focuses management’s attention on activities as a way of
improving the value that customers receive as well as the pro t realised by an
organisation
administrative costs: costs involved in administering the business of an organisation
analytical review: an auditing procedure frequently used to review income statements
assignment: the actual relationship between what causes the cost to be incurred and the
cost objects (products, services, divisions, contracts, investments, and so on) to which
costs are to be assigned; tracing of costs to cost objects; concerned with identifying the
relationship between the cost and the object for which the total cost is calculated
B
balanced scorecard: widely-used modern multidimensional performance management
system

benchmarking: measures relative performance levels; organisations compare their own
performance against benchmarks in industry and take corrective action as needed
best t line: the line that reduces the sum of the squares of regression errors
bill of materials le: (in relation to MRP) details the quantity, type and quality of each of
the materials required for each nal product principles of management accounting
break-even chart: depicts the break-even point graphically
break-even point: represents the level of activity where neither a pro t nor a loss is made,
being the level of activity where total sales revenue equals total costs
budgetary slack: an allowance built into a budget when a manager intentionally over-
estimates expenses or under-estimates expected income in order to meet set targets more
easily
C
cash budget: re ects cash ow items where the period in which the transaction is recorded
is the period in which the cash ow takes place
clock card or time sheet: used to record the presence of employees at work
constraint: see limiting factor
continuous budget: see rolling budget
controllability: evaluating managers’ performance based on those aspects over which they
have control
correlation: degree of association between two variables such as cost and activity, which
may be either positive or negative
cost–bene t model: an approach to problem areas where management determines the cost
of investigating a speci c variance, measured against the bene t that is likely to be
obtained from taking corrective action
cost behaviour: volatility of costs and revenues with respect to changes in sales and
production levels
cost driver: the factor that causes costs to be incurred
cost object: the item to which the cost is to be traced
cost of quality: the sum of the costs that arise from activities associated with prevention,
identi cation, repair and recti cation of poor quality, and opportunity costs from lost
production time and lost sales as a result of poor quality
cost to company: total budgeted cost
cost-volume-pro t (CVP) analysis: interrelationship between activity levels, costs and an
organisation’s pro ts, analysing how cost behaviour, production levels and sales volumes
impact an organisation’s pro t
D
decision package: a discrete, stand-alone organisational activity
departmental rate: an overhead rate is determined for each department in an organisation

differential cost: a cost that differs between two alternatives
direct cost: a cost which it is economically feasible to trace to the cost object
direct labour costs: costs where it is economically feasible to trace the amount of labour that
is physically expended on a product
direct materials: physical inputs that can be traced in an economically feasible manner to
the product that is manufactured
drum-buffer-rope (DBR): the tool used to subordinate activities for the purposes of the
theory of constraints
dual pricing system: may be employed in order to satisfy both the transferring and the
receiving unit where transfer pricing disputes cannot be resolved
duration driver: amount of time spent on an activity
E
economic value added (EVA®): a nancial performance measure based on accounting
information that takes the organisation’s weighted average cost of capital into account,
expressed in monetary terms
economist’s model: an approach to CVP analysis which recognises that the rate of change
in total costs and total revenue is unlikely to remain constant as volumes change
enterprise resource planning (ERP): an integrated suite of application software modules
that provides operational, managerial and strategic information for enterprises to
improve productivity, quality and competitiveness
external constraints: arise from the environment within which an organisation operates and
on which it relies in order to achieve its goals
F
FIFO ( rst-in- rst-out): method of determining the cost of materials which assumes that
materials are issued in the sequence in which they were ordered and assigns an issue
price accordingly
xed budget: drawn up for a speci c activity level and used to gain an overall picture of the
business plan
xed cost: a cost that in total is unresponsive to a change in activity
xed manufacturing overheads: xed amounts paid on a regular basis in a manufacturing
environment; costs incurred in converting materials into nished goods
exed budget: prepared by separating expected xed costs from expected variable costs,
and adjusted when there are uctuations in costs
exed budget variance: variance between the pro t as shown in the exed budget and the
actual pro t as a result of changes in the expected price or
quantity of the underlying inputs
function: classi cation of costs in the nancial statements in accordance with the function of
the cost

G
generic strategies: consist of three main strategies: cost leadership, differentiation and focus
goal congruence: individuals and units take actions that are in their self-interest and
simultaneously also in the best interest of the organisation as a whole
H
high-low method: a mathematical approach which involves calculating the equation of a
line to split a mixed cost into its variable and xed components
I
ideal standards: represent perfect working conditions, with no allowance for spoilage or
inef ciency; often seen as unattainable
incremental budgeting: the term used for the traditional approach to budgeting, where the
previous year’s results are used as a basis for unit costs, which are then adjusted for
in ationary increases as well as increases and decreases in budgeted volumes to
determine expected income and expenditure for the following year
independent (units): undertaking very different activities (with a minimum of managerial
supervision or intervention)
indirect cost: a cost which it is impossible or not economically feasible to trace to the cost
object
integrated accounting system: a costing system which is fully integrated with the nancial
accounting system, making use of a number of control accounts and/or subsidiary ledger
accounts for this purpose
intensity driver: measure of the amount of demand on resources
interdependent (units): performing similar operations that need to be closely coordinated
457
interlocking accounting system: comprises two entirely separate accounting systems,
running side by side, with only one control account linking the two systems
intermediate product or service: a product or service that is transferred from one unit of an
organisation to another unit in the same organisation
internal constraints: arise from the internal operations of an organisation, such as
insuf cient staff training, or inadequate machine capacity
internal reporting: involves a combination of past information, together with future-
orientated information, such as forecasts and budgets, to enable management to perform
their duties of planning, control and decision-making
inventoriable cost: the kind of cost that is included in inventory for nancial accounting
purposes
inventory: (in relation to the theory of constraints) the sum of direct materials inventory,
work-in-progress inventory, nished goods inventory, research and development cost,

plant and machinery, and buildings
inventory le: (in relation to MRP) speci es exactly when and how many units of each of
the materials should be purchased, taking into account lead times of purchasing materials
and the manufacture of components
J
job card: record of materials and their costs in relation to a particular job
job-costing system: a system designed to deal with the calculation of the cost of jobs, each
of which is unique, requiring an input of differing quantities of material, labour and
allocated overhead cost
just-in-time (JIT) system: a management philosophy rather than merely a production
technique; focuses the organisation’s efforts on performing value-adding activities on
demand while minimising waste
K
kaizen costing: used when an organisation strives for continuous improvement, designed
to support the cost management efforts inherent in target costing
key performance indicator (KPI): a metric used to quantify the performance an
organisation aims to achieve
L
least squares method: see linear regression analysis
least squares regression: a statistical approach to establishing the equation of the line that
best ts all of the data points provided
life-cycle costing (LCC): the maintenance of cost records that accumulate the costs incurred
over the lifespan of a product, service or physical asset
limiting factor (constraint): a scarce resource of which there is a limited supply and which
affects the ability of the organisation to earn pro ts
linear regression analysis: tting historical information into a formula whereby it is
possible to distinguish between variable and xed portions; used to assist in forecasting
what the total cost will be when there is a new level of activity in the future; also known
as the least squares method
M
make-or-buy decision (outsourcing decision): entails evaluating the costs of
manufacturing a component internally in contrast to acquiring it from an external party
manufacturing cells: (usually) u-shaped work stations in just-in-time factories, where each
product group is, as far as practical, produced within the cell to minimise movement of
work-in-progress inventory

manufacturing costs: inventoriable costs relating to manufacturing
market value added (MVA): a performance measure linked to value-based management; an
external measure indicating how shareholders have been affected by the actions taken by
management
master budget: summary of all the functional budgets and the cash budget, pro-viding an
overall picture of the planned performance for the budget period; culminates in budgeted
nancial statements
master parts le: (in relation to MRP) details all the account lead times of purchasing
materials and the manufacture of components
master production schedule: (in relation to MRP) details demand forecasts for nished
products
materials requirement planning (MRP): a system that converts a production schedule into
a listing of the materials and components required to meet that schedule, so that adequate
[inventory] levels are maintained and items are available when needed
mixed cost: a cost that consists of two components, usually a variable and a xed
component
N
non-inventoriable costs: those costs that are not included in inventory for nancial
accounting purposes; other operating costs, often subdivided into selling costs and
administrative costs
normal distribution table: a table illustrating for statistical purposes the normal range
within which one can be con dent, at a certain level of probability (although never 100%),
that the true value lies; it also shows the standard deviations to be added or subtracted
for a certain probability level
normal losses: losses which are expected or anticipated and arise when the process is
running according to plan, provided for by incorporating budgeted losses into the normal
cost of production
not-for-pro t organisation: an organisation the primary purpose of which is not pro t
maximisation, although it may – to a limited extent – engage in economic activity in
pursuit of its primary purpose
O
operating expenses: (in relation to the theory of constraints) include all operating costs
(other than direct materials and direct services) incurred to generate throughput,
including labour costs, whether direct or indirect, and including both idle time and
operating time; they also include expenses such as rent, electricity and depreciation
operational budget: a budget prepared for a single nancial period, usually a year or less,
to control normal operating costs

opportunity cost: the best bene t forgone by taking the proposed course of action, arising
only when capacity constraints exist, which means that additional capacity is scarce
outsourcing decision: see make-or-buy decision
P
perfectly competitive market: exists when a homogeneous product or service with equal
buying and selling prices is sold in a market where individual buyers and sellers cannot
affect prices by their own actions
performance evaluation: assesses something that has already happened; necessary for the
management of future performance
performance management: aims to eliminate undesirable actions and to encourage
desirable actions by units and individuals
performance measure: an opinion formed, using a yardstick, on how well a unit or
individual has performed
period cost: a cost that is recognised as an expense immediately on being incurred
plant-wide rate: a single overhead rate for an organisation in its entirety; determined by
accumulating the total overheads incurred across the organisation and dividing that by
the allocation base determined as the most suitable for the enterprise
principal budgeting factor: a limiting factor in relation to budgeting, among which are
sales demand, availability of raw materials, machine capacity, and availability of cash and
sources of funding
probability theory: concept of expected values which may be used for budgeting where
there is a great degree of uncertainty about future events
process costing: a system used to determine the cost of a large number of identical product
units produced in a continuous process
product cost: a cost that is absorbed in inventory and deferred until the inventory is sold
product-level target cost: the difference between the proposed selling price and the desired
pro t margin
production volume variance: represents the difference between the budgeted xed
overhead and the xed overhead allocated to products or services
productive hours: used to calculate the hourly direct labour rate
projection: an expected future trend pattern obtained by extrapolation, based on the notion
that past events can serve as an indication of what will happen in the future
public sector organisation: an organisation the purpose of which is to serve the public;
funded by the government
pull system: a system whereby each workstation starts work only once the next workstation
on the production line requires it to do so, and where materials are ordered only once the
rst workstation requires them; based on a time-phased order-release system which
schedules and releases work and purchase orders as and when they are required in the
production system

push-through system: a system whereby, as production starts, the output of one production
section is ‘pushed’ to the next section, regardless of whether or not the receiving section is
ready for the input
R
regression error: the distance between the line and the point where the points do not sit
exactly on the line in a graph illustrating a linear relationship
relative sales values: see value-based overhead allocation system
relevance: the incremental effect on costs and revenues of the actions of management
relevant cost: a differential future cash ow
relevant range: de nes the range of activity over which the assumptions made concerning
the behaviour of costs and revenue remain valid
residual income (RI): a nancial performance measure based on accounting information,
expressed in monetary terms
responsibility centre: a centre responsible for speci c activities, the performance of which
is the responsibility of a speci c manager; usually divided into cost, revenue, pro t and
investment centres
return on investment (ROI): a popular nancial performance measure based on accounting
information; a short-term measure based on historical results, re ecting the return earned
over the period for which it is measured, to the exclusion of all potential future results;
expressed as a percentage
return on sales (ROS): a short-term measure based on historical results, re ecting the
return earned over the period for which it is measured, to the exclusion of all potential
future results; calculated as income divided by revenue, and expressed as a percentage
reverse costing: see target costing
rolling budget (continuous budget): prepared on a regular basis for the next year or other
short-term period, and where the existing budget is continuously updated, as in the case
of cash budgets
rule of thumb model: a subjective process used to identify problem areas, where previous
experience and knowledge of the business assist in the process
S
sales mix: the proportion in which an organisation’s products and services are sold or
delivered
scatter graph or diagram: a graphical method of cost estimation that plots various
observations of aggregate costs against the activity level
shadow price: an increase in value created by having available one additional unit of a
limiting resource at the original cost
shareholder value analysis (SVA): a performance measure linked to the concept of value-
based management

slack variable: represents the amount of a constraining resource or item that is left unused
after the optimal production mix has been achieved
stakeholder: any group or individual with a legitimate interest in the activities of an
organisation
standard cost: a cost used instead of the actual purchase cost and which remains constant
throughout a period
static budget variance: represents the difference between the pro t or loss as originally
planned at a xed level of output, and the pro t or loss actually made
step cost: a cost that is available only in xed allotments; it varies with the activity level in a
stepwise manner, not a linear fashion
strategic budget: a long-term budget, set up for a period usually between three and 15
years, and where the scope is much less detailed than in the case of an operational budget
strategic business units: autonomous units responsible for planning, developing,
producing and marketing their own products
sunk cost: a cost that has already been incurred and consequently cannot be altered by, and
is therefore not relevant to, the decision
supply chain management (SCM): a network of organisations involved in the different
processes and activities which produce value in the form of products and services
T
target costing (reverse costing): a way of reducing the costs of future products by
concentrating on cost management during product development
theory of constraints: an approach to production management which aims to maximise
sales revenue less material and variable overhead costs, focusing on factors such as
bottlenecks, which act as constraints to maximisation
throughput: (in relation to the theory of constraints) the rate at which money is generated,
calculated by deducting the money paid to suppliers (for direct materials and direct
services) from the money obtained from customers (in the form of sales), without
deducting labour expenses from sales
throughput ratio: calculated as the throughput per unit of constrained activity, divided by
the operating expenses per unit of constrained activity
timing: relates to the date and time period when a cost or cash ow is recognised in the
income statement
total quality management (TQM): a customer-centric approach premised on the principle
of ‘get it right rst time’; emphasises preventative measures
‘traditional’ overhead allocation system: a volume- or value-based overhead allocation
system
transaction driver: measures the number of times an activity is performed
transfer price: the price at which goods or services are transferred between different units
of the same organisation

t-statistic or t-stat: compares the size of the standard error of the coef cient to the size of the
coef cient itself, in order to provide an understanding of the relative size of the standard
error
V
value chain: the sequence of business activities by which value is added to the products or
services produced by an organisation
value chain analysis: used by organisations to attain competitive advantage by breaking
down an organisation into its strategically relevant activities so as to understand cost
behaviour as well as sources of existing and potential differentiation
value-based management (VBM): the management of all aspects of a company with the
aim of maximising shareholder wealth
value-based overhead allocation system: a method of allocating overhead costs where
overheads are allocated in proportion to the selling prices of products (also known as
‘relative sales values’)
variable costing: involves the accumulation and reporting of cost information within a
format that enables short-term planning, control and decisionmaking
variable costing system: requires all xed costs to be recognised as an expense in the period
in which they are incurred
variable costs: costs which increase (or decrease) in proportion with increases (or decreases)
in the level of activity, or which may change in relation to another activity
variable manufacturing overheads: overheads which vary in proportion to production
changes
variable overhead variance: calculated as the difference between the total actual costs of
variable overhead and the standard cost of variable overhead, as re ected in the exed
budget
volume variance: variance between the exed budget pro t and the static budget pro t as a
result of the difference between planned and actual production levels
volume-based overhead allocation system: refers to any method of allocating overhead
costs that is based on some measure related to production or service volumes
W
weighted average: method of determining the cost of materials which prices the inventory
at an average price which is re-calculated each time materials are received
work-in-progress (WIP): partially completed units at the end of a costing period in a
process costing system, where additional costs will be incurred in the following period to
complete the units

zero-base budgeting (ZBB): an approach to budgeting which rejects the principle of
incremental budgeting and advocates that a budget should be prepared from ‘scratch’, or
zero, and that every item in a budget has to be speci cally justi ed in order to be
included

Index
Page numbers in bold refer to gures and tables
A
ABB see activity-based budgeting (ABB)
ABC see activity-based costing (ABC)
ABM see activity-based management (ABM)
abnormal gains 221, 229, 237, 248
abnormal losses 221, 229, 230, 232, 233, 234, 235, 237, 238, 246, 248, 249
absorption costing 29, 30, 31, 80, 95, 96, 105–138 see also variable costing
income statement 109
summary 111
system 80, 95, 96, 106, 111, 122, 124, 125, 413–416
versus variable costing 80
absorption pro t 124
accept-or-reject decision 315
accountant’s model 78, 79, 80, 84 see also CVP analysis
accounting
concepts
entries 423
accounting matching principle 122
accuracy 39, 40, 54, 80, 150, 174, 177, 387
achievable standards 396, 397
activity analysis 565
activity-based budgeting (ABB) 176
activity-based costing (ABC) 95, 145, 146, 150, 157, 166–176, 177, 183, 186, 187, 188, 191, 198,
316, 435, 518, 522, 541, 547, 553, 565, 582
compared with traditional allocation systems 173–174
limitations of 174–176
theory of constraints (TOC) 547–548
activity-based management (ABM) 176, 177, 437, 564, 565–566, 576, 580, 581, 582
operational 565
strategic 566
activity levels 380, 403
activity rates 169, 175
ad hoc nature 5

administrative costs 17, 21, 25, 101, 156, 191
administrative expenditure budget 363
aggregate 397
allocating costs 20
allocation rate 111
analytical review 19, 35
appraisal costs 568
arm’s-length relationship 579
assignment 10, 11, 20–22, 30, 183
assignment of costs 183
Association of Chartered Certi ed Accountants (ACCA) 1
autocratic style 382
autonomous
receiving unit 515
transferring unit 515
units 480, 481, 490, 511, 514, 515, 517
B
‘backward looking’ 474
balanced scorecard 473, 493–494, 496
objectives 493–494
batch-level activities 167
benchmarking 436, 437, 497, 541, 551–553, 554, 575, 582, 618–619 see also accounting concepts
competitive 551, 552
functional 552
internal 551, 552
strategic 552
types of 551–552
best t line 47
Beyond Budgeting¨ 387
Round Table 387
big data 6
bottleneck activity 542, 543, 553
bottlenecks 78, 542
‘brand name’ clothes 314
break-even analysis 81, 126
break-even chart 83, 96
break-even level 126
break-even point 81, 84
budget committee 361

budget manual 361
budget period 361
budget process 381, 387
role of management account 387
budget sequence in preparation 362–363
budgetary
control 380
control process 382
slack 381
budgeted losses 229
budget-setting process 381
budgeting
alternative approaches 374
impact on motivation of managers 381
incremental 374–375
negotiated style of 383
traditional approach 374
zero-base 375
budgeting process 374
role of key performance indicators
role of ratio analysis
budgets
cash budgets 365–368
cost centre 362
xed and exed 380
human resources 362
master budget 368
materials purchases 362
objectives of 360
operational 361
planning and control 359
probability theory 377
production 362, 364
responsibility for 361
sales 362
sequence in preparation 362–364
strategic 361
tactical 361
business
categories 146
process 548

proposition 140
strategy 1
units 146
business process re-engineering (BPR) 548 see also accounting concepts
by-product costing 196, 263, 273
by-products 264
C
capacity
constraint 291, 292, 330, 542
excess 518
xed overhead variance 416
idle 169, 307
machine 330, 362, 543, 545
maximum 14, 545
normal 108, 125, 169
practical 169
production 95, 363, 542
reserved 518
safety 298
spare 126, 298, 307
theoretical 169
capital expenditure
budget 330, 363
postponement 368
capital investments
appraisal 351
decisions 575
priorities 351
capital structure 1
case studies 7, 31, 57, 97, 128, 178, 210, 249, 273, 318, 352, 388, 438, 497, 523, 582
cash
availability of 362
de cit 367
differential ow 22, 288
ow 288, 364, 365, 368, 388
ow items 365
future ow 10
generation of 387
on hand 367

out ow 491
remuneration 494, 495
resources 362
surplus 367
cash budget 363, 365, 367, 368
drawing up 365–367
management action based on 367–368, 368
cash ow crisis 492
cause-and-effect relationship 20
centralisation 480
centralised organisational structures 480–482
certainty 53, 292, 317
decisions under conditions of 292–305
Chartered Global Management Accountant (CGMA) 575
Chartered Institute of Management Accountants (CIMA) 222, 378
chronological steps 544
CIMA de nition 3
CIMA syllabus 3
classi cation issue 115
classi cation level 115
clock cards 202
closing-down decisions 301–305
qualitative issues 304–305
quantitative issues 302–303
simpler approach 303–304
‘closing inventories’ line 113
closing inventory adjustments 115 see also opening inventory adjustments
coef cient of determination 49
competitive advantage 563, 564
competitive environment 575
component-level target costs 572, 573
computer packages for linear programming 351
consecutive processes 245–246
process ow 246
constant gross pro t calculation 267
constant gross pro t percentage 269–270, 272
constraint(s) 330 see also limiting factor
capacity 291, 292, 330
elevate 545, 547
exploit the 545–546, 545
exploiting 547

external 543, 545
identi cation of 545, 545
internal 543, 545
long term 330
operational 329, 349
short term 330, 541
subordination of other activities theory of 435, 541, 542–548
TOC reports 547
contemporary management accounting concepts 541
continuous budget see rolling budget
continuous feedback on performance 386–387
contribution 81
importance of 330
contribution line 112
contribution margin formula 81, 82–83, 85
contribution margin ratio 82, 83
control 2, 3, 5, 10, 30, 40, 106, 111, 113, 146, 210, 312, 361, 382, 387, 388, 394, 416, 423, 477, 479,
480, 481, 488, 493, 496
in 418
out of 418
control accounts 205, 207
control measure 380, 434
control reports 382, 387
control system 387, 434
controllability 477, 479
‘controllability concept’ 479
controllability principle 495
conversion costs 222, 222, 264, 283
core business 124
core competence 590
core objectives 146
core purpose 604
cornerstones 140
corporate governance procedures 2
correlation 379
correlation coef cient 49
corrective action 397
cost accounting
concepts 106–113
methods 258
problems 264

records 201
treatment 264, 266
cost allocation 107, 122, 146, 174, 175, 497, 594
approaches 146
basis 150
system 150, 157
cost assignment 20
cost behaviour 10, 11, 12–20, 40, 56, 78, 106, 465, 579
means of predicting 55
principles 19
cost–bene t analysis 618
cost–bene t models 417, 418
cost centre 476, 517
budgets 362
discretionary 476
managers 362
standard 476
cost classi cation 9–31, 139
cost control 174, 548
account 206
measures 548
cost drivers 40, 166, 575
appropriate 204, 363
determination of total cost 41–42
effect on cost of activities 565
identi cation of 168–169, 174, 176
impact of 435
plausibility 41
traditional 363
cost elements 115
applying concept of relevance 305–309
labour 307–308
materials 305–307
cost estimation 39–56
factors affecting accuracy 54–55
methods 40, 55
techniques 44
cost objects 11, 20, 146, 166, 283, 394, 566, 575, 589
assign costs to 169–174
cost of production 111, 115, 150, 223, 226, 229, 236
cost of quality 568–570, 575

categories 568–570
components 570, 570
report 568, 569
cost of sales 30, 107, 111, 114, 169, 196, 201, 313, 424, 431, 432, 549, 569
cost pool 166, 167, 168, 169
batch-level activities 167
facility-sustaining activities 167
inappropriate 514
product-level activities 167
total cost per activity 169
unit-level activities 167
cost reduction 493, 548, 553, 578
cost reduction challenge 572, 573
cost standards, determination of 395–397
cost to company 202
cost-based transfer prices 513
cost–bene t model 417
cost-plus pricing 314
cost-volume-pro t (CVP) analysis
accountant’s model 78
assumptions and limitations 94
economist’s model 78
relevant range 78, 80, 80, 85, 95
cost-volume-pro t (CVP) relationships 77–96
costing
direct see variable costing
environmental life cycle 575, 576
integration with nancial accounting systems 205
kaizen 568, 573, 574, 576
life cycle 564, 573, 576, 581
marginal 111
relevant 22, 25, 139, 465
reverse 571
standard see standard costing
target see target costing
variable see variable costing
cost(s)
allocating 20, 106
appraisal 568, 569, 560
conversion 222, 222, 237, 245, 264, 283
delivery 30

differential 22, 24, 289
direct 6, 20, 21, 21, 31, 146, 196, 222
expired 126
external failure 568, 569, 560
xed 12, 14–16, 30, 31, 44, 79, 79, 80, 80, 81, 82, 82, 83, 83, 84, 84, 85, 86, 86, 87, 89, 90, 91, 92,
95, 96, 106, 107, 109, 111, 113, 123, 124, 126, 127, 139, 140, 143, 144, 167, 169, 174, 204, 222,
297, 297, 314, 315, 330, 380, 413, 518
ow of 222, 222
future 22, 290, 291, 305, 307
historic 55
indirect 6, 20, 21, 21, 146, 196, 197
internal failure 568, 569, 560
inventoriable 25, 106
labour 25, 26, 41, 56, 57, 59, 201, 204, 222, 543
manufacturing 30, 111, 122, 156, 395, 401
materials 12, 237
mixed 11, 12, 17–19, 40, 56
non-inventoriable 25, 106
non-manufacturing 29, 106, 107, 111, 113, 127
opportunity 291, 568
overhead 11, 30, 146, 147, 149, 157, 166, 168, 169, 174, 177, 196, 197, 204, 205, 210, 222, 283,
316, 363, 395, 413
packaging 30
period 29, 106, 107, 124, 413
per unit 400, 577
prevention 568, 569, 570
product 29, 31, 80, 108, 169, 571, 572
quality 569, 570, 580, 581
step 12, 16, 79
sunk 22, 25, 289
target 572, 573
variable 12, 12–14, 24, 57, 79, 81, 82, 82, 85, 95, 96, 106, 107, 111, 113, 127, 380, 405, 413, 547
creditors’ payment period 374
critical success factors 475
cumulative average–time learning model 57
cumulative doubling approach 57
CVP analysis see cost-volume-pro t (CVP) analysis
D
data analytics 6

decentralisation 480, 511
potential bene ts 480
potential negative consequences 481
requirements for successful 481–482
decentralised organisational structures 480, 496, 510
decentralised organisations 481, 511, 522
decision package 375
decision trees 311–313
decision-making 246–248, 287, 313, 317
arbitrary allocation of costs distorts 91
centralised 481
delegation of 480
in relation to joint costs 271
long-term 107
management 167, 423
under operational constraints 329–352
power 589
problems 239
relevant costs for 177
relevant information for 287–317
short-term 96, 106, 107, 111, 113, 126, 127, 174, 313, 330
strategic/long term 2, 174, 361
variable costing relevance 126
decisions
closing down 301–305
make-or-buy 298–300
outsourcing 298, 337 see make-or-buy decision
pricing 108, 127, 288, 313–317, 423
special order 292–298
sub-optimal 30, 480, 481, 589
under conditions of certainty 292–305
under conditions of uncertainty 309–313
degrees of effort 20
devolved network 387 see also traditional centralised
delivery costs 30
departmental rate 157–159
differential cash ow 288
differential cost 22, 24
differential future cost 289
differential future income 289
dif culty, level of 396–397

digital technologies 176
direct cost 6, 20–21, 112, 146, 196, 222, 283
direct costing 111
direct labour 25–26, 54, 59, 144, 197, 204, 210, 222, 222, 394, 405, 409, 410, 433, 444, 550 see also
indirect labour
productive hours available 202
total cost of 202–203
variance 405, 409–411, 446, 447
direct materials 25, 117, 118, 197, 222, 222, 246, 444, 446, 543, 547, 553
direct materials variance 405, 407–409
mix 438, 444, 445–446
negative 550
yield 438, 444, 446
dis-economies 14
diverse products 150
drum-buffer-rope (DBR) 544, 546
dual pricing 517
Du Pont analysis 482
duration driver 54, 168
E
earnings per share (EPS) 474, 492
economic conditions 475, 552
economic reality 125, 126, 127, 431
economic value added (EVA¨) 482, 486–487, 496
economically feasible 20, 21, 25, 146, 283
economies of scale 14, 315, 564, 577, 620
economist’s model 78–80 see also CVP analysis
economy 420, 493, 496, 581
effectiveness 30, 374, 496, 552, 566
ef ciency 54, 57, 246, 419, 435, 496, 546, 552, 565, 566
elastic 314 see also inelastic
end-use customer(s) 569, 578, 578, 580
engineering
reverse 552, 573
studies 395, 396
value 573, 574
environment related
activities 575
impacts 575

indicators 575
environmental management accounting 575–576
equation of a/the line 44, 47
computerised approach using Microsoft Excel¨ 49–54
manual approach 47–49
equivalent production statement 223, 239, 258
equivalent units 224, 227, 239, 259
ethical considerations 521
exchange rates 521
expected values 311, 377
experience curve 57, 59
experience levels 421, 447
external constraints 543, 545 see also internal constraints
external failure costs 548, 549, 568, 569, 570, 570, 575 see also internal failure costs
external user(s) 4, 140 see also internal user(s)
F
FIFO see rst-in- rst-out facility-sustaining activities 167
favourable variances 399 see also unfavourable variances
feasible region, establish 340, 343
nal tableau
derive 347
interpret 346, 347–348
nancial accounting
approach 177
classi cation 10
information 106, 476
integrating with costing accounting 205–210
objective 156
principles 139
pro t 23
reports 106
requirements 25
rules 30, 416
standards 106, 107, 111, 201
statement 156
nancial accounting systems 205 see also cost accounting
nancial performance measures
determining income 490–491
determining investment 487–490

determining required rate of return 490
economic value added (EVAª) 482, 486–487
multinational considerations 491
residual income (RI) 482, 484–486
return on investment (ROI) 482, 483–484
return on sales (ROS) 482, 487
nancial measures 492
nancial reporting
reporting functions 394
versus management accounting 4, 4
rst-in- rst-out (FIFO) 198, 221, 226, 283 see also last-in- rst-out (LIFO)
process costing using 239–245
xed budget 380
exed budget variance 397
xed costs 12, 14–16, 21, 30, 31, 79, 79, 80, 82, 82, 84, 85, 87, 87, 89, 91, 92, 95, 96, 106, 107, 109,
111, 113, 123, 124, 126, 127, 139, 140, 169, 174, 204, 222, 272, 314, 315, 330, 380, 413, 518
xed manufacturing overheads 26, 80, 107, 108, 109, 111, 117, 120, 122, 126, 127, 395, 401, 413,
437
xed overhead
variances 412–416
xed overheads 26, 107–108, 127, 204–205, 210, 401, 405, 427, 435
exed budget 380, 406, 407, 409, 411, 413
preparing 380–381
variance 397, 398, 402, 404
focus strategy 564–565
function 10, 11, 25, 30
accounting 363, 579
appraisal 569
cost classi cation 25–29
cost information 10, 11
objective 340, 341, 343
of management accountant 286, 313
strategic 5
supply 550
funding
available 330
for future 572
long term 361
sources of 362, 488
future cash ows 22, 23, 484, 485, 487
future cost(s) 22, 55, 176, 196, 290, 305, 307, 394

differential 289
non-differential 289
versus opportunity cost 291–292
future events 377, 421
future income 290, 292, 305
differential 289
non-differential 289
future performance 437, 474
G
gains
abnormal 229, 237, 248
generic strategies 317, 564, 565, 582, 620
cost leadership 564, 565
differentiation 564, 565, 579
focus 564, 565
Porter’s 317, 564–565
‘get it right rst time’ 567 see also total quality management (TQM)
global competition 564
global economic environment 564
global standard 124
globalisation 106, 542, 578
goal congruence 481, 482, 485, 490, 496, 510, 511, 512, 522
goal congruent
system 481
transfer prices 514
graph/schedule approach 57, 62–64
graphical method, of linear programming
feasible region 340, 343
limiting factors 340, 341–343
objective function 340, 341
optimal production mix 340, 344
steps in 340
variables 340, 341
gross pro t 110, 111, 124, 267, 313
gross pro t line 110
gross pro t margin 374
H
head of ce overheads 401

high-low method 40, 44–46, 49, 56, 57, 139, 143, 378, 381, 390, 597
preparing projections using 378–379
shortcomings 46
historic cost data 55
historic records 395, 396
historic inef ciencies 396
historical data 378
other methods for preparing projections using 379
preparing projections using 378–379
holistic picture 125
I
ideal standards 396, 397
idle
capacity 169
time 202
time variance 447
imposed budgets
relative advantage over participative budgets 383
relative disadvantage compared with participative budgets 383
incremental budgeting 374–376, 385, 386, 388, 396 see also zero-base budgeting
incremental contribution 515, 517
incremental cost 515, 517, 518
incremental unit–time learning model 57, 59–66
independent units 481, 482
indirect cost 6, 9, 20, 21, 31, 146, 154, 155, 157, 196, 197, 207, 514 see also direct costs
indirect labour costs 26, 204
inelastic 314 see also elastic
in ation 123
in ationary
effects on variances 420
increases 374
pressures 420
information technology (IT) 2, 6, 159, 160, 376, 553, 578
input quantities 394, 395, 396
inspection
audits 569
costs 549
of production output 230
point 231, 236, 249, 545

time 40
integrated accounting system
accounting entries 205–206
T accounts 208–209
integrated report 6
integrated reporting 493
Integrated Reporting Committee of South Africa 493
intensity driver 54, 168 see also cost drivers
interdependent (units) 481, 482
interlocking accounting system 205, 206
interlocking job costing system
accounting entries 206
T accounts 209–210
intermediate product or service 512, 513, 515, 518, 521, 522
intermediate product level 521
internal constraints 543 see also external constraints
internal failure costs 548, 568
internal reporting 4, 30
International Accounting Standards 264
IAS 1 25
IAS 2 25, 29, 30, 107, 108, 109, 124, 127, 146, 154, 156, 230, 239, 268, 270, 395, 511
IAS 16 519
IAS 24 511
joint costs 270–271
international borders 520, 521, 522
International Financial Reporting Standards (IFRS) 4, 395, 423
international transfers 520
inventoriable costs 25, 106 see also non-inventoriable costs
inventory
closing 111, 114, 119–122, 201, 367, 395, 423
levels 95, 119, 122, 123, 362, 368, 553
losses 420
management 420
opening 114, 116–119, 123, 125, 363, 367
inventory valuation 106, 107, 113, 127, 395
absorption costing 127
accumulating product costs 315
FIFO method 134, 198–199, 226
inaccurate 423
incorrect 224
LIFO method 226

pro t measurement 124
speci c identi cation 200, 226
standard costing 226, 395, 427
standard costs 201
weighted average method 199, 226
investment
centre 476–477, 517
de nition 488
determining 487–490
investor ratios 374
irrelevant information 289
elements of 289, 290–291
versus relevant information 290
J
JIT principles 548
JIT system 548, 549, 550, 551 see also just-in-time system
job card 197
job costing 195
objectives 196
job costing system 196, 197, 204, 205, 206, 210
elements of cost 196–205
joint costing 263 see also by-product costing
joint costs 264
and nancial reporting 270–271
cost accounting treatment of 264–270
in relation to decision-making 271–272
joint process 264, 265, 272, 273
joint products 264, 265, 267–270, 271, 273
constant gross pro t calculation 267
constant gross pro t percentage 269–270
market values at split-off point 268, 272
net realisable value 269
physical measures 267–268
just-in-time (JIT) 396, 548
just-in-time environment 550
performance measurement 550–551
just-in-time manufacturing 576
just-in-time philosophy 434

just-in-time (JIT) systems 197, 396, 434, 435, 437, 514, 548–551, 566, 570, 579, 580, 582 see also
accounting concepts
K
kaizen costing 568, 573, 574, 576, 581
key facets 567
key performance indicator (KPI) 374, 475
key performance indicators (KPIs) 475
role in budgeting process 374
key success factors 565
King IV Report on Corporate Governance™ 493
L
labour
costs 41, 56, 57, 201, 204, 222, 543
determining cost
direct 25–26, 54, 56, 59, 117, 201, 222 see also indirect
ef ciency 54, 57, 420, 421, 437, 447, 550
equation 342
xed 307
hours 57, 58, 59, 147, 158, 403
idleness 447
indirect 26, 204 see also direct
inputs 57, 395
-related effects 421
semi-skilled 403, 446
shadow price 339
skilled 401, 446
time 58, 59
total costs 57
unskilled 401
variable 307
labour variances 405, 446, 447
direct 405, 409–411
idle time 447
mix and yield 446
last-in- rst-out (LIFO) 198, 226
learning curve 57, 59
cumulative average–time learning model 57, 59–60, 67
cumulative average time per unit 57, 58

cumulative doubling approach 57, 60, 61–62
cumulative total labour hours 57, 58
experience curve 59
graph/schedule approach 57, 60, 62–64
incremental unit–time learning model 57, 59–60
learning rate 57, 59
learning tempo 57, 58
mathematical approach 57, 60, 64–68
learning curve effect 56, 57, 395, 421, 447
learning curve index 57, 65, 67
learning rate 57, 59, 60, 61, 62, 67
learning tempo 57, 58, 59
least squares regression 40, 47–54
level of output 79, 80, 397
life-cycle costing (LCC) 564, 573, 575, 576–577, 577, 581
marketing, service and support costs 577
pre-production costs 576, 581
production costs 576–577
limiting factors (constraint) 330–337, 339, 340, 344, 345, 349, 351, 352
contribution per unit of limiting factors (CULF) 332, 335, 336, 340, 349
determine and rank the contribution 340, 342–343
establish, for linear programming 340, 341–342
graph of, for linear programming 340, 343, 343
multiple 336, 351
shadow prices 345
single 330–334
two potentially 334–337
line-by-line analysis 401
linear programming
budgeting 350
capital investment appraisal 351
computer packages 351
graphical method 339–344
in practice 350–351
limitations 351
maximum payment for additional resources 350
operational constraints scenarios 349–350
shadow prices 345–346
simplex method 346–349
steps in 340
linear regression analysis 379

linear relationship 44
equation 44
liquidity 374
long-term pricing 127, 315–316 see also
short-term pricing
long-term survival 351, 492
losses 217–233
abnormal 229, 233–235
identi ed at end of process 230–231
identi ed before end of process 231–233
normal 243, 246, 248, 258–262
normal and abnormal units sold as scrap 236–239
loss leader 316, 317
M
machine capacity 330, 362, 543, 545
make-or-buy decisions 288, 298–300, 337–338 see also outsourcing decision
qualitative issues 300
quantitative issues 299–300
scarce resources 337–338
management
activity-based 437, 564, 565–566
total quality 566–571
management accountants 2, 5, 6, 16, 106, 198, 317, 416, 492, 493, 495, 553
role in budget process 387
management accounting
de nition 2–3
information 3, 154, 283, 477, 491, 564, 604
introduction 1
modern 5–6
versus nancial reporting 4
management information, levels of 5
operational 5
strategic 5
tactical 5
management information systems 3
management reporting 394
manager(s)
cost centre 362
functional 361, 362

human resources 362
impact of budgeting on motivation 381–382
line 382, 383, 386, 387
non- nancial 83
production 362
purchasing 362
sales 362
manpower 330
manufacturing cells 548, 549
manufacturing costs 25, 26, 29, 30, 106–127, 286, 395
manufacturing items 110 see also non-manufacturing items
manufacturing overheads 25, 26, 80, 153, 156, 222
xed 26, 80, 107, 108, 108, 109, 117, 119, 120, 126, 127, 395, 401, 413, 437
non- 108, 108, 153, 154, 401
variable 26, 117, 120, 395
manufacturing process 26, 30, 403, 433
margin of safety 88–89
marginal costing 111
market share 315, 316, 407, 438, 442–443, 492, 572, 581
market share variance 442–443
market size 407, 438, 442,
market size variance 442–443
market segmentation 565, 566
market values
at the split-off point 268, 272
marketing classi cation 169
master budget 364, 368–373
matching principle 122
materials
costs 12, 237
direct 25, 118, 120, 197, 216, 222, 222, 246, 405, 434, 446, 543, 547, 553
quality 420, 434, 570
raw see raw materials
-related effects 420
variance 407
materials ordering and handling system 197, 197
materials purchases budget 362
mathematical approach 40, 44, 57, 60, 64–68 see also high-low method
mathematical calculations 316
maximum transfer price 515
McDonaldisation 435–436

minimum transfer price 515
mix variance 444
mixed cost 17–19, 46, 55, 56
graph 18, 18
mixed costs 11, 12, 44, 17–19, 40, 56
modern mechanised environments 435
modern organisations 382
motivating force 382
motivation of managers 381
impact of budgeting 381
multidimensional performance management system 493
multiple regression 54
N
negative aspects 382
net realisable value 267, 269, 270, 272, 424
‘niche’ strategy 564 see focus strategy
non- nancial measures 492, 551
non-manufacturing costs 29, 106, 107, 111, 112, 113, 115, 119, 122, 127
non-inventoriable costs 25, 106
non-value-adding activities 549, 567
normal distribution table 49, 53
normal losses 229, 230, 232, 234, 237, 238, 243, 246, 247, 248, 258–262
not-for-pro t enterprises 3, 11, 495
not-for-pro t sectors 564
numerical perspective 148
O
objective function
establish 340, 341, 346
express as an equation 340, 347
identify optimal point 340, 343
objectives
job costing 196
of budgets 360–361
opening inventory adjustments 115
operating expenses 543
operating variance 421
operational ABM 565, 581
operational budgets 361

operational constraints 329–349
decision-making under 329–352
operational decisions 2, 480
opportunity cost 24, 238, 289, 289, 291, 292, 297, 298, 515, 516, 549, 568, 569 see also future
costs
calculation of 306
versus future cost 291–292
optimal production mix 340, 344, 347, 348, 350
organisational hierarchy 387
traditional centralised 387 see also devolved network
organisational structures 480
centralised 480
decentralised 480–482, 496, 510
outsourcing decision 298, 337, 627 see make-or-buy decision
over-allocation 108
overhead absorption rates 363
overhead allocation 145–177, 401
activity-based techniques 147
traditional system 169, 174
value-based system 147, 169
volume-based system 147, 169
overhead expenses 204–205
xed 204–205
variable 204
P
packaging costs 30
participation 382
participative budgets 382, 383
participative style 382
penetration pricing 316
perfectly competitive market 512, 513
performance
continuous feedback 386
evaluation 10, 31, 60, 360, 361, 382, 394, 474, 475, 477, 479, 480, 481, 491, 492, 494, 522,
measurement 125, 127, 388, 394, 434, 476, 492, 493, 494, 511, 550, 590
rewarding 494–495
targets 494
performance evaluation 10, 31, 60, 360, 361, 382–383, 394, 398, 474, 475, 477, 479, 480, 481,
491, 492, 494, 522, 565, 589, 590

performance evaluation criteria 474, 475
performance management 393, 403, 416, 423, 437, 465, 473–497, 519
performance management system 512
performance measures 433, 474, 475, 482, 487, 491, 492, 494, 496, 519, 546, 550, 554, 582
nancial 433, 482–491, 492, 494, 496
multidimensional 492–494
period cost 29, 106, 107, 111, 112, 124, 169, 203, 235, 238, 401, 413
personnel records 202
‘per unit’ costs 400
physical measures method 267, 268, 270, 272
planned losses 229
planning horizon 361
planning variance 421
plant-wide rate 157, 158 see also departmental rate
plant-wide overhead allocation rate 158
poor quality 567
Porter’s generic strategies 564
Porter’s value chain 580, 580
Porter’s value system 580
potential competitors 521
practical capacity 169
premium pricing 316
pre-production costs 576
preventative maintenance 549
preventative measures 567
prevention costs 568
price
elasticity 314
setters versus takers 314
skimming 316
takers versus setters 314
variance 397, 404
pricing
decision 108, 314
cost-plus 314, 315, 316, 571, 581, 582
cost-plus versus target costing 314–315
dual 517, 519
long term 315–316
penetration 316
premium 316
short term 315

strategies 316–317
principal budgeting factor 362, 364
private sector 1
probability theory 377 see also budgeting
problem areas 394
process costing 196, 210, 221–262, 273, 283, 286, 589, 601, 604
formula 222
process costing system 264, 283
process improvement tools 565
product
bundling 316
differentiation 316
product-level activities 167
production budget 362, 363–365
product cost 29, 31, 80, 108, 169, 177, 313, 314, 315, 548, 571, 572
accumulating 315 see inventory valuation
statement 227
product life cycle 576
production departments 159
production levels 397
production volume variance 412, 434
product-level target cost 572–573, 573
product-level target costing process 572
productive hours 201, 202
pro t
actual 397, 398, 417
centre 476
gure 107
formula 81–82, 94, 95, 96
impact on 80, 125, 126
operating 417
reconciliation of actual to standard 417
standard 324, 406, 417
target 86–88
pro t margin
allowable 573
desired 571, 572, 581
gross 374
pro tability measurement 108
projecting sales 379
projections 315, 378–379, 388

high-low method 378–379
linear regression analysis 379
preparing using historic data 379
prototype cost 572
public sector 1
public sector organisations 3, 11, 495–496
pull system 434
Q
qualitative information 3, 298
qualitative measures 492
quality
cost of 568–571, 575
de ciency 570
dimensions of 567, 567
quality improvement programme 567, 568
quality level 568
quantitative information 3, 298
quantitative measures 492
quantitative methods 56
quantity standards 395
quantity variance 397, 404 see ‘usage variance’
formulae 404
isolation of 404
R
rand value 447
ratio analysis, role in budgeting process 374
ratios
current 374
debt 374
gearing 374
investor 374
quick 374
raw materials 30, 246, 264, 265, 273, 330, 340, 345, 346, 347, 350, 351, 360, 362, 363, 364, 420,
422, 424, 570, 580
reconciliation process 123
recurring fee
supplementing transfer price
regression analysis 49

regression error 47, 47, 53
regression formula 48
regulatory nes 575
relationship factors
relative sales values 147 see value-based overhead allocation system
relevance 5, 10, 11, 22–25, 30, 107, 126, 127, 174, 289–292, 289, 465
applying concept to basic cost elements 305–308
understanding concept of
relevant cost 22, 272, 273, 315, 317
relevant costing 22, 25, 139, 317, 465, 551
relevant information
elements of relevant and irrelevant 289, 289, 290
for decision-making 287–316
versus irrelevant information 290–291
relevant range 14, 14, 15, 22, 42, 44, 45, 46, 55, 78, 80, 80, 85, 95
required rate of return 363, 486, 490, 491, 496
reporting period 492
residual income (RI) 482, 484, 490, 491, 496
responsibility accounting 476–479, 496
responsibility centre 360, 476, 517
return on capital employed (ROCE) 374, 488
return on investment (ROI) 475, 482, 483–484, 488, 496 see also nancial performance
measures
return on sales (ROS) 482, 483, 487, 496 see also nancial performance measures
advantages 487
disadvantages 487
revenue
centre 476
revenue variance 405–407
reverse costing 571 see target costing
revision of standards 422
reward strategies 2
risk management 2
robotic processes 6
rolling basis 376
rolling budget 376 see continuous budget
root causes 394
routine task 548
rule of thumb model 417, 418

sales
budget 360
levels 127
mix 91, 92, 95, 96, 407, 438, 439
mix ratios 96
mix variance 438, 439
quantity variance 438, 439
volume 125
scarce resources 330, 337
scatter diagrams 379
scatter graph 40, 42–44, 56
scrap 236, 237, 248, 264, 265, 265, 266, 267, 270, 273, 570
seasonal uctuations 108
seasonality 108
self-constructed assets 519
selling price establishing 572
target 572, 573
sensitivity analysis 85
service customisation 578
service organisations 413, 436
shadow price 339, 517
shadow prices 339, 349, 351, 517
and linear programming 345–346
shareholder bene t 492
shareholder value analysis 10, 22, 30, 146, 387, 486
short-term decision-making 111
short-term pricing 315 see also long-term pricing
once-off special orders 315
short-term relevancy principles 315
short-term time horizon 126
simplex method 346 see also linear programming
skills development levy 202
slack 344, 546
slack variable 347
solvency 374
South African Institute of Chartered Accountants (SAICA) 1
special order decision 292
speci c identi cation 198, 200
spending variance 412
spillage 229
split-off point 264

spoilage 397
stakeholder 492, 493, 494, 496, 572, 581
stakeholders 2, 3, 4, 6, 30, 175, 493, 495, 575
standard cost 201, 204, 395, 406, 407, 409, 411, 423, 424
standard costing 393–437
benchmarking 436
bene ts 434
criticisms of 433–435
in service organisations 436
standard error 49
standard revenue 403
standards
achievable 396, 397
basic 396
ideal 396
interrelationship with budgets 394–395
revision of 422–423
statement of cash ows 364, 368
static budget 397
variance 397, 403
static measure 568
‘statistical calculations’ 49
statistical models 417
statistics 378
step costs 12, 16–17
strategic
ABM 565
budgets 361
business units 480
considerations 521
decisions 1
reasons 521
sub-optimal decisions 30, 480, 481, 589
sunk cost 22, 25, 289, 289
supply chains 578, 579
supply chain integration 578
supply chain management (SCM) 574, 578–579, 580, 582
support service department costs 159
support service departments 159
synchronised supply chains 578

T
t-stat 53
t-statistic 53 see also t-stat
table method 404–405
target cost 314
target costing 314, 315, 434, 564, 571–574, 576, 578, 581, 582
targets
agreeing on 494–495
failure to meet 361
setting 552
theory of constraints (TOC) 435, 541, 542–548 see also accounting concepts
steps in implementing 545, 545–547
three Es 495, 496
throughput 541, 542, 543, 544, 545, 548, 553
accounting 543, 547, 553
accounting ratio (TPAR) 543
contribution 553
margins 547
ratio 543
time sheets 202
time-and-motion studies 396, 447
timing 5, 10, 11, 29–30, 31, 55
total assets
employed 488
held 488
less current liabilities 488
total quality management (TQM) 549, 564, 566–571, 575, 580, 581, 582
success factors 568
traceability 146
traceable 477
tracing costs 20
traditional overhead allocation system 147, 177
traditional system 548
transaction driver 54, 168 see also cost drivers
transfer price 510
transfer price boundaries 511
transfer prices 481, 509, 511, 513
cost-based 513–514
negotiated 514
transfer pricing 509

decentralisation 511
international transfers 520
principles of 511
resolving problems 517–519
shadow prices 517
strategic and ethical considerations 521–522
transfers
across international borders 521
triple bottom line 492
triple context 493
turnover
asset 374, 483
growth in 374
inventory 374
U
uncertainty 88, 91, 292, 311, 377
under-allocation 108
underlying inputs 398
unethical
actions 492
behaviour 492
unfavourable variances 399
unit sales (demand) 314
‘use it or lose it’ 382
‘usage variance’ 407 see quantity variance
V
value chain 396, 579
activities 580
analysis 564, 579
value for money (VFM) 495
value system 580
value-adding activities 548
value-based overhead allocation system 147
value-based techniques 147
value-creating activities 580
variable costing 29, 30, 106, 107, 111–113
income statement 115, 115
reporting format 113

strengths and weaknesses 124–127
system 30, 80, 95, 96, 122, 123
variable costs 12–14, 405
variable manufacturing overheads 26
variable overhead variance 411–412
variable pro t 124
variance accounts 431–433
variance analysis 394, 435
variances
calculation of 397
interpretation of 418
investigation of 417
planning 421, 447
possible causes of 420–421
volume 397
volume-based overhead allocation system 147
volume-based techniques 147
W
wage system 202
wastage 229
waste 264
weighted-average 96, 198, 199
‘window dressing’ 126
work environment 421, 447
work-in-progress (WIP) 224–229, 424
balances 246
closing 224–226
opening 226–229
Y
yardstick 496
yield variance 444
Z
zero defects 549
zero income 521
zero pollution 575
zero-base budgeting (ZBB) 375, 396

Table of contents
Cover
Title Page
Copyright
Abridged table of contents
Contents
Preface
Foreword
Acknowledgements
CHAPTER 1 INTRODUCTION TO MANAGEMENT
ACCOUNTING
1.1 Introduction
1.3 Financial reporting versus management accounting
CHAPTER 2 COST CLASSIFICATION
2.1 Introduction
2.2 Cost behaviour
2.3 Assignment
2.4 Relevance
2.5 Function
2.6 Timing
2.7 Summary
Conclusion: Cost classi cation and other topics in this book

Basic questions
Long questions
CHAPTER 3 COST ESTIMATION
3.1 Introduction
3.2 Cost drivers
3.3 Scatter graph
3.4 High-low method
3.6 Factors affecting the accuracy of cost estimation
3.7 Other means of estimating costs and predicting cost
behaviour
3.8 Summary
Conclusion: Cost estimation and other topics in this book
Appendix 3.1 Learning curves
Basic questions
Long questions
CHAPTER 4 COST-VOLUME-PROFIT RELATIONSHIPS
4.1 Introduction
4.2 CVP analysis – the accountant’s and economist’s models
4.5 Break-even analysis with multiple products
4.6 CVP analysis assumptions and limitations
4.7 Summary
Conclusion: Cost-volume-pro t relationships and other
topics in this book
Basic questions
Long questions
CHAPTER 5 ABSORPTION VERSUS VARIABLE COSTING

5.1 Introduction
5.3 The impact of changes in inventory on pro t
5.4 Strengths and weaknesses of absorption and variable
costing
5.5 Summary
Conclusion: Absorption versus variable costing and other
topics in this book
Basic questions
Long questions
ADVANCED READING INTEGRATION SECTION:
CHAPTERS 1 TO 5
CHAPTER 6 OVERHEAD ALLOCATION
6.1 Introduction
6.3 Allocation of support service department costs
6.5 Activity-based management and activity-based
budgeting
6.7 Summary
Conclusion: Overhead allocation and other topics in this
book
Basic questions
Long questions
CHAPTER 7 JOB COSTING
7.1 Introduction
7.3 The elements of cost in a job costing system

7.4 Integrating the costing and nancial accounting systems
7.5 Summary
Conclusion: Job costing and other topics in this book
Basic questions
Long questions
CHAPTER 8 PROCESS COSTING
8.1 Introduction
8.2 Calculations in a process costing system
8.4 Decision-making
8.5 Summary
Conclusion: Process costing and other topics in this book
Basic questions
Long questions
Appendix 8.1 Normal losses revisited – the ‘short cut’
method of accounting for normal losses
CHAPTER 9 JOINT AND BY-PRODUCT COSTING
9.1 Introduction
9.3 Joint costs and nancial reporting
9.4 Joint costs in relation to decision-making
9.5 Summary
Conclusion: Joint and by-product costing and other topics
in this book
Basic questions
Long questions
CHAPTERS 6 TO 9

CHAPTER 10 RELEVANT INFORMATION FOR DECISION-
MAKING
10.1 Introduction
10.2 Understanding the concept of relevance
10.4 Applying the concept of relevance to basic cost
elements
10.5 Decisions under conditions of uncertainty
10.7 Summary
Conclusion: Relevant costs for decision-making and other
topics in this book
Basic questions
Long questions
CHAPTER 11 DECISION-MAKING UNDER OPERATIONAL
CONSTRAINTS
11.1 Introduction
11.4 Make-or-buy decisions and scarce resources
11.6 Linear programming: the graphical method
11.7 Shadow prices and linear programming
11.8 Linear programming: the simplex method
11.9 Concluding on operational constraints scenarios
11.11 Summary
Conclusion: Decision-making under operational constraints

Basic questions
Long questions
CHAPTER 12 BUDGETS, PLANNING AND CONTROL
12.1 Introduction
12.3 Strategic, tactical and operational budgets
12.5 Determining the principal budgeting factor
12.8 Cash budgets
12.10 The role of ratio analysis and key performance
indicators in the budgeting process
12.13 Preparing projections using historical data
12.16 Fixed and exed budgets
12.17 Preparing a exed budget
12.18 Impact of budgeting on the motivation of managers
12.19 Participation and performance evaluation
12.22 The role of the management accountant in the budget
process
12.24 Summary

Conclusion: Budgets, planning and control and other topics
in this book
Basic questions
Long questions
CHAPTER 13 STANDARD COSTING
13.1 Introduction
13.2 Standards and the interrelationship between standards
and budgets
13.3 Standard costing and inventory valuation
13.6 Reconciliation of actual pro t to standard pro t
13.15 Variance analysis in modern mechanised
environments
13.16 Standard costing in service organisations
13.18 Summary
Conclusion: Standard costing and other topics in this book
Appendix 13.1 Advanced standard costing concepts
Basic questions
Long questions

CHAPTERS 10 TO 13
CHAPTER 14 PERFORMANCE MANAGEMENT
14.1 Introduction
14.3 Centralised and decentralised organisational structures
14.5 Multidimensional performance measures
14.6 Agreeing on targets and rewarding performance
14.7 Not-for-pro t and public sector organisations
14.8 Summary
Conclusion: Performance management and other topics in
this book
Basic questions
Long questions
CHAPTER 15 TRANSFER PRICING
15.1 Introduction
15.11 Summary
Conclusion: Transfer pricing and other chapters in this book

Appendix 15.1 Determining transfer prices in perfect and
imperfect markets
Basic questions
Long questions
CHAPTER 16 CONTEMPORARY MANAGEMENT
ACCOUNTING CONCEPTS
16.1 Introduction
16.5 Benchmarking
16.6 Summary
Conclusion: Contemporary management accounting
concepts and other topics in this book
Basic questions
Long questions
CHAPTER 17 COMPETITIVE ADVANTAGE
17.1 Introduction
17.5 Target costing
17.9 Summary
Conclusion: Competitive advantage and other chapters in
this book
Basic questions

Long questions
CHAPTERS 14 TO 17
INTEGRATION SECTION SOLUTIONS
Glossary
Index
Guide
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Principles of Management Accounting A SA Perspective 3e (2020)

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Published in South Africa by

e moral rights of the author have been asserted.

Principles of Management Accounting: A South African Perspective 3e

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Chapter 1 Introduction to management accounting

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CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING

Shelley-Anne Roos (updated by John Williams)

CHAPTER 2 COST CLASSIFICATION

CHAPTER 3 COST ESTIMATION

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CHAPTER 4 COST-VOLUME-PROFIT RELATIONSHIPS

CHAPTER 5 ABSORPTION VERSUS VARIABLE COSTING

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ADVANCED READING INTEGRATION SECTION: CHAPTERS 1 TO 5

Shelley-Anne Roos (updated by John Williams)

CHAPTER 6 OVERHEAD ALLOCATION

CHAPTER 7 JOB COSTING

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CHAPTER 8 PROCESS COSTING

CHAPTER 9 JOINT AND BY-PRODUCT COSTING

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ADVANCED READING INTEGRATION SECTION: CHAPTERS 6 TO 9

John Williams and Shelley-Anne Roos

CHAPTER 10 RELEVANT INFORMATION FOR DECISION-MAKING

CHAPTER 11 DECISION-MAKING UNDER OPERATIONAL CONSTRAINTS

Appie Pienaar & Dewald Joubert

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CHAPTER 12 BUDGETS, PLANNING AND CONTROL

Appie Pienaar and Elton Pullen

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CHAPTER 13 STANDARD COSTING

Jonathan Streng and Elton Pullen

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ADVANCED READING INTEGRATION SECTION: CHAPTERS 10 TO 13

John Williams and Shelley-Anne Roos

CHAPTER 14 PERFORMANCE MANAGEMENT

CHAPTER 15 TRANSFER PRICING

Shelley-Anne Roos and Elton Pullen

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CHAPTER 16 CONTEMPORARY MANAGEMENT ACCOUNTING CONCEPTS

Richard Chivaka and Shelley-Anne Roos

CHAPTER 17 COMPETITIVE ADVANTAGE

Richard Chivaka and Shelley-Anne Roos

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ADVANCED READING INTEGRATION SECTION: CHAPTERS 14 TO 17

INTEGRATION SECTION SOLUTIONS

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This third edition of Principles of Management Accounting: A South

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This foreword to the Principles of Management Accounting: A South

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Associate Professor Owen Skae

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The authors and publisher gratefully acknowledge permission to

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