BEP (units) = Fixed Cost/Contribution per unit
Option 1 = GHS5,000/3.0 = 1,667 loaves of bread
Option 2 = GHS3,000/2.5 = 1,200 loaves of bread

DOL = Total Contribution / Operating Profit
Option 1 = GHS30,000/ GHS25,000 = 1.20
Option 2 = GHS25,000/ GHS22,000 = 1.14

Percentage change in Operating Income = DOL x % change in Sales
Option 1 = 1.20 x 25% = 30.00%
Option 2 = 1.14 x 25% = 28.50%
Expected Operating Income
Option 1 = GHS25,000 + (30.00% x GHS25,000) = GHS22,500
Option 2 = GHS22,000 + (28.5% x GHS22,000) = GHS28,270

Decision Point
In choosing between the two options DOL plays a key role. DOL of option 1which is 1.20 as against 1.14 of option 2 shows that option 1 has a higher return/risk for any given level of sales than option 2. The increased risk in option 2 provides an opportunity for an increased return or profit level when units sold go beyond 4,000 units. Because 4,000 is the units at which operating income of both options are the same.

Thus, since management expects units sold to be 10,000 units, then option 1 is more beneficial . On the other hand, if management has reason to believe that units to be sold will fall below 4,000 units, then option 2 is more beneficial.

Determination of units at which operating incomes of both options are the same
3.0u – 5,000 = 2.5u – 3000
3.0u – 2.5u = -3,000 + 5,000
0.5u/0.5 = 2,000/0.5 = 4,000 loaves of bread.

Justifications for the use of Payback Method

• It is considered useful when firms face liquidity constraints and require a fast payment of their investments.
• It serves as a simple first level screening device that indentifies those projects that should be subjected to more rigorous investigations.
• It provides a rough measure of risk, based on the assumption that the longer it takes for a project to pay for itself, the riskier it is.

Justification for the use of ARR

• ARR is a widely used financial measure of managerial performance. So managers are likely to be interested in how any new investment contributes to the business units’ overall accounting rate of return.

Limitations of Payback Method

• It ignores the time value of money
• It ignores cash flows that are earned after the payback period

Limitations of ARR

• The ARR fails to take into consideration the time value of money
• It relies on a percentage return rather than an absolute value

Methods used in measuring performance:

• Financial Performance: analyse profitability, liquidity and risk. Financial Indicators include Profit, Revenue, Costs, Share Price and cash flow.
• Non-Financial Performance: This can usefully be applied to employees and product/service quality. Non-Financial Indicators may include Quality of Service, Measures of customer satisfaction, Lateness.

Qualities of Good Performance Measurement

• The Zero Based Budgeting is a method where all expenses have to be justified for every new period. The Activity Based Budgeting is a budgeting method where all the activities that invite cost in all functional areas in an organisation are recorded and the relationship between them is analysed.
• In Zero Based Budgeting, all functions in an organisation are analysed for its needs and costs.
• Zero Based Budgeting can also be termed as a re-evaluation of the program and expenditures of an organisation.
• The Activity Based Budgeting aligns all activities with the objectives.
• The Activity Based Budgeting helps in effective analysis of the profit potential of an organisation’s services and its products.

• Different activity levels will provide a foundation for the base package and incremental packages of Zero Based Budgeting.
• It will ensure that the organisation’s overall strategy and any actual or likely changes in that strategy will be taken into account because it attempts to manage the business as the sum of its interrelated parts.
• Critical Success Factors will be identified and performance measures devised to monitor progress towards them.
• Because concentration is focused on the whole of an activity, not just its separate parts, there is more likelihood of getting it right first time. For eg what is the use of being able to produce goods in time for their despatch date if the budget provides insufficient resources for the distribution manager who has to deliver them.

• This tool helps determine whether cash balances remain sufficient to fulfil regular obligations and whether minimum liquidity and cash balance requirements stipulated by banks or internal company regulations are maintained. It also helps a company determine whether too much cash is retained that could be otherwise used in productive activities. Companies that borrow from banks need to monitor their cash coverage ratio and preparing a cash budget constitutes the first step in calculating this ratio.
• Cash budgets identify the amount of cash required to fulfil immediate, short-term obligations without utilization of overdraft protection or lines of credit. Businesses use this information to determine the extent of credit sales. Offering credit and extending credit periods usually increases sales. A company with excess cash can afford to sell on credit and thereby boost profitability. Conversely, a company hard-pressed for cash might decide to sell products at discounted prices for cash. Offering such discounts may be cheaper than the cost of overdraft fees or credit interest.
• Companies use cash budgets to make plans for optimal utilization of cash. The goal is to retain only the minimum required working capital, investing the surplus cash in productive ventures, such as making profitable investments, expanding production capacity, purchasing raw materials in bulk and in using cash to obtain favourable discounts. Companies hard-pressed for cash can take many steps to improve their position, such as reducing credit sales, postponing or reducing dividends, collecting credit early, rescheduling debt repayment and other pay-outs, cutting back on manufacturing products that require resources but do not yield much cash in the short term, and so on. Companies also look at a cash budget to determine the extent of cash available, if any, to finance capital expenditures.
• Preparing a cash budget sheds light on where cash goes. Individuals and companies can analyse each item of expenditure to determine the purpose of such expenditure and the value received in return for the expense. This allows them to cut down on unproductive expenses, bring in financial efficiency, and improve the quality of financial decisions.

• The behavior of total revenue is linear. This implies that the price of the product or service will not change as sales volume varies within the relevant range.
• The behavior of total expenses is linear over the relevant range. This implies expenses can be categorized as fixed, variable or semi-variable. Total fixed expenses remain constant as activity changes, and unit variable expenses remains unchanged as activity varies.
  Secondly, the efficiency of the production process and workers remain constant.
• In multi-product organizations the sales mix remain constant over the relevant range.
• In manufacturing firms, the inventory at the beginning and end of the period are the same. This means unit produced are all sold.

Sales mixed = 2: 1: 1
50%:25%:25%

In proportion of High = 59.5 = 60   ;  Medium= 60    ;   Low= 119

The relevant cost for determining the EOQ are the holding cost and the ordering cost.
The Holding cost includes:
i. -opportunity cost of investment in stock
ii. -incremental insurance cost.
iii. -incremental warehouse and storage cost
iv. -incremental material handling cost.
v. -cost of obsolescence and deterioration of stock.
The ordering cost includes:
i. -Clerical cost of preparing purchase order purchase order
ii. -Receiving deliveries
iii. -paying invoices

Transaction motive – this occurs whenever there is a need to hold stocks to meet production and sales requirement and that it is not possible to meet this requirement instantaneously.

The precautionary motive – If a firm decides to hold an additional amount of stock to cover the possibility that it may have underestimated its future production and sales requirement or when the supply of raw materials may be unreliable because of uncertain event affecting the supply of raw materials this is called precautionary motive for requiring stock.

Speculative motive – When it is expected that future inputs prices may change, a firm might maintain higher or lower levels of stock to speculate on the expected increase or decrease in future prices. Quantitative models does not take into consideration the speculative motives, but management should be aware that optimum stock levels do depend to a certain extent on expected price movement. If input prices is expected to rice then management should stock to take advantage of input price savings.

Economic order quantity – this is the ordering quantity where total cost of holding and ordering cost is at its minimum. It is the most economical quantity to order in order to minimize both incremental holding cost and ordering cost.
Relevance of Economic Order Quantity

• It is relevant in the sense that it is the optimal quantity that ensure optimal use of resources.
• It is also relevant because it will assist to ensure that there will be minimal occurrence of stock out and excessive holding of stock with its associated consequence like inability to satisfy customers, deterioration and high rate of losses due to overstocking.
  

ANNUAL ORDERING COST = 200,000/EOQ X 200 = GHC8,945
200,000/ 4,472 X 200 = GHC 8,945

EOQ/2 X HOLDING COST PER UNIT = 4,472/2 X 4 = 8,945

Annual demand / EOQ
200,000/ 4472 = APPROX 45 times

EOQ X PURCHASE PRICE
4472 X 80 = GHC 357,760

Calculation of contribution that will be lost if Double bed cease production.

Potential contribution to fixed cost that will be lost                                         425,000

From this calculation it implies that a contribution of GHC425,000 will be lost if double bed production ceases. Profit will decline by this figure since fixed cost component will still be incurred. Therefore the company should continue production.

Student who approach it the long way to achieve a profit reduction of GHC425,000 should be awarded the full marks as shown below:

ALTERNATIVELY:

INCOME STATEMENT (During Double Bed production)

INCOME STATEMENT (During Double Bed shut down)

In this case profit reduced from GHC 930,000 to GHC 505,000 a reduction of GHC425,000.

INCOME STATEMENT (for 80 units of each product)

The order should be rejected because it will result in incremental loss of GHS 22,885.71 unless shalom is ready to pay higher price to cover the additional cost associated with producing the extra units.

However if a student depreciate the asset at 5 per the quarter divided by 3 to obtain 11,633 it should be accepted as a correct answer. This will affect profit, depreciation and accumulated depreciation.

Sales price variance
(Actual contribution – standard contribution) x actual quantity
(¢55 – ¢50) x 9000 = ¢45,000F

Sales volume variance
(Actual volume – standard volume) x standard contribution
(9000 – 10,000) x 50 = 50,000A

Total sales variance

Material price variance + material usage variance
22,250A – 66,250A = 88,500A

Wage rate variance + labour efficiency variance = total wage variance
¢42,750A + ¢33,750A = ¢76,500A

Fixed overhead expenditure variance + variable overhead expenditure + variable overhead efficiency variance.
10,000F + 12,500F + 7,500A = 15,000A = 15,000F

This represents constant standard that are unchanged over long period. The main advantage of basic standard is that a base is provided for comparison with actual cost through a period of years with the same standard and efficiency trends can be established over time. When changes occur in the method of production, price levels or other relevant factors, basic standards are not very useful since they do not represent current target.

This represent perfect performance. Ideal standards are minimum cost that are possible under the most efficient operating condition. They are unlikely to be used because they may have negative impact on employee performance.

This standard represent those cost that should be incurred under efficient operating conditions. They are difficult but not impossible to achieve. Allowance are made for normal spoilage, machine breakdowns and idle cost.

i) Prediction of future cost that can be used for decision making.
ii) Provide a challenging target that can serve as a motivation for employee.
iii) Assist in setting target.
iv) Act as control device by highlighting exceptions
v) Simplifying the task of tracing cost to product for measuring profitability and inventory valuation.

i) Variance analysis concentrates on only a narrow range of costs, and does not give sufficient attention to issues such as quality and customer satisfaction.
ii) Standard costing pays too much emphasis on direct labour cost. Direct labour is only a small proportion of cost in modern manufacturing environment and so this emphasis is not appropriate.
iii) Many of the variances in standard costing system focus on the control of short term variable costs. In modern manufacturing environment majority of cost including direct labour cost tends to be fixed in the short run.
iv) The use of standard costing relies on existence of repetitive operations and relatively homogeneous output. Nowadays many Organisation are forced continually to respond to customers’ changing requirement, with the result that output and operations are not so repetitive.
v) Standard costing system were developed when the business environment was more stable and less prone to change. The current business environment is more dynamic and it is not possible to assume stable conditions.
vi) Standard costing system assumes that performance to standard is acceptable. Today’s business environment is more focused on continuous improvement.
vii) Most standard costing systems produce control statements weekly or monthly. The modern manager needs much more prompt control information in order to function efficiently in a dynamic business environment.                     (Any 4 points)