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ACCA PasscardsPaper F5Performance Management

Passcards for exams up to June 2015

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Fundamentals Paper F5Performance Management

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First edition 2007, Eighth edition June 2014ISBN 9781 4727 1124 3

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Page iii

ContentsPreface

Welcome to BPP Learning Medias ACCA Passcards for Paper F5 Performance Management. They focus on your exam and save you time. They incorporate diagrams to kick start your memory. They follow the overall structure of the BPP Study Texts, but BPPs ACCA Passcards are not just a

condensed book. Each card has been separately designed for clear presentation. Topics are self containedand can be grasped visually.

ACCA Passcards are still just the right size for pockets, briefcases and bags.Run through the Passcards as often as you can during your final revision period. The day before the exam, tryto go through the Passcards again! You will then be well on your way to passing your exams.

Good luck!

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ContentsPreface

Page1 Costing 12 Modern management accounting

techniques 53 Cost volume profit (CVP) analysis 154 Limiting factor analysis 275 Pricing decisions 336 Short-term decisions 457 Risk and uncertainty 518 Budgetary systems 639 Quantitative analysis in budgeting 7110 Budgeting and standard costing 7911 Variance analysis 83

Page12 Planning and operational variances 9913 Performance analysis and behavioural

aspects 10914 Performance management information

systems 11715 Sources of management information and

management reports 12716 Performance measurement in private

sector organisations 13317 Divisional performance and transfer

pricing 13918 Further aspects of performance

management 145

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1: Costing

Topic List

CostingAbsorption costingAbsorption costing vs marginal costing

You will have covered the basics of these costing methodsin your earlier studies but you need to make sure you arefamiliar with the concepts and techniques so you cananswer interpretation questions.

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Absorption costingvs marginal costing

Absorption costing

Costing

A management informationsystem which analyses past,present and future data to providea bank of data for themanagement accountant to use.

The process of determining thecost of products, services oractivities. Methods includeabsorption costing and processcosting.

Cost accounting

Costing



Absorptioncosting

Costing

1: CostingPage 3

Inventory valuations Pricing decisions Establishing profitability of products

Practical reasons for using absorption costing

What is absorption costing?Absorption costing is a method of sharing out overheads incurred amongst units produced.

Allocation

Apportionment

Absorption under/over-absorbed overhead

123


When sales fluctuate because of seasonality insales demand but production is held constant,absorption costing avoids large fluctations in profit.

Marginal costing fails to recognise the importanceof working to full capacity and its effects on pricingdecisions if cost plus method of pricing is used.

Prices based on marginal cost (minimum prices)do not guarantee that contribution will cover fixedcosts.

In the long run all costs are variable, andabsorption costing recognises these long-runvariable costs.

It is consistent with the requirements of accountingstandards.

Arguments in favour of absorptioncosting

It shows how an organisations cash flows andprofits are affected by changes in sales volumessince contribution varies in direct proportion tounits sold.

By using absorption costing and setting aproduction level greater than sales demand, profitscan be manipulated.

Separating fixed and variable costs is vital fordecision-making.

For short-run decisions in which fixed costs do notchange (such as short-run tactical decisionsseeking to make the best use of existingresources), the decision rule is to choose thealternative which maximises contribution, fixedcosts being irrelevant.

Arguments in favour of marginal costing


Absorption costing

Costing


2: Modern management accounting techniques

Topic List

Activity based costing (ABC)Target costingLife cycle costingThroughput accountingEnvironmental accounting

All five techniques covered are equally important andequally examinable.You need to develop a broadbackground in management accounting techniques.In Section B in the exam, these topics may be thesubject of a 10-mark question but not a 15-markquestion.You should also expect them to feature inSection A MCQs.


Targetcosting

Life cyclecosting

Environmentalaccounting

Throughputaccounting

Activity basedcosting (ABC)

Outline of an ABC systemIdentify major activities.Use cost allocation and apportionment methods to theseactivities (cost pools).Identify the cost drivers which determine the size of thecosts of each activity.For each activity, calculate an absorption rate per unit ofcost driver.Charge overhead costs to products on the basis of theirusage of the activity (the number of cost drivers they use).

An increase in support services, which are unaffected bychanges in production volume, varying instead with therange and complexity of products.

An increase in overheads as a proportion of total costs.

Features of a modern manufacturingenvironment

Implies all overheads are related to production volume. Developed at a time when organisations produced only a

narrow range of products and overheads were only asmall fraction of total costs.

Tends to allocate too great a proportion of overheads tohigher volume products.

Leads to over production?

Inadequacies of absorption costing

1

2

3

4

5

Cost drivers Volume related (eg labour hrs) for costs that vary with

production volume in the short-term (eg power costs) Transactions in support departments for other costs (eg

number of production runs for the cost of setting-upproduction runs)


2: Modern management accounting techniquesPage 7

ExampleCost of goods inwards department = $10,000Cost driver for goods inwards activity = number ofdeliveriesDuring 20X0 there were 1,000 deliveries, 200 ofwhich related to product X. 4,000 units of product Xwere produced.Cost per unit of cost driver = $10,000 1,000 = $10Cost of activity attributable to product X = $10 200 = $2,000Cost of activity per unit of X = $2,000 4,000 =$0.50

Merits of ABC Simple (once information obtained) Focuses attention on what causes costs to

increase (cost drivers) Absorption rates more closely linked to causes of

overheads because many cost drivers are used

Criticisms of ABC More complex and so should only be introduced if

provides additional information Can one cost driver explain the behaviour of all

items in a cost pool? Cost drivers might be difficult to identify



Life cyclecosting



Targetcosting

Determineproduct concept

Determine currently-achievable cost

Establish targetprice Establish

desired profitmargin

Set targetcost

Calculate cost gap

Try to close the gap

The target costing process

Involves setting a target cost by first of allidentifying a target selling price and thendeducting the required profit margin to reach atarget cost.

The initial estimated cost is likely to be higherthan the target cost a cost gap.

Measures to close the cost gap should beways to reduce costs without loss of value tothe customer: may involve some product re-design, removal of non-value-adding features,use of more standard components, alternativematerials for some product parts.

Target costing



Life cyclecosting



Targetcosting


Life cycle costingThis method tracks and accumulates costsand revenues over a products entire life.

DevelopmentIntroductionGrowth

1

2

4

3

5

MaturityDecline

AimTo obtain a satisfactory return from a product over its expected life.Life cycle costing is a planning technique rather than a traditional method of measuring and accounting forproduct costs.

Life cycle costs include: Costs incurred at product design, development and testing stage. Advertising and sales promotion costs when the product is first introduced to the market. Expected costs of disposal/clean-up/shutdown when the product reaches the end of its life.



Life cyclecosting



Targetcosting

Design costs out of products Minimise the time to market Minimise breakeven time Maximise the length of the life span Minimise product proliferation Manage the products cashflows

Maximising the return over the productlife cycle

Cost visibility is increased Individual product profitability is better

understood More accurate feedback information is provided

on success or failure of new products Useful planning technique, to forecast profitability

of a new product over its life. Can help todetermine target sales prices and costs.

Advantages



Life cyclecosting



Targetcosting


In the short run, all costs except materials are fixed. The ideal inventory level is zero and so unavoidable, idle

capacity in some operations must be accepted. WIP is valued at material cost only, as no value is added and

no profit earned until a sale takes place.

Principal concepts of throughput accounting

An approach to production managementwhich aims to turn materials into sales asquickly as possible, thereby maximising the netcash generated from sales. It focuses onremoving bottlenecks (binding constraints) toensure evenness of production flow.

Theory of constraints (TOC)

Production conceptsJIT purchasing and production as much as possibleUse bottleneck resource to the full and as profitably as possibleAllow idle time on non-bottleneck resourcesSeek to increase availability of bottleneck resourceWhen constraint on bottleneck resource is lifted and it is no longera bottleneck, a different bottleneck resource takes over

12345



Life cyclecosting



Targetcosting

Throughput accounting Developed from TOC as an alternative cost andmanagement accounting system in a Just in Timeproduction environment.

TA measurements Throughput accounting (TA) ratio

A product is not profitable if its TA ratio is less than 1.

Maximising throughput and profitProfit maximised by maximising throughput per unit ofbottleneck resource (= factory hour).Products can be ranked in order of profitability accordingto either throughput per factory hour or TA ratio.

Throughput = Sales Direct materials costFactory costs = All costs other than direct materialscostsAll factory costs per period are assumed to be fixedcosts.Throughput Factory costs = Profit

hour factory per costFactory hour factory per Throughput

ratioTA =




Life cyclecosting



Targetcosting

Environmental management accounting

Typical environmental costs

Identifying environmental costs associatedwith individual products and services canassist with pricing decisions.

Ensuring compliance with regulatorystandards.

Potential for cost savings.

Why environmental costs are important

The generation and analysis of both financial andnon-financial information in order to supportenvironmental management processes.

Consumables and raw materials Transport and travel Waste and effluent disposal Water consumption Energy




Life cyclecosting


Targetcosting

Input / output analysis Environmental activity-based costing

Life-cycle costingEnvironmental costs are considered from the designstage right up to end-of-life costs such asdecomissioning and removal.This may influence the design of the product itself,saving on future costs.

Environment related costs such as costs relating to asewage plant or an incinerator are attributed to jointenvironmental cost centres.

Environment driven costs such as increaseddepreciation or higher staff wages are allocated togeneral overheads.Flow cost accounting

Operates on the principal that what comes in must go out.Output is split across sold and stored goods and residual(waste). Measuring these categories in physical quantitiesand monetary terms forces businesses to focus onenvironmental costs.

Material flows through an organisation are divided into threecategories Material System Delivery and disposalThe values and costs of each material flow are calculated. Thismethod focusses on reducing material, thus reducing costs andhaving a positive effect on the environment.Waste (negative products) are given a cost as well as good output(positive products). Seek to reduce costs of negative products.


3: Cost volume profit (CVP) analysis

Topic List

Breakeven pointC/S ratioSales/product mix decisionsTarget profit and margin of safetyMulti-product breakeven chartsFurther aspects of CVP analysis

You need to be completely confident of the aspectsof breakeven analysis covered in your earlierstudies.It is vital to remember that for multi-product breakevenanalysis, a constant product sales mix (whenever xunits of product A are sold, y units of product B and zunits of product C are also sold) must be assumed.


Further aspectsof CVP analysis

Multi-productbreakeven charts

Target profit andmargin of safety

Sales/productmix decisions

C/S ratioBreakeven point

Example (J Co)Used throughout this chapter

Example

BudgetProduct Sales

PriceVblecost

Salesunits

M $7 $3 6,000N $15 $5 2,000

Calculating multi-product breakeven point Calculate weighted average contribution per unit (from budget)

= WAC per unit Breakeven in units = Fixed costs/WAC per unit Breakeven units for each product in same proportion to unit

sales in the budget

Fixed costs $33,000Budgeted contn = ($4 6,000) + ($10 2,000) = $44,000WAC per unit = $44,000/(6,000 + 2,000) = $5.50Breakeven in total units = $33,000/$5.50 = 6,000 unitsSales of M = 6,000 (6,000/8,000) = 4,500 unitsSales of N = 6,000 (2,000/8,000) = 1,500 units



Breakeven point




C/S ratio

3: Cost volume profit (CVP) analysisPage 17

ExampleCalculating breakeven with multi-product C/S ratio Calculate budgeted contribution Calculate budgeted sales ratio Calculate weighted average C/S

ratio from these two figures Breakeven in sales revenue =

Fixed costs/Weighted average C/Sratio

Breakeven for each product is inthe same proportion to theirbudgeted sales revenue

Budgeted contribution = ($4 6,000) + ($10 2,000) = $44,000Budgeted sales = ($7 6,000) + ($15 2,000) = $42,000 +$30,000 = $72,000Weighted average C/S ratio = 44,000/72,000 = 0.6111 or 61.11%Breakeven = $33,000/0.6111 = $54,000 in sales revenueBreakeven product M = $54,000 (42,000/72,000) = $31,500 insales revenueBreakeven product N = $54,000 (30,000/72,000) = $22,500 insales revenue



Breakeven point




C/S ratio

You may be given the C/S ratio for each product in the sales mix and the budgeted proportions of sales revenuefrom each product.

ExampleProduct X C/S ratio = 33%Product Y C/S ratio = 57%The products will be sold in a ratio where Product X providestwice as much sales revenue as Product Y.Selling ratio = 2:1Weighted average C/S ratio = (33% 2/3) + (57% 1/3) = 41%Breakeven in sales revenue = Fixed costs/41%

Any change of products in the budgeted sales mix will alter the weighted average contribution per unit and theweighted average C/S ratio, and this will change the breakeven point.



Breakeven point




C/S ratio

3: Cost volume profit (CVP) analysis

Calculate the revised overall C/S ratioAlpha Beta Total

C/S ratio (as in ) 0.5713 0.6667Market share (2/7:5/7) 0.2857 0.7143

_____ _____ ______

0.1632 0.4762 0.6394_____ _____ ______

_____ _____ ______

Changing the product mixABC Co sells products Alpha and Beta in the ratio 5:1 at the same selling price per unit. Beta has a C/S ratio of66.67% and the overall C/S ratio is 58.72%. How do we calculate the overall C/S ratio if the mix is changed to 2:5?

Calculate the missing C/S ratio Calculate original market share (Alpha 5/6,

Beta 1/6). Calculate weighted C/S ratios.

Beta: 0.6667 0.1667 = 0.1111Alpha: 0.5872 0.1111 = 0.4761

Calculate the missing C/S ratio.Alpha Beta Total

C/S ratio 0.5713 * 0.6667Market share 0.8333 0.1667

______ ______ ______

0.4761 0.1111 0.5872______ ______ ______

______ ______ ______

* 0.4761/0.8333

1

1

The overall C/S ratio has increased because ofthe increase in the proportion of the mix of theBeta, which has the higher C/S ratio.

2

Page 19



Breakeven point




C/S ratio

Example continued (J co)Calculating sales to achieve target profitwith multi-product sales Calculate weighted average contribution

per unit (from budget) = WAC per unit Calculate target contribution = Fixed costs

+ Target profit Sales to achieve target profit = Target

contribution/WAC per unit Units of sale for each product in same

proportion to unit sales in the budget

The company wants to achieve target profit of $22,000.Weighted average contribution per unit (calculatedpreviously) = $5.50Target contribution = $33,000 fixed costs + $22,000 targetprofit = $55,000Sales to achieve target profit = $55,000/$5.50 = 10,000 unitsRequired sales of M = 10,000 (6,000/8,000) = 7,500 unitsRequired sales of N = 10,000 (2,000/8,000) = 2,500 unitsThis target is above the budgeted sales volumes.



C/S ratio method: Calculating sales to achievetarget profit with multi-product salesSales revenue to achieve a target profit = Target contribution/Weighted average C/S ratio

Margin of safetyA measure of risk in the budget, indicating possibilityof failing to break evenMargin of safety in units = Budgeted sales Breakeven salesMOS expressed as a percentage of the budgetedsales



Breakeven point




C/S ratio

Example continued (J co)From the budgetBudgeted sales in units = 8,000 units in totalBreakeven sales volume (calculated previously) =6,000 unitsMargin of safety = 2,000 unitsMargin of safety = (2,000/8,000) 100% = 25%Actual sales can fall short of the budget by 25% (inthe budgeted proportions in the sales mix) beforethe company fails to break even.

Example continued (J co)The company wants to achieve target profit of$22,000.Weighted average C/S ratio (calculated previously)= 0.6111Target contribution = $55,000Sales revenue to achieve target profit =$55,000/0.6111 = $90,000Required sales of M = $90,000 (42,000/72,000)= $52,500Required sales of N = $90,000 (30,000/72,000)= $37,500



Breakeven point




C/S ratio


A multi-product breakevenchart can only be drawn on

the assumption that thesales proportions are fixed.

There are three possible approaches to preparing multi-product breakeven charts.Output in $ sales and a constant product mixProducts in sequenceOutput in tems of % of forecast sales and a constant product mix

Breakeven chart

123



Breakeven point




C/S ratio

P/V chartSuppose Js sales budget is 6,000 units of Mand 1,200 units of N.Revenue (6,000 $7 + 1,200 $15) = $60,000Variable costs (6,000 $3 + 1,200 $5) =$24,000On the chart, products are shown individually,from left to right, in order of size of decreasingC/S ratio.

Cum CumC/S ratio sales profit

$000 $000N 66.67% 18 *(18)M 57.14% 60 6

* (1,200 $15) (12,000 $5) $30,000



The overall company breakeven point. Which products should be expanded in output (the most profitable in terms of

C/S ratio) and which, if any, should be discontinued. What effect changes in selling price and sales revenue would have on breakeven

point and profit. The average profit (the solid line which joins the two ends of the dotted line)

earned from the sales of the products in the mix.

What the multi-product P/V chart highlights


Further aspects of CVP analysis

Breakeven point




C/S ratio

Graphical representation of cost and revenuedata can be more easily understood by non-financial managers.

Highlighting the breakeven point and margin ofsafety gives managers an indication of the levelof risk involved.

Advantages of CVP analysis

It is assumed that fixed costs are the same intotal and variable costs are the same per unit atall levels of output.

It is assumed that sales prices will be constantat all levels of activity.

Production and sales are assumed to be thesame.

Uncertainty in estimates of fixed costs and unitvariable costs is often ignored.

Limitations of CVP analysis


4: Limiting factor analysis

Topic List

Formulating the problemFinding the solutionSlack, surplus and shadow prices

Limiting factor analysis is a technique used to determinean optimum product mix which will maximise contributionand profit.Linear programming is used where there is more thanone resource constraint.


Slack, surplus andshadow prices

Finding the solution

Formulatingthe problem

ExampleA company makes two products, standard and deluxe.Relevant data are as follows.

Standard Deluxe Availability per month

Profit per unit $15 $20Labour hours

per unit 5 10 4,000Kgs of material

per unit 10 5 4,250

Step 1. Define variables Let x = number of standards produced

each month

Let y = number of deluxes producedeach month

Step 2. Establish constraints Labour 5x + 10y 4,000 Material 10x + 5y 4,250 Non-negativity x 0, y 0

Step 3. Construct objective function Contribution (C) = 15x + 20y





4: Limiting factor analysisPage 29

There are two methods you need to know about whenfinding the solution to a linear programming problem.

Graphical method Using equations

Graphical methodStep 1. Graph the constraints

Labour 5x + 10y = 4,000if x = 0, y = 400if y = 0, x = 800Material 10x + 5y = 4,250if x = 0, y = 850if y = 0, x = 425

150

400

850

200 425 800

Material

Feasible region

Labour

y

x





Using equations Graph constraints and establish

feasible area. Determine all possible intersection

points of constraints and axesusing simultaneous equations.

Calculate profit at each intersectionpoint to determine which is theoptimal solution.

Step 2. Establish the feasible area/regionThis is the area where all inequalities are satisfied (areaabove x axis and y axis (x 0, y 0), below materialconstraint () and below labour constraint ()

Step 3. Add an iso-contribution lineSuppose C = $3,000 so that if C = 15x + 20y then if x =0, y = 150 and if y = 0, x = 200 and (sliding your ruleracross the page if necessary) find the point furthest fromthe origin but still in the feasible area

Step 4. Use simultaneous equations to find the x and ycoordinates at the optimal solution, the intersection of thematerial and labour constraints (x = 300, y = 250)





4: Limiting factor analysisPage 31

SlackOccurs when maximum availability of a resourceis not used.The resource is not binding at the optimal solution.Slack is associated with constraints.

Surplus

Shadow price

Occurs when more than a minimum requirementis used.Surplus is associated with constraints eg aminimum production requirement.

It is the increase in contribution created by the availability of an extra unit of a limited resource at its originalcost.

It is the maximum premium an organisation should be willing to pay for an extra unit of a resource.It provides a measure of the sensitivity of the result.It is only valid for a small range before the constraint becomes non-binding or different resources becomecritical.


Notes


5: Pricing decisions

Topic List

Pricing policy and the marketDemandProfit maximisationPrice strategies

Pricing of an organisations products or services is anessential part of its profitability and survival.There are many factors influencing prices andorganisations may have different price strategies.


Pricestrategies

Profitmaximisation

DemandPricing policyand the market

1 Demand2 Market in which the organisation operates

3 Price sensitivity 4 Price perception 5 Compatibility with other products6 Competitors

Most important factor based on economic analysis of demand

Varies amongst purchasers. If cost can be passed on not price sensitive

How customers react to prices. If product price , buymore before further rises

Eg operating systems on computers. User wants widerange of software available

Prices may move in unison (eg petrol). Alternatively, pricechanges may start price war

PERFECT COMPETITIONMany buyers and sellers, one product

MONOPOLYOne seller who dominates many buyers

MONOPOLISTIC COMPETITIONA large number of suppliers offer similar

(not identical) productsOLIGOPOLY

Relatively few competitive companiesdominate the market


7 Competition fromsubstitute products

8 Suppliers9 Inflation10 Quality 11 Incomes12 Ethics

Eg train prices , competitionfrom coach or air travel Demand is the most important factor

influencing the price of a product

Price

Demand

Demand increases as prices are lowered

If organisations product price ,suppliers may seek price rise in supplies

Price changes to reflect increase in priceof supplies

Customers tend to judge quality by price

When household incomes rising, price notso important. When falling, important

Exploit short-term shortages throughhigher prices?

5: Pricing decisionsPage 35


Pricestrategies

Profitmaximisation


Price elasticity of demand ()A measure of the extent of change in market demand for a good, in response to a change in its price

= change in quantity demanded, as a % of demand change in price, as a % of price

Inelastic demand < 1 Steep demand curve Demand falls by a smaller % than % rise in price Pricing decision: increase prices

Elastic demand > 1 Shallow demand curve Demand falls by a larger % than % rise in price Pricing decision: decide whether change in cost

will be less than change in revenue

The price of the good The price of other goods The size and distribution of household incomes Tastes and fashion Expectations Obsolescence

Variables which influence demand



Demand and the individual firm The demand equation

The total cost function

Influenced by: Product life cycle Quality Marketing

Price Product Place Promotion

The equation for the demand curve isP = a bQP is the priceQ is the quantity demandeda is the price at which demand = 0

b is quantity in change

price in change

Cost behaviour can be modelled using equations and linear regression analysis. A volume-based discountis a discount given for buying in bulk which reduces the variable cost per unit and therefore the slope of thecost function is less steep.


Profitmaximisation

Pricestrategies


Determining the profit-maximising selling price/output level Method 1: using equations

ExampleMC = 320 0.2xMR = 1,920 16.2x Profits are maximised when320 0.2x = 1,920 16.2xie when x = 100

You could also be provided with/asked to determine the demand curve in order to calculate the priceat this profit-maximising output level.

Note the distinction betweenselling price and MR.

Profits are maximisedwhen MC = MR.



Method 2: visual inspection of tabulation of dataWork out the demand curve and hence the priceand total revenue (PQ) at various levels ofdemand.Calculate total cost and hence marginal cost ateach level of demand.Calculate profit at each level of demand, therebydetermining the price and level of demand thatmaximises profit.

2

1

3

The marginal revenue equationMR = a 2bQQ is the quantity demandeda is the price at which demand = 0b is change in price

change in quantity


Profitmaximisation

Pricestrategies


ExampleA company currently sells a product at a priceof $2. Monthly sales are 60,000 units.It has been estimated that for every $0.10increase or decrease in the price, monthlydemand will fall or rise by 1,000 units.Costs per month are fixed costs of $60,000 andvariable costs of $0.50 per unit.What is the profit maximising price and whatwould be the monthly profit at this price?

SolutionIf demand equation is P = a bQa is $2 + (60,000/1,000) $0.10 = $8b = 0.10/1,000 = 0.0001So P = 8 0.0001Q

MR = 8 0.0002QMC = 0.50 (= marginal cost per unit)Profit maximised where 8 0.0002Q = 0.50Q = 37,500P = 8 (0.0001 37,500) = $4.25 per unitContribution per unit = $3.75Monthly profit = (37,500 $3.75) $60,000 = $80,625


Profitmaximisation

Pricestrategies



In practice, cost is one of the most important influences on price Full cost-plus Marginal cost-plus

Full cost-plus pricingis a method ofdetermining the salesprice by calculating thefull cost of the productand adding a percentagemark-up for profit.

ExampleVariable cost of production = $4 per unitFixed cost of production = $3 per unitPrice is to be 40% higher than full costFull cost per unit = $(4 + 3) = $7Price = $7

= $9.80100

140%

AdvantagesQuick, simple, cheap methodEnsures company covers fixedcosts

DisadvantagesDoesnt recognise profit-maximising combination of priceand demandBudgeted output needs to beestablishedSuitable basis for overheadabsorption needed


Profitmaximisation

Pricestrategies


Marginal cost-plus pricingis a method of determining the sales price by adding a profit marginonto either marginal cost of production or marginal cost of sales.

AdvantagesSimple and easy methodMark-up percentage can bevariedDraws management attentionto contribution

DisadvantagesDoes not ensure thatattention paid to demandconditions, competitors pricesand profit maximisationIgnores fixed overheads somust make sure sales pricehigh enough to make profit

ExampleDirect materials = $15Direct labour = $3Variable overhead = $7Price = $40Profit = $40 $(15 + 3 + 7) = $15Profit margin = 100% = 60%$25

$15



Other pricing strategies New products

Market penetrationlow prices when product launched

Market skimmingcharge high prices when product launched

Complementary product pricing use a loss leader Product-line pricing prices reflect cost proportions or demand relationships Volume discounting reduction in price for large sales orders Relevant cost pricing for special orders determine a minimum price Price discrimination the practice of charging different prices for the same product for different groups

of buyers


Notes


6: Short-term decisions

Topic List

Relevant costsMake or buy decisionsFurther processing and shutdown

The overriding requirement of information needed tomake decisions is relevance. Decision-making questionsrequire a discussion of non-quantifiable factors as well ascalculations to support a particular option.


Relevant costs

Further processingand shutdown

Make or buydecisions

Relevant costs

is a cost which would not be incurred ifthe activity to which it related did notexist.

Avoidable costis the benefit which would have beenearned but which has been given up, bychoosing one option instead of another.

Opportunity cost

is the difference in thecost of alternatives.

Differential costis an item of expenditure which can be directlyinfluenced by a given manager within a given time span.

Controllable cost

Relevant costs are Future Incremental Cash flows


6: Short-term decisionsPage 47

Costs that are not relevant:exclude from decision analysis

Sunk costs

Costsalready incurred

Costs committed by aprevious decision

Unavoidable costs: costs thatwill be incurred whatever thedecision, such as fixed costs

Non-cash expenses:depreciation

Relevant cost of materialsIf materials not in stock Purchase price

If materials in stock andused regularly

Purchase price

If materials in stock but nolonger used

Higher of disposal value orincremental profit fromalternative use

Relevant cost of labourIf labour would otherwise beidle but paid

No incremental cost.Relevant cost = 0

If labour is in short supplyand would be diverted fromother work

Cost of labour time plus anyvariable overhead pluscontribution forgone bymoving labour from otherprofitable work




Relevant costs

A make or buy problem involves a decision by an organisation about whether it should make a product/carryout an activity with its own internal resources, or whether it should pay another organisation to make theproduct/carry out the activity.

No scarce resource

With scarce resources

Relevant costs are the differential costs between the two options

Where a company must subcontract work to make up a shortfall in its ownproduction capacity, its total costs are minimised by subcontracting work which addsthe least extra marginal cost per unit of scarce resource saved by subcontracting.


6: Short-term decisionsPage 49

Example (limited labour time)A B

Variable cost of making $16 $14Variable cost of buying $20 $19Extra variable cost of buying $4 $5Labour hours saved by buying 2 2Extra variable cost of buyingper hour saved $2 $2.50Priority for making in-house 2nd 1st

Outsourcing

Advantages

Superior quality andefficiencyCapital is freed upGreater capacity andflexibility to cope withchanges in demand

Disadvantages

Reliability of supplierLoss of control andflexibilityEffect on existingworkforce

is the use of external suppliers for finishedproducts, components or services.




Relevant costs

Further processing decisions

Any short-term decision must consider qualitative factors related to the impact onemployees, customers, competitors and suppliers

Whether or not to shut down afactory/department/product line because it ismaking a loss or too expensive to run.

Whether closure should be permanent ortemporary.

Shut down decisions

Calculate what is earned by the process atpresent (perhaps in comparison with others).Calculate what will be the financialconsequences of closing down (selling machines,redundancy costs etc).Compare the results and act accordingly.Bear in mind that some fixed costs may nolonger be incurred if the decision is to shut downand they are therefore relevant to the decision.

4

3

2

1

A joint product should be processed furtherpast the split-off point if sales revenue minusfurther processing costs exceeds its salesrevenue at the split-off point.The apportionment of joint processing costs isirrelevant to the decision.


7: Risk and uncertainty

Topic List

Risk and uncertaintyExpected valuesDecision rulesDecision treesValue of informationSensitivity analysisSimulation models

This chapter covers some of the techniques that themanagement accountant can use to take account of anyrisk or uncertainty surrounding decisions.


Sensitivityanalysis

Expectedvalues

Simulationmodels

Decisionrules

Decisiontrees

Value ofinformation

Risk anduncertainty

Riskinvolves situations or events which may or maynot occur, but whose probability of occurrence canbe calculated statistically and the frequency oftheir occurrence predicted from past records

Uncertaintyinvolves events whose outcome cannot bepredicted with statistical confidence.Market research can be used to reduceuncertainty.

Attitude to riskRisk seeker A decision maker interested in the

best outcomes no matter how smallthe chance that they may occur

Risk neutral A decision maker concerned withwhat will be the most likely outcome

Risk averse A decision maker who acts on theassumption that the worst outcomemight occur


7: Risk and uncertaintyPage 53

Expected values (EV)indicate what an outcome is likely to be in thelong-term with repetition.

ExampleIf contribution could be $10,000, $20,000 or$30,000 with respective probabilities of 0.3, 0.5and 0.2, the EV of contribution =

$ $10,000 0.3 3,000$20,000 0.5 10,000$30,000 0.2 6,000

_____

EV of contribution 19,000_____

_____

The expected value will never actually occur.

Sensitivityanalysis

Expectedvalues

Simulationmodels

Decisionrules

Decisiontrees

Value ofinformation

Risk anduncertainty

Use of EV criterion for decision-making:Choose the option with highest EV of profit orlowest EV of cost.Go ahead with 'yes' or 'no' decision if there isan EV of profit.

1

2


MaximinThe play it safe basis for decision-making.Choose the least unattractive worst outcome.

Maximax

Minimax regretThe opportunity loss basis for decision-making.Minimise the regret from making the wrongdecision.

Different people will reach different decisions onthe same problem.

Defensive and conservative

Ignores probability of each differentoutcome taking place

Ignores probabilities Over optimistic

Looks at the best possible result.

Sensitivityanalysis

Expectedvalues

Simulationmodels

Decisionrules

Decisiontrees

Value ofinformation

Risk anduncertainty



Profit tableOption

AOption

BOption

COutcome 1 5,000 3,000 2,000Outcome 2 4,000 6,000 4,000Outcome 3 6,000 8,000 10,000

Regret tableOption

AOption

BOption

COutcome 1 0 2,000 3,000Outcome 2 2,000 0 2,000Outcome 3 4,000 2,000 0

Example

Decision: Choice of option Maximin Choose Option A minimum profit = $4,000 Maximax Choose Option C maximum possible profit = $10,000 Minimax regret Choose Option B smallest regret = $2,000


Sensitivityanalysis

Expectedvalues

Simulationmodels

Decisionrules

Decisiontrees

Value ofinformation

Risk anduncertainty

Preparation

Start with a (labelled) decision point.2

Add branches for each option/alternative.3

If the outcome of an option is 100% certain,the branch for that alternative is complete.

4

If the outcome of an option is uncertain(because there are a number of possibleoutcomes), add an outcome point.

5

For each possible outcome, add a branch(with the relevant probability) to the outcomepoint.

6

Always work chronologically from left toright.

1A

XYA

XYA

B

XYA 0.7

0.3B



Evaluating the decisionWork from right to left and calculate the EV of revenue/cost/contribution/profit at each outcome point (rollbackanalysis).

ExampleAs a result of an increase in demand for a town's car parking facilities, the owners of a car park arereviewing their business operations. A decision has to be made now to select one of the following threeoptions for the next year.Option 1: Make no change. Annual profit is $100,000. There is little likelihood that this will provoke new

competition this year.Option 2: Raise prices by 50%. If this occurs there is a 75% chance that an entrepreneur will set up in

competition this year. The Board's estimate of its annual profit in this situation would be asfollows.

2A WITH a new competitor 2B WITHOUT a new competitorProbability Profit Probability Profit

0.3 $150,000 0.7 $200,0000.7 $120,000 0.3 $150,000


Sensitivityanalysis

Expectedvalues

Simulationmodels

Decisionrules

Decisiontrees

Value ofinformation

Risk anduncertainty

Option Expected profit$'000

1 1002 1433 (180 50) 130

Option 3: Expand the car park quickly, at a cost of $50,000, keeping prices the same. The profits are thenestimated to be like 2B above, except that the probabilities would be 0.6 and 0.4 respectively.

At C, expected profit = (150 0.3) + (120 0.7) = $129,000At D, expected profit = (200 0.7) + (150 0.3) = $185,000At B, expected profit = (129 0.75) + (185 0.25) = $143,000At E, expected profit = (200 0.6) + (150 0.4) = $180,000


Sensitivityanalysis

Expectedvalues

Simulationmodels

Decisionrules

Decisiontrees

Value ofinformation

Risk anduncertainty


The value of perfect informationWork out the EVs of all options and see whichis best.

See what decision would be taken with perfectinformation (if all the outcomes were known inadvance with certainty) and calculate the EV.The value of perfect information (the amountyou would be willing to pay to obtain it)= EV of the action you would take with theinformation EV without the information.

1

3

2

ExampleProfit if strong Profit/(loss) if

demand weak demandOption A $4,000 $(1,000)Option B $1,500 $600Probability 0.3 0.7

EV of A = 4,000 0.3 + (1,000) 0.7 = $500EV of B = 1,500 0.3 + 600 0.7 = $870 Choose B

With perfect information, if demand is strong choose Abut if demand is weak choose B. EV with perfect information = 0.3 4,000 + 0.7 600

= $1,620 Value of perfect information = $(1,620 870)

= $750Alternatively a decision tree can be used.


Sensitivityanalysis

Expectedvalues

Simulationmodels

Decisionrules

Decisiontrees

Value ofinformation

Risk anduncertainty

ExampleThe probabilities are as follows.P (research says success) = 0.47P (research says failure) = 0.53If the survey says successP (success) = 45/47 = 0.957P (failure) = 2/47 = 0.043If the survey says failureP (success) = 15/53 = 0.283P (failure) = 38/53 = 0.717

X Co is trying to decide whether or not to build a shoppingcentre. The probability that the centre will be successful based onpast experience is 0.6.X Co could conduct market research to help with the decision. If the centre is going to be successful there is a 75% chance

that the market research will say so. If the centre is not going to be successful there is a 95%

chance that the survey will say so.

The information can be tabulated as follows.Actual

Success Failure TotalResearch Success ** 45 2 47 * given

Failure *** 15 38 53 ** 0.75 60___ ___ ___

Total * 60 40 100 *** balancing figure___ ___ ___

___ ___ ___



Sensitivityanalysis

Expectedvalues

Simulationmodels

Decisionrules

Decisiontrees

Value ofinformation

Risk anduncertainty

Approach 1 Estimate by how much avariable would need to differ from its estimatedvalue before the decision would change.

Approach 2 Estimate whether adecision would change if a variablewas X% higher than expected.

Approach 3Estimate by how much avariable would need todiffer before a decisionmaker was indifferentbetween two options.

Sensitivity analysis is oneform of what-if? analysis

The essence of all approaches to sensitivity analysis is to carry outcalculations with one set of values for the variables and then substitute otherpossible values for the variables to see how this effects the overall outcome.

ExampleOption 2 is $10,000 more expensive than option 1 and involves taking adiscount of 10% from a supplier from whom you purchase $50,000 ofgoods (before discount) pa for 4 years. Ignore the time value of money.Discount needs to be $10,000 (difference) + $20,000 (current discount)if option 2 is as good as option 1. (4 $50,000) X% = $30,000 X = 15% (rate at which you are indifferent between the two options)


Sensitivityanalysis

Expectedvalues

Simulationmodels

Decisionrules

Decisiontrees

Value ofinformation

Risk anduncertainty

Simulation models ExampleNumbers

Daily demand Probability assignedUnits17 0.15 00-1418 0.45 15-5919 0.40 60-99

1.00Random numbers for a simulation overthree days are 761301.

RandomDay number Demand

1 76 192 13 173 01 17

can be used to deal with decision problemsinvolving a number of uncertain variables.Random numbers are used to assign values to thevariables.


8: Budgetary systems

Topic List

Planning and control cycleTraditional budgetary systemsZero based budgeting (ZBB)Other systemsBudgeting issues

There are a range of budgetary systems and types whichcan be used. The traditional approach of incrementalbudgeting is not always appropriate or useful.


Planning andcontrol cycle

Othersystems

Traditionalbudgetary systems

Budgeting issues

Zero basedbudgeting (ZBB)

Planningprocess

Controlprocess

Step 1

Step 2

Step 3

Step 4

Step 5

Step 6

Step 7

Identify objectives

Identify alternative courses of action(strategies) which might contributetowards achieving the objectives

Evaluate each strategy

Choose alternativecourses of action

Implement the long-termplan in the form of the annual budget

Measure actual resultsand compare with the plan

Respond todivergences from plan

The planning and control cycle


Othersystems


Budgeting issues


8: Budgetary systemsPage 65


These are budgets which, by recognising differentcost behaviour patterns, change as activity levelschange. At the planning stage, flexible budgets can be

drawn up to show the effect of the actualvolumes of output and sales differing frombudgeted volumes.

At the end of a period, actual results can becompared to a flexed budget (what resultsshould have been at actual output and salesvolumes) as a control procedure.

Flexible budgets

These are prepared on the basis of an estimatedvolume of production and an estimated volume ofsales. No variants of the budget are made to coverthe event that actual and budgeted activity levelsdiffer and they are not adjusted (in retrospect) toreflect actual activity levels.

Fixed budgets

This involves adding a certain percentage to lastyears budget to allow for growth and inflation. Itencourages slack and wasteful spending to creepinto budgets.

Incremental budgeting



Othersystems


Budgeting issues


ZBBThis approach treats the preparation of the budget for each period as an independent planning exercise: the initial budgetis zero and every item of expenditure has to be justified in its entirety to be included.

Three-step approach to ZBBDefine decision packages(description of a specific activityso that it can be evaluated andranked).

Evaluate and rank packages onthe basis of their benefit to theorganisation.

Allocate resources according tothe funds available and theranking of packages.

Mutually exclusive packages

Incrementalpackages

1 2 3

ZBB is more useful in saving costs in administrative areas rather than in production operations or front-lineservices.


Othersystems


Budgeting issues




Involves time and effort Can cause suspicion when introduced Costs and benefits of different alternative courses

of action can be difficult to quantity Ranking can prove problematic

Disadvantages of ZBB

Identifies and removes inefficient and/or obsoleteoperations

Provides a psychological impetus to employees toavoid wasteful expenditure

Leads to a more efficient allocation of resources

Advantages of ZBB

At its simplest, ABB involves the use of costs determined using ABC inbudgets. More formally, it involves defining the activities that underlie thefigures in each function and using the level of activity to decide howmuch resource should be allocated, how well it is being managed and toexplain variances from budget.

Activity based budgeting (ABB)



Othersystems


Budgeting issues


Continuous/rolling budgetsContinuous/rolling budgets arecontinuously updated by adding a furtheraccounting period (month or quarter) whenthe earlier accounting period has expired. Organisational changes Environmental

considerations New technology Inflation

Dynamic conditions making original budgetinappropriate

Reduce uncertainty Up-to-date budget always available Realistic budgets are better motivators

Advantages of rolling budgets

Involve more time, effort and money

Disadvantages of rolling budgets


Othersystems


Budgeting issues




Sources of budget information Difficulties of changing budgetary practices

Allowing for uncertainty

Past data Sales forecasts Production department costing information

Resistance by employees Loss of control Time consuming and expensive training Cost of implementation Lack of accounting information and systems in

place

Flexible budgeting Rolling budgets Probabilistic budgeting Sensitivity analysis


Notes


9: Quantitative analysis in budgeting

Topic List

Analysing fixed and variable costsLearning curvesExpected values and spreadsheets

This chapter looks at where the figures which go intobudgets come from. There are a number of quantitativetechniques which are used in budgeting.


Learningcurves

Expected valuesand spreadsheets

Analysing fixed andvariable costs

The high-low method may give inaccurate cost estimations as it assumes costs at the extremes ofactivity are representative.

The fixed and variable elements of semi-variablecosts can be determined by the high-low method.

Step 1. Review past records of costs

Step 2. Determine

Select period with highest activity levelSelect period with lowest activity level

Total cost at high activity level (TCH)Total cost at low activity level (TCL)Total units at high activity level (TUH)Total units at low activity level (TUL)

Step 3. Calculate variable cost per unit =

Step 4. Determine fixed costs by substituting variable cost per unit = TCH (TUH VC per unit)TULTUHTCLTCH


Learningcurves



9: Quantitative analysis in budgetingPage 73

TheoryAs cumulative output doubles, thecumulative average time per unitproduced falls to a fixed percentage of theprevious cumulative average time per unit.

Note that cumulative average time = averagetime per unit for all units produced so far,back to and including the first unit made.

Product made largely by labour effort Brand new or relatively short-lived

product Complex product made in small

quantities for special orders

When does learning curve theoryapply?

ExampleAssume a 90% learning effect applies.

CumulativeCumulative average time Total time

output per unit required Incremental time takenUnits Hours Hours Total hours Hours/unit

1 50.00 ( 1) 50.02* ( 90%) 45.00 ( 2) 90.0 40.0 ( 1) 40.04* ( 90%) 40.50 ( 4) 162.0 72.0 ( 2) 36.08* ( 90%) 36.45 ( 8) 291.6 129.6 ( 4) 32.4

* Output doubled each time


Learningcurves



Formula for the learning curveThe learning effect can be shown as a learningcurve.

The formula for learning curve (a) shown above isY = axb

where Y = cumulative average time per unitx = the cumulative number of unitsa = the time for the first unitb = the learning coefficient or index

= log of learning rate / log of 2

This formula will be provided in the exam if it is needed.

As the learning effect is a function of labour,only labour costs and other variable costsdirectly dependent on labour are affected.

Materials should not be affected unless early onin the learning process they are usedinefficiently.

Fixed overhead expenditure should beunaffected (but some problems might be causedin an organisation that uses absorption costing).

Costs affected



Learning rateWhen learning rate is r%, the cumulativeaverage time per unit is r% of what it was beforeevery time that cumulative output doubles.

Learning rate 80%Outputunits

Cumulativeaverage time per

unit (hours)Total time to

date

1 1,000 1,0002 800 1,6004 640 2,5608 512 4,096

To calculate additional time for nth unitUse the formulaCalculate cumulative average time for first (n 1) units =t1

Calculate total time for first (n 1) units = (n 1) t1Calculate cumulative average time for first n units = t2Calculate total time for first n units = n t2Calculate additional time for nth unit = (n t2) [(n 1) t1]


Learningcurves



To calculate the marginal (incremental) cost ofmaking extra units of a product.

To quote selling prices for a contract, whereprices are calculated at a cost plus apercentage mark-up for profit.

To prepare realistic production budgets andmore efficient production schedules.

To prepare realistic standard costs for costcontrol purposes.

Where learning curve theory can be used

Learning curve effect is not always present. It assumes stable conditions which allow

learning to take place. It assumes a certain degree of motivation

amongst employees. Breaks between repeating production of an

item must not be too long or workers willforget and learning will have to begin again.

It may be difficult to obtain enough accuratedata to decide what the learning factor is.

Learning will eventually cease.

Limitations of learning curve theory


Learningcurves




Expected values Spreadsheet packagescan be used in budgeting to determine the bestcombination of expected profit and risk.

are used to build business models and conductwhat if analysis.

assigns probabilities to different conditions.

Probabilistic budgeting DisadvantagesA minor error in design can affect the validityof dataVery easy to corruptCan become over-dependent on them andlose sight of original intentionCannot take account of qualitative factors

Most likely Worst possible Best possible

Expected value of profits


Notes


10: Budgeting and standard costing

Topic List

Standard costsSetting standardsFlexible budgets

This chapter revises standard costing and looks at howstandards are set.Flexible budgets are vital for planning and control.


Standardcosts

Flexiblebudgets

Settingstandards

To act as a control device (variance analysis) To value inventories and cost production To assist in setting budgets and evaluating

managerial performance To enable the principle of management by

exception to be practiced To provide a prediction of future costs for use in

decision-making situations To motivate staff and management by providing

challenging targets To provide guidance on possible ways of

improving efficiency

Uses of standard costing

It is most suited to mass productionand repetitive assembly work.

The responsibility for derivingstandards should be shared betweenmanagers able to provide the necessaryinformation about levels of expectedefficiency, prices and overhead costs.


Standardcosts

Flexiblebudgets

Settingstandards

10: Budgeting and standard costingPage 81

Ideal Perfect operating conditions Unfavourable motivational impactAttainable Allowances made for inefficiencies and wastage Incentive to work harder (realistic but challenging)Current Based on current working conditions No motivational impactBasic Unaltered over a long period of time Unfavourable impact on performance

Types of performance standard

Ideal standards can be seen as long-term targets but are not very useful forday-to-day control purposes.

Current standards are useful duringperiods when inflation is high. They canbe set on a month by month basis.


Standardscosts

Setting standards

Flexiblebudgets

Flexible budgets

Decide whether costs are fixed, variable orsemi-variable.Split semi-variable costs into their fixed andvariable components using the high-lowmethod.Flex the budget to the required activity level.

2

3

1These are budgets which, by recognising different costbehaviour patterns, change as activity levels change. At the planning stage, flexible budgets can be

drawn up to show the effect of the actual volumesof output and sales differing from budgetedvolumes.

At the end of a period, actual results can becompared to a flexed budget (what results shouldhave been at actual output and sales volumes) asa control procedure.

Many cost items in modern industry are fixed costs so the value of flexible budgets is dwindling.Principle of controllability

Managers of responsibility centres should only be held accountable for costs over which they have some influence.


11: Variance analysis

Topic List

Basic variancesOperating statementsInvestigating variancesMaterials mix and yield variancesSales mix and quantity variances

Variance analysis is a key technique in managementaccounting.You will have covered the basic variances inyour earlier studies but you need to make sure you arefamiliar with the calculations so you can answerinterpretation questions.F5 will examine the more complicated variances such asmaterials mix and yield.


Basicvariances

Materials mix andyield variances

Sales mix andquantity variances

Investigating variances

Operatingstatements

Example to be used throughout this chapterStandard cost of product A $Materials (5 kgs $10 per kg) 50Labour (4 hrs $5 per hour) 20Variable o/hds (4 hrs $2 per hour) 8Fixed o/hds (4 hrs $6 per hour) 24

___

102___

___

Actual resultsProduction 1,000 unitsSales 900 unitsMaterials 4,850 kgs, $46,075Labour 4,200 hrs, $21,210Variable o/hds $9,450Fixed o/hds $25,000Selling price $140 per unitBudgeted results

Production 1,200 unitsSales 1,000 unitsSelling price $150 per unit


11: Variance analysisPage 85

Material total variance

Material price variance

Material usage variance

Example$

1,000 units should have cost ( $50) 50,000but did cost 46,075

______

Material total variance 3,925 (F)______

______

$4,850 kgs should have cost ( $10) 48,500

but did cost 46,075______

Material price variance 2,425 (F)______

______

1,000 units should have used 5,000 kgsbut did use 4,850 kgs

______

Variance in kgs 150 kgs (F) standard cost per kg $10

______

Material usage variance $1,500 (F)______

______

The difference between what the output actually cost,and what it should have cost, in terms of material.

This can be divided into two sub-variances.

The difference between the standard cost of thematerial that should have been used and the standardcost of the material that was used.

The difference between what the material used didcost and what it should have cost.


Basicvariances




Operatingstatements

Example$


______

Labour total variance 1,210 (A)______

______

$4,200 hrs should have cost ( $5) 21,000

but did cost 21,210______

Labour rate variance 210 (A)______

______

1,000 units should have used 4,000 hrsbut did use 4,200 hrs

______

Variance in hours 200 hrs (A) standard rate per hour $5

______

Labour efficiency variance $1,000 (A)______

______

Labour total varianceThe difference between what the output actually costand what it should have cost, in terms of labour.

Again this can be divided into two sub-variances.

Labour rate variance The difference between whatthe labour used did cost andwhat it should have cost.

The difference between the standard cost of the hoursthat should have been worked and that standard cost ofthe hours that were worked. When idle time occurs, theefficiency variance is based on hours actually worked(not hours paid for) and an idle time variance (hours ofidle time standard rate per hour) is calculated.

Labour efficiency variance



Example$


_____

Variable prod o/hd total variance 1,450 (A)_____

_____

$4,200 hrs should have cost ( $2) 8,400

but did cost 9,450_____

Variable prod o/hd expd variance 1,050 (A)_____

_____

Labour efficiency variance in hrs 200 hrs (A) standard rate per hour $2

_____

Variable prod o/hd efficiencyvariance $400 (A)

_____

_____

Variable production overhead total varianceThe difference between what the output should havecost and what it did cost, in terms of variableproduction overhead.

Variable production o/hd expenditure varianceThe difference between the actual variable productionoverhead incurred and the amount that should havebeen incurred in the hours actively worked.

Variable production o/hd efficiency varianceThe difference between the standard cost of thehours that should have been worked and the standardcost of the hours that were worked.


Basicvariances




Operatingstatements

The total variance is the difference between fixed production overhead incurred and fixed productionoverhead absorbed (= under- or over-absorbed fixed production overhead).

Example $Actual prodn at std rate(1,000 $24) 24,000Budgeted prodn at std rate(1,200 $24) 28,800

______

Volume variance 4,800 (A)*______

______

*(A) because actual output lessthan budgeted output

Example $Overhead incurred 25,000Overhead absorbed(1,000 $24) 24,000

______

Under-absorbedoverhead/totalvariance 1,000 (A)*

______

______

Example $Budgeted o/hd (1,200 $24) 28,800Actual overhead 25,000

______

Expenditure variance 3,800 (F)______

______

Causes of under/over-absorption Actual expenditure budgeted

expenditure expenditure variance Actual prodn (units or hrs)

budgeted prodn volume variance

Expenditure varianceThe difference between budgetedand actual fixed productionoverhead expenditure.

Volume varianceThe difference between actualand budgeted production units standard absorption rate per unit.



ExampleBudgeted hours (1,200 4) 4,800 hrsActual hours 4,200 hrs

_____

Variance in hrs 600 hrs(A) std rate per hr $6

_____

Capacity variance $3,600 (A)______

______

ExampleLabour efficiency variance in hrs 200 hrs (A) standard rate per hr $6

______

Efficiency variance $1,200 (A)______

______

Volume efficiency varianceShows how much of the under/over-absorption is dueto efficiency of labour/plant.

Volume capacity varianceShows how much of the under/over-absorption is dueto hours worked being more or less than budgeted.

The difference between the number ofhours that production should havetaken and the number of hours worked standard absorption rate per hour.

The difference between budgetedhours of work and actual hours worked standard absorption rate per hour.

This is usually the labourefficiency variance in hoursand so is also similar to the

variable productionoverhead efficiency

variance.

In a marginalcosting system there is

no volume variance.


Basicvariances




Operatingstatements

Selling price varianceA measure of the effect on expected profit of adifferent selling price to standard.

Sales volume varianceA measure of the effect on expected profitof a different sales volume to that budgeted.

ExampleBudgeted sales volume 1,000 unitsActual sales volume 900 units

____

Variance in units 100 units(A) std profit margin per unit( $(150 102)) $48

____

Sales volume variance $4,800 (A)______

______

Example$

Revenue from 900 units should have been ( $150) 135,000

but was ( $140) 126,000______

Selling price variance 9,000 (A)______

______

The difference between the actual unitssold and the budgeted quantity, valued atthe standard profit per unit.

The difference between what the salesrevenue should have been for the actualquantity sold, and what it was.

Dont forget to valuethe sales volume

variance at standardcontribution margin ifmarginal costing is in

use.



Basicvariances




Operatingstatements

Most common presentation (marginal costing)$ $

Budgeted profit XBudgeted fixed production overhead X

___

Budgeted contribution XSales variances (price and volume) X

___

Actual sales minus std variable cost of sales XVariable cost variances X

___

Actual contribution XBudgeted fixed production overhead XExpenditure variance X

__

Actual fixed production overhead X__

Actual profit X___

___

Most common presentation (absorption costing)$ $

Budgeted profit XSales variances price X

volume X___

X___

Actual sales minus standard cost of sales XCost variances $ $

(F) (A)Material price etc XFixed o/hd volume etc X

___ ___

X X X___ ___ ___

Actual profit X___

___

Within an ABC system efficiency variances for longer-term variable overheads are the difference between the levelof activity that should have been needed and the actual activity level, valued at the standard rate per activity.


Basicvariances




Operatingstatements

Material price (F) unforeseen discounts received(A) price increase, careless purchasing

Material usage (F) material used higher quality thanstandard

(A) defective material, waste, theftLabour rate (F) use of less skilled (lower paid) workers

(A) rate increaseIdle time (always (A)) machine breakdown, illnessLabour efficiency (F) better quality materials

(A) lack of trainingOverhead expenditure (F) cost savings

(A) excessive use of servicesOverhead volume production greater or less than

budgeted

Reasons for variances

Materiality Type of standard used Controllability Variance trend Costs v benefits Interdependence (eg material price (F) and

material usage (A))

Factors affecting the significance ofvariances

Efficient/inefficient operations Measurement errors Out of date standards Random/chance fluctuations

Causes of variances



Rule of thumb methodDeciding a limit and if variance is within limit notinvestigated, if outside limit action is taken.

Statistical significance modelUse of historical data to calculate expected averageand standard deviation. Variance investigated only ifgreater distance from average than normaldistribution suggests is likely if process is in control.

Limits set randomly

Limits different for unfavourable

Fixed percentage limits hide significantabsolute losses

Unimportant/expected fluctuations highlightedunnecessarily

Costs/benefits of investigations not highlighted Past history of variances ignored

Drawbacks of method

Important costs with small variationshighlighted if variances rise significantly

Costs with normal large variations nothighlighted unless variations excessive

BUTHow do you ascertain standard deviations ofexpenditure?

Advantages of method


Basicvariances




Operatingstatements

If a product requires two or more raw materials, and the proportions of the materials are changeable andcontrollable, the materials usage variance can be split into a mix variance and a yield variance.

Materials mix varianceA measure of whether the actual mix is cheaper or more expensive that the standard and calculated as thedifference between the actual total quantity used in the standard mix and the actual quantity used in the actualmix, valued at standard costs.

Find the standard proportions of the mix Calculate the standard mix of the actual material used Find (in kgs, litres etc for each input) the difference between what should have been used (as calculated

above) and what was used Value at standard costs

The mix variance in quantity is always zero.



Materials mix varianceExample

Standard cost $Material X 2kg at $10 per kg 20Material Y 3 kg at $5 per kg 15

35

Actual usage = 280 kg of X and 320 kg of Y:total 600 kg

Actualmix

Standard mixof actual total

quantity (ratio 2:3)

Mixvariance

Standardprice

Mixvariance

kg kg kg $ per unit $X 280 240 40 (A) 10 400 (A)Y 320 360 40 (F) 5 200 (F)

600 600 0 200 (A)An adverse mix variance indicates a more expensive mix ofmaterials than standard.


Basicvariances




Operatingstatements

Materials yield variance in total Materials yield variance for individual materials

A BStd usage for actual output 260 kgs 390 kgsActual usage in std mix 240 kgs 360 kgs

___ ___

Yield variance in kgs 20 kgs(F) 30 kgs(F) std cost per kg $10 $5

____ ____

Yield variance in $ $200 (F) $150 (F)____ ____

____ ____

Arises because there is adifference between what theinputs should have been forthe output achieved and theactual inputs.

Calculated as the differencesbetween std inputs for actualoutput and std mix of actualtotal input, valued at std costs.

ExampleStd input to produce 1 unit of X:A 20 kgs $10 $200B 30 kgs $5 $150

__ ____

50 kgs $350__ ____

__ ____

In May, 13 units of X were producedfrom 250 kgs of A and 350 kgs of B.

A measure of the effect oncosts of inputs yielding more orless than expected.

Calculated as the differencebetween the expected outputfrom the actual input and theactual output, valued at thestandard cost per unit ofoutput.

(250 + 350)kgs should have yielded ( 50kgs) 12Xbut did yield 13X

__

Yield variance in units 1X (F) standard cost per unit of output $350

____

Yield variance in $ $350 (F)____

____



Basicvariances




Operatingstatements

Occurs when the proportions of thevarious products sold are different fromthose in the budget.

Shows the difference in contribution / profitbecause of a change in sales volume fromthe budgeted volume of sales.

If a company sells more than one product, it is possible to analyse the overall sales volume variance into asales mix variance and a sales quantity variance.

Sales mix variance Sales quantity variance

UnitsActual sales (standard mix) XStandard sales (standard mix) XDifference XDifference standard profit or contn $X (A)/(F)

UnitsShould mix (actual quantity, standard mix) XDid mix (actual quantity, actual mix) X Difference X Difference standard profit or contn $X (A)/(F)


Actualsales mix

Standard mix of actualtotal quantity (ratio 1:2)

Mixvariance

Standardprice

Mixvariance

units units units $ per unit $A 700 480 220 (F) 8 1,760 (A)B 740 960 220 (A) 5 1,100 (F)

1,440 1,440 0 660 (F)

Basicvariances




Operatingstatements

ExampleBudgetedsales

Units Std profitper unit

Budgetedprofit

Product $ $A 500 8 4,000B 1,000 5 5,000

1,500 9,000

Sales quantity variance

Weighted average standard profit per unit = $9,000/1,500 = $6Actual sales = 700 units of A and 740 units of B

UnitsBudgeted total sales 1,500Actual total sales (700 + 740) 1,440Sales quantity variance (units) 60 (A)Weighted avge std profit $6Sales quantity variance in $ $360 (A)


12: Planning and operational variances

Topic List

IntroductionSalesMaterialsLabour

When a standard cost is revised during a budget period,variances can be analysed into planning variances (forwhich operational managers are not responsible) andoperational variances (which are the responsibility of anoperational manager).


MaterialsSalesIntroduction Labour

Arise because of inaccurateplanning/faulty standards and sonot controllable by operationalmanagers but by seniormanagement.Calculated by comparing anoriginal standard with a revisedstandard.

Caused by adverse/favourable operational performance.Calculated by comparing actual results with a realistic,revised standard/budget.

Planning variances

Operational variances

Highlight controllable anduncontrollable variances

Increase both managersacceptance of the use ofvariances for performancemeasurement and managersmotivation

Improve planning andstandard-setting processes asstandards are more accurate,relevant and appropriate

Operational variances providea fairer reflection of actualperformance

Advantages

Difficulty in determiningrealistic standards

Danger of managersattempting to explain allvariances as planning errors

Time-consuming preparation Do not provide an overall

picture of the total variance

Disadvantages


12: Planning and operational variancesPage 101

Planning and operational variances

A revised budget can be calculated using revised standards so that only operational variances arehighlighted when actual results are compared to the revised budget.

Revised budget

Materials Labour Sales

Price Usage Rate Efficiency Revise the sales budget forchanges in market size, market

share, price, volume


MaterialsSalesIntroduction

Total planning and operational variancesExample

The standard material cost of a product is $3 (3 kgs $1). Actual material costs were$250,000 when 70,000 units were made and 200,000 kgs of material were used. With thebenefit of hindsight, management realises that a more realistic standard material cost forcurrent conditions would be $4.20 (3.5 kgs $1.20).

$Revised standard cost

(70,000 $4.20) 294,000Original standard cost

(70,000 $3) 210,000_______

Total planning variance 84,000 (A)_______

_______

$70,000 units should have cost

(using revised std of $4.20) 294,000but did cost 250,000Total operational variance 44,000 (F)

Labour


LabourMaterialsSalesIntroduction


ExampleOriginal sales budget = 5,000 units per month, based on expected market share of 20%Standard profit per unit = $8In retrospect, market size re-estimated at 35,000 units per monthSo in retrospect revised budget sales should have been 7,000 units = 20% of marketActual sales = 7,200 units

Market size variance = sales volume planning variance) Market share variance (= sales volume operationalvariance)

UnitsOriginal sales budget 5,000Revised sales budget 7,000Market size variance in units 2,000 (F)Standard profit per unit $8Market size variance in $ profit $16,000 (F)

UnitsExpected sales (revised budget) 7,000Actual sales 7,200Market share variance in units 200 (F)Standard profit per unit $8Market share variance in $ profit $1,600 (F)


LabourMaterialsSalesIntroduction

ExampleOriginal standard material cost: 3kg at $6 per kg = $18Revised standard cost: 4kg at $5 per kg = $20Actual production = 2,000 units. They used 8,300 kg, costing $40,800.

Material price planning variance$

Original standard price 6Revised standard price 5Price planning variance 1 (F)Quantity used (kg) 8,300Price planning variance $8,300 (F)

Material price operational variance$

8,300 kg should cost ( $5) 41,500They did cost 40,800Price operational variance 700 (F)



Material usage planning varianceFor 2,000 units out

2015 bpp f5 passcards

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