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For Examinations to June 2017

ACCAPaper F5 | PERFORMANCE MANAGEMENT

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ACCA

PAPER F5

PERFORMANCE MANAGEMENT

REVISION ESSENTIALS HANDBOOK


®

©2016 DeVry/Becker Educational Development Corp. All rights reserved.

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CONTENTS

©2016 DeVry/Becker Educational Development Corp. All rights reserved. (i)

CONTENTS Page Syllabus (iii) Approach to examining (iv) Formulae sheet (v) Core topics (vi) Cost accounting 0101 Developments in management accounting 0201 Relevant cost analysis 0301 Cost volume profit analysis 0401 Limiting factor decisions 0501 Pricing 0601 Risk and uncertainty 0701 Budgeting 0801 Quantitative analysis in budgeting 0901 Standard costing 1001 Basic variance analysis 1101 Advanced variance analysis 1201 Planning and operational variances 1301 Performance measurement 1401 Further aspects of performance analysis 1501

CONTENTS

©2016 DeVry/Becker Educational Development Corp. All rights reserved. (ii)

Page Divisional performance evaluation 1601 Transfer pricing 1701 Performance management information systems 1801 Additional reading 1901 Article – Approaching written questions 2001 Article – Target costing and lifecycle costing 2101 Article – Throughput accounting and the theory of constraints 2201 Article – Environmental management accounting 2301 Article – Cost volume profit analysis 2401 Article – The learning rate and learning effect 2501 Article – Materials mix and yield variances analysis 2601 Article – Performance measurement 2701 Article – Interpreting financial data 2801 Article – Performance measurement and the balanced scorecard 2901 Article – Transfer pricing 3001 Examiner’s report – September/December 2015 3101 Analysis of specimen and past examinations 3201 Examination technique 3301 CAUTION: These notes offer guidance on key issues. Reliance on these alone is insufficient to pass the examination

SYLLABUS

©2016 DeVry/Becker Educational Development Corp. All rights reserved. (iii)

SYLLABUS

Aim

To develop knowledge and skills in the application of management accounting techniques to quantitative and qualitative information for planning, decision-making, performance evaluation, and control

Main capabilities

On successful completion of this paper candidates should be able to:

A Explain and apply cost accounting techniques

B Select and appropriately apply decision-making techniques to facilitate business decisions and promote efficient and effective use of scarce business resources, appreciating the risks and uncertainty inherent in business and controlling those risks

C Identify and apply appropriate budgeting techniques and methods for planning and control and use standard costing systems to measure and control business performance and to identify remedial action

D Identify and discuss performance management information and measurement systems and assess the performance of an organisation from both a financial and non-financial viewpoint, appreciating the problems of controlling divisionalised businesses and the importance of allowing for external aspects.

Position of the paper in the overall syllabus

The syllabus for Paper F5 Performance Management builds on the knowledge gained in Paper F2 Management Accounting and prepares those candidates who choose to study Paper P5 Advanced Performance Management at the Professional level.

APPROACH TO EXAMINING

©2016 DeVry/Becker Educational Development Corp. All rights reserved. (iv)

Format of the examination

The syllabus is assessed by a three-hour and 15 minute paper-based or computed-based examinations (CBE) consisting of section A, section B and section C.

Section A will contain 15 objective test (OT) questions of 2 marks each.

Section B will contain three OT cases comprised of 5 multiple choice questions each.

Section C will consist of two 20-mark constructed response (long) questions.

The constructed response questions may come from any part of the syllabus except part A (specialist cost and management accounting techniques). The OTs in Section A and Section B questions can cover any areas of the syllabus.

Note that from September 2016 there is no distinction between 3 hours of writing time and 15 minutes reading and planning time Candidates will be permitted to start writing in their answer booklet from the start of the exam

FORMULAE SHEET

©2016 DeVry/Becker Educational Development Corp. All rights reserved. (v)

Formulae Sheet

Learning curve

Y = axb

Where:

Y = cumulative average time per unit to produce x units

a = the time taken for the first unit of output

x = the cumulative number of units produced

b = the index of learning (log LR/log 2)

LR = the learning rate as a decimal

Demand curve

P = a – bQ

b = quantity in change

price in change

a = price when Q = 0

MR = a – 2bQ

CORE TOPICS

©2016 DeVry/Becker Educational Development Corp. All rights reserved. (vi)

CORE TOPICS Tick when completed

Specialist cost and management accounting techniques

Activity based costing Target costing Life-cycle costing Throughput accounting Environmental accounting

Decision-making techniques

Relevant cost analysis Cost Volume Profit analysis Limiting factors Pricing decisions Make-or-buy and other short –term decisions Dealing with risk and uncertainty

Budgeting

Budgetary systems Behavioural aspects of budgeting Beyond budgeting

Quantitative analysis in budgeting

Tick when completed

Standard costing and variance analysis

Budgeting and standard costing

Material mix and yield variances

Sales mix and quantity variances

Planning and operational variances

Behavioural aspects of standard costing

Performance management systems

Performance management information systems

Sources of management information

Management reports

The scope of performance management

Divisional performance and transfer pricing

Performance analysis in not for profit organisations and the public sector

External considerations and behavioural aspects

COST ACCOUNTING

©2016 DeVry/Becker Educational Development Corp. All rights reserved. 0101

1 TRADITIONAL COSTING

1.1 Marginal costing

Only variable costs are included in the cost per unit:

$ per unit Direct materials x Direct labour x

__ Prime cost x Variable production overhead x

–– Marginal cost inventory valuation x

––

Contribution is revenue minus variable costs.

Contribution shows by how much profit increases if output increases by 1 unit.

1.2 Absorption costing

Fixed overheads are also included in the cost per unit:

$/unit Prime cost (direct materials + direct labour) x Variable production overhead x Fixed production overhead x –– Absorption costing inventory valuation x ––

Overheads are absorbed using a pre-determined overhead absorption rate (e.g. labour hours, machine hours, per unit basis.)

For example labour hours

Absorption rate = hourslabour Budgeted

overheads fixed Budgeted

Overhead cost per unit = labour hours for one unit of product × overhead absorption rate

COST ACCOUNTING


2 ACTIVITY BASED COSTING (ABC)

2.1 The concept

Identifies the activities for which overhead costs are incurred.

Costs are then apportioned to different products based on how much each product uses the activity.

2.2 Steps

1. Identify the major activities (e.g. machine set ups).

2. Determine the “driver” for each activity (e.g. the number of setups).

3. Calculate cost per unit of driver for each activity (e.g.

hoursman Totalcosts emaintenanc Total

).

4. Apportion costs of each activity to different products based on the number of units of driver used.

5. Calculate the cost per unit of each product = total cost (calculated in 4) ÷ number of units produced.

2.3 Advantages and disadvantages of ABC

Advantages

Better decision making (by providing more accurate information of products profitability).

Cost can be designed out of products by eliminating unnecessary activities.

When cost plus methods of pricing are used, prices based on ABC are likely to reflect more accurately the true cost of producing a product.

Disadvantages

Selection of cost drivers may not be easy.

Additional time and cost of setting up and administering the system.

Exclusion of non-production overheads can be difficult.

Many judgemental decisions still required in the construction of an ABC system.

DEVELOPMENTS IN MANAGEMENT ACCOUNTING


1 TARGET COSTING

1.1 Aim and use

In a competitive market, a business has to sell at the market price, irrespective of the cost of production.

Target costing aims to reduce the production cost per unit so that an acceptable profit margin can be made given that the selling price cannot be increased.

$ Selling price X Less: required margin (X) ––– Target cost X Actual (Budgeted cost) X –––

1.2 Steps in target costing

1. Determine the selling price using market research.

2. Deduct the required profit margin and deduct from the price to obtain the target cost.

3. Compare actual (or budgeted) cost per unit with the target cost to ascertain the cost gap.

4. Identify ways to narrow the gap.

Target costing is more effective if used during the design of a new product, as costs can be “designed out”. For existing products, costs will have to be “controlled out” which is normally more difficult.

1.3 Application to service industries

Target costing is less useful in service industries because:

Services are more likely to be customised so standard services may not exist;

Higher portion of costs are indirect and it may be harder to reduce these;

Reducing costs may have a bigger impact on quality of service.

1.4 Methods to narrow the gap

Eliminate features of the product not valued by customers.

Standardise components & design with lower number of components.

Employ lower grade staff with training.

Outsource parts of manufacture.

COST GAP



2 LIFECYCLE COSTING

2.1 Product lifecycle

Development Introduction Growth Maturity Decline

Lifecycle costing

Involves budgeting and monitoring the costs, revenues and cash flows generated by a product over its whole life rather than on a period-by-period basis.

Lifecycle cost per unit = all costs incurred over the life of the product ÷ the number of units produced.

2.2 Costs involved

Committed costs – decisions made in the development stage will determine a high portion of the overall costs that will be incurred over the life of the product.

Actual costs typically incurred during the product lifecycle are:

Stage Fixed costs Variable costs

Planning and design

Design Prototypes Market research

Production and sales

Advertising Production Sales Design updates

Materials Direct labour Variable overheads Sales commissions

Service and abandonment

Decommission factories

Servicing

2.3 Benefits of life cycle costing

Management will plan the pricing strategy of a product over its whole life rather than on a short-term basis.

Decision-making will be based on more relevant information as management has a full picture of the product over its life rather than the current period only.



3 THROUGHPUT ACCOUNTING

3.1 Theory of constraints

Applies to production lines where products pass through a sequence of processes:

Bottlenecks are processes that work slower than all

others. They limit output of the whole production line.

To maximise profit

Identify the bottlenecks.

Rank products in order of throughput contribution per hour of bottleneck (i.e. return per factory hour).

Slow down non-bottleneck resources to work at the speed of the bottlenecks to avoid build-up of work in progress.

Find ways to eliminate the bottleneck (e.g. working overtime or reducing time spent on the bottleneck).

3.2 Throughput contribution

Materials are the only truly variable cost in the short run.

Throughput contribution = sales revenue – cost of materials.

Use throughput contribution for decision making not traditional contribution.

3.3 Throughput Accounting Ratio (TPAR)

TPAR = hourfactory per Cost hourfactory per Return

Return per factory hour =

unitper used resource bottleneck of Hoursunitpet Throughput

Cost per factory hour = available hours resource Bottleneck

costsfactory Other

Meaning of TPAR

TPAR > 1 product profitable TPAR = 1 break even TPAR < 1 product makes a loss

How to improve TPAR

Eliminate bottlenecks or reduce time spent on bottleneck resources.

Reduce other factory costs.

Process 1

Process 2

Process 3



4 ENVIRONMENTAL MANAGEMENT ACCOUNTING (EMA)

4.1 Definition

EMA aims to provide internal information to management in the form of physical information on the use of energy, water and materials (including waste), and monetary information on environment related costs and savings.

4.2 Relevance for business

Bennett and James suggested six benefits of EMA:

(1) Capex decisions can take account of environmental impact of investments.

(2) Better understanding of environmental costs normally hidden within other overheads.

(3) Reducing waste and saving energy.

(4) Understanding environmental effects on life cycle costs (e.g. costs of recycling at end of product life).

(5) Stakeholders are interested in environmental performance measures.

(6) Involving management accountants in longer term strategic decision making for environment-related issues.

4.3 Environmental costs

Broad definitions (e.g. as proposed by the US Environmental Protection Agency) are:

Conventional costs – buying inputs with environmental relevance (e.g. energy);

Potentially hidden costs – items with environmental relevance hidden in overheads;

Contingent costs – such as cleaning up damage; Image and relationship costs.

Hansen and Mendova’s more narrow definition:

Environmental prevention costs – such as redesigning production processes to reduce pollution;

Environmental detection costs;

Environmental internal failure costs – cost of cleaning up pollution before it is released into the environment.

Environmental external failure costs – cost of cleaning up pollution after release into the environment.



4.4 EMA techniques

Use of environmental reports showing the costs such as those proposed by Hansen and Mendova.

ABC extended to include environmental activities and their appropriate drivers.

Input/output (mass balance) analysis – reconciles quantities input with quantities of output (in kg, litres etc.). This highlights waste.

Flow cost accounting – a more sophisticated input/output analysis that produces physical and monetary information about inputs and outputs of each process.

Life cycle costing – includes environmental costs such as packaging costs in a products life cycle.

RELEVANT COST ANALYSIS


1 RELEVANT COSTS

1.1 Meaning

Only costs (and revenues) affected by a decision are “relevant”:

Relevant Non-relevant

Future, incremental, cash flows.

Historic costs, sunk costs apportioned fixed costs non-cash items (depreciation, profit/loss on sale).

Avoidable costs. Committed costs.

Controllable. Common costs “management charges”.

2 OPPORTUNITY COST

2.1 Key point

All opportunity costs are “relevant”.

Not all relevant costs are opportunity costs.

2.2 Definition

“The value of the benefit sacrificed . . . in favour of an alternative.” “The potential benefit foregone (from the best rejected course of action).”

Clearly arise in use of scarce resources.

2.3 Potential difficulties

Estimating future costs/revenues (benefit sacrificed).

Identifying alternative uses (and best alternative forgone).

Ignores effect on accounting profit.

Ignores any risk associated with each alternative.

3 ONE OFF CONTRACTS

3.1 Minimum price

Minimum price of a contract is the relevant cost.

At this price no profit or loss will be made.



3.2 Materials

Replacement cost = current purchase cost.

3.3 Relevant costs of labour

If work can be done in idle time, relevant cost is zero.

If labour is fully employed relevant cost is the additional payments required:

to hire additional labour; overtime payments.

If labour is fully employed and no further labour is available:

direct cost of labour (wages); plus lost contribution from other production.

This is equivalent to revenue foregone less costs (other than labour) saved.

3.4 Non-current assets

If asset is rented rental costs over the period of use is relevant.

If asset is acquired specially, relevant cost is cost of acquisition less expected sale proceeds at the end of the contract.

In warehouse?

Replacement cost

Used regularly?

Opportunity cost (e.g. scrap value)

No

No

Yes

Yes



Deprival value

The value of an existing asset if a business were to be deprived of it is:

RC = Replacement cost NRV = Net realisable value EV = Economic value (i.e. PV of expected future earnings)

Lower of (2)

RC and Higher of (1)

NRV EV

(1) Asset should be in use ( EV) or sold ( NRV)

whichever is higher.

(2) Asset should be replaced only if replacement cost is lower than (1).

3.5 Non-financial factors

The contract may develop the business’s experience.

A contract may be undertaken for price less than relevant cost if it provides experience or improves business reputation ( further business in the future).

A contract may be declined if it would harm the business’s reputation.

4 SHUT DOWN DECISIONS

Financial point of view

A loss-making division should only be closed if costs saved exceed the revenue lost by closing the division.

Fixed costs that would still be incurred if the division were to be closed are not relevant.

Non-financial factors

A decision to close a division should consider, for example:

Poor morale as a result of redundancies; Loss of skills; Effect on demand for other products.



5 FURTHER PROCESSING DECISIONS

A product that can be sold in its existing form may be further processed and sold for a higher price.

If additional revenue gained by further processing exceeds additional costs, the product should be processed further.

6 MAKE OR BUY

Outsourcing

Means buying goods or services externally rather than performing the in-house.

Is commonly used for services such as office cleaning, accounting and payroll.

Is also used in production where part or all of the production of a product is outsourced – often to a partner in a country that enjoys lower labour costs.

Advantages of outsourcing

Lower costs. Fixed costs may become variable. Management can focus on core competencies. Access to a greater range of experts. Better quality of service or product.

Disadvantage of outsourcing

Loss of control.

Security of confidential data.

Risk of financial failure of partner.

Negative image if staff in-house are made redundant.

Make v buy – financial considerations

Make products where cost of manufacture < cost of outsourcing.

Cost of manufacture should include all additional costs that would be incurred if the product is made in-house. This may include some fixed costs.

COST VOLUME PROFIT ANALYSIS


1 BREAKEVEN ANALYSIS

1.1 Breakeven point

The level of activity at which neither a profit nor a loss is made.

1.2 Simplifying assumptions

Variable cost per unit remains constant.

Selling price per unit remains fixed.

No significant change in inventory levels.

Only a single product or constant sales mix if more than one product is made.

2 CHARTS

2.1 Breakeven chart

Total revenue

Total cost

$

Profit at volume Y

Loss at volume X

Volume (units) Break even point

Y X



2.2 Profit Volume Chart (PV Chart)

3 MATHEMATICAL APPROACH

3.1 Contribution

In any decision connected with varying levels of production, fixed costs are not relevant.

Unit contribution = Selling price – variable cost per unit.

Unit contribution shows additional profit from selling an additional unit.

3.2 Breakeven formulae

Break-even point (units) oncontributiUnit oncontributi Total

Target profits

Sales units to achieve a target profit

= oncontributiUnit

profit requiredcost Fixed

3.3 C/S ratio (Contribution margin)

Shows portion of selling price which contributes to profits and fixed costs

= unitper price Sellingunitper onContributi

Break even revenue ratio C/Scost Fixed

3.4 Margin of safety

The amount by which anticipated or existing activity exceeds break-even:

In units = Budgeted sales – Breakeven sales

As a percentage = %100sales Budgeted

sales Breakeven-sales Budgeted

BEP

$ Profit

Volume

Profit at volume Y

Loss at volume X

Y X 0



4 MULTI-PRODUCT ANALYSIS

4.1 Assumption

Sales mix is constant (otherwise an infinite number of break-even points exist).

4.2 Calculation of breakeven revenue

Breakeven revenue = ratio C/S average Weighted

cost Fixed

Where:

Weighted average C/S ratio = revenue Total

oncontributi Total

4.3 Multi- Product P/V Charts

Horizontal axis (X axis) shows revenue, while vertical axis (Y axis) shows profit.

Two approaches (assumptions):

(1) sales made in constant mix at all volumes; or (2) products are ranked according to the C/S ratio.

Assuming constant mix

A straight line is drawn between two points.

First point is where revenue is zero, the loss will be equal to the fixed cost.

Second point is budgeted profit at budgeted revenue.

Assume sales by profitability

Use a table to calculate revenue and profits at each of the following points:

Revenue = 0;

Sales of product with highest C/S ratio only at maximum demand for that product;

Sales of products with first and second highest C/S ratios at maximum demand for these products;

Etc.



Plot the points on a graph (gives a “bow-shaped” line):

Revenue $000

Profit $000

Fixed costs

0

LIMITING FACTOR DECISIONS


1 LIMITING FACTOR DECISIONS

1.1 Key factor analysis

Where output is limited by shortage of one or more inputs, profit is maximised by maximising contribution.

1.2 One limited factor

Steps in deciding which product(s) to manufacture, when only one input is limited:

1. Calculate contribution per unit generated by each product.

2. Identify the number of units (kg/litres) of the limited factor used by each product.

3. (1) ÷ (2) contribution per unit of limited factor generated by each product.

4. Produce the product(s) that generate the highest contribution per unit of limited factor.

1.3 Shadow price

The additional contribution that would be generated if one additional unit of a limited resource is made available.

Represents the highest premium over the standard price that should be paid for additional units of the resource.

2 MAKE OR BUY DECISION

In situations where production of some products will be outsourced due to shortage of a scarce resource. Fixed costs remain unaffected.

Making in-house is cheaper. Saving per unit of scarce resources are calculated as:

unitper used resource scarce of units ofNumber make cost to Variable price in-Buy

Rank products in order of highest saving per unit of scarce resource.

Determine how many units of each product line will be made in-house and how many bought in to maximise savings of making in-house.

3 MULTI-LIMITING FACTORS

3.1 Linear programming

Where more than one input is limited, linear programming is used to determine the mix of output that maximises contribution.

At F5, iso-contribution (“graphical”) method must be used to solve linear programming unless equation method is specifically asked for. Other methods (e.g. simplex are outside of the syllabus).



3.2 Drawing the graph

1. Define the variables (x, y). 2. Formulate the objective function (e.g. contribution). 3. Express constraints in terms of inequalities. 4. Plot all constraints on graph and identify the feasible

region.

The optimal solution can be found using either:

objective function (iso-contribution) method; or simultaneous equation method.

3.3 Example – problem formulation

A company makes two products, tables and chairs. Each table generates contribution of $20, and each chair generates contribution of $5. Skilled labour is in short supply, and only 180 labour hours are available each week. Each table requires 2 hours of labour, and each chair requires 3 hours. Wood is limited to 40m2 (square metres) per week. Each table requires 0.5m2, and each chair requires 0.75m2.

Steps in setting up the linear program

1. Define the variables: Let x = output of tables and y = output of chairs.

2. Define the objective function: Contribution C = 20x + 5y

3. Express the constraints:

Labour: 2x + 3y 180 Wood: 0.5x + 0.75y 40 Non-negativity: x 0, y 0.

3.4 Objective function (iso contribution) method

A sample contribution line is plotted in the feasible region (e.g. C = 1,000 shows all combinations of x and y that provide contribution of 1,000).

Identify the point furthest from the origin, where a line parallel to the sample line is still in the feasible region (e.g. using a ruler). This is where contribution is maximised.

If necessary (e.g. at an intersection of constraints) find x and y at the optimal point using equations – never read from a graph.

This method must be used to unless the simultaneous equation method is asked for.



3.5 Simultaneous equation method

1. Determine the values of x and y at each “corner” point of the feasible region (e.g. A, B, C and D):

2. Calculate contribution at each point by substituting the

values of x and y in the contribution function.

Solve for x and y at B and C using simultaneous equations – never read from the graph.

3. Select the point with the highest contribution.

4 FURTHER CONSIDERATIONS

4.1 Shadow price

To calculate in a linear programming situation:

1. Restate the constraint for the scarce resource, increasing the amount available by 1 unit.

2. Recalculate the solution to the linear programme.

3. Calculate contribution for the recalculated solution.

4. Shadow price is the recalculated contribution less the original contribution obtained.

4.2 Slack

The difference between the amount of a scarce resource available and the amount used at the optimal level of output.

Slack is zero if a constraint is “binding” (i.e. if the optimal point lies on the constraint).

Knowing the amount of slack is useful for planning:

If small, the resource may become binding if production increases, so managers should identify additional sources.

PRICING


1 COST BASED PRICING APPROACHES

1.1 Full cost plus pricing

Add a mark-up to total absorption cost (full cost).

Advantages

If budgeted sales level is achieved profit will be made. Useful for justifying price rises. Information available from the costing system.

Disadvantages

Ignores price demand relationship.

Size of mark-up is arbitrary.

Method of absorbing fixed overheads will have an effect on the cost and therefore the price.

1.2 Marginal cost pricing

Add a mark-up to marginal cost (production and non-production).

Advantage

Useful for short-term decision making. If price covers variable costs, profit will be increased.

Information available from the costing system.

Disadvantage

Price may not cover fixed overheads ⇒ unsuitable for long-term pricing decisions.

Ignores price demand relationship

Size of mark-up is arbitrary

1.3 Return on investment pricing

Prices set to achieve a target percentage return on the capital invested in production:

units sales Budgeted

employed capital%target cost full Budgeted

Advantages

Considers capital invested and short-term costs. Target ROI can be adjusted to take account of risk.

Disadvantage

Ignores price demand relationship.

1.4 Opportunity cost (relevant cost pricing)

Used for pricing one off projects and special orders Price = relevant cost + mark up

PRICING


2 ECONOMIST’S MODEL

2.1 Demand curve

P = a – bQ Exam formula

Where

P = price

Q = quantity demanded

a = price when Q = 0

b = quantity in change

price in change

2.2 Marginal revenue

The increase in total revenue from selling one more unit of a product or service.

MR = a– 2bQ Exam formula

To maximise revenue: MR = 0, solve Q and place Q in the demand curve equation to find corresponding price.

2.3 Marginal cost

The increase in total cost from producing and selling one additional unit of a product.

Assume marginal cost = variable cost. (But take account of any discounts.)

2.4 Maximising profits

To maximise profits identify Q such that MR = MC. Sell this level of output.

Put the value of Q into the demand curve to find the price that should be charged.

2.5 Tabular approach

If demand Q and costs have been given for various prices, a tabular approach may be used to calculate the profit maximising price.

The table should show total revenue, total costs and total profit for each price. The price that generates the highest profit would be set.

PRICING


3 OTHER PRICING STRATEGIES

3.1 Market skimming

Set initially high price and sell to elite segment of market to make large profit margins.

Later lower prices to attract a larger share of the market.

Products usually confer some status or “snob” value on the initial buyers.

Used to launch new product where competitors do not have similar products in the market.

Also appropriate where high product development costs need to be recovered before competitors enter the market.

3.2 Market penetration policy

Set low price when product is launched to attract customers away from competitors’ products.

Later increase prices when loyal customer base has been achieved.

Used to launch new products into markets where competitors already sell similar products or for commodity-type products.

Effective if market is price sensitive.

3.3 Complementary product pricing

Where products are used together. Set a discounted price for one product with the aim of increasing sales of the second product (e.g. a low price for printers and a high price for printer cartridges).

3.4 Price discrimination

Setting different prices for the same product in different markets, to maximise profit in each market.

To succeed there must be barriers to prevent buying in the lower price market to sell in the higher price one.

3.5 Loss leaders

Selling one product at a loss to attract customers who will then buy other products which make profits.

3.6 Going rate pricing

Charging the market rate. May be used for products in the maturity phase.

PRICING


3.7 Product line pricing

The prices of related products are set together.

Two popular approaches are:

1. Product bundling: selling a group of products for less than the sum of the individual product prices.

2. Setting the price of the basic model and basing price of more sophisticated models on pre-determined differentials.

3.8 Volume discounting

Selling at a lower price if customers buy more than a specified number of units.

4 FACTORS INFLUENCING PRICE

4.1 Level of demand

Higher demand leads to higher prices. Demand influenced by:

Income Price of substitutes Price of complementary goods Consumer tastes and fashion Advertising

4.2 Price elasticity of demand

Price elasticity at demand calculated as:

1P1P2P

1Q1Q2Q

Where: P1 is current price Q1 is current demand (units) P2 is new price Q1 is new demand level

Interpretation

If PED > 1, demand is elastic. Small change in price brings greater change in demand. Increasing price leads to fall in revenue.

If PED <1 demand is inelastic. Increasing price leads to increase in revenue.

PRICING


4.3 Product life cycle

Introduction – price skimming or penetration pricing.

Growth – price reduced if skimming was used, or increased if penetration pricing was used.

Maturity – profit maximising price.

Decline – lower prices to sell off inventories.

4.4 Competitors

May have to take market price in competitive market.

4.5 Customers

Large customers may demand lower prices.

4.6 Perfect competition

Many sellers Many buyers Homogenous products No barriers to entry Perfect information Sellers will have to accept market price.

RISK AND UNCERTAINTY


1 EXPECTED VALUE

1.1 The concept

Expected value of an opportunity = the sum of all possible outcomes × their associated probability:

EV = xip(xi)

Example

Contribution could be $5,000, $30,000 or $50,000 with respective probabilities of 0.2, 0.5 and 0.3: $

$5,000 0.2 1,000 $30,000 0.5 15,000 $50,000 0.3 15,000

–––––– EV of contribution 31,000

–––––– Advantage

Reduces information to one choice.

Disadvantage

Ignores risk. Unsuitable for one off decisions. Difficulty of estimating probabilities of different

outcomes.

1.2 Value of perfect information

Value of perfect information = EV with perfect information – EV without perfect information.

Example

A decision maker has to choose between 3 courses of action on a daily basis – A, B and C. When making the decision, the decision maker does not know what the state of the market will be – it could be 1, 2 or 3. Possible outcomes are:

Action A B C 1 10 (25) 200 State of 2 200 300 (500) market 3 20 30 40 Probability of each state of the market is:

1 0.3 State of 2 0.5 market 3 0.2



EV without perfect information

EV of each action:

A: (10 × 0.3) + (200 × 0.5) + (20 × 0.2) = $107 B: ((25) × 0.3) + (300 × 0.5) + (30 × 0.2) = $148.5 C: (200 × 0.3) + ((500) × 0.5) + (40 × 0.2) = ($182).

Without perfect information the decision maker would select action B and the EV would be $148.50.

EV with perfect information

If the decision maker could commission a report to accurately predict the state of the market on each particular day, the decisions should be:

Action chosen Outcome Probability 1 C 200 0.3 State of 2 B 300 0.5 market 3 C 40 0.2 EV with perfect information: (200 × 0.3) + (300 × 0.5) + (40 × 0.2) = $218

EV of perfect information is: $218 – $148.05 = $69.50

1.3 Value if imperfect information

Value of imperfect information = EV with imperfect information – EV without information.

Best calculated using decision trees (see below).

1.4 Decision trees

Used to show the EV of each path, to identify which path has the highest EV.

Decision fork (or point)

A point at which a decision maker has to decide between two or more decisions.

Unsuitable for one off decisions.

Chance fork (or outcome point)

Where there are several possible outcomes – normally two or more for each decision.

Probabilityp

Probabilityq

Outcome B

Outcome A



2 RISK ATTITUDE AND DECISION RULES

2.1 Types of risk preference

Risk seekers – take high risks if high returns are possible (e.g. gamblers).

Risk neutral – ignore risk and select option with highest EV.

Risk averse – avoid taking on risk.

2.2 Decision rules Action A B C 1 10 (25) 200 State of 2 200 300 (500) market 3 20 30 40

Maximax rule – the course of action that gives the highest potential outcome is chosen (i.e. B).

Maximin rule – the action with the highest minimum outcome is chosen (i.e. A).

Minimax regret rule – select option with lowest maximum regret.

Table of regrets A B C State of 1 190 225 Nil market 2 100 Nil 800 3 20 10 Nil

E.g. regret of A under state of market 1 is not choosing C (i.e. 200 – 10 = 190). Maximum regret associated with each decision is: A: 190 B: 225 C: 800

A minimax regret decision maker would therefore choose decision A.



3 SENSITIVITY ANALYSIS AND SIMULATION

3.1 Sensitivity analysis

Shows how responsive a decision is to changes in the variables.

Calculate by how much each variable (individually) can change in percent terms before a decision would change (e.g. when a forecast profit becomes a forecast loss).

3.2 Simulation

Use of mathematical or computer models to simulate complex situations involving the interaction of many variables whose outcome is uncertain.

Stages in Monte Carlo simulation

Specify the variables.

Specify the relationship between the variables.

Attach probability distributions to each variable.

Simulate the environment by generating random outcomes for each variable.

Repeat the simulation many times to obtain a probability distribution for the likely outcomes.

4 REDUCING UNCERTAINTY

4.1 Focus groups

A meeting in which a pre-selected group is shown a proposed new product or service and asked to discuss it.

4.2 Market research

The systematic gathering of information to find out:

Who are the customers? Where are they located? What quantity and quality do they want? What is the best time to sell? What is the long-term price? Who are the competitors?

Primary data is original data collected especially for an organisation.

Secondary data is data that is public.

BUDGETING


1 BUDGETARY CONTROL SYSTEM

1.1 Typical budgetary control cycle

Budget prepared for a period.

Compare actual results against the budget.

Take action to ensure adverse variances do not recur in future period.

1.2 Objectives of a system of budgeting

C – Coordination R – Responsibility U – Utilisation M – Motivation P – Planning E – Evaluation T – Telling

2 THE PERFORMANCE HIERARCHY

2.1 Long-term planning

First step in long-term planning involves setting the objectives of the organisation.

Typical hierarchy of objectives

MISSION

CORPORATE OBJECTIVES

UNIT OBJECTIVES

Mission – reason for the existence of the organisation.

Corporate objectives – what the organisation must do to achieve the mission. They are usually quantifiable.

Unit objectives – for a particular business unit.

2.2 Role of budgeting in long-term planning

Budget covers an accounting period (typically one year).

Sets out how current period will contribute to the long-term plan.

BUDGETING


3 DIFFERENT TYPES OF BUDGETARY SYSTEMS

3.1 Top down v bottom up budgeting

Bottom up (participative) budgeting – managers participate in budget preparation for their department.

Top down – budgets are prepared by senior management and imposed on departmental managers.

In reality decision is not between top down and bottom up but how much participation managers have.

Advantages of participation

Managers are more motivated to “own” the budget.

Managers have better knowledge of situation “at the coal face”.

Advantages of top down

Non-financial managers may not have the financial knowledge to prepare budgets.

Preparing budgets centrally may minimise problems (e.g. budget slack).

3.2 Rolling budgets

Budget horizon is kept constant by adding another month (or quarter) to the end of the budgeted period as each month (or quarter) expires.

Advantage

Budget is always updated to reflect external changes. It remains relevant.

Disadvantages

Time consuming. Budgets may be updated to hide inefficiencies.

Appropriateness

In changing environments where changes mean that budget assumptions become out of date very quickly.

3.3 Incremental budgeting

Current year’s actual or budgeted figures are the starting point in preparing the next year’s budget.

Adjustments are made for planned changes and inflation.

Advantages

The easiest and quickest method of budgeting. Coordination between departments is easier.

Disadvantages

Does not encourage managers to challenge whether budgeted spending is necessary.

Encourages “spend it or lose it” mentality.

BUDGETING


3.4 Zero based budgeting

Features

Managers identify the activities they wish to perform (e.g. making particular products, training).

Managers produce a decision package for each activity, showing costs and revenues (and qualitative factors).

Budget committee reviews decision packages and selects those to be accepted. These form the budget.

Advantages

Resources allocated to activities that best meet the organisation’s objectives.

Forces managers to question all items of budgeted expenditure.

Disadvantage

Time consuming.

Appropriateness

Useful in organisations where a high portion of costs are discretionary.

Useful in public sector bodies for allocating scarce resources.

3.5 Activity based budgeting

Budgets are based on activity-based principles.

1. Estimate the budgeted output.

2. Identify the number of units of driver required for each activity to produce the output.

3. Ascertain if the organisation has the appropriate resources to perform the activities identified. If not, cut down activity or invest in additional resources.

4 UNCERTAINTY IN THE ENVIRONMENT

4.1 Flexible budgets

Several budgets are prepared using the same budget assumptions, but based on different activity levels (sales/production units).

At the end of the year, the budget with the activity level closest to the actual is used for comparison.

4.2 Flexed budgets

Prior to comparing the budget with actual, recalculate the budget using actual activity levels.

Comparison of budgeted and actual is more valid as both are based on same level of activity.

BUDGETING


5 BEHAVIOURAL ASPECTS OF BUDGETING

5.1 Factors

Managers’ evaluations may be affected by whether they achieve their budgets.

Budget should motivate managers to perform better.

5.2 Hopwood’s management styles

Budget constrained organisations – budgets are taken very seriously and managers are expected to achieve them. This leads to a lack of trust between managers and superiors. Managers will not take risks.

Profit conscious style – budgets are used but applied more flexibly. Managers are also judged on how they contribute to the longer term aims of the organisation.

Non-accounting style – financial performance is not seen as very important.

5.3 Level of difficulty

If budget is too easy individuals will not be motivated to improve performance.

If budgets are too difficult, managers will be demotivated.

Research suggests that targets that are just out of reach are optimal for motivation.

5.4 Standards

Ideal standards – assume 100% efficiency. Likely to demotivate.

Basic standards – based on historic averages. Likely to be too easy.

Expected standards – take into account an expected level of inefficiency (normal loss).

Current standards – adjust the expected standard to reflect current operating conditions.

6 BEYOND BUDGETING

6.1 Weaknesses of traditional budgeting

Budgeting takes up too much managers’ time.

Budgets are out of “kilter” with modern business. Managers must react quickly to changes in the external environment, while budgets are prepared many months before the period to which they relate.

Primary drivers of value today are intellectual capital (e.g. brands), which are often outside the scope of financial budgeting systems.

Managers’ “gaming” activities means the budget process loses its validity.

BUDGETING


Gaming examples

Negotiating the lowest targets and highest rewards. Always hitting the target whatever it takes (implies

manipulation of data). Not putting the customer before the sales target. Never sharing knowledge or resources with other teams. Always meeting the numbers; never beating them. Always spending the budget (or otherwise lose it).

6.2 The “Beyond Budgeting” Model

1. Targets are based on key performance indicators (KPIs) rather than purely profit or cost based.

2. Uses stretch goals for planning that are not linked to management reward schemes.

3. Uses rolling budgets to keep budgets up to date.

4. Uses relative measures (e.g. benchmarks) for evaluation of managers rather than fixed measures, so managers are not punished for factors beyond their control.

5. Devolves responsibility for planning away from the centre to the front line.

6. Allocates resources based on whether projects meet pre-determined criteria (e.g. NPV) rather than whether they are in the budget.

6.3 Advantages and disadvantages

Divisional managers will be motivated.

Managers work together instead of competing for resources.

Quicker response to changes in customer needs.

Performance focussed on objectives of organisation, not financial numbers.

Organisational culture may not support this. Not appropriate for organisations in which financial

control is crucial to success.

QUANTITATIVE ANALYSIS FOR BUDGETING


1 FORECASTING METHODS

1.1 Simple average growth models

Future growth (e.g. of sales) may be forecast based on the average (mean) of past growth rates:

Simple mean (%) =

n1year Sales

1year Sales -n year Sales

× 100

Geometric mean (%) =

1

1year Salesnyear Sales

n × 100

Example

Sammy is trying to forecast the expected growth in sales of its new smart phone. Historic data for sales during the last three years is:

20X1: 1,000 units 20X3: 1,600 units.

Historic annual growth in sales per year:

Simple mean =

000,1

000,1600,121 ×100 = 30%

Geometric mean (%) =

1

000,1600,1

2 × 100 = 26.5%

The geometric mean is more accurate, but the simple mean can normally be used as an approximation.

1.2 High-low method

Estimates fixed and variable costs based on historic amounts:

Variable cost per unit = Total costs at high - total costs at lowOutput at high - output at low (units)

Fixed costs = Total costs at high – total variable costs at high



Example

Total overhead costs for the last four months were:

Month Output Total cost (units) $ 1 3,000 3,500 2 2,400 3,000 3 3,600 4,350 4 4,000 4,800

High = 4,000 units (month 4) and low = 2,400 units (month 2)

Variable cost per unit = 4,8003,0004, 000 2, 400

= $1.125

Fixed costs = 4,800 – (4,000 × 1.125) = $300.

Therefore monthly fixed costs are $300 and variable overheads per unit are $1.125.

2 LEARNING CURVE THEORY

2.1 The learning effect

The cumulative average time per unit decreases by a constant % every time total output doubles.

2.2 Tabulation

The time taken to make the first unit of a product is 100 minutes. A 95% learning rate applies:

Cumulative Cumulative Cumulative Output average time total time 1 100 95 2 95 190 4 90.25 361 8 85.74 686 2.3 Learning curve formula

y = ax Exam formula

Where

y = cumulative average time per unit to produce x units a = time taken for the first unit of output x = cumulative number of units produced b = the index of learning (log LR/log 2)

The value of b will be provided.



Technique

If asked for time of nth unit (incremental time):

Calculate total time for first n units = cumulative average time for n units × n

Calculate total time for first (n – 1) units = cumulative average time for first (n – 1) units × (n – 1).

The difference is the time taken for the nth unit.

2.4 Conditions for a learning curve to apply

Activity is labour intensive. Repetitive tasks. Low labour turnover. No prolonged breaks in production.

2.5 Applications of theory

Setting standards Budgeting Pricing Planning labour requirements

2.6 Reservations

Difficult to estimate learning rate for new products.

Cannot be used if there is a break in production.

Unions may impose go slow agreements (i.e. learning curve does not apply).

2.7 Steady state

A point where no further learning takes place. Incremental cost of additional units becomes constant.

2.8 Calculating learning rate

Typically you will be given the total cumulative time taken for several levels of output and asked to calculate the learning rate. Adopt the following approach:

Calculate the cumulative average time per unit for two output levels a and b, where cumulative output at b is double cumulative output at a.

Learning rate =

aat unit per timeaverage cumulative bat unit per timeaverage Cumulative × 100



3 USE OF COMPUTER SPREADSHEETS

3.1 Benefits of using spreadsheets in budgeting

Totals are calculated automatically and updated if any details change (e.g. total costs).

Budgets can easily be flexed.

Master budgets can be linked to subsidiary budgets so changes in subsidiary will automatically be reflected in the master budget.

3.2 Dangers of using spreadsheets in budgeting

Errors in formulae.

Unauthorised changes to spreadsheets.

Lack of training.

STANDARD COSTING


1 USE OF STANDARD COSTS

1.1 By management

A standard is a benchmark showing the expected level of performance.

Standard cost – the expected cost of producing a single unit of a product or service. Made up of:

Standard quantity of inputs per unit; Standard price per unit of input.

Variance shows the difference between the standard and actual performance.

Standard costs and variance analysis are used to measure and increase the economy, efficiency and effectiveness of the production process.

1.2 Variance investigation

Objective is to improve operations.

Next period’s operations →

Compare actual performance with

standard → Analyse

variances

↑ Start ↓

Implement corrective action(s)/

amend standards

Identify the

issues/questions to be addressed

↑ ↓

←← Receive explanations/answers ←←

STANDARD COSTING


2 DERIVING STANDARDS

2.1 Ideal standards

Standards that can only be obtained under ideal operating circumstances.

Remind managers of what could be achieved.

Unlikely to be achieved leading to demotivated managers.

2.2 Practical standards

Challenging but achievable under existing operating conditions.

Achievable so managers will not be demotivated

Variances will highlight only abnormal conditions that need to be brought to the attention of management.

3 CONTROLLABILITY

Managers should only be judged on things that are within their control.

If managers’ performance is evaluated using variances it is important to ensure that factors outside of the control of the manager are taken into account.

BASIC VARIANCE ANALYSIS


1 VARIANCE ANALYSIS

1.1 Sales variances

Sales volume variance

Actual sales (units) X less: budgeted sales (units) X –– Difference X × standard profit/contribution per unit* ($) X –– Sales volume variance ($) X –– * standard profit per unit if absorption costing is used. Standard contribution if marginal costing is used. Sales price variance $ Actual sales × actual price X Actual sales × standard price X –– Sales price variance X ––

1.2 Materials variances

Materials price variance $ Actual materials × actual price X Actual materials × standard price X –– Materials price variance X –– Materials usage variance Actual materials used (units)* X Standard quantity for actual output (units)* X –– Difference X × standard cost per unit ($) X –– Materials usage variance ($) X –– * typically kg or litres.



1.3 Labour variances

Labour rate variance

$ Hours paid × actual wage rate X Hours paid × standard wage rate X –– Labour rate variance X –– Labour efficiency variance

Hours worked X Standard hours for actual output X –– Difference X × standard wage rate per hour ($) X –– Labour efficiency variance ($) X ––

1.4 Variable overhead variance

Variable overhead rate variance $ Actual variable overhead cost (=Actual hours at actual rate) X Actual hours worked × standard overhead rate per hour X –– Variable overhead rate variance X –– Variable overhead efficiency variance

Hours worked X Standard hours for actual output X –– Difference X × standard overhead rate per hour ($) X –– Variable overhead efficiency variance ($) X ––



1.5 Fixed overhead variances

Fixed overhead expenditure variance

$ Actual fixed overheads X Budgeted fixed overheads X –– Fixed overhead expenditure variance X –– Fixed overhead volume variance*

Actual production (units) X Budgeted production (units) X –– Difference (units) X × standard fixed overhead cost per unit ($) X –– Fixed overhead volume variance ($) X –– If fixed overheads are absorbed using an hourly basis (e.g. labour or machine hours) the volume variance may be analysed further:

Fixed overhead capacity variance*

Actual hours X Budgeted hours X –– Difference X × standard fixed overhead absorption rate per hour ($) X –– Fixed overhead capacity variance ($) X –– Fixed overhead efficiency variance*

Hours worked X Standard hours for actual output X –– Difference X × standard fixed overhead absorption rate per hour X –– Fixed overhead efficiency variance X ––

* The fixed overhead volume, capacity and efficiency variances arise only under absorption costing.



2 CAUSES OF VARIANCES

Sales volume – the effect on profit of selling more/less units than budgeted.

Sales price – the effect on sales revenues of selling at a non-standard price.

Materials price – the effect on purchases expense of paying a non-standard price for materials. Using a different quality of materials may cause this. This may affect other variances (e.g. materials usage variance).

Materials usage – the effect of losses, rejects, defects, wastage, etc.

Labour rate – the effect on payroll expense of paying workers a non-standard wage. Causes may include employing a different skill of labour than was expected when the standard was set.

Labour efficiency – the productivity of workers. This may be related to the rate variance (e.g. a higher rate than standard may increase motivation and hence efficiency).

Variable overhead efficiency – calculated as for labour efficiency (i.e. if workers productivity increases machinery is operated for fewer hours and incurs less variable overhead costs such as electricity).

Variable overhead rate – the effect of paying a non-standard rate per hour for variable overheads.

Fixed overhead expenditure – the real spending difference between budgeted and actual fixed costs. Do not flex fixed costs; they should not change with the level of activity.

Fixed overhead volume – only exists under absorption costing (represents under/over-absorption of fixed costs which does not arise under marginal costing.

It does not show a real spending difference;

It is simply a reconciling item due to the cost accountant’s method of charging fixed costs to the statement of profit or loss.

ADVANCED VARIANCE ANALYSIS


1 MATERIALS MIX AND YIELD VARIANCES

1.1 The concept

Where the standard cost of a product includes two or more materials, the usage variance can be sub-analysed into two additional variances – the mix and yield variances:

Total materials cost variance

Price variance Usage variance

Mix variance

Yield variance

1.2 Materials mix variance

The best approach is to use a table:

Actual Actual quantity quantity in standard used mix Difference Variance litres/kgs litres/kgs litres/kgs $ A B (B–A) (B–A)×Sp Material 1 Material 2 Material 3 ––– ––– ––– ––– X X 0 $Y ––– ––– ––– ––– 1.3 Materials yield variance

The simplest way to calculate is:

to compare actual output and expected output for actual input; and

multiply the difference by the standard cost per unit.



Example

The standard cost of a gin and tonic in a bar in London is 50 ml gin at $5 per litre and 300 ml tonic water at $1 per litre.

During one evening, 100 gin and tonics were served. 7 litres of gin and 33 litres of tonic were used.

Mix variance

Actual Actual Standard Variance quantity quantity minus actual mix standard mix actual Litres Litres Litres

Gin 7 5.7 (1.3) (6.5) Tonic 33 34.3 1.3 1.3

––– –––– ––– ––– 40 40 0 (5.2) ––– –––– ––– –––

Analysis

Bar staff mixed “stronger” gin and tonics than the standard.

Since gin is more expensive than tonic this resulted in a more expensive mix than the standard.

The variance is adverse.

Yield variance

40 litres of mix should yield 114 gin and tonics. 40 litres did yield 100 gin and tonics. Shortage: 14 gin and tonics. Standard cost of 1 gin and tonic: ($5 × 0.05) + ($1 × 0.3) = $0.55. Yield variance (adverse) = 14 × $0.55 = $7.70

1.4 Interpreting material mix and yield variances

Favourable mix variance means a higher % of cheaper input (hence lower % of more expensive input) has been used.

May lead to lower quality of output.

Favourable yield variance means less waste than expected. This might be related to the mix variance.

A poor quality mix (favourable mix variance) might lead to a lower yield.

Cigarette manufacturers who blend a mix of tobacco into the final product routinely calculate such variances. If they use relatively more of a cheap but low quality tobacco they may find a favourable mix variance but adverse yield variance.



2 SALES MIX AND QUANTITY VARIANCES

2.1 The concept

In situations where similar products are sold, perhaps differentiated by brands, the budget will assume a standard mix of sales.

If actual sales mix varies from budget and each product has very different margins this will affect profits.

Total sales variance

Price variance Volume variance

Mix variance

Quantity variance

2.2 Calculating the sales mix variance

Example

Bob sells two products, A and B. He budgets to sell 8 units of A per day and 4 units of B per day. The standard margin (contribution per unit) is $10 per unit for A and $5 per unit for B. Actual sales on one particular day were 10 units of A and 8 units of B.

Sales mix variance

Similar in nature to the materials mix variance. A tabular approach works best:

Product Actual Actual Diff. Standard Sales sales sales margin mix actual standard variance mix mix (units) (units) (units) $ $ A 10 12 (2) 10 (20) B 8 6 2 5 10 –– –– –– –– 18 18 0 (10) –– –– –– ––

Sales mix variance is $10 is adverse because less units of A have been sold and more units of B. A has a higher margin than B.



2.3 Sales quantity variance

The difference between actual sales (in the standard mix) and budgeted sales. Using a tabular approach:

Product Actual Diff. Standard Sales sales margin mix standard Budgeted variance mix sales (units) (units) (units) $ $ A 12 8 4 10 40 B 6 4 2 5 10 –– –– –– –– 18 12 6 50 –– –– –– ––

2.4 Interpreting sales mix and quantity variance

Sales mix

Only useful in situations where products are substitutes for each other.

Implies consumers have switched between products, buying one as an alternative to the other.

Adverse suggests switching from a high margin product to a low margin one. May reflect:

hard economic circumstances (e.g. due to recession); or

price increases.

Favourable suggests the opposite.

Sales quantity variance

Reflects factors that affect total sales of all products.

Adverse may be due to new competitors or a fall in incomes of consumers.

PLANNING AND OPERATIONAL VARIANCES


1 REVISION OF BUDGETS AND STANDARDS

Managers may be judged on the results of variance analysis or comparison of actual results against budget.

Budgets and standards should be revised in following situations:

events occurred during the period outside of the control of the manager;

experience shows original budget/standard was unrealistic.

Budgets/standards should not be revised to hide inefficiencies.

Changes should be approved by senior managers.

2 PLANNING AND OPERATIONAL VARIANCES

2.1 Problems of traditional variance analysis

If inappropriate standards are not revised variances will be affected by matters outside of the control of the manager.

It may be appropriate to revise standards at the end of the period prior to performing variance analysis as discussed in §1.

Operational variances

Are calculated in exactly the same way as traditional variances by comparing actual performance against the revised standard.

Reflect “true” performance as they are based on a more reliable standard.

Planning variances

Show the effect of revising the standard on the standard cost of actual output.

2.2 Calculation of planning and operational variances

Exam approach – calculate basic variance (e.g. material price) and then analyse into planning and operational.



Materials price and labour rate variance

Traditional price (rate) variance

$ Actual Q* × actual price** X − Actual Q × standard price X ––– Price variance X ––– –––

Planning price Operational price (rate) variance (rate) variance

$ $ Actual Q × std price X Actual Q × actual price X Actual Q × new std price X Actual Q × new std price X ––– ––– Planning price variance X Operational price variance X ––– –––

* Q is units of materials or hours or labour. ** price for materials = rate for labour. *** usage for materials = efficiency for labour.

Materials usage and labour efficiency variance

Basic usage (efficiency) variance

Actual Q used X − Standard Q for actual output X ––– Difference X × standard price ($) X ––– Basic usage (efficiency) variance *** X –––

Planning usage Operational usage (efficiency) variance (efficiency) variance Std Q for actual X Actual Q used X − New std Q for actual X − New std Q for actual X ––– ––– Difference X Difference X × standard price per unit X × standard price per unit X ––– ––– Planning usage variance X Operational usage variance X ––– –––



2.3 Learning curve and labour variances

Labour efficiency variances may require an expected learning curve to be taken into account.

Standard labour hours will be based on a standard cost for the first unit(s) with an expected learning rate.

Approach

Calculate the standard labour hours for actual output taking into account the learning rate.

Compare this to the actual labour hours and multiply by the standard rate per labour hour.

2.4 Market volume and market share variances

Traditional sales volume variance Actual sales (units) X Budgeted sales (units) X –– Difference (units) X × standard margin per unit ($) X –– Sales volume variance ($) X ––

Budgeted sales may be revised at the end of the year if the market size was bigger/smaller than expected.

Sales volume variance analysed into:

Market volume variance (a planning variance); Market share variance (an operational variance).

Market volume variance Revised budgeted sales (units)* X Original budgeted sales (units) X –– Difference (units) X × standard margin per unit ($) X –– Market volume variance ($) X __ * Revised budget quantity may be calculated as actual market size × budgeted market share.

Market share variance Units Actual sales X Revised budgeted sales X –– Difference X × standard margin per unit ($) X –– Market share variance ($) X ––

PERFORMANCE MEASUREMENT


1 FINANCIAL PERFORMANCE INDICATORS

1.1 Return on capital

Return on equity

ROE = Equity

taxbeforeProfit × 100

Return on capital employed

ROCE = debt termlong plusEquity

taxandinterest beforeProfit × 100

Profit and capital must be “matched”:

If profit is before interest, capital must include long-term debt.

If profit is after interest, only equity should be included.

1.2 Profit margins

Gross profit margin = Revenue

profit Gross × 100

Net profit margin = Revenue

profitNet × 100

1.3 Asset turnover ratio

Asset turnover = debt termlong plusEquity

Sales

Analysis of return on capital employed

ROCE = Operating profit margin ×Asset turnover

Operating profit margin = Sales

taxandinterest beforeProfit

1.4 Liquidity

Current ratio = × 100

1.5 Gearing

Gearing ratio = debt plusEquity

Debt × 100

1.6 Interest cover

Interest cover = expenseInterest

tax andinterest beforeProfit times



2 NON-FINANCIAL PERFORMANCE INDICATORS

2.1 Financial performance measures

Weakness

Short-term improvements in financial performance may be at the expense of longer term (e.g. cutting back on R&D spending).

Performance measurement should encourage a longer-term view (e.g. by using a mix of financial and non-financial performance indicators).

2.2 Key performance indicators (KPIs)

KPIs measure how the organisation performs in relation to its critical success factors.

2.3 Operational performance indicators

Having set operational performance indicators, managers should set performance indicators at all levels of the business – both financial and non-financial – that are consistent with the key performance indicators.

2.4 Non-financial performance indication (NFPIs)

Advantages of using NFPIs in addition to financial measures

They focus on the drivers of future business performance (e.g. quality).

Using only financial measures may lead to short-term behaviour.

May be less easily manipulated.

May be compiled more quickly.

FURTHER ASPECTS OF PERFORMANCE ANALYSIS


1 BALANCED SCORECARD

1.1 Introduction

Measures performance from four perspectives:

Financial – how do we look to our shareholders?

Customer – how do our customers see us?

Internal business – what must we excel at?

Learning and growth – how must we grow and change to meet changes in the business environment?

1.2 Balanced scorecard approach

A small number of critical success factors is identified

for each perspective and KPIs chosen for each.

1.3 Advantages and disadvantages

Advantages

Performance measured from different perspectives (not just financial).

Performance measures focus on the strategy of the organisation through the critical success factors.

Small number of KPIs means management focus on what is important.

Disadvantages

Training and change in organisational culture will be required before introducing it.

May be difficult to identify critical success factors and KPIs.

Difficulty in setting targets for each KPI. Customer Perspective

Financial Perspective

Internal Business Processes

Learning and Growth

Vision And

Strategy

FURTHER ASPECTS OF PERFORMANCE ANALYSIS


2 SERVICE INDUSTRIES

2.1 Characteristics of service industries

Simultaneity – the consumption of the service takes place at the time of performance.

Perishability – services cannot be stored.

Heterogeneity – each time a service is performed, it will be different.

Intangibility – can be difficult to determine what clients value in a service.

2.2 Fitzgerald and Moon building block model

Model includes six dimensions for measuring performance in services businesses:

Profitability Competitiveness Quality Resource utilisation Flexibility Innovation

3 NON-PROFIT SECTOR

3.1 Identifying objectives

Identifying objectives complicated because:

There are many stakeholders, possibly with differing objectives.

Often difficult to quantify objectives (e.g. improve health).

3.2 Value for money frameworks

Non-profit organisations have limited resources with which to achieve their aims.

Performance measurement focuses on value for money.

“3Es”

A framework used to measure performance in public sector:

Economy (e.g. total costs per hospital bed);

Efficiency (e.g. patients treated per doctor);

Effectiveness (e.g. how many patients do not return within three months.)

DIVISIONAL PERFORMANCE EVALUATION


1 DIVISIONAL PERFORMANCE EVALUATION

1.1 Measurement characteristics

Goal congruence – measures should encourage division to make decisions consistent with company objectives.

Controllability – divisions should only be assessed on what is within their control.

1.2 Possible measures

Cost centres Costs v budgets Cost per unit Labour turnover

Profit centres Controllable profit Sales variances Profit margins Customer returns

Investment centre Return on investment Residual income Liquidity ratios Number of new products

2 RETURN ON INVESTMENT (ROI)

A relative measure. Is essentially the same measure as ROCE (and accounting rate of return – ARR).

ROI = employed Capital

profit leControllab

Capital employed = Non-current assets minus net current assets.

Advantages

Relative measure – easy to compare divisions. Focuses attention on scarce capital resources. Easily understood.

Disadvantages

ROI increases as assets become older because of lower carrying amount (“net book value”).

May discourage investment in new non-current assets.

May lead to goal incongruence – projects may be rejected if they reduce division’s ROI even though their return exceeds the cost of capital.

DIVISIONAL PERFORMANCE EVALUATION


3 RESIDUAL INCOME (RI)

An absolute measure ($).

Residual income = Pre-tax profit less imputed interest charge for capital invested.

Imputed interest = Capital employed × interest rate.

Interest rate is usually company’s cost of capital (but can be adjusted to take account of the division’s risk.

Advantages

Goal congruence:

Project return > cost of capital positive residual income ⇒ will be accepted by divisional manager.

Risk-adjusted interest rate can be used.

Disadvantages

Not easily understood.

Difficult to compare divisions of different sizes.

Problems associated with both ROI and RI.

TRANSFER PRICING


1 TRANSFER PRICING

1.1 Objectives of a good transfer pricing system

Autonomy

Goal congruence

Fair to both buyer and seller for performance evaluation purposes.

2 OPPORTUNITY COST APPROACH

2.1 Selling division perspective

Minimum transfer price is the higher of:

External market price (less any savings due to internal transfer).

Variable cost + opportunity cost of supplying the goods.

Opportunity cost = lost contribution from sale of goods externally (for same or other products).

If transfer can be provided from spare capacity, opportunity cost = 0.

2.2 Buying division perspective

Maximum transfer price acceptable is the lower of:

External market price; and

Net revenue of the division (i.e. ultimate selling price less costs incurred in the buying division). If transfer price exceeds this, the buying division makes a loss.

3 PRACTICAL APPROACHES

3.1 Market price

Adjusted market price – market price less savings from internal transfer (e.g. due to lower delivery costs).

Advantages

Leads to goal congruence if selling division is at full capacity.

Encourages efficiency in the supplying division.

Disadvantages

May lead to incongruent decisions where selling division has spare capacity.

Market prices may fluctuate.

TRANSFER PRICING


3.2 Cost plus approach

Advantages

Easy to calculate.

Covers all costs of selling division

Disadvantages

Inefficiencies in selling division are passed on to buying division.

Setting mark-up is arbitrary.

May lead to incongruent behaviour.

3.3 Incongruent behaviour

Transfer price is higher than market price, so buying division buys externally, or does not produce at all.

Marginal cost plus opportunity cost to selling division is less than the market price.

4 DUAL PRICING

Where no transfer price can be found which is acceptable to both parties, but the head office wants both divisions to trade.

A higher price is credited to the buying division, and a lower price debited to the buying division.

Head office absorbs the difference.

PERFORMANCE MANAGEMENT INFORMATION SYSTEMS


1 INFORMATION SYSTEMS

People, procedures and possibly computer hardware and software, working together to collect, store, process and communicate information.

Performance management information systems provide information to assist management in planning, control and decision making.

1.1 Anthony’s model

Strategic

Tactical

Operational

Planning info

Control info

Strategic planning

Setting goals and objective for the organisation over the long-term (e.g. which products to make and which markets to be in.)

Tactical management

Concerned with managing the resources of the organisation over the medium term to achieve the long-term strategy (e.g. preparing the budget, recruiting staff).

Operational management

Managing day-to-day operations of the business (e.g. ordering inventory preparing the staff rota).

Characteristics of information

Strategic management information will be longer term, less structured (ad hoc) and contain large amounts of external information (e.g. competitor analysis, market forecasts).

Tactical management information is provided on a regular basis and contains both internal and external information (e.g. variance reports and comparison of actual revenues and costs against the budget).

Operational management is transaction based.



1.2 Modern IT systems

Transaction processing systems collect data about all transactions. May be automated (e.g. EFT systems in retailers) and contain controls to ensure the validity and accuracy of the data entered.

Batch processing systems process transactions in batches periodically (e.g. monthly payroll).

Real time systems process transactions as they occur.

Management information systems (MIS) convert data from internal and external sources into information that may be used by management. For example:

Decision Support Systems (DSS) assist in complex decision-making. Typically analyse large amounts of data and provide information about the likely outcome of decisions based on programmed rules and assumptions.

Executive information systems (EIS) assist senior management’s decision making by providing summarised information from both internal and external sources relevant to meeting the strategic goals of the organisation.

An Enterprise Resource Planning System (ERPS) provides a seamless flow of information across the whole organisation using a shared database (i.e. all departments use the same system).

Business intelligence systems identify trends and relationships in large volumes of data (e.g. supermarkets, store information about what their loyalty card holders buy and analyse this to identify trends).

1.3 Systems theory

A system takes inputs and processes them to produce

outputs (e.g. transport system, information system).

It has a boundary, which defines where the system exists.

What is outside of the system is the environment.

Open systems react (adapt) to changes in their environment.

Closed systems do not. (Are rare in the real world.)



A closed organisation will be internally-focused. Production may be based on what it can produce rather than what the customer actually wants. This may lead to surplus inventory of finished goods, for example.

An organisation that does not anticipate changes in customer needs will not succeed in the long run.

2 SOURCES OF MANAGEMENT INFORMATION

2.1 Principal sources

Internal

The accounting system. Inventory system. Payroll systems. Purchase processing system. Sales processing system. Qualitative type information (e.g. customer

satisfaction). This could come from customer surveys.

External

Primary information – tailored information commissioned by the entity (e.g. market research).

Secondary information – information produced for general use (e.g. government statistics or market reports).

Intranets are private internal networks in an organisation that allow sharing of information.

The Internet is a useful source of information.

2.2 Direct costs of information

Design and implementation costs. Day to day running costs (including staff costs of

accounting staff, maintaining and repairing hardware). Storage costs (e.g. hardware costs such as servers). Data capture costs – the costs of getting the data into

the system in the first place. Processing costs – the costs of setting up the

information system, and the salaries of the operators of the system.

2.3 Indirect costs of information

Capital costs.

One-off revenue costs (e.g. analysing and designing system).

Costs associated with external sources – primary sources.

Costs associated with external sources – secondary sources.



3 MANAGEMENT REPORTS

3.1 Controls

Purpose of controls

Reports are only prepared when the benefits of the report exceed the cost of producing it.

Reports should only be sent to relevant managers.

Information is not duplicated.

Only relevant information is included in the report

Types of controls

Agreeing the format of reports in advance. Distribution lists.

3.2 Confidential information

Information security protects information and information systems from harm resulting from hacking, operational error, sabotage and other threats.

Privacy is restricting knowledge to authorised persons.

General security controls

Training all staff in computer security procedures.

Staffing arrangements (e.g. vetting job applicants before employment).

Physical controls over access to information systems.

Logical access controls (e.g. passwords and system logs).

Hacking

Deliberate unauthorised access to a system and the data within it.

Measures to prevent hacking

Firewalls control the traffic between an internal network and an external network (e.g. the internet).

Data encryption.

ADDITIONAL READING


ARTICLES

The following technical articles written by members of the F5 examining team can be found on the ACCA website at http://www.accaglobal.com/uk/en/student/exam-support-resources/fundamentals-exams-study-resources/f5/technical-articles.html

Decision trees The learning rate and learning effect ** Throughput accounting and the theory of constraints (parts 1 and 2) ** Transfer pricing * Environmental management accounting ** Cost volume profit analysis ** Material mix and yield variances ** Comparing budgeting techniques Target costing and lifecycle costing – by Ken Garrett ** Transfer pricing – by Ken Garrett ** Interpreting financial data ** Linear programming Approaching written questions ** Examiner’s reports September and December 2015 ** * There are two articles about Transfer Pricing ** These are summarised in the sections that follow.

SPECIAL FEATURE

Examiner’s approach article – see http://www.accaglobal.com/uk/en/student/exam-support-resources/fundamentals-exams-study-resources/f5/technical-articles/examiner-approach-to-paper-f5.html

APPROACHING WRITTEN QUESTIONS



For the full article see the ACCA’s website.

The skills papers, of which F5 is one, are often the first in which students have had to tackle written questions.

Candidates are required to write clearly and set out workings logically and neatly. The following four skills are required:

(1) correctly interpret requirements;

(2) actively read scenario based questions highlighting what is relevant for each part of the requirement;

(3) use that information to perform calculations that are carefully structured and clearly set out, with workings shown in an easy-to-follow layout;

(4) write accurately and coherently using simple English rather than long rambling sentences that have no structure and no real content.

Where subjects that were in F2 are repeated in F5, the skills required are over and above the knowledge required in F2.

Step by step approach to the exam on the day

Reading time

Although the 15 minutes reading time allowance is no longer separate, you should still:

Read all the requirements and the questions;

Think about the order in which you will do the questions – best question first;

Allocate 3 hours appropriately between the sections and questions.

When it comes to answering the question, be strict with your time allocation. Spending too long on one question is likely to mean that you cannot do it anyway (so move on and come back to it later) or you are going beyond what the examiner requires. How much an examiner expects you to write is directly linked to the marks available and therefore to the time available.

When reading any question:

The requirement should be the first thing you read.

What is the point in reading a scenario if you do not know what you are looking for?

Underline the “content” (e.g. target costing) and the “instruction” (i.e. what it is telling you to do).



In constructed response questions, the instruction is a verb (e.g. calculate, describe, interpret, discuss) that has been carefully chosen by the examiner. If you do not read or understand it you may well find that you are not actually answering the question. If you are not answering the question you are not earning marks. Each of the common exam instructions is dealt with below.

Answering numerical questions

Calculate – you just have to work something out.

Derive – sometimes requires more than simply being able to calculate a figure as a candidate is required to use their powers of deduction to derive something. For example derive an equation showing the relationship between price and quantity.

Estimate – suggests that the answer cannot be calculated with certainty. For example, if calculating the cost of a batch using an 80% learning rate, this rate reflects only what the business thinks will happen, but will not be confirmed until it has happened.

Candidates who perform poorly on the numerical parts of F5 often do so due to:

failure to study the whole syllabus sufficiently well;

a disorganised approach (i.e. no logical progression through calculations and lack of referenced workings).

You should go into the exam with a “toolbox” of what is going to help you answer the questions. For example, if it is a linear programming question, go into your toolbox and pull out your five-step guide for linear programming:

define the variables state the objective function state the constraints draw the graph find the solution.

The problem with F5 is that students go into the exam with only a few tools in their “box”. If you put the work in, you will reap the rewards.

Answering “wordy” questions

The real cause of poor performance in written questions is failure to grasp what to write and how much to write:

Describe Give a narrative about something. For example “describe suitable non-financial performance indicators for a hospital”. A mere list is insufficient – so state also how they might be calculated.

Outline This requires a fairly brief and well-organised overview, without the level of detail that would be required in “describe” (e.g. “outline the objectives of a budgetary control system”).



Compare Discuss similarities between two or more things and draw conclusions. For example, “compare product costs using ABC with traditional costing”. You need to state why the costs are different. This means looking in detail at the product costs and ascertaining the reason why the overheads absorbed into one product are higher under one method than the other.

Identify This means pinpoint and state. This can be quite simple, requiring knowledge rather than skill. Sometimes, candidates may have to identify points from within a question scenario which requires more skill.

Discuss This means give views on a subject, supporting it with facts and logical reasoning. For example, “discuss the effect that variances have on staff motivation”. Opinions must be sound and well-reasoned. To state that variances are de-motivational without explaining why is worthless. Also you are expected to look at both sides of the story.

Explain Means to give a reason for something. This is a common requirement. It is not the same as to describe. For example, to explain an action (why it happened) is not the same as describing the action (what happened).

Suggest Means give a suitable idea or solution, in situations where there may be more than one answer to the question being asked. For example, how a cost gap could be closed. There are many possible ways to do this.

Justify State why a particular answer or position makes sense. For example, to justify the use of back flush accounting, you would have to mention the relative immateriality of inventory.

Conclusion

F5 is not an especially hard paper if candidates:

Work hard to gain knowledge of areas that they have not practiced;

Highlight the requirements of each question and keep referring back to them;

Practice questions until their approach and layout become “second nature” so there will be sufficient time in the exam to think about the issues in the question.

TARGET COSTING AND LIFECYCLE COSTING




Typically, in conventional costing, once the absorption cost of units has been calculated, a mark-up (or gross profit percentage) is used to determine the selling price and the profit per unit.

There are two flaws in this approach:

1. The product’s price is based on its cost, but no one might want to buy at that price.

2. The costs incorporated are the current costs only. There may be other important costs which are not part of these categories, but without which the goods could not have been made (e.g. research and development costs and any close down costs at the end of the product’s life).

Target costing

Target costing is very much a marketing approach to costing.

Instead of starting with cost and working to the selling price, target costing starts with the selling price of a product and works back to the cost by removing the profit element. This means the business has to find ways to not exceed that cost.

For example, if a company normally expects a mark-up on cost of 50% and estimates that a new product will sell successfully at a price of $12, then the maximum cost of production should be $8.

This is a powerful discipline imposed on the company. The main results are:

The establishment of multi-functional teams making the design and manufacturing decisions needed to determine the price and feature combinations that are most likely to appeal to potential buyers of products.

An emphasis on the planning and design stage. This becomes very important to the cost of the product.

Here are some of the decisions, made at the design stage, which can affect the cost of a product:

The features of the product; How to avoid “over design”; The number of components needed; Whether the components are standard or specialised; The complexity of machining and construction; Where the product can be made; What to make in-house and what to sub-contract; The quality of the product; The batch size in which the product can be made.



ABC can also play an important part in target costing. By understanding the cost drivers (cost causers) a company can better control its costs.

Value engineering aims to reduce costs by identifying those parts of a product or service which do not add value – where “value” is made up of both:

Use value (the ability of the product or service to do what it sets out to do – its function) and

Esteem value (the status that ownership or use confers).

The aim of value engineering is to maximise use and esteem values while reducing costs.

For example, if you are selling perfume, the design of its packaging is important. To reduce costs by economising too much on packaging would damage the esteem value.

Lifecycle costing

When seeking to make a profit on a product it is essential that the total revenue arising from the product exceeds total costs, whether these costs are incurred before, during or after the product is produced.

The cost phases of a product can be identified as:

Phase Examples of types of cost

Design Research, development, design and tooling

Manufacture Material, labour, overheads etc.

Operation Distribution, advertising and warranty claims

End of life Environmental clean-up, disposal and decommissioning

The four principal lessons of lifecycle costing are:

All costs should be taken into account when working out the cost of a unit and its profitability.

Attention to all costs will help to reduce the cost per unit and will help an organisation achieve its target cost.

Many costs will be linked. For example, more attention to design can reduce manufacturing and warranty costs.

Costs are committed and incurred at very different times. A committed cost is a cost that will be incurred in the future because of decisions that have already been made.

Typically by the end of the design phase approximately 80% of costs are committed. For example, the design will largely dictate material, labour and machine costs.

THROUGHPUT ACCOUNTING AND THE THEORY OF CONSTRAINTS



This is a summary of a two part article written by a member of the examining team. For the full articles see the ACCA’s website. “The Goal: A Process of ongoing improvement” by Eli Goldratt and Jeff Cox, originally published in 1984, presents the theory of constraints and throughput accounting as a novel.

Alex Rogo, a plant manager at a fictional manufacturing plant, is forced to question the belief that success in manufacturing is represented by a 100% efficient factory (i.e. everyone and every machine is busy 100% of the time).

Alex’s journey begins with a chance meeting with his old physics teacher Jonah. Alex is proudly telling Jonah about the improvements in efficiency at the factory. Jonah is quick to question whether these have actually led to an improvement in profits.

In fact, although the plant has become seemingly more efficient, it has huge inventory levels and is constantly failing to meet order deadlines.

The goal of the factory needs to be more clearly defined. Jonah helps Alex do this by explaining that it will be achieved by increasing throughput while simultaneously reducing inventory and operational expenses.

Throughput: the rate at which the system generates money through sales;

Inventory: all the money that the system has invested in purchasing things that it intends to sell;

Operational expense: all the money that the system spends in order to turn inventory into throughput.

Working out how to achieve the goal

Alex takes his son and other boys on a 10-mile hike. Alex realises that if everyone is to stay in one group, the group can only go as fast as the slowest walker. The slow walker is a bottleneck that prevents the group from going faster.

Identifying bottlenecks

Alex and his team identify obvious bottlenecks where big piles of inventory sit in front of two machines.

Observation shows that these machines are sometimes idle because workers are taking their breaks or working on other non-bottleneck machines.



Alex learns that an hour lost on a bottleneck machine is an hour lost for the whole system. From then on, the bottleneck machines are permanently manned.

The need to accept idle time

Alex realises that all machines must work at the pace of the bottleneck machines. It is important to let non-bottleneck machines and workers sit idle when they have produced to the capacity of the bottleneck machines. It is only wasteful to produce parts that are not needed or cannot be processed.

Throughput and just-in-time (JIT)

Given that producing excess inventory both pushes costs up and prevents throughput, it becomes clear that throughput accounting and JIT operate very well together.

Alex reduces batch sizes substantially. If batch sizes are halved:

inventory costs are also halved; and

lead time is halved which gives a competitive advantage.

Throughput increases dramatically because of increased sales volumes; leading to a significantly lower operating cost per unit.

The five focussing steps

The theory of constraints is applied in five focussing steps:

Step 1 – Identify the system’s bottleneck

It is usually quite simple to work out what the bottleneck resource is. Step 2 – Decide how to exploit the system’s bottleneck

This means making sure that the bottleneck is actively used and producing as many units as possible (e.g. by making sure that there are always workers at bottleneck machines). Step 3 – Subordinate everything else to the decisions made in Step 2

The production capacity of the bottleneck resource should determine the production schedule for the organisation as a whole. By definition, the system does not require-non bottleneck resources to be used to their full capacity. Pushing more work into the system than the constraints can deal with results in excess work in progress and extended lead times.



Step 4 – Elevate the system’s bottlenecks

Increase the output of the bottleneck resources. This normally requires capital expenditure. However, it is important not to ignore Step 2 and go straight into Step 4, as there may be untapped production capacity that can be exploited.

Step 5 – Go back to Step 1

When a bottleneck has been elevated, another one will appear, often in the form of another machine that can now process fewer units than the elevated bottleneck. The system should be one of ongoing improvement.

Limiting factor analysis and throughput accounting

An exam question may ask how a bottleneck can be exploited by maximising throughput using an optimum production plan.

The mechanics of the calculation of “throughput return per unit of bottleneck resource” is very similar to the key factor analysis calculation on “contribution per unit of scarce resource”.

“Throughput” is selling price less direct material cost (only). This is not the same as contribution because throughput accounting recognised that all other costs are largely fixed (e.g. workers are not hired on a daily basis and laid off when they are not busy).

Example 1

Beta co produces three products:

E F G $ $ $ Selling price per unit 120 110 130 Direct material cost per unit 60 70 85 Hours per unit required on bottleneck 5 4 3 Maximum demand 30,000 25,000 40,000 There are 320,000 bottleneck hours available each month.

Required:

Calculate the optimum product mix each month.

Answer E F G

$ $ $ Selling price per unit 120 110 130 Direct material cost per unit 60 70 85 ––– ––– ––– Throughput per unit 60 40 45 ––– ––– ––– Hours per unit required on bottleneck 5 4 3 ⇒ Return per factory hour $12 $10 $15 Ranking



Production plan to maximise throughput (320,000 hours)

Total Total hours throughput

000 $000 Produce 40,000 units of G 120 1,800 Produce 30,000 units of E 150 1,800 Produce 12,500 units F (50,000 ÷ 4) 50 500 –––– –––––– 320 4,100 –––– –––––– Example 2

Cat Co makes a product using three machines – X, Y and Z. The capacity of each machine is:

Machine X Y Z Capacity per week 800 600 500

Demand for the product is 1,000 units per week. For every additional unit sold net present value increases by $50,000. Cat Co is considering the following possible investments (they are not mutually exclusive):

(1) Replace machine X with a newer model costing $6 million

(2) Purchase a second machine Y to increase capacity by 550 units per week for $6.8 million

(3) Upgrade machine Z at a cost of $7.5 million to increase capacity to 1,050 units.

Required:

Determine Cat Co’s best course of action.

Answer

Initially machine Z is the bottleneck. Therefore neither investment 1 or 2 should be considered first, since X and Z are not currently bottlenecks.

How does capacity change with choices available?

Machine X Y Z Demand Capacity per week 800 600 500* 1,000 Invest in Z 800 600* 1,050 1,000 Invest in Z and Y 800* 1,150 1,050 1,000 Invest in Z, Y and X 1,100 1,150 1,050 1,000* * = Bottleneck resource, represents maximum capacity of system. Y becomes the bottleneck resource after investment in Z.



Financial viability of options:

Z Z & Y Z, Y & X Additional sales units: (new bottleneck – 500) 100 300 500 $000 $000 $000 Benefit ($50,000 per additional unit) 5,000 15,000 25,000 Cost (7,500) (14,300) (20,300) –––––– –––––– –––––– Net benefit (2,500) 700 4,700 –––––– –––––– –––––– ⇒ Cat Co should invest in all three machines if it has enough cash to do so.

This example shows how as one bottleneck is elevated, another one appears.

Ratios

Return per factory hour = Throughput per unit ÷ Time on bottleneck resource per unit

Cost per factory hour = Total factory costs ÷ Total time available on bottleneck resource. Total factory costs = Sum of all operational costs

Throughput accounting ratio (TPAR) = Return per factory hour ÷ Cost per factory hour

If TPAR > 1, the rate at which cash from sales is generated > the rate at which costs are incurred.

ENVIRONMENTAL MANAGEMENT ACCOUNTING




Introduction to EMA

Environmental management accounting (“EMA”) is a sub-set of management accounting. Management accounts are prepared to provide information which is used to assess the business’s historic performance and, how it can be improved.

EMA focuses on things such as:

the cost of energy and water and the disposal of waste and effluent;

financial costs and benefits of buying from more environmentally-aware suppliers who are ;

reputational risk (from failure to comply with environmental regulations).

EMA uses some standard accountancy techniques to identify, analyse, manage and hopefully reduce environmental costs in a way that provides mutual benefit to the company and the environment, although sometimes it is only possible to provide benefit to one of these parties.

Definition of EMA

EMA is the identification, collection, analysis and use of two types of information for internal decision making:

physical information on the use, flows, and destinies of energy, water and materials (including waste),

monetary information on environmental-related cost, earnings and savings.”

Importance of the environment to business

(1) Society as a whole has become more environmentally aware, with people becoming increasingly aware about the “carbon footprint”.

(2) Environmental costs are becoming huge for some companies particularly those operating in highly industrialised sectors. These need to be managed.

(3) Regulation is increasing, with penalties for non-compliance also increasing



Managing environmental costs is difficult:

(1) It is difficult to define EMA and the actual costs involved. The US Environmental Protection Agency made a distinction between four types of costs:

(i) conventional costs (e.g. raw materials and energy);

(ii) potentially hidden costs captured by accounting systems but getting hidden in “general overheads”;

(iii) contingent costs (e.g. site clean-up costs): and

(iv) image and relationship costs that, by their nature, are intangible.

On the other hand, the United Nations Division for Sustainable Development (UNDSD) described environmental costs as comprising of two components:

(i) costs incurred to protect the environment (e.g. measures taken to prevent pollution); and

(ii) costs of wasted material, capital and labour including inefficiencies.

These definitions do not contradict each other; they just look at the costs from slightly different angles.

(2) Many environment costs captured by the accounting system are difficult to separately identify as they are found within the category of “general overheads

UNDSD identified four management accounting techniques for identifying and allocating environmental costs:

(i) input/output analysis; (ii) flow cost accounting; (iii) ABC; and (iv) lifecycle costing.

Input/output analysis

This records material inflows and balances this with material outflows on the basis that what comes in must go out.

Flow cost accounting

This uses not only material flows but also the organisational structure. It divides material flows into three categories: material, system, and, delivery and disposal. The values and costs of each of the three are calculated. The aim of flow cost accounting is to reduce the quantity of materials which, as well as having a positive effect on the environment, should have a positive effect on a business’s total costs in the long run.



ABC

This allocates internal costs to cost centres and cost drivers on the basis of the activities that give rise to the costs. It distinguishes between environmental-related costs, which can be attributed to joint cost centres, and environment-driven costs, which tend to be hidden on general overheads.

Life cycle costing

This technique requires the full environmental consequences, and, therefore, costs, arising from production of a product to be taken account across its whole lifecycle.

(3) It is only after environmental costs have been defined, identified and allocated that a business can begin the task of trying to control them. Consider an organisation whose main environmental costs are: i) waste and effluent disposal, ii) water consumption, iii) energy, iv) transport and travel, and v) consumables and raw materials.

(i) Waste – there are lots of environmental costs associated with waste (e.g. costs of unused raw materials and disposal, taxes for landfill, fines for compliance failures).

It is possible to identify how much material is wasted in production using the “mass balance” approach (i.e. the weight of materials bought compared to the product yield). Potential cost savings may be identified. As well as monetary cost, waste has environmental costs (e.g. lost land resources from burying waste and the generation of greenhouse gases).

(ii) Water is actually paid for twice by businesses – first to buy it and second to dispose of it. So the organisation needs to identify where water is used and how consumption can be decreased.

(iii) Energy – EMA may help to identify inefficiencies and wasteful practices and, therefore, opportunities for cost savings.

(iv) EMA can help to generate cost savings in Transport and travel. At a basic level, a business can invest in more fuel-efficient vehicles.

(v) Consumables and raw materials costs are usually easy to identify and senior managers may help to identify where savings can be made (e.g. toner cartridges for printers can be refilled instead of replaced). This should result in a financial saving and be better for the environment as toner cartridges are difficult to dispose of.





Objective of CVP analysis

CVP analysis looks at the effects on differing levels of activity on the profit of the business. In the short-run, profitability often hinges upon volume, as sales price and the costs of materials and labour are usually known with some degree of accuracy in the short run.

The break-even point is where total revenues and total costs are equal. There are three methods for ascertaining the break-even point:

(1) Equation method

Total revenue – Total variable costs – Total fixed costs = Profit (USP × Q) – (UVC × Q) – FC = P

Example

Company A makes product X. The selling price for product X is $50 and its variable costs are $30. The contribution per unit (sales price less variable costs) is $20. Fixed costs are $200,000 per year.

(50Q) – (30Q) – 200, 000 = P.

Set P to zero to find breakeven point:

(50Q) – (30Q) – 200, 000 = 0 20Q – 200,000 = 0 20Q = 200,000

Q = 10,000 units.

If company A sells exactly 10,000 units, it will break even, and if it sells more than 10,000 units it will make a profit.

(2) Contribution margin method

If P = 0, Q = fixed costs ÷ unit contribution margin.

(3) Graphical method

The total costs and total revenue lines are plotted on a graph. $ are shown on the y-axis, and units on the x-axis. The point where the total cost and revenue lines intersect is the break-even point.



Fixed costs

Total revenue

Total costs

Break even point

$000

Units sold Ascertaining sales volume to achieve a target profit

A business may want to know how many items it must sell to obtain a target profit:

Q = UCM

PFC

Margin of safety

This indicates by how much sales can decrease before a loss occurs (i.e. the excess of budgeted revenues over break-even revenues).

It may be calculated as a percentage:

sales Budgetedsales evenbreak -sales Budgeted

100

It could be calculated in revenue terms as:

Budgeted sales Break-even sales Selling price

Contribution to sales (C/S) ratio

Shows how much each $ sold actually contributes towards fixed cost.

In single product situations C/S ratio = unit contribution ÷ unit selling price:

In multi-product situations, calculate a weighted average C/S ratio. This can then be used to find CVP information (e.g. breakeven point, margin of safety).

Weighted average C/S ratio = total expected contribution ÷ total expected sales:

It can also be used to calculate break-even revenue:



Break-even point (revenue) = ratio C/Scosts Fixed

To achieve a target profit: ratio S/C

profit required plus costs Fixed

Multi-product profit volume charts The profit volume graph focuses purely on showing a profit/loss line and does not separately show the cost and revenue lines.

In a multi-product environment it is common to show two lines on the graph:

a straight line, which assumes a constant mix of products; and

a “bow-shaped” line, which assumes its most profitable product is sold first, then the next most profitable product, and so on.

To draw the graph, it is necessary to work out the C/S ratio of each product being sold, before ranking the products in order of profitability.

It is useful to draw a quick table (prevents mistakes in the exam hall) to ascertain each of the points that need to be plotted on the graph to plot the profit/loss lines:

Contribution Cumulative Revenue Cumulative Profit/loss revenue $000 $000 $000 $000 (Fixed costs) 0 (X) 0 0X (up to budgeted sales) XX XX XX XX Y (up to budgeted sales) XX XX XX XX The graph can then be drawn, showing cumulative sales on the x-axis and cumulative profit/loss on the y-axis – e.g:

Sales $000

$000

350

200

200

582 1,000 1,650

Sales in constant mix Most profitable first



Limitations of CVP analysis

The limitations are the assumptions:

There is a single product or multiple products sold in a fixed mix.

Volume is the only factor that changes. All other variables remain constant. There are many reasons why the assumption may not hold true (e.g. economics of scale).

The total cost and total revenue functions are linear. This is only likely to hold within a short run restricted level of activity.

Costs can be classified as fixed or variable. In reality some may be semi fixed.

Fixed costs remain constant over the “relevant range” levels of activity in which the business has experience and can therefore perform a degree of accurate analysis.



THE LEARNING RATE AND LEARNING EFFECT

For the full article see ACCA’s website.

A brief history

The learning effect is a human phenomenon – people become quicker at performing repetitive tasks:

First reported observation goes back as far as 1925 in aircraft manufacturing industry.

TP Wright established that it was possible to accurately predict how much labour time would be required to build planes in the future.

Wright identified that the cumulative average time per unit decreased by a fixed percentage each time cumulative output doubled.

In aircraft industry, learning rate was 80%, different rates occur in different industries.

! An 80% learning rate means that as cumulative output doubles, the cumulative average time per unit falls by 20%.

Since cumulative production is required to double in order for the cumulative average time to decrease, the learning effect becomes much less significant as production increases.

Cumulative average time

Cumulative output

When cumulative output is low, the learning curve is

steepest, but flattens as cumulative output increases. It becomes a straight line when the learning effect ends.

The learning curve applies when:

The process is repetitive; There is continuity of workers; Workers do not taking prolonged breaks during the

process.



Importance of the learning effect

If management accountants fail to take into account any learning rate in planning, control and decision making, serious consequences will result.

Decision making

A company is introducing a new product to the market and bases the price on full absorption cost plus a mark-up.

If the labour cost is that of the first unit, the product will be launched at a price that is far too high (uncompetitive).

The company may decide not to launch the product at all as it believes it cannot offer a competitive price.

Planning and control

Standard costs must provide an accurate basis for the calculation of variances.

If the learning effect is ignored, all labour usage variances should be favourable because standard labour hours will be too high.

F5 examinations

In December 2011, learning curve was examined in the context of lifecycle costing. Candidates were asked to calculate a revised lifecycle cost per unit. This involved working out the incremental labour time taken to produce the final 100th unit before the learning effect ended.

In June 2009 the learning curve was tested in the context of target costing. This time an average cost for the first 128 units made was required.

The learning curve formula Y = axb is always given on the formula sheet in the exam. Although a value for ‘b’ is usually given, there is no reason why this should always be the case.

Tip! Take a scientific calculator into the exam. Take care not to round learning curve calculations too soon.

Going forward, calculations of the learning rate itself may be required using both the tabular and algebraic (formula) method.



Example 1

P Co recently launched a new product. The actual number of batches produced during the first four months and the actual time taken to produce them is as follows:

Month Incremental number Incremental labour of batches hours taken June 1 200 July 1 152 August 2 267.52 September 4 470.8 Required:

Calculate the rate of learning that arose during the period.

Answer

Month Incremental Incremental Cumulative Cumulative Cumulative number of labour number of total average batches hours batches hours hours per batch June 1 200 1 200 200 July 1 152 2 352 176 August 2 267.52 4 619.52 154.88 September 4 470.8 8 1,090.32 136.29 Learning rate: 176 ÷ 200 = 88% 154.88 ÷ 176 = 88% 136.29 ÷ 154.88 = 88% Example 2

The first batch of a new product took six hours to make and the total time for the first 16 units was 42.8 hours, at which point the learning effect came to an end.

Calculate the rate of learning.



Answer

The easiest way to do this is to use a combination of the tabular approach plus a little bit of maths:

Cumulative number Cumulative total Cumulative average of products made hour per unit 1 6 6 2 ? 6 × r 4 ? 6 × r2

8 ? 6 × r3

16 ? 6 × r4

⇒ 42.8 = 16 × (6 × r4) ⇒ 2.675 = (6 × r4) ⇒ 0.4458333 = r4

⇒ 0.8171 = r

This means the learning rate is approximately 82%.

An alternative method involves some more difficult maths and the use of the inverse log function. Candidates would not be expected to use this method.

MATERIALS MIX AND YIELD VARIANCE ANALYSIS



For the full article see ACCA’s website.

Material usage variance

Recap

The material usage variance analyses the difference between how much actual material we have used for our production relative to how much we expected to use based on standard usage levels.

Any difference between the standard and actual cost would be dealt with by the material price variance.

There can be many reasons for an adverse material usage variance, e.g.:

inferior quality materials have been purchased; changes in the production process have been made; or increased quality controls have been introduced

resulting in more items being rejected.

Further variance analysis involving material mix

Most products consist of several different materials, so the more detailed mix and yield variances can be calculated. If it is possible to combine different levels of component materials to make the same product, this may result in differing yields.

Material mix refers to the quantity of each material used (i.e. inputs).

Yield refers to how much product is produced (i.e. output).

Materials mix variance

The optimum mix of materials will be the one that balances the cost of each of the materials with the yield that they generate. The yield must also reach certain quality standards.

Managers may fail to adhere to the standard mix. This would result in a materials mix variance.

How do we calculate the mix variance?

Actual Actual quantity quantity in standard used mix Difference Variance litres litres litres $ A XX XX XX XX B XX XX XX XX –––––– –––––– –––––– –––––– XXX XXX XX XX –––––– –––––– –––––– ––––––

Tutorial note: When calculating the difference, calculate the standard mix minus the actual mix. If the resulting variance is negative, it will be adverse.



It is essential that for every variance you calculate, you state whether it is favourable or adverse. These can be denoted by a clear “A” or “F”. This leads to mistakes.

The key to variance analysis is to understand what is actually happening rather than rely on rote learn formulae.

Materials yield variance

Where there is a difference between the actual and standard level of output for a given set of inputs, a material yield variance arises.

Yield variance

Expected output given materials used XXX litres Actual output XXX litres ––––––––– Shortage/ surplus XX litres X standard cost per litre of output $X ––––––––– Yield variance $XX

Making observations about variances

There is a direct relationship between materials mix and yield variance. Using a cheaper mix of materials may result in a significantly lower yield.

The overall net effect is the material usage variance which is the sum of the two variances.

Understanding the bigger picture

Quality issues cannot be dealt with by this variance analysis.

It can be tempting for production managers to change the product mix to make savings; however, if the quality of the product is adversely affected, this is damaging to the reputation of the business and hence its long-term survival prospects.

In the long run it may be deduced from an adverse sales volume variance, as demand for the businesses products decreases.

Any sales volume variance that does arise as a result of poor quality products is likely to arise in a different period from the one in which the mix and yield variances arose, and the correlation will then be more difficult to prove.



Poor quality materials may be more difficult to work with.

This may lead to an adverse labour efficiency variance, as the workforce takes longer than expected to complete the work.

This could lead to higher overhead costs and so on.

However, such consequences will occur in the same period as the mix and yield variance and are therefore more likely to be identified and the problem resolved.

Never underestimate the extent to which a perceived “improvement” in one area (e.g. a favourable materials mix variance) can lead to a real deterioration in another area (e.g. decreased yield, poorer quality, higher labour costs, lower sales volumes, and ultimately lower profitability).

Always mention such interdependencies when discussing variances in exam questions. The “number crunching” is relatively simple once you understand the principles; the higher skills lie in the discussion that surrounds the numbers.




This is a summary of an article that is no longer available on the ACCA web site. The question “Thatcher International Park” is included in the Specimen Exam.

One of the key areas of the F5 syllabus is performance measurement and control. It is, perhaps, more integral to the whole area of performance management than any other topic examined under the syllabus.

This article focuses on a classic performance measurement question, which involves a combination of financial and non-financial analysis.

Thatcher International Park (TIP) is a theme park and has for many years been a successful business, which has traded profitably.

About three years ago the directors reduced the expenditure made on new thrill rides, reduced routine maintenance where possible (deciding instead to repair equipment when it broke down) and made a commitment to regularly increase admission prices.

The last two years of financial results are shown opposite.

TIP operates in a country where the average rate of inflation is around 1% per annum.

Table 1: Tip’s financial results

20X4 20X5 $000 $000 Sales 5,250 5,320 Less expenses: Wages 2,500 2,200 Maintenance – routine 80 70 Repairs 260 320 Directors salaries 150 160 Directors bonuses 15 18 Other costs (including depreciation) 1,200 1,180 ––––––– –––––– Net profit 1,045 1,372 ––––––– –––––– Book value of assets at start of year 13,000 12,000 Dividend paid 500 650 Number of visitors 150,000 140,000 Required:

(a) Assess the financial performance of TIP using the information given above. (14 marks)



(b) During the early part of 20X4 TIP employed a newly qualified management accountant. He quickly became concerned about the potential performance of TIP and to investigate his concerns he started to gather data to measure some non-financial measures of success. The data he has gathered is shown in Table 2 [Not reproduced].

Required:

Assess the quality of the service that TIP provides to its customers using Table 1 and any other relevant data and indicate the risks it is likely to face if it continues with its current policies.

Breaking down the question

Broadly speaking, keep the majority of comments about non-financial aspects to part (b).

Perform some preliminary calculations to ascertain the relative movements been between the two years.

In this type of question, it makes most sense to look at % increase or decrease in each figure (see Workings).

Note the absence of a calculation for “other costs”. This is because the movement in it from year to year is so small that it is not worth mentioning.

Movement in sales, on the other hand, is also relatively small but is mentioned because:

(1) sales in a key figure and cannot be ignored; and (2) we know enough about other things going on in the

business (e.g. reduction in the number of visitors) to be able to draw valid conclusions about sales.

The following workings are set out as the examiner expects to see them (i.e. labelled and referenced). While, in the real world, such analysis would be expected to appear after any commentary (e.g. as an appendix), since you are not being asked for a report here it does not matter whether you show them at the beginning or end of your answer.

Workings

(1) Sales growth is $5,320,000/$5,250,000 = 1.3%

(2) Average admission prices were:

20X4: $5,250,000/150,000 = $35 per person 20X5: $5,320,000/140,000 = $38 per person

An increase of $38/$35 = 8.57%

(3) Directors pay up by $160,000/$150,000 = 6.7%

(4) Directors bonuses levels up from $15,000/$150,000 or 10% to $18,000/$160,000 or 12.5% of turnover. An increase of 20%



(5) Wages are down by ($2,500,000 – $2,200,000/$2,500,000) or 12%

(6) Routine maintenance down by ($80,000 – $70,000)/$80,000 = 12.5%

(7) Repairs up by ($320,000 – 260,000)/$260,000 = 23%

(8) Loss of customers (150,000 – 140,000/150,000) = 6.7%

(9) Profits up by $1,372,000/$1,045,000 = 31.3%

(10) Return on assets:

20X4: $1,045,000/$13,000,000 = 8.03% 20X5: $1,372,000/$12,000,000 = 11.4%

Using calculations and setting out your answer

These calculations are merely a starting point. “Assessing the financial performance” means discussing it and commenting on whether it is poor or strong.

It is important that your answer does not become “a sea of words” (i.e. just pages of writing with no headings and no structure). Your headings could be taken from your workings (e.g. “sales”, “directors’ pay and bonuses” etc).

A poor answer on sales would be this:

“Sales

These have increased by 1.3% in the year.”

A good answer for sales would read as follows:

Sales

Sales have increased by 1.3% (W1) in 20X5, as compared to 20X4. Since inflation was 1%, the increase is barely above the inflation rate. This means that, in real terms, sales have hardly increased at all. From the financial information provided, we can see that the number of visitors in 20X5 has fallen from 150,000 to 140,000. This means that the average admission price in 20X5 was $38 per person, compared to $35 per person in 20X4, an increase of 8.57% (W2). While it is good that the company has been able to secure an increase in admission price, it is not good that this has potentially been partly responsible for a fall in visitor numbers.

The good answer starts with the percentage increase from the referenced working and adds to it other information from the question or from the workings that is relevant to the figure being discussed (in this case, inflation and admission prices). Only then is it possible to make comments that have any kind of validity.



To further emphasise the importance of looking at the overall picture rather than one figure in isolation, consider “maintenance and repairs”. While maintenance costs have decreased by $10,000, repairs have increased by $60,000. It is clear that, because routine maintenance has not been carried out, machines are breaking down and repairs are, therefore, required.

A poor answer to this part of the question would be this.

“Routine maintenance costs

These have fallen by 12.5%, which is a good reduction.

Repair costs

These have increased by 23%, which is substantial.”

A good answer, on the other hand, would read something like this:

“Routine maintenance and repair costs

In 20X5, routine maintenance costs fell by 12.5% (W6), a fall of $10,000. At the same time, however, repair costs increased 23% (W7), a $60,000 increase. By looking at these two figures together, one can only conclude that the lack of routine maintenance was a poor decision and is costing the business dearly in terms of increased repair costs. The decision to reduce maintenance by the company needs to be reviewed urgently.”

Part (b)

It is important to adopt some kind of structure for your answer.

Time spent thinking rather than writing is time well spent.

In this question the examiner has told you what headings to use by using italics for the words ‘quality’ and ‘risks’.

When discussing quality ask yourself the question ‘In a business like this, what affects my enjoyment of the service?’ The answer will be – how many rides are available to ride on and how long I have to queue each time. The reliability of rides and average queuing time are therefore appropriate sub headings.

Part (b) is only worth five marks so it warrants substantially less time being spent on it than part (a) Often in these types of questions there is far more you could say than the time that is available. The key is to get good coverage.

Use the marks available as a guide as to how much to write. There are no set marking rules such as “one mark per valid point”. Marks vary from question to question.

INTERPRETING FINANCIAL DATA


INTERPRETING FINANCIAL DATA


The purpose of this article is to point students in the right direction when studying the interpretation of financial data – which is a major topic in the F5 syllabus.

Students are advised to look at the question “Ties only” while reading this article, as extracts from the question are used to illustrate points and explain the techniques needed.

“Ties only” is available on ACCA’s www (in December 2007 exam) and included in Becker’s Study Question Bank.

Assessing financial performance

Candidates were asked to assess the financial performance of the business in its first two quarters, when sales had jumped 61% from Quarter 1 to Quarter 2. This calculation should present no problem ((Q2/Q1)-1) expressed as a % increase). However, an “assessment” requires a qualitative comment or two. A percentage alone will not gain a pass mark.

In most questions there will be some background information – you should use it. Ties only operated in a competitive environment – as stated in the question – and so a 61% increase in one-quarter sounds pretty good in a competitive situation, and to say so will earn a mark. It was also the first two quarters of the business year and so this level of growth is impressive – another mark. If you then go on to say that such high growth rates are often hard to maintain, you will gain another mark. Top-scoring students should be aiming to make these kinds of observations.

Hypothesising as to why the growth is happening is also a source of marks. Revenue growth can be the result of extra volume or increasing prices. In the case of Ties Only, it is much more likely to be increased volume; the price will surely be constrained by competition, and from the information provided in Part (b), you can work out that prices are falling (although that calculation was not required). Suggesting that Ties Only has secured more customers and hence increased volume of sales, scored a mark.

Candidates must be brave and commit themselves. You must express an opinion. It is not acceptable to suggest that management investigate. Although in the real world this may well happen, in the exam hall you have to demonstrate that you know where to look.

PERFORMANCE MEASUREMENT AND THE BALANCED SCOREDCARD




Decentralisation is the delegation of decision-making responsibility. Today, it is impossible for one person to make all decisions, even in a small company – senior managers delegate decision-making responsibility to subordinates.

One danger of decentralisation is that managers make decisions that are not in the best interests of the overall company – so called dysfunctional decisions.

A good performance measure should:

Provide an incentive for the divisional manager to make decisions which are in the best interests of the overall company (goal congruence)

Only include factors for which the manager/division can be held accountable

Recognise the long-term objectives as well as the short-term objectives of the organisation.

Typical financial performance measures for divisions, depending on the type of division are:

Cost centre – standard costing variances Profit centre – controllable profit Investment centre – return on investment and

residual income.

Cost centres

For standard costing variances, problems include: Focuses on short-term cost minimisation – this may

conflict with objectives such as quality Deciding who is responsible for the variance – for

example, is the production manager or the purchasing manager responsible for material purchase variances.

Setting standards in the first place is difficult. Profit centres

When assessing the performance of a divisional manager, we should consider only the costs and revenues that are under the control of that manager (controllable divisional profit). When assessing the performance of the division, we should look at costs and revenues traceable to the division (traceable divisional profits). For example, depreciation of machinery would be a cost that is traceable to the division, but is not controllable by the manager, because the manager of a profit centre does not make investment decisions. Investment centres

Two measures commonly used for investment centre managers are return on investment and residual income.



Return on investment (ROI) =

investment )(traceable leControllabprofit )(traceable leControllab

Residual income = controllable (traceable) profit – imputed interest charge on investment.

Example

Division X currently has net assets of $10 million and profits of $2.2 million per annum. It is considering two proposals:

Proposal 1 – an investment in assets of $1 million to earn an additional profit of $0.15 million.

Proposal 2 – selling noncurrent assets at their net book value of $2.3 million. This would reduce profits by 0.3 million. The proceeds from sale would be remitted to head office (i.e. they would reduce divisional investment.)

Division X’s cost of capital is 10%.

Required:

Calculate the current ROI and residual income of the division. Show how they would change under each of the proposals.

Solution

Current situation

ROI = million 10million 2.2

= 22%.

Residual income: = 2.2 million – (10 million × 10%) = $1.2 million.

If proposal 1 is accepted

ROI = million 1 illion

million 0.15 million 2.2

m 10=

illionmillion 2.35

m 11 = 21.4%

Residual income = 2.35million – (11 million × 10%) = 1.25 million.

Comment

The return of the proposal is million 1

million 0.15 = 15%.

Since this exceeds the cost of capital, from the overall company point of view, the proposal should be accepted.

If the manager of the division is judged on ROI however, the proposal may be rejected, as it would reduce the divisional ROI from the current 22% to 21.4%. Thus ROI can result in dysfunctional behaviour.



The proposal generates positive residual income however, so would be accepted by a manager who is judged on this.

If proposal 2 is accepted

ROI = million 2.3 - illionmillion 0.3 - million 2.2

m 10 = 24.7%

Residual income = 1.9million – (7.7 million × 10%) = 1.13 million.

Comment

This proposal should be rejected, as the return on the assets disposed of is 13%. If ROI were used as the performance measure, however, the proposal would be accepted as it increases the divisions ROI. If residual income were used, the proposal would be rejected.

Conclusion – in both cases, ROI has led to dysfunctional behaviour, while the use of residual income has led to the right decision being made.

Relative merits of ROI and residual income

ROI is a relative measure. This ignores the absolute profit – for example an investment of $100 invested at 25% would only generate $25, while an investment of $1 million invested at a rate of 15% generates $150,000. Which would you prefer?

Residual income is consistent with net present value approach to investment appraisal. This is the theoretically superior way to make investment decisions. (Net present value is not in the F5 syllabus.)

On the other hand residual income makes it difficult to compare the performance of divisions of different sizes.

Both methods suffer from the fact that if assets are valued at net book value, the ROI and residual income improve as the assets get older. This may encourage managers to retain old machinery.



Non-financial performance indicators

Weaknesses of traditional financial performance indicators include the following:

Single factor measures (e.g. ROI and residual income) do not give a complete picture of divisional performance

Single factor numbers may be distorted (for example by accepting proposal 2 in the example above – thus improving measured ROI.

May lead to dysfunctional behaviour.

Financial performance indicators have therefore been used more commonly in recent years.

Balanced Scorecard

The balanced scorecard approach to performance measurement attempts to measure the performance of an organisation under 4 headings:

Financial success Customer satisfaction Process efficiency Growth

Organisations should attempt to identify Key performance indicators that can be used to measure performance under each heading. Key performance indicators are based on the organisation’s critical success factors. Critical success factors are performance requirements that are fundamental to an organisation’s success-for example innovation in the electronics industry.

Key performance indicators should be:

Specific (for example, profit is specific, financial performance is not as it could mean different things to different people.)

Measurable

Relevant – to achievement of a critical success factor.



Example

A training company providing tuition for ACCA exams could have the following performance indicators:

Perspective Critical success Factors

Key performance indicators

Financial Shareholder wealth Dividend yield % increase in share price

Cash flow Actual v budget

Customer perspective

Exam success Pass rates v nationalPremier college status

Process efficiency

Resource utilisation % room occupancy

Average class size Average tutor teaching

Growth New products % sales from new courses

Advantages of the balanced scorecard

Measures performance in a variety of ways.

Difficult for managers to hide the true picture if multiple measures are used.

Encourages a longer term view of business performance.

It is flexible – measures can be changed over time to reflect changing priorities.

Difficulties of balanced scorecard

Setting standards for key performance indicators (targets).

There may be trade-offs (i.e. performance is good in some areas, poor in others).

TRANSFER PRICING


TRANSFER PRICING

See the ACCA’s website for the full article by Ken Garrett.

When transfer prices are needed

Transfer prices are almost inevitably needed whenever a business is divided into more than one department or division.

Transfer price is the monetary value used to record goods or services leaving one department and entering the next.

For every $1 increase in the transfer price, selling will make $1 more profit and buying division will make $1 less profit.

Changing the transfer price will have the following effects:

1. Performance evaluation – whether measured by return on investment (ROI) or residual income (RI).

2. In a system of performance related pay, remuneration of employees in each division will be affected, as profits will change.

3. Make/abandon/buy-in decisions. If the transfer price is too high, the receiving might abandon the product line or buy in cheaper component from outside suppliers.

4. Motivation. If a transfer price is such that it is impossible for a division to make a profit, its employees would probably be demotivated. In contrast, the other division would make profits easily and its employees would not be motivated to work more efficiently.

5. Investment appraisal. The cash inflows arising from an investment are most certainly going to be affected by the transfer price, so capital investment decisions can depend on the transfer price.

6. Taxation and profit remittance. If the divisions are in different countries the profits earned in each country will depend on transfer prices. This could affect the overall tax burden of the group.

Characteristics of a good transfer price

Preserves divisional autonomy. Divisional managers are likely to resent being told by head office which products they should make or sell.

Perceived as being fair for the purposes of divisional performance evaluation and investment decisions.

Permits each division to make a profit.

Encourages divisions to make decisions that maximise group profits (i.e. goal congruence).

TRANSFER PRICING


The economic transfer price rule

Minimum transfer price (fixed by transferring division) marginal cost of transfer-out division.

Maximum transfer price (fixed by receiving division) net marginal revenue of transfer-in division.

Example Division A Division B $ $ Transfer-in price – 50 Own costs Variable 18 10 Fixed 12 10 Divisional profit/mark up 20 40 ––– ––– Transfer-out/final sale price 50 90 ––– –––

The minimum transfer price acceptable to Division A would be $18, as this is the marginal cost of production.

For Division B the transfer-in price should be no greater than the net marginal revenue (marginal revenue less own marginal costs) = $80 ($90 $10).

A $50 transfer price would work, since it is $18 and $80. Both parties will find it worth trading at that price.

The economic rule leads to decisions in the interests of the group as a whole:

If the final selling price (for Division B) were to fall to $25, the group could not make a contribution as the group’s variable cost is $28 ($18 + $10).

The transfer price that would make both divisions trade must be no less than $18 for Division A, but no greater than $15 (net marginal revenue) for Division B. No workable transfer price is available and the divisions would not trade with each other.

Problems with this approach

Variable costs and final selling prices will change continually in the real world.

The range of transfer prices set (from $18 to $80) is large, and therefore the respective profits of the two divisions could vary vastly depending on where within the range they agree the final price.

TRANSFER PRICING


Practical approaches

1. Variable cost

Transfer price = Variable cost of the transferring division

Produces good economic decisions, since the buying division’s marginal costs (including the transfer price) will be the same as those of the group.

Performance measurement is distorted – Division A makes a loss, while Division B is not charged enough to cover all the costs of manufacture.

There is little incentive for Division A to be efficient if all the marginal costs are covered by a transfer price.

2. Full cost

Transfer price = Full absorption cost

Is more satisfactory for Division A, as it will now cover its costs.

Can lead to dysfunctional behaviour if transfer price is too high as it does not reflect marginal cost to the company (e.g. buying division buys externally for a price higher than the marginal cost of selling division).

3. Market price

Both divisions make a profit if they operate at normal industry efficiencies.

Objective transfer price not based on arbitrary mark ups.

Could lead to dysfunctional behaviour, as fixed costs and profits of the selling division become variable (marginal) costs to the buying division.

4. Variable cost plus lump sum

Transfer price is variable cost plus periodic lump sum for fixed costs and profit.

Buying Division (B) has the correct cumulative variable cost information to make good decisions

Lump sum allows the divisions ultimately to be treated fairly with respect to performance measurement.

5. Dual pricing

In this approach, Division A transfers out at a cost plus mark up (perhaps a market price), and Division B transfers in at variable cost. Therefore Division A can make a motivating profit while Division B has good economic data about cumulative group variable costs. Obviously the divisional current accounts will not agree and some period-end adjustments will be needed to reconcile those and to eliminate fictitious inter divisional profits.

EXAMINER’S REPORT – DECEMBER 2015


This is a summary of the examiner’s reports for September and December 2015. The questions referred to are those in ACCA’s “hybrid” paper for September/December 2015. The full reports can be found on the ACCA web site.

Section A

The majority attempted all the questions.

Section B

Question 1 (10 marks)

Part (a) required knowledge of the steps involved in target costing.

This was well answered by most candidates.

Part (b) required candidates to discuss the benefits and difficulties faced in implementing target costing within a service provider.

It was pleasing to see that many were aware of how service providers differ from manufacturers.

A common error was to explain the characteristics of service providers but not apply them to target costing.

! Read the question – the requirement asked for benefits and difficulties; two separate things.

Some failed to achieve full marks as they only addressed half of the requirement.

! Candidates should break up their written answers with headings where:

to give the answer structure; and to ensure that the whole requirement is met.


This question required candidates to assess the performance of a company.

Part (b) required a discussion whether a statement made by the company’s managing director regarding performance was true. The statement made two key points – stronger answers took each point in turn and assessed its validity.

A significant minority misinterpreted (or did not read?) the requirement and discussed the performance of the company, and how it might improve.

Part (c) tested knowledge of the terms efficiency and effectiveness in a VFM framework and their application in this scenario.

A pleasing number scored very well on this part – applying knowledge to the information in the scenario.

EXAMINER’S REPORT – DECEMBER 2015



Part (a) required calculation of materials mix and materials yield variances.

Was generally well done.

Many used standard price per unit rather than standard price per kilogram in the mix variance.

In calculating standard quantity in standard mix (for the yield variance) many used standard cost card quantities rather than standard quantity for actual output.

Part (b) asked for reasons why an adverse variance yield variance might arise. Common errors/ issues were:

Giving reasons for a favourable variance.

Failure to expand on why an issue may cause an adverse yield.

Question 4

This covered multi-product CVP analysis for a business selling three products.

It was encouraging to see that many were well prepared for these questions.

Part (a) required calculation of the weighted average C/S ratio and was well-answered by most.

Many simply took the mean of the individual contribution to sales ratios.

Part (c) asked for a multi-product breakeven chart.

Many answers gave a P/V chart.

! Read requirements carefully.

Question 5

Part (a) required calculations of ROI and a justification of the figures being used.

Many forgot or otherwise failed to justify their figures.

Controllable profit should have been used. (However, if net profit was used with appropriate justification, it would have been acceptable.)

In part (b) the bonuses of the managers had to be calculated.

Inattention to detail let down a majority; how the bonus was to be calculated needed to be read carefully.

ANALYSIS OF SPECIMEN AND PAST EXAMINATIONS


Section A 1 June 2015

December 2014

Specimen Exam

Specialist cost and management accounting

5 MCQs 5 MCQs 5 MCQs

Decision making techniques 5 MCQs 5 MCQs 5 MCQs

Budgeting and control 1 MCQ 3 MCQs 4 MCQs

Standard costing and variance analysis 3 MCQs 2 MCQs 2 MCQs

Performance measurement 6 MCQs 5 MCQs 4 MCQs

Numerical/non-numerical items 9/11 8/12 8/12

1 This section is no longer published by ACCA.



Section B December 2015

September2015

June 2015

December 2014

Specimen Exam

Marks for numerical/ non-numerical Not known Not known 31/29 29/31 32/28 Activity based costing ● ● Target costing ● Throughput accounting ● ● Relevant costing ● Cost volume profit analysis ● Limiting factor decisions ● Pricing ● Risk and uncertainty ● ● Types of budgeting ● ● Learning curve theory ● Mix and yield variances ● ● Operational and planning variances ● ● ● Performance measurement ● ● Further aspect of performance analysis ● ● Divisional performance measures ● ● Transfer pricing ●



SPECIMEN EXAM

General comments

The specimen exam introduces the exam format that takes effect from September 2016:

Section A: 15 Objective test (OT) questions of two marks each

Section B: three 10-mark “OT cases”, each containing five OTs worth two marks each

Section C: two 20 mark “constructed response” questions.

Questions in Section A and B will be drawn from the whole syllabus; Section C could cover any syllabus area except specialist cost and management accounting techniques.

While OT questions have been used in the F5 exam since December 2014, OT cases are introduced for the first time in September 2016. All exam questions prior to December 2014 were constructed response questions of 20 marks each.

Practicing previous exam questions is an effective method of preparation. However, rather than download previous exam papers from the ACCA website (which are as originally published in an old format) it is recommended that you use an ACCA Approved Revision Question Bank with questions in the current format.

Section A (MCQs) No. of items

Cost and management accounting techniques 5 Decision making techniques 3 Budgeting and control (includes variance analysis) 2 Performance measurement and control 5 Overall requiring calculations 8

Section B

Case one – Qs 16 – 20

Focusses on throughput accounting with two questions requiring calculation.

Case two – Qs 21 – 25

Deals with learning curve theory, budgeting and pricing with three questions involving calculation.

Case three – Qs 26 – 30

Tests relevant costing and includes three questions requiring calculation.



Section C

Question 1 (20 marks) – variance analysis

Part (a) asks for a calculation of variances for two divisions (11 marks). Part (b) asks for a discussion of the usefulness of the material price planning and operational variances.

Parts (a) involves fairly straightforward calculations. 9 marks were for calculating basic traditional variances, showing that there are plenty of easy marks available.

Part (b) requires the higher skill of being able to evaluate the variances.

Question 2 (20 marks) – performance measurement

Part (a), worth 14 marks, requires assessment of the financial performance of a company that operates a theme park. A statement of profit or loss is provided for two years, along with some narrative.

Part (b), worth 6 marks, provides some additional non-financial performance measures and asks for an assessment of the quality of service and an indication of the risks of the company continuing with its current policies.

When answering part (a), you should be aiming to provide meaningful comments that add value, rather than simply making superficial comments giving percentage increases or decreases.

Spend plenty of time planning such a question:

Identify the key trends – balances that have changed significantly in both % terms and $ terms.

Identify the reasons for the trends – from the qualitative information given – you may also need to think about possible causes.

Identify other things that may be related. In this case, there was a fall in maintenance expenditure and the cost of repairs had increased.

Having planned in this way, write your answer. A good approach is for each trend to write:

What happened? Why did it happen? What other items were affected? Give an opinion.

Finally, do not try to comment on everything, just on the major trends identified. This means your report focuses on the important areas, without distracting the user with less interesting details.

There are two parts to the requirement of part (b) – to assess the quality of service and to indicate the risks of continuing with the current policies. This shows the importance of reading the requirements carefully, it would be easy to miss the second requirement.

EXAMINATION TECHNIQUE


Reading and planning time

With effect from September 2016 there will no longer be a distinction between the 15 minutes reading and planning time and the three hours writing time. Candidates will be permitted to start writing in their answer booklet from the start of the exam.

However, you must still allow time, during the exam, to read and plan the Section C questions, in particular.

Overall approach

Start by planning your approach: Which order to do the questions in, and writing a timetable on the front page of your answer booklet.

Do Section C questions first – spend 36 minutes on each question. Do your best Section C question first.

Do Section B after completing Section C. Again do the Section B questions in order of preference with your best question first. Spend 18 minutes on each case

54 minutes before the end of the exam, start Section A.

SECTION A

Each item will have one correct answer and three “distractors” (plausible but incorrect answers).

Avoid reading the answers to calculation questions until you have completed your own calculations to avoid being fooled into choosing a distractor.

Although the average time per item should be 3.6 minutes it is likely that some items, particularly narrative ones, will require less time while others will require more.

If an item looks particularly difficult or time consuming, skip it initially, and return to it when you have answered all of the “easier” questions.

It is important to give yourself sufficient time to answer the easy questions since you are more likely to get these right.

After dealing with the easy questions, return to the difficult questions. If you do not have time to attempt these properly:

Eliminate any obviously wrong distractors and guess from the remaining alternatives.



SECTION B

The “case-based” OT questions will consist of a scenario followed by five OT questions.

One or two of the five, particularly the last two, may be fairly easy qualitative questions that are independent of the case study and calculations. Do these first.

Attempt the remaining questions.

After 18 minutes on a particular case, guess any uncompleted questions and move on to the next.

SECTION C

You should apportion your time carefully between the parts of each question and ensure you attempt all parts of each question.

Numerical elements

Before starting a computation, picture your route. Do this by noting down the steps you are going to take and imagining the layout of your answer.

Write clearly and leave space between each step.

Include all your workings and cross-reference them to the face of your answer.

Write your assumptions – if you are not sure how to interpret something in the question then state your assumed interpretation.

If you later notice a mistake in your answer, it is not worthwhile spending time amending the consequent effects of it. The marker of your script will not punish you for errors caused by an earlier mistake.

Written elements

Planning

Read the requirement carefully to identify exactly what is required and how many separate points you are being asked to address.

Note down relevant thoughts on your plan.

Give your plan a structure which you will follow when you write up the answer.



Presentation

Use headings and sub-headings to give your answer structure and to make it easier to read.

Use short paragraphs for each point that you are making.

Separate paragraphs by leaving at least one line of space between each.

Use bullet points where this seems appropriate (e.g. for a list of advantages/disadvantages) – however each bullet point must be followed by a full sentence.

Write legibly using a good quality black pen. Consider using block capitals throughout.

Style

Long philosophical debate does not impress markers.

Where relevant give real life examples to support our comments.

If you write appropriate comments based on previous calculations which contained errors, you can still receive all the marks for the comments.

If you could not complete the calculations required for comment then assume an answer to the calculations. As long as your comments are consistent with your assumed answer you can still pick up all the marks for the comments.

As you write refer back to the requirement to ensure that you are answering it with relevant comments.

Keywords

Part of the secret of doing well in these exams is to actually understand what the question is asking. See the section Approaching Written Questions for further explanation of the following key words:

Describe” = “set out the characteristics of”

“Explain” = make plain, clarify, elucidate

“State” = express in words

“Discuss” = give balanced views on and conclude

“List” = make a list of like things

“Justify” = give reasoning

“Identify” (e.g. from the scenario)

“Comment” = make observations, appraise or examine

“Suggest” = propose or put forward

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Revision Essentials Handbook includes:

• ACCAsyllabusaimandmaincapabilities

• Coretopicschecklist

• Summaryofessentialfactsandtheory

• Furtherreading

• Relevantarticles

• Comprehensiveanalysisofpastexaminations

• Examiners'feedbackforthelastexamsession

• Examtechnique

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