F5_Intro+CN_J12_final.pdf by John Smith

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The Academy Paper F5 Performance Management June 2012 Course Notes

These materials are for use on PwC Business Academy courses only and are not for resale. These course notes have been prepared with permission of Kaplan Publishing and Kaplan retains the copyright for all contents.

Part 1 INTRO PACK

Content â&#x20AC;&#x201C; F5 INTRODUCTION

1. Exam technique 2. Tables and Formula Sheet 3. Past Exams 4. Relevant Articles from Student Accountant

1. EXAM TECHNIQUE 1.1. Exam Format    

15 minutes reading and planning time (RAPT) 3 hours for answering the questions 5 compulsory questions, 20 marks per each question Questions have both computational and discursive elements.

Paper F5, Performance management, seeks to examine candidates' understanding of how to manage the performance of a business. Generally the paper will seek to draw questions from as many of the syllabus sections as possible.

1.2. Examination Tips Spend the first few minutes of the examination reading the paper and planning your answers. During the reading time you may annotate the question paper but not write in the answer booklet. In particular you should use this time to ensure that you understand the requirements, highlighting key verbs, consider which parts of the syllabus are relevant and plan key calculations. Divide the time you spend on questions in proportion to the marks on offer. One suggestion for this examination is to allocate 1.8 minutes to each mark available, so a 20-mark question should be completed in approximately 36 minutes. Spend the last five minutes reading through your answers and making any additions or corrections. If you get completely stuck with a question, leave space in your answer book and return to it later. If you do not understand what a question is asking, state your assumptions. Even if you do not answer in precisely the way the examiner hoped, you should be given some credit, if your assumptions are reasonable. You should do everything you can to make things easy for the marker. The marker will find it easier to identify the points you have made if your answers are legible. Case studies: Most questions will be based on specific scenarios. To construct a good answer first identify the areas in which there are problems, outline the main principles / theories you are going to use to answer the question, and then apply the principles / theories to the case. It is essential that you tailor your comments to the scenario given. Essay questions: Some questions may contain short essay-style requirements. Your answer should have a clear structure. It should contain a brief introduction, a main section and a conclusion. Be concise. It is better to write a little about a lot of different points than a great deal about one or two points. Computations: It is essential to include all your workings in your answers. Many computational questions require the use of a standard format. Be sure you know these formats thoroughly before the exam and use the layouts that you see in the answers given in this book and in model answers. Reports, memos and other documents: some questions ask you to present your answer in the form of a report or a memo or other document. So use the correct format - there could be easy marks to gain here.

2. TABLES AND FORMULAE SHEET

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 b = the index of learning (log LR/log 2) LR = the learning rate as a decimal

Regression analysis y=a+bx b=

n∑xy-∑x∑y n∑x2 -(∑x)2 ∑y b∑x n n n∑xy-∑x∑y (n∑x2 -(∑x)2 )(n∑y 2 -(∑y)2 )

Demand curve

P = a – bQ

a = price when Q = 0

MR = a – 2bQ

b = change in price change in quantity

3. PAST EXAMS (questions, answers) Exam June 2011 Exam December 2010 Exam June 2010

Performance Management Monday 13 June 2011

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted. Formulae Sheet is on page 8. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F5

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 1

Cement Co is a company specialising in the manufacture of cement, a product used in the building industry. The company has found that when weather conditions are good, the demand for cement increases since more building work is able to take place. Last year, the weather was so good, and the demand for cement was so great, that Cement Co was unable to meet demand. Cement Co is now trying to work out the level of cement production for the coming year in order to maximise profits. The company doesn’t want to miss out on the opportunity to earn large profits by running out of cement again. However, it doesn’t want to be left with large quantities of the product unsold at the end of the year, since it deteriorates quickly and then has to be disposed of. The company has received the following estimates about the probable weather conditions and corresponding demand levels for the coming year: Weather Good Average Poor

Probability 25% 45% 30%

Demand 350,000 bags 280,000 bags 200,000 bags

Each bag of cement sells for $9 and costs $4 to make. If cement is unsold at the end of the year, it has to be disposed of at a cost of $0·50 per bag. Cement Co has decided to produce at one of the three levels of production to match forecast demand. It now has to decide which level of cement production to select. Required: (a) Construct a pay off table to show all the possible profit outcomes.

(8 marks)

(b) Decide the level of cement production the company should choose, based on the following decision rules: (i)

Maximin

(1 mark)

(ii) Maximax

(1 mark)

(iii) Expected value

(4 marks)

You must justify your decision under each rule, showing all necessary calculations. (c) Describe the ‘maximin’ and ‘expected value’ decision rules, explaining when they might be used and the attitudes of the decision makers who might use them. (6 marks) (20 marks)

Heat Co specialises in the production of a range of air conditioning appliances for industrial premises. It is about to launch a new product, the ‘Energy Buster’, a unique air conditioning unit which is capable of providing unprecedented levels of air conditioning using a minimal amount of electricity. The technology used in the Energy Buster is unique so Heat Co has patented it so that no competitors can enter the market for two years. The company’s development costs have been high and it is expected that the product will only have a five-year life cycle. Heat Co is now trying to ascertain the best pricing policy that they should adopt for the Energy Buster’s launch onto the market. Demand is very responsive to price changes and research has established that, for every $15 increase in price, demand would be expected to fall by 1,000 units. If the company set the price at $735, only 1,000 units would be demanded. The costs of producing each air conditioning unit are as follows: Direct materials Labour Fixed overheads Total cost

$ 42 12 (1·5 hours at $8 per hour. See note below) 6 (based on producing 50,000 units per annum) ––– 60 –––

Note The first air conditioning unit took 1·5 hours to make and labour cost $8 per hour. A 95% learning curve exists, in relation to production of the unit, although the learning curve is expected to finish after making 100 units. Heat Co’s management have said that any pricing decisions about the Energy Buster should be based on the time it takes to make the 100th unit of the product. You have been told that the learning co-efficient, b = –0·0740005. All other costs are expected to remain the same up to the maximum demand levels. Required: (a) (i)

Establish the demand function (equation) for air conditioning units;

(3 marks)

(ii) Calculate the marginal cost for each air conditioning unit after adjusting the labour cost as required by the note above; (6 marks) (iii) Equate marginal cost and marginal revenue in order to calculate the optimum price and quantity. (3 marks) (b) Explain what is meant by a ‘penetration pricing’ strategy and a ‘market skimming’ strategy and discuss whether either strategy might be suitable for Heat Co when launching the Energy Buster. (8 marks) (20 marks)

[P.T.O.

Noble is a restaurant that is only open in the evenings, on SIX days of the week. It has eight restaurant and kitchen staff, each paid a wage of $8 per hour on the basis of hours actually worked. It also has a restaurant manager and a head chef, each of whom is paid a monthly salary of $4,300. Noble’s budget and actual figures for the month of May was as follows: Number of meals Revenue: Food Drinks

Budget 1,200 $ 48,000 12,000 –––––––

Actual 1,560 $ 60,840 11,700 ––––––––

60,000 Variable costs: Staff wages Food costs Drink costs Energy costs Contribution Fixed costs: Manager’s and chef’s pay Rent, rates and depreciation Operating profit

(9,216) (6,000) (2,400) (3,387)

72,540 (13,248) (7,180) (5,280) (3,500)

(21,003) ––––––– 38,997 (8,600) (4,500) –––––––

(13,100) –––––––– 25,897 –––––––

(29,208) –––––––– 43,332 (8,600) (4,500) –––––––

(13,100) –––––––– 30,232 ––––––––

The budget above is based on the following assumptions: 1

The restaurant is only open six days a week and there are four weeks in a month. The average number of orders each day is 50 and demand is evenly spread across all the days in the month.

The restaurant offers two meals: Meal A, which costs $35 per meal and Meal B, which costs $45 per meal. In addition to this, irrespective of which meal the customer orders, the average customer consumes four drinks each at $2·50 per drink. Therefore, the average spend per customer is either $45 or $55 including drinks, depending on the type of meal selected. The May budget is based on 50% of customers ordering Meal A and 50% of customers ordering Meal B.

Food costs represent 12·5% of revenue from food sales.

Drink costs represent 20% of revenue from drinks sales.

When the number of orders per day does not exceed 50, each member of hourly paid staff is required to work exactly six hours per day. For every incremental increase of five in the average number of orders per day, each member of staff has to work 0·5 hours of overtime for which they are paid at the increased rate of $12 per hour. You should assume that all costs for hourly paid staff are treated wholly as variable costs.

Energy costs are deemed to be related to the total number of hours worked by each of the hourly paid staff, and are absorbed at the rate of $2·94 per hour worked by each of the eight staff.

Required: (a) Prepare a flexed budget for the month of May, assuming that the standard mix of customers remains the same as budgeted. (12 marks)

(b) After preparation of the flexed budget, you are informed that the following variances have arisen in relation to total food and drink sales: Sales mix contribution variance Sales quantity contribution variance

$1,014 Adverse $11,700 Favourable

Required: BRIEFLY describe the sales mix contribution variance and the sales quantity contribution variance. Identify why each of them has arisen in Noble’s case. (4 marks) (c) Noble’s owner told the restaurant manager to run a half-price drinks promotion at Noble for the month of May on all drinks. Actual results showed that customers ordered an average of six drinks each instead of the usual four but, because of the promotion, they only paid half of the usual cost for each drink. You have calculated the sales margin price variance for drink sales alone and found it to be a worrying $11,700 adverse. The restaurant manager is worried and concerned that this makes his performance for drink sales look very bad. Required: Briefly discuss TWO other variances that could be calculated for drinks sales or food sales in order to ensure that the assessment of the restaurant manager’s performance is fair. These should be variances that COULD be calculated from the information provided above although no further calculations are required here. (4 marks) (20 marks)

(a) Brace Co is an electronics company specialising in the manufacture of home audio equipment. Historically, the company has used solely financial performance measures to assess the performance of the company as a whole. The company’s Managing Director has recently heard of the ‘balanced scorecard approach’ and is keen to learn more. Required: Describe the balanced scorecard approach to performance measurement.

(10 marks)

(b) Brace Co is split into two divisions, A and B, each with their own cost and revenue streams. Each of the divisions is managed by a divisional manager who has the power to make all investment decisions within the division. The cost of capital for both divisions is 12%. Historically, investment decisions have been made by calculating the return on investment (ROI) of any opportunities and at present, the return on investment of each division is 16%. A new manager who has recently been appointed in division A has argued that using residual income (RI) to make investment decisions would result in ‘better goal congruence’ throughout the company. Each division is currently considering the following separate investments: Capital required for investment Sales generated by investment Net profit margin

Project for Division A $82·8 million $44·6 million 28%

Project for Division B $40·6 million $21·8 million 33%

The company is seeking to maximise shareholder wealth. Required: Calculate both the return on investment and residual income of the new investment for each of the two divisions. Comment on these results, taking into consideration the manager’s views about residual income. (10 marks) (20 marks) 5

[P.T.O.

Thin Co is a private hospital offering three types of surgical procedures known as A, B and C. Each of them uses a pre-operative injection given by a nurse before the surgery. Thin Co currently rent an operating theatre from a neighbouring government hospital. Thin Co does have an operating theatre on its premises, but it has never been put into use since it would cost $750,000 to equip. The Managing Director of Thin Co is keen to maximise profits and has heard of something called ‘throughput accounting’, which may help him to do this. The following information is available: 1

All patients go through a five step process, irrespective of which procedure they are having: – – – – –

step step step step step

1: 2: 3: 4: 5:

consultation with the advisor; pre-operative injection given by the nurse; anaesthetic given by anaesthetist; procedure performed in theatre by the surgeon; recovery with the recovery specialist.

The price of each of procedures A, B and C is $2,700, $3,500 and $4,250 respectively.

The only materials’ costs relating to the procedures are for the pre-operative injections given by the nurse, the anaesthetic and the dressings. These are as follows: Procedure A $ per procedure Pre-operative nurse’s injections 700 Anaesthetic 35 Dressings 5·60

Procedure B $ per procedure 800 40 5·60

Procedure C $ per procedure 1,000 45 5·60

There are five members of staff employed by Thin Co. Each works a standard 40-hour week for 47 weeks of the year, a total of 1,880 hours each per annum. Their salaries are as follows: – – – – –

Advisor: $45,000 per annum; Nurse: $38,000 per annum; Anaesthetist: $75,000 per annum; Surgeon: $90,000 per annum; Recovery specialist: $50,000 per annum.

The only other hospital costs (comparable to ‘factory costs’ in a traditional manufacturing environment) are general overheads, which include the theatre rental costs, and amount to $250,000 per annum. 5

Maximum annual demand for A, B and C is 600, 800 and 1,200 procedures respectively. Time spent by each of the five different staff members on each procedure is as follows:

Advisor Nurse Anaesthetist Surgeon Recovery specialist

Procedure A Hours per procedure 0·24 0·27 0·25 0·75 0·60

Procedure B Hours per procedure 0·24 0·28 0·28 1 0·70

Procedure C Hours per procedure 0·24 0·30 0·33 1·25 0·74

Part hours are shown as decimals e.g. 0·24 hours = 14·4 minutes (0·24 x 60). Surgeon’s hours have been correctly identified as the bottleneck resource.

Required: (a) Calculate the throughput accounting ratio for procedure C. Note: It is recommended that you work in hours as provided in the table rather than minutes.

(6 marks)

(b) The return per factory hour for products A and B has been calculated and is $2,612路53 and $2,654路40 respectively. The throughput accounting ratio for A and B has also been calculated and is 8路96 and 9路11 respectively. Calculate the optimum product mix and the maximum profit per annum.

(7 marks)

(c) Assume that your calculations in part (b) showed that, if the optimum product mix is adhered to, there will be excess demand for procedure C of 696 procedures per annum. In order to satisfy this excess demand, the company is considering equipping and using its own theatre, as well as continuing to rent the existing theatre. The company cannot rent any more theatre time at either the existing theatre or any other theatres in the area, so equipping its own theatre is the only option. An additional surgeon would be employed to work in the newly equipped theatre. Required: Discuss whether the overall profit of the company could be improved by equipping and using the extra theatre. Note: Some basic calculations may help your discussion.

(7 marks) (20 marks)

[P.T.O.

Formulae Sheet

Learning curve Y = axb Where Y = a= x= b= LR =

cumulative average time per unit to produce x units the time taken for the first unit of output the cumulative number of units produced the index of learning (log LR/log2) the learning rate as a decimal

Regression analysis y=a+bx

Q [\ [ y Q [2 x)2

\ E x n n

Q [\- [ y 2

(Q [ x)2 )(n \ 2 y)2 )

Demand curve P = a – bQ b=

change in price change in quantity

a = price when Q = 0 MR = a – 2bQ

End of Question Paper

Answers

Fundamentals Level – Skills Module, Paper F5 Performance Management 1

June 2011 Answers

Cement Co (a)

Pay off table Prob.*

DEMAND

Weather Good Average Poor

$’000 $’000 $’000

350,000 $’000 1,750 (1) 1,085 (2) 325

0·25 0·45 0·3

SUPPLY (no. of bags) 280,000 $’000 1,400 1,400 640

200,000 $’000 1,000 1,000 1,000

* The probability column is only shown so as to help in part (b) (iii)’s calculations. Profit per bag sold in coming year = $9 – $4 = $5 Loss per bag disposed of = $4 + $0·50 = $4·50 (1) 350,000 x $5 = $1,750,000 (2) [280,000 x $5] – [70,000 x $(4·50)] = $1,085,000 etc (b)

(i)

Maximin – identify the worst outcome for each level of supply and choose the highest of these worst outcomes.

Worst

350,000 $’000 325

SUPPLY (no. of bags) 280,000 $’000 640

200,000 $’000 1000

The highest of these is $1,000,000 therefore choose to supply only 200,000 bags to meet poor conditions. (ii)

Maximax – identify the best outcome for each level of supply and choose SUPPLY (no. of bags) 350,000 280,000 $’000 $’000 Best 1,750 1,400

the highest of these best outcomes. 200,000 $’000 1,000

The highest of these is $1,750,000 therefore choose to supply 350,000 bags to meet good conditions. (iii) Expected value – use the probabilities provided in order to calculate the expected value of each of the supply levels. Good Average Poor

(0·25 x $1,750,000) + (0·45 x $1,085,000) + (0·30 x $325,000) = $1,023,250 (0·7 x $1,400,000) + (0·3 x $640,000) = $1,172,000 1 x $1,000,000 = $1,000,000

The expected value of producing 280,000 bags when conditions are average is the highest at $1,172,000, therefore this supply level should be chosen. (c)

Maximin and expected value decision rules The ‘maximin’ decision rule looks at the worst possible outcome at each supply level and then selects the highest one of these. It is used when the outcome cannot be assessed with any level of certainty. The decision maker therefore chooses the outcome which is guaranteed to minimise his losses. In the process, he loses out on the opportunity of making big profits. It is often seen as the pessimistic approach to decision-making (assuming that the worst outcome will occur) and is used by decision makers who are risk averse. It can be used for one-off or repeated decisions. The ‘expected value’ rule calculates the average return that will be made if a decision is repeated again and again. It does this by weighting each of the possible outcomes with their relative probability of occurring. It is the weighted arithmetic mean of the possible outcomes. Since the expected value shows the long run average outcome of a decision which is repeated time and time again, it is a useful decision rule for a risk neutral decision maker. This is because a risk neutral person neither seeks risk or avoids it; they are happy to accept an average outcome. The problem often is, however, that this rule is often used for decisions that only occur once. In this situation, the actual outcome is unlikely to be close to the long run average. For example, with Cement Co, the closest actual outcome to the expected value of $1,172,000 is the outcome of $1,085,000. This is not too far away from the expected value but many of the others are really different.

The Energy Buster (a)

Profit In order to ascertain the optimum price, you must use the formula P = a – bQ Where P = price; Q = quantity; a = intersection (price at which quantity demanded will be nil); b = gradient of the demand curve. The approach is as follows: (i)

Establish the demand function b = change in price/change in quantity = $15/1,000 = 0·015. We know that if price = $735, quantity = 1,000 units. Establish ‘a’ by substituting these values for P, Q and b into our demand function: 735 = a – 0·015Q 15 + 735 = a Therefore a = 750. Demand function is therefore P = 750 – 0·015Q

(ii)

Establish marginal cost The labour cost of the 100th unit needs to be calculated as follows: Formula = y = axb. a = 1·5 Therefore, if x = 100 and b= –·0740005, then y = 1·5 x 100–0·0740005 = 1·0668178 Therefore cost per unit = 1·0668178 x $8 = $8·5345 Total cost for 100 units = $853·45. If x = 99, y = 1·5 x 99–0·0740005 = 1·0676115 Therefore cost per unit = $8·5408 Total cost for 99 = $845·55 Therefore cost of 100th unit = $853·45 – $845·55 = $7·90. Therefore total marginal cost = $42 + $7·90 = $49·90. Fixed overheads have been ignored as they are not part of the marginal cost.

(iii) Find profit (1) Establish the marginal revenue function MR = a – 2bQ MR = 750 – 0·03Q (2) Equate MC and MR 49·90 = 750 – 0·03Q 0·03Q = 700·1 Q = 23,337 (3) Find optimum price P = 750 – (0·015 x 23,337) = $399·95 (b)

(i)

Penetration pricing With penetration pricing, a low price would initially be charged for the Energy Buster. The idea behind this is that the price will make the product accessible to a larger number of buyers and therefore the high sales volumes will compensate for the lower prices being charged. A large market share would be gained and possibly, the Energy Buster might become accepted as the only industrial air conditioning unit worth buying. The circumstances that would favour a penetration pricing policy are: –

highly elastic demand for the Energy Buster i.e. the lower the price, the higher the demand. The preliminary research does suggest that demand is elastic.

–

if significant economies of scale could be achieved by Heat Co, then higher sales volumes would result in sizeable reductions in costs. This is not the case here, since learning ceases at 100 units.

–

if Heat Co was actively trying to discourage new entrants into the market. In this case, new entrants cannot enter the market anyway, because of the patent.

–

if Heat Co wished to shorten the initial period of the Energy Buster’s life cycle so as to enter the growth and maturity stages quickly. We have no evidence that this is the case for Heat Co, although it could be.

From the above, it can be seen that this could be a suitable strategy in some respects but it is not necessarily the best one. (ii)

Market skimming With market skimming, high prices would initially be charged for the Energy Buster rather than low prices. This would enable Heat Co to take advantage of the unique nature of the product, thus maximising sales from those customers who like to have the latest technology as early as possible. The most suitable conditions for this strategy are: –

the product is new and different. This is indeed the case with the Energy Buster.

–

the product has a short life cycle and high development costs that need to be recovered quickly. The life cycle is fairly short and high development costs have been incurred.

–

since high prices attract competitors, there needs to be barriers to entry in order to deter competitors. In Heat Co’s case, there is a barrier, since it has obtained a patent for the Energy Buster.

–

the strength and sensitivity of demand are unknown. Again, this is not the case here.

Once again, the Energy Buster meets only some of the conditions which would suggest that although this strategy may be suitable the answer is not clear cut. The fact that high development costs have been incurred and the life cycle is fairly short are fairly good reasons to adopt this strategy. Whilst we have demand curve data, we do not really know just how reliable this data really is, in which case a skimming strategy may be a safer option.

Noble restaurant (a)

Flexed budget Number of meals Food sales (1) Drink sales (1) Total revenue Variable costs: Staff wages (2) Food costs (3) Drink costs (4) Energy costs (5)

Contribution Fixed costs: Manager’s and chef’s pay Rent, rates and depreciation

1,560 $ 62,400 15,600 –––––––

78,000 (12,672) (7,800) (3,120) (4,234) ––––––– (27,826) ––––––– 50,174 (8,600) (4,500) ––––––– (13,100) ––––––– 37,074 ––––––– –––––––

Operating profit (1) Food revenue Food revenue = 1,560 x $40 = $62,400 Drinks revenue = 1,560 x ($2·50 x 4) = $15,600.

(2) Staff wages Average number of orders per day = 1,560/(6 days x 4 weeks) = 65 per day. Therefore extra orders = 15 per day. 8 staff x 1·5 hours x 6 days x 4 weeks = 288 extra hours. At $12 per hour = $3,456 extra wages. Total flexed wages = $9,216 + $3,456 = $12,672. (3) Food costs Food costs = 12·5% x $62,400 = $7,800. (4) Drink costs Drinks costs = $15,600 x 20% = $3,120. (5) Energy costs Standard total hours worked = (8 x 6) x 6 days x 4 weeks = 1,152 hours. Extra hours worked = 288 (working 2). Total hours = 1,152 + 288 = 1,440. At $2·94 per hour = $4,234.

(b)

The sales mix contribution variance measures the effect on profit of changing the mix of actual sales from the standard mix. The sales quantity contribution variance measures the effect on profit of selling a different total quantity from the budgeted total quantity. The mix variance is adverse here. Since meal B generates a higher contribution than meal A, the adverse variance shows that more of meal A must have been sold, relative to B, than budgeted. Since the quantity variance is favourable, this means that the total quantity of meals sold (in the standard mix) was higher than expected, as evidenced by the number of meals sold being 1,560 rather than the budgeted 1,200.

(c)

Two other variances Drink sales As well as the price variance for drinks sales, the sales margin volume variance could be calculated. This will examine the difference between the standard volume of sales that would ordinarily be expected for this number of customers (1,560 x 4 drinks) compared to the actual volume of drinks sold because of the drinks promotion (1,560 x 6 drinks). Since the variance is calculated by applying the increase in volume to the standard margin, this variance will be favourable. In addition, the total sales margin price variance for drinks sales could be split into an operational and a planning variance. The manager is only responsible for any operational variance and any part of the sales margin variance that relates to a planning error (i.e. the last minute decision by the owner to run the drinks promotion) should be separated out. This way, the manager will not be held accountable for matters outside of his control. Food sales By running the half price drinks offer promotion, more customers have been attracted to the restaurant. Drinks have been treated as a ‘loss leader’ i.e. sold at a low price in order to entice customers. It would therefore be relevant to calculate some variances in relation to food sales in order to show how the drinks promotion has increased food sales. The most obvious one to calculate would be the sales margin volume variance for food sales. NOTE: Candidates only needed to mention two variances.

Brace Co (a)

Balanced scorecard The balanced scorecard is a strategic management technique for communicating and evaluating the achievement of the strategy and mission of an organisation. It comprises an integrated framework of financial and non-financial performance measures that aim to clarify, communicate and manage strategy implementation. It translates an organisation’s strategy into objectives and performance measurements for the following four perspectives: Financial perspective The financial perspective considers how the organisation appears to shareholders. How can it create value for its shareholders? Kaplan and Norton, who developed the balanced scorecard, identified three core financial themes that will drive the business strategy: revenue growth and mix, cost reduction and asset utilisation. Customer perspective The customer perspective considers how the organisation appears to customers. The organisation should ask itself: ‘to achieve our vision, how should we appear to our customers?’. The customer perspective should identify the customer and market segments in which the business units will compete. There is a strong link between the customer perspective and the revenue objectives in the financial perspective. If customer objectives are achieved, revenue objectives should be too. Internal perspective The internal perspective requires the organisation to ask itself the question – ‘what must we excel at to achieve our financial and customer objectives?’. It must identify the internal business processes that are critical to the implementation of the organisation’s strategy. Kaplan and Norton identify a generic process value chain consisting of three processes: the innovation process, the operations process and the post-sales process. Learning and growth perspective The learning and growth perspective requires the organisation to ask itself whether it can continue to improve and create value. If an organisation is to continue having loyal, satisfied customers and make good use of its resources, it must keep learning and developing. It is critical that an organisation continues to invest in its infrastructure – i.e. people, systems and organisational procedures – in order to provide the capabilities that will help the other three perspectives to be accomplished.

(b)

Divisional performance ROI: Division A Net profit = $44·6m x 28% = $12·488m ROI = $12·488m/$82·8m = 15·08% Division B Net profit = $21·8m x 33% = $7·194m ROI = $7·194m/$40·6m = $17·72% Residual income: Division A Divisional profit = $12·488m Capital employed = $82·8m Imputed interest charge = $82·8m x 12% = 9·936m Residual income = $12·488m – $9·936m = $2·552m. Division B Divisional profit = $7·194m Capital employed = $40·6m Imputed interest charge = $40·6m x 12% = $4·872m Residual income = $7·194 – $4·872 = $2·322m. Comments If a decision about whether to proceed with the investments is made based on ROI, it is possible that the manager of Division A will reject the proposal whereas the manager of Division B will accept the proposal. This is because each division currently has a ROI of 16% and since the Division A investment only has a ROI of 15·08%, it would bring the division’s overall ROI down to less than it’s current level. On the other hand, since the Division B investment is higher than its current 16%, the investment would bring the division’s overall ROI up. When you consider what would actually be best for the company as a whole, you come to the conclusion that, since both investments have a healthy return, they should both be accepted. Hence, the fact that ROI had been used as a decision-making tool has led to a lack of goal congruence between Division A and the company as whole. This backs up what the new manager of Division A is saying. If they used residual income in order to aid the decision-making process, both proposals would be accepted by the divisions since both have a healthy RI. In this case, RI helps the divisions to make decisions that are in line with the best interests of the company. Once again, this backs up the new manager’s viewpoint. It is important to note, however, that each of the methods has numerous advantages and disadvantages that have not been considered here.

(a)

Throughput accounting ratio (TAR) TAR is traditionally defined as: return per factory hour/cost per factory hour. In this context, we are dealing with a hospital, so it will be: return per hospital hour/cost per hospital hour. Since, in throughput accounting, all costs except material costs are treated as fixed costs, total hospital costs will be all the salaries plus the general overheads: $45,000 + $38,000 + $75,000 + $90,000 + $50,000 + $250,000 = $548,000. Total hours of bottleneck resource, the surgeon’s time, = 40hrs x 47 weeks = 1,880 hours. Therefore cost per hospital hour = $548,000/1,880 = $291·49. Return per hospital hour now needs to be calculated. Selling price per unit Materials cost: – injection – anaesthetic – dressings Throughput per unit Time on BNR in hours Return per hour ($) TAR

$ 4,250 (1,000) (45) (5·6) ––––––––– 3,199·40 ––––––––– 1·25 2,559·52 $2,559·52/$291·49 = 8·78

(b)

Optimum production plan Limiting factor analysis can be used to determine the optimum production plan. Each procedure first needs to be ranked according to its TAR, then as many of each procedure should be performed as possible, starting with the most profitable procedure first. A $ 8·96 2

TAR Ranking Name B A C

Number 800 600 504

Hrs each 1 0·75 1·25

B $ 9·11 1

Total hours 800 450 630 –––––– 1,880 –––––– ––––––

T/P per hour 2,654·40 2,612·53 2,559·52

C $ 8·78 3 Total T/P 2,123,520 1,175,638·5 1,612,497·6 –––––––––––– 4,911,656·1 –––––––––––– ––––––––––––

The optimum production plan is therefore to perform the maximum number of procedures A and B (600 and 800 respectively) and perform only 504 of procedure C. Total profit will be: Throughput Less total costs Profit (c)

$ 4,911,656·1 (548,000) –––––––––––– 4,363,656·1 –––––––––––– ––––––––––––

Profitability increase At present, if the company adheres to the optimum production plan above, it will be satisfying customer demand for procedures A and B but not for procedure C. The most obvious way to try and increase profit would be to try and exploit demand for procedure C. There are two main factors that would need to be overcome in order for this demand to be exploited. Firstly, another surgeon would need to be employed. Most other members of staff clearly have excess time available, because the surgeon’s required time is at least double their required time. The recovery specialist, however, is currently used for 1,292·96 hours [(600 x 0·6) + (800 x 0·7) + (504 x 0·74)]. This staff member therefore has 587·04 spare hours available (1,880 – 1,292·96). This is enough to carry out the additional 696 procedures of C, gvien that each one uses 0·74 hours of the recovery specialist’s time (0·74 x 696 = 515·04). If another surgeon was employed he would be able to meet all of the excess demand for procedure C, which would be 696 procedures (1,200 – 504). Secondly, the other theatre would need to be equipped with the necessary equipment so that the second surgeon could operate in it. A quick calculation will show that this cost will be more than covered even in the first year (and the theatre cost is capital anyway, and will be benefitted from over many years). T/P from additional 696 procedures (696 x 1·25 x $2,559·52) = Cost of equipment Surgeon’s fee

$ 2,226,782 (750,000) (90,000) –––––––––– 1,386,782 ––––––––––

Without even taking into account future years, on the basis of one year’s throughput alone, it is worth equipping the second theatre provided that a suitably qualified second surgeon can be found.

Fundamentals Level – Skills Module, Paper F5 Performance Management

June 2011 Marking Scheme Marks

(a)

(b)

Pay off table Calculation of profit Calculation of loss ‘Demand’ label ‘Supply’ label Weather column Supply column – 350,000 Supply column – 280,000 Supply column – 200,000

1 1 0·5 0·5 0·5 1·5 1·5 1·5 ––– 8 –––

Decision criterion (i)

(ii)

Maximin Selecting highest of the low

1 –––

Maximax Selecting highest of the high

1 –––

(iii) Expected value Calculating EV when good Calculating EV average Calculating EV when poor Selecting highest

(c)

1 1 1 1 ––– 4 –––

Maximin and EV Describe maximin Used when outcome cannot be assessed with any certainty Risk averse/pessimistic One-off/repeated decisions Describe EV Risk neutral Repeated decisions Maximum marks Total marks

1 1 1 1 2 1 1 ––– 6 ––– 20 ––– –––

Marks 2

(a)

Profit using demand-based approach (i)

(ii)

Establish demand function: Find b Find a Write out demand function

1 1 1 ––– 3 –––

Find MC: Average cost of 100 Total cost of 100 Average cost of 99 Total cost of 99 Difference Correct total MC excluding fixed cost

1 1 1 1 1 1 ––– 6 –––

(iii) Establish MR function Equate MC and MR to find Q Find optimum price

(b)

1 1 1 ––– 3 –––

Market based strategies Penetration pricing Each valid point

1 ––– 4 –––

Max Market skimming Each valid point

1 ––– 4 ––– 20 ––– –––

Max Total marks

Marks 3

(a)

Flexed budget Food sales Drink sales Total revenue Staff wages Food costs Drinks costs Energy costs Variable costs total Contribution Manager’s and chef’s pay Rent & Rates Operating profit

(b)

Explanation of variances Suggestions of reason for variances

(c)

Variance discussions Each variance

1 1 1 1·5 1 1 1·5 1 1 0·5 0·5 1 ––– 12 ––– 2 2 ––– 4 –––

2 ––– 4 ––– 20 ––– –––

Maximum Total marks

(a)

Balanced scorecard approach Stating what it is Financial perspective Customer perspective Internal perspective Learning and growth perspective

2 2 2 2 2 ––– 10 –––

Maximum (b)

ROI/RI ROI for A ROI for B RI for A RI for B

1 1 2 2 ––– 6 –––

Maximum for ROI/RI Comments A rejects, B accepts under ROI Both accept under RI ROI produces wrong decision for company RI produces right decision Manager right Other factors to consider

1 1 1 1 1 1 ––– 6 ––– 10 ––– 20 ––– –––

Maximum for comments

Total marks

Marks 5

(a)

(b)

(c)

TAR Cost per hour Return per hour – C Ratio – C

3 2 1 ––– 6 –––

Optimum production plan Ranking Optimum number of A Optimum number of B Optimum number of C Total throughput Less cost Profit

1 1·5 1·5 1·5 0·5 0·5 0·5 ––– 7 –––

Discussion Demand satisfied for A & B Unsatisfied demand for C Calculation re recovery specialist Would need another surgeon Other staff have lots of idle time Need extra theatre time Profit calculation Financially feasible Each other valid point Conclusion

1 1 2 1 1 1 1 1 1 1 ––– 7 ––– 20 ––– –––

Maximum Total marks

Performance Management Monday 13 December 2010

Time allowed Reading and planning: Writing:

15 minutes 3 hours

The Association of Chartered Certified Accountants

Paper F5

Fundamentals Level â&#x20AC;&#x201C; Skills Module

This is a blank page. The question paper begins on page 3.

ALL FIVE questions are compulsory and MUST be attempted 1

Carad Co is an electronics company which makes two types of televisions – plasma screen TVs and LCD TVs. It operates within a highly competitive market and is constantly under pressure to reduce prices. Carad Co operates a standard costing system and performs a detailed variance analysis of both products on a monthly basis. Extracts from the management information for the month of November are shown below: Total number of units made and sold Material price variance Total labour variance

1,400 $28,000 A $6,050 A

Note 1 2 3

Notes (1) The budgeted total sales volume for TVs was 1,180 units, consisting of an equal mix of plasma screen TVs and LCD screen TVs. Actual sales volume was 750 plasma TVs and 650 LCD TVs. Standard sales prices are $350 per unit for the plasma TVs and $300 per unit for the LCD TVs. The actual sales prices achieved during November were $330 per unit for plasma TVs and $290 per unit for LCD TVs. The standard contributions for plasma TVs and LCD TVs are $190 and $180 per unit respectively. (2) The sole reason for this variance was an increase in the purchase price of one of its key components, X. Each plasma TV made and each LCD TV made requires one unit of component X, for which Carad Co’s standard cost is $60 per unit. Due to a shortage of components in the market place, the market price for November went up to $85 per unit for X. Carad Co actually paid $80 per unit for it. (3) Each plasma TV uses 2 standard hours of labour and each LCD TV uses 1·5 standard hours of labour. The standard cost for labour is $14 per hour and this also reflects the actual cost per labour hour for the company’s permanent staff in November. However, because of the increase in sales and production volumes in November, the company also had to use additional temporary labour at the higher cost of $18 per hour. The total capacity of Carad’s permanent workforce is 2,200 hours production per month, assuming full efficiency. In the month of November, the permanent workforce were wholly efficient, taking exactly 2 hours to complete each plasma TV and exactly 1·5 hours to produce each LCD TV. The total labour variance therefore relates solely to the temporary workers, who took twice as long as the permanent workers to complete their production. Required: (a) Calculate the following for the month of November, showing all workings clearly: (i)

The sales price variance and sales volume contribution variance;

(6 marks)

(ii) The material price planning variance and material price operational variance;

(2 marks)

(iii) The labour rate variance and the labour efficiency variance.

(7 marks)

(b) Explain the reasons why Carad Co would be interested in the material price planning variance and the material price operational variance. (5 marks) (20 marks)

[P.T.O.

The Accountancy Teaching Co (AT Co) is a company specialising in the provision of accountancy tuition courses in the private sector. It makes up its accounts to 30 November each year. In the year ending 30 November 2009, it held 60% of market share. However, over the last twelve months, the accountancy tuition market in general has faced a 20% decline in demand for accountancy training leading to smaller class sizes on courses. In 2009 and before, AT Co suffered from an ongoing problem with staff retention, which had a knock-on effect on the quality of service provided to students. Following the completion of developments that have been ongoing for some time, in 2010 the company was able to offer a far-improved service to students. The developments included: – – – – –

A new dedicated 24 hour student helpline An interactive website providing instant support to students A new training programme for staff An electronic student enrolment system An electronic marking system for the marking of students’ progress tests. The costs of marking electronically were expected to be $4 million less in 2010 than marking on paper. Marking expenditure is always included in cost of sales

Extracts from the management accounts for 2009 and 2010 are shown below: 2009 $’000 Turnover Cost of sales Gross profit Indirect expenses: Marketing Property Staff training Interactive website running costs Student helpline running costs Enrolment costs

2010

$’000 72,025 (52,078) –––––––– 19,947

3,291 6,702 1,287 – – 5,032 ––––––

Total indirect expenses Net operating profit

$’000

$’000 66,028 (42,056) ––––––– 23,972

4,678 6,690 3,396 3,270 2,872 960 –––––– (16,312) –––––––– 3,635 ––––––––

(21,866) ––––––– 2,106 –––––––

On 1 December 2009, management asked all ‘freelance lecturers’ to reduce their fees by at least 10% with immediate effect (‘freelance lecturers’ are not employees of the company but are used to teach students when there are not enough of AT Co’s own lecturers to meet tuition needs). All employees were also told that they would not receive a pay rise for at least one year. Total lecture staff costs (including freelance lecturers) were $41·663 million in 2009 and were included in cost of sales, as is always the case. Freelance lecturer costs represented 35% of these total lecture staff costs. In 2010 freelance lecture costs were $12·394 million. No reduction was made to course prices in the year and the mix of trainees studying for the different qualifications remained the same. The same type and number of courses were run in both 2009 and 2010 and the percentage of these courses that was run by freelance lecturers as opposed to employed staff also remained the same. Due to the nature of the business, non-financial performance indicators are also used to assess performance, as detailed below. 2009 Percentage of students transferring to AT Co from another training provider Number of late enrolments due to staff error Percentage of students passing exams first time Labour turnover Number of student complaints Average no. of employees

8% 297 48% 32% 315 1,080

2010 20% 106 66% 10% 84 1,081

Required: Assess the performance of the business in 2010 using both financial performance indicators calculated from the above information AND the non-financial performance indicators provided. NOTE: Clearly state any assumptions and show all workings clearly. Your answer should be structured around the following main headings: turnover; cost of sales; gross profit; indirect expenses; net operating profit. However, in discussing each of these areas you should also refer to the non-financial performance indicators, where relevant. (20 marks)

[P.T.O.

The Cosmetic Co is a company producing a variety of cosmetic creams and lotions. The creams and lotions are sold to a variety of retailers at a price of $23·20 for each jar of face cream and $16·80 for each bottle of body lotion. Each of the products has a variety of ingredients, with the key ones being silk powder, silk amino acids and aloe vera. Six months ago, silk worms were attacked by disease causing a huge reduction in the availability of silk powder and silk amino acids. The Cosmetic Co had to dramatically reduce production and make part of its workforce, which it had trained over a number of years, redundant. The company now wants to increase production again by ensuring that it uses the limited ingredients available to maximise profits by selling the optimum mix of creams and lotions. Due to the redundancies made earlier in the year, supply of skilled labour is now limited in the short-term to 160 hours (9,600 minutes) per week, although unskilled labour is unlimited. The purchasing manager is confident that they can obtain 5,000 grams of silk powder and 1,600 grams of silk amino acids per week. All other ingredients are unlimited. The following information is available for the two products: Cream 3 grams 1 gram 4 grams 4 minutes 3 minutes

Materials required: silk powder (at $2·20 per gram) – silk amino acids (at $0·80 per gram) – aloe vera (at $1·40 per gram) Labour required: skilled ($12 per hour) – unskilled (at $8 per hour)

Lotion 2 grams 0·5 grams 2 grams 5 minutes 1·5 minutes

Each jar of cream sold generates a contribution of $9 per unit, whilst each bottle of lotion generates a contribution of $8 per unit. The maximum demand for lotions is 2,000 bottles per week, although demand for creams is unlimited. Fixed costs total $1,800 per week. The company does not keep inventory although if a product is partially complete at the end of one week, its production will be completed in the following week. Required: (a) On the graph paper provided, use linear programming to calculate the optimum number of each product that the Cosmetic Co should make per week, assuming that it wishes to maximise contribution. Calculate the total contribution per week for the new production plan. All workings MUST be rounded to 2 decimal places. (14 marks) (b) Calculate the shadow price for silk powder and the slack for silk amino acids. All workings MUST be rounded to 2 decimal places. (6 marks) (20 marks)

The Gadget Co produces three products, A, B and C, all made from the same material. Until now, it has used traditional absorption costing to allocate overheads to its products. The company is now considering an activity based costing system in the hope that it will improve profitability. Information for the three products for the last year is as follows: Production and sales volumes (units) Selling price per unit Raw material usage (kg) per unit Direct labour hours per unit Machine hours per unit Number of production runs per annum Number of purchase orders per annum Number of deliveries to retailers per annum

A 15,000 $7.50 2 0·1 0·5 16 24 48

B 12,000 $12 3 0·15 0·7 12 28 30

C 18,000 $13 4 0·2 0·9 8 42 62

The price for raw materials remained constant throughout the year at $1·20 per kg. Similarly, the direct labour cost for the whole workforce was $14·80 per hour. The annual overhead costs were as follows: Machine set up costs Machine running costs Procurement costs Delivery costs

$ 26,550 66,400 48,000 54,320

Required: (a) Calculate the full cost per unit for products A, B and C under traditional absorption costing, using direct labour hours as the basis for apportionment. (5 marks) (b) Calculate the full cost per unit of each product using activity based costing.

(9 marks)

(c) Using your calculation from (a) and (b) above, explain how activity based costing may help The Gadget Co improve the profitability of each product. (6 marks) (20 marks)

Some commentators argue that: ‘With continuing pressure to control costs and maintain efficiency, the time has come for all public sector organisations to embrace zero-based budgeting. There is no longer a place for incremental budgeting in any organisation, particularly public sector ones, where zero-based budgeting is far more suitable anyway.’ Required: (a) Discuss the particular difficulties encountered when budgeting in public sector organisations compared with budgeting in private sector organisations, drawing comparisons between the two types of organisations. (5 marks) (b) Explain the terms ‘incremental budgeting’ and ‘zero-based budgeting’.

(4 marks)

(3 marks)

(d) Discuss the view that ‘there is no longer a place for incremental budgeting in any organisation, particularly public sector ones,’ highlighting any drawbacks of zero-based budgeting that need to be considered. (8 marks) (20 marks)

[P.T.O.

Formulae Sheet

Learning curve Y = axb Where y = a= x= b= LR =

Regression analysis y=a+bx

Q [\ [ y Q [2 x)2

\ E x n n

Q [\- [ y (Q [ x)2 )(n \ 2 y)2 ) 2

Demand curve P = a – bQ b=

change in price change in quantity

a = price when Q = 0

End of Question Paper

Answers

Fundamentals Level – Skills Module, Paper F5 Performance Management 1

(a)

(i)

December 2010 Answers

Sales price variance and sales volume variance Sales price variance = (actual price – standard price) x actual volume

Plasma TVs LCD TVs

Actual price

Standard price

Difference

$ 330 290

$ 350 300

$ –20 –10

Actual volume

750 650

Sales price Variance $ 15,000 A 6,500 A ––––––– 21,500 A –––––––

Sales volume contribution variance = (actual sales volume – budgeted sales volume) x standard margin

Plasma TVs LCD TVs

(ii)

Actual sales volume

Budgeted sales volume

Difference

750 650 –––––– 1,400 ––––––

590 590 –––––– 1,180 ––––––

160 60

Standard margin $ 190 180

Sales volume variance $ 30,400 F 10,800 F ––––––– 41,200 F –––––––

Material price planning and purchasing operational variances Material planning variance = (original target price – general market price at time of purchase) x quantity purchased ($60 – $85) x 1,400 = $35,000 A. Material price operational variance = (general market price at time of purchase – actual price paid) x quantity purchased. ($85 – $80) x 1,400 = $7,000 F.

(iii) Labour rate and labour efficiency variances Labour rate variance = (standard labour rate per hour – actual labour rate per hour) x actual hours worked. Actual hours worked by temporary workers: Total hours needed if staff were fully efficient = (750 x 2) + (650 x 1·5) = 2,475. Permanent staff provide 2,200 hours therefore excess = 2,475 – 2,200 = 275. However, temporary workers take twice as long, therefore hours worked = 275 x 2 = 550 Labour rate variance relates solely to temporary workers, therefore ignore permanent staff in the calculation. Labour rate variance = ($14 – $18) x 550 = $2,200 A. Labour efficiency variance = (standard labour hours for actual production – actual labour hours worked) x standard rate. (275 – 550) x $14 = $3,850 A. (b)

Explanation of planning and operational variances Before the material price planning and operational variances were calculated, the only information available as regards material purchasing was that there was an adverse material price variance of $28,000. The purchasing department will be assessed on the basis of this variance, yet, on its own, it is not a reliable indicator of the purchasing department’s efficiency. The reason it is not a reliable indicator is because market conditions can change, leading to an increase in price, and this change in market conditions is not within the control of the purchasing department. By analysing the materials price variance further and breaking it down into its two components – planning and operational – the variance actually becomes a more useful assessment tool. The planning variance represents the uncontrollable element and the operational variance represents the controllable element. The planning variance is a really useful for providing feedback on just how skilled management are in estimating future prices. This can be very easy in some businesses and very difficult in others. The operational variance is more meaningful in that it measures the purchasing department’s efficiency given the market conditions that prevailed at the time. It therefore ignores factors that the purchasing department cannot control, which in turn, stops staff from becoming demotivated.

Turnover Turnover has decreased from $72·025 million in 2009 to $66·028 million in 2010, a fall of 8·3%. However, this must be assessed by taking into account the change in market conditions, since there has been a 20% decline in demand for accountancy training. Given this 20% decline in the market place, AT Co’s turnover would have been expected to fall to $57·62m if it had kept in line with market conditions. Comparing AT Co’s actual turnover to this, it’s actual turnover is 14·6% higher than expected. As such, AT Co has performed fairly well, given market conditions. It can also be seen from the non-financial performance indicators that 20% of students in 2010 are students who have transferred over from alternative training providers. It is likely that they have transferred over because they have heard about the improved service that AT Co is providing. Hence, they are most likely the reason for the increased market share that AT Co has managed to secure in 2010. Cost of sales Cost of sales has decreased by 19·2% in 2010. This must be considered in relation to the decrease in turnover as well. In 2009, cost of sales represented 72·3% of turnover and in 2010 this figure was 63·7%. This is quite a substantial decrease. The reasons for it can be ascertained by, firstly, looking at the freelance staff costs. In 2009, the freelance costs were $14·582m. Given that a minimum 10% reduction in fees had been requested to freelance lecturers and the number of courses run by them was the same year on year, the expected cost for freelance lecturers in 2010 was $13·124m. The actual costs were $12·394m. These show that a fee reduction of 15% was actually achieved. This can be seen as a successful reduction in costs. The expected cost of sales for 2010 before any cost cuts, was $47·738m assuming a consistent ratio of cost of sales to turnover. The actual cost of sales was only $42·056m, $5·682m lower. Since freelance lecturer costs fell by $2·188m, this means that other costs of sale fell by the remaining $3·494m. Staff costs are a substantial amount of this balance but since there was a pay freeze and the average number of employees hardly changed from year to year, the decreased costs are unlikely to be related to staff costs. The decrease is therefore most probably attributable to the introduction of online marking. AT Co expected the online marking system to cut costs by $4m, but it is probable that the online marking did not save as much as possible, hence the $3·494m fall. Alternatively, the saved marking costs may have been partially counteracted by an increase in some other cost included in cost of sales. Gross profit As a result of the above, the gross profit margin has increased in 2010 from 27·7% to 36·3%. This is a big increase and reflects very well on management. Indirect expenses – Marketing costs: These have increased by 42·1% in 2010. Although this is quite significant, given all the improvements that AT Co has made to the service it is providing, it is very important that potential students are made aware of exactly what the company now offers. The increase in marketing costs has been rewarded with higher student numbers relative to the competition in 2010 and these will hopefully continue increasing next year, since many of the benefits of marketing won’t be felt until the next year anyway. The increase should therefore be viewed as essential expenditure rather than a cost that needs to be reduced. –

Property costs: These have largely stayed the same in both years.

–

Staff training: These costs have increased dramatically by over $2 million, a 163·9% increase. However, AT Co had identified that it had a problem with staff retention, which was leading to a lower quality service being provided to students. Also, due to the introduction of the interactive website, the electronic enrolment system and the online marking system, staff would have needed training on these areas. If AT Co had not spent this money on essential training, the quality of service would have deteriorated further and more staff would have left as they became increasingly dissatisfied with their jobs. Again, therefore, this should be seen as essential expenditure. Given that the number of student complaints has fallen dramatically in 2010 to 84 from 315, the staff training appears to have improved the quality of service being provided to students.

–

Interactive website and the student helpline: These costs are all new this year and result from an attempt to improve the quality of service being provided and, presumably, improve pass rates. Therefore, given the increase in the pass rate for first time passes from 48% to 66% it can be said that these developments have probably contributed to this. Also, they have probably played a part in attracting new students, hence improving turnover.

–

Enrolment costs have fallen dramatically by 80·9%. This huge reduction is a result of the new electronic system being introduced. This system can certainly be seen as a success, as not only has it dramatically reduced costs but it has also reduced the number of late enrolments from 297 to 106.

Net operating profit This has fallen from $3·635m to $2·106m. On the face of it, this looks disappointing but it has to be remembered that AT Co has been operating in a difficult market in 2010. It could easily have been looking at a large loss. Going forward, staff training costs will hopefully decrease. Also, market share may increase further as word of mouth spreads about improved results and service at AT Co. This may, in turn, lead to a need for less advertising and therefore lower marketing costs.

It is also apparent that AT Co has provided the student website free of charge when really, it should have been charging a fee for this. The costs of running it are too high for the service to be provided free of charge and this has had a negative impact on net operating profit. Note: Students would not have been expected to write all this in the time available. Workings (Note: All workings are in $'000) 1.

Turnover Decrease in turnover = $72,025 – $66,028/$72,025 = 8·3% Expected 2010 turnover given 20% decline in market = $72,025 x 80% = $57,620 Actual 2010 turnover CF expected = $66,028 – $57,620/$57,620 = 14·6% higher

Cost of sales Decrease in cost of sales = $42,056 – $52,078/$52,078 = 19·2% Cost of sales as percentage of turnover: 2009 = $52,078/$72,025 = 72·3% 2010 = $42,056/$66,028 = 63·7% Freelance staff costs: in 2009 = $41,663 x 35% = $14,582 Expected cost for 2010 = $14,582 x 90% = $13,124 Actual 2010 cost = $12,394 $12,394 – $14,582 = $2,188 decrease $2,188/$14,582 = 15% decrease in freelancer costs Expected cost of sales for 2010, before costs cuts, = $66,028 x 72·3% = $47,738. Actual cost of sales = $42,056. Difference = $5,682, of which $2,188 relates to freelancer savings and $3,494 relates to other savings.

Gross profit margin 2009: $19,947/$72,025 = 27·7% 2010: $23,972/$66,028 = 36·3%

Increase in marketing costs = $4,678 – $3,291/$3,291 = 42·1%

Increase in staff training costs = $3,396 – $1,287/$1,287 = 163·9%

Decrease in enrolment costs = $960 – 5,032/5,032 = 80·9%

Net operating profit Decreased from $3,635 to $2,106. This is fall of 1,529/3,635 = 42·1%

(a)

Optimum production plan Define the variables Let x = no. of jars of face cream to be produced Let y = no. of bottles of body lotion to be produced Let C = contribution State the objective function The objective is to maximise contribution, C C = 9x + 8y State the constraints Silk powder Silk amino acids Skilled labour

3x + 2y ≤ 5,000 1x + 0·5y ≤ 1,600 4x + 5y ≤ 9,600

Non-negativity constraints: x, y ≥ 0 Sales constraint: y ≤ 2,000 Draw the graph Silk powder 3x + 2y = 5,000 If x = 0, then 2y = 5,000, therefore y = 2,500 If y = 0, then 3x = 5,000, therefore x = 1,666·7 Silk amino acids 1x +0·5y = 1,600 If x = 0, then 0·5y = 1,600, therefore y = 3,200 If y = 0, then x = 1,600 Skilled labour 4x + 5y = 9,600 If x = 0, then 5y = 9,600, therefore y = 1,920 If y = 0, then 4x = 9,600, therefore x = 2,400

3,500

3,000

+0 = ·5y 1,6

3x 2y

2,500

5,0 00

Bottles of body lotion

y = 2,000

2,000

1,500

c 1,000

c= 9x

500

0 a 0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

Jars of face cream Silk powder

Silk amino acids

Skilled labour

Feasible region

Maximum sales of lotion

Iso-contribution line

Solve using iso-contribution line If y =800 and x = 0, then if C = 9x + 8y C = (8 x 800) = 6,400 Therefore, if y = 0, 9x = 6,400 Therefore x = 711·11 Using the iso-contribution line, the furthest vertex from the origin is point c, the intersection of the constraints for skilled labour and silk powder. Solving the simultaneous equations for these constraints: 4x + 5y = 9,600 x3 3x + 2y = 5,000 x4 12x + 15y = 28,800 12x + 8y = 20,000 Subtract the second one from the first one 7y = 8,800, therefore y = 1,257·14. If y = 1,257·14 and: 4x + 5y = 9,600 Then 5 x 1,257·14 + 4x = 9,600 Therefore x= 828·58 If C = 9x + 8y C = $7,457·22 + $10,057·12 = $17,514·34

(b)

Shadow prices and slack The shadow price for silk powder can be found by solving the two simultaneous equations intersecting at point c, whilst adding one more hour to the equation for silk powder. 4x +5y = 9,600 3x + 2y = 5,001

x3 x4

12x + 15y = 28,800 12x + 8y = 20,004 Subtract the second one from the first one 7y = 8,796, therefore y = 1,256·57 3x + (2 x 1,256·57) = 5,001. Therefore x = 829·29 C = (9 x 829·29) + (8 x 1,256·57) = $17,516·17 Original contribution = $17,514·34 Therefore shadow price for silk powder is $1·83 per gram. The slack for amino acids can be calculated as follows: (828·58 x 1) + (0·5 x 1,257·14) = 1,457·15 grams used. Available = 1,600 grams. Therefore slack = 142·85 grams.

(a)

Cost per unit under full absorption costing Total annual overhead costs: Machine set up costs Machine running costs Procurement costs Delivery costs

$ 26,550 66,400 48,000 54,320 –––––––– 195,270 ––––––––

Overhead absorption rate: Production volumes Labour hours per unit Total labour hours

A 15,000 0·1 1,500

B 12,000 0·15 1,800

C 18,000 0·2 3,600

Total

6,900

Therefore, overhead absorption rate = $195,270/6,900 = $28·30 per hour Cost per unit: A $ Raw materials ($1·20 x 2/3/4kg) 2·4 Direct labour ($14·80 x 0·1/0·15/0·2hrs) 1·48 Overhead ($28·30 x 0·1/0·15/0·2 hrs) 2·83 ––––– Full cost per unit 6·71 ––––– (b)

B $ 3·6 2·22 4·25 ––––– 10·07 –––––

C $ 4·8 2·96 5·66 ––––– 13·42 –––––

Cost per unit using full absorption costing Cost drivers: Cost pools Machine set up costs Machine running costs Procurement costs Delivery costs

Cost Cost Cost Cost

per per per per

machine set up machine hour order delivery

$ 26,550 66,400 48,000 54,320 –––––––– 195,270 ––––––––

Cost driver 36 production runs (16 + 12 + 8) 32,100 machine hours (7,500 + 8,400 + 16,200) 94 purchase orders (24 + 28 + 42) 140 deliveries (48 + 30 + 62)

$26,550/36 = $737·50 $66,400/32,100 = $2·0685 $48,000/94 = $510·6383 $54,320/140 = $388

Allocation of overheads to each product:

Machine set up costs Machine running costs Procurement costs Delivery costs

A $ 11,800 15,514 12,255 18,624 ––––––– 58,193 –––––––

B $ 8,850 17,375 14,298 11,640 ––––––– 52,163 –––––––

C $ 5,900 33,510 21,447 24,056 ––––––– 84,913 –––––––

Number of units produced

15,000

12,000

18,000

$ 3·88

$ 4·35

$ 4·72

A $ 2·4 1·48 3·88 ––––– 7·76 –––––

B $ 3·6 2·22 4·35 –––––– 10·17 ––––––

C $ 4·8 2·96 4·72 –––––– 12·48 ––––––

Overhead cost per unit Total cost per unit Materials Labour Overheads

(c)

Total $ 26,550 66,400 48,000 54,320 –––––––– 195,270 ––––––––

Using activity-based costing When comparing the full unit costs for each of the products under absorption costing as compared to ABC, the following observations can be made: Product A The unit cost for product A is 16% higher under ABC as opposed to traditional absorption costing. Under ABC, it is $7·76 per unit compared to $6·71 under traditional costing. This is particularly significant given that the selling price for product A is $7·50 per unit. This means that when the activities that give rise to the overhead costs for product A are taken into account, product A is actually making a loss. If the company wants to improve profitability it should look to either increase the selling price of product A or somehow reduce the costs. Delivery costs are also high, with 48 deliveries a year being made for product A. Maybe the company could seek further efficiencies here. Also, machine set up costs are higher for product A than for any of the other products, due to the larger number of production runs. The reason for this needs to be identified and, if possible, the number of production runs needs to be reduced. Product B The difference between the activity based cost for B as opposed to the traditional cost is quite small, being only $0·10. Since the selling price for B is $12, product B is clearly profitable whichever method of overhead allocation is used. ABC does not really identify any areas for concern here. Product C The unit cost for C is 7% lower under ABC when compared to traditional costing. More importantly, while C looks like it is making a loss under traditional costing, ABS tells a different story. The selling price for C is $13 per unit and, under ABC, it costs $12·48 per unit. Under traditional absorption costing, C is making a loss of $0·42 per unit. Identifying the reason for the differences in C, it is apparent that the number of production runs required to produce C is relatively low compared to the volumes produced. This leads to a lower apportionment of the machine set up costs to C than would be given under traditional absorption costing. Similarly, the number of product tests carried out on C is low relative to its volume. ABC is therefore very useful in identifying that C is actually more profitable than A, because of the reasons identified above. The company needs to look at the efficiency that seems to be achieved with C (low number of production runs less testing) and see whether any changes can be made to A, to bring it more in line with C. Of course, this may not be possible, in which case the company may consider whether it wishes to continue to produce A and whether it could sell higher volumes of C.

(a)

Difficulties in the public sector In the public sector, the objectives of the organisation are more difficult to define in a quantifiable way than the objectives of a private company. For example, a private company’s objectives may be to maximise profit. The meeting of this objective can then be set out in the budget by aiming for a percentage increase in sales and perhaps the cutting of various costs. If, on the other hand, the public sector organisation is a hospital, for example, then the objectives may be largely qualitative, such as ensuring that all outpatients are given an appointment within eight weeks of being referred to the hospital. This is difficult to define in a quantifiable way, and how it is actually achieved is even more difficult to define. This leads onto the next reason why budgeting is so difficult in public sector organisations. Just as objectives are difficult to define quantifiably, so too are the organisation’s outputs. In a private company the output can be measured in terms of sales revenue. There is a direct relationship between the expenditure that needs to be incurred i.e. needs to be input in order to achieve the desired level of output. In a hospital, on the other hand, it is difficult to define a quantifiable relationship between inputs and outputs. What is more easy to compare is the relationship between how much cash is available for a particular

area and how much cash is actually needed. Therefore, budgeting naturally focuses on inputs alone, rather than the relationship between inputs and outputs. Finally, public sector organisations are always under pressure to show that they are offering good value for money, i.e. providing a service that is economical, efficient and effective. Therefore, they must achieve the desired results with the minimum use of resources. This, in itself, makes the budgeting process more difficult. (b)

Incremental and zero-based budgeting ‘Incremental budgeting’ is the term used to describe the process whereby a budget is prepared using a previous period’s budget or actual performance as a base, with incremental amounts then being added for the new budget period. ‘Zero-based budgeting’, on the other hand, refers to a budgeting process which starts from a base of zero, with no reference being made to the prior period’s budget or performance. Every department function is reviewed comprehensively, with all expenditure requiring approval, rather than just the incremental expenditure requiring approval.

(c)

Stages in zero-based budgeting Zero-based budgeting involves three main stages:

(d)

Activities are identified by managers. These activities are then described in what is called a ‘decision package’. This decision package is prepared at the base level, representing the minimum level of service or support needed to achieve the organisation’s objectives. Further incremental packages may then be prepared to reflect a higher level of service or support.

Management will then rank all the packages in the order of decreasing benefits to the organisation. This will help management decide what to spend and where to spend it.

The resources are then allocated based on order of priority up to the spending level.

No longer a place for incremental budgeting The view that there is no longer a place for incremental budgeting in any organisation is a rather extreme view. It is known for encouraging slack and wasteful spending, hence the comment that it is particularly unsuitable for public sector organisations, where cash cutbacks are being made. However, to say that there is no place for it at all is to ignore the drawbacks of zero-based budgeting. These should not be ignored as they can make ZBB implausible in some organisations or departments. They are as follows: –

Departmental managers will not have the skills necessary to construct decision packages. They will need training for this and training takes time and money.

–

In a large organisation, the number of activities will be so large that the amount of paperwork generated from ZBB will be unmanageable.

–

Ranking the packages can be difficult, since many activities cannot be compared on the basis of purely quantitative measures. Qualitative factors need to be incorporated but this is difficult.

–

The process of identifying decision packages, determining their purpose, costs and benefits is massively time consuming and therefore costly.

–

Since decisions are made at budget time, managers may feel unable to react to changes that occur during the year. This could have a detrimental effect on the business if it fails to react to emerging opportunities and threats.

It could be argued that ZBB is more suitable for public sector than for private sector organisations. This is because, firstly, it is far easier to put activities into decision packages in organisations which undertake set definable activities. Local government, for example, have set activities including the provision of housing, schools and local transport. Secondly, it is far more suited to costs that are discretionary in nature or for support activities. Such costs can be found mostly in not for profit organisations or the public sector, or in the service department of commercial operations. Since ZBB requires all costs to be justified, it would seem inappropriate to use it for the entire budgeting process in a commercial organisation. Why take so much time and resources justifying costs that must be incurred in order to meet basic production needs? It makes no sense to use such a long-winded process for costs where no discretion can be exercised anyway. Incremental budgeting is, by its nature, quick and easy to do and easily understood. These factors should not be ignored. In conclusion, whilst ZBB is more suited to public sector organisations, and is more likely to make cost savings in hard times such as these, its drawbacks should not be overlooked.

Fundamentals Level – Skills Module, Paper F5 Performance Management

(a)

(b)

(i)

Sales price variance Sales volume variance

(ii)

Purchasing planning variance Purchasing efficiency variance

December 2010 Marking Scheme Marks 3 3 ––– 6 ––– 1 1 ––– 2 –––

(iii) Actual hours worked Labour rate variance Labour efficiency variance

3 2 2 ––– 7 –––

Each valid reason

1 ––– 5 ––– 20 –––

Marks 2

Turnover 8·3% decrease Actual t/o 14·6% higher Performed well CF market conditions Transfer of students

0.5 0.5 1 1 ––– 3 –––

Max. turnover Cost of sales 19·2% decrease 63·7% of turnover 15% fee reduction from freelance staff Other costs of sale fell by $3·555m Online marking did not save as much as planned

0.5 0.5 2 2 1 ––– 5 –––

Max. COS Gross profit – numbers and comment

Indirect expenses: Marketing costs 42·1% increase Increase necessary to reap benefits of developments Benefits may take more than one year to be felt

0.5 1 0.5

Property costs – stayed the same

0.5

Staff training 163·9% increase Necessary for staff retention Necessary to train staff on new website etc Without training, staff would have left Less student complaints

0.5 1 1 1 1

Interactive website and student helpline Attracted new students Increase in pass rate

1 1

Enrolment costs Fall of 80·9% Result of electronic system being introduced Reduced number of late enrolments

0.5 1 1 ––– 9 –––

Max. Indirect expenses Net operating profit Fallen to $2·106 Difficult market Staff training costs should decrease in future Future increase in market share Lower advertising cost in future Charge for website

0.5 1 1 1 1 1 ––– 3 ––– 20 –––

Max. net operating profit

Marks 3

(a)

(b)

(a)

(b)

(c)

Optimum production plan Assigning letters for variables Defining constraint for silk powder Defining constraint for amino acids Defining constraint for labour Non-negativity constraint Sales constraint: x Sales constraint: y Iso-contribution line worked out The graph: Labels Silk powder Amino acids Labour line Demand for x line Demand for y line Iso-contribution line Vertices a–e identified Feasible region shaded Optimum point identified Equations solved at optimum point Total contribution

0.5 0.5 0.5 0.5 0.5 0.5 0.5 1 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 1 3 1 ––– 14 –––

Shadow prices and slack Shadow price Slack

4 2 ––– 6 ––– 20 –––

Contribution per unit Overhead absorption rate Cost for A Cost for B Cost for C

2 1 1 1 ––– 5 –––

Cost under ABC Correct cost driver rates Correct overhead unit cost for A Correct overhead unit cost for B Correct overhead unit cost for C Correct cost per unit under ABC

5 1 1 1 1 ––– 9 –––

Using ABC to improve profitability One mark per point about the Gadget Co

1 ––– 6 ––– 20 –––

Marks 5

(a)

Explanation Difficulty setting objectives quantifiably Difficulty in saying how to achieve them Outputs difficult to measure No relationship between inputs and outputs Value for money issue

2 1 2 2 2 ––– 5 –––

Maximum (b)

(c)

(d)

Incremental and zero-based budgeting Explaining ‘incremental budgeting’ Explaining ‘zero-based budgeting’

2 2 ––– 4 –––

Stages involved in zero-based budgeting Each stage

1 ––– 3 –––

Discussion Any disadvantage of inc. that supports statement (max. 3) Incremental budgeting is quick and easy Any disadvantage of ZBB that refutes statement (max. 3) Easier to define decision packages in public sector more appropriate for discretionary costs Conclusion Maximum

1 1 1 2 2 1 ––– 8 ––– 20 –––

Performance Management Monday 14 June 2010

Time allowed Reading and planning: Writing:

15 minutes 3 hours

The Association of Chartered Certified Accountants

Paper F5

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 1

Brick by Brick (BBB) is a building business that provides a range of building services to the public. Recently they have been asked to quote for garage conversions (GC) and extensions to properties (EX) and have found that they are winning fewer GC contracts than expected. BBB has a policy to price all jobs at budgeted total cost plus 50%. Overheads are currently absorbed on a labour hour basis. BBB thinks that a switch to activity based costing (ABC) to absorb overheads would reduce the cost associated to GC and hence make them more competitive. You are provided with the following data: Overhead category Supervisors Planners Property related Total

Annual overheads $ 90,000 70,000 240,000 –––––––– 400,000 ––––––––

Activity driver

Site visits Planning documents Labour hours

Total number of activities per year 500 250 40,000

A typical GC costs $3,500 in materials and takes 300 labour hours to complete. A GC requires only one site visit by a supervisor and needs only one planning document to be raised. The typical EX costs $8,000 in materials and takes 500 hours to complete. An EX requires six site visits and five planning documents. In all cases labour is paid $15 per hour. Required: (a) Calculate the cost and quoted price of a GC and of an EX using labour hours to absorb the overheads. (5 marks) (b) Calculate the cost and the quoted price of a GC and of an EX using ABC to absorb the overheads. (5 marks) (c) Assuming that the cost of a GC falls by nearly 7% and the price of an EX rises by about 2% as a result of the change to ABC, suggest possible pricing strategies for the two products that BBB sells and suggest two reasons other than high prices for the current poor sales of the GC. (6 marks) (d) One BBB manager has suggested that only marginal cost should be included in budget cost calculations as this would avoid the need for arbitrary overhead allocations to products. Briefly discuss this point of view and comment on the implication for the amount of mark-up that would be applied to budget costs when producing quotes for jobs. (4 marks) (20 marks)

Sticky Wicket (SW) manufactures cricket bats using high quality wood and skilled labour using mainly traditional manual techniques. The manufacturing department is a cost centre within the business and operates a standard costing system based on marginal costs. At the beginning of April 2010 the production director attempted to reduce the cost of the bats by sourcing wood from a new supplier and de-skilling the process a little by using lower grade staff on parts of the production process. The standards were not adjusted to reflect these changes. The variance report for April 2010 is shown below (extract). Variances Material price Material usage Labour rate Labour efficiency Labour idle time

Adverse $

Favourable $ 5,100

7,500 43,600 48,800 5,400

The production director pointed out in his April 2010 board report that the new grade of labour required significant training in April and this meant that productive time was lower than usual. He accepted that the workers were a little slow at the moment but expected that an improvement would be seen in May 2010. He also mentioned that the new wood being used was proving difficult to cut cleanly resulting in increased waste levels. Sales for April 2010 were down 10% on budget and returns of faulty bats were up 20% on the previous month. The sales director resigned after the board meeting stating that SW had always produced quality products but the new strategy was bound to upset customers and damage the brand of the business. Required (a) Assess the performance of the production director using all the information above taking into account both the decision to use a new supplier and the decision to de-skill the process. (7 marks) In May 2010 the budgeted sales were 19,000 bats and the standard cost card is as follows:

Materials (2kg at $5/kg) Labour (3hrs at $12/hr) Marginal cost Selling price Contribution

Std cost $ 10 36

Std cost $

46 68 22

In May 2010 the following results were achieved: 40,000kg of wood were bought at a cost of $196,000, this produced 19,200 cricket bats. No inventory of raw materials is held. The labour was paid for 62,000 hours and the total cost was $694,000. Labour worked for 61,500 hours. The sales price was reduced to protect the sales levels. However, only 18,000 cricket bats were sold at an average price of $65. Required: (b) Calculate the materials, labour and sales variances for May 2010 in as much detail as the information allows. You are not required to comment on the performance of the business. (13 marks) (20 marks)

[P.T.O.

Cut and Stitch (CS) make two types of suits using skilled tailors (labour) and a delicate and unique fabric (material). Both the tailors and the fabric are in short supply and so the accountant at CS has correctly produced a linear programming model to help decide the optimal production mix. The model is as follows: Variables: Let W = the number of work suits produced Let L = the number of lounge suits produced Constraints Tailors’ time: 7W + 5L ≤ 3,500 (hours) – this is line T on the diagram Fabric: 2W + 2L ≤ 1,200 (metres) – this is line F on the diagram Production of work suits: W ≤ 400 – this is line P on the diagram Objective is to maximise contribution subject to: C = 48W + 40L On the diagram provided the accountant has correctly identified OABCD as the feasible region and point B as the optimal point. CS – Production Plan L Feasible region OABCD Optimal point B

800

P 600

400 B 240 200

E C T

Cont 0 200

D 400

F 600

800

Required: (a) Find by appropriate calculation the optimal production mix and related maximum contribution that could be earned by CS. (4 marks) (b) Calculate the shadow prices of the fabric per metre and the tailor time per hour.

(6 marks)

The tailors have offered to work an extra 500 hours provided that they are paid three times their normal rate of $1路50 per hour at $4路50 per hour. Required: (c) Briefly discuss whether CS should accept the offer of overtime at three times the normal rate.

(6 marks)

(d) Calculate the new optimum production plan if maximum demand for W falls to 200 units.

(4 marks) (20 marks)

[P.T.O.

Hammer is a large garden equipment supplier with retail stores throughout Toolland. Many of the products it sells are bought in from outside suppliers but some are currently manufactured by Hammer’s own manufacturing division ‘Nail’. The prices (a transfer price) that Nail charges to the retail stores are set by head office and have been the subject of some discussion. The current policy is for Nail to calculate the total variable cost of production and delivery and add 30% for profit. Nail argues that all costs should be taken into consideration, offering to reduce the mark-up on costs to 10% in this case. The retail stores are unhappy with the current pricing policy arguing that it results in prices that are often higher than comparable products available on the market. Nail has provided the following information to enable a price comparison to be made of the two possible pricing policies for one of its products. Garden shears Steel: the shears have 0·4kg of high quality steel in the final product. The manufacturing process loses 5% of all steel put in. Steel costs $4,000 per tonne (1 tonne = 1,000kg) Other materials: Other materials are bought in and have a list price of $3 per kg although Hammer secures a 10% volume discount on all purchases. The shears require 0·1kg of these materials. The labour time to produce shears is 0·25 hours per unit and labour costs $10 per hour. Variable overheads are absorbed at the rate of 150% of labour rates and fixed overheads are 80% of the variable overheads. Delivery is made by an outsourced distributor that charges Nail $0·50 per garden shear for delivery. Required: (a) Calculate the price that Nail would charge for the garden shears under the existing policy of variable cost plus 30%. (6 marks) (b) Calculate the increase or decrease in price if the pricing policy switched to total cost plus 10%.

(4 marks)

(d) Discuss whether the retail stores should be allowed to buy in from outside suppliers if the prices are cheaper than those charged by Nail. (6 marks) (20 marks)

Jump has a network of sports clubs which is managed by local managers reporting to the main board. The local managers have a lot of autonomy and are able to vary employment contracts with staff and offer discounts for membership fees and personal training sessions. They also control their own maintenance budget but do not have control over large amounts of capital expenditure. A local managerâ&#x20AC;&#x2122;s performance and bonus is assessed relative to three targets. For every one of these three targets that is reached in an individual quarter, $400 is added to the managerâ&#x20AC;&#x2122;s bonus, which is paid at the end of the year. The maximum bonus per year is therefore based on 12 targets (three targets in each of the four quarters of the year). Accordingly the maximum bonus that could be earned is 12 x $400 = $4,800, which represents 40% of the basic salary of a local manager. Jump has a 31 March year end. The performance data for one of the sports clubs for the last four quarters is as follows Qtr to 30 June 2009 Number of members 3,000 Member visits 20,000 Personal training sessions booked 310 Staff days 450 Staff lateness days 20 Days in quarter 90

Qtr to 30 September 2009 3,200 24,000 325 480 28 90

Qtr to Qtr to 31 December 2009 31 March 2010 3,300 3,400 26,000 24,000 310 339 470 480 28 20 90 90

Agreed targets are: 1. 2. 3.

Staff must be on time over 95% of the time (no penalty is made when staff are absent from work) On average 60% of members must use the clubsâ&#x20AC;&#x2122; facilities regularly by visiting at least 12 times per quarter On average 10% of members must book a personal training session each quarter

Required: (a) Calculate the amount of bonus that the manager should expect to be paid for the latest financial year. (6 marks) (b) Discuss to what extent the targets set are controllable by the local manager (you are required to make a case for both sides of the argument). (9 marks) (c) Describe two methods as to how a manager with access to the accounting and other records could unethically manipulate the situation so as to gain a greater bonus. (5 marks) (20 marks)

[P.T.O.

Formulae Sheet

Learning curve Y = axb Where y = a= x= b= LR =

average cost per batch cost of first batch total number of batches produced learning factor (log LR/log 2) the learning rate as a decimal

Regression analysis y=a+bx b=

n∑xy-∑x∑y n∑x2 -(∑x)2

∑y b∑x n n

n∑xy-∑x∑y 2

n∑x -(∑x)2 )(n∑y 2 -(∑y)2 )

Demand curve P = a – bQ b=

change in price change in quantity

a = price when Q = 0

End of Question Paper

Answers

Fundamentals Level – Skills Module, Paper F5 Performance Management 1

(a)

June 2010 Answers

Costs and quoted prices for the GC and the EX using labour hours to absorb overheads: Materials Labour

300hrs x $15/hr

Overheads

300hrs x $10/hr (W1)

GC $ 3,500 4,500 500hrs x $15/hr

EX $ 8,000 7,500

3,000 500hrs x $10/hr

––––––– 11,000 ––––––– 16,500 –––––––

Total cost Quoted price

5,000 ––––––– 20,500 ––––––– 30,750 –––––––

(W1). Overhead absorption rate is calculated as $400,000/40,000hrs = $10/hr (b)

Costs and quoted prices for the GC and the EX using ABC to absorb overheads: Materials Labour

GC $ 3,500 4,500

300hrs x $15/hr 500hrs x $15/hr

Overheads – Supervisor – Planners – Property

EX $ 8,000 7,500

(W2)/(W3) (W2)/(W3) (W2)/(W3)

180 280 1,800 ––––––– 10,260 ––––––– 15,390 –––––––

Total cost Quoted price

1,080 1,400 3,000 ––––––– 20,980 ––––––– 31,470 –––––––

(W2) Supervisor Planners Property

Costs 90,000 70,000 240,000

Number of drivers 500 250 40,000

Cost per driver 180 280 6

(W3) Cost per driver (W2) GC EX (c)

Supervisor $180 180 x 1 = 180 180 x 6 = 1,080

Planner $280 280 x 1 = 280 280 x 5 = 1,400

Property $6 6 x 300 = 1,800 6 x 500 = 3,000

The pricing policy is a matter for BBB to decide. They could elect to maintain the current 50% mark-up on cost and if they did the price of the GC would fall by around 7% in line with the costs. This should make them more competitive in the market. They could also reduce the prices by a little less than 7% (say 5%) in order to increase internal margins a little. It is possible that the issue lies elsewhere. If the quality of the work or the reputation and reliability of the builder is questionable then reducing prices is unlikely to improve sales. It is conceivable that BBB has a good reputation for EX but not for GC, but more likely that a poor reputation would affect all products. Equally poor service levels or lack of flexibility in meeting customer needs may be causing the poor sales performance. These too will not be ‘corrected’ by merely reducing prices. It is also possible that the way salesmen discuss or sell their products for the GC is not adequate so that in some way customers are being put off placing the work with BBB. BBB is in competition and it perhaps needs to reflect this in its pricing more (by ‘going rate pricing’) and not seek to merely add a mark-up to its costs. BBB could try to penetrate the market by pricing some jobs cheaply to gain a foothold. Once this has been done the completed EX or GC could be used to market the business to new customers. The price of the EX would also need consideration. There is no indication of problems in the selling of the EX and so BBB could consider pushing up their prices by around 2% in line with the cost increase. On the figures in my answer the price goes up for a typical extension to $31,470 from $30,750 a rise of $720. This does not seem that significant and so might not lose a significant number of sales. The reliability and reputation of a builder is probably more important than the price that they charge for a job and so it is possible that the success rate on job quotes may not be that price sensitive.

(d)

Marginal costs are those costs that are incurred as a consequence of the job being undertaken. In this case they would include only the materials and the labour. If overheads are included then this is known as total absorption costing. Overheads are for many businesses fixed by nature and hence do not vary as the number of jobs changes. In a traditional sense any attempt to allocate costs to products (by way of labour hours for example) would be arbitrary with little true meaning being added to the end result. The overhead absorption rate (OAR) is merely an average of these costs (over labour hours) and is essentially meaningless. This switch (to marginal costing) would also avoid the problem of the uncertainty of budget volume. Budget volume is needed in order to calculate the fixed cost absorption rate. The marginal cost (MC) is more understandable by managers and indeed customers and a switch away from total absorption cost (TAC) could have benefits in this way. Clearly if overheads are going to be excluded for the cost allocations then they would still have to be covered by way of a bigger margin added to the costs. In the end all costs have to be paid for and covered by the sales in order to show a profit. A more modern viewpoint is that activity causes costs to exist. For example, it is the existence of the need for site visits that gives rise to the need for a supervisor and therefore, for his costs. If the activities that drive costs are identified, more costs can then be directly traced to products, hence eradicating the need for arbitrary apportionment of many overhead costs. This has the benefit of all costs being covered, rather than the potential shortfall that can arise if marginal cost plus pricing is used. In the long run businesses have to cover all costs including fixed overheads in order to make a profit, whichever pricing strategy is adopted.

(a)

The performance of the production director could be looked at considering each decision in turn. The new wood supplier: The wood was certainly cheaper than the standard saving $5,100 on the standard the concern though might be poor quality. The usage variance shows that the waste levels of wood are worse than standard. It is possible that the lower grade labour could have contributed to the waste level but since both decisions rest with the same person the performance consequences are the same. The overall effect of this is an adverse variance of $2,400, so taking the two variances together it looks like a poor decision. As the new labour is trained it could be that the wood usage improves and so we will have to wait to be sure. The impact that the new wood might have had on sales cannot be ignored. No one department within a business can be viewed in isolation to another. Sales are down and returns are up. This could easily be due to poor quality wood inputs. If SW operates at the high quality end of the market then sourcing cheaper wood is risky if the quality reduces as a result. The lower grade of labour used: SW uses traditional manual techniques and this would normally require skilled labour. The labour was certainly paid less, saving the company $43,600 in wages. However, with adverse efficiency and idle time of a total of $54,200 they actually cost the business money overall in the first month. The efficiency variance tells us that it took longer to produce the bats than expected. The new labour was being trained in April 2010 and so it is possible that the situation will improve next month. The learning curve principle would probably apply here and so we could expect the average time per bat to be less in May 2010 than it was in April 2010.

(b)

Variance for May 2010: Material price variance ($196,000/40,000 – 5) x 40,000 = $4,000 Fav Material usage variance (40,000 – (19,200 x 2)) x $5/kg = $8,000 Adv Labour rate variance ($694,000/62,000 – 12) x 62,000 = 50,000 Fav Labour efficiency variance (61,500 – 57,600) x 12 = 46,800 Adv Labour idle time variance 500 x 12 = 6,000 Adv Sales price variance (68 – 65) x 18,000 = 54,000 Adv Sales volume contribution variance (18,000 – 19,000) x 22 = 22,000 Adv

(a)

The optimal production mix can be found by solving the two equations given for F and T. 7W + 5L = 3,500 2W + 2L = 1,200 Multiplying the second equation by 2·5 produces: 7W + 5L = 3,500 5W + 5L = 3,000 2W = 500 W = 250 Substituting W = 250 in the fabric equation produces: 2 x 250 + 2L = 1,200 2L = 700 L = 350

The optimal solution is when 250 work suits are produced and 350 lounge suits are produced. The contribution gained is $26,000: C = 48W + 40L C = (48 x 250) + (40 x 350) C = 26,000 (b)

The shadow prices can be found by adding one unit to each constraint in turn. Shadow price of T 7W + 5L = 3,501 2W + 2L = 1,200 Again multiplying the second equation by 2·5 produces: 7W + 5L = 3,501 5W + 5L = 3,000 2W = 501 W = 250·5 Substituting W = 250·5 in the fabric equation produces: (2 x 250·5) + 2L = 1,200 2L = 1,200 – 501 L = 349·5 Contribution earned at this point would be = (48 x 250·5) + (40 x 349·5) = 26,004 which is an increase of $4. Hence the shadow price of T is $4 per hour. Shadow price of F 7W + 5L = 3,500 2W + 2L = 1,201 Again multiplying the second equation by 2·5 produces: 7W + 5L = 3,500·0 5W + 5L = 3,002·5 2W = 497·5 W = 248·75 Substituting W = 248·75 in the fabric equation produces: (2 x 248·75) +2L = 1,201 2L = 1,201 – 497·5 L = 351·75 Contribution earned at this point would be = (48 x 248·75) + (40 x 351·75) = 26,010, which is an increase of $10. Hence the shadow price of F is $10 per metre.

(c)

The shadow price represents the maximum premium above the normal rate a business should be willing to pay for more of a scarce resource. It is equal to the increased contribution that can be gained from gaining that extra resource. The shadow price of labour here is $4 per hour. The tailors have offered to work for $4·50 – a premium of $3·00 per hour. At first glance the offer seems to be acceptable. However, many businesses pay overtime at the rate of time and a half and some negotiation should be possible to create a win/win situation. Equally some consideration should be given to the quality aspect here. If excessive extra hours are worked then tiredness can reduce the quality of the work produced.

(d)

If maximum demand for W falls to 200 units, the constraint for W will move left to 200 on the x axis of the graph. The new optimum point will then be at the intersection of: W = 200 and 2W + 2L = 1,200 Solving these equations simultaneously, if: W = 200, then (2 x 200) + 2L = 1,200 Therefore L = 400. So, the new production plan will be to make 400L and 200W

(a)

Price under existing policy Steel (0·4/0·95 x $4·00) Other materials ($3·00 x 0·9 x 0·1) Labour (0·25 x $10) Variable overhead (0·25 x $15) Delivery Total variable cost Mark-up 30% Transfer price

(b)

$ 1·68 0·27 2·50 3·75 0·50 –––––– 8·70 2·61 –––––– 11·31 ––––––

The only difference would be to add the fixed costs and adjust the mark-up %. Existing total variable cost Extra fixed cost (0·25 x $15 x 0·8) Total cost Mark-up 10% Transfer price

$ 8·70 3·00 –––––– 11·70 1·17 –––––– 12·87 ––––––

The price difference is therefore 12·87 – 11·31 = $1·56 per unit (c)

As far as the manufacturer is concerned, including fixed costs in the transfer price will have the advantage of covering all the costs incurred. In theory this should guarantee a profit for the division (assuming the fixed overhead absorption calculations are accurate). In essence the manufacturer is reducing the risk in his division. The accounting for fixed costs is notoriously difficult with many approaches possible. Including fixed costs in the transfer price invites manipulation of overhead treatment. One of the main problems with this strategy is that a fixed cost of the business is being turned into a variable cost in the hands of the seller (in our case the stores). This can lead to poor decision-making for the group since, although fixed costs would normally be ignored in a decision (as unavoidable), they would be relevant to the seller because they are part of their variable buy in price.

(d)

Degree of autonomy allowed to the stores in buying policy. If the stores are allowed too much freedom in buying policy Hammer could lose control of its business. Brand could be damaged if each store bought a different supplier’s shears (or other products). On the other hand, flexibility is increased and profits could be made for the business by entrepreneurial store managers exploiting locally found bargains. However, the current market price for shears may only be temporary (sale or special offer) and therefore not really representative of their true market ‘value’. If this is the case, then any long-term decision to allow retail stores to buy shears from external suppliers (rather than from Nail) would be wrong. The question of comparability is also important. Products are rarely ‘identical’ and consequently, price differences are to be expected. The stores could buy a slightly inferior product (claiming it is comparable) in the hope of a better margin. This could seriously damage Hammer’s brand. Motivation is also a factor here, however. Individual managers like a little freedom within which to operate. If they are forced to buy what they see as an inferior product (internally) at high prices it is likely to de-motivate. Also with greater autonomy, the performance of the stores will be easier to assess as the store managers will have control over greater elements of their business.

(a)

Bonus calculation: Qtr to Qtr to Qtr to 30 June 2009 30 September 2009 31 December 2009 Staff on time? On-time % Bonus earned? Members visits Target visits Actual visits Bonus earned?

430/450 = 95·5% Yes

452/480 = 94·2% No

442/470 = 94·0% No

460/480 = 95·8% Yes

60% x 3,000 x 12 = 21,600 20,000 No

60% x 3,200 x 12 = 23,040 24,000 Yes

60% x 3,300 x 12 = 23,760 26,000 Yes

60% x 3,400 x 12 = 24,480 24,000 No

Qtr to Qtr to Qtr to 30 June 2009 30 September 2009 31 December 2009 Personal training Target Actual sessions Bonus earned

Qtr to 31 March 2010

10% x 3,000 = 300 310 Yes

10% x 3,200 = 320 325 Yes

10% x 3,300 = 330 310 No

Qtr to 31 March 2010 10% x 3,400 = 340 339 No

Total

Bonus; hits’

2 Bonus; hits’

2 6

The bonus earned by the manager would be 6 x $400 = $2,400, which is 50% of the total bonus available. (b)

An important principle of any target based bonus system is that the targets must be based on controllable aspects of the manager’s role. Staff on time The way in which a manager manages staff can have a big bearing on whether or not an individual staff member is keen to work and arrive on time. We are told that the local manager has the power to vary employment contracts so he should be able to agree acceptable shift patterns with staff and reward them for compliance. In this respect the lateness of staff is controllable by the manager. On the other hand an individual staff member may be subject to home pressures or problems with public or other transport meaning that even they cannot control the time of arrival at work on some days. The manager cannot control these events either. If this problem became regular for a member of staff then the local manager could vary the contract of employment accordingly. Overall, lateness to work is controllable by the local manager. Member use of facilities The local manager controls the staff and hence the level of customer service. Good quality customer services would probably encourage members to use the facilities more often. Equally, by maintaining the club to a high standard then the local manager can remove another potential reason for a member not to use the facilities regularly. On the other hand customers are influenced by many factors outside of the club. Their state of health or their own work pressures can prevent members being able to come to the club. Overall, the local manager can only partly control the number of member visits. Personal training sessions Again, the local manager controls the level of customer service and the standard of maintenance in the personal training department. He also has control over prices so, if the bookings fall, he is able to reduce price or make special offers to encourage use of the facilities. On the other hand, personal training sessions may be seen as a luxury by customers and in times of financial difficulty they are expendable by them. Personal training sessions are often available from other sources and competition can force down the sales of the club. The manager can respond to that by improving services. He cannot, however, make significant investment in improving the facilities without board approval. Overall, the local manager can only partly control the number of personal training sessions booked.

(c)

There are a variety of methods that the performance data can be manipulated: Cut off The unethical manager could record visits in a different period than was actually the case. For example in quarter three the target for personal training sessions was not met by 20 sessions. This was probably obvious to the manager in the last few days of that quarter. He could have therefore recorded some sessions as having taken place in the next quarter. Indeed, only one session would have to be moved in this way in order for the manager to meet the target in the final quarter and gain another $400 of bonus.

Reduce prices to below economic levels to encourage use The targets that the manager is subject to are mainly volume driven. A reduction in prices would harm profitability but would not damage the managerâ&#x20AC;&#x2122;s bonus potential. More sessions are bound to follow if the price is set low enough. (Other ideas would be acceptable including advising staff to take the day off if they were going to be late. This would damage service levels admittedly, but would potentially gain a bonus for lateness.)

Fundamentals Level – Skills Module, Paper F5 Performance Management

(a)

(b)

(c)

(d)

June 2010 Marking Scheme Marks 1 1 1 1 1

Materials Labour OAR Overhead costs per unit Price Total

Materials Labour Overheads per unit per category (3 categories) – 1 mark each Price Total

0·5 0·5 3 1 5

GC reduce price by 7% GC reduce by < 7% Quality, reputation, reliability, sales documentation quality EX increase price by 2% EX hold price Total

1 1 2 1 1

MC and TAC definitions FC explanation of issue Margin increase needed Total

1 2 1

4 –––– 20 ––––

Total

(a)

(b)

Assessment of wood decision Assessment of labour decision Sales consequences Total

2·5 2·5 2 7

MPV MUV LRV LEV LIT SPV SVCV

2 2 2 2 1 2 2 13 –––– 20 ––––

Total

(a)

Marks

Optimal point calculation Contribution

3 1 4

(b)

For each shadow price

3 6

(c)

Rate discussion Other factors e.g. tiredness, negotiation

3 3 6

(d)

Find optimum point Solve 2 equations Conclusion

1 2 1 4 –––– 20 ––––

Total

(a)

(b)

(c)

(d)

Marks 1 1 1 1 1 1

Steel Other material Labour Variable overhead Delivery Mark-up Total

Fixed cost Mark-up Total

2 2

Covers all cost Risk Fixed cost accounting Converts a FC to VC Total (max)

1 1 1 2

Market price may be temporary Brand Profitability Flexibility Control Motivation Performance assessment Comparability Total (max)

1 1 1 1 1 1 1 1

6 –––– 20 ––––

Total

(a)

(b)

(c)

Marks

Per target Total

2 6

For each target – supporting controllability For each target – denying controllability Target

1·5 1·5

For each idea of manipulation up to

2·5

5 –––– 20 ––––

Total

4. ARTICLES

Paper F5 examiner's approach 01 Sep 2010 Environmental Management Accounting 28 July 2010 Performance Management 15 July 2010 Cost-volume-profit analysis 15 July 2010 Throughput accounting 8 February 2010 Materials mix and yield variances 8 February 2010 Target costing and lifecycle costing 8 February 2010 Activity-based costing 11 January 2010

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f5 examiner’s approach RELEVANT TO ACCA QUALIFICATION PAPER F5

I took over as the new Paper F5, Performance Management examiner from Geoff Cordwell and my first exam will be sat by students in December 2010. There are numerous changes being made to both Fundamental level papers and Professional level papers in the future, but these won’t come into effect until June 2011 exams. Prior to that, it will be necessary for me to write a lengthier article covering the changes to Paper F5 that are taking place at that point. Since there are no such changes coming into effect this year that will affect December 2010’s paper, and since I am making no radical departures in my approach to Paper F5 as compared to my predecessor, this article will be brief. If you want a summary of the key areas of the current Paper F5 syllabus and the format of the Paper F5 paper, you should refer back to Geoff Cordwell’s examiner’s approach article of January 2009 (www. accaglobal.com/students/acca/exams/f5/ exam_int/f5.pdf). My background First of all, let me tell you a little bit about myself. I studied law at both degree and professional level before going on to qualify as a Chartered Accountant with Coopers & Lybrand (now known as Pricewaterhouse Coopers) in 1998. I started teaching straight after qualification, although I had a brief period of working for KPMG, gaining invaluable further practical experience. Over the years I have taught a variety of subjects to trainee accountants at two of the leading training providers. These subjects have ranged from law, tax, financial accounting and auditing through to management accounting subjects. I’ve also written material and delivered a number of bespoke courses to non-accountants, covering law, financial accounting and management accounting. In 2003 I became an examiner for CAT Paper 1, Financial Accounting and CAT Paper 10, Managing Finances. I relinquished the CAT Paper 1 role some years ago to bring my ACCA work in line with my teaching, which by then was focusing mainly on management accounting subjects. In 2009, I accepted the role as Paper F5 examiner.

My approach to exam writing My colleagues say that they can always work out what is going on in my life by the content of my exam questions. If my garden is being landscaped, there may well be a question based on a landscape gardening business. If I’ve spent days on end sat at my computer writing, it may be about computers! And so on... If you want to get an idea about my style, you should look at some of my past questions for CAT Paper 10. I try to make questions original and true to life, rather than focusing purely on the traditional manufacturing environment, which only plays a small part in the world of commerce now in many parts of the world. I believe that exam questions should be set out clearly in order to give candidates the best opportunity to impart their knowledge and I try hard to present information in a logical format, using structured notes where possible. Some may argue that in the real world information is not always accessed in such an ordered way. My response to that would be that, in the real world, we can refer to textbooks and senior colleagues too, but we can’t in exams unfortunately. I want to give candidates the best possible opportunity of passing the Paper F5 exam by being as prescriptive as possible in my requirements. In my view, there is nothing worse than a candidate who fails an exam not because they don’t know the syllabus but because they could not work out what was expected of them from the requirement. I am very aware that for a significant number of people sitting ACCA exams, English is not their first language and this makes understanding the exam paper so much more difficult. Such candidates should be commended; I studied French until I was 18 but I’m sure that I would struggle today to sit an exam paper in French (or even order food correctly in a French restaurant perhaps!). As with other examiners, I therefore try to be vigilant at all times about the need for clarity of English, especially when writing requirements. Don’t be surprised to see requirements broken down a little more than you are used to; I’m trying to help you.

Preparing for the exam The best preparation that you can still do for the Paper F5 exam is to practise as many past papers as possible. I may be a new examiner but the syllabus remains the same. My beliefs about what Paper F5 aims to achieve are fundamentally the same as my predecessor. It’s essentially a management accounting paper that also requires you to interpret financial information as you would in the real world. As a starting point, you need to walk into the exam with your metaphorical toolkit: your set of management accounting techniques that you’ve learnt and practised for the exam. Many of these have been introduced in Paper F2, Management Accounting, so if you were exempt from this exam, you still need to make sure that you are comfortable with its subject matter. Part of the skill required in Paper F5 is that sometimes, you won’t be told which tool you need to take out of the bag, metaphorically speaking. You may need to work that out. Then, you may have to go on and discuss what you have done or what the information means. Sometimes it is inevitable that the discussion follows the numbers, so you need to make sure that you are able to do the numbers, but rest assured: where your discussion follows your numbers, you will be given credit for what you have written even if your numbers were wrong. To all of you sitting the exam in December, good luck. Having said that, luck should have little to do with it. Make sure that you cover all key areas of the syllabus in your revision; you can’t question spot. Also, refer to the advice given in the numerous articles written by both myself and other writers in the Student Accountant archive, both on particular topics and on exam technique, in order to give you the best chance of passing. Ann Irons is examiner for Paper F5

Paper F5 microsite Access the Paper F5 microsite at www.accaglobal. com/f5

Make sure that you cover all key areas of the syllabus in your revision; you can’t question spot. Also, refer to the advice given in the articles in the Student Accountant archive, in order to give you the best chance of passing.

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environmental management relevant to acca qualification paper F5 from june 2011

The new Paper F5 syllabus, which is effective from June 2011 onwards, introduces the area of environmental management accounting for the first time. It has, so far, been examined only in Paper P5 but, with its growing importance, it seemed appropriate to introduce it at an earlier level. The two requirements of the Paper F5 syllabus are as follows: ¤ discuss the issues businesses face in the management of environmental costs ¤ describe the different methods a business may use to account for its environmental costs. You should note that the Paper F5 syllabus examines ‘environmental management accounting’ rather than ‘environmental accounting’. Environmental accounting is a broader term that encompasses the provision of environment-related information both externally and internally. It focuses on reports required for shareholders and other stakeholders, as well of the provision of management information. Environmental management accounting, on the other hand, is a subset of environmental accounting. It focuses on information required for decision making within the organisation, although much of the information it generates could also be used for external reporting.

students should note that the Paper F5 syllabus examines ‘environmental management accounting’ rather than ‘environmental accounting’. Environmental accounting is a broader term that encompasses the provision of environment-related information both externally and internally. The aim of this article is to give a general introduction on the area of environmental management accounting, followed by a discussion of the first of the two requirements listed above. The second of them has already been covered in a high level of detail in Shane Johnson’s article of June 2004 (www.accaglobal. com/students/student_accountant/ archive/2004/42/1073480), so I will only provide a summary of the four main environmental cost accounting techniques

An introduction to environmental management accounting (EMA) Many of you reading this article still won’t be entirely clear on what environmental management accounting actually is. You will not be alone! There is no single textbook definition for it, although there are many long-winded, jargon ridden ones available. Before we get into the unavoidable jargon, the easiest way to approach it in the first place is to step back and ask ourselves what management accounting itself is. Management accounts give us an analysis of the performance of a business and are ideally prepared on a timely basis so that we get up-to-date management information. They break down each of our different business segments (in a larger business) in a high level of detail. This information is then used to assess how the business’ historic performance has been and, moving forward, how it can be improved in the future.

student accountant issue 15/2010 Studying Paper F5? Performance objectives 12, 13 and 14 are relevant to this exam

accounting Environmental management accounting is simply a specialised part of the management accounts that focuses on things such as the cost of energy and water and the disposal of waste and effluent. It is important to note at this point that the focus of environmental management accounting is not all on purely financial costs. It includes consideration of matters such as the costs vs benefits of buying from suppliers who are more environmentally aware, or the effect on the public image of the company from failure to comply with environmental regulations. Environmental management accounting 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. For example, activity-based costing may be used to ascertain more accurately the costs of washing towels at a gym. The energy used to power the washing machine is an environmental cost; the cost driver is ‘washing’.

Once the costs have been identified and information accumulated on how many customers are using the gym, it may actually be established that some customers are using more than one towel on a single visit to the gym. The gym could drive forward change by informing customers that they need to pay for a second towel if they need one. Given that this approach will be seen as ‘environmentally-friendly’, most customers would not argue with its introduction. Nor would most of them want to pay for the cost of a second towel. The costs to be saved by the company from this new policy would include both the energy savings from having to run fewer washing machines all the time and the staff costs of those people collecting the towels and operating the machines. Presumably, since the towels are being washed less frequently, they will need to be replaced by new ones less often as well.

Environmental management accounting is a specialised part of the management accounts that focuses on the cost of energy and water and the disposal of waste and effluent.

In addition to these savings to the company, however, are the all-important savings to the environment since less power and cotton (or whatever materials the towels are made from) is now being used, and the scarce resources of our planet are therefore being conserved. Lastly, the gym is also seen as an environmentally friendly organisation and this, in turn, may attract more customers and increase revenues. Just a little bit of management accounting (and common sense!) can achieve all these things. While I always like to minimise the use of jargon, in order to be fully versed on what environmental management accounting is really seen by the profession as encompassing today, it is necessary to consider a couple of the most widely accepted definitions of it. In 1998, the International Federation of Accountants (IFAC) originally defined environmental management accounting as: ‘The management of environmental and economic performance through the development and implementation of appropriate environment-related accounting systems and practices. While this may include reporting and auditing in some companies, environmental management accounting typically involves lifecycle costing, full cost accounting, benefits assessment, and strategic planning for environmental management.’

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Then, in 2001, The United Nations Division for Sustainable Development (UNDSD) emphasised their belief that environmental management accounting systems generate information for internal decision making rather than external decision making. This is in line with my statement at the beginning of this article that EMA is a subset of environmental accounting as a whole. The UNDSD make what became a widely accepted distinction between two types of information: physical information and monetary information. Hence, they broadly defined EMA to be 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 wastes) ¤ monetary information on environment-related cost, earnings and savings.

To summarise then, for the purposes of clarifying the coverage of the Paper F5 syllabus, my belief is that EMA is internally not externally focused and the Paper F5 syllabus should, therefore, focus on information for internal decision making only. It should not be concerned with how environmental information is reported to stakeholders, although it could include consideration of how such information could be reported internally. For example, Hansen and Mendoza (1999) stated that environmental costs are incurred because of poor quality controls. Therefore, they advocate the use of a periodical environmental cost report that is produced in the format of a cost of quality report, with each category of cost being expressed as a percentage of sales revenues or operating costs so that comparisons can be made between different periods and/or organisations. The categories of costs would be as follows:

This definition was then adopted by an international consensus group of over 30 nations and thus eventually adopted by IFAC in its 2005 international guidance document on ‘environmental management accounting’.

the management of environmental costs can be a difficult process. This is because first, just as EMA is difficult to define, so too are the actual costs involved. Second, having defined them, some of the costs are difficult to separate out and identify. Third, the costs can need to be controlled but this can only be done if they have been correctly identified.

¤ Environmental prevention costs: the costs of activities undertaken to prevent the production of waste. ¤ Environmental detection costs: costs incurred to ensure that the organisation complies with regulations and voluntary standards. ¤ Environmental internal failure costs: costs incurred from performing activities that have produced contaminants and waste that have not been discharged into the environment. ¤ Environmental external failure costs: costs incurred on activities performed after discharging waste into the environment. It is clear from the suggested format of this quality type report that Hansen and Mendoza’s definition of ‘environmental cost’ is relatively narrow. Managing environmental costs There are three main reasons why the management of environmental costs is becoming increasingly important in organisations. First, society as a whole has become more environmentally aware, with people becoming increasingly aware about the ‘carbon footprint’ and recycling taking place now in many countries. A ‘carbon footprint’ (as defined by the Carbon Trust) measures the total greenhouse gas emissions caused directly and indirectly by a person, organisation, event or product.

student accountant issue 15/2010

Companies are finding that they can increase their appeal to customers by portraying themselves as environmentally responsible. Second, environmental costs are becoming huge for some companies, particularly those operating in highly industrialised sectors such as oil production. In some cases, these costs can amount to more than 20% of operating costs. Such significant costs need to be managed. Third, regulation is increasing worldwide at a rapid pace, with penalties for non-compliance also increasing accordingly. In the largest ever seizure related to an environmental conviction in the UK, a plant hire firm, John Craxford Plant Hire Ltd, had to not only pay £85,000 in costs and fines but also got £1.2m of its assets seized. This was because it had illegally buried waste and also breached its waste and pollution permits. And it’s not just the companies that need to worry. Officers of the company and even junior employees could find themselves facing criminal prosecution for knowingly breaching environmental regulations. But the management of environmental costs can be a difficult process. This is because first, just as EMA is difficult to define, so too are the actual costs involved. Second, having defined them, some of the costs are difficult to separate out and identify. Third, the costs can need to be controlled but this can only be done if they have been correctly identified in the first place. Each of these issues is dealt with in turn below.

Much of the information that is needed to prepare environmental management accounts could actually be found in a business’ general ledger. Defining environmental costs Many organisations vary in their definition of environmental costs. It is neither possible nor desirable to consider all of the great range of definitions adopted. A useful cost categorisation, however, is that provided by the US Environmental Protection Agency in 1998. They stated that the definition of environmental costs depended on how an organisation intended on using the information. They made a distinction between four types of costs: ¤ conventional costs: raw material and energy costs having environmental relevance ¤ potentially hidden costs: costs captured by accounting systems but then losing their identity in ‘general overheads’ ¤ contingent costs: costs to be incurred at a future date, eg clean up costs ¤ image and relationship costs: costs that, by their nature, are intangible, for example, the costs of preparing environmental reports. The UNDSD, on the other hand, described environmental costs as comprising of: ¤ costs incurred to protect the environment, eg measures taken to prevent pollution and ¤ costs of wasted material, capital and labour, ie inefficiencies in the production process.

Neither of these definitions contradict each other; they just look at the costs from slightly different angles. As a Paper F5 student, you should be aware that definitions of environmental costs vary greatly, with some being very narrow and some being far wider. Identifying environmental costs Much of the information that is needed to prepare environmental management accounts could actually be found in a business’ general ledger. A close review of it should reveal the costs of materials, utilities and waste disposal, at the least. The main problem is, however, that most of the costs will have to be found within the category of ‘general overheads’ if they are to be accurately identified. Identifying them could be a lengthy process, particularly in a large organisation. The fact that environmental costs are often ‘hidden’ in this way makes it difficult for management to identify opportunities to cut environmental costs and yet it is crucial that they do so in a world which is becoming increasingly regulated and where scarce resources are becoming scarcer.

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It is equally important to allocate environmental costs to the processes or products which give rise to them. Only by doing this can an organisation make well-informed business decisions. For example, a pharmaceutical company may be deciding whether to continue with the production of one of its drugs. In order to incorporate environmental aspects into its decision, it needs to know exactly how many products are input into the process compared to its outputs; how much waste is created during the process; how much labour and fuel is used in making the drug; how much packaging the drug uses and what percentage of that is recyclable etc etc. Only by identifying these costs and allocating them to the product can an informed decision be made about the environmental effects of continued production. In 2003, the UNDSD identified four management accounting techniques for the identification and allocation of environmental costs: input/ outflow analysis, flow cost accounting, activity based costing and lifecycle costing. These are referred to later under ‘different methods of accounting for environmental costs’. Controlling environmental costs It is only after environmental costs have been defined, identified and allocated that a business can begin the task of trying to control them.

It is only after environmental costs have been defined, identified and allocated that a business can begin the task of trying to control them. As we have already discussed, environmental costs will vary greatly from business to business and, to be honest, a lot of the environmental costs that a large, highly industrialised business will incur will be difficult for the average person to understand, since that person won’t have a detailed knowledge of the industry concerned. I will therefore use some basic examples of easy-to-understand environmental costs when considering how an organisation may go about controlling such costs. Let us consider an organisation whose main environmental costs are as follows: ¤ waste and effluent disposal ¤ water consumption ¤ energy ¤ transport and travel ¤ consumables and raw materials. Each of these costs is considered in turn below. Waste There are lots of environmental costs associated with waste. For example, the costs of unused raw materials and disposal; taxes for landfill; fines for compliance failures such as pollution. It is possible to identify how much material is wasted in production by using the ‘mass balance’ approach, whereby the weight of materials bought is compared to the product yield. From this process, potential cost savings may be identified.

In addition to these monetary costs to the organisation, waste has environmental costs in terms of lost land resources (because waste has been buried) and the generation of greenhouse gases in the form of methane. Water You have probably never thought about it but businesses actually pay for water twice – first, to buy it and second, to dispose of it. If savings are to be made in terms of reduced water bills, it is important for organisations to identify where water is used and how consumption can be decreased. Energy Often, energy costs can be reduced significantly at very little cost. Environmental management accounts may help to identify inefficiencies and wasteful practices and, therefore, opportunities for cost savings. Transport and travel Again, environmental management accounting can often help to identify savings in terms of business travel and transport of goods and materials. At a simple level, a business can invest in more fuel-efficient vehicles, for example.

student accountant issue 15/2010

Consumables and raw materials These costs are usually easy to identify and discussions with senior managers may help to identify where savings can be made. For example, toner cartridges for printers could be refilled rather than replaced. This should produce a saving both in terms of the financial cost for the organisation and a waste saving for the environment (toner cartridges are difficult to dispose of and less waste is created this way). Accounting for environmental costs In the context of Paper F5, when the syllabus requires you to describe the different methods of accounting for environmental costs, it aims to cover two areas: ¤ Internal reporting of environmental costs, which has already been discussed in the introduction. ¤ Management accounting techniques for the identification and allocation of environmental costs: the most appropriate ones for the Paper F5 syllabus are those identified by the UNDSD, namely input/outflow analysis, flow cost accounting, activity-based costing and lifecycle costing. Since these have been more than adequately covered by Shane Johnson’s article in the June 2004 edition of Student Accountant, I have only covered them briefly here. Much of Shane’s article goes above and beyond what is required for Paper F5, since the purpose of that article was to cover knowledge required by the advanced performance management paper, Paper P5.

Input/outflow analysis This technique records material inflows and balances this with outflows on the basis that, what comes in, must go out. So, if 100kg of materials have been bought and only 80kg of materials have been produced, for example, then the 20kg difference must be accounted for in some way. It may be, for example, that 10% of it has been sold as scrap and 90% of it is waste. By accounting for outputs in this way, both in terms of physical quantities and, at the end of the process, in monetary terms too, businesses are forced to focus on environmental costs. Flow cost accounting This technique uses not only material flows but also the organisational structure. It makes material flows transparent by looking at the physical quantities involved, their costs and their value. It divides the material flows into three categories: material, system and delivery and disposal. The values and costs of each of these three flows are then 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’ total costs in the long run.

Activity-based costing ABC allocates internal costs to cost centres and cost drivers on the basis of the activities that give rise to the costs. In an environmental accounting context, it distinguishes between environment-related costs, which can be attributed to joint cost centres, and environment‑driven costs, which tend to be hidden on general overheads. Lifecycle costing Within the context of environmental accounting, lifecycle costing is a technique which requires the full environmental consequences, and, therefore, costs, arising from production of a product to be taken account across its whole lifecycle, literally ‘from cradle to grave’. Summary I hope you now have a clearer idea about exactly what environmental management accounting is and why it’s important. While I have tried to give some simple, practical examples and explanations, a certain amount of jargon is unavoidable in this subject area. Enjoy your further reading. Ann Irons is examiner for Paper F5

activity-based costing distinguishes between environment-related costs and environment‑driven costs hidden on general overheads.

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performance relevant to acca qualification paper F5

One of the key areas of the Paper F5 syllabus is that of performance measurement and control. It is perhaps more integral to the whole area of performance management than any other topic examined under the syllabus. How disappointing then, that these questions are often among the poorest answered on the paper. It would not be possible, in a single article, to cover every type of performance measurement question that could be examined. This article will therefore focus on a classic performance measurement question, which involves a combination of financial and non-financial analysis. I will take you through the performance measurement question that appeared in the December 2009 paper, step by step, showing you how I would expect such a question to be answered. The question read as follows: 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 decided to capitalise on their success and 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. Once an admission price is paid customers can use any of the facilities and rides for free. These steps increased profits considerably, enabling good dividends to be paid to the owners and bonuses to the directors. 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 2008 and 2009 2008 2009 $ $ Sales 5,250,000 5,320,000 Less expenses: Wages 2,500,000 2,200,000 Maintenance – routine 80,000 70,000 Repairs 260,000 320,000 Directors salaries 150,000 160,000 Directors bonuses 15,000 18,000 Other costs (including depreciation) 1,200,000 1,180,000 Net profit Book value of assets at start of year Dividend paid Number of visitors

1,045,000

1,372,000

13,000,000 500,000 150,000

12,000,000 650,000 140,000

student accountant issue 14/2010 Studying Paper F5? Performance objectives 12, 13 and 14 are relevant to this exam

measurement Required: (a) Assess the financial performance of TIP using the information given above. (14 marks) During the early part of 2008 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 opposite. Required: (b) 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. (6 marks) (20 marks) Breaking down the question It is clear from the way that the requirements are split that Part (a) is asking about financial performance and Part (b) is asking about non-financial performance. Broadly speaking, you should, therefore, keep the majority of your comments about non-financial aspects to Part (b). Having said this, there will sometimes be times when it will be relevant to mention the non‑financial effect of something when discussing the financial effect and you should do this, being sure not to deviate too far away from what the requirement is asking you to do.

Table 2: tip’s non-financial measures of success 2008 2009 Hours lost due to breakdown of rides (Note 1) 9,000 hours 32,000 hours Average waiting time per ride 20 minutes 30 minutes Note 1: TIP has 50 rides of different types. It is open 360 days of the year for 10 hours each day. (a) Assess the financial performance of TIP using the information given above Before any kind of comment can be made about financial performance, it is important to perform some preliminary calculations in order to ascertain what the relative movements have been from 2008 to 2009. Be sure that you read your year headings correctly and don’t get the 2008 figures mixed up with the 2009 ones. It seems like an obvious point but candidates do make this mistake fairly regularly. This would render the whole of your answer wrong; not a good start. While financial statements are usually shown with the most recent year on the left‑hand side and the older year on the right‑hand side, management accounts usually show the years the other way round. The fact is, you can’t presume anything and you just have to read the question carefully.

The next point to consider is what kind of analysis needs to be prepared. You should note that it will rarely be appropriate to look at numbers in absolute rather than relative terms. What does it matter, for example, if repairs are $320,000 in 2009? This means nothing unless we have something to compare them to, whether this is prior year figures, as in this case, or budgeted figures or industry averages, as could be the case in another question. In this type of question, it makes most sense to look at the percentage increase or decrease in each of our figures from 2008 to 2009. This has been done in the section headed ‘Workings’ below. You will see that I haven’t performed 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. Also, we do not really know what costs are in here, other than depreciation, so we can’t really make many comments. Our movement in sales, on the other hand, is also relatively small but has been mentioned.

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It is important that your answer does not become ‘a sea of words’, ie just pages of writing with no headings and no structure. If you have not been given guidance as to how to lay out your answer by the examiner, you must decide what an appropriate format would be. The reason for this is that, first, sales in a key figure and can’t be ignored and secondly, we know enough about other things going on in the business (eg reduction in the number of visitors) in order to be able to draw valid conclusions about sales. I have set out my workings as I would like to see them in your exam scripts, namely, all labelled up with a working reference. While, in the real world, such analysis would be expected to appear after any commentary as a kind of appendix, since you are not being asked for a report here it doesn’t really matter whether you show them at the beginning or end of your answer.

Workings: (W1) Sales growth is $5,320,000/$5,250,000 = 1.3% (W2) Average admission prices were: 2008: $5,250,000/150,000 = $35 per person 2009: $5,320,000/140,000 = $38 per person An increase of $38/$35 = 8.57% (W3) Directors pay up by $160,000/$150,000 = 6.7% (W4) Directors bonuses levels up from $15,000/$150,000 or 10% to $18,000/$160,000 or 12.5% of turnover. This is an increase of 20% (W5) Wages are down by ($2,500,000 – $2,200,000/$2,500,000) or 12% (W6) Routine maintenance down by ($80,000 - $70,000)/$80,000 = 12.5% (W7) Repairs up by ($320,000260,000)/$260,000 = 23% (W7) Loss of customers is (150,000 – 140,000/150,000) = 6.7% (W9) Profits up by $1,372,000/$1,045,000 = 31.3% (W8) Return on assets: 2008: $1,045,000/$13,000,000 = 8.03% 2009: $1,372,000/$12,000,000 = 11.4%’

Using the calculations you have prepared and setting out your answer It may surprise you, as indeed it surprised me, to find that a number of candidates got no further on this question than performing the calculations above. These calculations, whilst essential to answering the question, would only ever be worth a relatively small number of the marks and are merely a starting point. ‘Assessing the financial performance’ means discussing it and commenting on in what respects it is poor or maybe strong. It is important that your answer does not become ‘a sea of words’, ie just pages of writing with no headings and no structure. If you have not been given guidance as to how to lay out your answer by the examiner, you must decide what an appropriate format would be. In this case, your headings could be taken from your workings, eg ‘sales’, ‘directors’ pay and bonuses’ etc. You should then start your discussion of each point by first referring to the calculation that you have performed in the relevant working. It is critical that, having referred to the percentage movement in the figure under discussion from year to year, you don’t just leave it like that. For example, a poor answer on sales would be this:

Sales These have increased by 1.3% in the year. A poor, but slightly less poor answer might read:

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Sales These have increased by 1.3% (W1) in the year. This is good. The second answer is slightly better than the first because it references the percentage increase to the workings and also makes a comment about the increase. However, what does ‘good’ mean? How can we say whether a 1.3% increase in sales is good or bad if we don’t refer to inflation rates (if provided in the question, as in this case), admission prices and visitor numbers? Whenever you are making a comment, ask yourself: ‘Why do I care? Why is it important?’. This will help you to follow your thoughts through. A good answer for sales would read as follows:

Sales Sales have increased by 1.3% (W1) in 2009, as compared to 2008. 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 2009 has fallen from 150,000 to 140,000. This means that the average admission price in 2009 was $38 per person, compared to $35 per person in 2008, 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.

You can see that the good answer starts with the percentage increase in sales from the workings 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, let’s look at ‘maintenance and repairs’. Routine maintenance costs have fallen by 12.5%. On the face of things, this looks good. However, we cannot comment on maintenance costs without considering how repair costs have been affected. These have increased by 23%. We also need to go further here and comment on the actual amounts involved (or look at the total costs for maintenance and repairs and comment on the total percentage increase). While maintenance costs have decreased by a mere $10,000, repairs have increased by $60,000. This tells us nearly everything we need to know about what has happened. It is clear that, because routine maintenance has not been carried out, machines are breaking down and repairs are, therefore, required. This assessment is further supported by the non-financial information, which tells us that the hours due to breakdown of rides has increased from 9,000 hours in 2008 to 32,000 hours in 2009. Although it would be inappropriate to talk about the effect of this on quality of service and risks in Part (a), since we would then be stepping into the requirement of Part (b), it should be mentioned in passing.

So, 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 2009, 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, and the fact that hours due to lost breakdown of rides increased from 9,000 hours in 2008 to a huge 32,000 hours in 2009, 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 and problems with the rides. The decision to reduce maintenance by the company needs to be reviewed urgently. By this point, it is hopefully clear that there is little point in simply doing a few calculations and making meaningless comments. In questions on performance measurement, you need to look at each figure as part of an overall set of data, bringing other data in where relevant. A figure in isolation, such as sales, tells us little about what has really happened during the year. It is only by bringing other information in that any true assessment on financial performance can be made.

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This principal can equally be applied to any assessment of non-financial performance, as considered below. Part (b) 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. Once again, it is important that you adopt some kind of structure for your answer, rather than just producing a ‘sea of words’. By using the structure of headings, you make yourself focus on what the requirement is actually asking you to do. This should stop you from ‘rambling’, ie talking about things that are not being asked of you and not relevant. Whenever I used to answer exam questions, I would refer back to the requirement many times while writing, constantly asking myself: ‘Am I answering the question?’. Time spent thinking rather than writing is time well spent. In this particular question, the examiner has basically told you what headings to use by using italics for the words ‘quality’ and ‘risks’. The fact that you are being asked about qualitative aspects of the situation means that you are obviously being asked about non-financial performance. Most of the information that is relevant to this discussion has already been given to you in the question (number of visitors, hours due to breakdown of rides and average waiting time). It is also possible (although not essential) to work out lost capacity in 2008 and 2009, ie percentage of hours lost out of total hours available in order to make a year on year comparison. This would be done as follows:

Capacity of rides in hours is 360 days x 50 rides x 10 hours per day = 180,000 2008 lost capacity is 9,000/180,000 = 0.05 or 5% 2009 lost capacity is 32,000/180,000 = 0.177 or 17.8% When discussing quality, it is important to 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 the rides and average queuing time are therefore appropriate subheadings. You could also mention that the rides need to be safe as well, or you could leave this to your discussion on risks. Then, when discussing ‘risks’ in the second part of your answer to Part (b), you need to think about what the potential outcomes of the current policies are. In order to answer this, you first need to have a clear idea about the policies that have been adopted. These are mentioned in the preamble of the question and include reduced expenditure on new rides, a move from routine maintenance to reactive repairs and an increase in prices. Where you are giving a number of points in an answer, like here, it is useful to bullet point them. This not only makes your answer easier to mark, but it makes you aware of how much you are saying.

Regarding this last point – how much you should say in performance measurement questions – you should be largely guided by the marks available. 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. This is particularly the case in Part (a) here. The key is to get good coverage. It is pointless, for example, to spend half of your time discussing sales in Part (a), meaning that you don’t get enough time to cover all the other key figures. Your answers must always be balanced. Summary ¤ Present calculations in a referenced list ¤ Don’t consider any one piece of information or number in isolation ¤ Use headings wherever possible and avoid writing ‘a sea of words’ ¤ When you are writing a statement, eg ‘sales have increased by 1.3%’ always ask yourself the question ‘why do I care?’. This will help you make a meaningful point and take a thought through to its logical conclusion. ¤ Read all the requirements and make sure that you don’t start talking about, eg requirement (b) in requirement (a), as you will then find that you have nothing to say when you get to requirement (b). ¤ 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. Ann Irons is examiner for Paper F5

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cost-volumeprofit relevant to acca qualification paper F5

In any business, or, indeed, in life in general, hindsight is a beautiful thing. If only we could look into a crystal ball and find out exactly how many customers were going to buy our product, we would be able to make perfect business decisions and maximise profits. Take a restaurant, for example. If the owners knew exactly how many customers would come in each evening and the number and type of meals that they would order, they could ensure that staffing levels were exactly accurate and no waste occurred in the kitchen. The reality is, of course, that decisions such as staffing and food purchases have to be made on the basis of estimates, with these estimates being based on past experience. While management accounting information can’t really help much with the crystal ball, it can be of use in providing the answers to questions about the consequences of different courses of action. One of the most important decisions that needs to be made before any business even starts is ‘how much do we need to sell in order to break‑even?’ By ‘break‑even’ we mean simply covering all our costs without making a profit.

CVP analysis looks primarily at the effects of differing levels of activity on the financial results of a business. The reason for the particular focus on sales volume is because, in the short-run, sales price, and the cost of materials and labour, are usually known with a degree of accuracy. This type of analysis is known as ‘cost-volume-profit analysis’ (CVP analysis) and the purpose of this article is to cover some of the straight forward calculations and graphs required for this part of the Paper F5 syllabus, while also considering the assumptions which underlie any such analysis. THE OBJECTIVE OF CVP ANALYSIS CVP analysis looks primarily at the effects of differing levels of activity on the financial results of a business. The reason for the particular focus on sales volume is because, in the short-run, sales price, and the cost of materials and labour, are usually known with a degree of accuracy. Sales volume, however, is not usually so predictable and therefore, in the short-run, profitability often hinges upon it. For example, Company A may know that the sales price for product x in a particular year is going to be in the region of $50 and its variable costs are approximately $30.

It can, therefore, say with some degree of certainty that the contribution per unit (sales price less variable costs) is $20. Company A may also have fixed costs of $200,000 per annum, which again, are fairly easy to predict. However, when we ask the question: ‘Will the company make a profit in that year?’, the answer is ‘We don’t know’. We don’t know because we don’t know the sales volume for the year. However, we can work out how many sales the business needs to make in order to make a profit and this is where CVP analysis begins. Methods for calculating the break‑even point The break-even point is when total revenues and total costs are equal, that is, there is no profit but also no loss made. There are three methods for ascertaining this break-even point:

student accountant issue 14/2010 Studying Paper F5? Performance objectives 12, 13 and 14 are relevant to this exam

analysis 1 The equation method A little bit of simple maths can help us answer numerous different cost‑volume-profit questions. We know that total revenues are found by multiplying unit selling price (USP) by quantity sold (Q). Also, total costs are made up firstly of total fixed costs (FC) and secondly by variable costs (VC). Total variable costs are found by multiplying unit variable cost (UVC) by total quantity (Q). Any excess of total revenue over total costs will give rise to profit (P). By putting this information into a simple equation, we come up with a method of answering CVP type questions. This is done below continuing with the example of Company A above. Total revenue – total variable costs – total fixed costs = Profit (USP x Q) – (UVC x Q) – FC = P (50Q) – (30Q) – 200,000 = P

It would, therefore, be inappropriate to use a unit fixed cost since this would vary depending on output. Sales price and variable costs, on the other hand, are assumed to remain constant for all levels of output in the short-run, and, therefore, unit costs are appropriate. Continuing with our equation, we now set P to zero in order to find out how many items we need to sell in order to make no profit, ie to break even: (50Q) – (30Q) – 200,000 = 0 20Q – 200,000 = 0 20Q = 200,000 Q = 10,000 units. The equation has given us our answer. If Company A sells less than 10,000 units, it will make a loss; if it sells exactly 10,000 units, it will break-even, and if it sells more than 10,000 units, it will make a profit.

Note: total fixed costs are used rather than unit fixed costs since unit fixed costs will vary depending on the level of output.

The contribution margin method uses a little bit of algebra to rewrite our equation above, concentrating on the use of the ‘contribution margin’.

2 The contribution margin method This second approach uses a little bit of algebra to rewrite our equation above, concentrating on the use of the ‘contribution margin’. The contribution margin is equal to total revenue less total variable costs. Alternatively, the unit contribution margin (UCM) is the unit selling price (USP) less the unit variable cost (UVC). Hence, the formula from our mathematical method above is manipulated in the following way: (USP x Q) – (UVC x Q) – FC = P (USP – UVC) x Q = FC + P UCM x Q = FC + P Q = FC + P UCM So, if P=0 (because we want to find the break-even point), then we would simply take our fixed costs and divide them by our unit contribution margin. We often see the unit contribution margin referred to as the ‘contribution per unit’. Applying this approach to Company A again: UCM = 20, FC = 200,000 and P = 0. Q = FC UCM Q = 200,000 20 Therefore Q = 10,000 units

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3 The graphical method With the graphical method, the total costs and total revenue lines are plotted on a graph; $ is shown on the y axis and units are shown on the x axis. The point where the total cost and revenue lines intersect is the break-even point. The amount of profit or loss at different output levels is represented by the distance between the total cost and total revenue lines. Figure 1 opposite shows a typical break-even chart for Company A. The gap between the fixed costs and the total costs line represents variable costs. Alternatively, a contribution graph could be drawn. While this is not specifically covered by the Paper F5 syllabus, it is still useful to see it. This is very similar to a break-even chart, the only difference being that instead of showing a fixed cost line, a variable cost line is shown instead. Hence, it is the difference between the variable cost line and the total cost line that represents fixed costs. The advantage of this is that it emphasises contribution as it is represented by the gap between the total revenue and the variable cost lines. This is shown for Company A in Figure 2 opposite. Finally, a profit–volume graph could be drawn, which emphasises the impact of volume changes on profit (Figure 3 on page 7). This is key to the Paper F5 syllabus and is discussed in more detail later in this article.

FIGURE 1: COMPANY A: Break-even CHART $ 1,200,000

Total revenue

1,000,000

800,000 Total costs Break-even point

600,000

400,000 Fixed costs 200,000

0 0

5,000 10,000 15,000 20,000 25,000 30,000 35,000 Units sold

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FIGURE 2: COMPANY A: contribution graph

Ascertaining the sales volume required to achieve a target profit As well as ascertaining the break-even point, there are other routine calculations that it is just as important to understand. For example, a business may want to know how many items it must sell in order to attain a target profit.

$ 1,200,000

1,000,000

Total revenue Contribution

800,000

Total costs Break-even point Variable costs

600,000

Example 1 Company A wants to achieve a target profit of $300,000. The sales volume necessary in order to achieve this profit can be ascertained using any of the three methods outlined above. If the equation method is used, the profit of $300,000 is put into the equation rather than the profit of $0: (50Q) – (30Q) – 200,000 = 300,000 20Q – 200,000 = 300,000 20Q = 500,000 Q = 25,000 units.

400,000

200,000 Alternatively, the contribution method can be used: 0 0

5,000

10,000

15,000

20,000

25,000

Units sold

A contribution graph shows the difference between the variable cost line and the total cost line that represents fixed costs. An advantage of this is that it emphasises contribution as it is represented by the gap between the total revenue and variable cost lines.

UCM = 20, FC = 200,000 and P = 300,000. Q = FC + P UCM Q = 200,000 + 300,000 20 Therefore Q = 25,000 units. Finally, the answer can be read from the graph, although this method becomes clumsier than the previous two. The profit will be $300,000 where the gap between the total revenue and total cost line is $300,000, since the gap represents profit (after the break-even point) or loss (before the break-even point.)

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This is not a quick enough method to use in an exam so it is not recommended. Margin of safety The margin of safety indicates by how much sales can decrease before a loss occurs, ie it is the excess of budgeted revenues over break-even revenues. Using Company A as an example, let’s assume that budgeted sales are 20,000 units. The margin of safety can be found, in units, as follows: Budgeted sales – break-even sales = 20,000 – 10,000 = 10,000 units. Alternatively, as is often the case, it may be calculated as a percentage: Budgeted sales – break-even sales/ budgeted sales. In Company A’s case, it will be 10,000/20,000 x 100 = 50%. Finally, it could be calculated in terms of $ sales revenue as follows: Budgeted sales – break-even sales x selling price = 10,000 x $50 = $500,000. Contribution to sales ratio It is often useful in single product situations, and essential in multi‑product situations, to ascertain how much each $ sold actually contributes towards the fixed costs. This calculation is known as the contribution to sales or C/S ratio. It is found in single product situations by either simply dividing the total contribution by the total sales revenue, or by dividing the unit contribution margin (otherwise known as contribution per unit) by the selling price:

For Company A: $20/$50 = 0.4 In multi-product situations, a weighted average C/S ratio is calculated by using the formula: Total contribution/total sales revenue This weighted average C/S ratio can then be used to find CVP information such as break-even point, margin of safety etc. Example 2 As well as producing product x described above, Company A also begins producing product y. The following information is available for both products:

Product x

Product y

Sales price $50 Variable cost $30 Contribution per unit $20 Budgeted sales (units) 20,000

$60 $45 $15 10,000

The weighted average C/S ratio can be once again calculated by dividing the total expected contribution by the total expected sales: (20,000 x $20) + (10,000 x $15) / (20,000 x $50) + (10,000 x $60) = 34.375%

The C/S ratio is useful in its own right as it tells us what percentage each $ of sales revenue contributes towards fixed costs; it is also invaluable in helping us to quickly calculate the break-even point in $ sales revenue, or the sales revenue required to generate a target profit. The break-even point can now be calculated this way for Company A: Fixed costs / contribution to sales ratio = $200,000/0.34375 = $581,819 of sales revenue. To achieve a target profit of $300,000: Fixed costs + required profit / contribution to sales ratio = $200,000 + $300,000/0.34375 = $1,454,546. Of course, such calculations provide only estimated information because they assume that products x and y are sold in a constant mix of 2x to 1y. In reality, this constant mix is unlikely to exist and, at times, more y may be sold than x. Such changes in the mix throughout a period, even if the overall mix for the period is 2:1, will lead to the actual break-even point being different than anticipated. This point is touched upon again later in this article.

contribution to sales ratio is often useful in single product situations, and essential in multi‑product situations, to ascertain how much each $ sold actually contributes towards the fixed costs.

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Multi-product profit–volume charts When discussing graphical methods for establishing the break-even point, we considered break-even charts and contribution graphs. These could also be drawn for a company selling multiple products, such as Company A in our example. The one type of graph that hasn’t yet been discussed is a profit–volume graph. This is slightly different from the others in that it focuses purely on showing a profit/ loss line and doesn’t separately show the cost and revenue lines. In a multi‑product environment, it is common to actually show two lines on the graph: one straight line, where a constant mix between the products is assumed; and one bow-shaped line, where it is assumed that the company sells its most profitable product first and then its next most profitable product, and so on. In order to draw the graph, it is therefore necessary to work out the C/S ratio of each product being sold before ranking the products in order of profitability. It is easy here for Company A, since only two products are being produced, and so it is useful to draw a quick table (prevents mistakes in the exam hall) in order to ascertain each of the points that need to be plotted on the graph in order to show the profit/ loss lines. See Table 3 on the right. The graph can then be drawn (Figure 3 on page 7), showing cumulative sales on the x axis and cumulative profit/loss on the y axis. It can be observed from the graph that, when the company sells its most profitable product first (x) it breaks even earlier than when it sells products in a constant mix. The break-even point is the point where each line cuts the x axis.

Table 3: figure 3 continued Product x Product y Sales price $50 $60 Variable cost $30 $45 Contribution per unit $20 $15 Budgeted sales (units) 20,000 10,000 C/S ratios 0.4 0.25 Weighted average C/S ratio 0.34375 Product ranking 1 2 (most profitable first) Product Contribution $’000 (Fixed costs) 0 X 400 Y 150

Cumulative Revenue profit/loss $’000 $’000 (200) 0 200 1,000,000 350 650,000

Cumulative revenue $’000 0 1,000,000 1,650,000

In order to draw a multi-product/volume graph it is necessary to work out the C/S ratio of each product being sold. Limitations of cost-volume‑profit analysis ¤ Cost-volume-profit analysis is invaluable in demonstrating the effect on an organisation that changes in volume (in particular), costs and selling prices, have on profit. However, its use is limited because it is based on the following assumptions: Either a single product is being sold or, if there are multiple products, these are sold in a constant mix. We have considered this above in Figure 3 and seen that if the constant mix assumption changes, so does the break-even point.

¤ All other variables, apart from volume, remain constant, ie volume is the only factor that causes revenues and costs to change. In reality, this assumption may not hold true as, for example, economies of scale may be achieved as volumes increase. Similarly, if there is a change in sales mix, revenues will change. Furthermore, it is often found that if sales volumes are to increase, sales price must fall. These are only a few reasons why the assumption may not hold true; there are many others.

technical

FIGURE 3: COMPANY A: multi-product–volume chart $ 400,000 Product y 300,000

tab le

fir

200,000

ofi

100,000

Sales in constant mix

¤ The total cost and total revenue functions are linear. This is only likely to hold true within a short-run, restricted level of activity. ¤ Costs can be divided into a component that is fixed and a component that is variable. In reality, some costs may be semi-fixed, such as telephone charges, whereby there may be a fixed monthly rental charge and a variable charge for calls made. ¤ 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. It will either have operated at those activity levels before or studied them carefully so that it can, for example, make accurate predictions of fixed costs in that range. ¤ Profits are calculated on a variable cost basis or, if absorption costing is used, it is assumed that production volumes are equal to sales volumes.

0 0

Ann Irons is examiner for Paper F5

200,000

400,000

600,000

1,000,000 800,000

1,400,000 1,200,000

Product x

–100,000

–200,000

–300,000

Sales $000

1,800,000 1,600,000

technical

throughput and backflush Throughput accounting and backflush accounting have been developed in response to relatively modern advances in manufacturing: 1 The increased reliance by manufacturing businesses on sophisticated and expensive facilities and machinery. This greatly increases the proportion of costs which are fixed. (This was one reason why activity-based costing has become more important: if fixed costs are more significant they should be dealt with more accurately.) 2 A recognition that holding inventory is likely to be a waste of resource. 3 The increased use of just-in-time manufacturing, so that inventory (particularly work-in-progress) is much reduced and its valuation is therefore less important. Throughput accounting Throughput accounting has a very direct relationship with decision making and performance management. It begins by focusing on what an organisation’s purpose is – its goal – and seeks to help organisations attain their purpose by increasing their ‘goal units’. The approach can be applied to both profit-seeking and not-for-profit organisations, provided meaningful goal units can be identified.

Throughput accounting has a very direct relationship with decision making and performance management. It focuses on what an organisation’s purpose is – its goal – and helps attain it by increasing their ‘goal units’.

RELEVANT to ACCA QUAlification paper F5 Example 1 Take a not-for-profit organisation which performs a medical screening service in three sequential stages: 1 Take an X-ray. 2 Interpret the result. 3 Recall patients who need further investigation/tell others that all is fine. The ‘goal unit’ of this organisation will be to progress a person through all three stages. The number of people who complete all the stages is the organisation’s throughput, and the organisation should seek to maximise its throughput. However, there will always be a limit to throughput, and the resource which sets that limit is called the ‘bottleneck resource’.Adding more detail to the medical screening process above: Process Take an X-ray

Time/patient (hours) 0.25

Total hours available/week 40

Interpret the result

0.10

Recall patients who need further investigation/ tell others that all is fine

0.20

You can easily see from this table that the maximum number of patients (goal units) who can be dealt with in each process is: X-rays: 40/0.25 = 160 Interpret results: 20/0.10 = 200 Recall etc: 30/0.20 = 150

Studying Paper F5? Performance objectives 12, 13 and 14 are linked

accounting accounting So, the recall procedure is the bottleneck resource. Throughput, and thereby the organisation’s performance, cannot be improved until that part of the process can deal with more people. Therefore, to improve throughput: 1 Ensure there is no idle time in the bottleneck resource, as that will be detrimental to overall performance (idle time in a non‑bottleneck resource is not detrimental to overall performance). 2 See if less time could be spent on the bottleneck activity. 3 Finally, increase the bottleneck resource available. In Example 1, increasing the bottleneck resource, or the efficiency with which it is used, might be relatively cheap and easy to do because this is a simple piece of administration while the other stages employ expensive machinery or highly skilled personnel. There is certainly no point in improving the first two stages if things grind to a halt in the final stage; patients are helped only when the whole process is completed and they are recalled if necessary. The traditional approach to decision making in a profit-seeking organisation is to use contribution analysis. The contribution per unit is the difference between the selling price of a unit and the marginal cost of a unit, where marginal cost consists of the material, variable labour and variable overhead per unit. Example 2 will remind you of this approach. A typical cost card for a product is as follows:

$ Selling price Material 20 Labour 30 Variable overhead 10 Fixed overhead 25 Total absorption cost Profit per unit

$ 140

85 55

The cost card is based on a budgeted output of 10,000 units. In this example, the marginal cost (the additional cost caused when one more unit is made) is $60 per unit ($20 + $30 + $10). The contribution per unit is: $140 - $60 = $80 The contribution is the amount by which you ‘win the race’: each extra unit sold brings in $140, but each extra unit made causes costs of $60, so after making and selling one more unit the business is better off by $80, the contribution. The fixed cost element is independent of the number of units actually made. It is based on budgeted output and budgeted fixed costs and, working backwards, the total budgeted fixed costs must have been: $25 x 10,000 = $250,000 A typical calculation then made using this information is to find the break even point, which is this example is 250,000/80 = 3,250 units.

The traditional approach to decision making in a profit-seeking organisation is to use contribution analysis. The contribution per unit is the difference between the selling price of a unit and the marginal cost of a unit.

student accountant issue 03/2010

technical

in example 2, The contribution approach is not wrong in principle, but the assumptions it makes about cost behaviour often do not accurately reflect the reality of a modern manufacturing business. the notion that there are significant variable labour and overhead costs is suspect.

In Example 2, contribution is the goal unit. If that is maximised, so is profit, which is the goal of a profit-seeking organisation. The contribution approach is not wrong in principle, but the assumptions it makes about cost behaviour often do not accurately reflect the reality of a modern manufacturing business. In particular, the notion that there are significant variable labour and overhead costs is suspect. Many of these businesses rely on sophisticated automated systems that run continuously with relatively little manual involvement. Even when production is slack, provided the downturn is expected to be short lived, most employees will still be paid because it is expensive to dismiss workers and then to rehire and retrain them. For short-term fluctuations in production it would be more accurate to consider labour costs and all overheads to be fixed, leaving material as the only truly variable cost. If all costs except material are fixed, businesses will become richer provided the sales revenue per unit exceeds material price per unit. In effect, sales price less material price is the new contribution per unit, but to make clear what we are talking about this is not called ‘contribution’: it is called ‘throughput’. In fact, ‘throughput’ is sometimes usefully known as ‘throughput contribution’:

Throughput = selling price – material per unit per unit per unit Throughput = sales revenue – cost of materials Throughput is generated only when a sale is made. Increasing inventory does not increase throughput. See Table 1 in Example 3 below. Available hours: 5,000 machine hours, 6,000 labour hours, 2,500 quality control hours. The factory is modern and highly automated. Despite the presentation of the information, it is considered that all costs, except material, are effectively fixed. The first step in managing the performance of an organisation is to discover the limits to its performance. What is the bottleneck resource here? From the data we can identify the bottleneck resource as seen in Table 2 opposite. So the bottleneck resource, the one which limits output, is machine hours. There is more than enough of the other two resources. If the company can’t make everything it wants to, it has to decide on an optimum production plan. Because the factory is highly automated and material is the only truly variable cost, throughput will be the appropriate measure to use when calculating how much the manufacture and sale of each unit increases the company’s wealth (see Table 3 opposite).

table 1, example 3 Product A Product B Product C Expected demand/budgeted output (units) 8,000 10,000 6,000 Selling price per unit ($) 130 100 135 Material cost per unit 33 20 40 Labour cost per unit 30 24 36 Variable overhead cost per unit 25 20 30 Fixed overhead cost per unit 15 12 18 Machine hours/unit 0.25 0.2 0.3 Labour hours per unit 0.25 0.2 0.3 Quality control time per unit 0.1 0.1 0.1

table 2, example 3 Needed for full production Available Machine hours 0.25 x 8,000 + 0.2 x 10,000 + 0.3 x 6,000 = 5,800 5,000 Labour hours 0.25 x 8,000 + 0.2 x 10,000 + 0.3 x 6,000 = 5,800 6,000 Quality control hours 0.10 x 8,000 + 0.1 x 10,000 + 0.1 x 6,000 = 2,400 2,500

table 3, example 3 Product Selling price Material ($) ($) A 130 33 B 100 20 C 135 40

table 4, example 3 Product Throughput/unit Machine hours/unit ($) A 97 0.25 B 80 0.20 C 95 0.30

We can’t simply conclude from this that Product A must be best because it earns more per unit than the other products. It is essential to take into account the use that each product makes of the bottleneck resource. Here, machine hours have been identified as the bottleneck resource. These are uniquely precious and must be used up in the best possible way. This can be done by calculating for each unit: Throughput Time in bottleneck resource and then using the answers to rank the products as shown in Table 4 above.

Throughput/unit ($) 97 80 95

Throughput/machine hour = Rank return/factory hour ($/hour) 388 2 400 1 317 3

This shows that priority should be given to making Product B, the highest earner per machine hour, then to Product A, and finally to Product C. The production plan would therefore be as seen in Table 5 on page 5.

in example 3, machine hours have been identified as the bottleneck resource. These are uniquely precious and must be used up in the best possible way.

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table 5, example 3 Units Machine Machine (bottleneck) hours/unit hours used Product B 10,000 0.20 2,000 Product A 8,000 0.25 2,000 Product C (balance) 3,333 0.30 1,000 (balance) Maximum machine hours available 5,000

Throughput ($) 10,000 x 80 = 800,000 8,000 x 97 = 776,000 3,333 x 95 = 316,635 1,892,635

Total expected non-material costs (from the original budget) = Product A: 8,000 x (30 + 25 + 15) = 560,000 Product B: 10,000 x (24 + 20 + 12) = 560,000 Product C: 6,000 x (36 + 30 + 18) = 504,000 The throughput/machine hour (or return/factory hour) shows the rate at which throughput can be earned when making and selling each product. Similarly, if the total expected non-material costs are divided by the available machine hours then the cost per factory hour is obtained: $1,624,000/5,000 = $324.80 So, for every hour the machine operates (which really means for every hour the factory operates as nothing else matters if the machine is the bottleneck resource), running costs accrue at the rate of $324.80/hour. The products the factory makes earn a net $388 for Product A, $400 for Product B and £317 for Product C.

Profit

(1,624,000) 268,635

Products A and B are clearly worth making and selling because their earning rates (return/factory hour) exceed the factory spending rate on fixed costs (cost/factory hour). Product C is more difficult to deal with. If the factory costs are truly fixed then Product C is still worth making as it earns a throughput amount of $317/factory hour – which is a lot better than earning nothing. However, if the fixed costs identified with Product C ( $504,000) could actually be avoided, then Product C should be abandoned as it costs more to run the factory to make the product than the product can earn. Instead of directly comparing return/factory hour to costs/factory hour, it is common to express these amounts as ratios, known as throughput accounting ratios (TAR), as shown in Table 6 opposite.

Instead of directly comparing return/factory hour to costs/factory hour in example 3, it is common to express these amounts as ratios, known as throughput accounting ratios (TAR), as shown in Table 6 .

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Ì ßÞ ÔÛê ôÛ È ßÓÐ ÔÛí

Return/factory hour Costs/factory hour Throughput accounting ratio

out already. Its interpretation is: 1 The higher the better (but we already knew the ranking of the products from the return/ factory hour) 2 The TAR should be greater than 1 if a product is worthwhile (earning rate greater than spending rate). Organisations should focus on how they can increase their TAR. Obvious routes are to increase selling prices, decrease material costs, or decrease factory costs. Provided a TAR is greater than 1 it will be worth trying to increase throughput, and this must be done by eliminating idle time in the bottleneck resource, increasing the bottleneck resource (until another resource becomes the bottleneck), or decreasing the use the product makes of the bottleneck resource. Þ Backflush accounting is a costing short cut. It relies on a business having immaterial amounts of work-in-progress and is therefore particularly suitable for businesses operating just-in-time inventory management. If the amount of work-in-progress is negligible, what is the point in meticulously valuing it? Fretting that some products might be 25% complete and others 60% complete, and then adding carefully calculated labour and overheads to these (immaterial) items, is a complete waste of time and effort.

Ì ¸®±«¹ ¸°«¬ ¿ ½ ½ ±«² ¬·² ¹®¿ ¬·±Ð ®±¼ «½ ¬ß Ð ®±¼ «½ ¬Þ Ð ®±¼ «½ ¬Ý 388.00 400.00 317.00 324.80 324.80 324.80 1.17 1.21 0.93 In backflush accounting, costs are not associated with units until they are completed or sold. Backflush accounting is sometimes called delayed costing, which is a helpful name, as costs are not allocated to production until after events have occurred. Standard costs are then used to work backwards to flush out manufacturing costs into production, splitting them between stocks of finished goods (if any) and cost of sales. No costs, whether material or conversion costs, are allocated to work-in-progress. The traditional and backflush approaches can be illustrated by Figures 1 and 2 on page 8. Ê There are two variants of backflush accounting and they differ according to what are called ‘trigger points’. Trigger points are the events which cause costs to be moved into inventories.

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student accountant issue 03/2010

figure 1: traditional costing

Material

Materials account Costs in

Costs out to WIP

Conversion costs Costs in

WIP stage 1

WIP stage 2

Finished goods

To cost of sales

Costs out to WIP

figure 2: backflush accounting

Material

Materials account Costs in

Costs out to finished goods

Conversion costs Costs in

Costs out to finished goods

Finished goods

To cost of sales

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Return/factory hour Costs/factory hour Throughput accounting ratio

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technical

materials mix yield Since long ago, variance analysis has been an area that evokes fear in students worldwide. Students enter the exam hall, desperately running through the formulae used to calculate all the different variances, fearful of forgetting them before they have managed to put pen to paper. Then the inevitable happens: they turn over the exam paper and a variance question stares back at them. Frantically, they scribble down all the formulae before they are lost forever. Alas, they can’t remember it quite accurately enough. Is it actual quantity x standard price or standard quantity x actual price? Panic grips them. Logic flies out of the window. They move desperately on to the next question. Does this sound like a familiar story to you? If it does, carry on reading. This article might help you. Many articles have been written about variance analysis over the years, but the purpose of this one is to cover the area of calculating materials mix and yield variances. While the calculation of a mix variance can also be done for sales, this is not covered by the Paper F5 syllabus at present. Therefore, I shall concentrate purely on the materials balance here.

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

RELEVANT TO ACCA QUALIFICATION PAPER P5

Materials usage variance Most students have relatively little difficulty in calculating a straightforward materials usage variance. As a reminder, let’s recap on what the material usage variance is and how it is calculated. The material usage variance analyses the difference between how much actual material we used for our production relative to how much we expected to use, based on standard usage levels. So, for example, if we made 5,000 items using 11,000kg of material A and our standard material usage is only 2kg per item, then we clearly used 1,000kg of material more than we expected to (11,000kg - [2 kg x 5,000 items]). In terms of how we value this difference, it must be at standard cost. Any difference between standard and actual cost would be dealt with by the materials price variance. There can be many reasons for an adverse materials usage variance. It may be that inferior quality materials have been purchased, perhaps at a lower price. This may be reflected in a favourable materials price variance: the materials were cheaper but as a result there was perhaps more waste. On the other hand, it may be that changes to the production process have been made, or that increased quality controls have been introduced, resulting in more items being rejected. Whatever the cause, it can only be investigated after separate material usage variances have been calculated for each type of material used and then allocated to a responsibility centre.

student accountant issue 04/2010 Studying Paper F5? Performance objectives 12, 13 and 14 are linked

Further variance analysis where several materials are used The fact that most products will be comprised of several, or sometimes hundreds of different materials, leads us back to the more detailed materials mix and yield variances that can be calculated in these instances. In many industries, particularly where the product being made undergoes a chemical process, it may be possible to combine different levels of the component materials to make the same product. This, in turn, may result in differing yields, dependent on the mix of materials that has been used. Note, when we talk about the materials ‘mix’ we are referring to the quantity of each material that is used to make our product ie we are referring to our inputs. When we talk about ‘yield’, on the other hand, we are talking about how much of our product is produced, ie our output. Materials mix variance In any process, much time and money will have been spent ascertaining the exact optimum mix of materials. 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. Let us take the example of a chemical, C, that uses both chemicals A and B to make it. Chemical A has a standard cost of $20 per litre and chemical B has a standard cost of $25 per litre. Research has shown that various combinations of chemicals A and B can be used to make C, which has a standard selling price of $30 per litre. The best two of these combinations have been established as:

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.

and variances Mix 1: 10 litres of A and 10 litres of B will yield 18 litres of C; and Mix 2: 8 litres of A and 12 litres of B will yield 19 litres of C. Assuming that the quality of C produced is exactly the same in both instances, the optimum mix of materials A and B can be decided by looking at the cost of materials A and B relative to the yield of C. Mix 1: (18 x $30) - (10 x $20) - (10 x 25) = $90 contribution Mix 2: (19 x $30) - (8 x $20) - (12 x $25) = $110 contribution. Therefore, the optimum mix that minimises the cost of the inputs compared to the value of the outputs is mix 2: 8/20 material A and 12/20 material B. The standard cost per unit of C is (8 x $20)/19 + (12 x $25)/19 = $24. However, if the cost of materials A and B changes or the selling price for C changes, production managers may deviate from the standard mix. This would, in these circumstances, be a deliberate act and would result in a materials mix variance arising. It may be, on the other hand, that the materials mix changes simply because managers fail to adhere to the standard mix, for whatever reason. Let us assume now that the standard mix has been set (mix 2) and production of C commences. 1,850kg of C is produced, using a total of 900kg of material A and 1,100kg of material (2,000kg in total). The actual costs of materials A and B were at the standard costs of $20 and $25 per kg respectively. How do we calculate the materials mix variance?

technical

The variance is worked out by first calculating what the standard cost of our 1,850kg worth of C would have been if the standard mix had been adhered to, and comparing that figure to the standard cost of our actual production, using our actual quantities. My preferred approach has always been to present this information in a table as shown in Table 1 below. The materials mix variance will be $46,000 $45,500 = $500 favourable. Remember: 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’ but avoid showing an adverse variance by simply using brackets. This leads to mistakes. The formula for this is shown below, but if you were to use it, the variance for each type of material must be calculated separately. (Actual quantity in standard mix proportions actual quantity used) x standard cost. As a student, I was never a person to blindly learn formulae and rely on these to get me through. I truly believe that the key to variance analysis is to understand what is actually happening. If you understand what the materials mix variance is trying to show, you will work out how to calculate it. However, for those of you who do prefer to use formulae, the workings would be as follows:

Material A: (800kg - 900kg) x $20 = $2,000 Adverse Material B: (1,200kg - 1,100kg) x $25 = $2,500 Favourable Net variance = $500 favourable. In this particular example, I have kept things simple by keeping all actual costs in line with the standards. The reality is that, in the real world, actual costs will often vary from standards. Why haven’t I covered this above? Because any variance in materials price is always dealt with by the materials price variance. If we try and bring this into our mix variance, we begin distorting the one thing that we are trying to understand – how the difference in materials Mix has affected our cost, rather than how the difference in price has affected our cost. Why haven’t I considered the fact that although our materials mix variance is $500 favourable, our changed materials mix may have produced less of C than the standard mix? Because this, of course, is where the materials yield variance comes into play. The materials mix variance focuses on inputs, irrespective of outputs. The materials yield variance, on the other hand, focuses on outputs, taking into account inputs.

Table 1: calculating the standard cost of 1,850kg worth of C (standard mix) Actual usage in standard proportions: Actual usage in actual proportions: Var. $ $ $ A = 800kg (8/20 x 2,000kg) x $20 16,000 A = 900kg x $20 18,000 2,000A B = 1,200kg (12/20 x 2,000kg) x $25 30,000 B = 1,100kg x $25 27,500 2,500F Total 46,000 Total 45,500 500F

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’ but avoid showing an adverse variance by simply using brackets. This leads to mistakes.

Materials yield variance Where there is a difference between the actual level of output for a given set of inputs and the standard output for a given set of inputs, a materials yield variance arises. In our optimum mix, we calculated that 20kg of inputs of A and B should produce 19kg of our output, C. We are effectively saying that there is a loss rate of 5% (20 - 1/20) in our process, ie our outputs, in kg, should be 95% of our inputs. Applying this to our example then, we can say that we would have expected our inputs of 2,000kg to yield an output of 95% of 2,000kg, ie 1,900 kg. Our actual yield was only 1,850kg, which is 50kg less than we would have expected. To calculate the materials yield variance, all we have to do is value this difference between the actual yield (1,850kg) and the expected yield for our given set of inputs (1,900kg) at the standard cost of our output, C, ie at $24 per kg. It is easy to see how to calculate this when we look at it logically and present it in a very simple table as shown in Table 2. No formula really needs to be learnt if you understand the logic behind the materials yield variance and grasp the principle that any price differences between actual and standard are always dealt with by the price variance alone. However, for those who do prefer to use a formula, the materials yield variance formula is:

Making observations about variances From our example, it can be seen that there is a direct relationship between our materials mix variance and our materials yield variance. By using a mix of materials that was different from standard, we have resulted in a saving of $500, in standard cost terms. However, the downside of this is that our cheaper mix of materials has resulted in a significantly lower yield of material CÂ than we would have got had our standard mix of materials been adhered to. This yield was $1,200 lower than it would have been, which is over double the amount that we saved by using a cheaper mix of materials. Overall, by netting the two variances off against each other, we have an adverse material usage variance of $700 ($1,200 A less $500 F). As indicated earlier on in the article, this could have been calculated on its own, without breaking it down further into its mix and yield elements, by comparing the quantity of materials we expected to use (based on standard usage) for our actual production to the quantity of material we actually did use for our production. Using my preferred method of a table, our calculations would look like Table 3 over the page. Actual production of 1,850kg requires an input of 1,947kg (1,850 x 100/95) in total of A and B

(Actual yield - standard yield from actual input of material) x standard cost per unit of output. (1,850kg - 1,900kg) x $24 = $1,200 Adverse.

Table 2: value difference between actual and expected yield at standard cost of C Actual yield Standard yield for actual quantities input Difference Standard cost per kg Var. 1,850kg 1,900kg 50kg $24 $1,200A

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

student accountant issue 04/2010

technical

it is important to stress the fact that quality issues cannot really be dealt with by this variance analysis. there is also a direct relationship between the mix and the yield variance and that neither of these can be considered in isolation.

Table 3: calculating the adverse material usage variance ($700) Standard quantity for actual production Actual quantity Var. $ $ $ A = 7,780kg (1,947 x 8/20) x $20 15,600 A = 900kg x $20 18,000 2,400A B = 1,168kg (1,947 x 12/20) x $25 29,200 B = 1,100kg x $25 27,500 1,700F Total 44,800 Total 45,500 700A

Again, if you like to learn the formula, this is shown below, although it would have to be applied separately to each type of material. (Standard quantity for actual production - actual quantity) x standard cost Understanding the bigger picture Now that you understand how to deal with the numerical side of materials mix and yield variances, and the fact that these are simply a detailed breakdown of the materials usage variance, it is also important to stress the fact that quality issues cannot really be dealt with by this variance analysis. I have mentioned the fact that there is a direct relationship between the mix and the yield variance and that neither of these can be considered in isolation. In addition to this, however, it is also essential to understand the importance of producing products that are of a consistently good quality. It can be tempting for production managers to change the product mix in order to make savings; these savings may lead to greater bonuses for them at the end of the day. 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. While substituting poor quality input materials may in some cases lead to yield volumes that are the same as those achieved with higher quality materials, the yield may not be of the same quality.

Unfortunately, this factor cannot be incorporated into the materials yield variance. In the long run, it may be deduced from an adverse sales volume variance, as demand for the business’s product decreases, but it is likely to take time for sales volumes to be affected. 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. Similarly, poorer 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, in turn, could lead to higher overhead costs, and so on. Fortunately, consequences such as these will occur in the same period as the mix 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 (eg a favourable materials mix variance) can lead to a real deterioration in another area (eg decreased yield, poorer quality, higher labour costs, lower sales volumes, and ultimately lower profitability). Always make sure you mention such interdependencies when discussing your 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. Ann Irons is examiner for Paper F5

technical

target and lifecycle Target costing and lifecycle costing can be regarded as relatively modern advances in management accounting so it is worth first looking at the approach taken by conventional costing.

RELEVANT to ACCA QUAlification paper F5

Target costing and lifecycle costing can be regarded as relatively modern advances in management accounting, so it is worth first looking at the approach taken by conventional costing. Typically, conventional costing attempts to work out the cost of producing an item incorporating the costs of resources that are currently used or consumed. Therefore, for each unit made the classical variable costs of material, direct labour and variable overheads are included (the total of these is the marginal cost of production), together with a share of the fixed production costs. The fixed production costs can be included using a conventional overhead absorption rate or they can be accounted for using activity-based costing (ABC). ABC is more complex but almost certainly more accurate. However, whether conventional overhead treatment or ABC is used the overheads incorporated are usually based on the budgeted overheads for the current period. Once the total 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. The mark-up is chosen so that if the budgeted sales are achieved, the organisation should make a profit. 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. The product might incorporate features which customers do not value and therefore do not want to pay for, and competitors’ products might be cheaper, or at least offer better value for money. This flaw is addressed by target costing.

2 The costs incorporated are the current costs only. They are the marginal costs plus a share of the fixed costs for the current accounting period. There may be other important costs which are not part of these categories, but without which the goods could not have been made. Examples include the research and development costs and any close down costs incurred at the end of the product’s life. Why have these costs been excluded, particularly when selling prices have to be high enough to ensure that the product makes a profit. To make a profit, total revenue must exceed total costs in the long term. This flaw is addressed by lifecycle costing. Target costing Target costing is very much a marketing approach to costing. The Chartered Institute of Marketing defines marketing as: ‘The management process responsible for identifying, anticipating and satisfying customer requirements profitably.’ In marketing, customers rule, and marketing departments attempt to find answers to the following questions: ¤ Are customers homogeneous or can we identify different segments within the market? ¤ What features does each market segment want in the product? ¤ What price are customers willing to pay? ¤ To what competitor products or services are customers comparing ours? ¤ How will we advertise and distribute our products? (There are costs associated with those activities too.)

student accountant issue 03/2010

Marketing says that there is no point in management, engineers and accountants sitting in darkened rooms dreaming up products, putting them into production, adding on, say 50% for mark-up then hoping those products sell. At best this is corporate arrogance; at worst it is corporateÂ suicide. Note that marketing is not a passive approach, and management cannot simply rely on customers volunteering their ideas. Management should anticipate customer requirements, perhaps by developing prototypes and using other market research techniques. The really important information relating to a new product is:

cus What tom wil ers l pay ?

do nt? a at Wh ersÂ w m o t cus

New product

What do competitors offer?

Marketing says that there is no point in management, engineers and accountants sitting in darkened rooms dreaming up products and adding on a 50% mark-up then hoping those products sell.

costing costing Of course, there will probably be a range of products and prices, but the company cannot dictate to the market, customers or competitors. There are powerful constraints on the product and its price and the company has to make the required product, sell it at an acceptable and competitive price and, at the same time, make a profit. If the profit is going to be adequate, the costs have to be sufficiently low. Therefore, instead of starting with the cost and working to the selling price by adding on the expected margin, target costing will start with the selling price of a particular product and work back to the cost by removing the profit element. This means that the company has to find ways of not exceeding 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: Cost + Mark-up = Selling price 100% 50% 150% $8 $4 $12 This is a powerful discipline imposed on the company. The main results are: Â¤ The establishment of multifunctional teams consisting of marketing people, cost accountants, production managers, quality control professionals and others. These teams are vital to the design and manufacturing decisions required to determine the price and feature combinations that are most likely to appeal to potential buyers of products.

technical

¤ An emphasis on the planning and design stage. This becomes very important to the cost of the product because if something is designed such that it is needlessly expensive to make, it does not matter how efficient the production process is, it will always be a struggle to make satisfactory profits. 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. You will see from this list that activity-based costing can also play an important part in target costing. By understanding the cost drivers (cost causers) a company can better control its costs. For example, costs could be driven down by increasing batch size, or reducing the number of components that have to be handled by stores. The concept of value engineering (or value analysis) can be important here. 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).

target costing places great emphasis on controlling costs by good product design and production planning, but those up‑front activities also cause costs. There might be other costs incurred after a product is sold such as warranty costs and plant decommissioning.

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. The perfume could be held in a plain glass (or plastic) bottle, and although that would not damage the use value of the product, it would damage the esteem value. The company would be unwise to try to reduce costs by economising too much on packaging. Similarly, if a company is trying to reduce the costs of manufacturing a car, there might be many components that could be satisfactorily replaced by cheaper or simpler ones without damaging either use or esteem values. However, there will be some components that are vital to use value (perhaps elements of the suspension system) and others which endow the product with esteem value (the quality of the paint and the upholstery). Lifecycle costing As mentioned above, target costing places great emphasis on controlling costs by good product design and production planning, but those up‑front activities also cause costs. There might be other costs incurred after a product is sold such as warranty costs and plant decommissioning. 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. This is the concept of life cycle costing, and it is important to realise that target costs can be driven down by attacking any of the costs that relate to any part of a product’s life. The cost phases of a product can be identified as:

Phase Design Manufacture Operation End of life

Examples of types of cost Research, development, design and tooling Material, labour, overheads, machine set up, inventory, training, production machine maintenance and depreciation Distribution, advertising and warranty claims Environmental clean-up, disposal and decommissioning

There are four principal lessons to be learned from lifecycle costing: ¤ 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. More attention to training can machine maintenance costs. More attention to waste disposal during manufacturing can reduce end-of life 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. Costs are incurred only when a resource is used.

Typically the following pattern of costs committed and costs incurred is observed: 100 % costs committed or incurred

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. This is the concept of life cycle costing.

student accountant issue 03/2010

Costs committed

80 60 40

Design phase

Manufacturing and operations phase End of life phase

Costs incurred

0 Time

The diagram shows that 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. The company can try to haggle with suppliers over the cost of components but if, for example, the design specifies 10 units of a certain component, negotiating with suppliers is likely to have only a small overall effect on costs. A bigger cost decrease would be obtained if the design had specified only eight units of the component. The design phase locks the company in to most future costs and it this phase which gives the company its greatest opportunities to reduce those costs.

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Conventional costing records costs only as they are incurred, but recording those costs is different to controlling those costs and performance management depends on cost control, not cost measurement. A numerical example of target and life cycle costing A company is planning a new product. Market research information suggests that the product should sell 10,000 units at $21.00/unit. The company seeks to make a mark-up of 40% product cost. It is estimated that the lifetime costs of the product will be as follows: 1 Design and development costs $50,000 2 Manufacturing costs $10/unit 3 End of life costs $20,000 The company estimates that if it were to spend an additional £15,000 on design, manufacturing costs/ unit could be reduced. Required (a) What is the target cost of the product? (b) What is the original lifecycle cost per unit and is the product worth making on that basis? (c) If the additional amount were spent on design, what is the maximum manufacturing cost per unit that could be tolerated if the company is to earn its required mark-up?

Solution The target cost of the product can be calculated as follows: (a) Cost + Mark-up = Selling price 100% 40% 140% $15 $6 $21 (b) The original life cycle cost per unit = ($50,000 + (10,000 x $10) + $20,000)/10,000 = $17

This cost/unit is above the target cost per unit, so the product is not worth making.

($50,000 + $15,000 + $20,000)/10,000 = $8.50

Therefore, the maximum manufacturing cost per unit would have to fall from $10 to ($15 - $8.50) = $6.50. Ken Garrett is a freelance lecturer and author

technical

activity-based Conventional costing distinguishes between variable and fixed costs. Typically, it is assumed that variable costs vary with the number of units of output (and that these costs are proportional to the output level) whereas fixed costs do not vary with output. This is often an over-simplification of how costs actually behave. For example, variable costs per unit often increase at high levels of production where overtime premiums might have to be paid or when material becomes scarce. Fixed costs are usually fixed only over certain ranges of activity, often stepping up as additional manufacturing resources are employed to allow high volumes to be produced. Variable costs per unit can at least be measured, and the sum of the variable costs per unit is the marginal cost per unit. These are the extra costs caused when one more unit is produced. However, there has always been a problem dealing with fixed production costs such as factory rent, heating, supervision and so on. Making a unit does not cause more fixed costs, yet production cannot take place without these costs being incurred. To say that the cost of producing a unit consists of marginal costs only will understate the true cost of production and this can lead to problems. For example, if the selling price is based on a mark‑up on cost, then the company needs to make sure that all production costs are covered by the selling price. Additionally, focusing exclusively on marginal costs may cause companies to overlook important savings that might result from better controlled fixed costs.

Fixed costs are usually fixed only over certain ranges of activity, often stepping up as additional manufacturing resources are employed to allow high volumes to be produced.

RELEVANT to ACCA QUAlification paper F5 The conventional approach to dealing with fixed overhead production costs is to assume that the various cost types can be lumped together and a single overhead absorption rate derived. The absorption rate is usually presented in terms of overhead cost per labour hour, or cost per machine hour. This approach is likely to be an over-simplification, but it has the merit of being relatively quick and easy. EXAMPLE 1 See Table 1 opposite. The budgeted labour hours must be 112,000 hours. This is derived from the budgeted outputs of 20,000 ordinary units which each take five hours (100,000 hours) to produce, and 2,000 deluxe units which each take six hours (12,000 hours). Therefore, the fixed overhead absorption rate per labour hour is $224,000/112,000 = $2/hour. The costing of the two products can be continued by adding in fixed overhead costs to obtain the total absorption cost for each of the products. See Table 2 opposite. For future reference, note that the total costs accounted for (if production goes according to plan) will be = 20,000 x 85 + 2,000 x 102 = $1,904,000. The conventional approach outlined above is satisfactory if the following conditions apply: 1 Fixed costs are relatively immaterial compared to material and labour costs. This is the case in manufacturing environments which do not rely on sophisticated and expensive facilities and machinery. 2 Most fixed costs accrue with time. 3 There are long production runs of identical products with little customisation.

student accountant issue 02/2010 Studying Paper F5? Performance objectives 12, 13 and 14 are linked

table 1, example 1 Budget Ordinary units Deluxe units Units produced 20,000 2,000 Costs per unit: Material Labour 5 hours at $12/hour Variable overhead 5 hours at $1/hour Marginal costs

$ 10 60 6 hours at $12/hour 5 6 hours at $1/hour 75

$ 12 72 6 90

Budgeted fixed production overheads are $224,000

table 2, example 1 Budget Ordinary units Deluxe units Units produced 20,000 2,000 Marginal costs Fixed overheads 5 hours at $2/hour Total absorption cost/unit

However, much modern manufacturing relies on highly automated, expensive manufacturing plants â&#x20AC;&#x201C; so much so that some companies do not separately identify the cost of labour because there is so little used. Instead, factory labour is simply regarded as a fixed overhead and added in to the fixed costs of running the factory, its machinery, and the sophisticated information technology system which coordinates production.

$ 75 10 6 hours at $2/hour 85

$ 90 12 102

Additionally, many companies rely on customisation of products to differentiate themselves and to enable higher margins to be made. Dell, for example, a PC manufacturer, has a website which lets customers specify their ownÂ PC in terms of memory size, capacity, processor speed etc. That information is then fed into their automated production system and the specified computer is built, more or less automatically.

Conventional costing distinguishes between variable and fixed costs. Typically, it is assumed that variable costs vary with the number of units of output (and that these costs are proportional to the output level) whereas fixed costs do not vary with output.

costing

technical

to get a more accurate estimate of what each unit costs to produce we have to examine what activities are necessary to produce each unit, because activities usually have a cost attached. This is the basis of activity-based costing (ABC).

Instead of offering customers the ability to specify products, many companies offer an extensive range of products, hoping that one member of the range will match the requirements of a particular market segment. In Example 1, the company offers two products: ordinary and deluxe. The company knows that demand for the deluxe range will be low, but hopes that the price premium it can charge will still allow it to make a good profit, even on a low volume item. However, the deluxe product could consume resources which are not properly reflected by the time it takes to make those units. These developments in manufacturing and marketing mean that the conventional way of treating fixed overheads might not be good enough. Companies need to know the causes of overheads, and need to realise that many of their ‘fixed costs’ might not be fixed at all. They need to try to assign costs to products or services on the basis of the resources they consume.

Ordinary units are produced in long production runs, with each batch consisting of 2,000 units.

EXAMPLE 2 An analysis of the fixed overheads of $224,000 shows that they consist of: $ Batch set-up costs 90,000 Stores – material handling etc 92,000 Other (rent etc) 42,000 Total 224,000

The ABC process is as follows:

Deluxe units are produced in short production runs, with each batch consisting of 100 units. Each ordinary unit consists of 20 components, each deluxe unit of 30 components. What we want to do is to get a more accurate estimate of what each unit costs to produce, and to do this we have to examine what activities are necessary to produce each unit, because activities usually have a cost attached. This is the basis of activity-based costing (ABC). The old approach of simply pretending that fixed costs are incurred because of the passage of time, and that they can therefore be accounted for on the basis of labour (or machine) time spent on each unit, is no longer good enough. Diverse, flexible manufacturing demands a more accurate approach to costing.

1 Identify a distinct ‘fixed’ overhead cost. 2 Identify the activity that causes that cost. In ABC terminology, that activity is the ‘cost driver’, but it might be better to think of it as the ‘cost causer’. 3 Work out the cost incurred each time the activity occurs. 4 Determine how many units are made for each incidence of the cost causer. This is likely to vary for each type of unit. 5 Work out the cost that can be traced into each unit produced. See Figure 1 below.

figure 1: the abc process Identify a cost

Identify what causes/drives it

Calculate the cost per causal event

Trace the cost into the units produced

The old approach of simply pretending that fixed costs are incurred because of the passage of time, and that they can be accounted for on the basis of labour (or machine) time spent on each unit, is no longer good enough. Diverse, flexible manufacturing demands more accurate costing.

student accountant issue 02/2010

EXAMPLE 3 Applying these steps to the fixed cost breakdown shown in Example 2 results in the following analysis: Batch set-up costs 1 Cost of set-ups = $90,000 2 Cost driver (or cost causer) = each batch set‑up (presumably) 3 The number of set-ups are: For ordinary units 20,000/2,000 = 10 For deluxe units 2,000/100 = 20 Total set-up occasions 30 Cost per set-up

90,000/30 = $3,000

4 Each set-up produces 2,000 ordinary units Each set-up produces 100 deluxe units 5 Ordinary units: $3,000/2,000 = $1.50/unit Deluxe units: $3,000/100 = $30/unit

Material handling costs 1 Cost of material handling 2 Cost driver will be number of components handled (presumably) 3 The number of material handling events for the year = 20 x 20,000 + 30 x 2,000 = 460,000 (from the information given above) Cost per material handling event = $92,000/460,000 = $0.20 4 Each ordinary unit takes 20 items of material Each deluxe unit takes 30 items of material 5 Each ordinary unit will cost $0.2 x 20 = $4/unit Each deluxe unit will cost $0.2 x 30 = $6/unit Other fixed overheads will have to be absorbed on a labour hour rate because there is no information provided that would allow a better approach: $42,000/112,000 = $0.375/labour hour The ABC approach to costing therefore results in the figures shown in Table 3 below. Check: total costs accounted for if all goes according to budget = 20,000 x 82.375 + 128.25 x 2,000 = $1,904,000, as before.

table 3, example 3 Budget Ordinary units Deluxe units Units produced 20,000 2,000 Marginal costs (as before) Fixed overheads: Set-up Material handling Other 5 hours at 0.375 Total absorption cost/unit

75.00

90.00

1.50 4.00 1.875

30.00 6.00 2.25

6 hours at 0.375

82.375

128.25

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COMPARING THE APPROACHES Ordinary units Deluxe units Total absorption cost/unit – conventional approach 85.000 102.00 Total absorption cost/unit – ABC approach 82.375 128.25 You will see that the ABC approach substantially increases the cost of making a deluxe unit. This is primarily because the deluxe units are made in small batches. Each batch causes an expensive set-up, but that cost is then spread over all the units produced in that batch – whether few (deluxe) or many (ordinary). It can only be right that the effort and cost incurred in producing small batches is reflected in the cost per unit produced. There would, for example, be little point in producing deluxe units at all if their higher selling price did not justify the higher costs incurred. In addition to estimating more accurately the true cost of production, ABC will also give a better indication of where cost savings can be made. Remember, the title of Paper F5 is Performance Management, implying that accountants should be proactive in improving performance rather than passively measuring costs. For example, it’s clear that a substantial part of the cost of producing deluxe units is set-up costs (almost 25% of the deluxe units’ total costs).

Working on the principle that large cost savings are likely to be found in large cost elements, management’s attention will start to focus on how this cost could be reduced. For example, is there any reason why deluxe units have to be produced in batches of only 100? A batch size of 200 units would dramatically reduce those set-up costs. The traditional approach to fixed overhead absorption has the merit of being simple to calculate and apply. However, simplicity does not justify the production and use of information that might be wrong or misleading. ABC undoubtedly requires an organisation to spend time and effort investigating more fully what causes it to incur costs, and then to use that detailed information for costing purposes. But understanding the drivers of costs must be an essential part of good performance management. Ken Garrett is a freelance writer and lecturer

ABC undoubtedly requires an organisation to spend time and effort investigating more fully what causes it to incur costs, and then to use that detailed information for costing purposes. But understanding the drivers of costs must be an essential part of good performance management.

Part 2 COURSE NOTES

Content Chapter 1

ADVANCED COSTING METHODS

Chapter 2

CVP ANALYSIS

Chapter 3

PLANNING WITH LIMITING FACTORS

Chapter 4

PRICING DECISIONS

Chapter 5

MAKE-OR-BUY AND OTHER SHORT-TERM DECISIONS

Chapter 6

DEALING WITH RISK AND UNCERTAINTY IN DECISION MAKING

Chapter 7

BUDGETING

Chapter 8

QUANTITATIVE ANALYSIS

Chapter 9

STANDARD COSTING AND VARIANCES ANALYSIS

Chapter 10

ADVANCED VARIANCES

Chapter 11

PERFORMANCE MEASUREMENT AND CONTROL

Chapter 12

DIVISIONAL PERFORMANCE AND TRANSFER PRICING

Chapter 13

PERFORMANCE MEASUREMENT IN NFPO

Chapter 14

SOLUTION

Chapter 1 – ADVANCED COSTING METHODS SYLLABUS OBJECTIVES A

SPECIALIST COST AND MANAGEMENT ACCOUNTING TECHNIQUES

1 a) b) c)

ACTIVITY BASED COSTING Identify appropriate cost drivers under ABC. .[1] Calculate costs per driver and per unit using ABC.[2] Compare ABC and traditional methods of overhead absorption based on production units, labour hours or machine hours.[2]

2 a) b) c)

TARGET COSTING Derive a target cost in manufacturing and service industries.[2] Explain the difficulties of using target costing in service industries. [2] Suggest how a target cost gap might be closed.[2]

3 a) b) c)

LIFE-CYCLE COSTING Identify the costs involved at different stages of the lifecycle.[2] Derive a life cycle cost in manufacturing and service industries. .[2] Identify benefits of lifecycle costing.[2]

4 a) b) c)

THROUGHPUT ACCOUNTING Calculate and interpret a throughput accounting ratio (TPAR).[2] Suggest how a TPAR could be improved.[2] Apply throughput accounting to a multiproduct decision making problem.[2]

4 a) b)

ENVIRONMENTAL ACCOUNTING Discuss the issues business face in the management of environmental costs. [1] Describe the different methods a business may use to account for its environmental costs. [1]

ACCA F5 Chapter 1 – Advanced costing methods

1- 1

ACTIVITY BASED COSTING (ABC)

1.1

Absorption costing - recap

F2 covered two methods of costing products: Absorption and Marginal costing (‘traditional methods’): Absorption costing:

Under absorption costing, inventory is valued at VARIABLE production costs plus a portion of FIXED production overheads determined by the Overhead Absorption Rate (OHAR). 

Traditional method, valid many years ago

− − 

Labour intensive or machine intensive mass production of standard items Fixed overheads were relatively low in proportion to variable costs imprecision of overheads in units was not significant to decision making.

Now complex manufacturing environment:

− − − −

Large investments in information systems, robotics, and other advances in manufacturing Customised batches Indirect costs now high in relation to direct costs Non volume related support activities - High proportion of overhead activities is not related to production volume (production scheduling, order handling..)



Service industries – absorption costing is not convenient for same reasons

1.2

Activity based costing

Cost pool - activity that consumes resources and for which overhead costs are identified and allocated. For each cost pool, there should be a cost driver (quality control, ordering) 1-2

ACCA F5 Chapter 1 – Advanced costing methods

Cost driver - unit of activity that consumes resources. Factor influencing the level of cost. (# of inspections, # of orders) Steps to follow: 

Step 1:

Identify activities that consume resources and incur overhead costs.



Step 2:

Allocate overhead costs to the activities that incur them. In this way, each identified activity becomes a cost pool for overhead costs. It is important that overhead costs should be directly allocated to a cost pool. There should not be any arbitrary apportionment of overhead costs.



Step 3:

Determine the cost driver for each activity or cost pool.



Step 4:

Collect data about actual activity for the cost driver in each cost pool



Step 5:

Calculate the overhead cost of products or services. This is done by calculating an overhead cost per unit of the cost driver (a cost per unit of activity). Overhead costs are then charged to products or services on the basis of activities used for each product /service.

Illustration

A company manufactures two products, P and Q. Monthly data relating to production and sales are as follows.

Direct material cost per unit Direct labour hours per unit Direct labour cost per unit Sales demand

Product P

Product Q

$15 1 hour $20 100 units

$20 2 hours $40 950 units

Production overheads are $200,000 each month and are absorbed on a direct labour hour basis. The management accountant has produced a report on the potential value of ABC as a preferred alternative to the traditional absorption costing system, and has found that there are five main areas of activity that can be said to consume overhead costs. The management accountant has gathered the following monthly information: Activity Setting up Machining Order handling Quality control Engineering

Total cost $ 20,000 80,000 20,000 20,000 60,000 200,000

Cost driver

Total

Number of setups Machine hours Number of orders Number of inspections Engineering hours

4 2,000 4 5 1,000

1 100 1 1 500

3 1,900 3 4 500

Calculate the costs, in total and per unit, for Product P and Q, using absorption costing and ABC. 1

Solution

ABC Activity

Total

Setting up

Total Cost driver cost($) 20,000 Number of setups

Machining

80,000 Machine hours

2,000

100

1,900

Order handling

20,000 Number of orders

Quality control

20,000 Number of inspections

Engineering

60,000 Engineering hours

1,000

500

OH per unit of cost driver

200,000

ACCA F5 Chapter 1 – Advanced costing methods

1- 3

ABC cost card

Absorption costing

1.3

Absorption costing versus ABC



Allocations of OH – under ABC reapportionment of service dept cost is avoided (ABC establishes separate cost pools for support activities – despatching)



Absorption of OH



Absorption costing – 2 absorption bases to charge OH to products (labour and machine hrs)



ABC – absorption bases = cost drivers  absorption rates are more closely linked to the caused of OH costs

1-4

ACCA F5 Chapter 1 – Advanced costing methods

Illustration (K 13)

Cabal makes and sells two products, Plus and Doubleplus. The direct costs of production are $12 for one unit of Plus and $24 per unit of Doubleplus. Information relating to annual production and sales is as follows:

Annual production and sales Direct labour hours per unit Number of orders Number of batches Number of setups per batch Special parts per unit

Plus

Doubleplus

24,000 units 1.0 10 12 1 1

24,000 units 1.5 140 240 3 4

Information relating to production overhead costs is as follows: Activity

Cost driver

Setup costs Special parts handling Other materials handling Order handling Other overheads

Number of setups Number of special parts Number of batches Number of orders

Annual cost $ 73,200 60,000 63,000 19,800 216,000 432,000

OH per unit of cost driver

Other overhead costs do not have an identifiable cost driver, and in an ABC system, these overheads would be recovered on a direct labour hourâ&#x20AC;&#x2122;s basis. (a) Calculate the production cost per unit of Plus and of Doubleplus if the company uses traditional absorption costing and the overheads are recovered on a direct labour hours basis. (b) Calculate the production cost per unit of Plus and of Doubleplus if the company uses ABC. 2

Solution

ACCA F5 Chapter 1 â&#x20AC;&#x201C; Advanced costing methods

1- 5

1-6

ACCA F5 Chapter 1 â&#x20AC;&#x201C; Advanced costing methods

1.4

Advantages and disadvantages of ABC

Advantages 

Recognises complexity of manufacturing with its multiple cost drivers – complexity of manufacturing increased (wider product ranges, shorter product life cycle, more complex production processes).



Facilitates good understanding what drives a cost – in more competitive environment company must be able to assess product profitability more realistically.



Is concerned with all overhead cost (not only production OH) – in modern manufacturing environment  high proportion of non production OH (design, quality control, customer services, production planning).



Can be used in product and service costing.

Disadvantages 

It is impossible to allocate all overhead costs to specific activities



ABC costs are based on assumptions and simplifications. The choice of both activities and cost drivers might be inappropriate.



ABC can be more complex to explain to the stakeholders of the costing exercise.



The benefits obtained from ABC might not justify the costs.



Implementing of ABC might be problematic.

Illustration

A manufacturing business makes a product in two models, model M1 and model M2:

Annual sales Number of sales orders Sales price per unit Direct material cost per unit Direct labour hours per unit Direct labour rate per hour Special parts per unit Production batch size Setups per batch Production batch size Cost pools Setup costs Material handling costs Special part handling costs Customer invoicing costs Overhead analysis

$ 97,600 42,000 50,000 31,000 108,000 328,600

Model M1

Model M2

8,000 units 60 $54 $11 2.0 hours $8 2 2,000 units 1 1

8,000 units 250 $73 $21 2.5 hours $8 8 100 units 3 1

Cost driver Number of setups Number of batches Number of special parts Number of sales orders Direct labour hours

A customer has indicated an interest in placing a large order for either model M1 or M2, and the sales manager wished to try to sell the higher priced model M2. (a) Calculate the profit per unit for each model, using ABC. (b) Using the information above indicate what advice you would give to the sale manager on the basis of the information provided by your ABC analysis.

ACCA F5 Chapter 1 – Advanced costing methods

1- 7

1-8

Solution

ACCA F5 Chapter 1 â&#x20AC;&#x201C; Advanced costing methods

TARGET COSTING



Target costing is a modern product costing tool: First, the company sets a competitive price for its product. Next, it determines a desired profit margin. Finally, a ‘target cost’ is determined by subtracting the desired profit from the pre-determined price. It then becomes the goal of the production department to manufacture this product at the ‘target price.’

2.1

Implementing target costing



Determine product specification



Set selling price (for desired market share)



Estimate required profit (based on return on sales / investments)



Calculate target cost = price – profit



Compile estimated cost



Calculate target cost gap = estimated cost – target cost



Close the gap  “design out “ cost prior to production x “control out” cost during a production



Negotiate with customer

Illustration

Car manufacturer wants to calculate cost of a new car, price will be set at $20,000, and profit margin required 9%. What is target cost? 4

Solution

2.2

Implications of using target costing 

Change the way managers think about the relationship btw cost, price, profit:

− − 

Focus on:

− − 

Traditional approach: develop product, determine cost, set selling price Target: develop product, determine price and desired margin  cost that must be achieved

Price-led costing Customers – requirements for quality, cost and time are incorporated into the product. Value of features > cost of providing them.

Design – cost control is pushed to design stage.

ACCA F5 Chapter 1 – Advanced costing methods

1- 9

2.3

Closing the cost gap

Cost gap: when the current cost of a product is greater than the target cost. How to reduce the cost gap: 

Components – reducing # of components, standard vs specialised component



Material – eliminated (cut down packaging), cheaper, different (less waste)



Staff – training to make them efficient, cheaper



Technology – more efficient



Economies of scale – what production volume is needed to get them?



Key: Value analysis – what features are essential to customer perceive quality

2.4

Target costing and service industries



Target costing was introduced by major Japanese manufacturers for use in a manufacturing environment:  



This environment facilitates use of a target cost approach since:  



1-10

a new product was to be designed to meet the target cost A substantial part of the production cost consisted of bought in materials.

Design of product can be changed to match cost requirements. Large manufacturers are able to exert pressure on (usually much smaller) suppliers to reduce their prices

Service industries are less favourable for the use of target costing: 

more difficult to make service comparisons than product comparisons, making it harder to determine a market driven price.



introduction of new products and services in service industries occurs far less frequently than in a manufacturing environment (e.g. Sony and Toyota introduce new models on a regular basis)  the equivalent of manufacturing design teams are rarely found in service industries.



Bought in material is insignificant  little scope for exerting pressure on external suppliers.



The major cost of any new product or service is salaries and unless lower cost delivery mechanisms (e.g. the internet) or radically different ways of working can be exploited there is limited scope for substantial cost reduction.

ACCA F5 Chapter 1 – Advanced costing methods

LIFECYCLE COSTING

3.1

Definition



3.2



Concept which traces all costs to a product over its complete life cycle from design to phase-out,



Includes the pre-production stage and post sale costs (e.g. warranties, customer service, marketing, and distribution costs).



Enables a product’s true profitability to be determined at the end of its economic life.

Traditional costing techniques based around annual periods may give misleading impression of the costs and profitability of a product: 

R&D is not related to product that causes them  w/o against revenue generated by existing products  existing products appears less profitable



All non production costs are recorded as expenses for the period.

Life cycle costs Product planning and design stage   

R&D (design, testing, production process) Cost of purchasing any technical data Training cost

Manufacturing stage    

Production costs Distribution costs (transportation, handling) Marketing costs Inventory costs (holding spare parts, field maintenance)

Abandonment stage 

3.3

Retirement and disposal

Product life cycle

ACCA F5 Chapter 1 – Advanced costing methods

1- 11



Development – cost incurred, no revenue



Introduction (launch) – product introduced, but potential customers are unaware of new product  advertising, promotion



Growth



− −

Marketing will continue Market share up, demand up  sales increase, fixed costs recovered

− − −

Profit will increase as initial set up and initial fixed costs recovered Marketing & distribution economies achieved Price competition and product differentiation will erode profitability

Maturity

Decline stage

− − −

Marketing cost cut Production economies lost as volume falls Replacement product needs to be developed (R&D etc) or additional development cost to refine the model to extend life cycle

3.4

LC costing and traditional methods - comparison



Traditional methods are based on annual periods



Under traditional methods: R&D, design, set-up, marketing cost are

 5



Reported aggregated, charged annually (R&D, design, production setup, marketing and customer service costs are traditionally reported on an aggregated basis for all products and recorded as a period expense)



Charged against products that did not cause them (Lifecycle costing traces these costs to individual products over their entire life cycles, to aid comparison with product revenues generated.

Cost are more visible with LC costing  better relationship between cost – revenues Illustration (K 34)

The following details relate to a new product that has finished development and is about to be launched. Time period R & D costs $m Marketing costs $m Production cost per unit ($) Production volume (millions)

Development Finished 20

Launch 1 year

Growth 1 year

Maturity 1 year

Decline 1 year

5 1 1

4 0.9 5

3 0.8 10

0.9 0.9 4

The launch price is proving a contentious issue between managers. The marketing manager is keen to start with a low price of around $8 to gain new buyers and achieve target market share. The accountant is concerned that this does not cover costs during the launch phase and has produced the following schedule. Launch phase: Amortised R&D costs (20 ÷ 4) Marketing costs Production costs (1 million × $1 per unit) Total Total production (units) Cost per unit

$ million 5.0 5.0 1.0 11.0 1 million $11.00

Prepare revised cost per unit schedule looking at the whole lifecycle and comment. 1-12

ACCA F5 Chapter 1 – Advanced costing methods

Solution

3.5

Importance of early stages of LC 

90% of the product’s lifecycle costs are determined by decisions made in the development and launch stages. Focussing on costs after the product has entered production results in only a small proportion of lifecycle costs being manageable. Therefore tight control in design stage (before launch) is important, as most costs are committed (locked-in) at this point of time.



Cost reduction at planning + design + development stage are critical to cost management process (as such costs are fixed, huge and committed)

3.6

Maximising return over product LC



Design cost OUT of the product (rather than control them)– careful design of product/manufacturing processes etc (90% determined at early stages)



Minimise time to market 

Time to market = time from conception to launch



Critical to get product to market ASAP, as:

− − 

Longer period without rivals (and therefore higher market share) Total life might not lengthen if launch delayed (might result in permanently lost sales). Better to include extra cost to keep launch on schedule

Maximise length of LC 

The longer LC, the greater the profit that will be generated:

− − −

Get product as quickly as possible to the market Find another uses of the product Find another markets for product

3.7

Customer lifecycle costing



Each customer generates revenue and causes costs  maximise return from customer over its LC  retain customers (loyalty programs): 

Existing customers tend to be more profitable than new customers, because:

− −

Initial cost are high (bank: opening account) Existing customers use its bank for different services (share purchase, exchange...)

ACCA F5 Chapter 1 – Advanced costing methods

1- 13

THROUGHPUT ACCOUNTING

4.1

Concepts/ assumptions/ definitions



Assumes a modern manufacturing environment following JIT principles: the company minimizes inventory and only produces units when customers place orders.



Maximizing cash flow is the main financial objective. This is achieved by maximizing factory output—everything that is produced is sold under JIT. Thus, the more a company produces, the greater its cash flow.



Assumes that labour is a fixed cost in the short term—the only variable cost to consider is raw materials.



Uses a new concept of contribution called ‘Throughput contribution,’ This is calculated by subtracting materials from selling price. (Throughput contribution = selling price – materials).



“Bottlenecks” slow production and limit cash flow: throughput accounting aims to focus attention on identifying and removing bottlenecks, maximizing cash flow.

4.2

Performance measures



Theory of constraints (F2 and next chapter) – profit is maximised when contribution per scarce resource is maximised.



Performance is measured by calculating a ratio: ‘throughput contribution per hour’ (i.e. cash generated per hour after paying for materials) over ‘Other factory costs per hour’ (essentially the hourly cost of running the factory). This is called “Throughput Accounting Ratio,” or TPAR.



Throughput contribution per hour=



Factory cost per hour =

throughput per unit =A hrs of bottleneck to produce unit

total operating cost per period total capacity of bottleneck hr



Throughput accounting ratio TPAR = A/B



If TPAR is > 1, the product should make a profit. If TPAR is < 1, the production should make a loss.



Criticism:





Concentrates on short term.



Difficult to apply to longer term (as majority cost variable)  ABC more appropriate for measuring and controlling performance.

How to improve TPAR – see fraction and work it out from the fraction:

− − − −

1-14

Increase sales price Reduce material cost per unit Reduce operating expenses Reduce time to make product and increase productivity of assembly work force

ACCA F5 Chapter 1 – Advanced costing methods

Illustration (K 19)

A business manufactures a single product that it sells for $10 per unit. The cost of material for each unit of product sold is $3. Total operating expenses are $50,000 each month. Labour hours are limited to 20,000 hours each month. Each unit of product takes 2 hours to assemble. Calculate the throughput accounting ratio. 6

Solution

4.3

Decision making

Throughput accounting may be applied to a multi product decision-making problem in the same way as conventional key factor analysis: Step 1: calculate the throughput for each product. Step 2: identify the bottleneck constraint. Step 3: calculate the throughput per minute of the bottleneck resource for each product to rank the alternatives. Step 4: allocate resources using this ranking. 7

Illustration

Co makes two products (A, B) and has identified that a bottleneck occurs during assembly. Details of the products:

Sales price Material Direct labour Assembly time per unit mins

Product A

Product B

25 5 10 20

16 3 8 15

Total assembly mins available: 1,000min How should the two products be prioritised? 7

Solution

ACCA F5 Chapter 1 â&#x20AC;&#x201C; Advanced costing methods

1- 15

Illustration (K 21)

Justin Thyme manufactures four products, A, B, C and D. Sales price Materials cost Direct labour cost Machine time per unit mins Labour time per unit mins Weekly sales demand units

A 1.40 0.60 0.40 5 2 2,000

B 0.80 0.30 0.20 2 1 2,000

C 1.20 0.60 0.40 3 2 2,500

D 2.80 1.00 1.00 6 5 1,500

Machine time is a bottleneck resource and the maximum capacity is 400 machine hours each week. Operating costs, including direct labour costs, are $5,440 each week. Direct labour costs are $12 per hour, and direct labour workers are paid for a 38hour week, with no overtime. (a) Determine the quantities of each product that should be manufactured and sold each week to maximise profit and calculate the weekly profit. (b) Calculate the throughput accounting ratio at this profit-maximising level of output and sales 8

1-16

Solution

ACCA F5 Chapter 1 â&#x20AC;&#x201C; Advanced costing methods

ENVIRONMENTAL MANAGEMENT ACCOUNTING (EMA)



Article : Ann Irons 2010, Shane Johnson 2004



Importance





Organizations are beginning to recognise that both environmental awareness and management are important for long-term survival.



New legal requirements require this



Stakeholders expect environmental awareness and sensitivity



Important for managing risk, e.g. averting environmental disasters

Identifying 

Internal costs: e.g. regulatory costs, permits, taxes, decommissioning costs



External environmental costs: e.g. carbon emissions, usage of energy and water, forest degradation



Environmental prevention costs – costs preventing production of waste



Environmental detection costs – costs to ensure compliance with regulations



Environmental internal failure costs – production of waste



Environmental external failure costs – costs incurred on activities after discharging the waste

DISCUSS the issues business face in the management of environmental costs 

Reductions of waste generation and of material input (resource consumption) are one of the key activities in environmental management, to lower the environmental impact of manufacturing industry.



Management of environmental costs – obstacles: 

EMA is difficult to define and the actual costs involved as well (many diff definitions)



Some of the costs are difficult to separate out and identify, accounted for as general O/H



Difficult to control the environmental costs Cost of waste: lost land resources (waste has been buried), generation of methane Cost of water: cost of buying plus cost of disposal Cost of energy: identification of inefficiencies Cost of transport and travel: fuel efficient vehicles Consumables and raw material: e.g. toner cartridges for printers could be refilled rather than replaced

ACCA F5 Chapter 1 – Advanced costing methods

1- 17



DESCRIBE the different methods a business may use to account for its environmental costs 

INPUT/OUTPUT analysis The purchased input (100%) is balanced against the outputs (produced, sold and stored goods waste...) Materials (incl. Energy and water) are measured in physical units. Output is measured in physical units and in monetary terms -> it forces the company to focus on environmental costs. Output – product, scrap recycled, disposal, rest not accounted for



Flow cost accounting Similar to the above It measures the flow and stock of “materials,” which include raw materials, parts and components in the manufacturing process, in terms of both physical and monetary units. The costs are managed in the categories of material cost, system cost, and delivery and disposal cost.





It helps businesses reduce the amount of waste generation itself, instead of expanding waste recycling.



Reduced waste generation directly leads to the reduction of material input and material cost,



This also leads to increased efficiency in processing and waste treatment operations.

Life cycle costing The whole environment costs should be taken into account – from “cradle to grave”. Design-out environmentally driven costs.



Activity based costing Environmental costs removed from general overheads These costs are traced to activities; cost drivers are calculated and assigned to products or services in the same manner as ABC.

1-18

ACCA F5 Chapter 1 – Advanced costing methods

Chapter 2 â&#x20AC;&#x201C; CVP ANALYSIS SYLLABUS OBJECTIVES B

DECISION-MAKING TECHNIQUES

Cost volume profit analysis

Explain the nature of CVP analysis.[2]

Calculate and interpret break-even point and margin of safety.[2]

Calculate contribution to sales ratio (single and multi-product situation) and demonstrate an understanding of its use [2]

Calculate target profit or revenue (single and multi-product situation) and demonstrate an understanding of its use [2]

Prepare break-even charts and profit volume charts and interpret the information contained within each, including multiproduct situation. [2]

Discuss the limitations of CVP analysis for planning and decision making [2]

OVERVIEW

ARTICLE Ann Irons, examiner F5 Cost Volume Profit Student Accountant Issue14/2010

ACCA F5 Chapter 2 â&#x20AC;&#x201C; Planning with limiting factors

2-1

OBJECTIVE OF CVP ANALYSIS



One of the most important decisions that need to be made is HOW MUCH DO WE NEED TO SELL IN ORDER TO BREAK-EVEN? (break-even means to cover all cost (VAR+FIX) without making profit)



CVP looks primarily at the effect of differing levels of activity (sales volume) on the financial result of business. WHY?  other variables (sales price, material cost , labour cost etc) known in short run, but sales volume not



CVP analysis is the study of interrelationships between cost, volume and profit at various level of activity.

ASSUMPTIONS OF CVP 

Can apply to one product or constant mix



Fixed cost same in total



Unit variable cost same at all levels of output



Sales price constant at all levels of output



Production=sales

METHODS OF CALCULATING BREAKEVEN POINT (BEP)



BEP: Company does not do any profit nor loss (total revenue = total cost)

3.1

Equation method p...unit price v...unit variable cost q.. number of units produced and sold FC...fixed cost P...profit Total revenue TR = p x q Total cost TC = v x q + FC TR-TC = P Breakeven (in units): P = 0 TR-TC = 0 P x q – v x q - FC=0 Q x (p-v) = FC Q = FC / (p-v)

3.2

Contribution margin method (no difference, you can ignore) qx(p-v)=(FC+P) q=(FC+P)/(p-v)

2-2

ACCA F5 Chapter 2 – CVP analysis

3.3

Graphs

Breakeven graph

Contribution graph

Profit Volume (P/V) graph

ACCA F5 Chapter 2 â&#x20AC;&#x201C; CVP analysis

2- 3

Illustration (Article)

Sales price $50, unit variable cost $30, fixed costs $200,000 per annum. How many sales the business needs to make in order to breakeven. 1

Solution

TARGET PROFIT

Illustration (Article) – target profit

Sales price $50, unit variable cost $30, fixed costs $200,000 per annum. What is sales volume necessary to achieve target profit of $300,000? 2

Solution (Article) – target profit

MARGIN OF SAFETY



Difference in units between the budgeted sales volume and the breakeven sales volume.



It can be expressed

2-4



in units



in $ (sales revenue)



as percentage of budgeted sales volume

ACCA F5 Chapter 2 – CVP analysis

Illustration (Article) – margin of safety

Sales price $50, unit variable cost $30, fixed costs $200,000 per annum, budgeted sales 20,000 units. Find margin of safety a/ in units b/ as percentage of budgeted sales volume c/ in terms of sales revenue 3

Solution (Article) – margin of safety

CONTRIBUTION TO SALES RATIO (C/S)



Also called Profit/Volume ratio (P/V)



C/S ratio = contribution/sales = (p-v)/p

6.1

Interpretation



It is a measure of how much contribution is earned from $1 of sales

Illustration – C/S ratio interpretation

Sales price $50, unit variable cost $30, fixed costs $200,000 per annum. What is C/S ratio? 4

Solution

ACCA F5 Chapter 2 – CVP analysis

2- 5

6.2

Alternative way of calculating BEP



At BEP: contribution = FC



Therefore at BEP C/S = contribution/sales = FC/sales

Illustration – C/S ratio BEP

C/S ratio of product A is 40%. Fixed cost $200,000. P=$50. Calculate BEP. 5

2-6

Solution

ACCA F5 Chapter 2 – CVP analysis

BREAKEVEN ANALYSIS – MULTIPRODUCT SITUATION



Major assumption: 

Constant product mix (that allows us to calculate weighted average contribution per mix) or



All products in the mix have same C/S ratio

7.1

BEP

Illustration

Company A produces products x and y, fixed cost $200,000: p v p-v budgeted sales

x $50 $30 $20 20,000

y $60 $45 $15 10,000

Calculate BEP for x and y. 1. Contribution per mix: p-v ratio contribution

x $20 2 40

y $15 1 15 $55 per mix

2. BEP in number of mixes At BEP: total contribution = FC  FC/contribution per mix = number of mixes at BEP $200,000/ $55=3,636.36 number of mixes 3. BEP in number of units of x and y X: 3,636.36 x 2 = 7,272.73= 7,273 rounded Y: 3,636.36 x 1 = 3,636.36 = 3,636 rounded 10,909 4. BEP in terms of revenue X: 7,273 x $50 = $363,600 Y: 3,636 x $60 = $218,160 $581,760 Answer: Breakeven point is $581,760 provided mix of product is 2X:1Y Breakeven point is (not production of 10,909 units – as it depends on sales mix) 7,273 units of X and 3,636 units of Y that implies product mix 2X:1Y.

ACCA F5 Chapter 2 – CVP analysis

2- 7

7.2

BEP using C/S 

Step1: Calculate weighted average C/S for mix − 1a/ contribution per mix − 1b/ revenue per mix



Step2: Calculate BEP (sales revenue for mix)

Illustration – BEP multiple products using C/S

Company A produces products x and y, fixed costs $200,000: x y p $50 $60 v $30 $45 p-v $20 $15 budgeted sales 20,000 10,000 Calculate BEP for x and y. 7

Solution - BEP multiple products using C/S

1. Average C/S for mix

X in mix $20x2=$40 $50x2 = $100

1a/ contribution per mix 1b/ revenue per mix 2. BEP (in sales revenue for mix)

Y in mix $15x1=$15 $60x1=$60

mix $55 $160 55/160=34.375%

3. BEP in sales revenue for product 3a/ sales revenue ratio for products 3b/ BEP in sales revenue for products

4. BEP in sales volume for product if required

Note: You might be given C/S ratios for individual products and sales mix. You can calculate average C/S per mix as weighted average of product C/S ratios. Result will not be exactly the same as if average C/S per mix is calculated as contribution per mix/sales revenue per mix, but it is accepted method. Using information from illustration 7 above: p v p-v mix C/S 2-8

x $50 $30 $20 2 40%

y $60 $45 $15 1 25% ACCA F5 Chapter 2 – CVP analysis

Weighted average C/S = 2/3 x 40% + 1/3 x 25% = 35%. It is slightly different from average C/S ration per mix of 34.375%.

7.3

Target profit – multiple products

Logic is same as for single product: pxq-vxq-FC=P  q(p-v) = FC+P  contribution = FC+P Therefore number of mixes to achieve target profit P is calculated as (FC+P)/contribution per mix 8

Illustration – target profit multiple products

Company A produces products x and y, fixed costs $200,000: p v p-v budgeted sales

x $50 $30 $20 20,000

y $60 $45 $15 10,000

What are level of sales of x and y if target profit is $300,000? 8a

Solution – target profit multiple products

Step 1: Contribution per mix: p-v ratio contribution

Step 2: Required # of mixes

Step 3: Required sales in units and $ for each product Product X

# of mixes # of units in mix

units

sales revenue $

Solution – target profit multiple products – using C/S

Step 1

C/S ratio for mix (see Illustration 7) 34.375%

Step 2

Required total revenue for target profit of $300,000 pxq-vxq-FC=P  contribution = FC+P

Step3:

Required sales for each product: 3a/ sales revenue ratio for products 3b/ sales revenue for products

ACCA F5 Chapter 2 – CVP analysis

X: Y: 2- 9

7.4

Margin of safety – multiple products



Difference between budgeted sales in standard mix and breakeven sales in standard mix. Can be expressed in units, in $ (sales revenue), as percentage of budgeted sales.

Illustration – Margin of safety – multiple products

Company produces X and Y in ratio 2:3. Fixed cost for period $300,000. Budgeted sales revenue for period $750,000. X 10 6

P V

y 15 5

Calculate margin of safety in terms of revenue and also as percentage of budgeted sales. 9

Solution – Margin of safety – multiple products

Margin of safety is difference between sales (volume or revenue) at BEP and budgeted sales (volume or revenue), therefore we have to calculate BEP first: 1. Contribution per mix x

p v p-v

Contribution per mix = 2. BEP in a number of mixes At BEP FC=contribution, therefore total contribution at BEP = ........................,which represents .................................. mixes 3. BEP in number of units and in sales revenue Product X Y

# of mixes # of units in mix

units

sales revenue $

4. Margin of safety budgeted sales BEP sales Margin of safety products)

...............

in the standard mix (allocate total sales in ratio of 4/9 (2x10$/3x15$) if required for individual

Margin of safety as % of budgeted sales =...

2 - 10

ACCA F5 Chapter 2 – CVP analysis

7.5

Charts – multiple products



Total cost and revenue chart



Cumulative cost and revenue chart



Profit/Volume chart (P/V) – mentioned in article by examiner

Illustration – Multiple product charts

Company A produces products x and y, fixed cost $200,000: p v p-v budgeted sales

x $50 $30 $20 20,000

y $60 $45 $15 10,000

Produce a/ Total cost and revenue chart b/ Cumulative cost and revenue chart c/ Profit/Volume chart (P/V) – mentioned in article by examiner 10

Solution – a/ Total cost and revenue chart units 20,000x$30= 10,000x$45= 30,000

VAR X VAR Y

COST ($) 600,000 450,000 1,050,000 200,000 1,250,000

Fixed cost Total cost/revenues

units 20,000x$50= 10,000x$60= 30,000

REVENUE ($) 1,000,000 600,000 1,600,000

ssdf Total revenue C Total costs 1600 000 1 250 000

200 000 Output (units) 30 000

ACCA F5 Chapter 2 – CVP analysis

2 - 11

Solution – b/ Cumulative cost and revenue chart Cumulative units

Fixed cost X (20,000 units) X+Y(20,000+10,000) units

20,000 30,000

Cum. costs ($) 200,000 800,000 1,250,000

Cum. revenue($) 1,000,000 1,600,000

Costs and revenue in $

1 600 000

1 250 000

200 000 Output (units) 30 000

Solution – c/ P/V chart

By convention, products with higher C/S ratio are shown first X C/S ratio: 0.4 Y C/S ratio: 0.25 Contribution Fixed cost X Y

2 - 12

20,000x$20=400 10,000x$15=150

Cum profit/loss (k$) (200) 200 350

Revenue (k$)

Cum revenue (k$)

20,000x$50=1,000 10,000x$60=600

1,000 1,600

ACCA F5 Chapter 2 – CVP analysis

LIMITATIONS AND ADVANTAGES OF CVP

8.1

Limitations

Limitations of CVP are mostly derived from its assumptions: 

p,v,FC constant – this assumption is a great simplification: 

FC are not constant , they changes with the level of output (most FC are step GC)



price might decrease at higher level of output (competition, low demand...)



variable costs are not constant – learning curve, economies of scale, diseconomies of scale (extra overtime...)



Production does not equal to sales – changes in inventory levels are ignored



Mix is not constant



Costs are divided into fixed and variable, semi-fixed costs are ignored

8.2

Advantages

  

Breakeven charts are easily understood by non-financial people CVP analysis enables (within limited range) to identify BEP C/S ratio indicates profitability of products

ACCA F5 Chapter 2 – CVP analysis

2 - 13

2 - 14

ACCA F5 Chapter 2 â&#x20AC;&#x201C; CVP analysis

Chapter 3 â&#x20AC;&#x201C; PLANNING WITH LIMITING FACTORS SYLLABUS OBJECTIVES B

DECISION-MAKING TECHNIQUES

Multi-limiting factors and the use of linear programming and shadow pricing

Identify limiting factors in a scarce resource situation and select an appropriate technique...[2]

Determine the optimal solution plan where organisation is restricted by a single limiting factor, including within the context of make/buy decisions .[2]

Formulate and solve a multiple scarce resource problem both graphically and using simultaneous equations as appropriate.[2]

Explain and calculate shadow prices (dual prices) and discuss their implications on decision making and performance management. [2]

Calculate slack and explain the implications of the existence of slack for decision making and performance management (excluding simplex and sensitivity to changes in objective functions).[2]

OVERVIEW

ACCA F5 Chapter 3 â&#x20AC;&#x201C; Planning with limiting factors

3-1

PLANNING WITH ONE LIMITING FACTOR



‘Limiting factors’ are factors that place a maximum limit on an organization’s output. It could be production capacity, lack of financing, lack of demand, or other factors. In F5, the limiting factor in the exam question will either be a shortage of MATERIAL or LABOR.



Use marginal costing principles. The objective is to maximize contribution per unit of limiting factor (even if the question asks you to maximize profit, you achieve this by maximizing contribution.)



Steps to be followed:



Identify limiting factor



Contribution per limiting factor



Rank



Allocate resources

Illustration (K 08/09 57)

Z Inc makes two products which both use the same type of materials and grades of labour, but in different quantities as shown by the table below: Product A 3 $20

Labour hours/unit Material/unit

Product B 4 $15

During each week the maximum number of labour hours available is limited to 600, and the value of material available is limited to $6,000. Each unit of product A made and sold earns Z Inc a contribution of $5 and each unit of product B earns $6 per unit. The demand for these products is limited to 100 of each per week. What is the optimum production plan? 1

Solution (K 08/09 57)

1/ Identify limiting factor A B

Labour hrs

material

2/ Contribution per limiting factor A

units

labour needed

material needed

3/ Rank 4/ Plan A B

3-2

Units

hrs

hrs used

contribution earned

ACCA F5 Chapter 3 – Planning with limiting factors

Assumptions 

single quantifiable objective – e.g. maximise contribution. In reality there may be multiple objectives (maximising return while minimising risk)



Each product uses same quantity of the scarce resource per unit: (2 hours to make a unit of X). In reality economies of scale / learning effects.



Contribution per unit is constant. In reality may not be the case:

− − − 

Products are independent – it is possible to prioritise product A at the expense of B. In reality this may be difficult:

− − 

the selling price may have to be lowered to sell more discounts available as quantity of materials increases economies of scale

customers may expect to buy both products together the products may be manufactured jointly together.

Scenario is short term

SEVERAL LIMITING FACTORS – LINEAR PROGRAMMING



Same logic but 2 types of problems:  



Maximise profit--this means maximize contribution. (See Illustration 2, Hebrus). Minimise costs (J Farm – see Illustration 3)

Steps to be followed:     

Define variables (in exam max 2) Define and formulate objective (max contribution, C = 5x+6y) Formulate constraints (X,Y>=0, 6X+3Y<=36, 4X+8Y<=48)draw the graph  feasible region solve equations AND show it in graph  optimal production plan answer!



Assumptions – same as for 1 limiting factor

Illustration (K 91)

Hebrus Inc manufactures summerhouses and garden sheds. Each product passes through a cutting process and an assembly process. One summerhouse, which makes a contribution of $50, takes six hours' cutting time and four hours' assembly time; while one shed makes a contribution of $40, and takes three hours' cutting time and eight hours' assembly time. There is a maximum of 36 cutting hours available each week and 48 assembly hours. Cutters are paid $10 per hour and assembly workers $15 per hour. Formulate and solve the linear programming problem. 2

Solution

ACCA F5 Chapter 3 – Planning with limiting factors

3-3

3-4

ACCA F5 Chapter 3 â&#x20AC;&#x201C; Planning with limiting factors

EXAM TIP Instead of profit maximising problem, the question might be formulated as cost minimising problem. See illustration below 3

Illustration (K 96)

J Farms Ltd can buy two types of fertiliser which contain the following percentage of chemicals: Type X Type Y

Nitrates 18 3

Phosphates 5 2

Potash 2 5

For a certain crop the following minimum quantities (kg) are required: Nitrates 100kg, Phosphates 50kg, Potash 40kg Type X costs £10 per kg and type Y costs £5 per kg. J Farms Ltd currently buys 1,000 kg of each type and wishes to minimise its expenditure on fertilisers. (a) Write down the objective function and the constraints for J Farms Ltd. (b) Draw a graph to illustrate all the constraints (equations/inequalities), shading the feasible region. (c) Recommend the quantity of each type of fertiliser which should be bought and the cost of these amounts. (d) Find the saving J Farms Ltd can make by switching from its current policy to your recommendation.

ACCA F5 Chapter 3 – Planning with limiting factors

3-5

3-6

ACCA F5 Chapter 3 â&#x20AC;&#x201C; Planning with limiting factors

SLACK AND SURPLUSES



Slack – if the optimum solution results in using less than the maximum resource available, then a spare capacity arises  underutilised machine can be hired out



Surplus – more than minimum requirement is used.

Illustration – K09/10 - 57 (slightly modified)

Alfred Co is preparing its production plan for the coming month. It manufactures two products, the flak trap FT and sap trap ST: Contribution Labour skilled hrs Labour semiskilled Material

$50 10 5 6kg

$40 10 25 4kg

The supply of skilled labour is limited to 2,000 hours/month and the supply of semiskilled labour is limited to 2,500 hours/month. Maximum demand for flak traps is 150 units/month, maximum demand for sap traps is 80 units/month. At least 20 ST must be made every month. 1. Formulate the linear programming problem. 2. Find optimal combination of FT and ST 3. Which resource is binding and where slack or surplus exists? 4

Solution

1. Formulate linear programming problem FT ST

Material 6kg 4kg -

lab skilled 10hr 10hr max 2,000

lab semi skilled 5hr 25hr max 2,500

max demand 150 units 80 units

Constraints are: Material: no constraints  no equation Labour skilled: 10FT+ 10ST<=2,000 Labour semi-skilled: 5FT+25ST<=2,500 Minimum production of ST: ST>=20 Non negativity: FT,ST>=0 Contribution maximising function is: Z= 50FT+40ST  max 3. Find optimal solution Optimal solution: 150 FT, 50 ST

ACCA F5 Chapter 3 – Planning with limiting factors

3-7

3. Which resource is binding and where slack or surplus exists? After substitution: Labour skilled: 10hrx150+10hr x 50=2,000 = availability – binding constraint Labour semi - skilled: 5hrx150+25hr x 50=2,000 <2,500  slack 500hr

Surplus is 30 ST (50-20)

3-8

ACCA F5 Chapter 3 – Planning with limiting factors

SHADOW PRICES

In real life it is often possible to obtain more of the limited resource, but usually for the higher price. For example we can get more labour by paying for overtime. The shadow price ( the dual price) is the maximum amount that we would pay for one extra unit of the limited resource. 

shadow price of a resource is an increase in value (usually extra contribution) which would be created by having available one additional unit of a limiting resource at its original cost.



It therefore represents the maximum premium that the firm should be willing to pay for one extra unit of each constraint.



Noncritical constraints will have zero shadow prices as slack exists

4.1

Calculation of shadow prices 

Step 1: add one unit to the constraint concerned, while leaving the other critical constraint unchanged.



Step 2: solve the revised simultaneous equations to derive a new optimal solution.



Step 3: calculate the revised optimal contribution. The increase is the shadow price for the constraint under consideration.

Tip for exam  show graphical approach as well

4.2

Using shadow prices 

The relevant cost of a resource = normal cost + shadow price



Thus shadow prices can be used for decision making in the same way as any other relevant costs

Illustration (K 98)

Using the following data, calculate the shadow price for machining time. Maximise C = 80x + 75y (contribution), subject to (i) 20x + 25y ≤ 500 (machining time) (ii) 40x + 25y ≤ 800 (finishing time) The optimal solution at the intersection of the above constraints is: x = 15, y = 8. 5

Solution

ACCA F5 Chapter 3 – Planning with limiting factors

3-9

Illustration (K99)

Suppose a linear programming problem gives the following results. Constraint Skilled labour Unskilled labour Materials

Normal cost

Shadow price

$20/hour $10/hour $5/kg

$12/hour zero $3/kg

(a) Which two constraints give rise to the optimal solution? (b) Overtime is paid at 'time and a half'. Is it worth paying overtime to help relax constraints? (c) A new product has been proposed with the following proposed costs and revenues Selling price Skilled labour – 2 hours@$20/hour Unskilled labour – 1 hour@$10/hour Materials – 3kg@$5/kg

$ 40 10 15

Profit per unit

$ 80

65 15

Assuming that the constraints cannot be relaxed, should the new product be manufactured? 6

3-10

Solution

ACCA F5 Chapter 3 – Planning with limiting factors

Illustration (examiner – article March 2008)

A profit seeking firm has two constraints: labour, limited to 16,000hours, and materials, limited to 15,000kg. The firm manufactures and sells two products, X and Y. To make X, the firm uses 3kg of material and 4 hours of labour, whereas to make Y, the firm uses 5kg of material and 4 hours of labour. The contributions made by each product are $30 for X and $40 for Y. The cost of materials is normally $8 per kg, and the labour rate is $10 per hour. Required:

a) Calculate the optimum solution. b) Calculate the material shadow price, comment. c) How many materials the firm should buy? Solution (examiner – article March 2008)

ACCA F5 Chapter 3 – Planning with limiting factors

3-11

3-12

ACCA F5 Chapter 3 â&#x20AC;&#x201C; Planning with limiting factors

Chapter 4 â&#x20AC;&#x201C; PRICING DECISIONS SYLLABUS OBJECTIVES B

DECISION-MAKING TECHNIQUES

Pricing decisions

(a)

Explain the factors that influence the pricing of a product or service. [2]

(b)

Explain the price elasticity of demand.[1]

(c)

Derive and manipulate a straight line demand equation. Derive an equation for the total cost function (including volume-based discounts).[2]

(d)

Evaluate a decision to increase production and sales levels considering incremental costs, incremental revenues and other factors. [2]

(e)

Determine prices and output levels for profit maximisation using demand based approach to pricing (both tabular and algebraic methods) [2]

(f)

Explain different price strategies, including: [2] (i) all forms of cost plus (ii) skimming (iii) penetration (iv) complementary product (v) product line (vi) volume discounting (vii) discrimination (viii) relevant cost.

(f)

Calculate a price from a given strategy using cost plus and relevant cost.[2]

OVERVIEW

ACCA F5 Chapter 4 â&#x20AC;&#x201C; Pricing decisions

4-1

FACTORS THAT INFLUENCE PRICING

1.1

Introduction



Pricing is important because: It makes a pivotal contribution to profit maximisation – the overriding aim of most businesses. Businesses make profits by selling goods and services at a price higher than their cost. The amount that they are able to sell will often be determined by the price charged for the goods and services. Pricing is one of the four components of the marketing mix, the others being:

   

 product  place  promotion Decisions in relation to all four components should be made within the context of the overall marketing strategy.

1.2

Approaches: Cost, customers, competition



Cost based pricing 

Price = cost + mark-up

− −

Cost subjective - might be: full cost, manufacturing cost, variable cost mark-up subjective, reflects:

− the risk involved in the product − competitors’ mark-ups − desired profit and/or ROCE (return on capital employed) − type of cost used − type of product, etc 

Mark-up vs margin

Illustration

If the full cost of an item is $540, calculate the selling price using a 25% mark-up and a 25% profit margin: 1

4-2

Solution

ACCA F5 Chapter 4 – Pricing decisions



Customers based pricing – marketer’s approach 

Reflects customers’ perceptions of the benefits they will enjoy (e.g. convenience, status, etc.).



This approach:

− − − 

has regard to costs – customer-based pricing must ensure that financial objectives are met, BUT Exploits the willingness of customers to pay a multiple of the cost price if they perceive the benefits to be substantial. Reflects a belief that the greater the understanding of the wants, needs and values of your customer the better placed you are to price the product.

Competition based pricing 

A setting a price based upon the prices of competing products.



Competing products can be classified as:

− − − −

The same type of product – easily distinguished from one’s own products: – price changes by competitors will not have a material impact. The same type of product – not easily distinguished from one’s own products: – price changes by competitors will have a material impact. Substitute products that may be bought instead of your type of product (e.g. buy ice cream instead of soft drinks on a hot day). Impact of price changes will depend on relative price/performance of substitute.

Factors 1.4 Different types of market structure 

The price that a business can charge for its products or services will be determined by the market in which it operates. 

perfectly competitive market

− − − − −



every buyer or seller is a 'price taker', and no participant influences the price of the product it buys or sells Zero Entry/Exit Barriers – easy to enter / exit Perfect Information - Prices and quality of products are assumed to be known to all consumers and producers. Companies aim to maximise profits. Firms aim to sell where marginal costs meet marginal revenue, where they generate the most profit. Homogeneous Products – The characteristics of any given market: good or service do not vary across suppliers.

Imperfect competition refers to the market structure that does not meet the conditions of perfect competition. Forms include :

− −

−

ACCA F5 Chapter 4– Pricing decisions

Monopoly, in which there is only one seller of a good. The seller dominates many buyers and can use its market power to set a profit maximising price. (Microsoft) Oligopoly, in which a few companies dominate the market and are interdependent firms, must take into account likely reactions of their rivals to any change in price, output or forms of non-price competition. (UK: four companies (Tesco, Asda, Sainsbury's and Morrisons) share 74.4% of the grocery market) Monopolistic competition, in which products are similar, but not identical. There are many producers ('price setters') and many consumers in a given market, but no business has total control over the market price.

4-3

DEMAND

2.1

Relationship



The higher price P of good, the lower quantity Q demanded

2.2

PED



Price elasticity of demand (PED) – measure of extent of change in Q in response to change in P   

% change in Q/ % change in P >1 – elastic  very responsive < 1 – inelastic  not responsive

Price elasticity of demand (PED) =

% change in Q % change in price P

A high PED means that the demand is very sensitive to changes in price, or elastic (i.e. the quantity demanded falls by a larger percentage than the percentage rise in price). Elastic demand means that consumers are sensitive to the price at which a product is sold and will not buy it if the price rises by what they consider too much. A low PED means that the demand is not very sensitive to changes in price = or inelastic (i.e. the quantity demanded falls by a smaller percentage than the percentage increase in price). i.e. consumers will pay almost any price for the product; a producer can raise prices without much hurting demand for its product. 2

Illustration (K 08/09 - 91 )

Retailer plans to increase price of a text book from $20 to $22. PED = -1,25. What will be the impact of the price rise on sales (currently 300 units pa) and revenue?

4-4

ACCA F5 Chapter 4 – Pricing decisions

2.3

Straight line demand equation

Illustration (K125)

Find the linear relationship between price (P) and the quantity demanded (Q) in relation to following sales and demand data: Selling price of $300 = sales of 500 units per month. Selling price of $330 = sales of 400 units per month. 3

Solution

ACCA F5 Chapter 4â&#x20AC;&#x201C; Pricing decisions

4-5

TOTAL COST EQUATION

3.1

Linear relationship, no discounts

Total cost = fixed costs + (variable costs * activity level), or: y = kx+q

Illustration

If the total cost of a product is given as: Y = 4,800 + 8x (a) The fixed cost is $ (b) The variable cost per unit is $ (c) The total cost of producing 100 units is $

3.2

Cost equation including volume based discounts

Total cost equation must be derived for each volume range. 5

Illustration (K 09/10 89)

Fixed costs $100,000. Variable costs per unit $5 for volume up to 1,000 units. Volume above 1,000 units receives 5% discount on all units. This gives: • Y = 100,000 + 5x for x≤1,000 • Y = 100,000 + 4.75x for x>1,000. Graph

4-6

ACCA F5 Chapter 4 – Pricing decisions

DECISIONS TO INCREASE PRODUCTION AND SALES



increased contribution (sales less variable costs) generated by the increased sales must exceed additional fixed costs incurred as a result of increased sales



other factors need to be considered such as:   

the impact on future sales beyond the current period the impact of rejection on customer goodwill whether the extra sales would help build the firm's brand.

Illustration (K 130)

A company produces and sells one product and its forecast for the next financial year is as follows: Sales 100,000 units @ $8 material labour

$000 300 200

Contribution ($3 per unit) Fixed costs Net profit

$000 800 (500) 300 150 150

In an attempt to increase net profit, two proposals have been put forward: (a) To launch an advertising campaign costing $14,000. This will increase the sales to 150,000 units, although the price will have to be reduced to $7. (b) To produce some components at present purchased from suppliers. This will reduce material costs by 20% but will increase fixed costs by $72,000. Decide whether these proposals should be pursued. 6

Solution

ACCA F5 Chapter 4– Pricing decisions

4-7

PROFIT MAXIMISING PRICE/OUTPUT LEVEL

5.1

Tabular approach the optimum selling price is achieved when a profit is maximised



Management produced the following estimate of the sales demand and costs: Price $

Units

40 38 36 34 32 30 28

10 11 12 13 14 15 16

Total revenue $ 400 418 432 442 448 450 448

Total costs $ 360 364 370 378 388 400 414

Profit $ 40 54 62 64 60 50 34

Illustration (K 120)

XYZ Ltd is introducing a new product. Details of the costs are as follows: Hire costs – hiring the machinery to manufacture the product will cost $200,000 pa. This machine will enable 60,000 units pa to be produced. Additional machines can be hired at $80,000 pa. Each machine hired enables capacity to be increased by 20,000 units pa, but it is not possible to increase production beyond 90,000 units because of shortage of space. The minimum rental period is for one year and the variable cost is estimated to be $6 per unit produced. There are no other fixed costs that can be specifically traced to the product. Marketing management has estimated the maximum selling prices for a range of output from 50,000 units to 90,000 units. The estimates are as follows: Units sold Selling price ($)

50,000 22

60,000 20

70,000 19

80,000 18

90,000 17

90,000× 15

× At $15, demand will be in excess of 90,000 units but production capacity will limit the sales. Required: What is the optimum selling price? 7

Solution $

4-8

ACCA F5 Chapter 4 – Pricing decisions

5.2

Equations – reflects article from 30 Sep 04 by David Foster



Maximum profit is achieved at the point where marginal revenue = marginal cost



Marginal revenue / Marginal cost represent the additional revenue/cost of one extra unit of output.

Illustration (Article 30 Sep 04, David Foster)

What quantity of products I have to sell in order to achieve maximum profit. What selling price will achieve that? How much is the maximum profit. Price (per unit in $]) (Price/ demand equation): P = 30 – 0.25Q Marginal revenue:

MR = 30 – 0.5Q

Total cost function:

TC = 100 + 5Q

Solution

ACCA F5 Chapter 4– Pricing decisions

4-9

5.3

Equations â&#x20AC;&#x201C; Deriving MR from demand curve

You might be given demand equation P= -kQ+q. Marginal revenue can be derived from demand. MR = -2kQ+q (given in exam formula sheet). 9

Illustration (Deriving MR from demand curve)

XY used market research to determine that if price of $300 is charged to product A, demand will be 13,000 units. It also has been established that demand will rise/fall by 12 units for every 2$fall/rise in the selling price. Marginal cost (variable cost) of product A=85$. What is profit maximizing selling price?

4-10

Solution

ACCA F5 Chapter 4 â&#x20AC;&#x201C; Pricing decisions

PRICING STRATEGIES

6.1

Cost plus pricing



Full cost + mark-up = price



Mark up x Margin!



Disadvantages    



Need to adjust prices to market and demand Budget output volume needs to be established (overhead absorption rate) Suitable basis for overhead absorption Does not guarantee profit

Advantages   

Quick, simple, cheap  can be delegated to junior management Widely used Decision based on price in excess of full cost  price will cover all fixed costs and make profit (at normal capacity)

6.2

Market skimming



Exploits sections of market insensitive to price changes. Initially high prices may be charged to take advantage of the novelty appeal of a new product when demand is initially inelastic. Once the market becomes saturated the price can be reduced to attract that part of the market that has not been exploited.



Conditions:



Where product is new / different and has little direct competition – Customers are prepared to pay high prices so as to be 'one-up' on other people who do not own one. 

Where the strength of demand and the sensitivity of demand to price are unknown:

− − 

Where high prices in the early stages of a product’s life might generate high initial cash flows: - firm with liquidity problem may prefer market skimming for this reason. 

Where products have a short life cycle, and there is a need to:

− − 

It is much easier to lower prices than to increase them. Psychologically it is better to begin with a high price, which can then be lowered

recover their development costs make a profit quickly

High prices  potential competitors will be tempted to enter the market. Barriers must be present:

− − −

Patent protection Prohibitively high capital investment Strong brand royalty

6.3

Penetration pricing strategy



Charging of low prices when a product is initially launched in order to gain rapid acceptance of the product. Once market share is achieved, prices are increased.

ACCA F5 Chapter 4– Pricing decisions

4-11



Circumstances: 

If the firm wishes to discourage new entrants to the market



If the firm wishes to shorten the initial period of the product’s life cycle in order to enter the growth and maturity stages as quickly as possible.



If there are significant economies of scale to be achieved from high volume output  quick penetration into the market is desirable in order to gain unit cost reductions.



If demand is highly elastic and so would respond well to low prices.

For penetration pricing to be effective: 

Total market (in which the firm is operating) must be substantial



Anticipated market share must be significant.



Penetration pricing, if exploited to the full, becomes predatory pricing; its objective is to eliminate competition through use of unsustainably low prices. Predatory pricing is illegal.

6.4

Complementary product pricing



Complementary product - one that is used with another product. (razors and razor blades)



Complementary goods





Provide suppliers with additional power over the consumer.



Potentially enable suppliers to lock consumers into an ongoing stream of purchases by ensuring that only proprietary consumables (e.g. printer cartridges) can be used in their products.



Enable suppliers to increase the consumer’s switching cost – in order to use cheaper cartridges the consumer would have to abandon his original printer and purchase one that allowed him to use nonproprietary cartridges.

Strategies 

Major product (printer, camera) is priced at low figure – to encourage the purchase and lock the consumer into subsequent purchases of high priced consumables.



Major product (membership of golf club) is priced high – to create a barrier to entry and exit and the consumer is locked into subsequent purchases of low priced facilities (green fees).

6.5

Product line pricing strategy



Product line - range of products that are intended to meet similar needs of different target audiences. Thus all products within a product line are related but may vary in terms of style, colour, quality (dinner service).



Product line pricing works by: 

Capitalising on consumer interest in a number of products within a range.



Making the price entry point for the basic product relatively cheap.



Pricing other items in the range more highly – in order to ‘complete the set’ the consumer has to pay substantially more for the additional matching items.

6.6

Volume discounting pricing strategy



forms: - Quantity discounts and Cumulative quantity discounts



benefits from this strategy:

4-12



Increased customer loyalty – cumulative quantity discounts ‘lock in’ the customer since further purchases can be made at a lower cost per unit.



Attracting new customers – exceptional level of discount can be offered to new customers on a one-off basis, enabling the supplier to ‘get his foot in the door’. ACCA F5 Chapter 4 – Pricing decisions



Lower sales processing costs – an increased proportion of his sales take the form of bulk orders.



Lower purchasing costs – his increased sales volumes enable him to enjoy discounts from his suppliers



Discounts help to sell items that are bought primarily on price.



Competitive advantage – discounts encouraging customers to concentrate their orders rather than try out new suppliers.



Clearance of surplus stock

6.7

Price discrimination



where a company sells the same products at different prices in different markets.



This is possible if:   

the seller can determine the selling price customers can be segregated into different markets customers cannot buy at lower price in one market and sell at higher price in other market.



Segmentation on basis of: time, age, gender, type of service, geographical location…

6.8

Relevant cost pricing



Relevant cost – see chapter 5



Here relevant costs are used to arrive at a minimum tender price for a one-off tender



The use of relevant costs is only suitable for a one-off decision since:

− − −

ACCA F5 Chapter 4– Pricing decisions

fixed costs may become relevant in the long run there are problems estimating incremental cash flows there is a conflict between accounting measures such as profit and this approach.

4-13

4-14

ACCA F5 Chapter 4 â&#x20AC;&#x201C; Pricing decisions

Chapter 5 –

MAKE-OR-BUY AND OTHER SHORT-TERM DECISIONS

SYLLABUS OBJECTIVES B

DECISION-MAKING TECHNIQUES

Relevant costs analysis

Explain concept of relevant costing

Identify and calculate relevant costs for a specific decision situations from given data

Explain and apply the concept of opportunity costs

Make-or-by and other short-term decision

Explain the issues surrounding make vs buy and outsourcing decisions [2]

Calculate and compare ‘make’ costs with ‘buying’ costs.[2]

Compare in-house costs and outsource costs of completing tasks and consider other issues surrounding this decision.[2]

Apply relevant costing principles in situations involving make or buy in, shut down, one-off contracts and the further processing of joint products.[2]

OVERVIEW

ACCA F5 Chapter 5 – Make-or-by and other short-term decisions

5-1

IDENTIFYING RELEVANT COSTS

1.1

Relevant costs



Relevant costs are future incremental cash-flows that occur as a consequence of a decision. 

Future - costs from past are not relevant

− −

sunk costs (R&D incurred before project started to be considered) committed costs (cost as a result of past contracts and will be incurred irrespective of investment decision – not cancellable leasing for 5 yrs)



Cash – flows (CF) – e.g. depreciation to be excluded



Incremental – include only cash-flows that arises as direct consequence of decision

(Fixed salary of worker is $1,000 per week, but there is nothing to do. If we accept project and he will get a job in project and we receive additional $400 from project, it is considered as final CF – cost of $1,000 is not relevant as it would be incurred anyway) 

Relevant costs are also: 

Costs that would not be incurred if activity they relate to did not exist



Opportunity costs

1.2

Irrelevant costs



sunk costs – as they already were incurred, can not be influenced by investment decision and therefore not relevant



committed costs – costs as a result of past decisions



depreciation – not CF

1.3

Principles and specifics for short term decisions

Machinery 

Machine already bought – sunk cost, therefore not relevant



Depreciation – not relevant as not CF



Relevant costs are: hire charges and fall in resale value of owned assets through use

Illustration

Company is considering whether to undertake some project for customer. Machinery required: a/ special machine to be hired for contract (5 months), total hire charges $200. b/ all other machinery already within company on hire purchase terms. Co pays $400 pm ($50 interest, $350 capital repayment). Last hire purchase payment to be made in 3 months time. Cash price for machinery was $8,500 3 years ago. Depreciation is $300 pm. Machinery is not required for other more profitable jobs in this period. Machine would lose $300 in its potential sale value if it is used for project. What is the relevant cost of machinery? 1

5-2

Solution

ACCA F5 Chapter 5 – Make-or-by and other short-term decisions

Labour 

If paid irrespective of the decision made  not incremental and therefore not relevant



If could be put into alternative use  relevant cost = variable cost + contribution forgone

Illustration Labour

A division of ABC Ltd has received an enquiry from one of its major customers for a special order for a component that will require 1,100 skilled labour hours and that will incur other variable costs of $6,500. Skilled labour is currently in short supply and if the company accepts the order then it will be necessary to reduce production of component X. Details of the cost per unit and the selling price of the component X are as follows: $ $ Selling price 100 Less: Direct labour (5 hours at $10 per hour) 50 Other variable costs 15 65 Contribution to profits 35 What is the minimum selling price the company should accept for the special order? 2

Solution Labour

ACCA F5 Chapter 5 – Make-or-by and other short-term decisions

5-3

Materials 

Not in stock, must be purchased  current replacement cost (purchase cost)



In stock, intended to be replaced  current replacement cost (purchase cost)



In stock and will not be replaced – higher of: a/ resale value b/ alternative use

Illustration Material

You were approached by customer who will pay for special job $20,000. You need following material: Material A B C D

Units needed

Units at stock

1,000 900 1,100 300

0 500 700 300

Book value $ / unit 3 4 4

Realisable value $ / unit 3.5 3.0 6.0

Replacement cost $ / unit

Relevant cost $

7 6 5 8

- B is used regularly - C and D are in stock as result of previous overbuying, they have restricted use. No other use for C. - D can be used as substitute for 400 units of material E, which cost $4 (E is not currently in stock). 3

5-4

Solution Material

ACCA F5 Chapter 5 – Make-or-by and other short-term decisions

ONE-OFF CONTRACTS

When business is presented with one off contract, you should apply relevant costing principles to establish the cash-flows associated with the project. The minimum contract price = total of the relevant CF associated with the project. 4

Illustration ( K 157)

Mr Smith has been asked to quote a price for a special contract. He has already prepared his tender but has asked you to review it for him. He has pointed out to you that he wants to quote the minimum price as he believes this will lead to more lucrative work in the future. Mr Smith’s tender: Material

Labour Fixed overheads 3,500 hrs @ $12 per hr Costs of preparing the tender: Minimum profit (5% of total costs) Minimum tender price

A 2,000 kg @ $10 per kg B 1,000 kg @ $15 per kg C 500 kg @ $40 per kg D 50 litres @ $12 per litre Skilled 1,000 hrs @ $25 per hr Semiskilled 2,000 hrs @ $15 per hr Unskilled, 500 hrs @ $10 per hr Mr Smith's time other expenses

$ 20,000 15,000 20,000 600 25,000 30,000 5,000 42,000 1,000 500 7,725 166,825

Other information Material A • 1,000 kg of this material is in stock at a cost of $5 per kg. • Mr Smith has no alternative use for his material and intends selling it for $2 per kg. • However, if he sold any he would have to pay a fixed sum of $300 to cover delivery costs. • The current purchase price is $10 per kg. Material B • There is plenty of this material in stock at a cost of $18 per kg. • The current purchase price has fallen to $15 per kg. • This material is constantly used by Mr Smith in his business. Material C • The total amount in stock of 500 kg was bought for $10,000 some time ago for another one-off contract that never happened. • Mr Smith is considering selling it for $6,000 in total or using it as a substitute for another material, constantly used in normal production. • If used in this latter manner it would save $8,000 of the other material. • Current purchase price is $40 per kg. Material D • There are 100 litres of this material in stock. • It is dangerous and if not used in this contract will have to be disposed of at a cost to Mr Smith of $50 per litre. • The current purchase price is $12 per litre. Skilled labour • Mr Smith only hires skilled labour when he needs it. • $25 per hour is the current hourly rate. Semi-skilled labour • Mr Smith has a workforce of 50 semi-skilled labourers who are currently not fully employed. • They are on annual contracts and the number of spare hours currently available for this project is 1,500. Any hours in excess of this will have to be paid for at time-and-a-half. • The normal hourly rate is $15 per hour.

ACCA F5 Chapter 5 – Make-or-by and other short-term decisions

5-5

Un-skilled labour • These are currently fully employed by Mr Smith on jobs where they produce a contribution of $2 per unskilled labour hour. • Their current rate is $10 per hour, although extra could be hired at $20 an hour if necessary. Fixed overheads • This is considered by Mr Smith to be an accurate estimate of the hourly rate based on his existing production. Costs of preparing the tender • Mr Smith has spent 10 hours working on this project at $100 per hour, which he believes is his charge out rate. • Other expenses include the cost of travel and research spent by Mr Smith on the project. Profit •

This is Mr Smith’s minimum profit margin which he believes is necessary to cover 'general day-to-day expenses of running a business'.

Required: Calculate and explain for Mr Smith what you believe the minimum tender price should be. 4

5-6

Solution

ACCA F5 Chapter 5 – Make-or-by and other short-term decisions

MAKE OR BUY DECISION



Should the company make or outsource a product?



Not only cost consideration  other consideration (ideas for discussion in exam): 

Continuity and control of supply. Is outside supplier reliable to meet the requirements in terms of

− 

Specialist skills

− 

Does the external supplier possess specialist skills in this area of work that are not available in house and which add to the quality of the product or service?

Alternative use of resources

− − − 

Quantity, quality, delivery dates, price stability, security

Can the resources used to make this article be transferred to another activity which will save cost or increase revenue? Will valuable skilled staff who could be usefully deployed elsewhere in the business, be freed up? Does the article require substantial in-house expertise which will be lost if it is outsourced?

Social / legal

− − −

Will the decision affect contractual or ethical obligations to employees or business connections? Potential difficulties in agreeing and enforcing contract terms. The length of the contract (the risk of being ‘locked in’)



Confidentiality - Is there a risk of loss of confidentiality, particularly if the external supplier performs similar work for rival companies.



Operational gearing - Would outsourcing enable overheads to be reduced?

− 

Scheduling

− − 

If so, what would be the impact on operational gearing and what would be the level of improvement in the margin of safety?

Will the outsourcing necessitate any rescheduling of deliveries to customers? If so, what will be the impact on customers and can the rescheduling be negotiated without compensation being payable to customers?

Customer reaction:

− −

Do customers attach importance to the components being manufactured in-house? If they do, it may be necessary to confirm with them that they would be happy for the components to be outsourced and to provide any assurances that they may require.

ACCA F5 Chapter 5 – Make-or-by and other short-term decisions

5-7

3.1

Make or buy – no limiting factors

Relevant costs are differential costs btw the two options 5

Illustration

VAR cost (incl. var prod OH) $ Directly attributable FC $ Production units Committed cost Subcontractor offer $

$50,000

15 1,500 1,000

17 4,000 2,000

6 6,000 4,000

10 7,000 3,000

Make or buy? (Determine whether any of the components should be bought in from the external supplier) 5

Solution

Discussion: 1/ Company saved

2/ Relevant cost are

3/ Further considerations     5-8

spare capacity subcontractor – reliable with delivering times, quality etc to keep control over production x experience& skill from subcontractor are estimates reliable? … ACCA F5 Chapter 5 – Make-or-by and other short-term decisions

3.2

Make or buy – limiting factors (other than sales)/ scarce resources/ no spare capacity

Total cost are minimised if units bought from subcontractor have lowest extra variable cost per unit of scarce resource. 6

Illustration

Company manufactures 3 parts A, B, C  for an assembly of 5,000 final products ( we need to have 5,000 units of each part). A B C Assembly cost Total variable cost

Var. cost ($) 22 33 25 25 105

machine hours 3 2 5

Company has 20,000 hours of machines in a year; subcontractor can supply A, B, C for $32, $38, $35. Advice. 6

Solution

1/ What is the limiting factor?

2/ Calculate extra variable cost per limiting factor

3/ Ranking 4/ Plan

ACCA F5 Chapter 5 – Make-or-by and other short-term decisions

5-9

SHUT DOWN DECISIONS



Decisions involved:  



In practice it involves also longer term considerations:   



Non current assets sales and redundancy cost negligible Income from non current assets = redundancy cost

Qualitative factors to be considered:   



Savings in annual operating cost for # of years in future Non current assets will be for sale Employees redundant/ relocated  lump sum compensation

Here simplified into short term decision  assumptions:  



Whether to close down product line, department etc (as too expensive or loss making) If shut down – temporarily or permanently?

What impact on employee morale What signal it gives to competitors/ customers How suppliers will be affected (loss of GW, damage to future relations…)

By stopping product you:   

Lose contribution (x) Save directly attributable fixed costs x If resources can be switched to another product, you get additional contribution and you have additional fixed costs.



Examples are often formulated as non correct allocation of overheads  so product that seemed to make loss will actually make profit after correcting the allocation.

Illustration (K 155)

The management of Fiona Co is considering the closure of one of its operations and the financial accountant has submitted the following report: Department Sales (units) Sales ($) Direct material Direct labour Production overhead Gross profit Expenses Net profit ($)

1 5,000 150,000 75,000 25,000 5,769 44,231 (15,384) 28,847

2 6,000 240,000 150,000 30,000 6,923 53,077 (18,461) 34,616

3 2,000 24,000 10,000 8,000 2,308 3,692 (6,155) (2,463)

Total 13,000 414,000 235,000 63,000 15,000 101,000 (40,000) 61,000

In addition to the information supplied above, you are told that: • production overheads of $15,000 have been apportioned to the three departments on the basis of unit sales volume • expenses are head office overhead, again apportioned to departments on the basis of sales volume As management accountant, you further ascertain that, on a cost driver basis: • 50% of the production overheads can be directly traced to departments and so could be allocated on the basis 2:2:1. • Similarly 60% of the expenses can be allocated 3:3:2. • In addition: – 80% of the so-called direct labour is fixed and cannot be readily allocated - the remaining 20% can be better allocated on the basis of sales Prepare a report for management including a restatement of the financial position in terms of contribution made by each department and making a clear recommendation – close dept 3?

5-10

ACCA F5 Chapter 5 – Make-or-by and other short-term decisions

Solution

ACCA F5 Chapter 5 â&#x20AC;&#x201C; Make-or-by and other short-term decisions

5-11

JOINT PRODUCT FURTHER PROCESSING DECISIONS



Joint products - the manufacture of one product makes inevitable the manufacture of other products.



Joint products have substantial sales value.



Point at which individual products become identifiable - split off point / separation point.



Costs incurred before the split off point (joint or pre-separation costs) must be shared between joint products produced.



After separation products may be sold immediately or may be processed further. Any post separation costs are allocated directly to the product on which they are incurred.



When deciding whether to process a product further or to sell after split off only future incremental cash flows should be considered:  

Any difference in revenue. Any extra costs – both further processing costs and any differences in selling costs.



Note: pre-separation costs are sunk at this stage and thus not relevant

Illustration (K 166)

A firm makes three joint products, X, Y and Z, at a joint cost of $400,000. Joint costs are apportioned on the basis of weight. Products X and Z are currently processed further. Product X Y Z

Weight at split off (tonnes)

Further processing costs (variable, $000)

600 200 200

800 400

Sales ($000) 980 120 600

An opportunity has arisen to sell all three products at the split off point : X: $200,000, Y: $120,000, Z: $160,000. Which of products X and Z should the firm process further? 8

5-12

Solution

ACCA F5 Chapter 5 – Make-or-by and other short-term decisions

Chapter 6 – DEALING WITH RISK AND UNCERTAINTY IN DECISION MAKING SYLLABUS OBJECTIVE B

DECISION-MAKING TECHNIQUES

Dealing with risk and uncertainty in decision making

Suggest research techniques to reduce uncertainty, e.g. focus groups, market research.[2]

Explain the use of simulation, expected values and sensitivity.[1]

Apply expected values and sensitivity to decision making problems. [2]

Apply the techniques of maximax, maximin, and minimax regret to decision making problems including the production of profit tables.[2]

Draw a decision tree and use it to solve a multi-stage decision problem

Calculate the value of perfect information

OVERVIEW

ACCA F5 Chapter 6 – Dealing with risk and uncertainty in decision making

6-1

RISK AND UNCERTAINTY



Risk - The probability of an event and its consequences.  



Downside exposure (‘pure risk’) – outcomes are less favourable than expected. Upside exposure (‘speculative risk’) – outcomes are more favourable than expected.

Risk vs. uncertainty 

Risk – quantifiable – several possible outcomes, but on basis of past relevant experience probabilities are assigned to outcomes, thus allowing use of mathematical techniques.



Uncertainty – unquantifiable – several possible outcomes, but little past experience, thus difficult to assign probabilities  no math techniques

Risk preference   

Risk seeker – interest in best outcome no matter how risky the option is Risk neutral Risk averse decision maker acts with assumption that worst outcome might occur



Risk management - the process of understanding and managing the risks that the organisation is inevitably subject to in attempting to achieve its corporate objectives.



Situations where it is important to reduce uncertainty    

6-2

further development of existing products entry into a new market launch of a new product or service diversification.

ACCA F5 Chapter 6 – Dealing with risk and uncertainty in decision making

RESEARCH TECHNIQUES

2.1

Market research - types



Market research can be used to assess and reduce uncertainty.



It is systematic process of gathering, analysing and reporting data about markets to investigate / describe / measure… situation facing a company.



Data collected 

Primary (from first hand from sample of respondents)  field research

− − − − 

Motivational – WHY - what are the factors that influence why consumers buy product x techniques: depth interviewing, group interviewing (focus groups), word association testing, triad testing Measurement research – HOW MANY - quantification of issue Techniques: random sampling, quota sampling, panelling, surveying by post, observation

Secondary (from previous surveys, other published facts, experts)  desk research

2.2

Focus groups



Focus groups - common market research tool   



Features     



Problems     



Results are qualitative and are not statistically significant. They can provide marketing managers, product managers, and market researchers with much helpful information. Their use as a research tool however is limited - it is difficult to measure the results objectively. Their cost and logistical complexity is frequently cited as a barrier, especially for smaller companies. They can aid businesses in decision making and in the development of marketing strategies and promotional campaigns, by providing qualitative information from well defined target audiences. small size  group membership not be representative. groups may feel pressured to give the “right” answer to questions. dominant individuals can skew discussion require a skilled moderator individuals feel under pressure to agree with others rather than expressing their own opinions.

Where used:     



small groups (8-10) selected from a broader population interviewed through facilitator led round table discussions questioned in order to gather their opinions and reactions to a particular subject or marketing orientated issues, known as test concepts

to gather qualitative data from target groups of consumers in relation to consumer products in the new product development process, e.g. to test consumer reaction to new product concepts and prototypes to ascertain both perceptions of and reactions to a brand image to test marketing programmes, as they can provide an indication of how consumers will react to specific advertising messages and other types of marketing communications to learn more about consumer habits, product usage, and service

E.g. of use   

television companies to obtain voters’ reactions to possible candidates for political party leadership banks to assess consumer reactions to new electronic banking products pharmaceutical companies to test reactions to new drug concepts.

ACCA F5 Chapter 6 – Dealing with risk and uncertainty in decision making

6-3

PROBABILITIES AND EXPECTED VALUES



Expected value EV

- indicates what outcome is likely to be in the long term with repetition - weighted average of possible outcomes, weights = probabilities

Illustration

Expected outcomes from a project considering different economic developments: n

Expected CF (a)

Probability (b)

(a)x(b)

400 600 700 -

0.3 0.4 0.3 1

120 240 210 570

recession normal boom Expected value 



Advantages of EVs 

Recognises that there are several possible outcomes and is, therefore, more sophisticated than single value forecasts.



Enables the probability of the different outcomes to be quantified.



Leads directly to a simple optimising decision rule.



Calculations simple.

Limitations of EVs 

The probabilities are subjective.



The EV is weighted average of the probability distribution, indicating the average payoff if the project is repeated many times. This has little meaning for a one-off project.



Ignores risk - The EV gives no indication of the dispersion of possible outcome around the EV. The more widely spread out the possible results are, the more risky the investment is usually seen to be.



Ignores the investor’s attitude to risk. EV support risk neutral attitude (as risk-neutral decision maker will ignore any variability in the range of possible outcomes)

Assumptions: 

There is a reasonable basis for making the forecasts and estimating the probability of different outcomes.



The decision is relatively small in relation to the business. Risk is then small in magnitude.



The decision is for a category of decisions that are often made - repetitive. A technique which maximises average payoff is then valid.

Questions: Choose from 2 mutually exclusive options (both same EV – same profit, but different variance of outcomes – discussion): lower variance  lower risk

6-4

ACCA F5 Chapter 6 – Dealing with risk and uncertainty in decision making

Illustration

Both options will produce income of $ 30,000. Which one should be chosen (mutually exclusive)? Option A Probability 0.3 0.5 0.2 2

Option B Probability 0.05 0.30 0.35 0.3

cost 15,000 21,000 30,000 Solution

cost 15,000 18,000 23,000 24,000

1/ Calculate expected values of cost for both options: Option A (p) 0.3 0.5 0.2

cost (x) 15,000 21,000 30,000

(p)x(x) 4,500 10,500 6,000 21,000

(p) 0.05 0.30 0.35 0.3

Option B cost (x) 15,000 18,000 23,000 24,000

(p)x(x) 750 5,400 8,050 7,200 21,400

Option A has lower expected cost and therefore would be chosen using expected values. However, further analysis is needed;  Option A has higher spread of values  higher standard deviation (variance). EV does not say anything about risk, risk is analysed by using standard deviation. 2/ Calculate standard deviation (variance) If you calculate standard deviation (see F2), s(A) = $5,196, s(B) = $2,905 It means that option B is less risky than option A. Which option will be selected depends on risk attitude management to risk.

ACCA F5 Chapter 6 – Dealing with risk and uncertainty in decision making

6-5

ď Ž 3

Profit tables (pay-off matrix) â&#x20AC;&#x201C; useful way to represent and analyse a scenario where there is a range of possible outcomes and variety of possible responses. Illustration Pay off matrix

A bar owner is considering whether to offer lunchtime meals. He has estimated that daily demand will either be for 10 meals (probability 0.3) or 20 meals (probability 0.7). Each meal costs $5 to prepare and would be priced $15. Meals must be prepared in advance. a/ Calculate expected demand per day b/ Prepare pay-off matrix showing the outcomes if the owner decides to make in advance 10, 17 and 20 meals (alternatives, strategies). Determine optimal strategy. 3

6-6

Solution

ACCA F5 Chapter 6 â&#x20AC;&#x201C; Dealing with risk and uncertainty in decision making

DECISION RULES – MAXIMIN, MAXIMAX, MINIMAX

4.1

Maximin decision rule



Alternative that maximises minimum profit is chosen (the best worst outcome)



Criticism  

4.2

Maximax decision rule



Alternative that Maximises maximum profit is chosen (the best possible result)



Criticism  

Illustration

Defensive and conservative (safety first principle) Ignores probability of each different outcome

Overoptimistic Ignores probability of each different outcome

A company is choosing which of three new products to make (A, B or C) and has calculated likely payoffs (profits) under three possible scenarios (I, II or III), giving the following payoff table. Using maximax, what alternative would be chosen? Using maximin, what alternative would be chosen? Scenario I II III 4

A 20 40 50

B 80 70 (10)

C 10 100 40

A 20 40 50

B 80 70 (10)

C 10 100 40

Solution

Scenario I II III maximin maximax

4.3

Minimax regret

 

Minimises maximum regret Regret – opportunity loss through having made wrong decision

Opportunity loss (regret) table for above Illustration Scenario I II III Maximum regret

A 60 (80-20) 60 0 60

B 0 (80-80) 30 60 60

C 70 (80-10) 0 10 70

Workings: For scenario I – maximum profit is achieved if product B is chosen. Therefore if we chosen product A – we lost 60, if we chosen product C – we lost 70 (80 – 10) For scenario II – maximum profit is achieved if product C is chosen. In case we decided for product a – we lost 60 (100 -40) Using minimax regret rule, what alternative would be chosen?  A or B, but probably B as second highest regret outcome for B is 30 (second highest for A 60). ACCA F5 Chapter 6 – Dealing with risk and uncertainty in decision making

6-7

Illustration

Hofgarten Newsagents stocks a weekly magazine which advertises local second-hand goods. Marie, the owner, can buy the magazines for 15c each and sell them at the retail price of 25c. At the end of each week unsold magazines are obsolete and have no value. Marie estimates a probability distribution for weekly demand which looks like this: Weekly demand (units) Probability 10 0.20 15 0.55 20 0.25 (i) What is the expected value of demand? (ii) If Marie is to order a fixed quantity of magazines per week how many should that be? Assume no seasonal variations in demand. (iii) Using payoff matrix from (ii) recommend how many magazines should be bought based on a/ maximax, b/ maximin, c/ minimax regret. 5

6-8

Solution

ACCA F5 Chapter 6 â&#x20AC;&#x201C; Dealing with risk and uncertainty in decision making

SENSITIVITY ANALYSIS



Involves changing the value of variable and see how results are affected (how sensitive are decision options to changes in individual variables). Takes each uncertain factor (variable) in turn and calculates the change that would be necessary (in that factor) before the original decision is reversed.



Examples: 

How responsive the project’s NPV is to changes in variables that are used to calculate NPV. Analysis provides most sensitive (critical) variables and the extent to which those variables may change before investment results in negative NPV. Sensitivity = NPV / (PV of project variable). By how much the sales must decrease to get NPV = 0 (and therefore to get to the point where decision is changed)?



Flexible budgeting



Linear programming

Disadvantages: -

changes in each variable are isolated- unrealistic as variables are often interdependent does not examine the probability that any particular variation in cost or revenues might occur does not identify correct decision

Advantages: 6

simple identifies critical estimates Illustration - Sensitivity analysis and Expected values

A manager has identified the following two possible outcomes for a process: Outcome Poor Good

Probability Financial implications ($000s) 0.4 Loss of 20 0.6 Profit of 40

The expected value has been calculated as EV = 0.4 × (-20) + 0.6 × 40 = +16. This would suggest that the opportunity should be accepted. 6

Solution

(a) Sensitivity to the estimated loss if a poor outcome materializes However, suppose the likely loss if results are poor has been underestimated. What level of loss would change the decision? In effect we want a breakeven estimate. Let the loss be “L”. EV = (0.4 × L) + (0.6 × 40) Setting the EV to be zero (reverse of original decision): 0 = (0.4 × L) + (0.6 × 40)  24 - 0.4L = 0, so L = 24 / 0.4 = 60 Thus the potential loss would have to be $60,000 (i.e. 200% larger) before invalidating the decision to accept. (b) Sensitivity to the estimated probability However, suppose the probability of a loss has been underestimated. What is the breakeven probability? Let the probability of a loss be “p”. Thus the probability of a good outcome would change to (1-p). EV = p × (–20)+ (1–p) × 40 Setting the EV to be zero: 0 = p × (–20)+ (1–p) × 40  40 - 60p = 0 so p = 40/60 = 2/3 or 0.67 Thus the probability of a poor outcome would have to be 0.67 before the decision to accept was wrong. ACCA F5 Chapter 6 – Dealing with risk and uncertainty in decision making

6-9

SIMULATION MODELS

Simulation is a modelling technique that allows the effect of more than one variable changing at the same time to be addressed. It is often used in capital investment appraisals. 



Monte Carlo simulation (uses statistical simulation methods), is capable of addressing the most complex applications. It involves: 

the constant random generation of values for uncertain variables to simulate a model



the consideration of all possible combinations of variables (unlike sensitivity analysis which considered the effect of changing just one variable at a time).

Monte Carlo simulation can include all random events that might affect the success or failure of a proposed project, as identified in the scenario planning. For example: 

a competitor appearing



changes in consumer taste



changes in inflation or exchange rates, etc.

There are major drawbacks of simulation: 

It is not a technique for making a decision, only for obtaining more information about the possible outcomes.



Models can become extremely complex, particularly where dependent probabilities are involved.



Thus the time and costs involved in their construction can be more than is gained from the improved decisions.



Probability distributions may be difficult to formulate.

Illustration

The simulation process breaks down into three stages, and is greatly helped by the use of a computer. Stage 1: Specify major areas of uncertainty and their implications for variables. Variables will differ between investment projects but typical examples are as follows: (i) Market details (market size, selling price, market growth rate, market share) (ii) Investment costs (investment required, residual value of investment.) (iii) Operating costs (variable costs, fixed costs, taxation, useful life of plant) Stage 2: Specify the relationships between variables to calculate NPV. Sales revenue = market size × market share × selling price. Net cash flow = sales revenue — (variable costs + fixed costs + taxation), etc. Stage 3: Simulate the environment. • Attach a probability distribution to each variable • For example, we may have the following estimates of variable cost: Variable cost per unit ($) 4.00 Probability 0.3

4.50 0.5

5.00 0.2

• Random numbers are then assigned to represent the above probability distribution. Variable cost per unit ($) 4.00 Probability 0.3 Random number range 00-29 6-10

4.50 0.5 30-79

5.00 0.2 80-99 ACCA F5 Chapter 6 – Dealing with risk and uncertainty in decision making

• If two digit random numbers are then generated, the probability of occurrence of each range will reflect the underlying probability distribution. • Probability distributions and random number ranges are assigned to each variable. Care must be taken at this stage to allow for dependence between variables. • For example, selling price and market share could clearly be related and it could be necessary to specify a probability distribution of market shares for each selling price. • Finally to simulate the project we need to do the following: – – –

draw a random number for each variable (most computers can generate random numbers) select the value of each variable corresponding with the selected random number and compute NPV repeat the process many times until we have a probability distribution of returns.

The results of a simulation exercise will be a probability distribution of NPVs.

Instead of choosing between expected values, decision makers can now take the dispersion of outcomes and the expected return into account. 8

Illustration (K 187)

Assess the use of simulation for a chain of betting shops. 8

Solution

ACCA F5 Chapter 6 – Dealing with risk and uncertainty in decision making

6-11

DECISION TREES



Decision tree is a diagram that illustrates choices and possible outcomes of decision.



How to draw decision tree:

Alternative 1 Decision dsfdddf

Possible outcome

point

Alternative 2

Outcome point

Possible outcome

 9

Evaluation of decision – roll back analysis: work from the right to the left Illustration Drawing decision tree

The company is considering to launch the product. Product will be sold for $10. If the product is launched, there is 80% probability that sales will be 8,000 units and 20% probability that sales will be 10,000 units. Unit cost will be $6 with probability 60% and $7 with probability 40%. If product will not be launched, Co will receive $15,000 as compensation from competitor. 9

6-12

Solution

ACCA F5 Chapter 6 – Dealing with risk and uncertainty in decision making

THE VALUE OF INFORMATION



Perfect information – guarantees predict the future with 100% accuracy.



Imperfect information – better than no information but could be wrong in prediction of the future



Value of perfect information is the difference btw EV of profit wit perfect information and EV of profit without perfect information.

Illustration

Perfect information

Projects X and Y, only one of them can be selected. Profits and other conditions are as follows: Probability

Strong demand

0.4

$5,000

$2,000

Low demand

0.6

$(1,500)

$1,000

a/ What would be a decision, based on expected values, if perfect info of demand is not available b/ Calculate value of perfect information about demand. 10

Solution

Strong demand

0.4

$5,000

$2,000

$800

Low demand

0.6

$(1,500)

$(900)

$1,000

$600

$1,100

$1,400

Based on EVs, project Y would be selected as it as higher EV of profit. b/ Project Y is more profitable, if there is low demand, but project X is more profitable, if there is strong demand. Perfect information tells us with certainty, if demand is strong or weak. Forecast demand (perfect info)

project chosen

Strong demand

0.4

$5,000

$2,000

Low demand

0.6

$1,000

$600

EV of profit with perfect information

$2,600

Value of perfect information (2,600-1,400)= $1,200 Company would be willing to pay for perfect info anything up to $2,600.

ACCA F5 Chapter 6 – Dealing with risk and uncertainty in decision making

6-13

10.1

Perfect information and decision trees

Option of obtaining perfect information can be incorporated into decision tree. 11

Illustration Perfect information and decision trees

See Illustration 10. Suppose that perfect information can be obtained for $500. Draw decision tree and evaluate alternatives. 11

6-14

Solution

ACCA F5 Chapter 6 â&#x20AC;&#x201C; Dealing with risk and uncertainty in decision making

Chapter 7 â&#x20AC;&#x201C; BUDGETING SYLLABUS OBJECTIVES C

BUDGETING

Objectives

Outline the objectives of a budgetary control system.[2]

Explain how corporate and divisional objectives may differ and can be reconciled.[2]

Identify and resolve conflicting objectives and explain implications.[2]

Behavioural aspects of budgeting

Identify the factors which influence behaviour.[2]

Discuss the issues surrounding setting the difficulty level for a budget.[2]

Explain the benefits and difficulties of the participation of employees in the negotiation of targets.[2]

Budgetary systems

Explain how budgetary systems fit within the performance hierarchy.[2]

Select and explain appropriate budgetary systems for an organisation (systems to include: top down, bottom up, rolling, zero base, activity base, incremental and feedforward control).[2]

Describe the information used in budget systems and the sources of the information needed.[2]

Explain the difficulties of changing a budgetary system.[2]

Explain how budget systems can deal with uncertainty in the environment.[2]

Types of budget

Indicate the usefulness and problems with different budget types (zero base, activity based, incremental, master, functional, flexible).[2]

Explain the difficulties of changing the type of budget used.[2]

OVERVIEW

ACCA F5 Chapter 7 â&#x20AC;&#x201C; Budgeting 1

7- 1

PURPOSE OF BUDGETS

A budget is a quantitative plan prepared for a specific time period. It is normally expressed in financial terms and prepared for one year. 

Firm must consider: − what it wants to achieve (its objectives) − how it intends to get there (its strategy) − what resources will be required (its operating plans) − how well it is doing in comparison to the plan (control).

The budget is a short-term operating plan, linked to the corporate plan and will be used for detailed control.

1.1

Aims of budgeting



Planning - A budgeting process forces a business to look to the future. If a business does not look to the future it will fail in the short, medium or long-term.



Control - Actual results are compared against the budget and action is taken as appropriate. In many respects this is the most important aspect of budgeting.



Communication - The budget may form the basis of the reporting hierarchy. It is a formal communication channel that allows junior and senior managers to converse.



Co-ordination - The budget allows the business to coordinate all diverse actions towards a common corporate goal.



Evaluation - The budget may be used to evaluate the financial results of a part of the business such as a cost centre. It may further be used to evaluate the actions of a manager within the business. The costs and revenues appraised must be within the control of that which we are evaluating.



Motivation - The budget may be used as a target for managers to aim for. Reward should be given for operating within or under budgeted levels of expenditure.



Authorisation and delegation.

THE PERFORMANCE HIERARCHY

Planning hierarchy (F2)



Strategic planning - long term, looks at the whole organisation, defines resource requirements.



Tactical planning - medium term, looks at the department/divisional level, specifies how to use resources.



Operational planning - very short term, very detailed and is mainly concerned with control. Most budgeting activities fall within operational planning and control

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ACCA F5 Chapter 7 – Budgeting



Strategic plans will have to be translated into medium term tactical plans, which in turn need to be converted into detailed budgets. Similarly a firm’s mission will be translated into strategic goals, which are then expressed as tactical targets, which again end up as short term operational targets.



The aim is that if a manager achieves short-term budgetary targets than there is more chance of meeting tactical goals and ultimately success for strategic plans.

2.1

Budgets and performance management

Responsibility accounting divides the organisation into budget centres, each of which has a manager who is responsible for its performance. The budget is the target against which performance of budget centre/manager is measured. 

Advantages of this approach

− − − 

There is a clear published target known throughout the organisation that is linked to the overall organisation aims (goal congruence). Managers may be involved in setting the targets, which may make them more realistic. Budget targets can be linked to individual rewards, which may provide motivation to improve performance.

Disadvantages

− −

Managers may work towards specific short-term budget targets to the detriment of long-term organisational goals. Managers may distort results to try to exceed targets and gain rewards.

Management by exception is the practice of focusing on activities which require attention and ignoring those which appear to be conforming to expectations. When measuring performance it may be appropriate to concentrate on activities which are deviating from plan. 

Managers should use a flexed budgeting approach to adjust fixed budget targets to reflect actual volumes of output achieved.



Managers should only be assessed against costs and revenues that are within their control (the controllability principle’). Failure to do this can be demotivating if, say, a manager fails to achieve a target due to factors outside their control.

BEHAVIOURAL ASPECTS OF BUDGETING

3.1

Budgets and behaviour

Dysfunctional behaviour is when individual managers seek to achieve their own objectives at the expense of the objectives of the organisation. A key performance management issue is to ensure that the system of targets and measures used does not encourage such behaviour but rather encourages goal congruence. Budget slack (or bias) is a deliberate overestimation of expenditure and/or underestimation of revenues in the budgeting process. This can happen because managers want easy targets (e.g. for an “easy life” or to ensure targets are exceeded and bonuses won) or simply to “play the system”. Either way, this results in a budget that is poor for control purposes and meaningless variances.

ACCA F5 Chapter 7 – Budgeting

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3.2

Management styles (Hopwood) (Linking of reward systems to target)

Styles Research was carried out by Hopwood (1973) into the manufacturing division of a US steelworks, involving a sample of more than 200 managers with cost centre responsibility. Hopwood identified three distinct styles of using budgetary information to evaluate management performance. 

Budget constrained style – main emphasis in performance evaluation is the manager’s success in meeting budget targets in the short-term, with no consideration for other aspects of performance that are not targeted in the budget. A manager is criticised for poor results compared to the budget, for example if his actual spending exceeds the budget limit.



Profit conscious style – The performance of a manager is measured in terms of his ability to increase the overall effectiveness of his area of responsibility, in relation to meeting the longer-term objectives of the organisation. At a cost centre level of responsibility, performance might be judged in terms of reducing costs over the longer-term, rather than meeting short-term cost targets. Short-term budgetary information needs to be used with care and in a flexible way to achieve this purpose.



Non accounting style – performance evaluation is not based on budgetary information, and accounting information plays a relatively unimportant role. Other, non-accounting performance indicators, such as quality, are as important as the budget targets.

Behavioural effects Each style of performance evaluation had the following behavioural effects: 

Budget constrained - much attention was given to costs and there was a high degree of job-related pressure and tension. This often led to the manipulation of data in accounting reports.



Profit conscious - there was still a high involvement with costs but less job-related pressure  less manipulation of accounting data. Relationships between managers and their colleagues and superiors were better than with a budget constrained style.



Non accounting - the results were very similar to the profit conscious style, except for a much lower concern with cost information.

Hopwood found some evidence that better managerial performance was achieved where a profit-conscious or non-accounting style was in use. Poor performance was often associated with a budget-constrained style. Subsequent studies by Otley (1978) involving profit centre managers in the UK coal mining industry contradicted Hopwood’s earlier findings. One particular area of difference was that the UK study showed a closer link between the budget-constrained style and good performance. The manager evaluated on a rather tight budget-constrained basis tended to meet the budget more closely than if it was evaluated in a less rigid way.

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ACCA F5 Chapter 7 – Budgeting

3.3

Setting the difficulty level of budget

Targets will assist motivation and appraisal if they are at the right level: Too difficult  will demotivate staff, too easy  managers are unlikely to strive for optimal performance. 

Expectations budget - set at current achievable levels. This is unlikely to motivate managers to improve but may give more accurate forecasts for resource planning.



Aspirations budget - set at a level which exceeds the achievable level. This will motivate managers to improve if it is seen as attainable but may always result in an adverse variance.

 potential for conflict btw: a/ using budget for planning/control purposes b/ using one to motivate staff. 

Targets should be:

− − − − −

3.4

communicated in advance dependent on factors controllable by the individual based on quantifiable factors linked to appropriate rewards and penalties chosen carefully to ensure goal congruence

Participation in setting targets (see also chapter 7 – more details)

Managers may be involved in setting targets or these may be imposed by senior managers without consultations 

Advantages of participation

− − 

increased motivation (ownership of target) better understanding of an individual manager’s aspiration level so that the target can be set at a suitable level for an individual.

Disadvantages

− − −

time consuming may result in a wide range of targets which are seen as unfair managers may understate targets to make them easier to achieve (i.e. incorporate budgetary slack) negotiation may become a political process, which draws attention from running the business

ACCA F5 Chapter 7 – Budgeting

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CONFLICTING OBJECTIVES

A divisional manager acts for the best of his division, but it could be at the same time against interest of Co and other divisions. Setting objectives is a political process. The implications of the conflicts and the method of resolution will often be specific to the organisation and will depend on:   

the specific purpose for which the budget is to be used the management style and culture of the organisation the knowledge and experience of the managers preparing budgets.

Goal congruence – when managers working in their best interest also act in harmony with the goals of the organisation. 3 – Behavioural aspects of budgeting

4.1

Types of conflicts

Company x division – – –

objective of company is to increase shareholders‘ wealth  any project with NPV>0 should be accepted, but divisions might be assessed on accounting measures such as profit manager rejects project that dilute divisional performance, even though they beat company’s target resolution: share options for managers, cash based targets

Division x division Divisions may compete for limited financial resources when setting budgets. Conflict might be solved via: − Prioritisation – certain goals get priority over others, can be difficult to rank − Negotiation – bargaining process − Compromise – something is won, something lost − Satisfycing - satisfactory rather than optimal solution is found Short-termism

− − −

Managers cut R&D to hit short term targets but erode long term competences. Managers reject projects that are “slow starters” even though they have positive NPV Resolution: Use more non financial indicators that focus on key long term issues (quality, productivity etc), Link bonuses to longer time periods.

Individualism

− −

7-6

The risk of budgetary slack when managers participate in target setting. Resolution: Greater scrutiny of budgets, better training of managers

ACCA F5 Chapter 7 – Budgeting

BUDGETARY SYSTEMS

5.1

Top down (imposed) and bottom up (participatory) budgeting

Top down - A budget that is set without allowing the ultimate budget holder to have the opportunity to participate in the budgeting process. 

When effective: − Newly formed organisation − Very small business − In periods of financial crisis − When operational management lack budgeting skills



Advantages − Strategic plans will be incorporated into planned activities − Coordination btw plans and objectives of divisions − Input from inexperienced /uninformed lower level employees decreased − Period of time to produce budget is shorter



Disadvantages − Dissatisfaction, low morale amongst employees, low motivation − Low team spirit − Acceptance of organisational goals/ objectives limited − Budget could be perceived as punitive device

Bottom up / participative budgeting – budget holders have opportunity to participate in the budgeting process 



When effective: − Well established organisation − Very large organisation − In periods of economic ups − When operational management has strong budgeting skills Advantages Based on information from employees most familiar with the department Knowledge spread among several levels of management is pulled together Increased motivation (ownership of the budget) Increases operational managers commitment and understanding Specific resource requirements included SM overview is mixed with operational level detail

− − − − − −

Disadvantages − senior managers may resent loss of control − bad decisions from inexperienced managers − budgets may not be in line with corporate objectives as managers lack a strategic perspective and will focus just on divisional concerns. − budget preparation is slower and disputes can arise − figures may be subject to bias if junior managers either try to impress or set easily achievable targets (budgetary slack) − certain environments may preclude participation, e.g. sales manager may be faced with long term contracts already agreed

Negotiated style of budgeting – btw what SM really like and what junior management believe is feasible. ACCA F5 Chapter 7 – Budgeting

7-7

5.2

Incremental budgets



Starts with the previous period’s budget or actual results and adds (or subtracts) an incremental amount to cover inflation and other known changes.



Suitable for stable businesses, where costs are not expected to change significantly (rent, salaries ok, advertising and discretionary cost – not ok)



There should be good cost control and limited discretionary costs.



Advantages:

− − − 

quickest and easiest method assuming that the historic figures are acceptable, only the increment needs to be justified avoids ‘reinventing the wheel’.

Disadvantages

− − − − 5.3

builds in previous problems and inefficiencies, e.g. an overspending may result in a larger budget allowance next year. uneconomic activities may be continued, e.g. the firm may continue to make a component in-house when it might be cheaper to outsource. managers may spend unnecessarily to use up their budgeted expenditure allowance this year, thus ensuring they get the same (or a larger) budget next year. Encourages slack and wasteful spending to be incorporated into budgets

Zero based budgeting (ZBB)



requires each cost element to be specifically justified, as though the activities to which the budget relates were being undertaken for the first time. Without approval, the budget allowance is “zero”.



It is especially useful for

− − − 

It is important that managers involved in ZBB examine their current practices very carefully. Questions they should ask themselves include:

− − − 

7-8

service departments such as stores, maintenance, marketing, finance, discretionary costs such as research and development public sector organisations such as local authorities.

Is the activity essential? What would happen if it ceased? Is the provision of the activity at the correct level? Are there other alternatives for achieving the same effect?

Stages in the implementation of ZBB: 

(1) Managers should specify, for their responsibility centres, those activities that can be individually evaluated.



(2) Each of the individual activities is then described in a decision package. The decision package should state the costs and revenues expected from the given activity. It should be drawn up in such a way that the package can be evaluated and ranked against other packages.

− −

Mutually exclusive package – different methods of obtaining same objective Incremental package – divide activity into # of different levels; base package = minimum effort& cost to carry out activity, other packages describe incremental cost & benefits when added to the base



(3) Each decision package is evaluated and ranked usually using cost/benefit analysis.



(4) The resources are then allocated to the various packages. ACCA F5 Chapter 7 – Budgeting



Advantages

− − − − − − − − 

Disadvantages

− − − − − − − − 1

Inefficient or obsolete operations can be identified and discontinued. It creates inquisitorial attitude, rather than one which assumes that current practices represent value for money. Wasteful expenditure is avoided. Managers are forced to consider alternative methods of achieving their objectives. ZBB leads to increased staff involvement at all levels. This should lead to better communication and motivation. Attention is focused on outputs in relation to value for money. Knowledge and understanding of the cost behaviour patterns of the organisation will be enhanced. Resources should be allocated efficiently and economically.

The time involved and the cost of preparing the budget is much greater than for less elaborate budgeting methods. In some organisations because of the heavy paperwork involved ZBB has become known as ‘Xerox based budgeting’. It may emphasise short-term benefits to the detriment of long-term benefits. There is a need for management skills that may not be present in the organisation. Managers, staff and unions may feel threatened. The rankings of packages may be subjective where the benefits are of a qualitative nature. It is difficult to compare and rank completely different types of activity. The budgeting process may become too rigid and the company may not be able to react to unforeseen opportunities or threats. Incremental costs and benefits of alternative courses of action are difficult to quantify accurately. Illustration ZBB

A company is conducting a ZBB exercise, and a decision package is being prepared for its materials handling operations. • The manager responsible has identified a base package for the minimum resources needed to perform the materials handling function. This is to have a team of five workers and a supervisor, operating without any laboursaving machinery. The estimated annual cost of wages and salaries, with overtime, would be $375,000. • In addition to the base package, the manager has identified an incremental package. The company could lease two fork lift trucks at a cost of $20,000 each year. This would provide a better system because materials could be stacked higher and moved more quickly. Health and safety risks for the workers would be reduced, and there would be savings of $5,000 each year in overtime payments. • Another incremental package has been prepared, in which the company introduces new computer software to plan material handling schedules. The cost of buying and implementing the system would be $60,000, but the benefits are expected to be improvements in efficiency that reduce production downtime and result in savings of $10,000 each year in overtime payments. The base package would be considered essential, and so given a high priority. The two incremental packages should be evaluated and ranked. Here, the fork lift trucks option might be ranked more highly than the computer software. In the budget that is eventually decided by senior management, the fork lift truck package might be approved, but the computer software package rejected on the grounds that there are other demands for resources with a higher priority.

ACCA F5 Chapter 7 – Budgeting

7-9

Illustration ZBB (K 217)

Solution ZBB

5.4

Activity based budgeting (ABB)

A method of budgeting based on an activity framework and utilising cost driver data in the budget setting and variance feedback processes. 



7-10

Advantages of ABB are similar to those provided by activity based costing (ABC):

−

It draws attention to the costs of ‘overhead activities’. This can be important where overhead costs are a large proportion of total operating costs.

−

It provides information for the control of activity costs, by assuming that they are variable, at least in the longer term.

−

It provides a useful basis for monitoring and controlling overhead costs, by drawing management attention to the actual costs of activities and comparing actual costs with what the activities were expected to cost.

−

It also provides useful control information by emphasising that activity costs might be controllable if the activity volume can be controlled.

−

ABB can provide useful information for a total quality management (TQM) programme, by relating the cost of an activity to the level of service provided (for example, stores’ requisitions processed) – do the user departments feel they are getting a cost-effective service?

Disadvantages

−

It could be argued that in the short-term many overhead costs are not controllable and do not vary directly with changes in the volume of activity for the cost driver. The only cost variances to report would be fixed overhead expenditure variances for each activity.

−

A considerable amount of time and effort might be needed to establish an ABB system, for example to identify the key activities and their cost drivers.

−

ABB might not be appropriate for the organisation and its activities and cost structures.

−

A budget should be prepared on the basis of responsibility centres, with identifiable budget holders made responsible for the performance of their budget centre. A problem with ABB could be to identify clear individual responsibilities for activities.

Activity matrix (see K 221)

ACCA F5 Chapter 7 – Budgeting

5.5

Rolling budgets



Kept continuously up to date by adding another accounting period (e.g. month or quarter) when the earliest accounting period has expired.



Aim: To keep tight control and always have an accurate budget for the next 12 months.



Suitable if accurate forecasts cannot be made, or for any area of business that needs tight control.



Dynamic conditions – actual conditions may differ from anticipated when budget prepared – why :

− − − − − 

Advantages of rolling budgets:

− − − − 

Organisational changes (structure, new agreements with workforce – flex working,) New technology Environmental conditions Inflation Level of activities the budgeting process should be more accurate there should be much better information upon which to appraise the performance of management the budget will be much more ‘relevant’ by the end of the traditional budgeting period it forces management to take the budgeting process more seriously.

Disadvantages

− − − 5.6

they are more costly and time consuming an increase in budgeting work may lead to less control of the actual results there is a danger that the budget may become the last budget ‘plus or minus a bit’.

Feed-forward control



Feed-forward control system – compares budgeted results against forecast



Feedback system – compares actual historical results with budgeted results.



Advantages





Encourages managers to be proactive and deal with problems before they occur



Before casting on a monthly or continuous basis can save time when it comes to completing a quarterly or annual budget

Disadvantages 

Time consuming as control reports must be produced regularly



May require sophisticated forecasting system – expensive

Illustration (K 224)

A sales manager receives monthly control report about sales values. Budgeted sales for the year to 31 December are $600,000 in total. At the end of April the manager might receive the following feedback control report. Product P1 P2 P3 Total

budget 35 20 25 80

ACCA F5 Chapter 7 – Budgeting

Month actual 38 14 23 75

variance 3F 6A 2A 5A

budget 90 50 50 190

Cumulative actual 94 39 45 178

variance 4F 11A 5A 12A

7-11

Alternatively, the sales manager might be presented with a feed-forward control report Product P1 P2 P3 Total

budget 240 150 210 600

Latest forecast for year 250 120 194 564

Expected variance 10F 30A 16A 36A

The use of a feed forward control system means that corrective action can be taken to avoid expected adverse variances.

5.7

Fixed and flexible budgets (more detail in chapter 10)

Fixed budget

− −

designed to remain unchanged regardless of the volume of output/sales (master budget prepared before beginning of the budget period) when actual volumes during control period are achieved, it is not adjusted retrospectively to new level of activity

Flexible budget

− −

7-12

designed to change as volume of output changes used at a/ planning stage – contingency flex budgets for different level of output b/ for budgetary control –flexed (changed) to the actual level and compared with actual results

ACCA F5 Chapter 7 – Budgeting

BUDGET PREPARATION (COVERED IN F2)

6.1

Master budget

The master budget is the budget into which all subsidiary budgets are consolidated. The master budget normally comprises: • budgeted statement of comprehensive income • budgeted statement of financial position • budgeted cash flow statement (cash budget). Assuming that the level of demand is the principal budget factor, the various functional, departmental and master budgets will be drawn up in the following order.

6.2

Functional budgets

Functional budgets are prepared and consolidated to produce the master budget. The normal assumption is that demand is the principal budget factor. Production budget: budgeted production = sales + closing inventory-opening inventory Losses – loss percentage is based on the input units

ACCA F5 Chapter 7 – Budgeting

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SELECTING A SUITABLE BUDGETARY SYSTEM

Factors, which will determine suitability include:

− − − −

type of organisation type of industry type of product and product range culture of the organisation.

INFORMATION FOR BUDGETING

The main sources of information − previous year’s actual results

−

other internal sources which may include manager’s knowledge concerning the state of repair of fixed assets, training needs of staff, long-term requirements of individual customers, etc.

−

estimates of costs of new products using work study techniques, technical estimates from research and development, etc.

−

statistical techniques such as linear regression may help to forecast sales. EOQ may be used to forecast optimal inventory levels

−

external sources of information may include suppliers' price lists, estimates of inflation and exchange rate movements, strategic analysis of the economic environment. Senior managers may incorporate assumptions concerning competitor actions based on the analysis of the market.

CHANGING A BUDGETARY SYSTEM

Changing a budgetary system is a very time consuming process and the following issues should be considered:

−

Is suitably trained staff available to implement the change successfully?

−

Will changing the system take up management time which should be focusing on production or sales?

−

All staff involved in the budgetary process will need to be trained in the new system and understand the procedure to be followed in changing to the new approach. A lack of understanding builds resistance to change.

−

All costs of the systems change should be evaluated against the perceived benefits. These may include new system costs, training, downtime of existing staff, consultancy fees, development of new statistical models and sources of information suitable for the new budgetary system. Benefits may be difficult to quantify and therefore a rigorous investment appraisal of the project may be difficult to prepare.

Note: the above issues can result in an organization continuing to use a budgeting system it knows to be suboptimal.

7-14

ACCA F5 Chapter 7 – Budgeting

BUDGETING AND UNCERTAINTY

1.1

Factors which contribute to the uncertainty surrounding the budget setting and budgetary control process

 

Internal to the organisation but not controllable in the short-term. These would include productivity and efficiency factors which may be controlled in the longer term by retraining and investment. External factors: (i) sales may be lower owing to recession (ii) customers may be lost owing to lack of goods because of lower productivity (iii) inflation (iv) government fiscal policy (v) natural disasters (vi) changes in supplier costs and terms of supply.

− − − − − −

1.2

Dealing with uncertainty − − −

rolling budgets sensitivity analysis (‘what if?’ analysis) simulation.

SPREADSHEETS IN BUDGETING

A spreadsheet is a computer package which stores data in a matrix format where the intersection of each row and column is referred to as a cell. Advantages

−

A typical spreadsheet can handle approximately 8,000 rows and over 200 columns, enough to accommodate a very complex model.

−

Formulae and look up tables can be used so that if any figure is amended, all the figures will be immediately recalculated. This is very useful for carrying out sensitivity analysis.

−

The results can be printed out or distributed to other users electronically quickly and easily.

−

Most programs can also represent the results graphically e.g. balances can be shown in a bar chart:

Disadvantages of spreadsheets

−

Spreadsheets for a particular budgeting application will take time to build up and develop. There is no benefit in taking many hours to develop a spreadsheet which is then only used occasionally to complete a task which could easily be done efficiently using a manual method.

−

Data can be accidentally changed (or deleted) without the user being aware of this occurring.

−

Errors in design, particularly in the use of formulae, can produce invalid output. Due to the complexity of the model, these design errors may be difficult to locate.

−

The manipulation of the data using such a mathematical approach may lead to the loss of the original concepts, these being replaced with a seemingly accurate set of output reports. In the context of budgets and forecasts it must be remembered that such output is based on data which are estimates and which may therefore be incorrect.

−

Security issues, whether due to unauthorized access (e.g. hacking) or a loss of back up files.

ACCA F5 Chapter 7 – Budgeting

7-15

7-16

ACCA F5 Chapter 7 â&#x20AC;&#x201C; Budgeting

Chapter 8 – QUANTITATIVE ANALYSIS SYLLABUS OBJECTIVES C

BUDGETING

Quantitative analysis in budgeting

Analyse fixed and variable cost elements from total cost data (high/low and regression).[2]

Explain the use of forecasting techniques. (Techniques: time series, simple average growth models and estimates based on judgement and experience.) Predict a future value from provided time series analysis data using both additive and proportional data.[2]

Estimate the learning effect and apply the learning curve to a budgetary problem. This includes calculations on steady states.[2]

Discuss the reservations with the learning curve.[2]

Apply expected values and explain the problems and benefits.[2]

Explain the benefits and dangers inherent in using spreadsheets in budgeting.[1] – CH 8

OVERVIEW

ACCA F5 Chapter 9 – Quantitative analysis

9-1

1   

ANALYSING FIXED AND VARIABLE COSTS You will be given historical data (level of activity = # of units and total cost) Task: What is the variable cost and fixed cost. You have to find equation of total cost (y=k.x+q, TC = v* #of units + FC) cost (y)

TC = v . x + FC

v. x FC

units (x)

1.1

The high-low method

3 step approach – you do not have to remember if draw the graph 

Select the highest and lowest activity levels, and their costs. (Note: do not take the highest and lowest costs).



Find the variable cost/unit. Variable cost/unit = (Cost at high level of activity – Cost at low level activity)/ (High level activity – Low level activity)



Find the fixed cost, using either the high or low activity level. Fixed cost = Total cost at activity level — Total variable cost

Disadvantages   

It assumes that activity is the only factor affecting cost and the relationship is constant It assumes that historical costs reliably predict future cost (but conditions might change). It uses only two values, the highest and the lowest, so the results may be distorted due to random variations in these values.

Advantages - Easy to understand and easy to use 1

Illustration (K241)

Cost data for the six months to 31 December 20X8 is as follows: Month Units Inspection cost $

Jul 340 2,240

Aug 300 2,160

Sep 380 2,320

Oct 420 2,400

Nov 400 2,360

Dec 360 2,280

a/ Find variable cost per unit and total fixed cost b/ Estimate total cost if output is 500 units

8-2

ACCA F5 Chapter 8 – Quantitative analysis

1.2

Linear regression analysis

Least square technique, statistical method  calculate the line of best fit (equation)

y =k⋅x+q

k – found as regression coefficient

q = y − kx ⇒ q =

n ∑ xy - ∑ x ∑ y 2

∑ y − k∑ x n

Given in exam formula sheet!!!

n ∑ x 2 − (∑ x )

Given in exam formula sheet!!!

n – sample size (number of pair data for x and y) For analysis of fixed and variable cost can be used when x = level of activity and y = total cost, but can be used for prediction of relationship between any 2 dependent variables (see illustration below). 2

Illustration (K 244)

A company has recorded expenditure on advertising and resulting sales for six months as follows: Month Advert exp (k$) Sales (k$)

Mar 20 170

Apr 40 240

May 50 260

Jun 60 300

Jul 30 220

Aug 40 250

a/ Calculate line of best fit (using regression analysis) b/ Forecast sales when advertising expenditure is $50,000 and comment on your answers 2

Solution

1 2 3 4 5 6

Mar Apr May Jun Jul Aug

20 40 50 60 30 40 240

170 240 260 300 220 250 1,440 y

∑x

∑

x2 400 1,600 2,500 3,600 900 1,600 10,600 x2

∑

Line of best fit – equation of any line: y = k ⋅ x + q 1/ k?

k is gradient and is given as regression coeff k =

xy 3,400 9,600 13,000 18,000 6,600 10,000 60,600 xy

∑

y2 28,900 57,600 67,600 90,000 48,400 62,500 355,000 y2

∑

∑ xy - ∑ x∑ y = 6 ⋅ 60,600 − 240 ⋅1,440 = 3 6 ⋅10,600 − 240 n ∑ x − (∑ x )

Therefore y = 3 ⋅ x + q 2/ q?

q = y − 3⋅ x =

∑ y − 3 ⋅ ∑ x = 1,44 − 3 ⋅ 240 = 240 n

3/ equation of the line is y = 3 ⋅ x + 240 This means that when advertising expenditure is zero, sales will be $120,000, and for every $1 spent on advertising, sales will increase by $3. B/

If advertising expenditure is $50,000 (x=$50,000), sales are forecasted at y = 3 ⋅ 50,000 + 240 = $390,000

ACCA F5 Chapter 8 –Quantitative analysis

8-3

Note: Strength of the linear relationship between 2 variables (and therefore usefulness of regression analysis) is measured by Correlation coefficient ( r ) and Coefficient of determination ( r ) – should be close to 1. 2

(n∑ x

n ∑ xy - ∑ x ∑ y 2

)(

− (∑ x ) n ∑ y 2 − (∑ y ) 2

)

Assumptions 

Linear cost (relationship) should be assumed (correlation coeff close to 1)



To estimate value of y for x outside the range of x values  assume that cost behave in the same way outside the range of known x values



Historical data should be accurately recorded



Conditions should continue into the future (allow for expected changes)



Amount of data available (< 10 – unreliable)

Illustration – correlation coeff

Calculate correlation coefficient for advertising expenditure and sales as given in illustration 1 and comment 3

Solution

∑ xy - ∑ x∑ y  n  ∑ x − (∑ x )  n ∑ y − (∑ y )   n

  

6 x60,600 − 240 x1,440

(6 x10,600 − 240 )⋅ (6 x355,000 − 1,440 ) 2

= 0,21

Positive correlation (with increasing advertising expenditure sales are increasing) Strength of relationship is low – only (r2= 0,21x021=0,0441) 4% of changes in sales is caused by changes in advertising expenditure. Sales are not therefore dependent on advertising expenditure.

4  

FORECASTING TECHNIQUES Presumptions is that past provide guidance for future Therefore past data must be assessed for appropriateness for intended purpose: 

Time period to be long enough (to include periodically paid cost)



Data examined (influenced by technology changes, changes in production methods, resource costs, weather conditions, strikes…?)



Methods of data collection/ accounting policies



Appropriate choice of dependent and independent variables

E.g.: sales forecast  # of methods to be combined 

Sales personnel asked to provide estimates  based on judgement and experience



Market research



Average growth model



Time series



Mathematical models

8-4

ACCA F5 Chapter 8 – Quantitative analysis

2.1

Estimates based on judgement and experience

2.2

Average growth model – do not remember formula (logic only)!

Illustration Average growth rate

Year X1 Sales (k$) 120

X2 130

X3 165

X4 205

X5 240

Calculate average growth rate. 4

Solution

2.3

Time series



Series of figures/values recorded over time



Graph of time series – historigram



Pattern of behaviour can be extrapolated into the future  aim is to find trend line  HOW: 

Regression analysis (see above)



Components of time series:

− − − −

T: Trend – long term movement over time in values recorded S: Seasonal variations – short term regular fluctuations (1 year) C: Cyclical variations – medium term changes (economic cycle) R: Residual/random variations – non recurring, unpredictable – change in government, fire

Actual time series Y = T+S+C+R C – outside scope of exam, R – ignored as negligible  Y=T+S ACCA F5 Chapter 8 –Quantitative analysis

8-5

Moving averages (help to determine trend) T 

Removes seasonal variations from time series by process of averaging  leaves set of figures representing trend



Odd and even numbers (length of period)  if even  average of average

Illustration – moving averages, uneven number of periods

Year Sales

X0 400

X1 380

X2 450

X3 440

X4 490

X5 450

X6 500

Take a moving average over a period of 3 years. 5

Solution– moving averages, uneven number of periods

Year Sales

X0 400

X1 380

X2 450

X3 440

X4 490

X5 450

Sales (MA of 3)

410

423

460

480

Working: X1 = (400+380+450)/3 6

Illustration – moving averages, even number of periods

Year Q1 Sales units 700

Q2 950

Q3 550

Q4 800

Q1 750

Q2 970

Q3 550

Q4 820

Calculate a moving average trend 6

Solution – moving averages, even number of periods

As it is even number of periods, we have to calculate it in 2 stages (as MA of 4 would not be related to any quarter, but somewhere between Q2 and Q3) Year Q1 Sales units 700 1/ MA(4) 2/ MA(2)

Q2 950

Q3 550 750

Q4 800 762.50

756.25 Q3

Q1 750 767.5

765 Q4

Q2 970 767.5

767.5 Q1

Q3 550

Q4 820

772.5 770 Q2

Finding the seasonal variations S 

Additive model Y=T+S (+R)  S=Y-T



Proportional model (Multiplicative) Y=TxS (xR)  S=Y/T

Trend T is found by moving averages (or by regression analysis), S is found by Y-T or Y/T

8-6

ACCA F5 Chapter 8 – Quantitative analysis

7 Illustration (K 247) A company has found that the trend in the quarterly sales of its furniture is well described by the regression equation: y = 150 + 10X y x=1 x=2 x=5

equals quarterly sales ($000) represents the first quarter of 20X2 represents the second quarter of 20X2 represents the first quarter of 20X3,

Multiplicative model applies. The mean seasonal quarterly index for its furniture sales is as follows: Quarter Seasonal index

1 80

2 110

3 140

4 70

(a) Using the regression equation, estimate the trend values in the company’s furniture sales for each quarter of 20X7 (b) Using the seasonal index, prepare sales forecasts for the company’s quarterly furniture sales in 20X7 (c) State what factors might cause your sales forecasts to be in error. 7

Solution

ACCA F5 Chapter 8 –Quantitative analysis

8-7

LEARNING CURVES

As workers become more familiar with the production of a new product, average time (and average cost) per unit will decline. Wrights Law: as cumulative output doubles, the cumulative average time per unit falls to a fixed percentage (referred to as the learning rate) of the previous average time.



Calculation 

reducing cumulative average time by learning rate each time output doubles in a table



using the formula: y = cumulative average time (or average cost) per unit or per batch a =time (or cost) for first unit or batch b =log r/log 2 (r = rate of learning, expressed as a decimal) x = cumulative output in units or in batches



 8-8

Conditions/ assumptions for the learning effect to apply: 

the activity is labour intensive



a repetitive process for each unit



low turnover of labour



early stages of production



no prolonged breaks in production

Applications of the learning effect: 

pricing decisions – prices will be set too high if based on the costs of making the first few units



work scheduling – less labour per unit will be required as more units are made



limiting factor decisions



standard setting



budgeting.

Cessation of the learning effect (steady state): 

machines have reached the limits of safe running speeds



machine efficiency restricts further improvements



‘go slow’ agreements

Limitations ACCA F5 Chapter 8 – Quantitative analysis



Learning curve not always present



Assumes stable conditions  but labour T/O



Assumes motivation amongst employees



Breaks btw repeating production (workers forget)



Obtain accurate data to assess %



Production techniques might change  long time for standard production method to emerge

Illustration Learning curve – using formula

75% learning curve applies to production of item X. To date (end of Nov) 250 units have been produced. Budgeted production for December is 60 units. The cost of very first unit of X was $130. Calculate budgeted total labour cost for December and average labour cost per unit produced in December. 8

Solution Learning curve – using formula

Illustration - learning curve – using table (see Wrights law  reduce average time by learning rate every time when output doubles)

The first unit of a new car requires 100 hours to make. A 90% learning curve applies. The production times would be as follows: Number of units produced 1 2 4 8

Learning rate 90% 90% 90% 90%

Cumulative average time required per unit

ACCA F5 Chapter 8 –Quantitative analysis

Total time required

Incremental time for additional units

8-9

3.1

Application of the learning effect to budgeting

Budgeted costs must therefore take into account any expected learning curve when they are being formulated. 10

Illustration (K 252)

A Swiss watch making company wishes to determine the minimum price it should charge a customer for a special order of watches. Customer has requested a quotation for 10 watches (1 batch), but might subsequently place an order for a further 10. Material costs are $30 per watch. It is estimated that the first batch of 10 watches will take 100 hours to manufacture and an 80% learning curve is expected to apply. Labour plus variable overhead costs amount to $3 per hour. Setup costs are $1,000 regardless of the number of watches made. (a) What is the minimum price the company should quote for the initial order if there is no guarantee of further orders? (b) What is the minimum price for the follow-on order? (c) What would be the minimum price if both orders were placed together? (d) Having completed the initial orders for a total of 20 watches (price at the minimum levels recommended in (a) and (b)), the company thinks that there would be a ready market for this type of watch if it brought the unit selling price down to $45. At this price, what would be the profit on the first 140 â&#x20AC;&#x2DC;mass productionâ&#x20AC;&#x2122; models (i.e. after the first 20 watches) assuming that marketing costs totalled $250? 10

8-10

Solution

ACCA F5 Chapter 8 â&#x20AC;&#x201C; Quantitative analysis

Illustration – learning curve and modern manufacturing

Discuss whether the learning curve is likely to apply in a modern manufacturing environment. 11

Solution



Modern manufacturing environments may be very capital intensive and the learning effect cannot apply if machines limit the speed of labour. – Learning curve



Products have short lives in a modern manufacturing environment and therefore new products will be introduced on a regular basis. This makes it likely that there will be learning effects.



The more complex the product the more likely that the learning curve will be significant and the longer it will take for the learning curve to reach a plateau (beyond which no more learning can take place).



The learning effect requires that production is repetitive with no major breaks in which the learning effect may be lost. JIT production has moved towards multi-skilled and multitasked workers. It is possible that some of the benefits of the learning effect in a single tasking environment may be lost.



The production of small batches of possibly different products in response to customer demand may also lead to the loss of some of the learning effect.

ACCA F5 Chapter 8 –Quantitative analysis

8-11

8-12

ACCA F5 Chapter 8 â&#x20AC;&#x201C; Quantitative analysis

Chapter 9 â&#x20AC;&#x201C; STANDARD COSTING AND VARIANCES ANALYSIS SYLLABUS OBJECTIVES D

STANDARD COSTING AND VARIANCES ANALYSIS

Budgeting and standard costing

Explain the use of standard costs.[2]

Outline the methods used to derive standard costs and discuss the different types of costs possible.[2]

Explain the importance of flexing budgets in performance management. [2]

Prepare budgets and standards that allow for waste and idle time.[2]

Explain and apply the principle of controllability in the performance management system.[2]

Prepare a flexed budget and comment on its usefulness.[2]

Basic variances and operating statement

(a)

Calculate, identify the cause of and interpret basic variances:[1] (i) sales price and volume (ii) materials total, price and usage9 (iii) labour total, rate and efficiency (iv) variable overhead total, expenditure and efficiency (v) fixed overhead total, expenditure and, where appropriate, volume, capacity and efficiency.

(b)

Explain the effect on labour variances where the learning curve has been used in the budget process.[2]

(c)

Produce full operating statements in both a marginal cost and full absorption costing environment, reconciling actual profit budgeted profit.[2]

(d)

Calculate the effect of idle time and waste on variances including where idle time has been budgeted for.[2]

(f)

Explain the possible causes of idle time and waste and suggest methods of control.[2]

(g)

Calculate, using a simple situation, ABC based variances.[3]

ACCA F5 Chapter 9 â&#x20AC;&#x201C; Standard costing and variances analysis

9-1

OVERVIEW

9-2

ACCA F5 Chapter 9 â&#x20AC;&#x201C; Standard costing and variances analysis

THE USE/ PURPOSE OF STANDARD COST



Standard cost – estimated unit cost



Standard cost card of product

Illustration Standard cost card

K Ltd makes product A, Budgeted output for the year: 900 units Standard details for one unit: Direct materials: 40 square metres at $5.30 per square metre Direct wages: Bonding department: 24 hours at $5.00 per hour Finishing department: 15 hours at $4.80 per hour

• • •

Total fixed production overhead for period are $36,000 and are absorbed on a unit basis. Prepare a standard cost card for one unit. 1

Solution Standard cost card

Standard cost card for product A Direct materials

Unit cost $5.30 per m2

Requirement 40m2

$ 212

Direct labour - Bonding - Finishing

$5 per hr $4.80 per hr

24 hrs 15 hrs

120 72

$1.50 $1

24 hrs 15 hrs

36 15

Prime cost Variable overhead - Bonding - Finishing

Variable production cost Fixed production overheads Total production cost (standard full cost of production) Nonproduction overheads Total cost

1.1

The uses of standard costing



Principal uses



212

192 404

51 455 40 495 xx xx



To value inventories and cost production (alternative to FIFO, LIFO)



To act as control technique / device (standard established, actual and std compared, variances to be investigated, control action taken)

Also can be used:     



Setting budgets and evaluation managerial performance Enables “management by exception” (only significant diff reported / investigated) Forecast for decision making Targets set up – motivation Simplification of accounting

Standard costing as control technique involves:    

Standard (estimated) costs are set Actuals are collected Comparison actuals x std  difference is called variance Variances are analysed  variance analysis

ACCA F5 Chapter 10– Standard costing and variances analysis

10-3

Question: Company uses standard costing system. What are the possible advantages for control function?



Uses of std costing (more accurate budgets, yardsticks again which cost can be measured, leads to efficiency and economies, cost consciousness, management by exception principle, motivation…) 

Where std costing can be used – more suitable for repetitive assembly work and mass production

DERIVING STANDARDS

2.1

Types of standards



Ideal – based upon ideal operating conditions

− −

No wastage, scrap, idle time Behaviour: adverse motivational impact (diff btw actuals and target always adverse, unattainable) Attainable – based upon efficient (not ideal) operating conditions



− −

Includes allowances for normal material losses, machines breakdowns Behaviour: if they provide realistic but challenging target, might encourage to work harder Current – based upon current operating conditions



− − −

Current wastage, current inefficiencies Useful if current conditions abnormal Behaviour: will not motivate to do more/ differently than now Basic – long term stds, remain unchanged for years



− −

Used to show trends Behaviour: not motivational impact as easily achieved

2.2

Where to get info for setting standards



Material costs

− − − −

Purchase contracts signed, pricing discussions with suppliers Forecast of market prices/ inflation Knowledge of bulk purchase discounts Quality of material required



Labour – payroll



Material usage / labour efficiency – technical specifications



Overheads

− −

OAR = budgeted fixed production OH/ production volume Production volume depends on   

Volume capacity (10 clerks work 150 hrs each monthly  1,500 hrs) Efficiency (efficiency ratio is 105%) Production volume (budgeted output) therefore: 1,500 hrs*1,05 = 1,575 hrs



Sales price and margin - Manufacturing cost, Demand, Competition, Inflation



Question: What problems the company can face when sets the standards? (how to incorporate inflation, what type of std, quality of material to be used, seasonal var, bulk discount, time to construct stds, system to establish stds…)

9-4

ACCA F5 Chapter 9 – Standard costing and variances analysis

WASTE AND IDLE TIME

3.1

Wastage

  

Evaporation, spillage, natural wastage Wastage before start of production  material purchase budget affected Wastage during production  material usage budget affected

Illustration Wastage

3.2

Idle time



Caused by

− − 3

machine breakdowns not enough work (bottlenecks in production, shortage of orders) Illustration Idle time

Product A requires 5 labour hours. 20% of working hours are idle time. How long will be worker paid to produce 10 units? (Worker is paid for both productive and non productive time).

ACCA F5 Chapter 10– Standard costing and variances analysis

10-5

FLEXIBLE BUDGETS



Flexible x fixed budget (see chapter 8)



Flexible budget used for a/ planning b/ control (performance management)

4.1

Planning stage – preparing a flexible budget



Steps: 

1/ determination of cost behaviour pattern (fixed, variable, semi variable) – see chapter 8



2/ calculate budget cost allowance (expected expenditure) for different level of output (marginal costing techniques):

− − − 4

FC: budgeted fixed cost VC: units* v Semi variable cost: TC = FC + v * units (high/low method, regression, or FC will be given)

Illustration Flexible budget – planning stage

a/ Prepare budget for 2009 for direct labour cost and OH expenses of production dept flexed at activity levels of 70% & 100%. - direct labour hourly rate $3.90 - 100% activity represents 80,000 direct labour hrs - VAR: - indirect labour $0.80 per direct labour hour - consumables $0.45 per direct labour hour - canteen 5% of direct and indirect labour cost - semi-variable cost – relate to direct labour hrs in the same manner as in last 4 years Year # direct labour hrs Cost $ - fixed cost:

X1 60,000 20,800

- depreciation - management salaries

X2 58,000 20,100

X3 55,000 19,600

X4 50,000 17,800

$17,000 $20,000

b/ Calculate budget cost allowance (expected expenditure) for 2009 assuming that 70,000 direct labour hrs are worked.

9-6

ACCA F5 Chapter 9 – Standard costing and variances analysis

4.2

Controlling – performance management



Compare actual results and budget (flexed to actual level of activity)  variances



Meaningless to compare fixed budget with actual

Illustration Flexible budget - controlling

Production and sales of X (units) Sales Variable costs: Direct material Direct labour Semi-variable cost (1) Fixed costs: D i ti Depreciation Total costs Profit (1)

FIXED 2,000 $ 20,000

ACTUAL 4,000 $ 40,000

FLEXED VAR (Act x flex) 4,000 $ 40,000

7,000 4,000 3,900

12,000 6,000 7,000

(7,000/2,000)x4,000 = 14,000 (4,000/2,000)x4,000 = 8,000 1.2x4,000+1,500= 6,300

2,000 (F) 2,000 (F) 700 (A)

2 000 2,000 16,900 3,100

2 200 2,200 27,200 12,800

2,000 30,300 9,700

200 (A) 3,100 (F)

– Semi-variable cost consists of fixed cost $1,500 plus variable cost of $1.20 per unit made and sold.

a/ Produce flexible budget (by using marginal costing techniques) 

VAR flexed = VAR orig *( 4,000/2,000)



FIX cost flexed = FIX cost orig



SEMI-VAR = FC+ v * units new (4,000)

b/ Produce Variances (A = adverse, F = favourable) c/ Analyse In selling 4,000 units , expected profit should be $9,700, but actual was $12,800  by $3,100 more (total favourable variance) Reasons: 1/ COSTS (flexed x actual)

material Labour Semivar Depreciation

2,000 (F) 2,000 (F) 700 (A) 200 (A) 3,100 (F)

2/ SALES VOLUME (fixed x flexed) - additional contribution earned: Revenue increased by Cost increased by -material -Labour -semivar -fixed cost Full variance statement: Fixed budget profit VARIANCES:

Actual profit

sales volume Material Labour Semivar Depreciation

20,000 (7,000) (4,000) (2,400) 0 (not dependent on sales) 6,600 (F)

3,100 6,600 (F) 2,000 (F) 2,000 (F) 700 (A) 200 (A) 9,700 12,800

ACCA F5 Chapter 10– Standard costing and variances analysis

10-7

4.2

Flexible budgets in practice (limitations)



Splitting semi-variable cost could be problem



Fixed cost can behave in steps/jumps



Assumptions under which original budget was made must be taken into account (inflation, limiting factors…)

4.3

Flexible budgets in modern environment



Many costs in modern environment are fixed (and therefore usefulness of flexible budgets is limited/ questioned): 

Manufacturing industries – plant cost (depn, rent) are fixed and in high proportion



Wages tend to be fixed



Service industries – labour and overheads will be majority of costs (tend to be fixed)

CONTROLLABLE AND NON CONTROLLABLE COSTS



Controllable costs – can be directly influenced by manager within given time span



Controllability principle – manager should be held accountable for cost over which has some influence/control.



Variable cost – controllable in short term (price fixed, but efficiency can be influenced)



Cost not controllable by junior manager can be controlled by senior manager (overtime paid x new hires)



Cost not controllable by manager in one dept can be controllable by manager in another dept (material cost could be controllable by production dept – wastage or purchasing dept – prices)



Some cost uncontrollable (inflation)



Some controllable in long term rather than short term (production cost  technology changes)



Controllability of FC  



Apportioned cost  



9-8

Committed FC (rent) – controllable in long term Discretionary FC (advert, R&D) – controllable in short term

Apportioned rent to production dept – non controllable Apportioned maintenance cost to production departments could be controllable

Dual/ joint responsibility – some cost is joint responsibility of more managers/depts

ACCA F5 Chapter 9 – Standard costing and variances analysis

6 6.1 



BASIC VARIANCES Overview Selling PRICE variance (diff in price * actual q sold) 

Measures the effect on expected profit of a selling price different to the standard selling price



It is the difference between what the sales revenue should have been for the actual quantity sold, and what it was.

Selling VOLUME variance (diff units * std profit per unit / marginal costing: * std contribution per unit) 

Measures the increase or decrease in the expected profit as a result of the sales volume being higher or lower than budgeted.



It is the difference between the budgeted sales volume and the actual sales volume multiplied by the standard profit per unit. (contribution).

Material TOTAL variance - difference between what the output (units produced) DID cost and what it SHOULD HAVE cost in terms of material 

Material PRICE variance (actual # kg SHOULD cost x DID cost)



Material USAGE variance(actual # units SHOULD use kg x DID use kg * std price)

Labour TOTAL variance - - difference between what the output (units produced) DID cost and what it SHOULD HAVE cost in terms of labour 

Labour RATE variance (actual hr SHOUL cost x DID cost)



Labour EFFICIENCY variance (actual # of units SHOULD take hr x DID take hr … *std lab rate)

Variable production OH TOTAL variance – (see in detail below 6.4) 

Variable production OH EXPENDITURE variance



Variable production OH EFFICIENCY variance

Fixed production OH TOTAL- (see in detail below 6.3) 

Fixed production OH EXPENDITURE



Fixed production OH VOLUME

− −

Fixed production OH VOLUME EFFICIENCY Fixed production OH VOLUME CAPACITY

ACCA F5 Chapter 10– Standard costing and variances analysis

10-9

6 Illustration (K 284) – Basic variances Riki Ltd, produces and sells one product only. The standard cost and price for one unit being as follows: Direct material A – 10 kilograms at $12 per kg Direct material B – 6 kilograms at $5 per kg Direct wages – 5 hours at $8 per hour Fixed production overhead Total standard cost Standard gross profit Standard selling price

$ 120 30 40 60 250 50 300

The fixed production overhead included in the standard cost is based on an expected monthly output of 750 units. Riki Ltd uses an absorption costing system. During April 2000 the actual results were as follows: Sales 700 units @ $320 Direct materials: A: 7,500 Kg B: 3,500 Kg Direct wages 3,400 hours Fixed production overhead Gross profit

$ 224,000 91,500 20,300 27,880 37,000 176,680 47,320

Note: Riki Ltd does not hold any inventories. You are required to calculate following variances: Selling price, sales volume, material price, material usage, labour rate, labour efficiency, fixed overhead expenditure and fixed overhead volume. (Note: go through 6.3 Fixed OH vars and Illustration 7 before calculating Fixed OH vars)

9-10

ACCA F5 Chapter 9 – Standard costing and variances analysis

ACCA F5 Chapter 10â&#x20AC;&#x201C; Standard costing and variances analysis

10-11

9-12

ACCA F5 Chapter 9 â&#x20AC;&#x201C; Standard costing and variances analysis

6.2

Reasons for variances

Variance Sales volume variance Sales price variance

Materials price variance

Materials usage variance

Labour rate Idle time

Labour efficiency

OH expenditure

OH volume

Possible causes Favourable Adverse • Price change • Price change • Change in size of market • Change in size of market • Change in market share - competition • Change in market share - competition • Unplanned price increase • Unplanned price reduction • Deliberate –drop price to boost sales • Change in quality • Competition • Change in supplier • Change in supplier • Different material bought • Different material bought • Efforts of purchasing department - • Purchasing department discounts • Commodity price changes • Commodity price changes • Different materials (higher quality) link • Different materials (defective material) link to to price price • Different machinery • Different machinery • Production department-excessive waste, • Efforts of production department theft, stricter quality control • Change in mix of materials • Change in mix of materials • Different grade of labours – cheaper • Different grade of labours –more expensive • Pay increase • strikes N/A • machine breakdown • not available material • illness of worker • bottlenecks • work motivation • lack of training • not available material • errors in allocating time to jobs • errors in allocating time to jobs • Different machinery • Change in quality of material • Change in quality of material-substandard • economical use of services • Machines wearing out • Change in type of services • Machines overworked due to changes in production volume –excessive use • Change in type of services • Output higher than budgeted • Output less than budgeted

ACCA F5 Chapter 10– Standard costing and variances analysis

10-13

6.3

Fixed overhead variances

Over – absorption - > Favourable Under – absorption -> Adverse 7

Illustration (K 282), Fixed overhead variances

The following information is available for J Ltd for Period 4:

Fixed production overheads Units Labour hours

Budget

Actual

$22,960 6,560

$24,200 6,460 12,600 hrs

The standard time to produce each unit is 2 hours Calculate: (i) Fixed overhead total variance (ii) Fixed overhead expenditure variance (iii) Fixed overhead volume variance (iv) Fixed overhead capacity variance (v) Fixed overhead efficiency variance Budgeted overhead absorption rate per unit is $22,960/6560 = $3.50 per unit produced. Budgeted overhead absorption rate per hour is $22,960/ (2hr*6,560) = $1.75 per hour worked. (i) Fixed overhead total variance – diff btw OH incurred and absorbed  Over/under absorbed OH. Fixed overhead incurred $24,200 Fixed overhead absorbed (6,460 units*$3.50) = $22,610 $1,590 (A) – less absorbed than budgeted (ii) Fixed overhead expenditure variance – diff btw OH budgeted and incurred Fixed overhead incurred Fixed overhead budgeted

9-14

$24,200 $22,960 $1,240 (A) – incurred more than budgeted

ACCA F5 Chapter 9 – Standard costing and variances analysis

(iii) Fixed overhead volume variance – diff btw actual and budgeted volume * OAR per unit Budgeted units Actual units Diff

6,560 6,460 100 units less  was absorbed by 100*$3.50 = $350 less (A) – as volume lower than expected

It is because: a/ they worked less efficiently (slowly) and therefore produced less units, and therefore less OH is absorbed  efficiency variance (same in hrs as labour rate variance but valued in OAR per hour). b/ they worked less hours than budgeted, and therefore produced less units  capacity variance (OAR per hour) (iv) Fixed overhead volume efficiency variance – diff btw # of hrs that actual production should have taken and actually taken * OAR per hour 6,460 units SHOULD take (x2h) = 12,920 hrs 12,600 hrs DID take 320 hrs (F) * $1.75 = $ 560 (F) (v) Fixed overhead volume capacity variance – diff btw total budgeted hrs and actual hrs * OAR per hour Budgeted hours Actual hrs

6,560*2hr =13,120 12,600 520hr less (A) *$1,75 = $ 910 (A) – as workers worked by 520hrs less

Variances may be summarized as follows: (ii) Fixed overhead expenditure variance (iv) Fixed overhead capacity variance (v) Fixed overhead efficiency variance (iii) Fixed overhead volume variance (i) Fixed overhead total variance 8

560 (F) 910 (A)

$ 1240 (A) 350 (A) 1,590 (A)

Illustration Fixed overhead variances

The following information is available for K Ltd for Period 4: Budget Fixed production overheads $20,000 Units 1,000 Labour hours The standard time to produce each unit is 5 hours

Actual $20,450 1,100 5,400 hrs

Calculate all fixed overhead variances.

ACCA F5 Chapter 10– Standard costing and variances analysis

10-15

6.4

Variable production overhead variances

9 Illustration Standard variable production overhead cost for product Z is 2 hrs @ $1.5 = $3 per unit. During the period 400 units of product Z was made. Labour worked 820 hrs. Variable overhead costs were $1,300. Calculate: a) Variable overhead total variance b) Variable production overhead expenditure variance c) Variable production overhead efficiency variance d) Calculate the expenditure and efficiency variance if 60 hours out of 820 was recorded as idle time 9 a/

Solution Variable overhead TOTAL variance

It is the difference between what the output (actual units produced) should have cost and what it did cost in terms of variable production overhead. 400 units of Z should cost (x $3) Did cost b/

1,200 1,300 $100 A

Variable production overhead EXPENDITURE variance

It is the difference between the amount of variable production overhead that should have been incurred in the actual hours actively worked, and the actual amount of variable production overhead incurred. (similar as labour rate  how much the actual hours SHOULD cost (valued at standard variable overhead cost per unit) and how much they DID cost) 820 hours should have cost (x $1.5) Did cost c/

1,230 1,300 $70A

Variable production EFFICIENCY variance

it is the difference between: how many hours the actual output SHOULD take and how many hours it DID take – valued at standard variable OH cost per hour (similar as labour efficiency) 400 units of Z SHOULD take (x2hr) 800hr but DID take 820hr 20 hr (A) x std rate per hr x $1.50 $30 (A) d/

Variable production overhead variances with IDLE TIME

hours paid .....820, actually worked (820-60) = 760 hours It is assumed that variable overheads are incurred during active working hours and are not incurred during idle time (machines are not running -> power is not consumed => we have to take 760 hours even though we paid for 820. EXPENDITURE 760 hours should have cost (x $1.5) Did cost EFFICIENCY 400 units of Z should take (x 2hrs) Did take x standard rate per hour x ($1.5) 9-16

1,140 1,300 $160A 800 760 40 hr F $60 F ACCA F5 Chapter 9 – Standard costing and variances analysis

IDLE TIME AND WASTE VARIANCES

7.1

Idle time variance

  

Idle time is adverse variance Budget – idle time can already be incorporated  adverse variance will result from excess over budgeted idle time. Part of labour efficiency variance  shown separately from Productive labour efficiency variance (based on active hrs) Total labour variance Labour rate variance

Labour efficiency variance (did production take more/less hrs than expected based on hrs paid) Productive efficiency variance (production takes more/less hrs than expected based on hrs worked)

Excess idle time variance (diff btw expected idle time and actual idle time)

Illustration K 290

ZS plc has a target time (standard time) of 0.5 hours per unit, at cost of $5 per hour and expects there to be non-productive time equal to 5% of hours paid. The following details relate to the month of December: Units produced Hours paid Non-productive hours Wage cost Wage rate variance

5,400 3,000 165 $15,000 $Nil

Calculate the overall labour efficiency variance and analyse it between productive efficiency and excess idle time variances. 10

Solution

Labour efficiency variance Expected idle time of 5% should be included in standard time to produce 1 unit. 5,400 units SHOULD take (x 0.5hrsx100/95) 5,400 units DID take

2,842hrs 3,000hrs 158hrs (A) x std cost of 5$ per hr = $790 (A)

Labour efficiency variance – productive (ACTIVE HRS ONLY!!!) 5,400 units SHOULD take (x 0.5hrs) 5,400 units DID take (3,000-165)

2,700hrs 2,835hrs 135hrs (A) x std cost of 5$ per hr x 100/95 = $711 (A)

For each productive hour worked there will be 5% non-productive time paid. Standard rate per hour should take this into account. ACCA F5 Chapter 10– Standard costing and variances analysis

10-17

Excess idle time variance Expected idle time (3,000hrsx5%) Actual idle time

150hrs 165 hrs 15 hrs (A)x x std cost of 5$ per hr x 100/95=$79 (a)

For each productive hour worked there will be 5% non-productive time paid. The standard rate per hour should take this into account. Summary Labour efficiency variance â&#x20AC;&#x201C; productive Excess idle time variance Labour efficiency variance 11

711 (A) 79 (A) 790 (a)

Illustration Idle time (K 291)

The following data relates to T plc for the month of January: Standard productive time per unit Standard wage rate per paid hour Actual production Standard idle time as a percentage of hours paid Actual hours paid Actual idle time hours

2 hours $4.00 1,200 units 4% 2,600 110

Calculate the labour efficiency variance and analyse it between productive efficiency and idle time. 11

9-18

Solution

ACCA F5 Chapter 9 â&#x20AC;&#x201C; Standard costing and variances analysis

7.2 12

Wastage and material variances Illustration

Specifications for products A and B: A contains 3 units material X, B contains 6 units X During processing 15% of X is lost Std price X = $9 Demand for period 1 is budgeted: A 2,200 units, B 2,800 units. Return from customers requiring free replacement will be 4% and 2% resp. of goods delivered to customers. No stock planned. Calculate material purchase budget for period 1 for component X.

ACCA F5 Chapter 10â&#x20AC;&#x201C; Standard costing and variances analysis

10-19

OPERATING STATEMENTS



Regular report for management that compares actual cost and revenues and budgeted cost and revenues and shows variances. Different forms exist but in exams  reconcile budgeted profit to actual profit

8.1

Operating statements in absorption costing $

Budgeted profit Sales variances – price - volume

x x

Actual sales less standard cost of sales Material price Material usage Labour rate Labour efficiency Labour idle time Var OH exp Var OH efficiency Fix OH exp Fix OH volume Actual profit Check: Sales Materials Labour Var OH Fix OH

A $ x x

x x

x x $ x x x x

Actual profit 13

F $ x x

$ x x x

x x $ x

x x

Illustration (K 284) – (Riki above ) – Operating statement – absorption costing

You are required to reconcile budgeted profit with actual profit for the period, calculating the following variances: Selling price, sales volume, material price, material usage, labour rate, labour efficiency, fixed overhead expenditure(8,000 F) and fixed overhead volume (3,000 A).

9-20

ACCA F5 Chapter 9 – Standard costing and variances analysis

8.2

Operating statements in marginal costing

Differences in variances btw absorption costing and marginal costing 

Fixed OH variances = expenditure variance only



Sales volume variance valued at standard contribution margin (not standard profit margin)

Template $

Budgeted profit Add budgeted fixed OH Budgeted contribution Sales variances – price - volume

x x

Actual sales less standard cost of sales Material price Material usage Labour rate Labour efficiency Labour idle time Var OH exp Var OH efficiency Actual contribution Budgeted fixed OH Fixed OH EXPENDITURE variance Less Actual fixed OH

F $ x x

A $ x x

x x x

Actual profit Check: Sales Materials Labour Var OH Fix OH

x x

(x) x

$ x x x x

Actual profit 14

$ x x x

$ x

x x

Illustration (K 284) – (Riki above) – Operating statement – marginal costing

Assume Co operates a marginal costing system and recalculate any variances necessary and produce operating statement. Remember!!! • no fixed OH VOLUME variance, only fixed OH EXPENDITURE variance • sales VOLUME variance is valued at Std contribution per unit = … • other variances unchanged.

ACCA F5 Chapter 10– Standard costing and variances analysis

10-21

ABC AND VARIANCE ANALYSIS



All overheads treated as variable cost. They vary with 

production level (short term) - same approach as traditional approach for variable OH



activity (longer term) – extremely similar to var OH

Approach for longer term variable overheads





Expenditure variances – diff btw what expenditure should have been for actual level of activity and actual expenditure



Efficiency variances – diff btw level of activity that should have been needed and actual activity level, valued at standard rate per activity.

Illustration ABC

Info relates to ordering activity during January. Budget 10,000 2,000 orders $100,000

Output Activity level Total cost of activity

Actual 11,000 1,700 orders $92,000

Calculate OH expenditure and efficiency variances relating to ordering activity. 15

Solution ABC

OH EXPENDITURE VARIANCE (= “price variance” = p x q, where p= price per order, q= number of orders) 

Cost driver rate: Each order should cost $100,000/2,000 orders = $50/order 1,700 orders

SHOULD cost (x$50) = $85,000 $ 92,000 DID cost $7,000 (A)

OH EFFICIENCY VARIANCE 

Each unit of output should use (2,000/10,000=0.2 order) 11,000 units

SHOULD use (x0.2) = 2,200 orders 1,700 orders DID use 500 orders (F)x$50 = $25,000 (F)

USEFULNESS Cost per order was ABOVE budget. It took more orders than planned given actual level of production.

9-22

ACCA F5 Chapter 9 – Standard costing and variances analysis

INVESTIGATING VARIANCES

10.1

When to investigate



Materiality – small variations are natural (as std cost are long term average cost), they will cancel out in long term and further investigation is waste of time



Controllability – uncontrollable variance (worldwide increase in RM prices, central decision to increase salary to workers) call for the change of plan, not for investigation.



Type of standard (how the standard is set)– if ideal used, variance will be always adverse. If inflation exists and is reflected in standard in mid year expected price, first half year variances will be favourable, second half adverse



Variance trend – provides indication whether variance is fluctuating around standard or whether becomes out of control.



Interdependence btw variances – variances should not be looked at in isolation. Some variances occur as a result of others. If they are interrelated, one of them will usually be + and another -.



Cost of investigation

10.2

Why arise



Naturally as fluctuation around long term average cost



Also: 

Poor budgeting / out of date stds - inflation, technology changes, learning curve effect  control action – review and update stds



Poor recording cost / measurement errors – materials wrongly classified, wastage unrecorded  control action to improve accuracy of recording



Operational reasons - investigation highlight cause of inefficiency  control action is to eliminate inefficiency (stricter supervision to reduce wastage)



Random – std is average, therefore unpredictable fluctuation in predictable range is expected  no control action necessary.

10.3

Criteria and techniques for investigation



Rule of thumb model – investigate all variance over $x or over x% 

Drawbacks:

− − − − − 

Decision on % Different % for favourable / adverse var? What if some var jumps from LT 2% to 8%, but as materiality 10%, it is not investigated  ignores past history of variances Some expenditures fluctuates naturally (seasonality) Low cost expenditures will often have var exceeding 10%, but in total they will be insignificant

Statistical significance model 

Historical data used to calculate EV and standard deviation for individual expenditures



Advantages: − important costs that are normally stable will be investigated if variance increases − costs that usually fluctuates by large amounts will not be investigated unless variance extremely large

ACCA F5 Chapter 10– Standard costing and variances analysis

10-23

Statistical control charts

9-24



Variances and control limits are marked in chart in time  shows trend



Cumulative sum charts – cumulative sum of variances is plotted – if “natural” fluctuation up and down, it fluctuates around std, if significant var occurs, it takes a drift up or down



Advantage multiple period approach – trends are detectable earlier

ACCA F5 Chapter 9 – Standard costing and variances analysis

Chapter 10 â&#x20AC;&#x201C; ADVANCED VARIANCES SYLLABUS OBJECTIVES D

STANDARD COSTING AND VARIANCES ANALYSIS

Material mix and yield variances

Calculate, identify the cause of and explain mix and yield variances.[2]

Explain the wider issues involved in changing mix e.g. cost, quality and performance measurement issues.[2]

Identify and explain the interrelationship between price, mix and yield.[2]

Suggest and justify alternative methods of controlling production

Sales mix and quantity variances

Calculate, identify the cause of and explain sales mix and quantity variances.[2]

Identify and explain the relationship of the sales volume variances with the sales mix and quantity variances.[2]

Planning and operational variances

Calculate a revised budget.[2]

Identify and explain those factors that could and could not be allowed to revise an original budget.[2]

Calculate planning and operational variances for sales (including market size and market share) materials and labour.[2]

Explain and resolve the manipulation issues in revising budgets.[3]

Behavioural aspects of standard costing

Describe the dysfunctional nature of some variances in the modern environment of JIT and TQM.[2]

Discuss the behavioural problems resulting from using standard costs in rapidly changing environments.[2]

Discuss the effect that variances have on staff motivation and action.[2

OVERVIEW

ACCA F5 Chapter 10â&#x20AC;&#x201C; Advanced variances

10-1

MATERIAL MIX AND YIELD VARIANCES

1.1

Introduction



It makes sense to analyse material usage variance into MIX and YIELD variance if:





More than 1 type of material goes IN the product



Where proportions of materials are changeable and controllable

Examples 

Chair may use leather for the top and metal for the legs – those items are discrete, it does not make sense to increase proportion of material for legs and for the top



Mixed fruit baby food/ juice combines (contains) a mixture of strawberry concentrate and apples concentrate – makes sense to analyse usage variance into mix and yield.

By changing proportions of material, we change: 

Total cost of unit (higher proportion of strawberries than apples make juice more expensive)  MIX



Yield (INPUT kg / OUTPUT kg) (higher proportion of strawberries than apples may result in less kg at input to produce 1 litre of juice at output as apples are not as juicy as strawberries)  YIELD

Illustration

To produce 1l of juice, we need 2kg of strawberries and 1 kg of apples (2/3) 2 kg of strawberry (1/3) 1 kg of apples

at $3.00 per kg at $2.00 per kg

If we change the mix (less strawberries, more apples), the mix would be cheaper: (1/3) 1 kg of strawberry (2/3) 2 kg of apples

at $3.00 per kg at $2.00 per kg

$ 6.0 2.0 8.0 $ 3.0 4.0 7.0

BUT by changing the proportions in the mix, the efficiency (yield) of the combined material usage may change  for e.g. we have to use more than 3kgs of fruit at input to get 1 litre of juice at output as apples are not as juicy as strawberries, there is more waste from apples etc: $ (1/3) 1.2 kg of strawberry at $3.00 per kg 3.6 4.8 (2/3) 2.4 kg of apples at $2.00 per kg 8.4

10-2

ACCA F5 Chapter 10 – Advanced variances

1.2

Definitions



Mix variance - Difference between actual mix and standard mix (at actual quantity)



Yield variance - Measures the difference between the expected input for the output achieved and actual input.  Actual usage (standard mix) x standard usage (standard mix)

1.3

Interpretation



Mix – A favourable total mix variance would suggest that a higher proportion of a cheaper material is being used hence reducing the overall average cost per unit.



Yield – An adverse total yield variance would suggest that less output has been achieved for a given input, i.e. that the total input in volume is more than expected for the output achieved.



These variances may be interrelated. A favourable material mix variance may lead to an adverse yield variance and vice versa. This is due to difference in quality between materials used.



Any change in mix can be judged by the impact on the overall total materials variance.

1.4

Mix and yield variances – no complications

Illustration

Standard materials for 1 unit of ABC X Y

2kg@ $2.50 per kg 5kg@ $4.00 per kg

$ 5 20 25

During the period 1 2,000kg of material X (costing $5,200) and 3,000kg of material Y (costing $12,800) were used to produce 650 units of ABC. Calculate: a/ price variances b/ mix variances c/ yield variances – in total and for each individual material

ACCA F5 Chapter 10 – Advanced variances

10-3

10-4

ACCA F5 Chapter 10 â&#x20AC;&#x201C; Advanced variances

1.5

Losses, mix and yield

Illustration

Company produces product ABC, uses material S,T. Standard and actual quantities in period 1 were as follows:

Material S Material T

kg 30,000 15,000

Standard $/kg 2.50 4.00

total $ 75,000 60,000

kg 25,000 17,000

Actual $/kg 2.50 4.00

total $ 62,500 68,000

Losses during procession of material are expected at level of 15% of material input. Actual output during the period 1 was 40,000 kg of ABC. Required: Calculate price, mix and yield variances.

ACCA F5 Chapter 10 â&#x20AC;&#x201C; Advanced variances

10-5

Illustration (K 08/09 – 321)

270 tonnes 70 tonnes costing $16,100 430 tonnes costing $48,355

Required: a/ Prepare all material variances and b/ discuss their causes. 4

10-6

Solution (K 08/09 – 321)

ACCA F5 Chapter 10 – Advanced variances

1.6

Changing mix – wider issues



Changing the mix can impact   

Cost Quality Performance measurement.

Illustration (K 322)

A company produces precast concrete sections for the construction industry. The mix of materials used to produce the concrete can be varied and different mixes are suitable for different products. Discuss the issues that management should consider when setting standard material costs. 5

Solution

For each product management should consider the optimum mix of input materials that will maximise profits to the business. This may involve consideration of: 

the relationship between cost, quality and price. Reducing the cost of input materials by using a greater proportion of a cheaper material may reduce the quality of the product and lead to a reduction in the price that can be charged;



costs of reduced quality. Using a greater proportion of a cheaper input material may lead to higher quality failure costs;



impact on other variances. Increasing the proportion of a cheaper input material may result in increased labour costs or overhead costs if this leads to more time having to be spent producing a product. Increased rejects may lead to higher overhead costs.

It may be the case that, whilst changing a material mix could lead to an overall favourable material variance this could have an adverse impact on the profitability of the business if prices have to be reduced because of reduced quality or quality failure costs exceed material cost savings. Thus it is important to set the standard mix at the level which optimises profit taking all factors into consideration. 6

Illustration (K 322)

Discuss how the performance measurement system should be designed when the mix of input materials can be varied in a process. 6

Solution

In a performance measurement system managers are often rewarded for improving the performance of cost and/or revenues under their control. The production manager may be responsible for the material mix decision and, if the reward system is based on achieving cost savings, then the cheapest mix may be used. This may have a detrimental effect on company profit if quality is reduced and this leads to a lower price or quality failure costs. It may therefore be preferable to reward managers on the basis of total company profit so that the full impact of the mix decision is taken into account.

1.7

The control of production processes in manufacturing environment



In modern manufacturing environment using mix and yield variances for control purposes may be inadequate/ not possible. Other methods:          

detailed timesheets % idle time productivity % yield, % waste quality measures e.g. reject rate average cost of inputs/ average cost of output average prices achieved for finished products average margins % on time deliveries customer satisfaction ratings.

ACCA F5 Chapter 10 – Advanced variances

10-7

SALES MIX AND QUANTITY VARIANCES



Relevant when there is more than 1 product being sold.



A further breakdown of the sales volume variance.



Sales mix variance: explains the effect on profit due to changing the mix of products sold



Sales quantity variance: explains the effect on profit due to changing the quantity of products sold

Illustration (K 300) – Sales mix and quantity variances

CAB Co operates an absorption costing system and sells three products B, R, and K, which are substitutes for each other. The following standard selling price and cost data relate to these three products: Product B K R

Unit Selling Price $14.00 $15.00 $18.00

Direct Material/Unit 3 kgs @ $1.80 / Kg 1.25 kgs @ $3.28 / Kg 1.94 kgs @ $2.50 / Kg

Direct Labour/Unit 0.5 Hours @ $ 6.50 / Hour 0.8 Hours @ $ 6.50 / Hour 0.7 Hours @ $ 6.50 / Hour

B 0.3 hours 10,000

K 0.6 hours 13,000

R 0.8 hours 9,000

Actual volumes and selling prices for the three products in the last period were as follows: Product Actual selling price per unit Actual production and sales (units)

B $14.50 9,500

K $15.50 13,500

R $19.00 8,500

Required: Calculate the following variances for overall sales for the last period: (1) Sales price variance (2) Sales volume profit variance (3) Sales mix profit variance (4) sales quantity profit variance 7

10-8

Solution (K 300) – Sales mix and quantity variances

ACCA F5 Chapter 10 – Advanced variances

ACCA F5 Chapter 10 â&#x20AC;&#x201C; Advanced variances

10-9

PLANNING AND OPERATIONAL VARIANCES

3.1

Introduction

It does not make sense to compare the actual result with the budget set at the beginning of the year if we know that the standards were not accurately set. Original standard cost card

Original flexed budget

Original Flexed budget

Revised flexed budget

Planning variances

Actual results

Operational variances Traditional variances



A planning variance - Compares an original standard with a revised standard (a realistic benchmark)



An operational variance - Compares an actual result with the revised standard



Budget revision - Advantages



10-10



operational performance appraised by reference to realistic targets



future budgets more realistic

Budget revision - Disadvantages 

may be biased



may need external information



original budget not a motivator



operating problems may be excused by poor planning

ACCA F5 Chapter 10 – Advanced variances

3.2 8

Planning and operational variances - materials Illustration (K 328) – no usage considered, only price – 1 planning error

The standard cost per unit of raw material was estimated to be $5.20 per unit. The general market price at the time of purchase was $5 per unit and the actual price paid was $5.18 per unit. 10,000 units of the raw materials were purchased during the period. Calculate the planning and operational materials price variances.

Illustration ( K 329) – 2 planning errors (price and usage var)

Holmes Ltd uses one raw material for one of their products. The standard cost per unit at the beginning of the year was $28, (Standard material cost per unit = 7 kg per unit at $4 per kg = $28) In the middle of the year the supplier had changed the specification of the material slightly due to problems experienced in the country of origin, so that the standard had to be revised: Stand material cost per unit = 8 kg per unit at $3.80 per kg = $30.40. The actual output for November was 1,400 units. 11,000 kg of material was purchased and used at a cost of $41,500. Calculate all planning and operational material variances.

ACCA F5 Chapter 10 – Advanced variances

10-11

Illustration

Examiner (Article 4/09)

10-12

ACCA F5 Chapter 10 â&#x20AC;&#x201C; Advanced variances

3.3

Planning and operational variances - labour



there must be at least 2 grades, paid at different rate, substitutable



variances can be analysed into:



uncontrollable planning variance due to environmental changes (e.g. unskilled labour is substituted for skilled labour because of conditions in the labour market)



controllable - operating

Illustration (K 329– 1 planning error)

The standard hours per unit of production for a product are 5 hours. Actual production for the period was 250 units and actual hours worked were 1,450 hours. The standard rate per hour was $10. Because of a shortage of skilled labour it has been necessary to use unskilled labour and it is estimated that this will increase the time taken by 20%. Calculate the planning and operational efficiency variances.

ACCA F5 Chapter 10 – Advanced variances

10-13

Illustration â&#x20AC;&#x201C; 2 planning errors

Standard direct labour cost for product Revised std

4 hrs x $5 = $20 6 hrs x $4 = $24

Actual: 1,000 units produced, 6,200 hrs worked at cost of $23,800. Calculate planning and operational variances:

10-14

ACCA F5 Chapter 10 â&#x20AC;&#x201C; Advanced variances

3.4

Planning and operational variances – sales

Sales variances –

a/ price: difference in price * actual quantity b/ volume: difference in quantity * standard contribution – marg costing (or standard profit – absorb costing)

Illustration – Sales volume planning and operational variance

Company ABC budgeted to make and sell 500 units of a product ABC in a week (5 days) period: Budgeted sales Variable cost Contribution Fixed costs Profit

(100 units a day) (500 units * $70)

$ 50,000 35,000 15,000 8,000 7,000

On day 4 production came to a halt as raw material ran out and new supply was not received until the day 5 – company lost 1 day of production and sales. Actual results in the period: Budgeted sales Variable cost Contribution Fixed costs Profit

(420 units) (420 units * $70)

$ 42,000 29,400 12,600 8,000 4,600

In retrospect, it is decided that optimum budget, given the loss of production on day 4, would have been to sell only 400 units. Calculate planning and operational variances.

ACCA F5 Chapter 10 – Advanced variances

10-15

Illustration – sales price variance

ABC budgeted to sell 12,000 units of a product ABC during period 1. Budgeted sales price $12/unit, variable cost $4/unit. Actual sales were 12,000 units and variable cost $48,000, sales revenue was $8/unit. However it was realised that budgeted sales price of $12 was optimistic and price of $6 would have been much more realistic. Calculate planning and operational variances.

NOTE: in questions you will not be given planned volume xy and revised volume xz, but you will be given your planned volume and information that market for product declined by x% and market share by y%. 

Change in market volume is not controllable by the Co  therefore results in planning variance



Change in market share is controllable by the Co  therefore results in operational variance

Illustration – market share, market volume

Co budgeted sales of product A 10,000 units. Std contribution is $10.50/ unit. A recession in 2008 meant that market for product A declined by 7%. Company’s market share also fell by 14%. Actual sales were 8,000 units. Calculate planning and operational variances.

10-16

ACCA F5 Chapter 10 – Advanced variances

Illustration (K 326)- Sales volume variance â&#x20AC;&#x201C; market share, market volume

A company sets its sales budget based on an average price of $14 per unit and sales volume of 250,000 units. Competition was more intense than expected and the company only achieved sales of 220,000 and had to sell at a discounted price of $12.50 per unit. The company was unable to reduce costs so profit per unit fell from $4 per unit to $2.50 per unit. It was estimated that the total market volume grew by 10% from 1,000,000 units to 1,100,000 units. (a) Calculate the sales price and volume variances. (b) Analyse the volume variances into market share and market size. (c) Discuss whether the price variance is a planning or operational variance.

ACCA F5 Chapter 10 â&#x20AC;&#x201C; Advanced variances

10-17

Illustration (K 330)

POV Ltd uses a standard costing system to control and report upon the production of its single product. An abstract from the original standard cost card of the product is as follows: $

Selling price per unit Less: 4 kg materials @ $20 per kg 6 hours labour @ $7 per hour

80 42

Contribution per unit For period 3:

$ 200 122 78

2,500 units were budgeted to be produced and sold but the actual production and sales were 2,850 units.

The following information was also available: (1)

At the commencement of period 3 the normal material became unobtainable and it was necessary to use an alternative. Unfortunately, 0.5 kg per unit extra was required and it was thought that the material would be more difficult to work with. The price of the alternative was expected to be $16.50 per kg. In the event, actual usage was 12,450 kg at $18 per kg.

(2)

Weather conditions unexpectedly improved for the period with the result that a 50c per hour bad weather bonus, which had been allowed for in the original standard, did not have to be paid. Because of the difficulties expected with the alternative material, management agreed to pay the workers $8 per hour for period 3 only. During the period 18,800 hours were paid for.

After using conventional variances for some time, POV Ltd is contemplating extending its system to include planning and operational variances. (a)

Prepare a statement reconciling budgeted contribution for the period with actual contribution, using conventional material and labour variances.

(b)

Prepare a similar reconciliation statement using planning and operational variances.

(c)

Explain the meaning of the variances shown in statement ( b)

10-18

ACCA F5 Chapter 10 â&#x20AC;&#x201C; Advanced variances

10-19

2.5

When should a budget be revised?

There must be a good reason for deciding that the original standard cost is unrealistic. Deciding in retrospect that expected costs should be different from the standard should not be an arbitrary decision, aimed perhaps at shifting the blame for poor results from poor operational management to poor cost estimation. A good reason for a change in the standard might be: 

a change in one of the main materials used to make a product or provide a service



an unexpected increase in the price of materials due to a rapid increase in world market prices (e.g. the price of oil or other commodities)



a change in working methods and procedures that alters the expected direct labour time for a product or service



an unexpected change in the rate of pay to the workforce.

These type of situations do not occur frequently. The need to report planning and operational variances should therefore be an occasional rather than regular event. If the budget is revised on regular basis, the reasons for this should be investigated. It may be due to management attempting to shift the blame for poor results or due to a poor planning process. The aim of variance reporting should be to: 

identify responsibilities for performance, and



attempt to put a realistic value to the costs or benefits arising from that performance.

If different managers are responsible for planning and operations, the responsibility for the variances can be attributed to the appropriate manager, and the principles of responsibility accounting can be properly applied. However, frequent ‘errors’ in the ex ante standard should not happen, except in unusual circumstances, and the need to report planning and operational variances should therefore be occasional rather than a regular event. 18

Illustration (K 331)

A company is operating in a fast changing environment and is considering whether analysing existing variances into a planning and operational element would help to improve performance. Discuss the advantages and disadvantages of the approach. 18

Solution

Advantages may include: • Variances are more relevant , especially in a turbulent environment. • The operational variances give a ‘fair’ reflection of the actual results achieved in the actual conditions that existed. • Managers are, theoretically, more likely to accept and be motivated by the variances reported which provide a better measure of their performance. • The analysis helps in the standard setting earning process, which will hopefully result in more useful standards in the future. Disadvantages: • The establishment of ex-post budgets is very difficult. Managers, whose performance is reported to be poor using such a budget, are unlikely to accept them as performance measures because of the subjectivity in setting such budgets. • There is a considerable amount of administrative work involved first to analyse the traditional variances and then to decide on which are controllable and which are uncontrollable. • The analysis tends to exaggerate the interrelationship of variances, providing managers with a ‘prepacked’ list of excuses for below standard performance. Poor performance is often excused as being the fault of a badly set budget.

10-20

ACCA F5 Chapter 10 – Advanced variances

MODERN MANUFACTURING ENVIRONMENT

4.1

Total quality management (TQM)



TQM is a business management strategy aimed at embedding awareness of quality in all organizational processes.



TQM is a method by which management and employees can become involved in the continuous improvement of the production of goods and services. It is a combination of quality and management tools aimed at increasing business and reducing losses due to wasteful practices.



TQM is the continuous improvement in quality, productivity and effectiveness through a management approach focusing on both process and the product.



Fundamental features include: 

prevention of errors before they occur;



importance of total quality in the design of systems and products;



real participation of all employees;



commitment of senior management to the cause;



recognition of the vital role of customers and suppliers;



recognition of the need for continual change.

4.2

JIT



JIT is an inventory strategy implemented to improve the return on investment of a business by reducing in-process inventory and its associated carrying costs. This means that goods are only produced when they are needed, eliminating large stocks of materials and finished goods.



Key characteristics for successfully operating such a system are:





High quality:

possibly through deploying TQM systems.



Speed:

rapid throughput to meet customers ’ needs.



Reliability:

computer-aided manufacturing technology will assist.



Flexibility:

small batch sizes and automated techniques are used.



Low costs:

through all of the above.

Main features      



keep minimum stock level frequent regular deliveries guaranteed fast delivery times, supplier must have stock – deliver instantly forced to improve the quality of the working (no waste, less damage) faster production to decrease the level of WIP and FG finished goods on expected demand level (unable to assess), ideal situation demand pool manufacturing, i.e. produce specifically to meet the demand. (sofas)

Benefits 

In case of low stock levels, less warehouse costs, rent, costs of warehouse personnel,



Better quality working (less wastage...)



Efficiency savings (faster production, e.g. saving labour costs)



More able to meet the customer demand

ACCA F5 Chapter 10 – Advanced variances

10-21

VARIANCE ANALYSIS IN MODERN MANUFACTURING ENVIRONMENT



Standard product costs are associated with traditional manufacturing systems producing large quantities of standard items.



Key features of companies operating in a JIT and TQM environment are:



10-22



high level of automation



high levels of overheads and low levels of direct labour costs



customised products produced in small batches



low stocks



emphasis on high quality.

Variance analysis may not be appropriate because: 

Standard product costs apply to manufacturing environments in which quantities of an identical product are output from the production process. They are not suitable for manufacturing environments where products are nonstandard or are customised to customer specifications.



It is doubtful whether standard costing is of much value for performance setting and control in automated manufacturing environments. There is an underlying assumption in standard costing that control can be exercised by concentrating on the efficiency of the workforce. Direct labour efficiency standards are seen as a key to management control. However, in practice, where manufacturing systems are highly automated, the rates of production output and materials consumption are controlled by the machinery rather than the workforce.



Variances are the difference between actual performance and standard, measured in cost terms. The significance of variances for management control purposes depends on the type of standard cost used. For example, adverse variances with an ideal standard have a different meaning from adverse variances calculated with a current standard.



Emphasis on continuous improvement: Standard costing and adherence to a preset standard is inconsistent with the concept of continuous improvement, which is applied within TQM and JIT environments.



When standard costing was first devised, the main elements of product costs were direct materials and direct labour. In modern manufacturing, production overhead costs are often a high proportion of total production costs. Standard costing is therefore not an appropriate system of performance measurement or effective management control.



Variance analysis is often carried out on an aggregate basis (total material usage variance, total labour efficiency variance and so on) but in a complex and constantly changing business environment more detailed information is required for effective management control.



Monitoring performance is important: Variance analysis control reports tend to be made available to managers at the end of a reporting period. In the modern business environment managers need more ‘real time’ information about events as they occur.



Shorter product life cycles in the modern business environment mean that standard costs will need to be reviewed and updated frequently. This will increase the cost of operating a standard cost system but, if the standards are not updated regularly, they will be of limited use for planning and control purposes. The extra work involved in maintaining up-to-date standards might limit the usefulness and relevance of a standard costing system.

ACCA F5 Chapter 10 – Advanced variances

Illustration (K 331)

Comment on whether standard costing applies in both manufacturing and service businesses and how it may be affected by modern initiatives of continuous performance improvement and cost reduction. 19

Solution

Standard costing is most suited to organisations whose activities consist of a series of common or repetitive operations. Typically, mass production manufacturing operations are indicative of its area of application. It is also possible to envisage operations within the service sector to which standard costing may apply, though this may not be with the same degree of accuracy of standards which apply in manufacturing. For example, hotels and restaurants often use standard recipes for preparing food, so dealing with conference attendance can be like a mass production environment. Similarly, banks will have common processes for dealing with customer transactions, processing cheques, etc. It is possible therefore that the principles of standard costing may be extended to service industries. In modern manufacturing and service businesses, continuous improvement and cost reduction are topical. In order to remain competitive it is essential that businesses address the cost levels of their various operations. To do this they have to deal with the costing of operations. But the drive to ‘cost down’ may mean in some cases that standards do not apply for long before a redesign or improvement renders them out of date. In such a setting an alternative to the use of standard costs is to compare actual costs with those of the previous operating period. We have seen above that a standard costing system has a variety of purposes. It is for management to judge their various reasons for employing standard costing and, consequently, whether their aims of continuous improvement and cost reduction render the system redundant.

STANDARD COST AND BEHAVIOURAL ISSUES



Standard costs are set with a view to measuring actual performance against the standard, and reporting variances to the managers responsible. The aims of setting standards include: 

setting a target for performance



motivating the managers responsible to achieve those targets



holding these managers accountable for actual performance



perhaps rewarding managers for good performance and



criticising them for poor performance.

6.1

Standards as a target for achievement (type of standard set)



Individuals might respond to standards in different ways, according to the difficulty of achieving the standard level of performance. 

When a standard level of performance is high (ideal standard), employees and their managers will recognise that they cannot achieve it. Since the target is not achievable, they might not even try to get near it.



When the standard of performance is not challenging (current standard), employees and their managers might be content simply to achieve the standard without trying to improve their performance.



An attainable standard might be set which challenges employees and their managers to improve their performance. If this attainable standard is realistic, it might provide a target that they try to achieve.



Basic standard: May motivate employees since it gives them a long term target to aim for. However, the standard may become out of date quickly and as a result may actually demotivate employees.

6.2

Standard costs and motivation



An argument in favour of setting attainable standards is that they can be used to motivate employees and their managers to improve performance. However, this argument is based on the assumption that individuals are motivated by challenging targets. This is not necessarily the case. 

If the standard is too difficult, it could have the opposite effect and demotivate individuals.



Even if the standard is attainable, individuals will not necessarily be motivated to achieve it. It might be necessary to provide motivation in the form of a bonus or other type of reward for achieving the standard.

ACCA F5 Chapter 10 – Advanced variances

10-23



Individuals might prefer standards to be set at a low level of performance, in order to avoid the need to work harder.

6.3

Participation in standard setting



It has been suggested that if managers and employees can participate in the standard setting process, their motivation will improve. 

Employees might become involved in trying to improve performance levels.



Having set the standards, employees will be motivated to try to achieve the targets they have set for themselves.



Participation in standard setting could therefore be a way of achieving improvements in performance. However, the effectiveness of participation in setting standards depends on a variety of factors, such as the type of staff involved, the attitudes of their managers, the organisation structure and culture, and the nature of the work.



Should the employees be involved in setting the standards (K 288)?:

In favour • • • • •

Against participation way to achieve improvements motivation more likely to be accepted by staff morale and performance likely to improve better understanding of expectations

• • • • •

willingness to share responsibilities for budgeting time consuming standards may be easily achievable (slacks) may result in conflict suggestions may be ignored

6.4

Pay as a motivator



If standards are used as a way of encouraging employees to improve their performance, motivation could be provided in the form of higher pay (or other rewards) if targets are reached or exceeded.



However, if employees are offered a bonus for achieving standard costs, this could increase their incentive to set low standards of performance, and include ‘slack’ in the standard cost. Lower standards will increase the probability that the standards will be achieved and a bonus will be earned.

10-24

ACCA F5 Chapter 10 – Advanced variances

Chapter 11 - PERFORMANCE MEASUREMENT AND CONTROL SYLLABUS OBJECTIVE E

PERFORMANCE MEASUREMENT AND CONTROL

The scope of performance measurement

Describe and calculate and interpret financial performance indicators (FPIs) for profitability, liquidity and risk in both manufacturing and service businesses. Suggest methods to improve these measures.[2]

Describe, calculate and interpret nonfinancial performance indicators (NFPIs) and suggest methods to improve the performance indicated.[2]

Explain the causes and problems created by short-termism and financial manipulation of results and suggest methods to encourage a long-term view.[2]

Explain and interpret the Balanced Scorecard, and the Building Block model proposed by Fitzgerald and Moon.[2]

Discuss the difficulties of target setting in qualitative areas.[2]

OVERVIEW

ACCA F5 Chapter 11 â&#x20AC;&#x201C; Performance measurement and control

11 - 1

PERFORMANCE MEASUREMENT



Performance measurement



11- 2



aims to establish how something (machine, division) or somebody (manager) is doing in relation to a plan



vital part of control process

Performance measures may be divided into: 

Financial performance indicators



Non financial performance indicators

Performance measures are 

Quantitative



Qualitative – subjective and judgemental; valuable if derived from several sources

Which measures are most appropriate for a particular organisation? Factors to consider: 

Measurement requires resources – people, equipment and time to collect and analyse information.



Performance must be measured in relation to something – against the objectives and plans



Measures must be relevant



Both short and long-term achievements must be measured. Long term goals require more effort and many organisations prefer to focus instead on short-term financial results even though a longerterm view may eventually offer higher benefits. A possible reason for this near-term focus is the increasing competitiveness and high staff turnover. This builds a culture of short-term permanent employment, where employees do not foresee themselves to stay on with any organisation long enough to see any long-term plans bear fruit. This problem was exacerbated by short-term performance targets (e.g. quarterly ROE) against which the top management’s performance was measured and their incentive schemes benchmarked. One possible solution for such long-term goals, which cannot be realised for many years, is to identify meaningful output-oriented milestones that lead to achieving the long-term outcome.



Measures must be fair, include only controllable factors



A variety of measures should be used – balanced score cards



Realistic estimates - The measures agreed by the employer and employee have to be ambitious and challenging, and at the same time, be realistic and attainable. Too little means employees fall into complacency; too much and they start to rebel or leave. This requires a careful balance.



Measurement needs responses and the selected measures require an ongoing monitoring

ACCA F5 Chapter 11 – Performance measurement and control

FINANCIAL PERFORMANCE INDICATORS (RATIO ANALYSIS)



Financial performance indicators analyse





Profitability



Liquidity



Risk

Ratio analysis considerations: 

Many ratios use figures at a particular point in time and thus may not be representative of the position throughout a period. For example, seasonal trade or large one off items may make year end figures uncharacteristic.



Ratios are of little use in isolation. Compare against:

− − −

budgets, for control purposes last year’s figures to identify trends competitors’ results and/or industry averages to assess performance.



Ratios can be manipulated by management. A well known example of ‘window dressing’ is to issue spurious invoices before the year end and then issue credit notes just after.



As with variances, ratios indicate areas for further investigation, rather than giving a definitive answer for management.

2.1

Measuring profitability



PBT is better than PAT as there might be unusual variations in tax charge from year to year which would not affect underlying profitability of Co



Also used PBIT in ratios

2.1.1

Return on Capital Employed (ROCE) 

measures the efficiency and profitability of capital investments undertaken by a corporation. A firm acquires capital assets such as trucks, computers, etc to help makes its business operations more efficient, cut down on costs and realize greater profits or acquire more market share.



It indicates whether the company is earning sufficient revenues and profits in order to make the best use of its capital assets.

ROCE =

PBIT capital employed

Capital employed = Shareholders’ funds + payables (>1 year)+ LT provisions for liabilities and charges = total assets – current liabilities

ACCA F5 Chapter 11 – Performance measurement and control

11 - 3



Comparisons to be made 

Change in ROCE over period



Comparison with ROCE of other Companies



Comparison of ROCE with current market borrowing rates:

− − 

Is Co making ROCE which suggests that it is making profitable use of its current borrowing? What would be cost of extra borrowing to the Co if needed more loans and is making sufficiently high ROCE to afford them?

Further analysis of ROCE ROCE

= profit margin x asset turnover

PBIT PBIT sales revenue = × capital employed sales revenue Capital employed

2.1.2.



Asset turnover – measure of how well the asset of a business are being used to generate sales. If this indicates poor performance then fixed asset utilisation and working capital management may be further examined.



Profit margin - if ROCE indicates poor performance then the margin would indicate if it is due to low margin or poor overhead control and further ratios can be calculated to investigate.



Also comment on change in turnover from Y1 to Y2 - growth can be due to prices or/and volume

Gross profit margin, Net profit margin Gross profit margin

Net profit margin

GP sales NP sales

Sales margin = sales – cost of sales

2.1.3.

Asset turnover Turnover Capital employed

2.1.4.

EPS – Earnings per share



Profit attributable to each ordinary share

PAT and after preference divs × 100% # of ordinary shares 

11- 4

Therefore all interest on prior-charge capital (loan stock, debentures, preference shares) and tax have to be deducted from PBIT to arrive at profit attributable to shareholders. ACCA F5 Chapter 11 – Performance measurement and control



EPS must be seen in context – considerations: 

EPS is used to compare results of the Co over time. (Is EPS growing?/ rate of growth of EPS?/ rate of growth increasing/decreasing?)



EPS should not be used blindly to compare earnings of one Co with another (different nominal value of shares)



Comparison over time within one Co – must be calculated consistently (changes in share capital)



EPS is based on past data and it can be manipulated by changes in accounting policies and by mergers and acquisitions.

Illustration

A company has the following income statements: Turnover Less Cost of sales Gross profit Less expenses Net profit

Year 1 $ 50,000 35,000 15,000 10,000 5,000

Year 2 $ 80,000 48,000 32,000 24,000 8,000

Although the net profit margin is the same for both years – 10%, the gross profit margin is not. Year 1

15,000/50,000= 30%

Year 2 32,000/80,000 = 40%

Is this good or bad for the business? 1

Solution

ACCA F5 Chapter 11 – Performance measurement and control

11 - 5

Illustration (K 08/09 - 360)

Below are the financial statements for T for the years ended 30 June 2010 and 2011: Income statements

Revenue Cost of sales Gross profit Operating expenses Profit from operations Finance costs Profit before tax Tax Net profit

2011 $‘000

2012 $‘000

150,000 (60,000) 90,000 (28,500) 61,500 (10,000) 51,500 (13,600) 37,900

180,000 (65,000) 115,000 (39,900) 75,100 (12,000) 63,100 (17,300) 45,800

2010 $‘000

2011 $‘000

190,000

266,200

12,000 37,500 500 240,000 10,000 4,000 78,900 92,900

15,000 49,300 330,500 12,000 5,000 30,000 99,700 146,700

125,000

150,000

10,600 11,500 240,000

11,700 9,100 13,000 330,500

Dividends of $25m were paid to shareholders in each year. Balance sheets

Property, plant and equipment Current assets Inventory Receivables Bank Share capital Share premium Revaluation reserve Retained earnings Noncurrent liabilities Loan Current liabilities Trade payables Overdraft Taxation Required: (a) For each of the two years, calculate the following ratios for T: Gross profit margin Operating profit margin Net profit margin ROCE Asset utilisation

Gross profit ÷ Revenue Operating profit ÷ Revenue Net profit ÷ Revenue Operating profit ÷ Capital Revenue ÷ Capital employed

20X5

20X6

(b) Suggest reason why T's ratios have changed

11- 6

ACCA F5 Chapter 11 – Performance measurement and control

2.2

Measuring liquidity



Liquidity = amount of cash a Co can obtain quickly to settle its debts.



Liquid assets = current assets that will (or could soon be) converted into cash and cash (inventory – depends)



Ratios can be found using year end or average figures

2.1.2

Current ratio current assets current liabilitie s

2.2.2

Quick ratio current assets - inventories current liabilitie s

2.2.3

Accounts receivable payment period/ AR days AR ⋅ 365 sales



2.2.4

Notes: 

Balance sheet value of accounts receivable might be abnormally high/low  therefore ratio might be distorted



Sales excludes VAT, but accounts receivable includes VAT

AP payment period/ AP days

AP ⋅ 365 purchases or COS 

2.2.5

Increase in AP days is often sign of lack of long term finance or poor management of current assets, resulting in use of extended credit from suppliers

Inventory turnover period (inventory days)

inventory turnover period = 



inventory ⋅ 365 COS

Increase in inventory days indicates: 

Slowdown in trading



Build up in inventory levels

Inventory days + receivables days  gives indication of how soon inventory is convertible into cash

ACCA F5 Chapter 11 – Performance measurement and control

11 - 7

Illustration (K 08/09 - 365)

(a) For each of the two years, calculate the following ratios for T: Current ratio Quick ratio Inventory holding period Receivables collection period Payables payment period

CAs ÷ Current liabilities (CAs — Inventory)÷ Current liabilities Inventory ÷ Cost of sales × 365 Receivables ÷ Revenue × 365 Trade payables ÷ Cost of sales ×365

2010

2011

(b) Suggest reasons why T’s ratios have changed:

11- 8

ACCA F5 Chapter 11 – Performance measurement and control

2.3

Measuring risk (Gearing ratios)



Gearing = amount of debt finance a Co uses relative to its equity finance



Debt is cheaper than equity  but high level of debt creates financial risk from different points of view:





The company as a whole – can not pay interest, can not pay debt when it falls due  liquidation



Debt lenders – Co can not pay debt  liquidation  risk that debt lenders will not recover their finance  more risky  require higher interest yield



Ordinary shareholders → higher interest  lower dividends if any  higher expected return from investment (MV of shares depend on gearing)

Financial risk of the Co is measured by  

Gearing ratios Interest cover

2.3.1

Financial gearing ratios



Measures relationship btw equity and debt (note: debt also includes preference shares) – measures the extent to which a Company is funded by debt

debt debt or debt + equity equity 

Debt = debentures, loans, preference shares! … so called prior-charge capital



Equity = share capital, revaluation reserves, retained earnings …



Interpretation: Company is low geared if ratio is < 0,5 (resp. <1)



Volatility - The more geared Co  the greater percentage change in PAT available to shareholders for any given percentage change in PBIT (higher level of financial gearing will have increased variability of returns to shareholders)

Illustration – Volatility – assume no tax for simplification Co A

Co B

Assets

20,000

Share capital – ord shares 10% loan notes

20,000 20,000

10,000 10,000 20,000

Co A

Co B

Co A

Co B

1,500 0 1,500

1,500 (1,000) 500

2,000 0 2,000

2,000 1,000 1,000

PBIT Interest PAT

ACCA F5 Chapter 11 – Performance measurement and control

change: 25% A,B change: 25% A, 50% B

11 - 9

2.3.2

Interest cover

PBIT interest 

Measures adequacy of debt; measures adequacy of a company’s profit relative to interest payments on its debt.



< 3 is considered low



high level of interest cover is “good” but can be interpreted as a company failing to exploit gearing opportunities to fund its projects

2.3.3

Dividend cover

PAT dividends 

This shows how many times over the profits could a company have paid the dividend. For example, if the dividend cover is 3, this means that the firm's profit attributable to shareholders was three times the amount of dividend paid out.



Dividend cover is a measure of the ability of a company to maintain the level of dividend paid out.



The higher the cover, the better the ability to maintain dividends if profits drop. This need to be looked at in the context of how stable a company's earnings are: a low level of dividend cover might be acceptable in a company with very stable profits, but the same level of cover at company with volatile profits would indicate that dividends are at risk.

2.3.4

Operating gearing

Operating gearing (operational gearing) measures the company’s business risk. Business risk refers to the risk of making only low profits, or even losses, due to nature of the business that the company is involved in. 

Measures the extent to which company’s operating cost are fixed rather than variable.



High fixed costs increase operational gearing.

fixed cost var iable cos t

fixed cost total cos t

contribution (sales - varible COS) PBIT



if contribution is high but PBIT low  fixed cost high



high proportion of fixed cost  high operational gearing



higher operational gearing  higher volatility of PBIT

Illustration

Sales Variable Costs Fixed Costs Operating profit

Company A 5.0 3.0 1.0 1.0

Company B 5.0 1.0 3.0 1.0

What is the level of operating gearing in each and what would be the impact on each of a 10% increase in sales?

11- 10

ACCA F5 Chapter 11 – Performance measurement and control

Solution

Fixed costs/Variable costs

Company A

Company B

1/3 = 0.33

3/1 = 3

Company B carries a higher operating gearing because it has higher fixed costs. Its operating earnings will therefore be more volume-sensitive:

Sales Variable costs Fixed costs PBIT

A $m 5.0 (3.0) (1.0) 1.0

A 10% inc 5.5 (3.3) (1.0) 1.2

B $m 5.0 (1.0) (3.0) 1 .0

B 10% inc 5.5 (1.1) (3.0) 1.4

Firm B has enjoyed an increase in PBIT of 40% whilst Firm A has had an increase of only 20%. In the same way a decrease in sales would bring about a greater fall in B’s earnings than in A’s. 6

Illustration (K 08/09 367)

(a) For each of the two years, calculate the following ratios for T: Gearing Gearing Interest cover Dividend cover

Debt ÷ (Debt + Equity) Debt ÷ Equity PBIT ÷ Finance costs Net profit ÷ Dividends

2010

2011

(b) Suggest reasons why T’s ratios have changed:

ACCA F5 Chapter 11 – Performance measurement and control

11 -11

EXAM TIP If the question asks you to COMMENT ON FINANCIAL PERFORMANCE: 1/ calculate all ratios for profitability, liquidity, working capital and financial risk (or business risk) as stated above for both financial years 2/ present them in a neat table Profitability - ROCE (PBIT/ cap employed) - GPM (gross profit/sales) - NPM (…)

(20/110) x

CY 18% x

(25/110) x

PY 23% x

Liquidity - quick - acid Working capital ratios -

AR days AP days Inventory days …

Financial risk Financial gearing Operational gearing . . . 3/ you can also calculate any changes in receivables/ payables/ sales from PY to CY 4/ COMMENT on each item a/ how it changed b/ why c/ implications

11- 12

ACCA F5 Chapter 11 – Performance measurement and control

NON FINANCIAL PERFORMANCE INDICATORS

3.1

Critical success factors and key performance indicators



A firm’s success usually involves focussing on a small number of critical areas where they must win. These critical success factors (CSFs) vary from business to business but could include, e.g.     

Having a wide range of products that people want. Brand name. Low prices. Quick delivery. Customer satisfaction.



Most of these are best assessed using nonfinancial performance indicators. Financial performance appraisal often reveals the ultimate effect of operational factors and decisions but nonfinancial indicators are needed to monitor causes.



CSFs need to be translated into key performance indicators (KPIs). These are what we can measure and set targets on – in order to achieve the CSFs identified. For example, customer satisfaction could be measured using the following:   

Customer repurchase rate. % cancellation rate within 7 days. % of sales returns due to problems



Again, many KPIs are nonfinancial.

Illustration (K 369)

BAA (the former state owned British Airports Authority) uses regular customer surveys for measuring customer perceptions of a wide variety of service quality attributes, including, the cleanliness of its facilities, the helpfulness of its staff and the ease of finding one’s way around the airport. Public correspondence is also analysed in detail, and comment cards are available in the terminals so that passengers can comment voluntarily on service levels received. Duty terminal managers also sample the services and goods offered by outlets in the terminals, assessing them from a customer perspective. They check the cleanliness and condition of service facilities and complete detailed checklists, which are submitted daily to senior terminal managers. The company has also a wealth of internal monitoring systems that record equipment faults and failures, and report equipment and staff availability. These systems are supported by the terminal managers who circulate the terminals on a fulltime basis, helping customers as necessary, reporting any equipment faults observed and making routine assessments of the level of service provided by BAA and its concessionaires. 

Growing emphasis on NFPIs because: 

Concentration on too few variables – focus only on monetary items  managers ignore other important variables that can not be expressed in monetary terms



Lack of information on quality – traditional responsibility accounting systems fail to provide information on the quality or importance of operations



Changes in cost structures - in modern environment - massive investment and short life cycles. Greater proportion of cost is sunk/ fixed/ designed into products before start of production  therefore during production it is too late to control cost



Changes in competitive environment – financial measures do not provide full picture of company’s performance



Changes in manufacturing environment



NFPIs are better indicator of future prospects – FPIs tend to focus on ST.

ACCA F5 Chapter 11 – Performance measurement and control

11 -13

BALANCED SCORECARD



Approach to performance management that uses both financial and non financial indicators and focuses on 4 different perspectives



Perspectives: 

Financial – how do we create value for our shareholders?

− 

Customer – what is it about us that customers value?

− 

Gives rise to targets that matter to customers: cost, delivery, inspection, handling etc

Internal – what processes must we excel at to achieve our financial and customer objectives?

− 

Covers traditional measures : growth, profitability and shareholder value

Aims to improve internal processes and decision making

Innovation and learning – how can we continue to improve and create future value?

−

Considers the business capacity to maintain its competitive position through the acquisition of new skills and development of new products

Within each of these categories a company should seek to identify series of critical success factors (goals, targets) and key performance indicators. 



Advantages 

Considers both internal and external matters



Considers financial and non financial measures and links them together



It is related to key elements of Co’s strategy

Disadvantages    

11- 14

Selection of measures Obtaining info Information overload Conflict between measures

ACCA F5 Chapter 11 – Performance measurement and control

Illustration (K 08/09 375) Balance score card example

Perspective Financial

Customer Internal Innovation and learning

Critical success factors CSF Cost reduction Asset utilisation Growth Risk management Price Quality Time Operational process After-sales process Employees Technology leadership Manufacturing learning Time to market

KPI

BUILDING BLOCK MODEL



Fitzgerald and Moon



Attempt to overcome problems associated with performance measurement of service businesses



Characteristics of services (that distinguish services from manufacturing)





Intangibility



Simultaneity/inseparability



Perishability



Heterogeneity/ variability



No transfer of ownership

Fitzerald and Moon provide building blocks for standard (KPI), rewards (incentives given to management who achieve standard) and dimensions (sources of cash-flows) for performance measurement systems in service industries.

ACCA F5 Chapter 11 – Performance measurement and control

11 -15



Standards (KPIs) 

Ownership

− − 

Achievability

− 

Standards need to be set high enough (to motivate) but not so high (demotivating )

Equity

− 

Employees should participate in setting budgets  more likely to accept standards, will be motivated  morale is improved Disadvantage: budgetary slack

Rewards

Performance of different business units should not be measured against same standards if some unit has inherent advantage unconnected with their own efforts

Reward structure of performance measurement should guide individual to work towards standards. Three issues to be considered:





Clarity – Co’s objectives must be clearly understood by those whose performance is being appraised



Motivation – individuals should be motivated to work in pursuit of the Co’s strategic objectives (goal clarity and budget participation contribute to motivation)



Controllability – managers should have a certain level of controllability for their areas of responsibility

Dimension Dimensions are critical success factors for the business and suitable measures must be developed to measure each performance dimension. 

Competitive performance – focuses on sales growth, market share and customer base



Financial performance – focuses on profitability, capital structure, liquidity etc



Quality of service – looks at matters like reliability, responsiveness, competence, communication, tidiness, aesthetics etc



Flexibility – has 3 aspects:



−

Right speed of delivery • punctuality is vital, measures - waiting time in queues, late trains • timeliness – is reporting deadline met? – days late

−

Response to customer specifications • Legal advice – tailored 100%, surveys • Mass service – customisation not possible

−

Coping with demand • Mass service – railway - overcrowding • Service shops – queuing • Professional service - overtime worked

Resource utilisation – how efficiently resources are utilised

− − − 11- 16

Measured in terms of productivity – but depends of type of service Accountants: chargeable hours /total man hours Hotels: - rooms occupied/ rooms available ACCA F5 Chapter 11 – Performance measurement and control

− 

Railway: passenger miles/ train miles

Innovation – assessed in terms of innovation process and success of individual innovations

o o

Individual innovation - measured in terms of whether they bring about improvements in the other 5 dimensions Innovating process – can be measured in terms: − How much it costs to develop new service (R&D amount and how quickly it is recovered from new service sales) − How effective the process is (new services/ total services) − How quickly it can develop new service

BEHAVIOURAL AND EXTERNAL CONSIDERATIONS

6.1

Short-termism and manipulation



Performance measures are used to monitor the progress of divisions and business units and may also be used to measure the performance of managers. Achievement of target FPIs may be linked to a reward system in order to motivate managers to improve performance. To be useful reward systems must:  

link reward to effort give regular feedback.



This usually means that reward systems are based on the achievement of short-term, measurable targets agreed with the manager.



However, targets must be selected and interpreted carefully as they can lead to: 

Short-termism •

Where there is bias towards ST rather than LT performance

•

Decisions which involve the sacrifice of LT objectives:

− − − − − 

Manipulation of financial results

• • 

postponing capital expenditure projects to protect ST CF cutting R&D expenditure to save operating cost (but reducing prospects for future product development) reducing quality control (to save operating costs (but affecting reputation and GW) cutting training costs/ recruitment reducing level of customer service

especially if rewards linked to performance changing the timing of capital purchases, speeding/delaying payments /receipts etc

Methods to encourage long-term view 

Making ST targets realistic



Link managers’ rewards to share price



Set mix of quality and financial targets



Capital investment decisions may be reviewed centrally and judged on the basis of net present value (NPV).

ACCA F5 Chapter 11 – Performance measurement and control

11 -17

6.2

Behavioural issues



The purpose of performance measurement is to control and motivate the organisation to improve performance. Care must be taken when designing a performance measurement system to avoid dysfunctional behaviour and demotivation.



Measures designed to assess the performance of a division or its manager should:





provide incentives to promote performance as a division with overall company objectives – goal congruence



only incorporate factors for which the manager (division) can be held responsible (accountable) – motivation



recognise both financial and nonfinancial aspects of performance



recognise longer-term, as well as short-term objectives.

Potential problems with inappropriate measures: 

manipulation of information provided by managers



demotivation and stress-related conflict between a manager, his subordinates and his superiors



excessive concern for control of short-term costs, possibly at the expense of longer term profitability

6.3

External considerations



Performance measures need to be considered in the context of the environment external to the business to gain a full understanding of how the business has performed and to develop actions which should be taken to improve performance. External considerations which are particularly important are:   

stakeholders market conditions competitors.

Stakeholders 

Stakeholders are groups of people who have legitimate interest in the activities of Co



Types:   



Internal (employees, management ) Connected (shareholders, customers, suppliers, financiers) External (community, government, pressure groups, tax authorities)

Stakeholders’ objectives/ interest: 

Internal:

− −

11- 18

Continuation and growth of Co Individual interests (jobs, money, promotion, safe working conditions)

ACCA F5 Chapter 11 – Performance measurement and control



Connected:

− − − − 

External:

− − 

Shareholders (corporate str)– increase in SH wealth (measured by profitability, P/E, dividends etc) Bankers (CF)– security of loan, adherence to loan agreements Suppliers (purchase str) – profitable sales, payments of goods, LT relationship Customers (product str) – goods as promised, future benefits

Government – jobs, training, tax Pressure groups, charities, society – pollution, rights, other

Performance measures 

Stakeholders will have different objectives and companies may deal with this by having a range of performance measures. Performance required by different stakeholders may conflict, and therefore the company may adopt an approach of satisfactory performance in each area rather than optimising profit at the expense of other objectives.

  

Employees – morale index Shareholders – share price, dividend yield Government - % of products conforming to environmental regulations

Market conditions/ Economic environment 

Economic growth  



Local economic trends    



Local business rationalising/ expanding? Office rents up/ down? House prices? Labour rates

Inflation   



Growth/ recession? How demand is affected?

High rate – difficult to plan, uncertainty in future financial returns? Rate encouraging investment in domestic industries? High rate //> increase in wages?

Interest rates 

Is cost of borrowing increasing  impact on profitability?



FX rates



Government fiscal policy  



Impact of tax policies on Co How VAT affects demand

Government spending – for company that acts as supplier of government

ACCA F5 Chapter 11 – Performance measurement and control

11 -19

11- 20

ACCA F5 Chapter 11 â&#x20AC;&#x201C; Performance measurement and control

Chapter 12 – DIVISIONAL PERFORMANCE AND TRANSFER PRICING SYLLABUS OBJECTIVES E

PERFORMANCE MEASUREMENT AND CONTROL

Divisional performance and transfer pricing

Explain the basis for setting a transfer price using variable cost, full cost and the principles behind allowing for intermediate markets.[2]

Explain how transfer prices can distort the performance assessment of divisions and decisions made.[2]

Explain the meaning of, and calculate, Return on Investment (ROI) and Residual Income (RI), and discuss their shortcomings.[2]

Compare divisional performance and recognise the problems of doing so

OVERVIEW

ACCA F5 Chapter 12 – Divisional performance and transfer pricing

12-1

DIVISIONALISATION



Large organisations can be structured 

Functionally (by activities – production, sales, research)



Divisionally (split into divisions by products/services – and then within division functionally)



Divisional structure will lead to decentralisation of decision making process



Advantages of divisionalisation 

Quality of decisions improved (as divisional managers have local knowledge)



Decisions taken more quickly (as info does not have to pass to/ from top management)



Divisional managers are motivated more (as they have an authority to act)



Top management is freed up from detailed involvement in day to day operations



Divisions provide training grounds for future members of top management

Disadvantages





Co is divided into number of self interested segments  decisions taken are in interest of one division but might be conflicting with interests of others  dysfunctional decision making

−

How to prevent it - Some centralised authority must be maintained to ensure that all divisions are working towards same objective  goal congruence



Cost of activities that are common to all divisions (running acc dept) might be greater



Top management , by delegating decision making to divisional managers, may lose control

1.1

Responsibility accounting



Creation of divisions allows for operation of responsibility accounting.



With responsibility accounting, there are 3 types of responsibility centres (depending on decentralisation level)   

Cost centre Profit centre Investment centre

Type of resp. centre Cost centre

Manager has control over… - Controllable cost

Profit centre

- Controllable cost and Sales prices - No authority to alter level of investment

Investment centre

- Controllable cost and Sales prices - Output volumes - Investment in non current assets and WC

Performance measures - total cost - cost variances - cost per unit and other ratios - NFPIs – quality, productivity... All above PLUS: -sales, sales variance - profit, margins - Market share - NFPIs relating to customer satisfaction All above PLUS: Return on investment (ROI) – see below Residual income (RI) – see below Other financial ratios

Managers / centres performance must be assessed on controllable factors only  manager of cost centre should only be assessed on controllable cost



12-2

ACCA F5 Chapter 12 – Divisional performance and transfer pricing

RETURN ON INVESTMENT (ROI)



ROI = Profit/ capital invested 

PBIT – after depreciation but before interest - but see discussion below



Capital invested – non current assets + WC – but see discussion below



Average values preferred to YE values

2.1

Measuring ROI – what asset base?



Profit after depreciation/ net assets (NBV) 

Problem 1: If constant annual profit and same assets (without policy of regular replacement)  ROI will give false impression of improving performance over time  therefore there might be disincentive to reinvest in new assets as ROI would fall



Problem 2: Performance of 2 divisions can not be compared (for same reasons as above  if D1 has new assets and D2 has worn assets and they have same profits and same assets at cost, ROI D2 will be much higher than ROI D1)



But this approach is widely used

− − 

Profit after depreciation/ gross assets (costs) 

Removes Problem 1 and 2 above (relating to NBV) but:



Ignores age factor – does not distinguish btw old and new assets:

− − 

Normally accepted method of calculating ROI Cos are continually buying new non current assets to replace old ones, so total NBV will remain fairly constant

Older assets cost more to repair/ maintain – so in future profitability might be reduced as assets get older Inflation and technological change alter the cost of non current assets – quantity and technological character of non current assets might be very different

What to include in asset base? 

If manager’s performance assessed → only assets which can be traced directly the division and are controllable by manager



If division performance assessed  proportion of investment in head office assets need to be included (because division could not operate without support of head office)



Problem: if managers’ large bonus depends on ROI, they can alter asset base (increase payables, decrease receivables…)

2.2

Measuring ROI – what profit base?



If division manager assessed  profit should be based on revenues and cost controllable by manager (therefore service and head office costs except for those directly attributable to division should be excluded)



If division is assessed – inclusion of general service and head office

ACCA F5 Chapter 12 – Divisional performance an transfer pricing

12- 3

2.3

ROI and new investment



If divisions are judged by ROI, new investment will be accepted only if it increases total ROI of divisions



It leads to rejecting investments which are beneficial for group (as they have ROI > cost of capital and therefore produce positive NPV) if investment ROI < division ROI



Therefore ROI should not be used to guide investment decisions, but there is motivational problem (good investment decisions would make managers performance seem worse)

2.4

ROI – advantages and disadvantages summary



Advantages 

It is widely used and accepted.



As a relative measure it enables comparisons to be made with divisions or companies of different sizes.



It can be broken down into secondary ratios for more detailed analysis.

Disadvantages



12-4



It may lead to dysfunctional decision making, e.g. a division with a current ROI of 30% would not wish to accept a project offering an ROI of 25%, as this would dilute its current figure.



Different accounting policies can confuse comparisons (e.g. depreciation policy)



ROI increases with age of asset if NBVs are used, thus giving managers an incentive to hang on to possibly inefficient, obsolescent assets.



May encourage manipulation of profit and asset base figures.

ACCA F5 Chapter 12 – Divisional performance and transfer pricing

RESIDUAL INCOME (RI)



Measure of profits of division after deducting notional interest cost (PBIT – notional interest on capital)

Illustration (K 398)

An investment centre has net assets of $800,000, and made profits before interest of $160,000. The notional cost of capital is 12%. If performance is measured by RI, the RI for the period is: 1

Solution

Profit before interest Notional interest (12% × $800,000) RI

160,000 96,000 64,000



Investment centre managers who make investment decisions on the basis of short-term performance will want to undertake any investments that add to RI.

3.1

Advantages and weaknesses of RI compared to ROI



Advantages





It encourages investment centre managers to make new investments if they add to RI. A new investment might add to RI but reduce ROI. In such a situation, measuring performance by RI would reduce the probability of dysfunctional behaviour.



Making a specific charge for interest helps to make investment centre managers more aware of the cost of the assets under their control. (more flexible – different cost of capital can be applied to investment with different risk)



The notional interest charge might be a reasonably good measure of the economic cost of the capital employed in the investment centre. (In contrast ROI has no real significance in financial or economic terms.)

Disadvantages 

It does not facilitate comparisons between divisions.



It does not relate the size of a division’s profit to the assets employed in order to obtain that profit.



It is based on accounting measures of profit and CE which may be subject to manipulation.

3.2

RI vs ROI – marginally profitable investments



Under RI: Marginally profitable investments (RI>0) will be undertaken (as they increases divisional RI)



Under ROI: profitable investments (RI>0) might not be undertaken (if ROI of new investment < ROI of division)

ACCA F5 Chapter 12 – Divisional performance an transfer pricing

12- 5

Illustration (K 399)

Investment centre has net assets of $800,000, made profits before interest of $160,000. The notional cost of capital is 12%. An opportunity has arisen to invest in a new project costing $100,000. The project would have a four year life, and would make cash profits of $40,000 each year. Required: (a) What would be the average ROI with and without the investment? Would the investment centre manager wish to undertake the investment if performance is judged on ROI in Year 1? (b) What would be the average annual RI with and without the investment? Would the investment centre manager wish to undertake the investment if performance is judged on RI in Year 1? To calculate ROI and RI, use the value for capital employed as at the start of Year 1. 2

Solution

Exam tip: Questions will focus on behavioural aspects of investment centre measurement: 

why it is considered necessary to use RI to measure performance rather than ROI



why RI might influence manager’s investment decision differently etc

12-6

ACCA F5 Chapter 12 – Divisional performance and transfer pricing

COMPARING DIVISIONAL PERFORMANCE

ROI and RI are common methods but other methods could be used: 

Variance analysis – is a standard means of monitoring and controlling performance. Care must be taken in identifying the controllability of, and responsibility for, each variance.



Ratio analysis – there are several profitability and liquidity measures that can be applied to divisional performance reports.



Other management ratios – under this heading would come contribution per key factor and sales per employee or square foot as well as industry specific ratios such as transport costs per mile, brewing costs per barrel, overheads per chargeable hour, etc. The role of NFPIs is often key here.



Other information – such as staff turnover, market share, new customers gained, innovative product developed.

Problems involved in comparing divisional performance 

Divisions may operate in different environments. A division earning ROI of 10% when the industry average is 7% may be considered to be performing better than division earning ROI of 12% when the industry average is 15%.



The transfer pricing policy may distort divisional performance.



Divisions may have assets of different ages. A division earning a high ROI may do so because assets are old and fully depreciated. This may give a poor indication of future potential performance.



There may be difficulties comparing divisions with different accounting policies (e.g. depreciation).



Evaluating performance on the basis of a few indicators may lead to manipulation of data. A wider range of indicators may be preferable which include nonfinancial measures. It may be difficult to find nonfinancial indicators which can easily be compared if divisions operate in different environments.

ACCA F5 Chapter 12 – Divisional performance an transfer pricing

12- 7

TRANSFER PRICING



Transfer price - price at which goods/ services are transferred from one division to another within the same organisation. The transfer price represents ‘revenue per unit’ to the profit centre ‘selling’ the good/service and ‘cost per unit’ to the profit centre ‘buying’ the good/service.



Transfer pricing is purely an internal bookkeeping exercise, which does not affect the overall profitability of the organisation; transfer sales of D 1 will cancel with purchases of D2, but transfer price spreads the total profit between D1 and D2.

5.1

Objectives of transfer pricing



Goal congruence - The decisions made by each profit centre manager should be consistent with the objectives of the organisation as a whole. A common feature of exam questions is that a transfer price is set that does result in suboptimal behaviour.



Performance measurement - The performance of each division should be capable of being assessed and a good transfer price would enable each centre to be evaluated on the basis of profit.



Autonomy - The system used to set transfer prices should seek to maintain the autonomy of profit centre managers. If autonomy is maintained, managers tend to be more highly motivated but suboptimal decisions may be made.



Minimising the global tax liability - When a divisionalised company operates entirely within one tax regime the transfer pricing policy will have a minimal impact on the corporate tax bill. However multinational companies can and do use their transfer pricing policies to move profits around the world and thereby minimise their global tax liabilities.



Recording of movement of goods and services - In practice, an extremely important function of the transfer pricing system is simply to assist in recording the movement of goods and services.



Fair allocation of profits between divisions - Most of the advantages claimed for divisionalisation are behavioural. Insofar as transfer pricing has a material effect on divisional profit it is essential that managers perceive the allocation of corporate profit as being fair if the motivational benefits are to be retained.

A number of these objectives can conflict with each other, and prove difficult to achieve in practice. It is highly unlikely that any one method would meet all the firm’s requirements in all circumstances; the best that can be hoped for

5.2

Theoretical transfer pricing



Limits within which transfer price should fall are: 

Minimum – marginal cost + opportunity cost



Maximum – lower of:

− −

lowest market price at which the receiving division could purchase goods externally selling price less marginal cost of receiving division

Opportunity cost





Maximum contribution forgone by supplying division in transferring internally



Contribution forgone by not using same facilities for their next best alternative use

If there is no external market and no alternative use of facilities  transfer price = standard variable cost If there is external market and no alternative (more profitable) use of facilities  transfer price = market price

12-8

ACCA F5 Chapter 12 – Divisional performance and transfer pricing

Illustration - TP range – no external market for product (based on article 10/09 – Ken Garret)

Market for intermediate product does not exist and composition of cost, mark-up, transfer price is as follows: Transfer-in price Own cost - var Own cost - fix Divisional profit Transfer-out/ Final sale price 

MIN TP (fixed by selling div): For Div A, TP must be >= to VAR(A) – to make a contribution

− 



MIN TP = 18$

MAX TP (fixed by receiving div): For Div B, TP + VAR(B) <= selling price (selling price must cover all variable cost of B; total variable cost of B = TP+VAR (B)

− −



Div B ($) 50 10 10 20 90 -- outside customers

Rules on TPs are necessary to get Div A and Div B to trade with one another: 



Div A ($) 18 12 20 50

MAX TP = $90-$10 = $80 It is said that TP<= net marginal revenue (=revenue – VAR(B))

TP= $50 is in range <18,80> and therefore it will work

This rule will permit interdivisional market happen AND give correct economic decision for the group (as if selling price will be too low for the group to make positive contribution, no operative TP is available) 

If selling price = $25  MIN TP >= $18, MAX TP <= $25-$10=$15  no TP is available.



If selling price = $29 -> MIN TP >=$18, MAX TP <= $29-$10 = $19  TP for e.g. $18.50 available

Goal congruence: Head office needs to impose TP in appropriate range, confident that both divisions will choose to act in a way that maximises group profit. Head office gives each division impression of making autonomous decisions, but in reality each division has been manipulated into making choices head office wants.

ACCA F5 Chapter 12 – Divisional performance an transfer pricing

12- 9

Illustration - TP range – external market for product (based on article 10/09 – Ken Garret)

Market for intermediate product exists and composition of cost, mark-up, transfer price is as follows: Transfer-in price Own cost - var Own cost - fix Divisional profit Transfer-out/ Final sale price

Div A ($) 18 12 20 50

Div B ($) 50 10 10 20 90 -- outside customers

Product can be sold to or bought from a market at 40$





Div A wants to transfer to div B (at 50$) rather then sell externally at $40



Div B wants to buy externally at 40$ rather then from div A at $50



Impact for group  if div B buys externally at 40$, VAR (group) = VAR (A)+VAR (B) +additional VAR (B) = 18$+40$+10$ = 68$. If div B buys internally from A, VAR (group) = $18+$10=$28



Therefore TP must be <= market price



At the same time TP must be <= selling price less additional VAR (B).

Product can be sold to or bought from a market at 60$





Div A wants to sell externally (60$) rather then transfer to div B (at 50$)



Div B wants to buy from div A (at 50$) rather then externally (at $60).



If div A has limited capacity, then all div A output is sold externally and div B must buy externally at 60$



Impact for group  if div B buys externally at 60$, VAR (group) = VAR (A)+VAR (B) +additional VAR (B) = 18$+60$+10$ = 88$. If div B buys internally from A, VAR (group) = $18+$10=$28.



Therefore div A must be encouraged to sell to div B  TP must be high enough to compensate div A for contribution lost by selling internally.



Minimum TP = $18+($60-$18) = $60

BUT where exactly to set TP? Where are the problems?





Performance of divisions: The higher TP, the more profitable div A is and the less profitable div B is



Range derived above is dynamic (as variables and selling price are not constant)

5.3

Practical approaches to transfer pricing



In the real word transfer prices are set using the following techniques: 

Production cost

− −

12-10

Variable Full cost, full cost plus, variable cost plus



Market prices.



Negotiation.

ACCA F5 Chapter 12 – Divisional performance and transfer pricing

5.3.1

Variable cost of transferring division



Advantage: Produces very good economic decision





Because VAR (group) = total VAR (B)



TP=$18, total VAR (B) = 18$+10$ = 28$, VAR (group) = 28$



Goal congruence between div B ‘s wish to maximise its profit and group maximising its profit. If revenue exceeds total VAR (B), it will do so for the group.

Disadvantages: 

Div A will make loss as its fixed cost can not be covered  de-motivating



Performance measurement is distorted



No incentive or iv A to be efficient if all marginal cost are covered by TP (inefficiencies will be passed to div B)  USE STANDARD VAR!!!!

5.3.2

Cost based transfer prices - Full cost/ full cost plus/ variable cost plus



If there is no market price then the transfer price is based on cost. It should be based on standard cost rather than actual cost (transfer price based on actual cost would give the transferring division no incentive to control costs as any cost overrun could be passed to the buying division)



Based on full cost (including fixed OH absorbed) – but transferring division makes no profit and dysfunctional decision making



Based on full cost plus – some profit margin included in transfer price and dysfunctional decision making



Based on variable cost – transferring division does not cover fixed costs but perfect decision making

Lets suppose T is set at level of full cost of transferring division: Transfer-in price Own cost - var Own cost - fix Divisional profit Transfer-out/ Final sale price

Div A ($) 18 12 0 30

Div B ($) 30 10 10 40 90 -- outside customers



Div A covers full cost (breakeven)



Disadvantage: it leads to dysfunctional decisions because VAR (group) < total VAR (B) - div B can make decision that maximises its profit but not maximises group profit: 

Selling price = $35, div B will not trade as $35 does not cover VAR (B) = 30+10=40$. However, from a group perspective, VAR (group) = $18+$10 = $28 and positive contribution would be made.

PROBLEM: TP based on full cost, var cost plus, full cost plus and market price result in fixed cost and profit being perceived as variable cost in div B. Therefore div B has wrong data to enable it to make good economic decisions for the group. Once you get away from TP = VAR (A), there is always risk of dysfunctional decisions.

ACCA F5 Chapter 12 – Divisional performance an transfer pricing

12-11

5.3.3

Market prices



Advantage: It is often seen as the optimum transfer price as all managers concerned will view it as fair; not based on arbitrary mark-ups.



Problems with market based transfer prices 

Dysfunctional decision making (see above)



No intermediate market price – product/ service might not be readily available on the open market (an example might be a partly completed car being transferred from one division to another).



Market price might not be independent - it would occur if the transferring division was in the position of a monopolist both within the company and in the outside market.



Difficulty in agreeing a source of market prices - Debates will occur over the size, quality, timing and location of internal transfers compared with a range of published prices.



The need to adjust prices for different volumes - Prices quoted may well not relate to the levels of transfers that are likely to take place. In the same way, the extent of reductions due to saved selling costs will be difficult to estimate.



Published prices may be fictitious - This is variation on previous problem but is typified by those products for which it is customary for seller to publish price, then the buyer to negotiate a lower figure.

5.4

Transfer pricing and dysfunctional decision making



Transfer price based on absorbed total cost can lead to dysfunctional behaviour in the buying division. This is because, although the total cost is made up of fixed and variable cost elements relating to the supplying division, the transfer price per unit is regarded by the receiving division manager as variable.



In situations where the receiving division has spare production capacity, the manager may make the decision not to accept business at a lower selling price than usual, because it would apparently not make a profit or even a contribution for that division. However, for the company as a whole, the special price does exceed total variable costs and in the short-term it would be worthwhile to accept the business.



There are two approaches which preserves economic info inherent in variable cost while permitting div A to make profits and allowing better performance evaluation 

Variable cost plus lump sum

− − − − 

Two-part pricing (dual pricing)

− − − −

12-12

Transfers are made at VAR (A) Periodically transfer is made between A and B to account for fixed cost and profit (lump sum is linked to value of goods transferred) Div B has correct cumulative VAR cost data to make good decisions Lump sum transfers allow divisions to be treated fairly in respects to performance measurement

Div A transfers out at cost plus mark-up Div B transfers in at VAR (A) Divisional current accounts do not agree, period end adjustment needed Div A makes motivational profit, div B has good economic data about cumulative group variable cost.

ACCA F5 Chapter 12 – Divisional performance and transfer pricing

Illustration (K 403)

A company operates two divisions, Able and Baker. Able manufactures two products, X and Y. Product X is sold to external customers for $42 per unit. The only outlet for product Y is Baker. Baker supplies an external market and can obtain its semi-finished supplies (product Y) from either Able or an external source. Baker currently has the opportunity to purchase product Y from an external supplier for $38 per unit. The capacity of division Able is measured in units of output, irrespective of whether product X, Y or a combination of both are being manufactured. The associated product costs are as follows:

Variable costs per unit Fixed overheads per unit Total unit costs

X $ 32 5 37

Y $ 35 5 40

Using the above information, advise on the determination of an appropriate transfer price for the sale of product Y from division Able to division Baker under the following conditions: (i) when division Able has spare capacity and limited external demand for product X (ii) when division Able is operating at full capacity with unsatisfied external demand for product X. 5

Solution

ACCA F5 Chapter 12 â&#x20AC;&#x201C; Divisional performance an transfer pricing

12-13

Illustration (K 407)

Manuco Ltd has been offered supplies of special ingredient Z at a transfer price of $15 per kg by Helpco Ltd, which is part of the same group of companies. Helpco Ltd processes and sells special ingredient Z to customers external to the group at $15 per kg. Helpco Ltd bases its transfer price on total cost plus 25% profit mark-up. Total cost has been estimated as 75% variable and 25% fixed. Discuss the transfer prices at which Helpco Ltd should offer to transfer special ingredient Z to Manuco Ltd in order that group profit maximising decisions may be taken on financial grounds in each of the following situations: (i) Helpco Ltd has an external market for all its production of special ingredient Z at a selling price of $15 per kg. Internal transfers to Manuco Ltd would enable $1.50 per kg of variable packing cost to be avoided. (ii) Conditions are as per (i) but Helpco Ltd has production capacity for 3,000kg of special ingredient Z for which no external market is available. (iii) Conditions are as per (ii) but Helpco Ltd has an alternative use for some of its spare production capacity. This alternative use is equivalent to 2,000kg of special ingredient Z and would earn a contribution of $6,000. 6

Solution

12-14

ACCA F5 Chapter 12 â&#x20AC;&#x201C; Divisional performance and transfer pricing

Illustration (K 08/09 424)

Kwaree Inc, producing a range of minerals, is organised into two trading groups â&#x20AC;&#x201C; one group handles wholesale business and the other deals with sales to retailers. One of its products is a moulding clay. The wholesale group extracts the clay and sells it to external wholesale customers as well as to the retail group. The production capacity is 2,000 tonnes per month, but at present sales are limited to 1,000 tonnes wholesale and 600 tonnes retail. The transfer price agreed is $180 per tonne, in line with the existing external wholesale trade price. The retail group produces 100 bags of refined clay from each tonne of moulding clay, which it sells at $4 per bag. It would sell a further 40,000 bags if the retail trade price were reduced to $3.20 per bag. Other data relevant to the operation: Wholesale group Variable cost per tonne $70 Fixed cost per month $100,000

Retail group $60 $40,000

You are required to prepare estimated profit statements for the current month for each group and for Kwaree Inc as a whole when producing at: (a) 80% capacity (b) 100% capacity, utilising the extra sales to supply the retail trade. Comment on your results. 7

Solution (K 08/09 424)

ACCA F5 Chapter 12 â&#x20AC;&#x201C; Divisional performance an transfer pricing

12-15

12-16

ACCA F5 Chapter 12 â&#x20AC;&#x201C; Divisional performance and transfer pricing

Chapter 13 – PERFORMANCE MEASUREMENT IN NFPO SYLLABUS OBJECTIVE E

PERFORMANCE MEASUREMENT AND CONTROL

Performance analysis in non-for-profit organisations and the public sector

Comment on the problems of having non-quantifiable objectives in performance management.[2]

Explain how performance could be measured in these sectors.[2]

Comment on the problems of having multiple objectives in these sectors.[2]

Outline Value for Money (VFM) as a public sector objective.[1]

OVERVIEW

ACCA F5 Chapter 13 – Performance measurement in NFPO

13-1

THE PROBLEM OF NON-QUANTIFIABLE OBJECTIVES



The not-for-profit sector incorporates a diverse range of operations (national government, local government, charities, executive agencies, trusts etc). The critical thing about such operations is that they are not motivated by a desire to maximise profit.



Many of the benefits arising from expenditure are non-quantifiable (certainly not in monetary terms, e.g. social welfare). The same can be true of costs. So any cost/benefit analysis is necessarily quite judgemental, i.e. social benefits versus social costs as well as financial benefits versus financial costs. The danger is that if benefits cannot be quantified, then they might be ignored.



Another problem is that these organisations often do not generate revenue but have a fixed budget for spending within which they have to keep (i.e. a capital rationing problem). Value for money (‘VFM’) is often quoted as an objective here but it does not get round the problem of measuring ‘value’.

Illustration (K 416)

A hospital might use a cheaper cleaning firm because of difficulties evaluating how well the cleaning is being done. This may create problems in many areas:

− − −

It may indirectly lead to the spread of infection which is costly to eliminate. Nursing staff may become demotivated as they are unable to carry out their own work effectively. The general public may lose confidence in the quality of the service.

PERFORMANCE MEASUREMENT IN NFPO

Not-for-profit organisations may have some non-quantifiable objectives but that fact does not exempt them from the need to plan and control their activities. 2

Illustration (K417)

University is an example of a NFPO whose objectives include the provision of a VFM service. The costs of the service must be compared with budgets but other performance indicators may be used in total for the establishment and within each faculty/department. These measures include: Overall:



− − − − −

Faculty:



− − − − − − − −

13-2

numbers of students amount of research funding received proportion of successful students (by grade) quality of teaching – as measured by student and inspector assessments number of publications by staff.

cost per student cost per examination pass number of library books per student average age of library books. availability of learning resources, e.g. personal computer (PC) staff/student ratio students per class number of teaching hours per member of staff

ACCA F5 Chapter 13 – Performance measurement in NFPO

THE PROBLEM OF MULTIPLE OBJECTIVES



Multiple stakeholders in NFPOs give rise to multiple objectives so there is a need to prioritise/compromise.



Objectives may:



be difficult to define



change as a result of the political process



be achievable in different ways.

Illustration (K 08/09 – 441) – Performance measurement in NFPO

A museum may have the following objectives:

− − −

Educating the public. Research. Preservation and restoration.

One possible conflict here could arise if the decision to charge an entry fee were considered. This would raise funds for research but discourage potential visitors.

Illustration (K419)

Describe the different groups of stakeholders in an international famine relief charity. Explain how the charity may have conflicting objectives and the impact this may have on the effective operation of the organisation. 4

Solution

The stakeholders will include donors, people needing aid, voluntary staff, paid staff, the governments of the countries granting and receiving aid. There may be conflicting objectives. Donors and people needing aid will want all of the funds to be spent on famine relief. Management staff may require a percentage of the funds to be spent on administration and promotion in order to safeguard the long-term future of the charity. Donors may have their own views on how donations should be spent which conflict with management staff. The charity may wish to distribute aid according to perceived need. Governments in receiving countries may have political reasons for distorting information relating to need. These conflicts may make it difficult to set clear objectives on which all stakeholders agree.

ACCA F5 Chapter 13 –Performance measurement in NFPO

13-3

VALUE FOR MONEY (VFM)

4.1

VFM as objective



DEF: achieving the desired level and quality of service at the most economical cost



NFPO best serve society’s interest when the gap btw the benefits they provide and the cost of providing those benefits is the greatest. This is termed VFM and it is not dissimilar from the concept of profit maximisation, apart from the fact that society’s interest are being maximised rather than profit.



VFM is important concept because NFPO:

− − − − 4.2

often use public funds raised through taxation or donation do not produce financial results such as profit figures have no clear priority of objectives face an increasing demand for accountability.

Measuring VFM

Assessing whether the organisation provides value for money involves looking at the functioning of all aspects of the system. Performance measures have been developed to permit evaluation of each part separately.



Economy: Minimising the costs of inputs required to achieve a defined level of output.



Efficiency: Ratio of outputs to inputs – achieving a high level of output in relation to the resources put in (input driven) or providing a particular level of service at reasonable input cost (output-driven).



Effectiveness: Whether outputs are achieved that match the predetermined objectives (extent to which declared objectives are met)

13-4

ACCA F5 Chapter 13 – Performance measurement in NFPO

4.3

Problems with measuring of VFM

VFM as concept assumes there is a yardstick against which to measure the achievement of objectives. But: 

NFP tend to have multiple objectives (even if they all an be clearly identified it is impossible to say which is overriding objective)



Outputs can seldom be measured in a way that is generally agreed to be meaningful (are good exam results alone adequate measure of quality of teaching?)

Possible solutions: 

Performance can be judged in terms of inputs



Accept that performance measurement must to some extent be subjective. Judgement can be made by experts



Comparison against others, against historical results, unit cost measurements (cost of patient day)

Illustration ( K 08/09 – 441) – problem of multiple objectives

Many UK local authorities in the 1970s were judged to be making an inefficient use of the resources available to them. They undertook most of their activities (e.g. council house maintenance, road repairs, maintenance of parks and gardens, etc.) using large numbers of direct council employees. It was often found that the use of obsolete equipment and inefficient working practices (strict job demarcation was widespread) resulted in the operation involving excessive costs. Financial management initiatives in the 1980s required local authorities to put much of their activities ‘out to tender’. Private contractors submit bids in order to undertake programmes of work for the local authorities. If councils retain a direct works department, then that department has to bid in competition with private contractors for most available work.

Illustration (K 420)

A local authority may have ‘maintaining an acceptable quality of life for elderly residents’ as one of its objectives. It has several means, by which it may achieve this objective, including: • providing ‘meals on wheels’ (Social Services Department) • providing a mobile library (Libraries Department) • maintaining access to and facilities in local parks (Parks Department) • providing police support to the elderly at home (Police Department) • providing nursing homes (Housing Department). Explain how the local authority would determine whether the service was effective in providing VFM. 6

Solution

All of these departmental activities contribute to achievement of the objective. The problem is to find the optimum combination of spending for each of the departments. Many elderly people continue to live in their own homes, but are just on the threshold of requiring accommodation in a nursing home. A small cutback in spending in one area (e.g. the withdrawal of a mobile library) may push a lot of elderly people over that threshold. There is then an enormous demand for extra spending by the Housing Department. Nursing home accommodation is an expensive last resort in caring for the elderly. An occasional visit by a care worker or a police officer may enable many elderly people to stay in their own homes for much longer than would otherwise be the case. The key to effectiveness is in finding an optimum pattern of spending to achieve a given objective in providing VFM.

ACCA F5 Chapter 13 –Performance measurement in NFPO

13-5

13-6

ACCA F5 Chapter 13 â&#x20AC;&#x201C; Performance measurement in NFPO

Chapter 14 – SOLUTION CHAPTER 1 – ADVANCED COSTING METHODS ABC 1

Illustration ABC

A company manufactures two products, P and Q. Monthly data relating to production and sales are as follows.

Direct material cost per unit Direct labour hours per unit Direct labour cost per unit Sales demand

Product P

Product Q

$15 1 hour $20 100 units

$20 2 hours $40 950 units

Total cost $ 20,000 80,000 20,000 20,000 60,000 200,000

Cost driver

Total

Number of setups Machine hours Number of orders Number of inspections Engineering hours

4 2,000 4 5 1,000

1 100 1 1 500

3 1,900 3 4 500

Calculate the costs, in total and per unit, for Product P and Q, using absorption costing and ABC. 1

Solution

ABC Steps 1-4 already done for us. Step 5 – calculate the overhead costs for products - we have to calculate for eg: a/ how much it costs to proceed 1 order (OH cost per unit of cost driver) b/ allocate „ordering overheads“ among products (based on number of orders for individual products) Activity Setting up Machining Order handling Quality control Engineering

Total cost $ 20,000 80,000 20,000 20,000 60,000 200,000

Cost driver

Total

# of setups Machine hrs # of orders # of inspections Engin. hrs

4 2,000 4 5 1,000

1 100 1 1 500

3 1,900 3 4 500

OH cost per unit of cost driver 20,000/4=5,000 8,000/2,000=40 20,000/4=5,000 60,000/1000=60

P 5,000x1=5,000 40x100=4,000 5,000x1=5,000 4,000x1=4,000 60x500=30,000 48,000

Q 15,000 76,000 15,000 16,000 30,000 152,000

ABC cost card (cost per unit of product/service) material labour overheads

P 15 20 (48,000/100)=480 515

ACCA F5 Chapter 14 – Solution

Q 20 40 (152,000/950) = 160 220

14- 1

ABSORPTION COSTING Overhead absorption rate (OAR) =

total.overheads 200,000 = = 100$ / labour.hr direct.labour.hours 2,000 *

*1hr x 100 units + 2 hr x 950 units = 2,000 hrs Absorption costing cost card

P 15 20 1x100=100 135

material labour overheads

Q 20 40 2x100=200 260

CONCLUSION Products that are produced in small volumes tend to be undercharged by overheads under absorption costing. 2

Illustration (K 14) ABC

Annual production and sales Direct labour hours per unit Number of orders Number of batches Number of setups per batch Special parts per unit

Doubleplus 24,000 units 1.5 140 240 3 4

Information relating to production overhead costs is as follows: Activity

Cost driver

Setup costs Special parts handling Other materials handling Order handling Other overheads

Number of setups Number of special parts Number of batches Number of orders

Annual cost $ 73,200 60,000 63,000 19,800 216,000 432,000

Other overhead costs do not have an identifiable cost driver, and in an ABC system, these overheads would be recovered on a direct labour hour’s basis. (a) Calculate the production cost per unit of Plus and of Doubleplus if the company uses traditional absorption costing and the overheads are recovered on a direct labour hours basis. (b) Calculate the production cost per unit of Plus and of Doubleplus if the company uses ABC. 2

Solution

(a) Absorption costing Workings (OAR) Budgeted overhead costs Budgeted direct labour hours (24,000 × 1.0) + (24,000 × 1.5) OAR = (432,000$/60,000 )= Cost card: Direct costs OH absorbed Full production cosi 14 - 2

(7.2x1)

Plus ($) 12.00 7.20 19.20

(7.2x1.5)

$432,000 60,000 $7.20 Doubleplus I($) 24.00 10.80 34.80 ACCA F5 Chapter 14 – Solution

(b) ABC 1. COST DRIVERS

Plus Doubleplus 12 240 (12x1) 12 (3x240) 720 (24,000x1) 24,000 (24,000x4) 96,000 10 140 24,000 (24,000x1.5) 36,000

Batches Setups Special parts Orders Direct labour hours

Total 252 732 120,000 150 60,000

2. Cost driver rates Activity

Cost driver

Setup costs Special parts handling Other materials handling Order handling Other overheads

Number of setups Number of special parts Number of batches Number of orders

3. Allocation of OH Activity

Cost driver

Cost $

Setup costs Parts handling Other mat. handli Order handling Other overheads

No of setups No of parts No of batches N0 of orders

73,200 60,000 63,000 19,800 216,000

Annual cost $ 73,200 60,000 63,000 19,800 216,000 432,000

$73,200/732 $60,000/120,000 $63,000/252 $19,800/150 $216,000/60,000

432,000

4. Cost card under aABC Direct cost Overheads cost per unit Full cost under ABC SUMMARY Using traditional absoprtion costing Using ABC Assume the selling prices are Using absorption costing sales margins are ABC sales margins are

ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

Plus $ 12.00 4.33 16.33

Cost driver rate $73,200/732 $60,000/120,000 $63,000/252 $19,800/150 $216,000/60,000

$100 per setup $0.50 per part $250 per batch $132 per order $3.60 per hour

Cost driver rate $100 per setup $0.50 per part $250 per batch $132 per order $3.60 per hour

Plus

Doubleplus

(12x100$)=1,200 (0.5$x24,000)=12,000 (250$x12) =3,000 (132$x10)=1,320 (3.6$x24,000) 86,400

# of units OH per unit

103,920 24,000 4.33

(720x100$)=72,000 (0.5$x96,000)=48,000 (250$x240)=60,000 (132$x140)=18,480 (3.60$x24,000x1.5)= 129,600 328,080 24,000 13.67

Doubleplus $ 24.00 13.67 37.67 Plus $19.20 $16.33 $25.00 23.2% 34.7%

Doubleplus $34.80 $37.67 $40.00 13.0% 5.8%

14 - 3

Illustration ABC

A manufacturing business makes a product in two models, model M1 and model M2:

Setup costs Material handling costs Special part handling costs Customer invoicing costs Overhead analysis

97,600 42,000 50,000 31,000 108,000 328,600

Model M1

Model M2

8,000 units 60 $54 $11 2.0 hours $8 2 2,000 units 1 1

8,000 units 250 $73 $21 2.5 hours $8 8 100 units 3 1

Cost driver Number of setups Number of batches Number of special parts Number of sales orders Direct labour hours

Solution

A/ Cost card Sale proce Material Labour (2x8$) OH (workings)

M1 54 (11) (16) (8.45) $18.55

(2,5x8$)

M2 73 (21) (20) (32.625) $(0.622)

B/ M1 is more profitable than M2 > customers should be persuaded to buy M1. It does not mean M2 (loss making) should be ceased. Analysis of contribution and fixed costs should be done, which OH are avoidable etc, what are incremental CFs, if M2 ceased, there might be loss in sales of M1 as well ... WORKINGS 1/ COST DRIVERS Cost pools Setup costs Material handling costs Special part handling costs Invoicing costs Overhead analysis

14 - 4

$ 97,600 42,000 50,000 31,000 108,000 328,600

Cost driver

Total

Number of setups Number of batches Number of special parts Number of sales orders Direct labour hours

4 (8,000/2,000)=4 (2x8,000)=16,000 60 (2x8,000)=16,000

(80x3) 240 (8,000/100)=80 (8x8,000)=64,000 250 (2.5x8,000)=20,000

244 84 80,000 310 36,000

ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

2/. COST DRIVER RATES Cost pools Setup costs Material handling costs Special part handling costs Invoicing costs Overhead analysis

$ 97,600 42,000 50,000 31,000 108,000 328,600

Cost driver

Total

Number of setups Number of batches Number of special parts Number of sales orders Direct labour hours

244 84 80,000 310 36,000

Cost driver rate (97,600/244) (42,000/84) (50,000/80,000) (31,000/31) (108,000/36,000)

400$ per setup 500$ per batc 0.625$ per1 part 100$ per order 3$ per labour hr

3/ ALLOCATION OF COST Cost pools Setup costs Material handling costs Special part handling costs Invoicing costs Overhead analysis

$ 97,600 42,000 50,000 31,000 108,000 328,600

Cost driver

Number of setups Number of batches Number of special parts Number of sales orders Direct labour hours

4X400$=1,600 4X500$=2,000 16,000X0.625$=10,000 60X100$=6,000 16,000X3$=48,000 67,600 8,000 8.45$

240X400$=96,000 80X500$=40,000 64,000X0.635$=40,000 250X100$=25,000 20,000X3$=60,000 261,000 8,000 32.625$

# of units OH/unit

ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

14 - 5

Target costing 4

Illustration Target costing

Car manufacturer wants to calculate cost of a new car, price will be set at $20,000, and profit margin required 9%. What is target cost? 4

Solution

Profit required: 9% *$20,000 = $1,800 Target cost: $20,000 - $1,800 = $18,200

Lifecycle costing 5

Illustration (K 25) Lifecycle costing

Development Finished 20

Launch 1 year

Growth 1 year

Maturity 1 year

Decline 1 year

5 1 1

4 0.9 5

3 0.8 10

0.9 0.9 4

$ million 5.0 5.0 1.0 11.0 1 million $11.00

Prepare revised cost per unit schedule looking at the whole lifecycle and comment. 5

Solution

Total cycle costs Total R&D costs Total Marketing costs Total Production costs Total Lifecycle costs Total production (units) Cost per unit

$ million 5 + 4 + 3 + 0.9 1 × 1 + 5 × 0.9 + 10 × 0.8 + 4 × 0.9 (1 + 5 + 10 + 4) million 50 ÷ 20

$ million 20.0 12.9 17.1 50 20 million $2.50

Comment • The cost was calculated at $11 per unit during the launch phase. Based on this cost, the accountant was right to be concerned about the launch price being set at $8 per unit. • However, looking at the whole lifecycle the marketing manager’s proposal seems more reasonable. • The average cost per unit over the entire life of the product is only $2.50 per unit. Therefore, a starting price of $8 per unit would seem reasonable and would result in a profit of $5.50 per unit.

14 - 6

ACCA F5 Chapter 14 – Solution

Throughput accounting 6

Illustration (K 19) TPAR

Solution

Throughput per assembly hour = $(10 – 3)/2 hours = $3.50 Operating expenses per assembly hour = $50,000/20,000 hours = $2.50 Throughput accounting ratio = $3.50/$2.50 = 1.40 7

Illustration (K 08/09 40) – Decision making

Co makes two products (A, B) and has identified that a bottleneck occurs during assembly. Details of the products: Product A

Product B

25 5 10 20

16 3 8 15

Sales price Material Direct labour Assembly time per unit mins

Total assembly mins available: 1,000min How should the two products be prioritised? 7

Solution

Step 1 THROUGHPUT

A (25-5) 20$

B (16-3) 13$

Step 2 BOTTLENECK (assembly mins)

20min

15min

Step 3 THROUGHPUT/BOTTLENECK

1$/min

0.87$/min

RANK Step 4 PLAN

If in question is specified for eg that demand for A is 30 and for B 100, production plan would be : Product

Mins/unit Total units

Total mins consumed

A B

20min 15min

30x20mins=600mins 26x15min = 390mins

30units ? units (400min/15min=26,67 units  26units)

990mins

ACCA F5 Chapter 14 – Solution

14 - 7

Illustration (K 21)

Justin Thyme manufactures four products, A, B, C and D. A 1.40 0.60 0.40 5 2 2,000

Sales price Materials cost Direct labour cost Machine time per unit mins Labour time per unit mins Weekly sales demand units

B 0.80 0.30 0.20 2 1 2,000

C 1.20 0.60 0.40 3 2 2,500

D 2.80 1.00 1.00 6 5 1,500

Solution

(a) Step 2: Determine the bottleneck constraint. Is it machine time? We have: 400 machine hours available each week = 24,000 machine minutes We need: 2,000x5+2,000x2+2,500x3+1,500x6=30,500 machine mins

Sales price Materials cost Step1: Throughput/ unit

A $ 1.40 0.60 0.80

Step 2: Bottleneck per unit Step 3: Throughput/bottleneck Step 4: Rank

5 minutes $0.16 4

B $ 0.80 0.30 0.50 2 minutes $0.25 2

C $ 1.20 0.60 0.60

D $ 2.80 1.00 1.80

3 minutes $0.20

6 minutes $0.30

Step 5: Allocate resources (Production plan) The profitmaximising weekly output and sales volumes are as follows. Product D B C A

Units 1,500 2,000 2,500 20,500 (3,500/5) 700

Machine minutes

Throughput per unit($)

Total throughput($)

9,000 4,000 7,500

1.80 0.50 0.60

2,700 1,000 1,500

3,500 (balance) –––––– 24,000

0.80

560 –––––– 5,760 ( 5,440) 320

total TP less Operating expenses Profit

(b) TPAR Throughput per machine hour: $5,760/400 hours = $14.40 Cost (operating expenses) per machine hour: $5,440/400 hours = $13.60 TPAR: $14.40/$13.60 = 1.059

14 - 8

ACCA F5 Chapter 14 – Solution

CHAPTER 2 – CVP ANALYSIS Breakeven point 1

Illustration (Article)

Sales price $50, unit variable cost $30, fixed costs $200,000 per annum. How many sales the business needs to make in order to breakeven 1 Solution (Article) - breakeven $ TR = 50Q TC = 200 000 + 30Q 500 000 200 000

10 000

The Equation method (50Q) – (30Q) – 200,000 = 0 20Q – 200,000 = 0 20Q = 200,000 Q = 10,000 units The Contribution method Unit contribution margin (UCM) = 20 Total fixed costs (FC) = 200,000 Profit (P) = 0 Q = (FC+P)/ UCM Q = (200,000+0)/20 Q = 10,000 units

Target profit 2

Illustration (Article) – target profit

Sales price $50, unit variable cost $30, fixed costs $200,000 per annum. What is sales volume necessary to achieve target profit of $300,000? 2

Illustration (Article) – target profit

ACCA F5 Chapter 14 – Solution

14 - 9

The Equation method (50Q) – (30Q) – 200,000 = 300,000 20Q – 200,000 = 300,000 20Q = 500,000 Q = 25,000 units The Contribution method Unit contribution margin (UCM) = 20 Total fixed costs (FC) = 200,000 Profit (P) = 300,000 Q = (FC+P)/ UCM Q = (200,000+300,000)/20 Q = 25,000 units

Margin of safety 3

Illustration (Article) – margin of safety

Solution (Article) – margin of safety $

TR = 50 . Q

1 000 000 TC = 200 000 + 30Q

500 000 500 000

10 000 10 000 20000

a) in units

Budgeted sales – break-even sales = 20,000 – 10,0000 (illustration 1) = 10,000 units b) as percentage of budgeted sales volume (Budgeted sales - break-even sales)/ Budgeted sales = (20,000 – 10,0000)/20,000 *100 = 50 % c) in terms of sales revenue (Budgeted sales - break-even sales) * selling price = (20,000 – 10,0000) * $ 50 = $ 500,000

Contribution to sales ratio 4

Illustration – C/S ratio interpretation

Sales price $50, unit variable cost $30, fixed costs $200,000 per annum. What is C/S ratio? 4 Solution – C/S ratio C/S = 20/50=40% It means that for every$1of sales, a contribution of 40p is earned. 14 - 10

ACCA F5 Chapter 14 – Solution

Illustration – C/S ratio BEP

C/S ratio of product A is 40%. Fixed cost $200,000. P=$50. Calculate BEP.

Solution – C/S ratio BEP

At BEP: contribution=FC Therefore at BEP C/S = FC/sales = 200,000/sales=0.4 Breakeven sales in $ = 200,000/0.4= $500,000 Breakeven in units: $500,000/$50=10,000 units.

ACCA F5 Chapter 14 – Solution

14 - 11

Multiproduct situation – BEP smallest mix 6

Illustration BEP using smallest mix

Company A produces products x and y, fixed cost $200,000: p v p-v budgeted sales

x $50 $30 $20 20,000

y $60 $45 $15 10,000

Calculate BEP for x and y. 6

Solution

1. Contribution per mix: p-v ratio contribution

x $20 2 40

y $15 1 15 $55 per mix

14 - 12

ACCA F5 Chapter 14 – Solution

Multiproduct situation – BEP using C/S 7

Illustration – BEP multiple products using C/S

Company A produces products x and y, fixed costs $200,000: p v p-v budgeted sales

x $50 $30 $20 20,000

y $60 $45 $15 10,000

Calculate BEP for x and y. 7

Solution - BEP multiple products using C/S

1. Average C/S for mix

X in mix $20x2=$40 $50x2 = $100

1a/ contribution per mix 1b/ revenue per mix

Y in mix $15x1=$15 $60x1=$60

2. BEP (in sales revenue for mix)

mix $55 $160 55/160=34.375%

At BEP FC=Contribution  C/S = 0.34375=200,000/sales  sales =$581,818 3. BEP in sales revenue for product 3a/ sales revenue ratio for products

50x2:60x1  100:60  5:3

3b/ BEP in sales revenue for products

X: (5/8) x $581,818 = $363,636 Y: (3/8) x $581,818 = $218,182 $581,818

4. BEP in sales volume for product if required Note: You might be given C/S ratios for individual products and sales mix. You can calculate average C/S per mix as weighted average of product C/S ratios. Result will not be exactly the same as if average C/S per mix is calculated as contribution per mix/sales revenue per mix, but it is accepted method. Using information from illustration 7 above: p v p-v mix C/S

x $50 $30 $20 2 40%

y $60 $45 $15 1 25%

Weighted average C/S = 2/3 x 40% + 1/3 x 25% = 35%. It is slightly different from average C/S ration per mix of 34.375%.

ACCA F5 Chapter 14 – Solution

14 - 13

Multiproduct situation – target profit 8

Illustration – target profit multiple products

Company A produces products x and y, fixed costs $200,000: p v p-v budgeted sales

x $50 $30 $20 20,000

y $60 $45 $15 10,000

What are level of sales of x and y if target profit is $300,000? 8a

Solution – target profit multiple products

Step 1: Contribution per mix: p-v ratio contribution

x $20 2 40

y $15 1 15 $55 per mix

Step 2: Required # of mixes (FC+P)/contribution per mix = ($200,000+$300,000)/$5 5= 9,090.91 mixes Step 3: Required sales in units and $ for each product Product X: Y:

# of mixes # of units in mix 9,090.91 x2 = 9,090.91 x1 =

units 18,181.82 = 18,182 rounded 9,090.91 = 9,091 rounded

Solution – target profit multiple products – using C/S

Step 1

C/S ratio for mix (see Illustration 7) 34.375%

Step 2

Required total revenue for target profit of $300,000

p$ x$50= x$60=

sales revenue $ $909,100 $545,460 $1,454,560

pxq-vxq-FC=P  contribution = FC+P (200,000+300,000)/sales = 34.375%  sales = $ 500,000/0.34375 = $1,454,545 Step3:

14 - 14

Required sales for each product: 3a/ sales revenue ratio for products

50x2:60x1  100:60  5:3

3b/ sales revenue for products

X: (5/8) x $1,454,545 = $909,091 Y: (3/8) x $1,454,545 = $545,454

ACCA F5 Chapter 14 – Solution

Multiproduct situation – margin of safety 9

Illustration – Margin of safety – multiple products

Company produces X and Y in ratio 2:3. Fixed cost for period $300,000. Budgeted sales revenue for period $750,000. P V

X 10 6

y 15 5

Calculate margin of safety in terms of revenue and also as percentage of budgeted sales. 9

Solution – Margin of safety – multiple products

Margin of safety is difference between sales (volume or revenue) at BEP and budgeted sales (volume or revenue), therefore we have to calculate BEP first: 1. Contribution per mix p v p-v

x 10 6 4

y 15 5 10

Contribution per mix = 2x4$+3x10$=38$ 2. BEP in a number of mixes At BEP FC=contribution, therefore total contribution at BEP = $300,000,which represents $300,000/$38 = 7,894.74 mixes 3. BEP in number of units and in sales revenue Product X: Y:

# of mixes # of units in mix 7,894.74 2 = 7,894.74 3 =

units 15,789.48= 15,789 rounded 23,684.22 = 23,684 rounded

4. Margin of safety budgeted sales BEP sales Margin of safety products)

p$ x$10= x$15=

sales revenue $ $157,890 $355,260 $513,150

$750,000 $513,150 236,850 in the standard mix (allocate total sales in ratio of 4/9 (2x10$/3x15$) if required for individual

Margin of safety as % of budgeted sales (236,850/750,000) = 32%

ACCA F5 Chapter 14 – Solution

14 - 15

Multiproduct situation – charts 10

Illustration – Multiple product charts

Company A produces products x and y, fixed cost $200,000: p v p-v budgeted sales

x $50 $30 $20 20,000

y $60 $45 $15 10,000

Produce a/ Total cost and revenue chart b/ Cumulative cost and revenue chart c/ Profit/Volume chart (P/V) – mentioned in article by examiner 10

Solution – a/ Total cost and revenue chart units 20,000x$30= 10,000x$45= 30,000

VAR X VAR Y

COST ($) 600,000 450,000 1,050,000 200,000 1,250,000

Fixed cost Total cost/revenues

units 20,000x$50= 10,000x$60= 30,000

REVENUE ($) 1,000,000 600,000 1,600,000

ssdf Total revenue i) Total costs 1600 000 1 250 000

200 000 Output (units) 30 000

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ACCA F5 Chapter 14 – Solution

Solution – b/ Cumulative cost and revenue chart Cumulative units

Fixed cost X (20,000 units) X+Y(20,000+10,000) units

20,000 30,000

Cum. costs ($) 200,000 800,000 1,250,000

Cum. revenue($) 1,000,000 1,600,000

Costs and revenue in $

1 600 000

1 250 000

200 000 Output (units) 30 000

Solution – c/ P/V chart

By convention, products with higher C/S ratio are shown first X C/S ratio: 0.4 Y C/S ratio: 0.25 Contribution Fixed cost X Y

ACCA F5 Chapter 14 – Solution

20,000x$20=400 10,000x$15=150

Cum profit/loss (k$) (200) 200 350

Revenue (k$)

Cum revenue (k$)

20,000x$50=1,000 10,000x$60=600

1,000 1,600

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CHAPTER 3 – PLANNING WITH LIMITING FACTORS 1 limiting factor 1

Illustration – 1limiting factor

Z Inc makes two products which both use the same type of materials and grades of labour, but in different quantities as shown by the table below: Product A Product B Labour hours/unit 3 4 Material/unit $20 $15 During each week the maximum number of labour hours available is limited to 600, and the value of material available is limited to $6,000. Each unit of product A made and sold earns Z Inc a contribution of $5 and each unit of product B earns $6 per unit. The demand for these products is limited to 100 of each per week. What is the optimum production plan? 1

Solution

1/ Identify limiting factor A B

Labour hrs 3 4

material 20$ 15$ Available

Labour is limiting factor

units 100 100

labour needed 300 400 700 600 Shortage 100 surplus

2/ Contribution per limiting factor A Contribution $ 5 Labour hours 3 Contribution/lab hrs 1.66

B 6 4 1.5

3/ Rank

4/ Plan A B

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1 Units hrs 100 3 75 (300/4) 4

hrs used 300 300 (balancing fig)

material needed 2,000 1,500 3,500 6,000 2,500

contribution earned 5x100=500 6x75=450

ACCA F5 Chapter 14 – Solution

More limiting factors 2

Illustration MAX PROBLEM

Solution

FORMULATE PROBLEM Step 1 – define the variables Let x = the number of summerhouses produced each week y = the number of garden sheds produced each week. Step 2 – define and formulate the objective function. The objective here is to maximise contribution 50x + 40y -> max Step 3 – formulate the constraints. The constraints (limitations) here are the amounts of cutting and assembly time available. If 1 summerhouse requires 6 hours' cutting time, x summerhouses require 6x hours' cutting time. If 1 shed requires 3 hours' cutting time, y sheds require 3y hours' cutting time. Hence total cutting time required = 6x + 3y hours. Similarly, if one summerhouse and one shed require 4 and 8 hours' assembly time respectively, the total assembly time for x summerhouses and y sheds will be 4x + 8y. The conventional way of setting out the constraints is to place the units utilised on the left, and those available on the right; the inequality sign is the link. Constraint Cutting time Assembly time

Utilised (i) (ii)

6x + 3y 4x + 8y

Available ≤ ≤

36 48

In addition, two other logical constraints must be stated (NON-NEGATIVITY), i.e. x > 0 and y > 0 These simply state that negative amounts of garden sheds or summerhouses cannot be made. SOLVE THE PROBLEM DRAW THE GRAPH > FIND FEASIBLE AREA The cutting time constraint is an inequality 6x + 3y ≤ 36 which represents a region on the graph. To identify this region we draw the line 6x + 3y = 36 (equality) and then determine which side of the line is feasible. This process is repeated for each constraint. For the equation 6x + 3y = 36 – cutting time constraint when x = 0, y = 36/3 = 12 when y = 0, x =36/6 = 6 To graph this constraint, we draw a straight line between the points (0,12) and (6, 0). For the equation 4x + 8y = 48 – assembly time constraint when x = 0, y = 48/8 = 6 when y = 0, x =48/4 = 12 To graph this constraint, we draw a straight line between the points (0, 6) and (12, 0). ACCA F5 Chapter 14 – Solution

14 - 19

FIND OPTIMAL SOLUTION ISOLINE An isocontribution line is a line where all the points represent an equal contribution. The contribution for Hebrus is given by the equation, C = 50x + 40y â&#x20AC;˘ If we choose a contribution of, say, $200 we can draw an isocontribution line 200 = 50x + 40y when x = 0, y = 200/40 = 5 when y = 0, x = 200/50 = 4 To graph the line, we draw a straight line between the points (0, 5) and (4, 0). This line is shown on the graph below. If we choose another contribution of, say, $240 we can draw an isocontribution line 240 = 50x + 40y when x = 0, y = 240/40 = 6 when y = 0, x = 240/50 = 4.8 To graph the line, we draw a straight line between the points (0, 6) and (4.8, 0). This line is shown on the graph below. The isocontribution lines move to and from the origin in parallel; the arrow indicates increasing contribution. The object is to get on the highest contribution line within (just touching) the binding constraints.

The optimum point is found by drawing an example of an isocontribution line on the diagram (any convenient value of C will do), and then placing a ruler against it. Then, by moving the ruler away from the origin (in the case of a maximisation problem) or towards the origin (in the case of a minimisation problem) but keeping it parallel to the isocontribution line, the last corner of the feasible solution space which is met represents the optimum solution. To find the optimal point for Hebrus we have used an isocontribution line for a contribution of $165. However, either of the isocontribution lines discussed above, or another isocontribution line, could have been 14 - 20

ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

used instead. 165 = 50x + 40y when x = 0, y = 165/40 = 4.125 when y = 0, x = 165/50 = 3.3 To graph the line, we draw a straight line between the points (0, 4.125) and (3.3, 0). This line is shown on the graph below.

Optimal point: The highest available isocontribution line occurs at point Q. Answer the question, i.e. calculate the contribution at the optimal point. Reading from the graph, at point Q x = 4 and y = 4. This gives a maximum contribution of C = (50 × 4) + (40 × 4) = $360. FIND OPTIMAL SOLUTION EQUATIONS Possible maximums can be at points P[0,6], Q [?,?] and R [6,0]. Q is at the intersection of the two constraint lines: 4x + 8y = 48  6x + 3y = 36  y=(36-6x)/3=12-2x Replace y in assembly contraint: 4x+8(12-2x)=48 -> x=4 Back to cutting time constraint; y=12-2x=12-8=4 Therefore Q=[4,4] CALCULATE CONTRIBUTION AT POTENTIAL POINTS OF MAXIMUM AND CHOOSE THE HIGHEST ONE Function: z=50x+40y P [0,6] z=40x6=240 Q [4,4] z=50x4+40x4=360 > the hihgest R [6,0] z=50x6=300

ACCA F5 Chapter 14 – Solution

14 - 21

Illustration (K 96) MIN PROBLEM

J Farms Ltd can buy two types of fertiliser which contain the following percentage of chemicals: Type X Type Y

Nitrates 18 3

Phosphates 5 2

Potash 2 5

Solution

(a) Let x = number of kg of X purchased Let y = number of kg of Y purchased Total cost: z = 10x + 5y, the objective function which has to be minimised. The constraints exist on the chemical composition of the fertilisers: Nitrates: 0.18x + 0.03y ≥ 100 Phosphates: 0.05x + 0.02y ≥ 50 Potash: 0.02x + 0.05y ≥ 40 Non negativity: x ≥ 0, y ≥ 0 (b) In this example, all the points where the lines cut the axes are required, so that the easiest way to draw the constraints is to calculate these points. 0.18x + 0.03y = 100 x = 0  y = 100/0.03 = 3,333.3 y = 0  x = 100/0.18 = 555.5 0.05x + 0.02y = 50 x = 0  y = 50/0.02 = 2,500 y = 0  x = 50/0.05 = 1,000 0.02x + 0.05y = 40 x = 0  y = 40/0.05 = 800 y = 0  x = 40/0.02 = 2,000

14 - 22

ACCA F5 Chapter 14 – Solution

(c) Considering the vertices (i.e. corners) of the feasible area. A: [x = 0 y = 3,333.3] z = 10x + 5y = 10(0) + 5(3,333.3) = $16,666.50 B: Solving 0.18x + 0.03y = 100 and 0.05x + 0.02y = 50 gives B [x = 238.1 and y = 1,904.8] z = 10(238.1) + 5(1,904.8) = $11,905 C: Solving 0.05x + 0.02y = 50 and 0.02x + 0.05y = 40 gives C [x = 809.5 and y = 476.2] z = 10(809.5) = 5(476.2) = $10,476 D: [x = 2,000 y = 0] Z = 10(2,000) + 5(0) = $20,000 Thus C gives the point of minimum cost with x = 809.5 and y = 476.2, i.e. 809.5 kg of X and 476.2 kg of Y, total cost $10,476. Alternatively, an iso-cost line for z = 20,000 (say) could be plotted and moved downwards. This would identify point C as the optimum point on the graph, and the values of x and y could be determined using simultaneous equations as above. (d) The current policy costs: 1,000 ($10) + 1,000 ($5) = $15,000, so the saving made is of $(15,000 -10,476) = $4,524

ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

14 - 23

Slack and surplus 4

Illustration – K09/10 - 57 (slightly modified)

Alfred Co is preparing its production plan for the coming month. It manufactures two products, the flak trap FT and sap trap ST: Contribution Labour skilled hrs Labour semiskilled Material

$50 10 5 6kg

$40 10 25 4kg

Solution

1. Formulate linear programming problem FT ST

Material 6kg 4kg -

lab skilled 10hr 10hr max 2,000

lab semi skilled 5hr 25hr max 2,500

max demand 150 units 80 units

14 - 24

ACCA F5 Chapter 14 – Solution

14 - 25

Shadow price 5

Illustration (K 98)

Solution

Solution Shadow price for Machining time – the constraints become: (i) 20x + 25y ≤ 501 (ii) 40x + 25y ≤ 800 Simultaneous equations solution: Subtracting (i) from (ii) gives: 20x = 299 and thus x = 14.95 Inserting into (i) gives (20 ×14.95) + 25y = 501 25y = 202 y = 8.08 Therefore Optimum (new) = [14.95;8.08] Value of contribution function Z: Z(optimum old) = (15 × $80) + (8 × $75) = $1,800. Z (optimum new)= (14.95 × $80) + (8.08 × $75) = $1,802. The shadow price per machine hour is thus $2. It means that maximum price per additional unit of machining time is OLD PRICE+2$

14 - 26

ACCA F5 Chapter 14 – Solution

Illustration (K99)

Suppose a linear programming problem gives the following results. Constraint Skilled labour Unskilled labour Materials

Normal cost

Shadow price

$20/hour $10/hour $5/kg

$12/hour zero $3/kg

$ 80

40 10 15

65 15

Profit per unit Assuming that the constraints cannot be relaxed, should the new product be manufactured? 6

Solution a)

Critical constraints have non-zero dual prices, so the optimal solution will be at the intersection of skilled labour and materials.

(b) For skilled labour overtime will cost $30 per hour and the benefit will be 20+12=$32 per hour. The overtime is thus worth while and will generate a net $2 per hour benefit. For unskilled labour there is already slack so overtime is not worthwhile.

Selling price Skilled labour – 2 hours @ (20+12) Unskilled labour – 1 hour @ 10 Materials – 3kg @ (5+3) Loss per unit

80 (64) (10) (24) ––– (18) –––

Incorporating the contribution lost elsewhere by reallocating scarce resources, the new product is not viable.

ACCA F5 Chapter 14 – Solution

14 - 27

Illustration (examiner – article March 2008)

a) Calculate the optimum solution. b) Calculate the material shadow price, comment. c) How many materials the firm should buy?

7 Solution (examiner – article March 2008) The first step in any linear programming problem is to produce the equations for constraints and the contribution function, which should not be difficult at this level. In our example, the materials constraint will be 3X + 5Y ≤ 15,000, and the labour constraint will be 4X + 4Y ≤ 16,000. You should not forget the non-negativity constraint, if needed, of X,Y ≥ 0. The contribution function is 30X + 40Y = C a) The optimal point is X = 2,500 and Y = 1,500, which generates $135,000 in contribution. Check this for yourself (see Working 1). b)

Suppose the shadow price of materials is $5 per kg (this is verifiable by calculation – see Working 2).

We need to find out how many materials are needed at point D on the graph, the point at which 4,000 units of Y are produced. To make 4,000 units of Y we need 20,000kg of materials. Consequently, the maximum amount of extra material required is 5,000kg (20,000 - 15,000).

Working 1

The optimal point is at point B, which is at the intersection of: 3X + 5Y = 15,000 and 4X + 4Y = 16,000 Multiplying the first equation by four and the second by three we get: 12X + 20Y = 60,000 12X + 12Y = 48,000 The difference in the two equations is: 8Y = 12,000, or Y = 1,500 Substituting Y = 1,500 in any of the above equations will give us the X value: 3X + 5 (1,500) = 15,000 3X = 7,500 X = 2,500 The contribution gained is (2,500 x 30) + (1,500 x 40) = $135,000 Working 2: Shadow price of materials

To find this we relax the material constraint by 1kg and resolve as follows: 3X + 5Y = 15,001 and 4X + 4Y = 16,000 Again, multiplying by four for the first equation and by three for the second produces: 12X + 20Y = 60,004 12X + 12Y = 48,000 8Y = 12,004 Y = 1,500.5 Substituting Y = 1,500.5 in any of the above equations will give us X: 3X + 5 (1,500.5) = 15,001 3X = 7,498.5 X = 2,499.5 The new level o f contribution is: (2,499.5 x 30) + (1,500 x 40) = $135,005 The increase in contribution from the originál optimal is the shadow price: 142,505 - 142,500 = $5 per kg.

14 - 28

ACCA F5 Chapter 14 – Solution

CHAPTER 4 – PRICING DECISIONS Markup, margin 1

Illustration

If the full cost of an item is $540, calculate the selling price using a 25% mark-up and a 25% profit margin: 1 • • •

Solution A 25% markup would produce a selling price of $675 ($540 × 125/100). A 25% profit margin would produce a selling price of $720 [$540 × (100/75)].

Demand elasticity 2

Illustration (K 08/09 - 91 )

Retailer plans to increase price of a text book from $20 to $22. PED = -1,25. What will be the impact of the price rise on sales (currently 300 units pa) and revenue? 2

Solution (K 08/09 - 91 )

Price elasticity of demand (PED) =

% change in Q % change in price P

PED = =1.25 % change in P = (22-20)/22 % change in Q = PED x % change in P % change in Q = -1.25 x (22-20)/22 % change in Q = -12.5% Current Q = 300 New Q = (100 % - 12.5 %) x 300 = 87.5% x 300 = 262,5 units = 263 units Change in Q = 300 – 263 = 37 units Sales revenue – current = 300 x $20 = $6,000 -New = 263 x $22 = $5,764 ($236) Increase in price of 2$ will produce decrease in sales and sales revenue by $236.

Demand line/equation 3

Illustration (K125)

Solution P = a – bQ – b (gradient) = (330 – 300) ÷ (400 – 500) = – 0.3 remembering that price (P) = 300 when 500 units are sold and substituting 0.3 for b 300 = a – (0.3 × 500) 300 = a – 150 a = 300 + 150 = 450 So the linear relationship (or demand function equation) is: P = 450 – 0.3Q.

ACCA F5 Chapter 14 – Solution

14 - 29

Total cost function/equation 4

Illustration and solution

If the total cost of a product is given as: Y = 4,800 + 8x (a) The fixed cost is $ 4,800 (b) The variable cost per unit is $ 8 (c) The total cost of producing 100 units is $ 5,600

Decision to increase production/sales 6

Illustration (K 130)

A company produces and sells one product and its forecast for the next financial year is as follows: Sales 100,000 units @ $8 material labour

$000 300 200

Contribution ($3 per unit) Fixed costs Net profit

$000 800 (500) 300 150 150

Solution

Proposal (a) will increase the sales revenue but the increase in costs will be greater: Sales (150,000 @ $7) Variable costs (150,000 @ $5) Fixed costs plus advertising Net profit This is lower than the current forecast.

$000 1,050 750 –––– 300 164 –––– 136

Proposal (b) •

reduces variable costs by $60,000 ($300,000 x 20%)

•

but increases fixed costs by $72,000 and is therefore not to be recommended unless the total volume increases as a result of the policy (e.g. if the supply of the components were previously a limiting factor).

14 - 30

ACCA F5 Chapter 14 – Solution

Conclusion Neither proposal should be accepted.

ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

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Profit maximising P/Q level – tabelar approach 7

Illustration (K 120)

50,000 22

60,000 20

70,000 19

80,000 18

90,000 17

90,000× 15

× At $15, demand will be in excess of 90,000 units but production capacity will limit the sales. Required: What is the optimum selling price? 7

Solution

(K 106)

Price per unit

$ 22

$ 19

$ 18

$ 17

$ 15

Variable cost per unit

Contribution per unit

Number of units sold

50,000

60,000

70,000

80,000

90,000

Total Contribution, in $000

800

840

910

960

990

810

Less Fixed costs, in $000

200

280

360

Net Profit in $000

600

640

630

680

630

450

Conclusion: To maximise profit, price should be $18, output 80,000 and one extra machine should be hired.

14 - 32

ACCA F5 Chapter 14 – Solution

Profit maximising P/Q level – equations 8

Illustration (Article 30 Sep 04, David Foster)

MR = 30 – 0.5Q

Total cost function:

TC = 100 + 5Q

Solution

(Article 30 Sep 04, David Foster)

For profit maximisation: marginal revenue (MR) = marginal cost (MC). MR = 30 - 0.5Q. total fixed cost per period of £100 and a variable cost (VC) of £5 per unit. (MC=VC) MC = £5 MR = MC 30 - 0.5Q = 5. 25 = 0.5Q Q = 25 ÷ 0.5 Q = 50 This means that the quantity that needs to be sold in order to maximise profits is 50 units per period. To establish the selling price per unit at level of demand Q = 50 P = 30 - 0.25Q P = 30 - 0.25 x 50 P = 30 - 12.5 P = 17.5 The profit maximising selling price is £17.50 per unit. Maximum profits per period: Total revenue = price x quantity = 17.50 x 50 = Less Total cost = 100 (total fixed) + 5 x 50 (total variable) = Total profit (maximum)

850 (350) 500

In Figure 1, the linear price/demand, marginal revenue and marginal cost functions are shown. The profit maximising point is where the MR and MC lines intersect. At this point the quantity demanded is 50 units and the corresponding value on the price/demand function is a price of £17.50. Figure 1: the Lindfield question

ACCA F5 Chapter 14 – Solution

14 - 33

Profit maximising p/Q level – deriving Mr from demand 9

Illustration (Deriving MR from demand curve)

Solution

1. Demand curve: y=-kx+q k(gradient) = 2$/12=0.166666$ per unit y=-0.16666666x+q q: (13,000;300): 300=-0.1666666x13,000+q  q=2,467 y=-0.166666x+2467 (P=-0.1666666Q+2467)

2. Profit is maximized when MR=MC MC = $85 MR=?  MR can be derived from demand equation: MR =-2 x 0.1666666Q + 2,467 MC=MR 85 = -2 x 0.1666666Q + 2,467 Q = 7,146 3. What price will achieve that? P= -0.166666 x 7,146 + 2,467= $ 1,276

14 - 34

ACCA F5 Chapter 14 – Solution

CHAPTER 5 â&#x20AC;&#x201C; MAKE/BUY AND OTHER SHORT-TERM DECISIONS Relevant costing 1

Illustration Machinery

Company is considering whether to undertake some project for customer. Machinery required: a/ special machine to be hired for contract (5 months), total hire charges $200. b/ all other machinery already within Co on hire purchase terms. Co pays $400 pm ($50 interest, $350 capital repayment). Last hire purchase payment to be made in 3 months time. Cash price for machinery was $8,500 3 years ago. Depreciation is $300 pm. Machinery is not required for other more profitable jobs in this period. Machine would lose $300 in its potential sale value if it is used for project. What is the relevant cost of machinery? 1

Solution

Hire charge special machine Hire chargw existing machine Cash price of existing machine Depreciation Loss in resale value 2

$200

$300 $500

$400pm $8,500 $300

yes, it is incremental futire CF, consequence of desicion no, it will be paid irrespective of decision made no, sunk cost no, not CF yes, direct consequence of using machinery, future CF

Illustration Labour

Solution Labour

Addiitonal other variable cost Lost contribution of X Direct labour cost 3

(1,100hrs/5hrs)=220units of X x$35 = (1,110hrsx$10)

$6,500 $7,700 $11,000 $25,200

Illustration Material

You were approached by customer who will pay for special job $20,000. You need following material: Material A B C D

Units needed 1,000 900 1,100 300

Units at stock 0 500 700 300

Book value $ / unit 3 4 4

Realisable value $ / unit 3.5 3.0 6.0

Replacement cost $ / unit

Relevant cost $

7 6 5 8

14 - 35

3 Material

Solution Material Units needed

A B C D Total

Units at stock

1,000 900 1,100 300

Book value $ / unit

0 500 700 300

Realisable value $ / unit

3 4 4

Replacement cost $ / unit

Relevant cost $

7 6 5 8

($7x1,000) (500x $6 + 400x $6) (700x$3 + 400x$5)

3.5 3.0 6.0

7,000 5,400 4,100 1,800 18,300

Notes: 1/ Book value is always irrelevant 2/ material C): Relevant cost units in stock which will not be replaced = opportunity cost is realisable value Relevant cost units out of stock = current purchase price 3/ material D Sale Alternative use (material E)

= 300 x $6 = $1,800 > we take higher of = 400 x $4 = $1,600

Oneoff contracts 4

Solution ( K 157)

Material A 1,000 kgs @ $2 – $300 (note 1) 1,000 kgs @ $10 Material B (note 2) 1,000 kgs @$15 Material C (note 3) 500 kgs – opportunity cost Material D (note 4) 50 litres @ $50 Skilled labour (note 5) 1,000 hrs @ $25 Semiskilled labour (note 6) 500 hrs @ $22.50 Unskilled labour (note 7) 500 hrs @ $12 (opportunity cost)

$ 1,700 10,000 ——— 11,700

Minimum tender price = total of relevant cash flows

15,000 8,000 (2,500) 25,000 11,250 6,000 ——— 74,450 ———

Notes (1) There are 1,000 kgs in stock and these will not be replaced. These would otherwise be sold at a net gain of $1,700. This gain is therefore foregone as a result of using this material in the contract. The other 1,000kgs are out of stock and therefore the relevant cost is the current purchase price of $10 per kg. (2) The material is in stock but will be replaced and therefore the relevant cost is the current purchase price of $15 per kg. (3) The material is in stock and there are two options if this material is not used for the contract: Option 1 – Sell it for $6,000. Option 2 – Use it as a substitute and save $8,000. Option 2 is preferable. This is therefore the opportunity cost of using it in the contract. (4) The material is in stock and will not be replaced. The cost of disposing of 50 litres will be saved (@ $50/litre, i.e. $2,500). Saving this cost is a relevant benefit. (5) The incremental cost of paying for the labour needed. (6) 1,500 spare hours have already been paid for as the workforce are on annual contracts. The additional cash flow is therefore the extra 500 hours that are needed at timeandahalf. (7) For each hour diverted from their normal jobs contribution of $2 will be foregone. This together with the cost of paying the workers to do the project amounts to a relevant cost of $12 per kg. They would not be hired at $20 per hour as this is more expensive. (8) Fixed overheads can be ignored as they are not incremental. (9) Costs of preparing the tender are all sunk costs and hence must be ignored. (10) Profit element should be ignored since a minimum contract price is being calculated.

14 - 36

ACCA F5 Chapter 14 – Solution

Make or buy 5

Illustration - make or buy no limiting factors

VAR cost (incl. var prod OH) $ Directly attributable FC $ Production units Committed cost Subcontractor offer $

$50,000

15 1,500 1,000

17 4,000 2,000

6 6,000 4,000

10 7,000 3,000

Make or buy? (Determine whether any of the components should be bought in from the external supplier) 5

Solution

Relevant cost are diferential cost btw making and buying  a/ diff in unit VAR b/ diff in directly attributable FC (saved if outsourced) A 15 13 (2) 1,000 (2,000) (1,500) (3,500)

Unit VAR – making Unit VAR – buying Units Extra VAR of buying FC saved Total cost of buying

B 17 21 4 2,000 8,000 (4,000) 4,000

C 6 9 3 4,000 12,000 (6,000) 6,000

D 10 12 2 3,000 6,000 (7,000) (1,000)

Discussion: 1/ Company saved by buying : 2/ Relevant cost are:

A/ $3,500pa (purchase cost < marginal cost per unit if made out) D/ $1,000 pa (because of saving in FC)

Variable cost of in-house production Variable cost of subcontracted units FC directly attributable

3/ Further considerations     6

spare capacity subcontractor – reliable with delivering times, quality etc to keep control over production x experience& skill from subcontractor are estimates reliable?..

Illustration – make or byuy limiting factors

Company manufactures 3 parts A, B, C  for an assembly of 5,000 final products ( we need to have 5,000 units of each part). A B C Assembly cost Total variable cost

Var. cost ($) 22 33 25 25 105

machine hours 3 2 5

Company has 20,000 hours of machines in a year; subcontractor can supply A, B, C for $32, $38, $35. Advice.

ACCA F5 Chapter 14 – Solution

14 - 37

Solution

1/ What is the limiting factor? Machine hrs needed: A/ 5000x3 = B/ 5,000x2= c/ 5,000x5= We have To buy

15,000 10,000 25,000 50,000 (20,000) 30,000

Which product to subcontract? Which add the least to cost -> least extra cost per hour of own time saved 2/ Calculate extra variable cost per limiting factor VAR of making VAR of buying Extra VAR of buying Machine hrs saved by buying Extra VAR per hr saved

A 22 32 10 3 3.3

B 33 38 5 2 2.5

C 25 35 10 5 2

3/ Rank

A B

hr/unit 3 2

units 5,000 2,500

hrs total 15,000 5,000

VAR/unit VAR total $ 22$ 110,000 33$ 82,500

B C

2 5

2,500 5,000

5,000 25,000

38$ 35$

4/ Plan To make To buy

(C is cheapest to buy, therefore I start to make A  B -> C)

95,000 175,000 462,500

Closing decisions 7

Illustration (K 155)

1 5,000 150,000 75,000 25,000 5,769 44,231 (15,384) 28,847

2 6,000 240,000 150,000 30,000 6,923 53,077 (18,461) 34,616

3 2,000 24,000 10,000 8,000 2,308 3,692 (6,155) (2,463)

Total 13,000 414,000 235,000 63,000 15,000 101,000 (40,000) 61,000

ACCA F5 Chapter 14 – Solution

Solution

First of all we must restate the figures so that they present the situation in its true light. Only relevant cash flows should be considered. This will enable each department to be readily evaluated on its locally controllable performance. Department 1 2 3 Total Sales volume (units) 5,000 6,000 2,000 13,000 Sales value ($) 150,000 240,000 24,000 414,000 Cost of sales: ($) Direct material 75,000 150,000 10,000 235,000 Direct labour (note 1) 4,846 5,815 1,939 12,600 Prodn overhead (note 2) 3,000 3,000 1,500 7,500 Expenses (note 3) 9,000 9,000 6,000 24,000 –––––– –––––– –––––– –––––– Contribution ($) 58,154 72,185 4,561 134,900 Other costs ($): Labour (note 4) (50,400) Overhead (note 5) (7,500) Expenses (note 6) (16,000) –––––– Net profit 61,000 –––––– Notes (1) 80% of the labour cost is fixed and is therefore excluded from the contribution calculation. The remaining 20% has been allocated on the basis of sales volume. (2) Only 50% of the production overheads can be directly allocated to the departments. This has been allocated in the ratio 2:2:1. (3) Only 60% of the expenses can be directly traced to the departments. This has been allocated in the ratio 3:3:2. (4) Fixed cost of labour is 80%. (5) This is the remaining 50% of overheads that can't be allocated to departments. (6) This is the remaining 40% of expenses that can't be allocated to departments. Conclusion From the restated figures department 3 should be kept open since: – The department is making a contribution of $4,561 to the overall profit of the business. – The apparent loss arises purely from inappropriate apportionment of overheads and expenses. – If the department were closed: – there would be a loss of $4,561 contribution to the business and – on the assumption there would be no further saving on fixed costs, the profit would be reduced to $56,439.

Joint products 8

Illustration (K 166) joint products

A firm makes three joint products, X, Y and Z, at a joint cost of $400,000. Joint costs are apportioned on the basis of weight. Products X and Z are currently processed further. Product

Weight at split off (tonnes)

Further processing costs (variable, $000)

600 200 200

800

X Y Z

400

Sales ($000) 980 120 600

An opportunity has arisen to sell all three products at the split off point .: X: $200,000, Y: $120,000, Z: $160,000. Which of products X and Z should the firm process further?

ACCA F5 Chapter 14 – Solution

14 - 39

Solution

The preseparation (i.e. “joint”) costs are not incremental and so can be ignored. The only incremental cash flows are as follows: Product X Y Z $000 $000 $000 Additional revenue from further processing 780 n/a 440 Additional costs from further processing 800 n/a 400 ––––––– ––––––– Benefit/ (cost) of further processing (20) 40 ––––––– ––––––– Thus only Z should be processed further.

CHAPTER 6 – DEALING WITH RISK AND UNCERTAINTY IN DECISION MAKING Pay off matrix and EV 3

Illustration Pay off matrix

Solution

a/ EV = 0.3x10 + 0.7x20 = 17 meals per day b/ Pay off matrix Probability

Scenario (demand)

Decision (# of meals prepared) - alternatives 10 17 20 100 (W1) 65 (W2) 50 100 170 200 100 138,5 155

0.3 10 0.7 20 Expected value (of profit) Workings: W1: sale Cost

10x15=150 10x5=(50) 100

W2:

sale cost

10x15=150 17x5=(85) 65

Optimal plan is to prepare 20 meals a day, giving profit of 155.

Maximin, maximax, minimax regret 4

Illustration – maximin, maximax

A 20 40 50

B 80 70 (10)

C 10 100 40 ACCA F5 Chapter 14 – Solution

Solution

Scenario I II III maximin maximax 5

A 20 40 50 20 50

B 80 70 (10) (10) 80

C 10 100 40 10 100

Illustration

Solution

(i) EV of demand = (10 × 0.20) + (15 × 0.55) + (20 × 0.25) = 15.25 units per week. (ii) The first step is to set up a decision matrix of possible strategies (numbers bought) and possible demand, as follows: P=25, v=15, contribution (p-v)=10 p

Scenario (demand)

0.20

10 10x10=100

0.55 0.25 1

15 20 EV:

10x10=100 10x10=100 100

strategy 15 (10x10-5x15) or (10x25-15x15)=25 10x15=150 10x15=150 125

20 10x25-20x15=(50) 15x10-5x15=75 20x10=200 81.25

Based on EV decision rule, Marie sould buy 15 magazines as i gives her in a long term profit of 125. (iii)

maximax C(200) Using maximax, optimist would buy 20 mgazines, giving him MAXimum profit of $200. Maximin A(100) Using maximin, pessimist would choose to buy 10 magazines, giving him MINimim possible profit of $100. Minimax regret B(75) – see table below Using minimax regret, sore loser would choose to buy 15 magazines, limiting is opportunity loss to $75.

Scenario/strategy 10 15 20

ACCA F5 Chapter 14 – Solution

10 0 50 100

15 75 0 50

20 150 75 0

14 - 41

Simulation 8

Illustration (K 187)

Assess the use of simulation for a chain of betting shops. 8

Solution

Simulation would be particularly useful on an operational level for analysing the possible implications of a single event, such as a major horse race or football match: • Possible outcomes are easy to identify (e.g. win, lose, draw, 2:1, 3:0, etc) • Quoted odds can help to estimate probabilities. • The outcomes of the simulation could be used to assess impact on cash flow, whether bets should be laid off with other betting agents to reduces risk. Simulation could also be used for wider strategic analysis such as for assessing the possibility and implications of stricter antigambling legislation.

Decision trees 9

Illustration Drawing decision tree

The Co is considering to launch the product. Product will be sold for $10. If the product is launched, there is 80% probability that sales will be 8,000 units and 20% probability that sales will be 10,000 units. Unit cost will be $6 with probability 60% and $7 with probability 40%. If product will not be launched, Co will receive $15,000 as compensation from competitor. 9

14 - 42

Solution

ACCA F5 Chapter 14 – Solution

CHAPTER 8 â&#x20AC;&#x201C; BUDGETING 2

Illustration ZBB (K 217)

For a number of years, the research division of Z Inc has produced its annual budget (for new and continuing projects) using incremental budgeting techniques. The company is now under new management and the annual budget for 20X4 is to be prepared using ZBB techniques. Explain how Z Inc could operate a ZBB system for its research projects. 2 Solution ZBB Stage 1: Managers should specify the activities that can be evaluated The managers/researchers responsible for each project should decide which projects they wish to undertake in the forthcoming period. These projects will be a mixture of continued projects and new projects. Stage 2: Each activity is described in a decision package For the projects which have already been started and which the managers want to continue in the next period, we should ignore any cash flows already incurred (they are sunk costs), and we should only look at future costs and benefits. Similarly, for the new projects we should only look at the future costs and benefits. Stage 3: Each decision package is evaluated and ranked Different ways of achieving the same research goals should also be investigated and the projects should only go ahead if the bendit exceeds the cost. Stage 4: Resources are allocated to the various packages Once all the potential projects have been evaluated if there are insufficient funds to undertake all the worthwhile projects, then the funds should be allocated to the best projects on the basis of a costbenefit analysis. ZBB is usually of a highly subjective nature. (The costs are often reasonably certain, but usually a lot of uncertainty is attached to the estimated benefits.) This can be shown by the example of a research division where the researchers may have their own pet projects, which they are unable to view in an objective light.

ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

14 - 43

CHAPTER 9 – QUANTITATIVE ANALYSIS High-low 1

Illustration (K241)

Cost data for the six months to 31 December 20X8 is as follows: Month Units Inspection cost $

Jul 340 2,240

Aug 300 2,160

Sep 380 2,320

Oct 420 2,400

Nov 400 2,360

Dec 360 2,280

a/ Find variable cost per unit and total fixed cost b/ Estimate total cost if output is 500 units 2

Solution (K221)

USING HIGHLOW Step 1: Select the highest and lowest activity levels and their costs Six months to 31/12/X8 Highest month Lowest month Range Step 2: Find the variable cost per unit

Units produced 420 300 ––– 120

Inspection costs($) 2,400 2,160 ––– 240

Variable cost per unit = $240/120 = $2 per unit Step 3: Find the fixed cost Fixed inspection costs are, therefore: $2,400 — (420 units × $2) = $1,560 per month or $2,160 — (300 units × $2) = $1,560 per month i.e. the relationship is of the form y = $1,560 + $2x. Step 4: Use these costs to forecast the total costs for 500 units. Total cost = fixed cost + variable cost Total cost = $1,560 + ($2 × 500) Total cost = $2,560 USING GRAPH AND TOTAL COST EQUATION

Y=kx+q (TC=vx+FC) k=(2,400-2,160)/(420-300)=2 y=2x+q q: [300; 2,160]: 2,160=2,300+q  q=1,560 y=2x+1,560 b/ x=500: y=2x500+1,560 =2,560

14 - 44

ACCA F5 Chapter 14 – Solution

Forecasting techniques 4

Illustration Average growth rate

Year X1 Sales(k$) 120

X2 130

X3 165

X4 205

X5 240

Calculate average growth rate. 4 Solution F= O x (1+g)n n=4, Future sales = $240, Original sales = $120 240=120 x (1+g)4  g = 18.92% 7 Illustration (K 247) A company has found that the trend in the quarterly sales of its furniture is well described by the regression equation: y = 150 + 10X y x=1 x=2 x=5

equals quarterly sales ($000) represents the first quarter of 20X2 represents the second quarter of 20X2 represents the first quarter of 20X3,

Multiplicative model applies. The mean seasonal quarterly index for its furniture sales is as follows: Quarter Seasonal index

1 80

2 110

3 140

4 70

ACCA F5 Chapter 14 – Solution

14 - 45

TREND

SEAS INDEX

SALES FORECAST

X=21

y=10x+150=

360

0.8

288

X=22

y=10x+150

370

1.1

407

x-23

y=10x+150

380

1.4

532

x=24

y=10x+150

390

0.7

273

(c) The two main factors that may cause errors are: (1) Extrapolation error – we may be forecasting too far beyond the original regression. (2) We are ignoring any residual variation and cyclical variation. As a result, the forecast may be inaccurate.

14 - 46

ACCA F5 Chapter 14 – Solution

Learning curve 8

Illustration Learning curve – using formula

Solution Learning curve – using formula

y = a⋅x

log 75% log2

= 130 ⋅ x

− 0.415

1/ budgeted total cost December Cummulative average cost:

Total cost till end of Nov: Total cost till end of Dec: Total cost incurred in Dec

X=250:

y = 130 ⋅ 250 −0.415 = 13.14

X=310:

y = 130 ⋅ 310 −0.415 = 12.02

250x13.14=3,285 310x12.02=3,726 441

2/ Average cost per unit in December: 441/60 units = 7.35 9

Illustration + solution - learning curve – using table (see Wrights law)

The first unit of a new car requires 100 hours to make. A 90% learning curve applies. The production times would be as follows: Number of units produced 1 2 4 8 10

Learning rate 90% 90% 90% 90%

Cumulative average time required per unit 100 90 (90%x100) 81 (90%x90) 73 (90%x81)

Total time required

100 180((2x90) 324 (4x81) 583 (8x73)

Incremental time for additional units 100 80 for 2nd unit 144 for 3th and 4th unit 259 for 5th-8th units

Illustration (K 252)

14 - 47

price, what would be the profit on the first 140 ‘massproduction’ models (i.e. after the first 20 watches) assuming that marketing costs totalled $250? 10

Solution

(a) Initial order

Material (10 × $30) Labour and variable overhead (100 × $3) Settingup cost (see note)

300 300 1,000 –––––– $1,600 MIN price (1,600/10)=$160

Total

Note: If there is no guarantee of a follow-up order, the setup costs must be recovered on the initial order. (b) Follow-on order

y = a⋅x

log 80% log2

= 100 ⋅ x

− 0.322

X=2 (2 batches):

y = 100 ⋅ 2 −0.322 = 80  TC=80x2=160hrs

X=1:

y = 100 ⋅ 1−0.322 = 100 

TC=100hrs

Second batch therefore takes 160-100=60rs Costs are therefore: Material (10 × $30) Labour and variable overhead (60 × $3)

$ 300 180 –––––– 480  MIN price 480/10=48

Total

Note: the set up costs have been recovered on the initial order and can therefore be ignored. (c) Both orders together

y = 100 ⋅ 2 −0.322 = 80hrs  total labour hrs = 80x2=160hrs Total costs are: Material (20 × $30) Labour (160 hours x $3) Setup cost Total

600 480 1,000 2,080  MIN price each (2080/20)= $104

(d) Mass production (140 watches after first 20 watches) X=16 (2+14): X=2

y = 100 ⋅ 16 −0.322 = 40.96hrs 

y = 100 ⋅ 2 −0.322 = 80hrs 

total (16) = 665.4hrs total (2) = 160hrs

Batch 3-16 takes (665.4-160rs) = 495.36hrs (140 watches) Cost Material (140 × $30) Labour and variable overhead (495.36 × $3) Marketing Total cost

14 - 48

4,200 1,486 250 5,936  cost: 5,936/140=$42.4 < $45

ACCA F5 Chapter 14 – Solution

CHAPTER 10 – STANDARD COSTING AND VARIANCES ANALYSIS 2

Illustration Wastage

Each unit of production (final product) requires 5kg of material A. 10% is lost during production process. Number of units produced in period: 10,000. How many kilograms of material A is needed for production? We need 5kg of material as the OUTPUT of the process. 10% is lost during the process. Therefore on INPUT we have to have more. Output = 90% = 5kg Input: = 100%  = (5kg/90)x100=5.56kg -kg required for production (5kgx10,000) - loss (balancing fig) Kgs on input (10,000x5/0.9) 3

kg 50,000 5,555 55,555

Illustration Idle time

Product A requires 5 labour hours. 20% of working hours are idle time. How long will be worker paid to produce 10 units? (Worker is paid for both productive and non productive time). 5hrs must be output  80%. On input (100%) = (5hrs/80)x100=62,5 hrs 4

Illustration Flexible budget – planning stage

X1 60,000 20,800

- depreciation - management salaries

Direct labour Other vAR Indirect labour consumables canteen Total VAR Semi-variable cost (W1) Fixed costs: D i ti Depreciation Salary Total FIX Total budgeted costs

ACCA F5 Chapter 14 – Solution

X2 58,000 20,100

X3 55,000 19,600

X4 50,000 17,800

$17,000 $20,000

3.90x56,000 0.80x56,000 5%x(218+45) 0,3x56,000+2,800

70% (70%x80,000=56,000hrs) 218,4 44,8 25,2 13,2 302 19,6

3.90x80,000 0.80x80,000 5%x(312+64) 0,3x80,000+2,800

100% (80,000hrs) 312 64 36 19 431 26,8

2 000 17

2 200 17

20 37 359

20 37 495

14 - 49

Working 1 – split of semivariable cost Lab hrs 50,000  total cost 17,800 Lab hrs 60,000  total cost 20,800 Y=kx+q K=(20,800-17,800)/(60,000-50,000) = 0,3  y=3x+q Q=?: [50,000;17,800]: 17,800=0.3x50,000+q  q=2,800 Y=3x+2,800  unit var = 0.3, fix cost = 2,800 b/ Calculate budget cost allowance (expected expenditure) for 2009 assuming that 70,000 direct labour hrs are worked. Variable cost: Semivariable cost: Fixed cost:

70,000hrs x ($302,000/56,000hrs) = 0.3x70,000+2,800=

$377,500 $23,800 $37,000 $438,000

Basic variances 6 Illustration (K 284) – Basic variances Riki Ltd, produces and sells one product only. The standard cost and price for one unit being as follows: Direct material A – 10 kilograms at $12 per kg Direct material B – 6 kilograms at $5 per kg Direct wages – 5 hours at $8 per hour Fixed production overhead Total standard cost Standard gross profit Standard selling price

$ 120 30 40 60 250 50 300

Sales 700 units @ $320 Direct materials: A: 7,500 Kg B: 3,500 Kg Direct wages 3,400 hours Fixed production overhead

91,500 20,300 27,880 37,000 176,680 47,320

Gross profit Note: Riki Ltd does not hold any inventories.

You are required to calculate following variances: Selling price, sales volume, material price, material usage, labour rate, labour efficiency, fixed overhead expenditure and fixed overhead volume. (Note: go through 6.3 Fixed OH vars and Illustration 7 before calculating Fixed OH vars) 6Solution Riki (K 284) – Basic variances Material A variances -price:

-usage:

14 - 50

7,500kg SHOULD cost (x$12) = DID cost

$90,000 $91,500 $1,500 (A)

700units SHOULD take (x10kg) = 7,000kg 7,500kg DID take 500kg (A) x $12 = $6,000 (A)

ACCA F5 Chapter 14 – Solution

Material B variances -price:

Labour variances

3,500kg SHOULD cost (x$5) = DID cost

$17,500 $20,300 $2,800 (A)

-usage:

700units SHOULD take (x6kg) = DID take

4,200kg 3,500kg 700kg (F) x $5 = $3,500 (F)

-rate:

3,400hrs SHOULD cost (x$8) = DID cost

$27,200 $27,880 $680 (A)

-efficien: 700units SHOULD take (x5hrs) = 3,500hrs 3,400hrs DID take 100hrs (F) x $8 = $800 (F) Fixed OH variances OAR per unit = $60/unit OAR per labour hour = 60$/5hrs = $12/hr -total (diff actual x absorbed):

Actual Absorbed (700unitsx$60)=

-expenditure: (diff actual x budget) Actual Fix OH Budgeted Fix OH ($60x750units)=

$37,000 $42,000 $5,000 overabsorbed ď&#x192; (F) $37,000 $45,000 $8,000 (F)

-volume:(diff act and budgeted volume x OAR per unit) Actual units 700 units 750 units Budgeted units 50 units less (A)x$60=3,000 (A) -efficiency (they worked slowly) 700 units SHOULD take (x5hrs)= 3,500hrs 3,400hrs DID take 100hrs (F)x$12 = $1,200 (F) -capacity (they worked at the same pace as planned, but less hrs) Actual hrs: 3,400hrs Budgeted hrs: 750units x 5hrs = 3,750hrs 350hrs (A)x$12 = $4,200(A) Sales variances

- price:

700 units SHOULD give (x$300) = $210,000 $224,000 DID give (x$320) = $14,000 (F)

-volume: 700-750 = 50 units less sold x $50 = $2,500 (A)

ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

14 - 51

Fixed overhead variances 8

Illustration - Fixed overhead variances

The following information is available for K Ltd for Period 4: Budget Fixed production overheads $20,000 Units 1,000 Labour hours The standard time to produce each unit is 5 hours Calculate all fixed overhead variances. 8

Actual $20,450 1,100 5,400 hrs

Solution - Fixed overhead variances

OAR per unit = $20,000/1,000 units = $20/unit OAR per labour hour = $20,000/(5hrsx1,000units) = $4/hr -total (diff actual x absorbed):

Actual Absorbed (1,100unitsx$20)=

-expenditure: (diff actual x budget) Actual Fix OH Budgeted Fix OH

$20,450 $22,000 $1,550 overabsorbed ď&#x192; (F) $20,450 $20,000 $450 (A)

-volume:(diff act and budgeted volume x OAR per unit) Actual units 1,100 units 1,000 units Budgeted units 100 units (F)x$20=2,000 (F) overabsorbed -efficiency (they worked quickly) 1,100 units SHOULD take (x5hrs)= 5,500hrs 5,400hrs DID take 100hrs (F)x$4 = $400 (F) -capacity (they worked at the same pace as planned, but more hrs) Actual hrs: 5,400hrs Budgeted hrs: 1,000units x 5hrs = 5,000hrs 400hrs (F)x$4 = $1,600(F) SUMMARY: $ (ii) Fixed overhead expenditure variance 450 (A) (iv) Fixed overhead capacity variance 1,600 (F) 400 (F) (v) Fixed overhead efficiency variance 2,000 (F) (iii) Fixed overhead volume variance (i) Fixed overhead total variance 1,550 (F)

Idle time variance 11

Illustration Idle time (K 291)

The following data relates to T plc for the month of January: Standard productive time per unit Standard wage rate per hour Actual production Standard idle time as a percentage of hours paid Actual hours paid Actual idle time hours

2 hours $4.00 1,200 units 4% 2,600 110

Calculate the labour efficiency variance and analyse it between productive efficiency and idle time.

14 - 52

ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

Solution Idle time

Labour total:

1,200units SHOULD cost (x2hr x (1/0.96) x $4)= DID cost (2,600hrx$4)=

-rate:

2,600hrs SHOULD cost (x$4)= DID cost

$10,400 $10,400 $0

$10,000 $10,400 $400 (A)

-efficiency (total-non-productive): 1,200units SHOULD take (x2hr/0.96)= DID take

2,500hrs 2,600hrs 100hrs (F) x $4 = 400$ (F)

-efficiency productive: 1,200 SHOULD take (x2hrs)= 2,400hrs DID take (2,600-110) 2,490hrs 90hrs (A) x $4x (1/0.96)=$375 (A) -idle:

budgeted idle time: 4%x2,600hrs= 104hrs 110hrs Actual 6hrs (A) x $4/0.96=$25 (A)

SUMMARY: Productive labour efficiency var Excess idletime var Non productive (total) labour efficiency var Labour rate var Labour total

$375 (A) $25 (A)

$400 (A) $0

$400

Wastage variance 12

Illustration – wastage and material variances

Specifications for products A and B: A contains 3 units material X, B contains 6 units X During processing 15% of X is lost Std price X = $9 Demand for period 1 is budgeted: A 2,200 units, B 2,800 units. Return from customers requiring free replacement will be 4% and 2% resp of goods delivered to customers. No stock planned. Calculate material purchase budget for period 1 for component X. 12

Solution – wastage and material variances

Demand (units) Returns Demand with returns Free replacement

(2,200/0.96)

Standard input X Losses Input allowing for losses

(3/0.85)

Cost A: 3.53x$9x2,292= Cost B: 7.06x$9x2,857= Total cost X:

$77,817 $181,534 $259,351

ACCA F5 Chapter 14 – Solution

A 2,200 4% 2,292 92 A 3 x 3.53

(2,800/0.98)

B 2,800 2% 2,857 57 B 6 x 7.06

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Operating statements 13

Solution (K 264) – (Riki above ) – Operating statement – absorption costing

Operating statement Budgeted profit (750 × $50) Sales volume variance Standard profit on actual sales Selling price variance Cost variances: Material price (combined) Material usage (combined) Labour rate Labour efficiency Fixed overhead expenditure Fixed overhead volume

800 8,000 ——— 8,800

Total

A (4,300) (2,500) (680) (3,000) ——— 10,480

Actual profit Check: Sales 700x320$= Mat A Mat B Wages Fix OH

91,500 20,300 27,880 37,000

$ 37,500 (2,500) 35,000 14,000

(1,680) ——— 47,320 ———

224,000

(176,680) 47,320

Solution (K 264) – (Riki above) – Operating statement – marginal costing

Sales volume var: 700-750 units = 50 units (A) x 110$ =$5,500 Operating statement

$ 37,500 45,000 82,500

Budgeted profit (750 × $50) + budgeted fix OH (750x60$) Budgeted contribution Sales volume variance Selling price variance

5,500 (A) 14,000 (F)

Cost variances: Material price Material usage Labour rate Labour efficiency Total Actual contribution Budget fix OH Fix OH expenditure var Actual Fix OH Actual profit Check: Sales 700x320$= Mat A Mat B Wages Fix OH

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91,500 20,300 27,880 37,000

F 3,500 800 4,300 (45,000) 8,000 (F)

A 2,800+1500 6,000 680 --------10,980

(37,000)

91,000

6,680 (A) 84,320

47,320

224,000

(176,680) 47,320 ACCA F5 Chapter 14 – Solution

CHAPTER 11 – ADVANCED VARIANCES Mix and yield 2

Illustration Mix and yield (no losses)

Standard materials for 1 unit of ABC X Y

$ 5 20 25

2kg@ $2.50 per kg 5kg@ $4.00 per kg

Solution Mix and yield (no losses)

PRICE VAR X Y

2,000kg 3,000kg

MIX VAR X Y

SHOULD COST x$2.50= $5,000 x$4= $12,000

MIX ACTUAL 2,000 kg 3,000 kg 5,000 kg

DID COST $5,200 $12,800

MIX STD (ACT Q) (2/7) 1,429 kg (5/7) 3,571 kg 5,000 kg

VAR ($) 200 (A) 800 (A) $1,000 (A) VAR (kg) 571 (A) x$2,50= 571 (F) x$4= 0 kg

VAR($) 1,428 (A) 2,284 (F) $856 (F)

YIELD (what IN should be for given OUTPUT) 650 units USED (STD MIX) SHOULD USE VAR (kg) X (2/7) 1,429 kg (650x2kg) 1,300 kg 129kg (A) x$2.50= (650x5kg) 3,250 kg 321kg (A) x$4= Y (5/7) 3,571 kg 5,000 kg 4,550 kg NOTE: If not required yield for individual materials, you can calculate YIELD TOTAL:

VAR ($) $323 (A) $1,284 (A) $1,607 (A)

a/ What IN should be for given OUTPUT 650 units SHOULD use (x7kg) = DID use

4,550 kg 5,000 kg 450 kg (A) x $3.57 (W1) =$1,607 (A)

W1: Standard materials for 1 unit of ABC X Y

2kg@ $2.50 per kg 5kg@ $4.00 per kg 7kg

$ 5 20 25

 average standard cost per kg of input = 25/7 = $3.57

b/ What should be at OUTPUT for actual INPUT 5,000 kg SHOULD produce (5,000/7kg) = DID produce

ACCA F5 Chapter 14 – Solution

714.3 units of output 650 units of output 64.3 units (A) x 25$ = $1,607 (A)

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Illustration – Mix and yied with losses

Company produces product ABC, uses material S,T. Standard and actual quantities in period 1 were as follows: kg 30,000 15,000

Material S Material T

Standard $/kg 2.50 4.00

total $ 75,000 60,000

kg 25,000 17,000

Actual $/kg 2.50 4.00

total $ 62,500 68,000

Losses during procession of material are expected at level of 15% of material input. Actual output during the period 1 was 40,000 kg of ABC. Calculate price, mix and yield variances. 3

Solution – Mix and yied with losses

PRICE VAR MIX VAR S T

no variance (act = std)

MIX ACTUAL 25,000 kg 17,000 kg 42,000 kg

$1,000 (A)

MIX STD (ACT Q) (30/45) 28,000 kg (15/45) 14,000 kg 42,000 kg

VAR (kg) 3,000(A) x$2,50= 3,000 (F) x$4= 0 kg

VAR($) 7,500(A) 12,000 (F) $4,500 (F)

YIELD 40,000 kg of ABC S T

NOTE: Yield total: 40,000kgs of ABC W1: kg 30,000 15,000 45,000

S T

USED (STD MIX) (30/45) 28,000 kg (15/45) 14,000 kg 42,000 kg

SHOULD USE (30/45) 31,373 kg (15/45) 15,686 kg 47,059 kg (=40,000kg/0.85)

SHOULD use DID use

47,059 kg (40,000/0.85) 42,000 kg 5,059 kg (F) x$3 (W1)=$15,177 (F)

Standard $/kg 2.50 4.00

total $ 75,000 60,000 135,000

VAR (kg) 3,373kg (F) x$2.50= 1,686kg (F) x$4=

VAR ($) $8,433 (F) $6,744 (F) $15,177 (F)

 1kg cost 135,000/45,000=$3

Illustration (K 08/09 – 321) – Mix and yield with losses

The following shows the standard input and cost for 6 tonnes of output Tonnes $ Malt barley 2.0 @ $230 460 Feed barley 8.0 @ $110 880 Total 10.0 1,340 Yield loss 40% (4.0) 0 Expected output 6.0 1,340 The actual input, output and costs are shown below: Production 270 tonnes Input – Malt barley 70 tonnes costing $16,100 – Feed barley 430 tonnes costing $48,355 Required: a/ Prepare all material variances and b/ discuss their causes. 4 Solution PRICE VAR Malt Feed

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70t 430t

SHOULD COST x$230= $16,100 x$110= $47,300

DID COST $16,100 $48,355

VAR ($) 0 1,055(A) $1,055 (A)

ACCA F5 Chapter 14 – Solution

MIX VAR Malt Feed

MIX ACTUAL 70t 430t 500t

MIX STD (ACT Q) (2/10) 100t (8/10) 400t 500t

VAR (t) 30 (F) 30 (A) 0t

x$230= x$110=

VAR($) 6,900 (F) 3,300(A) $3,600 (F)

YIELD 270t of output Malt Feed

USED (in STD MIX) (2/10) 100t (8/10) 400t 500t

SHOULD USE (2/10) 90t (8/10) 360t 450t (270t x 10/6)

SUMMARY: Standard material cost for 270 tonnes of output ($1,340/6 × 270) Actual material cost Total material variance This is made up of: Price variance Mix variance Yield variance

VAR (t) 10t (A) 40t (A)

x$230= x$110=

VAR ($) $2,300(A) $4,400 (A) $6,700 (A)

$60,300 $64,455 $4,155 A

$1,055 A $3,600 F $6,700 A $ 4,155

b/ Causes:  The price variance is adverse because the feed barley price is higher than expected. 

The mix variance is favourable because a greater proportion of feed barley has been used than would normally be used in the standard mix. Feed barley is a cheaper material than malt barley.



The yield variance is adverse because less output has been achieved than was expected from the materials input.



It is possible that changing the mix to include a greater proportion of cheaper feed barley has led to the reduction in yield. Overall this has led to a total adverse usage variance of $3,100 and this will adversely affect profit.

Sales mix and quantity 7 Illustration (K 300) – Sales mix and quantity variances CAB Co operates an absorption costing system and sells three products B, R, and K, which are substitutes for each other. The following standard selling price and cost data relate to these three products: Product B R K

Unit Selling Price $14.00 $15.00 $18.00

Direct Material/Unit 3 kgs @ $1.80 / Kg 1.25 kgs @ $3.28 / Kg 1.94 kgs @ $2.50 / Kg

Direct Labor/Unit 0.5 Hours @ $ 6.50 / Hour 0.8 Hours @ $ 6.50 / Hour 0.7 Hours @ $ 6.50 / Hour

Budget fixed production overhead for the last period was $81,000. This was absorbed on a machine hour basis. The standard machine hours for each product and the budgeted levels of production and sales for each product for the last period are: Product B K R Standard machine hours per unit 0.3 hours 0.6 hours 0.8 hours Budgeted production and sales (units) 10,000 13,000 9,000 Actual volumes and selling prices for the three products in the last period were as follows: Product Actual selling price per unit Actual production and sales (units)

B $14.50 9,500

K $15.50 13,500

R $19.00 8,500

Calculate (1) Sales price variance, (2) Sales volume profit variance,(3) Sales mix profit variance,(4) sales quantity profit variance

ACCA F5 Chapter 14 – Solution

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7 Solution (K 300) – Sales mix and quantity variances Budgeted sales quantity in standard mix at standard profit: Product Quantity Standard Profit $ B 10,000 $4 40,000 R 13,000 $5 39,000 K 9,000 $5 45,000 –––––– –––––– 32,000 124,000 ––––– –––––– Average standard profit per unit = 124,000 / 32,000 = $3.875 per unit Actual sales quantity in actual mix at actual selling price less standard cost: Product Quantity Actual Selling Price standard cost $ B 9,500 (14.5 -10.0) 42,750 R 13,500 (15.5 - 12.0) 47,250 K 8,500 (19.0 - 13.0) 51,000 –––––– –––––– 31,500 141,000 –––––– –––––– Actual sales quantity in actual mix at standard profit: Product Quantity Actual Selling Price less standard cost $ B 9,500 $4 38,000 R 13,500 $3 40,500 K 8,500 $5 42,500 –––––– –––––– 31,500 121,000 –––––– –––––– Actual sales quantity in standard mix at standard profit : Uusing the average standard profit per unit calculated earlier :31,500 x 3.875 = $122,062 (i) Sales price variance = 141,000 - 121,000 = $20,000 (F) (ii) Sales volume profit variance = 121,000 - 124,000 = $3,000 (A) (iii) Sales mix profit variance = 121,000 - 122,062 = $1,062 (A) (iv) Sales quantity profit variance = 122,062 - 124,000 = $1,938 (A)

Planning and operational variances 8

Illustration (K 328) – no usage considered, only price – 1 planning error

Solution (K 328) – no usage considered, only price – 1 planning error

ORIGINAL BUDGET: 10,000 units x $5.20 = $52,000 REVISED BUDGET:

10,000 units x $5 =

$50,000

ACTUAL:

10,000 units x 5.18=

$51,800

2,000 (F) planning price var $1,800 (A) operational price var

Planning variance: The improvement in technology resulted in a lower price per unit and hence a favourable variance. This is a planning difference and is therefore uncontrollable by management. Operational variance: The cost per unit was higher than the revised budgeted cost resulting in the adverse variance. This variance is controllable by management and should be linked to their performance evaluation. 9

Illustration ( K 329) – 2 planning errors (material price and usage var)

Holmes Ltd uses one raw material for one of their products. The standard cost per unit at the beginning of the year was $28, (Standard material cost per unit = 7 kg per unit at $4 per kg = $28)

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ACCA F5 Chapter 14 – Solution

In the middle of the year the supplier had changed the specification of the material slightly due to problems experienced in the country of origin, so that the standard had to be revised: Stand material cost per unit = 8 kg per unit at $3.80 per kg = $30.40. The actual output for November was 1,400 units. 11,000 kg of material was purchased and used at a cost of $41,500. Calculate all planning and operational material variances. 9

Solution( K 329) â&#x20AC;&#x201C; 2 planning errors (price and usage var)

ORIGINAL BUDGET: 1,400 units

x7kg

x$4

=$39,200

1,400 units

x8kg

x$4

=$44,800

1,400 units

x8kg

x$3.80

=$42,560

x$3.80

=$41,800

x$?

=$41,500

REVISED BUDGET:

11,000kg ACTUAL:

1,400 units

Examiner (Article 4/09)

Illustration

x?kg

$5,600 (A) usage planning $2,240 (F) price planning $760 (F) usage operational $300 (F) price operational

Lowland Skiing had planned, when it originally produced its budget, to buy its artificial snow for $5 per kg. Budgeted production was 10,000 units. Product requires 10kg of snow. However, due to subsequent improvements in technology, manufacturers around the world reduced their prices to $4.85 per kg. This latter figure is now considered to be a fair target price for the purpose of performance assessment for the budget period. Revised usage - the product requires only 9.5kg per unit. The actual price paid was $4.75, as the Lowland Skiing buying department negotiated strongly for a better price. The actual material use was 108,900kg and 11,000 units were produced. Calculate all planning and operational material variances. 10 Solution Examiner (Article 4/09) Planing material variances Material price planning variance: (4.85 - 5) x 11,000 x 9.5 = 15,675 FAV Material usage planning variance: ((9.5 x 11,000) - (10 x 11,000)) x 5 = 27,500 FAV The total planning error is thus $15,675 FAV + $27,500 FAV, or $43,175 FAV in total. This is a provable figure, as it is the diference between ex-poste and the ex-ante budget both flexed for actual production levels. Ex-poste budget as flexed = 5 x 10 x 11,000 = $550,000 Ex-ante budget as flexed = 4.85 x 9.5 x 11,000 = $506,825 The difference is $43,175 Operational variances compare the differences between actual and revised budget figures. The calculations here are less controversial: Material price operational variance: (4.75 - 4.85) x 108,900 = 10,890 FAV Material usage operational variance: (108,900 - (9.5 x 11,000)) x 4.85 = 21,340 ADV The total operational variance is $10,450 ADV. Total variance It is possible to reconcile total planning variance ($43,175 FAV) and total operational variance ($10,450 ADV) as $32,725 FAV: Actual spend: 108,900 x 4.75 = $517,275 Flexed budget spend: (5 x 10 x 11,000) = $550,000 Total variance $32,725 FAV Using SCHEME: ORIGINAL BUDGET: 11,000 units

x10kg

x$5

=$550,000

11,000 units

x9.5kg

x$5

=$522,500

11,000 units

x9.5kg

x$4.85

=$506,825

x$4.85

=$528,165

x$4.75

=$517,275

REVISED BUDGET:

108,900kg ACTUAL:

11,000 units

ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

x?kg

$27,500 (F) usage planning $15,675 (F) price planning $21,340 (A) usage operational $10,890(F) price operational

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Illustration (K 329– 1 planning error, labour)

Solution

ORIGINAL BUDGET: 250 units x5hrs

x$10

=$12,500

REVISED BUDGET:

250 units x(5x1.20)hr x$10

=$15,000

ACTUAL:

250 units x? Hrs

=$14,500

x$10

$2,500 (A) - Planning labour efficiency $500 (F)

-Operational labour efficiency

Illustration – 2 planning errors, labour

Standard direct labour cost for product Revised std

4 hrs x $5 = $20 6 hrs x $4 = $24

Actual: 1,000 units produced, 6,200 hrs worked at cost of $23,800. Calculate planning and operational variances: 12

Solution

ORIGINAL BUDGET: 1,000 units

x4 hrs

x$5

=$20,000

1,000 units

x6 hrs

x$5

=$30,000

1,000 units

x6 hrs

x$4

=$24,000

x$4

=$24,800

x$?

=$23,800

REVISED BUDGET:

6,200hrs ACTUAL: 13

1,000 units

x? hrs

$10,000 (A) efficiency planning $6,000 (F) rate planning $800 (A) efficiency operational $1,000 (F) rate operational

Illustration – Sales volume planning and operational variance

Company ABC budgeted to make and sell 500 units of a product ABC in a week (5 days) period: $ Budgeted sales (100 units a day) 50,000 Variable cost (500 units * $70) 35,000 Contribution 15,000 Fixed costs 8,000 Profit 7,000 On day 4 production came to a halt as raw material ran out and new supply was not received until the day 5 – company lost 1 day of production and sales. Actual results in the period: $ Budgeted sales (420 units) 42,000 Variable cost (420 units * $70) 29,400 Contribution 12,600 Fixed costs 8,000 Profit 4,600 In retrospect, it is decided that optimum budget, given the loss of production on day 4, would have been to sell only 400 units. Calculate planning and operational variances.

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ACCA F5 Chapter 14 – Solution

Solution – Sales volume planning and operational variance

Volume revised from 500 units to 400 units: ORIGINAL BUDGET: 500 units x $30 =

$15,000

REVISED BUDGET:

400 units x $30 =

$12,000

ACTUAL:

420 units x $30=

$12,600

3,000 (A) sales volume planning $800 (F) sales volume operational

Illustration – sales price variance planning and eeprational

Solution – sales price variance

ORIGINAL BUDGET: 12,000 units x $12 =

$144,000

REVISED BUDGET:

12,000 units x $6 =

$72,000

ACTUAL:

12,000 units x $8=

$96,000

$72,000 (A) sales price planning $24,000 (F) sales price operational

Illustration – market share, market volume

Solution

Budget: 10,000 units Revised (impact of market volume) 93%x10,000 units = 9,300 units Actual: 8,000 units ORIGINAL BUDGET: 10,000 units x $10.50 = $105,000 REVISED BUDGET:

9,300 units x $10.50 = $97,650

ACTUAL:

8,000 units x $10.50= $84,000

$7,350 (A) sales volume planning (market volume) $13,650 (A) sales volume operational (market share)

Illustration (K 326)- Sales volume variance – market share, market volume

ACCA F5 Chapter 14 – Solution

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16 (a)

Solution

Sales price TOTAL variance

= 220,000 Ă&#x2014; ($14 - $12.50) = $330,000 (A)

Sales volume TOTAL variance = (250,000 - 220,000) Ă&#x2014; $4 = $120,000 (A) (b) Split of volume variance into market share and market size: ORIGINAL BUDGET: 250,000 units

x $4 =

$1,000,000

REVISED BUDGET:

250,000x(1,100/1,000) units

x $4 =

$1,100,000

ACTUAL:

220,000 units

x $4=

$880,000

$100,000 (F) (market volume) $220,000 (A) (market share)

(c) It could be argued that the increased competition in the market was not foreseen when the budget was set and the variance is thus a planning variance. However, this line of reasoning would suggest that any unforeseen issues give rise just to planning variances. Perhaps sales managers should have identified potential threats sooner? Also, once extra competition was experienced, managers had to decide how to respond. This could have involved additional advertising rather than price cuts, e.g. it could be argued that price cuts were made to try (unsuccessfully) to protect market share, in which case managers should be held (at least partly) responsible for such a decision. 17

Illustration (K 330)

POV Ltd uses a standard costing system to control and report upon the production of its single product. An abstract from the original standard cost card of the product is as follows: $ $ Selling price per unit 200 Less: 4 kg materials @ $20 per kg 80 42 6 hours labour @ $7 per hour 122 Contribution per unit 78 For period 3, 2,500 units were budgeted to be produced and sold but the actual production and sales were 2,850 units. The following information was also available. (1)

(2)

After using conventional variances for some time, POV Ltd is contemplating extending its system to include planning and operational variances. (a)

Prepare a statement reconciling budgeted contribution for the period with actual contribution, using conventional material and labour variances.

(b)

Prepare a similar reconciliation statement using planning and operational variances.

(c)

Explain the meaning of the variances shown in statement ( b)

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ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

17 a)

Solution Reconciliation of budgeted and actual contribution using conventional variances

Budgeted contribution: Variances: Sales volume Direct material – Price – Usage Direct labour – Rate – Efficiency

2,500 × $78 Favourable $ 27,300 24,900

——— 52,200 ———

Adverse $ 21,000 18,800 11,900 ——— 51,700 ———

Actual contribution Assumption: No sales price variance. Workings Conventional variances

$ 195,000

500 ———— 195,500 ————

Materials Price = (Actual material purchased × std price) - (Actual cost of material purchased)= (12,450 × $20) -(12,450 × $18) = $249,000 - $224,100 = $24,900 F Usage = (Std quantity for actual production × std price)- (Actual material used at std price= (2,850 × 4 x$20) (12,450 × $20) = $228,000 — $249,000 = $21,000 A (ii) Labour Rate = (Actual hrs worked × std direct labour rate) —(Actual hrs worked × actual hourly rate) = (18,800 × $7) - (18,800 × $8) = $131,600 — $150,400= $18,800 A Efficiency = (Std hours of actual production × std rate) — (Actual hours worked × std rate) = (2,850 × 6 × $7) —-(18,800 × $7) = $119,700 — $131,600 = $11,900 A (i)

Sales volume Contribution = (Budgeted sales units × standard contribution per unit) — (Actual sales units × standard contribution per unit) = (2,500 × $78) — (2,850 × $78) = $195,000 — $222,300= $27,300 F (b) Reconciliation statement using planning and operational variances Budgeted contribution for actual sales: Planning variances: Material – Price – Usage Labour – Rate: weather – Rate: material

(2,850 × $78 ) Favourable ($) 44,887.50

Revised budgeted contribution Operational variances:

($77.75 × 2,850) Favourable $

Material – Price – Usage Labour – Rate – Efficiency

Actual contribution

ACCA F5 Chapter 14 – Solution

8,550.00 ............ 53,437.50

6,187.50 0 ———— 6,187.50

Adverse($)

$ 222,300.00

28,500 25,650 54,150 Adverse $ 18,675.00 13,600.00 ———— 32,275.00

(712.50) 221,587.50

26,087.50 195,500.00

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Workings Planning variances (i) Material Price = (2,850 × (4 + 0.5) × $20) — (2,850 × (4 + 0.5) × $16.50)= $256,500 — $211,612.50= $44,887.50 F Usage = (2,850 × 4 × $20) — (2,850 × 4.5 × $20)= $228,000 — $256,500 = $28,500 A (ii)

Labour rate (1) Weather bonus = (2,850 × 6 × $7) — (2,850 × 6 × $6.50)= $119,700 — $111,150= $8,550 (F) (2) Alternative material difficulties = (2,850 × 6 × $6.50) — (2,850 × 6 × $8)= $111,150 — $136,800= $25,650 A

Therefore, revised unit contribution is as follows. Selling price Direct material: Direct labour:

4.5 × $16.50 6 × $8

$ 74.25 48.00 ———

Contribution

$ 200.00 ———— (122.25) ———— 77.75

Operational variances (i) Material -Price = (12,450 × $16.50) — (12,450 × $18)= $205,425 — $224,100= $18,675 A - Usage = (2,850 × 4.50 × $16.50) — (12,450 × $16.50)= $211,612.5 — $205,425= $6,187.5 F (ii) Labour -Rate = 0 -Efficiency = (2,850 × 6 × $8) — (18,800 × $8)= $136,800 — $150,400 = $13,600 A (c) The analysis of variances in part (b) makes it possible to separate those variances which are noncontrollable (the planning variances) from the variances which are controllable by the individual managers (the operational variances). In this case the change in type of material used was unavoidable. Similarly, the change in weather conditions could not have been anticipated. The cost implications of these changes are reflected in the planning variances. Management’s attention should be focused primarily on the operational variances. In particular, why did the firm pay $18 per kg for material when this was expected to cost $16.50? The operational material usage variance indicates that less material was used than expected – this could be due to the workers spending longer working with the material (as evidenced by the adverse efficiency variance.

14 - 64

ACCA F5 Chapter 14 – Solution

CHAPTER 12 - PERFORMANCE MEASUREMENT AND CONTROL 1

Illustration

A company has the following income statements: Turnover Less Cost of sales Gross profit Less expenses Net profit

Year 1 $ 50,000 35,000 15,000 10,000 5,000

Year 2 $ 80,000 48,000 32,000 24,000 8,000

Although the net profit margin is the same for both years – 10%, the gross profit margin is not. Year 1

15,000/50,000= 30%

Year 2 32,000/80,000 = 40%

Is this good or bad for the business? 1

Solution

The increase in gross profit margin indicates a higher difference between the prices realised and cost of sales and as such represent a positive trend. The net profit margin stayed the same suggesting that the company is loosening its expenses management. This suggests an area for improvement with administration, selling and distribution expenses or interest costs requiring tighter control. 2

Solution (K 08/09 - 360)

(a) For each of the two years, calculate the following ratios for T: Gross profit margin Operating profit margin Net profit margin ROCE

Gross profit ÷ Revenue Operating profit ÷ Revenue Net profit ÷ Revenue Operating profit ÷ Capital

Asset utilisation

Revenue ÷ Capital employed

20X5 90/150=60% 61.5/150=41% 37.9/150=25.3% 61.5/(92.9 + 125)=28.2% 150/(92.9 + 125)=0.69 times

20X6 115/180=63.9% 75.1/180=41.7% 45.8/150=25.4% 75.1/(146.7 + 150)=25.3% 180/(146.7 + 150)=0.61 times

(b) Suggest reason why T's ratios have changed Gross profit margin increased:  Increase in sales due to increasing volume sold and so economies of scale result in lower costs per unit sold  Increase in sales price per unit  Changes in product mix Operating profit margin unchanged:  Increase in expenses such as advertising to boost revenue  Increased depreciation charges following acquisitions of net current assets (NCAs)  Poor control of cists since revenue increased by 20% but operating expenses increased by 40% Net profit margin unchanged:  Increase in finance costs in line with increase in revenue. Increased borrowing to fund expansion has resulted in increased finance costs. ROCE and Asset utilisation have fallen:  No change in operating profit margin and so fall is due to fall in asset utilisation  Revaluation of NCAs will reduce asset utilisation (and ROCE) but not a ‘real’ deterioration in efficiency  Significant increase in NCAs during year. If acquired near year end, will not have generated returns as yet.  ACCA F5 Chapter 14 – Solution

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Solution

(K 08/09 - 365)

(a) For each of the two years, calculate the following ratios for T: Current ratio Quick ratio Inventory holding period

CAs ÷ Current liabilities (CAs — Inventory)÷ Current liabilities Inventory ÷ Cost of sales × 365

Receivables collection period

Receivables ÷ Revenue × 365

Payables payment period

Trade payables ÷ Cost of sales ×365

20X5 50,000/22,100=2.3:1 38,000/22,100=1.7:1 12,000/60,000 ×365= 73 days 37,500/150,000 ×365= 91 days 10,600/60,000 ×365= 65 days

20X6 64,300/33,800=1.9:1 49,300/33,800=1.5:1 15,000/65,000 ×365= 84 days 49,300/180,000 ×365= 100 days 111,700/65,000 ×365= 68 days

(b) Suggest reasons why T’s ratios have changed: Possible reasons why T’s ratios have changed: Inventory holding period increased:  Build-up of inventory levels as a result of increased capacity following expansion of non-current assets  Increasing inventory levels in response to increased demand for product Receivables collection period increased:  Deliberate policy to attract customers  Poor credit control procedures Payables payment period largely unchanged. Overall liquidity situation deteriorated:  Current and quick ratios have both fallen but not yet at level that give cause for concern. However, T is showing signs of liquidity issues with significant overdraft at year end. This is partially due to increasing inventory-holding and receivablescollection periods but suppliers being paid more or less as quickly as last year. It appears that the increase in non-current assets has also been partially funded via the overdraft. 6

Solution

(K 08/09 367)

(a) For each of the two years, calculate the following ratios for T: Gearing

Debt ÷ (Debt + Equity)

Gearing Interest cover Dividend cover

Debt ÷ Equity PBIT ÷ Finance costs Net profit ÷ Dividends

20X5 125/(125 + 92.9)= 57.4% 125/92.9= 134.6% 61.5/10= 6.15 times 37.9/25= 1.5 times

20X6 150/(150 + 146.7)= 50.5% 150/146.7= 102.2% 75.1/12= 6.26 times 45.8/25= 1.8 times

(b) Suggest reasons why T’s ratios have changed: Gearing fallen:  Primarily due to revaluation of NCAs. Without revaluation, gearing in line with previous year.  Increase in loan, but also an increase in equity financing  Additional finance used to increase NCAs and on other measures to expand company, e.g. increased advertising expenditure  Gearing ratio appears quite high, but interest cover also high and so not an immediate cause for concern. Dividend cover is adequate. As well as measuring risk, you may be asked to comment how identified risks might affect performance measures.

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ACCA F5 Chapter 14 – Solution

Illustration (K 347)

Examples of service quality measures and mechanisms at BAA plc are shown below: Quality

Measures

Mechanisms

Access Aesthetics Cleanliness Comfort Communication Competence Courtesy Friendliness Reliability Responsiveness Security

walking distance/ease of finding way around staff appearance/airport appearance/quality of catering environment and equipment crowdedness information clarity/clarity of labelling and pricing staff efficiency management courtesy of staff staff attitude equipment faults staff responsiveness efficiency of security checks/

surveys/operational data surveys/inspection surveys/inspection surveys/inspection surveys/inspection inspection surveys/inspection surveys/inspection surveys/inspection surveys/inspection surveys/ internal data

Illustration (K 08/09 375) Balance score card example

Perspective Financial

Customer Internal Innovation and learning

ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution

KPI Benchmark costs versus competitors ROI Percentage of income from new customers Sales order book Benchmark prices versus competitors Defect rate Delivery lead times Cycle time Rectification time Staff turnover Time to develop next generation of products Process tie to maturity New product introduction vs competition

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CHAPTER 13 – DIVISIONAL PERF AND TRANSFER PRICING ROI, RI 2

Illustration (K 399)

Investment centre has net assets of $800,000, made profits before interest of $160,000. The notional cost of capital is 12%. An opportunity has arisen to invest in a new project costing $100,000. The project would have a four year life, and would make cash profits of $40,000 each year. (a) What would be the average ROI with and without the investment? Would the investment centre manager wish to undertake the investment if performance is judged on ROI in Year 1? (b) What would be the average annual RI with and without the investment? Would the investment centre manager wish to undertake the investment if performance is judged on RI in Year 1? To calculate ROI and RI, use the value for capital employed as at the start of Year 1. 2 a)

Solution ROI

Without the investment $160,000 $800,000 20.0%

Profit Capital employed ROI

With the investment $175,000 $900,000 19.4%

ROI would be lower; therefore the centre manager will not want to make the investment. since his performance will be judged as having deteriorated. However, this results in dysfunctional behaviour since the company's target is only 12%. b)

Profit Notional interest RI

Without the investment With the investment $ $ 160,000 175,000 ($800,000 × 12%) (96,000) ($900,000 × 12%) (108,000) 64,000 67,000

The investment centre manager will want to undertake the investment because it will increase RI. This is the correct decision for the company since RI increases by $3,000 as a result of the investment.

Transfer pricing 5

Solution Able and Baker

(i) The transfer price should be set between $35 and $38. Able has spare capacity, therefore the marginal costs to the group of Able making a unit is $35. If the price is set above $38, Baker will be encouraged to buy outside the group, decreasing group profit by $3 per unit. (ii) If Able supplies Baker with a unit of Y, it will cost $35 and they (both Able and the group) will lose $10 contribution from X. So long as the bought in external price of Y to Baker is less than $45, Baker should buy from that external source. The transfer price should therefore be set at $45. 6

Solution Manuco

The general rule of transfer pricing to assist in profit maximising decisions is to set transfer price equal to marginal cost plus net opportunity cost to the group. (i) Since Helpco Ltd has an external market, which is the opportunity foregone, the relevant transfer price would be the external selling price of $15 per kg. This will be adjusted to allow for the $1.50 per kg avoided on internal transfers due to packing costs not required. The transfer price should be $15 - $1.50 = $13.50 per kg. 14 - 68

ACCA F5 Chapter 14 – Solution

(ii) In this situation Helpco has no alternative opportunity for 3,000kg of its special ingredient Z. It should, therefore, offer to transfer this quantity at marginal cost. This is variable cost less packing costs avoided = $9 — $1.50 = $7.50 per kg. (Note: Total cost = $15 × 80% = $12, Variable cost = $12 × 75% = $9.) The remaining amount of special ingredient Z should be offered to Manuco Ltd at the adjusted selling price of $13.50 per kg as in (i) above. (iii) Helpco Ltd has an alternative use for some of its production capacity, which will yield a contribution equivalent to $3 per kg of special ingredient Z ($6,000/2,000kg). The balance of its square capacity (1,000kg) has no opportunity cost and should still be offered at marginal cost. Helpco Ltd should offer to transfer: 2,000kg at $7.50 + $3 = $10.50 per kg; 1,000kg at $7.50per kg (=MC); and the balance of requirements at $13.50 per kg. 7

Solution (K 08/09 424) Kwaree

80% Sales outside 1,000 t x 180$ 60,000 bags x $4

Internal transfers 600x 180$ Var cost 1,600t x 70$ 600t x 60$ Fixed cost Profit

180

108 (112) (100) 76

Retail

Kwaree

240

180 240

(108)

(36) (40) 56

(112) (36) (140) 132

100% Sales outside 1,000 t x 180$ 100,000 bags x $3,2 Internal transfers 1,000x 180$ Var cost 2,000t x 70$ 1,000t x 60$ Fixed cost Profit

WS 180

180 (140) (100) 120

Retail

Kwaree

320

180 320

(180)

(60) (40) 40

(140) (60) (140) 160

If it is assumed that the group (divisional) managers of Kwaree Inc are being measured in terms of the profitability of their divisions, then the effect on divisional profits of utilising the spare capacity in the wholesale group can be summarised as follows: 80% capacity 100% capacity Increase/ decrease

Profits Wholesale 76 120 44

Profits Retail 56 40 (16)

Profit Kwaree 132 160 28

As a result of utilising spare capacity, the profits of Kwaree would increase by $28,000. However, the wholesale group profits would increase by $44,000, whereas the manager of the retail group would see his division’s profits fall by $16,000. This fall is caused by the reduction in the selling price per bag of the moulding clay, affecting all the sales of the retail group and not only the additional sales. The manager of the retail group, acting independently, is unlikely to accept a decision to increase his production and sales if, as a result, the profit on which he is assessed is likely to decline. The action which he sees to be most beneficial for the retail group, for which he is responsible, is not the action which is in the best interests of the whole company. This is an example of suboptimisation. Ideally the transfer price should be such that the profits of wholesale and retail groups and the company would all increase as a result of moving from the 80% to 100% capacity. A transfer price must be adopted which will encourage the higher level of transfer to take place – since Kwaree Inc then makes an additional $28,000 profit. At the moment it will not occur since the retail group can see its profits fall. The only way to encourage the retail group to increase its purchases from the wholesale group is to reduce the transfer price. Note: it is not sufficient to simply determine a new transfer price at which the retail group’s profit at full capacity is higher than that at 80% under the old transfer price. Once a price is set, the manager of the retail group will pick the operating level that gives him maximum profit. Thus the new transfer price must ensure that the profits operating at 100% capacity exceed those when operating at 80% capacity under the new transfer price.

CHAPTER 14 – PERFORMANCE MEASUREMENT IN NFPO ACCA F5 Chapter 14 – Solution

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ACCA F5 Chapter 14 â&#x20AC;&#x201C; Solution