ACCA. For Examinations to June Paper F5 PERFORMANCE MANAGEMENT. Revision Essentials

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1 E For Examinations to June 2015 PL Revision Essentials ACCA SA M Paper F5 PERFORMANCE MANAGEMENT Becker Professional Education has more than 20 years of experience providing lectures and learning tools for ACCA Professional Qualifications. We offer ACCA candidates high-quality study materials to maximise their chances of success.

2 Becker Professional Education, a global leader in professional education, has been developing study materials for ACCA for more than 20 years, and thousands of candidates studying for the ACCA Qualification have succeeded in their professional examinations through its Platinum and Gold ALP training centers in Central and Eastern Europe and Central Asia.* Becker Professional Education has also been awarded ACCA Approved Content Provider Status for materials for the Diploma in International Financial Reporting (DipIFR). Nearly half a million professionals have advanced their careers through Becker Professional Education's courses. Throughout its more than 50-year history, Becker has earned a strong track record of student success through world-class teaching, curriculum and learning tools. We provide a single destination for individuals and companies in need of global accounting certifications and continuing professional education. *Platinum Moscow, Russia and Kiev, Ukraine. Gold Almaty, Kazakhstan Becker Professional Education's ACCA Study Materials All of Becker s materials are authored by experienced ACCA lecturers and are used in the delivery of classroom courses. Study System: Gives complete coverage of the syllabus with a focus on learning outcomes. It is designed to be used both as a reference text and as part of integrated study. It also includes the ACCA Syllabus and Study Guide, exam advice and commentaries and a Study Question Bank containing practice questions relating to each topic covered. Revision Question Bank: Exam style and standard questions together with comprehensive answers to support and prepare students for their exams. The Revision Question Bank also includes past examination questions (updated where relevant), model answers and alternative solutions and tutorial notes. Revision Essentials*: A condensed, easy-to-use aid to revision containing essential technical content and exam guidance. *Revision Essentials are substantially derived from content reviewed by ACCA s examining team.

3 ACCA PAPER F5 PERFORMANCE MANAGEMENT REVISION ESSENTIALS For Examinations to June DeVry/Becker Educational Development Corp. All rights reserved. (i)

4 No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the author, editor or publisher. This training material has been published and prepared by Becker Professional Development International Limited 16 Elmtree Road Teddington TW11 8ST United Kingdom. ISBN-13: Copyright 2014 DeVry/Becker Educational Development Corp. All rights reserved. All rights reserved. No part of this training material may be translated, reprinted or reproduced or utilised in any form either in whole or in part or by any electronic, mechanical or other means, now known or hereafter invented, including photocopying and recording, or in any information storage and retrieval system. Request for permission or further information should be addressed to the Permissions Department, DeVry/Becker Educational Development Corp. These are condensed notes focusing on key issues for those of you who lead busy, mobile lives or for those of you who want to revise in a more focused fashion DeVry/Becker Educational Development Corp. All rights reserved. (ii)

5 CONTENTS CONTENTS Page Syllabus (v) Core topics (vi) Costing systems and techniques 0101 Activity based costing 0201 Developments in management accounting 0301 Relevant costing 0401 CVP analysis 0501 Limiting factor decisions 0601 Pricing 0701 Risk and uncertainty 0801 Budgeting 0901 Quantitative techniques for budgeting 1001 Basic variance analysis 1101 Advanced variance analysis 1201 Planning and operational variances 1301 Performance measurement 1401 Further aspects of performance measurement DeVry/Becker Educational Development Corp. All rights reserved. (iii)

6 CONTENTS 2014 DeVry/Becker Educational Development Corp. All rights reserved. (iv) Page Divisional performance evaluation 1601 Transfer pricing 1701 Performance management information systems 1801 Article Approaching written questions 1901 Article Target costing and lifecycle costing 2001 Article Environmental management accounting 2101 Article Materials mix and yield variances 2201 Article Performance measurement 2301 Article Interpreting financial data 2401 Article Performance measurement and the balanced scorecard 2501 Article Transfer pricing 2601 Analysis of specimen exam 2701 Examination Technique 2801 Further reading 2901 These are condensed notes focusing on key issues and offering a limited number of examples and exercises for those of you who lead busy, mobile lives or for those of you who want to revise in a more focused fashion. Be Warned: These notes only offer guidance on key issues. On their own they are not enough to pass the examination.

7 INTRODUCTION Aim To develop knowledge and skills in the application of management accounting techniques to quantitative and qualitative information for planning, decision-making, performance evaluation, and control Main capabilities On successful completion of this paper candidates should be able to: A Explain and apply cost accounting techniques B Select and appropriately apply decision-making techniques to facilitate business decisions and promote efficient and effective use of scarce business resources, appreciating the risks and uncertainty inherent in business and controlling those risks C D Identify and apply appropriate budgeting techniques and methods for planning and control Use standard costing systems to measure and control business performance and to identify remedial action SYLLABUS 2014 DeVry/Becker Educational Development Corp. All rights reserved. (v) E Identify and discuss performance management information systems and assess the performance of a business from both a financial and non-financial viewpoint, appreciating the problems of controlling divisionalised businesses and the importance of allowing for external aspects. Position of the paper in the overall syllabus The syllabus for Paper F5, Performance Management, builds on the knowledge gained in Paper F2, Management Accounting, and prepares those candidates who choose to study Paper P5, Advanced Performance Management, at the Professional level. Format of the examination The syllabus is assessed by a three-hour paper-based examination.. Section A of the exam comprises 20 multiple choice questions of 2 marks each.

8 Section B of the exam comprises three 10 mark questions and two 15 mark questions. The two 15 mark questions will come from any part of the syllabus except Section A, specialist cost and management accounting techniques. The section A questions and the other questions in Section B can cover any areas of the syllabus. SYLLABUS 2014 DeVry/Becker Educational Development Corp. All rights reserved. (vi)

9 CORE TOPICS CORE TOPICS CHECKLIST Tick when completed Specialist cost and management accounting techniques Budgeting Activity based costing Budgetary systems Target costing Types of Budget Life-cycle costing Quantitative analysis in budgeting Throughput accounting Behavioural aspects of budgeting Environmental accounting Decision-making techniques Relevant cost analysis Cost Volume Profit analysis Limiting factors Pricing decisions Make-or-buy and other short term decisions Dealing with risk and uncertainty 2014 DeVry/Becker Educational Development Corp. All rights reserved. (vii) Standard costing and variance analysis Budgeting and standard costing Material mix and yield variances Sales mix and quantity variances Planning and operational variances Behavioural aspects of standard costing Tick when completed

10 Performance management systems Performance management information systems Sources of management information Management reports The scope of performance management Divisional performance and transfer pricing Performance analysis in not for profit organisations and the public sector External considerations and behavioural aspects CORE TOPICS CHECKLIST Tick when completed 2014 DeVry/Becker Educational Development Corp. All rights reserved. (viii)

11 COSTING SYSTEMS AND TECHNIQUES Marginal costing In marginal costing (MC) inventory is valued to include only variable production cost: $ per unit Direct materials x Direct labour x Prime cost x Variable production overhead x Marginal cost inventory valuation x An important principle in management accounting is contribution. Contribution is revenue minus variable costs. It shows how much the profit of an organisation increases if output increases by 1 unit. Absorption costing In an absorption costing (AC) system all production costs are included in inventory valuation. This involves using some basis to absorb fixed production overheads into the cost of making one unit of a product. COSTING SYSTEMS AND TECHNIQUES 2014 DeVry/Becker Educational Development Corp. All rights reserved Prime cost (direct materials + direct labour) Variable production overhead Fixed production overhead Absorption costing inventory valuation $/unit x x x x Overheads are absorbed using some pre determined overhead absorption rate. This absorption rate might be based on labour hours, machine hours or even a per unit basis. If labour hours are used, for example the absorption rate is calculated as: Budgeted fixed overheads Budgeted labour hours After this, the cost per unit of each product is calculated by multiplying the labour hours used for one unit of the product by this overhead absorption rate.

12 Activity Based Costing Activity based costing aims to analyse overhead costs in more depth to identify what activities cause those costs. The costs are then apportioned to different products based on how much each products uses the activity: The steps in an activity based costing exercise can be summarised as follows: 1. Identify the major activities that each department performs (e. g. maintaining machines). 2. Determine the driver for each activity that is the factor that causes the cost of the activity to vary (e. g. time taken, man hours). 3. Calculate an absorption rate per unit of driver for each activity this may be based on budgeted or actual costs. (e.g. maintenance cost per man hour = Total maintenance costs ) Total man hours ACTIVITY BASED COSTING 2014 DeVry/Becker Educational Development Corp. All rights reserved Calculate the total cost that will be absorbed by each product (e. g. Product A used 1,000 hours of maintenance. Therefore Product A will absorb 1,000 hours rate calculated in step 3 above). Each product will include costs from several activities. 5. Calculate the cost per unit of each product by dividing the total cost (calculated in 4) by the number of units produced. Advantages and disadvantages of activity based costing Advantages Better decision making (by providing more accurate information of products profitability) Cost can be designed out of products by eliminating unnecessary activities. When cost plus methods of pricing are used, prices based on ABC are likely to reflect more accurately the true cost of producing a product.

13 Disadvantages Selection of cost drivers may not be easy. Additional time and cost of setting up and administering the system. Exclusion of non-production overheads can be difficult. Many judgemental decisions still required in the construction of an ABC system. ACTIVITY BASED COSTING 2014 DeVry/Becker Educational Development Corp. All rights reserved. 0202

14 DEVELOPMENTS IN MANAGEMENT ACCOUNTING Target costing Objective to identify the required cost per unit of a product so that an acceptable margin can be achieved even when selling at a competitive price. $ Selling price Less: required margin Target cost Actual (Budgeted cost) () The following steps are used: Determine the price that customers would be prepared to pay for the product. Determine the required profit margin. Deduct this from the price to obtain the target cost. DEVELOPMENTS IN MANAGEMENT ACCOUNTING COST GAP 2014 DeVry/Becker Educational Development Corp. All rights reserved Estimate the actual cost of the product (or budgeted cost for products in the design phase). Identify ways to eliminate the gap between the actual and target cost. Target costing is more effective if used during the design of a new product, as costs can be designed out. For existing products, costs will have to be controlled out which is normally more difficult. Benefits of target costing Requires organisations to focus on the external environment as price is based on market rather than use of cost plus methods of pricing. Product design takes into account those facets of a product that customers are prepared to pay for, and removes those that customers do not value. Cost control is considered at the design stage of a product when it is easier to eliminate costs. In practice, companies that have adopted target costing tend to have lower costs per unit.

15 Lifecycle costing Traditional management accounting provides information about product costs and revenues only for the period covered by the management accounts. Management do not see the picture of the profits or losses over the whole life of the product. Costs per unit typically include only manufacturing costs and ignore costs incurred in developing the product and costs that may be incurred at the end of the product s lifecycle, such as disposal costs. Lifecycle costing involves budgeting and monitoring the costs, revenues and cash flows generated by a product over its whole life rather than on a period-by-period basis. Much of the costs of a product are determined at the design stage, so it is important that at this stage future revenues are considered, to ensure that over the whole life, the revenues will exceed the costs. Life cycle cost per unit can also be calculated. This takes the total of all costs incurred over the life of the product, and divides by the number of units produced. DEVELOPMENTS IN MANAGEMENT ACCOUNTING 2014 DeVry/Becker Educational Development Corp. All rights reserved Benefits of life cycle costing Management will plan the pricing strategy of a product over its whole life rather than on a short-term basis. Decision-making will be based on more relevant information as management have the whole picture of the product over its life rather than the current period only. Throughput Accounting Ratio T.PA.R. = Return per factory hour Cost per factory hour Throughput pet unit Return per factory hour = Hours of bottleneck resource used per unit Cost per factory hour = Other factory costs Bottleneck resource hours available Aim: to focus the attention of management on production bottlenecks and how to maximize the throughput that can be generated in the presence of such bottlenecks. Throughout contribution however, material is the only truly variable cost in the short term.

16 Other factory costs = all other costs (including labour and variable overheads which are all fixed in the short term. Advantages of the t.p.a.r. Focuses the attention of management on eliminating bottlenecks. If a manager wishes to improve his or her measured throughput, there are three possible ways (mathematically) Increase selling price per unit or reduce material cost per unit. Unlikely in a competitive environment. Reduce fixed costs per hour of bottleneck but this may impact on quality Eliminate the bottleneck by investing in additional machinery, or redesigning processes so less time is spent on the bottleneck resource. Environmental management accounting Definition EMA aims to provide internal information to management in the form of physical information on the use of energy, water and materials (including waste), DEVELOPMENTS IN MANAGEMENT ACCOUNTING 2014 DeVry/Becker Educational Development Corp. All rights reserved and monetary information on environment related costs and savings. Need for environmental management accounting The environment has become an important political and social issue in the last 30 years. Organisations need to be aware of their environmental behaviour because: Poor environmental behaviour can harm the reputation of the organisation, which may lead to a fall in revenues. Organisations may incur fines and cost of cleaning up in cases of poor environmental behaviour for example causing pollution. Increasing government regulation has increased the costs of compliance with environmental laws and regulations. Organisations can save money by becoming more efficient at their use of scarce resources such as energy. Traditional management accounting does not show managers the environmental impact of the organisation s activities.

17 Environmental costs Various commentators have defined categories of environmental related costs. Broad definitions such as that proposed by the US Environmental protection agency are as follows: Conventional costs of buying inputs with environmental relevance such as energy Potentially hidden costs items with environmental relevance hidden in overheads Contingent costs such as cleaning up damage Image and relationship costs. Hansen and Mendova gave a more narrow definition of environmental costs: Environmental prevention costs such as redesigning production processes to reduce pollution Environmental detection costs Environmental internal failure costs cost of cleaning up pollution before it has been released into the environment. DEVELOPMENTS IN MANAGEMENT ACCOUNTING 2014 DeVry/Becker Educational Development Corp. All rights reserved Environmental external failure costs cost of cleaning up pollution after it has been released into the environment. Environmental management accounting techniques Use of environmental reports showing the costs such as those proposed by Hansen and Mendova. Activity based costing extended to include environmental activities and their appropriate drivers Input output (mass balance) analysis reconciles quantities input with quantities of output (in Kilos, litres etc.). This highlights waste. Flow cost accounting a more sophisticated version of input output analysis that produces physical and monetary information about the inputs and outputs of each process. Life cycle costing includes environmental costs such as packaging costs in a products life cycle.

18 1 RELEVANT COSTS 1.1 For decision-making Only costs (and revenues) affected by a decision are relevant. Relevant Future, incremental, cash flows. Non-relevant Historic costs, sunk costs apportioned fixed costs non-cash items (depreciation, profit/loss on sale). Avoidable costs. Committed costs. Controllable. Common costs management charges. RELEVANT COST ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved OPPORTUNITY COST 2.1 Key point All opportunity costs are relevant. Not all relevant costs are opportunity costs. 2.2 Definition The value of the benefit sacrificed... in favour of an alternative. The potential benefit foregone (from the best rejected course of action). Clearly arise in use of scarce resources. 2.3 Potential difficulties Estimating future costs/revenues (benefit sacrificed). Identifying alternative uses (and best alternative forgone). Ignores effect on accounting profit. Ignores any risk associated with each alternative.

19 3 RELEVANT COST OF SPECIFIC ITEMS 3.1 Relevant costs of materials Yes Replacement cost Are they used regularly? No Replacement cost Replacement cost = current purchase cost. Deprival value applies where materials are scarce ( 3.4). RELEVANT COST ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved No Already bought? Yes Opportunity cost (e.g. sale value) 3.2 Relevant costs of labour If work can be done in idle time, relevant cost is zero. If labour is fully employed relevant cost is the additional payments required: to hire additional labour; overtime payments. If labour is fully employed and no further labour is available: direct cost of labour (wages); plus lost contribution from other production. This is equivalent to revenue foregone less costs (other than labour) saved. 3.3 Overheads Additional (e.g. stepped) fixed overheads or those that can be saved are relevant. Reallocated/apportioned overheads are not relevant. Overhead absorption is not relevant (arbitrary).

20 3.4 Deprival value The value of an existing asset if a business were to be deprived of it is: RC RC NRV EV Lower of (2) and Higher of (1) NRV = Replacement cost = Net realisable value = Economic value (i.e. PV of expected future earnings) (1) Asset should be in use ( EV) or sold ( NRV) whichever is higher. RELEVANT COST ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved EV (2) Asset should be replaced only if replacement cost is lower than (1).

21 COST VOLUME PROFIT ANALYSIS This is a summary of the article that was published in Student Accountant magazine.. The objective of CVP analysis CVP analysis looks at the effects on differing levels of activity on the profit of the business. In the short-run, profitability often hinges upon volume, as sales price and the costs of materials and labour are usually known with some degree of accuracy in the short run. The break-even point is where total revenues and total costs are equal. There are three methods for ascertaining the breakeven point: 1. The equation method Total revenues are found by multiplying unit selling price (USP) by quantity sold (Q). Total costs are made up of total fixed costs (FC) and variable costs (VC). Total variable costs are found by multiplying unit variable cost (UVC) by total quantity. Any excess of total revenue over total costs will give rise to profit (P). Total revenue total variable costs total fixed costs = Profit. (USP Q) (UVC Q) FC = P CVP ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved Example Company A makes product x. The selling price for product x is $50 and its variable costs are $30. The contribution per unit (sales price less variable costs) is $20. Fixed costs are $200,000 per year. (50Q) (30Q) 200, 000 = P. If we now set P to zero to find breakeven point: (50Q) (30Q) 200, 000 = 0 20Q 200,000 = 0 20Q = 200,000 Q = 10,000 units. If company A sells exactly 10,000 units, it will break even, and if it sells more than 10,000 units it will make a profit. 2. The contribution margin method The unit contribution margin (UCM) is the unit-selling price (USP) less the unit variable cost (UVC). Hence the formula from our equation method can be manipulated in the following way:

22 (USP Q) (UVC Q) FC = P (USP UVC) Q = FC + P (UCM) Q = FC + P FC P Q = UCM So if P = 0 then we would simply take our fixed costs and divide them by out unit contribution margin. Applying this to company A again: UCM = 20, FC = 200,000 and P= 0 FC 200,000 Q = = UCM 20 Therefore Q = 10,000 units. 3. The graphical method The total costs and total revenue lines are plotted on a graph. $ are shown on the y-axis, and units on the x-axis. The point where the total cost and revenue lines intersect is the breakeven point. CVP ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved $000 Total revenue Units sold Break even point Total costs Fixed costs The distance between the total cost and total revenue line represents the amount of profit or loss at any different output levels. Profit-volume graphs are discussed in more detail later in the article.

23 Ascertaining the sales volume required to achieve a target profit A business may want to know how many items it must sell in order to obtain a target profit. Example (continued) Company A wants to achieve a target profit of $300,000. 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 = 500,000 Q = 25,000 units. Alternatively the contribution method can be used: UCM = 20, FC = 200,000 and P= 300,000. Q = FC P UCM 200, ,000 Q = 20 Therefore Q = 25,000. CVP ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved Finally the answer can be read from the graph. 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. This is not a quick enough method to use in the exam so it is not recommended. Margin of Safety The margin of safety indicates by how much sales can decrease before a loss occurs, i.e. 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. It may be calculated as a percentage: Budgeted sales - break even sales 100 budgeted sales 10,000 In company A s case it will be 100 = 50%. 20,000 Finally it could be calculated in terms of $ revenue as follows: Budgeted sales break-even sales selling price = 10,000 $50 = $50,000.

24 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 cost. This calculation is known as the contribution to sales or C/S ratio. It is found in single product situations by dividing the unit contribution by the selling price. For company A: $20/$50 = 0.4 In multi-product situations, a weighted average C/S ratio can then be used to find CVP information such as breakeven point, margin of safety etc. Example 2 Company A also begins producing product y. The following information is available for both products: Product x Product y Sales price $50 $60 Variable cost $30 $45 Contribution per unit $20 $15 C/S ratios Budgeted sales (units) 20,000 10,000 CVP ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved The weighted C/S ratio is the total expected contribution divided by the total expected sales: (20,000 20) + (10,000 15)/ (20,000 50) + (10,000 60) = %. The C/S ratio tells us what percentage each $1 of sales revenue contributes towards fixed costs. It can also be used to calculate the break-even point in $ revenue. The break-even point in for company A can be calculated in this way: Fixed costs $200,000 Break-even point (revenue) = = = C/S ratio % $581,818 of sales revenue. To achieve a target profit of $300,000: Fixed costs plus required profit C/S ratio $200,000 $300,000 = = revenue of $1,454, % Such calculations assume that products and Y are sold in a constant mix of 2x to 1y. In reality this constant mix is unlikely.

25 Multi product profit volume charts The profit volume graph focuses purely on showing a profit/ loss line and does not separately show the cost and revenue lines. In a multi-product environment it is common to show two lines on the graph: one straight line, where a constant mix of 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 necessary to work out the C/S ratio of each product being sold, before ranking the products in order of profitability. In the case of company A this is shown above, and it can be seen that since product A has a higher C/S ratio that product B, it would be ranked (and sold) first. 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 plot the profit/ loss lines: Product ranking 1 1 Contribution Cumulative Revenue Cumulative Profit/ loss revenue $000 $000 $000 $000 (Fixed costs) 0 (200) 0 0 (up to budgeted sales) ,000,000 1,000,000 Y (up to budgeted sales) ,000 1,650,000 CVP ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved The graph can then be drawn, showing cumulative sales on the x axis and cumulative profit/ loss on the Y axis: $000 Most profitable first 582 1,000 1,650 Sales $000 Sales in constant mix

26 Limitations of Cost volume profit analysis The limitations of CVP analysis are based on its assumptions: There is a single product, or there are multiple products sold in a fixed mix. If the product mix changes, so does the break-even point. Volume is the only factor that changes. All other variables remain constant. This may not hold true as for example economies of scale may be achieved as volume increases. If sales volumes are to increase price must fall. There are many other reasons why the assumption may not hold true. The total cost and total revenue functions are linear. This is only likely to hold within a short run restricted level of activity. Costs can be divided into fixed and variable. In reality some may be semi fixed. Fixed costs remain constant over the relevant range levels of activity in which the business has experience and can therefore perform a degree of accurate analysis. CVP ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved 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.

27 LIMITING FACTOR DECISIONS Limiting factor decisions involve maximising profits in circumstances where one or more of the inputs to production (materials, labour etc.) are scarce. Since fixed costs are unaffected by the level of output in the short run, maximising profits involves maximising contribution. Key Factor analysis Where only one input is limited, and the organisation has to decide which product to manufacture, the following steps are used: 1. Calculate the contribution per unit generated by each of the products. 2 Identify the number of units (kilos/litres) of the limited factor used by each product. 3 Dividing (1) by (2) gives the contribution per unit of limited factor generated by each product. 4 Produce the products that generate the highest contribution per unit of limited factor. LIMITING FACTOR DECISIONS 2014 DeVry/Becker Educational Development Corp. All rights reserved Make or buy decision The steps are the same as above except that we replace contribution per unit with the saving of variable cost of manufacturing over variable cost of purchase At the end after the production plan has been formulated as in (4) above we buy in the shortfall Care over this purchase must be taken to ensure the requisite quantity and quality of this purchase and reliability of delivery Linear Programming Where more than one input is limited, linear programming is used to determine the mix of output that maximises contribution. This is best illustrated by an example.

28 Example A company makes two products, tables and chairs. Each table generates contribution of $20, and each chair generates contribution of $5. Skilled labour is in short supply, and only 180 labour hours are available each week. Each table requires 2 hours of labour, and each chair requires 3 hours. Wood is limited to 40 square metres per week. Each table requires 0.5 square metres, and each chair requires 0.75 square metres. The following steps are followed in order to set up the linear program: 1. Define the variables: Let x = output of tables and y = output of chairs. 2. Define the objective function: Contribution C = 20 x + 5 y. 3 Define the constraints: Labour: 2 x + 3 y 180 Wood: 0.5 x y 40 Non-negativity: x 0, y 0. LIMITING FACTOR DECISIONS 2014 DeVry/Becker Educational Development Corp. All rights reserved Having set up the linear program, we attempt to solve it. If there are only two variables, then the linear program can be solved graphically. This involves plotting the constraints on a diagram, to identify the feasible region, which is the region showing all the possible production possibilities that could be achieved given the constraints. A sample contribution line is then plotted. We may for example draw the line C= 1000 (chosen randomly). This line shows all combinations of x and y that provide contribution of 1,000. This line crosses the x- axis at x= 20, y= 0, and crosses the y-axis at the point where y = 5, x = 0. Having drawn the line, place a ruler over it. Move the ruler away from the origin, always keeping it parallel to the sample contribution line, and move it as far away from the origin as possible while still being in the feasible region. The furthest point, where the line is still in the feasible region is the point where contribution is maximised.

29 PRICING Pricing policies should consider the 4 C s of pricing: Costs A company must cover its costs in the long run Competitors It should consider the market price of competing firms Customers A firm should take into amount how much its customers are prepared to pay Corporate objectives The firm s specified goal e.g. profit maximisation should be integrated with its pricing policy Economist s approach Demand curve: P = a bq (formula given in exam) P = price Q = quantity demanded a = price at which demand would be nil b = slope of the demand curve (price changes over the change in quantity demanded) Marginal revenue: MR = a 2bQ (formula given in exam) PRICING 2014 DeVry/Becker Educational Development Corp. All rights reserved MR = the change in revenue from selling one more unit note that the marginal revenue falls at twice the rate of the demand curve To maximise sales set MR = 0, solve Q and place Q in the demand curve equation to gain price. To maximise profits set MR = MC, solve for Q and place Q in the demand curve equation to gain price. Accountant s approaches Full cost Full total absorption cost is calculated and then an allowance for profit is added. Although costs are covered it takes no amount of customers or competition Marginal cost pricing Marginal variable cost is calculated and then an allowance for contribution is added. Not all costs are covered and as such should only be used in short-term relevant cost decision-making. Return on investment pricing Full total absorption cost is calculated and then the allowance for profit is based on the required return on the investment base. Its limitations are as for full cost pricing.

30 Strategic Approaches to pricing Market penetration policy Used to launch new products into competitive markets Initially set low price to attract customers away from competitors products. Later increase prices when loyal customer base has been achieved. Market skimming Used to launch new product where no similar products exist. Set initially high price and sell to elite segment of market to make large profit margins. Later lower prices to attract a larger share of the market. Products usually confer some status or snob value on the initial buyers. Going rate pricing Charging the market rate. May be used for products in the maturity phase. PRICING 2014 DeVry/Becker Educational Development Corp. All rights reserved Complementary pricing Where products are used together, complementary product pricing involves setting a discounted price for one product with the aim of increasing sales of the second product (e.g. charging a low price for printers, and a high price for printer cartridges). Product line pricing Product line pricing is where management sets the price of related products at the same time. This includes: Product bundling, where a group of products may be sold for a price that is lower than the total price of the individual products. Using the price of the basic product as the starting point for setting the price for more advanced versions of the product (e.g. the price of a 16GB i-pad is used as the starting point for determining the price of a 32GB i-pad etc.) Volume discounting This involves selling at a lower price if customers buy more than a specified number of units of the product.

31 Price discrimination This involves selling at different prices in different markets, with the aim of maximizing profits in each market. The markets must be separate with no possibility of arbitrage. Relevant cost pricing This means selling at relevant cost plus a margin. It is useful for one off contracts. PRICING 2014 DeVry/Becker Educational Development Corp. All rights reserved. 0703

32 RISK AND UNCERTAINTY Management accounting is concerned with the future and as such contains uncertainty and therefore risk. Risk preference A risk seeker is someone who is interested in the best outcome no matter how small the chance of success A risk averse decision maker does not like uncertainty and will try to avoid it. A decision maker is risk neutral if they are concerned with the most likely outcome i.e. the expected value Expected value (EV s) The expected value of an opportunity is equal to the sum of all possible outcomes, multiplied by their associated probability: (x) = x.p(x) RISK AND UNCERTAINTY 2014 DeVry/Becker Educational Development Corp. All rights reserved Example If contribution could be $5,000, $30,000 or $50,000 with respective probabilities of 0.2, 0.5 and 0.3. The expected value of the contribution $5, = 1,000 $30, = 15,000 $50, = 15,000 31,000 Value of perfect information Value of perfect information = Expected value with perfect information Expected value without perfect information. Example A decision maker has to choose between 3 courses of action on a daily basis A, B and C. When making the decision, the decision maker does not know what the state of the market will be it could be 1, 2 or 3. The following table shows the possible outcomes:

33 Action A B C 1 10 (25) 200 State of (500) market Probability of each state of the market is as follows: Probability State of market Expected value without perfect information Expected value of each action is as follows: A: (10 0.3) + ( ) + (20 0.2) = $107 B: ((25) 0.3) + ( ) + (30 0.2) = $148.5 C: ( ) + ((500) 0.5) + (40 0.2) = ($182). Without perfect information therefore, a decision maker using the expected value criteria would select action B, and the expected value would therefore be $ RISK AND UNCERTAINTY 2014 DeVry/Becker Educational Development Corp. All rights reserved Expected value with perfect information If the decision maker could commission a report that would accurately predict what the state of the market would be on each particular day, then instead of automatically selecting action B, the decision maker would make the following decisions: Predicted state Action of market chosen Outcome Prob 1 C State of 2 B market 3 C Expected value with perfect information is: ( ) + ( ) + (40 0.2) = $218. The expected value of perfect information therefore is: $218 $148.5 = $69.5 Other risk strategies Maximin rule the action with the highest minimum outcome is chosen i.e. course of action A. Maximax rule the course of action that gives the highest potential outcome is chosen -i.e. course of action B.

34 Minimax regret rule An economist s concept of minimising the maximum regret involving the construction of another table: Table of regrets A B C State of Nil market Nil Nil E.g. regret of A under state of market 1 is not choosing C i.e = 190. The maximum regret associated with each decision is: A: 190 B: 225 C: 800 A minimax regret decision maker would therefore choose decision A as this has the lowest maximum possible regret.. Decision trees Where a decision involves multiple stages, and several outcomes are possible as a result of each decision, a decision tree may be drawn to summarise the situation. The expected value of each path through the tree can then be calculated, to identify which paths have the highest expected value. RISK AND UNCERTAINTY 2014 DeVry/Becker Educational Development Corp. All rights reserved In drawing the tree, there are two types of branches or forks: Decision fork (or point) This is a point at which a decision maker has to decide between two or more decisions. Action a Action b Action c Chance fork (or outcome point) This occurs where there are several possible outcomes normally for each decision taken there will be two or more possible outcomes. Probability p Probability q Outcome B Outcome A

35 BUDGETING Objectives of a system of budgeting: C Coordination R Responsibility U Utilisation M Motivation P Planning E Evaluation T Telling Alternative systems of budgeting Fixed v Flexible v Flexed A fixed budget is prepared once, and remains unchanged when used for comparison with actual results. Under flexible budgeting, several budgets are prepared using the same budget assumptions, but based on different activity levels (sales/production units). At the end of the year, the budget with the activity level closest to the actual is used for comparison. A flexed budget system involves flexing the original budget at the end of the year to reflect the actual activity levels, based on the original budget assumptions. BUDGETING 2014 DeVry/Becker Educational Development Corp. All rights reserved Rolling Budgets Rather than preparing the budget once a year, the organisation continually updates the budget. Typically the budget will be prepared for the next twelve months. At the end of each month, another month s budget is added. Intervening months budgets may also be changed, if factors outside the control of the company have made the original budgets inappropriate. Activity based budgeting Budgets are based on activity-based principles. Incremental v Zero Based Budgeting Incremental budgeting is performed by taking the previous year s actual or budgeted figures and adding adjustments for inflation and other factors that have changed. Disadvantage of incremental budgeting is that it accepts costs simply because they were there last year without questioning whether they are really necessary. Zero based budgeting Managers identify the activities they wish to perform. (E.g. making particular products, training.)

36 Managers produce a decision package for each activity, showing costs and revenues, as well as qualitative factors. Budget committee reviews decision packages and selects those it wishes to accept. These form the budget. Advantage is that budget process examines each cost, and relates it to the activities the company will perform, rather than just accepting costs because they were in previous year. Disadvantage very time consuming. Behavioural Aspects of Budgeting Responsibility accounting Responsibility is delegated to managers via the budget. They are then evaluated on how they perform in comparison with the budget. Level of difficulty If budget is not achievable, it will de-motivate. If it is too easy, it will not challenge. BUDGETING 2014 DeVry/Becker Educational Development Corp. All rights reserved Top down v Bottom up Bottom up (participative) budgeting means managers prepare their own budgets. A budget committee then approves these. Top down means that budgets are prepared centrally, and imposed on managers. Bottom up has the following advantages: Managers are more motivated to take ownership of the budget Managers have better knowledge of situation at the coal face Top down has the following advantages Non-financial managers may not have the financial knowledge to prepare budgets Preparing the budgets centrally may minimise problems such as adding slack to budgets. Controllability principle Managers should only be judged on things they control. They should not be blamed for adverse factors outside of their control such as increases in the price of commodities on world markets

37 QUANTITATIVE TECHNIQUES FOR BUDGETING Forecasting methods Future growth (e.g. of Sales) may be forecast based on the average (mean) of past growth rates. Sales year n - Sales year 1 Simple mean (%) = Sales year n Geometric mean (%) = Sales year n n Sales year 1 Example Sammy is trying to forecast the expected growth in sales of its new smart phone. The company has historic data for sales units during the last three years as follows: 201: 1,000 units 203: 1,600 units. Historic annual growth in sales per year was as follows: QUANTITATIVE TECHNIQUES FOR BUDGETING 2014 DeVry/Becker Educational Development Corp. All rights reserved Simple mean (%) = Sales year n - Sales year 1 Sales year 1 n (((1,600-1,000)/(1,000))/2) 100 = 30% 100 = Geometric mean (%) = 1, = 26.5% 1,000 The geometric mean is more accurate, but the simple mean can normally be used as an approximation. Fixed and variable overheads The values of fixed and variable costs can be estimated based on historic values of total costs, using the high low method: Variable cost per unit = Total costs at high - total costs at low Output at high - output at low (units) Fixed costs = Total costs at high total variable costs at high

38 Example Total overhead costs for the last four months were as follows: Month Output Total cost (units) $ 1 3,000 3, ,400 3, ,600 4, ,000 4,800 High = 4,000 units (month 4) and low = 2,400 units (month 2) Variable cost per unit = 4,800 3,000 = $ , 000 2, 400 Fixed costs = 4,800 (4, ) = $300. Therefore monthly fixed costs are $300 and variable overheads per unit are $ Learning curve theory The cumulative average time per unit decreases by a constant % every time total output doubles. When does it apply? If the product is made largely by labour effort QUANTITATIVE TECHNIQUES FOR BUDGETING 2014 DeVry/Becker Educational Development Corp. All rights reserved A new product is being made, and workers need to learn the skill. Example The time taken to make the first unit of a product is 100 minutes. A 95% learning rate applies: Cumulative Cumulative Cumulative Output average time total time Formula for the learning curve y = ax b Where y = cumulative average time per unit to produce x units a = time taken for the first unit of output x = total number of units produced b = the index of learning (log LR/log 2) This formula is provided in the exam.

39 Technique If asked for time of 7th unit, work out average time for 6 units and 7 units, work out total time and then take the difference. QUANTITATIVE TECHNIQUES FOR BUDGETING 2014 DeVry/Becker Educational Development Corp. All rights reserved. 1003

40 BASIC VARIANCE ANALYSIS Sales volume variance Actual sales (units) less: budgeted sales (units) Difference standard profit/ contribution per unit* ($) Sales volume variance ($) * standard profit per unit if absorption costing is used. Standard contribution if marginal costing is used. Sales price variance Actual sales actual price Actual sales standard price Sales price variance $ BASIC VARIANCE ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved Materials price variance Actual materials actual price Actual materials standard price Materials price variance Materials usage variance $ Actual materials used (units)* Standard quantity for actual output (units)* Difference standard cost per unit* Materials usage variance * here units would typically be kgs or litres.

41 Labour rate variance Hours paid actual wage rate Hours paid x standard wage rate Labour rate variance Labour efficiency variance Hours worked Standard hours for actual output Difference standard wage rate per hour Labour efficiency variance Variable overhead rate variance Actual hours at actual rate (Actual variable overhead cost) Actual hours worked at standard overhead rate per hour Variable overhead rate variance BASIC VARIANCE ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved Variable overhead efficiency variance Hours worked Standard hours for actual output Difference standard overhead rate per hour Variable overhead efficiency variance Fixed overhead expenditure variance Actual fixed overheads Budgeted fixed overheads Fixed overhead expenditure variance

42 Fixed overhead volume variance* Actual production (units) Budgeted production (units) Difference (units) standard fixed overhead cost per unit Fixed overhead volume variance If fixed overheads are absorbed using an hourly basis such as labour hours or machine hours, the volume variance may be analysed further: BASIC VARIANCE ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved Fixed overhead capacity variance* Actual hours Budgeted hours Difference standard fixed overhead absorption rate per hour Fixed overhead capacity variance Fixed overhead efficiency variance* Hours worked Standard hours for actual output Difference standard fixed overhead absorption rate per hour Fixed overhead efficiency variance * The fixed overhead volume, capacity and efficiency variances are only calculated if the business is using absorption costing.

43 Discussion points In addition to calculating variances, the examiner requires you to be able to explain what the variances actually show. While it is not feasible to provide a comprehensive list of possible causes of the variances, here is some guidance as to what may have caused variances. Sales volume variance; measures the effect on profit of selling more/less units than budgeted. Sales price variance; measures the effect on sales revenues of selling at a non-standard price Materials price variance; measures the effect on purchases expense of paying a non-standard price for materials. Using a different quality of materials may cause this. This may impact other variances such as the materials usage variance. Materials usage variance measures the effect of losses, rejects, defects wastage etc. Labour rate variance; measures the effect on payroll expense of paying workers a non-standard wage. Causes may include employing a different skill of labour than was expected when the standard was set. BASIC VARIANCE ANALYSIS 2014 DeVry/Becker Educational Development Corp. All rights reserved Labour efficiency variance; measures the productivity of workers. This may be related to the rate variance; if workers have been paid a higher rate than standard, they may have become more motivated and therefore worked more efficiently. Variable overhead efficiency variance; calculated in the same way as labour efficiency i.e. if workers have good productivity the machinery operates for fewer hours and incurs less variable overhead costs such as electricity. Variable overhead rate variance; measures the effect of paying a non-standard rate per hour for variable overheads such as electricity. Fixed overhead expenditure variance; the pure spending difference between budgeted and actual fixed costs. Do not flex fixed costs; they should not change with the level of activity Fixed overhead volume variance; only exists if using absorption costing as it represents under or overabsorption of fixed costs which does not occur under marginal costing. Be careful when interpreting this variance; it does not show a real spending difference, it is simply a reconciling item caused by the cost accountant s method of charging fixed costs through the income statement.