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The exam
• Five compulsory questions: 20 marks
each
• Time allowed: 3hours plus 15 minutes
reading time
• Balance typically 50:50 between
calculations and discussion aspects
The examiner’s key concerns
• Students need to be able to interpret any numbers they calculate and see the limitations of their financial analysis.
• In particular financial performance indicators may give a limited perspective and NFPIs are often needed to see the full picture.
• Questions will be practical and realistic, so will not dwell on unnecessary academic complications.
• Many questions will be designed so discussion aspects can be attempted even if students have struggled with calculation aspects.
1. Advanced costing methods
• ABC.
• Target costing.
• Lifecycle costing.
• Throughput accounting.
• Environmental Accounting
Activity Based Costing (ABC)
Steps
1. Identify major activities.
2. Identify appropriate cost drivers (note:
you may have to justify your choice
here in the exam).
3. Collect costs into pools based upon the
activities.
4. Charge costs to units of production
based on cost driver volume.
Advantages of ABC
• More realistic costs.
• Better insight into cost drivers, resulting in better cost control.
• Particularly useful where overhead costs are a significant proportion of total costs.
• ABC recognises that overhead costs are not all related to production and sales volume.
• ABC can be applied to all overhead costs, not just production overheads.
• ABC can be used just as easily in service costing as in product costing.
Criticisms of ABC
• It is impossible to allocate all overhead
costs to specific activities.
• 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.
Implications of ABC
• Pricing - more realistic costs improve
cost-plus pricing.
• Sales strategy - more realistic margins
can help focus sales strategy.
• Decision making – for example,
research and development can be
directed at products with better margins.
Target Costing
Steps
1. Estimate a market driven selling price for
a new product. (E.g. to capture a required
market share).
2. Reduce this figure by the firm‟s required
level of profit. (E.g. based on target ROI).
3. Produce a target cost figure for product
designers to meet.
4. Reduce costs to provide a product that
meets that target cost.
Closing the target cost gap
• Value analysis
• Focus is on reducing cost without
compromising perceived value.
• Can labour savings be made?
• Can productivity be improved?
• What production volume is needed to
achieve economies of scale?
Closing the target cost gap –
cont.
• Could cost savings be made by
reviewing the supply chain?
• Can any materials be eliminated?
• Can a cheaper material be substituted
without affecting quality?
• Can part-assembled components be
bought in to save on assembly time?
• Can the incidence of the cost drivers be
reduced?
Implications of target
costing• Pricing – might identify sufficient cost
savings to reduce the target price.
• Cost control – target cost motivates
managers to find new ways of saving
costs.
Lifecycle costing
Life cycle costing
• Is the profiling of cost over a product‟s
life, including the pre-production stage.
• Tracks and accumulates the actual
costs and revenues attributable to each
product from inception to abandonment.
• Enables a product‟s true profitability to
be determined at the end of its
economic life.
Implications of lifecycle costing
• Pricing decisions can be based on total lifecycle costs rather than simply the costs for the current period.
• Decision making - a timetable of life cycle costs helps show what costs need to be recovered.
• Control - Lifecycle costing reinforces the importance of tight control over locked-in costs, such as R&D.
• Performance reporting - Life cycle costing costs to products over their entire life cycles, to aid comparison with product revenues generated in later periods.
Throughput
Background
• Application of key factor analysis to
production bottlenecks.
• The only totally variable costs are the
purchase cost of raw materials /
components
• Direct labour costs are not wholly
variable.
Throughput
Multi-product decisions
• Rank products by looking at the
throughput per hour of bottleneck
resource time
• Throughput = Revenue – Raw Material
Costs
Throughput
Throughput accounting ratio (TPAR)
Throughput per hour of bottleneck
resource
Operating expenses per hour of
bottleneck resource
Throughput
How to improve the TPAR
• Increase the sales price to increase the
throughput per unit.
• Reduce total operating expenses, to
reduce the cost per hour.
• Improve productivity, reducing the time
required to make each unit of product.
Contribution = Sales Value – All Variable Costs
Units 0 100 500 1000 1500
Contribution(£) 0 1000 5000 10000 15000
Fixed Costs(£) (10000) (10000) (10000) (10000) (10000)
Profit(£) (10000) (9000) (5000) 0 5000
Profit = (Contribution per unit x units) - Fixed Costs
A product has a sales price of £20 and a variable cost of £10 per unit
Contribution per unit 10 10 10 10
Profit per unit 0 (90) (10) 50
2. CVP Analysis
Environmental costs
Environmental costs
Internal costs directly impact on the income statement of a company.
improved systems
waste disposal
costs
product take back
costs
regulatory costs
upfront costs
backend
Costs
External Costs are imposed on society at large but not borne by the company that generates the cost in the first instance
carbon emissions
usage of energy and
water
forest degradation
health care costs
social welfare costs
Break-even analysis
The Break-even chart
£
Output (units)
Fixed Costs
Breake
ven
Point
Breakeven point:
The point where
total costs = total
sales revenueand
Where there is
neither a profit or
loss
B/E Point (units) = Fixed Costs
Contribution per Unit
Chapter 4
The Margin of Safety
£
Fixed Costs
Sales Revenue
Total Costs
Breakeven
Output
Budgeted
Output
Margin of safety
The Margin of Safety represents the level by which output can fall
before the organisation makes a loss
Margin of Safety = Budgeted Output – Breakeven Output
Budgeted Output
X 100%
Chapter 4
Contribution to Sales ratio
Chapter 4
Contribution to Sales Ratio (C/S ratio)
=
(Contribution per unit) / Unit Sales Price
Breakeven Point in Sales Value
=
Fixed Costs / C/S ratio
Sales for a certain level of profit = Fixed Costs + Required Profit
Contribution per Unit
Basic Breakeven chart
Chapter 4
0
Sales Revenue
10
20
30
Fixed Costs
40
Breakeven point
20 30 40 50 60 70Number of units
£’000
Contribution Breakeven chart
Sales Revenue
10
Variable Costs
Breakeven point
20 30 40 50 60 70Number of units
£’000
Fixed Costs
Contribution
Chapter 4
The Profit-Volume Chart
The profit-volume chart presents information in a way that clearly shows
the change in the level of profit – using data from the previous data table:
0
+£5000
-£10000
1000 1500
Profit
Output
Page 30
Chapter 4
Limitations/Assumptions of
CVP
Costs behaviour is assumed to be linear
Revenue is assumed to be linear
Volume Produced = Volume Sold
Ignores inflation
Assumes a constant sales mix
Chapter 4
3. Planning with limited factors
• Key factor analysis – one resource
in short supply
• Linear Programming – two or more
scarce resources
Key factor analysis
1. Calculate contribution per unit.
2. Calculate contribution per unit of the
limiting factor.
3. Rank in order.
4. Allocate resources – make first up to
max demand, then second,...
Linear programming
1. Define variables
2. Define the objective
3. Set out constraints
4. Draw graph showing constraints and
identify the feasible region
5. Identify optimal point
6. Solve for optimal solution
7. Answer the question
Linear programming
Assumptions
• A single quantifiable objective.
• Each product always uses the same
quantity of the scarce resources per
unit.
• The contribution per unit is constant.
• Products are independent – e.g. sell A
not B.
• The scenario is short term.
Linear programming
Slack
• Slack is the amount by which a
resource is under utilized. It will occur
when the optimum point does not fall on
the given resource line.
Linear programming
Shadow (or dual) prices
• The extra contribution that results from
having one extra unit of a scarce
resource.
• The max premium (i.e. over the normal
cost) that the firm should be willing to
pay for one extra unit of each constraint.
• Non-critical constraints will have zero
shadow prices as slack exists already.
Linear programming
Calculating dual prices
1. Add one unit to the constraint
concerned, while leaving the other
critical constraint unchanged.
2. Solve the revised equations to derive a
new optimal solution.
3. Calculate the revised optimal
contribution. The increase is the
shadow price
Linear programming
Range of applicability of dual prices
• The dual price only applies as long as
extra resources improve the optimal
solution
• i.e. the constraint line concerned moves
out increasing the size of the feasible
region and moving the optimal point.
• Eventually other constraints become
critical.
Calculation aspects
Price elasticity of demand (PED)
• PED = % change in demand / %
change in price.
• PED >1 (elastic) revenue increases if
the price is cut.
• PED <1 (inelastic) revenue increases if
the price is raised.
Calculation aspects
Equation of a straight line demand
curve
• P = a – bQ
• “a” = the price at which demand would
fall to zero
• “b” = gradient = change in price/change
in demand
• Calculate “b” first
Pricing approaches
• Cost plus pricing
• Price skimming
• Penetration pricing
• Linking pricing decisions for different
products
• Volume discounts
• Price discrimination
• Relevant cost pricing
Cost plus pricing
• Establish cost per unit – options include
MC, TAC, prime cost
• Calculate price using target mark-up or
margin
• Often used as a starting point even
when using other methods
Cost plus pricing
Advantages
• Widely used and accepted.
• Simple to calculate if costs are known.
• Selling price decision may be delegated
to junior management.
• Justification for price increases.
• May encourage price stability.
Cost plus pricing
Disadvantages
• Ignores link between price and demand.
• No attempt to establish optimum price.
• Which absorption method?
• Does not guarantee profit
• Which cost?
• Inflexibility in pricing.
• Circular reasoning.
Price skimming
• Set a high initial price to „skim off‟
customers who are willing to pay extra.
• Prices fall over time.
• Suitability?
Penetration pricing
• Set a low initial price to gain market
share
• If a high volume is achieved, the low
price could be sustainable.
• Suitability?
Linking pricing decisions for
different products
• Basic idea: product A is cheap to attract
customers who then also buy the higher
margin product B.
• Key issue is the extent to which
customer must buy the other products.
• Suitability?
Volume discounts
• Discount for individual large order.
• Cumulative quantity discounts.
• Suitability?
Price discrimination
• Have different prices in different
markets for the same product.
• Suitability?
5. Make v buy and other short
term decisions
• Relevant costing principles.
• Make v buy decisions.
• Shut down decisions.
• Joint products – the further processing
decision.
Relevant costing principles
• Include
– Future incremental cash flows.
– Opportunity costs
• Exclude
– Depreciation.
– Sunk costs.
– Unavoidable costs.
– Apportioned fixed overheads.
– Financing cash flows (e.g. interest).
Make v buy
Decision
• Look at future incremental cash flows.
• Watch out for opportunity costs –
especially whether or not spare capacity
exists and alternative uses for capacity.
• Practical factors?
Shut down decisions
Decision
• Look at future incremental cash flows.
– Apportioned overheads not relevant
– Closure costs – e.g. redundancies.
– Alternative uses for resources?
• Practical factors?
Joint products
The further processing decision
• Look at future incremental cash flows:
– sell at split off v process further and then
sell.
• Pre-separation (“joint”) costs not
relevant
– only include post split-off aspects.
6. Risk and uncertainty
• Basic concepts.
• Research techniques.
• Scenario planning.
• Simulation.
• Expected values.
• Sensitivity.
• Payoff tables.
Basic concepts
• Risk = variability in future returns.
• Investors‟ risk aversion
• Upside v downside
• Risk v uncertainty
• Risk = probability x impact
Research techniques
• Desk research
– Company records.
– General economic intelligence.
– Specific market data.
• Field research
– Opinion v motivation v measurement
– Questionnaires, experiments, observation.
– Group interviews, triad testing, focus
groups.
Scenario planning
1 Identify high-impact, high-uncertainty
factors.
2 Identify different possible futures.
3 Identify consistent future scenarios.
4 “Write the scenario”.
5 For each scenario identify and assess
possible courses of action for the firm.
6 Monitor reality.
7 Revise scenarios and strategic options
Simulation
1 Apply probabilities to key factors in
scenario analysis.
2 Use random numbers to select a
particular scenario and calculate
outcome.
3 Repeat until build up a picture of
possible outcomes
4 Make decision based on risk aversion.
Expected values
Advantages
• Recognises that there are several
possible outcomes.
• Enables the probability of the different
outcomes to be taken into account.
• Leads directly to a simple optimising
decision rule.
• Calculations are relatively simple.
Expected values
Disadvantages
• probabilities used are subjective.
• EV is the average payoff. Not useful for
one-off decisions.
• EV gives no indication of risk
• Ignores the investor‟s attitude to risk.
Sensitivity
• Identify key variables by calculating how
much an estimate can change before
the decision reverses.
• Can only vary one estimate at a time.
Payoff tables
• Prepare table of profits based on
different decision choices and different
possible scenarios.
• Four different ways of making a
decision.
– 1 Expected values
– 2 Maximax
– 3 Maximin
– 4 Minimax regret
7. Budgeting I
• The purposes of budgeting.
• Budgets and performance
management.
• The behavioural aspects of budgeting.
• Conflicting objectives.
The purpose of budgets
• Forecasting
• Planning
• Control
• Communication
• Co-ordination
• Evaluation
• Motivation
• Authorisation and delegation
Budgets and performance
management
Responsibility accounting
• 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
the performance of the budget centre or
the manager is measured.
Management by exception
1 Set up standard costs, prepare budgets
and set targets.
2 Measure actual.
3 Compare actual to budget (e.g. via
variances).
4 Investigate reasons for differences and
take action.
Behavioural aspects of budgeting
Key issues
– Dysfunctional behaviour – want goal
congruence.
– Budgetary slack.
Management styles (Hopwood)
– Budget constrained
– Profit conscious
– Non-accounting
Target setting and motivation
• Expectations v aspirations
• Ideal target?
• Targets should be:
– communicated in advance
– dependent on controllable factors
– based on quantifiable factors
– linked to appropriate rewards
– chosen to ensure goal congruence.
Participation
Advantages of participative budgets
• Increased motivation
• Should contain better information,
• Increases managers‟ understanding and
commitment
• Better communication
• Senior managers can concentrate on
strategy.
Participation
Disadvantages of participative budgets
• Loss of control
• Inexperienced managers
• Budgets not in line with objectives
• Budget preparation slower and disputes
can arise
• Budgetary slack
• Certain environments may preclude
participation
8. Budgeting II
• Rolling v periodic.
• Incremental budgeting.
• Zero based budgeting (ZBB).
• Activity based budgeting (ABB).
• Feedforward control.
• Flexible budgeting.
• Selecting a budgetary system.
• Dealing with uncertainty.
• Use of spreadsheets.
Rolling v periodic budgeting
Periodic budgets
• The budget is prepared for typically one
year at a time. No alterations once the
budget has been set.
• Suitable for stable businesses where
forecasting is easy and where tight
control is not necessary.
Rolling v periodic budgeting
Rolling (continuous) budgets
• A budget kept continuously up to date
by adding another accounting period
when the earliest 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 if need tight control.
Incremental budgeting
• Start with the previous period‟s budget
or actual results and add (or subtract)
an incremental amount to cover inflation
and other known changes.
• Suitable for stable businesses where
costs are not expected to change
significantly. There should be good cost
control and limited discretionary costs.
Zero based budgeting
Preparing a budget from a zero base,
justifying all expenditure.
1 Identify all possible services and then cost
each service (decision packages)
2 Rank the decision packages
3 Identify the level of funding that will be
allocated to the department.
4 Use up the funds in order of the ranking
until exhausted.
Activity based budgeting
• Use ABC for budgeting purposes:
1 Identify cost pools and cost drivers.
2 Calculate a budgeted cost driver rate
3 Produce a budget for each department or
product by multiplying the budgeted cost
driver rate by the expected usage.
Feed forward control
• Feed-forward control is defined as the
„forecasting of differences between
actual and planned outcomes and the
implementation of actions before the
event, to avoid such differences.
• E.g. using a cash-flow budget to
forecast a funding problem and as a
result arranging a higher overdraft well
in advance of the problem.
Selecting a budgetary system
Determinants
• Type of organisation.
• Type of industry.
• Type of product and product range.
• Culture of the organisation.
Changing a budgetary system
Factors to consider
• Time consuming
• Are suitably trained staff are available to
implement the change successfully?
• Management time
• Training needs.
• Cost v benefits for the new system:
Incorporating risk and uncertainty
• Flexible budgeting.
• Rolling budgets.
• Scenario planning.
• Sensitivity analysis.
• “What if” analysis using spreadsheets
9. Quantitative analysis
• High-low.
• Regression and correlation.
• Time series analysis.
• Learning curves.
High-low
1: Select the highest and lowest activity
levels, and their costs.
2: Find the variable cost/unit.
3: Find the fixed cost, using either level.
Fixed cost = Total cost at activity level – total
variable cost.
Time series analysis
• Four components:
1 the trend
2 cyclical variations
3 seasonal variations
4 residual variations.
• Additive model
Actual = Trend + Seasonal Variation
• Multiplicative model
Actual = Trend x Seasonal Variation
Learning curves
• As cumulative output doubles, the
cumulative average time per unit falls to
a fixed % (the learning rate) of the
previous average.
• Y = axb
y = average cost per batch
a = cost of first batch
x = total number of batches produced
b = learning factor (log LR/log 2)
10. Standard costing and basic
variances
• Standard costing.
• Recap of basic variances from F2.
• Labour variances with idle time.
• Variance investigation.
Standard costing
• A pre-determination of what a product is
expected to cost under specific working
conditions.
Standard costing
Advantages
– Annual detailed examination
– Performance appraisal
– Management by exception
– Simplifies bookkeeping
• Disadvantages / problems
– Standards not updated
– Cost
– Unrealistic standards can demotivate staff
11. Advanced variances
• Materials mix and yield variances.
• Other targets for controlling production.
• Planning and operational variances.
• Modern manufacturing environments.
Other targets for controlling
production processes
• Detailed timesheets, % idle time.
• Productivity, % yield, % waste.
• Quality measures e.g. reject rate.
• Average cost of inputs, output.
• Average margins.
• % on-time deliveries.
• Customer satisfaction ratings.
Modern manufacturing
environments
Total Quality Management (TQM)
• TQM is the continuous improvement in
quality, productivity and effectiveness
through a management approach
focusing on both process and the
product.
Modern manufacturing
environments
Just-in–time (JiT)
• JIT is a pull-based system of planning
and control.
• Pulling work through the system in
response to customer demand.
• Goods are only produced when they are
needed.
• This eliminates large inventories of
materials and finished goods.
Ratio analysis
Preliminaries
• Ratios may not be representative of the
position throughout a period.
• Need a basis for comparison.
• Ratios can be manipulated
• Ratios indicate areas for further
investigation rather than giving answers.
Profitability ratios
• ROCE = Operating Profit x 100%
Capital Employed
• Gross margin = Gross profit x 100%
Sales
• Net margin = Net profit x 100%
Sales
• Asset turnover = Sales / capital employed
• ROCE = asset turnover x net margin
Liquidity / working capital ratios
• Current ratio = current assets / current liabilities
• Quick ratio = quick assets/ current liabilities
Quick assets = current assets – inventory
• Receivables days = receivables / sales x 365
• Payables days = payables / purchases x 365
• Inventory days = inventory / cost of sales x 365
Ratios to measure risk
• Financial gearing = debt/equity
• Financial gearing = debt / (debt + equity)
• Dividend cover = PAT / total dividend
• Interest cover = PBIT / interest
• Operating gearing = fixed costs / variable costs
• Operating gearing = contribution / PBIT
Non-financial performance
indicators
• Financial performance appraisal often
reveals the ultimate effects of
operational factors and decisions but
non-financial indicators are needed to
monitor causes.
• Critical success factors often non-
financial
• Stakeholder objectives may also be
non-financial
Behavioural aspects
• Measures designed to assess
performance should:
– provide incentives to promote goal
congruence.
– only incorporate factors for which the
manager can be held responsible.
– recognise both financial and non financial
aspects of performance.
– recognise longer-term, as well as short
term, objectives.
Behavioural aspects
• Potential problems with inappropriate
measures
– manipulation of information provided by
managers
– demotivation and stress-related conflict
– excessive concern for control of short term
costs, possibly at the expense of longer-
term profitability.
• Transfer pricing.
• Divisional performance measurement.
13. Transfer pricing and
divisional
Performance measurement
Transfer pricing
Objectives
• Goal congruence
• Performance measurement.
• Autonomy.
• Minimising global tax liability.
• To record the movement of goods and
services.
• Fair split of profit between divisions.
Transfer pricing
- Exam questions
Will often be given a TP and asked to
comment. Look at the following.
• Implications for divisional performance –
e.g. is a target ROI achieved?
• Resulting manager behaviour - does it
give dysfunctional decision making –
e.g. will a manager reject a new product
that is acceptable to the company as a
whole?
Transfer pricing
- General rule
• TP = marginal cost + opportunity cost
• In a perfectly competitive market,
TP = market price.
• If spare capacity exists,
TP = marginal cost.
• With production constraints,
TP = marginal cost + opportunity cost of not
using those resources elsewhere.
Divisional performance
measurement
Key considerations
• Manager or division?
• Type of division.
– Cost centre
– Profit centre
– Investment centre
Residual Income (RI)
RI = Pre tax controllable profits – imputed
charge for controllable invested capital
14. Performance measurement
in not-for-profit organisations
• Objectives.
• Performance Measurement.
Objectives
Planning for NFPs usually more complex.
• Multiple objectives
• Difficult to quantify objectives
• Conflicts between stakeholders
• Difficult to measure performance
• Different ways to achieve the same
objective
• Objectives may be politically driven