f5 atc pass card 2012.pdf

2012 EDITION | Revision Essentials

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ACCA Paper F5 | PERFORMANCE MANAGEMENT

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ACCA

PAPER F5

PERFORMANCE MANAGEMENT

REVISION ESSENTIALS

JUNE 2012

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©2012 DeVry/Becker Educational Development Corp. All rights reserved. (ii)

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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.

CONTENTS

©2012 DeVry/Becker Educational Development Corp. All rights reserved. (iii)

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 1501

CONTENTS

©2012 DeVry/Becker Educational Development Corp. All rights reserved. (iv)

Page

Divisional performance evaluation 1601

Transfer pricing 1701

Further reading 1801

Approaching written questions 1901

Target costing and lifecycle costing 2001

Environmental management accounting 2101

Materials mix and yield variances 2201

Measuring planning variances 2301

Performance measurement 2401

Interpreting financial data 2501

Performance measurement and the balanced scorecard 2601

Transfer pricing 2701

Comprehensive analysis of past exams 2801

Examiner’s feedback 2901

Examination Technique 3001

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.

SYLLABUS

©2012 DeVry/Becker Educational Development Corp. All rights reserved. (v)

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, apply, and evaluate cost accounting techniques

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

C Identify and apply appropriate budgeting techniques and methods for planning and control

D Use standard costing systems to measure and control business performance and to identify remedial action

E 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

Students must have a thorough knowledge of the material in Paper F2 Management Accounting and a good knowledge of other knowledge papers. Performance Management is further developed in paper P5 Advanced Performance Management.

Format of the examination

The syllabus is assessed by a three-hour paper-based examination. The exam contains five compulsory questions of 20 marks each. Generally, the paper will seek to draw questions from as many of the syllabus sections as possible.

CORE TOPICS CHECKLIST

©2012 DeVry/Becker Educational Development Corp. All rights reserved. (vi)

CORE TOPICS Tick when completed

Specialist cost and management accounting techniques

� Costing systems and techniques �

� Activity based costing �

� Developments in management accounting �

Decision making techniques

� CVP analysis �

� Limiting factor decisions �

� Pricing �

� Risk and uncertainty �

Tick when completed

Budgeting

� Budgeting �

� Quantitative techniques for budgeting �

Standard costing and variance analysis

� Basic variance analysis �

� Advanced variance analysis �

� Planning and operational variances �

Performance measurement

� Performance measurement �

� Further aspects of performance measurement �

� Divisional performance evaluation �

� Transfer pricing �

COSTING SYSTEMS AND TECHNIQUES

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 0101

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.

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

hourslabour Budgeted

overheads fixed Budgeted

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.

ACTIVITY BASED COSTING


Activity Based Costing

Activity based costing is an approach to costing that attempts to identify the main activities that are performed, and to identify the costs associated with these activities. The costs of production are then calculated based on the amount of activity that is consumed in producing an item:

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 =

hoursman Total

costs emaintenanc Total

4. 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.

ACTIVITY BASED COSTING


Disadvantages

� Selection of cost drivers may not be easy.

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

� Exclusion of non-production overheads can be difficult.

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

DEVELOPMENTS IN MANAGEMENT ACCOUNTING


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.

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.

� Estimate the actual cost of the product. Identify ways to “eliminate” the gap between actual cost and target.

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.

Lifecycle costing

Lifecycle costing involves budgeting and monitoring the costs, revenues and cash flows generated by a product over its whole lifecycle 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.

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

� Throughput accounting ratio is a performance measure. It is designed 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 means revenue less cost of materials. It is similar in principle to contribution- however, material is considered to be the only truly variable cost.

� Having identified the key bottleneck, for each product, calculate the throughput generated per hour of bottleneck time (similar to contribution per unit of limiting factor in key factor analysis.)

� Calculate the fixed cost per hour of bottleneck time- calculated by taking all other costs (including labour and “variable overheads” which are all fixed in the short run) and dividing by the number of hours of bottleneck resource available during the period.

� Dividing the throughput generated per hour by the fixed cost per hour gives the throughput accounting (t.a.) ratio for each product.

� Make the products with the highest t.a. ratio first.

Advantages of the t.a. ratio

� 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

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



Need for environmental management accounting

The environment has become an important political and social issue in the past 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.

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.

A more narrow definition of environmental costs was given by Hansen and Mendova:

� 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.



� 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.

RELEVANT COST ANALYSIS


1 RELEVANT COSTS

1.1 For decision-making

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

Relevant Non-relevant

� Future, incremental, cashflows.

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

� Avoidable costs. � Committed costs.

� Controllable. � Common costs “management charges”.

2 OPPORTUNITY COST

2.1 Key point

� All opportunity costs are “relevant”.

� Not all relevant costs are opportunity costs.

2.2 Definition

“The value of the benefit sacrificed . . . in favour of an alternative.”

“The potential benefit foregone (from the best rejected course of action).”

� Clearly arise in use of scarce resources.

2.3 Potential difficulties

� Estimating future costs/revenues (benefit sacrificed).

� Identifying alternative uses (and best alternative forgone).

� Ignores effect on accounting profit.

� Ignores any risk associated with each alternative.



3 RELEVANT COST OF SPECIFIC ITEMS

3.1 Relevant costs of materials

Have materials been

purchased?

Are they used

regularly?

Replacement

cost

Replacement

cost

Yes

Opportunity cost

(e.g. sale value)

No

Yes No

� Replacement cost = current purchase cost.

� Deprival value applies where materials are scarce (§3.4).

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 a scarce resource relevant cost amounts* to:

� 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).



3.4 Deprival value

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

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

Lower of (2)

RC and Higher of (1)

NRV EV

(1) Asset should be in use (⇒ EV) or sold (⇒ NRV) whichever is higher.

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

CVP ANALYSIS


COST VOLUME PROFIT ANALYSIS

This is a summary of the article by Ann Irons that was published in Student Accountant magazine. Ann is the examiner for F5.

The objective of CVP analysis

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

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

1. 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

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:

CVP ANALYSIS


(USP ×Q) ─ (UVC ×Q) ─FC = P

(USP ─UVC) ×Q = FC + P

(UCM) ×Q = FC + P

Q = UCM

PFC +

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

Q = UCM

FC =

20

200,000

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 break-even point.

Fixed costs

Total revenue

Total costs

Break even point

$000

200

400

600

800

Units sold

10,000 20,000

The amount of profit or loss at any different output levels is represented by the distance between the total cost and total revenue line.

Profit-volume graphs are discussed in more detail later in the article.

CVP ANALYSIS


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 = UCM

PFC +

Q = 20

300,000200,000 +

Therefore Q = 25,000.

Finally the answer cab 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:

sales budgeted

saleseven break sales Budgeted × 100

In company A’s case it will be 20,000

10,000× 100 = 50%.

Finally it could be calculated in terms of $ revenue as

follows: Budgeted sales − break-even sales x selling price = 10,000 × $50 = $50,000.

CVP ANALYSIS


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 break even 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 0.4 0.25 Budgeted sales (units) 20,000 10,000

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) = 34.375%.

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:

Break-even point (revenue) = ratio C/S

costs Fixed =

34.375%

$200,000=

$581,819 of sales revenue.

To achieve a target profit of $300,000:

ratio C/S

profit required plus costs Fixed

= 34.375%

$300,000$200,000 += revenue of $1,454,546.

Such calculations assume that products X and Y are sold in a constant mix of 2x to 1y. In reality this constant mix is unlikely.

CVP ANALYSIS


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 X (up to budgeted sales) 400 200 1,000,000 1,000,000 Y (up to budgeted sales) 150 350 650,000 1,650,000

The graph can then be drawn, showing cumulative sales on the x axis and cumulative profit/ loss on the Y axis:

Sales $000

$000

350

200

−200

582 1,000 1,650

Sales in constant mix Most profitable first

CVP ANALYSIS


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.

� 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.

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.

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.



Example

A company makes two products, tables and chairs. Each table generates contribution of $20, and each chair generates contribution of $5. However, 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:

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

Define the objective function. This is the thing which we are trying to maximise. In this case it is contribution: C = 20 x + 5 y. (because each unit of x generates contribution of 20, each unit of y generates contribution of 5)

Define the constraints:

Labour: 2 x + 3 y ≤ 180

Wood: 0.5 x + 0.75 y ≤ 40

Non negativity: x ≥ 0, y ≥ 0.

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, that is the region showing all the possible production possibilities which 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.

PRICING


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 quality demanded)

Marginal revenue -MR = a– 2bQ (formula given in exam)

MR = the change in revenue from selling one more unit 2bQ = 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.

PRICING


Strategic Approaches to pricing

Market penetration policy

In accordance with the product development life cycle (PDLC) this involves a policy of low prices when the product is in its growth phase to obtain market share.

Market skimming

Can be used with the PDLC and involves charging high prices during the introductory phase usually when the company has brought a new product to the market.

Going rate pricing

During the maturity phase of the PLDC a company may adopt this policy of charging the market rate.

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 is concerned with the most pessimistic outcome

� 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) = px

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

$5,000 × 0.2= 1,000

$30,000 × 0.5= 15,000

$50,000 × 0.3 = 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:



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

Probability of each state of the market is as follows:

Probability 1 0.3 State of 2 0.5 market 3 0.2 Expected value without perfect information

Expected value of each action is as follows:

A: (10 × 0.3) + (200 × 0.5) + (20 × 0.2) = $107

B: ((25) × 0.3) + (300 × 0.5) + (30 × 0.2) = $148.5

C: (200 × 0.3) + ((500) × 0.5) + (40 × 0.2) = ($182).

Without perfect information therefore, a decision maker using the expected value criteria would select action B, and the expected value would therefore be $148.5.

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 200 0.3 State of 2 B 300 0.5 market 3 C 40 0.2 Expected value with perfect information is: (200 × 0.3) + (300 × 0.5) + (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.



� 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 1 190 225 Nil market 2 100 Nil 800 3 20 10 Nil E.g. regret of A under state of market 1 is not choosing C i.e. 200 - 10 = 190.

The decision rule becomes A as this option 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.

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.

Probabilityp

Probabilityq

Outcome B

Outcome A

BUDGETING


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.

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.

BUDGETING


Zero based budgeting

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

� Managers produce a decision package for each activity, showing costs and revenues, 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.

Top down v Bottom up

� Bottom up means managers prepare their own budgets. These are then approved by a budget committee. 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.

BUDGETING


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.

Potential weaknesses of budgeting

� Budgeting takes up too much managers’ time.

� Budgets prepared 15 months before the end of the accounting period to which they relate become out of date.

� Managers “gaming” activities means the budget process loses its validity. Gaming includes:

� Adding slack to budgets to make them easier to perform

� Never beating the budget significantly

� Always spending what’s in the budget.

� In some organisations, funds are only available for projects in the budget. This may constrain managers who identify potential new projects after the budget process.

� Too much focus on profits is not consistent with the overall goals of the organisation- to maximise the wealth of shareholders

QUANTITAVE TECHNIQUES FOR BUDGETING


QUANTITATIVE TECHNIQUES FOR BUDGETING

Regression analysis

� Least squares technique to derive the cost function y = a + bx Where

b = ( )22 xx

yxxy

∑−∑

∑∑−∑

n

n

a = n

y∑ –

n

b y∑

n = number of observations

b = gradient

You do not need to learn this formula- it is given in the exam paper.

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

� For identical products where the process is starting from new Standards then need to be adjusted when learning is taking place

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 1 100 95 2 95 190 4 90.25 361 8 85.74 686

QUANTITAVE TECHNIQUES FOR BUDGETING


Formula for the learning curve

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

This formula is provided in the exam.

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.

Trend analysis

A time series is a set of data recorded over a period of time. It could be made up of:

� Trend (T) – the “long-term” effect when fluctuations have been smoothed out

� Cyclical variation (C) – the “long-term” effect when fluctuations have been smoothed out

� Seasonal variation (S) – an annual cycle of variations

� Randomly occurring variations due to non-recurring influences

BASIC VARAINCE ANALYSIS


“BASIC” VARIANCE ANALYSIS

� A standard cost is a budgeted cost per unit of a product. Setting standards requires assumptions to be made about the quantity of inputs used per unit of a product, and the price paid for those quantities.

� Having standards makes the budgeting process much easier. The budget is effectively prepared by multiplying the budgeted sales and production quantity of each item by the standard cost and revenue per unit.

� Variance analysis is a detailed investigation into why actual profits differ from budget, and compares the actual costs against the standards.

The formulas for the variances are as follows:

Notation:

AQ: Actual quantity (AH = Actual Hours)

BQ: Budgeted quantity (SH = Standard Hours)

AP: Actual Price (AR = Actual Rate)

SP:Standard Price (SR = Standard Rate)

SMn-:Standard Margin

Sale variances:

� Sales Volume: (AQ – BQ) SMn

� Sales Price: (AP – SP) AQ

Materials variances:

� Price: (SP – AP) AQp

� Usage: (SQ – AQu) SP

Labour variances:

� Rate: (SR – AR) AHp

� Idle time: (AHw – AHp) SR

� Efficiency: (SH – AHw) SR

Variable Overheads:

� Rate: (SR – AR) Ahw

� Efficiency (SH – AHw) SR



Fixed Overheads

Expenditure: Budgeted fixed cost – Actual fixed cost If absorption costing is being used, additional variances may be calculated:

� Volume: (AQ – BQ) × Standard rate per unit or (SH – BH)

If fixed overheads are absorbed using some hourly basis, (labour hours, machine hours) the volume variance may be further analysed into:

� Capacity: (AH – BH) SR

� Efficiency: (SH – AH) SR

(SR means standard overhead absorption rate per hour)

The only differences between variance analysis using absorption and marginal costing are:

� Sales volume variance is valued at standard profit per unit for absorption, and standard contribution per unit for marginal.

� There is only one fixed overhead variance for marginal costing- the expenditure overhead.

The examiner often provides variances in the exam and expects you to be able to provide suggestions as to the causes of these. If this is the case, ensure you read the scenario carefully as there are often clues given in the scenario as to the causes. Below is some guidance as to possible causes of variances in general terms:

� Sales volume variance; measures the effect on standard margin of selling more/less units than expected.

� 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

� Materials usage variance measures the effect of losses, rejects, defects wastage etc. Remember to used a flexed budget for materials quantity to compare to the actual quantity used

� Labour idle time variance; measures the cost to the company of paying workers who are not working e.g. due to machine breakdowns, materials stock-outs.

� Labour rate variance; measures the effect on payroll expense of paying workers a non-standard wage



� Labour efficiency variance; measures the productivity of workers Remember to use a flexed budget for labour hours to compare to the actual hours worked.

� 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 over-absorption 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.

ADVANCED VARIANCE ANALYSIS



Materials mix variance and yield variances

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

Total materials cost variance

Price variance Usage variance

Mix variance

Yield variance

Materials mix variance

The best approach to the mix variance is to use a tabular approach:

Actual Actual quantity

quantity in standard used mix Difference Variance litres/kgs litres/kgs litres/kgs $

A B (B − A) (B −A) x Sp Material 1 Material 2 Material 3 ___ ___ ___ ___ X X 0 $Y ___ ___ ___ ___

Materials yield variance

The simplest way to calculate this is to compare:

Actual output – expected output for actual input. Multiply the difference by the standard cost per unit.



Example

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

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

Mix variance

Actual Actual standard Variance quantity quantity minus actual mix standard mix actual Litres Litres Litres Gin 7 5.7 (1.3) (6.5) Tonic 33 34.3 1.3 1.3 __ __ __ __

40 40 0 (5.2)

The mix variance shows that the bar staff mixed stronger gin and tonics than the standard. Since Gin is more expensive than tonic, this would lead to a more expensive mix than the standard. The variance is adverse.

Yield variance

40 litres of mix should yield 114 gin and tonics. 40 litres did yield 100 gin and tonics Shortage: 14 gin and tonics. Standard cost of 1 gin and tonic: ($5 × 0.05) + ($1 × 0.3) = $0.55. Yield variance (adverse) = 14 × $0.55 = $7.7.

Such variances are routinely calculated by cigarette manufacturers who blend a mix of tobacco into the final product. If they use relatively more of a cheap but low quality tobacco they may find a favourable mix variance but adverse yield variance.

Sales mix and quantity variances

� Used to analyse the sales volume variance where the sales budget includes a standard mix of products. This usually occurs in situations where similar products are sold, perhaps differentiated by brands, and each brand has very different margins.



Total sales variance

Price variance Volume variance

Mix variance

Quantity variance

Example

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

� Similar in nature to the materials mix variance. Using a tabular approach works best:

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

Sales quantity variance

� Takes the difference between actual sales (in the standard mix) and budgeted sales. Again a tabular approach works well:

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



Activity based costing variances

Where ABC is used, the following approach is taken to calculating variances:

� Expenditure variance: Actual overhead cost – Standard for actual number of units of driver.

� Efficiency: (Actual units of driver – standard units of driver for actual output) × standard cost of one unit of driver.

Example

Budgeted output = 30 million units Budgeted number of setups = 3,000 Standard cost per setup = $400. Actual output = 24.2 million Actual number of setups = 2,200 Actual setup costs = $900,000. Expenditure variance:

Actual expenditure 900,000 Standard for actual number of setups 880,000 ––––––– Expenditure variance 20,000 (adverse)

Efficiency variance

Actual number of setups 2,200 Standard for actual output 2,420 –––––– 220 Standard cost of 1 setup $400 –––––– Efficiency variance $88,000 (favourable) Incorporating idle time and waste into standards

Management may expect a certain amount of idle time, and treat this as normal. If so, this “normal” idle time may be included in the standard labour cost of a product.

Example

Wage cost per hour is $12. However, management expects labour to be idle for 20% of the time. The standard cost of labour is therefore adjusted to $15 per productive hour.

Idle time variance: Actual idle time X Less expected X (20% of hours paid) Difference Multiply difference by adjusted standard cost ($15) per productive hour to get idle time variance.

PLANNING AND OPERATIONAL VARIANCES


Planning and operational variances

� Variance analysis is used to provide information about the performance of operations, by comparing actual performance against a standard.

� When the standard itself is found to be inappropriate, the standard should be revised before variance analysis is performed.

� Standards may be revised if:

� Factors outside of the organisation mean that the assumptions on which standards were based become inappropriate. (For example, the bankruptcy of a major supplier may mean alternative suppliers had to be found.)

� The original standard is found to have been unrealistic.

� Standards should not be revised to take into account internal inefficiencies.

� In practice, judgement may be required to decide if a standard should be revised or not.

Planning variances compare the standard cost of actual output using the original standard with the standard cost of output using the revised standard.

Calculation of planning variances relating to costs (e.g.

materials or labour).

Planning usage variance

$ Original SQ x original SP x actual output X Revised SQ x original SP x actual output X –– Planning usage variance X ––

Planning price variance

$ Revised SQ x original SP x actual output X Revised SQ x revised SP x actual output X –– Planning price variance X ––

Calculation of operational variances is exactly the same as “basic variance analysis” above. The only thing that changes is the standard itself.

PLANNING AND OPERATIONAL VARIANCES


Planning and operational variances relating to the sales

volume variance

The sales volume variance can be calculated using the following format:

Units Actual sales X Budgeted sales X –– Difference X X standard margin per unit X –– Sales volume variance X –– Where the sales budget is revised at the end of the year before performing variance analysis, perhaps because the actual market size was very different to what was anticipated when the original budget was prepared, the sales volume variance can be split into two parts:

� Market volume variance (a planning variance)

� Market share variance (an operational variance)

Market volume variance

Units Revised budgeted sales* X Original budgeted sales X –– Difference X X standard margin per unit X –– Market volume variance X *Note- the revised budget quantity may have been calculated as the actual market size x budgeted market share. Market share variance

Units Actual sales X Revised budgeted sales X –– Difference X X standard margin per unit X –– Market share variance X ––

PERFORMANCE MEASUREMENT



Financial performance evaluation

Benefits to shareholders

Main objective of an organisation, from the perspective of the owners, is to maximise wealth. Financial performance evaluation is therefore normally performed from the perspective of the shareholders.

Ratios

Return on capital employed (ROCE)

Equity

taxbeforeProfit × 100

debt termlong plusEquity

taxandinterest beforeProfit × 100

Profit margins

Gross profit margin = Revenue

profit Gross× 100

Net profit margin = Revenue

profitNet × 100

Liquidity

Current ratio = sliabilitieCurrent

assetsCurrent × 100

Gearing

Gearing ratio = debt plusEquity

Debt× 100

Conflict between Short Run and long run financial

performance

� Short run improvements in financial performance may be at the expense of longer term, e.g. cutting back on R&D spending.

� Performance measurement should encourage a longer-term view, possibly by using a mix of financial and non-financial performance indicators. (See below)



Non-financial performance indication (NFPIs)

Use of NFPIs in addition to financial measures has several advantages:

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

� Using only financial measures may lead to short term behaviour

� May be less easily manipulated

� May be compiled more quickly.

Key performance indicators

� Key performance indicators measure how the organisation performs in relation to its critical success factors.

Operational performance indicators

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

FURTHER ASPECTS OF PERFORMANCE MEASUREMENT


FURTHER APSECTS OF PERFORMANCE

MEASUREMENT

Balanced scorecard approach

This is an attempt to combine financial indicators and non-financial indicators to cover all relevant areas of performance such as:

� Financial perspective – designed to make the company survive and prosper by reference to profitability, cash flow, market share

� Customer perspective – designed to give responsive supply and quality and is concerned with on-time delivery, % of returns and customer satisfaction.

� Internal business perspective – designed to give manufacturing excellence and productivity and is concerned with reduced cycle times and engineering efficiency

� Innovation and learning perspective – designed to reduce the time to market and improve technological leadership by looking at the number of new product introductions and the time to develop the next set of products.

Fitzgerald and Moon

The following characteristics that distinguish services from manufacturing businesses:

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

� Perishability – services cannot be stored

� Heterogeneity – e ach time a service is performed, it will be different.

� Intangibility – w hat consumers value in a service can be difficult to determine.

In their building blocks model, Fitzgerald and Moon defined six “dimensions” through which a service industry can monitor its performance:

� Profitability

� Competitiveness

� Quality

� Resource utilisation

� Flexibility

� Innovation

FURTHER ASPECTS OF PERFORMANCE MEASUREMENT


Non profit organisations

Performance measurement in non profit organisations is complicated by the fact that:

� There are many stakeholders, possibly with differing objectives. Which objectives are the priority ones?

� The organisations have limited resources within which to try to achieve their aims.

� Performance measurement in the non profit sector focuses on the “three ees:

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

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

� Effectiveness – how good is the hospital (e.g. how many patients do not return within three months.)

DIVISIONAL PERFORMANCE EVALUATION


DIVISIONAL PERFORMANCE EVALUATION

Return on investment (ROI)

� ROI is essentially the same measure as ROCE and ARR

� It is important only to only include costs, revenues and elements of the assets base controlled by the manager when performing a managerial evaluation.

debt termLong employed Capital

taxationandinterest beforeProfit

+ × 100%

� This has the benefit of providing a relative evaluation for comparative purposes or

� May be used for investment appraisal where the manager can compare an investment’s ROI with the target ROI. If the division’s ROI is the same as the company’s ROI then this will produce goal congruent behaviour. If not however, then dysfunctional behaviour may happen (e.g. division’s ROI is 5%, company’s required rate 20%, project under appraisal 10%. The manager would accept the project but should reject it).

Residual income (RI)

� To overcome this problem, RI calculations may be used. The calculation is profit – imputed interest (capital employed multiplied by cost of capital)

� If positive the project is accepted, if negative the project is rejected and as such is an absolute measure like NPV. Discounted RI indeed reconciles to NPV.

Problems associated with both ROI and RI

� Both measures use accounting profits and are short term i.e. if positive RI or target ROI’s are not met in the first period then the project may be rejected even though a positive NPV may be observed over the whole life of the project. The risk of short-termism may be reduced through:

� Relegating the divisional managing director to profit centre status and make the capital investment decision at group level based on NPV. However this could be de-motivating.

� Adjust the manager’s target ROI or RI downwards in the earlier years of the project. This will not be de-motivating.

TRANSFER PRICING


TRANSFER PRICING

Objectives of a good transfer pricing system:

� Autonomy

� Goal congruence

� Fair to both buyer and seller for performance evaluation purposes.

Opportunity cost approach to transfer pricing

From the perspective of the selling division, minimum transfer price is the higher of:

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

� Variable cost + opportunity cost of supplying the goods.

From the perspective of the buying division, the maximum transfer price acceptable is the lower of:

� External market price

� Net revenue of the division. Net revenue means ultimate selling price, less costs incurred in the buying division. If the transfer price exceeds this, the buying division will make a loss.

An alternative way of looking at the second criteria is: Variable cost + shadow price.

If a price exists which meets the criteria above, it will automatically satisfy the objectives of a good transfer pricing system.

Practical Approaches to transfer pricing

Cost plus approach

� Easy to calculate

� Covers all costs of selling division

� Setting mark up is arbitrary

� Inefficiencies in selling division are passed on to buying division.

� May lead to incongruent decisions.

Market price

� Easy to obtain

� Fair

� May lead to incongruent decisions (e.g. where selling division has spare capacity, and buying division buys externally)

TRANSFER PRICING


Dual Pricing

Where no transfer price can be found which is acceptable to both parties, but the head office wants both divisions to trade internally, dual pricing may be used. A higher price is credited to the buying division, and a lower price debited to the buying division- the head office absorbs the difference.

FURTHER READING


FURTHER READING

Relevant Articles in Student Accountant

The ACCA website (www.accaglobal.com) includes the following articles to paper F5. The articles can be downloaded from the following link:

http://www.accaglobal.com/en/student/qualification-resources/acca-qualification/acca-exams/f5-exams.

At this stage in your studies you may not have time to read all of these. Those marked with an asterisk are highly recommended:

� “Throughput accounting and the theory of constraints” (parts 1 and 2) by Ann Irons, October 2011

� “Environmental management accounting” by Ann Irons, July 2010 (summarised in this document)*

� “Performance measurement” by Ann Irons, July 2010 (summarised in this document)*

� “Cost volume profit analysis” by Ann Irons July 2010 (summarised in this document)*

� “Quantitative aspects of budgeting” by Ken Garret, March 2010

� “Comparing budgeting techniques” by Ann Irons, March 2010*

� “Behavioural Aspects of Budgeting” by Ken Garret, March 2010*

� “Materials mix and variance analysis” by Ann Irons, March 2010 (summarised in this document)

� “Exam analysis- Variances” by Louise Cookson, March 2010

� “Throughput accounting” by Ken Garrett, Feb 2010

� “Target costing and Lifecycle costing” by Ken Garrett, Feb 2010* (summarised in this document)

� “Activity based costing” by Ken Garrett, Jan 2010

� “Approach to written questions- F5” by Ann Irons, November 2009- (summarised in this document)*

� Transfer Pricing by Ken Garrett, Oct 2009 (summarised in this document)

� Not for profit organisations- Part 1 & 2, by Robert Souster, Sept/Oct 2009

FURTHER READING


� “Measuring planning variances” by Geoff Cordwell, April 2009 (summarised in this document)

� “The risks of uncertainty” by Michael Pogue April 2009

� “Interpreting financial data” by Geoff Cordwell, May 2008 (summarised in this document)*

� “Linear Programming “by Geoff Cordwell, March 2008

� “Performance measurement” by Steve Jay, April 2004 (summarised in this document).

Examiner’s reports

These are available from the ACCA web site. The report for the latest exam is summarised at the end of this document.

The full examiners reports can be downloaded from the ACCA web site using the following link:

http://www.accaglobal.com/en/student/qualification-resources/acca-qualification/acca-exams/f5-exams

Other reading

For both paper F5 and other ACCA papers it is useful to regularly read good quality financial press such as the Financial Times or The Economist. Both can be viewed on-line:

� www.ft.com

� www.economist.com

APPROACHING WRITTEN QUESTIONS


This is a summary of an article written by Ann Irons- the new examiner for paper F5. Ann’s first exam will be the December 2010 exam, but she has reviewed the June 2010 exam, and is involved in managing the marking of it.

One of the reasons for the poor pass rate at paper F5 is because the skills papers, of which paper F5 is one, are often the firs time that students have had to tackle written questions. No longer is it sufficient to simply learn materials and churn out calculations.

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

� correctly interpret requirements

� actively read scenario based questions highlighting what is relevant for each part of the requirement

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

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

Another reason for the poor pass rate is that candidates do not understand the differences between F2 and F5. Where subjects that were in F2 are repeated in F5, the skills required of you are over and above the knowledge required in F2. (See the article “The difference between F2 and F5” published in January 2010).

Step by step approach to the exam on the day

Reading time

During the 15 minutes reading time you should:

� Read all the requirements and the questions

� Think about the order in which you will do the questions- best question first.

� Allocate the 180 minutes of exam time among the questions.

When it comes to answering the question, be sure that you are strict with your time allocation. If you are spending too long on one question it is either because you can’t do it anyway (in which case move on and come back to it later) or you are saying too much and going beyond what the examiner expected of you. How much an examiner expects you to write is directly linked to the marks available and therefore to the time available.



In the reading time you should have a chance to read the requirements of all five questions. Remember the requirement should be the first thing that you look at in a question. What is the point in reading a question if you don’t know what you are looking for? When you read the requirement, underline the ‘content’- for example target costing, and the ‘instruction’- what it is telling you to do.

The instruction could be a variety of verbs such as calculate, describe, interpret, and discuss. The one thing that you can be sure of is that the verb has been carefully thought about by the examiner. If you don’t read and understand the instruction carefully then you will find that you are not actually answering the question. If you are not answering the question you are not earning marks. Each of the common exam instructions are dealt with below.

Answering numerical questions

Calculate - you just have to work something out.

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

Estimate – suggests that the answer cannot be calculated with certainty. For example, when calculating the cost of a batch when there is an 80% learning rate, the learning rate itself reflects what the business THINKS will happen, but it is not certain until it has happened.

The mechanics of estimating and deriving are very similar to calculating.

Why do candidates perform poorly on the numerical parts of Paper F5? In my opinion it is often because of failure to study the whole syllabus well enough in the first place. Anyone who thinks they can question spot is sadly mistaken.

Another reason why candidates score poorly on numerical questions is because they approach the question in a disorganised fashion, with no logical progression through the calculations and no clear numbered workings. You should go into the exam with a toolbox of the tools that are going to help you answer the questions. For example, if it is a linear programming question, go into your toolbox and pull out your five-step guide for linear programming:

� define the variables

� state the objective function

� state the constraints

� draw the graph

� find the solution.



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

Answering wordy questions

Candidates are not penalised for the fact that English may be their second language. The real cause of the poor performance in written questions is that candidates appear unable to grasp what to write and how much to write- i.e. they don’t understand the instruction. Further clarification of all the main instructions you would expect to find in an F5 exam is given below.

Describe give some sort of narrative about something. For example “describe suitable non financial performance indicators for a hospital” It would not be enough merely to list the items- you would have to go a step further and describe how they might be calculated.

Interpret explain in your own words and give your opinion about it. For example “interpret the balanced scorecard approach.” This is quite a high level requirement that will usually be reflected with higher marks.

Outline this requires a fairly brief and well-organised overview, without the level of detail that would be required in “describe”. For example ‘outline the objectives of a budgetary control system’.

Compare discuss similarities between two or more things and draw conclusions. For example, compare product costs using activity based costing with product costs using traditional costing. You need to say why the costs are different. This will involve looking in detail at the product costs and ascertaining the reason why the overheads absorbed into one product are higher under one method than the other.

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



Discuss this requires a candidate to give their own thoughts on a subject, supporting it with facts and logical reasoning. For example you could be asked to discuss the effect that variances have on staff motivation. The opinions you give must be sound and well reasoned. It is no good saying that variances are demotivational for example without explaining why. Also you are expected to look at both sides of the story.

Explain this means that you need to give a reason for something. This is a very common requirement.

Evaluate you are being asked to decide on the merits of something. This requirement would not be expected to arise much in F5- most of the evaluation is reserved for P5.

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

Justify you need to state why a particular answer or position makes sense. For example, if you were asked to justify the use of backflush accounting in an organisation, you would have to mention the relative immateriality of inventory.

Conclusion

F5 is not an especially hard paper if candidates:

� work hard to gain knowledge of areas that they have not practiced

� Underline the content and instruction of all requirements at the beginning of each question and keep referring back to them.

� Keep practicing questions until your approach and layout becomes second nature giving you the time in the exam to think about the issues in the question.

TARGET COSTING AND LIFECYCLE COSTING



by Ken Garrett – 28 Apr 2011

This is a summary of an article that appeared in the student accountant magazine in April 2011. The full article can be downloaded from the ACCA web site.

Typically, conventional costing attempts to work out the cost of producing an item incorporating the costs of resources that are currently used or consumed. 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. 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. 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:

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 corporate 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.

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:

� 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.

� 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 ABC 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).

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 lifecycle 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 Examples of types of cost

Design Research, development, design and tooling

Manufacture Material, labour, overheads, machine set up, inventory, training, production machine maintenance and depreciation

Operation Distribution, advertising and warranty claims

End of life 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 reduce 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:

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 that gives the company its greatest opportunities to reduce those costs.

Ken Garrett is a freelance lecturer and author

ENVIRONMENTAL MANAGEMENT ACCOUNTING



This is a summary of the article that was published in Student Accountant magazine, written by the examiner Ann Irons.

Introduction to environmental management accounting

Environmental management accounting (hereafter “EMA”) is a sub-set of management accounting. Management accounts give us an analysis of the performance of the business and are ideally prepared on a timely basis so that we get up-to-date management information. They break down each of our difference 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.

EMA focuses on things such as the cost of energy and water and the disposal of waste and effluent, including both financial costs as well as cost versus benefit issues related to 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.

EMA uses some standard accountancy techniques to identify, analyse, manage and hopefully reduce environmental costs in a way that provides mutual benefit to the company and the

environment, although sometimes it is only possible to provide benefit to one of these parties.

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 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.



Additionally, the environment can benefit as less power and cotton (i.e. material for towels) 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 organization and this, in turn, may attract more customers and increase revenues.

Definition of EMA

There is no one single definition, but a widely accepted one that was adopted by the IFAC (International Federation of Accountants) in its 2005 international guidance document on EMA: “EMA is the identification, collection, analysis and use of two types of information for internal decision making: i) physical information on the use, flows, and destinies of energy, water and materials (including waste), and ii) monetary information on environmental-related cost, earnings and savings.”

Importance of the environment to business

There are three main reasons why the management of environmental costs is becoming increasing important in organizations. 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’ measures the total greenhouse gas emissions caused directly and indirectly

by a person, organization, event or product. Second, environmental costs are becoming huge for some companies (in some cases amounting to more than 20% of operating costs); particularly those operating in highly industrialized sectors such as oil production. These need to be managed. Third, regulation is increasing worldwide at a rapid pace, with penalties for non-compliance also increasing accordingly. Its not just the companies, officers – even junior employees – could find themselves facing criminal prosecution for knowingly breaching environmental regulations.

The management of environmental costs is difficult, mainly for the three reasons outlined below.

A) It is difficult to define EMA and the actual costs involved. Many organizations vary in their definition of environmental costs. The US Environmental Protection Agency stated that the definition of environmental costs depended on how an organization intended on using the information. They made a distinction between four types of costs: conventional costs such as raw materials and energy, potentially hidden costs captured by accounting systems but getting hidden in ‘general overheads’, contingent costs such as site clean up costs, and image and relationship costs that by their nature are intangible. On the other hand, the United Nations



Division for Sustainable Development (UNDSD) described environmental costs as comprising of two components: costs incurred to protect the environment such as measures taken to prevent pollution, and costs of wasted material, capital and labour including inefficiencies. These definitions do not contradict each other; they just look at the costs from slightly different angles. 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.

B) Many of the environment costs captured by the accounting system are difficult to separately identify as they are found within the category of ‘general overheads’. Time and effort is needed to separate them and allocate them to the product or process, which gave rise to them. The UNDSD identified four management accounting techniques for the identification and allocation of environmental costs: input/output analysis, flow cost accounting, activity based costing and lifecycle costing. The input/output analysis records material inflows and balances this with material outflows on the basis that what comes in must go out. So, if 100 kg of materials are purchased and only 80kg of materials have been produced then the 20kg need to be accounted for in some way, perhaps 2kg sold as

scrap and 18kg discarded as waste. Flow cost accounting uses not only material flows but also the organizational structure. It divides material flows into three categories: material, system, and, delivery and disposal. The values and costs of each of the three are calculated. The aim of flow cost accounting is to reduce the quantity of materials which, as well as having a positive effect on the environment, should have a positive effect on a business’ total costs in the long run. Activity-based costing allocates internal costs to cost centres and cost drivers on the basis of the activities that give rise to the costs. It distinguishes between environmental-related costs, which can be attributed to joint cost centres, and environment-driven costs, which tend to be hidden on general overheads. Life cycle costing is a technique that requires the full environmental consequences, and, therefore, costs, arising from production of a product to be taken account across its whole lifecycle.



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

i) Waste – there are lots of environmental costs associated with waste. 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 cost items, 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.

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

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

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

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

MATERIALS MIX AND YIELD VARIANCE ANALYSIS


MATERIALS MIX AND YIELD VARIANCE

ANALYSIS

This is a summary of the article written by Ann Irons that was published in the Student Accountant Magazine. The calculations have been reworked using the approach taken in the ATC International Study system for the purpose of consistency.

Material 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 have used for are production relative to how much we expected to use based on standard usage levels. So, for example, if we had made 5,000 items using 11,000 litres of material A and out standard material usage is only 2litre per item, then we clearly used 1,000litre more than we expected to. In terms of how we value the difference, it must be at standard cost. Any difference between the standard and actual cost would be dealt with by the material price variance.

There can be many reasons for an adverse material usage variance. It may be that inferior quality materials have been purchased- perhaps at a lower price. It may be that changes in the production process have been made, or that increased

quality controls have been introduced resulting in more items being rejected.

Further variance analysis where several materials are

used

Most products comprise of several different materials, so the more detailed mix and yield variances can be calculated. 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. When we talk about material mix, we are referring to the quantity of each material that is used to make our product i.e. 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- i.e. our output.

Materials mix variance

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

For example, chemical C 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.

Let us assume that the standard mix has been set: 8 litres of A and 12 litres of B will yield 19 litres of C. The standard cost for 1 litre of C is therefore $24.21 (8 × 20 + 12 × 25).



If the cost of materials A and B changes, production managers may deviate from the standard mix. Managers may simply fail to adhere to the standard mix for whatever reason. This would result in a materials mix variance.

Let us assume now that production of C commences. 1,850 litres of C is produced using a total of 900 litres of A and 1,100 litres of B (2,000 litres in total). The actual costs of A and B were at the standard costs of $20 and $25 per litre respectively. How do we calculate the mix variance?

Actual Actual quantity quantity in standard used mix Difference Variance litres litres litres $ A 900 800 (100) (2,000) B 1,100 1,200 100 2,500 –––––– –––––– –––––– –––––– 2,000 2,000 0 500 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.

As a student I was never a person to blindly learn formulae (for variances) 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.

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.

Materials yield variance

Where there is a difference between the actual and standard level of output for a given set of inputs, a material yield variance arises. In our optimum mix, we calculated that 20litres of inputs A and B (8 litres of A and 12 litres of B) should produce 19litre of our output C. We are effectively saying that there is a loss rate of 5% (1/20) in our process.

Applying this to our example we can say that we would have expected our inputs of 2,000 litre to yield an output of 1,900litre (2,000 × 95%).



The yield variance is:

Expected output 1,900 litres Actual output 1,850 litres –––––– Shortage 50 litres X standard cost per litre of output 24.21 –––––– Yield variance (adverse) 1,210.5 The variance is adverse because the actual yield (output) was less than expected.

Making observations about variances

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. However, our cheaper mix of materials has resulted in a significantly lower yield- the yield was $1,211 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 $711 ($1,211 A less $500 F).

Understanding the bigger picture

Quality issues cannot be dealt with by this variance analysis. It is essential to understand the importance of producing products that are of 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 year. 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.

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 businesses products decreases, but it is likely to take some 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, poor quality materials may be more difficult to work with. This may lead to an adverse labour efficiency variance as the workforce takes longer than expected to complete the work. This 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 and yield variance and are therefore more likely to be identified and the problem resolved.

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

MEASURING PLANNING VARIANCES


MEASURING PLANNING VARIANCES –

BY GEOFF CORDWELL

This is a summary of an article prepared by the previous examiner for F5, Geoff Cordwell. The full article can be downloaded from the ACCA web site.

There are many possible ways of calculating planning variances. This article sets out the examiner’s preferred approach, based on the example given.

Example

The following information is given regarding the standard cost of artificial snow for a ski resort. After the original budget had been prepared the subsequent improvements in technology lead to manufacturers reducing their prices to $4.85 per kilo. This was considered to be a fair target, so the standard was revised. The standard usage was also revised.

Original Revised Actual Budget Budget spending (Ex-ante) (Ex-post) Material price per kilo ($) 5 4.85 4.75 Material per unit (kilos) 10 9.5 Material used (kilos) 108,900 Production (units) 10,000 10,000 11,000

In exams, the information would be given in the form of a scenario, rather than in a table as above. Students would be expected to be able to interpret the information given in the table so as to prepare their own table.

Planning variances

The examiner believes that planning variances should be based on the actual level of output, rather than on the original budgeted level of output.

Material price planning variance

Actual output × revised budget materials per unit

× revised budget price per kilo

(11,000 × 9.5 × 4.85) 506,825

Actual output × revised budget materials per unit

× original budget price per kilo

(11,000 × 9.5 × 5) 522,500 ––––––– Material planning price variance (favourable) 15,675 –––––––

MEASURING PLANNING VARIANCES


Material usage planning variance

Actual output × revised budgeted materials

per unit (11,000 × 9.5) 104,500 Actual output × original budgeted materials

per unit (11,000 × 10) 110,000 ––––––– Variance (Kilos) 5,500 Original budget price per kilo 5 ––––––– Variance $ (Favourable) 27,500 ––––––– Total variance: (15,675 + 27,500) 43,175 This can be proved as follows: Original budgeted cost of 11,000 units

(11,000 × 5 × 10) 550,000 (Ex post budget flexed) Revised budgeted cost of 11,000 units

(11,000 × 4.85 × 9.5) 506,825 ––––––– Difference 43,175

Interpretation

Operational variances (calculated as normal, using the revised standard instead of the original standard) are the only variances within management control, so they alone should be used to assess the performance of management.

Care must be taken when revising standards- managers may wish to manipulate the operational variances- for example by not revising the standard price downward- this would result in a more favourable operational price variance.




This is a summary of an article written by the examiner Ann Irons in student accountant magazine. The full article can be downloaded from the ACCA web site.

This article will 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 1,045,000 1,372,000 ––––––––– –––––––– Book value of assets at start of year 13,000,00012,000,000 Dividend paid 500,000 650,000 Number of visitors 150,000 140,000



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.

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 below:

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.

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).

(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.

You should note that it will rarely be appropriate to look at numbers in absolute rather than relative terms. 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. Our movement in sales, on the other hand, is also relatively small but has been mentioned.

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 (e.g. 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 ($320,000- 260,000)/$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’, i.e. just pages of writing with no headings and no structure. In this case, your headings could be taken from your workings, e.g. ‘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:

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.

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’, i.e. 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, i.e. 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 × 50 rides × 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, e.g. ‘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, e.g. 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

INTERPRETING FINANCIAL DATA


Interpreting financial data

This is a summary of an article written by the previous examiner and was published in the May 2008 Student Accountant. The full article can be downloaded from the ACCA web site.

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

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

Tutors note: the question “Ties only” is included in the Study Question Bank.

Assessing financial performance

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

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

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

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

PERFORMANCE MEASUREMENT AND THE BALANCED SCOREDCARD



This section is a summary of an article by Steve Jay. The

full article can be read on the ACCA web site, by

navigating towards the technical articles relevant to

paper F5.

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

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

A good performance measure should:

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

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

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

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

� Cost centre- standard costing variances

� Profit centre- controllable profit

� Investment centre- return on investment and residual income.

Cost centres

For standard costing variances, problems include:

� Focuses on short term cost minimisation- this may conflict with objectives such as quality

� Deciding who is responsible for the variance- for example, is the production manager or the purchasing manager responsible for material purchase variances.

� Setting standards in the first place is difficult.

Profit centres

When assessing the performance of a divisional manager, we should consider only the costs and revenues that are under the control of that manager (controllable divisional profit). When assessing the performance of the division, we should look at costs and revenues traceable to the division (traceable



divisional profits). For example, depreciation of machinery would be a cost that is traceable to the division, but is not controllable by the manager, because the manager of a profit centre does not make investment decisions.

Investment centres

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

Return on investment (ROI) =

investment )(traceable lecontrollab

profit )(traceable leControllab

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

Example

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

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

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

Division X’s cost of capital is 10%.

Required:

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

Solution

Current situation

ROI = million

million

10

2.2= 22%.

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

If proposal 1 is accepted

ROI = millionmillion

millionmillion

110

15.02.2

+

+=

million

million

11

35.221.4%

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

Comment-

The return of the proposal is million

million

1

15.0 = 15%.



Since the return on the proposal is greater than the cost of capital of the company, from the overall company point of view, the proposal should be accepted. If the manager of the division is judged on ROI however, the proposal may be rejected, as it would reduce the divisional ROI from the current 22% to 21.4%. Thus the use of ROI can result in dysfunctional behaviour. The proposal generates positive residual income however, so would be accepted by a manager who is judged using this criterion.

If proposal 2 is accepted

ROI = millionmillion

millionmillion

3.210

3.02.2

−

−= 24.7%

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

Comment

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

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

Relative merits of ROI and residual income

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

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

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

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



Non financial performance indicators

Weaknesses of traditional financial performance indicators include the following:

� Single factor measures such as ROI and residual income do not give a complete picture of divisional performance

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

� May lead to dysfunctional behaviour.

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

Balanced Scorecard

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

� Financial success

� Customer satisfaction

� Process efficiency

� Growth

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

Key performance indicators should be:

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

� Measurable

� Relevant- to achievement of a critical success factor.



Example

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

Perspective Critical success Factors

Key performance indicators

Financial Shareholder wealth Dividend yield % increase in share price

Cash flow Actual v budget

Customer perspective

Exam success Pass rates v national Premier college status

Process efficiency

Resource utilisation % room occupancy

Average class size Average tutor teaching

Growth New products % sales from new courses

Advantages of the balanced scorecard

� Measures performance in a variety of ways

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

� Encourages a longer term view of business performance

� It is flexible- measures can be changed over time to reflect changing priorities

Difficulties of balanced scorecard

� Setting standards for key performance indicators (targets)

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

TRANSFER PRICING


TRANSFER PRICING

This is a summary of an article by Ken Garret, published in the Student Accountant Magazine. The full article can be downloaded from the ACCA website.

When transfer prices are needed

Transfer prices are almost inevitably needed whenever a business is divided into more than one department or division. Usually goods and services will flow between the divisions, and each will report its performance separately. The accounting system will usually record goods or services leaving one department and entering the next, as some monetary value must be used to record this. That monetary value is the transfer price.

Imagine Division A makes components for a cost of $30 and these are transferred to Division B for $50. Division B incurs own costs of $20 and then sells to outside customers for $90. As things stand, each division makes a profit of $20 per unit.

You will appreciate that for every $1 increase in the transfer price, Division A will make $1 more profit and Division B will make $1 less profit. Changing the transfer price will have knock on effects on the following areas:

1. Performance evaluation. The success of each division whether measured by return on investment (ROI) or residual income (RI) will be changed.

2. Performance related pay – If there is a system of performance related pay, the remuneration of employees in each division will be affected as profits will change.

3. Make/abandon/buy in decisions. If the transfer price is too high, it may become impossible for the receiving division to make any contribution. The division might abandon the product line or buy in cheaper component from outside suppliers.

4. Motivation – if a transfer price was such than one division found it impossible to make a profit then the employees in that division would probably be demotivated. In contrast the other division would have an easy ride as it would make profits easily, and would not be motivated to work more efficiently.

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

TRANSFER PRICING


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

Characteristics of a good transfer price

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

� Be perceived as being fair for the purposes of divisional performance evaluation and investment decisions.

� Permit each division to make a profit

� Encourage divisions to make decisions that maximise group profits – if the decisions that will maximise divisional profit also maximise group profit. This is known as goal congruence.

The economic transfer price rule

Minimum transfer price (fixed by transferring division)

≥marginal cost of transfer out division.

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

Example

Division A Division B $ $ Transfer in price - 50 Own costs Variable 18 10 Fixed 12 10 Divisional profit/ mark up 20 40 ––– ––– Transfer out/ final sale price 50 90 ––– ––– The minimum transfer price acceptable to Division A would be $18, as this is the marginal cost of production. A transfer price of $19 for example would not be as popular with Division A as would a transfer price of $50, but at least it offers the prospect of contribution, eventual break even and profit.

For the transfer in Division (Division B) the transfer in price plus its own marginal costs must be no greater than the marginal revenue from outside sales. This allows the division to make a contribution (or at least not make a negative one). In this example, the transfer price must be no higher than $80 as $80 + $10 (own variable cost) = $90 (marginal revenue).

TRANSFER PRICING


The transfer price rule for Division B can be restated to say that the transfer price should be no greater than the net marginal revenue, where net marginal revenue is marginal revenue less own marginal costs. Here net marginal revenues

= $80 ($90 −$10).

So a transfer price of $50 would work, since it is ≥ $18 and ≤ $80. Both parties will find it worth trading at that price.

The economic rule of transfer pricing suggested above also leads to decisions that are in the interests of the group as a whole. If in the example above, the final selling price (for Division B) were to fall to $25, the group could not make a contribution because $25 is less than the group’s total variable cost of $18 + $10. The transfer price that would make both divisions trade must be no less than $18 for Division A, but no greater than $15 (net marginal revenue) for Division B. So clearly no workable transfer price is available, and the divisions would not trade with each other.

Therefore all head office needs to do is to impose a transfer price within the appropriate range, confident that both divisions will act in a way that maximised group profit.

The problem with this approach is that variable costs and final selling prices will change continually in the real world and this can be difficult to manage. A second problem is that the range of transfer prices set (from $18 to $10) is large, and therefore the respective profits of the two divisions could vary vastly depending on where within the range they agree the final price.

Practical approaches to transfer pricing

1. Variable cost

A transfer price is set at the variable cost of the transferring division produced good economic decisions, since the buying division’s marginal costs (including the transfer price) will be the same as those of the group. However, there are drawbacks:

� Division A will make a loss, as its fixed costs will not be covered.

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

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

TRANSFER PRICING


2. Full cost

A transfer price set at full cost of $30 is more satisfactory for Division A, as it will now break even. However, it can lead to dysfunctional behaviour. If the final market price fell to $35, Division B would not trade, because its marginal cost would be $40, (transfer in price of $30 plus own marginal costs of $10). However, from a group point of view the marginal cist is only $28 ($18 + $10) and a positive contribution would be made even at a selling price of $35.

3. Market price

A transfer price set to the market price of the transferred goods should give both divisions the opportunity to make profit if they operate at normal industry efficiencies.

Market price provides an objective transfer price not based on arbitrary mark ups, and will therefore be perceived as being fair to both divisions.

As with full cost, a market cost could also lead to dysfunctional behaviour however, as they result in fixed costs and profits of the selling division being variable (marginal) costs to the buying division. A similar approach, variable cost plus would have the same disadvantage. In fact, once you get away from a transfer price equal to the variable cost in the transferring division, there is always the risk of

dysfunctional decision being made unless an upper limit – equal to the net marginal revenue in the receiving division is also imposed.

4.Variable cost plus lump sum

In this approach, transfers are made at variable cost. The periodically a lump sum is transferred from the buying division to the selling division to account for fixed costs and profit. It is argued that the buying Division (Division B) has the correct cumulative variable cost information to make good decisions, yet the lump sum transfers allow the divisions ultimately to be treated fairly with respect to performance measurement. The size of the periodic lump sum would be linked to the quantity or value of goods transferred.

5.Dual pricing

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

TRANSFER PRICING


Conclusion

Transfer prices are vitally important when motivation, decision-making, performance measurement and investment decisions are taken into account – and these are the factors that so often separate successful from unsuccessful businesses.

COMPREHENSIVE ANALYSIS OF PAST EXAMINATIONS


Topic Dec 11 Jun 11 Dec 10 Jun 10 Dec 09 Jun 09 Dec 08 Jun 08

Traditional management and cost accounting √

Activity Based Costing √ √ √

Developments in management accounting:

Target costing √

Life cycle costing √ √

Backflush accounting

Throughput accounting √ √

Short term decision making:

Relevant costs √ √ √ √

One off contracts √

Shut down decisions

Further processing decisions

Limiting factor decisions:

One limited factor

Make or buy √

Linear programming √ √ √

Pricing √ √ √




Risk and Uncertainty √

Expected values √ √

Maximax, maximin, minimax regret √

Decision trees

Budgeting √ √ √ √ √ √

Quantitative Techniques for Budgeting

Regression/ correlation √

Time series analysis √

Learning curve theory √ √ √

Use of spreadsheets

Standard costing and variance analysis:

Basic variances √ √

Causes of variances √




Advanced variance analysis:

Materials mix and yield variances √ √

Sales mix and quantity variances √

Activity based costing variances √

Variances incorporating idle time/ learning curve

Usefulness of variances/ behavioural impact √

Behavioural aspects of standard costing

Planning and operational variances √ √ √

Performance measurement:

Performance hierarchy

Financial performance indicators √ √

Non financial performance indicators √ √




Further aspects of performance measurement:

The Balanced Scorecard √

Performance measurement in service industries

√

Performance measurement in non profit organisations

Benefits and problems of performance measurement systems

Divisional performance evaluation √ √ √

Transfer Pricing √ √

Note – the current examiner’s first exam was the December 2010 exam

EXAMINERS FEEDBACK


DECEMBER 2011 EXAM

The following is a summary of the comments made by the examiner after the December 2011 exam. The full examiner’s report can be downloaded from the ACCA web site.

http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012e/F5_examreport_d11.pdf]

� To their credit many candidates seemed to have taken on board my advice to start with their best question first and then continue to answer the questions in order of their best questions.

� Candidates also seem to be taking advice about getting the easy marks first on a question. This often meant that, for example, candidates answered the written requirement in 4 (c) before tackling the numbers in 4 (a) and (b).

� Small improvements are being seen in the way candidates are setting out their answers, showing their workings and tackling written requirements.

� The biggest single reason for failure in the F5 exam in December 2011 was definitely big knowledge gaps that many candidates seem to have.

Question One

This was a nice, straightforward relevant costing question, which should have been well answered by most people. It proved to be one of the most poorly answered questions on the paper.

� The biggest problem with this question was that many candidates clearly don’t understand relevant costing.

� Another problem was that the notes given by candidates didn’t explain the figures being used well enough. Many candidates just wrote down that a cost was included because it was “relevant” but didn’t say why. This is not an explanation and did not score marks.

Question two

This question covered transfer pricing. Part (a) contained the easy marks with a simple requirement to prepare a profit statement.

� There were many perfect answers here because the requirement was not difficult.

� Weaker candidates simply didn’t know what the words “profit statement” meant and just produced some workings showing total profit for the company.

EXAMINERS FEEDBACK


Part (b) asked for a calculation of the maximum profit that could be earned if transfer pricing was optimised.

� The logic behind this was totally lost on the majority of candidates.

Question three

Part (a) was where the bulk of the easy marks were on this paper: a requirement to identify and explain six objectives of a budgetary control system.

� A good number of answers scored full marks. On the whole, candidates either knew the answer or didn’t.

� A small number of candidates did not know what participative budgeting was so they scored nothing in part (b).

� Some candidates did not tackle part (b) in the best way, which was to use the objectives of part (a) as headings in order to give the answer some structure.

Question four

This question covered life cycle costing.

� Part (c) was where the easy marks were, and many candidates scored full marks for this, with a good number of candidates tackling this part first to get the easy marks.

� Part (a) read: ‘calculate the life cycle cost per unit.’ Anyone who just calculated a cost per unit for each of the three years totally missed the point of life cycle costing.

Question five

Finally the variance question.

� A significant number of candidates scored full marks on the materials usage, mix and quantity variance.

� Part (c) contained a couple of easy marks on the steps involved in allocating overheads using activity based costing. People who didn’t know the steps decided to just tell me everything they knew about activity base costing instead although, to be fair, this often wasn’t a lot.

EXAMINATION TECHNIQUE



In the exams to date, the pass rate for paper F5 has not been high. Candidates are advised to read the examiner’s comments. The following is a list of the key failings demonstrated by students according to the examiner’s reports to date. These comments were re inforced at the ACCA teachers’ conference in February 2011:

� Poor time management- with many candidates not answering all four questions.

� Failure to note the marks allocated to sections of questions, with some candidates writing three pages for an 8-mark section of a question.

� Poor layout of answers- including excessive crossing out, failure to label workings, no tabulation, and use of essay style for numerical calculations.

� Failure to answer the question asked- instead candidates writing everything they know about a topic in the hope that some of it will be relevant.

� Ignoring clues given in scenarios. For example, the examiner mentioned that the “machines had been running well.” Many candidates still mentioned that one possible cause of idle time was machine breakdowns.

� Inability to do performance evaluation questions- performance evaluation is the core of paper F5, and is what distinguishes F5 from F2.

� Poor interpretation of financial information. In a performance measurement exam, interpreting financial data is essential.

a. Say what happened

b. Say why it may have happened

c. Offer an opinion.

Examination technique

Time allocation

You must use the 1.8 minutes per mark rule.

� Spend no more than 36 minutes on a question. Never overrun, even if you think its “going well.” A few minutes spent finishing a question or tidying up are minutes wasted.

� Use the 1.8 minutes rule as a guide to how long to spend on each sub section.



Written sections of questions

Spend a few minutes planning what you are going to write before diving in and writing:

� Note the requirement of the question carefully (and ensure you focus on this)

� Spend a minute or two brainstorming - coming up with possible ideas that can be used. Try to use ideas from the scenario rather than from your study system. Be prepared to come up with some original thought.

� Ensure you take into account “clues” given in the scenario. The examiner gives information for a reason.

� Think about the structure of your answer- taking into account the marking scheme. The golden rule of 1 mark per point made is a fairly good one.

When writing your answer bear in mind that the examiner likes well constructed short points. Two to three sentences per mark, with a space after each point makes it easier for the marker to mark.

Refer whenever appropriate to the information in the scenario (but don’t simply copy this into your answer.)

Numerical sections

� Think about the layout of your solution. What calculations must you do? Is there a quicker way? Is all the information available for you to actually do the calculations that you require?

� Do detailed workings below your main answer. Label each working carefully, and reference the figures in your main answer to the appropriate workings.

� Marks are given for method rather than getting the “right answer”. If you make an arithmetical slip, don’t go back and correct all previous workings. Live with the mistake. You will only lose a mark or 2, so it’s not worth spending time correcting.

� Ensure that the marker can understand your logic- a small amount of narrative helps markers.

The keywords

Part of the secret of doing well in these exams is to actually understand what the question is asking. Here are a few key words and their meaning to help you.

� “Describe” = “set out the characteristics of”. Use brief sentences but give more depth than if the instruction was “state” (see below).



� “Explain” = make plain, clarify, elucidate. For example, defining a term does not explain it, but providing an illustration may do so.

� “State” =e express in words. Use one short sentence (bullet point) to make each answer point.

� “Discuss” = give balanced views on and conclude (where appropriate).

� “List” = make a list of like things.

� “Justify” = give reasoning.

� “Identify” e.g. from the scenario. This requirement is often implied rather than expressly stated. For example, “Describe the risks ….” requires that the risks be identified before they can be described.

� “Comment” = make observations, appraise and/or examine (critically).

� “Suggest” = propose or put forward.

� In addition to these words here are few extra hints to help you refine your technique;

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Revision Essentials includes:

• ACCA syllabus aim and main capabilities

• Core topics checklist

• Summary of essential facts and theory

• Further reading

• Relevant articles

• Comprehensive analysis of past examinations

• Examiners' feedback for the last exam session

• Exam technique

Revision Essentials are not quality assured by ACCA but their content is substantially derived from materials which have been quality assured by ACCA.

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