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ACCA ATC F5 Revision Essentials June 12
ACCA ATC F5 Revision Essentials June 12
ACCA
Paper F5 | PERFORMANCE MANAGEMENT
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ACCA
PAPER F5
PERFORMANCE MANAGEMENT
REVISION ESSENTIALS
JUNE 2012
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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
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
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.
Activity Based Costing 4. Calculate the total cost that will be absorbed by each
product. (E.g. Product A used 1,000 hours of
Activity based costing is an approach to costing that attempts
maintenance. Therefore Product A will absorb 1,000
to identify the main activities that are performed, and to
hours × rate calculated in step 3 above). Each product
identify the costs associated with these activities. The costs
will include costs from several activities.
of production are then calculated based on the amount of
activity that is consumed in producing an item: 5. Calculate the cost per unit of each product by dividing
the total cost (calculated in 4) by the number of units
The steps in an activity based costing exercise can be
produced.
summarised as follows:
Advantages and disadvantages of activity based costing
1. Identify the major activities that each department
performs. (E.g. maintaining machines). Advantages
2. Determine the “driver” for each activity- that is the Better decision making (by providing more accurate
factor that causes the cost of the activity to vary. (E.g. information of products profitability)
time taken, man hours).
Cost can be designed out of products by eliminating
3. Calculate an absorption rate per unit of driver for each unnecessary activities.
activity- this may be based on budgeted or actual costs.
(e.g. maintenance cost per man hour = When cost plus methods of pricing are used, prices
Total maintenance costs based on ABC are likely to reflect more accurately the
true cost of producing a product.
Total man hours
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.
Replacement Are they used If labour is fully employed and a scarce resource
cost regularly? relevant cost amounts* to:
Yes No
direct cost of labour (wages); plus
lost contribution from other production.
Replacement Opportunity cost
cost (e.g. sale value) * This is equivalent to revenue foregone less costs
(other than labour) saved.
Replacement cost = current purchase cost. 3.3 Overheads
Deprival value applies where materials are scarce Additional (e.g. stepped) fixed overheads or those that
(§3.4). can be saved are relevant.
Lower of (2)
NRV EV
RC = Replacement cost
NRV = Net realisable value
EV = Economic value
(i.e. PV of expected future earnings)
FC + P
Q=
UCM 600
So if P = 0 then we would simply take our fixed costs and Break even
point
divide them by out unit contribution margin.
400
Applying this to company A again: Fixed costs
Ascertaining the sales volume required to achieve a target Finally the answer cab be read from the graph. The profit will
profit be $300,000 where the gap between the total revenue and
total cost line is $300,000 since the gap represents profit.
A business may want to know how many items it must sell in
This is not a quick enough method to use in the exam so it is
order to obtain a target profit.
not recommended.
Example (continued)
Margin of Safety
Company A wants to achieve a target profit of $300,000. If
The margin of safety indicates by how much sales can
the equation method is used, the profit of $300,000 is put into
decrease before a loss occurs, i.e. it is the excess of budgeted
the equation rather than the profit of $0.
revenues over break-even revenues. Using company A as an
(50Q) ─ (30Q) ─200, 000 = 300,000 example, let’s assume that budgeted sales are 20,000 units.
The margin of safety can be found, in units, as follows:
20Q = 500,000
Budgeted sales − break-even sales = 20,000 −10,000 =
Q = 25,000 units.
10,000 units.
Alternatively the contribution method can be used:
It may be calculated as a percentage:
UCM = 20, FC = 200,000 and P= 300,000. Budgeted sales break even sales
× 100
FC + P budgeted sales
Q=
UCM 10,000
In company A’s case it will be × 100 = 50%.
200,000 + 300,000 20,000
Q=
20 Finally it could be calculated in terms of $ revenue as
Therefore Q = 25,000. follows: Budgeted sales − break-even sales x selling price =
10,000 × $50 = $50,000.
Contribution to sales ratio The weighted C/S ratio is the total expected contribution
divided by the total expected sales:
It is often useful in single product situations, and essential in
multi product situations to ascertain how much each $ sold (20,000 × 20) + (10,000 × 15)/ (20,000 × 50) + (10,000 × 60)
actually contributes towards the fixed cost. This calculation = 34.375%.
is known as the contribution to sales or C/S ratio. It is found
in single product situations by dividing the unit contribution The C/S ratio tells us what percentage each $1 of sales
by the selling price. revenue contributes towards fixed costs.
For company A: $20/$50 = 0.4 It can also be used to calculate the break-even point in $
revenue. The break-even point in for company A can be
In multi product situations, a weighted average C/S ratio can calculated in this way:
then be used to find CVP information such as break even
point, margin of safety etc. Fixed costs $200,000
Break-even point (revenue) = = =
Example 2 C/S ratio 34.375%
$581,819 of sales revenue.
Company A also begins producing product y. The following
information is available for both products: To achieve a target profit of $300,000:
Fixed costs plus required profit
Product x Product y
C/S ratio
Sales price $50 $60
Variable cost $30 $45 $200,000 + $300,000
Contribution per unit $20 $15 = = revenue of $1,454,546.
34.375%
C/S ratios 0.4 0.25
Budgeted sales (units) 20,000 10,000 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.
Limitations of Cost volume profit analysis Profits are calculated on a variable cost basis or, if
The limitations of CVP analysis are based on its absorption costing is used, it is assumed that
assumptions: production volumes are equal to sales volumes.
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.
Advantage is that budget process examines each cost, Bottom up has the following advantages:
and relates it to the activities the company will perform, Managers are more motivated to take ownership of the
rather than just accepting costs because they were in budget
previous year.
Managers have better knowledge of situation “at the
Disadvantage – very time consuming. coal face”
Behavioural Aspects of Budgeting Top down has the following advantages
Responsibility accounting Non financial managers may not have the financial
knowledge to prepare budgets
Responsibility is delegated to managers via the budget.
They are then evaluated on how they perform in Preparing the budgets centrally may minimise problems
comparison with the budget. such as adding slack to budgets.
Controllability principle Too much focus on profits is not consistent with the
overall goals of the organisation- to maximise the
Managers should only be judged on things they control.
wealth of shareholders
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.
Formula for the learning curve Seasonal variation (S) – an annual cycle of variations
b
y = ax
Where Randomly occurring variations due to non-recurring
y = cumulative average time per unit to produce x units influences
a = time taken for the first unit of output
x = number of units produced
b = the index of learning (log LR/log 2)
Fixed Overheads The examiner often provides variances in the exam and
expects you to be able to provide suggestions as to the causes
Expenditure: Budgeted fixed cost – Actual fixed cost
of these. If this is the case, ensure you read the scenario
carefully as there are often clues given in the scenario as to
If absorption costing is being used, additional variances may be
the causes. Below is some guidance as to possible causes of
calculated:
variances in general terms:
Volume: (AQ – BQ) × Standard rate per unit or (SH – BH) Sales volume variance; measures the effect on standard
If fixed overheads are absorbed using some hourly basis, (labour margin of selling more/less units than expected.
hours, machine hours) the volume variance may be further
analysed into:
Sales price variance; measures the effect on sales
revenues of selling at a non-standard price
Capacity: (AH – BH) SR Materials price variance; measures the effect on
purchases expense of paying a non-standard price for
Efficiency: (SH – AH) SR materials
(SR means standard overhead absorption rate per hour)
Materials usage variance measures the effect of losses,
The only differences between variance analysis using rejects, defects wastage etc. Remember to used a flexed
absorption and marginal costing are: budget for materials quantity to compare to the actual
quantity used
Sales volume variance is valued at standard profit per unit
for absorption, and standard contribution per unit for Labour idle time variance; measures the cost to the
marginal. company of paying workers who are not working e.g.
due to machine breakdowns, materials stock-outs.
There is only one fixed overhead variance for marginal
costing- the expenditure overhead. Labour rate variance; measures the effect on payroll
expense of paying workers a non-standard wage
Planning and operational variances Planning variances compare the standard cost of actual
output using the original standard with the standard cost of
Variance analysis is used to provide information about output using the revised standard.
the performance of operations, by comparing actual
performance against a standard. Calculation of planning variances relating to costs (e.g.
materials or labour).
When the standard itself is found to be inappropriate,
the standard should be revised before variance analysis Planning usage variance
is performed. $
Standards may be revised if: Original SQ x original SP x actual output X
Revised SQ x original SP x actual output X
Factors outside of the organisation mean that the ––
assumptions on which standards were based Planning usage variance X
become inappropriate. (For example, the ––
bankruptcy of a major supplier may mean Planning price variance
alternative suppliers had to be found.)
$
The original standard is found to have been Revised SQ x original SP x actual output X
unrealistic. Revised SQ x revised SP x actual output X
––
Standards should not be revised to take into account
Planning price variance X
internal inefficiencies.
––
In practice, judgement may be required to decide if a
standard should be revised or not. 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 relating to the sales Market volume variance
volume variance
Units
Revised budgeted sales* X
Original budgeted sales X
The sales volume variance can be calculated using the
––
following format:
Difference X
Units X standard margin per unit X
Actual sales X ––
Budgeted sales X Market volume variance X
––
Difference X *Note- the revised budget quantity may have been calculated
X standard margin per unit X as the actual market size x budgeted market share.
––
Sales volume variance X Market share variance
––
Units
Actual sales X
Where the sales budget is revised at the end of the year
Revised budgeted sales X
before performing variance analysis, perhaps because the
––
actual market size was very different to what was anticipated
Difference X
when the original budget was prepared, the sales volume
X standard margin per unit X
variance can be split into two parts:
––
Market share variance X
Market volume variance (a planning variance)
––
Market share variance (an operational variance)
Profit before interest and tax Performance measurement should encourage a longer-
× 100 term view, possibly by using a mix of financial and
Equity plus long term debt
non-financial performance indicators. (See below)
Profit margins
Gross profit
Gross profit margin = × 100
Revenue
Net profit
Net profit margin = × 100
Revenue
Customer perspective – designed to give responsive Intangibility – w hat consumers value in a service can
supply and quality and is concerned with on-time be difficult to determine.
delivery, % of returns and customer satisfaction. In their building blocks model, Fitzgerald and Moon defined
Internal business perspective – designed to give six “dimensions” through which a service industry can
manufacturing excellence and productivity and is monitor its performance:
concerned with reduced cycle times and engineering Profitability
efficiency
Competitiveness
Innovation and learning perspective – designed to
reduce the time to market and improve technological Quality
leadership by looking at the number of new product Resource utilisation
introductions and the time to develop the next set of
products.
Flexibility
Innovation
Fair to both buyer and seller for performance evaluation Practical Approaches to transfer pricing
purposes. Cost plus approach
Opportunity cost approach to transfer pricing Easy to calculate
From the perspective of the selling division, minimum Covers all costs of selling division
transfer price is the higher of:
Setting mark up is arbitrary
External market price (less any savings due to internal
transfer) Inefficiencies in selling division are passed on to buying
division.
Variable cost + opportunity cost of supplying the goods.
From the perspective of the buying division, the maximum
May lead to incongruent decisions.
transfer price acceptable is the lower of: Market price
External market price Easy to obtain
Net revenue of the division. Net revenue means Fair
ultimate selling price, less costs incurred in the buying
division. If the transfer price exceeds this, the buying May lead to incongruent decisions (e.g. where selling
division will make a loss. division has spare capacity, and buying division buys
externally)
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.
The ACCA website (www.accaglobal.com) includes the “Behavioural Aspects of Budgeting” by Ken Garret,
following articles to paper F5. The articles can be March 2010*
downloaded from the following link: “Materials mix and variance analysis” by Ann Irons,
http://www.accaglobal.com/en/student/qualification- March 2010 (summarised in this document)
resources/acca-qualification/acca-exams/f5-exams.
“Exam analysis- Variances” by Louise Cookson, March
At this stage in your studies you may not have time to read 2010
all of these. Those marked with an asterisk are highly
recommended: “Throughput accounting” by Ken Garrett, Feb 2010
“Throughput accounting and the theory of constraints” “Target costing and Lifecycle costing” by Ken Garrett,
(parts 1 and 2) by Ann Irons, October 2011 Feb 2010* (summarised in this document)
“Environmental management accounting” by Ann “Activity based costing” by Ken Garrett, Jan 2010
Irons, July 2010 (summarised in this document)* “Approach to written questions- F5” by Ann Irons,
“Performance measurement” by Ann Irons, July 2010 November 2009- (summarised in this document)*
(summarised in this document)* Transfer Pricing by Ken Garrett, Oct 2009 (summarised
“Cost volume profit analysis” by Ann Irons July 2010 in this document)
(summarised in this document)* Not for profit organisations- Part 1 & 2, by Robert
“Quantitative aspects of budgeting” by Ken Garret, Souster, Sept/Oct 2009
March 2010
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
This is a summary of an article written by Ann Irons- the new Another reason for the poor pass rate is that candidates do
examiner for paper F5. Ann’s first exam will be the not understand the differences between F2 and F5. Where
December 2010 exam, but she has reviewed the June 2010 subjects that were in F2 are repeated in F5, the skills required
exam, and is involved in managing the marking of it. of you are over and above the knowledge required in F2. (See
the article “The difference between F2 and F5” published in
One of the reasons for the poor pass rate at paper F5 is
January 2010).
because the skills papers, of which paper F5 is one, are often
the firs time that students have had to tackle written Step by step approach to the exam on the day
questions. No longer is it sufficient to simply learn materials
Reading time
and churn out calculations.
During the 15 minutes reading time you should:
Candidates are required to write clearly and set out workings
logically and neatly. The following four skills are required: Read all the requirements and the questions
correctly interpret requirements Think about the order in which you will do the
questions- best question first.
actively read scenario based questions highlighting
what is relevant for each part of the requirement Allocate the 180 minutes of exam time among the
questions.
use that information to perform calculations that are
carefully structured and clearly set out, with workings When it comes to answering the question, be sure that you
shown in an easy-to-follow layout are strict with your time allocation. If you are spending too
long on one question it is either because you can’t do it
write accurately and coherently using simple English anyway (in which case move on and come back to it later) or
rather than long rambling sentences that have no you are saying too much and going beyond what the
structure and no real content. 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 Estimate – suggests that the answer cannot be calculated with
requirements of all five questions. Remember the certainty. For example, when calculating the cost of a batch
requirement should be the first thing that you look at in a when there is an 80% learning rate, the learning rate itself
question. What is the point in reading a question if you don’t reflects what the business THINKS will happen, but it is not
know what you are looking for? When you read the certain until it has happened.
requirement, underline the ‘content’- for example target The mechanics of estimating and deriving are very similar to
costing, and the ‘instruction’- what it is telling you to do. calculating.
The instruction could be a variety of verbs such as calculate, Why do candidates perform poorly on the numerical parts of
describe, interpret, and discuss. The one thing that you can be Paper F5? In my opinion it is often because of failure to
sure of is that the verb has been carefully thought about by study the whole syllabus well enough in the first place.
the examiner. If you don’t read and understand the Anyone who thinks they can question spot is sadly mistaken.
instruction carefully then you will find that you are not Another reason why candidates score poorly on numerical
actually answering the question. If you are not answering the questions is because they approach the question in a
question you are not earning marks. Each of the common disorganised fashion, with no logical progression through the
exam instructions are dealt with below. calculations and no clear numbered workings. You should go
Answering numerical questions 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
Calculate - you just have to work something out. programming question, go into your toolbox and pull out
Derive – sometimes requires more than simply being able to your five-step guide for linear programming:
calculate a figure as a candidate is required to use their define the variables
powers of deduction to derive something. For example derive state the objective function
an equation showing the relationship between price and state the constraints
quantity.
draw the graph
find the solution.
The problem with F5 is that students go into the exam with Outline this requires a fairly brief and well-organised
only a few tools in their ‘box’. If you put the work in, you overview, without the level of detail that would
will reap the rewards. be required in “describe”. For example ‘outline
the objectives of a budgetary control system’.
Answering wordy questions
Compare discuss similarities between two or more things
Candidates are not penalised for the fact that English may be
and draw conclusions. For example, compare
their second language. The real cause of the poor
product costs using activity based costing with
performance in written questions is that candidates appear
product costs using traditional costing. You
unable to grasp what to write and how much to write- i.e.
need to say why the costs are different. This
they don’t understand the instruction. Further clarification of
will involve looking in detail at the product
all the main instructions you would expect to find in an F5
costs and ascertaining the reason why the
exam is given below.
overheads absorbed into one product are higher
Describe give some sort of narrative about something. under one method than the other.
For example “describe suitable non financial
Identify this means pinpoint and list. It can be quite
performance indicators for a hospital” It would
simple, requiring knowledge rather than skill.
not be enough merely to list the items- you
Sometimes, however, candidates may have to
would have to go a step further and describe
identify points from within a question scenario,
how they might be calculated.
and this requires more skill.
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.
Discuss this requires a candidate to give their own Justify you need to state why a particular answer or
thoughts on a subject, supporting it with facts position makes sense. For example, if you were
and logical reasoning. For example you could asked to justify the use of backflush accounting
be asked to discuss the effect that variances in an organisation, you would have to mention
have on staff motivation. The opinions you the relative immateriality of inventory.
give must be sound and well reasoned. It is no
Conclusion
good saying that variances are demotivational
for example without explaining why. Also you F5 is not an especially hard paper if candidates:
are expected to look at both sides of the story.
work hard to gain knowledge of areas that they have not
Explain this means that you need to give a reason for practiced
something. This is a very common requirement.
Underline the content and instruction of all
Evaluate you are being asked to decide on the merits of requirements at the beginning of each question and keep
something. This requirement would not be referring back to them.
expected to arise much in F5- most of the
evaluation is reserved for P5. Keep practicing questions until your approach and
layout becomes second nature giving you the time in
Suggest this means give a suitable idea or solution, in the exam to think about the issues in the question.
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.
TARGET COSTING AND LIFECYCLE COSTING product's life. This flaw is addressed by lifecycle
costing.
by Ken Garrett – 28 Apr 2011
TARGET COSTING
This is a summary of an article that appeared in the student
accountant magazine in April 2011. The full article can be Target costing is very much a marketing approach to costing.
downloaded from the ACCA web site. The Chartered Institute of Marketing defines marketing as:
Typically, conventional costing attempts to work out the cost Marketing says that there is no point in management,
of producing an item incorporating the costs of resources that engineers and accountants sitting in darkened rooms
are currently used or consumed. Once the total absorption dreaming up products, putting them into production, adding
cost of units has been calculated, a mark-up (or gross profit on, say 50% for mark-up then hoping those products sell. At
percentage) is used to determine the selling price and the best this is corporate arrogance; at worst it is corporate
profit per unit. The mark-up is chosen so that if the budgeted suicide.
sales are achieved, the organisation should make a profit.
Note that marketing is not a passive approach, and
There are two flaws in this approach: management cannot simply rely on customers volunteering
their ideas. Management should anticipate customer
1. The product's price is based on its cost, but no one
requirements, perhaps by developing prototypes and using
might want to buy at that price. This flaw is addressed
other market research techniques.
by target costing.
Therefore, instead of starting with the cost and working to
2. The costs incorporated are the current costs only. They
the selling price by adding on the expected margin, target
are the marginal costs plus a share of the fixed costs for
costing will start with the selling price of a particular product
the current accounting period. There may be other
and work back to the cost by removing the profit element.
important costs which are not part of these categories,
This means that the company has to find ways of not
but without which the goods could not have been made.
exceeding that cost.
Examples include the research and development costs
and any close down costs incurred at the end of the
For example, if a company normally expects a mark-up on Here are some of the decisions, made at the design stage,
cost of 50% and estimates that a new product will sell which can affect the cost of a product:
successfully at a price of $12, then the maximum cost of
production should be $8: The features of the product
The establishment of multifunctional teams consisting Where the product can be made
of marketing people, cost accountants, production What to make in-house and what to sub-contract
managers, quality control professionals and others.
These teams are vital to the design and manufacturing The quality of the product
decisions required to determine the price and feature
combinations that are most likely to appeal to potential The batch size in which the product can be made.
buyers of products. You will see from this list that ABC can also play an
important part in target costing. By understanding the cost
An emphasis on the planning and design stage. This
drivers (cost causers) a company can better control its costs.
becomes very important to the cost of the product
For example, costs could be driven down by increasing batch
because if something is designed such that it is
size, or reducing the number of components that have to be
needlessly expensive to make, it does not matter how
handled by stores.
efficient the production process is, it will always be a
struggle to make satisfactory profits.
The concept of value engineering (or value analysis) can be LIFECYCLE COSTING
important here. Value engineering aims to reduce costs by
As mentioned above, target costing places great emphasis on
identifying those parts of a product or service which do not
controlling costs by good product design and production
add value - where “value” is made up of both:
planning, but those up-front activities also cause costs. There
Use value (the ability of the product or service to do might be other costs incurred after a product is sold such as
what it sets out to do - its function) and warranty costs and plant decommissioning. When seeking to
make a profit on a product it is essential that the total revenue
Esteem value (the status that ownership or use confers). arising from the product exceeds total costs, whether these
The aim of value engineering is to maximise use and esteem costs are incurred before, during or after the product is
values while reducing costs. produced. This is the concept of lifecycle costing, and it is
important to realise that target costs can be driven down by
For example, if you are selling perfume, the design of its attacking any of the costs that relate to any part of a product's
packaging is important. The perfume could be held in a plain life. The cost phases of a product can be identified as:
glass (or plastic) bottle, and although that would not damage
the use value of the product, it would damage the esteem Phase Examples of types of cost
value. The company would be unwise to try to reduce costs Design Research, development, design and tooling
by economising too much on packaging.
Manufacture Material, labour, overheads, machine set up,
Similarly, if a company is trying to reduce the costs of inventory, training, production machine
manufacturing a car, there might be many components that maintenance and depreciation
could be satisfactorily replaced by cheaper or simpler ones
without damaging either use or esteem values. However, Operation Distribution, advertising and warranty claims
there will be some components that are vital to use value End of life Environmental clean-up, disposal and
(perhaps elements of the suspension system) and others decommissioning
which endow the product with esteem value (the quality of
the paint and the upholstery).
There are four principal lessons to be learned from lifecycle example, the design specifies 10 units of a certain
costing: component, negotiating with suppliers is likely to have only a
small overall effect on costs. A bigger cost decrease would
All costs should be taken into account when working be obtained if the design had specified only eight units of the
out the cost of a unit and its profitability. component. The design phase locks the company in to most
Attention to all costs will help to reduce the cost per future costs and it this phase that gives the company its
unit and will help an organisation achieve its target cost. greatest opportunities to reduce those costs.
Additionally, the environment can benefit as less power and by a person, organization, event or product. Second,
cotton (i.e. material for towels) is now being used, and the environmental costs are becoming huge for some companies
scarce resources of our planet are therefore being conserved. (in some cases amounting to more than 20% of operating
Lastly, the gym is also seen as an environmentally friendly costs); particularly those operating in highly industrialized
organization and this, in turn, may attract more customers sectors such as oil production. These need to be managed.
and increase revenues. Third, regulation is increasing worldwide at a rapid pace,
with penalties for non-compliance also increasing
Definition of EMA
accordingly. Its not just the companies, officers – even junior
There is no one single definition, but a widely accepted one employees – could find themselves facing criminal
that was adopted by the IFAC (International Federation of prosecution for knowingly breaching environmental
Accountants) in its 2005 international guidance document on regulations.
EMA: “EMA is the identification, collection, analysis and
The management of environmental costs is difficult, mainly
use of two types of information for internal decision making:
for the three reasons outlined below.
i) physical information on the use, flows, and destinies of
energy, water and materials (including waste), and ii) A) It is difficult to define EMA and the actual costs
monetary information on environmental-related cost, involved. Many organizations vary in their definition of
earnings and savings.” environmental costs. The US Environmental Protection
Agency stated that the definition of environmental costs
Importance of the environment to business
depended on how an organization intended on using the
There are three main reasons why the management of information. They made a distinction between four
environmental costs is becoming increasing important in types of costs: conventional costs such as raw materials
organizations. First, society as a whole has become more and energy, potentially hidden costs captured by
environmentally aware, with people becoming increasingly accounting systems but getting hidden in ‘general
aware about the ‘carbon footprint’ and recycling taking place overheads’, contingent costs such as site clean up costs,
now in many countries. A ‘carbon footprint’ measures the and image and relationship costs that by their nature are
total greenhouse gas emissions caused directly and indirectly intangible. On the other hand, the United Nations
Division for Sustainable Development (UNDSD) scrap and 18kg discarded as waste. Flow cost
described environmental costs as comprising of two accounting uses not only material flows but also the
components: costs incurred to protect the environment organizational structure. It divides material flows into
such as measures taken to prevent pollution, and costs three categories: material, system, and, delivery and
of wasted material, capital and labour including disposal. The values and costs of each of the three are
inefficiencies. These definitions do not contradict each calculated. The aim of flow cost accounting is to reduce
other; they just look at the costs from slightly different the quantity of materials which, as well as having a
angles. As a Paper F5 student, you should be aware that positive effect on the environment, should have a
definitions of environmental costs vary greatly, with positive effect on a business’ total costs in the long run.
some being very narrow and some being far wider. Activity-based costing allocates internal costs to cost
centres and cost drivers on the basis of the activities that
B) Many of the environment costs captured by the
give rise to the costs. It distinguishes between
accounting system are difficult to separately identify as
environmental-related costs, which can be attributed to
they are found within the category of ‘general
joint cost centres, and environment-driven costs, which
overheads’. Time and effort is needed to separate them
tend to be hidden on general overheads. Life cycle
and allocate them to the product or process, which gave
costing is a technique that requires the full
rise to them. The UNDSD identified four management
environmental consequences, and, therefore, costs,
accounting techniques for the identification and
arising from production of a product to be taken
allocation of environmental costs: input/output analysis,
account across its whole lifecycle.
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
C) It is only after environmental costs have been defined, iii) Energy - EMA may help to identify inefficiencies
identified and allocated that a business can begin the and wasteful practices and, therefore,
task of trying to control them. Lets consider an opportunities for cost savings.
organization whose main environmental costs are: i)
iv) EMA can help to generate cost savings in
waste and effluent disposal, ii) water consumption, iii)
Transport and travel. At a basic level, a business
energy, iv) transport and travel, and v) consumables and
can invest in more fuel-efficient vehicles.
raw materials.
v) Consumables and raw materials costs are usually
i) Waste – there are lots of environmental costs
easy to identify and discussions with senior
associated with waste. For example, the costs of
managers may help to identify where savings can
unused raw materials and disposal; taxes for
be made. For example toner cartridges for printers
landfill; fines for compliance failures such as
can be refilled instead of replaced. This should
pollution. It is possible to identify how much
result in a financial saving and better for the
material is wasted in production by using the
environment as toner cartridges are difficult to
‘mass balance’ approach, whereby the weight of
dispose 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.
MATERIALS MIX AND YIELD VARIANCE quality controls have been introduced resulting in more items
ANALYSIS being rejected.
This is a summary of the article written by Ann Irons that Further variance analysis where several materials are
was published in the Student Accountant Magazine. The used
calculations have been reworked using the approach taken in
Most products comprise of several different materials, so the
the ATC International Study system for the purpose of
more detailed mix and yield variances can be calculated. It
consistency.
may be possible to combine different levels of the component
Material usage variance materials to make the same product. This in turn may result
in differing yields. When we talk about material mix, we are
As a reminder, let’s recap on what the material usage
referring to the quantity of each material that is used to make
variance is and how it is calculated. The material usage
our product i.e. we are referring to our inputs. When we talk
variance analyses the difference between how much actual
about yield on the other hand we are talking about how much
material we have used for are production relative to how
of our product is produced- i.e. our output.
much we expected to use based on standard usage levels. So,
for example, if we had made 5,000 items using 11,000 litres Materials mix variance
of material A and out standard material usage is only 2litre
The optimum mix of materials will be the one that balances
per item, then we clearly used 1,000litre more than we
the cost of each of the materials with the yield that they
expected to. In terms of how we value the difference, it must
generate. The yield must also reach certain quality standards.
be at standard cost. Any difference between the standard and
actual cost would be dealt with by the material price For example, chemical C uses both chemicals A and B to
variance. make it. Chemical A has a standard cost of $20 per litre and
chemical B has a standard cost of $25 per litre.
There can be many reasons for an adverse material usage
variance. It may be that inferior quality materials have been Let us assume that the standard mix has been set: 8 litres of
purchased- perhaps at a lower price. It may be that changes in A and 12 litres of B will yield 19 litres of C. The standard
the production process have been made, or that increased cost for 1 litre of C is therefore $24.21 (8 × 20 + 12 × 25).
If the cost of materials A and B changes, production As a student I was never a person to blindly learn formulae
managers may deviate from the standard mix. Managers may (for variances) and rely on these to get me through. I truly
simply fail to adhere to the standard mix for whatever reason. believe that the key to variance analysis is to understand what
This would result in a materials mix variance. is actually happening. If you understand what the materials
mix variance is trying to show, you will work out how to
Let us assume now that production of C commences. 1,850
calculate it.
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 Why haven’t I considered the fact that although our materials
and B were at the standard costs of $20 and $25 per litre mix variance is $500 favourable our changed materials mix
respectively. How do we calculate the mix variance? may have produced less of C than the standard mix? Because
this of course is where the materials yield variance comes
Actual
into play.
Actual quantity
quantity in standard Materials yield variance
used mix Difference Variance
Where there is a difference between the actual and standard
litres litres litres $
level of output for a given set of inputs, a material yield
A 900 800 (100) (2,000)
variance arises. In our optimum mix, we calculated that
B 1,100 1,200 100 2,500
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
2,000 2,000 0 500 favourable
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
Remember it is essential that for every variance you expected our inputs of 2,000 litre to yield an output of
calculate, you state whether it is favourable or adverse. These 1,900litre (2,000 × 95%).
can be denoted by a clear ‘A’ or ‘F’ but avoid showing an
adverse variance by simply using brackets. This leads to
mistakes.
MEASURING PLANNING VARIANCES – In exams, the information would be given in the form of a
BY GEOFF CORDWELL scenario, rather than in a table as above. Students would be
expected to be able to interpret the information given in the
This is a summary of an article prepared by the previous
table so as to prepare their own table.
examiner for F5, Geoff Cordwell. The full article can be
downloaded from the ACCA web site. Planning variances
There are many possible ways of calculating planning The examiner believes that planning variances should be
variances. This article sets out the examiner’s preferred based on the actual level of output, rather than on the original
approach, based on the example given. budgeted level of output.
Example Material price planning variance
The following information is given regarding the standard Actual output × revised budget materials per unit
cost of artificial snow for a ski resort. After the original × revised budget price per kilo
budget had been prepared the subsequent improvements in (11,000 × 9.5 × 4.85) 506,825
technology lead to manufacturers reducing their prices to Actual output × revised budget materials per unit
$4.85 per kilo. This was considered to be a fair target, so the × original budget price per kilo
standard was revised. The standard usage was also revised. (11,000 × 9.5 × 5) 522,500
Original Revised Actual –––––––
Budget Budget spending Material planning price variance (favourable) 15,675
(Ex-ante) (Ex-post) –––––––
Material price per kilo ($) 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
2009. This has been done in the section headed ‘Workings’ 2009: $5,320,000/140,000 = $38 per person
below.
An increase of $38/$35 = 8.57%
You will see that I haven’t performed a calculation for ‘other
(W3) Directors pay up by $160,000/$150,000 = 6.7%
costs’. This is because the movement in it from year to year
is so small that it is not worth mentioning. Our movement in (W4) Directors bonuses levels up from $15,000/$150,000 or
sales, on the other hand, is also relatively small but has been 10% to $18,000/$160,000 or 12.5% of turnover. This is an
mentioned. increase of 20%
The reason for this is that, first, sales in a key figure and (W5) Wages are down by ($2,500,000 –
can’t be ignored and secondly, we know enough about other $2,200,000/$2,500,000) or 12%
things going on in the business (e.g. reduction in the number
(W6) Routine maintenance down by ($80,000 -
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 $70,000)/$80,000 = 12.5%
them in your exam scripts, namely, all labelled up with a (W7) Repairs up by ($320,000- 260,000)/$260,000 = 23%
working reference. While, in the real world, such analysis
would be expected to appear after any commentary as a kind (W7) Loss of customers is (150,000 – 140,000/150,000) =
of appendix, since you are not being asked for a report here it 6.7%
doesn’t really matter whether you show them at the (W9) Profits up by $1,372,000/$1,045,000 = 31.3%
beginning or end of your answer.
(W8) Return on assets:
Workings:
2008: $1,045,000/$13,000,000 = 8.03%
(W1) Sales growth is $5,320,000/$5,250,000 = 1.3%
2009: $1,372,000/$12,000,000 = 11.4%
(W2) Average admission prices were:
2008: $5,250,000/150,000 = $35 per person
Using the calculations you have prepared and setting out Sales
your answer
These have increased by 1.3% (W1) in the year. This is good.
It may surprise you, as indeed it surprised me, to find that a
The second answer is slightly better than the first because it
number of candidates got no further on this question than
references the percentage increase to the workings and also
performing the calculations above. These calculations, whilst
makes a comment about the increase. However, what does
essential to answering the question, would only ever be worth
‘good’ mean? How can we say whether a 1.3% increase in
a relatively small number of the marks and are merely a
sales is good or bad if we don’t refer to inflation rates (if
starting point. ‘Assessing the financial performance’ means
provided in the question, as in this case), admission prices
discussing it and commenting on in what respects it is poor
and visitor numbers? Whenever you are making a comment,
or maybe strong.
ask yourself: ‘Why do I care? Why is it important?’ This will
It is important that your answer does not become ‘a sea of help you to follow your thoughts through. A good answer for
words’, i.e. just pages of writing with no headings and no sales would read as follows:
structure. In this case, your headings could be taken from
Sales
your workings, e.g. ‘sales’, ‘directors’ pay and bonuses’ etc.
You should then start your discussion of each point by first Sales have increased by 1.3% (W1) in 2009, as compared to
referring to the calculation that you have performed in the 2008. Since inflation was 1%, the increase is barely above
relevant working. It is critical that, having referred to the the inflation rate. This means that, in real terms, sales have
percentage movement in the figure under discussion from hardly increased at all. From the financial information
year to year, you don’t just leave it like that. For example, a provided, we can see that the number of visitors in 2009 has
poor answer on sales would be this: fallen from 150,000 to 140,000. This means that the average
admission price in 2009 was $38 per person, compared to
Sales
$35 per person in 2008, an increase of 8.57% (W2). While it
These have increased by 1.3% in the year. is good that the company has been able to secure an increase
in admission price, it is not good that this has potentially
A poor, but slightly less poor answer might read:
been partly responsible for a fall in visitor numbers.
You can see that the good answer starts with the percentage about the effect of this on quality of service and risks in Part
increase in sales from the workings and adds to it other (a), since we would then be stepping into the requirement of
information from the question or from the workings that is Part (b), it should be mentioned in passing.
relevant to the figure being discussed (in this case, inflation
So, a poor answer to this part of the question would be this.
and admission prices). Only then is it possible to make
comments that have any kind of validity. Routine maintenance costs
To further emphasise the importance of looking at the overall These have fallen by 12.5%, which is a good reduction.
picture rather than one figure in isolation, let’s look at
‘maintenance and repairs’. Routine maintenance costs have Repair costs
fallen by 12.5%. On the face of things, this looks good. These have increased by 23%, which is substantial.
However, we cannot comment on maintenance costs without
considering how repair costs have been affected. These have A good answer, on the other hand, would read something like
increased by 23%. We also need to go further here and this:
comment on the actual amounts involved (or look at the total Routine maintenance and repair costs
costs for maintenance and repairs and comment on the total
percentage increase). While maintenance costs have In 2009, routine maintenance costs fell by 12.5% (W6), a fall
decreased by a mere $10,000, repairs have increased by of $10,000. At the same time, however, repair costs increased
$60,000. This tells us nearly everything we need to know 23% (W7), a $60,000 increase. By looking at these two
about what has happened. It is clear that, because routine figures together, and the fact that hours due to lost
maintenance has not been carried out, machines are breaking breakdown of rides increased from 9,000 hours in 2008 to a
down and repairs are, therefore, required. huge 32,000 hours in 2009, one can only conclude that the
lack of routine maintenance was a poor decision and is
This assessment is further supported by the non-financial costing the business dearly in terms of increased repair costs
information, which tells us that the hours due to breakdown and problems with the rides. The decision to reduce
of rides has increased from 9,000 hours in 2008 to 32,000 maintenance by the company needs to be reviewed urgently.
hours in 2009. Although it would be inappropriate to talk
By this point, it is hopefully clear that there is little point in Time spent thinking rather than writing is time well spent.
simply doing a few calculations and making meaningless
In this particular question, the examiner has basically told
comments. In questions on performance measurement, you
you what headings to use by using italics for the words
need to look at each figure as part of an overall set of data,
‘quality’ and ‘risks’. The fact that you are being asked about
bringing other data in where relevant. A figure in isolation,
qualitative aspects of the situation means that you are
such as sales, tells us little about what has really happened
obviously being asked about non-financial performance.
during the year. It is only by bringing other information in
Most of the information that is relevant to this discussion has
that any true assessment on financial performance can be
already been given to you in the question (number of visitors,
made.
hours due to breakdown of rides and average waiting time). It
This principal can equally be applied to any assessment of is also possible (although not essential) to work out lost
non-financial performance, as considered below. capacity in 2008 and 2009, i.e. percentage of hours lost out of
total hours available in order to make a year on year
Part (b) assess the quality of the service that TIP provides to
comparison. This would be done as follows:
its customers using table 1 and any other relevant data and
indicate the risks it is likely to face if it continues with its Capacity of rides in hours is 360 days × 50 rides × 10 hours
current policies. per day = 180,000
Once again, it is important that you adopt some kind of 2008 lost capacity is 9,000/180,000 = 0.05 or 5%
structure for your answer, rather than just producing a ‘sea of
2009 lost capacity is 32,000/180,000 = 0.177 or 17.8%
words’. By using the structure of headings, you make
yourself focus on what the requirement is actually asking you When discussing quality, it is important to ask yourself the
to do. This should stop you from ‘rambling’, i.e. talking question: ‘In a business like this, what affects my enjoyment
about things that are not being asked of you and not relevant. of the service?’ The answer will be – how many rides are
Whenever I used to answer exam questions, I would refer available to ride on and how long I have to queue each time.
back to the requirement many times while writing, constantly The reliability of the rides and average queuing time are
asking myself: ‘Am I answering the question?’ therefore appropriate subheadings. You could also mention
that the rides need to be safe as well, or you could leave this Summary
to your discussion on risks.
Present calculations in a referenced list
Then, when discussing ‘risks’ in the second part of your
answer to Part (b), you need to think about what the potential Don’t consider any one piece of information or number
outcomes of the current policies are. In order to answer this, in isolation
you first need to have a clear idea about the policies that have Use headings wherever possible and avoid writing ‘a
been adopted. These are mentioned in the preamble of the sea of words’
question and include reduced expenditure on new rides, a
move from routine maintenance to reactive repairs and an When you are writing a statement, e.g. ‘sales have
increase in prices. Where you are giving a number of points increased by 1.3%’ always ask yourself the question
in an answer, like here, it is useful to bullet point them. This ‘why do I care?’ This will help you make a meaningful
not only makes your answer easier to mark, but it makes you point and take a thought through to its logical
aware of how much you are saying. conclusion.
Regarding this last point – how much you should say in Read all the requirements and make sure that you don’t
performance measurement questions – you should be largely start talking about, e.g. requirement (b) in requirement
guided by the marks available. Part (b) is only worth five (a), as you will then find that you have nothing to say
marks so it warrants substantially less time being spent on it when you get to requirement (b).
than Part (a). Often in these types of questions, there is far
more you could say than the time that is available. This is Use the marks available as a guide as to how much to
particularly the case in Part (a) here. The key is to get good write. There are no set marking rules such as ‘one mark
coverage. It is pointless, for example, to spend half of your per valid point’. Marks vary from question to question.
time discussing sales in Part (a), meaning that you don’t get Ann Irons is examiner for Paper F5
enough time to cover all the other key figures. Your answers
must always be balanced.
Interpreting financial data In most questions there will be some background information
– you should use it. Ties only operated in a competitive
This is a summary of an article written by the previous
environment – as stated in the question – and so a 61%
examiner and was published in the May 2008 Student
increase in one-quarter sounds pretty good in a competitive
Accountant. The full article can be downloaded from the
situation, and to say so will earn a mark. It was also the first
ACCA web site.
two quarters of the business year and so this level of growth
The purpose of this article is to point students in the right is impressive – another mark. If you then go on to say that
direction when studying the interpretation of financial data – such high growth rates are often hard to maintain, you will
which is a major topic in the Paper F5 syllabus. gain another mark. Top-scoring students should be aiming to
make these kinds of observations.
Students are advised to look at the question “Ties only” while
reading this article, as extracts from the question are used to Hypothesising as to why the growth is happening is also a
illustrate points and explain the techniques needed. source of marks. Revenue growth can be the result of extra
volume or increasing prices. In the case of Ties Only, it is
Tutors note: the question “Ties only” is included in the Study
much more likely to be increased volume; the price will
Question Bank.
surely be constrained by competition, and from the
Assessing financial performance information provided in Part (b), you can work out that prices
are falling (although that calculation was not required).
Candidates were asked to assess the financial performance of Suggesting that Ties Only has secured more customers, and
the business in its first two quarters, when sales had jumped hence increased volume of sales, scored a mark.
61% from Quarter 1 to Quarter 2. This calculation should
present no problem ((Q2/Q1)-1) expressed as a % increase). Candidates must be brave and commit themselves. You must
However, an “assessment” requires a qualitative comment or express an opinion. It is not acceptable to suggest that
two. A percentage alone will not gain a pass mark. 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.
divisional profits). For example, depreciation of machinery Division X’s cost of capital is 10%.
would be a cost that is traceable to the division, but is not
Required:
controllable by the manager, because the manager of a profit
centre does not make investment decisions. Calculate the current ROI and residual income of the
division. Show how they would change under each of the
Investment centres
proposals.
Two measures commonly used for investment centre
Solution
managers are return on investment and residual income.
Current situation
Return on investment (ROI) =
Controllable (traceable) profit 2.2million
ROI = = 22%.
controllable (traceable) investment 10million
Residual income = controllable (traceable) profit – imputed Residual income: = 2.2 million – (10 million × 10%) = $1.2
interest charge on investment. million.
Division X currently has net assets of $10 million and profits 2.2million + 0.15million 2.35million
ROI = = 21.4%
of $2.2 million per annum. It is considering two proposals: 10million + 1million 11million
Proposal 1- an investment in assets of $1 million to earn an Residual income = 2.35million – (11 million × 10%) = 1.25
additional profit of $0.15 million. million.
Proposal 2- selling non current assets at their net book value Comment-
of $2.3 million. This would reduce profits by 0.3 million. The
0.15million
proceeds from sale would be remitted to head office (i.e. they The return of the proposal is = 15%.
would reduce divisional investment.) 1million
Since the return on the proposal is greater than the cost of Relative merits of ROI and residual income
capital of the company, from the overall company point of
view, the proposal should be accepted. If the manager of the ROI is a relative measure. This ignores the absolute
division is judged on ROI however, the proposal may be profit- for example an investment of $100 invested at
rejected, as it would reduce the divisional ROI from the 25% would only generate $25, while an investment of
current 22% to 21.4%. Thus the use of ROI can result in $1 million invested at a rate of 15% generates
dysfunctional behaviour. The proposal generates positive $150,000. Which would you prefer?
residual income however, so would be accepted by a Residual income is consistent with net present value
manager who is judged using this criterion. approach to investment appraisal. This is the
If proposal 2 is accepted theoretically superior way to make investment
decisions. (Net present value is not in the syllabus for
2.2million − 0.3million paper F5).
ROI = = 24.7%
10million − 2.3million
On the other hand residual income makes it difficult to
Residual income = 1.9million – (7.7 million × 10%) = 1.13 compare the performance of divisions of different sizes.
million.
Both methods suffer from the fact that if assets are
Comment valued at net book value, the ROI and residual income
This proposal should be rejected, as the return on the assets improve as the assets get older. This may encourage
disposed of is 13%. If ROI were used as the performance managers to retain old machinery.
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.
Non financial performance indicators Organisations should attempt to identify Key performance
indicators that can be used to measure performance under
Weaknesses of traditional financial performance indicators
each heading. Key performance indicators are based on the
include the following:
organisation’s critical success factors. Critical success factors
Single factor measures such as ROI and residual income are performance requirements that are fundamental to an
do not give a complete picture of divisional organisation’s success-for example innovation in the
performance electronics industry.
Single factor numbers may be distorted (for example by Key performance indicators should be:
accepting proposal 2 in the example above- thus Specific (for example, profit is specific, financial
improving measured ROI. performance is not as it could mean different things to
May lead to dysfunctional behaviour. different people.)
The transfer price rule for Division B can be restated to say The problem with this approach is that variable costs and
that the transfer price should be no greater than the net final selling prices will change continually in the real world
marginal revenue, where net marginal revenue is marginal and this can be difficult to manage. A second problem is that
revenue less own marginal costs. Here net marginal revenues the range of transfer prices set (from $18 to $10) is large, and
= $80 ($90 −$10). therefore the respective profits of the two divisions could
vary vastly depending on where within the range they agree
So a transfer price of $50 would work, since it is ≥ $18 and ≤ the final price.
$80. Both parties will find it worth trading at that price.
Practical approaches to transfer pricing
The economic rule of transfer pricing suggested above also
leads to decisions that are in the interests of the group as a 1. Variable cost
whole. If in the example above, the final selling price (for A transfer price is set at the variable cost of the transferring
Division B) were to fall to $25, the group could not make a division produced good economic decisions, since the buying
contribution because $25 is less than the group’s total division’s marginal costs (including the transfer price) will
variable cost of $18 + $10. The transfer price that would be the same as those of the group. However, there are
make both divisions trade must be no less than $18 for drawbacks:
Division A, but no greater than $15 (net marginal revenue)
for Division B. So clearly no workable transfer price is Division A will make a loss, as its fixed costs will not
available, and the divisions would not trade with each other. be covered.
Therefore all head office needs to do is to impose a transfer Performance measurement is distorted – Division A
price within the appropriate range, confident that both makes a loss, while Division B is not charged enough to
divisions will act in a way that maximised group profit. 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.
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.
Note – the current examiner’s first exam was the December 2010 exam
Part (b) asked for a calculation of the maximum profit that Question four
could be earned if transfer pricing was optimised.
This question covered life cycle costing.
The logic behind this was totally lost on the majority of
candidates.
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
Question three
easy marks.
Part (a) was where the bulk of the easy marks were on this
paper: a requirement to identify and explain six objectives of Part (a) read: ‘calculate the life cycle cost per unit.’
a budgetary control system. Anyone who just calculated a cost per unit for each of
the three years totally missed the point of life cycle
A good number of answers scored full marks. On the costing.
whole, candidates either knew the answer or didn’t.
Question five
A small number of candidates did not know what
participative budgeting was so they scored nothing in Finally the variance question.
part (b). A significant number of candidates scored full marks on
the materials usage, mix and quantity variance.
Some candidates did not tackle part (b) in the best way,
which was to use the objectives of part (a) as headings Part (c) contained a couple of easy marks on the steps
in order to give the answer some structure. 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.
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