ACCA F5 2013 notes

ACCA Paper F5 Performance Management For exams in 2013

Notes

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ExPress Notes ACCA F5 Performance Management

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Contents

About ExPress Notes 3

1. Specialist Cost & Management Accounting Techniques

7

2. Decision Making Techniques 10

3. Budgeting 21

4. Standard Costing and Variance Analysis 25

5. Performance Measurement & Control 34



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Chapter 1

Specialist Cost & Management Accounting Techniques

KEY KNOWLEDGE Activity Based Costing (ABC)

ABC is a method that seeks to group overhead costs according to the activities causing those costs. The activities giving rise to the costs are called “cost drivers”. By linking costs to activities (cost drivers), it becomes possible to charge costs to the agents undertaking those activities.

EXAMPLE

A factory clinic with total annual costs of $500,000 serves two Workshops A and B. Workshop A has 200 employees and Workshop B has 300 employees.



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A conventional way of apportioning the cost would be on the basis of employees: Workshop A: (200/500) x 500,000 = 200,000 Workshop B: (300/500) x 500,000 = 500,000

300,000

An ABC approach might look at the number of visits to the clinic by the employees of A and B. Workshop A: 150 visits p.a. Workshop B: 70 visits p.a. In this case, the apportionment could be: Workshop A: (150/220) x 500,000 = 340,909 Workshop B: ( 70/220) x 500,000 = 500,000

159,091

The different levels of usage may reflect different degrees of occupational hazard present in the two workshops. ABC advantages: provides a more precise way to determine costs per unit of output, especially since not all overhead costs are driven by production volumes. Budgetary planning, pricing decisions and managing performance are all facilitated by ABC. ABC disadvantages: it can be complex and costly to implement. It is not a “plug-in-and-go” system! It is therefore imperative that management carefully weigh the costs against the (expected) benefits from ABC before deciding to implement it.

KEY KNOWLEDGE Target costing

This is a market-oriented approach to costing which starts by identifying the likely price that a product can fetch in the market, deducts the profit that the product is expected to earn, and arrives at the maximum (target) cost of manufacturing the product. Such a method usually requires successive iterations in order to close a “cost gap”, i.e. where the costs are above the targeted level. Product re-design, alternative materials and production processes are examined in order to achieve the desired level of costs.



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KEY KNOWLEDGE Life-cycle costing

A product normally “lives” beyond one accounting period and the costs connected to its development/design, launch and maintenance fall unevenly across time periods. This method takes a comprehensive view of the costs relating to the product throughout its life-cycle.

KEY KNOWLEDGE Back-flush Accounting

This is a simplified costing method which can be used in conditions of short operational cycles and low inventories. Companies working on a Just-In-Time (JIT) basis may practise it, as it avoids the detailed tracking of costs during production; instead, it records costs when goods are completed. These costs are then “back-flushed” through the system based on standard costs.

KEY KNOWLEDGE Throughput accounting

This method is also consistent with a JIT environment and focuses on the bottlenecks in a production process; by eliminating these bottlenecks, it raises the amount of output that can flow through the process (assuming there is demand for the output – the idea is not to produce for inventory!). The throughput accounting approach itself considers all costs (including direct labour) as fixed and treats only direct materials as being variable in the short term.



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Chapter 2

Decision Making Techniques

START Relevant costs

One of management’s responsibilities involves making decisions affecting the firm in the short-run based on relevant costs.

What is relevance? A relevant cost is a cash cost which is uniquely incurred (or avoided) as a consequence of taking a decision; cash, because it is the main determinant of value (unlike accounting profit); and unique in the sense that is not common to the alternative choices that are under consideration.



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EXAMPLE

A company seeking to determine whether to continue to transport its products by truck or to switch to the railroad discovers that insurance costs are identical in both choices; in that case, insurance costs are not relevant to the decision.

If, however, there is a difference in the two insurance costs, then one can speak of the difference between the two choices as being “incremental”; this difference (referred to in some places as the “differential”) is relevant to the decision under consideration.

Future

Relevant costs refer to the future, i.e. they can be influenced prospectively by choice. It follows that:

Sunk costs are not relevant: They have already taken place and cannot be reversed.

Committed costs, if they cannot be avoided, are likewise not relevant, even if the timing of their occurrence is in the future. Their “unavoidability” has already been established in the past (making them effectively the equivalent of sunk costs).

In keeping with the above logic, relevant costs therefore involve cash, are incremental and relate to the future.

Relevant costs need to be identified with care, as they may include opportunity costs.

EXAMPLE

A company considers building a storage facility on the site of a parking lot. If the parking lot had been generating parking fees which will now be lost, then this foregone revenue is an opportunity cost.

KEY KNOWLEDGE Break-even Analysis



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Cost-Volume-Profit (CVP) Analysis

The breakeven formula

Total Costs = Fixed Costs + Unit Variable Cost x Number of Units

Total Revenue = Sales Price x Number of Units

If

TC = Total Costs,

FC = Fixed Costs,

V = Unit Variable Cost,

X = Number of Units,

TR = Total Revenue,

SP = Selling Price,

C = SP – V = Unit Contribution and

CM%= C/SP = Contribution Margin,

Then the break-even point (the output level at which TR=TC) is:

• In units sold: X = FC/C • In dollar sales: TR = FC/CM%

http://en.wikipedia.org/wiki/File:CVP-TC-FC-VC-Sales-Contrib-VC-PL-compat.s�



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• Safety Margin = Budgeted Sales – Break-even point (units/dollars) • C is an important indicator, as it shows the contribution of each unit sold towards

covering fixed costs. Therefore, in the short run, the firm may prefer to produce/sell below break-even in order to recover some of its fixed costs.

Relevant costs, incremental analysis and linear programming

• Relevant costs are costs expected to vary with the action taken o Past (sunk) costs are irrelevant o Fixed costs are irrelevant if there is idle capacity o Variable (marginal) costs are relevant o Opportunity costs (foregone benefits) are relevant

• Incremental analysis uses relevant costs in order to quantify the short-term effects of business decisions taken.

Applying incremental analysis in business decision-making

• Accept or reject a special order o Accept if selling price exceeds variable production cost and there is spare

capacity • Make (in-sourcing) or buy (out-sourcing)

o Outsource least efficient activities if full capacity reached • Capital budgeting

o Invest if marginal cost of investing is below marginal cost of not investing (marginal benefit foregone)

• Disinvestment o Divest if (marginal revenue generated + cost of resulting idle capacity +

severance payments + restoration costs) fall below marginal cost of production + salvage value of assets

Determining optimal mix of products where there are limiting factors

It addresses the problem of maximizing or minimizing a linear function subject to linear constraints. The constraints may be equalities or inequalities.

START Pricing decisions

The pricing of a product or service is crucially influenced by several factors:



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Internal: How much does it cost us to produce it? External: How much is a customer willing to pay for it? The latter is further influenced by how much the competition is charging for the same (or similar) product or service.

KEY KNOWLEDGE The price elasticity of demand (PED)

This measures the sensitivity of (customer) demand to a change in prices. There is usually an inverse relationship: when price goes up, demand goes down (and vice versa). PED = % change in price

% change in demand

EXAMPLE

A cinema increases its ticket prices from $4 to $6; as a result, the number of cinema goers drops from 2,000 to 1,500. The PED = (500/2000) = 25% (2/4) 50%

= 0.5 (Note:Ignore + or – signs; take the absolute value)

In the above example, demand is considered inelastic, because the PED < 1. When PED > 1, then demand is considered elastic.

KEY KNOWLEDGE Demand Equation

Whereas the PED is expressed in percentages, the demand equation (or function) is portrayed as a downward sloping straight line which shows price and demand combinations in their full values. The equation is expressed as P = a – bQ Where:



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P = price – corresponding to the dependent variable (y-axis) on a graph; Q = (Quantity) demanded – corresponding to the independent variable (x-axis); a = the maximum price (where Q = 0) -- corresponding to the y-intercept; and b = the slope of the (negatively-sloping) line (change in P / change in Q)

EXAMPLE

On an average Saturday night, a cinema (capacity: 225) attracts 150 visitors at a price of $5. If the price of the ticket is decreased by $0.50 then 25 more people will come. In order to fill up the cinema, the ticket price would have to be set at: 5 = a – (0.50/25) x 150; therefore, a = 8, and P = 8 – 0.02Q At Q = 225, P = $3.50

KEY KNOWLEDGE Total Cost Function

An equation can also be formulated to express the relationship between total costs and variable costs: Y = aX + b Where: Y = Total costs; X = Output – corresponding to the independent variable; a = fixed cost – corresponding to the Y-intercept;



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b = the variable cost per unit -- corresponding to the slope of the total cost line

EXAMPLE

The variable cost per unit of a bottling process is 10 cents per unit. Fixed costs amount to $5,000. At an output level of 20,000 units, what is the total cost? Y = $5,000 + ($0.10) x 20,000 = $7,000 When working with bulk discounts and other sales volumes, it is important to make sure that fixed costs remain unchanged over the output range covered. If they increase (as a result of expanding the production capacity, for example) then the new (higher) level of fixed costs need to be included in the calculation of total costs.

KEY KNOWLEDGE Pricing Strategies

There are a variety of pricing strategies with which one should be familiar: Cost plus: A mark-up is added to a given cost base (which can be variable or full production cost).

Skimming: Enter the market at a high price to catch customers willing and able to pay the price.

Penetration pricing: Go in at a very low price to win market share.

Premium pricing: Maintain a high price due to the nature of the product.

Target pricing: This method “backs into” the price by calculating the required profit and the possible production costs first.

Promotional Pricing: These are in support of campaigns to raise customer awareness of a product.

Perceived value pricing: Plays on perception of value and what the market is willing to pay.

Value Pricing: Increasing the value content of the product so as to defend market share (in times of difficult economic conditions or competition).



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Product-line pricing: Sell a “core” product cheaply and price high related products.

Volume-discounting pricing: The bigger the order, the lower the price per unit.

Discriminatory pricing: Pricing the same product at different levels in different markets (geographical) or market segments (customers).

Psychological Pricing: Plays on the emotion of the consumer.

Product Bundle Pricing: Combining products into one pack and pricing it overall.

Complementary product pricing: This refers to products that are used in conjunction with other products (e.g. printers and cartridges, razor grips and blades, staplers and staples, automobiles and spare parts). Typically, the approach to pricing may be low for the main product and more expensive for the “re-fills”. Relevant cost pricing: Basing the price on a keen (accurate) understanding of the real costs of the product or service. Make-Buy

A make-buy decision requires the determination of all relevant costs.

EXAMPLE

An automotive components producer can supply itself externally with car heaters for $210 per unit. In considering whether to make these internally, the company calculates that an equivalent unit can be made in 2 labour hours using $100 worth of materials.

Labour is currently at full capacity producing carburettors which generate contribution of $100. A carburettor takes 2.5 hours to produce. Labour costs $10 per hour. The carburettor also absorbs fixed overhead costs at the rate of $20 per labour hour.

The relevant costs are ($): Materials: 100 Contribution lost (carburettors): 80 Labour (added-back): 200

20

It is cheaper to produce internally.

Shut Down decisions



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Whether to close a plant making (accounting) losses depends on relevant costs:

Superior

Revenues (m) 40

Costs (m) (44)

Profits (m) (4)

If 25% of the costs are fixed costs allocated by H.O., then it appears that closing the plant will leave the company worse off, as 40m in revenues and only 33m in costs will disappear. A careful examination of all costs needs to be made before arriving at a final decision.

START Risk and Uncertainty

Risk, whichever way it is defined, is a quantification of probability. In other words, it is susceptible to measurement, statistically or mathematically. Risk may be viewed as relating to objective probabilities. Uncertainty, in contrast to risk, is not capable of being quantified. It has also been referred to as subjective probability (or unmeasurable uncertainty). Expected Value

Profit/(Loss) Probability

Expected Value

340 10% 34.0 766 20% 153.2 278 50% 139.0 450 18% 81.0

(230) 2% (4.6)

100% 402.6



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KEY KNOWLEDGE Sensitivity

Sensitivity Analysis This asks the following question: What happens to the NPV of a project if certain key variables are altered. It is a one-dimensional approach as it isolates and alters each (key) variable in turn in order to measure the impact. Sensitivities by scenario One can also go beyond determining project sensitivity to one variable and define scenarios, in which several variables move simultaneously (as outlined in the previous paragraph). Based on these scenarios, the NPV outcomes can be evaluated.

KEY KNOWLEDGE Simulation

Simulation -- Monte Carlo This is a simulation model that uses probability distribution analysis to analyze the possible outcomes of a project. It is built on the simultaneous changes of many variables, the relationships between these variables being defined in advance, e.g. if price is reduced, how much demand may go up. Each variable itself has a probability distribution and the combinations of variables are modeled through running the model repeatedly by computer, resulting in a distribution of simulation results.

KEY KNOWLEDGE Maximax, maximin and minimax regret

In the absence of (numerical) probabilities, a decision maker may act on the basis of his attitude toward uncertainty. Here are examples of three techniques as they relate to the following choices regarding developing a business:



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Profits Strategy 1 2 3 Outcomes: A 25 30 20 B 50 35 55 C 60 40 45 Maximax – going for the upside: Chooses Strategy 1 (to keep the door open to a profit of 60). Maximin – limit the downside: Choose Strategy 2 (one cannot do worse than 30). Minimax regret – limit the opportunity cost of getting it wrong. To determine this, one needs to quantify the “regrets” under each Outcome. For example: If the Outcome turns out to be A, then Strategy 2 (=30) would have been the best strategy. Regrets: Choosing Strategy 1 (=25) would have “missed” by 5 (30-25); while Choosing Strategy 3 (=20) would have “missed” by 10 (30-20). We can modify the table above to show all the regrets (opportunity costs) under each Outcome: Regrets Strategy 1 2 3 Outcomes: A (5) Best (10) B (5) (20) Best C Best (20) (15) Maximum regrets (5) (20) (15) Conclusion: Minimizing the maximum regret leads to Strategy 1.



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Chapter 3

Budgeting

START The Big Picture

Budgets A budget is a quantitative plan addressing the future. Budgetary control systems seek to monitor performance against the budget in a timely way so that deviations can be identified and rectified. The system can only work as well as the care and thought that went into defining performance targets to be measured, and the incentives (and sanctions) that follow from achievement (or not) of those targets. Goal congruence at all levels of the organisation – corporate, divisional and individual – must exist for a budget, and its attendant control systems, to be effective.

Problems frequently encountered when using conventional budgets:

• They invite “gaming” of the system; • They can be inflexible; • They are often imposed from the top – “Top Down”; • There is an indirect connection with the company’s strategy; • They are used for too many different purposes;



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• They reinforce centralising tendencies in the company; • There is a lack of goal congruence between corporate, divisional and individual goals

KEY KNOWLEDGE Budgetary Systems / Types of Budgets

Fixed

• A fixed budget is not adjusted to the actual volume of output (activity level)

Flexible vs. Flexed

The distinction is sometimes overlooked:

• Flexible: designed to change according to actual volumes of output; usually done before the start of the budgetary period as a sort of scenario planning;

• Flexed: This is done “after the fact” and is based on the actual level of activity achieved.

Zero-based (ZBB)

• Each year, budget owners must justify the entire budget (build it from zero)

• At odds with incremental budgeting (where only changes need justification, hence encouraging the “spend it or lose it” mentality)

• A three-step approach to ZBB:

1. Define “decision packages” (i.e. activities that result in costs or revenues), distinguishing between “mutually exclusive packages” (alternative activities to achieve the same result) and “incremental packages” (base level of input needed + additional inputs)

2. Evaluate and rank packages (based on the benefit to the organisation) 3. Allocate resources across packages, considering ranking and seniority of

responsible managers

Activity-based (ABB)

• No budget owners (departments, functions), but budgeted activity cost (ABC costing)

• Budgeted activity cost = demand for activity * unit cost of activity



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• More detailed and accurate than traditional budgets, especially regarding indirect costs

Incremental Such budgets are based on what went on during the period before. Typically, this approach results in modest changes and adjustments to the earlier budget. At worst, they retain and perpetuate inefficiencies and old assumptions. This might be termed the “lazy man’s budget”.

KEY KNOWLEDGE Quantitative Analysis in Budgeting

The High-Low method and regression analysis have been covered in F2. Learning Curves Learning curve effects can be applied to variance analysis, as they allow standards to be adapted to a dynamic situation, i.e. one where the time to produce units declines with the increase in output.

EXAMPLE

A product requires 20 hrs of labour per unit at a cost of $6 per hr. A traditional labour standard would expect 4 units to be produced in 80 hrs at a labour cost of $480. If a 90% learning curve effect applies, then one would expect the 4 units to be completed in less time. How long will they require? Utilizing the formula: y = axb Where: y = cumulative time required per unit a = time to produce the first unit (in the example above = 20) x = cumulative number of units produced ( = 4 units) b = log r/log2 r = learning curve ( = 90%)



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We solve for: y = 20 X 4-.1522 = 16 (remember: this is the cumulative time per unit) Therefore, 4 units will require 64 hrs (16x4) Conclusion: Based on the above, 64 hrs define the standard against which the time required to produce 4 units should be compared when calculating the labour efficiency variance.

KEY KNOWLEDGE Behavioural Aspects of Budgeting

There are numerous inter-relationships between types of budgets, budgeting processes and the motivation of employees: Top-Down budgets may be necessary from a coordination point of view; however they can be de-motivating to employees; Bottom-Up budgets allow useful employee input, but they may create exaggerated expectations on the part of the employee that his/her voice will be heard. Unrealistic budgets – with unachievable targets – can be de-motivating (as can budgets which are easily achieved, since most people stop working when they reach the targets!).



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Chapter 4

Standard Costing & Variance Analysis

START The Big Picture

Standard costs are useful in that they assist the budgeting and planning process before an activity commences, as well as the analysis of actual costs (including variance analysis) as the activity proceeds.

KEY KNOWLEDGE Basic Variances and Operating Statements

Variances Variance analysis is the process by which the differences between actual and budgeted (standard) results are quantified and examined. Variances can either be favorable (F) or adverse (A).



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EXAMPLE

The following is a fully-worked illustration based on the following data: Cost card (per unit) Materials (5kgs x $9 per kg) 45 Labour (3hrs x $6 per hr) 18 Variable O/Hs (3 hrs x $3 per hr) 9 Fixed O/Hs (3 hrs x $5 per hr) 87

15

Budget Production: 1,100 units Sales: 1,000 units Sales Price: $120 / unit Actual results Production: 1,000 units Sales: 950 units Materials: 4,900 kg, $45,025 Labour: 3,100 hrs, $19,050 Variable O/Hs: $9,250 Fixed O/Hs: $17,000 Sales price: $115 / unit Variances analysis is best performed by asking a series of parallel questions in a systematic way: Material variances

(i) Material price variance

• Materials used (4,900 kg) should have cost @ $9 44,100 • Materials (4,900 kg) did cost

Materials price variance $925 (A) 45,025



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(ii) Material usage variance

• 1,000 units should have used @ 5 kg 5,000 kg • 1,000 units did use 4,900

Materials usage variance 100 kg (F) kg

@ standard $9 $900 (F) Materials total variance: $ 25 (A) Labour variances

(i) Labour rate variance

• Labour (3,100 hrs) should have cost @ $6 18,600 • Labour (3,100 hrs) did cost

Labour rate variance $450 (A) 19,050

(ii) Labour efficiency variance

• 1,000 units should have taken @ 3 hrs 3,000 hrs • 1,000 units did take 3,100

Labour efficiency variance 100 hrs (A) hrs

@ standard $6 $600 (A) Labour total variance: $ 1,050 (A) Note: Labour variances can be influenced by “learning curve” effects: as work processes are mastered, the time required to produce a given level of output should decline.

Variable O/H variances

(i) Variable O/H expenditure variance

• 3,100 hrs should have cost @ $3 9,300 • 3,100 hrs did cost

Variable O/H expenditure variance 50 (F) 9,250

(ii) Variable O/H efficiency variance

• 1,000 units should have taken @ 3 hrs 3,000 hrs • 1,000 units did take 3,100 hrs



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Variable O/H efficiency variance 100 hrs (A) @ standard $3 $300 (A) Variable O/H total variance: $ 250 (A) Fixed O/H variances Fixed O/H total variance

• Overhead actually incurred $17,000 • Overhead absorbed (1,000 units x $15)

Fixed O/H total variance $ 2,000 (A) $15,000

This can be broken down into two components:

(i) Fixed O/H expenditure variance

• Budgeted O/H should have cost (1,100 units x $15) 16,500 • Actual O/H cost

Fixed O/H expenditure variance $500 (A) 17,000

(ii) Fixed O/H volume variance

• Budgeted production 1,100 units • Actual production 1,000

Fixed O/H volume variance 100 units (A) units

@ standard $15 $1,500 (A) Sales volume variance The absorption costing system calculates sales volume variances as follows:

• Budgeted sales volume 1,000 • Actual sales volume 950

Sales volume variance 50 (A)

@ standard margin ($120-$87) $1,650 (A) Sales price variance

• 950 units should have sold @$120 114,000 • Actual revenues (950 units x $115) 109,250

Sales price variance 4,750 (A)



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Operating statement A reconciliation between profit budgeted (absorption costing) and that realized follows: Budgeted profit 33,000 Sales volume variance 1,650 (A) Sales price variance 4,750 (A) 26,600 Cost variances: Materials F A Price 925 Usage 900 Labour Rate 450 Efficiency 600 Variable Expenditure 50 Efficiency 300 Fixed Expenditure 500 Volume 1,500 950 4,275 3,325 (A)

Actual profit 23,275 Note: Closing inventory is valued at standard cost



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Marginal costing

A marginal approach to costing focuses on the variable (marginal) costs generated in a business and considers fixed costs as period costs. This allows the company to be able to quantify the amount by which its costs rise, if it produces/sells an additional unit of output.

Based on the data above, an Operating Statement based on Marginal costing follows:

Budgeted contribution 48,000 Sales volume variance 2,400 (A) Sales price variance 4,750 (A) 40,850 Cost variances: Materials F A Price 925 Usage 900 Labour Rate 450 Efficiency 600 Variable Expenditure 50 Efficiency 300 950 2,275 1,325 (A)

Actual contribution 39,525 Fixed O/Hs Budgeted 16,500 Fixed O/Hs Expenditure variance 500 (17,000) Actual profit 22,525

Absorption costing and Marginal costing Operating Statements compared

When preparing the Operating Statements, note that Marginal Costing:

• Starts with standard contribution (not profit); and • Recognizes only Fixed O/H expenditure variance

Variance analysis can also be applied to the Activity-Based Costing (ABC) system.



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KEY KNOWLEDGE Mix and Yield Variance

Mix and yield variance When materials are combined in the production process in standard proportions, with the possibility of substituting one for the other, then the materials usage variance can be broken down into two further measures: Mix: This examines the (monetary) impact of altering the proportions of the two materials. Yield: This focuses on the total amount of inputs to produce the output achieved. The sum of the mix and yield variances is equal to the materials usage variance.

EXAMPLE

One unit of product requires the following standard inputs: $ Material X: 5 kg @ $8 40 Material Y: 10kg @ $3 70

30

In a given period, actual production of 12 units required 50 kg of X and 145 kg of Y. Mix variance: Important! The analysis is made on the basis of actual usage: 195 kg (50 kg of X and 145 kg of Y): X Y The standard mix of actual input should have been: 65 130 (X:Y = 5:10) The actual mix was: 50 145 Mix variances (kg): 15 (F) 15 (A) Cost ($): $8 $3 Variance ($): $120(F) $45(A) Mix variance $75(F)



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Interpretation: More of the cheaper material (Y) and less of the more expensive one (X) were used, resulting in an overall favorable variance relating to the mix. Yield variance: Important! The analysis is made on the basis of standard mix (X:Y = 5:10): X Y The yield (12 units) should have used 180 kg 60 120 Actual input (195 kg) expressed in standard mix 65 130 Yield variances (kg): 5 (A) 10 (A) Cost ($): $8 $3 Variance ($): $40(A) $30(A) Yield variance $70(A) Interpretation: This analysis eliminates the (distorting) influence of the differing mixes by “normalizing” them (according to standard). It permits focus to be placed only on the impact of having used a greater amount of materials than the standard. The sum of the mix and yield variances (above) equal the materials usage variance: $5 (F). Note: Some prefer an alternative approach to calculating the yield variance.

1) The actual usage (195 kg) should, according to the standard, produce 13 units (195/15 = 13)

2) The actual number of units produced: 12 units 3) The difference of 1 unit (13-12) is adverse and valued at standard cost: $70 (A).

KEY KNOWLEDGE Planning and Operational Variances

Due to changing market and technical circumstances, standards may become outdated. In such cases, it may be necessary to alter a standard, even during a budget period already in progress. Planning and operational variances capture these changes in two steps:



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Planning variance: Compares results based on the revised standard compared to the initial standard. The result is usually considered to be outside the area of control of management. Operational variance: Compares actual results with the budget based on the revised standard. This is often considered to be within the control of management. The distinction above between “controllable” and “uncontrollable” factors is critical insofar as it relates to the idea of “responsibility accounting”, i.e. expecting people who have delegated authority to take responsibility for decisions within their area of control.

KEY KNOWLEDGE Behavioural Aspects of Standard Costing

Standard costing in the “wrong” environment can be like a duck out of water.

• If products are non-standard; or

• Standards are changing rapidly (due to technical or market developments); or

• Manufacturing processes involve a high degree of automation with little labour input, then standard costing may not be very useful.



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Chapter 5

Performance Measurement and Control

KEY KNOWLEDGE The scope of performance measurement

Balanced scorecard

The balance scorecard addresses a number of parameters (or “perspectives”) in monitoring business performance by asking the following questions:

• Financial perspective: “To succeed financially how should we appear to our shareholders?”

• Customer perspective: “To achieve our vision how should we appear to our customers?”

• Internal business processes: “To satisfy our shareholders and customers what business processes must we excel at?”

• Learning and growth: “To achieve our vision how will we sustain our ability to change and improve?”



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Fitzgerald and Moon

This model addresses itself to service companies.

The Dimensions refer to what is measured; among them, one must distinguish between:

• Results (Profit; Competitiveness) and

• Determinants (Quality; Resource utilization; Flexibility and Innovation) The Standards define the “rules” by which business performance is judged and the Rewards are available to those achieving good performance. Notice that much emphasis is given to human motivational factors: Standards must be achievable and fair (equity); employees must “buy-in” to the rules; Rewards must be clear and within the possibility (controllability) of the employee to be motivating. Qualitative measures Service quality is an area that can be difficult to assess in “objective” terms. Certain actions can be measured numerically and serve as an indication for quality; for example, measuring

DimensionsProfit

CompetivenessQuality

Resource utilisationFlexibility

Innovation

StandardsOwnership

AchievabilityEquity

RewardsClarity

MotivationControllability



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the turn-around time (in days or minutes) in responding to customer requests: naturally, the quicker (one reacts), the better. To be fully useful, however, such a measure assumes two things: (1) that the action being measured is of value (or relevance) to the customer; and (2) that one has a rule or a benchmark as to what constitutes a maximum acceptable turn-around time (from the client’s point of view). Purely qualitative factors, such as client satisfaction, can be measured by employing a scale; e.g. a scale of 1-5, with 5 = Very satisfied, to 1 = Dissatisfied. (Note: to avoid confusion, it may be better to use the labels without numbers, and to assign numbers when analyzing the results.)

KEY KNOWLEDGE Divisional Performance and Transfer Pricing

There are various bases on which transfer prices can be determined:

• Market price

• Outlay cost (standard) + opportunity cost to the seller

• Outlay cost (actual) + opportunity cost to the seller

• Outlay cost + notional mark-up

• Production cost (full absorption)

• Best bargain (negotiation between divisions)

Divisional performance and internal (transfer) pricing

Divisional objectives may not be aligned with one another or with corporate objectives.

Return on Investment (ROI) at the Divisional Level

Earnings can be measured at the divisional level in relation to the financial resources they use. The ROI measure is very similar to ROCE (return on capital employed) with the only exception being the use of profit in the formula:

ROI = Capital Employed

Net Profit



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ROI as defined above is commonly used for investment appraisal and for business sector (divisional) performance, whereas ROCE is common at the overall corporate level.

EXAMPLE

A division head with an actual ROI of 20% may be reluctant to accept a project offering a 15% ROI, especially if his bonus is based on ROI achieved.

If the corporate overall ROI target is 12%, then the division head is missing a value-creating opportunity.

Residual Income (RI)

Convert results into monetary magnitudes:

Residual Income = Divisional EBIT (minus) Imputed interest

Where

Imputed interest = Capital Employed X Capital charge (or cost of capital)

A positive result adds profits to the division beyond the incremental capital cost. An investment should be accepted if the RI is positive.

Drawbacks of RI and ROI

EXAMPLE

A division of a corporation currently generating an ROI of 12% is examining a new project which requires an investment of $4.5m. Cash inflows are expected to be $1.5m p.a. and the cost of capital: 10%



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ROI and RI computations will be as follows:

Year 1 2 3 4 NBV initial 4500 3375 2250 1125

Net cash inflow 1500 1500 1500 1500

Depreciation -1125 -1125 -1125 -1125

Profit 375 375 375 375

Capital charge(10%) -450 -337.5 -225 -112.5

RI -75 37.5 150 262.5

ROI 8% 11% 17% 33% From both RI and ROI points of view, the project does not look favorable to the division, even if it would be from the corporate point of view. (Eg, at a cost of capital of 10%, the project has a positive net present value). Performance analysis in not for profit organisations and the public sector

Not-for-profit organizations share many similar issues with profit-making firms in terms of careful management of costs and ensuring that organizational objectives are being fulfilled. External considerations and behavioural aspects Performance management systems which are completely internal (introverted) in focus risk losing touch with the external world. A system of external bench-marking serves to counteract the tendency of individuals to perform only to a sufficient level rather than to a superior level.

Organizations that figure out how to motivate and actualize the true potential in people will win.

(end of ExPress notes)

Documents

ACCA F5 2013 notes